STARRETT L S CO - Annual Report: 2005 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(check one)

For the fiscal year ended June 25, 2005

OR

For the transition period from              to             

Commission File No. 1-367

THE L.S. STARRETT COMPANY

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code 978-249-3551

Securities registered pursuant to Section 12(b) of the Act:

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 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  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    Yes  ¨    No  x

Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

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

The Registrant had 5,416,591 and 1,230,177 shares, respectively, of its $1.00 par value Class A and B common stock outstanding on December 25, 2004. On that date, the aggregate market value of the common stock held by nonaffiliates was approximately $116,000,000.

The exhibit index is located on page 39.

Documents incorporated by reference

Definitive Proxy Statement for October 12, 2005 Annual Meeting

Table of Contents

PART I

Item 1 - Business

The Company was founded in 1880 and incorporated in 1929 and is engaged in the business of manufacturing industrial, professional, and consumer products. The total number of different items made and sold by the Company exceeds 5,000. Among the items produced are precision tools, electronic gages, dial indicators, gage blocks, granite surface plates, vision systems, optical measuring projectors, tape measures, levels, chalk products, squares, band saw blades, hole saws, hacksaw blades, jig saw blades, reciprocating saw blades, M1^® lubricant, and precision ground flat stock and drill rod. Much of the Company’s production is concentrated in hand measuring tools (such as micrometers, steel rules, combination squares and many other items for the individual craftsman and other markets) and precision instruments (such as vernier calipers, height gages, depth gages and measuring instruments that manufacturing companies buy for the use of their employees).

These tools and instruments are sold throughout the United States and Canada and over 100 foreign countries, primarily to distributors. By far the largest consumer of these products is the metalworking industry, but other important consumers are automotive, aviation, marine and farm equipment shops, do-it-yourselfers and tradesmen such as builders, carpenters, plumbers and electricians. One retailer, Sears, accounted for approximately 11% of the Company’s sales in fiscal 2005, and the Company’s top two customers accounted for approximately 17% of sales. The Company ended its relationship with W.W. Grainger, a significant customer, during fiscal 2005. The effect this will have on total Company sales and profits is unknown since much of the Grainger business is expected to be picked up by other Company distributors, although no such assurances can be made.

Most of the Company’s products are made from steel purchased from steel mills. Forgings, castings, and a few small finished parts are purchased from other manufacturers. Raw materials have always been readily available to the Company and, in most cases, the Company does not rely on sole sources. In the event of unavailability of purchased materials, the Company would be adversely affected, as would its competitors. Similarly, the ability of the Company to pass along raw material price increases is dependent on the competitive situation and cannot be assured.

At June 25, 2005, the Company had 2,219 employees, approximately 54% of whom were domestic. This represents an increase from June 26, 2004 of 169 employees primarily due to the initiation of operations in the Dominican Republic and additional capacity in Brazil. None of the Company’s operations are subject to collective bargaining agreements. In general, the Company considers its relations with its employees to be excellent. Because of various stock ownership plans, Company domestic personnel hold a large share of Company stock and the Company believes that this dual role of owner-employee has been good for morale over the years.

The Company is one of the largest producers of mechanics’ hand measuring tools and precision instruments. In the United States, there are three other major companies and numerous small competitors in the field, including direct foreign competitors. As a result, the industry is highly competitive. During the fiscal year ended June 25, 2005, there were no material changes in the Company’s competitive position. However, during recent years, the Company’s revenues have been negatively affected by the general migration of manufacturing to low cost production areas, such as China, where the Company does not have a substantial market presence. In addition, margins on the Company’s consumer products, such as tape measures and levels, are under constant pressure due to the increasing market dominance of the large national

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home and hardware retailers. The Company is currently responding to such competition by expanding its manufacturing and distribution in China and developing a low cost manufacturing site in the Dominican Republic.

In saws and precision ground flat stock in the United States, the Company competes with many manufacturers. The Company competes principally through the high quality of its products and the service it provides its customers. The market for most of the Company’s products is subject to economic conditions affecting the industrial manufacturing sector, including capital spending by industrial companies.

The operations of the Company’s foreign subsidiaries are consolidated in its financial statements. The subsidiaries located in Brazil, Scotland, and China are actively engaged in the manufacture and distribution of hacksaw and band saw blades and a limited line of precision tools and measuring tapes. Subsidiaries in Australia, Mexico and Germany are engaged in distribution of the Company’s products. During fiscal 2005, the Company completed the establishment of manufacturing operations in the Dominican Republic, primarily for its Evans division. The Company expects its foreign subsidiaries to continue to play a significant role in its overall operations. A summary of the Company’s foreign operations is contained in the footnotes to the Company’s fiscal 2005 financial statements under the caption “OPERATING DATA” found in Item 8 of this Form 10-K.

