UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.  20549

FORM 10-Q

For the quarterly period ended: February 29, 2008

Or

For the transition period from:                         To:                         

Commission File Number:  000-23996

SCHMITT INDUSTRIES, INC.

(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant has (1) filed all reports required to be filed by Section 13 of 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 o

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

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

The number of shares of each class of common stock outstanding as of March 31, 2008

Common stock, no par value                                                   2,870,160

SCHMITT INDUSTRIES, INC.

INDEX TO FORM 10-Q

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PART I - FINANCIAL INFORMATION

Item 1.    Financial Statements

SCHMITT INDUSTRIES, INC.

CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

The accompanying notes are an integral part of these financial statements.

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SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND NINE MONTHS ENDED FEBRUARY 29, 2008 AND FEBRUARY 28, 2007

(UNAUDITED)

The accompanying notes are an integral part of these financial statements.

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SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED FEBRUARY 29, 2008 AND FEBRUARY 28, 2007

(UNAUDITED)

The accompanying notes are an integral part of these financial statements.

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SCHMITT INDUSTRIES, INC.

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

AND COMPREHENSIVE INCOME

FOR THE NINE MONTHS ENDED FEBRUARY 29, 2008

(UNAUDITED)

The accompanying notes are an integral part of these financial statements.

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SCHMITT INDUSTRIES, INC.

NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS

Note 1:

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The consolidated financial information included herein has been prepared by Schmitt Industries, Inc. (the Company or Schmitt) and its wholly owned subsidiaries.  In the opinion of management, the accompanying unaudited Consolidated Financial Statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly its financial position as of February 29, 2008 and its results of operations for the three and nine months ended February 29, 2008 and February 28, 2007 and its cash flows for the nine months ended February 29, 2008 and February 28, 2007.  The consolidated balance sheet at May 31, 2007 has been derived from the Annual Report on Form 10-K for the fiscal year ended May 31, 2007.  The accompanying unaudited financial statements and related notes should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended May 31, 2007.  Operating results for the interim periods presented are not necessarily indicative of the results that may be experienced for the fiscal year ending May 31, 2008.  Certain amounts in prior periods’ financial statements have been reclassified to conform to the current periods’ presentation.  These reclassifications did not affect consolidated net income.

Revenue Recognition and Accounts Receivable

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collectability is reasonably assured.  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.  Substantially all product sales are sold FCA (free carrier) shipping point and any related shipping and handling costs are expensed as incurred and included in cost of sales.

Recent Issued Accounting Pronouncements

The Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48) in June 2006.  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in our financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes” (SFAS 109).  Additionally, in May 2007, the FASB published FASB Staff Position No. FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48” (FSP FIN 48-1).  FSP FIN 48-1 is an amendment to FIN 48.  It clarifies how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits.  FSP FIN 48-1 is effective upon the initial adoption of FIN 48.  The provisions of FIN 48 are effective for our fiscal year beginning June 1, 2007.  The adoption of FIN 48 did not have a material impact on the Company’s results of operations and cash flows.  Refer to Note 5 of the Notes to Consolidated Interim Financial Statements for discussion of the impact of adoption of FIN 48.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157).  SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements.  The provisions of SFAS 157 are effective for the fiscal year beginning June 1, 2008.  The Company is currently evaluating the impact of the provisions of SFAS 157.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities including an Amendment of FASB Statement No. 115” (SFAS 159).  SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value.  The provisions of SFAS 159 are effective for the fiscal year beginning June 1, 2008.  The Company is currently evaluating the impact of the provisions of SFAS 159.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations, which replaces SFAS No 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting.  It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred.  SFAS No. 141R is effective beginning June 1, 2009 and will apply prospectively to business combinations completed on or after that date.

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In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51, which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in earnings. SFAS No. 160 is effective beginning June 1, 2009 and will apply prospectively, except for the presentation and disclosure requirements, which will apply retrospectively.  The Company is currently evaluating the impact of the provisions of SFAS 160.

Note 2:

LINE OF CREDIT

The Company has a $1.0 million bank line of credit secured by U.S. accounts receivable, inventories and general intangibles which expires on March 1, 2009.  Interest is payable at the bank’s prime rate, 6% as of February 29, 2008.  There were no outstanding balances on the line of credit at February 29, 2008.

Note 3:

STOCK OPTIONS AND STOCK-BASED COMPENSATION

Stock-based compensation includes expense charges for all stock-based awards to employees and directors granted under the Company’s stock option plan.  Stock-based compensation recognized during the period is based on the value of the portion of the stock-based award that will vest during the period, adjusted for expected forfeitures.  Compensation cost for all stock-based awards is recognized using the straight-line method.  Stock-based compensation recognized in the Company’s Consolidated Financial Statements for the three and nine months ended February 29, 2008 includes compensation cost for stock-based awards granted prior to, but not fully vested as of, May 31, 2006.  There were no stock-based awards granted subsequent to May 31, 2006.  The Company uses the Black-Scholes option pricing model as its method of valuation for stock-based awards.  The Black-Scholes option pricing model requires the input of highly subjective assumptions, and other reasonable assumptions could provide differing results.  These variables include, but are not limited to:

·                 Risk-Free Interest Rate.  The Company bases the risk-free interest rate on the implied yield currently available on U.S. Treasury issues with an equivalent remaining term approximately equal to the expected life of the award.

