STARRETT L S CO - Annual Report: 2006 (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 24, 2006

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 if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No   x

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 amendment to this Form 10-K.     x

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

Large Accelerated Filer  ¨    Accelerated Filer  x    Non-Accelerated Filer  ¨

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

The Registrant had 5,586,892 and 1,076,300 shares, respectively, of its $1.00 par value Class A and B common stock outstanding on December 24, 2005. On that date, the aggregate market value of the common stock held by nonaffiliates was approximately $116,000,000.

There were 5,673,894 and 1,000,535 shares, respectively, of the Registrant’s $1.00 par value Class A and Class B common stock outstanding as of September 20, 2006.

The exhibit index is located on page 50.

Documents incorporated by reference

Portions of the Proxy Statement for October 11, 2006 Annual Meeting (Part III)

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). During fiscal 2006, the Company developed wireless data collection solutions as part of its new product development efforts.

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. The Company’s top two customers accounted for approximately 14% of sales during fiscal 2006. 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 has been picked up by other Company distributors during fiscal 2005 and 2006.

On April 28, 2006, the Company acquired the assets of Tru-Stone Technologies Inc. (Tru-Stone). This represents a strategic acquisition for the Company in that it provides an enhancement of the Company’s granite surface plate capabilities. This acquisition provides access to high-end metrology which serves the electronics and flat panel display industries. In addition, profit margins for our standard surface plate business are expected to improve as the Company’s existing granite surface plate facility is consolidated into Tru-Stone where average gross margins have been higher.

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 24, 2006, the Company had 2,129 employees, approximately 54% of whom were domestic. This represents a net decrease from June 25, 2005 of 90 employees. The decreased employment is primarily due to work force reductions in Charleston, S.C. and Brazil and the plant closing in Puerto Rico. These decreases were offset by the addition of 93 Tru-Stone employees. 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.

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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 24, 2006, 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 home and hardware retailers. The Company is currently responding to such competition by expanding its manufacturing and distribution in China and has developed 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 blades, band saw blades, hole saws and a limited line of precision tools and measuring tapes. Subsidiaries in Canada, 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 Note 12 to the Company’s fiscal 2006 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 $56.0 million at June 24, 2006 and $57.0 million at June 25, 2005. The Company uses the last-in, first-out (LIFO) method of valuing most domestic inventories (approximately 62% of all inventories). LIFO inventory amounts reported in the financial statements are approximately $24.0 million and $21.8 million, respectively, lower than if determined on a first-in, first-out (FIFO) basis at June 24, 2006 and June 25, 2005.

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 2006, 2005 and 2004 were approximately $2.9 million, $3.3 million and $3.0 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

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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 Annual Report Form 10-K.

Item 1A – Risk Factors

SAFE HARBOR STATEMENT

UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This Annual Report on Form 10-K and the Company’s 2006 Annual Report to Stockholders, including the President’s letter, contains forward-looking statements about the Company’s business, competition, sales, gross margins, 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:

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. This has occurred with the Company’s move to the Dominican Republic from South Carolina. Indeed, the relocation, restructuring and closure of our Evans Rule Division’s Charleston, South Carolina facility and start up of that Division’s Dominican Republic operations was a factor contributing to the Company’s fiscal 2006 loss. 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

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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 may be difficult to forecast.

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 sales and 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 Competition: The Company’s business is subject to direct and indirect competition from both domestic and foreign firms. In particular, low cost 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.

Risks Related to Customer Concentration: Sales to the Company’s top two customers accounted for approximately 14% of revenues in fiscal 2006. The Company ended its relationship with W.W. Grainger, which was previously one of the three largest customers, during fiscal 2005. Sears sales and unit volume has decreased significantly during fiscal 2006. This situation is problematic and if the Sears brands (i.e., Craftsman) we support are no longer viable, this would have a negative effect on the Company’s financial performance. The further loss or reduction in orders by Sears or any of the Company’s remaining large customers, including reductions due to market, economic or competitive conditions could adversely affect business and results of operations. Moreover, 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. 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 2006, the cost of steel rose approximately 5%. 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.

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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. There would also be a similar risk for the Company’s underfunded UK plan.

Risks Related to Acquisitions: Acquisitions, such as our acquisition of Tru-Stone in fiscal 2006, involve special risks, including, the potential assumption of unanticipated liabilities and contingencies, difficulty in assimilating the operations and personnel of the acquired businesses, disruption of the Company’s existing business, dissipation of the Company’s limited management resources, and impairment of relationships with employees and customers of the acquired business as a result of changes in ownership and management. While the Company believes that strategic acquisitions can improve its competitiveness and profitability, these activities could have an adverse effect on the Company’s business, financial condition and operating results.

