Fiscal 2009 Compared to Fiscal 2008

Overview The Company is engaged in the business of manufacturing over 5,000 different products for industrial, professional and consumer markets. As a global manufacturer with major subsidiaries in Brazil, Scotland, and China, the Company offers a broad array of products to the market through multiple channels of distribution globally. Net sales decreased 16% in fiscal 2009 compared to fiscal 2008. The Company continued to experience the severity of the global economic recession during the most recent quarter. The severe decline is due to the unprecedented slowdown in the global economy and the rapid strengthening of the U.S. dollar. This is a direct reflection of the financial market crisis, lack of liquidity and weak consumer confidence. The resultant effect has been a massive de-stocking throughout the supply chain which caused the most significant drop in Company sales in the third quarter ending March 28, 2009 in the past thirty years. Historically, the Company has lagged the economy and we expect the current harsh economic realities will be with the Company for the balance of this calendar year. For fiscal 2009, the Company incurred a net loss of $3.2 million, or $(0.49) per basic and diluted share compared to a net income of $10.8 million or $1.64 per basic and diluted share for fiscal 2008. This represents a decrease of $14.0 million comprised of a decrease in gross margin of $16.7 million, the aforementioned goodwill charge of $5.3 million, a decrease of $3.3 million in other income (expense) offset by a decrease of $2.8 million in selling, general and administrative costs and a decrease in income tax expense of $8.4 million from a $6.1 million provision in fiscal 2008 to a $2.3 million benefit in fiscal 2009. The above items are discussed below.

Net Sales Net sales for fiscal 2009 were down $38.7 million or 16% compared to fiscal 2008. North American sales decreased $27.7 million or 21%, reflecting declining U.S. demand partly caused by the widening of the recession in the manufacturing sector, decreased sales in Canada and Mexico, and lower Evans Rule sales. The declines are primarily related to unit volume declines. The impact of any price concessions and new product sales was not material. It is likely that the Company's results will continue to be impacted by the current global economic recession. Foreign sales (excluding North America) decreased 9.9% (1% increase in local currency), driven by the weakening of the Brazilian Real, British Pound, Euro, and Australian Dollar against the U.S. dollar, offset by a growth in Chinese operations ($0.4 million increase). Beyond exchange rate effects, the declines were mainly related to unit volume declines relative to the global economic collapse.

Earnings (loss) before taxes (benefit) The pre-tax loss for fiscal 2009 was $5.6 million, which includes $5.3 million impairment charge for goodwill, compared to pre-tax earnings of $16.9 million for fiscal 2008. This represents a decrease of pre-tax earnings of $22.4 million. This is comprised of a decrease in gross margin of $16.7 million and a decrease of $3.3 million in other income offset by a decrease in selling, general and administrative costs of $2.8 million. The decrease in gross margin is primarily attributable to the overall decline in sales from fiscal 2008 to fiscal 2009 ($10.5 million gross margin effect).

In response to the downturn in sales volume, the Company has reduced spending on raw materials and indirect production costs. The Company has also cut salaries at certain locations by 10% and has reduced hourly labor costs through shortened work weeks, layoffs and attrition. These reductions are done with careful consideration so as not to compromise customer service levels or the retention of key employees. This is having an approximate $2.0 million impact per quarter on cost of sales and selling, general and administrative costs. In addition, layoffs instituted in April 2009 at certain domestic locations, are having an approximate $1.1 million impact per quarter on cost of sales and selling, general and administrative costs. Finally, a reduction in labor force in Brazil is expected to have a $.2 million impact per quarter. This is in addition to temporary salary cuts in Brazil taking place over the next 6 months for a savings of $.4 million. Although the Company's recent order activity is down compared to historical levels, this decline is spread relatively proportionately across most of our customers. The Company fully expects order activity to rebound once the supply chain de-stocking abates and excess inventory levels at the Company's distributors are depleted. The Company does not anticipate any liquidity constraints given the adequacy of its working capital and its available credit line. See further discussion under Liquidity and Capital Resources.

Significant Fourth Quarter Activity As shown in footnote 14 to the Consolidated Financial Statements, the Company incurred a loss before income taxes of $3.9 million during the fourth quarter of fiscal 2009. This was primarily attributable to the decrease in gross margin caused by the 9% decrease in sales from the third to fourth quarter and to the recording of a $.8 million severance charge by the Company's Brazilian subsidiary.

