SCHMITT INDUSTRIES INC - Quarter Report: 2001 August (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended: August 31, 2001

Or

For the transition period from:                To:               

Commission File Number: 0-23996

SCHMITT INDUSTRIES, INC.
(Exact name of registrant as specified in its charter)

2765 NW Nicolai Street, Portland, Oregon 97210
(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 / /

The number of shares of each class of common stock outstanding as of August 31, 2001

Common stock, no par value 7,467,474

SCHMITT INDUSTRIES, INC.

INDEX TO FORM 10-Q

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PART I—FINANCIAL INFORMATION

    Item 1.      Financial Statements

SCHMITT INDUSTRIES, INC.
CONSOLIDATED BALANCE SHEETS

ASSETS

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, 2001 AND 2000
(UNAUDITED)

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, 2001 AND 2000
(UNAUDITED)

The accompanying notes are an integral part of these financial statements

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SCHMITT INDUSTRIES, INC.
NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS
THREE MONTHS ENDED AUGUST 31, 2001 AND 2000
(UNAUDITED)

Note 1:

    The accompanying unaudited financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information, and all adjustments considered necessary for a fair presentation have been included. Operating results for the three-month period ended August 31, 2001 are not necessarily indicative of the results that may be experienced for the fiscal year ending May 31, 2002.

    These financial statements are those of the Company and its wholly owned subsidiaries. All significant inter-company accounts and transactions have been eliminated in the preparation of the consolidated financial statements.

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: New Accounting Pronouncements

    On July 20, 2001, the FASB issued SFAS No. 141, Business Combinations. SFAS No. 141 establishes new standards for accounting and reporting requirements for business combinations and will require that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Use of the pooling-of-interest method will be prohibited. The Company adopted this statement during the first quarter of fiscal 2002. Management does not believe that SFAS No. 141 will have a material impact on the Company's consolidated financial statements.

    On July 20, 2001, the FASB also issued FASB Statement No. 142 (FAS 142) Goodwill and Other Intangible Assets. FAS 142 changes the accounting for goodwill and certain other intangible assets from an amortization method to an impairment-only approach. Upon adoption of FAS 142, goodwill and certain other intangible assets will be tested at the reporting unit annually and whenever events or circumstances occur indicating that goodwill and certain other intangible assets might be impaired. Amortization of goodwill and certain other intangible assets, including goodwill recorded in past business combinations, will cease. The adoption date for the Company will be June 1, 2002. The Company has not yet determined what the impact of FAS 142 will be on the Company's results of operations and financial position.

Note 4: EPS Reconciliation

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Note 5: Comprehensive (Loss)

    The long-term investment is classified as an "Available-for-sale security". As required under Statement of Financial Accounting Standards No. 115, all unrealized gains and losses, net of tax benefits, are included in Accumulated Other Comprehensive Income (Loss) and reported as a separate component of Other Comprehensive Income (Loss) in Stockholders' Equity until realized. The cumulative translation adjustment consists of unrealized gains/losses from translation adjustments on intercompany foreign currency transactions that are of a long-term nature.

Note 6: Segments of Business

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Note 7: Line of credit

    The Company has a $1.5 million unsecured short-term line of credit agreement with a commercial bank. The line is guaranteed by the Company's wholly owned subsidiary, Schmitt Measurement Systems, Inc. Interest is payable at the bank's prime rate minus 0.25%, or LIBOR +2.00%. The line of credit is renewable annually. As of August 31, 2001 and May 31, 2001 $400,000 and $200,000 was outstanding respectively. There are certain covenants related to the earnings of the company and the current ratio. As of August 31, 2001 the company was in compliance with the working capital requirement but was in violation of the net income requirement. As of August 31, the Bank has waived its default rights with respect to this violation.

