Schmitt Industries (SMIT) 10-Q 2007 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.   20549

FORM 10-Q

x        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended: August 31, 2006

Or

o        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from:                                                 To:                   

Commission File Number:  000-23996

SCHMITT INDUSTRIES, INC.

(Exact Name of Registrant as Specified in its Charter)

Oregon	93-1151989
(State of Incorporation)	(IRS Employer ID Number)

2765 NW Nicolai Street, Portland, Oregon 97210-1818

(Address of Registrant’s Principal Executive Office)

(503) 227-7908

(Registrant’s Telephone Number)

Indicate by check mark whether the registrant has (1) filed all reports required to be filed by Section 13 of 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes     x    No      o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes    o     No       x

The number of shares of each class of common stock outstanding as of September 25,

Common stock, no par value 2,644,753

SCHMITT INDUSTRIES, INC.

INDEX TO FORM 10-Q

Part I - FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Balance Sheets: –  August 31, 2006 and May 31, 2006 (unaudited)
	Consolidated Statements of Operations: –  For the Three Months Ended August 31, 2006 and 2005 (unaudited)
	Consolidated Statements of Cash Flows: –  For the Three Months Ended August 31, 2006 and 2005 (unaudited)
	Consolidated Statement of Changes in Stockholders’ Equity: –  For the Three Months Ended August 31,2006 (unaudited)
	Notes to Consolidated Interim Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
Part II - OTHER INFORMATION
Item 6.	Exhibits and Reports on Form 8-K
Signatures
Certifications

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PART I - FINANCIAL INFORMATION

Item 1.    Financial Statements

SCHMITT INDUSTRIES, INC.
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

	August 31, 2006			May 31, 2006
ASSETS
Current assets
Cash and cash equivalents	$	2,295,886		$	1,552,072
Short-term investments	2,472,476			1,985,940
Accounts receivable, net of allowance of $16,658 and $52,186 at August 31, 2006 and May 31, 2006, respectively	1,654,376			1,983,090
Inventories	3,032,789			3,241,590
Prepaid expenses	91,467			77,626
Deferred tax asset	115,715			116,080
	9,662,709			8,956,398
Property and equipment
Land	299,000			299,000
Buildings and improvements	1,283,830			1,275,922
Furniture, fixtures and equipment	1,181,078			1,180,648
Vehicles	96,849			96,849
	2,860,757			2,852,419
Less accumulated depreciation and amortization	(1,687,695		)	(1,643,047		)
	1,173,062			1,209,372
Other assets
Long-term deferred tax asset	393,535			552,380
Other assets	199,752			208,405
	593,287			760,785
Total assets	$	11,429,058		$	10,926,555
LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	416,637		$	403,490
Accrued commissions	236,867			250,835
Accrued payroll liabilities	133,080			138,801
Other accrued liabilities	303,833			237,149
Income taxes payable	54,076			60,237
Current portion of long-term obligations	12,777			15,204
Total current liabilities	1,157,270			1,105,716
Long-term obligations	4,020			6,408
Stockholders’ equity
Common stock, no par value, 20,000,000 shares authorized, 2,642,919 and 2,625,045 shares issued and outstanding at August 31, 2006 and May 31, 2006, respectively	8,033,075			7,946,976
Accumulated other comprehensive loss	(123,405		)	(220,051		)
Retained earnings	2,358,098			2,087,506
Total stockholders’ equity	10,267,768			9,814,431
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	11,429,058		$	10,926,555

The accompanying notes are an integral part of these financial statements.

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SCHMITT INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED AUGUST 31, 2006 AND 2005
(UNAUDITED)

	Three Months Ended August 31,
	2006		2005
Net sales	$	3,072,552	$	2,664,677
Cost of sales	1,474,261		1,236,568
Gross profit	1,598,291		1,428,109
Operating expenses:
General, administration and sales	1,111,762		1,021,674
Research and development	21,209		14,508
Total operating expenses	1,132,971		1,036,182
Operating income	465,320		391,927
Other income (expense)	40,272		1,970
Income before income taxes	505,592		393,897
Provision for income taxes	235,000		151,000
Net income	$	270,592	$	242,897
Net income per common share:
Basic	$	0.10	$	0.09
Diluted	$	0.10	$	0.09

The accompanying notes are an integral part of these financial statements.

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SCHMITT INDUSTRIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED AUGUST 31, 2006 AND 2005
(UNAUDITED)

	Three Months Ended August 31,
	2006			2005
Cash flows relating to operating activities
Net income	$	270,592		$	242,897
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	52,664			55,167
Stock based compensation	13,459			—
Deferred taxes	159,210			120,000
Tax benefit related to stock options	32,253			—
(Increase) decrease in:
Accounts receivable	328,714			454,425
Inventories	208,801			171,835
Prepaid expenses	(13,841		)	14,521
Increase(decrease) in:
Accounts payable	13,147			(79,386		)
Accrued liabilities and customer deposits	46,995			(46,267		)
Income taxes payable	(6,161		)	31,000
Net cash provided by operating activities	1,105,833			964,192
Cash flows relating to investing activities
Purchase of short-term investments	(1,986,536		)	—
Maturities of short-term investments	1,500,000			—
Purchase of property and equipment	(7,701		)	(50,088		)
Net cash used in investing activities	(494,237		)	(50,088		)
Cash flows relating to financing activities
Repayments on long-term obligations	(4,815		)	(11,885		)
Common stock issued on exercise of stock options	40,387			58,570
Net cash provided by financing activities	35,572			46,685
Effect of foreign exchange translation on cash	96,646			30,367
Increase in cash and cash equivalents	743,814			991,156
Cash and cash equivalents, beginning of period	1,552,072			1,176,959
Cash and cash equivalents, end of period	$	2,295,886		$	2,168,115
Supplemental Disclosure of Cash Flow Information
Cash paid during the period for interest	$	450		$	175
Cash paid during the period for income taxes	$	50,028		$	300

The accompanying notes are an integral part of these financial statements.

