RESULTS OF OPERATIONS

Overview

Schmitt Industries, Inc. designs, manufactures and markets computer controlled vibration detection and balancing equipment (the Balancer segment) to the worldwide machine tool industry and, through its wholly owned subsidiary, Schmitt Measurement Systems, Inc., precision laser-based surface measurement products, laser-based distance 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 year ended May 31, 2009 (Fiscal 2009), total sales decreased $1.9 million or 16.8% to $9.5 million from $11.4 million in the year ended May 31, 2008 (Fiscal 2008). Balancer segment sales focus throughout the world on end-users, rebuilders and original equipment manufacturers of grinding machines with the target geographic markets in North America, Asia and Europe. Balancer sales decreased $1.4 million or 17.2% to $7.0 million in Fiscal 2009 compared to $8.4 million in Fiscal 2008. The Fiscal 2009 decrease in worldwide balancer sales is due to lower volumes of shipments as the worldwide automotive industry has been severely impacted by the global economic downturn. The Measurement segment product line consists of both laser-based light-scatter and distance measurement and dimensional sizing products. Total Measurement sales decreased $477,000 or 15.9% to $2.5 million in Fiscal 2009 compared to $3.0 million in Fiscal 2008. The decrease is primarily due to the lower volumes of shipments of surface measurement products to disk drive and silicon wafer manufacturers.

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 partially resulted in higher research and development costs of $391,000 during Fiscal 2009. These higher expenses negatively impacted operating results during Fiscal 2009.

Net loss was $2.2 million or $0.75 per fully diluted share for the year ended May 31, 2009 as compared to net income of $1.1 million or $0.39 per fully diluted share for the year ended May 31, 2008. Earnings per share for Fiscal 2009 as compared to the prior year were also negatively impacted due to the issuance of 200,000 shares of common stock used in connection with the acquisition of Xtero during the third quarter of Fiscal 2008.

Critical Accounting Policies

Revenue Recognition-The Company recognizes revenue for sales and billing for freight charges upon delivery of the product to the customer at a fixed or determinable price with a reasonable assurance of collection, passage of title to the customer as indicated by shipping terms and fulfillment of all significant obligations, pursuant to the guidance provided by Staff Accounting Bulletin No. 104, "Revenue Recognition," issued by the Securities and Exchange Commission in December 2003. For sales to all customers, including manufacturer representatives, distributors or their third-party customers, these criteria are met at the time product is shipped. When other significant obligations remain after products are delivered, revenue is recognized only after such obligations are fulfilled. In addition, judgments are required in evaluating the credit worthiness of our customers. Credit is not extended to customers and revenue is not recognized until we have determined that collectibility is reasonable assured.

Allowance for Doubtful Accounts-Our policy is to maintain allowances for estimated losses resulting from the inability of our customers to make required payments. Credit limits for all customers are established based upon several factors, including but not limited to financial condition and stability, payment history, published credit reports and use of credit references. On a monthly basis, management performs various analyses to

Inventories-As a designer and manufacturer of high technology systems, we are exposed to a number of economic and industry factors that could result in portions of our inventories becoming either obsolete or in excess of anticipated usage. These factors include, but are not limited to, technological changes in our markets, our ability to meet changing customer requirements, competitive pressures in products and prices, and the availability of key components from our suppliers. Our policy is to record inventory write-downs when conditions exist that suggest our inventories may be in excess of anticipated demand for our products and market conditions. We regularly evaluate the ability to realize the value of our inventories based upon a combination of factors including the following: historical usage rates, forecasted sales or usage, product end of life dates, estimated current and future market values and new product introductions. Purchasing requirements and alternative usage avenues are explored within these processes to mitigate inventory exposure. When recorded, our write-downs are intended to reduce the carrying value of our inventories to their net realizable value and establish a new cost basis.

Deferred Taxes-The Company applies the asset and liability method in recording income taxes, under which deferred income tax assets and liabilities are determined, based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using currently enacted tax rates and laws. Additionally, deferred tax assets are evaluated and a valuation allowance is established if it is more likely than not that all or a portion of the deferred tax asset will not be realized. Management continues to review the level of the valuation allowance on a quarterly basis. There can be no assurance that the Company's future operations will produce sufficient earnings so that the deferred tax assets can be fully utilized.

Intangible Assets-There is a periodic review of intangible and other long-lived assets for impairment. This review consists of the analysis of events or changes in circumstances that would indicate the carrying amount of the assets may not be recoverable. Recoverability is determined by comparing the forecasted future undiscounted net cash flows from the operations to which the assets relate, based on management's best estimates using the appropriate assumptions and projections at the time, to the carrying amount of the assets. If the carrying value is determined to be in excess of future operating cash flows, the asset is considered impaired and a loss is recognized equal to the amount by which the carrying amount exceeds the estimated fair value of the assets.

