**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D. C.  20549**

 

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# ** **

# **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 June 30, 2005**                                                                     |
| ** **                                                                                                                 | ** **                                                                                                |
| ** **                                                                                                                 | **Or**                                                                                                    |
| ** **                                                                                                                 | ** **                                                                                                |
| **o**                                                                                                                      | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934.** |
| ** **                                                                                                                 | ** **                                                                                                |
| **For the  transition period  from       to       ** |
| ** **                                                                                                                 | ** **                                                                                                |
| **Commission  File Number:  1-15177**                                                                                 |

 

**DIGITAL ANGEL CORPORATION**

(Exact name of registrant as specified in itscharter)

 
| **DELAWARE**                                                     | ** ** | **52-1233960**                     |
|------------------------------------------------------------------|------------|------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (IRS Employer  Identification No.) |
|                                                             |
| **490  Villaume Avenue, South Saint Paul, Minnesota, 55075**     |
| (Address of registrant’s  principal executive offices)      |
|                                                             |
| **(651) 455-1621**                                               |
| (Registrant’s telephone  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 theSecurities Exchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

 

Yes     ý    No     o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule12b-2 of the Exchange Act).

 

Yes     o    No     ý

 

As of the close of business on August 3, 2005,there were 43,847,314 shares outstanding of the issuer’s $0.005 per share parvalue common stock.

 

 

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**DIGITALANGEL CORPORATION**

 

TABLE OF CONTENTS

 
| **Item**                                 | ** ** | **Description**                                                                             | ** ** |
|------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
|                                     |       |                                                                                        |       |
| PART I – FINANCIAL INFORMATION |       |
|                                     |       |                                                                                        |       |
| 1.                                       |       | Financial Statements                                                                        |       |
| 2.                                       |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       |
| 3.                                       |       | Quantitative and  Qualitative Disclosures About Market Risk                                 |       |
| 4.                                       |       | Controls and Procedures                                                                     |       |
|                                     |       |                                                                                        |       |
| PART II – OTHER INFORMATION    |       |
|                                     |       |                                                                                        |       |
| 1.                                       |       | Legal Proceedings                                                                           |       |
| 2.                                       |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                |       |
| 4.                                       |       | Submission of  Matters to A Vote of Securityholders                                         |       |
| 6.                                       |       | Exhibits                                                                                    |       |
|                                     |       |                                                                                        |       |
| SIGNATURE                                |       |
| CERTIFICATIONS                           |       |
| EXHIBITS                                 |       |

 

2

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**PART I   FINANCIAL INFORMATION**

 

Item1.   FinancialStatements.

 

**DIGITALANGEL CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS**(In thousands, exceptpar value)

 
| ** **                                                                                                                                                                       | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                                       |       |                    |       |                        |       |
| **Current Assets**                                                                                                                                                               |       |                    |       |                        |       |
| Cash                                                                                                                                                                             |       | **$**                   | **12,662** | ** **                  | $          | 17,492 |   |
| Restricted cash                                                                                                                                                                  |       | **—**              | ** ** | 327                         |       |
| Accounts receivable (net of allowance for  doubtful accounts of $255 in 2005 and $241 in 2004)                                                                                   |       | **8,128**               | ** ** | 7,641                       |       |
| Due from Verichip Corporation                                                                                                                                                    |       | **66**                  | ** ** | **—**                  |       |
| Inventories                                                                                                                                                                      |       | **8,390**               | ** ** | 6,232                       |       |
| Other current assets                                                                                                                                                             |       | **1,374**               | ** ** | 1,235                       |       |
| Net assets from discontinued operations                                                                                                                                          |       | **—**              | ** ** | 6                           |       |
| **Total Current  Assets**                                                                                                                                                        |       | **30,620**              | ** ** | 32,933                      |       |
|                                                                                                                                                                             |       | ** **              | ** ** |                        |       |
| **Property and  Equipment, net**                                                                                                                                                 |       | **8,161**               | ** ** | 5,947                       |       |
| ** **                                                                                                                                                                       |       | ** **              | ** ** |                        |       |
| **Goodwill**                                                                                                                                                                     |       | **53,624**              | ** ** | 48,997                      |       |
| ** **                                                                                                                                                                       |       | ** **              | ** ** |                        |       |
| **Other Intangible  Assets, net**                                                                                                                                                |       | **3,649**               | ** ** | 4,011                       |       |
| ** **                                                                                                                                                                       |       | ** **              | ** ** |                        |       |
| **Other Assets, net**                                                                                                                                                            |       | **598**                 | ** ** | 785                         |       |
| ** **                                                                                                                                                                       |       | **$**                   | **96,652** | ** **                  | $          | 92,673 |   |
| **Liabilities and  Stockholders’ Equity**                                                                                                                                   |       | ** **              | ** ** |                        |       |
| **Current Liabilities**                                                                                                                                                          |       | ** **              | ** ** |                        |       |
| Line of credit and current maturities of  long-term debt                                                                                                                         |       | **$**                   | **1,946**  | ** **                  | $          | 99 |   |
| Accounts payable                                                                                                                                                                 |       | **4,964**               | ** ** | 3,936                       |       |
| Accrued expenses and other current  liabilities                                                                                                                                  |       | **3,284**               | ** ** | 4,371                       |       |
| Deferred revenue                                                                                                                                                                 |       | **1,195**               | ** ** | 1,204                       |       |
| Due to Applied Digital Solutions, Inc.                                                                                                                                      |       | **6**                   | ** ** | 23                          |       |
| Net liabilities from discontinued  operations                                                                                                                                    |       | **71**                  | ** ** | —                      |       |
| **Total Current  Liabilities**                                                                                                                                                   |       | **11,466**              | ** ** | 9,633                       |       |
| ** **                                                                                                                                                                       |       | ** **              | ** ** |                        |       |
| **Long-Term Debt And  Notes Payable**                                                                                                                                            |       | **3,505**               | ** ** | 2,285                       |       |
| ** **                                                                                                                                                                       |       | ** **              | ** ** |                        |       |
| **Deferred Revenue**                                                                                                                                                             |       | **640**                 | ** ** | 744                         |       |
| ** **                                                                                                                                                                       |       | ** **              | ** ** |                        |       |
| **Total Liabilities**                                                                                                                                                            |       | **15,611**              | ** ** | 12,662                      |       |
| ** **                                                                                                                                                                       |       | ** **              | ** ** |                        |       |
| **Commitments And  Contingencies (See Note 10)**                                                                                                                                 |       | ** **              | ** ** |                        |       |
| ** **                                                                                                                                                                       |       | ** **              | ** ** |                        |       |
| **Minority Interest**                                                                                                                                                            |       | **567**                 | ** ** | 249                         |       |
| ** **                                                                                                                                                                       |       | ** **              | ** ** |                        |       |
| **Stockholders’  Equity**                                                                                                                                                   |       | ** **              | ** ** |                        |       |
| Preferred stock: Authorized 1,000 shares,  of $1.75 par value, 0 outstanding in 2005 and 1 outstanding in 2004                                                                   |       | **—**              | ** ** | 1                           |       |
| Common stock: Authorized 95,000 shares, of  $.005 par value; 44,225 shares issued and 43,847 shares outstanding in 2005  and 43,475 shares issued and 43,425 outstanding in 2004 |       | **222**                 | ** ** | 217                         |       |
| Additional paid-in capital                                                                                                                                                       |       | **211,874**             | ** ** | 207,875                     |       |
| Accumulated deficit                                                                                                                                                              |       | **(129,858**            | **)**      | (128,474                    | )          |
| Treasury stock (carried at cost, 378 in  2005 and 50 in 2004)                                                                                                                    |       | **(1,580**              | **)**      | (43                         | )          |
| Accumulated other comprehensive (loss)  income                                                                                                                                   |       | **(184**                | **)**      | 186                         |       |
| **Total Stockholders’  Equity**                                                                                                                                             |       | **80,474**              | ** ** | 79,762                      |       |
|                                                                                                                                                                             |       | **$**                   | **96,652** | ** **                  | $          | 92,673 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

3

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**(In thousands, except per share data)

(Unaudited)

 
| ** **                                                                | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                | ** ** | **2005**                                      | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                      |       |                                          |       |                                        |       |   |   |   |   |
| Product  revenue                                                          | ** ** | **$**                                         | **14,247** |                                        | $          | 9,403 | ** ** | **$** | **26,944** |   | $ | 19,914 |   |
| Service  revenue                                                          | ** ** | **613**                                       |       | 667                                         | ** ** | **1,319** |   | 927 |   |
| Total net  revenue                                                        | ** ** | **14,860**                                    |       | 10,070                                      |       | **28,263** |   | 20,841 |   |
|                                                                      |       |                                          |       |                                        |       |   |   |   |   |
| Cost of  products sold                                                    | ** ** | **7,918**                                     |       | 5,479                                       |       | **15,021** |   | 11,608 |   |
| Cost of  services sold                                                    | ** ** | **302**                                       |       | 435                                         |       | **607** |   | 548 |   |
|                                                                      |       |                                          |       |                                        |       |   |   |   |   |
| Gross profit                                                              | ** ** | **6,640**                                     |       | 4,156                                       |       | **12,635** |   | 8,685 |   |
|                                                                      |       |                                          |       |                                        |       |   |   |   |   |
| Selling,  general and administrative expenses                             | ** ** | **6,118**                                     |       | 4,303                                       |       | **11,446** |   | 8,727 |   |
| Research and  development expenses                                        | ** ** | **1,119**                                     |       | 850                                         |       | **2,205** |   | 1,519 |   |
|                                                                      | ** ** | ** **                                    | ** ** |                                        |       | ** ** |   |   |   |
| Operating  loss                                                           | ** ** | **(597**                                      | **)**      | (997                                        | )          | **(1,016** | ) | (1,561 | ) |
|                                                                      | ** ** | ** **                                    | ** ** |                                        |       | ** ** |   |   |   |
| Interest  income                                                          | ** ** | **83**                                        | ** ** | 8                                           |       | **159** |   | 16 |   |
| Interest  expense                                                         | ** ** | **(79**                                       | **)**      | (247                                        | )     | **(180** | ) | (503 | ) |
| Realized and unrealized losses on Applied  Digital common stock           | ** ** | **—**                                    | ** ** | (26                                         | )          | **—** | ** ** | (2,612 | ) |
| Other income                                                              | ** ** | **7**                                         | ** ** | 20                                          |       | **33** | ** ** | 58 |   |
|                                                                      |       | ** **                                    | ** ** |                                        |       |   | ** ** |   |   |
| Loss before  taxes, minority interest and discontinued operations         | ** ** | **(586**                                      | **)**      | (1,242                                      | )          | **(1,004** | **)** | (4,602 | ) |
|                                                                      |       | ** **                                    | ** ** |                                        |       |   | ** ** |   |   |
| Income taxes                                                              |       | **(86**                                       | **)**      | —                                      | ** ** | **(86** | **)** | — |   |
| Minority  interest share of losses (income)                               | ** ** | **(219**                                      | **)**      | 3                                           |       | **(294** | **)** | (3 | ) |
|                                                                      |       | ** **                                    | ** ** |                                        |       |   | ** ** |   |   |
| Net loss from continuing operations                                       |       | **(891**                                      | **)**      | (1,239                                      | )          | **(1,384** | **)** | (4,605 | ) |
|                                                                      |       | ** **                                    | ** ** |                                        |       | ** ** | ** ** |   |   |
| Loss from discontinued operations                                         |       | **—**                                    | ** ** | (750                                        | )          | **—** | ** ** | (1,128 | ) |
|                                                                      |       | ** **                                    | ** ** |                                        |       | ** ** | ** ** |   |   |
| Net loss                                                                  | ** ** | **$**                                         | **(891**   | **)**                                       | $          | (1,989 | ) | ** ** | **(1,384** | **)** | $ | (5,733 | ) |
|                                                                      |       | ** **                                    | ** ** |                                        |       | ** ** | ** ** |   |   |
| Loss per common  share-basic and diluted:                                 |       |                                          | ** ** |                                        |       |   | ** ** |   |   |
|                                                                      |       |                                          | ** ** |                                        |       |   | ** ** |   |   |
| Loss from continuing operations                                           |       | **(0.02**                                     | **)**      | (0.04                                       | )     | **(0.03** | **)** | (0.15 | ) |
| Loss from  discontinued operations                                        | ** ** | ** **                                    | **—** | ** **                                  |       | (0.02 | ) | ** ** | **—** | ** ** |   | (0.03 | ) |
| Net loss per  common share –basic and diluted                        | ** ** | **$**                                         | **(0.02**  | **)**                                       | $          | (0.06 | ) | **$** | **(0.03** | **)** | $ | (0.18 | ) |
|                                                                      |       |                                          | ** ** |                                        |       |   | ** ** |   |   |
| Weighted  average number of common shares outstanding - basic and diluted | ** ** | **43,917**                                    | ** ** | 32,691                                      |       | **43,792** | ** ** | 31,604 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

