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: February 28, 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:  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 (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the proceeding 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     .                                               ý Yes o No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

Accelerated filer o

Non-accelerated filer ý

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes ý No

 

The number of shares of each class of common stock outstanding as of March 31, 2006

Common stock, no par value

2,616,128

 

 

SCHMITT INDUSTRIES, INC.

 

INDEX TO FORM 10-Q

 

 

Part I - FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Balance Sheets:
	–    February 28, 2006 and May 31, 2005 (unaudited)
	Consolidated Statements of Operations:
	–    For the Three and Nine Months Ended February 28, 2006 and 2005 (unaudited)
	Consolidated Statements of Cash Flows:
	–    For the Nine Months Ended February 28, 2006 and 2005 (unaudited)
	Consolidated Statement of Changes in Stockholders’ Equity:
	–    For the Nine Months Ended February 28,2006 (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

 

2

 

PART I - FINANCIAL INFORMATION

 

Item 1.    Financial Statements

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

 

		February 28, 2006			May 31, 2005
ASSETS
Current assets
Cash and cash equivalents		$	1,107,411		$	1,176,959
Short-term investments		1,475,940			—
Accounts receivable, net of allowance of $48,335 and $41,366 at February 28, 2006 and May 31, 2005, respectively		1,672,493			2,109,143
Inventories		3,386,809			3,533,313
Prepaid expenses		110,744			104,292
Deferred tax asset		116,080			92,319
		7,869,477			7,016,026
Property and equipment
Land		299,000			299,000
Buildings and improvements		1,273,831			1,214,348
Furniture, fixtures and equipment		1,158,545			1,120,946
Vehicles		96,849			96,849
		2,828,225			2,731,143
Less accumulated depreciation and amortization		(1,594,537		)	(1,462,637		)
		1,233,688			1,268,506
Other assets
Long-term deferred tax asset		767,044			547,681
Other assets		217,057			243,009
		984,101			790,690
Total assets		$	10,087,266		$	9,075,222
LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable		$	516,402		$	497,206
Accrued commissions		237,778			275,745
Accrued payroll liabilities		100,354			102,883
Other accrued liabilities		90,341			141,550
Income taxes payable		29,514			26,147
Current portion of long-term obligations		23,437			32,114
Total current liabilities		997,826			1,075,645
Long-term obligations		8,778			20,756
Stockholders’ equity
Common stock, no par value, 20,000,000 shares authorized, 2,616,128 and 2,559,687 shares issued and outstanding at February 28, 2006 and May 31, 2005, respectively		7,765,010			7,496,098
Accumulated other comprehensive loss		(256,944		)	(254,654		)
Retained earnings		1,572,596			737,377
Total stockholders’ equity		9,080,662			7,978,821
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	10,087,266		$	9,075,222

 

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

 

3

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 28, 2006 AND 2005

(UNAUDITED)

 

		Three Months Ended February						Nine Months Ended February 28,
		2006			2005			2006			2005
Net sales		$	2,707,123		$	2,563,121		$	7,977,607		$	7,475,645
Cost of sales		1,293,476			1,097,387			3,630,222			3,170,129
Gross profit		1,413,647			1,465,734			4,347,385			4,305,516
Operating expenses:
General, administration and sales		1,146,765			1,210,445			3,439,926			3,443,175
Research and development		26,070			9,679			59,709			42,395
Total operating expenses		1,172,835			1,220,124			3,499,635			3,485,570
Operating income		240,812			245,610			847,750			819,946
Other income		21,464			13,019			21,012			19,905
Income before income taxes		262,276			258,629			868,762			839,851
Provision for income taxes		64,500			6,000			33,543			18,000
Net income		$	197,776		$	252,629		$	835,219		$	821,851
Net income per common share:
Basic		$	0.08		$	0.10		$	0.32		$	0.33
Diluted		$	0.07		$	0.09		$	0.30		$	0.30

 

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

 

4

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED FEBRUARY 28, 2006 AND 2005

(UNAUDITED)

 