Recently issued accounting pronouncements

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

Discussion of Operating Results



                                                             Year Ended May 31,
                                        2009                          2008                        2007
Balancer sales                $  6,971,079        73.4 %      $  8,414,120     73.7 %     $  7,923,627     66.7 %
Measurement sales                2,530,129        26.6 %         3,007,137     26.3 %        3,958,449     33.3 %

Total sales                      9,501,208       100.0 %        11,421,257    100.0 %       11,882,076    100.0 %
Cost of sales                    5,361,088        56.4 %         5,305,144     46.4 %        5,254,205     44.2 %

Gross profit                     4,140,120        43.6 %         6,116,113     53.6 %        6,627,871     55.8 %

Operating expenses:
General, administration
and sales                        5,033,617        53.0 %         4,628,003     40.5 %        4,770,996     40.2 %
Research and development         1,019,440        10.7 %           628,150      5.5 %           88,425      0.7 %

Total operating expenses         6,053,057        63.7 %         5,256,153     46.0 %        4,859,421     40.9 %

Operating income (loss)         (1,912,937 )     (20.1 %)          859,960      7.5 %        1,768,450     14.9 %
Other income                        49,682         0.5 %           251,282      2.2 %          226,375      1.9 %

Income (loss) before
income taxes                    (1,863,255 )     (19.6 %)        1,111,242      9.7 %        1,994,825     16.8 %
Provision (benefit) for
income taxes                       290,269         3.1 %             8,138      0.1 %          710,000      6.0 %

Net income (loss)             $ (2,153,524 )     (22.7 %)     $  1,103,104      9.7 %     $  1,284,825     10.8 %

Sales-Sales in the Balancer segment decreased $1.4 million, or 17.2%, to $7.0 million for Fiscal 2009 compared to $8.4 million for Fiscal 2008. This decrease is primarily due to decreased sales in North America and Europe during the year. North American sales decreased $1.0 million, or 25.1%, in Fiscal 2009 compared to the prior year. European sales decreased $411,000, or 25.9%, in Fiscal 2009 compared to Fiscal 2008. Market demand in Asia for the Balancer segment products was flat with that region showing a decrease of $22,000, or 0.8%, for Fiscal 2009 compared to the prior year. The decreases in North America and Europe are primarily due to lower volumes of shipments caused by weaknesses in the global economy and softening of the worldwide automotive, bearing and aircraft industries and its impact on the machine tool industry. The European market is also negatively impacted by greater competition with other European companies. The global economic crisis has not impacted the Chinese market as much as other regions of the world resulting in relatively flat sales in Asia. 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 global economy.

Sales in the Measurement segment decreased $477,000, or 15.9%, to $2.5 million in Fiscal 2009 compared to $3.0 million in Fiscal 2008. The decrease is primarily due to the lower volumes of shipments of laser-based surface measurement products to disk drive and silicon wafer manufacturers. These industries have undergone significant consolidation as manufacturers merged or exited the markets resulting in a redeployment of equipment rather than making additional investments in capital equipment. Fiscal 2009 sales of laser-based dimensional sizing products increased slightly, $18,000 or 0.9%, as compared to Fiscal 2008.

Sales in the Balancer segment increased $490,000, or 6.2%, to $8.4 million for Fiscal 2008 compared to $7.9 million for Fiscal 2007. This increase is primarily due to increased sales in North America and Asia during the year. North American sales increased $401,000, or 11.2%, in Fiscal 2008 compared to the prior year. Market demand in Asia for the Balancer segment products remained strong with that region showing an increase of $327,000, or 13.4%, for Fiscal 2008 compared to the prior year. European sales decreased $68,000, or 4.1%, in Fiscal 2008 compared to Fiscal 2007. The increase in North American and Asian sales is primarily the result of a recovery from softer balancer sales experienced over the past two years due to weaknesses in the worldwide automotive, bearing and aircraft industries and its impact on the machine tool industry. The European market has

Sales in the Measurement segment decreased $951,000, or 24.0%, to $3.0 million in Fiscal 2008 compared to $4.0 million in Fiscal 2007. The decrease is primarily due to the lower volumes of shipments of surface measurement products to disk drive and silicon wafer manufacturers. These industries have undergone significant consolidation as manufacturers merged or exited the markets resulting in a redeployment of equipment rather than making additional investments in capital equipment. Fiscal 2008 sales of laser-based distance measurement and dimensional sizing products increased slightly, $5,000, as compared to Fiscal 2007.

Gross margin-Gross margin for Fiscal 2009 decreased to 43.6% as compared to 53.6% for Fiscal 2008. This decrease is due to changes in the product sales mix shifting towards lower margin products and increases in reserves for excess and obsolete inventory. Balancer margins were also negatively impacted as a result of higher sales in foreign markets as a large portion of those sales are made through distributors who receive favorable pricing. Gross margin for Fiscal 2008 decreased to 53.6% as compared to 55.8% for Fiscal 2007. This decrease is due to the product sales mix shifting towards lower margin products.

