Schmitt Industries, Inc. designs, manufactures and markets computer controlled balancing equipment (the Balancer Segment) primarily to the machine tool industry. Through its wholly owned subsidiary, Schmitt Measurement Systems, Inc. (SMS), the Company designs, manufactures and markets precision laser-based measurement systems and ultra sonic measurement systems for a variety of industrial applications (the Measurement Segment). The Company also sells and markets its products in Europe through its wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom. The accompanying unaudited financial information should be read in conjunction with our Annual Report filed with the Securities and Exchange Commission (SEC) on Form 10-K for the fiscal year ended May 31, 2008. Certain amounts in prior periods' financial information have been reclassified to conform to the current period's presentation. These reclassifications did not affect consolidated net income.

Forward-Looking Statements

This Quarterly Report filed with the SEC on Form 10-Q (the "Report"), including "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 2 herein contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 regarding future events and the future results of Schmitt Industries, Inc. and its consolidated subsidiaries (the "Company") that are based on management's current expectations, estimates, projections and assumptions about the Company's business. Words such as "expects," "anticipates," "intends," "plans," "believes," "sees," "estimates" and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements due to numerous factors, including, but not limited to, those discussed in the "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this Report as well as those discussed from time to time in the Company's other Securities and Exchange Commission filings and reports. In addition, such statements could be affected by general industry and market conditions. Such forward-looking statements speak only as of the date of this Report or, in the case of any document incorporated by reference, the date of that document, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this Report. If we update or correct one or more forward-looking statements, investors and others should not conclude that we will make additional updates or corrections with respect to other forward-looking statements.

RESULTS OF OPERATIONS

Overview

Schmitt Industries, Inc. designs, manufactures and markets computer controlled balancing equipment (the Balancer segment) to the worldwide machine tool industry and, through its wholly owned subsidiary, Schmitt Measurement Systems, Inc., precision laser-based test and measurement products and ultrasonic measurement systems (the Measurement segment) for a variety of industrial applications worldwide. The Company sells and markets its products in Europe through its wholly owned subsidiary, Schmitt Europe Ltd. ("SEL"), located in the United Kingdom. The Company is organized into two operating segments: the Balancer segment and the Measurement segment.

For the three months ended November 30, 2008, total sales decreased $122,000, or 3.9%, to $3.0 million from $3.1 million in the three months ended November 30, 2007. For the six months ended November 30, 2008, total sales increased $733,000, or 13.4%, to $6.2 million from $5.4 million for the six months ended November 30, 2007. Balancer segment sales primarily come from end-users, rebuilders and original equipment manufacturers of grinding machines with the target geographic markets of North America, Asia and Europe. Balancer segment sales decreased $52,000, or 2.2%, to $2.3 million for the three months ended November 30, 2008 compared to $2.3 million for the three months ended November 30, 2007. Balancer segment sales increased $420,000, or 10.1%, to $4.6 million for the six months ended November 30, 2008 compared to $4.2 million for the six months ended November 30, 2007. The Measurement segment product line consists of both laser light-scatter surface measurement and dimensional sizing products. Total Measurement segment sales decreased $69,000, or 8.9%, to $714,000 for the three months ended November 30, 2008 compared to $784,000 for the three months ended November 30, 2007. Total Measurement segment sales increased $313,000, or 24.2%, to $1.6 million for the six months ended November 30, 2008 compared to $1.3 million for the six months ended November 30, 2007.

During the third quarter of Fiscal 2008, the Company completed its acquisition of Xtero Datacom, Inc. ("Xtero"). The Company acquired Xtero's business including its patented technologies that utilize ultrasonic measurement systems to remotely measure and report via satellite to a secure website the capacity and volumes of large chemical storage tanks anywhere in the world. This acquisition resulted in higher research and development costs of $61,000 during the three months ended November 30, 2008 and $263,000 during the first six months of Fiscal 2009. These higher expenses negatively impacted operating results during the first half of Fiscal 2009.

