Washington, DC 20549

FORM 10-Q

Commission File Number:  000-24413

TROY GROUP, INC.

(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 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   ý   No   o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).   Yes   o   No   ý

As of October 14, 2004, 10,639,877 shares of the Registrant’s Common Stock were outstanding.

TROY GROUP, INC.

Quarterly Report on Form 10-Q for the

Quarterly Period Ended May 31, 2004

INDEX

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PART I:  FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

TROY GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(a)                                  Derived from the audited consolidated financial statements for the year ended November 30, 2003

See Notes to Condensed Interim Consolidated Financial Statements.

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TROY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS
OF INCOME

(Unaudited)

(in thousands, except per share amounts)

See Notes to Condensed Interim Consolidated Financial Statements.

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TROY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS

(Unaudited)

(in thousands)

See Notes to Condensed Interim Consolidated Financial Statements.

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TROY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(Unaudited)

(in thousands except share amounts)

See Notes to Condensed Interim Consolidated Financial Statements

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TROY GROUP, INC.

NOTES TO CONDENSED INTERIM CONSOLIDATED

FINANCIAL STATEMENTS

(unaudited)

Note 1.  Basis of Presentation

The accompanying unaudited consolidated financial statements of TROY Group, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals and adjustments) considered necessary for a fair presentation have been included.  Operating results for the three and nine months ended August 31, 2004 are not necessarily indicative of the results that may be expected for the year ending November 30, 2004.  For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for its fiscal year ended November 30, 2003.

Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” prescribes accounting and reporting standards for all stock-based compensation plans, including employee stock option plans. As allowed by SFAS No. 123, the Company has elected to continue to account for its employee stock-based compensation plan using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations, which does not require compensation to be recorded if the consideration to be received is at least equal to the fair value of the common stock to be received at the measurement date. Under the requirements of SFAS No. 123, non-employee stock-based transactions require compensation to be recorded based on the fair value of the securities issued or the services received, whichever is more reliably measurable.

The following table illustrates the effect on net income and net income per share had compensation costs for the stock-based compensation plan been determined based on the fair values of awards on the grant date under the provisions of SFAS No. 123, for the three-month and nine-month periods ended August 31, 2004 and 2003 (amounts in thousands, except per share data):

Recent Accounting Pronouncements

In May 2003 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial

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Instruments with Characteristics of both Liabilities and Equity, which requires that certain financial instruments previously presented as equity or temporary equity be presented as liabilities.  Such instruments include mandatory redeemable preferred and common stock, and certain options and warrants.  SFAS No.150 is effective for financial instruments issued, entered into or modified after May 31, 2003 and is generally effective at the beginning of the first interim period beginning after June 15, 2003.  The adoption of SFAS No.150 did not have an effect on the Company’s financial position or results of its operations.

In 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51, as revised. Prior to FIN 46, a company generally included another entity in the company’s financial statements only if it controlled the entity through ownership of the majority voting interests.  FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties.  The Company adopted FIN 46 effective with the quarter ending May 31, 2004, and has determined it does not have any variable interest entities that are required to be consolidated in its financial statements.

Note 2.  Inventories

Inventories consisted of the following at August 31, 2004 and November 30, 2003 (amounts in thousands):

Note 3.  Other Assets

Other assets consisted of the following at August 31, 2004 and November 30, 2003 (amounts in thousands):

Note 4.  Goodwill and Intangible Assets

The Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, effective December 1, 2002 and performed the initial transitional impairment test as of that date. The provisions of SFAS No. 142 require that the Company allocate its goodwill to its various reporting units, determine the carrying value of those businesses, and estimate the fair value of the reporting units so that a two-step goodwill impairment test can be performed. The Company’s reporting units represent components of its operating segments, which are the same as the reportable segments, identified in Note 11. In the first step of the goodwill impairment test, the fair value of each reporting unit is compared to its carrying value. If the fair value exceeds the carrying value, goodwill is not impaired and no further testing is performed. If the carrying value exceeds the fair value, then the second step must be performed, and the implied fair value of the reporting unit’s goodwill must be determined and compared to the carrying value of the goodwill for the reporting unit. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then an impairment loss equal to the difference is recorded.

For the year ended November 30, 2003, no impairment loss was recognized. However, future goodwill impairment tests

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could result in a charge to earnings. The Company will continue to evaluate goodwill on an annual basis as of the beginning of the fourth fiscal quarter, and whenever events and changes in circumstances indicate that there may be a potential impairment.