		Nine Months Ended February 28,
		2006			2005
Cash flows relating to operating activities
Net income		$	835,219		$	821,851
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		158,412			157,818
Deferred taxes		(243,124		)	—
Tax benefit related to stock options		175,365			—
(Increase) decrease in:
Accounts receivable		436,650			(178,666		)
Inventories		146,504			(746,722		)
Prepaid expenses		(6,452		)	(63,442		)
Income taxes receivable		—			41,429
Increase(decrease) in:
Accounts payable		19,196			40,170
Accrued liabilities and customer deposits		(91,705		)	3,186
Income taxes payable		3,367			—
Net cash provided by operating activities		1,433,432			75,624
Cash flows relating to investing activities
Purchase of short - term investments		(1,475,940		)	—
Maturities of short - term investments		—			—
Purchase of property and equipment		(97,642		)	(118,631		)
Disposals of property and equipment		—			7,903
Net cash used in investing activities		(1,573,582		)	(110,728		)
Cash flows relating to financing activities
Additions to long - term obligations		—			27,861
Repayments on long - term obligations		(20,655		)	(38,067		)
Common stock issued on exercise of stock options		93,547			119,583
Net cash provided by financing activities		72,892			109,377
Effect of foreign exchange translation on cash		(2,290		)	(20,097		)
Increase in cash and cash equivalents		(69,548		)	54,176
Cash and cash equivalents, beginning of period		1,176,959			604,194
Cash and cash equivalents, end of period		$	1,107,411		$	658,370
Supplemental Disclosure of Cash Flow Information
Cash paid during the period for interest		$	489		$	—
Cash paid during the period for income taxes		$	113,365		$	26,974

 

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

 

5

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

FOR THE NINE MONTHS ENDED FEBRUARY 28, 2006

(UNAUDITED)

 

		Shares		Amount			Accumulated other comprehensive loss			Retained earnings			Total			Total comprehensive income (loss)
Balance, May 31, 2005		2,559,687		$	7,496,098		$	(254,654	)	$	737,377		$	7,978,821
Stock options exercised and related tax benefit of $175,365		56,441		268,912			—			—			268,912
Net income		—		—			—			835,219			835,219			$	835,219
Other comprehensive (loss)		—		—			(2,290		)	—			(2,290		)	(2,290		)
Balance, February 28, 2006		2,616,128		$	7,765,010		$	(256,944	)	$	1,572,596		$	9,080,662
Comprehensive income, nine months ended February 28, 2006																$	832,929

 

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

 

6

 

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 February 28, 2006 and its results of operations and its cash flows for the nine months ended February 28, 2006 and 2005.  The consolidated balance sheet at May 31, 2005 has been derived from the Annual Report on Form 10-K for the fiscal year ended May 31, 2005.  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, 2005.  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, 2006.  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 Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 151, “Inventory Costs - an Amendment to ARB No. 43, Chapter 4” in November 2004.  This Statement requires that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) costs be recognized as current-period charges.  In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities.  The Company does not expect this pronouncement to have a material impact on the financial statements.

 

The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3”.  This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed.  The Company does not expect this pronouncement to have a material impact on the financial statements.

 

The Financial Accounting Standards Board revised Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” in December 2004.  Under the revised standard, the Company will be required to recognize compensation cost, related to its stock options, beginning in the first fiscal quarter of the year beginning June 1, 2006.  The cost of services received from employees in exchange for awards of share-based compensation generally shall be measured based on the grant-date fair value of the equity instruments issued.  The Company expects the effect of this pronouncement to approximate the proforma amounts disclosed in Note 4.

 

Note 4:                   Stock – Based Compensation

 

The Company has elected to follow the accounting provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”, 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 is 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.

 

7

 

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation:

 

		Three Months Ended February 28,						Nine Months Ended February 28,
		2006			2005			2006			2005
Net income, as reported		$	197,776		$	252,629		$	835,219		$	821,851
Add: Stock-based employee compensation expense included in reported net income, net of tax		—			—			—			—
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax		(4,811		)	(41,985		)	(14,436		)	(171,305		)
Pro forma net income		$	192,965		$	210,644		$	820,783		$	650,546
Earnings per share – basic
As reported		$	0.08		$	0.10		$	0.32		$	0.33
Pro forma		$	0.07		$	0.08		$	0.32		$	0.26
Earnings per share – diluted
As reported		$	0.07		$	0.09		$	0.30		$	0.30
Pro forma		$	0.07		$	0.08		$	0.30		$	0.24

 

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

 

The Company continues to measure compensation cost for it’s stock option plan using the method of accounting prescribed by APB 25.  In electing to continue to follow APB 25 for expense recognition purposes, the Company is required to provide the expanded disclosures required under SFAS No. 148 for stock-based compensation granted, including disclosure of pro forma net income and earnings per share, as if the fair value based method of accounting defined in the SFAS No. 123, had been adopted.