Income Taxes The effective rate was 42.0% for fiscal 2009, reflecting a combined federal, state and foreign worldwide rate adjusted for permanent book/tax differences, the most significant of which is the deduction allowable for the Brazilian dividend distributed in December 2008. The effective rate was 36.0% for fiscal 2008, reflecting similar components as fiscal 2009. A portion of recorded valuation allowances for certain foreign NOL's were eliminated during fiscal 2009 and fiscal 2008, reflecting current usage based upon current earnings. The change in the effective rate percentage from fiscal 2008 to fiscal 2009 reflects the greater impact of permanent book/tax differences on a lower base due to the loss in fiscal 2009.

No changes in valuation allowances relating to carryforwards for foreign NOL's, foreign tax credits and certain state NOL's are anticipated at this time other than reversals relating to realization of NOL benefits for certain foreign subsidiaries. The Company continues to believe it is more likely than not that it will be able to utilize its tax operating loss carryforward assets of approximately $8.8 million reflected on the balance sheet.

Fiscal 2008 Compared to Fiscal 2007

Overview For fiscal 2008, the Company realized net income of $10.8 million, or $1.64 per basic and diluted share compared to a net income of $6.7 million or $1.00 per basic and diluted share for fiscal 2007. This represents an increase in net income of $4.1 million comprised of an increase in gross margin of $10.4 million, an increase of $7.1 million in selling, general and administrative costs, an increase in other income (expense) of $4.7 million and an increase in income tax expense of $3.9 million from $2.2 million to $6.1 million. The above items are discussed in more detail below.

Net Sales Net sales for fiscal 2008 were up $20.0 million or 9% compared to fiscal 2007. North American sales increased .9% reflecting steady U.S. demand, increased sales in Canada, increased penetration in Mexico, and the acquisition of Kinemetrics on July 17, 2007, offset by lower Evans sales to Sears. Excluding the Evans Rule Division, North American sales increased $2.6 million (2%). Foreign sales (excluding North America) increased 22% (8% increase in local currency) driven by the strengthening of the Brazilian Real against the U.S. dollar, the strengthening of the British Pound against the U.S. dollar, growing sales for the Chinese operations ($2.8 million increase) and greater expansion worldwide into newer markets, including Eastern Europe, the Middle East and China.

Earnings (loss) before taxes (benefit) Pre-tax earnings for fiscal 2008 was $16.9 million compared to pre-tax earnings of $8.9 million for fiscal 2007. This represents an increase in pre-tax earnings of $8.0 million or an increase of 90% over the prior year. This is comprised of an increase in gross margin of $10.4 million and other income of $4.7 million, offset by an increase in selling, general and administrative costs of $7.1 million. The gross margin percentage increased from 29.6% in fiscal 2007 to 31.5% in fiscal 2008. This was primarily driven by better overhead absorption at certain domestic plants due to higher sales volumes ($1 million), the impact of lean manufacturing initiatives, a reduction in cost of sales at the Evans Rule Division, and better overhead absorption at the U.K. and Brazilian operations ($2.0 million). This increase was achieved in spite of certain material cost increases that could not be fully passed on to customers. Effects from LIFO liquidations in fiscal 2008 and 2007 were not considered material. Gross margins for fiscal 2009 could again be adversely impacted by material cost increases which cannot be fully passed on to customers and by increased competitive pressures in various markets. As indicated above, selling, general and administrative costs increased $7.1 million from fiscal 2007 to fiscal 2008, as the percentage of sales increased slightly from 25.0% in fiscal 2007 to 25.9% in fiscal 2008. The increase is a result of increased sales commissions, profit sharing and bonuses ($2.5 million), increases in marketing and advertising primarily relating to new product introductions ($.3 million), and the inclusion of nearly a full year of Kinemetrics' selling, general and administrative costs in fiscal 2008 ($1.9 million), and an increase in bad debt write-offs ($.1 million). The increase in other income (expense) from fiscal 2007 to fiscal 2008 of $4.7 million is a net of increased net interest income, increased net exchange gains and the higher gain on the sale of the Glendale, AZ facility ($1.7 million) in fiscal 2008 versus the gain on the sale of the Alum Bank plant in fiscal 2007 ($.3 million). The Company currently includes the Evans North Charleston facility on June 28, 2008 Balance Sheet as an asset held for sale of $1.9 million.