Net loss was $114,000, or $0.04 per fully diluted share, for the three months ended November 30, 2008 as compared to net income of $265,000, or $0.10 per fully diluted share, for the three months ended November 30, 2007. Net loss was $80,000, or $0.03 per fully diluted share, for the six months ended November 30, 2008 as compared to net income of $449,000, or $0.16 per fully diluted share, for the six months ended November 30, 2007. Earnings per share in the second quarter and the first half of Fiscal 2009 as compared to the same periods in the prior year were also negatively impacted due to the issuance of 200,000 shares of the Company's common stock issued in connection with the acquisition of Xtero during the third quarter of Fiscal 2008.

Critical Accounting Policies

There were no material changes in our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended May 31, 2008.

Recently Issued Accounting Pronouncements:

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

Discussion of Operating Results



                                                 Three Months Ended November 30,
                                                  2008                     2007
   Balancer sales                         $ 2,274,981      76.1 %   $ 2,327,165    74.8 %
   Measurement sales                          714,300      23.9 %       783,756    25.2 %

   Total sales                              2,989,281     100.0 %     3,110,921   100.0 %
   Cost of sales                            1,586,602      53.1 %     1,421,593    45.7 %

   Gross profit                             1,402,679      46.9 %     1,689,328    54.3 %

   Operating expenses:
   General, administration and sales        1,420,351      47.5 %     1,222,955    39.3 %
   Research and development                   250,894       8.4 %       189,902     6.1 %

   Total operating expenses                 1,671,245      55.9 %     1,412,857    45.4 %

   Operating income (loss)                   (268,566 )    -9.0 %       276,471     8.9 %
   Other income (expense)                      (2,214 )    -0.1 %        60,768     2.0 %

   Income (loss) before income taxes         (270,780 )    -9.1 %       337,239    10.8 %
   Provision (benefit) for income taxes      (157,113 )    -5.3 %        72,500     2.3 %

   Net income (loss)                      $  (113,667 )    -3.8 %   $   264,739     8.5 %


                                                  Six Months Ended November 30,
                                                  2008                     2007
   Balancer sales                         $ 4,576,903      74.0 %   $ 4,157,358    76.3 %
   Measurement sales                        1,605,763      26.0 %     1,292,568    23.7 %

   Total sales                              6,182,666     100.0 %     5,449,926   100.0 %
   Cost of sales                            3,122,607      50.5 %     2,525,233    46.3 %

   Gross profit                             3,060,059      49.5 %     2,924,693    53.7 %

   Operating expenses:
   General, administration and sales        2,743,269      44.4 %     2,199,791    40.4 %
   Research and development                   498,113       8.1 %       235,194     4.3 %

   Total operating expenses                 3,241,382      52.4 %     2,434,985    44.7 %

   Operating income (loss)                   (181,323 )    -2.9 %       489,708     9.0 %
   Other income                                18,017       0.3 %       133,546     2.5 %

   Income (loss) before income taxes         (163,306 )    -2.6 %       623,254    11.4 %
   Provision (benefit) for income taxes       (83,186 )    -1.3 %       174,000     3.2 %

   Net income (loss)                      $   (80,120 )    -1.3 %   $   449,254     8.2 %

Sales - Sales in the Balancer segment decreased $52,000, or 2.2%, to $2.3 million for the three months ended November 30, 2008 compared to $2.3 million for the three months ended November 30, 2007. This decrease is primarily due to lower unit sales volumes in North America and Europe offset by higher unit sale volumes in Asia during the second quarter of Fiscal 2009. Market demand in Asia for the Balancer segment products remained strong with that region showing an increase of $49,000, or 7.1%, for the three months ended November 30, 2008 compared to the same period in the prior year. European sales decreased $64,000, or 16.1%, in the second quarter of Fiscal 2009 compared to second quarter of Fiscal 2008. North American sales decreased $70,000, or 6.0%, in the three months ended November 30, 2008 compared to the same period in the prior year. As with the North American market, the duration of the strength or weakness in demand in Asia and Europe cannot be forecasted with any certainty given the weaknesses in the worldwide automotive, bearing and aerospace industries and its impact on the machine tool industry.