 

The Company has computed, for pro forma disclosure purposes, the value of each option granted using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:

 

		Three and Nine Months Ended February 28,
		2006		2005
Risk-free interest rate		6.00	%	4.00	%
Expected dividend yield		0	%	0	%
Expected life		5.3 years		6.5 years
Expected volatility		87	%	99	%

 

Note 5:                   EPS Reconciliation

 

		Three Months Ended February 28,				Nine Months Ended February 28,
		2006		2005		2006		2005
Weighted average shares (basic)		2,614,734		2,538,699		2,601,840		2,525,716
Effect of dilutive stock options		222,807		194,198		223,761		184,363
Weighted average shares (diluted)		2,837,541		2,732,897		2,825,601		2,710,079

 

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.

 

8

 

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.

 

In Fiscal 2005 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.  As a result, the valuation reserve for this asset was reduced as of May 31, 2005 to reflect the amount of the asset management expected to utilize in future fiscal periods.  At November 30, 2005 management concluded future operations would produce sufficient earnings so that additional portions of this asset could be used in future periods to reduce federal and state tax liabilities and the allowance was reduced by $281,000 to reflect the amount of the deferred tax asset management believes can be utilized in Fiscal 2006 and beyond.  This results in a net provision for income taxes of $33,543 for the nine months ended February 28, 2006.  The provision for income taxes is $64,500 for the three month period ended February 28, 2006.  Management believes the effective tax rate in future periods will reflect a normal combined state and federal rate.

 

Note 7:                   Segments of Business

 

Segment Information

 

		Three Months Ended February 28,
		2006						2005
		Balancer			Measurement			Balancer			Measurement
Gross sales		$	2,143,741		$	764,694		$	2,152,665		$	635,190
Intercompany sales		(178,746		)	(22,566		)	(215,553		)	(9,181		)
Net sales		$	1,964,995		$	742,128		$	1,937,112		$	626,009
Operating income		$	118,021		$	122,791		$	172,593		$	73,017
Intercompany rent expense (income)		$	(7,500	)	$	7,500		$	(7,500	)	$	7,500
Depreciation expense		$	34,657		$	8,771		$	34,681		$	11,505
Amortization expense		$	—		$	8,651		$	—		$	8,651
Capital expenditures		$	551		$	—		$	42,912		$	8,938

 

		Nine Months Ended February 28,
		2006						2005
		Balancer			Measurement			Balancer			Measurement
Gross sales		$	6,127,988		$	2,368,605		$	5,998,284		$	2,112,569
Intercompany sales		(451,816		)	(67,170		)	(614,455		)	(20,753		)
Net sales		$	5,676,172		$	2,301,435		$	5,383,829		$	2,091,816
Operating income		$	440,632		$	407,118		$	287,437		$	532,509
Intercompany rent expense (income)		$	(22,500	)	$	22,500		$	(22,500	)	$	(22,500	)
Depreciation expense		$	105,135		$	27,325		$	102,402		$	29,464
Amortization expense		$	—		$	25,952		$	—		$	25,952
Capital expenditures		$	36,945		$	60,697		$	101,368		$	17,263

 

9

 

Geographic Information

 