4

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITYFor The Six Months Ended June 30, 2005**(In Thousands)(Unaudited)

 
| ** **                                                       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | ** **        | ** ** | ** **             | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------|------------|-----------------|------------|----------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **  | ** ** | ** **      | ** ** | **Additional** | ** ** | ** **        | ** ** | ** **             | ** ** | **Other**         | ** ** | **Total**  | ** ** |
| ** **                                                       | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Treasury**   | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                       | ** ** | **Number**          | ** ** | **Amount**       | ** ** | **Number**  | ** ** | **Amount**      | ** ** | **Capital**    | ** ** | **Deficit**       | ** ** | **Stock**              | ** ** | **Income (Loss)** | ** ** | **Equity** | ** ** |
| **Balance -  December 31, 2004**                            |       | —              |       | $                | 1          |        | 43,425     |            | $          | 217            |       | $                 | 207,875    |                   | $          | (128,474          | )          | $          | (43        | ) | $ | 186 |   | $ | 79,762 |   |
| Net loss                                                         |       | —              |       | —           |       | —      |       | —          |       | —         |       | (1,384            | )          | —                 |       | —            |       | (1,384     | )          |
| Comprehensive loss - Foreign currency translation                |       | —              |       | —           |       | —      |       | —          |       | —         |       | —            |       | —                 |       | (370              | )          | (370       | )          |
| Total comprehensive loss                                         |       | —              |       | —           |       | —      |       | —          |       | —         |       | (1,384            | )          | —                 |       | (370              | )          | (1,754     | )          |
| Purchase of treasury stock                                       |       | —              |       | —           |       | —      |       | —          |       | —         |       | —            |       | (1,537                 | )          | —            |       | (1,537     | )          |
| Issuance of common stock to Applied Digital Solutions, Inc. |       | —              |       | —           |       | 644         |       | 3               |       | 3,497          |       | —            |       | —                 |       | —            |       | 3,500      |       |
| Conversion of Series A Preferred Stock                      |       | —              |       | (1               | )          | 14          |       | 1               |       | —         |       | —            |       | —                 |       | —            |       | —     |       |
| Exercise of stock options                                        |       | —              |       | —           |       | 20          |       | —          |       | 55             |       | —            |       | —                 |       | —            |       | 55         |       |
| Exercise of warrants                                             |       | —              |       | —           |       | 115         |       | 1               |       | 302            |       | —            |       | —                 |       | —            |       | 303        |       |
| Stock grant to former employee                                   |       | —              |       | —           |       | 7           |       | —          |       | —         |       | —            |       | —                 |       | —            |       | —     |       |
| Restricted stock issued to employees                             |       | —              |       | —           |       | —      |       | —          |       | 145            |       | —            |       | —                 |       | —            |       | 145        |       |
| **Balance – June 30, 2005**                            |       | —              |       | $                | —     |        | 44,225     |            | $          | 222            |       | $                 | 211,874    |                   | $          | (129,858          | )          | $          | (1,580     | ) | $ | (184 | ) | $ | 80,474 |   |
|                                                                  |            |                     |            |                  |            |             |            |                 |            |                |            |                   |            |                        |            |                   |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See the accompanying notes tocondensed consolidated financial statements.

 

5

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**DIGITALANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**(In thousands)(Unaudited)
| ** **                                                                   | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| **Cash Flows From Operating Activities**                                     |       |                                        |       |   |   |
| Net loss  from continuing operations                                         | ** ** | **$**                                       | **(1,384** | **)** | $ | (4,605 | ) |
|                                                                         |       |                                        | ** ** |   |   |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                        | ** ** |   |   |
| Loss from  discontinued operations                                           | ** ** | **—**                                  | ** ** | (1,128 | ) |
| Proceeds  from sale of Applied Digital common stock                          | ** ** | **—**                                  | ** ** | 2,687 |   |
| Equity-based  compensation                                                   | ** ** | **145**                                     | ** ** | 31 |   |
| Amortization  of debt discount and deferred financing costs                  |       | **—**                                  | ** ** | 124 |   |
| Depreciation  and amortization                                               | ** ** | **1,179**                                   | ** ** | 1,157 |   |
| Minority  interest                                                           | ** ** | **294**                                     | ** ** | 3 |   |
| Loss on  Applied Digital common stock                                        |       | **—**                                  | ** ** | 2,612 |   |
| Loss on  disposal of equipment                                               | ** ** | **5**                                       | ** ** | 39 |   |
| Change in  assets and liabilities:                                           |       |                                        | ** ** |   |   |
| Decrease  (increase) in restricted cash                                      | ** ** | **327**                                     | ** ** | (74 | ) |
| Decrease  (increase) in accounts receivable                                  | ** ** | **1,035**                                   | ** ** | (1,169 | ) |
| (Increase)  decrease in inventories                                          | ** ** | **(1,035**                                  | **)**      | 542 |   |
| Increase in  deferred costs                                                  | ** ** | **—**                                  | ** ** | (296 | ) |
| Increase in  other current assets                                            | ** ** | **(167**                                    | **)**      | (259 | ) |
| Decrease in  due to Applied Digital                                          | ** ** | **(17**                                     | **)**      | (250 | ) |
| Decrease in  accounts payable, accrued expenses and deferred revenue         | ** ** | **(1,837**                                  | **)**      | (113 | ) |
| Net cash provided by discontinued operations                                 | ** ** | **77**                                      | ** ** | 379 |   |
| **Net Cash Used In Operating Activities**                                    | ** ** | **(1,378**                                  | **)**      | (320 | ) |
|                                                                         |       |                                        | ** ** |   |   |
| **Cash Flows From Investing Activities**                                     |       |                                        | ** ** |   |   |
| (Increase)  decrease in other assets                                         | ** ** | **(204**                                    | **)**      | 18 |   |
| Payments for  property and equipment                                         | ** ** | **(675**                                    | **)**      | (235 | ) |
| Acquisition  costs, net of cash acquired                                     |       | **(893**                                    | **)**      | (20 | ) |
| Net cash  provided by discontinued operations                                |       | **—**                                  | ** ** | 383 |   |
| **Net Cash (Used In) Provided By Investing Activities**                      | ** ** | **(1,772**                                  | **)**      | 146 |   |
|                                                                         |       |                                        | ** ** |   |   |
| **Cash Flows From Financing Activities**                                     |       |                                        | ** ** |   |   |
| Amounts  borrowed on line of credit                                          | ** ** | **1,969**                                   | ** ** | 18,837 |   |
| Amounts paid  on line of credit                                              | ** ** | **(2,157**                                  | **)**      | (19,510 | ) |
| Payments on  notes payable and long-term debt                                | ** ** | **(367**                                    | **)**      | (355 | ) |
| Exercise of  stock options and warrants                                      | ** ** | **358**                                     | ** ** | 995 |   |
| Purchase of treasury stock                                                   | ** ** | **(1,537**                                  | **)**      | — |   |
| Payments for financing costs                                                 | ** ** | **—**                                  | ** ** | (20 | ) |
| **Net Cash Used In Financing Activities**                                    | ** ** | **(1,734**                                  | **)**      | (53 | ) |
|                                                                         |       |                                        | ** ** |   |   |
| **Effect of Exchange  Rate Changes on Cash**                                 |       | **54**                                      | ** ** | 3 |   |
|                                                                         |       |                                        | ** ** |   |   |
| **Net Decrease In Cash**                                                     | ** ** | **(4,830**                                  | **)**      | (224 | ) |
|                                                                         |       |                                        | ** ** |   |   |
| **Cash - Beginning Of Period**                                               | ** ** | **17,492**                                  | ** ** | 894 |   |
|                                                                         |       |                                        | ** ** |   |   |
| **Cash - End Of Period**                                                     | ** ** | **$**                                       | **12,662** | ** ** | $ | 670 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

6

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**DIGITAL ANGEL CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Dollars in thousands)(Unaudited)**

 

**1.****            ****The Company and Basis of Presentation**

 

DigitalAngel Corporation and its subsidiaries (“the Company”) develops and deployssensor and communications technologies that enable rapid and accurateidentification, location tracking, and condition monitoring of high-valueassets.  The Company operates in twosegments: Animal Applications and GPS and Radio Communications.

 

*Animal Applications—*develops, manufactures, and markets a broad line of electronic and visualidentification devices for the companion animal, livestock, laboratory animal,fish and wildlife markets worldwide.  Thepositive identification and tracking of cattle and hogs are crucial for assetmanagement and for disease control and food safety. In addition to the visualear tags, which have been sold by the Company since the late 1940’s, AnimalApplications utilizes radio frequency transmission (“RFID”) technologies in itselectronic ear tags and implantable microchips.

 

*GPS and Radio Communications—*consistsof the design, manufacture and support of GPS enabled equipment. Applicationsfor the segment’s products include location tracking and message monitoring ofvehicles, aircraft and people in remote locations through systems thatintegrate GPS and geosynchronous satellite communications and GPS enabledequipment and intelligent communications products and services for telemetry,mobile data and radio communications applications serving commercial andmilitary markets. Technology development in this segment includes theintegration and miniaturization into marketable products of two technologies: wirelesscommunications and position location technology (including global positioningsystems (GPS) and other systems).

 

On February 28,2005, the Company acquired Denmark-based DSD Holdings A/S and itswholly-owned subsidiaries Daploma International A/S and Digitag A/S.  DSD Holdings A/S became a wholly-ownedsubsidiary of Digital Angel Corporation. DSD Holdings A/S produces visual and radio frequency identification (“RFID”)tags as well as tamper-proof seals for packing and shipping applications.  DSD Holdings A/S’s operations are includedfrom the date of acquisition.   

 

As of June 30,2005, Applied Digital Solutions, Inc. (“Applied Digital” or “ADS”) owned24,291,673 shares or 55.4% of the Company’s common stock.

 

Theaccompanying unaudited condensed consolidated financial statements of theCompany as of June 30, 2005 and for the three and six month periods ended June 30,2005 and 2004 have been prepared in accordance with accounting principlesgenerally accepted in the United States of America for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X under the Securities Exchange Act of 1934.  Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements.  In the opinion of the Company’s management,all adjustments (including normal recurring adjustments) considered necessaryto present fairly the financial statements have been made.

 

Theconsolidated statements of operations for the three and six months ended June 30,2005 and 2004 are not necessarily indicative of the results that may beexpected for the entire year.  Thesestatements should be read in conjunction with the Digital Angel Corporation’saudited consolidated financial statements and related notes thereto for theyear ended December 31, 2004 which are included in the Company’s AnnualReport on Form 10-K.

 

Certainitems in the condensed consolidated financial statements for the 2004 periodshave been reclassified for comparative purposes.

 

7

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**2.****            ****Principles of Consolidation**

 

The June 30,2005 and 2004 condensed consolidated financial statements include the accountsof the Company and its wholly-owned and majority-owned subsidiaries (DSDHoldings A/S from the date of acquisition on February 28, 2005 andOuterLink Corporation from the date of acquisition on January 22,2004).  All significant intercompanyaccounts and transactions have been eliminated in consolidation.

 

**3.****            ****Revenue Recognition**

 

TheCompany, except for its subsidiary OuterLink Corporation, recognizes productrevenue at the time product is shipped and title has transferred, provided thata purchase order has been received or a contract has been executed, there areno uncertainties regarding customer acceptance, the sales price is fixed anddeterminable and collectibility is deemed probable. If uncertainties regardingcustomer acceptance exist, revenue is recognized when such uncertainties areresolved. There are no significant post-contract support obligations at thetime of revenue recognition. Digital Angel Corporation’s accounting policyregarding vendor and post contract support obligations is based on the terms ofthe customers’ contracts, billable upon occurrence of the post-sale support.Costs of products sold and services provided are recorded as the relatedrevenue is recognized. Digital Angel Corporation offers a warranty on itsproducts.  For non-fixed and fixed feejobs, service revenue is recognized based on the actual direct labor hours inthe job multiplied by the standard billing rate and adjusted to net realizablevalue, if necessary.  Other revenue isrecognized at the time service or goods are provided.  It is the Company’s policy to record contractlosses in their entirety in the period in which such losses are foreseeable.

 

TheCompany’s subsidiary, OuterLink Corporation, earns revenue from messagingservices, which generally provide for service on a month-to month basis andfrom the sale of related products to customers (communication terminals andsoftware).  OuterLink Corporation’smessaging service is only available through use of its products and suchproducts have no alternative use. Accordingly, service revenue is recognized as the services areperformed.  OuterLink Corporation’sproduct revenue, for which title and risk of loss transfers to the customer onshipment, is deferred upon shipment and is recognized ratably over theestimated customer service period, which customarily is 30 months.  

