**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C. 20549**

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# **FORM 10-Q**

| **x**                                             | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF**  |
|---------------------------------------------------|------------|---------------------------------------------------------------------|
| ** **                                        | ** ** | **THE SECURITIES EXCHANGE ACT OF  1934.**                           |
| ** **                                        | ** ** | ** **                                                          |
| **For the quarterly period ended June  30, 2006** |
| ** **                                        |
| **Or**                                            |
| ** **                                        |
| **o**                                             | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF** |
| ** **                                        | ** ** | **THE SECURITIES EXCHANGE ACT OF  1934.**                           |
|                                                   |            |                                                                     |  |

 

**Forthe transition period from              to              **

**CommissionFile Number: 1-15177**

**DIGITALANGEL CORPORATION**

(Exact name of registrant as specified in its charter)
| **DELAWARE**                                                    | ** ** | **52-1233960**                     |
|-----------------------------------------------------------------|------------|------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (IRS Employer  Identification No.) |

 

**490 Villaume Avenue, South SaintPaul, Minnesota, 55075**

(Address of registrant’s principal executive offices)

**(651) 455-1621**

(Registrant’s telephone number, including area code)

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

Yes  x  No  o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule12b-2 of the Exchange Act.

Large accelerated filer  o  Acceleratedfiler  o  Non-acceleratedfiler  x

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  o  No  x

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 
| **Class**                               | ** ** | **Outstanding at July  31, 2006** |
|-----------------------------------------|------------|--------------------------------------------------|
| Common Stock, $.005 par value per share |       | 44,893,923 shares                                |

 

 

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**DIGITAL ANGEL 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                                                                           |
| 1A.                                  |       | Risk Factors                                                                                |
| 4.                                   |       | Submission  of Matters to A Vote of Securityholders                                         |
| 6.                                   |       | Exhibits                                                                                    |
|                                 |       |                                                                                        |
| SIGNATURE                            |
| CERTIFICATIONS                       |
| EXHIBITS                             |

 

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**PART I FINANCIAL INFORMATION**

Item1.    Financial Statements.

**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**(In thousands, except par value)
| ** **                                                                                                                                                                             | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                             | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                                             | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **Current Assets**                                                                                                                                                                     | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Cash                                                                                                                                                                                   | ** ** | **$**                   | **7,091**  |                        | $          | 10,049 |   |
| Restricted  cash                                                                                                                                                                       | ** ** | **128**                 |       | 310                         |       |
| Accounts  receivable (net of allowance for doubtful accounts of $210 in 2006 and $212  in 2005)                                                                                   | ** ** | **6,900**               |       | 10,152                      |       |
| Accounts  receivable from VeriChip Corporation                                                                                                                                         | ** ** | **277**                 |       | 232                         |       |
| Inventories                                                                                                                                                                            | ** ** | **10,602**              |       | 8,657                       |       |
| Other  current assets                                                                                                                                                                  | ** ** | **1,967**               |       | 1,418                       |       |
| **Total Current Assets**                                                                                                                                                               | ** ** | **26,965**              |       | 30,818                      |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Property and Equipment, net**                                                                                                                                                        | ** ** | **8,341**               |       | 8,602                       |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Goodwill**                                                                                                                                                                           | ** ** | **51,197**              |       | 48,491                      |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Other Intangible Assets, net**                                                                                                                                                       | ** ** | **1,723**               |       | 1,813                       |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Other Assets, net**                                                                                                                                                                  | ** ** | **389**                 |       | 483                         |       |
| ** **                                                                                                                                                                             | ** ** | **$**                   | **88,615** |                        | $          | 90,207 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                         | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **Current Liabilities**                                                                                                                                                                | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Line of  credit and current maturities of long-term debt and notes payable                                                                                                             | ** ** | **$**                   | **3,125**  |                        | $          | 2,380 |   |
| Accounts  payable                                                                                                                                                                      | ** ** | **4,633**               |       | 5,381                       |       |
| Accrued  expenses and other current liabilities                                                                                                                                        | ** ** | **2,329**               |       | 3,232                       |       |
| Deferred  revenue                                                                                                                                                                      | ** ** | **988**                 |       | 1,324                       |       |
| Net  liabilities from discontinued operations                                                                                                                                          | ** ** | **68**                  |       | 84                          |       |
| **Total Current Liabilities**                                                                                                                                                          | ** ** | **11,143**              |       | 12,401                      |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Long-Term Debt And Notes  Payable**                                                                                                                                                  | ** ** | **3,577**               |       | 3,656                       |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Other Long Term Liabilities**                                                                                                                                                        | ** ** | **1,553**               |       | 1,086                       |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Total Liabilities**                                                                                                                                                                  | ** ** | **16,273**              |       | 17,143                      |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Commitments And Contingencies  (See Note 11)**                                                                                                                                       | ** ** | ** **              | ** ** | ** **                  | ** ** |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Minority Interest**                                                                                                                                                                  | ** ** | **550**                 |       | 618                         |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **Stockholders’ Equity**                                                                                                                                                          | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Preferred  stock: Authorized 1,000 shares, of $1.75 par value, none outstanding                                                                                                        | ** ** | **—**              | ** ** | **—**                  | ** ** |
| Common  stock: Authorized 95,000 shares, of $.005 par value; 44,894 shares issued and  44,516 shares outstanding in 2006 and 44,225 shares issued and 43,847  outstanding in 2005 | ** ** | **225**                 |       | 223                         |       |
| Additional  paid-in capital                                                                                                                                                            | ** ** | **213,932**             |       | 212,083                     |       |
| Accumulated  deficit                                                                                                                                                                   | ** ** | **(140,660**            | **)**      | (137,950                    | )          |
| Treasury  stock (carried at cost, 378 shares)                                                                                                                                          | ** ** | **(1,580**              | **)**      | (1,580                      | )          |
| Accumulated  other comprehensive loss                                                                                                                                                  | ** ** | **(125**                | **)**      | (330                        | )          |
| **Total Stockholders’ Equity**                                                                                                                                                    | ** ** | **71,792**              |       | 72,446                      |       |
| ** **                                                                                                                                                                             | ** ** | **$**                   | **88,615** |                        | $          | 90,207 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

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** **

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**(Inthousands, except per share data)

(Unaudited)
| ** **                                                                | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                                          | ** ** | **2005**                                                        | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                      |       |                                                              |       |                                                            |       |   |   |   |   |
| Product revenue                                                           | ** ** | **$**                                                             | **12,503** |                                                            | $          | 14,247 | ** ** | **$** | **27,645** |   | $ | 26,944 |   |
| Service revenue                                                           | ** ** | **453**                                                           |       | 613                                                             | ** ** | **1,133** |   | 1,319 |   |
| Total net  revenue                                                        | ** ** | **12,956**                                                        |       | 14,860                                                          | ** ** | **28,778** |   | 28,263 |   |
|                                                                      |       |                                                              |       |                                                            |       |   |   |   |   |
| Cost of products  sold                                                    | ** ** | **7,618**                                                         |       | 7,918                                                           | ** ** | **16,385** |   | 15,021 |   |
| Cost of services  sold                                                    | ** ** | **276**                                                           |       | 302                                                             | ** ** | **555** |   | 607 |   |
|                                                                      |       |                                                              |       |                                                            |       |   |   |   |   |
| Gross profit                                                              | ** ** | **5,062**                                                         |       | 6,640                                                           | ** ** | **11,838** |   | 12,635 |   |
|                                                                      |       |                                                              |       |                                                            |       |   |   |   |   |
| Selling, general  and administrative expenses                             | ** ** | **6,003**                                                         |       | 6,118                                                           | ** ** | **12,235** |   | 11,446 |   |
| Research and  development expenses                                        | ** ** | **1,151**                                                         |       | 1,119                                                           | ** ** | **2,341** |   | 2,205 |   |
|                                                                      | ** ** | ** **                                                        |       |                                                            | ** ** | ** ** |   |   |   |
| Operating loss                                                            | ** ** | **(2,092**                                                        | **)**      | (597                                                            | )          | **(2,738** | **)** | (1,016 | ) |
|                                                                      | ** ** | ** **                                                        |       |                                                            | ** ** | ** ** |   |   |   |
| Interest income                                                           | ** ** | **82**                                                            |       | 83                                                              | ** ** | **175** |   | 159 |   |
| Interest expense                                                          | ** ** | **(111**                                                          | **)**      | (79                                                             | )          | **(206** | **)** | (180 | ) |
| Other income                                                              | ** ** | **28**                                                            |       | 7                                                               | ** ** | **45** |   | 33 |   |
|                                                                      | ** ** | ** **                                                        |       |                                                            |       |   |   |   |   |
| Loss before  taxes and minority interest                                  | ** ** | **(2,093**                                                        | **)**      | (586                                                            | )          | **(2,724** | **)** | (1,004 | ) |
|                                                                      | ** ** | ** **                                                        |       |                                                            |       |   |   |   |   |
| Income tax (provision) benefit                                            | ** ** | **(12**                                                           | **)**      | (86                                                             | )          | **72** |   | (86 | ) |
| Minority  interest share of income                                        | ** ** | **(19**                                                           | **)**      | (219                                                            | )          | **(58** | **)** | (294 | ) |
|                                                                      | ** ** | ** **                                                        |       |                                                            |       |   |   |   |   |
| Net loss                                                                  | ** ** | **$**                                                             | **(2,124** | **)**                                                           | $          | (891 | ) | **(2,710** | **)** | $ | (1,384 | ) |
|                                                                      | ** ** | ** **                                                        |       |                                                            | ** ** | ** ** |   |   |   |
| Net loss per common share-basic and diluted                               | ** ** | **$**                                                             | **(0.05**  | **)**                                                           | $          | (0.02 | ) | $ | (0.06 | ) | $ | (0.03 | ) |
|                                                                      |       |                                                              |       |                                                            |       |   |   |   |   |
| Weighted average number  of common shares outstanding - basic and diluted | ** ** | **44,286**                                                        |       | 43,917                                                          | ** ** | **44,097** |   | 43,792 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITYFor The Six Months Ended June 30, 2006**(InThousands)(Unaudited)
| ** **                                                     | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated** | ** ** | **Treasury** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** |
|----------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|-------------------------|------------|-----------------|------------|--------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                     | ** ** | **Number**               | ** ** | **Amount**            | ** ** | **Number**              | ** ** | **Amount**      | ** ** | **Capital**  | ** ** | **Deficit**                           | ** ** | **Stock**                     | ** ** | **(Loss) Income** | ** ** | **Equity** | ** ** |
| ** **                                                     | ** ** | ** **               | ** ** | ** **            | ** ** | ** **              | ** ** | ** **      | ** ** | ** **   | ** ** | ** **                            | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance-December 31, 2005**                             |       | —                   |       | $                     | —     |                    | 44,225     |            | $          | 223          |       | $                                     | 212,083    |                          | $          | (137,950 | ) | $ | (1,580 | ) | $ | (330 | ) | $ | 72,446 |   |
| Net  loss                                                      |       | —                   |       | —                |       | —                  |       | —          |       | —       |       | (2,710                                | )          | —                        |       | — |   | (2,710 | ) |
| Comprehensive  (loss) income-foreign currency translation      |       | —                   |       | —                |       | —                  |       | —          |       | —       |       | —                                |       | —                        |       | 205 |   | 205 |   |
| Total  comprehensive loss                                      |       | —                   |       | —                |       | —                  |       | —          |       | —       |       | (2,710                                | )          | —                        |       | 205 |   | (2,505 | ) |
| Issuance  of common stock as consideration for DSD acquisition |       | —                   |       | —                |       | 282                     |       | 1               |       | 999          |       | —                                |       | —                        |       | — |   | 1,000 |   |
| Exercise  of stock options                                     |       | —                   |       | —                |       | 320                     |       | 1               |       | 562          |       | —                                |       | —                        |       | — |   | 563 |   |
| Restricted  stock issued                                       |       | —                   |       | —                |       | 67                      |       | —          |       | —       |       | —                                |       | —                        |       | — |   | — |   |
|                                                           |       |                     |       |                  |       |                    |       |            |       |         |       |                                  |       |                          |       |   |   |   |   |
| Amortization  of deferred compensation                         |       | —                   |       | —                |       | —                  |       | —          |       | $            | 162        |                                  | —     |                          | —     |   | — |   | 162 |   |
| Stock  compensation expense                                    |       | —                   |       | —                |       | —                  |       | —          |       | 126          |       | —                                |       | —                        |       | — |   | 126 |   |
|                                                           |       |                     |       |                  |       |                    |       |            |       |         |       |                                  |       |                          |       |   |   |   |   |
| **Balance-June 30, 2006**                                      |       | —                   |       | $                     | —     |                    | 44,894     |            | $          | 225          |       | $                                     | 213,932    |                          | $          | (140,660 | ) | $ | (1,580 | ) | $ | (125 | ) | $ | 71,792 |   |