The Company generally fills orders from finished goods inventories on hand. Sales order backlog of the Company at any point in time is negligible. Total inventories amounted to $57.0 million at June 25, 2005 and $43.3 at June 26, 2004. The Company uses the last-in, first-out (LIFO) method of valuing most domestic inventories (approximately 57% of all inventories). LIFO inventory amounts reported in the financial statements are approximately $21.8 and $20.1 million, respectively, lower than if determined on a first-in, first-out (FIFO) basis at June 25, 2005 and June 26, 2004.

When appropriate, the Company applies for patent protection on new inventions and presently owns a number of patents. Its patents are considered important in the operation of the business, but no single patent is of material importance when viewed from the standpoint of its overall business. The Company relies on its continuing product research and development efforts, with less dependence on its present patent position. It has for many years maintained engineers and supporting personnel engaged in research, product development, and related activities. The expenditures for these activities during fiscal years 2005, 2004 and 2003 were approximately $3.3 million, $3.0 million, and $2.9 million, respectively, all of which was expensed in the Company’s financial statements.

The Company uses trademarks with respect to its products. All of its important trademarks are registered.

Compliance with federal, state and local provisions that have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to protection of the environment is not expected to have a material effect on the capital expenditures, earnings and competitive position of the Company. Specifically, the Company has taken steps to reduce and control water discharges and air emissions.

Where To Find More Information

The Company makes its public filings with the Securities and Exchange Commission (“SEC”), including its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all exhibits and amendments to these reports, available free of charge at its website, www.starrett.com, as soon as reasonably practicable after the Company files such material with the SEC. Information contained on the Company’s website is not part of this report.

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Item 2 - Properties

The Company’s principal plant is located in Athol, Massachusetts on about 15 acres of Company-owned land. The plant consists of 25 buildings, mostly of brick construction of varying dates, with approximately 535,000 square feet of production and storage area.

The Webber Gage Division, Cleveland, Ohio, owns and occupies two buildings totaling approximately 50,000 square feet.

The Company-owned facility in Mt. Airy, North Carolina consists of two buildings totaling approximately 356,000 square feet. It is occupied by the Company’s Saw Division, Granite Surface Plate Division, Metrology Systems Division, and Ground Flat Stock Division.

The Company’s Evans Rule Division, located in North Charleston, South Carolina, owns and occupies a 173,000 square foot building. In addition, this division owns 11,000 square feet and leases 35,000 square feet of manufacturing space in Mayaguez, Puerto Rico, which the Company will vacate before the lease expires on December 31, 2005. This facility is being replaced by a 50,000 square foot leased facility in Santo Domingo, Dominican Republic.

The Company’s Exact Level Division has relocated to a 27,000 square foot facility in the Dominican Republic adjacent to the Evans facility. Its 50,000 square foot building located in Alum Bank, Pennsylvania is currently for sale.

The Company’s subsidiary in Itu, Brazil owns and occupies several buildings totaling 209,000 square feet. The Company’s subsidiary in Jedburgh, Scotland owns and occupies a 175,000 square foot building. Its wholly owned subsidiary, which manufactures optical measuring projectors and was previously located in Skipton, England, was consolidated into the Jedburgh plant during fiscal 2004. Its 33,000 square foot building in Skipton was sold during fiscal 2005. Two wholly owned subsidiaries in the Shanghai area of the People’s Republic of China lease approximately 41,000 square feet and 5,000 square feet.

In addition, the Company operates warehouses and/or sales-support offices in Arizona, Georgia, Canada, Australia, Mexico, Germany, Japan, and Argentina. The warehouse in Elmhurst, Illinois was sold during fiscal 2005.

In the Company’s opinion, all of its property, plant and equipment is in good operating condition, well maintained and adequate for its needs.

Item 3 - Legal Proceedings

As discussed in greater detail in the Company’s annual report of Form 10-K for the fiscal year ended June 26, 2004, the Company reached a settlement in August 2004 with the U.S. Department of Justice resulting in the termination of the government’s investigation of the Company’s CMM division. Under the terms of the settlement, the Company paid the government $.5 million, and the Company and its officers, directors, employees and shareholders were released from any causes of action relating to the false claims allegations in the complaint that were the subject of the investigation. The Company sold the assets of its CMM division to a third party in June 2005 for $1.5 million.

