**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, DC 20549**

 

 

**FORM 10-Q**

 
| **(Mark  One)** |
|-----------------|
| **ý**      | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|            |   |
|            | **For  the quarterly period ended August 31, 2002.** |
|            |   |
| **o**           | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|            |   |
|            | **For  the transition period from to** |

 

**CommissionFile Number:  000-24413**

**TROY GROUP, INC.**

(Exact name of registrantas specified in its charter)

 

| **Delaware**                              |   | **33-0807798**                        |
|-------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)           |   |                                  |
|                                      |   |                                  |
|                                      |   |                                  |
| **2331 South Pullman Street**             |   |                                  |
| **Santa Ana, California**                 |   | **92705**                             |
| (Address of principal  executive offices) |   | (Zip code)                            |

** **

**(949) 250-3280**

(Registrant’stelephone number, including area code)

 

                Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.       Yes ý  No  o

 

                As of October 11, 2002, therewere 10,649,092 shares of our common stock outstanding.

 

----

 

**TROY GROUP, INC.**

**Quarterly Report on Form 10-Q for the**

**Quarterly Period Ended August 31,2002**

**INDEX**

 
| **PART I:  FINANCIAL INFORMATION** |                                                                                                                   |   |
|-----------------------------------------|------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.                                 | Financial Statements                                                                                                   |   |   |
|                                    | Consolidated Balance Sheets  August 31, 2002 and November 30, 2001                                                     |   |   |
|                                    | Consolidated  Statements of Operations for the Three Months and Nine Months ended August  31, 2002 and August 31, 2001 |   |   |
|                                    |                                                                                                                   |   |   |
|                                    | Consolidated  Statements of Cash Flows for the Nine Months ended August 31, 2002 and August  31, 2001                  |   |   |
|                                    |                                                                                                                   |   |   |
|                                    | Notes to  Consolidated Financial Statements                                                                            |   |   |
| Item  2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                            |   |   |
| Item  3.                                | Quantitative  and Qualitative Disclosures About Market Risk                                                            |   |   |
| Item 4.                                 | Controls and  Procedures                                                                                               |   |   |
| **PART II:  OTHER INFORMATION**    |                                                                                                                   |   |
| Item  1.                                | Legal  Proceedings                                                                                                     |   |   |
| Item  2.                                | Changes  in Securities and Use of Proceeds                                                                             |   |   |
| Item 3.                                 | Defaults Upon  Senior Securities                                                                                       |   |   |
| Item  4.                                | Submission  of Matters to a Vote of Security Holders                                                                   |   |   |
| Item 5.                                 | Other Information                                                                                                      |   |   |
| Item 6.                                 | Exhibits and  Reports on Form 8-K                                                                                      |   |   |

 

 

2

----

 

**PART I:  FINANCIAL INFORMATION**

 

**ITEM 1. — FINANCIAL STATEMENTS**

** **

**TROYGROUP, INC.CONSOLIDATED BALANCE SHEETS**

**(in thousands, except share amounts)**

 
| **Assets**                                                                                                                        |   | **August 31,**  |   | **November  30,** |   |
|-----------------------------------------------------------------------------------------------------------------------------------|--------|-----------------|--------|-------------------|--------|
|                                                                                                                              |   | **2002**        |   | **2001**          |   |
|                                                                                                                              |   | **(Unaudited)** |   |              |   |
| Current assets:                                                                                                                   |   |            |   |              |   |
| Cash and cash  equivalents                                                                                                        |   | $               | 5,459  |              | $      | 1,210 |   |
| Investment in available-for-sale  securities                                                                                      |   | 1,323           |   | 5,181             |   |
| Accounts receivable, less allowance for doubtful  accounts of  $706 and $1,130,  respectively                                |   | 7,399           |   | 9,713             |   |
| Income tax  refund receivable                                                                                                     |   | 1,373           |   | 1,059             |   |
| Inventories                                                                                                                       |   | 7,135           |   | 9,251             |   |
| Prepaid expenses  and other                                                                                                       |   | 807             |   | 358               |   |
| Deferred tax  assets                                                                                                              |   | 2,480           |   | 2,480             |   |
| Total current assets                                                                                                              |   | 25,976          |   | 29,252            |   |
| Equipment and  leasehold improvements, net                                                                                        |   | 2,186           |   | 2,529             |   |
| Other assets, including receivable from stockholders  of $2,123 at August 31, 2002 and $1,666 at November 30, 2002                |   | 5,210           |   | 5,226             |   |
| Total assets                                                                                                                      |   | $               | 33,372 |              | $      | 37,007 |   |
|                                                                                                                              |   |            |   |              |   |
| **Liabilities and Stockholders’  Equity**                                                                                    |   |            |   |              |   |
| Current  liabilities:                                                                                                             |   |            |   |              |   |
| Current portion  of long-term debt                                                                                                |   | $               | 72     |              | $      | 70 |   |
| Accounts payable                                                                                                                  |   | 2,492           |   | 4,418             |   |
| Accrued expenses                                                                                                                  |   | 2,353           |   | 2,456             |   |
| Deferred revenue                                                                                                                  |   | 972             |   | 1,138             |   |
| Total current  liabilities                                                                                                        |   | 5,889           |   | 8,082             |   |
| Long-term debt,  net of current portion                                                                                           |   | 139             |   | 193               |   |
| Stockholders’  equity:                                                                                                       |   |            |   |              |   |
| Preferred stock,  par value $.01 per share, authorized 5,000,000 shares,                                                          |   |            |   |              |   |
| issued none                                                                                                                       |   | —          |   | —            |   |
| Common stock,  par value $.01 per share; authorized 50,000,000 shares, issued 2002  10,969,657 shares; and 2001 10,921,032 shares |   | 110             |   | 109               |   |
| Additional  paid-in capital                                                                                                       |   | 21,113          |   | 20,966            |   |
| Retained  earnings                                                                                                                |   | 7,296           |   | 8,753             |   |
|                                                                                                                              |   | 28,519          |   | 29,828            |   |
| Less cost of  treasury stock — 320,565 common shares in 2002 and 295,320 in 2001                                             |   | 1,175           |   | 1,096             |   |
| Total  stockholders’ equity                                                                                                  |   | 27,344          |   | 28,732            |   |
| Total  liabilities and stockholders’ equity                                                                                  |   | $               | 33,372 |              | $      | 37,007 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

3

----

 