Item 1B – Unresolved Staff Comments

None.

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, Ground Flat Stock Division and a distribution center. As previously noted, the Granite Surface Plate Division is currently being consolidated into Tru-Stone.

The Company’s Evans Rule Division, located in North Charleston, South Carolina, owns and occupies a 173,000 square foot building, which was shut down during fiscal 2006 and its operations moved to a new 50,000 square foot facility in the Dominican Republic. During fiscal 2006 the division also vacated its manufacturing space in Mayaquez, Puerto Rico and moved its operations to our new 50,000 square foot leased facility in Santo Domingo, Dominican Republic. The Company plans on selling the North Charleston facility in the near future.

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 was sold on September 21, 2006.

The Company’s subsidiary in Itu, Brazil owns and occupies several buildings totaling 209,000 square feet. The Company’s subsidiary in Jedburgh, Scotland

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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. A band saw weld center operating in Sheffield, England was closed in fiscal 2005. Two wholly owned subsidiaries in Suzhou and Shanghai of the People’s Republic of China lease approximately 41,000 square feet and 5,000 square feet, respectively.

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

A warehouse in Glendale, Arizona encompassing 35,000 square feet was closed in fiscal 2006 and the building is being held for sale.

With the acquisition of Tru-Stone in fiscal 2006, the Company added a 90,000 square facility in Waite Park, Minnesota.

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

The Company is, in the ordinary course of business, from time to time involved in 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 24, 2006.

PART II

Item 5 - Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

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 24, 2006, there were approximately 1,900 registered holders of Class A common stock and approximately 5,100 registered holders of Class B common stock.

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Summary of Stock Repurchases:

A summary of the Company’s repurchases of shares of its common stock for the three months ended June 24, 2006 is as follows:

ISSUER PURCHASES OF EQUITY SECURITIES

The 5,000 shares were purchased on the open market.

Item 6 - Selected Financial Data

Note that the significant increase in long-term debt is related to the Tru-Stone acquisition. See Note 3 to the Consolidated Financial Statements.

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

2006 versus 2005

Overview For fiscal 2006, the Company incurred a net loss of $3.8 million or ($.57) per basic and diluted share compared to a realization of net income of $4.0 million, or $.61 per basic and diluted share in fiscal 2005. This represents a decline in pre-tax earnings of $12.1 million. The reduction in

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pre-tax earnings occurred primarily at the gross margin line, with increases in selling, general and administrative expenses and gains on real estate and asset sales in fiscal 2005, which did not reoccur in fiscal 2006, accounting for the remaining pre-tax decline in operating income. As discussed below, lower pricing and lower volume at the Evans Division and increases in medical and pension costs caused lower margins. Also, certain items relating to the purchase accounting for the Tru-Stone acquisition and to the shutdown of the Evans Division Charleston plant were recorded in the fourth quarter. The above items are discussed in more detail below.

Sales Sales for fiscal 2006 were up $5.0 million or 3% compared to fiscal 2005. Domestic sales were down 1% reflecting lower pricing due to pressure from foreign competitors on certain product categories. Much of the domestic sales decline was related to the Evans Rule Division ($5.8 million). Excluding the Evans Rule Division, domestic sales increased $5.0 million (5%). Foreign sales were up 5% (4% decrease in local currency) driven by the strengthening of the Brazilian Real against the U.S. dollar, strong export sales from the Brazilian operations, and growing sales for the Chinese operations.

Earnings (loss) before taxes (benefit) The pretax loss for fiscal 2006 was $6.9 million compared to $5.2 million of pretax earnings for fiscal 2005. This represents a decrease of pretax earnings of $12.1 million. Approximately $7.1 million of this decrease is at the gross margin line. The gross margin percentage dropped from 27.4% in the prior year to 23.2% in the current year. This was primarily driven by the Evans Division as a result of the combination of lower pricing and unit volume primarily from its largest customer, Sears. In addition, this division has only been able to pass along a portion of its higher material costs to its customers. Domestic gross margins were reduced during fiscal 2006, as the Company experienced a $1.3 million increase in medical costs and a $1.8 million increase in pension costs for its domestic businesses. Also, an inventory adjustment recorded at the Suzhou, China plant during fiscal 2006 created a drop in margin compared to fiscal 2005. As the Dominican Republic moving costs continue to decline from levels experienced in fiscal 2006 and the full impact of Tru-Stone’s higher gross margins are experienced, the Company should see improvement in the gross margin percentage over the course of the next fiscal year.

