UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: August 31, 2003
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:  0-23996

 

SCHMITT INDUSTRIES, INC.

(Exact name of registrant’s principal executive office)

 

 

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                            ý                                    No                                o

 

The number of shares of each class of common stock outstanding as of August 31, 2003

 

 

SCHMITT INDUSTRIES, INC.

 

INDEX TO FORM 10-Q

 

Part I     -	FINANCIAL INFORMATION
Item 1    -	Financial Statements:
	Consolidated Balance Sheets: –   August 31, 2003 and May 31, 2003
	Consolidated Statements of Operations: –   For the Three Months Ended August 31, 2003 and 2002
	Consolidated Statements of Cash Flows: –   For the Three Months Ended August 31, 2003 and 2002
	Supplemental Disclosure of Cash Flow Information and Supplemental Schedule of Noncash Financing Activities
	Notes to Consolidated Interim Financial Statements –   Three Months Ended August 31, 2003 and 2002
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

 

2

 

PART I - FINANCIAL INFORMATION

Item 1.            Financial Statements

 

SCHMITT INDUSTRIES, INC.
CONSOLIDATED BALANCE SHEETS

 

		August 31, 2003			May 31, 2003
		Unaudited
ASSETS
Current assets
Cash		$	296,782		$	410,245
Accounts receivable, net of allowance of $24,060 at August 31, 2003 and May 31, 2003		1,346,513			1,324,200
Inventories		2,725,736			2,725,931
Prepaid expenses		153,159			167,192
Income taxes receivable		31,859			32,659
		4,554,049			4,660,227
Property and equipment
Land		299,000			299,000
Buildings and improvements		1,207,328			1,208,417
Furniture, fixtures and equipment		964,328			991,828
Vehicles		93,887			93,887
		2,564,543			2,593,132
Less accumulated depreciation and amortization		1,301,676			1,307,100
		1,262,867			1,286,032
Other assets
Long-term investment		6,800			6,800
Other assets		305,229			318,880
		312,029			325,680
TOTAL ASSETS		$	6,128,945		$	6,271,939
LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable		$	354,215		$	355,329
Accrued commissions		137,647			148,953
Accrued liabilities		69,776			78,080
Current portion of long-term debt		9,756			20,031
Total current liabilities		571,394			602,393
Long-term debt		2,670			4,273
Stockholders’ equity
Common stock, no par value, 20,000,000 shares authorized, 2,436,265 and 2,457,932 shares issued and outstanding at  August 31, 2003 and May 31, 2003 respectively (see note 10)		7,314,983			7,332,984
Accumulated other comprehensive loss		(305,757		)	(280,363		)
Accumulated deficit		(1,454,345		)	(1,387,348		)
Total stockholders’ equity		5,554,881			5,665,273
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	6,128,945		$	6,271,939

 

 

The accompanying notes are an integral part of these financial statements

 

3

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE MONTHS ENDED AUGUST 31, 2003 AND 2002

(UNAUDITED)

 

		Three Months Ended August 31,
		2003			2002
Net sales		$	1,648,201		$	2,001,191
Cost of sales		764,572			823,551
Gross profit		883,629			1,177,640
Operating expenses:
General, administration and sales		963,244			1,085,808
Research and development		9,020			80,677
Total operating expenses		972,264			1,166,485
Operating income (loss)		(88,635		)	11,155
Other income		21,638			57,160
(Loss) before income tax expense		(66,997		)	68,315
Income tax expense		—			13,000
Net (loss)		$	(66,997	)	$	55,315
Net (loss) income per common share:
Basic		$	(.03	)	$	.02
Diluted		$	(.03	)	$	.02

 

 

The accompanying notes are an integral part of these financial statements

 

4

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED AUGUST 31, 2003 AND 2002

(UNAUDITED)

 