**TROY GROUP, INC.**

**CONSOLIDATED STATEMENTS**

**OF OPERATIONS**

**(Unaudited)**

**(in thousands, except per share amounts)**

 
|                                      |   | **Three  Months Ended** |   | **Nine  Months Ended** |   |
|-------------------------------------------|--------|-------------------------|--------|------------------------|--------|
|                                      |   | **August 31,  2002**    |   | **August 31,  2001**   |   | **August 31,  2002** |   | **August 31,  2001** |   |
|                                      |   |                    |   |                   |   |   |   |   |   |
| Net sales                                 |   | $                       | 13,649 |                   | $      | 13,674 |   | $ | 41,245 |   | $ | 34,783 |   |
| Cost of goods sold                        |   | 10,214                  |   | 8,161                  |   | 26,658 |   | 21,243 |   |
| Gross profit                              |   | 3,435                   |   | 5,513                  |   | 14,587 |   | 13,540 |   |
|                                      |   |                    |   |                   |   |   |   |   |   |
| Operating expenses:                       |   |                    |   |                   |   |   |   |   |   |
| Selling, general and administrative       |   | 3,415                   |   | 3,584                  |   | 11,282 |   | 11,533 |   |
| Research and development                  |   | 1,696                   |   | 1,379                  |   | 5,221 |   | 4,400 |   |
| Amortization of intangible assets         |   | 130                     |   | 320                    |   | 390 |   | 960 |   |
| Operating income (loss)                   |   | (1,806                  | )      | 230                    |   | (2,306 | ) | (3,353 | ) |
|                                      |   |                    |   |                   |   |   |   |   |   |
| Interest income                           |   | 17                      |   | 102                    |   | 96 |   | 468 |   |
| Interest expense                          |   | (3                      | )      | (28                    | )      | (33 | ) | (92 | ) |
| Income (loss) before income taxes         |   | (1,792                  | )      | 304                    |   | (2,243 | ) | (2,977 | ) |
| Provision for (benefit from) income taxes |   | (627                    | )      | 84                     |   | (786 | ) | (1,031 | ) |
| Net income (loss)                         |   | $                       | (1,165 | )                      | $      | 220 |   | $ | (1,457 | ) | $ | (1,946 | ) |
|                                      |   |                    |   |                   |   |   |   |   |   |
| Net income (loss) per share:              |   |                    |   |                   |   |   |   |   |   |
| Basic                                     |   | $                       | (.11   | )                      | $      | .02 |   | $ | (.14 | ) | $ | (.18 | ) |
| Diluted                                   |   | $                       | (.11   | )                      | $      | .02 |   | $ | (.14 | ) | $ | (.18 | ) |
|                                      |   |                    |   |                   |   |   |   |   |   |
| Weighted-average shares outstanding:      |   |                    |   |                   |   |   |   |   |   |
| Basic                                     |   | 10,649                  |   | 10,667                 |   | 10,646 |   | 10,816 |   |
| Diluted                                   |   | 10,649                  |   | 10,803                 |   | 10,646 |   | 10,816 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

4

----

 

**TROY GROUP, INC.**

**CONSOLIDATED STATEMENTS**

**OF CASH FLOWS**

**(Unaudited)**

**(inthousands)**
|                                                                             |   | **Nine  Months Ended** |   |
|----------------------------------------------------------------------------------|--------|------------------------|--------|
|                                                                             |   | **August 31,  2002**   |   | **August 31,  2001** |   |
|                                                                             |   |                   |   |   |   |
| Cash flows from operating activities:                                            |   |                   |   |   |   |
| Net loss                                                                         |   | $                      | (1,457 | ) | $ | (1,946 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |   |                   |   |   |   |
| Depreciation and amortization                                                    |   | 980                    |   | 1,538 |   |
| Recovery of doubtful accounts                                                    |   | (212                   | )      | 308 |   |
| Deferred taxes                                                                   |   | —                 |   | (88 | ) |
| Accrued interest on available for sale securities                                |   | (85                    | )      | (314 | ) |
| Changes in operating assets and liabilities, net of  effects from acquisitions:  |   |                   |   |   |   |
| Accounts receivable                                                              |   | 2,526                  |   | 398 |   |
| Income tax refund receivable                                                     |   | (314                   | )      | 241 |   |
| Inventories                                                                      |   | 2,116                  |   | 2 |   |
| Prepaid expenses and other                                                       |   | (449                   | )      | (60 | ) |
| Accounts payable                                                                 |   | (1,927                 | )      | 538 |   |
| Accrued expenses                                                                 |   | (103                   | )      | 86 |   |
| Deferred revenue                                                                 |   | (167                   | )      | 57 |   |
| Net cash provided by operating activities                                        |   | 908                    |   | 760 |   |
| Cash flows from investing activities:                                            |   |                   |   |   |   |
| Acquisition of businesses                                                        |   | —                 |   | (1,980 | ) |
| Purchase of equipment and leasehold improvements                                 |   | (302                   | )      | (866 | ) |
| Purchase of available-for-sale securities                                        |   | (1,449                 | )      | (3,363 | ) |
| Maturities of available-for-sale securities                                      |   | 5,393                  |   | 9,148 |   |
| Capitalization of software development costs                                     |   | —                 |   | 814 |   |
| Increase in other assets, net                                                    |   | (319                   | )      | (1,835 | ) |
| Net cash provided by investing activities                                        |   | 3,323                  |   | 1,918 |   |
| Cash flows from financing activities:                                            |   |                   |   |   |   |
| Net borrowings on revolving line of credit                                       |   | —                 |   | — |   |
| Payments on notes payable                                                        |   | (52                    | )      | (50 | ) |
| Proceeds from issuance of common stock                                           |   | 149                    |   | 158 |   |
| Purchase of treasury stock                                                       |   | (79                    | )      | (918 | ) |
| Net cash provided by (used in) financing activities                              |   | 18                     |   | (810 | ) |
| Net increase in cash and cash equivalents                                        |   | 4,249                  |   | 1,868 |   |
| Cash and cash equivalents, beginning of period                                   |   | 1,210                  |   | 1,235 |   |
| Cash and cash equivalents, end of period                                         |   | $                      | 5,459  |   | $ | 3,103 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

5

----

 

**TROY GROUP, INC.NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS(UNAUDITED)**

 

**Note 1.  Basis of Presentation**

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith generally accepted accounting principles for interim financial informationand with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.  Inthe opinion of management, all adjustments (consisting of normal recurringaccruals and adjustments) considered necessary for a fair presentation havebeen included.  Operating results forthe three and nine months ended August 31, 2002 are not necessarily indicativeof the results that may be expected for the year ended November 30, 2002.  For further information, refer to thefinancial statements and footnotes thereto included in the Company’s AnnualReport on Form 10-K for its fiscal year ended November 30, 2001 (File No.000-24413).

 

**Note 2.  Inventories**

 

Inventories consisted ofthe following as of August 31, 2002 and November 30, 2001 (amounts inthousands):

 
|                                              |   | **August 31,  2002** |   | **November  30, 2001** |   |
|---------------------------------------------------|--------|----------------------|--------|------------------------|--------|
| Raw materials                                     |   | $                    | 4,904  |                   | $      | 6,997 |   |
| Work-in-process                                   |   | 766                  |   | 455                    |   |
| Finished goods                                    |   | 3,631                |   | 4,306                  |   |
| Reserve for slow  moving and obsolete inventories |   | (2,166               | )      | (2,507                 | )      |
| Total                                             |   | $                    | 7,135  |                   | $      | 9,251 |   |

 

**Note 3.  Investment in Available-for-sale Securities**

 

As of August 31, 2002,the Company had approximately $1.3 million in corporate debt securities withcontractual maturity dates of up to one year, which management has determinedshould be classified as available-for-sale. Market values approximated carrying values.  Accordingly, no unrealized gains or losses were recorded atAugust 31, 2002.  There were no gains orloss recognized for the nine months ended August 31, 2002 or August 31, 2001.

