UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended: November 30, 2007

 

Or

 

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

 

For the transition period from:                To:

 

Commission File Number: 000-23996

 

SCHMITT INDUSTRIES, INC.

(Exact name of registrant as specified in its charter)

 

 

2765 NW Nicolai Street, Portland, Oregon 97210-1818

(Address of principal executive offices) (Zip Code)

 

(503) 227-7908

(Registrant’s telephone number, including area code)

 

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

Yes

x

No     o

 

 

Indicate by check mark whether the registrant is a large 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   x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

 

The number of shares of each class of common stock outstanding as of January 15, 2008

Common stock, no par value

2,670,183

 

 

SCHMITT INDUSTRIES, INC.

 

INDEX TO FORM 10-Q

 

Part I - FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Balance Sheets: –    November 30, 2007 and May 31, 2007 (unaudited)
	Consolidated Statements of Operations: –    For the Three and Six Months Ended November 30, 2007 and 2006 (unaudited)
	Consolidated Statements of Cash Flows: –    For the Six Months Ended November 30, 2007 and 2006 (unaudited)
	Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income: –    For the Six Months Ended November 30, 2007 (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
Signatures
Certifications

 

2

 

PART I - FINANCIAL INFORMATION

 

Item 1.    Financial Statements

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

 

		November 30, 2007			May 31, 2007
ASSETS
Current assets
Cash and cash equivalents		$	2,263,306		$	1,513,061
Short-term investments		3,478,100			3,964,650
Accounts receivable, net of allowance of $25,865 and $20,818 at November 30, 2007 and May 31, 2007, respectively		1,533,061			1,461,511
Inventories		3,664,311			3,690,363
Prepaid expenses		59,647			71,331
Income taxes receivable		51,380			—
Deferred tax asset		138,875			144,957
		11,188,680			10,845,873
Property and equipment
Land		299,000			299,000
Buildings and improvements		1,348,080			1,336,181
Furniture, fixtures and equipment		839,982			826,380
Vehicles		95,848			97,955
		2,582,910			2,559,516
Less accumulated depreciation and amortization		(1,328,284		)	(1,333,738		)
		1,254,626			1,225,778
Other assets
Long-term deferred tax asset		566,180			32,780
Other assets		586,094			373,797
		1,152,274			406,577
TOTAL ASSETS		$	13,595,580		$	12,478,228
LIABILITIES & STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable		$	459,977		$	343,152
Accrued commissions		271,371			225,782
Accrued payroll liabilities		78,356			83,365
Other accrued liabilities		282,208			319,289
Income taxes payable		—			142,108
Total current liabilities		1,091,912			1,113,696
Other long term liabilities		602,217			—
Stockholders’ equity
Common stock, no par value, 20,000,000 shares authorized, 2,670,183 and 2,664,419 shares issued and outstanding at November 30, 2007 and May 31, 2007, respectively		8,152,835			8,114,251
Accumulated other comprehensive loss		(107,433		)	(122,050		)
Retained earnings		3,856,049			3,372,331
Total stockholders’ equity		11,901,451			11,364,532
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	13,595,580		$	12,478,228

 

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

 

3

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND SIX MONTHS ENDED NOVEMBER 30, 2007 AND 2006

(UNAUDITED)

 

		Three Months Ended November 30,						Six Months Ended November 30,
		2007			2006			2007			2006
Net sales		$	3,110,921		$	2,961,176		$	5,449,926		$	6,070,690
Cost of sales		1,421,593			1,319,244			2,525,233			2,830,467
Gross profit		1,689,328			1,641,932			2,924,693			3,240,223
Operating expenses:
General, administration and sales		1,222,955			1,295,480			2,199,791			2,407,242
Research and development		189,802			18,240			235,194			39,449
Total operating expenses		1,412,757			1,313,720			2,434,985			2,446,691
Operating income		276,571			328,212			489,708			793,532
Other income		60,768			45,973			133,546			86,245
Income before income taxes		337,339			374,185			623,254			879,777
Provision for income taxes		72,500			103,000			174,000			338,000
Net income		$	264,839		$	271,185		$	449,254		$	541,777
Net income per common share:
Basic		$	0.10		$	0.10		$	0.17		$	0.20
Diluted		$	0.10		$	0.10		$	0.16		$	0.20