Significant Fourth Quarter Activity During May and June of fiscal 2006, a charge to cost of sales was recorded for the flow-through of a portion of the purchase accounting adjustment to fair value for the work-in-process and finished goods inventory of Tru-Stone as of the acquisition date. The impact amounted to $.3 million (pre-tax). Also during the fourth quarter, charges were recorded under SFAS 146, Costs Associated with Exit Activities, for retention bonuses and reserves for inventory and fixed assets relating to the shutdown of the Evans Division Charleston plant, amounting to $.8 million (pre-tax). The Company intends to vacate and sell the building in the near future.

Income Taxes The effective tax rate for fiscal 2006 was 45%, reflecting the benefits of a release of tax reserves and return to provision adjustments offset by increases in valuation allowances for state NOL’s, foreign NOL’s and foreign tax credits. The release of tax reserves is a result of the close out of certain examination years and the reduced likelihood of future assessment due to changes in circumstances. The effective tax rate was 23% for fiscal 2005. The fiscal 2005 rate was 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.

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Net Income (Loss) per Share For purposes of better understanding the results from the Company’s manufacturing and distribution operations, management reviews results excluding certain items.

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

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

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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.

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.

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 2006, the Company was party to an interest swap arrangement more fully described in Note 9 to the Consolidated Financial Statements. The Company does not engage in trading, market-making or other speculative activities in 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 $21.1 million) 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 $2.2 million by $27,000. See Note 9 to the Consolidated Financial Statements for details concerning the Company’s long-term debt outstanding of $13.1 million.

LIQUIDITY AND CAPITAL RESOURCES

Despite the operating losses in fiscal 2006 and 2004, cash provided by operations has been positive in all periods presented. This was supplemented in fiscal 2004 by a reduction in inventories. However, during fiscal 2005

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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 from fiscal 2004 to fiscal 2005. This was partially offset by a reduction in receivables during that period.

“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 generating approximately $.7 million, $1.4 million and $.8 million of noncash income in fiscal 2006, 2005 and 2004, respectively. Consolidated retirement benefit expense (income) was approximately $1.2 million and $(.6) million in 2005, and $.7 million in 2004.

At the start of fiscal 2007, the Company switched from self-funding to a fixed monthly premium for both its domestic employee health care plans and its domestic worker’s compensation plan. This should reduce the cash flow uncertainty related to these Company expenses.

The Company’s investing activities consisted of the acquisition of Tru-Stone in fiscal 2006, 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 been relatively stable over each of the three years, although they are less than depreciation expense in each of those years. The fiscal 2005 proceeds from the sale of real estate and CMM business relate to the three asset sales discussed in Results of Operations above. Details of the Tru-Stone acquisition are disclosed in Note 3 to the Consolidated Financial Statements.

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 increased from $3.7 million at the end of 2005 to $16.3 million at the end of 2006, primarily due to the financing of the Tru-Stone acquisition.

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 $10 million line of credit, of which, as of June 24, 2006, $890,000 was 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 3.8 to one as of June 24, 2006 and 5.2 to one as of June 25, 2005.

REORGANIZATION PLANS

The continued migration of manufacturing to low cost 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 implementing 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.

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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. It 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.

On September 21, 2006, the Company sold 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 have been transferred to the Dominican Republic at an adjacent site. The Company plans to vacate and sell its Evans Rule facility in North Charleston, South Carolina in the near future. 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 Glendale, Arizona facility, which is expected to be sold in the first half of fiscal 2007. Also during fiscal 2006, the Company began a lean manufacturing initiative in its Athol, Massachusetts facility, which is expected to reduce costs over time. As discussed under Item 1, the Tru-Stone acquisition in April 2006 represents a strategic acquisition for the Company in that it provides an enhancement of the Company’s granite surface plate capabilities. Profit margins for the Company’s standard plate business are expected to improve as the Company’s existing granite surface plate facility is consolidated into Tru-Stone, where average gross margins have been higher.

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 the Company’s Consolidated 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 2004 the previously discussed charges connected with the concluded government investigation of the CMM division.

The allowance for doubtful accounts and sales returns of $1.4 million and $1.1 million at the end of fiscal 2006 and 2005, 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

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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.

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 (Note 8 to the Consolidated Financial Statements).