 

**Note 4.  Stock Option and Stock Warrant Plans**

 

During the nine monthsended August 31, 2002, the Company granted options to employees to acquire350,000 shares of common stock at a weighted-average exercise price of $4.03per share, 10,000 options were exercised at a weighted-average exercise priceof $2.94 per share,  and 703,000 optionswere forfeited at a weighted-average exercise price of $6.21 per share.  The following is a summary of totaloutstanding options and stock warrants at August 31, 2002:

 

6

----

 
|                          |   | **Options  and Warrants Outstanding** |   | **Options  and Warrants Exercisable**  |   |
|-------------------------------|--------|---------------------------------------|--------|----------------------------------------|--------|
| **Range of  Exercise Prices** |   | **Number of  Options**                |   | **Weighted-  Average  Exercise Price** |   | **Weighted-  Average  Remaining  Contractual Life** |   | **Number of  Options** |   | **Weighted-  Average  Exercise Price** |   |
| $2.94 — 4.51             |   | 857,666                               |   | $                                      | 3.88   |   | 8.1 years |   | 211,665 |   | $ | 2.99 |   |
| $6.31 — 8.75             |   | 740,000                               |   | $                                      | 7.35   |   | 7.1 years |   | 425,500 |   | $ | 7.25 |   |
| $13.16 — 14.25           |   | 25,000                                |   | $                                      | 13.38  |   | 7.3 years |   | — |   | — |   |
|                          |   | 1,622,666                             |   |                                   |   |   |   | 637,165 |   |   |   |

 

At August 31, 2002, therewere 1,209,000 shares remaining available for grant under the Company’s optionplans.

** **

**Note 5.  Net Income (Loss) Per Share**

 

The following table setsforth the computation of basic and diluted net income (loss) per share:

 
|                                                                                          |   | **Three  months ended**                             |   | **Nine  months ended**                              |   |
|-----------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|--------|-----------------------------------------------------|--------|
|                                                                                          |   | **(amounts  in thousands, except  per share data)** |   | **(amounts  in thousands, except  per share data)** |   |
|                                                                                          |   |                                                |   |                                                |   |   |   |   |   |
|                                                                                          |   | **August 31,  2002**                                |   | **August 31,  2001**                                |   | **August 31,  2002** |   | **August 31,  2001** |   |
| Numerator for basic and diluted net income (loss)  per share:                                 |   |                                                |   |                                                |   |   |   |   |   |
|                                                                                          |   |                                                |   |                                                |   |   |   |   |   |
| Net income (loss)                                                                             |   | $                                                   | (1,165 | )                                                   | $      | 220 |   | $ | (1,457 | ) | $ | (1,946 | ) |
|                                                                                          |   |                                                |   |                                                |   |   |   |   |   |
| Denominator for basic net income (loss) per share —  weighted-average shares outstanding |   | 10,649                                              |   | 10,667                                              |   | 10,646 |   | 10,816 |   |
| Effect of employee stock options and warrants                                                 |   | —                                              |   | 136                                                 |   | — |   | — |   |
| Denominator for diluted net income (loss) per share                                           |   | 10,649                                              |   | 10,803                                              |   | 10,646 |   | 10,816 |   |
|                                                                                          |   |                                                |   |                                                |   |   |   |   |   |
| Net income (loss) per share:                                                                  |   |                                                |   |                                                |   |   |   |   |   |
|                                                                                          |   |                                                |   |                                                |   |   |   |   |   |
| Basic                                                                                         |   | $                                                   | (.11   | )                                                   | $      | .02 |   | $ | (.14 | ) | $ | (.18 | ) |
| Diluted                                                                                       |   | $                                                   | (.11   | )                                                   | $      | .02 |   | $ | (.14 | ) | $ | (.18 | ) |

 

The dilutiveeffect of incremental shares of employee stock options and warrants for theperiods ended August 31, 2002 and 2001 would have been 53,000 and 68,000 forthe three and nine months ended August 31, 2002, respectively, and 136,000 and77,000 for the three and nine months ended August 31, 2001, respectively.

 

7

----

 

**Note 6.  Business Combination**

* *

*ExtendedSystems Incorporated*

 

On May 31, 2001, theCompany acquired in a purchase transaction certain assets and assumed certainliabilities of Extended Systems Incorporated, a print server manufacturer, inexchange for $1,672,000 in cash and $504,000 in direct expenses.  The total acquisition cost was $2,051,000 andwas allocated as follows:

 

| Inventories                 |   | $        | 1,600,000 |   |
|-----------------------------|--------|----------|-----------|--------|
| Equipment                   |   | 46,000   |      |
| Goodwill                    |   | 530,000  |      |
| Current liabilities assumed |   | (125,000 | )         |
|                        |   |     |      |
|                        |   | $        | 2,051,000 |   |

 

*Unaudited pro forma information*

 

Unaudited pro formaconsolidated results of operations for the nine months ended August 31, 2001 asthough Extended Systems Incorporated had been acquired as of December 1, 2000are as follows (amounts in thousands, except per share data):

 

|                                            |   | **Nine  Months Ended**

**August 31,  2001** |   |
|-------------------------------------------------|--------|----------------------------------------------|--------|
| Pro forma net sales                             |   | $                                            | 41,879 |   |
| Pro forma net loss                              |   | $                                            | (1,788 | ) |
| Pro forma net loss per share: basic and diluted |   | $                                            | (.17   | ) |

 

The above amounts reflectpro forma adjustments for amortization of intangibles and number of sharesoutstanding.  This pro forma financialinformation does not purport to be indicative of the results of operations hadthe Extended Systems Incorporated acquisition actually taken place at theearlier date.

 

**Note 7.  Segment Information**

 

The following tablessummarize revenues and net income (loss) by operating segment and unallocatedcorporate for the three and nine months ended August 31, 2002 and August 31,2001:

 
|                       |   | **Three  months ended**     |   | **Nine  months ended**      |   |
|----------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                       |   | **(amounts  in thousands)** |   | **(amounts  in thousands)** |   |
|                       |   |                        |   |                        |   |
|                       |   | **August 31,  2002**        |   | **August 31,  2001**        |   | **August 31,  2002** |   | **August 31,  2001** |   |
| Revenues:                  |   |                        |   |                        |   |   |   |   |   |
| Troy Systems               |   | $                           | 10,547 |                        | $      | 10,096 |   | $ | 32,134 |   | $ | 27,793 |   |
| Troy Wireless              |   | 3,157                       |   | 3,684                       |   | 9,314 |   | 7,212 |   |
| Less  intersegment revenue |   | (55                         | )      | (106                        | )      | (203 | ) | (222 | ) |
|                       |   | $                           | 13,649 |                        | $      | 13,674 |   | $ | 41,245 |   | $ | 34,783 |   |
|                       |   |                        |   |                        |   |   |   |   |   |
| Net income  (loss):        |   |                        |   |                        |   |   |   |   |   |
| Troy Systems               |   | $                           | 379    |                        | $      | 1,285 |   | $ | 2,914 |   | $ | 1,754 |   |
| Troy Wireless              |   | (813                        | )      | (384                        | )      | (2,068 | ) | (1,455 | ) |
| Unallocated  Corporate     |   | (731                        | )      | (681                        | )      | (2,303 | ) | (2,245 | ) |
|                       |   | $                           | (1,165 | )                           | $      | 220 |   | $ | (1,457 | ) | $ | (1,946 | ) |

 

8

----

 

Certain reclassificationshave been made to the August 31, 2001 segment information to conform to theAugust 31, 2002 presentation.

 
|                  |   | **August 31,  2002** |   | **November  30,  2001** |   |
|-----------------------|--------|----------------------|--------|-------------------------|--------|
| Segment Assets:       |   |                 |   |                    |   |
|                  |   |                 |   |                    |   |
| Troy Systems          |   | $                    | 11,842 |                    | $      | 13,395 |   |
| Troy Wireless         |   | 11,040               |   | 10,259                  |   |
| Unallocated Corporate |   | 41,661               |   | 28,663                  |   |
|                  |   | $                    | 64,543 |                    | $      | 52,317 |   |