Sales in the Balancer segment increased $420,000, or 10.1%, to $4.6 million for the six months ended November 30, 2008 compared to $4.2 million for the six months ended November 30, 2007. This increase is primarily due to higher unit sales volumes in Asia and Europe offset by slightly lower sales volumes in North America during the second half of Fiscal 2009. Market demand in Asia for the Balancer segment products remained strong with that region showing an increase of $336,000, or 26.0%, for the six months ended November 30, 2008 compared to the same period in the prior year. European sales increased $36,000, or 5.0%, in the first half of Fiscal 2009 compared to first half of Fiscal 2008. North American sales decreased $8,000, or 0.4%, in the six months ended November 30, 2008 compared to the same period in the prior year

Sales in the Measurement segment decreased $69,000, or 8.9%, to $714,000 in the three months ended November 30, 2008 compared to $784,000 in the three months ended November 30, 2007. Sales of laser-based dimensional sizing products increased $152,000, or 32.5%, in the three months ended November 30, 2008 as compared to the same period in the prior year primarily due to the lower volume of shipments in that prior year. Sales of laser-based surface measurement products in the three months ended November 30, 2008 as compared to the same period in the prior year decreased $220,000, or 69.6%, as sales to disk drive and silicon wafer manufacturers decreased. These industries have undergone significant technological change and consolidation as manufacturers merged or exited the markets resulting in a redeployment of equipment rather than the making of additional investments in capital equipment, and future sales cannot be forecasted with any certainty.

Sales in the Measurement segment increased $313,000, or 24.2%, to $1.6 million in the six months ended November 30, 2008 compared to $1.3 million in the six months ended November 30, 2007. Sales of laser-based dimensional sizing products increased $489,000, or 56.2%, in the six months ended November 30, 2008 as compared to same period in the prior year primarily due to the lower volume of shipments in that prior year. Laser-based surface measurement products decreased $176,000, or 41.7%, as sales to disk drive and silicon wafer manufacturers decreased.

Gross margin - Gross margin for the three months ended November 30, 2008 decreased to 46.9% as compared to 54.3% for the three months ended November 30, 2007. Gross margin for the six months ended November 30, 2008 decreased to 49.5% as compared to 53.7% for the six months ended November 30, 2007. These decreases were due to changes in the product sales mix shifting toward lower margin products.

Operating expenses - Operating expenses increased $258,000, or 18.3%, to $1.7 million for the three months ended November 30, 2008 as compared to $1.4 million for the three months ended November 30, 2007. General, administrative and selling expenses increased $197,000, or 16.1%, for the three months ended November 30, 2008 as compared to the same period in the prior year primarily due to higher professional fees associated with compliance costs for the implementation of Section 404 of the Sarbanes-Oxley Act, higher personnel costs due to increased headcount, higher stock based compensation and higher amortization expenses related to the identifiable intangibles acquired from Xtero. Research and development expenses increased $61,000, or 32.1%, as compared to the same period in the prior year primarily due to new product development associated with technologies acquired from Xtero and new product development related to existing product lines.

Operating expenses increased $806,000, or 33.1%, to $3.2 million for the six months ended November 30, 2008 as compared to $2.4 million for the six months ended November 30, 2007. General, administrative and selling expenses increased $543,000, or 24.7%, for the six months ended November 30, 2008 as compared to the same period in the prior year. Research and development expenses increased $263,000 as compared to the same period in the prior year. These increases are primarily due to the same reasons as noted above.

Other income - Other income consists of interest income, foreign currency exchange gain (loss) and other income (expense). Interest income was $27,000 and $67,000 for the three months ended November 30, 2008 and 2007, respectively. Interest income was $57,000 and $134,000 for the six months ended November 30, 2008 and 2007, respectively. Interest income has decreased due to lower interest rates and decreased cash and investment balances. Foreign currency exchange losses were $29,000 and $39,000 for the three and six months ended November 30, 2008, respectively. The foreign currency exchange loss was $7,000 and $0 for the three and six months ended November 30, 2007, respectively. The increase in the losses is primarily due to the rapid weakening of foreign currencies against the US dollar during the current period.

