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 roughness 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, 2012 (Fiscal 2012), total sales increased $2.9 million, or 25.6%, to $14.4 million from $11.5 million in the year ended May 31, 2011 (Fiscal 2011). 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, South America, Asia and Europe. Balancer sales increased $1.3 million, or 15.7%, to $9.3 million in Fiscal 2012 compared to $8.0 million in Fiscal 2011. The Fiscal 2012 increase in balancer sales is due to higher volumes of shipments as the worldwide automotive and manufacturing industries continue to recover from the global economic downturn, particularly in North America. The Measurement segment product line consists of laser-based light-scatter, distance measurement and dimensional sizing products and remote tank monitoring products. Total Measurement sales increased $1.7 million, or 48.5%, to $5.2 million in Fiscal 2012 compared to $3.5 million in Fiscal 2011. The increase is primarily due to higher volumes of shipments across all of the Measurement segment product lines.

Operating expenses have increased $484,000, or 8.3%, to $6.3 million in Fiscal 2012 from $5.8 million in Fiscal 2011. General, administrative and sales expenses increased $670,000, or 12.7%, in Fiscal 2012 to $6.0 million as compared to $5.3 million in the prior fiscal year. Research and development expenses decreased $186,000, or 36.9%, to $318,000 in Fiscal 2012 from $504,000 in Fiscal 2011.

Net income was $77,000, or $0.03 per fully diluted share, for the year ended May 31, 2012 as compared to a net loss of $205,000, or $0.07 per fully diluted share, for the year ended May 31, 2011.

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

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 evaluate accounts receivable balances to ensure recorded amounts reflect estimated net realizable value. This review includes accounts receivable agings, other operating trends and relevant business conditions, including general economic factors, as they relate to the Company's domestic and international customers. When a customer's account balance becomes past due, we initiate dialogue with the customer to determine the cause. If it is determined that the customer will be unable to meet its financial obligation to us, such as in the case of a bankruptcy filing, we record a specific allowance to reduce the related receivable to the amount we expect to recover given all of the information presently available.

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,
                                        2012                          2011                            2010
Balancer sales                $  9,265,008        64.2 %    $  8,011,179         69.7 %     $  4,670,723         68.6 %
Measurement sales                5,172,014        35.8 %       3,481,680         30.3 %        2,135,025         31.4 %

Total sales                     14,437,022       100.0 %      11,492,859        100.0 %        6,805,748        100.0 %
Cost of sales                    8,094,386        56.1 %       5,887,207         51.2 %        3,763,756         55.3 %

Gross profit                     6,342,636        43.9 %       5,605,652         48.8 %        3,041,992         44.7 %

Operating expenses:
General, administration and
sales                            5,967,359        41.3 %       5,297,083         46.1 %        4,184,100         61.5 %
Research and development           317,993         2.2 %         504,251          4.4 %          584,582          8.6 %

Total operating expenses         6,285,352        43.5 %       5,801,334         50.5 %        4,768,682         70.1 %

Operating income (loss)             57,284         0.4 %        (195,682 )       (1.7 %)      (1,726,690 )      (25.4 %)
Other income (expense)              37,260         0.3 %          (8,042 )       (0.1 %)          31,107          0.5 %

Income (loss) before income
taxes                               94,544         0.7 %        (203,724 )       (1.8 %)      (1,695,583 )      (24.9 %)
Provision for income taxes          17,123         0.1 %           1,659          0.0 %           15,430          0.2 %

Net income (loss)             $     77,421         0.5 %    $   (205,383 )       (1.8 %)    $ (1,711,013 )      (25.1 %)

Sales - Sales in the Balancer segment increased $1.3 million, or 15.7%, to $9.3 million for Fiscal 2012 compared to $8.0 million for Fiscal 2011. This increase is primarily due to higher unit sales volumes in North America offset by decreases in unit sales volumes in Asia and Europe during the year. North American sales increased $1.5 million, or 45.9%, in Fiscal 2012 compared to Fiscal 2011. Sales into Asia decreased $370,000, or 9.7%, in Fiscal 2012 compared to the prior year. Sales into Europe decreased $14,000, or 1.6%, in Fiscal 2012 compared to Fiscal 2011. Sales on other regions of the world increased $187,000, or 162.3%, during Fiscal 2012 as compared to the prior year. The increases in North America and other regions of the world are primarily due to higher volumes of shipments as the worldwide automotive and industrial markets in these regions continue to recover from the global economic downturn. The decreases in Asia and Europe are due to a reduction in orders as economic growth in China is slowing and the uncertainty regarding the European economy continues to have a negative impact on manufacturing. The levels of demand for our Balancer products in any of these geographic markets cannot be forecasted with any certainty given current economic trends and the historical volatility experienced in this market.