		Three Months Ended August 31,
		2003			2002
Cash Flows Relating to Operating Activities
Net (loss) income		$	(66,997	)	$	55,315
Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities:
Depreciation		33,344			47,297
Amortization		13,651			13,651
Deferred taxes		—			13,000
(Increase) decrease in:
Accounts receivable		(22,313		)	(87,994		)
Inventories		195			18,983
Prepaid expenses		14,033			(9,427		)
Income taxes receivable		800			99,777
Increase (decrease) in:
Accounts payable		(1,114		)	88,090
Accrued liabilities		(19,610		)	(1,487		)
Net cash (used in) provided by operating activities		(48,011		)	237,205
Cash Flows Relating to Investing Activities
Purchase of property and equipment		(10,179		)	(36,440		)
Disposals of property and equipment		—			4,102
Net cash used in investing activities		(10,179		)	(32,338		)
Cash Flows Relating to Financing Activities
Repayments on line of credit		—			(200,000		)
Repayments on long-term debt		(11,878		)	(28,459		)
Common stock issued on exercise of stock options		21,999			—
Common stock repurchased		(40,000		)	—
Net cash used in financing activities		(29,879		)	(228,459		)
Effect of foreign exchange translation on cash		(25,394		)	9,104
Decrease in cash		(113,463		)	(14,488		)
Cash, beginning of period		410,245			447,679
Cash, end of period		$	296,782		$	433,191
Supplemental Disclosure of Cash Flow Information
Cash paid during the period for interest		$	1,082		$	11,413
Cash paid during the period for income taxes		$	—		$	26,110
Supplemental Schedule of Noncash Financing Activities:
Increase (decrease) in market value of long-term investment		$	—		$	(509,000	)
Increase (decrease) in long-term deferred tax asset		$	—		$	173,000
Increase (decrease) in other comprehensive income		$	(25,394	)	$	(326,896	)

 

 

The accompanying notes are an integral part of these financial statements

 

5

 

SCHMITT INDUSTRIES, INC.

NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS

THREE MONTHS ENDED AUGUST 31, 2003 AND 2002

 

Note 1:

 

These financial statements are those of the Company and its wholly owned subsidiaries.  In the opinion of Management, the accompanying Consolidated Financial Statements of Schmitt Industries, Inc. contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly its financial position as of August 31, 2003 and its results of operations and its cash flows for the three-months ended August 31, 2003 and 2002.  Operating results for the three-month period ended August 31, 2003 are not necessarily indicative of the results that may be experienced for the fiscal year ending May 31, 2004.

 

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:                                                         Stock Based Compensation

 

Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (FAS 123) encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value. The Company has chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25).  The Company has adopted the disclosure only provisions of SFAS 123.  Accordingly, no compensation cost has been recognized for the stock option plans. Adjustments are made for options forfeited prior to vesting.

 

For the three months ended August 31, 2003 there were no options issued while for the three months ended August 31, 2002 the total value of options granted was computed to be $7,158, which would be amortized on the straight-line basis over the vesting period of the options.  If the Company had used the fair value based method of accounting for its plans, the Company’s net income (loss) and net income (loss) per share would approximate the pro forma disclosures below:

 

		Three Months Ended August 31,
		2003			2002
Net income (loss) as reported		$	(66,997	)	$	55,315
Stock based compensation determined under the fair value method		$	(6,963	)	$	(26,048	)
Net income (loss) pro forma		$	(73,960	)	$	29,267
Net income (loss) per share as reported:
Basic		$	(.03	)	$	.02
Diluted		$	(.03	)	$	.02
Net income (loss) per share pro forma:
Basic		$	(.03	)	$	.01
Diluted		$	(.03	)	$	.01

 

Pursuant to SFAS 123, the fair value of each option granted is estimated on the date of the grant using the Black-Scholes option and pricing model.  The weighted average assumptions used for the three months ended August 31, 2003 and 2002 were a risk-free interest rate of 3.50% for 2003 and 2002, an expected dividend yield of 0% for all years, an expected life of eight years for Fiscal 2003 and four years for Fiscal 2002, and a volatility of 104% and 119%, respectively.

 

The effects of applying SFAS No. 123 in the pro forma disclosure are not necessarily indicative of future amounts.

 

6

 

Note 4:                                                         New Accounting Pronouncements

 

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” (“FIN 46”). FIN 46 requires all Variable Interest Entities (“VIEs”) to be consolidated by the primary beneficiary. The primary beneficiary is the entity that holds the majority of the beneficial interests in the VIE. In addition, FIN 46 expands disclosure requirements for both VIEs that are consolidated as well as VIEs from which the entity is the holder of a significant amount of the beneficial interest, but not the majority. The disclosure requirements of FIN 46 are effective for all financial statements issued after January 31, 2003. The consolidation requirements of this interpretation are effective for all periods beginning after June 15, 2003. The adoption of FIN 46 did not have a material adverse impact on the Company’s financial position, results of operations or cash flows at this time.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”, which establishes standards for how certain financial instruments are classified when it has characteristics of both liabilities and equity.  SFAS No. 150 requires instruments which were previously classified as equity, that meet the scope of the pronouncement, be classified as liabilities.  The Company will begin applying the provisions of this statement in November 2003, but does not anticipate that it will have a material effect on the Company’s financial position, results of operations or cash flows.