 

See the accompanying notes to condensed consolidatedfinancial 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,**      | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** |
| **Cash  Flows From Operating Activities**                                    | ** ** | ** **                                                           | ** ** | ** ** | ** ** |
| Net loss                                                                     | ** ** | **$**                                                                | **(2,710** | **)** | $ | (1,384 | ) |
|                                                                         |       |                                                                 |       |   |   |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                                                                 |       |   |   |
| Equity-based compensation                                                    | ** ** | **288**                                                              |       | 145 |   |
| Depreciation and amortization                                                | ** ** | **956**                                                              |       | 1,179 |   |
| Minority interest                                                            | ** ** | **58**                                                               |       | 294 |   |
| Loss on disposal of equipment                                                | ** ** | **4**                                                                |       | 5 |   |
| Change in assets and liabilities:                                            |       |                                                                 |       |   |   |
| Decrease in restricted cash                                                  | ** ** | **195**                                                              |       | 327 |   |
| Decrease in accounts receivable                                              | ** ** | **3,399**                                                            |       | 1,035 |   |
| Increase in due from VeriChip Corporation                                    | ** ** | **(45**                                                              | **)**      | (63 | ) |
| Increase in inventories                                                      | ** ** | **(1,731**                                                           | **)**      | (1,035 | ) |
| Increase in other current assets                                             | ** ** | **(578**                                                             | **)**      | (167 | ) |
| Increase in due to ADS                                                       | ** ** | **—**                                                           |       | 46 |   |
| Decrease in accounts payable, accrued expenses and  deferred revenue         | ** ** | **(1,663**                                                           | **)**      | (1,837 | ) |
| Net cash (used in) provided by discontinued  operations                      | ** ** | **(16**                                                              | **)**      | 77 |   |
| **Net  Cash Used In Operating Activities**                                   | ** ** | **(1,843**                                                           | **)**      | (1,378 | ) |
|                                                                         |       |                                                                 |       |   |   |
| **Cash  Flows From Investing Activities**                                    | ** ** | ** **                                                           | ** ** | ** ** | ** ** |
| Increase (decrease) in other assets                                          | ** ** | **87**                                                               |       | (204 | ) |
| Payments for property and equipment                                          | ** ** | **(720**                                                             | **)**      | (675 | ) |
| Payments for acquisition costs                                               | ** ** | **(1,000**                                                           | **)**      | (893 | ) |
| **Net  Cash Used in Investing Activities**                                   | ** ** | **(1,633**                                                           | **)**      | (1,772 | ) |
|                                                                         |       |                                                                 |       |   |   |
| **Cash  Flows From Financing Activities**                                    | ** ** | ** **                                                           | ** ** | ** ** | ** ** |
| Amounts borrowed on line of credit                                           | ** ** | **2,427**                                                            |       | 1,969 |   |
| Amounts paid on line of credit                                               | ** ** | **(2,004**                                                           | **)**      | (2,157 | ) |
| Payments on notes payable and long-term debt                                 | ** ** | **(355**                                                             | **)**      | (367 | ) |
| Exercise of stock options and warrants                                       | ** ** | **563**                                                              |       | 358 |   |
| Payment of dividend to minority shareholder                                  | ** ** | **(140**                                                             | **)**      | **—** | ** ** |
| Purchase of treasury stock                                                   | ** ** | **—**                                                           |       | (1,537 | ) |
| **Net  Cash Provided by (Used in) Financing Activities**                     | ** ** | **491**                                                              |       | (1,734 | ) |
|                                                                         |       |                                                                 |       |   |   |
| **Effect of Exchange Rate Changes  on Cash**                                 | ** ** | **27**                                                               |       | 54 |   |
|                                                                         |       |                                                                 |       |   |   |
| **Net  Decrease In Cash**                                                    | ** ** | **(2,958**                                                           | **)**      | (4,830 | ) |
|                                                                         |       |                                                                 |       |   |   |
| **Cash -  Beginning Of Period**                                              | ** ** | **10,049**                                                           |       | 17,492 |   |
|                                                                         |       |                                                                 |       |   |   |
| **Cash - End Of Period**                                                     | ** ** | **$**                                                                | **7,091**  |   | $ | 12,662 |   |

 

Seethe accompanying notes to condensed consolidated financial statements.

6

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**DIGITAL ANGEL CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Dollars in thousands)(Unaudited)**

**1.****            ****The Companyand Basis of Presentation**

DigitalAngel Corporation and its subsidiaries (“the Company”) develop and deploysensor and communications technologies that enable rapid and accurateidentification, location tracking, and condition monitoring of high-valueassets. The Company operates in two segments: (1) Animal Applications and (2)GPS and Radio Communications.

*Animal Applications—* develops, manufactures, and markets a broad line ofelectronic and visual identification devices for the companion animal,livestock, fish and wildlife markets worldwide. The Animal Applications segmentconsists of our operations located in Minnesota, DSD Holdings A/S and itswholly-owned subsidiaries, located in Denmark and Poland, and Digital AngelInternational, Inc. and its subsidiaries located in Argentina and Brazil. 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—*consists of the design, manufacture and support of globalpositioning system (“GPS”) enabled equipment. The GPS and Radio Communicationssegment consists of the Company’s subsidiaries Signature Industries Limited(90.9% owned), located in the United Kingdom and OuterLink Corporation, locatedin Massachusetts. Applications for the segment’s products include locationtracking and message monitoring of vehicles, aircraft and people in remotelocations through systems that integrate geosynchronous satellitecommunications and GPS enabled equipment and intelligent communicationsproducts and services for telemetry, mobile data and radio communicationsapplications serving commercial and military markets. Technology development inthis segment includes the integration and miniaturization into marketableproducts of two technologies: wireless communications and position locationtechnology (including GPS and other systems).

OnFebruary 28, 2005, the Company acquired Denmark-based DSD Holdings A/S and itswholly-owned subsidiaries Daploma International A/S and Digitag A/S, includingDaploma International A/S’s 70%-owned subsidiary, Daploma Polska. DSD HoldingsA/S became a wholly-owned subsidiary of Digital Angel Corporation. DSD HoldingsA/S produces visual and RFID tags. DSD Holdings A/S’s operations are includedfrom the date of acquisition.

As of June30, 2006, Applied Digital Solutions, Inc. (“Applied Digital” or “ADS”)owned 24,573,788 shares or approximately 55.2% of the Company’s common stock.

Theaccompanying unaudited condensed consolidated financial statements of theCompany as of June 30, 2006 and for the three and six month periods ended June30, 2006 and 2005 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 donot include all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements. In the opinion of the Company’s management, alladjustments (including normal recurring adjustments) considered necessary topresent fairly the financial statements have been made.

Theconsolidated statements of operations for the three and six months ended June30, 2006 and 2005 are not necessarily indicative of the results that may beexpected for the entire year. These statements should be read in conjunctionwith the Digital Angel Corporation’s audited consolidated financial statementsand related notes thereto for the year ended December 31, 2005 which areincluded in the Company’s Annual Report on Form 10-K.

Certainitems in the condensed consolidated financial statements for the 2005 periodshave been reclassified for comparative purposes.

7

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**2.****            ****Principlesof Consolidation**

The June30, 2006 and 2005 condensed consolidated financial statements include the accountsof the Company and its wholly-owned and majority-owned subsidiaries (DSDHoldings A/S operations are included from the date of acquisition, February 28,2005). All significant intercompany accounts and transactions have beeneliminated in consolidation.

**3.****            ****RevenueRecognition**

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 fee jobs, service revenue is recognized basedon the actual direct labor hours in the job multiplied by the standard billingrate and adjusted to net realizable value, if necessary. Other revenue isrecognized at the time services or goods are provided. It is the Company’spolicy to record contract losses in their entirety in the period in which suchlosses are foreseeable.

The Company’ssubsidiary, OuterLink Corporation, earns revenue from messaging services andfrom the sale of related products to customers (communication terminals andsoftware). OuterLink Corporation’s messaging service is only available throughuse of its products and such products have no alternative use. Accordingly,service revenue is recognized as the services are performed. OuterLinkCorporation’s product revenue, for which title and risk of loss transfers tothe customer on shipment, is deferred upon shipment and is recognized ratablyover the estimated customer service period of 42 months in the six month periodended June 30, 2006 and 30 months in the six month period ended June 30, 2005.