On December 1, 2002, the Company completed the allocation of goodwill (including amounts previously classified as assembled workforce) to its reportable segments as part of its transitional impairment test. Goodwill allocated to the Company’s reportable segments as of November 30, 2003 and August 31, 2004 are as follows (amounts in thousands):

The Company’s intangible assets subject to amortization at August 31, 2004 and November 30, 2003 are composed of (amounts in thousands):

For long-lived assets, other than goodwill, Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, requires the evaluation for impairment whenever events or changes in circumstances have indicated that an asset may not be recoverable.  Long-lived assets evaluated for impairment are grouped with other assets to the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities.  If the sum of the projected undiscounted cash flows (excluding interest charges) is less than the carrying value of the assets, the assets will be written down to the estimated fair value, and the loss recognized in income from continuing operations in the period in which the determination is made.

In the second quarter of fiscal 2004, management evaluated the long-lived intangible assets for impairment using the methodology described above and determined that the asset representing the capitalized software development costs for ACH software was impaired. As a result, the unamortized amount of $284,000 at April 30, 2004 was written off in the second quarter.

Amortization expense related to intangible assets was approximately $18,000 and $11,000 for each of the three-month periods and $69,000 and $33,000 for each of the nine-month periods ended August 31, 2004 and 2003, respectively.

Estimated future amortization expense related to purchased intangible assets at August 31, 2004 is as follows:

Note 5. Line of Credit

The Company has a $5.0 million line-of-credit agreement with Comerica Bank.  As of August 31, 2004, there were no borrowings outstanding against the line of credit.  Borrowings under the line of credit bear interest at the lesser of the bank’s reference rate (4.50 % at August 31, 2004) less 0.25% or the bank’s LIBOR rate (2.00 % at August 31, 2004) plus 2% and are limited to 80% of eligible accounts receivable and 50% of eligible inventories if total liabilities to tangible effective net

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worth is greater than two to one.  No formula is required if total liabilities to tangible effective net worth is less than two to one. In connection with the line-of-credit agreement, the Company has a $650,000 standby letter-of-credit sub-limit, of which approximately $80,000 was outstanding at August 31, 2004.  This line of credit is secured by substantially all of the Company’s assets.  The borrowing arrangement requires the Company to comply with certain financial covenants and other restrictions, including its ability to pay dividends, and as of August 31, 2004 the Company was in compliance with those covenants. As of August 31, 2004, the Company had approximately $4.9 million in availability under the line of credit.  The line-of-credit borrowings are due on demand. The agreement may be terminated by either party at any time.

Note 6.  Stock Option and Stock Warrant Plans

During the nine months ended August 31, 2004, the Company granted 40,000 stock options to employees and a director. The following is a summary of total outstanding options and stock warrants at August 31, 2004:

At August 31, 2004, there were 1,714,000 shares remaining available for grant under the Company’s stock option plan.

Note 7.  Net Income Per Share

The following table sets forth the computation of basic and diluted net income per share (amounts in thousands, except per share data):

Note 8.  Contractual Obligations and Commercial Commitments

The Company has the following minimum non-cancelable contractual obligations and commercial commitments (amounts in thousands):

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The annual commitments reflected in the table above are based on our November 30 year-end.

The Company leases its operating facilities under non-cancelable operating lease agreements, including certain operating facilities from a company related through common ownership, which expire through 2008.  The related-party lease requires monthly payments of approximately $23,800.

**As of August 31, 2004 and November 30, 2003, we had a balance of advanced payments of $1,903,000 to affiliated stockholders in connection with the purchase of split dollar life insurance policies.  The Company and the stockholders have executed split-dollar agreements governing the unsecured non-interest bearing advances. The advances are due upon the death, termination or retirement of the Company’s Chairman, Chief Executive Officer and majority stockholder. We previously had committed to making payments on the split dollar life insurance policies based on continued employment; however, the Sarbanes-Oxley Act of 2002 prohibits extensions of credit in the form of a personal loan to certain Company insiders after July 29, 2002.  As a result, since July 29, 2002 we have not funded the annual premium payments on these policies.  If the SEC issues new regulations or other guidance that causes us to reevaluate our position, we may demand payment on the advances and terminate our participation in these arrangements.

Note 9.  Major Vendors

The Company purchases key components from a vendor and also sells products to this same vendor.  Purchases from this vendor for the nine months ended August 31, 2004 and 2003 were: $7,967,000 and $7,268,000, respectively.  Net payable balances to this vendor as of August 31, 2004 and November 30, 2003 were: $197,000 and $149,000, respectively.

Note 10. Major Customers

There were no customers that accounted for 10% or more of net sales in the three and nine months of fiscal 2004, or fiscal 2003.

Note 11.  Segment Information and Geographical Information

Segment Information

The following tables summarize net sales and net income by the Company’s operating segments, Secure Payment Systems and Wireless and Connectivity Solutions, for the three months and nine months ended August 31, 2004 and 2003 (amounts in thousands):

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The following schedule is presented to reconcile August 31, 2004 and November 30, 2003 segment assets to the amounts reported in the Company’s consolidated financial statements (amounts in thousands).