 

Note 5:                                                         EPS Reconciliation

 

		Three Months Ended August 31,
		2003		2002
Weighted average shares (basic)		2,434,334		2,468,424
Effect of dilutive stock options		—		241,183
Weighted average shares (diluted)		2,434,334		2,709,607

 

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.  Incremental shares were excluded from the diluted loss per share calculation, as their effect was anti-dilutive.

 

Note 6:                                                         Long-term investments

 

The Company owns 1,375,716 shares or slightly less than 10% of the outstanding shares of Air Packaging Technologies, Inc.  That company is engaged in the design, manufacture, marketing and sales of “Air Box” patented packaging systems used in the retail, industrial protective and promotional packaging markets worldwide.  This 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 or until unrealized losses are deemed to be “other than temporary”.  At August 31, 2003 the fair market value of the stock was equal to the value reported on the balance sheet.

 

Note 7:                                                         Long-term deferred tax asset

 

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.  The asset arose when the Company acquired the stock and therefore the net operating loss carryforwards of its wholly owned subsidiary, Schmitt Measurement Systems in 1996.  As the Company realizes Federal taxable income, the asset is used to reduce the Federal Income Tax expense reported in the Company’s earnings statement.  Due to the uncertainty of utilization of the Company’s NOLs and in consideration of other factors, management has recorded a valuation allowance on the deferred tax asset at August 31, 2003 and May 31, 2003 to reduce the net deferred tax asset to the amount that it has deemed will more likely than not be realized.

 

7

 

Note 8:                                                         Segments of Business

 

Segment Information

 

		Three Months Ended August 31,
		2003						2002
		Balancer Systems			Measurement Systems			Balancer Systems			Measurement Systems
Gross sales		$	1,680,147		$	168,499		$	1,719,381		$	520,753
Intercompany sales		$	(195,540	)	$	(4,905	)	$	(236,051	)	$	(2,892	)
Net sales		$	1,484,607		$	163,594		$	1,483,330		$	517,861
Income (loss) from operations		$	63,647		$	(152,282	)	$	(55,336	)	$	66,491
Intercompany rent		$	—		$	7,500		$	—		$	7,500
Depreciation expense		$	24,550		$	8,794		$	33,119		$	14,178
Amortization expense		$	5,000		$	8,651		$	5,000		$	8,651
Capital expenditures		$	3,214		$	6,965		$	24,891		$	11,549

 

Geographic Information

		Three Months Ended August 31,
		2003			2002
Geographic Sales
North American Sales
United States		$	707,475		$	1,219,742
Intercompany		$	—		$	(16,850	)
		$	707,475		$	1,202,892
Canada		$	24,969		$	33,880
Mexico		$	17,013		$	14,676
North American total		$	749,457		$	1,251,448
European Sales
Germany		$	125,304		$	161,886
Intercompany		$	—		$	—
Germany total		$	125,304		$	161,886
United Kingdom		$	303,475		$	338,764
Intercompany		$	(200,445	)	$	(222,093	)
United Kingdom total		$	103,030		$	116,671
Other European Sales		$	274,615		$	250,198
Total Europe		$	502,949		$	528,755
Asia		$	367,930		$	175,481
Others		$	27,865		$	45,507
		$	1,648,201		$	2,001,191

 

8

 

		Three Months Ended August 31,
		2003						2002
		United States			Europe			United States			Europe
Income (loss) from operations		$	(110,999	)	$	22,364		$	33,411		$	(22,256	)
Depreciation expense		$	31,726		$	1,618		$	43,664		$	3,633
Amortization expense		$	13,651		$	—		$	13,651		$	—
Capital expenditures		$	9,353		$	826		$	34,456		$	1,984

 

Long-term Assets

 

		August 31, 2003			May 31, 2003
Segment:
Balancer		$	968,462		$	994,798
Measurement		$	606,434		$	616,914
Geographic:
United States		$	1,552,575		$	1,588,599
Europe		$	22,321		$	23,113

 

Note – Europe is defined as the two European subsidiaries, Schmitt Europe, Ltd. and Schmitt Europa, GmbH

 

Note 9:                                                         Comprehensive (Loss)