 

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

 

4

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE SIX MONTHS ENDED NOVEMBER 30, 2007 AND 2006

(UNAUDITED)

 

		Six Months Ended November 30,
		2007			2006
Cash flows relating to operating activities
Net income		$	449,254		$	541,777
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		92,421			104,463
Loss on disposal of property and equipment		703			8,813
Deferred taxes		(17,145		)	190,970
Stock based compensation		15,305			26,918
Tax benefit related to stock options		10,175			8,739
Excess tax benefit from stock based compensation		(10,202		)
Other, net		6,962			—
(Increase) decrease in:
Accounts receivable		(59,304		)	409,557
Inventories		30,126			(68,979		)
Prepaid expenses		12,042			24,962
Income taxes receivable		(51,380		)	—
Increase (decrease) in:
Accounts payable		113,944			176,366
Accrued liabilities and customer deposits		692			(113,885		)
Income taxes payable		(22,562		)	(4,407		)
Net cash provided by operating activities		571,031			1,305,294
Cash flows relating to investing activities
Purchase of short-term investments		(6,013,450		)	(4,491,807		)
Maturities of short-term investments		6,500,000			3,000,000
Purchase of property and equipment		(104,591		)	(47,379		)
Proceeds from sale of property and equipment		100			—
Advances and payments on business being acquired		(229,576		)	—
Net cash provided (used) in investing activities		152,483			(1,539,186		)
Cash flows relating to financing activities
Repayments on long-term obligations		—			(9,648		)
Common stock issued on exercise of stock options		13,104			61,041
Excess tax benefit from stock based compensation		10,202			—
Net cash provided by financing activities		23,306			51,393
Effect of foreign exchange translation on cash		3,425			70,757
Increase (decrease) in cash and cash equivalents		750,245			(111,742		)
Cash and cash equivalents, beginning of period		1,513,061			1,552,072
Cash and cash equivalents, end of period		$	2,263,306		$	1,440,330
Supplemental Disclosure of Cash Flow Information
Cash paid during the period for interest		$	—		$	206
Cash paid during the period for income taxes		$	248,200		$	143,028

 

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

 

5

 

SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

AND COMPREHENSIVE INCOME

FOR THE SIX MONTHS ENDED NOVEMBER 30, 2007

(UNAUDITED)

 

							Accumulated
							other									Total
							comprehensive			Retained						comprehensive
		Shares		Amount			loss			earnings			Total			income
Balance, May 31, 2007		2,664,419		$	8,114,251		$	(122,050	)	$	3,372,331		$	11,364,532
Adoption of FIN 48										34,464			34,464
Stock options exercised and related tax benefit of $10,175		5,764		23,279			—			—			23,279
Stock based compensation				15,305			—						15,305
Net income		—		—			—			449,254			449,254			$	449,254
Other comprehensive income		—		—			14,617			—			14,617			14,617
Balance, November 30, 2007		2,670,183		$	8,152,835		$	(107,433	)	$	3,856,049		$	11,901,451
Comprehensive income, six months ended November 30, 2007																$	463,871

 

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

 

6

 

SCHMITT INDUSTRIES, INC.

NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS

 

Note 1:

 

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

The consolidated financial information included herein has been prepared by Schmitt Industries, Inc. (the Company or Schmitt) 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 November 30, 2007 and its results of operations and its cash flows for the three and six months ended November 30, 2007 and 2006. The consolidated balance sheet at May 31, 2007 has been derived from the Annual Report on Form 10-K for the fiscal year ended May 31, 2007. 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, 2007. 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, 2008. 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.