 

**4.****            ****Stock-Based Compensation**

 

TheCompany applies APB Opinion No. 25 and related Interpretations inaccounting for all its stock option plans. Accordingly, no compensation cost has been recognized under theseplans.  The Company has adopted thedisclosure-only provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation” and SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure,” which was released in December 2002as an amendment to SFAS No. 123. The following table illustrates the effect on net loss and earnings pershare if the fair value based method had been applied to all awards (inthousands, except per share data):

 
| ** **                                                                                                              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                              | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Reported net  loss                                                                                                      | ** ** | **$**                                | **(891**   | **)**                              | $          | (1,989 | ) | **(1,384** | **)** | $ | (5,733 | ) |
| Stock-based  employee compensation expense in reported net loss, net of related tax  effects                            | ** ** | **145**                              | ** ** | 31                                 |       | **145** | ** ** | 31 |   |
| **Stock-based employee compensation expense determined  under the fair value based method, net of related tax effects** | ** ** | **(1,526**                           | **)**      | **(2,111**                         | **)**      | **(2,760** | **)** | **(3,611** | **)** |
| Pro forma net loss                                                                                                      | ** ** | **$**                                | **(2,272** | **)**                              | $          | (4,069 | ) | **$** | **(3,999** | **)** | $ | (9,313 | ) |
|                                                                                                                    |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| Loss per share -basic and diluted                                                                                       |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| As reported                                                                                                             | ** ** | **$**                                | **(0.02**  | **)**                              | $          | (0.06 | ) | **$** | **(0.03** | **)** | $ | (0.18 | ) |
| Pro forma                                                                                                               | ** ** | **$**                                | **(0.05**  | **)**                              | $          | (0.12 | ) | **$** | **(0.09** | **)** | $ | (0.30 | ) |

 

In December 2004, SFAS No. 123 (revised2004), “Share-Based Payment” (SFAS 123R) was issued.  SFAS 123R replaced SFAS No. 123 andsupercedes APB Opinion No. 25.  TheCompany is required to adopt SFAS 123R beginning January 1, 2006.  SFAS 123R requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their fair values.  The pro forma disclosures previouslypermitted under SFAS 123 no longer will be an alternative to financialstatement recognition.  The Company hasbegun, but has not completed, evaluating the impact of the adoption of SFAS123R on its results of operations.  Inconnection with evaluating the impact of SFAS 123R, the Company is consideringthe potential implementation of different valuation methods to determine thefair value of share-based compensation. The Company believes the adoption of SFAS 123R will have a material impacton its results of operations, regardless of the valuation method used.

 

8

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**5.****            ****Inventory (in thousands)**

 
| ** **                            | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Raw materials                         |       | **$**                   | **3,706**  | ** **                  | $          | 3,115 |   |
| Work in process                       |       | **251**                 | ** ** | 137                         |       |
| Finished goods                        |       | **6,389**               | ** ** | 4,895                       |       |
|                                  |       | **10,346**              | ** ** | 8,147                       |       |
| Allowance for excess and obsolescence |       | **(1,956**              | **)**      | (1,915                      | )          |
| Net inventory                         |       | **$**                   | **8,390**  | ** **                  | $          | 6,232 |   |

 

**6.****            ****Stock Exchanges with Applied Digital Solutions, Inc.**

 

On February 25,2005, the Company enteredinto a Stock Purchase Agreement with Applied Digital.  The purpose of the February 25, 2005stock exchange with Applied Digital was to use the shares as partialconsideration for the acquisition of DSD Holdings A/S and its wholly-ownedsubsidiaries, Daploma International A/S and Digitag A/S, as described morefully in note 9.  The Company andApplied Digital entered into the share exchange because of the sellingshareholders’ desire, at the time the transaction was negotiated, to receivetheir consideration in Applied Digital common stock as opposed to the Company’scommon stock.  In addition, the Companyand Applied Digital mutually agreed that the stock purchase represented astrategic investment by Applied Digital whereby Applied Digital could increaseits ownership interest in the Company. Pursuantto the agreement, the Company issued 644,140 shares of its common stock toApplied Digital.  The Company received684,543 shares of Applied Digital common stock as consideration.  The exchange ratio of shares was basedupon the average of the volume-weighted-average price of the Company’s commonstock and Applied Digital’s common stock for the ten trading days immediatelypreceding, and not including, the transaction closing date which was $5.434 forthe Company’s common stock and $5.113 for Applied Digital’s common stock.  Thevalue of the stock exchanged was $3.5 million.  

 

On March 1,2004, the Company issued 3,000,000 shares of its common stock to AppliedDigital pursuant to the Stock Purchase Agreement (“Stock Purchase Agreement”)with Applied Digital dated August 14, 2003.  The Stock Purchase Agreement dated August 14,2003 was used as a method for the Company to obtain and sell shares of AppliedDigital in order to generate cash for operations in a period of time when othercapital was scarce or not available.  TheCompany believes the share exchange with Applied Digital, as compared toselling shares of Digital Angel, was beneficial because (i) the net yieldon the sale was higher as the Company did not have to pay an underwritingcommission and (ii) the Company believed the sale of Applied Digitalshares was preferable to the sale of Digital Angel shares because (a) alarger number of Applied Digital shares were outstanding in the hands ofunaffiliated holders (b) Applied Digital shares had a much larger volumeof stock trading on a daily basis and (c) Applied Digital shares had lowerstock price volatility than Digital Angel shares.  In addition, the Company and Applied Digitalmutually agreed that the stock purchase represented a strategic investment byApplied Digital whereby Applied Digital could increase its ownership interestin the Company.  

 

The purchase price per share for the sharesof the Company’s stock was based on the closing price of the Company’s commonstock on June 30, 2003 of $2.64 per share. This price was used because the Company and Applied Digital determinedthat this was a fair price and because it reflected the fair value of thesecurities before any impact of the Applied Digital Debenture holderspotentially hedging their position in the Company’s common stock and therebyaffecting the market price of the stock. In connection with this transaction, the Company granted a five yearwarrant to the Applied Digital Debenture holders to acquire up to 500,000shares of the Company’s common stock at an exercise price of $2.64 pershare.  The warrant was issued inconsideration for a waiver from the Applied Digital Debenture holders allowingApplied Digital to register the shares being issued in connection with theStock Purchase Agreement.  The exerciseprice of the warrant was determined in negotiation with the Applied DigitalDebenture holders.  The purchase price ofthe Applied Digital common stock was based on the average of the volume weightedaverage price of Applied Digital’s common stock for the ten trading daysimmediately preceding (and not including) the closing date.  In addition, as part of this transaction, theCompany granted a five year warrant to Applied Digital to purchase up to 1million shares of the Company’s common stock. The exercise price of the warrant was based on the daily volume weightedaverage price of the Company’s common stock for the first 10 consecutivetrading days of 2004 starting on January 2, 2004.

 

The Company accounted for this transaction ina manner similar to a private placement whereby the Company issued common stockand warrants in exchange for common stock of Applied Digital.  The Company’s intention was to sell theshares of Applied Digital to generate cash for its operations.  Accordingly, the Company accounted for theApplied Digital stock as a trading security under SFAS 115, “Accounting forCertain Investments in Debt and Equity Securities.”

 

 In the six months ended June 30, 2004,the Company recorded realized losses of $955,000 on the 910,000 shares ofApplied Digital common stock sold and an unrealized loss of $1,657,000 on theremaining 1,070,000 shares held by the Company. Fair value of the Applied Digital common stock was determined by quoted valuesreported on NASDAQ.  As of December 31,2004, the Company had sold all of the 1,980,000 shares of Applied Digitalcommon stock for $6.7 million.  In December 2004,Applied Digital exercised its warrant for 1,000,000 shares of commonstock.  Net proceeds to the Company uponexercise of the warrant were $3.74 million.

 

9

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**7.**             **DiscontinuedOperations**

 

In April 2004,our Board of Directors approved a plan to sell our Medical Systems segment. TheMedical Systems segment represented the business operations of Medical AdvisorySystems, Inc, which we acquired on March 27, 2002.  The Medical Systems segment was one of ourreporting units in accordance with SFAS 142, “Goodwill and Other IntangibleAssets”.  Accordingly, the financialcondition, results of operations and cash flows of our Medical Systems segmenthave been reported as discontinued operations for all periods presented. Thefollowing discloses the operating losses from discontinued operations for the threeand six months ended June 30, 2005 and 2004, consisting of lossesattributable to the Medical Systems segment:

 
| ** **                                    | ** ** | **Three-Months  Ended June 30,** | ** ** | **Six-Months  Ended June 30,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                    | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Product revenue                               |       | $                                     | —     |                                | $          | 40 |   | $ | — |   | $ | 204 |   |
| Service revenue                               |       | —                                |       | 32                                  |       | — |   | 223 |   |
| Total revenue                                 |       | —                                |       | 72                                  |       | — |   | 427 |   |
| Cost of products sold                         |       | —                                |       | 20                                  |       | — |   | 87 |   |
| Cost of services sold                         |       | —                                |       | 82                                  |       | — |   | 317 |   |
| Total cost of products and services sold      |       | —                                |       | 102                                 |       | — |   | 404 |   |
| Gross profit                                  |       | —                                |       | (30                                 | )          | — |   | 23 |   |
|                                          |       |                                  |       |                                |       |   |   |   |   |
| Selling, general and administrative  expenses |       | —                                |       | 648                                 |       | — |   | 1,046 |   |
| Other expense                                 |       | —                                |       | 72                                  |       | — |   | 105 |   |
| Loss from discontinued operations             |       | $                                     | —     |                                | $          | (750 | ) | $ | — |   | $ | (1,128 | ) |

 

The above resultsdo not include any allocated or common overhead expenses.  No benefit has been provided for income taxeson the losses attributable to the Medical Systems division.  The Company does not anticipate the MedicalSystems division incurring additional losses in the future.  However, in accordance with SFAS 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”, any additional operatinglosses or changes in the values of assets or liabilities will be reflected inthe financial condition and results of operations as incurred.

 

The net (liabilities) assets of discontinued operations as June 30,2005 and December 31, 2004, were comprised of the following:

 
| ** **                                              | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                              | ** ** | **(in thousands)**     | ** ** |
| Assets:                                                 |       |                   |       |                       |       |
| Accounts  receivable, net                               |       | $                      | —     |                       | $          | — |   |
| Inventory                                               |       | —                 |       | —                     |       |
| Other  current assets                                   |       | —                 |       | —                     |       |
| Property and  equipment, net                            |       | —                 |       | —                     |       |
| Goodwill and  other intangible assets, net              |       | —                 |       | —                     |       |
| Other assets                                            |       | 35                     |       | 135                        |       |
| Total Assets                                            |       | $                      | 35         |                       | $          | 135 |   |
|                                                    |       |                   |       |                       |       |
| Liabilities:                                            |       |                   |       |                       |       |
| Notes  payable and current maturities of long-term debt |       | $                      | —     |                       | $          | — |   |
| Accounts  payable                                       |       | —                 |       | —                     |       |
| Accrued  expenses and deferred revenue                  |       | 106                    |       | 129                        |       |
| Total  Liabilities                                      |       | $                      | 106        |                       | $          | 129 |   |
|                                                    |       |                   |       |                       |       |
| Net  (Liabilities) Assets                               |       | $                      | (71        | )                          | $          | 6 |   |

 

**8.****            ****Segment Information**

 

The Company is an advanced technology companyin the field of rapid and accurate identification, location tracking, andcondition monitoring of high-value assets. The Company’s operating segments are: Animal Applications and GPS andRadio Communications.  During 2004,Digital Angel Corporation sold substantially all the assets related to itsMedical Systems segment’s medical services business.  

 

It is onthis basis that management utilizes the financial information to assist inmaking internal operating decisions.  The

 

10

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Companyevaluates performance based on stand-alone segment operating income.

 

Followingis the selected segment data as of and for the three months ended June 30,2005 (in thousands):

 
| ** **                                                                        | ** ** | **Animal  Applications** | ** ** | **GPS and  Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------------|------------|------------------------------|------------|------------------|------------|
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Net revenue from external customers:                                              |       |                     |       |                               |       |                         |       |             |       |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Product                                                                           |       | $                        | 8,036      |                               | $          | 6,211                        |       | $                | —     |   | $ | 14,247 |   |
| Service                                                                           |       | 300                      |       | 313                                |       | —                       |       | 613              |       |
| Total revenue                                                                     |       | $                        | 8,336      |                               | $          | 6,524                        |       | $                | —     |   | $ | 14,860 |   |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Operating (loss) income                                                           |       | $                        | (1,078     | )                                  | $          | 481                          |       | $                | —     |   | $ | (597 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Loss before taxes, minority interest share  of income and discontinued operations |       | $                        | (1,081     | )                                  | $          | 495                          |       | $                | —     |   | $ | (586 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Total assets                                                                      |       | $                        | 81,024     |                               | $          | 15,628                       |       | $                | —     |   | $ | 96,652 |   |
|                                                                                   |            |                          |            |                                    |            |                              |            |                  |            |  |  |  |  |  |  |  |  |

 

Followingis the selected segment data as of and for the six months ended June 30,2005 (in thousands):

 
| ** **                                                                        | ** ** | **Animal  Applications** | ** ** | **GPS and  Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------------|------------|------------------------------|------------|------------------|------------|
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Net revenue from external customers:                                              |       |                     |       |                               |       |                         |       |             |       |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Product                                                                           |       | $                        | 15,917     |                               | $          | 11,027                       |       | $                | —     |   | $ | 26,944 |   |
| Service                                                                           |       | 716                      |       | 603                                |       | —                       |       | 1,319            |       |
| Total revenue                                                                     |       | $                        | 16,633     |                               | $          | 11,630                       |       | $                | —     |   | $ | 28,263 |   |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Operating (loss) income                                                           |       | $                        | (1,122     | )                                  | $          | 106                          |       | $                | —     |   | $ | (1,016 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |   |   |   |   |
| Loss before taxes, minority interest share  of income and discontinued operations |       | $                        | (1,102     | )                                  | $          | 98                           |       | $                | —     |   | $ | (1,004 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Total assets                                                                      |       | $                        | 81,024     |                               | $          | 15,628                       |       | $                | —     |   | $ | 96,652 |   |

 