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SCHMITT INDUSTRIES, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
FOR THE THREE MONTHS ENDED AUGUST 31, 2006
(UNAUDITED)

	Shares	Amount		Accumulated other comprehensive loss			Retained earnings		Total		Total comprehensive income
Balance, May 31, 2006	2,625,045	$	7,946,976	$	(220,051	)	$	2,087,506	$	9,814,431
Stock options exercised and related tax benefit of $32,253	17,874	72,640		—			—		72,640
Stock-based compensation	—	13,459		—			—		13,459
Net income	—	—		—			270,592		270,592		$	270,592
Other comprehensive income	—	—		96,646			—		96,646		96,646
Balance, August 31, 2006	2,642,919	$	8,033,075	$	(123,405	)	$	2,358,098	$	10,267,768
Comprehensive income, three months ended August 31, 2006											$	367,238

The accompanying notes are an integral part of these financial statements.

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SCHMITT INDUSTRIES, INC.
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS

Note 1:   Basis of Presentation

The consolidated financial information included herein has been prepared by Schmitt Industries, Inc. (the Company) and its wholly owned subsidiaries.  In the opinion of management, the accompanying unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly its financial position as of August 31, 2006 and its results of operations and its cash flows for the three months ended August 31, 2006 and 2005.  The consolidated balance sheet at May 31, 2006 has been derived from the Annual Report on Form 10-K for the fiscal year ended May 31, 2006.  The accompanying unaudited financial statements and related notes should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended May 31, 2006.  Operating results for the interim periods presented are not necessarily indicative of the results that may be experienced for the fiscal year ending May 31, 2007.  Certain amounts in prior periods’ financial statements have been reclassified to conform to the current periods’ presentation. These reclassifications did not affect consolidated net income.

Note 2:   Revenue Recognition

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is probable.  For sales to all customers, including manufacturer representatives, distributors or their third-party customers, these criteria are met at the time product is shipped.  When other significant obligations remain after products are delivered, revenue is recognized only after such obligations are fulfilled.

Note 3:   Recent Accounting Pronouncements

The FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) in June 2006.  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in our financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”.  The provisions of FIN 48 are effective for our fiscal year beginning June 1, 2007.  We are currently evaluating the impact of the provisions of FIN 48.

Note 4:   Stock options and Stock-Based Compensation

Stock-based compensation includes expense charges for all stock-based awards to employees and directors granted under the Company’s stock option plan.  On June 1, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment (Revised 2004)”, which requires the measurement and recognition of compensation for all stock-based awards made to employees and directors including stock options based on estimated fair values.  SFAS 123(R) supersedes previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), for periods beginning in fiscal 2007. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 relating to application of SFAS 123(R).  The Company has applied the provisions of SAB 107 in our adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of June 1, 2006, the first day of our 2007 fiscal year. In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for periods prior to the first quarter of fiscal 2007 have not been restated to reflect this change.  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.  The compensation cost for awards granted prior to May 31, 2006 is based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 while awards granted on or after June 1, 2006 follow the provisions of SFAS 123(R) to determine the grant date fair value and compensation cost. Compensation cost for all stock-based awards is recognized using the straight-line method.  Stock-based compensation recognized in the Company’s Consolidated Financial Statements for the first quarter of fiscal 2007 includes compensation cost for stock-based awards granted prior to, but not fully vested as of, May 31, 2006.  There were no stock-based awards granted subsequent to May 31, 2006.

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Upon adoption of SFAS 123(R), the Company continued to use the Black-Scholes option pricing model as its method of valuation for stock-based awards. The Company’s determination of the fair value of stock-based awards on the date of grant using an option pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables.  Although the fair value of stock-based awards is determined in accordance with SFAS 123(R) and SAB 107, the Black-Scholes option pricing 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 an equivalent remaining term approximately equal to the expected life of the award.

·Expected Life.  The expected life of awards granted represents the period of time that they are expected to be outstanding.  The Company determines the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules and 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 its common stock. The volatility factor the Company uses is based on its historical stock prices over the most recent period commensurate with the estimated expected life of the award. These historical periods may exclude portions of time when unusual transactions occurred.

·Expected Dividend Yield.  The Company has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero.

·Expected Forfeitures.  The Company uses relevant historical data to estimate pre-vesting option forfeitures. The Company records stock-based compensation only for those awards that are expected to vest.