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The Company is, in the ordinary course of business, from time to time involved in other litigation that is not considered material to its financial condition or operations.

Item 4 - Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended June 25, 2005.

PART II

Item 5 - Market for the Registrant’s Common Equity and Related Stockholder Matters

The Company’s Class A common stock is traded on the New York Stock Exchange. Quarterly dividend and high/low closing market price information is presented in the table below. The Company’s Class B common stock is generally nontransferable, except to lineal descendants, and thus has no established trading market, but it can be converted into Class A common stock at any time. The Class B common stock was issued on October 5, 1988, and the Company has paid the same dividends thereon as have been paid on the Class A common stock since that date. On June 25, 2005, there were 1,871 registered holders of Class A common stock and 1,520 registered holders of Class B common stock.

Summary of Stock Repurchases:

A summary of the Company’s repurchases of shares of its common stock for the three months ended June 25, 2005 is as follows:

ISSUER PURCHASES OF EQUITY SECURITIES

The 15,000 shares were purchased from the 401(K) plan and the 1,663 shares were purchased from an individual.

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Item 6 - Selected Financial Data

Items 7 and 7A- Management’s Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosure about Market Risk

RESULTS OF OPERATIONS

2005 versus 2004

Overview As more fully discussed below, for fiscal 2005 the Company realized net income of $4.0 million, or $.61 per basic and diluted share compared to a net loss of $2.4 million or $.35 per basic and diluted share for fiscal 2004. Fiscal 2005 includes the after tax gains on the sale of the Elmhurst, Illinois distribution facility, on the sale of the assets of the CMM division and the sale of the Skipton plant of $1.0 million ($.16 per share), $.5 million ($.07 per share) and $.7 million ($.10 per share), respectively. A significant portion of the loss for fiscal 2004, $2.9 million after tax or $.43 per share, was caused by charges incurred in connection with the government’s investigation of the CMM division and related matters discussed in more detail below. Fiscal 2004 also contains $.6 million after tax ($.09 per share) of relocation and closure expenses relating to the Skipton, England and Alum Bank, Pennsylvania manufacturing facilities, offset by a LIFO inventory liquidation benefit of $1.0 million after tax ($.15 per share). For purposes of better understanding the results from the Company’s manufacturing and distribution operations, management reviews results excluding all these unusual items. Without these unusual items the Company had pro forma net income (non-GAAP) in fiscal 2005 of $1.9 million, or $.28 per share, compared to pro forma net income (non-GAAP) of $.2 million, or $.02 per share, for fiscal 2004. See table below under Net Income (Loss) per share regarding disclosure of non-GAAP information.

Sales Sales for fiscal 2005 increased 9% compared to fiscal 2004. Foreign sales were up 28% (25% in local currency), while domestic sales were essentially flat for the year. The increase in foreign sales is largely attributable to the strong performance of our Brazilian operations in the South American markets. Foreign sales were also favorably impacted by the strengthening of the U.S. dollar during fiscal 2005. Domestic sales finished flat for the year, despite the full year’s impact of the loss of the Grainger business, previously one of the Company’s three largest customers. The impact, if any, of the loss of the Grainger business is difficult to estimate as customers who had previously purchased the Company’s products through Grainger have the ability to purchase our products through other distributors.

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Income (Loss) before income taxes and cumulative effect of change in accounting principle Pretax income for fiscal year 2005 was $5.2 million versus a pretax loss for fiscal year 2004 of $4.9 million. Both periods contain unusual items. In fiscal 2005, the pretax income of $5.2 million includes the gain on the sale of the Elmhurst, Illinois distribution facility, the gain on the sale of the assets of the CMM division and the gain on the sale of the Skipton plant of $1.5 million, $.6 million and $.7 million, respectively. Excluding these gains, the Company had pretax income of $2.4 million in fiscal 2005. Fiscal year 2004 includes $3.2 million to write down the CMM inventory to net realizable value and $1.4 million for settlement expenses and additional professional fees in connection with concluding the government investigation of the CMM Division in August 2004; in addition, the Company incurred $1.0 million in fiscal 2004 for severance, training, and relocation/closure expenses related to its Skipton, England and Alum Bank, Pennsylvania manufacturing facilities. Excluding the CMM division charges and the relocation expenses in 2004, the Company had pretax income of $.7 million in fiscal 2004. Therefore, the improvement of fiscal 2005 pro forma income before income taxes over fiscal 2004 is $1.7 million. The major item causing this improvement is better gross margins (27.4% compared to 26.4%, excluding the unusual items discussed above). The gross margin improvement of 1.0% is due primarily to lower headcount, higher production levels and associated increase in overhead absorption offset by higher material costs, the redundant personnel and occupancy costs associated with the transfer of manufacturing operations to the Dominican Republic, and the benefit of a LIFO inventory liquidation of $1.6 million in fiscal 2004. The overall margin improvement was partially offset by an overall increase in selling, general, and administrative costs of $3.1 million, which includes a $1.2 million increase in professional fees related to Sarbanes–Oxley compliance.