 

Revenue Recognition and Accounts Receivable

 

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured. 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. Substantially all product sales are sold FCA (free carrier) shipping point and any related shipping and handling costs are expensed as incurred and included in cost of sales.

 

Recent Issued Accounting Pronouncements

 

The Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) in June 2006. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in our financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes” (SFAS 109). Additionally, in May 2007, the FASB published FASB Staff Position No. FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48” (FSP FIN 48-1). FSP FIN 48-1 is an amendment to FIN 48. It clarifies how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. FSP FIN 48-1 is effective upon the initial adoption of FIN 48. The provisions of FIN 48 are effective for our fiscal year beginning June 1, 2007. The adoption of FIN 48 did not have a material impact on the Company’s results of operations and cash flows. Refer to Note 5 of the Notes to Consolidated Interim Financial Statements for discussion of the impact of adoption of FIN 48.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for the fiscal year beginning June 1, 2008. The Company is currently evaluating the impact of the provisions of SFAS 157.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities including an Amendment of FASB Statement No. 115” (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The provisions of SFAS 159 are effective for the fiscal year beginning June 1, 2008. The Company is currently evaluating the impact of the provisions of SFAS 159.

 

Note 2:

 

LINE OF CREDIT

 

The Company has a $1.0 million bank line of credit secured by U.S. accounts receivable, inventories and general intangibles which expires on March 1, 2009. Interest is payable at the bank’s prime rate, 7.5% as of November 30, 2007. There were no outstanding balances on the line of credit at November 30, 2007.

 

7

 

Note 3:

 

STOCK OPTIONS AND STOCK-BASED COMPENSATION

 

Stock-based compensation includes expense charges for all stock-based awards to employees and directors granted under the Company’s stock option plan. Stock-based compensation recognized during the period is based on the value of the portion of the stock-based award that will vest during the period, adjusted for expected forfeitures. Compensation cost for all stock-based awards is recognized using the straight-line method. Stock-based compensation recognized in the Company’s Consolidated Financial Statements for the three and six months ended November 30, 2007 includes compensation cost for stock-based awards granted prior to, but not fully vested as of, May 31, 2006. There were no stock-based awards granted subsequent to May 31, 2006. The Company uses the Black-Scholes option pricing model as its method of valuation for stock-based awards. The Black-Scholes option pricing model requires the input of highly subjective assumptions, and other reasonable assumptions could provide differing results. These variables include, but are not limited to:

 

•                  Risk-Free Interest Rate. The Company bases the risk-free interest rate on the implied yield currently available on U.S. Treasury issues with an equivalent remaining term approximately equal to the expected life of the award.

•                  Expected Life. The expected life of awards granted represents the period of time that they are expected to be outstanding. The Company determines the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules and pre-vesting and post-vesting forfeitures.

•                  Expected Volatility. The Company estimates the volatility of its common stock at the date of grant based on the historical volatility of its common stock. The volatility factor the Company uses is based on its historical stock prices over the most recent period commensurate with the estimated expected life of the award. These historical periods may exclude portions of time when unusual transactions occurred.

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

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

 

The Company has computed, to determine stock-based compensation expense recognized for the three and six months ended November 30, 2007 and 2006, the value of all stock options granted using the Black-Scholes option pricing model using the following assumptions:

 

 

At November 30, 2007 the Company had a total of 170,109 outstanding stock options (163,859 vested and exercisable and 6,250 non-vested) with a weighted average exercise price of $2.58. The Company estimates that a total of approximately $15,000 will be recorded as additional stock-based compensation expense over the period beginning with the quarter ending February 29, 2008 through the fiscal year ending May 31, 2008, for all options which are outstanding as of November 30, 2007, but which were not yet vested.