 

The following schedule ispresented to reconcile August 31, 2002 and November 30, 2001 segment assets tothe amounts reported in the Company’s consolidated financial statements (amountsin thousands). 

 
|                                |   | **August 31,  2002** |   | **November  30,  2001** |   |
|-------------------------------------|--------|----------------------|--------|-------------------------|--------|
| Total Assets of Reportable Segments |   | $                    | 64,543 |                    | $      | 52,317 |   |
| Intersegment Receivables            |   | (30,789              | )      | (14,928                 | )      |
| Investment in Subsidiaries          |   | (382                 | )      | (382                    | )      |
| Consolidated assets                 |   | $                    | 33,372 |                    | $      | 37,007 |   |

 

**Note 8.  Cash Flow Information**

 

Supplemental disclosure of cash flow information

 
|                             |   | **Nine  months ended**      |   |
|----------------------------------|--------|-----------------------------|--------|
|                             |   | **(amounts  in thousands)** |   |
|                             |   | **August 31,  2002**        |   | **August 31,  2001** |   |
| Cash paid during the period for: |   |                        |   |   |   |
| Interest                         |   | $                           | 46     |   | $ | 92 |   |
| Income taxes                     |   | $                           | 13     |   | $ | 81 |   |

 

9

----

 

**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

                The following discussion and analysis should be readin conjunction with our Condensed Consolidated Financial Statements and relatedNotes included in this report.  Thisreport contains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. The statements contained in this report that are not historical innature, particularly those that utilize terminology such as “may,” “will,”“should,” “expects,” “anticipates,” “estimates,” “believes” or “plans,” orcomparable terminology, are forward-looking statements based on currentexpectations and assumptions.

 

                Various risks and uncertaintiescould cause actual results to differ materially from those expressed inforward-looking statements.  These risksand uncertainties include our ability to consolidate operations and reducecosts; the continued demand for printed financial documents; our ability tooffset declining sales of our wired connectivity products; the success of themeasures we implemented to address inventory accounting controls; the marketacceptance of products incorporating wireless printing technologies; the impactof the delisting of our common stock from the Nasdaq National Market; ourability to hire and retain qualified management, technology and otherpersonnel; the impact of competition from existing and new technologies andcompanies; and the other factors set forth below under the heading “CertainImportant Factors” and in our other periodic reports and other documents thatwe file from time to time with the Securities and Exchange Commission.

 

                We own or have rights to trademarks that we use inconnection with the sale of our products. TROY®, *e*Check SecureTM, PrintraNetTM, TROYmarkTM,  StarACHTM, EtherwindTM, WindconnectTM,WindportTM, EtherSyncTM, Exact MICR TechnologyTM (ExMTTM) and Exact PositioningTechnologyTM (ExPTTM) are among the trademarks that we own.  This report also makes reference totrademarks and trade names of other companies.

 

**Background**

 

                TROY Group, Inc. is a worldwide provider ofenterprise output solutions.  For thepast three years we have been expanding beyond our core business in digitalcheck printing systems and related consumables by developing electronic paymentsystems and wired and wireless networking solutions.  Most of this new product expansion was accomplished through theacquisition and further investment in five small technology companies.  These acquisitions have been organized undertwo primary business segments:  TROYSystems and TROY Wireless.

 

                TROY Systems provides state-of-the-art paymentsystems ranging from high security digital check printing systems to electronicpayment and funds transfer solutions. Our systems are used to transfer monies between bank accounts usingpaper checks or electronic ACH (Automated Clearing House) processes.  Our products provide our customers withpayment solutions that offer security, speed, flexibility and efficiency.  Ameritrade, Inc., AT&T Corporation, Bankof America Corporation, Eastman Kodak Company, Farmers Group, Inc. (FarmersInsurance), Fidelity Investments, Ford Motor Company, IBM, Manpower Inc.,Morgan Stanley Dean Witter & Co., CSFBdirect, Track Data, Mr. Stock, Wal-MartStores, Inc., Wells Fargo & Company, Comerica Bank, Red Cross, G.E. CapitalIreland and Ford Credit Europe are among the TROY customers that purchasedpayment products during the last 12 months.

 

                TROY Wireless provides hardware and softwaresolutions that enable enterprises to share intelligent devices like printerseither wirelessly or using traditional networks.  We have been a supplier 

 

10

----

 

of hardwired networkprinting solutions since 1991.  Ourwireless products allow a wide range of devices to exchange information via *Bluetooth*TMand 802.11b short-range radio connections. Brother Industries, Ltd., Sony Corporation, Seiko Epson Corporation andDaimlerChrysler AG are among the TROY Wireless customers that have purchasedthese products during the last 12 months.

 

                We serve a wide variety of industries includingfinancial services, insurance, telecommunications, computer hardware,automotive, personnel, government and others. We distribute our solutions around the world and market our productsthrough a direct sales force and a network of distributors and value-addedresellers.  More than 5,000 customershave purchased our products and services during the last 12 months.

 

**Results of Operations**

 

                On October 15, 2002, we issued a press releaseannouncing that the filing of our Form 10-Q for the fiscal quarter ended August31, 2002 would be delayed.  We hadconducted physical inventory counts and discovered certain inventory shortfallsand other adjustments, which we preliminarily estimated to be approximately$1.5 million.  We delayed the filing ofour Form 10-Q for the fiscal quarter ended August 31, 2002 in order to give ussufficient time to review the causes of such inventory adjustments and todetermine if any of the financial statements for prior periods would need to berestated.  Following completion of thisreview, we determined that the final adjustments totaled approximately $1.2million, and that it would be necessary to restate our consolidated financialstatements as of and for the periods ended February 28, 2002 and May 31, 2002and to make conforming changes to “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” to reflect such restatement.

 

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

 
|                                          |   | **Three  Months Ended** |   | **Nine  Months Ended** |   |
|-----------------------------------------------|--------|-------------------------|--------|------------------------|--------|
|                                          |   | **August 31,  2002**    |   | **August 31,  2001**   |   | **August 31,  2002** |   | **August 31,  2001** |   |
| Net sales                                     |   | 100.0                   | %      | 100.0                  | %      | 100.0 | % | 100.0 | % |
| Cost of goods sold                            |   | 74.8                    |   | 59.7                   |   | 64.6 |   | 61.1 |   |
| Gross Profit                                  |   | 25.2                    |   | 40.3                   |   | 35.4 |   | 38.9 |   |
| Selling, general and  administrative expenses |   | 25.0                    |   | 26.2                   |   | 27.4 |   | 33.1 |   |
| Research and development  expenses            |   | 12.4                    |   | 10.1                   |   | 12.7 |   | 12.6 |   |
| Amortization of intangible  assets            |   | 1.0                     |   | 2.3                    |   | 0.9 |   | 2.8 |   |
| Operating income (loss)                       |   | (13.2                   | )      | 1.7                    |   | (5.6 | ) | (9.6 | ) |
| Interest income                               |   | 0.1                     |   | 0.7                    |   | 0.2 |   | 1.3 |   |
| Interest expense                              |   | —                  |   | (0.2                   | )      | — |   | (0.3 | ) |
| Income (loss) before income  taxes (credits)  |   | (13.1                   | )      | 2.2                    |   | (5.4 | ) | (8.6 | ) |
| Provision for income taxes  (credits)         |   | (4.6                    | )      | 0.6                    |   | (1.8 | ) | (3.0 | ) |
| Net income (loss)                             |   | (8.5                    | )%     | 1.6                    | %      | (3.6 | )% | (5.6 | )% |

 

**Three Months Ended August 31, 2002Compared to Three Months Ended August 31, 2001**

* *

*                NetSales*.  Our net sales were $13.6 million for thethree months ended August 31, 2002, with $10.5 million attributable to TroySystems and $3.1 million attributable to Troy Wireless.  Net sales in the three months ended August31, 2002 decreased by $25,000 from $13.7 million in the three months endedAugust 31, 2001.  This decrease in netsales represents a $470,000 increase in sales of our laser printers, proprietaryimaging supplies, services, and electronic payment solutions, and a decrease of

 

11

----

 

$495,000 in sales of ourconnectivity products.  Net sales werenot significantly affected by price changes.