Significant Fourth Quarter Activity As shown in footnote 14 to the Consolidated Financial Statements, only $2.2 million of the $10.8 million of net income realized during fiscal 2008 was earned in the fourth quarter. This reflects the recording of the profit sharing plan accrual of $.9 million for eligible domestic employees and a $.2 million accrual for executive bonuses. Both of these plans were approved by the Company's Board of Directors in June 2008 and as such, the entire year's accrual was recorded in the fourth quarter. In addition, certain offsetting adjustments were made for transfer pricing and return-to-provision adjustments netting to $.3 million in the fourth quarter.

Income Taxes The effective income tax rate was 36.0% for fiscal 2008, reflecting a combined federal, state and foreign worldwide rate adjusted for permanent book/tax differences, the most significant of which is the deduction allowable for the Brazilian dividend paid in December 2007. The effective tax rate for fiscal 2007 was 25%, reflecting the benefits of a release of tax reserves, the elimination of the valuation allowances for certain state and foreign NOL's and the benefit of the tax treatment of the Brazilian dividend. A net reduction resulted from a release of tax reserves, resulting from the close out of certain examination years and additional analysis of transfer pricing exposure and return to provision adjustments resulting from the preparation of various tax returns. Valuation allowances were eliminated during fiscal 2007 for certain state and foreign NOL's as strong earnings in fiscal 2007 increased the likelihood of realizing the benefits of those NOL's. Only minor changes in valuation allowances were made in fiscal 2008. The change in the effective rate percentage from fiscal 2007 to fiscal 2008 primarily relates to the fiscal 2007 release of the tax reserves and valuation allowance, as well as additional reserves for transfer pricing issues provided in fiscal 2008.

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.

As of June 28, 2008, the Company held $2.5 million in AAA-rated auction rate securities for which there were no current active quoted market prices. The Company liquidated this $2.5 million in September 2008 through November 2008 through the broker's announced buyback program for auction rate securities. Thus, the above securities were all redeemed at par value. No such investments are held as of June 27, 2009.

During fiscal 2008 and fiscal 2009, the Company was party to an interest swap arrangement more fully described in Note 11 to the Consolidated Financial Statements. This arrangement expired on April 28, 2009. The Company does not engage in tracking, 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 engages in a limited amount of hedging activity to minimize the impact of foreign currency fluctuations. Net foreign monetary assets are approximately $6.9 million as of June 27, 2009.

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 $2.4 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 $1.8 million by an immaterial amount. See Note 11 to the Consolidated Financial Statements for details concerning the Company's long-term debt outstanding of $1.3 million.

LIQUIDITY AND CAPITAL RESOURCES

                                                        Years ended in June ($000)
                                                      2009         2008          2007
  Cash provided by operations                       $    659     $  19,012     $ 12,849
  Cash provided by (used in) investing activities      5,469       (13,584 )       (852 )
  Cash (used in) financing activities                 (1,298 )      (6,851 )     (8,652 )

The significant increase in cash provided by operations from fiscal 2007 to fiscal 2008 was primarily driven by the $4.1 million improvement in net earnings, and an increase in non-cash items and other working capital changes ($2.0 million). Conversely, the significant decrease in cash provided by operations from fiscal 2008 to fiscal 2009 is primarily driven by the $14.1 million decrease in net earnings and working capital changes ($7.1 million). The non-cash items relating to depreciation and amortization are not expected to change significantly over the next few years.

"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 had been overfunded, retirement benefits in total generated approximately $1.6 million, $2.8 million and $1.1 million of noncash income in fiscal 2009, 2008 and 2007, respectively. Consolidated retirement benefit expense (income) was approximately $(0.8) million in 2009, $(1.7) million in 2008, and $.1 million in 2007.

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 has reduced the cash flow uncertainty related to these Company expenses.

The Company's investing activities consisted of the acquisition of Kinemetric Engineering in fiscal 2008, expenditures for plant and equipment, the investment of cash not immediately needed for operations and the proceeds from the sale of Company assets. Expenditures for plant and equipment have increased over each of the three years, although they are less than depreciation expense in each of those years. The Company will continue to invest in plant and equipment as necessary to optimize the operations of its plants. Details of the Kinemetric acquisition are disclosed in Note 6 to the Consolidated Financial Statements.