The Company has computed, to determine stock-based compensation expense recognized for the three months ended August 31, 2006 and for pro forma disclosure purposes for the three months ended August 31, 2005, the value of all stock options granted using the Black-Scholes option pricing model as prescribed by SFAS No. 123(R) using the following assumptions:

	Three Months Ended August 31,
	2006		2005
Risk-free interest rate	4.25-4.45	%	3.8-4.0	%
Expected life	4.7 years		4.0 years
Expected volatility	98	%	95-102	%

Stock-based Compensation Under FAS 123(R)

The following table summarizes stock-based compensation expense related to stock-based awards under SFAS 123(R) for the three-months ended August 31, 2006 and what certain operating results would have been without the effects of applying SFAS No. 123(R) in the first quarter of fiscal 2007.

	Three Months Ended August 31, 2006
	As reported		Pro Forma without effects of applying SFAS No. 123(R)
General, administration and sales	$	1,111,762	$	1,125,221
Income before income taxes	$	505,592	$	519,051
Net income	$	270,592	$	283,041
Cash flow from operating activities	$	1,105,833	$	1,105,833
Cash flow from financing activities	$	35,572	$	35,572
Basic earnings per share	$	0.10	$	0.11
Diluted earnings per share	$	0.10	$	0.10

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At August 31, 2006 the Company had a total of 197,371 outstanding stock options (166,622 vested and exercisable and 30,749 non-vested) with a weighted average exercise price of $2.51.  The Company estimates that a total of approximately $77,435 will be recorded as additional stock-based compensation expense over the period beginning with the quarter ending November 30, 2006 through the fiscal year ending May 31, 2009, for all options which are outstanding as of August 31, 2006, but which were not yet vested.

Outstanding Options				Exercisable Options
Number of Shares	Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (yrs)	Number of Shares	Weighted Average Exercise Price
80,914	$	1.20	5.5	80,914	$	1.20
84,957	2.30		7.8	82,458	2.30
5,000	5.80		9.2	2,500	5.80
26,500	6.58		9.1	750	6.58
197,371	$	2.51	7.1	166,622	$	1.84

Options granted, exercised, canceled and expired under the Company’s stock option plan during the three months ended August 31, 2006 are summarized as follows:

	Number of Shares		Weighted Average Exercise Price
Options outstanding May 31, 2006	216,496		$	2.52
Options granted	—
Options exercised	(17,875	)	2.26
Options forfeited/cancelled	(1,250	)	6.58
Options outstanding August 31, 2006	197,371		$	2.51

Pro Forma Information under SFAS 123 and APB 25

Prior to June 1, 2006, the Company elected to follow the accounting provisions of APB 25 for stock-based compensation and to furnish the pro forma disclosures required under SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.”  No stock-based employee compensation cost was reflected in net income because all options granted under the Company’s stock option plan had an exercise price equal to the market value of the underlying common stock on the date of the grant.

The following table illustrates the effect on the Company’s net income and basic and diluted net income per share for the three months ended August 31, 2005 had compensation cost for the plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS 123.

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Net income, as reported	$	242,897
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax	(5,436		)
Pro forma net income	$	237,461
Earnings per share – basic
As reported	$	0.09
Pro forma	$	0.09
Earnings per share – diluted
As reported	$	0.09
Pro forma	$	0.09

Note 5:   EPS Reconciliation

	Three months ended August 31,
	2006	2005
Weighted average shares (basic)	2,637,748	2,583,183
Effect of dilutive stock options	127,090	169,310
Weighted average shares (diluted)	2,764,838	2,752,493

Basic earnings per share are computed using the weighted average number of shares outstanding.  Diluted earnings per share are computed using the weighted average number of shares outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchase common stock.

Note 6:   Deferred Tax Assets

The Company applies the asset and liability method in recording income taxes, under which deferred income tax assets and liabilities are determined, based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using currently enacted tax rates and laws.  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 be realized.  The Company has recorded a substantial deferred tax asset related to the expected realization of net operating loss carryforwards for federal income tax purposes and other temporary differences between book and tax bases of assets and liabilities.  Due to the uncertainty of utilization of the Company’s net operating losses and in consideration of other factors, management recorded a valuation allowance on the deferred tax asset at May 31, 2003.

During Fiscal 2005 and 2006, management concluded future operations would produce sufficient earnings so that portions of this asset could be used in future periods to reduce federal and state tax liabilities and the allowance was reduced to reflect the amount of the deferred tax asset management believes can be utilized in future periods.  Our effective tax rate on consolidated net income was 46.5% and 38.3% in the first quarter of fiscal 2007 and 2006, respectively.  Our effective tax rate on consolidated net income differs from the federal statutory tax rate in the first quarter of fiscal 2007 primarily due to the Company not recording any tax benefits on net losses reported by the Company’s wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom.  Management believes the effective tax rate on consolidated net income in future periods will reflect a normal combined state and federal rate, net of the effect from net income or losses reported by SEL.