 

*                Cost ofGoods Sold*.  Cost of goods sold increased by $2.0 millionor 25.6% to $10.2 million in the three months ended August 31, 2002 from $8.2million in the three months ended August 31, 2001.  This increase primarily was due to an increase in the reserve forexcess and obsolete inventory of Troy Systems of $703,000, and severance costsof $169,000.  Cost of goods sold as apercentage of net sales increased to 75.0% in the three months ended August 31,2002 from 59.7% in the three months ended August 31, 2001, primarily due to theincrease in the inventory reserve and severance costs described above.

* *

*                GrossProfit*.  Gross profit decreased by $2.1 million to$3.4 million in the three months ended August 31, 2002 from $5.5 million in thethree months ended August 31, 2001. Gross profit as a percentage of net sales decreased to 25.2% in thethree months ended August 31, 2002 from 40.3% in the three months ended August31, 2001.  The decrease in gross profitwas primarily due to the inventory reserve increases and severance paymentsdiscussed above.

* *

*                Selling,General and Administrative Expenses*.  Selling,general and administrative expenses decreased by $169,000 or 4.7% to $3.4million in the three months ended August 31, 2002 from $3.6 million in thethree months ended August 31, 2001. This decrease primarily was due to a $60,000 reduction in the allowancefor doubtful accounts related to improved collections, and $177,000 in foreigncurrency gains, partially offset by $237,000 of severance expense and otherexpenses .  Selling, general andadministrative expenses as a percentage of net sales decreased to 25.0% in thethree months ended August 31, 2002 from 26.2% in the three months ended August31, 2001.

* *

*                Researchand Development Expenses*.  Research and developmentexpenses increased by $317,000 or 23.0% to $1.7 million in the three monthsended August 31, 2002 from $1.4 million in the three months ended August 31,2001, primarily due to increased spending for electronic payment software. Thetotal research and development expenses for the third quarter of fiscal 2002included $1.3 million for Troy Systems and $415,000 for Troy Wireless. Therewere no software development costs capitalized in the three months ended August31, 2002 and $551,000 were capitalized in the three months ended August 31,2001. Research and development expenses as a percentage of net sales was 12.4%in the three months ended August 31, 2002 and 10.1% in the three months endedAugust 31, 2001.

* *

*                Amortizationof Intangible Assets. *Amortization of intangible assetsdecreased by $190,000 or 59.4% to $130,000 in the three months ended August 31,2002 from $320,000 in the three months ended August 31, 2001.  This decrease was the result of thewrite-down of impaired long-lived assets at the end of fiscal year 2001.

* *

*                OperatingIncome (Loss)*.  Operating income (loss) decreased by $2.0million to a loss of $((1.8) million in the three months ended August 31, 2002from income of $230,000 in the three months ended August 31, 2001.  The operating loss as a percentage of netsales was (13.2)% in the three months ended August 31, 2002 compared to incomeof 1.7% in the three months ended August 31, 2001.

* *

*                InterestIncome.*  Interest income decreased by $85,000 to$17,000 in the three months ended August 31, 2002 from $102,000 in the threemonths ended August 31, 2001.  Thisdecrease is the result of reductions in our investment in available-for-salesecurities due to working capital requirements and lower rates of interest oninvested securities.

 

12

----

 

*                InterestExpense*.  Interest expense decreased by $25,000 to$3,000 in the three months ended August 31, 2002 from $28,000 in the threemonths ended August 31, 2001.  Thisdecrease was due to reductions in the balance due on notes payable.

* *

*                IncomeTaxes*.  Income taxes decreased to a $627,000 taxbenefit in the three months ended August 31, 2002 from an $84,000 tax expensein the three months ended August 31, 2001. This decrease is a result of decreased income before income taxes.  Income tax expense (benefit) as a percentageof pretax income (loss) was (35.0)% in the three months ended August 31, 2002compared to 27.6% in the three months ended August 31, 2001.

 

**Nine Months Ended August 31, 2002Compared to Nine Months Ended August 31, 2001**

* *

*                NetSales*.  Our net sales were $41.2 million for thenine months ended August 31, 2002, with $32.1 million attributable to TroySystems and $9.3 million attributable to Troy Wireless.  Net sales in the nine months ended August 31,2002 increased by $6.5 million, or 18.6%, from $34.8 million in the nine monthsended August 31, 2001.  This increase innet sales represents a $4.3 million increase in sales of our laser printers,proprietary imaging supplies, services, and electronic payment solutions, andan increase of $2.1 million in sales of our wireless and connectivity products,primarily due to the acquisition of certain assets of Extended Systems, Inc. onMay 31, 2001.  Net sales were notsignificantly affected by price changes.

* *

*                Cost ofGoods Sold*.  Cost of goods sold increased by $5.4 millionor 25.5% to $26.7 million in the nine months ended August 31, 2002 from $21.2million in the nine months ended August 31, 2001.  This increase was primarily due to increased net sales, inventoryreserve increases of $703,000 and severance costs of $169,000.  Cost of goods sold as a percentage of netsales increased to 64.6% in the nine months ended August 31, 2002 from 61.1% inthe nine months ended August 31, 2001, primarily due to the increase in theinventory reserve and severance costs described above.

* *

*                GrossProfit*.  Gross profit increased by $1.0 million to$14.6 million in the nine months ended August 31, 2002 from $13.5 million inthe nine months ended August 31, 2001. Gross profit as a percentage of net sales decreased to 35.4% in the ninemonths ended August 31, 2002 from 38.9% in the nine months ended August 31,2001.

* *

*                Selling,General and Administrative Expenses*.  Selling,general and administrative expenses decreased by $251,000 or 2.2% to $11.3million in the nine months ended August 31, 2002 from $11.5 million in the ninemonths ended August 31, 2001.  Thisdecrease was primarily due to a $285,000 reduction in the allowance fordoubtful accounts related to improved collections, and $177,000 in foreigncurrency gains, partially offset by $472,000 of severance expense.  Selling, general and administrative expensesas a percentage of net sales decreased to 27.4% in the nine months ended August31, 2002 from 33.1% in the nine months ended August 31, 2001.