 

		Three Months Ended August 31,
		2003			2002
Net income (loss)		$	(66,997	)	$	55,315
Other comprehensive (loss) income:
(Decrease) increase in fair market value of long-term investment, net of taxes		—			(336,000		)
Foreign currency translation adjustment		(25,394		)	9,104
Total comprehensive (loss)		$	(92,391	)	$	(271,581	)

 

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 taxes, are included in Accumulated Other Comprehensive Income (Loss) and reported as a separate component of 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 10:                                                  Stockholders’ Equity

 

Effective December 31, 2002, the Board of Directors of the Company approved a 1 for 3 reverse split of the Company’s Common Stock.  The Board was acting under the authority of the Company’s shareholders who approved the reverse split at their annual meeting held on October 5, 2001.  Stockholders of record on December 31, 2002, the effective date of the reverse stock split, received one share of Common Stock for every three shares of Common Stock held as of the effective date.  No fractional shares of common stock were issued as a result of the reverse stock split and each holder of the resulting fractional shares received a cash distribution for those fractional shares.  All share amounts have been adjusted, where applicable, to reflect this reverse split.

 

9

 

SCHMITT INDUSTRIES, INC.

FORM 10-Q

FIRST QUARTER FISCAL YEAR 2004

 

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

 

These financial statements are those of the Company and its wholly owned subsidiaries.  In the opinion of management, the accompanying Consolidated Financial Statements of Schmitt Industries, Inc. contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly its financial position as of August 31, 2003 and its results of operations and its cash flows for the three-months ended August 31, 2003 and 2002.  Operating results for the three-month period ended August 31, 2003 are not necessarily indicative of the results that may be experienced for the fiscal year ending May 31, 2004.

 

RESULTS OF OPERATIONS

 

Three months ended August 31, 2003 and 2002:

 

Sales in the first quarter of fiscal 2004 decreased to $1,648,201 versus $2,001,191 in the same period last year, with sales in the Balancer segment virtually equal to year ago levels while those in the Measurement segment decreased.  Worldwide sales of Balancer products were $1,484,607 in the first quarter of fiscal 2004 compared to $1,483,330 for the same period last year with sales in the Asian markets increasing 111% and North American and European markets decreasing by 21% and 6% respectively from prior year levels for the same period.  Measurement product sales totaled $163,594 in the first quarter of fiscal 2004 compared to $517,861 in the first quarter of fiscal 2003.  Measurement sales in the prior fiscal year included $202,000 for two large laser light scatter products while in the current year there were no sales of the higher value products.  In addition, with the consolidation of the Acuity Research products into the Portland, Oregon facility, production and therefore shipments were closed for a significant portion of the month of August 2003.

 

The global economic slowdown has impacted the Balancer segment sales over the past few fiscal quarters through reduced demand.  Beyond that, there are no other specific or quantifiable reasons for the decline in sales in North America and Europe.  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 targeted customers.  Over the past several 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 in North America and Europe as reasons for their reduced ordering activity.  Customers are seeing lack of demand for their products and as a result their demand for Schmitt Dynamic Balancing Systems has declined in recent fiscal periods.

 

The Measurement segment product line consists of both laser light-scatter and dimensional sizing products.    The business operations and prospects for these two product lines are summarized as follows:

 

Laser light-scatter products for disk drive and silicon wafer manufacturers – Until the acquisition of the Acuity Research subsidiary in fiscal 2001, the primary target markets for Measurement products were disk drive and silicon wafer manufacturers and companies and organizations involved in research efforts.  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 several months, 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.  Therefore, sales to customers in these industries can be very cyclical.

 

Laser light-scatter products for research organizations – Historically the Company has sold two to three of these systems in each fiscal year and expects to do the same in the current fiscal year as there are several sales quotes outstanding.  However, none of these sales occurred in the quarter ended August 31, 2003 as they had in the same quarter in the prior fiscal year.  This was the primary reason for the decline in sales for the most recent quarter when compared to the same quarter in the prior fiscal year.