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Note 7:   Segments of Business

Segment Information

	Three Months Ended August 31,
	2006						2005
	Balancer			Measurement			Balancer			Measurement
Gross sales	$	2,213,470		$	997,145		$	2,043,902		$	757,334
Intercompany sales	(129,540		)	(8,523		)	(132,348		)	(4,211		)
Net sales	$	2,083,930		$	988,622		$	1,911,554		$	753,123
Operating income	$	125,193		$	340,127		$	294,811		$	97,116
Intercompany rent expense (income)	$	(7,500	)	$	7,500		$	(7,500	)	$	7,500
Depreciation expense	$	36,636		$	7,376		$	37,141		$	9,375
Amortization expense	$	—		$	8,652		$	—		$	8,651
Capital expenditures	$	7,701		$	—		$	35,332		$	14,756

Geographic Information

	Three Months Ended August 31,
	2006			2005
Geographic Sales
North American
United States	$	1,541,878		$	1,495,342
Canada and Mexico	106,479			37,066
North American total	1,648,357			1,532,408
European
Germany	62,066			80,781
Intercompany	—			—
Germany total	62,066			80,781
United Kingdom	237,645			228,214
Intercompany	(138,063		)	(132,853		)
United Kingdom total	99,582			95,361
Other European	211,180			167,628
Total European	372,828			343,770
Asia	751,004			547,393
Other markets	300,363			241,106
Total Net Sales	$	3,072,552		$	2,664,677

	Three Months Ended August 31,
	2006					2005
	United States		Europe			United States		Europe
Operating income (loss)	$	553,856	$	(88,536	)	$	366,121	$	25,806
Depreciation expense	$	41,131	$	2,881		$	42,322	$	4,194
Amortization expense	$	8,652	$	—		$	8,651	$	—
Capital expenditures	$	7,400	$	301		$	46,500	$	3,588

Note – – Europe is defined as the European subsidiary, Schmitt Europe, Ltd.

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Long-term Assets

	August 31, 2006		May 31, 2006
Segment:
Balancer	$	1,295,386	$	1,483,166
Measurement	470,963		486,991
Geographic:
United States	$	1,748,161	$	1,949,390
Europe	18,188		20,767

Note 8:   Related Party Transactions

Effective June 1, 2004, the Company entered into a contract to provide consulting services to PulverDryer USA, Inc., (“PulverDryer”) pursuant to which PulverDryer paid the Company $8,000 a month from June 2004 through October 2004.  PulverDryer also buys certain products from the Company at normal prevailing rates.  The Company and PulverDryer extended the contract from November 1, 2004 forward at that same monthly fee of $8,000.  Product sales to PulverDryer during the fiscal quarters ended August 31, 2006 and 2005 totaled $11,578 and $63,106, respectively.

In connection with the contract, the Board authorized Wayne Case, the Company’s Chief Executive Officer, to provide advisory services to PulverDryer, and permitted Mr. Case to receive as compensation the total consulting fees paid by PulverDryer from June 2004 through October 2004.  Effective November 1, 2004, Mr. Case receives 40% of the ongoing consulting fee from PulverDryer, which percentage was determined by the Compensation Committee.  Mr. Case also serves on the board of directors of PulverDryer.

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations:

Schmitt Industries, Inc. designs, assembles and markets computer controlled balancing equipment (the Balancer Segment) primarily to the machine tool industry.  Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc. (SMS) the Company designs, manufactures and markets precision laser measurement systems (the Measurement Segment). The Company also sells and markets its products in Europe through its wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom.  The accompanying unaudited financial information should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended May 31, 2006.  Certain amounts in prior periods’ financial information have been reclassified to conform to the current periods’ presentation. These reclassifications did not affect consolidated net income.

RESULTS OF OPERATIONS

Overview

Balancer segment sales focus throughout the world on end-users, rebuilders and original equipment manufacturers of grinding machines with the target geographic markets in North America, Asia and Europe.  Combined Balancer sales increased 9.6% for the three months ended August 31, 2006 compared to the three months ended August 31, 2005.  Continued improved economic conditions in the worldwide automotive, bearing and aircraft industries and its impact on the machine tool industry are the reason for increased Balancer orders.  While machine tool industry customers are optimistic regarding short term demand for grinding machines, they remain uncertain as to the strength and duration of current business conditions in North America for their products which incorporate the Balancer segment product line.  North American sales decreased 5.7% in the three months ended August 31, 2006 compared to the three months ended August 31, 2005.  Market demand in Asia for the Balancer segment products remains strong with that region showing a 68.1% increase for the three months ended August 31, 2006 compared to the three months ended August 31, 2005.  The European market remains soft although total Balancer sales into that geographic market increased 10.2% during the three months ended August 31, 2006 compared to the three months ended August 31, 2005.  Sales in all Other markets decreased to $156,415 in the three months ended August 31, 2006 compared to $200,500 for the three months ended August 31, 2005, a 22% decrease.  The large percentage decrease was predominately a result of decreases in South America and Australia offset by increases in the Japanese market.  As with the North American market, the duration of the strong demand in Asia and Japanese markets cannot be forecasted with any certainty.

The Measurement segment product line consists of both laser light-scatter and dimensional sizing products.  Combined Measurement sales increased 29.7% for the three months ended August 31, 2006 compared to the three months ended August 31, 2005.  As noted below sales can be very cyclical in the Measurement segment.

Laser light-scatter products for disk drive and silicon wafer manufacturers – The primary target markets for Measurement products have been disk drive and silicon wafer manufacturers and companies and organizations involved in research efforts.  Certain segments of these targeted industries have seen consolidation into very large international manufacturers.  Sales totaled $493,026 for the three months ended August 31, 2006 compared to the $257,648 for the three months ended August 31, 2005.  Management and the sales staff monitor industry publications and public financial information in order to judge the potential demand for products by the targeted industries.  Over the past year, this information has indicated improving demand for and sales of the products of those industries.  Sales to customers in these industries can be very cyclical and therefore the impact of this recovery on sales to the Company’s laser light-scatter products is unknown at this time.