* *

*                Researchand Development Expenses*.  Research and developmentexpenses increased by $821,000, or 18.7 % to $5.2 million in the nine monthsended August 31, 2002 from $4.4 million in the nine months ended August 31,2001.  Of this increase, approximately$641,000 was due to development expenses for our electronic payment solutionsand $180,000 was due to development for our wireless products.  The total research and development expensesfor 2002 included $3.5 million for Troy Systems and $1.7 million for TroyWireless.  There were no softwaredevelopment costs capitalized in the nine months ended August 31, 2002 and$814,000 were capitalized in the nine months ended August 31, 2001. Researchand development expenses as a percentage of net sales were 12.7% in the nine monthsended August 31, 2002 and 12.6% in the nine months ended August 31, 2001.

 

13

----

 

*                Amortizationof Intangible Assets. *Amortization of intangible assetsdecreased by $570,000 or 59.4% to $390,000 in the nine months ended August 31,2002 from $960,000 in the nine months ended August 31, 2001.  This decrease was the result of thewrite-down of impaired long-lived assets at the end of fiscal year 2001.

* *

*                OperatingIncome (Loss)*.  The operating loss decreased by $1.1 millionto $(2.3) million in the nine months ended August 31, 2002 from a loss of$(3.4) million in the nine months ended August 31, 2001.  Operating loss as a percentage of net saleswas (5.6)% in the nine months ended August 31, 2002 compared to (9.6)% in thenine months ended August 31, 2001.

* *

*                InterestIncome.*  Interest income decreased by $372,000 to$96,000 in the nine months ended August 31, 2002 from $468,000 in the ninemonths ended August 31, 2001.  Thisdecrease is the result of reductions in our investment in available-for-salesecurities due to our stock repurchase program, working capital requirementsand lower rates of interest on invested securities.

* *

*                InterestExpense*.  Interest expense decreased by $59,000 to$33,000 in the nine months ended August 31, 2002 from $92,000 in the ninemonths ended August 31, 2001.  Thisdecrease was due to reductions in the balance due on notes payable.

* *

*                IncomeTaxes*.  Income taxes decreased to a $786,000 taxbenefit in the nine months ended August 31, 2002 from a $1.0 million taxbenefit in the nine months ended August 31, 2001.  This decrease is a result of a reduced loss before incometaxes.  Income tax expense (benefit) asa percentage of pretax income (loss) was (35.0)% in the nine months ended August31, 2002 compared to (34.6)% in the nine months ended August 31, 2001.

 

**Liquidity and Capital Resources**

 

                Cash flows provided by operating activities were$908,000 in the nine months ended August 31, 2002 compared to $760,000 providedby operating activities in the nine months ended August 31, 2001.  This increase was due primarily to adecrease in inventories and accounts receivable, and a net loss of $(1.5)million in 2002 compared to a net loss of $(1.9) million in 2001.  The accounts receivable decrease resultedprimarily from collections.

 

                Cash flows provided by investing activities were $3.3million in the nine months ended August 31, 2002 compared to $1.9 million inthe nine months ended August 31, 2001. Included in cash flows provided by investing activities in the ninemonths ended August 31, 2002 was $3.9 million in net maturities ofavailable-for-sale securities.  Inconnection with split-dollar life insurance arrangements with our majorstockholder, we previously had committed to funding the premium on three lifeinsurance policies for the foreseeable future. Annual premiums on these policies are approximately $586,000 per yearfor the next five years.

 

                Cash flows provided by financing activities were$18,000 in the nine months ended August 31, 2002 compared to cash flows used infinancing activities of $810,000 in the nine months ended August 31, 2001.  Included in cash flows provided by financingactivities in the nine months ended August 31, 2001 was $918,000 used for thepurchase of treasury stock.

 

                We have a $5,000,000 line-of-credit agreement with abank.  As of August 31, 2002, there wereno borrowings outstanding against the line of credit.  Borrowings under the line of credit bear interest at the lesserof the bank’s reference rate (4.75% at August 31, 2002) less 0.25% or thebank’s LIBOR rate (1.82% at August 31, 2002) plus 2% and are limited to 80% ofeligible accounts receivable and 50% of 

 

14

----

 

16 eligible inventoriesif total liabilities to tangible effective net worth is greater than two toone.  In connection with theline-of-credit agreement, we have a $650,000 standby letter-of-credit sublimitagreement of which approximately $80,000 was outstanding at August 31,2002.  This line of credit is secured bysubstantially all of our assets.  Ourborrowing arrangement requires us to comply with certain financial covenants,and at August 31, 2002 we were in compliance with those covenants.  As of August 31, 2002, we had approximately$4,920,000 in availability under the line of credit.  The line-of-credit borrowings are due on demand. The agreementmay be terminated by either party.

 

                We believe that existing cash balances, cashgenerated by operating activities, and funds available under our creditfacility will be sufficient to finance our operating activities for at leastthe next 12 months.  To the extent thatthe funds generated from these sources are insufficient to finance ouroperating activities, we would need to raise additional funds through public orprivate financing.  We cannot assure youthat additional financing will be available on terms favorable to us, or atall.

 

                In March 2001, Troy established a stock repurchaseprogram under which Troy’s common stock, with an aggregate market value up to$4.0 million, may be acquired in the open market.  As of August 31, 2002, Troy has purchased approximately 320,565shares of common stock in the open market, at an average price of $3.67 per share,under the stock repurchase program.  Approximately $2.8 million remains available for future commonstock repurchases.

 

**Contractual Obligations andCommercial Commitments**

 

                We have the followingcontractual obligations and commercial commitments. 

 
|                               |   | **Total** |      | **Less than  1 year*** |   | **1-3 years** |   | **4-5 years** |      | **After 5  years** |   |
|------------------------------------|--------|-----------|-----------|------------------------|--------|---------------|--------|---------------|-----------|--------------------|--------|
| Notes Payable                      |   | $         | 211,000   |                   | $      | 18,000        |   | $             | 193,000   |               | — |   | — |   |
| Related party operating lease      |   | 1,505,000 |      | 67,000                 |   | 809,000       |   | $             | 539,000   |               | $      | 90,000 |   |
| Other operating leases             |   | 765,000   |      | 134,000                |   | 631,000       |   | —        |      | —             |   |
| Split dollar life insurance policy |   | **        |      | **                     |   | **            |   | **            |      | **                 |   |
| Total                              |   | $         | 2,481,000 |                   | $      | 219,000       |   | $             | 1,633,000 |               | $      | 539,000 |   | $ | 90,000 |   |

 

----

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

 

**We previouslyhad committed to making payments on the split dollar life insurance policybased on continued employment. As of November 30, 2001 and August 31, 2002, wehad advanced $1,666,000 and $2,123,000, respectively, to stockholders inconnection with the purchase of split dollar life insurance policies.  The company and the stockholders haveexecuted a split-dollar agreement for the amount of the advance.  The advance is due on demand, however we donot anticipate demanding payment in the next 12 months and accordingly we haveclassified this amount as long-term.  The Sarbanes-Oxley Act of 2002 prohibits extensions of credit in theform of a personal loan to certain company insiders after July 29, 2002.  As a result, since July 29, 2002 the Companyhas not funded the annual premium payments on these policies.  If the SEC issues new regulations or otherguidance that causes us to reevaluate our position, we may demand payment onthe note and terminate the company’s participation in these arrangements.

 

15

----

 

**Critical Accounting Policies**

* *

*Use of estimates*

 

                The preparation of financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenue andexpenses during the reporting period. Actual results could differ from those estimates.

 

                The Company’s operations are affected by numerousfactors including market acceptance, changes in technologies and new laws andgovernment regulations and policies. The Company cannot predict what impact, if any, the occurrence of theseor other events might have on our operations. Significant estimates and assumptions made by management are used for,but not limited to, the allowance for doubtful accounts, the reserve for slowmoving or obsolete inventories and the carrying value of long-lived andintangible assets.