		Three Months Ended February 28,						Nine Months Ended February 28,
Geographic Sales		2006			2005			2006			2005
North American
United States		$	1,319,078		$	1,359,983		$	4,093,625		$	4,148,469
Canada and Mexico		82,181			44,162			136,445			130,549
North American total		1,401,259			1,404,145			4,230,070			4,279,018
European
Germany		115,961			159,731			277,328			419,209
Intercompany		(10,119		)	—			(10,293		)	—
Germany total		105,842			159,731			267,035			419,209
United Kingdom		273,168			354,062			756,562			994,646
Intercompany		(191,193		)	(224,734		)	(505,160		)	(635,208		)
United Kingdom total		81,975			129,328			251,402			359,438
Other European		334,251			314,745			748,889			837,047
Total European		522,068			603,804			1,267,326			1,615,694
Asia		559,713			432,441			1,718,079			1,301,916
Other markets		224,083			122,731			762,132			279,017
Total Net Sales		$	2,707,123		$	2,563,121		$	7,977,607		$	7,475,645

 

		Three Months Ended February 28,
		2006						2005
		United States			Europe			United States			Europe
Operating income (loss)		$	243,791		$	(2,979	)	$	279,795		$	(34,185	)
Depreciation expense		$	40,519		$	2,909		$	43,272		$	2,914
Amortization expense		$	8,651		$	—		$	8,651		$	—
Capital expenditures		$	—		$	551		$	46,862		$	4,988

 

		Nine Months Ended February 28,
		2006						2005
		United States			Europe			United States			Europe
Operating income (loss)		$	877,668		$	(29,918	)	$	926,289		$	(106,343	)
Depreciation expense		$	123,852		$	8,608		$	127,387		$	4,479
Amortization expense		$	25,952		$	—		$	25,952		$	—
Capital expenditures		$	94,845		$	2,797		$	113,643		$	4,988

 

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

 

10

 

Long-term Assets

 

		February 28, 2006			May 31, 2005
Segment:
Balancer		$	1,714,642		$	1,563,468
Measurement		503,147			495,728
Geographic:
United States		$	2,195,990		$	2,031,587
Europe		21,799			27,609

 

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 total $13,531 during the fiscal quarter ended February 28, 2006 and total $86,099 during the nine months ended February 28, 2006.

 

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.

 

11

 

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. Effective May 30, 2005 the Company has liquidated and dissolved the German Subsidiary, Schmitt Europa, GmbH.  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, 2005.  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 5.4% for the nine months ended February 28, 2006 compared to the nine months ended February 28, 2005.  Balancer sales for the three months ended February 28, 2006 increased 1.4% compared to the same fiscal quarter ended February 28, 2005.  Beginning in March 2004, improving economic conditions in North America resulted in increased sales in that geographic market.  Sales people, representatives and distributors throughout these geographic areas spend a large amount of time with targeted customers.  Many customers in the automotive, bearing and aircraft industries refer to improved economic conditions and its impact on the machine tool industry in North America as the reason for their increased orders, although the growth rate has slowed in the last three quarters.  While those customers are optimistic regarding short term demand for Balancer products, 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 2.2% in the nine months ended February 28, 2006 compared to the nine months ended February 28, 2005.  Market demand in Asia for the Balancer segment products remains strong with that region showing a 55.5% increase for the nine months ended February 28, 2006 compared to the nine months ended February 28, 2005.  The European market remains soft as total Balancer sales into that geographic market declined 32.9% during the nine months ended February 28, 2006 compared to the nine months ended February 28, 2005.  Sales in all Other markets increased to $678,230 in the nine months ended February 28, 2006 compared to the $210,564 for the nine months ended February 28, 2005, a 222% increase.  The large percentage increase was predominately a result of increases in the Japan and South American markets.  As with the North American market, the duration of the strong demand in Asia, Japan and South American 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 10% for the nine months ended February 28, 2006 compared to the nine months ended February 28, 2005.  Measurement sales for the three months ended February 28, 2006 increased 18.5% when compared to the same fiscal quarter ended February 28, 2005.  As noted below sales can be very cyclical in the Measurement segment.  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 – 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 $884,867 for the nine months ended February 28, 2006 compared to the $912,884 for the nine months ended February 28, 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 of these products were realized.

 

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Dimensional sizing products – These products are marketed and sold into a wide array of industries.  Sales totaled $1,416,568 for the nine months ended February 28, 2006 compared to the $1,178,932 for the nine months ended February 28, 2005.  In Fiscal 2004 Management built a sales distribution network covering all fifty states.  As a result of this action, the Company experienced increasing interest and sales in these products.  During the quarter ended August 31, 2003, Management consolidated the operations related to these products (which had been located in Menlo Park, California) into the Measurement segment operations in Portland, Oregon.  The relocation was completed as of August 31, 2003.   Since relocation to Portland, sales of these products were $1,763,307 and $1,023,278 in Fiscal 2005 and 2004, respectively.