 

Dimensional sizing products – Historically these have been marketed and sold into market segments different from the laser light scatter products.  Over the past several months, these sales have been relatively stable with most sales realized through repeat business and inquiries received through the Company’s web site.  Because of the market potential of these products, management has hired marketing and sales managers for these product lines.  The marketing manager joined the Company in fiscal 2003 and the sales manager in the current fiscal quarter.  These two people are building a North America sales representative network that will seek out business rather than respond to inquiries.  To date, sales representative organizations have been retained that cover fourty-three of the fifty states.  Management believes

 

10

 

organizations with be retained in the second quarter of the current fiscal year to cover the remainder of the United States and Canada.  During the fourth quarter of fiscal 2003, Management made the decision to consolidate the operations of Acuity (which had been located in Menlo Park, California) into the Measurement segment operations in Portland, Oregon.  This action reduced the engineering and administrative staff at Acuity by four people and, beginning in November 2003, reduces monthly rental costs by $7,500.   As a result of the physical relocation of the Acuity business in the most recent fiscal quarter, operations were suspended for a period of time and served to have a dampening effect on the sales volume of Acuity products.  The relocation was completed as of August 31, 2003 and therefore should not impact operations in the coming fiscal quarters.  Management believes these recent actions will increase sales while at the same time decrease fixed operating costs.

 

First quarter cost-of-sales increased to 46% of sales versus 41% in the same period last year.  Cost-of-sales of Balancer products for the three months ended August 31, 2003 was 46% compared to 48% for the three months ended August 31, 2002 while the cost-of-sales percentage of Measurement products was 50% for the first quarter of fiscal 2004 versus 22% in the same period last year.  The decrease in the cost of sales percentage for the Balancer segment was due to increasing unit sales prices in Europe where competitive market conditions generally result in lower sales prices and therefore higher cost-of-sales.  The increase in the cost-of-sales in the Measurement segment was due to the product sales mix plus the lower sales resulting in underabsorption of labor costs and overhead.

 

First quarter general, administrative and R&D expenses totaled $972,264 versus $1,166,485 for the same period last year.  As a percentage of revenues, operating expenses (including R&D) during the first quarter of fiscal 2004 were 59% compared to 58% for the same period last year.  The reason for the decrease in dollars was due to the lower sales and therefore a corresponding decrease in variable operating expense plus a decrease in payroll costs at the Acuity Research subsidiary.  The costs at Acuity decreased due to the reduction in engineering and administration staff that occurred due to the consolidation of Acuity operations in Portland during the quarter ended August 31, 2003.

 

Sales by the foreign subsidiaries totaled $502,522 for the most recent quarter versus $541,072 for the same quarter last year.  Soft market conditions in the European market are believed to be the reason for the decrease in sales.

 

In the three-month period ended August 31, 2003, the net loss was ($66,997) compared to net income of $55,315 for the same period last year.  Three-month net loss per share for the three months ended August 31, 2003 was ($.03) compared to net income, basic and diluted, of $.02 per share for the three months ended August 31, 2002.

 

LIQUIDITY AND CAPITAL RESOURCES

 

The Company’s ratio of current assets to current liabilities increased to 8.0 to 1 at August 31, 2003 compared to 7.7 to 1 at May 31, 2003.  As of August 31, 2003 the Company had $296,782 in cash compared to $410,245 at May 31, 2003.

 

During the three-months ended August 31, 2003, cash used in operating activities amounted to $48,011 with the changes described as follows:

 

•                  The net loss for the three-months ended August 31, 2003 of ($66,997) plus one non-cash item: depreciation and amortization of $46,995.

 

•                  Accounts receivable used cash as the balance increased by $22,313 (exclusive of the allowance for doubtful accounts) to an August 31, 2003 balance of $1,346,513compared to $1,324,200at May 31, 2003. At August 31, 2003, $24,060 in accounts receivable were considered a doubtful collection and therefore a reserve in that amount has been provided.  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 $195 to an August 31, 2003 balance of $2,725,736 compared to $2,725,931 at May 31, 2003.  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 decreased by $14,033 to $153,159 from a balance of $167,192 at May 31, 2003 with the decrease due to the amortization of prepaid trade show costs, professional fees and various business and life insurance costs.

 

11

 

•                  Trade accounts payable decreased by $1,114 to $354,215 from a balance of $355,329 at May 31, 2003.

 

•                  Other accrued liabilities (including commission, payroll items and other accrued expenses) decreased by $19,610 to a balance of $207,423 from $227,033 at May 31, 2003.

 

During the three months ended August 31, 2003, net cash used in investing activities was $10,179, consisting of net additions to property and equipment.  Net cash used in financing activities amounted to $29,879, which consists of repayments of long-term debt of $11,878, common stock issued to employees who exercised stock options of $21,999 and repurchases of common stock $40,000.