* *

*                Inventories*

 

                Inventories are valued at the lower of cost or marketon a first-in, first-out basis.  We usea standard cost system for purposes of determining cost.  The standards are adjusted periodically toensure they approximate actual costs. We write down the carrying value of our inventory to market value forestimated obsolete or excess inventory based upon assumptions about futuredemand and market conditions.  Wecompare current inventory levels on a product basis to our current salesforecasts in order to assess our inventory balance.  Our sales forecasts are based on economic conditions and trends(both current and projected), anticipated customer demand, expected futureproducts and other assumptions.  Ifactual market conditions are less favorable than those projected by management,additional write-downs may be required.

* *

*                Evaluationof long-lived and intangible assets*

 

                The Company periodically reviews the value of itslong-lived and intangible assets to determine if impairment has occurred bycomparing the carrying value of the long-lived assets with the lowest level ofidentifiable future net undiscounted cash flows expected to result from the useof the assets, including cash flows from disposition.  The Company recorded an impairment loss on certain long-livedassets during fiscal year 2001 based on an evaluation of projected operatingincome, cash flows and business prospects. In addition, management determinedother long-lived assets were not impaired. In making these determinations, theassumptions used by management about future cash flows are critical.  If these expected cash flows are notrealized, future additional impairment losses may be recorded.

* *

*                Revenuerecognition*

 

                We recognize revenue from the sale of our equipmentand supplies to end users, distributors, original equipment manufacturers (OEM)and resellers when the product is shipped and the title is transferred to thebuyer, net of an allowance for estimated returns, as long as no significantpost-delivery obligations exist and collection of the resulting receivable isprobable.  Revenue from equipmentmaintenance contracts is recorded as deferred income when billed and isrecognized straight-line over the term of the contract.  We accrue for warranty expense at the timerevenue is recognized and maintain a warranty accrual for estimated futurewarranty obligations based upon the relationship between historical andanticipated warranty costs and sales volumes. To the extent we experience increased warranty claim activity orincreased costs associated with servicing those claims, our warranty accrualwill increase resulting in decreased gross profit.

 

16

----

 

                We recognize revenue from software arrangements inaccordance with Statement of Position (“SOP”) 97-2, “Software RevenueRecognition” as amended by SOP 98-9, “Modification of SOP 97-2 with Respect toCertain Transactions.” Revenue is recognized when persuasive evidence of anarrangement exits and delivery has occurred, provided the fee is fixed ordeterminable, collectibility is probable and the arrangement does not requiresignificant customization or modification of the software.  For arrangements where the software requiressignificant customization or modification, the Company recognizes revenue forthe software license and consulting services portion of the arrangement uponcustomer acceptance.  Maintenancerevenue is recognized ratably over the term of the maintenance contract,typically 12 months.

 

                Revenue from software license agreements with OEMswhereby the Company provides ongoing support over the term of the contract isrecognized based on the greater of royalties’ earned or straight line over theterm of the contract.

* *

*                Allowancefor doubtful accounts*

 

                We maintain an allowance for doubtful accounts forestimated losses resulting from the inability of our customers to make requiredpayments.  The amount of the reserve isbased on historical experience and our analysis of the accounts receivableoutstanding.  If the financial conditionof our customers were to deteriorate, resulting in an impairment of theirability to make payments, additional allowances may be required which wouldresult in an additional expense in the period such determination was made.

* *

*                Incometaxes*

 

                Deferred taxes are provided on a liability methodwhereby deferred tax assets are recognized for deductible temporary differencesand operating loss and tax credit carryforwards and deferred tax liabilitiesare recognized for taxable temporary differences.  Temporary differences are the differences between the reported amountsof assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in theopinion of management, it is more likely than not that some portion or all ofthe deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects ofchanges in tax laws and rates on the date of enactment.

* *

*                Stock-basedcompensation*

 

                The Company accounts for stock-based employeecompensation under the requirements of Accounting Principles Board (APB)Opinion No. 25, which does not require compensation to be recorded if theconsideration to be received is at least equal to fair value of the shares tobe received at the measurement date. Nonemployee stock-based transactions are accounted for under therequirements of Statement No. 123, *Accounting for Stock-Based Compensation*,which requires compensation to be recorded based on the fair value of thesecurities issued or the services received, whichever is more reliablymeasurable.

 

**Recently IssuedAccounting Standards**

 

                In June 2001, the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting Standards No. 141 (SFASNo. 141), *BusinessCombinations*, and Statement of Financial Accounting Standards No.142 (SFAS No. 142), *Goodwill and Other Intangible Assets*.  SFAS No. 141 addresses financial accountingand reporting for business combinations and is effective for all businesscombinations after June 30, 2001.  SFASNo. 142 addresses financial accounting and reporting for acquired goodwill andother intangible assets and is effective for fiscal years beginning afterDecember 

 

17

----

 

15, 2001.  We will adopt SFAS No. 142 as of thebeginning of fiscal year 2003.  We arein the process of determining the expected impact on earnings and existinggoodwill and other intangibles upon adoption, which will include theelimination of goodwill amortization and may include additionalimpairment.  As of August 31, 2002,unamortized goodwill totaled $253,000.

 

                The FASB recently issued SFAS No. 143, *Accounting for Asset Retirement Obligations*,addressing financial accounting and reporting for obligations associated withthe retirement of tangible long-lived assets and the associated asset retirementcosts.  SFAS No. 143 requires anenterprise to record the fair value of an asset retirement obligation as aliability in the period in which it incurs a legal obligation associated withthe retirement of a tangible long-lived asset. SFAS No. 143 also requires the enterprise to record the contra to theinitial obligation as an increase to the carrying amount of the relatedlong-lived asset and to depreciate that cost over the remaining useful life ofthe asset.  The liability is changed atthe end of each period to reflect the passage of time and changes in theestimated future cash flows underlying the initial fair value measurement. SFASNo. 143 is effective for fiscal years beginning after June 15, 2002.  We are currently examining the impact of thispronouncement on the results of our operations and financial position.

 

                In August 2001, the FASB issued SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*, which supersedes previous guidance on financialaccounting and reporting for the impairment or disposal of long-lived assetsand for segments of a business to be disposed of.  Adoption of SFAS 144 is required no later than the beginning offiscal 2003.  Management does not expectthe adoption of SFAS 144 to have a significant impact on our financial positionor results of operations.  However,further impairment reviews may result in charges against earnings to write downthe value of long-lived assets.

 

                On April 30, 2002, the FASB issued SFAS No. 145, *Rescission of FASB Statements No. 4, 44 and 64,Amendment of FASB Statement No. 13, and Technical Corrections*.  This statement updates, clarifies andsimplifies existing accounting pronouncements. Statement 145 rescinds Statement 4, which required all gains and lossesfrom extinguishment of debt to be aggregated and, if material, classified as anextraordinary item, net of related income tax effect.  As a result, the criteria in Opinion 30 will now be used toclassify those gains and losses. Statement 64 amended Statement 4, and is no longer necessary becauseStatement 4 has been rescinded. Statement 44 was issued to establish accounting requirements for theeffects of transition to the provisions of the Motor Carrier Act of 1980.  Because the transition has been completed,Statement 44 is no longer necessary. Statement 145 amends Statement 13 to require that certain leasemodifications that have economic effects similar to sale-leaseback transactionsbe accounted for in the same manner as sale-leaseback transactions.  This amendment is consistent with the FASB’sgoal of requiring similar accounting treatment for transactions that havesimilar economic effects.  We will adoptStatement 145 in fiscal 2003. Statement 145 is not expected to have a materialimpact on our results of operations or financial position.