The Companyrecords a liability for product warranties at the time it is probable that awarranty liability has been incurred and the amount of loss can be reasonablyestimated. The Company’s warranty liability was $34,000 as of June 30, 2006.Following is a reconciliation of the Company’s product warranties (inthousands):

|                                                                               | ** ** | **Amount of  Liability** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------------|------------|
|                                                                          |       |                          |       |
| Balance as of  December 31, 2005                                         |       | $                             | 34         |   |
| Accruals for  warranties issued during the period                             |       | —                        |       |
| Accruals related  to pre-existing warranties (including changes in estimates) |       | —                        |       |
| Settlements made  (in cash or in kind) during the period                      |       | —                        |       |
| Balance as of June 30,  2006                                                  |       | $                             | 34         |   |

 

**4.****            ****Stock-BasedCompensation**

On January 1, 2006 we adopted SFAS No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R). SFAS 123R replaced SFAS No. 123 and supercedes APBOpinion No. 25. SFAS 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values. The pro forma disclosures previouslypermitted under SFAS 123 are no longer an alternative to financial statementrecognition. We adopted SFAS 123R using the modified prospective method whichrequires the application of the accounting standard as of January 1, 2006. Ourconsolidated financial statements as of and for the three and six month periodsended June 30, 2006 reflect the impact of adopting SFAS 123R. In accordancewith the modified prospective method, the consolidated financial statements forprior periods have not been restated to reflect, and do not include, the impactof SFAS 123R. See Note 8, Stock Options and Restricted Stock for furtherdetails.

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

|                                       | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Raw materials                         | ** ** | **$**                   | **3,463**  |                        | $          | 3,198 |   |
| Work in process                       | ** ** | **262**                 |       | 122                         |       |
| Finished goods                        | ** ** | **7,755**               |       | 7,006                       |       |
|                                  | ** ** | **11,480**              |       | 10,326                      |       |
| Allowance for excess and obsolescence | ** ** | **(878**                | **)**      | (1,669                      | )          |
| Net inventory                         | ** ** | **$**                   | **10,602** |                        | $          | 8,657 |   |

 

8

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**6.****            ****StockExchange with Applied Digital Solutions, Inc.**

OnFebruary 25, 2005, the Company entered into a Stock PurchaseAgreement with Applied Digital. The purpose of the stock exchange was to usethe shares as partial consideration for the acquisition of DSD Holdings A/S andits wholly-owned subsidiaries, Daploma International A/S and Digitag A/S,including Daploma International A/S’s 70%-owned subsidiary, Daploma Polska, asdescribed more fully in Note 10. The Company and Applied Digital entered intothe share exchange because of the selling shareholders’ desire, at the time thetransaction was negotiated, to receive their consideration in Applied Digitalcommon stock as opposed to the Company’s common stock. In addition, the stockpurchase represented a strategic investment by Applied Digital whereby AppliedDigital could increase its ownership interest in the Company. Pursuant to theagreement, the Company issued 644,140 shares of its common stock to AppliedDigital. The Company received 684,543 shares of Applied Digital common stock asconsideration. The exchange ratio of shares was based upon the average of thevolume-weighted-average price of the Company’s common stock and Applied Digital’scommon stock for the ten trading days immediately preceding, and not including,the transaction closing date which was $5.434 for the Company’s common stockand $5.113 for Applied Digital’s common stock. The value of the stock exchangedwas $3.5 million.

**7.**             **DiscontinuedOperations**

In April 2004, our Board of Directors approved a plan to sell ourMedical Systems segment. The Medical Systems segment represented the businessoperations of Medical Advisory Systems, Inc, which we acquired onMarch 27, 2002. The Medical Systems segment was one of our reporting unitsin accordance with SFAS 131, “Disclosures about Segments of an Enterprise andRelated Information”. Accordingly, the financial condition, results ofoperations and cash flows of our Medical Systems segment have been reported asdiscontinued operations for all periods presented. For the six months ended June30, 2006 and 2005, there were no losses attributable to the Medical Systemssegment. The Company does not anticipate the Medical Systems division incurringadditional 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.

Thenet liabilities of discontinued operations as of June 30, 2006 andDecember 31, 2005, were comprised of accrued expenses aggregating $68,000and $84,000, respectively.

**8.****            ****StockOptions and Restricted Stock**

*StockOption Plans*

As of June 30, 2006 the Company maintains the Amendedand Restated Digital Angel Corporation Transition Stock Option Plan (“DAC StockOption Plan”), which is described below, and has outstanding stock optionswhich were issued pursuant to another plan which was terminated on February 23,2006. On January 1, 2006 we adopted SFAS 123R, using the modified prospectivetransition method. Accordingly, during the six month period ended June 30, 2006we recorded stock-based compensation expense for awards granted in 2006 andawards granted prior to, but not yet vested as of January 1, 2006, as if thefair value method required for pro forma disclosure under SFAS 123 were ineffect for expense recognition purposes. Upon adoption of SFAS 123R we electedto continue using the Black-Scholes option pricing and we have recognizedcompensation expense using a straight-line amortization method. During thethree and six months ended June 30, 2006 we recorded $0.1 million and $0.3million, respectively, (this amount includes compensation for options grantedto non-employees and for restricted stock grants) in stock-based employeecompensation expense.

As of June 30, 2006, the DAC Stock Option Plan, whichis stockholder-approved, has 18,195,312 shares of common stock reserved forissuance, of which 17,701,516 shares have been issued and 493,796 remain availablefor issuance.  As of June 30, 2006 awards consisting of options topurchase 9,703,196 shares were outstanding under the DAC Stock Option Plan andawards consisting of options to purchase 476,820 shares were outstanding underthe Company’s terminated stock option plan. Additionally, restricted stockawards for 154,230 shares of common stock have been granted under the DAC StockOption Plan. Option awards are generally granted with exercise prices betweenmarket price and 110% of the market price of the Company’s stock at the date ofgrant; option awards generally vest over 3 to 9 years and have 10-yearcontractual terms. Certain option and share awards provide for acceleratedvesting if there is a change in control (as defined in the DAC Stock Option Plan).

*StockOption Activity*

The fair value of each option award is estimated onthe date of grant using a Black-Scholes valuation model. The followingassumptions were used for options granted in the six month periods ended June30, 2006 and 2005.

|                             | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                                        | ** ** | **2005** | ** ** |
| Risk-free interest rate     |       | 4.89                                                            | %          | 3.81 | % |
| Expected life (in years)    |       | 4-10                                                            |       | 5 |   |
| Dividend yield              |       | 0.0                                                             | %          | 0.0 | % |
| Expected volatility         |       | 87.19                                                           | %          | 106.09-111.95 | % |
| Weighted-average volatility |       | 87.19                                                           | %          | 108.71 | % |

 

9

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Ourcomputation of expected volatility is determined based on historicalvolatility. Our computation of expected life is determined based on historicalexperience of similar awards, giving consideration to the contractual terms ofthe stock-based awards, vesting schedules and expectations of future employeebehavior. The interest rate is based on the U.S. Treasury yield curve in effectat the time of grant.

Asummary of the Company’s stock option activity as of June 30, 2006, and changesduring the six months then ended is presented below (in thousands, except pershare amounts):
| ** **                     | ** ** | **Stock  Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------|------------|--------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|-------------------------------------|------------|
|                           |       |               |       |                                       |       |                                     |       |                                |       |
| Outstanding at January 1, 2006 |       | 9,955              |       | $                                          | 3.94       |                                     |       |                                |       |   |
| Granted                        |       | 2,100              |       | 3.26                                       |       |                                     |       |                                |       |
| Exercised                      |       | 320                |       | 1.75                                       |       |                                     |       |                                |       |
| Forfeited or Expired           |       | 55                 |       | 4.49                                       |       |                                     |       |                                |       |
| Outstanding at June 30, 2006   |       | 11,680             |       | $                                          | 3.87       |                                     | 8.07       |                                | $          | 2,069 | * |
| Exercisable at June 30, 2006   |       | 9,413              |       | $                                          | 4.02       |                                     | 7.62       |                                | $          | 2,049 | * |

----

* The intrinsicvalue of a stock option is the amount by which the market value of theunderlying stock exceeds the exercise price of the option. The market value ofour stock was $3.11 at June 30, 2006.

Theweighted-average grant-date fair value of options granted during the six-monthperiods ended June 30, 2006 and 2005 were $2.73 and $5.02 respectively. Thetotal intrinsic value of options exercised during the six-month periods endedJune 30, 2006 and 2005 was $644,000 and $72,000, respectively.

Asummary of the status of the Company’s nonvested stock options as of June 30,2006, and changes during the six month period ended June 30, 2006, is presentedbelow (in thousands, except per share amounts):

|                               | ** ** | **Stock Options** | ** ** | **Weighted Average  Grant-Date  Fair Value** | ** ** |
|-------------------------------|------------|------------------------|------------|--------------------------------------------------------|------------|
| ** **                    | ** ** | ** **             | ** ** | ** **                                             | ** ** |
| Nonvested at  January 1, 2006 |       | 217                    |       | $                                                      | 2.42       |   |
| Granted                       |       | 2,100                  |       | 2.73                                                   |       |
| Vested                        |       | (50                    | )          | 2.36                                                   |       |
| Nonvested at June 30,  2006   |       | 2,267                  |       | $                                                      | 2.70       |   |

 

As ofJune 30, 2006, there was $4.9 million of total unrecognized compensation costrelated to nonvested share-based compensation arrangements granted under theDAC Stock Option Plan.  That cost is expected to be recognized over aweighted-average period of 6.6 years.  The total fair value of sharesvested during the six months ended June 30, 2006, was $118,000.

Cash receivedfrom option exercise under all share-based payment arrangements for thesix-month periods ended June 30, 2006 and 2005, was $0.6 million and $55,000,respectively.

On January 13, 2004, the Company granted itsChief Executive Officer (CEO) aten-year option to purchase 1,000,000 shares of the Company’s common stock at$3.92 per share. This option was granted outside the Company’s stock plans andapproved by the Company’s shareholders on May 6, 2004. The option becameexercisable on December 30, 2005. As of June 30, 2006 the option remainsoutstanding.

On February 18, 2004, the Company granted itsChairman of the Board of Directors aten-year option to purchase 500,000 shares of the Company’s common stock at$3.43 per share. This option was granted outside the Company’s stock plans andapproved by the Company’s shareholders on May 6, 2004. The option becameexercisable on February 18, 2005. As of June 30, 2006 the option remainsoutstanding.

*Restricted Stock*

In March 2005, theCompany granted its Chairman of the Board 100,000 shares of the Company’srestricted stock. The restricted stock vested 50% on March 7, 2006 andwill vest 50% on March 7, 2007. The Company determined the value of thestock to be $506,000 based on the closing price of the Company’s stock on thedate of grant. The value of the restricted stock has been recorded as deferredcompensation and is being amortized to compensation expense over the two yearvesting period. In the six month period June 30, 2006, $125,000 was recognizedas compensation expense in the Company’s results of operations.