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.

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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 2006, 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.

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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

Athol, Massachusetts

We have audited the accompanying consolidated balance sheet of The L.S. Starrett Company and subsidiaries (the “Company”) as of June 24, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended June 24, 2006. 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 audit.

We conducted our audit 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 audit provides 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 24, 2006, and the results of its operations and its cash flows for the fiscal year then ended, 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 24 2006, based on Internal Control–Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated September 21, 2006 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.

/S/ Grant Thornton LLP

Boston, Massachusetts

September 21, 2006

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

The L.S. Starrett Company

Athol, Massachusetts

We have audited the accompanying consolidated balance sheet of The L.S. Starrett Company and subsidiaries (the “Company”) as of June 25, 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the two 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 the results of its operations and its cash flows for each of the two fiscal years in the period ended June 25, 2005, in conformity with accounting principles generally accepted in the United States of America.

/S/ Deloitte & Touche LLP

Boston, Massachusetts

September 8, 2005

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THE L.S. STARRETT COMPANY

Consolidated Statements of Operations

For the three years ended on June 24, 2006

(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 three years ended on June 24, 2006

(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 three years ended on June 24, 2006 (in thousands)

Note: Cumulative balances of unrealized net loss on investments, minimum pension liability and translation loss at June 24, 2006 are $(44), $(2,460), and $(13,405), respectively.

See notes to consolidated financial statements

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THE L.S. STARRETT COMPANY

Notes to Consolidated Financial Statements

1. SIGNIFICANT ACCOUNTING POLICIES

Description of the business and principles of consolidation: The Company is in the business of manufacturing industrial, professional, and consumer measuring and cutting tools and related products. The largest consumer of these products is the metalworking industry, but others include automotive, aviation, marine, farm, do-it-yourselfers, and tradesmen such as builders, carpenters, plumbers, and electricians. The consolidated financial statements include the accounts of The L. S. Starrett Company and its subsidiaries, all of which are wholly-owned. All significant Intercompany items have been eliminated. The Company’s fiscal year ends on the last Saturday in June. The fiscal years of the Company’s major foreign subsidiaries end in May.

Financial instruments and derivatives: The Company’s financial instruments consist primarily of cash, investments and receivables and current liabilities and long term debt. Current assets and liabilities, except investments, are stated at cost, which approximates fair market value. Long-term debts, which are at current market interest rates, also approximate fair market value. The Company has entered into an interest rate swap agreement to limit the amount of exposure resulting from increases in its variable LIBOR rate on its $12 million Reducing Revolver. This is being accounted for as an effective cash flow hedge under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.”

Cash: Cash is comprised of cash on hand and demand deposits.

Investments: Investments consist primarily of cash equivalents and marketable securities such as treasury bills, certificates of deposit, municipal securities, and money market funds. The Company considers all its investments “available for sale” and “highly liquid in nature.” As such, these investments are carried at market, with unrealized temporary gains and losses recorded as a component of stockholders’ equity. Included in investments at June 24, 2006 is $2.2 million of AAA rated Puerto Rico debt obligations that have maturities greater than one year but carry the benefit of possibly reducing repatriation taxes. These investments represent “core cash” and are part of the Company’s overall cash management and liquidity program and, under SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities,” are considered “available for sale.” The investments themselves are highly liquid, carry no early redemption penalties, and are not designated for acquiring non-current assets. Most other investments have maturities of less than one year.

Accounts receivable: Accounts receivable consist of trade receivables from customers. The provision for bad debts amounted to $596,000, $164,000 and $508,000 in fiscal 2006, 2005 and 2004, respectively. In establishing the allowance for doubtful accounts, management considers historical losses, the aging of receivables, trends in products returns and existing economic conditions.

Inventories: Inventories are stated at the lower of cost or market. For approximately 62% of all inventories, cost is determined on a last-in, first-out (LIFO) basis. For all other inventories, cost is determined on a first-in, first-out (FIFO) basis. LIFO inventories were $30.8 million and $22.9 million at the end of 2006 and 2005, respectively, such amounts being approximately $24.0 and $21.8 million, respectively, less than if determined on a FIFO basis. During fiscal 2004 the Company reduced the levels of certain LIFO inventories that were carried in the aggregate at lower costs prevailing in prior years. The effect of the LIFO inventory reduction was to increase 2004 net earnings by approximately $980,000 ($.15 per share).