Operating expenses-Operating expenses increased $797,000, or 15.2%, to $6.1 million for Fiscal 2009 as compared to $5.3 million for Fiscal 2008. General, administrative and selling expenses increased $406,000 or 8.8% for Fiscal 2009 as compared to Fiscal 2008. This increase is primarily due to higher personnel costs resulting from increased headcount, higher stock based compensation and higher amortization expenses related to the identifiable intangible assets acquired from Xtero, offset by lower commissions related to the decrease in sales. Research and development expenses increased $391,000 or 62.3% as compared to the prior year primarily due to new product development associated with the technologies acquired from Xtero and new product development related to existing product lines. Operating expenses increased $397,000, or 8.2%, to $5.3 million for Fiscal 2008 as compared to $4.9 million for Fiscal 2007. This increase is primarily due to increased research and development expenses of $540,000 related to technologies acquired from Xtero and expenses associated with the implementation of Section 404 of the Sarbanes-Oxley Act offset by lower personnel costs in general, administrative and sales expenses.

Other income-Other income consists of interest income, foreign currency exchange gain (loss) and other income (expense). Interest income was $74,000, $227,000 and $206,000 in Fiscal 2009, 2008 and 2007, respectively. Interest income has decreased due to lower investment balances and lower interest rates. Foreign currency exchange loss was $24,000 in Fiscal 2009. Foreign currency exchange gain was $25,000 and $21,000 in Fiscal 2008 and 2007, respectively.

Income tax provision-The effective tax rate in Fiscal 2009 was 15.6%. The effective tax rate on consolidated net loss differs from the federal statutory tax rate primarily due to research and experimentation credits, lower effective tax rates on net income reported by SEL and the effect of changes in tax contingencies offset by changes in the deferred tax valuation allowance, the expiration of capital loss carryforwards, a foreign jurisdiction statutory gain exclusion and certain expenses not deductible for income tax reporting. The effective tax rate in Fiscal 2008 was 0.7%. The effective tax rate on consolidated net income differs from the federal statutory tax rate primarily due to export tax incentives claimed during the year related to prior years, domestic manufacturing deduction, lower effective tax rates on net income reported by the Company's wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom, the net tax benefits related to a gain exclusion provision provided in Canada on the sale technology from the Canadian subsidiary to a US subsidiary and a reduction in the valuation allowance offset by certain expenses not deductible for income tax reporting. The effective tax rate was 35.6% for Fiscal 2007. Our effective tax rate on consolidated net income differs from the federal statutory tax rate primarily due to certain expenses not deductible for income tax reporting offset by lower effective tax rates on net income reported by SEL. The effective tax rate of 24.3% in Fiscal 2006 differs from the federal statutory tax rate primarily due to a reduction in the valuation allowance. Management believes the effective tax rate on consolidated net income in future periods will reflect a normal combined state and federal rate, net of the effect from expenses not deductible for income tax reporting purposes.

LIQUIDITY AND CAPITAL RESOURCES

The Company's working capital decreased $615,000 to $9.3 million as of May 31, 2009 compared to $9.9 million as of May 31, 2008. Cash, cash equivalents and available for sale short term investments decreased $1.3 million to $4.2 million as of May 31, 2009 from $5.5 million as of May 31, 2008. As of May 31, 2009, the Company had $4.2 million in cash and cash equivalents on hand compared to $3.0 million at May 31, 2008. As of May 31, 2009, the Company had no short term investments compared to $2.5 million at May 31, 2008. The Company moved their short term investments to money market funds as they matured during Fiscal 2009.

Cash used in operating activities was $1.2 million in Fiscal 2009 as compared to cash provided by operating activities of $890,000 in Fiscal 2008. The decrease was primarily due to decreases in net income, deferred taxes, accounts payable and taxes payable offset by increases in accounts receivable, depreciation and amortization, stock based-compensation, income taxes receivable and other accrued liabilities.

At May 31, 2009, we had accounts receivable of $1.1 million as compared to $1.6 million at May 31, 2008. The decrease in accounts receivable was due to lower sales in the fourth quarter of 2009 as compared to the fourth quarter in the prior year. At May 31, 2009, income taxes receivable were $334,000 due to the net loss incurred during Fiscal 2009. At May 31, 2009, total current liabilities decreased $495,000 to $906,000 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 incurred as compared to the prior year.

During the year ended May 31, 2009, net cash provided by investing activities was $2.3 million, which consisted of net maturities of short-term investments of $2.5 million offset by additions to property and equipment of $172,000. 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 May 31, 2009), or LIBOR plus 2.0%, (2.32% as of May 31, 2009). The agreement expires on March 1, 2011. There were no outstanding balances on the line of credit at May 31, 2009 and 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.