10

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In February 2005, theCompany granted an employee 54,230 shares of the Company’s restricted stock.The restricted stock vested 30% on February 25, 2006, will vest 30% onFebruary 25, 2007 and 40% on February 25, 2008. The Companydetermined the value of the stock to be $250,000 based on the closing price ofthe Company’s stock on the date of grant. The value of the restricted stock hasbeen recorded as deferred compensation and is being amortized to compensationexpense over the vesting period. In the six month period June 30, 2006 $37,000was recognized as compensation expense in the Company’s results of operations.

*Pro FormaInformation for Periods Prior to the Adoption of SFAS 123R*

Priorto the adoption of SFAS 123R, we provided the disclosures required under SFAS123 as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosures.” Employee stock-based compensation expenses recognized under SFAS 123 wasnot reflected in our results of operations for the three and six month periodsended June 30, 2005 for employee stock option awards as all stock options weregranted with an exercise price greater than or equal to the market value of theunderlying common stock on the date of grant. Previously reported results havenot been restated.

Thepro forma information for the three and six months ended June 30, 2005 was asfollows (in thousands, except per share amounts):

|                                                                                | ** ** | **For the Three  Months Ended  June 30, 2005** | ** ** | **For the Six  Months Ended  June 30, 2005** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| Reported net loss                                                              |       | $                                                                       | (891       | )                                                                     | $          | (1,384 | ) |
| Stock-based  compensation expense in reported net loss                         |       | 145                                                                     |       | 145                                                                   |       |
| Stock-based  compensation expense determined under the fair value based method |       | (1,526                                                                  | )          | (2,760                                                                | )          |
| Pro forma net loss                                                             |       | $                                                                       | (2,272     | )                                                                     | $          | (3,999 | ) |
|                                                                           |       |                                                                    |       |                                                                  |       |
| Loss per share (basic and diluted)                                             |       |                                                                    |       |                                                                  |       |
| As  reported                                                                   |       | $                                                                       | (0.02      | )                                                                     | $          | (0.03 | ) |
| Pro forma                                                                      |       | $                                                                       | (0.05      | )                                                                     | $          | (0.09 | ) |

 

**9.****            ****SegmentInformation**

The Company is an advanced technology company in thefield of rapid and accurate identification, location tracking, and conditionmonitoring of high-value assets. The Company’s operating segments are: (1)Animal Applications and (2) GPS and Radio Communications.

It is onthe basis of segment reporting that management utilizes the financialinformation to assist in making internal operating decisions. The Companyevaluates performance based on stand-alone segment operating income.

Followingis the selected segment data as of and for the three months ended June 30, 2006(in thousands):
| ** **                                                      | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|-----------------------------------|------------|------------------|------------|
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Net revenue from external customers:                            |       |                     |       |                                        |       |                              |       |             |       |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Product                                                         |       | $                        | 8,203      |                                        | $          | 4,300                             |       | $                | —     |   | $ | 12,503 |   |
| Service                                                         |       | 172                      |       | 281                                         |       | —                            |       | 453              |       |
| Total revenue                                                   |       | $                        | 8,375      |                                        | $          | 4,581                             |       | $                | —     |   | $ | 12,956 |   |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Operating loss                                                  |       | $                        | (1,413     | )                                           | $          | (679                              | )          | $                | —     |   | $ | (2,092 | ) |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Loss before income taxes and minority interest share of  income |       | $                        | (1,404     | )                                           | $          | (689                              | )          | $                | —     |   | $ | (2,093 | ) |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Total assets                                                    |       | $                        | 79,190     |                                        | $          | 9,425                             |       | $                | —     |   | $ | 88,615 |   |

 

11

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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 income (loss)                                           |       | $                        | (1,078     | )                                           | $          | 481                               |       | $                | —     |   | $ | (597 | ) |
|                                                              |       |                     |       |                                        |       |                              |       |             |       |
| Income (loss) before taxes and minority interest share of  income |       | $                        | (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, 2006(in thousands):
| ** **                                                      | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|-----------------------------------|------------|------------------|------------|
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Net revenue from external customers:                            |       |                     |       |                                        |       |                              |       |             |       |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Product                                                         |       | $                        | 19,288     |                                        | $          | 8,357                             |       | $                | —     |   | $ | 27,645 |   |
| Service                                                         |       | 589                      |       | 544                                         |       | —                            |       | 1,133            |       |
| Total revenue                                                   |       | $                        | 19,877     |                                        | $          | 8,901                             |       | $                | —     |   | $ | 28,778 |   |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Operating loss                                                  |       | $                        | (1,509     | )                                           | $          | (1,229                            | )          | $                | —     |   | $ | (2,738 | ) |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Loss before income taxes and minority interest share of  income |       | $                        | (1,475     | )                                           | $          | (1,249                            | )          | $                | —     |   | $ | (2,724 | ) |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Total assets                                                    |       | $                        | 79,190     |                                        | $          | 9,425                             |       | $                | —     |   | $ | 88,615 |   |

 

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 income (loss)                                           |       | $                        | (1,122     | )                                           | $          | 106                               |       | $                | —     |   | $ | (1,016 | ) |
|                                                              |       |                     |       |                                        |       |                              |       |             |       |
| Income (loss) before taxes and minority interest share of  income |       | $                        | (1,102     | )                                           | $          | 98                                |       | $                | —     |   | $ | (1,004 | ) |
|                                                              |       |                     |       |                                        |       |                              |       |             |       |
| Total assets                                                      |       | $                        | 81,024     |                                        | $          | 15,628                            |       | $                | —     |   | $ | 96,652 |   |

 

**10.****         ****Acquisitions**

Thefollowing describes the acquisitions by the Company (in thousands) in the sixmonths ended June 30, 2006 and the year ended December 31, 2005:
| **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            |       | $                      | 5,902      |                                            | $          | 8,008                                            |       | $                             | (2,106     | ) | Manufactures and  markets visual and  electronic RFID tags  for livestock. |   |
|                           |            |                    |            |                        |            |                                                 |            |                                                  |            |                               |            |  |  |  |

 

12

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OnFebruary 28, 2005, the Company acquired DSD Holdings A/S and itswholly-owned subsidiaries Daploma International A/S and Digitag A/S, includingDaploma International A/S’s 70%-owned subsidiary. DSD Holdings A/S became awholly-owned subsidiary of Digital Angel Corporation. Denmark-based DSDHoldings A/S through its subsidiaries manufactures and markets visual andelectronic RFID tags for livestock. The acquisition was accounted for under thepurchase 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 goodwillof $4.0 million and intangible assets of $2.0 million. The intangible assetsare customer relationships, tradename, patents and a non-compete agreement. Thecustomer relationships, patents and a non-compete agreement are being amortizedover periods ranging from 3 to 15 years. Amortization recorded in the sixmonths ended June 30, 2006 and 2005 was $90,000 and $100,000, respectively.

Under the terms of theDSD Holdings A/S acquisition, the Company purchased all of the outstandingcapital stock of DSD Holdings A/S in consideration for a purchase price ofseven times DSD Holdings A/S’s average annual EBITDA over the next three yearsless outstanding indebtedness at the end of the time period. An initial paymentof $3.5 million was made at closing through the delivery of Applied Digitalcommon stock valued at $3.5 million which the Company acquired from AppliedDigital in exchange for $3.5 million of Digital Angel Corporation common stock.To account for pre-closing pricing fluctuations the Company paid additionalconsideration of $195,000 to the shareholders of DSD Holdings A/S onJune 7, 2005.

Pursuant to the terms ofthe stock purchase agreement, at any time between the closing date of theacquisition and December 31, 2006 the Company had the right to buyout theremaining purchase price.  On April 13,2006, Digital Angel exercised its right to buyout the remaining purchase priceby electing to pay the set amount of $2.0 million. The $2.0 million buyoutprice was satisfied by a cash payment of $1.0 million made on April 13, 2006and the issuance on June 8, 2006 of $1.0 million worth of Digital Angel’sunregistered common stock, or 282,115 shares. The number of shares of DigitalAngel’s common stock that were exchanged was determined based upon the averageof the volume-weighted-average price of Digital Angel’s common stock for the 10trading days prior to the closing date of the share exchange agreement, or$3.545 per share.  LANO Holdings Aps,wholly owned by Lasse Nordfjeld, and Torsten Nordfjeld received 174,403 sharesand 28,268 shares, respectively, of the 282,115 shares issued to the formershareholders of DSD.  The $2.0 millionbuyout price was recorded as additional goodwill.

Applied Digital and theformer shareholders of DSD agreed to exchange, per the terms of a shareexchange agreement dated April 12, 2006, registered shares of Applied Digital’scommon stock for the unregistered shares of the Company’s common stock paid bythe Company to the former shareholders of DSD pursuant to the buyout agreement.Pursuant to the share exchange agreement, Applied Digital issued to the formershareholders of DSD 454,545 shares of Applied Digital’s common stock, valued at$972,249 and $27,751 in cash in exchange for the 282,115 shares of DigitalAngel common stock that the former shareholders of DSD received from theCompany in partial payment of the buyout, as more fully discussed above. Thenumber of shares of Applied Digital common stock that were exchanged wasdetermined based upon the average of the volume-weighted-average price of ourcommon stock for the two trading days immediately preceding, and not including,the transaction closing date of June 8, 2006, which was $2.14 per share.

In addition, on February 28, 2005 Digital Angelentered into employment agreements with the Chief Executive Officer of DSDHoldings A/S and its subsidiaries, Lasse Nordfjeld and his son, the Presidentof Daploma, Torsten Nordfjeld.

Digital Angel Corporation operates DSD Holdings A/Sand its operating subsidiaries from their current headquarters near Copenhagen,Denmark.

The resultsof DSD Holdings A/S have been included in the consolidated financial statementssince its date of acquisition. Unaudited pro forma results of operations forthe six months ended June 30, 2005 are included below. Such pro formainformation assumes that the above acquisition had occurred as ofJanuary 1, 2005, and revenue is presented in accordance with the Company’saccounting policies. This summary is not necessarily indicative of what theresults of operations of the Company would have been had it been a combinedentity during such periods, nor does it purport to represent results ofoperations for any future periods.
|                                               | ** ** | **For the Six  Months  Ended June 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------------------|------------|
| **(In thousands)**                       | ** ** | **2005**                                                    | ** ** |
| Net revenue                                   |       | $                                                           | 29,146     |   |
| Net loss                                      |       | $                                                           | (1,415     | ) |
| Net loss per common share - basic and diluted |       | $                                                           | (0.03      | ) |

 

**11.****         ****Litigation**

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

On October 20, 2004, the Company commenced anaction in the United Stated District Court for the District of Minnesotaagainst AllFlex USA, Inc. and Pet Health Services (USA), Inc. Thissuit claimed that Allflex was marketing and selling a syringe implantableidentification transponder that infringed a 1993 patent granted to the Companyfor syringe implantable identification 

13

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transponderspreviously found by the United States District Court for the District ofColorado to be enforceable. The suit also claimed that PetHealth was using,selling and/or distributing the same transponder in violation of the Company’spatent. The suit sought, among other things, an adjudication of infringementand that the infringing parties be enjoined from further improper action. Thesuit sought actual damages, punitive damages and interest, costs and attorneys’fees. Allflex asserted a counterclaim for breach of contract of an existinglicense agreement between the Company and Allflex and asserted a counterclaimseeking a declaration of the parties’ rights and obligations under the licenseagreement. Allflex also moved for a judgment on the pleadings, asserting thatthe license agreement should act as a bar to a case for infringement. The Companycontested the motion on the ground that Allflex’s actions exceed the scope ofthe license and constituted an impermissible infringement of the patent andasked the Court for leave to amend the complaint to assert a claim forinfringement of a separate patent licensed exclusively to the Company by BioMedic Data Systems. On June 23, 2005, the Court issued a ruling grantingthe Defendant’s motion for judgment on the pleadings and denying the Company’smotion for leave to amend.