·                 Expected Life.  The expected life of awards granted represents the period of time that they are expected to be outstanding.  The Company determines the expected life based on historical experience with similar awards, giving consideration to the contractual terms, vesting schedules and pre-vesting and post-vesting forfeitures.

·                 Expected Volatility.  The Company estimates the volatility of its common stock at the date of grant based on the historical volatility of its common stock.  The volatility factor the Company uses is based on its historical stock prices over the most recent period commensurate with the estimated expected life of the award.  These historical periods may exclude portions of time when unusual transactions occurred.

·                 Expected Dividend Yield.  The Company has never paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future.  Consequently, the Company uses an expected dividend yield of zero.

·                 Expected Forfeitures.  The Company uses relevant historical data to estimate pre-vesting option forfeitures.  The Company records stock-based compensation only for those awards that are expected to vest.

The Company has computed, to determine stock-based compensation expense recognized for the three and nine months ended February 29, 2008 and February 28, 2007, the value of all stock options granted using the Black-Scholes option pricing model using the following assumptions:

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At February 29, 2008 the Company had a total of 170,109 outstanding stock options (163,859 vested and exercisable and 6,250 non-vested) with a weighted average exercise price of $2.58.  The Company estimates that a total of approximately $7,650 will be recorded as additional stock-based compensation expense during the fourth quarter ending May 31, 2008, for all options which are outstanding as of February 29, 2008, but which were not yet vested.

Options granted, exercised, canceled and expired under the Company’s stock option plan during the three and nine months ended February 29, 2008 are summarized as follows:

Note 4:

EPS RECONCILIATION

Basic earnings per share are computed using the weighted average number of shares outstanding.  Diluted earnings per share are computed using the weighted average number of shares outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchase common stock.

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Note 5:

INCOME TAXES

The Company accounts for income taxes using the asset and liability method.  This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities.  Deferred tax assets are reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Adoption of FIN 48

Each year the Company files income tax returns in the various national, state and local income taxing jurisdictions in which it operates.  These tax returns are subject to examination and possible challenge by the taxing authorities.  Positions challenged by the taxing authorities may be settled or appealed by the Company.  As a result, there is an uncertainty in income taxes recognized in the Company’s financial statements in accordance with SFAS No. 109.  In 2006, the FASB issued FIN 48, which clarifies the application of SFAS 109 by defining criteria that an individual income tax position must meet for any part of the benefit of that position to be recognized in an enterprise’s financial statements and provides guidance on measurement, derecognition, classification, accounting for interest and penalties, accounting in interim periods, disclosure, and transition.

On June 1, 2007, the Company adopted the provisions of FIN 48.  The adoption of FIN 48 resulted in a $34,464 decrease in the Company’s liability for unrecognized tax benefits, which was accounted for as an increase to the June 1, 2007 retained earnings balance.  At June 1, 2007 the gross amount of unrecognized tax benefits was approximately $586,000, which includes approximately $150,000 of net unrecognized tax benefits that, if recognized, would reduce the Company’s effective income tax rate.  The Company settled liabilities of approximately $40,000 during the third quarter and nine months ended February 29, 2008, respectively, which resulted in a benefit and reduction of the Company’s effective income tax rate in the third quarter of Fiscal 2008.  Other long-term liabilities related to tax contingencies were $564,384 as of February 29, 2008.

Interest and penalties associated with uncertain tax positions are recognized as components of the “Provision for income taxes.”  The Company’s accrual for interest and penalties was $96,500 upon adoption of FIN 48.  The liability for payment of interest and penalties did not significantly change during the three or nine months ended February 29, 2008.

Several tax years are subject to examination by major tax jurisdictions.  In the United States, federal tax years for Fiscal 2004 and after are subject to examination.  In the United Kingdom, tax years for Fiscal 2006 and after are subject to examination.  In the United States, returns related to an acquired subsidiary for the year ended October 31, 1994 and final return for the period ended May 19, 1995 are also subject to examination.

Effective Tax Rate

Our effective tax rate on consolidated net income was 19.1% for the nine months ended February 29, 2008.  Our effective tax rate on consolidated net income differs from the federal statutory tax rate primarily due to the settlement of unrecognized tax benefits, the difference between prior years reported income tax provision and the actual filed income tax returns, certain expenses not deductible for income tax reporting offset by lower effective tax rates on net income reported by the Company’s wholly owned subsidiary, Schmitt Europe Ltd. (SEL), located in the United Kingdom.  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 settlement of unrecognized tax benefits, expenses not deductible for income tax reporting and net income or losses reported by SEL.

Note 6:

SEGMENTS OF BUSINESS

The Company has two reportable business segments: the design and assembly of dynamic balancing systems for the machine tool industry (Balancer), and the design and assembly of laser measurement systems (Measurement).  The Company operates in three principal geographic markets: North America, Europe and Asia.

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Segment Information

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Geographic Information-Net Sales by Geographic Area

Note — — Europe is defined as the European subsidiary, Schmitt Europe, Ltd.

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Segment and Geographic Assets