Sales in the Measurement segment increased $1.7 million, or 48.5%, to $5.2 million in Fiscal 2012 compared to $3.5 million in Fiscal 2011. Sales of laser-based distance measurement and dimensional-sizing products increased $772,000, or 28.3%, primarily due to a large, non-recurring sale during the fourth quarter of Fiscal 2012. Sales of remote tank monitoring products increased $479,000 to $581,000 during Fiscal 2012 due to the higher volume of shipments. Sales of laser-based surface measurement products increased $439,000, or 67.1%, primarily due to the sale of two CASI scatterometers. Future sales of laser-based or ultrasonic measurement products cannot be forecasted with any certainty given the historical volatility experienced in this market.

Sales in the Balancer segment increased $3.3 million, or 71.5%, to $8.0 million for Fiscal 2011 compared to $4.7 million for Fiscal 2010. This increase is primarily due to higher unit sales volumes in Asia, North America and Europe during the year. Asia sales increased $1.8 million, or 93.5%, in Fiscal 2011 compared to Fiscal 2010. North American sales increased $1.4 million, or 77.9%, in Fiscal 2011 compared to the prior year. European sales increased $108,000, or 13.5%, in Fiscal 2011 compared to Fiscal 2010. The increases across all geographies are primarily due to higher volumes of shipments as the worldwide automotive and industrial markets in these regions have begun to recover from the previous low levels due to the global economic downturn.

Gross margin - Gross margin in Fiscal 2012 decreased to 43.9% compared to 48.8% in Fiscal 2011. This decrease was primarily due to higher inventory reserves associated with an end-of-life SBS balancer product, higher labor and overhead costs related to the increased sales volumes offset by a reduction in inventory component costs. Gross margin in Fiscal 2011 increased to 48.8% compared to 44.7% in Fiscal 2010. This increase is primarily due to a shift in product sales mix with sales increasing in the Measurement segment, which typically have higher gross margins than the Balancer segment, and sales in the Balancer segment rebounding positively in the North American market, which generally have slightly higher margins than Asia due to the channel and distributor discounts required in Asia.

Operating expenses - Operating expenses increased $484,000, or 8.3%, to $6.3 million for Fiscal 2012 compared to $5.8 million in Fiscal 2011. General, administrative and sales expenses increased $670,000, or 12.7%, to $6.0 million in Fiscal 2012 compared to $5.3 million in the prior year. This increase is due primarily to higher personnel costs, higher commissions related to the increased sales and higher sales and marketing expenses. Research and development expenses decreased $186,000, or 36.9%, to $318,000 in Fiscal 2012 compared to $504,000 in Fiscal 2011. The decrease in research and development expense is primarily due to lower material costs associated with new product development related to existing product lines.

Operating expenses increased $1.0 million, or 21.7%, to $5.8 million for Fiscal 2011 compared to $4.8 million in Fiscal 2010. General, administrative and sales expenses increased $1.1 million, or 26.6%, to $5.3 million in Fiscal 2011 compared to $4.2 million in the prior year. This increase is due primarily to higher commissions related to the increase in sales, higher stock-based compensation and higher expenses associated with an international trade show that occurs every two years. Research and development expenses decreased $80,000, or 13.7%, to $504,000 in Fiscal 2011 as compared to $585,000 in Fiscal 2010. Research and development expenses decreased primarily due to lower material costs associated with new product development.