On July 21, 2005, Allflex filed an action in theUnited Stated District Court for the Northern District of Texas seeking adeclaratory judgment that it did not infringe the Bio Medic patent. The Companyhas not been served with this complaint and Allflex agreed to withdraw the complaintwithout prejudice.

On September 28, 2005, Allflex sought an award ofattorneys fees and costs based on a fee-shifting clause in the licenseagreement and under 35 U.S.C. §285, which provides for an award of attorneysfees and costs in exceptional cases. The Company contested this motion, and onOctober 6, 2005, the Court denied the motion in its entirety. 

Final judgment in the action was entered onFebruary 21, 2006. On March 20, 2006, the Company filed a notice of appealof the final judgment with the Federal Circuit Court of Appeals in Washington,D.C. The appeal is presently pending.

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

On October 20, 2004, the Company commenced anaction in the United States District Court for the District of Minnesotaagainst Datamars, Inc., Datamars, S.A., The Crystal Import Corporation,and Medical Management International, Inc. (“Banfield”). This suit claimsthat the defendants are marketing and selling syringe implantableidentification transponders manufactured by Datamars that infringe the Company’s1993 patent for syringe implantable identification transponders previouslyfound by the United States District Court for the District of Colorado to beenforceable. Certain of the locations in which the infringing transponders areor have been sold, include, but are not limited to, “Banfield, The Pet Hospital”of which certain locations are associated with PetSmart stores. The suit seeks,among other things, an adjudication of infringement and that the infringingparties be enjoined from further improper action. The suit also seeks actualdamages, punitive damages and interest, costs and attorneys’ fees. The Companybelieves that the suit is well-grounded in law and fact. Discovery in theaction has been commenced and is continuing. On February 28, 2006, theCourt conducted a hearing (the “Markman Hearing”) in which each of the partiespresented the Court with their views regarding the scope of the claims setforth in the subject patent. On May 22, 2006, the Court issued its order on theMarkman Hearing, largely adopting Digital Angel’s views on the scope of theclaims in the subject patent.  Theparties are continuing discovery in light of that order.

*CrystalImport Corporation v. Digital Angel, et al.*

On or about December 29, 2004, The Crystal ImportCorporation filed an action against AVID Identification Systems, Inc. andthe Company in the United States District Court for the Northern District ofAlabama. Crystal’s complaint primarily asserted federal and state antitrust andrelated claims against AVID, though it also asserted similar claims against theCompany. The Company filed a motion to dismiss the action for failure to statea claim on which relief could be granted, or in the alternative, to have theaction transferred to the United States District Court for the District ofMinnesota. On October 12, 2005, the Alabama Court denied the Company’smotion to dismiss the complaint, but granted the Company’s motion to transferthe action to Minnesota. Following the docketing of the action in Minnesota,the Company and AVID filed a motion seeking to stay the case until thecorresponding patent infringement actions have been resolved. Prior to thehearing on the motion, an agreement was reached pursuant to which the Courtentered an order on July 12, 2006 staying the action for 90 days withpermission to seek an additional stay thereafter. Given the uncertaintiesassociated with all litigation and given the early stage of this proceeding,the Company is unable to offer any assessment on the potential liabilityexposure, if any, to the Company from this lawsuit.

*DigitalAngel Corporation v. Corporativo SCM, S.A. de C.V.*

On or about June2, 2005, the Company filed a declaratory judgment action in the U.S. DistrictCourt for the District of Minnesota seeking to have the Court determine therights and liabilities of the Company under a 2002 distribution agreement withCorporativo SCM, S.A. de C.V., a Mexican company which entered into adistribution agreement for a product that was then under development by theCompany but the development of which was subsequently abandoned. Although thedistribution agreement required that any actions arising out of or related tothe agreement be filed within two years of the occurrence of the events givingrise to the claim, the Company received a letter in 2005 from the defendantthreatening to assert a claim notwithstanding the two year limit set forth inthe agreement. The defendant accordingly filed a motion to dismiss thedeclaratory judgment action, which the Court

14

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denied. On or aboutJanuary 10, 2006, the defendant filed an answer and asserted a counterclaimagainst the Company for fraud seeking damages in an amount in excess of$75,000. The Company filed a response denying the allegations of thecounterclaim, and moved to dismiss the counterclaim because it wasnot timely and failed to plead fraud with particularlity. The Court deniedthe Company’s motion to dismiss on May 8, 2006 and the Company filedan Answer to the Amended Counterclaim that, among other things,denies the allegations of the Amended Counterclaim and assertsaffirmative defenses.  The case is in the initial discovery stages. Given the uncertainties associated with all litigation and given the earlystage of this proceeding, the Company is unable to offer any assessment on thepotential liability exposure, if any, to the Company from this lawsuit.

**12.****         ****SupplementalCash Flow Information (in thousands)**
|                                                                      | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                           | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Interest paid                                                        | ** ** | **$**                                             | **199**    |   | $ | 201 |   |
| Taxes paid                                                           | ** ** | **59**                                            |       | 85 |   |
| Non-cash activity:                                                   |       |                                              |       |   |   |
| Issuance  of common stock for ADS common stock                       |       | —                                            |       | 3,500 |   |
| Issuance  of common stock to former shareholders of DSD Holdings A/S | ** ** | **1,000**                                         |       | — |   |
| Financing of equipment through capital lease                         | ** ** | **352**                                           |       | — |   |
|                                                                      |            |                                                   |            |  |  |  |  |

 

**13.****         ****RelatedParty Activity**

The Company has an exclusive eleven-year Distributionand Licensing Agreement dated March 4, 2002, amended December 28,2005, with VeriChip Corporation (VeriChip), a wholly-owned subsidiary ofApplied Digital, covering the manufacturing, purchasing and distribution of theCompany’s implantable microchip and the maintenance of the VeriChip Registry bythe Company. The amended agreement contains, among other things, minimumpurchase requirements in order to maintain exclusivity, whereby VeriChip isrequired to purchase $875,000, $1,750,000 and $2,500,000 for each of 2007, 2008and 2009, respectively, and $3,750,000 for 2010 and each year thereafter. Theagreement continues until March 2013, and, as long as VeriChip continuesto meet the minimum purchase requirements, will automatically renew annuallyunder its terms. The Distribution and Licensing agreement includes a licensefor the use of the Company’s technology in VeriChip’s identified markets. Underthe Distribution and Licensing Agreement the Company is the sole manufacturerand supplier to VeriChip. The existing terms with the Company’s sole supplierof implantable microchips, Raytheon Microelectronics Espana, SA, expire on June30, 2010.

Revenuerecognized under the Distribution and Licensing Agreement was $0.2 million and$0.5 million for the six months ended June 30, 2006 and 2005, respectively.

See Note 6for a description of the stock exchange transactions with Applied Digital.

Amounts duefrom VeriChip as of June 30, 2006 and December 31, 2005 were $277,000 and$232,000, respectively.

**Item 2. Management’s Discussion and Analysis of Financial Condition andResults of Operations.**

The followingdiscussion and analysis of our financial condition and results of operationsshould be read in conjunction with the accompanying financial statements andrelated notes thereto.

We consistof Digital Angel Corporation and our subsidiaries - Digital Angel TechnologyCorporation (“DATC”), Fearing Manufacturing, Inc., Timely Technology Corp.,Signature Industries Limited (90.9% owned subsidiary), OuterLink Corporation,DSD Holdings A/S and its subsidiaries Daploma International A/S (including its70%-owned subsidiary, Daploma Polska) and Digitag A/S, Digital Angel Holdings,LLC and Digital Angel International, Inc. and its subsidiaries DigitalAngel S.A. and Digital Angel do Brasil Produtos de Informatica LTDA.

15

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**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, 2006 and 2005 andis derived from the accompanying consolidated statements of operations includedin this report.
| ** **                                                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                      | ** ** | **%**                                           | ** ** | **%**                                         | ** ** | **%** | ** ** | **%** | ** ** |
| Product revenue                                                 |       | 96.5                                            |       | 95.9                                          |       | 96.1 |   | 95.3 |   |
| Service revenue                                                 |       | 3.5                                             |       | 4.1                                           |       | 3.9 |   | 4.7 |   |
| Total net  revenue                                              |       | 100.0                                           |       | 100.0                                         |       | 100.0 |   | 100.0 |   |
| Cost of products  sold                                          |       | 58.8                                            |       | 53.3                                          |       | 56.9 |   | 53.1 |   |
| Cost of services  sold                                          |       | 2.1                                             |       | 2.0                                           |       | 2.0 |   | 2.2 |   |
| Total cost of  products and services sold                       |       | 60.9                                            |       | 55.3                                          |       | 58.9 |   | 55.3 |   |
| Gross profit                                                    |       | 39.1                                            |       | 44.7                                          |       | 41.1 |   | 44.7 |   |
| Selling, general  and administrative expenses                   |       | 46.3                                            |       | 41.2                                          |       | 42.5 |   | 40.5 |   |
| Research and  development expenses                              |       | 8.9                                             |       | 7.5                                           |       | 8.1 |   | 7.8 |   |
| Operating loss                                                  |       | (16.1                                           | )          | (4.0                                          | )          | (9.5 | ) | (3.6 | ) |
| Interest income                                                 |       | 0.6                                             |       | 0.6                                           |       | 0.6 |   | 0.6 |   |
| Interest expense                                                |       | (0.9                                            | )          | (0.5                                          | )          | (0.7 | ) | (0.6 | ) |
| Other income                                                    |       | 0.2                                             |       | 0.0                                           |       | 0.2 |   | 0.0 |   |
| Loss before tax,  minority interest and discontinued operations |       | (16.2                                           | )          | (3.9                                          | )          | (9.4 | ) | (3.6 | ) |
| Income tax  expense                                             |       | (0.1                                            | )          | (0.6                                          | )          | 0.2 |   | (0.3 | ) |
| Minority  interest share of income                              |       | (0.1                                            | )          | (1.5                                          | )          | (0.2 | ) | (1.0 | ) |
| Net loss                                                        |       | (16.4                                           | )          | (6.0                                          | )          | (9.4 | ) | (4.9 | ) |

 

**Three Months EndedJune 30, 2006 Compared to the Three Months Ended June 30, 2005**

**Revenue**

Totalrevenue for the three months ended June 30, 2006 decreased $1.9 million, or12.8%, to $13.0 million when compared to $14.9 million in revenue for the threemonths ended June 30, 2005.

