**As filed with the Securities and Exchange Commissionon August 8, 2002**

** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**WASHINGTON, D. C.  20549

# ****

# **FORM 10–Q/A-2**

 

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

 

**Commission File Number: 1-15177**

 

**DIGITAL ANGEL CORPORATION**(Exact name of registrant as specified in itscharter)

 

| **DELAWARE**                                                    |   | **52-1233960**                     |
|-----------------------------------------------------------------|--------|------------------------------------|
| (State or other jurisdiction of incorporation or  organization) |   | (IRS Employer  Identification No.) |

**490 VillaumeAvenueSouth Saint Paul, Minnesota 55075(651) 455-1621**(Address, including zip code, and telephonenumber,including area code, of registrant’s principal executive offices)

 

**MedicalAdvisory Systems, Inc., 8050 Southern Maryland Blvd., Owings, Maryland, 20736  October 31**

(Formername, former address and former fiscal year, if changed since last report)

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.

Yes         ý            No           o

The number ofshares outstanding of each of the issuer’s classes of common stock as of theclose of business on May 7, 2002:

 

| **Class**                      |   | **Number of Shares** |
|--------------------------------|--------|----------------------|
| Common  Stock; $.005 Par Value |   | 26,320,311           |
|                           |   |                 |
|                           |   |                 |
|                           |   |                 |

 

 

 

 

----

 

**Explanatory Note**

This Amendment No. 2 to Quarterly Report onForm 10-Q amends and restates Part I, Item 1 and 2 of Amendment No. 1 to theRegistrant's Quarterly Report on Form 10-Q/A for the fiscal quarter ended March31, 2002, filed by the Registrant on July 23, 2002.  In particular, this Amendment amends and restates pages 5, 8, 11,12, 15, 16, 17 and 24 of Amendment No. 1 to correct certain errors that are notmaterial.  All other information andfinancial statements contained within Amendment No. 1 to the Registrant's Form10-Q/A remain unchanged.

 

 

2

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**DIGITAL ANGEL CORPORATION**

 

TABLEOF CONTENTS

 

 
| **Item**  | **Description**                                                                                                                                      |
|-----------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |                                                                                                                                                 |
|      | PART I — FINANCIAL  INFORMATION                                                                                                                 |
|      |                                                                                                                                                 |
| 1.        | Financial Statements                                                                                                                                 |
|      | Independent  Accountants Review Report                                                                                                               |
|      | Condensed Balance Sheets as  of   March 31, 2002 (unaudited) (as restated) and December 31, 2001                                                     |
|      | Condensed Statements  of Operations — for the   three months ended March 31, 2002 (unaudited) (as restated) and 2001  (unaudited) (as restated) |
|      | Condensed  Statement of Stockholders’ Equity — for the   three months ended March 31, 2002 (unaudited) (as restated)                       |
|      | Condensed Statements  of Cash Flows — for the  three months ended March 31, 2002 (unaudited) (as restated) and 2001  (unaudited) (as restated)  |
|      | Notes to  Condensed Financial Statements                                                                                                             |
| 2.        | Management’s  Discussion and Analysis of Financial Condition  and Results of Operations                                                    |
| 3.        | Quantitative and  Qualitative Disclosures About Market Risk*                                                                                         |
|      |                                                                                                                                                 |
|      | PART  II — OTHER INFORMATION                                                                                                                    |
|      |                                                                                                                                                 |
| 1.        | Legal Proceedings*                                                                                                                                   |
| 2.        | Changes In Securities and  Use of Proceeds*                                                                                                          |
| 3.        | Defaults Upon Senior  Securities*                                                                                                                    |
| 4.        | Submission of Matters to a  Vote of Security Holders*                                                                                                |
| 5.        | Other Information*                                                                                                                                   |
| 6.        | Exhibits and Reports on  Form 8-K*                                                                                                                   |
|      |                                                                                                                                                 |
| SIGNATURE |
| EXHIBITS  |

 

* Filed with Amendment No. 1 to Form 10–Q/A

 

3

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INDEPENDENT ACCOUNTANTSREVIEW REPORT

 

To the Board of Directors and Stockholders ofDigital Angel Corporation:

 

We have reviewed the accompanying condensed consolidated balance sheetof Digital Angel Corporation and subsidiaries as of March 31, 2002, and therelated condensed consolidated statements of operations, stockholders’ equity,and cash flows for the three-month period then ended.  We have also reviewed the combined statements of operations andcash flows of the Advanced Wireless Group (predecessor of Digital AngelCorporation) for the three-month period ended March 31, 2001.  These condensed consolidated financialstatements are the responsibility of the Company’s management.