Cash flows used in financing activities are primarily the payment of dividends. The Company increased its dividend from $.10 per share to $.12 per share during the fourth quarter of fiscal 2008. The Company has paid during fiscal 2009 and expects to consistently pay this increased dividend in the near future. 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. Purchases for fiscal 2009 and fiscal 2008 amounted to $.3 million and $.3 million, respectively. Overall debt has increased slightly from $10.0 million at the end of fiscal 2008 to $11.4 million at the end of fiscal 2009, primarily due to an increase in capitalized lease obligations in Brazil. However, as described in Note 11, the amount outstanding on the Company's line of credit as of August 31, 2009 is $2.5 million.

Effects of translation rate changes on cash primarily result from the movement of the U.S. dollar against the British Pound, the Euro and the Brazilian Real. The Company uses a limited number of forward contracts to hedge some of this activity and a natural hedge strategy of paying for foreign purchases in local currency when economically advantageous.

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 maintain consistent profitability, additional steps, beyond the salary reductions, layoffs, shortened work weeks as noted above, will have to be taken in order to maintain liquidity, including plant consolidations and work force and dividend reductions (see comments above). In addition to its cash and investments, the Company had maintained a $10 million line of credit, of which, as of June 27, 2009, $975,000 is being utilized in the form of standby letters of credit for insurance purposes. On April 28, 2009, the Company signed an amendment to its existing line of credit agreement extending the termination date of such agreement from April 28, 2009 to June 30, 2009. With this amendment, the scheduled principal payment of $2.4 million due under the Reducing Revolver was extended to June 30, 2009. Under the current credit line, the interest rate at June 27, 2009 for the Reducing Revolver is LIBOR plus 1.5% and 3.25% (Prime) for the line of credit. The Company has a working capital ratio of 4.4 to one as of June 27, 2009 and 4.8 to one as of June 28, 2008.

On June 30, 2009, The L.S. Starrett Company (the "Company") and certain of the Company's subsidiaries (the "Subsidiaries") entered into a Loan and Security Agreement (the "New Credit Facility") with TD Bank, N.A., as lender.

The New Credit Facility replaced the Company's previous Bank of America facility with a $23 million line of credit. On June 30, 2009, the Company utilized this line of credit to pay off the remaining balances on the Reducing Revolver and Line of Credit. The interest rate under the New Credit Facility is based upon a grid which uses the ratio of Funded Debt/EBITDA to determine the floating margin that will be added to one-month LIBOR. The initial rate is one-month LIBOR plus 1.75%. The New Credit Facility matures on April 30, 2012.

Availability under the New Credit Facility is subject to a borrowing base comprised of accounts receivable and inventory. The Company believes that the borrowing base will consistently produce availability under the New Credit Facility in excess of $23 million. In addition, the Company anticipates that it will not need to fully utilize the amounts available to the Company and its subsidiaries under the New Credit Facility. As of August 31, 2009, the Company had borrowings of $2.5 million under the New Credit Facility.

The New Credit Facility contains financial covenants with respect to leverage, tangible net worth, and interest coverage, and also contains customary affirmative and negative covenants, including limitations on indebtedness, liens, acquisitions, asset dispositions, and fundamental corporate changes, and certain customary events of default. Upon the occurrence and continuation of an event of default, the lender may terminate the revolving credit commitment and require immediate payment of the entire unpaid principal amount of the New Credit Facility, accrued interest and all other obligations. As of June 30, 2009, the Company was in compliance with the covenants required for testing at that time under the New Credit Facility.

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 second 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.

Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the Company's Consolidated Financial Statements. The following sections describe the Company's critical accounting policies.

Sales of merchandise and freight billed to customers are recognized when title passes and all substantial risks of ownership change, which generally occurs either upon shipment or upon delivery based upon contractual terms. Sales are net of provisions for cash discounts, returns, customer discounts (such as volume or trade discounts), cooperative advertising and other sales related discounts. Outbound shipping costs absorbed by the Company and inbound freight included in material purchases are included in the cost of sales.

The allowance for doubtful accounts of $0.7 million and $0.7 million at the end of fiscal 2009 and 2008, respectively, is based on our assessment of the collectability of specific customer accounts, the aging of our accounts receivable. While the Company believes that the allowance for doubtful accounts 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.

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.

The Company assesses the fair value of its goodwill generally based upon a discounted cash flow methodology. The discounted cash flows are estimated utilizing various assumptions regarding future revenue and expenses, working capital, terminal value, and market discount rates. If the carrying amount of the goodwill is greater than the fair value an impairment charge is recognized to the extent the recorded goodwill exceeds the implied fair value of goodwill.

Accounting for income taxes requires estimates of future benefits and 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 . . .