Income Taxes The effective income tax rate was 23% for fiscal 2005 and 52% for 2004. In fiscal 2005 Puerto Rico tax incentives, and somewhat lower foreign income tax rates all contribute to an overall effective tax rate that is normally slightly lower than the combined U.S. state and federal rate of approximately 38%. The fiscal 2005 rate was also impacted by an adjustment to the net deferred tax balances, resulting from a revision to the estimated combined state rate, an increase in the valuation allowance for certain foreign loss carryforwards which are not likely to be realized. This was offset by a reduction in the tax reserves as a result of the close out of certain examination years. Because of the loss in fiscal 2004, the rates are relatively high compared to our normal rate of about 35% because the least profitable operations are located in the jurisdictions with the highest tax rates.

Net Income (Loss) per share The following table summarizes the after tax effect of the sales in fiscal 2005 and the CMM investigation, plant relocations, and LIFO inventory liquidation benefits in fiscal 2004:

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The above table is designed to provide the reader with further information regarding certain significant events and provides a resultant pro forma net income amount which is not intended to be in accordance with generally accepted accounting principles. Management uses the above table to better understand the income generated from its core business and operations as described under Item 1 – Business. Although management believes the items above to be unusual, there is no assurance that similar items will not occur in the future.

RESULTS OF OPERATIONS

2004 versus 2003

Overview As more fully discussed below, for fiscal 2004 the Company incurred a net loss of $2.4 million, or $.35 per basic and diluted share, compared to a net loss of $10.6 million, or $1.60 per basic and diluted share, for 2003. A significant portion of the losses in both years was caused by the charges incurred in connection with the government’s investigation of the CMM division and related matters discussed in more detail below: in 2004, $2.9 million after tax or $.43 per share; and in 2003, $2.3 million or $.35 per share. Fiscal 2003 also included the writeoff of $6.1 million of goodwill (as discussed in the notes to the financial statements), or $.92 per share before and after tax; and fiscal 2004 contains $.6 million after tax ($.09 per share) of relocation and closure expenses related to the Skipton, England and Alum Bank, Pennsylvania manufacturing facilities. These charges were offset by LIFO inventory liquidation benefits of $1.0 million and $.6 million after tax in fiscal 2004 and fiscal 2003 ($.15 and $.09 per share, respectively). For purposes of better understanding the results from the Company’s manufacturing and distribution operations, management reviews results excluding all unusual items. Excluding all these unusual charges, the Company had pro forma net income (non-GAAP) in 2004 of $.2 million, or $.02 per share, compared to a pro forma net loss of $2.8 million, or $.42 per share in 2003. See table below under Net Income (Loss) per share regarding disclosure of non-GAAP information.

Sales Sales for fiscal 2004 increased 2% compared to 2003. Domestic sales were down 2% and foreign sales were up 12%. In local currency, foreign sales were down 2%, because the U.S. dollar has been weakening. Although domestic sales were down for the full year comparison, the quarter to quarter trend was up in fiscal 2004 whereas the trend was down in fiscal 2003. Domestic sales in the last six months of fiscal 2004 were 10% higher than in the last six months of fiscal 2003, reflecting improvement in the U.S. industrial manufacturing sector.

Loss before taxes and cumulative effect of change in accounting principle Excluding the effect in 2003 of the change in accounting principle mentioned above, the pretax losses for 2004 and 2003 were $4.9 million and $8.1 million, respectively. Both periods contain unusual charges related to the CMM division: in fiscal 2004, $3.2 million to write down the CMM inventory to net realizable value and $1.4 million for settlement expenses and additional professional fees in connection with concluding the government investigation of the CMM division (see below); and, in fiscal 2003, $3.7 million in connection with the government investigation of the CMM division ($2.1 million of this was charged to selling and general expense and $1.6 million to cost of sales). In addition, the Company incurred $1.0 million in fiscal 2004 for severance, training, and relocation/closure expenses related to its Skipton, England and Alum Bank, Pennsylvania manufacturing facilities. Excluding the CMM division charges in both years and the relocation expenses in 2004, the Company had pretax income of $.7 million in fiscal 2004 and a pretax loss of $4.4 million in fiscal 2003, a $5.1 million improvement.