Laser light-scatter products for research organizations – The Company continues to receive inquiries for these products and provide quotes to interested parties.  However, in the current fiscal quarter, no sales were realized.  The Company has received a deposit from a customer for an order for this product the Company expects to ship in November 2006.

Dimensional sizing products – These products are marketed and sold into a wide array of industries.  Sales totaled $483,026 for the three months ended August 31, 2006 compared to the $495,475 for the three months ended August 31, 2005.   Since relocation of operations related to these products to Portland was completed as of August 31, 2003, sales of these products have increased.  Sales of these industries can be cyclical and therefore the duration of the continued demand cannot be forecasted with any certainty

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Critical Accounting Policies

Revenue Recognition – The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectibility is probable.  For sales to all customers, including manufacturer representatives, distributors or their third-party customers, these criteria are met at the time product is shipped.  When other significant obligations remain after products are delivered, revenue is recognized only after such obligations are fulfilled.

Cash Equivalents and Short Term Investments – The Company generally invests excess cash in money market funds and investment grade highly liquid securities. The Company considers securities that are highly liquid, readily convertible into cash and have original maturities of less than three months when purchased to be cash equivalents.  At August 31, 2006, short-term investments are classified as available-for-sale.  The carrying amounts of cash equivalents and short term investments are stated at cost, which approximate fair market value because of their short maturities.  There were no related unrealized holding gains or losses at August 31, 2006.

Accounts Receivable – The Company maintains credit limits for all customers that are developed based upon several factors, including but not limited to payment history, published credit reports and use of credit references.  On a monthly basis, management performs various analyses to evaluate accounts receivable balances to ensure recorded amounts reflect estimated net realizable value.  This review includes accounts receivable agings, other operating trends and relevant business conditions, including general economic factors, as they relate to the Company’s domestic and international customers. If these analyses lead management to the conclusion that potential significant accounts are uncollectible, a reserve is provided.

Inventories – These assets are stated at the lower of cost or market on an average cost basis. Each fiscal quarter, management utilizes various analyses based on sales forecasts, historical sales and inventory levels to ensure the current carrying value of inventory accurately reflects current and expected requirements within a reasonable timeframe.

Deferred Tax Assets– The Company applies the asset and liability method in recording income taxes, under which deferred income tax assets and liabilities are determined, based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using currently enacted tax rates and laws. Additionally, deferred tax assets are evaluated and a valuation allowance is established if it is more likely than not that all or a portion of the deferred tax asset will not be realized.  In Fiscal 2005 and 2006, management concluded future operations would produce sufficient earnings so that a portion of this asset could be used in future periods to reduce federal and state tax liabilities.  Management continues to review the level of the valuation allowance on a quarterly basis. There can be no assurance that the Company’s future operations will produce sufficient earnings so that the deferred tax asset can be fully utilized.

Intangible Assets – There is a periodic review of intangible and other long-lived assets for impairment.  This review consists of the analysis of events or changes in circumstances that would indicate the carrying amount of the asset may not be recoverable. Recoverability is determined by comparing the forecasted future net cash flows from the operations to which the assets relate, based on management’s best estimates using the appropriate assumptions and projections at the time, to the carrying amount of the assets.  If the carrying value is determined to be in excess of  future operating cash flows, the asset is considered impaired and a loss is recognized equal to the amount by which the carrying amount exceeds the estimated fair value of the assets.   As of August 31, 2006, management does not believe impairment, as defined above, exists.

Recently issued accounting pronouncements:

The FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) in June 2006.  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in our financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”.  The provisions of FIN 48 are effective for our fiscal year beginning June 1, 2007.  We are currently evaluating the impact of the provisions of FIN 48.

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Discussion of operating results:

Three months ended August 31, 2006 and 2005:

	Three months ended August 31, 2006
	Consolidated			Balancer			Measurement
	Dollars		%	Dollars		%	Dollars		%
Sales	$	3,072,552	100.0	$	2,083,930	100.0	$	988,622	100.0
Cost of sales	1,474,261		48.0	1,142,542		54.8	331,719		33.6
Gross profit	1,598,291		52.0	$	941,388	45.2	$	656,903	66.4
Operating expenses	1,132,971		36.9
Operating income	$	465,320	15.1

	Three months ended August 31, 2005
	Consolidated			Balancer			Measurement
	Dollars		%	Dollars		%	Dollars		%
Sales	$	2,664,677	100.0	$	1,911,554	100.0	$	753,123	100.0
Cost of sales	1,236,568		46.4	930,355		48.7	306,213		40.7
Gross profit	1,428,109		53.6	$	981,199	51.3	$	446,910	59.3
Operating expenses	1,036,182		38.9
Operating income	$	391,927	14.7

Worldwide sales of Balancer products increased 9.6% in the three month period ended August 31, 2006 when compared to the same period in the prior fiscal year as sales to the Asian and European markets increased by 68.1% and 10.2%, respectively.  These increases were offset by a decrease in the North American market of 5.7% and a decline in Other markets which decreased 22% in the most current fiscal quarter when compared to the same period in the prior fiscal year.  Unit sales prices of Balancer products are relatively stable in each of the major markets and therefore any increases or decreases in the dollar amount of sales between fiscal periods can generally be attributed to an increase or decrease in the number of units sold.  The Balancer product sales increase in Asia is attributed to the continued expansion of the sales efforts in China.  Although Balancer sales to Europe increased in the most recent quarter the European market remains soft when compared to longer term historical results due to strong competition and weaker economic conditions in certain European Balancer markets.