Followingis the selected segment data as of and for the three months ended June 30,2004 (in thousands):

 
| ** **                                                                        | ** ** | **Animal  Applications** | ** ** | **GPS and  Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------------|------------|------------------------------|------------|------------------|------------|
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Net revenue from external customers:                                              |       |                     |       |                               |       |                         |       |             |       |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Product                                                                           |       | $                        | 5,779      |                               | $          | 3,624                        |       | $                | —     |   | $ | 9,403 |   |
| Service                                                                           |       | 334                      |       | 333                                |       | —                       |       | 667              |       |
| Total revenue                                                                     |       | $                        | 6,113      |                               | $          | 3,957                        |       | $                | —     |   | $ | 10,070 |   |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Operating loss                                                                    |       | $                        | (234       | )                                  | $          | (763                         | )          | $                | —     |   | $ | (997 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |   |   |   |   |
| Loss before taxes, minority interest share  of income and discontinued operations |       | $                        | (439       | )                                  | $          | (803                         | )          | $                | —     |   | $ | (1,242 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Total assets                                                                      |       | $                        | 60,303     |                               | $          | 17,067                       |       | $                | 26         |   | $ | 77,396 |   |

 

11

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Followingis the selected segment data as of and for the six months ended June 30,2004 (in thousands):

 
| ** **                                                                        | ** ** | **Animal  Applications** | ** ** | **GPS and  Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------------|------------|------------------------------|------------|------------------|------------|
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Net revenue from external customers:                                              |       |                     |       |                               |       |                         |       |             |       |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Product                                                                           |       | $                        | 12,788     |                               | $          | 7,126                        |       | $                | —     |   | $ | 19,914 |   |
| Service                                                                           |       | 397                      |       | 530                                |       | —                       |       | 927              |       |
| Total revenue                                                                     |       | $                        | 13,185     |                               | $          | 7,656                        |       | $                | —     |   | $ | 20,841 |   |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Operating loss                                                                    |       | $                        | (108       | )                                  | $          | (1,453                       | )          | $                | —     |   | $ | (1,561 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Loss before taxes, minority interest share  of income and discontinued operations |       | $                        | (3,082     | )                                  | $          | (1,520                       | )          | $                | —     |   | $ | (4,602 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Total assets                                                                      |       | $                        | 60,303     |                               | $          | 17,067                       |       | $                | 26         |   | $ | 77,396 |   |
|                                                                                   |            |                          |            |                                    |            |                              |            |                  |            |  |  |  |  |  |  |  |  |

 

**9.****            ****Acquisitions**

 

Thefollowing describes the acquisitions by the Company (in thousands):

 
| **Company  Acquired** | ** ** | **Date  Acquired** | ** ** | **Acquisition  Price** | ** ** | **Goodwill  and  Other Intangibles  Acquired** | ** ** | **Other Net  Assets and  Liabilities** | ** ** | **Business  Description** | ** ** |
|-----------------------|------------|--------------------|------------|------------------------|------------|------------------------------------------------|------------|----------------------------------------|------------|---------------------------|------------|
| DSD Holdings A/S      |       | 2/28/05            |       | $                      | 3,896      |                                           | $          | 4,743                                  |       | $                         | (847       | ) | Manufactures and  markets visual and electronic RFID tags for livestock. |   |
| OuterLink Corporation |       | 1/22/04            |       | $                      | 8,501      |                                           | $          | 8,522                                  |       | $                         | (21        | ) | Provider of  real-time, satellite-based automated tracking, wireless data transfer and  two-way messaging with large fleets of vehicles. |   |

 

On February 28,2005, the Company acquired DSD Holdings A/S and its wholly-owned subsidiariesDaploma International A/S and Digitag A/S. DSD Holdings A/S became a wholly-owned subsidiary of Digital AngelCorporation.  The acquisition wasaccounted for under the purchase method of accounting.   The excess of purchase price over the fair valueof the assets and liabilities of DSD Holdings A/S has been recorded as goodwill.  The acquisition of DSD Holdings A/S has beenrecorded based on preliminary estimates as of the date of acquisition.  Any changes to the preliminary estimatesduring the allocation period will be reflected as an adjustment togoodwill.  

 

Under the terms of the DSD Holdings A/Sacquisition, the Company purchased all of the outstanding capital stock of DSDHoldings A/S in consideration for a purchase price of seven times DSD HoldingsA/S’s average annual EBITDA over the next three years less outstandingindebtedness at the end of the time period and less 30% of the totalcompensation paid to Lasse Nordfjeld, CEO of DSD Holdings A/S.  An initial payment of $3.5 million was madeat closing through the delivery of Applied Digital common stock valued at $3.5million which the Company acquired from Applied Digital in exchange for $3.5million of Digital Angel Corporation common stock.  To account for pre-closing pricingfluctuations the Company paid additional consideration of $195,000 to theshareholders of DSD Holdings A/S on June 7, 2005.

 

In addition, Digital Angel entered intoemployment agreements with the CEO of DSD Holdings A/S and its subsidiaries,Lasse Nordfjeld and his son, the President of Daploma, Torsten Nordfjeld.

 

Denmark-based DSD Holdings A/S through itssubsidiaries manufactures and markets visual and electronic RFID tags forlivestock as well as tamper-proof seals for packing and shipping applications.  In considering the benefits of the DSDascquisition, the management of Digital Angel recognized the synergiesavailable with DSD’s highlyautomated and efficient manufacturing facility, as well as DSD’s presence insuccessfully developed markets in Europe, the Middle East, Japan and Australia.The acquisition provides Digital Angel with immediate expansion of its existingbusiness in the significant European market for livestock tagging andtracking.  

 

DigitalAngel Corporation operates DSD Holdings A/S and its operating subsidiaries fromtheir current headquarters near Copenhagen, Denmark.

 

On January 22, 2004, the Company acquired OuterLink Corporation,which became a wholly-owned subsidiary of Digital Angel Corporation.  The acquisition was accounted for under thepurchase method of accounting.   Theexcess of purchase price over the fair value of the assets and liabilities ofOuterLink Corporation was recorded as goodwill of $3.8 million and intangibleassets of $4.7 million. The intangible assets are customer relationships,trademarks and core technology.  Thecustomer relationships and core

 

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technology are being amortized over periods ranging from 4 to 8 years.The customer relationships and core technology are being amortized over periodsranging from 4 to 8 years.  Amortizationrecorded in the three-months ended June 30, 2005 and 2004 was $0.2 millionand $0.4 million, respectively. Amortization recorded in the six-months ended June 30, 2005 and2004 was $0.4 million and $0.4 million, respectively.  The trademark has anindefinite life.

 

The cost of the acquisition consisted of 100,000 shares of Series Apreferred stock valued at $8.3 million and acquisition costs of $0.2million.  The Series A preferredstock became convertible into four million shares of the Company’s common stockwhen the volume weighted average price of the Company’s common stock equals orexceeds $4.00 per share for ten consecutive trading days.  As of June 30, 2005, 99,976 preferredshares had been converted into 3.9 million shares of the Company’s commonstock.

 

The valuation of the stock was primarily based on historical tradinghistory and stock prices of the Company’s common stock and a marketabilitydiscount of 30%.  The acquisition costsconsist of legal and accounting related services that were direct costs of theacquisition.

 

In considering the benefits of the OuterLink Corporation acquisition,the management of Digital Angel Corporation recognized the strategic complementof OuterLink Corporation’s technologies and customer base with Digital AngelCorporation’s existing animal applications and military GPS business lines.

 

Theresults of DSD Holdings A/S and OuterLink Corporation have been included in theconsolidated financial statements since their dates of acquisition, February 28,2005 and January 22, 2004, respectively. Unaudited pro forma results of operations for the three months ended June 30,2004 and the six months ended June 30, 2005 and 2004 are includedbelow.  Such pro forma informationassumes that the above acquisitions had occurred as of January 1, 2005 and2004, and revenue is presented in accordance with the Company’s accountingpolicies.  This summary is notnecessarily indicative of what the results of operations of the Company wouldhave been had it been a combined entity during such periods, nor does itpurport to represent results of operations for any future periods.

 
| ** **                                     | ** ** | **For the  three months  ended June 30,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------|------------|
| **(In thousands)**                             | ** ** | **2004**                                       | ** ** |
| Net revenue                                    |       | $                                              | 10,798     |   |
| Net loss                                       |       | $                                              | (2,392     | ) |
| Net loss per  common share - basic and diluted |       | $                                              | (0.07      | ) |

 
| ** **                                     | ** ** | **For the six  months ended June 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|
| **(In thousands)**                             | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| Net revenue                                    |       | $                                           | 29,146     |   | $ | 22,522 |   |
| Net loss                                       |       | $                                           | (1,415     | ) | $ | (6,305 | ) |
| Net loss per  common share - basic and diluted |       | $                                           | (0.03      | ) | $ | (0.20 | ) |

 

**10.****                              ****Contingencies**

 

*DigitalAngel Corporation vs. Allflex USA, Inc and Pet Health Services (USA), Inc.*

 

On October 20, 2004, the Companycommenced an action in the United Stated District Court for the District ofMinnesota against AllFlex USA, Inc. and Pet Health Services (USA), Inc.  This suit claims that Allflex is marketingand selling a syringe implantable identification transponder that infringes a1993 patent granted to the Company for syringe implantable identificationtransponders previously found by the United States District Court for theDistrict of Colorado to be enforceable. The suit also claims that PetHealth is using, selling and/ordistributing the same transponder in violation of the Company’s patent.  The suit seeks, among other things, anadjudication of infringement and that the infringing parties be enjoined fromfurther improper action.  The suit seeksactual damages, punitive damages and interest, costs and attorneys’ fees.  Allflex has asserted a counterclaim forbreach of contract of an existing license agreement between the Company andAllflex and asserted a counterclaim seeking a declaration of the parties’rights and obligations under the license agreement.  Allflex also moved for a judgment on thepleadings, asserting that the license agreement should act as a bar to a casefor infringement.  The Company contestedthe motion on the ground that Allflex’s actions exceed the scope of the licenseand constitute an impermissible infringement of the patent and asked the Courtfor leave to amend the complaint to assert a claim against a separate patentlicensed exclusively to the Company by Bio Medic Data Systems.   On June 23, 2005, the Court issued aruling granting the Defendant’s motion for judgment on the pleadings anddenying the Company’s motion for leave to amend.  The Company continues to believe that thesuit is well-founded, and is considering whether to appeal the Court’s ruling.

 

On July 21, 2005, Allflex filed anaction in the United Stated District Court for the Northern District of Texasseeking a

 

13

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declaratory judgment that itdid not infringe the Bio Medic patent. The Company intends to contest this action and to assert its claimsunder the patent.

 

*Digital Angel Corporation vs. Datamars, Inc.,Datamars, S.A., The Crystal Import Corporation and Medical ManagementInternational, Inc.*

 

On October 20, 2004, the Companycommenced an action in the United States District Court for the District ofMinnesota against Datamars, Inc., Datamars, S.A., The Crystal ImportCorporation, and Medical Management International, Inc. (“Banfield”).  This suit claims that the defendants aremarketing and selling syringe implantable identification transpondersmanufactured by Datamars that infringe the Company’s 1993 patent for syringeimplantable identification transponders previously found by the United StatesDistrict Court for the District of Colorado to be enforceable.  Certain of the locations in which theinfringing transponders are sold, include, but are not limited to, “Banfield,The Pet Hospital” of which certain locations are associated with PetSmartstores.  The suit seeks, among otherthings, an adjudication of infringement and that the infringing parties beenjoined from further improper action. The suit also seeks actual damages, punitive damages and interest, costsand attorneys’ fees.  The Companybelieves that the suit is well-grounded in law and fact.  Discovery in the action has been commencedand is continuing.

 

*Crystal v.Digital Angel, et al.*

 

On or about December 29, 2004 The CrystalImport Corporation filed an action against AVID Identification Systems, Inc.and Digital Angel in the United States District Court for the Northern Districtof Alabama.  Crystal’s complaintprimarily asserts federal and state antitrust and related claims against AVID,though it also asserts similar claims against Digital Angel.  Given the uncertainties associated with alllitigation and given that this case was not commenced against Digital Angeluntil February 2, 2005, the Company is unable to offer any assessment onthe potential liability exposure, if any, to Digital Angel from thislawsuit.  The Company has filed a motionto dismiss the action for failure to state a claim on which relief could begranted, or in the alternative, to have the action transferred to the UnitedStates District Court for the District of Minnesota for consolidation with theDatamars patent infringement action referred to above or to have the actionstayed until the completion of the Datamars action.  The parties have filed briefs on the motion,but an oral argument has not been held, and no ruling on the motion has beenmade.  Discovery in the action has beencommenced and is continuing. 

 

**11.****         ****Supplemental Cash Flow Information (in thousands)**

 
| ** **                                            | ** ** | **Six Months  Ended June 30,** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                            | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| Interest paid                                         |       | **$**                               | **201**    |   | $ | 281 |   |
| Taxes paid                                            |       | **85**                              |       | — |   |
| Non-cash activity:                                    |       | ** **                          |       |   |   |
| Issuance of preferred stock for business  acquisition |       | **$**                               | —     |   | 8,300 |   |
| Issuance of common stock for ADS common  stock        |       | **3,500**                           |       | 7,920 |   |
| Conversion of debt into common stock                  |       | —                              |       | 583 |   |
|                                                       |            |                                     |            |  |  |  |  |

 

**12.****         ****Related Party Activity**

 

TheCompany has executed an exclusive eleven year Distribution and LicensingAgreement dated March 4, 2002 with Verichip Corporation (Verichip), awholly-owned subsidiary of Applied Digital, covering the manufacturing,purchasing and distribution of Verichip’s implantable microchip and themaintenance of the Verichip Registry by the Company.  The agreement includes a license for the useof the Company’s technology in Verichip’s identified markets.  The Company will be the sole manufacturer andsupplier to Verichip.  Revenue recognizedunder the Distribution and Licensing Agreement was $455,000 and $57,000 for thesix months ended June 30, 2005 and 2004, respectively.  Prior to January 1, 2005 and pursuant tomutual agreement between the Company, Applied Digital and Verichip Corporationamounts due from Verichip Corporation were offset against amounts the Companyowed to Applied Digital for certain general and administrative services,research and development services, directors and officers insurance and expensereimbursement.  Effective January 1,2005, all amounts due from Verichip Corporation are to be paid to theCompany.  