Income tax provision - The Company's effective tax rate on consolidated net income was 58.0% for the three months ended November 30, 2008 and 50.9% for the six months ended November 30, 2008. The Company's effective tax rate on consolidated net income differs from the federal statutory tax rate primarily due to certain expenses not being deductible for income tax reporting purposes offset by the domestic manufacturing deduction and adjustments to the current year provision related to the prior year tax returns. One of the items not deductible for income tax reporting is stock based compensation which was higher in the first half of Fiscal 2009 than we expect in the second half. This results in a higher effective tax rate for the first six months than we expect for the full fiscal year. Management believes the effective tax rate for Fiscal 2009 will be approximately 80.0% due to the items noted above. The effective tax rate in the three and six months ended November 30, 2007 was 21.5% and 27.9%, respectively.

Net income - Net income decreased $378,000 to a net loss of $113,000, or $0.04 per diluted share, for the three months ended November 30, 2008 as compared to net income of $265,000, or $0.10 per diluted share, for the three months ended November 30, 2007. Net income decreased $529,000 to a net loss of $80,000, or $0.03 per diluted share, from net income of $449,000, or $0.16 per diluted share, for the six months ended November 30, 2008 and 2007, respectively. Net income decreased due primarily to higher general, administrative and selling expenses, higher research and development expenses, lower gross margins and a higher effective tax rate offset by the impact of higher sales and the related gross profit during the three and six months ended November 30, 2008.

LIQUIDITY AND CAPITAL RESOURCES

The Company's working capital increased $56,000 to $9.9 million as of November 30, 2008 compared to $9.9 million as of May 31, 2008. Cash, cash equivalents and short term investments totaled $4.9 million and $5.5 million as of November 30, 2008 and May 31, 2008, respectively. As of November 30, 2008, the Company had $4.9 million in cash and cash equivalents on hand compared to $3.0 million at May 31, 2008. The Company had $0 and $2.5 million in short-term investments as of November 30, 2008 and May 31, 2008, respectively. The Company moved their short-term investments to money market funds as they matured during the second quarter of Fiscal 2009.

Cash used in operating activities totaled $529,000 for the six months ended November 30, 2008 as compared to cash provided by operating activities of $571,000 for the six months ended November 30, 2007. The decrease was primarily due to decreases in net income and income taxes payable, offset by increases in accounts receivable, depreciation and amortization and stock based compensation.

At November 30, 2008, the Company had accounts receivable of $1.9 million as compared to $1.6 million at May 31, 2008. The increase in accounts receivable of $278,000 is due to the timing of sales throughout the second quarter of Fiscal 2009 as compared to the fourth quarter in the prior fiscal year. At November 30, 2008, inventories increased $90,000 to $4.0 million as compared to $3.9 million as of May 31, 2008. At November 30, 2008, total other liabilities decreased $302,000 to $1.1 million as compared to $1.4 million at May 31, 2008. The decrease is primarily due to the timing of payments and decreases in taxes payable due to the net loss as compared to the prior year.

During the three months ended November 30, 2008, net cash provided by investing activities was $2.4 million, which consisted of maturities of short-term investments of $2.5 million offset by additions to property and equipment of $117,000. Additions to property and equipment consisted primarily of new manufacturing and office equipment.

The Company has a $1.0 million bank line of credit agreement secured by U.S. accounts receivable, inventories and general intangibles. Interest is payable at the bank's prime rate, 3.25% as of November 30, 2008, and the agreement expires on March 1, 2009. There were no outstanding balances on the line of credit at November 30, 2008 and May 31, 2008.

We believe that our existing cash and investments combined with the cash we anticipate to generate from operating activities, and our available line of credit and financing available from other sources will be sufficient to meet our cash requirements for the foreseeable future. We do not have any significant commitments nor are we aware of any significant events or conditions that are likely to have a material impact on our liquidity or capital resources.

Business Risks

The following are important factors that could cause actual results or events to differ materially from those contained in any forward-looking statements made by or on behalf of the Company (see the forward-looking statements disclaimer at the beginning of Item 2 in this Report). In addition, the risks and uncertainties described below are not the only ones that the Company faces. Unforeseen risks could arise and problems or issues that the Company now views as minor could become more significant. If the Company were unable to adequately respond to known or unknown risks, the Company's business, financial condition or results of operations could be materially adversely affected. In addition, the Company cannot be certain that any actions taken to reduce known or unknown risks and uncertainties will be effective.