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Long-lived assets: Buildings and equipment are depreciated using straight-line and accelerated methods over estimated useful lives as follows: buildings 15 to 50 years, building improvements 10 to 40 years, machinery and equipment 5 to 12 years, motor vehicles 3 to 5 years, computer hardware and software 3 to 7 years. Long-lived assets are reviewed for impairment when circumstances indicate the carrying amount may not be recoverable. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less cost to sell. Included in buildings and machinery and equipment at June 24, 2006 were $.1 million and $3.2 million, respectively, of construction in progress.

Intangible assets and goodwill: Intangibles are recorded at cost and are amortized on a straight-line basis over a 5 year period. Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. Goodwill is not subject to amortization but will be tested for impairment annually and at any time when events suggest impairment may have occurred. In the event that the carrying value of goodwill exceeds the fair value of the goodwill, an impairment loss would be recorded for the amount of that excess.

Revenue recognition: Revenue is recognized when inventory is shipped to the customer or installed if installation is necessary. While the Company does allow its customers the right to return in certain circumstances, revenue is not deferred, but rather a reserve for sales returns is provided based on experience, which historically has not been significant.

Advertising costs: The Company’s policy is to generally expense advertising costs as incurred unless the benefit of the advertising covers more than one quarterly period during the year. In these cases, the cost is amortized over the course of the fiscal year. The Company has not generally amortized such costs over more than a one year period. Advertising costs were expensed as follows: $5.2 million in 2006, $5.0 million in 2005 and $4.1 million in 2004.

Freight costs: The Company incurred approximately $5.0 million and $4.8 million in outbound shipping costs in fiscal 2005 and 2004, respectively. Approximately 25% of these shipping costs were billed to, and reimbursed by, customers. Beginning with the March 2005 quarter, the Company began recording all outbound freight as cost of sales rather than the previous practice of netting such costs against sales. Prior period amounts have not been reclassified as they are immaterial to the consolidated statements of operations.

Warranty expense: The Company’s warranty obligation is generally one year from shipment to the end user and is affected by product failure rates, material usage, and service delivery costs incurred in correcting a product failure. Any such failures tend to occur soon after shipment. Historically, the Company has not incurred significant predictable warranty expense and consequently its warranty reserves are not material. In the event a material warranty liability is deemed probable, a reserve is established for the event.

Income taxes: Deferred tax expense results from differences in the timing of certain transactions for financial reporting and tax purposes. Deferred taxes have not been recorded on approximately $46 million of undistributed earnings of foreign subsidiaries as of June 24, 2006 or the related unrealized translation adjustments because such amounts are considered permanently invested. In addition, it is possible that remittance taxes, if any, would be reduced by U.S. foreign tax credits. Valuation allowances are recognized if, based on the available evidence, it is more likely than not that some portion of the deferred tax assets will not be realized.

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Research and development: Research and development costs were expensed as follows: $2.9 million in 2006, $3.3 million in 2005, and $3.1 million in 2004.

Earnings per share (EPS): Basic EPS excludes dilution and is computed by dividing earnings available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution by securities that could share in the earnings. The Company had 5,540, 13,816, and 13,701 of potentially dilutive common shares in 2006, 2005 and 2004, respectively, resulting from shares issuable under its stock option plan. For 2005 these shares had no impact on the calculated per share amounts due to their magnitude. These additional shares are not used for the diluted EPS calculation in loss years.

Translation of foreign currencies: Assets and liabilities are translated at exchange rates in effect on reporting dates, and income and expense items are translated at rates in effect on transaction dates. The resulting differences due to changing exchange rates are charged or credited directly to the “Accumulated Other Comprehensive Loss” account included as part of stockholders’ equity.

Use of accounting estimates: The preparation of the financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of sales and expenses during the reporting period. 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. Amounts ultimately realized could differ from those estimates.

Reclassifications: Certain reclassifications have been made to prior year data to conform with current year presentation.

Other: Accounts payable and accrued expenses at June 24, 2006 consist primarily of accounts payable ($9.1 million), accrued benefits ($2.1 million) and accrued taxes other than income ($1.4 million).

2. RECENT ACCOUNTING PRONOUNCEMENTS

FSP FASB 109-1 and 109-2: In December 2004, the FASB issued FASB Staff Position No. 109-1, Application of FASB Statement No. 109 (SFAS 109), Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (FSP 109-1). FSP 109-1 clarifies that the manufacturer’s deduction provided for under the American Jobs Creation Act of 2004 (AJCA) should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. The Company has determined that the deduction has an insignificant impact on the results of fiscal 2006.