 

See Note6 for a description of the stock exchange transactions with Applied Digital.

 

**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with the accompanying financialstatements and related notes thereto.

 

14

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Weconsist of Digital Angel Corporation and its six subsidiaries - Digital AngelTechnology Corporation (“DATC”), Timely Technology Corp., Signature IndustriesLimited (90.9% owned subsidiary), OuterLink Corporation, DSD Holdings A/S andDigital Angel International, Inc.

 

**RESULTS OF OPERATIONS**

 

Thefollowing table summarizes our results of operations as a percentage of netoperating revenue for the three and six months ended June 30, 2005 and2004 and is derived from the accompanying consolidated statements of operationsincluded in this report.

 
| ** **                                                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                      | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                      | ** ** | **%**                                 | ** ** | **%**                               | ** ** | **%** | ** ** | **%** | ** ** |
| Product revenue                                                 |       | 95.9                                  |       | 93.4                                |       | 95.3 |   | 95.5 |   |
| Service revenue                                                 |       | 4.1                                   |       | 6.6                                 |       | 4.7 |   | 4.5 |   |
| Total net revenue                                               |       | 100.0                                 |       | 100.0                               |       | 100.0 |   | 100.0 |   |
| Cost of products sold                                           |       | 53.3                                  |       | 54.4                                |       | 53.1 |   | 55.7 |   |
| Cost of services sold                                           |       | 2.0                                   |       | 4.3                                 |       | 2.2 |   | 2.6 |   |
| Total cost of products and services sold                        |       | 55.3                                  |       | 58.7                                |       | 55.3 |   | 58.3 |   |
| Gross profit                                                    |       | 44.7                                  |       | 41.3                                |       | 44.7 |   | 41.7 |   |
| Selling, general and administrative expenses                    |       | 41.2                                  |       | 42.7                                |       | 40.5 |   | 41.9 |   |
| Research and development expenses                               |       | 7.5                                   |       | 8.4                                 |       | 7.8 |   | 7.3 |   |
| Operating loss                                                  |       | (4.0                                  | )          | (9.8                                | )          | (3.6 | ) | (7.5 | ) |
| Interest income                                                 |       | 0.6                                   |       | 0.1                                 |       | 0.6 |   | 0.1 |   |
| Interest expense                                                |       | (0.5                                  | )          | (2.5                                | )          | (0.6 | ) | (2.4 | ) |
| Loss on Applied Digital common stock                            |       | 0.0                                   |       | (0.3                                | )          | 0.0 |   | (12.6 | ) |
| Other income                                                    |       | 0.0                                   |       | 0.2                                 |       | 0.0 |   | 0.3 |   |
| Loss before tax, minority interest and discontinued  operations |       | (3.9                                  | )          | (12.3                               | )          | (3.6 | ) | (22.1 | ) |
| Income tax expense                                              |       | (0.6                                  | )          | 0.0                                 |       | (0.3 | ) | 0.0 |   |
| Minority interest share of income                               |       | (1.5                                  | )          | 0.0                                 |       | (1.0 | ) | 0.0 |   |
| Net loss from continuing operations                             |       | (6.0                                  | )          | (12.3                               | )          | (4.9 | ) | (22.1 | ) |
| Loss from discontinued operations                               |       | 0.0                                   |       | (7.4                                | )          | 0.0 |   | (5.4 | ) |
| Net loss                                                        |       | (6.0                                  | )          | (19.7                               | )          | (4.9 | ) | (27.5 | ) |

 

**ThreeMonths Ended June 30, 2005 Compared to the Three Months Ended June 30,2004**

 

**Revenue**

 

Revenuefor the three months ended June 30, 2005 increased $4.8 million, or 47.6%,to $14.9 million when compared to $10.1 million in revenue for the three monthsended June 30, 2004.

 

Revenuefor each of the operating segments was as follows (in thousands):

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Three Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Animal Applications          |       | $                                           | 8,336      |                                        | $          | 6,113 |   |
| GPS and Radio Communications |       | 6,524                                       |       | 3,957                                       |       |
| Total                        |       | $                                           | 14,860     |                                        | $          | 10,070 |   |

 

TheAnimal Applications segment’s revenue increased**$2.2 million, or 36.4%, in the three months ended June 30, 2005compared to the three month period ended June 30, 2004. The increase inrevenue was principally due to an increase in sales to fish and wildlifecustomers of $0.6 million, an increase in microchip and visual product sales tolivestock customers of $0.1, and the inclusion of $1.5 million of revenue fromDSD Holdings A/S.  DSD Holdings A/S wasacquired on February 28, 2005.  

 

The GPSand Radio Communications segment’s revenue increased $2.6 million, or 64.9% to$6.5 million in the three months ended June 30, 2005 from $3.9 million inthe three months ended June 30, 2004. The increase primarily relates to increased revenue

 

15

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atour subsidiary, Signature Industries, related to shipments of the G2R pilotlocator beacon to fulfill a contract with the government of India and shipmentsof upgraded antenna extensions to the United Kingdom Ministry of Defence.  

 

**Gross Profit and Gross Profit Margin**

 

Grossprofit for the three month period ended June 30, 2005 was $6.6 million, anincrease**of $2.5 million, or59.8%, compared to $4.1 million in the three month period ended June 30,2004. As a percentage of revenue, the gross profit margin increased to 44.7%for the three months ended June 30, 2005 from 41.3% for the three monthsended June 30, 2004.

 

Grossprofit from operations for each operating segment was as follows (in thousands):

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Three Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Animal Applications          | ** ** | $                                           | 3,175      |                                        | $          | 2,328 | ** ** |
| GPS and Radio Communications |       | 3,465                                       |       | 1,828                                       |       |
| Total                        |       | $                                           | 6,640      |                                        | $          | 4,156 |   |

 

Grossprofit margin from operations for each operating segment was:

 
| ** **                    | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Three Months  Ended June 30,  2004** | ** ** |
|-------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                    | ** ** | **%**                                       | ** ** | **%**                                       | ** ** |
| Animal  Applications          |       | 38.1                                        |       | 38.1                                        |       |
| GPS and Radio  Communications |       | 53.1                                        |       | 46.2                                        |       |

 

TheAnimal Applications segment’s gross profit increased $0.8 million, or 36.4%, inthe three month period ended June 30, 2005 compared to the three monthsended June 30, 2004.  We attribute$0.2 million of the increase to the previously mentioned sales increase and theinclusion of $0.6 million of gross profit from DSD Holdings A/S.  DSD Holdings A/S was acquired on February 28,2005.  The gross margin percentage was38.1% for the three month periods ended June 30, 2005 and June 30,2004.

 

The GPSand Radio Communications segment’s gross profit increased $1.6 million, or89.6%, in the three month period ended June 30, 2005 as compared to thethree month period ended June 30, 2004. The gross margin percentage increased to 53.1% in the three month periodended June 30, 2005 as compared to 46.2% in the three month period ended June 30,2004.  The increase in gross profitmargin results primarily from higher margins at our Signature Industries, Ltdsubsidiary related to shipments of the G2R pilot locator beacon.

 

**Selling, General and Administrative Expenses**

 

Selling,general and administrative expenses increased $1.8 million, or 42.2%, in thethree month period ended June 30, 2005 as compared to the three monthperiod ended June 30, 2004. As a percentage of revenue, selling, generaland administrative expenses were 41.2% and 42.7% for the three months ended June 30,2005 and 2004, respectively.

 

Selling,general and administrative expenses for each of the operating segments were asfollows (dollars in thousands):

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Three Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Animal Applications          |       | $                                           | 3,558      |                                        | $          | 1,909 |   |
| GPS and Radio Communications |       | 2,560                                       |       | 2,394                                       |       |
| Total                        |       | $                                           | 6,118      |                                        | $          | 4,303 |   |

 

Selling,general and administrative expenses as a percentage of revenue for each of theoperating segments were:

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Three Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | **%**                                       | ** ** | **%**                                       | ** ** |
| Animal  Applications         |       | 42.7                                        |       | 31.2                                        |       |
| GPS and Radio Communications |       | 39.2                                        |       | 60.5                                        |       |

 

TheAnimal Applications segment’s selling, general and administrative expensesincreased $1.6 million in the three month

 

16

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periodended June 30, 2005 as compared to the three month period ended June 30,2004 and as a percentage of revenue increased to 42.7% from 31.2% in the samerespective period.  The increase inselling, general and administrative expense relates primarily to a charge of$0.4 million for tail coverage on the Company’s Directors and Officersinsurance policy, $0.3 million in legal expenses related to the protection ofthe Company’s intellectual property, $0.1 million of compensation expenserelated to restricted stock grants, $0.2 million of compensation expenserelated to employee bonuses and $0.4 million of expense related to DSD HoldingA/S.  DSD Holding A/S was acquired on February 28,2005.

 

The GPSand Radio Communications segment’s selling, general and administrative expensesincreased $0.2 million to $2.6 million in the three month period ended June 30,2005 from $2.4 million in the three month period ended June 30, 2004.  The increase results from increased sales andmarketing expenses at our subsidiary, Signature Industries and increases in theexchange rate.  As a percentage ofrevenue, selling, general and administrative expenses decreased to 39.2% in thethree month period ended June 30, 2005 from 60.5% in the three monthperiod ended June 30, 2004 primarily due to the increase in sales in thecurrent period.

 

**Research and Development Expense**

 

Researchand development expense was $1.1 million in the three month period ended June 30,2005, an increase of $0.3 million, or 31.6%, from $0.8 million for the threemonth period ended June 30, 2004. As a percentage of revenue, research and development expense was 7.5%and 8.4% for the three months ended June 30, 2005 and 2004, respectively.

 

Researchand development expense for each of the operating segments was as follows (inthousands):

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Three Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| Animal Applications          |       | $                                           | 695        |                                        | $          | 653 |   |
| GPS and Radio Communications |       | 424                                         |       | 197                                         |       |
| Total                        |       | $                                           | 1,119      |                                        | $          | 850 |   |

 

17

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TheAnimal Applications segments research and development expense remained constantat $0.7 million in the three months ended June 30, 2005 and June 30,2004.

 

The GPSand Radio Communications segment’s research and development expense increased$0.2 million in the three months ended June 30, 2005 as compared to thethree months ended June 30, 2004. The increase is related to expenses at our subsidiary, OuterlinkCorporation, for the upgrade of its communication system hardware and software.

 

**Interest Expense**

 

Interestexpense was $0.1 million and $0.2 million for the three month periods ended June 30,2005 and 2004, respectively.  Interestexpense in the three months ended June 30, 2004 included discount amortizationand deferred debt cost amortization.

 

**Loss on Applied Digital Common Stock**

** **

On March 1,2004, Digital Angel Corporation issued 3,000,000 shares of its common stock anda warrant to purchase up to 1,000,000 shares of the Company’s common stock to AppliedDigital in exchange for 1,980,000 shares of Applied Digital’s common stock,exclusive of warrant proceeds.  In thequarter ended June 30, 2004, the Company recorded realized losses of $0.2million and unrealized gains of $0.2 million related to the stock exchange withApplied Digital.  As of December 31,2004, the Company had sold all of the 1,980,000 shares of Applied Digitalcommon stock for $6.7 million.  

 

**Income Taxes**

 

TheCompany had an effective income tax rate of 14.7% for the three month periodended June 30, 2005 and 0.0% for the three month period ended June 30,2004.  Income taxes for the three monthperiod ended June 30, 2005 relate to a 70% owned subsidiary of DaplomaInternational A/S.  The Company accountsfor income taxes under the asset and liability approach.  Deferred tax assets and liabilities arerecognized for the expected future tax consequences attributed to differencesbetween the financial statement carrying amounts of existing assets andliabilities and their respective tax basis. Deferred tax assets and liabilities are measured using the enacted taxrates expected to apply to taxable income in the years in which those temporarydifferences are expected to reverse.  Avaluation allowance is provided against net deferred tax assets when it is morelikely than not that a tax benefit will not be realized.  Income taxes included U.S. and foreign taxes.

 

**DiscontinuedOperations**

** **

During2004, the Company sold substantially all the assets of its Medical Systemssegment’s medical services business.