 

18

----

 

**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

                Market risk is therisk of loss to future earnings, to fair values or to future cash flows that mayresult from changes in the price of a financial instrument.  The value of a financial instrument maychange as a result of changes in interest rates, exchange rates, commodityprices, equity prices and other market changes.  Market risk is attributed to all market sensitive financialinstruments, including long-term debt.

 

                We do not utilize derivative financialinstruments.  Accordingly, our exposureto market risk is through our investments in available-for-sale securities andour bank debt which bears interest at variable rates.  Available-for-sale securities consist of corporate debt andmarketable equity securities.  Thesesecurities generally have contractual maturity dates of up to one year.  At August 31, 2002, market valuesapproximated carrying values.  Due tothe short-term maturities of these securities, management believes that thereis no significant market risk.  AtAugust 31, 2002, we had approximately $6.8 million in cash, cash equivalentsand investments in available-for-sale securities, and, accordingly, a sustaineddecrease in the rate of interest earned of 1% would cause a decrease in theamount of interest earned of $68,000. The bank debt is a revolving line of credit.  All borrowings bear interest based upon the reference rate perannum as announced by the bank (4.75% at August 31, 2002) less 0.25%.  At August 31, 2002, there were no amountsoutstanding under the line of credit agreement and, accordingly, a sustainedincrease in the reference rate of 1% would not cause our annual interestexpense to change.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

                Within the 90 daysprior to the date of this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures pursuant toRules 13a-14 and 13a-15 under the Securities Exchange Act of 1934, asamended.  Based upon that evaluation,our Chief Executive Officer and our Chief Financial Officer concluded that ourdisclosure controls and procedures are effective.

 

                On October 15, 2002, we issued a press releaseannouncing that the filing of our Form 10-Q for the fiscal quarter ended August31, 2002 would be delayed. We had conducted physical inventory counts anddiscovered certain inventory shortfalls and other adjustments. We delayed thefiling of our Form 10-Q for the fiscal quarter ended August 31, 2002 in orderto give us sufficient time to review the causes of such inventory adjustmentsand to determine if any of the financial statements for prior periods wouldneed to be restated.  We also reviewedour inventory accounting controls and determined that there were certainmaterial weaknesses.  As a result, wehave taken a number of corrective measures to address these weaknesses.  Our Irvine and Boise facilities have nowbeen closed and consolidated into our Wheeling facility, where the employeeshave more experience in using our materials management system.  In addition, we have implemented additionaltraining procedures to ensure that this continues to be the case, have hiredpersonnel with more experience in managing the accounting function in amanufacturing environment, and currently expect to install a new ERP system bythe end of fiscal year 2003.  TheCompany also intends to conduct quarterly physical inventory counts until it issatisfied that its systems are operating properly.  There were no other significant changes in our internal controlsor in other factors that could significantly affect these controls subsequentto the date of our evaluation.

 

19

----

 

**PARTII:  OTHER INFORMATION**

 

ITEM 1 - LEGAL PROCEEDINGS

 

Not applicable.

ITEM 2 - CHANGES IN SECURITIES AND USE OF PROCEEDS

 

Not applicable.

ITEM 3 - DEFAULTS UPON SENIOR SECURITIES

 

Not applicable.

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS

 

Not applicable.

 

ITEM 5 - OTHER INFORMATION

 

None.

ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K

 

(a)         Exhibits.

 
| **Exhibit   Number** | ** ** | **Description**                                                                                           |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------|
| 99.1                 |       | Certification of the  Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |
| 99.2                 |       | Certification of the  Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |

 

(b)         Reports on Form 8-K

On June 4, 2002, we fileda Current Report on Form 8-K dated May 28, 2002 under Item 4 regarding thedecision by our Board of Directors to dismiss McGladrey & Pullen LLP asour  independent public accountants.

On July 9, 2002,we filed a Current Report on Form 8-K dated July 5, 2002 under Item 4 regardingthe decision by our Board of Directors to appoint KPMG LLP as the ourindependent public accountants.

 

20

----

 

**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 
|           |   | TROY GROUP, INC.                                               |
|----------------|--------|----------------------------------------------------------------|
|           |   |                                                           |
| March 17, 2003 |   | /s/ Patrick J. Dirk                                            |
|           |   | Patrick J. Dirk                                                |
|           |   | Chairman, President and  Chief Executive Officer               |
|           |   |                                                           |
|           |   | /s/James W. Klingler                                           |
|           |   | James W. Klingler                                              |
|           |   | Vice President-Finance,  Treasurer and Chief Financial Officer |

 

21

----

 

**CERTIFICATIONS**

 

I, Patrick J. Dirk,certify that:

 

1.             I have reviewed this quarterly report on Form 10-Q ofTroy Group, Inc.;

 

2.             Based on my knowledge, this quarterly report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this quarterly report; and

 

3.             Based on my knowledge, the financial statements, andother financial information included in this quarterly report, fairly presentin all material respects the financial condition, results of operations andcash flows of the registrant as of, and for, the periods presented in thisquarterly report.

 

4.             The registrant’s othercertifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

(a)          designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

(b)          evaluated the effectiveness ofthe registrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this quarterly report (the “Evaluation Date”); and

(c)          presented in this quarterlyreport our conclusions about the effectiveness of the disclosure controls andprocedures based on our evaluation as of the Evaluation Date;

5.             The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee of registrant’sboard of directors (or persons performing the equivalent function):

(a)          all significant deficiencies inthe design or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

(b)          any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls; and

6.             The registrant’sother certifying officer and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
| March 17, 2003 |   | /s/ Patrick J. Dirk                    |
|----------------|--------|----------------------------------------|
|           |   | Patrick J. Dirk                        |
|           |   | President and Chief  Executive Officer |

 

22

----

 

**CERTIFICATIONS**

 

I, James W.Klingler certify that:

 

1.             I have reviewed this quarterly report on Form 10-Q ofTroy Group, Inc.;

 

2.             Based on my knowledge, this quarterly report does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this quarterly report; and

 

3.             Based on my knowledge, the financial statements, andother financial information included in this quarterly report, fairly presentin all material respects the financial condition, results of operations andcash flows of the registrant as of, and for, the periods presented in thisquarterly report.

 

4.             The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

(a)          designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

(b)          evaluated the effectiveness ofthe registrant’s disclosure controls and procedures as of a date within 90 daysprior to the filing date of this quarterly report (the “Evaluation Date”); and

(c)          presented in this quarterly reportour conclusions about the effectiveness of the disclosure controls andprocedures based on our evaluation as of the Evaluation Date;

5.             The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

(a)          all significant deficiencies inthe design or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

(b)          any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls; and

6.             The registrant’sother certifying officer and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.
| March 17, 2003 |   | /s/James W. Klingler                                           |
|----------------|--------|----------------------------------------------------------------|
|           |   | James W. Klingler                                              |
|           |   | Vice President-Finance,  Treasurer and Chief Financial Officer |

 

23

----

 

*The written statements required pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002, accompanied the filing of thisreport by correspondence to the Securities and Exchange Commission.*

 

 

24

----