Note 8: Restructuring reserve

    In the fourth quarter of the prior fiscal year, the Company established a liability of $106,764 for certain costs expected to be incurred in association with the restructuring of German operations. During the three months ended August 31, 2001 this liability changed as follows:

    All employees (five in total) were terminated effective May 31, 2001 and all payments to those employees since that date were under contractual agreements between those employees and the Company. Payments of the operating expenses included items related to the closure of the existing facility plus various legal and professional fees related to the restructure. This restructure is expected to be completed in the third quarter of fiscal 2002.

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SCHMITT INDUSTRIES, INC.
FORM 10Q
FIRST QUARTER FISCL YEAR 2002

Item 2 — Management's Discussion and Analysis of Financial Condition and Results of Operations:

    The following information contains certain forward-looking statements that anticipate future trends or events. These statements are based on certain assumptions that may prove to be erroneous and are subject to certain risks including but not limited to the uncertainties of the Company's new product introductions and the risks of increased competition and technological change in the Company's industries. Accordingly, actual results may differ, possibly materially, from the predictions contained herein.

Results of Operations:

Three months ended August 31, 2001 and 2000:

    Sales in the first quarter of fiscal 2002 decreased to $1,585,244 versus $1,942,990 in the same period last year, with decreases in both business segments. Worldwide sales of Balancer products were $1,337,726 in the first quarter of fiscal 2002 compared to $1,546,944 for the same period last year. Sales in both domestic and European markets were soft, trends expected to continue until the economies in both market areas improve. Measurement product sales totaled $247,518 in the first quarter of fiscal 2002 compared to $396,046 in the first quarter of fiscal 2001.

    The only significant factor affecting the decline in revenues in both the balancer and measurement product lines is the slowdown in the global economy. That has in turn resulted in a reduced demand for both balancer and measurement devices. Beyond that, there are not other specific or quantifiable reasons for the decline in sales. The balancer segment sales focus on end-users, rebuilders and original equipment manufacturers throughout the world. Sales people, representatives and distributors throughout these geographic areas spend a large amount of time with the targeted customers. Over the past twelve months they have found many of the customers in the automotive, bearing and aircraft industries have referred to the state of the economy and its impact on the machine tool industry as reasons for their reduced ordering activity. They are seeing lack of demand for their products and as a result their demand for Schmitt Dynamic Balancing Systems has declined.

    The primary target markets for Measurement products have historically been disk drive and silicon wafer manufacturers. Management and the sales staff monitor industry publications and public financial information in order to judge the potential demand for measurement products by these targeted industries. Over the past several months, all of this information has discussed at length declining demand for and sales of the products of those two industries and have generally defined industries that are in a severe recession. Also, frequent discussions with customers have confirmed the information presented in the public information and their inability to purchase measurement products due to their lack of a capital budget.

    First quarter cost-of-sales increased to 45% of sales versus 39% in the same period last year. Cost-of-sales of Balancer products was 46% and 42% for the three months ended August 31, 2001 and 2000 respectively while the cost of sales percentage of Measurement products was 42% for the third quarter 2001 versus 31% in the same period last year. The increase in the balancer segment cost of sales is due to the sales mix, particularly in Europe. Sales in those markets had higher proportionate sales of lower margin products than in the prior year. This will be corrected over time as the price lists of the German subsidiary were increased to match those of the Parent and United Kingdom Companies. It will take three to six months for these increases to become fully effective. The increase

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in the cost of sales in the measurement segment was due to the sales mix as, with the low volume, direct labor costs could not be fully absorbed by the level of sales.

    First quarter general, administrative and R&D expenses totaled $1,122,044 versus $1,139,464 for the same period last year. As a percentage of revenues, operating expenses (including R&D) during the first quarter of fiscal 2002 were 71% compared to 59% for the same period last year. Subsequent to August 31, 2001, Management initiated a program to significantly reduce operating expenses with the goal to reduce general, administrative and R&D expenses to a level that could have produced break-even operations on sales levels comparable to those realized in the most recent fiscal quarter.