Measurement product sales increased by a combined 29.7% in the most current fiscal quarter when compared to the same period in the prior fiscal year as sales of the Company’s surface measurement products increased by 91.4% and dimensional sizing  product sales decreased by 2.3%.  The Measurement segment’s largest market, North American, increased 33.7% in the three months ended August 31, 2006 compared to the three months ended August 31, 2005.  Sales in Japan were $91,640 in the three months ended August 31, 2006 compared to no Japanese sales in the three months ended August 31, 2005.  Market demand in Asia, the second largest geographic market for Measurement products, showed a 28% decrease for the three months ended August 31, 2006 compared to the three months ended August 31, 2005.  The European market also reported lower sales and showed a 17.8% sales decrease to $17,427 in the most current fiscal quarter when compared to the same period in the prior fiscal year.

Cost of sales for the Balancer segment increased (as a percentage of sales) in the most current fiscal quarter when compared to the same period in the prior fiscal year primarily due to the product sales mix as production labor and overhead costs were relatively stable.  Balancer margins were also negatively impacted as a result of higher sales in foreign markets as a large portion of those sales are made through distributors and OEM’s who receive pricing net of commissions and other sales costs.

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Cost of sales for the Measurement segment decreased (as a percentage of sales) in the most current fiscal quarter when compared to the same period in the prior fiscal year primarily due to the product sales mix as surface measurement products generate higher gross profit margins than dimensional sizing  products.

Sales by the foreign subsidiary totaled $406,708 for the most recent quarter versus $428,094 for the same quarter last year.  Approximately 8.6% of the decrease is due to lower unit sales volumes offset by a 3.6% increase due to the changes in foreign exchange rates between the two fiscal periods.  The lower sales volumes were realized as a result of the continued soft sales in European markets, which were partially offset by increases in other markets.

In the three month period ended August 31, 2006, net income was $270,592 ($.10 per fully diluted share) compared to net income of $242,897 ($.09 per fully diluted share) for the same period last year.  Net income was negatively impacted by the provision for income taxes, which increased to $235,000 for the three month period ended August 31, 2006 compared to the $151,000 provision for income taxes in the same period last year.  As more fully described in Note 6 of the Notes to Consolidated Interim Financial Statements, the provision for income taxes in the current fiscal quarter was not significantly impacted by a reduction in the deferred tax asset valuation allowance.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s ratio of current assets to current liabilities increased to 8.3 to 1 at August 31, 2006 compared to 8.1 to 1 at May 31, 2006.  Cash, cash equivalents and available for sale short term investments totaled $4,768,362 as of August 31, 2006 compared to $3,538,012 at May 31, 2006.  As of August 31, 2006 the Company had $2,295,886 in cash and cash equivalents compared to $1,552,072 at May 31, 2006.  As of August 31, 2006 the Company had $2,472,476 in short term investments compared to $1,985,940 at May 31, 2006.  Short term investments consisted of highly liquid A1-P1 rated commercial paper securities maturing through December 2006.

During the three months ended August 31, 2006, cash provided by operating activities amounted to $1,105,833 with the changes described as follows:

·          Net income for the three months ended August 31, 2006 of $270,592 plus non-cash items: depreciation and amortization of $52,664, stock-based compensation of $13,459, the decrease in deferred tax assets of $159,210 and the $32,253 tax benefit related to stock options.

·          Accounts receivable generated cash as the balance decreased by $328,714 to a August 31, 2006 balance of $1,654,376 compared to $1,983,090 at May 31, 2006, a 16.6% decrease. The Company generally experiences a payment cycle of 30-90 days on invoices, depending on the geographic market.  Management believes its credit and collection policies are effective and appropriate for the marketplace.  There can be no assurance that the Company’s collection procedures will continue to be successful, particularly with current economic conditions.

·          Inventories decreased $208,801 to a August 31, 2006 balance of $3,032,789 compared to $3,241,590 at May 31, 2006, a 6.4% decrease.  The Company maintains levels of inventory sufficient to satisfy normal customer demands plus an increasing short-term delivery requirement for a majority of its Balancer products.  Management believes its ability to provide prompt delivery gives it a competitive advantage for certain sales.

·          Prepaid expenses increased by $13,841 to $91,467 from a balance of $77,626 at May 31, 2006 with the increase due to prepaid fees, trade show costs and various business and insurance costs.

·          Trade accounts payable increased by $13,147 to $416,637 from a balance of $403,490 at May 31, 2006 primarily due to normal fluctuations in timing of payment of outstanding payable balances.

·     ��    Other accrued liabilities (including customer deposits, commissions, payroll items and other accrued expenses) increased by $46,995 to a balance of $673,780 from $626,785 at May 31, 2006.

During the three months ended August 31, 2006, net cash used in investing activities was $494,237, consisting of net additions to property and equipment of $7,701 and net purchases of short term investments of $486,536.  Net cash provided by financing activities amounted to $35,572 which consisted of repayments of long-term obligations of $4,815 net of common stock issued on exercised stock options of $40,387.