Geographical Information (amounts in thousands)

Note 12.  Cash Flow Information

Supplemental disclosure of cash flow information (amounts in thousands):

Note 13. Income Taxes

Deferred taxes are provided on a liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry forwards and deferred tax liabilities are recognized for taxable temporary differences.  Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases.  Deferred tax assets are reduced by a valuation allowance when it is determined to be more likely than not that some portion or all of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, the Company considers future taxable income and prudent and feasible tax planning strategies. The Company has placed substantial

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reliance on its current projections of future taxable income.  The Company re-assesses its projections of taxable income on a quarterly basis.  If it is determined that the Company would not be able to realize all or part of its deferred tax assets in the future, which would include the Company’s failure to materially meet its projections of taxable income, an adjustment to the carrying value of the deferred tax assets would be charged to income in the period in which such determination was made and may affect our annual effective income tax rate.

Management currently believes the deferred tax assets are more likely than not to be realized based on current expectations of future earnings and available tax planning strategies.  Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

The net deferred tax assets have been classified on the accompanying consolidated balance sheets as follows (in thousands):

Note 14. Proposed Merger

On May 26, 2004, we announced that TROY had entered into a merger agreement (the “Merger”) with Dirk, Inc., a company controlled by Patrick Dirk, the founder of TROY, and his family members (Mergerco), pursuant to which Mr. Dirk and his family will acquire the outstanding shares of TROY common stock that they do not already own.  TROY expects the Merger to close in November 2004.  The Merger is subject to approval by TROY stockholders as required under applicable state law, to completion of financing arrangements necessary to accomplish the Merger, and to certain other closing conditions.  On October 7, 2004, we filed a Definitive Proxy Statement on Schedule 14A and Amendment No.4 to Schedule 13E-3 in connection with the proposed Merger.

Note 15.  Litigation

In connection with the Prior Merger Proposal, on November 21, 2002, Tom Lloyd filed an action in the Superior Court of the State of California in and for Orange County against TROY and its directors, alleging that defendants breached their fiduciary duties in connection with the Prior Merger Proposal by attempting to provide the Dirk family with preferential treatment in connection with their efforts to complete a sale of TROY. The complaint sought to enjoin an acquisition of TROY by the Dirk family, as well as attorneys’ fees. Following termination of the Prior Merger Proposal, the plaintiff filed a motion for dismissal of the action and award of attorney’s fees and expenses of $387,250.  TROY filed a motion in support of the plaintiff’s motion for dismissal of the action and in opposition to plaintiff’s motion for fees.  On March 4, 2004 the court issued a ruling granting the motion for dismissal with prejudice, and granting the motion for attorney’s fees of $175,000. On April 30, 2004, TROY filed a notice of appeal. TROY has accrued an estimate of expenses to be incurred in connection with this litigation in fiscal 2003 in excess of the deductible amount, which was recorded as an expense in fiscal 2002.

Following the announcement of the merger, Osmium Partners LLC (“Osmium”), Ralph Hamer (“Hamer”), Roy Liedtkie (“Liedtkie”), Tilson Growth Fund, L.P. (“Tilson”), and Ray Stanley (“Stanley”) filed purported class action complaints in the California Superior Court for Orange County against TROY and our directors.  In all five actions plaintiffs allege that defendants breached their fiduciary duties in connection with the merger by attempting to provide the Dirk family with preferential treatment in connection with their efforts to complete a sale of TROY.  Plaintiffs in all five actions seek declaratory relief, an order enjoining the acquisition, and attorneys’ fees.  The Liedtkie complaint also names Mergerco and seeks damages.  Pursuant to a stipulated order, Osmium, Hamer, Liedtkie and Tilson have been consolidated, and these four plaintiffs have adopted the allegations of the Tilson complaint.  On September 13, 2004 defendants filed a demurrer to the Tilson complaint, and on September 21, they filed a demurrer to the Stanley complaint.  On September 17, Osmium and Stanley filed a motion for class certification.  On September 23, 2004, Liedtkie submitted a stipulation and proposed Order dismissing his action with prejudice.  That stipulation is subject to Court approval.  Discovery has commenced, but no trial date has been set in any of these actions.  If these actions are successful in enjoining the transaction, it could have a material adverse effect on our business, financial position, or results of operations.  Currently, the amount of such an adverse effect cannot be estimated.

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On September 7, 2004, TROY, Mergerco, and the Dirk Family Trust commenced an action against Westar Capital LLC (“Westar”) in the United States District Court for the Central District of California, for violations of the Williams Act, tortious interference with contract, tortious interference with prospective economic advantage, and unfair business practices.  The complaint alleges in this regard that Westar’s purported offers to purchase all of the outstanding stock of TROY are nothing more than shams designed to disrupt the market for TROY common stock and the proposed merger between TROY and Mergerco.  The complaint seeks damages of an unspecified amount as well as injunctive relief.  Westar has moved to dismiss the complaint, and set a hearing date of October 25.