    Sales by the foreign subsidiaries totaled $381,912 for the most recent quarter versus $444,117 for the same quarter last year. The decline was primarily a result of the restructure of the German subsidiary that started late in the prior fiscal year. During that process, sales were delayed for approximately thirty to forty days from mid-May to late June. With completion of the production and operations changes in June, sales returned to amounts comparable to the prior fiscal year. Marketing initiatives begun in the prior fiscal year in Europe are expected to produce sales comparable to the prior fiscal year, although this impact could be dampened until the soft market conditions in the European market improve.

    In the three-month period ended August 31, 2001, the net loss was $251,640 compared to net income of $29,138 for the same period last year. Three-month (loss) earnings per share, basic and diluted, were $.03 and $.00 for the three months ended August 31, 2001 and 2000 respectively.

Liquidity and Capital Resources:

    The Company's working capital position declined slightly to $3,997,357 at August 31, 2001 compared to $4,189,525 at May 31, 2001. Cash stood at $102,902 at August 31, 2001 compared to $291,083 at May 31, 2001.

    During the three months ended August 31, 2001, cash used in operations amounted to $385,228 with the changes described as follows:

•

The net loss for the quarter of $251,640 was reduced by one noncash item, depreciation and amortization of $62,425.



•

Accounts receivable provided cash as the balance decreased $9,178 to a balance at August 31, 2001 of $1,217,979 compared to $1,227,157 at May 31, 2001. This change from the end of fiscal 2001 is not considered significant. At August 31, 2001, no significant accounts receivable were considered a doubtful collection. The Company generally experiences a payment cycle of 30-80 days on invoices. Management believes its credit and collection policies are effective and appropriate for the marketplace and the Company has had no significant bad debt write-offs since its inception in 1986. There can be no assurance that the Company's collection procedures will continue to be successful, particularly with an economy that in many respects appears to be in a recession.



•

Inventories increased $80,533 from the balances at May 31, 2001, split equally between both industry segments. 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.

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•

Prepaid expenses decreased by $54,595 due to amortization of several items including prepaid trade show costs, professional fees and various business and life insurance costs.



•

Trade accounts payable decreased by $69,240 with the reduction due to the continued decline in purchasing activities in the US companies. The purchasing activities of those companies, particularly for inventory items, were lower in the weeks preceding August 31, 2001 than in the weeks preceding May 31, 2001.



•

Other accrued liabilities (including commission, payroll items and other accrued expenses) decreased by $109,903. The largest decrease was for the liability related to the restructure of operations in Germany ($59,433) and customer deposits ($21,171).

    During the three-month period ended August 31, 2001, net cash used investing activities was $15,357, consisting of additions to property and equipment. Net cash provided by financing activities amounted to $137,775, which consists of a $200,000 increase in the line of credit, less $25,000 in repayments of long-term debt and the purchase of shares of the Company's common stock for $37,225.

    Management believes that cash from operations, available credit resources and its working capital position could provide adequate funds on a short-term basis to cover currently foreseeable payments, commitments and payments under existing and anticipated supplier agreements. Management believes that such cash flow could be sufficient to finance current short-term operations, projected capital expenditures, anticipated short-term sales agreements and other contingencies during at least the next twelve months.

    Management is currently reviewing long-range capital requirements as they relate to funding of current operations. This analysis may or may not result in future decisions to seek additional funding for the Company via debt or equity to service the Company's future requirements.

Item 3 — Quantitative and Qualitative Disclosures About Market Risk:

Interest Rate Risk

    The Company does not have any derivative financial instruments as of August 31, 2001. However, the Company is exposed to interest rate risk. The Company 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 cash equivalents as well as interest paid on debt.

    The Company has a line of credit whose interest rate is based on various published prime rates that may fluctuate over time based on economic changes in the environment. The Company is subject to interest rate risk and could be subject to increased interest payments if market interest rates fluctuate. The Company does not expect any change in the interest rates to have a material adverse effect on the Company's results from operations.