Revenue foreach of the operating segments was as follows (in thousands):
|                              | ** ** | **Three Months  Ended June 30,  2006** | ** ** | **Three Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Animal Applications          |       | $                                                     | 8,375      |                                                  | $          | 8,336 |   |
| GPS and Radio Communications |       | 4,581                                                 |       | 6,524                                                 |       |
| Total                        |       | $                                                     | 12,956     |                                                  | $          | 14,860 |   |

 

The AnimalApplications segment’s revenue increased**approximately $39,000 in the threemonths ended June 30, 2006 compared to the three month period ended June 30,2005. Revenue for the three month period ended June 30, 2006 consistedprimarily of electronic and visual product sales to livestock customers ofapproximately $4.5 million, sales to companion animal customers ofapproximately $3.0 million and sales to fish and wildlife customers of $0.9million.

The GPS andRadio Communications segment’s revenue decreased approximately $1.9 million, or29.8% to approximately $4.6 million in the three months ended June 30, 2006from approximately $6.5 million in the three months ended June 30, 2005. Thedecrease in revenue was due to an approximately $2.1 million decrease in salesof Signature’s Sarbe products, offset by an increase in sales at Signature’sRadio Hire division of approximately $0.2 million. We attribute $1.2 million ofthe Sarbe product sales decrease to the completion of the Indian governmentcontract in May 2005 and $0.9 million of the Sarbe product sales decrease toother Sarbe product customers, including the UK Ministry of Defence.

**Gross Profit and Gross Profit Margin**

Grossprofit for the three month period ended June 30, 2006 was approximately $5.1million, a decrease**ofapproximately $1.6 million, or 23.8%, compared to approximately $6.6 million inthe three month period ended June 30, 2005. As a percentage of revenue, thegross profit margin decreased to 39.1% for the three months ended June 30, 2006from 44.7% for the three months ended June 30, 2005.

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Grossprofit from operations for each operating segment was as follows (inthousands):
|                              | ** ** | **Three Months  Ended June 30,  2006** | ** ** | **Three Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Animal Applications          |       | $                                                     | 2,806      |                                                  | $          | 3,175 |   |
| GPS and Radio Communications |       | 2,256                                                 |       | 3,465                                                 |       |
| Total                        |       | $                                                     | 5,062      |                                                  | $          | 6,640 |   |

 

Grossprofit margin from operations for each operating segment was:
|                              | ** ** | **Three Months  Ended June 30,  2006** | ** ** | **Three Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                                 | ** ** | **%**                                                 | ** ** |
| Animal Applications          |       | 33.5                                                  |       | 38.1                                                  |       |
| GPS and Radio Communications |       | 49.2                                                  |       | 53.1                                                  |       |

 

The Animal Applications segment’s gross profit decreasedapproximately $0.4 million, or 11.6%, in the three month period ended June 30,2006 compared to the three months ended June 30, 2005. The gross marginpercentage was 33.5% for the three month period ended June 30, 2006 compared to38.1% for the three month period ended June 30, 2005. We attribute the decreasein gross margin and gross margin percentage to additional freight and importationduties associated with providing inventory to South America from Denmark andthe United States.  The Company has initiatedmanufacturing of livestock tags in Argentina and anticipates that gross marginson South American sales will improve in the second half of 2006. Gross profitmargin for the three months ended June 30, 2006 excluding the impact of theSouth American initiative would have been 35.1%.

The GPS andRadio Communications segment’s gross profit decreased approximately $1.2million, or 34.9%, in the three month period ended June 30, 2006 as compared tothe three month period ended June 30, 2005. The decrease in gross profitrelates to the decrease in sales and decreased gross margin percentage. Thegross margin percentage decreased to 49.2% in the three month period ended June30, 2006 as compared to 53.1% in the three month period ended June 30, 2005.The decrease in gross margin percentage relates primarily to higher margins onG2R Sarbe locator beacons shipped under the contract with the government ofIndia in the three months ended June 30, 2005. Signature completed shipmentsunder the contract with the government of India in May 2005.

**Selling, General and Administrative Expenses**

Selling,general and administrative expenses decreased approximately $0.1 million, or1.9%, in the three month period ended June 30, 2006 as compared to the threemonth period ended June 30, 2005. As a percentage of revenue, selling, generaland administrative expenses were 46.3% and 41.2% for the three months endedJune 30, 2006 and 2005, respectively.

Selling, general and administrative expenses for each ofthe operating segments were as follows (dollars in thousands):
|                              | ** ** | **Three Months  Ended June 30,  2006** | ** ** | **Three Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Animal Applications          |       | $                                                     | 3,494      |                                                  | $          | 3,558 |   |
| GPS and Radio Communications |       | 2,509                                                 |       | 2,560                                                 |       |
| Total                        |       | $                                                     | 6,003      |                                                  | $          | 6,118 |   |

 

Selling,general and administrative expenses as a percentage of revenue for each of theoperating segments were:
|                              | ** ** | **Three Months  Ended June 30,  2006** | ** ** | **Three Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                                 | ** ** | **%**                                                 | ** ** |
| Animal Applications          |       | 41.7                                                  |       | 42.7                                                  |       |
| GPS and Radio Communications |       | 54.8                                                  |       | 39.2                                                  |       |

 

The AnimalApplications segment’s selling, general and administrative expenses decreasedapproximately $0.1 million in the three month period ended June 30, 2006 ascompared to the three month period ended June 30, 2005 and selling, general andadministrative expense as a percentage of revenue decreased to 41.7% from 42.7%in the same respective periods.

The GPS andRadio Communications segment’s selling, general and administrative expensesdecreased approximately $51,000 to approximately $2.5 million in the threemonth period ended June 30, 2006 from approximately $2.6 million in the threemonth period ended June 30, 2005. In the three months ended June 30, 2006decreased amortization expense at our subsidiary, OuterLink Corporation, waspartially offset by increased salary expense at our subsidiary, SignatureIndustries Limited.  As a

17

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percentage of revenue, selling,general and administrative expenses increased to 54.8% in the three monthperiod ended June 30, 2006 from 39.2% in the three month period ended June 30,2005. The increase in selling, general and administrative expense as apercentage of sales resulted primarily from the decrease in sales in thecurrent period.

All of theCompany’s out-of-the money, unvested stock options issued to current employees,officers and directors prior to November 15, 2005 were vested on December 30,2005, therefore equity based compensation expense related to stock optionsgranted prior to the adoption of SFAS 123R was immaterial.  On June 14, 2006 the Company granted 2.1million stock options to employees and directors of Digital AngelCorporation.  Compensation expenserelated to the 2.1 million stock options is expected to be approximately $4.5million and will be recognized over the weighted average period of 7.2 years.

**Research and Development Expense**

Researchand development expense was approximately $1.2 million in the three monthperiod ended June 30, 2006 compared to approximately $1.1 million for the threemonth period ended June 30, 2005. As a percentage of revenue, research anddevelopment expense was 8.9% and 7.5% for the three months ended June 30, 2006 and2005, respectively.

Researchand development expense for each of the operating segments was as follows (inthousands):
|                              | ** ** | **Three Months  Ended June 30,  2006** | ** ** | **Three Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Animal Applications          |       | $                                                     | 726        |                                                  | $          | 695 |   |
| GPS and Radio Communications |       | 425                                                   |       | 424                                                   |       |
| Total                        |       | $                                                     | 1,151      |                                                  | $          | 1,119 |   |

 

The AnimalApplications segment’s research and development expense was approximately $0.7million in the three month periods ended June 30, 2006 and 2005.  Research and development in the three monthperiod ended June 30, 2006 relates to continued product development.

The GPS andRadio Communications segment’s research and development expense wasapproximately $0.4 million in the three month periods ended June 30, 2006 and2005. Research and development in the three month period ended June 30, 2006relates to the continued development of OuterLink Corporation’s next generationof communication system hardware.

**Interest Expense**

Interestexpense was approximately $0.1 million for the three month periods ended June30, 2006 and 2005.

**Income Taxes**

The Companyrecorded an income tax provision of $12,000 in the three month period endedJune 30, 2006 compared to a tax provision of $86,000 for the three month periodended June 30, 2005. The income tax provision for the three month period endedJune 30, 2006 relates to a subsidiary of Daploma International A/S. The Companyaccounts for income taxes under the asset and liability approach. Deferred taxassets and liabilities are recognized for the expected future tax consequencesattributed to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax basis. Deferred taxassets and liabilities are measured using the enacted tax rates expected to applyto taxable income in the years in which those temporary differences areexpected to reverse. A valuation allowance is provided against net deferred taxassets when it is more likely than not that a tax benefit will not be realized.

**Six Months EndedJune 30, 2006 Compared to the Six Months Ended June 30, 2005**

**Revenue**

Revenue forthe six months ended June 30, 2006 increased $0.5 million, or 1.8%, to $28.8million when compared to $28.3 million in revenue for the six months ended June30, 2005.

Revenue foreach of the operating segments was as follows (in thousands):
|                              | ** ** | **Six Months  Ended June 30,  2006** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| Animal Applications          |       | $                                                   | 19,877     |                                                | $          | 16,633 |   |
| GPS and Radio Communications |       | 8,901                                               |       | 11,630                                              |       |
| Total                        |       | $                                                   | 28,778     |                                                | $          | 28,263 |   |

 

The AnimalApplications segment’s revenue increased**approximately $3.2 million, or 19.5%,in the six months ended June 

18

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30, 2006 compared to the six monthperiod ended June 30, 2005. The increase in revenue was principally due to anincrease in electronic and visual product sales to livestock customers ofapproximately $2.0 million, an increase in sales to companion animal customersof approximately $2.0 million, and $0.5 million to the inclusion of DSDHoldings A/S for an additional two months of operations in the six months endedJune 30, 2006.  DSD Holdings A/S wasacquired on February 25, 2005.  Theincreases in the Animal Application segment are offset by a decrease in salesto fish and wildlife customers of $0.9 million and a decrease in sales toVeriChip Corporation of $0.3 million.