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The following summarizes contractual obligations at August 31, 2006 and the effect on future liquidity and cash flows:

Years ending August 31,		Long term obligations		Operating leases		Total contractual obligations
	2007	$	12,777	$	64,002	$	76,779
	2008	4,020		53,302		57,322
	2009	—		8,682		8,682
	Total	$	16,797	$	125,986	$	142,783

Management has historically responded to business challenges that had a negative impact on operations and liquidity by reducing operating expenses, developing new products and attempting to penetrate new markets for the Company’s products.  As a result of these efforts, results of operations and cash flow from operations have improved.  Management believes its cash flows from operations, its available credit resources and its cash position will provide adequate funds on both a short-term and long-term basis to cover currently foreseeable debt payments, lease commitments and payments under existing and anticipated supplier agreements.  Management believes that such cash flow (without the raising of external funds) is sufficient to finance current operations, projected capital expenditures, anticipated long-term sales agreements and other expansion-related contingencies during Fiscal 2007 and 2008.  However, in the event the Company fails to achieve its operating and financial goals for Fiscal 2007, management may be required to take certain actions to finance operations in that time period.  These actions could include, but are not limited to, implementation of cost cutting measures and/or entering into additional borrowing arrangements collateralized by assets.

Business Risks

This report includes “forward-looking statements” as that term is defined in Section 21E of the Securities Exchange Act of 1934.  Forward-looking statements can be identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” “anticipates,” or “hopes,” or the negative of those terms or other comparable terminology, or by discussions of strategy, plans or intentions. For example, this section contains numerous forward-looking statements. All forward-looking statements in this report are made based on management’s current expectations and estimates, which involve risks and uncertainties, including those described in the following paragraphs. Among these factors are the following:

·Demand for Company products may change.

·New products may not be developed to satisfy changes in consumer demands.

·Failure to protect intellectual property rights could adversely affect future performance and growth.

·Production time and the overall cost of products could increase if any of the primary suppliers are lost or if any primary supplier increased the prices of raw materials.

·Fluctuations in quarterly and annual operating results make it difficult to predict future performance.

·The Company may not be able to reduce operating costs quickly enough if sales decline.

·The Company maintains a significant investment in inventories in anticipation of future sales.

·Future success depends in part on attracting and retaining key management and qualified technical personnel.

·The Company faces risks from international sales and currency fluctuations.

Such risks and uncertainties could cause actual results to be materially different from those in the forward-looking statements. Readers are cautioned not to place undue reliance on the forward-looking statements in this report. We assume no obligation to update such information.

Demand for Company products may change:

Over the past eight fiscal quarters, the Company has experienced increased demand for its Balancer products in North America.  These increases are attributed primarily to an improving economy in North America.  The conditions and

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circumstances could change in future periods and as a result demand for the Company’s products could decline.  Management is responding to these risks in two ways.  First, it appears there is a significant portion of the marketplace that is not using the automatic balancing products of the Company or any of its competitors.  The Company will therefore continue to devote part of its future R&D efforts toward developing products that will both broaden the scope of Balancing products offered to the current customer base.  Second, there are uses for the Company’s Balancer products in industries other than those in the Company’s historic customer base.  Management is devoting a significant portion of its time to identify these markets and educate those markets on the value of those products within their operations.

The laser light-scatter products of the Measurement segment have relied heavily upon sales to disk drive and silicon wafer manufacturers.  Conditions in those markets adversely affected sales beginning in Fiscal 1999 and those poor conditions continued into Fiscal 2004 and consequently, demand for drives fell over these periods. As the operations of those companies suffered, they in turn reduced capital spending resulting in minimal demand for and sporadic sales of the Company’s laser light-scatter products.  Industry forecasts are for improving conditions and the Company has experienced increasing sales in Fiscal 2006 and 2007 to those industries.  However, the long-term impact on demand for the Company’s surface Measurement products cannot be predicted with any certainty.

The semiconductor industry has also faced a down cycle over the past few fiscal years. Beginning in Fiscal 2002 the semiconductor industry experienced backlog cancellations, resulting in slower revenue growth and these conditions continued into Fiscal 2004.  The result is similar to disk drive manufacturers in that capital spending has declined significantly and consequently so has demand for and sales of the Company’s wafer products.  Some improvement in market conditions is forecasted to occur sometime in the next several months, although there is no certainty if and when those improvements will occur.

Management will continue to market these products to these historic markets as it appears no other technology has been introduced that would make the laser light-scatter products technologically obsolete.  There is the belief that once market conditions improve in the disk drive and silicon wafer markets, demand for the Company’s products and technology will increase although most likely not to historic levels.  Also, management believes there are other uses for the Company’s laser light scatter technology and continues to evaluate R&D efforts to develop new products and introduce them to the marketplace.

New products may not be developed to satisfy changes in consumer demands:

The failure to develop new technologies, or react to changes in existing technologies, could materially delay development of new products, which 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 opportunities may not be identified and developed and brought to market in a timely and cost-effective manner.  Products or technologies developed by other companies may render products or technologies obsolete or noncompetitive or a fundamental shift in technologies in the product markets could have a material adverse effect on the Company’s competitive position within historic industries.