Other income - Other income consists of interest income, foreign currency exchange gain (loss) and other income (expense). Interest income was $2,000, $4,000 and $11,000 in Fiscal 2012, 2011 and 2010, respectively. Interest income has decreased due to lower average cash and investment balances and lower interest rates. Foreign currency exchange gain was $18,000 and $19,000 in Fiscal 2012 and 2010, respectively. Foreign currency exchange loss was $10,000 in Fiscal 2011. The foreign currency exchange gain (loss) fluctuated with the strength of foreign currencies against the U.S. dollar during the respective periods. Other income consisted of an $18,000 gain on the sales of fixed assets for Fiscal 2012.

Income tax provision - The effective tax rate in Fiscal 2012 was 18.1%. The effective tax rate on consolidated net income in Fiscal 2012 differs from the federal statutory tax rate primarily due to the amount of income from foreign jurisdictions, changes in the deferred tax valuation allowance and certain expenses not being deductible for income tax reporting offset by tax credits related to research and experimentation expenses. The effective tax rate on consolidated net loss was (0.8)% for Fiscal 2011. The Company's effective tax rate on consolidated net loss differs from the federal statutory rate primarily due to the amount of income from foreign jurisdictions, changes in the deferred tax valuation allowance and certain expenses not being deductible for income tax reporting purposes, offset by tax credits related to research and experimentation expenses. The effective tax rate in Fiscal 2010 was (0.9)%. The effective tax rate on consolidated net loss in Fiscal 2010 differs from the federal statutory tax rate primarily due to the amount of income from foreign jurisdictions, changes in the deferred tax valuation allowance and certain expenses not being deductible for income tax reporting, offset by tax credits related to research and experimentation expenses.

LIQUIDITY AND CAPITAL RESOURCES

The Company's working capital increased $432,000 to $7.9 million as of May 31, 2012 compared to $7.5 million as of May 31, 2011. Cash and cash equivalents increased $16,000 from May 31, 2011 to $2.8 million as of May 31, 2012.

Cash provided by operating activities was $163,000 in Fiscal 2012 as compared to cash used in operations of $559,000 in Fiscal 2011. The increase is primarily due to increases in net income, decrease in inventory and an increase in accrued liabilities, offset by increases in accounts receivable and prepaid expenses and decreases in accounts payable.

At May 31, 2012, accounts receivable increased $662,000 to $2.5 million compared to $1.8 million as of May 31, 2011. The increase in accounts receivable is due to the increase in sales during Fiscal 2012. Inventories decreased $171,000 to $4.0 million as of May 31, 2012 compared to $4.1 million at May 31, 2011 due to increased inventory reserves related to an end-of-life SBS product. At May 31, 2012, total current liabilities increased $103,000 to $1.5 million as compared to $1.4 million at May 31, 2011. The increase is primarily due to an increase in other accrued liabilities associated with a customer deposit on a future order offset by lower accounts payables as compared to the prior year.

During the year ended May 31, 2012, net cash used in investing activities was $228,000, which primarily consisted of additions to property and equipment for new manufacturing and computer equipment and vehicles offset by the cash proceeds received from the sale of property and equipment.

The Company has a $2.0 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, 2012), or LIBOR plus 2.0%, (2.24% as of May 31, 2012). The agreement expires on March 1, 2014. There were no outstanding balances on the line of credit at May 31, 2012 and 2011.

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.

QUARTERLY FINANCIAL DATA

In thousands, except per share information (unaudited)



2011 Quarter Ended                         August 31          November 30          February 28         May 31
Sales                                     $     2,404        $       2,914        $       2,920        $ 3,254
Gross profit                              $     1,100        $       1,429        $       1,309        $ 1,769
Net income (loss)                         $      (113 )      $          41        $        (192 )      $    58
Net income (loss) per share, basic        $      (.04 )      $         .01        $        (.07 )      $   .02
Net income (loss) per share, diluted      $      (.04 )      $         .01        $        (.07 )      $   .02

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2012 Quarter Ended                         August 31          November 30          February 29         May 31
Sales                                     $     3,471        $       3,476        $       3,156        $ 4,332
Gross profit                              $     1,708        $       1,467        $       1,540        $ 1,628
Net income (loss)                         $       137        $         (78 )      $          13        $     6
Net income (loss) per share, basic        $       .05        $        (.03 )      $         .00        $   .00
Net income (loss) per share, diluted      $       .05        $        (.03 )      $         .00        $   .00