 

The followingdiscloses the operating losses from discontinued operations for the threemonths ended June 30, 2005 and 2004, consisting of losses attributable tothe Medical Systems segment:

 
| ** **                                    | ** ** | **Three-Months  Ended June 30,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Product  revenue                              |       | $                                     | —     |   | $ | 40 |   |
| Service  revenue                              |       | —                                |       | 32 |   |
| Total  revenue                                |       | —                                |       | 72 |   |
| Cost of  products sold                        |       | —                                |       | 20 |   |
| Cost of  services sold                        |       | —                                |       | 82 |   |
| Total cost  of products and services sold     |       | —                                |       | 102 |   |
| Gross profit                                  |       | —                                |       | (30 | ) |
| Selling,  general and administrative expenses |       | —                                |       | 648 |   |
| Other  expense                                |       | —                                |       | 72 |   |
| Loss from  discontinued operations            |       | $                                     | —     |   | $ | (750 | ) |

 

18

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**Six MonthsEnded June 30, 2005 Compared to the Six Months Ended June 30, 2004**

 

**Revenue**

 

Revenuefor the six months ended June 30, 2005 increased $7.4 million, or 35.6%,to $28.3 million when compared to $20.8 million in revenue for the six monthsended June 30, 2004.

 

Revenuefor each of the operating segments was as follows (in thousands):

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| Animal Applications          |       | $                                         | 16,633     |                                      | $          | 13,185 |   |
| GPS and Radio Communications |       | 11,630                                    |       | 7,656                                     |       |
| Total                        |       | $                                         | 28,263     |                                      | $          | 20,841 |   |

 

TheAnimal Applications segment’s revenue increased**$3.4 million, or 26.2%, in the six months ended June 30, 2005compared to the six month period ended June 30, 2004. The increase inrevenue was principally due to an increase in microchip and visual productsales to livestock customers of $0.9, sales to Verichip Corporation of $0.4million and the inclusion of $2.1 million of revenue from DSD HoldingsA/S.  DSD Holdings A/S was acquired on February 28,2005.  

 

The GPSand Radio Communications segment’s revenue increased $4.0 million, or 51.9% to$11.6 million in the six months ended June 30, 2005 from $7.6 million inthe six months ended June 30, 2004. The increase was principally due to increased sales of $3.6 million atour subsidiary, Signature Industries, related to shipments of the G2R pilotlocator beacon to fulfill a contract with the government of India and antennasto the United Kingdom Ministry of Defence. Additionally, sales at our subsidiary OuterLink Corporation increased$0.4 million in the six months ended June 30, 2005 as compared to the sixmonths ended June 30, 2004

 

**Gross Profit and Gross Profit Margin**

 

Grossprofit for the six month period ended June 30, 2005 was $12.6 million, anincrease**of $4.0 million, or45.5%, compared to $8.7 million in the six month period ended June 30,2004. As a percentage of revenue, the gross profit margin increased to 44.7%for the six months ended June 30, 2005 from 41.7% for the six months endedJune 30, 2004.

 

Grossprofit from operations for each operating segment was as follows (inthousands):

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| Animal Applications          | ** ** | $                                         | 6,589      |                                      | $          | 5,134 | ** ** |
| GPS and Radio Communications |       | 6,046                                     |       | 3,551                                     |       |
| Total                        |       | $                                         | 12,635     |                                      | $          | 8,685 |   |

 

Grossprofit margin from operations for each operating segment was:

 
| ** **                    | ** ** | **Six Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2004** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                    | ** ** | **%**                                     | ** ** | **%**                                     | ** ** |
| Animal  Applications          |       | 39.6                                      |       | 38.9                                      |       |
| GPS and Radio  Communications |       | 52.0                                      |       | 46.4                                      |       |

 

TheAnimal Applications segment’s gross profit increased $1.5 million, or 28.3%, inthe six month period ended June 30, 2005 compared to the six months ended June 30,2004.  We attribute $0.7 million of theincrease to the previously mentioned sales increase and increased gross profitmargin. The inclusion of $0.8 million of gross profit from DSD Holdings A/Scontributed to the total increase of $1.5 million.  DSD Holdings A/S was acquired on February 28,2005.  The gross margin percentage was39.6% for the six month period ended June 30, 2005 and 38.9% for the sixmonth period ended June 30, 2004.

 

The GPSand Radio Communications segment’s gross profit increased $2.5 million, or70.3%, in the six month period ended June 30, 2005 as compared to the sixmonth period ended June 30, 2004. The gross margin percentage increased to 52.0% in the six month periodended June 30, 2005 as compared to 46.4% in the six month period ended June 30,2004.  The increase in gross profitmargin results primarily from higher margins at our Signature Industries, Ltdsubsidiary related to shipments of the G2R pilot locator beacon.

 

19

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**Selling, General and Administrative Expenses**

 

Selling,general and administrative expenses increased $2.7 million, or 31.1%, in thesix month period ended June 30, 2005 as compared to the six month periodended June 30, 2004. As a percentage of revenue, selling, general andadministrative expenses were 40.5% and 41.9% for the six months ended June 30,2005 and 2004, respectively.

 

Selling,general and administrative expenses for each of the operating segments were asfollows (dollars in thousands):

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| Animal Applications          |       | $                                         | 6,341      |                                      | $          | 4,066 |   |
| GPS and Radio Communications |       | 5,105                                     |       | 4,661                                     |       |
| Total                        |       | $                                         | 11,446     |                                      | $          | 8,727 |   |

 

Selling,general and administrative expenses as a percentage of revenue for each of theoperating segments were:

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **%**                                     | ** ** | **%**                                     | ** ** |
| Animal  Applications         |       | 38.1                                      |       | 30.8                                      |       |
| GPS and Radio Communications |       | 43.9                                      |       | 60.9                                      |       |

 

TheAnimal Applications segment’s selling, general and administrative expensesincreased $2.3 million in the six month period ended June 30, 2005 ascompared to the six month period ended June 30, 2004 and as a percentageof revenue increased to 38.1% from 30.8% in the same respective period.  The increase in selling, general andadministrative expenses relates to increased legal, compensation and insuranceexpense and $0.5 million of expense related to DSD Holding A/S.  DSD Holding A/S was acquired on February 28,2005.

 

The GPSand Radio Communications segment’s selling, general and administrative expensesincreased $0.4 million to $5.1 million in the six month period ended June 30,2005 from $4.7 million in the six month period ended June 30, 2004.  The increase results from increased sales andmarketing expenses at our subsidiary, Signature Industries, related toexhibitions and associated travel expense. As a percentage of revenue, selling, general and administrative expensesdecreased to 43.9% in the six month period ended June 30, 2005 from 60.9%in the six month period ended June 30, 2004 primarily due to the increasein sales in the current period.

 

**Research and Development Expense**

 

Researchand development expense was $2.2 million in the six month period ended June 30,2005, an increase of $0.7 million, or 45.2%, from $1.5 million for the sixmonth period ended June 30, 2004. As a percentage of revenue, research and development expense was 7.8%and 7.3% for the six months ended June 30, 2005 and 2004, respectively.

 

Researchand development expense for each of the operating segments was as follows (inthousands):

 

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| Animal Applications          |       | $                                         | 1,370      |                                      | $          | 1,176 |   |
| GPS and Radio Communications |       | 835                                       |       | 343                                       |       |
| Total                        |       | $                                         | 2,205      |                                      | $          | 1,519 |   |

 

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TheAnimal Applications segments research and development expense increased $0.2million in the six months ended June 30, 2005 and June 30, 2004.  The increase relates primarily to thedevelopment of a radio frequency identification (RFID) antenna detectionsystem. 

 

The GPSand Radio Communications segment’s research and development expense increased$0.5 million in the six months ended June 30, 2005 as compared to the sixmonths ended June 30, 2004.  Theincrease is related to research and development expenses at our subsidiary,Outerlink Corporation. 

 

**Interest Expense**

 

Interestexpense was $0.2 million and $0.5 million for the six month periods ended June 30,2005 and 2004, respectively.  Interest expensefor the six month period ended June 30, 2004 includes discountamortization and deferred debt cost amortization.  There are no corresponding charges in the2005 period. 

 

**Loss on Applied Digital Common Stock**

 

On March 1,2004, Digital Angel Corporation issued 3,000,000 shares of its common stock anda warrant to purchase up to 1,000,000 shares of the Company’s common stock toApplied Digital in exchange for 1,980,000 shares of Applied Digital’s commonstock, exclusive of warrant proceeds.  Inthe six months ended June 30, 2004, the Company recorded realized lossesof $1.0 million on the approximately 910,000 shares of Applied Digital commonstock sold and unrealized losses of $1,657,000 on the 1,070,000 shares held bythe Company.  As of December 31, 2004,the Company had sold all of the 1,980,000 shares of Applied Digital commonstock for $6.7 million.  

 

**Income Taxes**

 

TheCompany had an effective income tax rate of 8.6% for the six month period endedJune 30, 2005 and 0.0% for the six month period ended June 30,2004.  Income taxes for the six monthperiod ended June 30, 2005 relate to a 70% owned subsidiary of DaplomaInternational A/S.  The Company accountsfor income taxes under the asset and liability approach.  Deferred tax assets and liabilities arerecognized for the expected future tax consequences attributed to differencesbetween the financial statement carrying amounts of existing assets andliabilities and their respective tax basis. Deferred tax assets and liabilities are measured using the enacted taxrates expected to apply to taxable income in the years in which those temporarydifferences are expected to reverse.  Avaluation allowance is provided against net deferred tax assets when it is morelikely than not that a tax benefit will not be realized.  Income taxes included U.S. and foreign taxes.

 

**DiscontinuedOperations**

 

During2004, the Company sold substantially all the assets of its Medical Systemssegment’s medical services business.

 

The followingdiscloses the operating losses from discontinued operations for the six monthsended June 30, 2005 and 2004, consisting of losses attributable to theMedical Systems segment:

 
| ** **                                    | ** ** | **Six-Months  Ended June 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                    | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| Product  revenue                              |       | $                                   | —     |   | $ | 204 |   |
| Service  revenue                              |       | —                              |       | 223 |   |
| Total revenue                                 |       | —                              |       | 427 |   |
| Cost of  products sold                        |       | —                              |       | 87 |   |
| Cost of  services sold                        |       | —                              |       | 317 |   |
| Total cost  of products and services sold     |       | —                              |       | 404 |   |
| Gross profit                                  |       | —                              |       | 23 |   |
| Selling,  general and administrative expenses |       | —                              |       | 1,046 |   |
| Other  expense                                |       | —                              |       | 105 |   |
| Loss from  discontinued operations            |       | $                                   | —     |   | $ | (1,128 | ) |

 

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**LIQUIDITY AND CAPITAL RESOURCES**

 

As of June 30,2005, the Company had cash, excluding restricted cash, of $12.7 millioncompared to $17.5 million at December 31, 2004.  Cash used in operating activities totaled$1.4 million and $0.3 million in the first six months of 2005 and 2004,respectively.

 

In thefirst six months of 2005, the use of cash was due primarily to the loss fromcontinuing operations of $1.4 million, an increase in inventory of $1.0 millionand a decrease in accounts payable, accrued expenses and deferred revenue of$1.8 million.  Offsetting these uses ofcash was depreciation and amortization of $1.2 million.

 

Inventorylevels increased by $2.2 million to $8.4 million at June 30, 2005 from$6.2 million at December 31, 2004 due to an increase in inventory at ourAnimal Applications segment and $1.4 million of acquired inventory in theacquisition of DSD Holdings A/S.

 

Accountspayable increased by $1.0 million to $5.0 million at June 30, 2005 from$3.9 million at December 31, 2004. The increase primarily relates to $1.1 million of accounts payableacquired in the acquisition of DSD Holdings A/S.

 

Accruedexpenses and other current liabilities decreased by $1.1 million, or 24.9%, to$3.3 million at June 30, 2005 from $4.4 million at December 31,2004.  

 

Investingactivities used cash of $1.8 million in the first six months of 2005 andprovided cash of $0.1 million in the first six months of 2004. In the first sixmonths of 2005, cash used was primarily for the acquisition of DSD Holdings A/Sand expenditures for plant property and equipment of $0.7 million.

 

Financingactivities used cash of $1.7 million and $53,000 in the first six months of 2005and 2004, respectively.  In the first sixmonths of 2005, cash used was primarily for the purchase of 328,100 shares oftreasury stock for $1.5 million.

 

TheCompany expects that current funds available and cash from operations willadequately fund the Company’s operations for the next twelve months.

 

*Debt,Covenant Compliance and Liquidity*

 

*InvoiceDiscounting Agreement* On April 9, 2003,Signature Industries Ltd. entered into a two-year Invoice Discounting Agreementwith The Royal Bank of Scotland Commercial Services Limited (“RBS”).  The Invoice Discounting Agreement, as amendedOctober 28, 2003 and June 21, 2005, provides for Signature to sellwith full title guarantee most of its receivables, as defined in the InvoiceDiscounting Agreement, as amended.  RBSprepays 80% of the receivables sold in the United Kingdom and 75% of thereceivables sold in the rest of the world, not to exceed an outstanding balanceof £750,000 ($1,350,000 at June 30, 2005) at any given time.  RBS pays Signature the remainder of thereceivable upon collection of the receivable. Receivables which remain outstanding 90 days from the end of the invoicemonth become ineligible and RBS may require Signature to repurchase thereceivable back.  The discounting chargeaccrues daily at an annual rate of 1.85% above the base rate, as defined in theamended Invoice Discounting Agreement (7.0% at June 30, 2005).  Signature pays a commission charge to RBS of0.16% of each receivable balance sold. The Invoice Discounting Agreement, as amended, requires a minimumcommission charge of £833 per month. Discounting charges of $24,000 and $32,000 are included in interestexpense for the six months ended June 30, 2005 and 2004, respectively.