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The major items causing the $5.1 million improvement were lower ($.6 million) exchange losses, primarily in Brazil, and better gross margins (26.4% compared to 22.9% or $6.3 million excluding the unusual charges as discussed above). The gross margin improvement of over 3 percentage points was due primarily to lower headcount, higher domestic production levels and associated increase in overhead absorption, and LIFO inventory liquidation benefits of $1.6 million in fiscal 2004 compared to $.9 million in fiscal 2003. These items were partially offset by higher interest expense ($.3 million) in Brazil due to borrowing in local currency and an overall $2.4 million increase in selling and general expense (excluding the expense of the government investigation) caused primarily by the effect of the weakening U.S. dollar on the translation of expenses into U.S. dollars in Scotland and Brazil. Also contributing to this $2.4 million increase in selling and general expense were higher domestic fringe benefit and insurance costs, mainly retirement.

Income Taxes The effective income tax rate was 52% for fiscal 2004 and 44% for 2003. Puerto Rico tax incentives, and somewhat lower foreign income tax rates all contribute to an overall effective tax rate that is normally slightly lower than the combined U.S. state and federal rate of approximately 38%. The large change in effective rate comes about because pretax results are close enough to breakeven in both years that permanent book/tax differences and jurisdictional tax rate differentials have an exaggerated effect when converted to percentages. Because of losses, the rates are relatively high compared to the Company’s historic rate of about 35% because the least profitable operations are located in the jurisdictions with the highest tax rates.

Net Income (Loss) per share The following table summarizes the after tax effect of the goodwill writeoff, the CMM investigation, plant relocations, and LIFO inventory liquidation benefits:

The above table is designed to provide the reader with further information regarding certain significant events and provides a resultant pro forma net income amount which is not intended to be in accordance with generally accepted accounting principles. Management uses the above table to better understand the income generated from its core business and operations as described under Item 1 –Business. Although management believes the items above to be unusual, there is no assurance that such items will not occur in the near future.

Coordinate Measuring Machine (CMM) division

As discussed in greater detail in the Company’s annual report of Form 10-K for the fiscal year ended June 26, 2004, the Company reached a settlement in August 2004 with the U.S. Department of Justice resulting in the termination of the government’s investigation of the Company’s CMM division. Under the terms of the settlement, the Company paid the government $.5 million, and the Company and its officers, directors, employees and shareholders were released

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from any causes of action relating to the false claims allegations in the complaint that were the subject of the investigation. No costs related to the investigation or the CMM replacement program were recorded in fiscal 2005. The Company sold the assets of its CMM division to a third party in June 2005 for $1.5 million.

As a result of the government investigation and the CMM replacement program initiated prior thereto in March 2002, the Company recorded reserves and charged pretax operations with $3.7 million ($.35 per share after tax) in fiscal 2003 and $1.4 million in fiscal 2004. In addition, the Company charged cost of sales and wrote down the carrying cost of its CMM inventory by $3.2 million to net realizable value in the December 2003 quarter of fiscal 2004.

Financial instrument market risk

Market risk is the potential change in a financial instrument’s value caused by fluctuations in interest and currency exchange rates, and equity and commodity prices. The Company’s operating activities expose it to risks that are continually monitored, evaluated, and managed. Proper management of these risks helps reduce the likelihood of earnings volatility. At June 2005 and 2004, the Company was not a party to any derivative arrangement and the Company does not engage in trading, market-making or other speculative activities in the derivatives markets. The Company does not enter into long-term supply contracts with either fixed prices or quantities. The Company does not engage in regular hedging activities to minimize the impact of foreign currency fluctuations. Net foreign monetary assets are approximately $4 million.

A 10% change in interest rates would not have a significant impact on the aggregate net fair value of the Company’s interest rate sensitive financial instruments (primarily variable rate investments of $26.3 million and debt of $3.7 million at June 25, 2005) or the cash flows or future earnings associated with those financial instruments. A 10% change in interest rates would impact the fair value of the Company’s fixed rate investments of approximately $2.3 million by $28,000.