 

8

 

 

Options granted, exercised, canceled and expired under the Company’s stock option plan during the three and six months ended November 30, 2007 are summarized as follows:

 

		Three Months Ended November 30, 2007					Six Months Ended November 30, 2007
		Number of Shares		Weighted Average Exercise Price			Number of Shares		Weighted Average Exercise Price
Options outstanding - beginning of period		171,359		$	2.58		175,873		$	2.57
Options granted		—					—
Options exercised		(1,250	)	2.30			(5,764	)	2.27
Options forfeited/cancelled		—					—
Options outstanding - November 30, 2007		170,109		$	2.58		170,109		$	2.58

 

Note 4:

 

EPS RECONCILIATION

 

		Three Months Ended November 30,				Six Months Ended November 30,
		2007		2006		2007		2006
Weighted average shares (basic)		2,669,180		2,647,245		2,668,528		2,642,468
Effect of dilutive stock options		107,636		193,045		114,419		198,020
Weighted average shares (diluted)		2,776,816		2,840,290		2,782,947		2,840,488

 

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

 

Note 5:

 

INCOME TAXES

 

The Company accounts for income taxes using the asset and liability method. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. Deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

 

9

 

Adoption of FIN 48

 

Each year the company files income tax returns in the various national, state and local income taxing jurisdictions in which it operates. These tax returns are subject to examination and possible challenge by the taxing authorities. Positions challenged by the taxing authorities may be settled or appealed by the Company. As a result, there is an uncertainty in income taxes recognized in the Company’s financial statements in accordance with SFAS No. 109. In 2006, the FASB issued FIN 48, which clarifies the application of SFAS 109 by defining criteria that an individual income tax position must meet for any part of the benefit of that position to be recognized in an enterprise’s financial statements and provides guidance on measurement, derecognition, classification, accounting for interest and penalties, accounting in interim periods, disclosure, and transition.

 

On June 1, 2007, the Company adopted the provisions of FIN 48. The adoption of FIN 48 resulted in a $34,464 decrease in the Company’s liability for unrecognized tax benefits, which was accounted for as an increase to the June 1, 2007 retained earnings balance. At June 1, 2007 the gross amount of unrecognized tax benefits was approximately $586,000, which includes approximately $150,000 of net unrecognized tax benefits that, if recognized, would reduce the Company’s effective income tax rate. Unrecognized tax benefits did not change significantly during the three or six month periods ended November 30, 2007.

 

Interest and penalties associated with uncertain tax positions are recognized as components of the “Provision for income taxes.”  The Company’s accrual for interest and penalties was $96,500 upon adoption of FIN 48. The liability for payment of interest and penalties did not significantly change during the three or six months ended November 30, 2007.

 

Several tax years are subject to examination by major tax jurisdictions. In the United States, federal tax years for Fiscal 2004 and after are subject to examination. In the United Kingdom, tax years for Fiscal 2006 and after are subject to examination. In the United States, returns related to an acquired subsidiary for the year ending October 31, 1994 and final return for the period ending May 19, 1995 are also subject to examination.

 

Our effective tax rate on consolidated net income was 27.9% for the six months ended November 30, 2007. Our effective tax rate on consolidated net income differs from the federal statutory tax rate primarily due to certain expenses not deductible for income tax reporting offset by lower effective tax rates on net income reported by the Company’s wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom. Management believes the effective tax rate on consolidated net income in future periods will reflect a normal combined state and federal rate, net of the effect from expenses not deductible for income tax reporting and net income or losses reported by SEL.

 

Note 6:

 

SEGMENTS OF BUSINESS

 

The Company has two reportable business segments: the design and assembly of dynamic balancing systems for the machine tool industry (Balancer), and the design and assembly of laser measurement systems (Measurement). The Company operates in three principal geographic markets: North America, Europe and Asia.