 

*CreditFacility*As of June 30, 2005, DSD Holdings isparty to a credit agreement with Danske Bank. The credit facility provides for borrowings up to DKK 12 million($1,944,000 at June 30, 2005).  At June 30,2005, the annual interest rate on the facility was 4.5%.  Borrowing availability under the facility asof June 30, 2005 was approximately $675,000.

 

*Stock Issuances to Applied Digital*On February 25, 2005, the Company entered into a Stock Purchase Agreement with Applied Digital.  Pursuant to the agreement the Company issued644,140 shares of its common stock to Applied Digital.  The Company received 684,543 shares ofApplied Digital common stock as consideration. The value of the stock exchanged was $3.5 million. The Applied Digitalcommon stock received by the Company was used as partial consideration for theacquisition of DSD Holdings A/S and its wholly-owned subsidiaries, DaplomaInternational A/S and Digitag A/S.

 

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*Stock Repurchase* On March 29, 2005, theCompany’s Board of Directors approved the repurchase of up to 1.5 millionshares of its common stock over a ninety day period commencing on March 30,2005.  As of June 30, 2005, theCompany purchased 328,000 shares for a total of $1.5 million.

 

Thefollowing table summarizes the Company’s fixed cash obligations as of June 30,2005 over various future years (in thousands):

 
| ** **                       | ** ** | ** ** | ** ** | **Payments Due  by Period** | ** ** |
|----------------------------------|------------|------------|------------|-----------------------------|------------|
| **Contractual cash obligations** | ** ** | **Total**  | ** ** | **Less than  1 Year**       | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **After  5 Years** | ** ** |
| Notes Payable and Long-Term Debt |       | $          | 5,451      |                        | $          | 1,946 |   | $ | 969 |   | $ | 544 |   | $ | 1,992 |   |
| Operating Leases                 |       | 18,350     |       | 706                         |       | 1,213 |   | 1,047 |   | 15,384 |   |
| Employment Contracts             |       | 1,313      |       | 1,166                       |       | 147 |   | — |   | — |   |
|                             |       | $          | 25,114     |                        | $          | 3,818 |   | $ | 2,329 |   | $ | 1,591 |   | $ | 17,376 |   |

 

**IMPACT OFRECENTLY ISSUED ACCOUNTING STANDARDS**

 

In December 2004, the FinancialAccounting Standards Board (FASB) issued Statement of Financial AccountingStandards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS123R), which replaces SFAS No. 123, “Accounting for Stock-BasedCompensation,” (SFAS 123) and supercedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.” SFAS 123R requires all share-based payments toemployees, including grants of employee stock options, to be recognized in thefinancial statements based on their fair values beginning with fiscal yearsafter June 15, 2005, with early adoption encouraged. The pro formadisclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. The Company is required toadopt SFAS 123R beginning January 1, 2006. Under SFAS 123R, the Companymust determine the appropriate fair value model to be used for valuingshare-based payments, the amortization method for compensation cost and thetransition method to be used at date of adoption. The transition methods includeprospective and retroactive adoption options. The Company has begun, but hasnot completed, evaluating the impact of the adoption of SFAS 123R on itsresults of operations. In connection with evaluating the impact ofSFAS 123R, the Company is considering the potential implementation ofdifferent valuation methods to determine the fair value of share-basedcompensation.  The Company believes theadoption of SFAS 123R will have a material impact on our results ofoperations, regardless of the valuation method used.

 

In November 2004, the FASB issued SFAS No. 151,“Inventory Costs, an amendment of ARB No. 43, Chapter 4.” SFAS No. 151amends Accounting Research Bulletin (“ARB”) No. 43, Chapter 4, to clarifythat abnormal amounts of idle facility expense, freight, handling costs andwasted materials (spoilage) should be recognized as current-period charges. Inaddition, SFAS No. 151 requires that allocation of fixed productionoverhead to inventory be based on the normal capacity of the productionfacilities. The Company is required to adopt SFAS 151 beginning January 1,2006. The Company believes the adoption of SFAS 151 will not have a materialimpact on the results of its operations, financial position or cash flows.

 

**Forward - Looking Statements and Associated Risk**

 

This Form 10-Qcontains forward-looking statements within the “safe harbor” provisions of thePrivate Securities Litigation Reform Act of 1995 with respect to our financialcondition, results of operations and business, and it includes statementsrelating to:

 

•                  ourgrowth strategies including, without limitation, our ability to deploy**new products and services;

•                  anticipatedtrends in our business and demographics;

•                  ourability to successfully integrate the business operations of recently acquiredcompanies;

•                  ourfuture profitability and liquidity; and

•                  regulatory,competitive or other economic influences.

 

Wordssuch as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates”and similar expressions also identify forward-looking statements.  These forward-looking statements are notguarantees of future performance and are subject to risks and uncertaintiesthat could cause actual results to differ materially from estimates or forecastscontained in the forward-looking statements. Some of these risks and uncertainties are beyond our control.

 

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**Risk Factors**

 

Youshould carefully consider the risk factors listed below.  These risk factors may cause our futureearnings to be less or our financial condition to be less favorable than weexpect.  These factors may also affectthe trading price of our common stock. You should read this section together with the other informationcontained herein.

 

**As of June 30,2005, our majority stockholder, Applied Digital Solutions, owns 55.4% of ourcommon stock, is able to completely control the board of directors and maysupport actions that conflict with the interests of the other stockholders.**

 

As of June 30,2005, Applied Digital Solutions is the beneficial owner of 55.4% of our commonstock, and it controls us with respect to all matters upon which ourstockholders may vote, including the selection of the Board of Directors,mergers, acquisitions, sale of additional equity securities and othersignificant corporate transactions. There can be no assurance as to how Applied Digital Solutions maysupport actions that are contrary to or conflict with the interests of theother stockholders.

 

**New accounting pronouncements may impact ourfuture results of operations.**

** **

In December 2004, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 123R “Share-Based Payment.” This statement, whichwill be effective in our first quarter of 2006, will change how we account forshare-based compensation, and may have a significant impact on our futureresults of operations.

 

We currently account for share-based paymentsto employees and directors using the intrinsic value method. Under this method,we generally do not recognize any compensation related to stock option grantswe issue under our stock option plans.

 

SFAS 123R will require us to recognizeshare-based compensation as compensation expense in the statement of operationsbased on the fair values of such equity on the date of the grant, with thecompensation expense recognized over the period in which the recipient isrequired to provide service in exchange for the equity award. This statementwill also require us to adopt a fair value-based method for measuring thecompensation expense related to share-based compensation. We have begun, buthave not completed, evaluating the impact of the adoption of SFAS 123R onour results of operations. In connection with evaluating the impact of SFAS 123R,we are considering the potential implementation of different valuation methodsto determine the fair value of share-based compensation. We believe theadoption of SFAS 123R will have a material impact on our results ofoperations, regardless of the valuation method used.

 

**We maycontinue to incur losses.**

 

Weincurred a net loss of $1.4 million for the six months ended June 30,2005. We also recorded a net loss of $5.0 million, $9.5 million and $92.4million for the years ended December 31, 2004, 2003 and 2002,respectively. Included in the $92.4 million loss for the year ended December 31,2002 is a goodwill impairment charge of $57.4 million, an asset impairmentcharge of $6.4 million, and a $18.7 million charge arising from theremeasurement of options in connection with the 2002 merger between DigitalAngel Acquisition Company, which was then a wholly-owned subsidiary of MedicalAdvisory Systems, and Digital Angel Corporation, which was then a 93% ownedsubsidiary of Applied Digital Solutions. No assurance can be given as to whether we will achieve profitability,if at all. Profitability depends on many factors, including the success ofmarketing programs, the maintenance and reduction of expenses, and the abilityto coordinate successfully the operations of our business units. If we fail toachieve and maintain sufficient profitability within the time frame expected byinvestors, the market price of our common stock may be adversely affected.

 

**Infringementby third parties on our intellectual property or development of substantiallyequivalent proprietary technology by our competitors could negatively affectour business.**

 

Oursuccess depends significantly on our ability to maintain patent and tradesecret protection, to obtain future patents and licenses, and to operatewithout infringing on the proprietary rights of third parties. There can be noassurance that the measures we have taken to protect our intellectual propertywill prevent its misappropriation or circumvention.  In addition, there can be no assurance thatany patent application, when filed, will result in an issued patent, or thatour existing patents, or any patents that may be issued in the future, willprovide us with significant protection against competitors. Moreover, there canbe no assurance that any patents issued to or licensed by us will not beinfringed upon or circumvented by others. Litigation to establish the validity of patents, to assert infringementclaims against others, and to defend against patent infringement claims can beexpensive and time-consuming, even if the outcome is in our favor.  We also rely to a lesser extent on unpatentedproprietary technology, and no assurance can be given that others will notindependently develop substantially equivalent proprietary information,techniques or processes or that we can meaningfully protect our rights to suchunpatented proprietary technology. Infringement on our intellectual property or the development ofsubstantially equivalent technology by our competitors could have a materialadverse effect on our business.

 

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**Domesticand foreign government regulation and other factors could impair our ability todevelop and sell our products in certain markets.**

 

Theelectronic animal identification market can be negatively affected by suchfactors as food safety concerns, consumer perceptions regarding cost andefficacy, international technology standards, national infrastructures, andslaughterhouse removal of microchips.

 

We arealso subject to federal, state and local regulation in the United States,including regulation by the FDA, FCC and the USDA, and in other countries.  We cannot predict the extent to which we maybe affected by further legislative and regulatory developments concerning ourproducts and markets.  We are required toobtain regulatory approval before marketing most of our products.  The regulatory process can be verytime-consuming and costly, and there is no assurance that we will receive theregulatory approvals necessary to sell our products under development.  Regulatory authorities also have theauthority to revoke approval of previously approved products for cause, torequest recalls of products and to close manufacturing plants in response toviolations.  Any such regulatory action,including the failure to obtain such approval, could prevent us from selling,or materially impair our ability to sell, our products in certain markets andcould negatively affect our business.

 

**We relyheavily on sales to government contractors of our animal identificationproducts, and any decline in the demand by these customers for our productscould negatively affect our business.**

 

Certaincustomers for electronic identification devices for fish are governmentcontractors that rely on funding from the United States government.  Since these contractors rely heavily ongovernment funds, any decline in the availability of such funds could result ina decreased demand by these contractors for our products.  Any decrease in demand by such customerscould have a material adverse effect on our financial condition and results ofoperations and result in a decline in the market value of our common stock.

 

**We dependon a single production arrangement with Raytheon Microelectronics Espana, SAfor our patented syringe-injectable microchips, and the loss of or anysignificant reduction in the production could have an adverse effect on ourbusiness.**

 

We relysolely on a production arrangement with Raytheon Microelectronics Espana, SAfor the manufacture of our patented syringe-injectable microchips that are usedin all of our implantable electronic identification products. In addition, wehave no formal written agreement with Raytheon for the production of ourmicrochips. Raytheon utilizes our proprietary technology and our equipment inthe production of our syringe-injectable microchips. The termination, or anysignificant reduction, by Raytheon of the assembly of our microchips or amaterial increase in the price charged by Raytheon for the assembly of ourmicrochips could have an adverse effect on our financial condition and resultsof operations.  In addition, Raytheon maynot be able to produce sufficient quantities of the microchips to meet anysignificant increased demand for our products or to meet any such demand on atimely basis.  Any inability orunwillingness of Raytheon to meet our demand for microchips would require us toutilize an alternative production arrangement and remove our automated assemblyproduction machinery from the Raytheon facility, which would be costly andcould delay production.  Moreover, ifRaytheon terminates our production arrangement, we cannot ensure that theassembly of our microchips from another source would be on comparable oracceptable terms.  The failure to makesuch an alternative production arrangement could have an adverse effect on ourbusiness.

 

**We dependon principal customers.**

 

Our fivelargest customers, in aggregate, accounted for 28.9% of our consolidatedrevenue in the six months ended June 30, 2005. Our subsidiary, SignatureIndustries, Ltd. is heavily dependent on contracts with domestic governmentagencies and foreign governments, including India and the United Kingdom,primarily relating to military applications. The loss of, or a significantreduction in, orders from these or our other major customers could have amaterial adverse effect on our financial condition and results of operations.

 

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**We competewith other companies in the visual and electronic identification and pilotlocator beacon markets, and the products sold by our competitors could becomemore popular than our products or render our products obsolete.**

 

Themarket for visual and electronic identification and pilot locator beaconproducts is highly competitive. We believe that our principal competitors inthe visual identification market for livestock are AllFlex USA and Y-TexCorporation and that our principal competitors in the electronic identificationmarket are AllFlex USA, Datamars SA and Avid Identification Systems, Inc.and that our principal competitors in the pilot locator beacon market areBoeing North American Inc., General Dynamics Decision Systems and TadiranSpectralink Ltd.

 

Inaddition, other companies could enter this line of business in the future.  Certain of our competitors have substantiallygreater financial and other resources than us. We may not be able to competesuccessfully with these competitors, and those competitors may develop ormarket technologies and products that are more widely accepted than ours orthat would render our products obsolete or noncompetitive.