The GPS andRadio Communications segment’s revenue decreased approximately $2.7 million, or23.5% to approximately $8.9 million in the six months ended June 30, 2006 fromapproximately $11.6 million in the six months ended June 30, 2005. The decreasein revenue was due to an approximately $3.2 million decrease in sales ofSignature’s Sarbe products, offset by an increase in sales at Signature’s RadioHire division of approximately $0.5 million. We attribute $2.2 million of theSarbe product sales decrease to the completion of the Indian governmentcontract in May 2005 and $1.0 million of the Sarbe product sales decrease toother Sarbe product customers, including the UK Ministry of Defence.

**Gross Profit and Gross Profit Margin**

Grossprofit for the six month period ended June 30, 2006 was approximately $11.8million, a decrease**ofapproximately $0.8 million, or 6.3%, compared to approximately $12.6 million inthe six month period ended June 30, 2005. As a percentage of revenue, the grossprofit margin decreased to 41.1% for the six months ended June 30, 2006 from44.7% for the six months ended June 30, 2005.

Grossprofit from operations for each operating segment was as follows (inthousands):
|                              | ** ** | **Six Months  Ended June 30,  2006** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| Animal Applications          |       | $                                                   | 7,457      |                                                | $          | 6,589 |   |
| GPS and Radio Communications |       | 4,381                                               |       | 6,046                                               |       |
| Total                        |       | $                                                   | 11,838     |                                                | $          | 12,635 |   |

 

Grossprofit margin from operations for each operating segment was:
|                              | ** ** | **Six Months  Ended June 30,  2006** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                               | ** ** | **%**                                               | ** ** |
| Animal Applications          |       | 37.5                                                |       | 39.6                                                |       |
| GPS and Radio Communications |       | 49.2                                                |       | 52.0                                                |       |

 

The AnimalApplications segment’s gross profit increased approximately $0.9 million, or13.2%, in the six month period ended June 30, 2006 compared to the six monthsended June 30, 2005. We attribute approximately $0.5 million of the increase tothe previously mentioned sales increases and $0.4 million to the inclusion ofDSD Holdings A/S for an additional two months of operations in the six monthperiod ended June 30, 2006. DSD Holdings A/S was acquired on February 28,2005. The gross margin percentage was 37.5% for the six month period ended June30, 2006 compared to 39.6% for the six month period ended June 30, 2005. Weattribute the decrease in gross margin percentage to additional freight andimportation duties associated with providing inventory to South America fromDenmark and the United States.  TheCompany has initiated manufacturing of livestock tags in Argentina andanticipates that gross margins on South American sales will improve in thesecond half of 2006. Gross profit margin for the six months ended June 30, 2006excluding the impact of the South American initiative would have been 38.9%.

The GPS andRadio Communications segment’s gross profit decreased approximately $1.7million, or 27.5%, in the six month period ended June 30, 2006 as compared tothe six month period ended June 30, 2005. The decrease in gross profit relatesto the decrease in sales and decreased gross margin percentage. The grossmargin percentage decreased to 49.2% in the six month period ended June 30,2006 as compared to 52.0% in the six month period ended June 30, 2005. Thedecrease in gross margin percentage relates primarily to higher margins on G2RSarbe locator beacons shipped under the contract with the government of Indiain the first six months of 2005. Signature completed shipments under the contract with the government ofIndia in May 2005.

**Selling, General and Administrative Expenses**

Selling,general and administrative expenses increased approximately $0.8 million, or6.9%, in the six month period ended  June30, 2006 as compared to the six month period ended June 30, 2005. As apercentage of revenue, selling, general and administrative expenses were 42.5%and 40.5% for the six months ended June 30, 2006 and 2005, respectively.

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

19

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|                              | ** ** | **Six Months  Ended June 30,  2006** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| Animal Applications          |       | $                                                   | 7,446      |                                                | $          | 6,341 |   |
| GPS and Radio Communications |       | 4,789                                               |       | 5,105                                               |       |
| Total                        |       | $                                                   | 12,235     |                                                | $          | 11,446 |   |

 

Selling,general and administrative expenses as a percentage of revenue for each of theoperating segments were:
|                              | ** ** | **Six Months  Ended June 30,  2006** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                               | ** ** | **%**                                               | ** ** |
| Animal Applications          |       | 37.5                                                |       | 38.1                                                |       |
| GPS and Radio Communications |       | 53.8                                                |       | 43.9                                                |       |

 

The AnimalApplications segment’s selling, general and administrative expenses increasedapproximately $1.1 million in the six month period ended June 30, 2006 ascompared to the six month period ended June 30, 2005 and selling, general andadministrative expense as a percentage of revenue decreased to 37.5% from 38.1%in the same respective periods. The increase in selling, general andadministrative expense relates primarily to a charge of approximately $0.2million in acquisition expenses, approximately $0.6 million in additionalcompensation expense, approximately $0.3 million of additional expense relatedto DSD Holding A/S and increased selling, general and administrative expensesin our South American subsidiaries of $0.2 million.  Such increases are offset by decreasedinsurance expense of $0.3 million. The six month period ended June 30, 2005includes 4 months of results for DSD Holdings A/S compared to six months ofresults in the six month period ended June 30, 2006.  DSD Holdings A/S was acquired on February 28,2005.

The GPS andRadio Communications segment’s selling, general and administrative expensesdecreased approximately $0.3 million to approximately $4.8 million in the sixmonth period ended June 30, 2006 from approximately $5.1 million in the six monthperiod ended June 30, 2005. The decrease in selling, general and administrativeexpense relates primarily to reduced intangible amortization expense at oursubsidiary, OuterLink Corporation. As a percentage of revenue, selling, generaland administrative expenses increased to 53.8% in the six month period endedJune 30, 2006 from 43.9% in the six month period ended June 30, 2005. Theincrease in selling, general and administrative expense as a percentage ofsales resulted primarily from the decrease in sales in the current period.

All of theCompany’s out-of-the money, unvested stock options issued to current employees,officers and directors prior to November 15, 2005 were vested on December 30,2005, therefore equity based compensation expense related to stock optionsgranted prior to the adoption of SFAS 123R was immaterial.  On June 14, 2006 the Company granted 2.1million stock options to employees and directors of Digital Angel Corporation.  Compensation expense related to the 2.1million stock options is expected to be approximately $4.5 million and will berecognized over the weighted average period of 7.2 years.

**Research and Development Expense**

Researchand development expense was approximately $2.3 million in the six month periodended June 30, 2006, an increase of approximately $0.1 million, or 6.2%, fromapproximately $2.2 million for the six month period ended June 30, 2005. As apercentage of revenue, research and development expense was 8.1% and 7.8% forthe six months ended June 30, 2006 and 2005, respectively.

Researchand development expense for each of the operating segments was as follows (inthousands):
|                              | ** ** | **Six Months  Ended June 30,  2006** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| Animal Applications          |       | $                                                   | 1,521      |                                                | $          | 1,370 |   |
| GPS and Radio Communications |       | 820                                                 |       | 835                                                 |       |
| Total                        |       | $                                                   | 2,341      |                                                | $          | 2,205 |   |

 

The AnimalApplications segment’s research and development expense was approximately $1.5million in the six month period ended June 30, 2006, an increase ofapproximately $151,000, or 11.0%, from approximately $1.4 million for the sixmonth period ended June 30, 2005. The increase is primarily related to newproduct development.

The GPS andRadio Communications segment’s research and development expense wasapproximately $0.8 million in the six month periods ended June 30, 2006 and2005. Research and development in the six month period ended June 30, 2006relates to the continued development of OuterLink Corporation’s next generationof communication system hardware.

**Interest Expense**

Interest expensewas approximately $0.2 million for the six month periods ended June 30, 2006and 2005.

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**Income Taxes**

The Companyrecorded an income tax benefit of approximately $72,000 in the six month periodended June 30, 2006 and an income tax provision of approximately $86,000 forthe six month period ended June 30, 2005. The income tax benefit for the sixmonth period ended June 30, 2006 relates to a subsidiary of DaplomaInternational A/S. The Company accounts for income taxes under the asset andliability approach. Deferred tax assets and liabilities are recognized for theexpected future tax consequences attributed to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax basis. Deferred tax assets and liabilities are measuredusing the enacted tax rates expected to apply to taxable income in the years inwhich those temporary differences are expected to reverse. A valuationallowance is provided against net deferred tax assets when it is more likelythan not that a tax benefit will not be realized.

**LIQUIDITY AND CAPITAL RESOURCES**

As of June30, 2006, the Company had cash of $7.1 million. Cash used in operatingactivities totaled approximately $1.8 million and approximately $1.4 million inthe first six months of 2006 and 2005, respectively.

In thefirst six months of 2006, the use of cash was due primarily to an increase ininventory of approximately $1.7 million, and a decrease in accounts payable,accrued expenses and deferred revenue of approximately $1.7 million. Offsettingthese uses of cash was depreciation and amortization of approximately $1.0million and non-cash equity based compensation of approximately $0.3 million.

Investing activities used cash of approximately $1.6million and approximately $1.8 million in the first six months of 2006 and2005, respectively. The Company purchased approximately $0.7 million ofproperty and equipment in the first six months of 2006 and 2005.  On April 13, 2006 the Companyexercised its right to buyout the remaining purchase price for the acquisitionof DSD Holdings. The $2 million buyout price was satisfied by a cash payment of$1 million paid in April 2006 and $1 million worth of the Company’sunregistered common stock issued in June 2006.

Financingactivities provided cash of approximately $0.5 million in the first six monthsof 2006 and used cash of approximately $1.7 million in the first six months of2005. In the first six months of 2006, proceeds to the Company related to stockoption exercises were approximately $0.6 million.  In the first six months of 2005,approximately $1.5 million of cash was used for the purchase of 328,100 sharesof treasury stock.

The Companyexpects that current available funds will adequately fund the Company’soperations for the next twelve months.

*Debt, CovenantCompliance and Liquidity*

*Invoice Discounting Agreement*On April 9, 2003, Signature Industries Limited entered into a two-yearInvoice Discounting Agreement with The Royal Bank of Scotland CommercialServices 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. RBS prepays 80% of the receivables sold inthe United Kingdom and 75% of the receivables sold in the rest of the world,not to exceed an outstanding balance of £750,000 ($1.3 million at June 30,2006) at any given time. RBS pays Signature the remainder of the receivableupon collection of the receivable. Receivables which remain outstanding 90 daysfrom the end of the invoice month become ineligible and RBS may requireSignature to repurchase the receivable back. The discounting charge accruesdaily at an annual rate of 1.85% above the base rate, as defined in the amendedInvoice Discounting Agreement (6.35% at June 30, 2006). Signature pays acommission charge to RBS of 0.16% of each receivable balance sold. The InvoiceDiscounting Agreement, as amended, requires a minimum commission charge of £833per month. Discounting charges of $21,000 and $11,000 are included in interestexpense for the six months ended June 30, 2006 and 2005, respectively. As ofJune 30, 2006, $0.4 million of receivables were financed under the InvoiceDiscounting Agreement.