Demand for Company products may change

During the first half of Fiscal 2009, the Company experienced increased sales of its Balancer products, primarily in Asia and Europe offset by lower sales volumes in North America. During Fiscal 2008, the Company experienced increased demand for its Balancer products in North America, its largest market, attributed primarily to an improving economy in North America. However, during Fiscal 2007, Balancer sales in North America declined when compared to Fiscal 2006. Economic conditions and circumstances, and therefore sales volumes, in our various markets could change materially in future periods, and as a result demand for the Company's products could decline.

The laser light-scatter surface measurement products of the Measurement segment have relied heavily upon sales to disk drive and silicon wafer manufacturers. Sales for the first half of Fiscal 2009 and for the full Fiscal 2008 and 2007 years have decreased 41.7%, 50.4% and 13.6%, respectively. Disk drive manufacturers have scaled back their outlook for the current calendar year, blaming a price war over high-capacity desktop computer drives, which now store as much as about one trillion bytes of data. With respect to handheld applications, disk drive manufacturers believe disk drive products with smaller than 1.8 inch form factors have to a large extent been replaced by competing storage technologies, such as solid state or flash memory. In addition, the silicon wafer industry is notoriously cyclical and is currently experiencing a downturn in demand. Consequently, the long-term impact on demand for the Company's surface measurement products in these two primary markets cannot be predicted with any certainty.

The acquisition of Xtero Datacom Inc. technology and the introduction of the Xact™ product may not become commercially viable and satisfy expected demand

On February 20, 2008, the Company completed the acquisition of Xtero Datacom Inc. ("Xtero") and Xtero's patented and patent pending technology for remote satellite sensing of large chemical storage tanks. Management believes the Xtero product called Xact™ has reached technological feasibility. Although our acquisition of Xtero with related research and development costs has negatively impacted current operating results, the acquisition should allow us to enter new measurement markets and is expected to add sales and profits to the Company in future years. However, the introduction of the Xact™ product may not be successful, anticipated market demand for the product may not materialize and additional product or market opportunities may not be identified and developed and brought to market in a timely and cost-effective manner, each of which could continue to negatively impact future operating results and result in large and immediate write-offs of recorded intangible asset balances.

New products may not be developed to satisfy changes in consumer demands

The failure to develop new technologies, or react to changes in existing technologies, could materially delay development of new products, which could result in decreased revenues and a loss of market share to competitors. Financial performance depends on the ability to design, develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. New product opportunities may not be identified and developed and brought to market in a timely and cost-effective manner. Products or technologies developed by other companies may render products or technologies obsolete or noncompetitive, or a fundamental shift in technologies in the product markets could have a material adverse effect on the Company's competitive position within historic industries.

Failure to protect intellectual property rights could adversely affect future performance and growth

Failure to protect existing intellectual property rights may result in the loss of valuable technologies or paying other companies for infringing on their intellectual property rights. The Company relies on patent, trade secret, trademark and copyright law to protect such technologies. There is no assurance any of the Company's U.S. patents will not be invalidated, circumvented, challenged or licensed to other companies.

Competition is intense and the Company's failure to compete effectively would adversely affect its business

Competition in the markets for the Company's products is intense. The speed with which companies can identify new applications for the Company's various technologies, develop products to meet those needs and supply commercial quantities at low prices to those new markets are important competitive factors. The principal competitive factors in the Company's markets are product features, performance, reliability and price. Many of the Company's competitors have greater financial, technical, research and development and marketing resources. No assurance can be given that the Company will be able to compete effectively in the future, and the failure to do so would have a material adverse effect on the Company's business, financial condition and results of operations.

Production time and the overall cost of products could increase if any of the primary suppliers are lost or if a primary supplier increased the prices of raw materials

Manufacturing operations depend upon obtaining adequate supplies of raw materials on a timely basis. The results of operations could be adversely affected if adequate supplies of raw materials cannot be obtained in a timely manner or if the costs of raw materials increased significantly.

Fluctuations in quarterly and annual operating results make it difficult to predict future performance

Quarterly and annual operating results are likely to fluctuate in the future due to a variety of factors, some of which are beyond management's control. As a result of quarterly operating fluctuations, it is important to realize quarter-to-quarter comparisons of operating results are not necessarily . . .