Foreign Currency Risk

    The Company operates subsidiaries in the United Kingdom and Germany. The Company's business and financial condition is, therefore, sensitive to currency exchange rates or any other restrictions imposed on their currencies. To date, the foreign currency exchange rates have not significantly impacted the Company's profitability.

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Business Risks

    This annual 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 "hopeful," or the negative of those terms or other comparable terminology, or by discussions of strategy, plans or intentions. For example, this outlook 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: changes in demand for company products; new products may not be developed to satisfy changes in consumer demands; failure to protect intellectual property rights could adversely affect future performance an growth: and 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. 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 Annual Report. We assume no obligation to update such information.

Changes in demand for Company products:

    Over the past several months, the Company experienced soft market demand for its Balancing Products. While the specific reasons are difficult to pinpoint, these can generally be attributed to economic conditions in the United States, specifically those in the grinding machine industry, the primary market for the Company's Balancer products. Based upon management's analysis, the decline in sales does not appear to arise from a shift in the customer base to competitor products.

    Management has responded to these soft market conditions in several 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. In response to this, late in the prior fiscal year, another field salesperson was hired. Second, the Company will devote a significant part of its R&D efforts in fiscal 2002 and 2003 toward developing products that will both broaden the scope of products offered to the current customer base and offer products for new markets so as to reduce the reliance on historic markets. Third, Management initiated a restructuring plan in Europe in the fourth fiscal quarter of 2001 that is intended to increase worldwide operating efficiency. All engineering design and manufacturing operations are now consolidated in the United States, a step that is expected to reduce operating costs. In addition, all European operations are now focused totally on marketing and sales. Finally, Management will continue to evaluate all operating costs and seek to reduce costs where necessary.

    The Measurement segment has relied heavily upon sales to disk drive and silicon wafer manufacturers. Conditions in those markets have adversely affected sales beginning in fiscal 1999 and those poor conditions continued into the first quarter of fiscal 2002. Disk drive demand is largely tied to and dependent upon demand for personal computers. In the prior fiscal year, personal computer manufacturers warned of lower sales expectations and many have initiated actions to significantly reduce costs. Consequently, demand for drives have fallen and operations of those companies have suffered with one result being reduced capital spending. This has resulted in minimal demand for and sales of the Company's TMS products. Industry forecasts are for these conditions to continue in the foreseeable future.

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    The semiconductor industry is also currently facing a down cycle. Beginning in fiscal 2001 the semiconductor industry experienced backlog cancellations, resulting in slower revenue growth. Industry forecasts are for these conditions to continue for the remainder of calendar 2001. 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.

    Management will continue to market these products to these historic markets as it appears no other technology has been introduced that would make the TMS 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. Also, there are other uses for the Company's laser light scatter technology and efforts will be directed toward the 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 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 having to pay 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 can be no assurance that 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 an adequate supplies of raw materials cannot be obtained in a timely manner or if the costs of raw materials increased significantly.

    Failure to effectively and efficiently transfer German Manufacturing Operations to Portland:

    In the fourth fiscal quarter of 2001, management initiated a plan to consolidate all manufacturing operations of the German subsidiary into its operations in Portland. The reasons for this consolidation were to decrease manufacturing costs, increase operating efficiencies and to eventually manufacture the products of SEG under the Company's ISO quality system. There can be no assurances the expected operating efficiencies can be achieved or that the engineering and manufacturing techniques can be successfully transferred to Portland.

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    Recent terrorist attacks in the United States could have unknown effects on economic conditions:

    The impact of the attacks in the United States in September 2001 could possibly have an adverse effect on demand for the Company's products. The terrorist attacks in September resulted in a decline of balancer product sales levels for that month. It is unknown if fear of possible additional attacks will harm the Company's markets on a long-range basis. Management is evaluating the potential impact but sufficient time has not yet passed to make a determination of the impact, if any.

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Part II — OTHER INFORMATION

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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.

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