 

10

 

Segment Information

 

		Three Months Ended November 30,
		2007						2006
		Balancer			Measurement			Balancer			Measurement
Gross sales		$	2,482,498		$	799,193		$	2,054,749		$	1,149,530
Intercompany sales		(155,333		)	(15,437		)	(156,545		)	(86,558		)
Net sales		$	2,327,165		$	783,756		$	1,898,204		$	1,062,972
Operating income		$	325,306		$	(48,735	)	$	6,579		$	321,633
Intercompany rent expense (income)		$	—		$	—		$	(7,500	)	$	7,500
Depreciation expense		$	31,259		$	7,276		$	35,798		$	7,349
Amortization expense		$	—		$	8,640		$	—		$	8,652
Advances and payments on business being acquired		$	229,576		$	—		$	—		$	—
Capital expenditures		$	73,001		$	20,626		$	20,815		$	18,610

 

		Six Months Ended November 30,
		2007						2006
		Balancer			Measurement			Balancer			Measurement
Gross sales		$	4,457,128		$	1,311,523		$	4,301,345		$	2,150,510
Intercompany sales		(299,770		)	(18,955		)	(286,084		)	(95,081		)
Net sales		$	4,157,358		$	1,292,568		$	4,015,261		$	2,055,429
Operating income		$	603,365		$	(113,657	)	$	111,991		$	681,541
Intercompany rent expense (income)		$	—		$	—		$	(15,000	)	$	15,000
Depreciation expense		$	61,086		$	14,056		$	72,434		$	14,725
Amortization expense		$	—		$	17,279		$	—		$	17,304
Advances and payments on business being acquired		$	229,576		$	—		$	—		$	—
Capital expenditures		$	76,467		$	28,024		$	28,769		$	18,610

 

11

 

Geographic Information-Net Sales by Geographic Area

 

		Three Months Ended November 30,						Six Months Ended November 30,
Geographic Sales		2007			2006			2007			2006
North American
United States		$	1,564,418		$	1,445,953		$	2,767,059		$	3,018,284
Canada and Mexico		118,350			14,712			203,180			121,191
Total North American		1,682,768			1,460,665			2,970,239			3,139,475
European
Germany		58,716			82,461			152,774			144,527
United Kingdom		315,336			357,932			582,142			602,085
Intercompany		(170,770		)	(243,103		)	(318,725		)	(381,165		)
Total United Kingdom		144,566			114,829			263,417			220,920
Other European		248,558			575,252			401,820			786,432
Total European		451,840			772,542			818,011			1,151,879
Asia		744,097			585,466			1,336,653			1,336,470
Other markets		232,216			142,503			325,023			442,866
Total Net Sales		$	3,110,921		$	2,961,176		$	5,449,926		$	6,070,690

 

		Three Months Ended November 30,
		2007						2006
		United States			Europe			United States			Europe
Operating income (loss)		$	158,316		$	118,255		$	289,921		$	38,291
Depreciation expense		$	36,560		$	1,975		$	40,306		$	2,841
Amortization expense		$	8,640		$	—		$	8,652		$	—
Advances and payments on business being acquired		$	229,576		$	—		$	—		$	—
Capital expenditures		$	93,627		$	—		$	39,110		$	315

 

		Six Months Ended November 30,
		2007						2006
		United States			Europe			United States			Europe
Operating income (loss)		$	316,175		$	173,533		$	863,557		$	(70,025	)
Depreciation expense		$	71,221		$	3,921		$	81,437		$	5,722
Amortization expense		$	17,279		$	—		$	17,304		$	—
Advances and payments on business being acquired		$	229,576		$	—		$	—		$	—
Capital expenditures		$	104,491		$	—		$	46,510		$	869

 

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

 

12

 

Segment and Geographic Assets

 

		November 30, 2007			May 31, 2007
Segment assets to total assets
Balancer		$	4,733,548		$	5,030,049
Measurement		1,999,979			1,792,731
Corporate assets		6,863,037			5,655,448
Total assets		$	13,596,564		$	12,478,228
Geographic assets to total assets
United States		$	13,058,739		$	11,819,905
Europe		537,825			658,323
Total assets		$	13,596,564		$	12,478,228

 

Note 7:

 

RELATED PARTY TRANSACTIONS

 

Effective June 1, 2004, the Company entered into a contract to provide consulting services to PulverDryer USA, Inc. (PulverDryer), pursuant to which PulverDryer paid the Company $8,000 a month from June 2004 through October 2004. PulverDryer also buys certain products from the Company at normal prevailing rates. The Company and PulverDryer extended the contract from November 1, 2004 forward at that same monthly fee of $8,000. Product sales to PulverDryer during the three months ended November 30, 2007 and 2006 totaled $150 and $7,945, respectively. Product sales to PulverDryer during the six months ended November 30, 2007 and 2006 totaled $3,828 and $19,523, respectively.