 

The following summarizes contractual obligations at August 31, 2003 and the effect on future liquidity and cash flows:

 

Years Ending August 31,		Capital Lease Obligations			Operating Leases			Total Contractual Obligations
2004		$	9,756		$	57,167		$	66,923
2005		2,670			33,967			36,637
2006		—			9,289			9,289
2007		—			2,322			2,322
Total		$	12,426		$	102,745		$	115,171

 

Specific business challenges faced by the Company over the past few years have had a negative impact on operations and liquidity.  Management has responded to these challenges by reducing operating expenses, developing new products and attempting to penetrate new markets for the Company’s products.  As a result of these efforts, Management believes its cash flows from operations, 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 2004. However, in the event the Company fails to achieve its operating and financial goals for fiscal 2004, 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 additional cost cutting measures, increased borrowings from existing credit facilities 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.

•                  The lack of a line of credit agreement could impact future liquidity.

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

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

 

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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:

 

For several months, the Company has experienced soft market demand in North America and Europe for its Balancer products.  While specific reasons are difficult to pinpoint, the low demand can generally be attributed to worldwide economic conditions, specifically those in the grinding machine industry, the primary market for the Company’s Balancer products.  Based upon analysis by management and the sales staff, the decline in sales does not appear to arise from the customer base shifting to competitor products.

 

Management has responded to these soft market conditions 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 a significant part of its R&D efforts in Fiscal 2004 and 2005 toward developing products that will both broaden the scope of products offered to the current customer base plus offer products for new markets thereby reducing the reliance on historic markets.  Second, Management has hired both a sales and marketing manager who are devoted exclusively to the Acuity products and who have the goal of building a sales representative network covering North America.

 

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 2003. Disk drive demand is largely tied to and dependent upon demand for personal computers.  In Fiscal 2001, personal computer manufacturers warned of lower sales expectations and many initiated actions to significantly reduce costs.  These soft market conditions have continued into Fiscal Years 2002 and 2003.  Consequently, demand for drives has fallen and operations of those companies have suffered with one result being reduced capital spending.  This has resulted in minimal demand for and sporadic sales of the Company’s TMS products.  Industry forecasts are for these conditions to continue in the foreseeable future.

 

The semiconductor industry is also currently facing a down cycle. Beginning in Fiscal 2002 the semiconductor industry experienced backlog cancellations, resulting in slower revenue growth and these conditions continued into Fiscal 2003.  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.  Forecasts for that industry are for improvements in market conditions to begin sometime in the next several months, although there is no certainty those improvements will occur during that time period.

 

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 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.

 

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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 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.  In the past, Management has responded to declining sales by instituting expense reduction programs that have significantly reduced the break-even sales point.  However, should sales decline significantly, 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.

 

The lack of a line of credit agreement could impact future liquidity:

 

The short-term credit line expired on April 30, 2003 and the commercial bank chose not to renew the arrangement.  While Management believes it could secure credit from another source, there is no guarantee this can be accomplished or, if it is accomplished, the terms may not be as favorable as those under the expired line of credit.

 

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, 2003.  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 cash equivalents as well as interest paid on debt.

 

The Company had a line of credit which expired on April 30, 2003, whose interest rate was based on various published prime rates that fluctuated over time based on economic changes in the environment.  The Company was subject to interest rate risk and could have been subject to increased interest payments as market interest rates fluctuated.

 

Foreign Currency Risk

 

The Company operates subsidiaries in the United Kingdom and Germany.  Therefore, the Company’s business and financial condition is 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.

 

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 Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended, within 90 days of the filing date of this report.  Based on their evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective.

 

(b)                                 There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced in paragraph (a) above.

 

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Part II - OTHER INFORMATION

 

Item 6.           Exhibits and Reports on Form 8-K

 

(a)   Exhibits

 

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

 

(b)   Reports on Form 8-K

 

The Company filed a Form 8-K on June 5, 2003 to announce the dismissal of PricewaterhouseCoopers LLP as principal accountant to audit the Company’s financial statements.

 

The Company filed a Form 8-K on June 27, 2003 to announce the retention of Grant Thornton LLP as principal accountant to audit the Company’s financial statements.

 

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:	10/14/2003	/s/ Wayne A. Case
		Wayne A. Case, President/CEO/Director
Date:	10/14/2003	/s/ Robert C. Thompson
		Robert C. Thompson, Chief Financial Officer

 

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