LIQUIDITY AND CAPITAL RESOURCES

Despite operating losses in 2004 and 2003, including the significant costs associated with the government’s investigation of the CMM division, cash provided by operations has been positive in all periods presented. By far the biggest factor contributing to this has been the reduction in inventories that began in mid-fiscal 2002, and had its most dramatic effect in fiscal 2003. However, during fiscal 2005 inventories increased as a result of plant start-ups in the Dominican Republic and additional Brazilian capacity, and as a hedge against raw material price increases. This is the primary cause of the reduction in cash provided by operations. This was offset by a reduction in receivables. “Retirement benefits” under noncash expenses in the detailed cash flow statement shows the effect on operating cash flow of the Company’s pension and retiree medical plans. Primarily because the Company’s domestic defined benefit plan is overfunded, retirement benefits in total are currently

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generating approximately $1.4 million of noncash income in fiscal 2005 ($.8 and $2.2 million in 2004 and 2003, respectively). Retirement benefit expense (income) was approximately $(.6) million in 2005, $.7 million in 2004 and $(.4) million in 2003.

The Company’s investing activities consist of expenditures for plant and equipment, the investment of cash not immediately needed for operations and the proceeds from the sale of Company assets. Expenditures for plant and equipment have increased over each of the three years, although they are less than depreciation expense in each of those years. The proceeds from the sale of real estate and CMM business relate to the three asset sales discussed in Results of Operations above.

Cash flows from financing activities are primarily the payment of dividends. The proceeds from the sale of stock under the various stock plans has historically been used to purchase treasury shares, although in recent years such purchases have been curtailed. Overall debt has been reduced from $5.8 million at the end of 2003 to $3.7 million at the end of 2005.

Liquidity and credit arrangements

The Company believes it maintains sufficient liquidity and has the resources to fund its operations in the near term. If the Company is unable to return to consistent profitability, additional steps will have to be taken in order to maintain liquidity, including plant consolidations and further workforce and dividend reductions (see Reorganization Plans below). The Company maintains a $15 million line of credit, of which, as of June 25, 2005, $890,000 is being utilized in the form of standby letters of credit for insurance purposes. Although the credit line is not currently collateralized, it is possible, based on the Company’s financial performance, that in the future the Company will have to provide collateral in order to maintain the credit agreement. The Company has a working capital ratio of 5.2 to one as of June 25, 2005 and 5.4 to one as of June 26, 2004.

REORGANIZATION PLANS

The continued migration of manufacturing to low wage countries has adversely affected the Company’s customer base and competitive position, particularly in North America. As a result, the Company has been rethinking almost all aspects of its business and is formulating plans to lower wage costs, consolidate operations, move its strategic focus from manufacturing location to product group and distribution channel, as well as to achieving the goals of enhanced marketing focus and global procurement. During fiscal 2004, the Company consolidated its Skipton, England optical comparator manufacturing into its manufacturing facility in Jedburgh, Scotland. The cost of this move, including severance costs, was approximately $800,000, which was partially offset by a $662,000 gain on the sale of the real estate reported during the first quarter of fiscal 2005. The Company is trying to sell its Alum Bank, Pennsylvania level manufacturing plant and has relocated the manufacturing to the Dominican Republic, where production began in fiscal 2005. The tape measure production of the Evans division facilities in Puerto Rico and Charleston, South Carolina will also be transferred to the Dominican Republic at an adjacent site. The Company’s goal is to achieve labor savings and maintain margins while satisfying the demands of its customers for lower prices. The Company has closed three warehouses, the most recent being the Elmhurst facility, which was sold during the fourth quarter of fiscal 2005. It has also consolidated its Gardner, Massachusetts product development facility into the Company’s Athol, Massachusetts facility during fiscal 2005. The Company also sold the assets of its CMM division to a third party in fiscal 2005.

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OFF-BALANCE SHEET ARRANGEMENTS

The Company does not have any material off-balance sheet arrangements as defined under the Securities and Exchange Commission rules.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. The first footnote to these financial statements describes the significant accounting policies and methods used in the preparation of the consolidated financial statements.

Judgments, assumptions, and estimates are used for, but not limited to, the allowance for doubtful accounts receivable and returned goods; inventory allowances; income tax reserves; employee turnover, discount, and return rates used to calculate pension obligations; normal expense accruals for such things as workers compensation and employee medical expenses; and of particular importance in fiscal 2003 and 2004 the previously discussed charges connected with the now concluded government investigation of the CMM division.

The allowance for doubtful accounts and sales returns of $1.1 million and $1.4 million at the end of fiscal 2005 and 2004, respectively, is based on our assessment of the collectibility of specific customer accounts, the aging of our accounts receivable and trends in product returns. While the Company believes that the allowance for doubtful accounts and sales returns is adequate, if there is a deterioration of a major customer’s credit worthiness, actual defaults are higher than our previous experience, or actual future returns do not reflect historical trends, the estimates of the recoverability of the amounts due the Company and sales could be adversely affected.