The FASB also issued FASB Staff Position No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004 (FSP 109-2). The AJCA introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FSP 109-2 provides accounting and disclosure guidance for the repatriation provision. At the present time, deferred taxes have not been recorded on approximately $46 million of undistributed earnings of foreign subsidiaries or the related unrealized translation adjustments because such amounts are considered permanently invested, and it is possible that remittance taxes, if any, would be reduced by U.S. foreign tax credits.

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In March 2005, the FASB issued Interpretation No. 47 (FIN 47), Accounting for Conditional Asset Retirement Obligations, an interpretation of SFAS 143, Accounting for Asset Retirement Obligations. FIN 47 requires that an entity recognize a liability for the fair value of a conditional asset retirement obligation if the fair value can be reasonably estimated. The only potential liability that Company operating management has identified relates to a limited amount of asbestos contained in some Athol production facilities. The Company has no current requirement under environmental regulations to remove this asbestos in its current state and no plans for maintenance, renovations or plant shutdown which might require removal. Therefore, no obligation can be reasonably estimated at this time and therefore, no liability has been recorded under FIN 47. This will be evaluated as circumstances change.

In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return (including a decision whether to file or not file a return in a particular jurisdiction). Under FIN 48, the financial statements will reflect expected future tax consequences of such positions presuming the taxing authorities full knowledge of the position and all relevant facts, but without considering time values. FIN 48 is effective for the Company for fiscal 2008. The Company is evaluating the impact of adopting FIN 48 on its consolidated financial position and results of operations.

The FASB also issued FASB Statement No. 151 (SFAS 151), Inventory Costs – An Amendment of ARB No. 43, Chapter 4. SFAS 151 requires that certain overhead costs under normal capacity production levels be capitalized while abnormal amounts be expensed when incurred. The Company’s current procedures follow these guidelines and therefore the adoption of SFAS 151 had no impact on the valuation of inventory or charges to cost of sales.

3. TRU-STONE ACQUISITION

On April 28, 2006, the Company acquired 100% of the assets of Tru-Stone Technologies, Inc. (“Tru-Stone”). The results of Tru-Stone’s operations have been included in the Consolidated Financial Statements since that date. The purchase price for Tru-Stone, including transaction costs, was approximately $20.0 million in cash, including an upward adjustment based on the level of Tru-Stone’s net working capital as of the closing date of the acquisition. The purchase price for the acquisition of Tru-Stone was funded in part by proceeds from a Reducing Revolver Credit Facility entered into in connection with the acquisition of Tru-Stone and existing cash.

The total purchase price was comprised as follows (in thousands):

The acquisition of Tru-Stone has been accounted for under the purchase method. As such, the cost to acquire Tru-Stone has been allocated to the respective assets and liabilities acquired based on their estimated fair values at the closing of the acquisition of Tru-Stone. The total purchase price has been

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allocated to assets acquired and liabilities assumed based on management’s best estimates of fair value, with the excess cost over the net tangible and identifiable intangible assets acquired being allocated to goodwill. No in-process research and development existed at the time of the acquisition. These allocations are subject to change pending a final analysis of the fair value of the assets acquired and liabilities assumed, which could result in changes from the information presented.

The allocation of the total purchase price of Tru-Stone’s net tangible and identifiable intangible assets was based on the estimated fair values as of April 28, 2006. The excess of the purchase price over the net tangible and identifiable intangible assets was allocated to goodwill. The total purchase price of $19,986 has been allocated as follows (in thousands):

The unaudited pro forma combined condensed statements of operations for the twelve months ended June 24, 2006 and June 25, 2005 give effect to the acquisition of Tru-Stone as if it had occurred on June 26, 2005, and June 27, 2004, respectively. The Tru-Stone financial statements included in the pro forma analysis are as of and for the fiscal years ended June 24, 2006 and June 25, 2005.

The pro forma information presented is for illustrative purposes only and is not necessarily indicative of the operating results that would have been achieved if the acquisition of Tru-Stone had occurred on June 26, 2005 and June 27, 2004, nor is it indicative of future operating results or financial position. The pro forma information should be read in conjunction with the accompanying notes thereto. The pro forma adjustments are based upon available information and certain assumptions that the Company believes are reasonable.

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UNAUDITED PRO FORMA COMBINED CONDENSED STATEMENT OF OPERATIONS

FOR THE FISCAL YEAR ENDED JUNE 24, 2006

(dollars in thousands, except for earnings per share)