 

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

 

Note 8:

 

SUBSEQUENT EVENT

 

The Company entered into a convertible promissory note agreement with Xtero Datacom, Inc. (Xtero) of Vancouver, British Columbia in February 2007 pursuant to which the Company agreed to loan up to $250,000 USD to Xtero to fund product development and testing of Xtero satellite measurement technologies. On October 5, 2007 Xtero and the Company announced the completion of an Interim Acquisition Agreement (Interim Agreement) to acquire Xtero pursuant to which the Company agreed to advance an additional $250,000 to Xtero, pay royalties of 15% to 25% to Xtero for product sales until closing and issue 200,000 shares of Schmitt common stock in exchange for 100% of Xtero at closing. Pursuant to the Interim Acquisition Agreement, Xtero has granted the Company an exclusive license for the Xtero technology, so that the Company can begin necessary production and marketing prior to closing of the Transaction described below. As of November 30, 2007, the Company had advanced $500,000 to Xtero, which funds have been used for patent work and other corporate product development and testing activities, and legal fees incurred by Xtero in connection with the structuring and negotiation of the Transaction. The Company has also reimbursed $89,055 of expenses incurred by or on behalf of Xtero since October 1, 2007, including operational expenses and consulting fees.

 

On December 14, 2007, the Company entered into an Arrangement Agreement with Xtero pursuant to which the Company, through its newly formed wholly owned subsidiary, Schmitt Industries (Canada) Limited, a British Columbia corporation (SCL), will acquire all of the issued and outstanding common shares of Xtero (the Transaction). The Arrangement Agreement was entered into in furtherance of the purposes of the Interim Agreement among Schmitt, Xtero and certain of Xtero’s shareholders. Upon closing of the Transaction, Xtero will become a wholly owned subsidiary of the Company and Schmitt will own and operate Xtero’s business, including its patented technologies. In addition, Xtero shareholders will be eligible to receive shares of SCL stock which are exchangeable for shares of Schmitt common stock on a one-for-one basis based on the after-tax earnings derived from Xtero products during a five-year earn-out program ending on May 31, 2013. The Transaction is subject to various conditions, including approval by Xtero shareholders, approval by a British Columbia court and other customary closing conditions, and is expected to close by the end of January 2008.

 

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

 

Schmitt Industries, Inc. designs, assembles and markets computer controlled balancing equipment (the Balancer Segment) primarily to the machine tool industry. Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc. (SMS), the Company designs, manufactures and markets precision laser measurement systems (the Measurement Segment). The Company also sells and markets its products in Europe through its wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom. The accompanying unaudited financial information should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended May 31, 2007. 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 3.5% for the six months ended November 30, 2007 compared to the six months ended November 30, 2006. Balancer sales for the three months ended November 30, 2007 increased 22.6% compared to the three months ended November 30, 2006. North American sales increased 11.8% in the six months ended November 30, 2007 and increased 38.8% in the three months ended November 30, 2007 when compared to the same periods ending November 30, 2006. Market demand in Asia for the Balancer segment products remains solid as that region showed a 9.4% increase for the six months ended November 30, 2007 and increased 33.7% in the three months ended November 30, 2007 when compared to the same periods ending November 30, 2006. The North American and Asian sales increase is predominately the result of a recovery from softer Balancer sales during the last fiscal year from recent weakness in the worldwide automotive, bearing and aircraft industries and its impact on the machine tool industry. Recent weakness in industrial production toward the end of 2006 especially in the motor vehicle sector, has caused production in other manufacturing industries to soften. These economic conditions in the worldwide automotive, bearing and aircraft industries and its impact on the machine tool industry were the reason for softer Balancer sales during the prior fiscal year. European market sales slowed as total Balancer sales into that geographic market decreased (12%) during the six months ended November 30, 2007 compared to the six months ended November 30, 2006 and have decreased (14.2%) during the most recent three month period ended November 30, 2007 when compared to the same periods ending November 30, 2006. Sales in all Other markets decreased (26.1%) in the six months ended November 30, 2007 and increased 9.2% for the three months ended November 30, 2007 when compared to the same periods ending November 30, 2006. As with the North American market, the business conditions in Asia and the European market cannot be forecasted with any certainty.