 

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 February 28, 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 February 28, 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 at November 30, 2005, 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 February 28, 2006, management does not believe impairment, as defined above, exists.

 

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Recently issued accounting pronouncements:

 

The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 151, “Inventory Costs - an Amendment to ARB No. 43, Chapter 4” in November 2004.  This Statement requires that abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) costs be recognized as current-period charges.  In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities.  The Company does not expect this pronouncement to have a material impact on the financial statements.

 

The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3”.  This Statement replaces APB Opinion No. 20, “Accounting Changes”, and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting for and reporting of a change in accounting principle. This Statement applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed.  The Company does not expect this pronouncement to have a material impact on the financial statements.

 

The Financial Accounting Standards Board revised Statement of Financial Accounting Standards No. 123, “Share-Based Payment” in December 2004.  Under the revised standard, the Company will be required to recognize compensation cost, related to its stock options, beginning in the first fiscal quarter of the year beginning June 1, 2006.  The cost of services received from employees in exchange for awards of share-based compensation generally shall be measured based on the grant-date fair value of the equity instruments issued.  The Company expects the effect of this pronouncement to approximate the proforma amounts disclosed in Note 4 of the Notes to Consolidated Interim Financial Statements.

 

Discussion of operating results:

 

Three months ended February 28, 2006 and 2005:

 

		Three months ended February 28, 2006
		Consolidated					Balancer					Measurement
		Dollars			%		Dollars			%		Dollars			%
Sales		$	2,707,123		100.0		$	1,964,995		100.0		$	742,128		100.0
Cost of sales		1,293,476			47.8		1,000,603			50.9		292,873			39.5
Gross profit		1,413,647			52.2		$	964,392		49.1		$	449,255		60.5
Operating expenses		1,172,835			43.3
Operating income		$	240,812		8.9

 

		Three months ended February 28, 2005
		Consolidated					Balancer					Measurement
		Dollars			%		Dollars			%		Dollars			%
Sales		$	2,563,121		100.0		$	1,937,112		100.0		$	626,009		100.0
Cost of sales		1,097,387			42.8		847,084			43.7		250,303			40.0
Gross profit		1,465,734			57.2		$	1,090,028		56.3		$	375,706		60.0
Operating expenses		1,220,124			47.6
Operating income		$	245,610		9.6

 

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Worldwide sales of Balancer products increased 1.4% in the three month period ended February 28, 2006 when compared to the same period in the prior fiscal year as sales to the Asian and Other markets (including Japan and South America) increased by 50.4% and 107.5%, respectively.  These increases were offset by a decrease in the North American market of 5.3% and a continued decline in the European market, which decreased 24.4% 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 and Other markets is attributed to expansion of the sales efforts in China and other market regions.  The decreased units sold in Europe are attributed to strong competition and weaker economic conditions in certain European Balancer markets.

 

Measurement product sales increased by a combined 18.5% in the most current fiscal quarter when compared to the same period in the prior fiscal year as sales of the Company’s dimensional sizing products increased by 38.6% and surface measurement product sales decreased by 6.3%.  The Measurement segment’s largest market, North American, increased 13.1% in the three months ended February 28, 2006 compared to the three months ended February 28, 2005.  Market demand in Asia, the second largest geographic market for Measurement products, showed a 2% increase for the three months ended February 28, 2006 compared to the three months ended February 28, 2005.  The European market continued to report higher sales and showed a sales increase to $80,075 in the most current fiscal quarter when compared to the $19,406 sold in the same period in the prior fiscal year.  The sales increase in Europe is attributed to expansion of the sales efforts in the Measurement product segment. 

 

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 who receive pricing net of commissions and other sales costs.

 

Sales by the foreign subsidiary totaled $468,029 for the most recent quarter versus $565,890 for the same quarter last year.  Approximately 12.9% of the decrease is due to lower unit sales volumes with the remainder 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 February 28, 2006, net income was $197,776 ($.07 per fully diluted share) compared to net income of $252,629 ($.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 $64,500 for the three month period ended February 28, 2006 compared to the $6,000 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.