Inventory purchases and commitments are based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and requirements, the Company may be required to increase the inventory reserve and, as a result, gross profit margin could be adversely affected.

The Company generally values Property, Plant and Equipment (PP&E) at historical cost less accumulated depreciation. Impairment losses are recorded when indicators of impairment, such as plant closures, are present and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount. The Company continually reviews for such impairment and believes that PP&E is being carried at its appropriate value.

Accounting for income taxes requires estimates of future tax liabilities. Due to temporary differences in the timing of recognition of items included in income for accounting and tax purposes, deferred tax assets or liabilities are recorded to reflect the impact arising from these differences on future tax payments. With respect to recorded tax assets, the Company assesses the likelihood that the asset will be realized. If realization is in doubt because of uncertainty regarding future profitability or enacted tax rates, the Company provides a valuation allowance related to the asset. Should any significant changes in the tax law or the estimate of the necessary valuation allowance occur, the Company would record the impact of the change, which could have a material effect on our financial position or results of operations.

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Pension and postretirement medical costs and obligations are dependent on assumptions used by actuaries in calculating such amounts. These assumptions include discount rates, healthcare cost trends, inflation, salary growth, long-term return on plan assets, employee turnover rates, retirement rates, mortality and other factors. These assumptions are made based on a combination of external market factors, actual historical experience, long-term trend analysis, and an analysis of the assumptions being used by other companies with similar plans. Actual results that differ from assumptions are accumulated and amortized over future periods. Significant differences in actual experience or significant changes in assumptions would affect pension and other postretirement benefit costs and obligations. See also Employee Benefit Plans (footnote 6).

CONTRACTUAL OBLIGATIONS

The following table summarizes future estimated payment obligations by period. The majority of the obligations represent commitments for production needs in the normal course of business.

It is assumed that certain items would continue on an annual basis after year 5. One year of payment has been included in the greater than 5 years column for disclosure purposes. Total future payments cannot be reasonably estimated beyond year 5.

ANNUAL NYSE CEO CERTIFICATION AND SARBANES-OXLEY SECTION 302 CERTIFICATIONS

In fiscal 2005, the Company submitted an unqualified “Annual CEO Certification” to the New York Stock Exchange as required by Section 303A.12(a) of the New York Stock Exchange Listed Company Manual. Further, the Company has filed with the Securities And Exchange Commission the certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 as exhibits to the Company’s Annual Report on Form 10-K.

SAFE HARBOR STATEMENT

UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This Annual Report on Form 10-K and the Company’s 2005 Annual Report to Stockholders, including the President’s letter, contains forward-looking statements about the Company’s business, competition, sales, expenditures, foreign operations, plans for reorganization, interest rate sensitivity, debt service, liquidity and capital resources, and other operating and capital requirements. In addition, forward-looking statements may be included in future Company documents and in oral statements by Company representatives to security analysts and investors. The Company is subject to risks that could cause actual events to vary materially from such forward-looking statements, including the following risk factors:

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Risks Related to Reorganization: The Company continues to evaluate plans to consolidate and reorganize some of its manufacturing and distribution operations. There can be no assurance that the Company will be successful in these efforts or that any consolidation or reorganization will result in revenue increases or cost savings to the Company. The implementation of these reorganization measures may disrupt the Company’s manufacturing and distribution activities, could adversely affect operations, and could result in asset impairment charges and other costs that will be recognized if and when reorganization or restructuring plans are implemented or obligations are incurred. If the Company is unable to maintain consistent profitability, additional steps will have to be taken, including further plant consolidations and workforce and dividend reductions.

Risks Related to Technology: Although the Company’s strategy includes investment in research and development of new and innovative products to meet technology advances, there can be no assurance that the Company will be successful in competing against new technologies developed by competitors.

Risks Related to Foreign Operations: Approximately 40% of the Company’s sales and 20% of net assets relate to foreign operations. Foreign operations are subject to special risks that can materially affect the sales, profits, cash flows, and financial position of the Company, including taxes and other restrictions on distributions and payments, currency exchange rate fluctuations, political and economic instability, inflation, minimum capital requirements, and exchange controls. In particular, the Company’s Brazilian operations, which constitute over half of the Company’s revenues from foreign operations, can be very volatile, changing from year to year due to the political situation and economy. As a result, the future performance of the Brazilian operations is inherently unpredictable.