 

The Measurement segment product line consists of both laser light-scatter and dimensional sizing products. Combined Measurement sales decreased (37.1%) for the six months ended November 30, 2007 compared to the six months ended November 30, 2006. Measurement sales for the three months ended November 30, 2007 decreased (26.3%) compared to the three months ended November 30, 2006. The decreased sales volume is primarily due to lack of complete system shipments of laser light-scatter products to disk drive manufacturers and reduced dimensional sizing product sales as well as reduced CASI Scatterometer sales. 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. Sales to these customers totaled $374,222 for the six months ended November 30, 2007 compared to the $783,046 for the six months ended November 30, 2006. Due to the significant challenges posed by the need to continually innovate and improve manufacturing efficiency and because of the increasing amounts of capital and research and development expenditure required, the disc drive industry has undergone significant consolidation as disc drive manufacturers and component suppliers merged or exited the industry. Through such combinations, disc drive manufacturers have also become increasingly vertically integrated. Sales to customers in these industries can be very cyclical and therefore the impact of the current weak demand in the disk drive industry on sales to the Company’s laser light-scatter products is unknown at this time and cannot be forecasted with any certainty.

 

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Laser light-scatter products for research organizations – The Company continues to receive inquiries for these products and provide quotes to interested parties. The Company completed the delivery of CASI Scatterometer software and other upgrades in the current fiscal quarter and expects to deliver a new CASI Scatterometer system in the third fiscal quarter of 2008. Measurement sales during the six months and three months ended November 30, 2006 included the delivery of a new CASI Scatterometer system.

 

Dimensional sizing products – These products are marketed and sold into a wide array of industries and used in applications from steel casting, paper production, crane control and medical imaging to micron level part and surface inspection. Sales decreased (16.9%) for the six months ended November 30, 2007 and decreased (19.5%) for the three months ended November 30, 2007 when compared to the same periods ending November 30, 2006. Sales of these products can be cyclical and therefore the duration of the continued demand cannot be forecasted with any certainty.

 

The Company entered into certain agreements (Transaction) with Xtero Datacom, Inc. (Xtero) of Vancouver, British Columbia beginning in February 2007 pursuant to which the Company will acquire all of the issued and outstanding common shares of Xtero. Upon closing of the Transaction, Xtero will become a wholly owned subsidiary of Schmitt and Schmitt will own and operate Xtero’s business, including its patented technologies for remote satellite sensing of large chemical storage tanks. The Transaction is subject to various conditions, including approval by Xtero shareholders, approval by a British Columbia court and other customary closing conditions, and is expected to close by the end of January 2008. Refer to Note 8 of the Notes to Consolidated Interim Financial Statements for further discussion of the Transaction.

 

Critical Accounting Policies

 

With the adoption of FIN 48 as of June 1, 2007, the Company has added “Uncertain Tax Positions” as a critical accounting policy. There are no other material changes in our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended May 31, 2007.

 

Uncertain Tax Positions – The Company accounts for uncertain tax positions in accordance with FIN 48. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. As such, the Company is required to make many subjective assumptions and judgments regarding income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time, accordingly, changes in the Company’s subjective assumptions and judgments can materially affect amounts recognized in the consolidated balance sheets and consolidated statements of operations. Refer to Note 5 of the Notes to Consolidated Interim Financial Statements for discussion of the impact of adoption of FIN 48.

 

Recently issued accounting pronouncements:

 

Refer to Note 1 of the Notes to Consolidated Interim Financial Statements for discussion of recently issued accounting pronouncements.

 

Discussion of Operating Results

 

Three months ended November 30, 2007 and 2006

 

		Three Months Ended November 30, 2007
		Consolidated					Balancer					Measurement
		Dollars			%		Dollars			%		Dollars			%
Sales		$	3,110,921		100.0		$	2,327,165		100.0		$	783,756		100.0
Cost of sales		1,421,593			45.7		1,116,262			48.0		305,331			39.0
Gross profit		1,689,328			54.3		$	1,210,903		52.0		$	478,425		61.0
Operating expenses		1,412,757			45.4
Operating income		$	276,571		8.9

 

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		Three Months Ended November 30, 2006
		Consolidated					Balancer					Measurement
		Dollars			%		Dollars			%		Dollars			%
Sales		$	2,961,176		100.0		$	1,898,204		100.0		$	1,062,972		100.0
Cost of sales		1,319,244			44.6		899,290			47.4		419,954			39.5
Gross profit		1,641,932			55.4		$	998,914		52.6		$	643,018		60.5
Operating expenses		1,313,720			44.4
Operating income		$	328,212		11.0

 

Worldwide sales of Balancer products increased 22.6% in the three month period ended November 30, 2007 when compared to the same period in the prior fiscal year as sales to the North American and Asian markets increased by 38.8% and 33.7%, respectively. These increases were offset by a decrease in the European markets which decreased (14.2%) in the most current fiscal quarter when compared to the same period in the prior fiscal year. Sales in Other markets of $143,684 in the three month period ended November 30, 2007 also increased 9.2% 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 North American and Asian sales increase is predominately the result of a recovery from softer Balancer sales during the last fiscal year from recent weakness in the worldwide automotive, bearing and aircraft industries and its impact on the machine tool industry. The Balancer product sales increase in Asia is also attributed to the continued expansion of the sales efforts in China. The European market remains soft when compared to longer term historical results due to strong competition and weaker economic conditions in certain European Balancer markets.

 

Measurement product sales decreased by a combined (26.3%) in the most current fiscal quarter when compared to the same period in the prior fiscal year due to sales of dimensional sizing products decreasing (19.5%), surface measurement products increasing 4% and the sale of a CASI Scatterometer in last year’s second fiscal quarter with no comparable sale this year. The Measurement segment’s largest market, North America, decreased (17.3%) in the three months ended November 30, 2007 compared to the three months ended November 30, 2006. Market demand in Asia, historically the second largest geographic market for Measurement products, showed a 2.8% increase for the three months ended November 30, 2007 compared to the three months ended November 30, 2006. The European market reported a sales decrease to $55,970 in the most current fiscal quarter when compared to the $310,986 sold in the same period in the prior fiscal year. The sales decrease in Europe is attributed to the decline of CASI Scatterometer sales noted above.

 

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. Cost of sales for the Measurement segment decreased slightly (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.

 

Sales by SEL totaled $519,703 for the most recent quarter versus $787,250 for the same quarter last year. Approximately 38.5% of the decrease is due to lower unit sales volumes offset by a 4.5% increase due to the changes in foreign exchange rates between the two fiscal periods. The lower sales volumes were realized primarily due to the sale of a CASI Scatterometer in last year’s second fiscal quarter with no comparable sale this year.

 

In the three month period ended November 30, 2007, net income was $264,839 ($.10 per fully diluted share) compared to net income of $271,185 ($.10 per fully diluted share) for the same period last year. Net income was negatively impacted primarily by higher research and development expenditures involving technologies related to the Xtero Transaction offset by a lower income tax provision for the three month period ended November 30, 2007 compared to the same period last year.

 

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