*Equipment Loans-DSD Holdings*  DSD Holdings is party to equipment loans whichare collateralized by production equipment. Principal and interest paymentstotaling approximately DKK 0.5 million ($84,000 USD at June 30, 2006) arepayable quarterly. Payments are due through January 2010. The interestrates on the loans are variable and range from 4.555% to 7.06% as of June 30,2006. As of June 30, 2006, the amount outstanding under the equipment loans was$1.0 million

*Line of Credit-DSD Holdings*  DSD Holdings and its wholly-owned subsidiary,Daploma International A/S, are party to a credit agreement with Danske Bank. OnJune 1, 2006, DSD Holdings and Daploma International A/S amended the borrowingavailability from DKK 12 million ($2.0 million USD at June 30, 2006) to DKK 18million ($3.0 million USD at June 30, 2006). In connection with the amendment, Digital Angel Corporation executed aLetter of Support which confirms that Digital Angel Corporation shall maintainits holding of 100% of the share capital of Daploma, and that Digital Angel shall neither sell, nor pledge, nor inany other way dispose of any part of Daploma or otherwise reduce its influenceon Daploma without the prior consent of Danske Bank A/S.  As of June 30, 2006 the amount outstandingunder the credit agreement was $2.3 million. The interest is determined quarterlyand is based on the international rates Danske Bank can establish on aloan in the same currency on the international market plus 2.0%. AtJune 30, 2006, the annual interest rate on the facility was 5.05%.Borrowing availability under the

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creditfacility considers guarantees outstanding. At June 30, 2006 the borrowingavailability on the credit agreement was DKK 3.7 million ($0.6 million at June30, 2006). The credit agreement shall remain effective until further notice.DSD Holdings can terminate the credit agreement and pay the outstanding balanceor Danske Bank may demand the credit line be settled immediately at anygiven time, without prior notice.

*Note Payable-DSD Holdings*  As of June 30, 2006, DSD Holdings is party toa note payable with Danske Bank. Principal payments of DKK 0.3 million ($50,400USD at June 30, 2006) plus interest are payable quarterly throughDecember 15, 2008. The interest rate on the note is calculated based onthe international rates Danske Bank can establish on a loan in DKK in theinternational market plus 2.0%. The interest rate on the note payable was 4.85%at June 30, 2006. As of June 30, 2006, the amount outstanding under the notepayable was $0.5 million.

*Mortgage Notes Payable*  The Company is party to a mortgage notespayable collateralized by land and building. Principal and interest paymentstotaling approximately $30,000 are payable monthly through October 2010. Thefinal payment of $2.0 million is due in November of 2010. The interest rate onthe note is fixed at 8.18%. As of June 30, 2006, the amount outstanding underthe mortgage note payable was $2.3 million.

*StockIssuances to Applied Digital* On February 25, 2005, the Company entered intoa Stock Purchase Agreement with Applied Digital. Pursuant to the agreement theCompany issued 644,140 shares of its common stock to Applied Digital. TheCompany received 684,543 shares of Applied Digital common stock asconsideration. The value of the stock exchanged was $3.5 million. The AppliedDigital common stock received by the Company was used as partial considerationfor the acquisition of DSD Holdings A/S and its wholly-owned subsidiaries,Daploma International A/S and Digitag A/S.

*StockRepurchase*On March 29, 2005, the Company’s Board of Directors approved the repurchaseof up to 1.5 million shares of its common stock over a ninety day periodcommencing on March 30, 2005. The Company purchased 328,000 shares for atotal of $1.5 million.

Thefollowing table summarizes the Company’s fixed cash obligations as of June 30,2006 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           |       | $          | 6,702      |                                      | $          | 3,125 |   | $ | 1,228 |   | $ | 2,349 | ** ** | **$** | **—** | ** ** |
| Operating Leases                           |       | 18,151     |       | 745                                       |       | 1,270 |   | 977 |   | 15,159 |   |
| Employment Contracts                       |       | 1,624      |       | 1,214                                     |       | 410 |   | — |   | — |   |
|                                       |       | $          | 26,477     |                                      | $          | 5,084 |   | $ | 2,908 |   | $ | 3,326 |   | $ | 15,159 |   |

 

**IMPACT OF RECENTLYISSUED ACCOUNTING STANDARDS**

InDecember 2004, SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS123R) was issued. SFAS 123R replaced SFAS No. 123 and supercedes APBOpinion No. 25. SFAS 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values. The pro forma disclosures previouslypermitted under SFAS 123 are longer an alternative to financial statementrecognition.

On January 1, 2006we adopted the provisions of SFAS 123R, using the modified prospectivetransition method. Accordingly, during the six months ended June 30, 2006 werecorded stock-based compensation expense for awards granted in 2006 and awardsgranted prior to, but not vested as of January 1, 2006, as if the fair valuemethod required for pro forma disclosure under SFAS 123 were in effect forexpense recognition purposes. In accordance with modified prospectivetransition method prior periods have not been restated. However, the pro formaeffects of recognizing the estimated fair value of stock based compensation forthe first quarter of 2005 are disclosed in Note 8 of the Notes to our CondensedConsolidated Financial Statements. Upon adoption of SFAS 123R we elected tocontinue using the Black-Scholes option pricing model and have recognizedcompensation expense using a straight-line amortization method.

All of the Company’sout-of-the-money, unvested stock options issued to current employees, officersand directors prior to November 15, 2005 were vested on December 30,2005, and, therefore, the initial adoption of SFAS 123R did not have a materialimpact on our consolidated results of operations and earnings (loss) per share.The purpose of the accelerated vesting was to enable the Company to avoidrecognizing in our statements of operations non-cash compensation expense associatedwith the options in future periods. As a result of the acceleration, we avoidedrecognition of approximately $8.6 million of compensation expense in ourstatement of operations over the course of the original vesting periods. Suchexpense was included in our pro forma stock-based compensation footnotedisclosure for the quarter ended December 31, 2005. The majority of theaccelerated options, absent the acceleration, would have been vested in 2006,with a smaller percentage vesting over the next 30 months. As of June 30, 2006,there was $4.9 million of total unrecognized compensation cost related tononvested share-based compensation arrangements granted under the DAC StockOption Plan.  That cost is expected to be recognized over a weighted-averageperiod of 6.6 years.

Although the initialadoption of SFAS 123R did not have a material impact on our consolidatedresults of operations and

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earnings (loss) pershare, as we grant more options or other share based compensation to employees,we expect that the impact may be material.

In June 2006, the FASB issued Interpretation No. 48, “Accounting forUncertainty in Income Taxes — an interpretation of FAS No. 109” (FIN 48), whichclarifies the accounting for uncertainty in income taxes. Currently, the accountingfor uncertainty in income taxes is subject to significant and variedinterpretations that have resulted in diverse and inconsistent accountingpractices and measurements. Addressing such diversity, FIN 48 prescribes aconsistent recognition threshold and measurement attribute, as well as clearcriteria for subsequently recognizing, derecognizing and measuring changes insuch tax positions for financial statement purposes. FIN 48 also requiresexpanded disclosure with respect to the uncertainty in income taxes. FIN 48 iseffective for fiscal years beginning after December 15, 2006. We have not yetdetermined the impact of FIN 48 on our consolidated financial position, resultsof operations, cash flows or financial statement disclosures.

**Forward-Looking Statements and Associated Risks**

ThisForm 10-Q contains forward-looking statements within the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995 with respectto our financial condition, results of operations and business, and it includesstatements relating to:

·                  our growth strategiesincluding, without limitation, our ability to deploy**new products and services;

·                  anticipated trends in ourbusiness and demographics;

·                  our ability to successfullyintegrate the business operations of recently acquired companies;

·                  our future profitability andliquidity; and

·                  regulatory, competitive orother economic influences.

Words suchas “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates”and similar expressions also identify forward-looking statements. Theseforward-looking statements are not guarantees of future performance and aresubject to risks and uncertainties that could cause actual results to differmaterially from estimates or forecasts contained in the forward-lookingstatements. Some of these risks and uncertainties are beyond our control. SeeItem 1A. Risk Factors included in our 2005 Annual Report on Form 10-K/A.

Our actualresults might differ materially from historical performance or currentexpectation. We do not undertake any obligation to update or revise publiclyany forward-looking statement, whether as a result of new information, futureevent or otherwise.

**Item 3. Quantitative and Qualitative Disclosures About 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 besubject to volatility because of currency fluctuations, inflation, and changesin political and economic conditions in these countries. Sales and expenses maybe denominated in local currencies and may be affected as currency fluctuationsaffect our product prices and operating costs or those of our competitors. Wedo not believe that any changes in currency fluctuations, inflation, andchanges in political and economic conditions would have a material affect onour business or our results of operations.

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.

**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 ChiefFinancial Officer concluded that our disclosure controls and procedures areeffective.

During the period covered by theForm 10-Q, there were no changes in our internal control over financialreporting that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

**PART II    OTHER INFORMATION**

**Item 1. Legal Proceedings.**

For information with respect to certain legal proceedings, see theinformation included under the caption entitled, “Litigation” (Note 11) of the “Notesto Condensed Consolidated Financial Statements” which is incorporated herein byreference.

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**Item 1A. Risk Factors**

Information regarding risk factors appears in Management’s Discussion andAnalysis of Financial Condition and Results of Operations-Forward LookingStatements and Associated Risks in Part I, Item 2 of this Form 10-Q.  There have been no material changes in ourrisk factors from those disclosed in our 2005 Annual Report on Form 10-K/A.

**Item 4.  Submission of Matters to aVote of Securityholders**

At the Annual Meeting of Stockholders held on May 4, 2006, thefollowing 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

Barry Edelstein

Howard S. Weintraub, Ph.D.

MichaelS. Zarriello

No fewerthan 40,766,057 were voted in favor of, no more than 938,461 shares werewithheld.

**PROPOSAL 2-RATIFICATIONOF THE APPOINTMENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

Thefollowing is the result of the stockholders’ vote on the ratification of theappointment of Eisner LLP as independent registered public accounting firm:
| For     |   | 41,475,644 | ** ** |
|---------|--------|------------|------------|
| Against |   | 70,058     |       |
| Abstain |   | 128,815    |       |

 

**Item 5. Other Information**

**Item 6. Exhibits**
|        | ** ** | **(a)    Exhibits**                                                                                                                                             |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                                                                                                |
| 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 Financial 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**

Pursuant to the requirements of the Securities Exchange Actof 1934, the Registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
|                  | DIGITAL ANGEL CORPORATION |
|-----------------------|---------------------------|
|                  | (Registrant)              |
|                  |                      |
| Dated: August 3, 2006 | By:                       | /s/ James P. Santelli |
|                  |                      | James P. Santelli |
|                  |                      | Senior Vice President and Chief Financial Officer |

 

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