Note 16.  Guarantees and Indemnities

Indemnifications

In the ordinary course of business, TROY enters into contractual arrangements under which TROY may agree to indemnify the third party in the arrangement from any losses incurred relating to services performed on behalf of TROY or for losses arising from certain events as defined within the particular contract, which may include litigation or claims relating to past performance.  These arrangements include, but are not limited to, TROY’s indemnification of its officers and directors to the maximum extent under the laws of the state of Delaware, the indemnification of its lessors for certain claims arising from the use of the facilities, and the indemnification of its bank for certain claims arising from the bank’s grants of credit to TROY.  Such indemnification obligations may not be subject to maximum loss clauses.  Historically, payments, if any, or if made or required related to these indemnifications have been immaterial.

Warranty

TROY accrues for warranty expense at the time revenue is recognized and maintains a warranty accrual for estimated future warranty obligations based upon the relationship between historical and anticipated warranty costs and sales volumes.  To the extent TROY experiences increased warranty claim activity or increased costs associated with servicing those claims, its warranty accrual will increase resulting in decreased gross profit.  The standard warranty period for TROY’s products ranges from one month to five years.

Deferred Revenue

TROY offers fixed-price support or maintenance contracts, including extended warranties, to its customers.  Revenue from equipment maintenance contracts on check printing equipment and software is recorded as deferred income when billed and is recognized straight-line over the term of the contract.

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and related Notes included in this report.  This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  The statements contained in this report that are not historical in nature, particularly those that utilize terminology such as “may,” “will,” “should,” “expects,” “anticipates,” “estimates,” “believes” or “plans,” or comparable terminology, are forward-looking statements based on current expectations and assumptions. Such forward looking statements include, but are not limited to, statements regarding the proposed merger with Dirk, Inc., our ability to finance our operating activities, our critical accounting policies and recent accounting pronouncements, international sales, compliance with laws and regulations, benefits of our ERP system, our current litigation and our efforts to defend such litigation.

Various risks and uncertainties could cause actual results to differ materially from those expressed in forward-looking statements.  These risks and uncertainties include, but are not limited to, completion of the proposed merger, the continued demand for printed financial documents; the useful life of our products, the market acceptance of products incorporating wireless printing technologies; the impact of competition from existing and new technologies and companies; the impact of litigation regarding the proposed merger; and the other factors set forth below under the heading “Certain Important Factors” and in our other periodic reports and other documents that we file from time to time with the Securities and Exchange Commission. These forward-looking statements speak only as of the date hereof.  We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

We own or have rights to trademarks that we use in connection with the sale of our products.  TROY®, eCheck Secure™, PrintraNet™, TROYmark™, StarACH™, Etherwind™, Windconnect™, Windport™, EtherSync™, Exact MICR Technology™ (ExMT™) and Exact Positioning Technology™ (ExPT™) are among the trademarks that we own.  This report also makes reference to trademarks and trade names of other companies.

All references to “TROY,” “we,” “us” or “our” means TROY Group, Inc. and its subsidiaries, except where it is made clear that the term means only the parent company.

Recent Developments

On May 26, 2004, we announced that TROY had entered into a merger agreement (the “Merger”) with Dirk, Inc., a company controlled by Patrick Dirk, the founder of TROY, and his family members, pursuant to which Mr. Dirk and his family will acquire the outstanding shares of TROY common stock that they do not already own.  TROY expects the Merger to close in November 2004.  The Merger is subject to approval by TROY stockholders as required under applicable state law, to completion of financing arrangements necessary to accomplish the Merger, and to certain other closing conditions.  On October 7, 2004, we filed a Definitive Proxy Statement on Schedule 14A and Amendment No. 4 to Schedule 13E-3 in connection with the proposed Merger.

Background

TROY offers a full range of products to its customers in two primary product lines: Secure Payment Systems and Wireless and Connectivity Solutions. Secure Payment Systems include Security Printing Solutions, which enable the secure printing and management of checks, and Financial Service Solutions, which enable secure electronic payments. Wireless and Connectivity Solutions includes hardware and software solutions that enable enterprises to share intelligent devices, such as printers, either wirelessly or using traditional networks.

Our products have been adopted by a wide variety of industries including electronic bill payment utilities, retail and brokerage firms, telecommunications, financial services, insurance, computer hardware, automotive, personnel and others.  We market our products in 55 countries and had more than 7,000 active customers in the past year.  In the first nine months of fiscal 2004, there were no customers who accounted for 10% or more of our net sales.

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Results of Operations

The following table sets forth, for the periods indicated, certain information derived from our consolidated statements of income expressed as a percentage of net sales: