SMIT Schmitt Industries Inc

PART I - FINANCIAL INFORMATION

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

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

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

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SCHMITT INDUSTRIES, INC.

The following table provides a reconciliation of cash and cash equivalents and restricted cash as reported within the Consolidated Balance Sheets as of February 29, 2020 and May 31, 2019 to the sum of the same such amounts as shown in the Consolidated Statement of Cash Flows for the respective periods then ended:

Statement of Cash Flows for the nine months ended February 29, 2020 and year ended May 31, 2019:

The amounts in money market funds as of February 29, 2020 and May 31, 2019 were $9,168,219 and $674,092, respectively.

Accounts Receivable

The Company maintains credit limits for all customers based upon several factors, including but not limited to financial condition and stability, payment history, published credit reports and use of credit references. Management performs various analyses to evaluate accounts receivable balances to ensure recorded amounts reflect estimated net realizable value. This review includes using accounts receivable agings, other operating trends and relevant business conditions, including general economic factors, as they relate to each of the Company’s domestic and international customers. In the event there is doubt about whether a customer account is collectible, a reserve is provided. If these analyses lead management to the conclusion that a customer account is uncollectible, the balance will be directly charged to bad debt expense. The allowance for doubtful accounts was $99,442 and $36,826 as of February 29, 2020 and May 31, 2019, respectively.

Inventories

Inventories are valued at the lower of cost or net realizable value with cost determined on the average cost basis. Costs included in inventories consist of materials, labor and manufacturing overhead, which are related to the purchase or production of inventories. Write-downs, when required, are made to reduce excess inventories to their net realizable values. Such estimates are based on assumptions regarding future demand and market conditions. If actual conditions become less favorable than the assumptions used, an additional inventory write-down may be required. As of February 29, 2020 and May 31, 2019 inventories consisted of:

Property and Equipment

Property and equipment are stated at cost, less depreciation and amortization. Depreciation is computed using the straight-line method over estimated useful lives of three to seven years for furniture, fixtures, and equipment; and twenty-five years for buildings and improvements. Expenditures for maintenance and repairs are charged to expense as incurred. As of February 29, 2020 and May 31, 2019, property and equipment consisted of:

Depreciation expense for the nine months ended February 29, 2020 and February 28, 2019 was $42,643 and $52,660, respectively.

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Lease Accounting

The Company determines if an arrangement is a lease or a service contract at inception. Where an arrangement is a lease the Company determines if it is an operating lease or a finance lease. Subsequently, if the arrangement is modified the Company reevaluates the classification.

Buildings leased to others under operating leases are included in property, plant and equipment. See Note 6.

Intangible Assets

Amortizable intangible assets, which include purchased technology and patents, are amortized over their estimated useful lives ranging from five to seventeen years. As of February 29, 2020 and May 31, 2019, amortizable intangible assets were $2,085,362 and $2,200,883, and accumulated amortization was $1,771,614 and $1,808,698, respectively.

Amortization expense for both the nine months ended February 29, 2020 and February 28, 2019 was $78,437.

Customer Deposits and Prepayments

Customer deposits and prepayments consists of amounts received from customers as prepayments for orders that have been received and have been produced but have not yet shipped, credit balances for items returned by customers for which refunds have not yet been provided and deposits made by customers in advance of production.

Use of Estimates

The preparation of the Consolidated Financial Statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Actual results could differ from those estimates.

NOTE 2:

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In February 2016, the Financial Accounting Standards Board (“FASB”) issued a new accounting standard on leasing. The new standard requires companies to record most leased assets and liabilities on the balance sheet, and also proposed a dual model for recognizing expense. The Company adopted the standard as of June 1, 2019, with retroactive reporting for prior periods (the comparative option). Adoption of these accounting changes did not have a material impact on the Consolidated Financial Statements.

In January 2017, the FASB issued a new accounting standard which clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions or disposals of assets or businesses. This guidance was effective for the Company beginning in 2019. Adoption of these accounting changes did not have a material impact on the Consolidated Financial Statements.

In May 2017, the FASB issued a new accounting standard which provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in ASC Topic 718. Under the guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. This guidance was effective for the Company beginning in 2019. Adoption of these accounting changes did not have a material impact on the Consolidated Financial Statements.

In June 2018, the FASB issued a new accounting standard which provides guidance that expands the scope of Topic 718 to include share-based payment transactions for acquiring goods and services from nonemployees. This guidance was effective for the Company beginning in 2019, with early adoption permitted. Adoption of these accounting changes did not have a material impact on the Consolidated Financial Statements.

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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 portion of the grant date fair value 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 Options

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:

There were no options granted during the nine months ended February 29, 2020.

At February 29, 2020, the Company had outstanding stock options to purchase 22,500 shares of Common Stock all of which are vested and exercisable with a weighted average exercise price of $1.70. As all options outstanding as of February 29, 2020 were fully vested, the Company estimates that $0 will be recorded as additional stock-based compensation expense during the year ending May 31, 2020.

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Options granted, exercised, canceled and expired under the Company’s stock-based compensation plans during the nine months ended February 29, 2020 are summarized as follows:

Restricted Stock Units

Service-based and market-based restricted stock units are granted to key employees and members of the Company’s Board of Directors. Service-based restricted stock units generally fully vest on the first anniversary date of the award. Market-based restricted stock units are contingent on continued service and vest based on the 15-day average closing price of the Company’s Common Stock equal or exceeding certain targets established by the Compensation Committee of the Board of Directors.

The lattice model utilizes multiple input variables that determine the probability of satisfying the market conditions stipulated in the award and calculates the fair value of each restricted stock unit. The Company used the following assumptions in determining the fair value of the restricted stock units:

During the nine months ended February 29, 2020, five tranches of the market-based restricted stock units granted in Fiscal 2019 vested.

During the nine months ended February 29, 2020, 62,780 service-based restricted stock units were granted and 46,863 immediately vested on the date of the grants.

Restricted stock unit activity under the Company’s stock-based compensation plans during the nine months ended February 29, 2020 is summarized as follows:

During the nine months ended February 29, 2020, the Company issued 23,000 shares of common stock related to restricted stock units which were granted, vested, and expensed in a prior period.

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During the nine months ended February 29, 2020, total restricted stock unit compensation expense recognized was $326,724 and has been recorded as general, administration and sales expense in the Consolidated Statements of Operations and Comprehensive Loss. Stock compensation expense related to non-vested restricted stock units with a time vesting condition was $10,393.

NOTE 4:

WEIGHTED AVERAGE SHARES AND RECONCILIATION

Basic net income (loss) per share is computed using the weighted average number of shares of Common Stock outstanding. Diluted net income (loss) per share is computed using the weighted average number of shares of Common Stock outstanding, adjusted for dilutive incremental shares attributed to outstanding options to purchase Common Stock and restricted stock units vested but not issued. Common stock equivalents for stock options are computed using the treasury stock method. In periods in which a net loss is incurred, no common stock equivalents are included since they are antidilutive and as such all stock options outstanding are excluded from the computation of diluted net loss in those periods.

For the three and nine months ended February 29, 2020, potentially dilutive securities consisted of options of 22,500 shares of Common Stock at $1.70 per share. Of these potentially dilutive securities, none of the shares of Common Stock underlying the options are included in the computation of diluted earnings per share because the Company incurred a net loss from continuing operations. In periods when a net loss is incurred in continuing operations, no Common Stock equivalents are included in the calculation of diluted net income or loss from discontinued operations or overall Company net income or loss since they are antidilutive. As such, all stock options outstanding are excluded from the computation of diluted net income in those periods.

Basic weighted average shares for the three and nine months ended February 29, 2020 and February 28, 2019 were as follows:

On December 3, 2019, the Company announced that its Board of Directors authorized a share repurchase plan to buy up to $2 million of its Common Stock. The Company intends to purchase shares from time to time through open market and private transactions in accordance with Securities and Exchange Commission rules. The plan is authorized through December 16, 2020.

On December 17, 2019, the Company acquired 365,490 shares of Common Stock (the “Shares”) at $3.25 per share from Walter Brown Pistor.

On January 31, 2020, the Company entered into an agreement with former director David Hudson to initiate a cashless exercise for 64,166 of his options, whereby the Company purchased 36,000 shares for $3.25 per share from Mr. Hudson to fund the exercise of his remaining 28,166 shares.

Through February 29, 2020, the Company has repurchased 46,932 Shares, at an average price of $3.10 per share, under its previously announced $2 million share repurchase plan, which was done in accordance with a 10b5-1 plan.

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. 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 to allow for the deferred tax asset to be fully utilized. The Company currently maintains a full valuation allowance against net deferred tax assets.

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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 ASC Topic 740.The Company applies this guidance 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, de-recognition, classification, accounting for interest and penalties, accounting in interim periods, disclosure, and transition.

Other long-term liabilities related to tax contingencies were $0 as of both February 29, 2020 and May 31, 2019. Interest and penalties associated with uncertain tax positions are recognized as components of the “Provision for income taxes.” The liability for payment of interest and penalties was $0 as of February 29, 2020 and May 31, 2019.

Several tax years are subject to examination by major tax jurisdictions. In the United States, federal tax years ended May 31, 2016 and after are subject to examination.

Effective Tax Rate

The effective tax rate for the three months ended February 29, 2020 was 1.7%. The effective tax rate on consolidated net income for the three months ended February 29, 2020 and 2018 differs from the federal statutory tax rate primarily due to changes in the deferred tax valuation allowance and the impact of certain expenses not being deductible for income tax reporting purposes. Management believes the effective tax rate for Fiscal 2020 will be approximately 1.6% due to the items noted above.

NOTE 6:

LEASES

On November 22, 2019, the Company entered in a commercial lease agreement, which has been accounted for pursuant to (ASU) No. 2016-02, “Leases (Topic 842)”. The Company elected the practical expedient to not separate lease and non-lease components and will present property revenues as other income, combined based upon the lease being determined to be the predominant component.

The lessor commercial agreement contains a 10-year term with a renewal option to extend, which will be considered a new, separate contract and will be recognized at the time the option is exercised on a straight-line basis over the renewal period, and early termination options based on established terms specific to the individual agreement. Minimum future lease payments receivable are as follows:

NOTE 7:

CUSTOMER CONCENTRATION

The Company’s largest 3 customers accounted for 26.6%, 8.1%, and 7.6% of our revenues, respectively, for the three months ended February 29, 2020 and 30.5%, 7.9%, and 3.8% of our revenues, respectively, for the nine months ended February 29, 2020.

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NOTE 8:

DISCONTINUED OPERATIONS

On October 10, 2019, the Company entered into an agreement (“Purchase Agreement”) to sell the Schmitt Dynamic Balance Systems (“SBS”) business line to Tosei Engineering Corp. and Tosei America, Inc. (collectively “Tosei” or Buyer) for a purchase price of $10,500,000 in cash. The transaction closed on November 22, 2019 and included certain assets held by the U.S. parent company and all the outstanding stock of the UK subsidiary, Schmitt Europe Limited. As a result, the financial position, results of operations, and cash flows relating to our SBS business line are reported as discontinued operations in the accompanying financial statements.

The consideration included $9,940,000 in unrestricted cash from the Buyer at closing, plus $420,000 to be placed into an escrow account, net of $140,000 in minimum cash settled via the funds flow at closing. Remaining escrow funds become unrestricted after certain events are completed and after one year from closing. The Purchase Agreement requires an adjustment to purchase price after closing based on the difference between (a) the calculated amount of working capital at closing and (b) the target working capital of $4,200,000. The closing working capital calculation resulted in $107,000 in net proceeds paid from Buyer to Seller in February 2020.

In connection with the Purchase Agreement, the Company entered into a Transition Service Agreement (“TSA”) with the Buyer during the transition of certain accounting and treasury processes. The Company has collected approximately $210,000 of cash belonging to the Buyer via the TSA that is included in the cash and cash equivalents, accounts receivable, and other accrued liabilities balances at February 29, 2020.

The following table summarizes the consideration and gain recognized in the nine months ended February 29, 2020 associated with the sale of the SBS Business:

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The following are the carrying amounts of assets and liabilities classified as held for sale and included as a part of discontinued operations:

The following is a composition of the line items constituting income from discontinued operations:

NOTE 9:

SUBSEQUENT EVENTS

In December 2019, a novel coronavirus disease (“COVID-19”) was reported and in January 2020, the World Health Organization (“WHO”) declared it a Public Health Emergency of International Concern. On February 28, 2020, the WHO raised its assessment of the COVID-19 threat from high to very high at a global level due to the continued increase in the number of cases andaffected countries, and on March 11, 2020, the WHO characterized COVID-19 as a pandemic.

The broader implications of COVID-19 on our results of operations and overall financial performance remain uncertain. We may experience constrained supply or slowed customer demand that could materially adversely impact our business, results ofoperations and overall financial performance in future periods. See Risk Factors for further discussion of the possible impact of the COVID-19 pandemic on our business.

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