Failure to protect intellectual property rights could adversely affect future performance and growth:

Failure to protect existing intellectual property rights may result in the loss of valuable technologies or paying other companies for infringing on their intellectual property rights.  The Company relies on patent, trade secret, trademark and copyright law to protect such technologies.  There is no assurance any of the Company’s U.S. patents will not be invalidated, circumvented, challenged or licensed to other companies.

Production time and the overall cost of products could increase if any of the primary suppliers are lost or if a primary supplier increased the prices of raw materials:

Manufacturing operations depend upon obtaining adequate supplies of raw materials on a timely basis.  The results of operations could be adversely affected if adequate supplies of raw materials cannot be obtained in a timely manner or if the costs of raw materials increased significantly.

Fluctuations in quarterly and annual operating results make it difficult to predict future performance:

Quarterly and annual operating results are likely to fluctuate in the future due to a variety of factors, some of which are beyond management’s control. As a result of quarterly operating fluctuations, it is important to realize quarter-to-quarter

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comparisons of operating results are not necessarily meaningful and should not be relied upon as indicators of future performance

The Company may not be able to reduce operating costs quickly enough if sales decline:

Operating expenses are generally fixed in nature and largely based on anticipated sales.  However, should future sales decline significantly and rapidly, there is no guarantee management could take actions that would further reduce operating expenses in either a timely manner or without seriously impacting the operations of the Company.

The Company maintains a significant investment in inventories in anticipation of future sales:

The Company believes it maintains a competitive advantage by shipping product to its customers more rapidly than its competitors.  As a result, the Company has a significant investment in inventories.  These inventories are recorded using the lower-of-cost or market method, which requires management to make certain estimates.  Management evaluates the recorded inventory values based on customer demand, market trends and expected future sales and changes these estimates accordingly.  A significant shortfall of sales may result in carrying higher levels of inventories of finished goods and raw materials thereby increasing the risk of inventory obsolescence and corresponding inventory write-downs.  As a result, the Company may not carry adequate reserves to offset such write-downs.

Future success depends in part on attracting and retaining key management and qualified technical and sales personnel:

Future success depends on the efforts and continued services of key management, technical and sales personnel.  Significant competition exists for such personnel and there is no assurance key technical and sales personnel can be retained nor assurances there will be the ability to attract, assimilate and retain other highly qualified technical and sales personnel as required.  There is also no guarantee key employees will not leave and subsequently compete against the Company. The inability to retain key personnel could adversely impact the business, financial condition and results of operations.

The Company faces risks from international sales and currency fluctuations:

The Company markets and sells its products worldwide and international sales have accounted for and are expected to continue to account for a significant portion of future revenue.  International sales are subject to a number of risks, including: the imposition of governmental controls; trade restrictions; difficulty in collecting receivables; changes in tariffs and taxes; difficulties in staffing and managing international operations; political and economic instability; general economic conditions; and fluctuations in foreign currencies.  No assurances can be given 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.

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Item 3.Quantitative and Qualitative Disclosures About Market Risk:

Interest Rate Risk

The Company did not have any derivative financial instruments as of August 31, 2006.  However, the Company could be exposed to interest rate risk at any time in the future and therefore, employs established policies and procedures to manage its exposure to changes in the market risk of its marketable securities.

The Company’s interest income and expense are most sensitive to changes in the general level of U.S. and European interest rates.  In this regard, changes in U.S. and European interest rates affect the interest earned on the Company’s interest bearing cash equivalents and short term investments.  The Company has a variable rate line of credit facility with a bank but there is no outstanding balance as of August 31, 2006.  Also, there is no other long-term obligation whose interest rates are based on variable rates that may fluctuate over time based on economic changes in the environment.  Therefore, at this time, the Company is not subject to interest rate risk on outstanding interest bearing obligations if market interest rates fluctuate and does not expect any change in the interest rates to have a material effect on the Company’s results from operations.

Foreign Currency Risk

The Company markets and sells its products worldwide and international sales have accounted for and are expected to continue to account for a significant portion of future revenue. The Company operates a subsidiary in the United Kingdom and acquires certain materials and services from vendors transacted in foreign currencies.  Therefore, the Company’s business and financial condition is sensitive to currency exchange rates or any other restrictions imposed on their currencies.  For the three months ended August 31, 2006 and 2005 results of operations included losses on foreign currency denominated transactions of $569 and $2,867, respectively.

Item 4.Controls and Procedures

(a)Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report.  Based on their evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective as of the end of the period covered by this report.

(b)There have been no changes in our internal controls that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION

Item 6.Exhibits

Exhibit	Description
3.1	Second Restated Articles of Incorporation of Schmitt Industries, Inc. (the “Company”). Incorporated by reference to Exhibit 3(i) to the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 1999.
3.2	Second Restated Bylaws of the Company Incorporated by reference to Exhibit 3(ii) to the Company’s Annual Report on Form 10-K for the fiscal year ended May 31, 1999.
4.1	See exhibits 3.1 and 3.2 for provisions of the Articles of Incorporation and Bylaws defining the rights of security holders.
31.1	Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act 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 Act of 2002.
32.1	Certification of Principal Executive Officer and Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

		SCHMITT INDUSTRIES, INC. (Registrant)
Date:	September 29, 2006	/s/ Wayne A. Case
				Wayne A. Case, President/CEO/Director
Date:	September 29, 2006	/s/ Michael S. McAfee
			Michael S. McAfee, Chief Financial Officer/Treasurer

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