Risks Related to Industrial Manufacturing Sector: The market for most of the Company’s products is subject to economic conditions affecting the industrial manufacturing sector, including the level of capital spending by industrial companies and the general movement of manufacturing to low cost foreign countries where the Company does not have a substantial market presence. Accordingly, economic weakness in the industrial manufacturing sector may, and in some cases has, resulted in decreased demand for certain of the Company’s products, which adversely affects performance. Economic weakness in the consumer market will also adversely impact the Company’s performance. In the event that demand for any of the Company’s products declines significantly, the Company could be required to recognize certain costs as well as asset impairment charges on long-lived assets related to those products.

Risks Related to Shifts in Manufacturing: The Company’s primary customers are in the manufacturing business and, in particular, in the metal working industry. Manufacturing is shifting to low wage countries where the Company does not have a substantial market presence. As a result, unless the Company can penetrate these markets, the Company’s sales and performance may be adversely affected.

Risks Related to Competition: The Company’s business is subject to direct and indirect competition from both domestic and foreign firms. In particular, low-wage foreign sources have created severe competitive pricing pressures. Under certain circumstances, including significant changes in U.S. and foreign currency relationships, such pricing pressures tend to reduce unit sales and/or adversely affect the Company’s margins.

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Risks Related to Customer Concentration: Sales to the Company’s two biggest customers accounted for approximately 17% of revenues in fiscal 2005. The Company has ended its relationship with W.W.Grainger, which was previously one of the three largest customers, during fiscal 2005. The loss or reduction in orders by any of the remaining customers, including reductions due to market, economic or competitive conditions, or the failure of the Company to replace the Grainger sales could adversely affect business and results of operations. Indeed, the Company’s major customers have, and may continue to, place pressure on the Company to reduce its prices. This pricing pressure may affect the Company’s margins and revenues and could adversely affect business and results of operations.

Risks Related to Insurance Coverage: The Company carries liability, property damage, workers’ compensation, medical, and other insurance coverages that management considers adequate for the protection of its assets and operations. There can be no assurance, however, that the coverage limits of such policies will be adequate to cover all claims and losses. Such uncovered claims and losses could have a material adverse effect on the Company. The Company self-insures for health benefits and retains risk in the form of deductibles and sublimits. Depending on the risk, deductibles can be as high as 5% of the loss or $500,000.

Risks Related to Raw Material and Energy Costs: Steel is the principal raw material used in the manufacture of the Company’s products. The price of steel has historically fluctuated on a cyclical basis and has often depended on a variety of factors over which the Company has no control. During fiscal 2005, the cost of steel rose approximately 10%. Because of competitive pressures, the Company generally has not been able to pass on these increases to the customer resulting in reduction to the gross margins. The cost of producing the Company’s products is also sensitive to the price of energy. The selling prices of the Company’s products have not always increased in response to raw material, energy or other cost increases, and the Company is unable to determine to what extent, if any, it will be able to pass future cost increases through to its customers. The Company’s inability to pass increased costs through to its customers could materially and adversely affect its financial condition or results of operations.

Risks Related to Stock Market Performance: Although the Company’s domestic defined benefit pension plan is significantly overfunded, a significant (over 30%) drop in the stock market, even if short in duration, could cause the plan to become temporarily underfunded and require the temporary reclassification of prepaid pension cost on the balance sheet from an asset to a contra equity account, thus reducing stockholders’ equity and book value per share.

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Item 8 - Financial Statements and Supplementary Data

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

The L.S. Starrett Company

We have audited the accompanying consolidated balance sheets of The L.S. Starrett Company and subsidiaries (the “Company”) as of June 25, 2005 and June 26, 2004, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three fiscal years in the period ended June 25, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of June 25, 2005 and June 26, 2004, and the results of its operations and its cash flows for each of the three fiscal years in the period ended June 25, 2005, in conformity with accounting principles generally accepted in the United States of America.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of June 25, 2005, based on Internal Control–Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated September 8, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting.

As more fully described in the notes to the financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142 during the year ended June 28, 2003.

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THE L.S. STARRETT COMPANY

Consolidated Statements of Operations

For the years ended in June (in thousands of dollars except per share data)

See notes to consolidated financial statements

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THE L. S. STARRETT COMPANY

Consolidated Statements of Cash Flows

For the years ended in June (in thousands of dollars)

See notes to consolidated financial statements

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THE L.S. STARRETT COMPANY

Consolidated Balance Sheets

(in thousands except share data)

See notes to consolidated financial statements

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THE L.S. STARRETT COMPANY

Consolidated Statements of Stockholders’ Equity

For the years ended in June, 2003 through 2005

(in thousands)