 

**Ourearnings will decline if we write off goodwill and other intangible assets.**

 

As of June 30,2005, we had recorded goodwill of $53.6 million. On January 1, 2002, weadopted SFAS No. 142, “Goodwill and Other Intangible Assets.”  SFAS No. 142 requires that goodwill andcertain intangibles no longer be amortized but instead be tested for impairmentat least annually by applying a fair value based test. During the fourthquarter of 2003, the Company performed the annual impairment test for goodwillusing a fair value based approach, primarily discounted cash flows. Anevaluation of the Medical Systems reporting unit indicated that $2.4 million ofgoodwill was impaired. Additionally, management estimated that certainintangible assets at our Medical Systems reporting unit were impaired by $0.6million.  Accordingly, the Companyrecorded an impairment charge of $3.0 million in the fourth quarter of2003.  During the fourth quarter of 2002,we recorded an impairment charge of $57.4 million for goodwill at our GPS andRadio Communications and Medical Systems reporting units.

 

We willassess the fair value of our goodwill annually or earlier if events occur orcircumstances change that would more likely than not reduce the fair value ofour goodwill below its carrying value. These events or circumstances wouldinclude a significant change in business climate, including a significant,sustained decline in an entity’s market value, legal factors, operatingperformance indicators, competition, sale or disposition of a significantportion of the business, or other factors. If we determine that significantimpairment has occurred, we would be required to write off the impaired portionof goodwill. Impairment charges could have a material adverse effect on ourfinancial condition and results of operations.

 

**Theexercise of options and warrants outstanding and available for issuance mayadversely affect the market price of our common stock*.***

 

As of June 30,2005, we had 10,024,000 options and 605,000 warrants outstanding to purchasefrom us a total of 10,629,000 shares of common stock at exercise prices rangingfrom $0.05 to $10.50 per share. The exercise of outstanding options andwarrants and the sale in the public market of the shares purchased upon suchexercise may adversely affect the market price of our common stock.

 

**Currencyexchange rate fluctuations could have an adverse effect on our sales andfinancial results.**

 

Wegenerate a portion of our sales and incur a portion of our expenses incurrencies other than U.S. dollars.  Tothe extent that we are unable to match revenues received in foreign currencieswith costs paid in the same currency, exchange rate fluctuations in any suchcurrency could have an adverse effect on our financial results.

 

**We dependon a small team of senior management, and we may have difficulty attracting andretaining additional personnel.**

 

Ourfuture success will depend in large part upon the continued services andperformance of senior management and other key personnel.  If we lose the services of any member of oursenior management team, our overall operations could be materially and adverselyaffected.  In addition, our future successwill depend on our ability to identify, attract, hire, train, retain andmotivate other highly skilled technical, managerial, marketing, purchasing andcustomer service personnel when they are needed.  Competition for these individuals isintense.  We cannot ensure that we willbe able to successfully attract, integrate or retain sufficiently qualifiedpersonnel when the need arises.  Anyfailure to attract and retain the necessary technical, managerial, marketing,purchasing and customer service personnel could have a material adverse effecton our financial condition and results of operations.

 

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**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

We haveoperations and sales in various regions of the world. Additionally, we mayexport and import to and from other countries. Our operations may therefore be subject to volatility because ofcurrency fluctuations, inflation, and changes in political and economicconditions in these countries. Sales and expenses may be denominated in localcurrencies and may be affected as currency fluctuations affect our productprices and operating costs or those of our competitors.

 

Wepresently do not use any derivative financial instruments to hedge our exposureto adverse fluctuations in interest rates, foreign exchange rates, fluctuationsin commodity prices or other market risks, nor do we invest in speculativefinancial instruments.

 

As of June 30,2005, we had short term investments of $11.2 million.  The short-term investments consist of highlyliquid securities between three and twelve months.  Due to the nature of our borrowings and ourshort-term investments, we have concluded that there is no material market riskexposure and, therefore, no quantitative tabular disclosures are required.

 

**Item 4.  Controls and Procedures**

 

As of theend of the period covered by this Form 10-Q, we carried out an evaluation,under the supervision and with the participation of our management, includingthe Chief Executive Officer and the Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures.  Based upon that evaluation,our Chief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures are effective. 

 

During the period covered by the Form 10-Q,there were no changes in our internal control over financial reporting thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**PART II    OTHER INFORMATION**

 

**Item 1.  Legal Proceedings.**

** **

***DigitalAngel Corporation vs. Allflex USA, Inc and Pet Health Services (USA), Inc.***

** **

On October 20, 2004, the Company commencedan action in the United Stated District Court for the District of Minnesotaagainst AllFlex USA, Inc. and Pet Health Services (USA), Inc.  This suit claims that Allflex is marketingand selling a syringe implantable identification transponder that infringes a1993 patent granted to the Company for syringe implantable identificationtransponders previously found by the United States District Court for theDistrict of Colorado to be enforceable. The suit also claims that PetHealth is using, selling and/ordistributing the same transponder in violation of the Company’s patent.  The suit seeks, among other things, anadjudication of infringement and that the infringing parties be enjoined fromfurther improper action.  The suit seeksactual damages, punitive damages and interest, costs and attorneys’ fees.  Allflex has asserted a counterclaim forbreach of contract of an existing license agreement between the Company andAllflex and asserted a counterclaim seeking a declaration of the parties’rights and obligations under the license agreement.  Allflex also moved for a judgment on thepleadings, asserting that the license agreement should act as a bar to a casefor infringement.  The Company contestedthe motion on the ground that Allflex’s actions exceed the scope of the licenseand constitute an impermissible infringement of the patent and asked the Courtfor leave to amend the complaint to assert a claim against a separate patentlicensed exclusively to the Company by Bio Medic Data Systems.  On June 23, 2005, the Court issued aruling granting the Defendant’s motion for judgment on the pleadings anddenying the Company’s motion for leave to amend.  The Company continues to believe that thesuit is well-founded, and is considering whether to appeal the Court’s ruling.

 

On July 21, 2005, Allflex filed anaction in the United Stated District Court for the Northern District of Texasseeking a declaratory judgment that it did not infringe the Bio Medicpatent.  The Company intends to contest thisaction and to assert its claims under the patent.

 

***Digital Angel Corporation vs.Datamars, Inc., Datamars, S.A., The Crystal Import Corporation and MedicalManagement International, Inc.***

 

On October 20, 2004, the Companycommenced an action in the United States District Court for the District ofMinnesota against Datamars, Inc., Datamars, S.A., The Crystal ImportCorporation, and Medical Management International, Inc. (“Banfield”).  This suit claims that the defendants aremarketing and selling syringe implantable identification transpondersmanufactured by Datamars that infringe the Company’s 1993 patent for syringeimplantable identification transponders previously found by the United StatesDistrict Court for the District of Colorado to be enforceable.  Certain of the locations in which theinfringing transponders are sold, include, but are not limited to, “Banfield,The Pet Hospital” of which certain locations are associated with PetSmartstores.  The suit seeks, among otherthings, an adjudication of infringement and that the infringing parties beenjoined from further improper action. The suit also seeks actual damages, punitive damages and interest, costsand attorneys’ fees.  The Companybelieves that the suit is well-grounded in law and fact.  Discovery in the action has been commencedand is continuing.

 

***Crystal v. Digital Angel, etal.***

 

On or about December 29, 2004 TheCrystal Import Corporation filed an action against AVID Identification Systems, Inc.and Digital Angel in the United States District Court for the Northern Districtof Alabama.  Crystal’s complaintprimarily asserts federal and state antitrust and related claims against AVID,though it also asserts similar claims against Digital Angel.  Given the uncertainties associated with alllitigation and given that this case was not commenced against Digital Angeluntil February 2, 2005, the Company is unable to offer any assessment onthe potential liability exposure, if any, to Digital Angel from thislawsuit.  The Company has filed a motionto dismiss the action for failure to state a claim on which relief could begranted, or in the alternative, to have the action transferred to the UnitedStates District Court for the District of Minnesota for consolidation with theDatamars patent infringement action referred to above or to have the actionstayed until the completion of the Datamars action.  The parties have filed briefs on the motion,but an oral argument has not been held, and no ruling on the motion has been made.  Discovery in the action has been commencedand is continuing. 

 

**Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds**

 

On June 8,2005, the Company issued 7,500 unregistered shares of its common stock, $0.005par value, to Dale Hutchins pursuant to an agreement to an agreement with theCompany’s Board of Directors.

 

On March 29,2005, the Company’s Board of Directors approved the repurchase of up to 1.5million shares of its common stock commencing on March 30, 2005terminating June 30, 2005.  As of June 30,2005, the Company purchased 328,100 shares for a total of $1.5 million.

 

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Thefollowing table illustrates issuer purchases of equity securities during thesix months ended June 30, 2005:

 
| **Period**                                 | ** ** | **Total Number  of  Shares  Purchased** | ** ** | **Average  Price  Paid Per Share** | ** ** | **Total Number  of Shares  Purchased as  Part of Publicly  Announced  Plan** | ** ** | **Maximum  Number of  Shares that  May Yet Be  Purchased  Under the Plans** | ** ** |
|--------------------------------------------|------------|-----------------------------------------|------------|------------------------------------|------------|-----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
|                                       |       |                                    |       |                               |       |                                                                              |       |                                                                             |       |
| Month 1 (January 1 - 31, 2005)        |       | —                                  |       | $                                  | —     |                                                                              | —     |                                                                             | —     |   |
| Month 2 (February 1 - 28, 2005)       |       | —                                  |       | —                             |       | —                                                                            |       | —                                                                           |       |
| Month 3 (March 1 - 31, 2005)          |       | 50,000                                  |       | 4.62                               |       | 50,000                                                                            |       | 1,450,000                                                                        |       |
| Month 4 (April 1-April 30, 2005) |       | 264,100                                 |       | 4.71                               |       | 264,100                                                                           |       | 1,185,900                                                                        |       |
| Month 5 (May 1-May 31, 2005)     |       | 14,000                                  |       | 3.86                               |       | 14,000                                                                            |       | 1,171,900                                                                        |       |
| Month 6 (June 1-June 30, 2005)   |       | —                                  |       | —                             |       | —                                                                            |       | —                                                                           |       |
| Total                                      |       | 328,100                                 |       | $                                  | 4.62       |                                                                              | 328,100    |                                                                             | —     |   |

 

**Item 4.  Submission of Matters to a Vote ofSecurityholders**

** **

At the Annual Meeting of Stockholders held on May 3,2005, the following proposals were adopted by the margins indicated:

 

**PROPOSAL 1-ELECTION OF DIRECTORS**

 

Thefollowing persons were elected as directors of the Company:

 

Kevin N.McGrath

Scott R.Silverman

John R.Block

Kevin H.McLaughlin

Howard S.Weintraub, Ph.D.

MichaelS. Zarriello

 

No fewerthan 39,019,131 were voted in favor of, no more than 2,053,149 shares werewithheld.

 

**PROPOSAL 2-APPROVALOF AMENDMENT TO 2002 STOCK PLAN INCREASING NUMBER OF SHARES**

 

Thefollowing is the result of the stockholders’ vote on the amendment to the 2002Transition Stock Option Plan.

 
| For              |   | 26,316,626 |   |
|------------------|--------|------------|--------|
| Against          |   | 2,747,311  |   |
| Abstain          |   | 98,007     |   |
| Broker  Non-Vote |   | 11,853,440 |   |

 

**PROPOSAL 3-RATIFICATIONOF THE APPOINTMENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Thefollowing is the result of the stockholders’ vote on the ratification of the appointmentof Eisner, LLP as independent registered public accounting firm:

 
| For     |   | 40,746,637 |   |
|---------|--------|------------|--------|
| Against |   | 172,047    |   |
| Abstain |   | 96,700     |   |

 

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**Item 6.  Exhibits**

 
| ** ** | ** ** | **(a)    Exhibits**                                                                                                                                                                                          |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                             |
| 3.1        |       | Amended and Restated Certificate  of Incorporation (incorporated by reference to Exhibit 3.1 to Amendment  No. 1 to our Registration Statement on Form S-3  (No. 333-110817) filed on January 23, 2004) |
|       |       |                                                                                                                                                                                                                             |
| 3.2        |       | Bylaws (incorporated by  reference to Exhibit 3.2 to Amendment No. 1 to our Registration  Statement on Form S-3 (No. 333-110817) filed on January 23,  2004)                                            |
|       |       |                                                                                                                                                                                                                             |
| 31.1       |       | Certification of Chief  Executive Officer under Rules 13a-14(a)/15d-14(a) under the  Securities and Exchange Act and Section 302 of the Sarbanes-Oxley Act of  2002.                                              |
|       |       |                                                                                                                                                                                                                             |
| 31.2       |       | Certification of Chief  Financial Officer under Rules 13a-14(a)/15d-14(a) under the  Securities and Exchange Act and Section 302 of the Sarbanes-Oxley Act of  2002.                                              |
|       |       |                                                                                                                                                                                                                             |
| 32.1       |       | Certification of Chief  Executive Officer Pursuant to 18 U.S.C Section 1350, as Adopted Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                    |
|       |       |                                                                                                                                                                                                                             |
| 32.2       |       | Certification of Chief  Financial Officer Pursuant to 18 U.S.C Section 1350, as Adopted Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                    |

 

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**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|                       |   | DIGITAL ANGEL CORPORATION |
|----------------------------|--------|---------------------------|
|                       |   | (Registrant)              |
|                       |   |                      |   |
| Dated: August 4, 2005 |   | By:                       | /S/ JAMES P. SANTELLI |   |
|                       |   |                      | James P. Santelli |   |
|                       |   |                      | Vice President - Finance and Chief  Financial Officer |   |

 

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