 

Nine months ended February 28, 2005 and 2004:

 

		Nine months ended February 28, 2006
		Consolidated					Balancer					Measurement
		Dollars			%		Dollars			%		Dollars			%
Sales		$	7,977,607		100.0		$	5,676,172		100.0		$	2,301,435		100.0
Cost of sales		3,630,222			45.5		2,758,516			48.6		871,706			37.9
Gross profit		4,347,385			54.5		$	2,917,656		51.4		$	1,429,729		62.1
Operating expenses		3,499,635			43.9
Operating income		$	847,750		10.6

 

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		Nine months ended February 28, 2005
		Consolidated					Balancer					Measurement
		Dollars			%		Dollars			%		Dollars			%
Sales		$	7,475,645		100.0		$	5,383,829		100.0		$	2,091,816		100.0
Cost of sales		3,170,129			42.4		2,471,556			45.9		698,573			33.4
Gross profit		4,305,516			57.6		$	2,912,273		54.1		$	1,393,243		66.6
Operating expenses		3,485,570			46.6
Operating income		$	819,946		11.0

 

Worldwide sales of Balancer products increased 5.4% in the nine months ended February 28, 2006 compared to the nine months ended February 28, 2005 as sales to the Asian markets increased by 55.5% offset by a decline in the North American market of 2.2%.  Sales in all Other markets increased to $678,230 in the nine months ended February 28, 2006 compared to the $210,564 for the nine months ended February 28, 2005, a 222% increase.  These increases were offset by decreases in the European market of 32.9%.  Unit sales prices of Balancer products are relatively stable 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 and Other markets is attributed to expansion of the sales efforts in China and other market regions.  The decreased units sold in Europe are attributed to strong European competition and weaker economic conditions in certain European markets.  The large percentage increase in Other markets was predominately a result of increases in the Japan and South American markets.

 

Measurement product sales increased 10% in the nine months ended February 28, 2006 compared to the nine months ended February 28, 2005 as sales of the Company’s dimensional sizing products increased by 20.2% offset by decreases in surface measurement products of 3.1%.  The sales of dimensional sizing products in the nine months ended February 28, 2006 compared to the nine months ended February 28, 2005 increased as they included more unit sales than in the same fiscal period in the prior year.

 

Cost of sales for both the Balancer and Measurement segments increased (as a percentage of sales) in the nine months ended February 28, 2006 compared to the nine months ended February 28, 2005 primarily due to the product sales mix as production labor and overhead costs were relatively stable.  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 who receive pricing net of commissions and other sales costs.

 

Sales by the foreign subsidiary totaled $1,352,414 for the nine months ended February 28, 2006 compared to sales of $1,564,096 in the nine months ended February 28, 2005.  Approximately 10.4% of the decrease is due to lower unit sales volumes with the remainder due to the changes in foreign exchange rates between the two fiscal periods.  The lower sales volumes were realized as a result of the soft sales in European markets, which were partially offset by increases in other markets primarily located in Asia and South America.

 

In the nine month period ended February 28, 2006, net income was $835,219 ($.30 per fully diluted share) compared to net income of $821,851 ($.30 per fully diluted share) for the same period last year.

 

LIQUIDITY AND CAPITAL RESOURCES

 

The Company’s ratio of current assets to current liabilities increased to 7.9 to 1 at February 28, 2006 compared to 6.5 to 1 at May 31, 2005.  Cash, cash equivalents and available for sale short term investments totaled $2,583,351 as of February 28, 2006 compared to $1,176,959 at May 31, 2005.  As of February 28, 2006 the Company had $1,107,411 in cash and cash equivalents compared to $1,176,959 at May 31, 2005.  As of February 28, 2006 the Company had $1,475,940 in short term investments compared to $-0- at May 31, 2005.   Short term investments consisted of highly liquid A1-P1 rated commercial paper securities maturing through July 2006.

 

During the nine months ended February 28, 2006, cash provided by operating activities amounted to $1,433,432 with the changes described as follows:

 

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