 

We conducted our reviews in accordance with standards established bythe American Institute of Certified Public Accountants.  A review of interim financial informationconsists principally of applying analytical procedures to financial data andmaking inquiries of persons responsible for financial and accountingmatters.  It is substantially less inscope than an audit conducted in accordance with auditing standards generallyaccepted in the United States of America, the objective of which is theexpression of an opinion regarding the financial statements taken as awhole.  Accordingly, we do not expresssuch an opinion.

 

Based on our reviews, we are not aware of any material modificationsthat should be made to the accompanying financial statements as of and for thethree-month period ended March 31, 2002 and 2001 for them to be in conformitywith accounting principles generally accepted in the United States of America.

 

As disclosed in Note 1, the Company has restated its financialstatements.

 

As discussed in Note 1,certain conditions indicate that the Company may be unable to continue as agoing concern.  The accompanyingfinancial statements do not include any adjustments to the financial statementsthat might be necessary should the Company be unable to continue as a goingconcern.

 

Eisner LLP

New York, New York

July 15, 2002

 

 

4

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PARTI    FINANCIAL INFORMATION

Item1.   Financial Statements.

 

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES****CONDENSED BALANCE SHEETS**(In thousands, except par value)

 
|                                                                                                                                                                             |   | **Digital Angel**   |        |              |       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|-------------|-------------------|------------|
|                                                                                                                                                                             |   | **Corporation and** |        |              |       |
|                                                                                                                                                                             |   | **Subsidiaries**    |        | **Advanced**      |       |
|                                                                                                                                                                             |   | **(Consolidated)**  |        | **Wireless**      |       |
|                                                                                                                                                                             |   | **March 31,**       |        | **Group**         |       |
|                                                                                                                                                                             |   | **2002**            |        | **(Combined)**    |       |
|                                                                                                                                                                             |   | **(As Restated**    |        | **December  31,** |       |
|                                                                                                                                                                             |   | **See Note 1)**     |        | **2001**          |       |
|                                                                                                                                                                             |   | **(Unaudited)**     |        |              |       |
| **Assets**                                                                                                                                                                       |   |                |        |              |       |
| **Current Assets**                                                                                                                                                               |   |                |        |              |       |
| Cash and cash equivalents                                                                                                                                                        |   | **$**               | **882**     |              | $          | 596 |   |
| Accounts receivable and unbilled receivables (net of allowance for  doubtful accounts of $403 in 2002 and $296 in 2001)                                                          |   | **4,590**           |        | 5,402             |       |
| Inventories                                                                                                                                                                      |   | **5,939**           |        | 5,819             |       |
| Due from Applied Digital Solutions, Inc.                                                                                                                                         |   | **108**             |        | -                 |       |
| Other current assets                                                                                                                                                             |   | **1,328**           |        | 733               |       |
| **Total Current Assets**                                                                                                                                                         |   | **12,847**          |        | 12,550            |       |
|                                                                                                                                                                             |   |                |        |              |       |
| **Property And Equipment, net**                                                                                                                                                  |   | **15,333**          |        | 14,476            |       |
|                                                                                                                                                                             |   |                |        |              |       |
| **Goodwill and Other Intangibles, net**                                                                                                                                          |   | **102,262**         |        | 72,876            |       |
|                                                                                                                                                                             |   |                |        |              |       |
| **Investment In Affiliates**                                                                                                                                                     |   | **256**             |        | 6,779             |       |
|                                                                                                                                                                             |   |                |        |              |       |
| **Other Assets, net**                                                                                                                                                            |   | **596**             |        | 698               |       |
|                                                                                                                                                                             |   |                |        |              |       |
|                                                                                                                                                                             |   | **$**               | **131,294** |              | $          | 107,379 |   |
|                                                                                                                                                                             |   |                |        |              |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                   |   |                | ** **  |              | ** ** |
|                                                                                                                                                                             |   |                |        |              |       |
| **Current Liabilities**                                                                                                                                                          |   |                |        |              |       |
| Notes payable and current maturities of long-term debt                                                                                                                           |   | **$**               | **254**     |              | $          | 82,643 |   |
| Accounts payable                                                                                                                                                                 |   | **4,117**           |        | 3,757             |       |
| Accrued expenses                                                                                                                                                                 |   | **4,373**           |        | 2,044             |       |
| **Total Current Liabilities**                                                                                                                                                    |   | **8,744**           |        | 88,444            |       |
|                                                                                                                                                                             |   |                |        |              |       |
| **Long-Term Debt And Notes Payable**                                                                                                                                             |   | **2,429**           |        | 2,425             |       |
|                                                                                                                                                                             |   |                |        |              |       |
| **Total Liabilities**                                                                                                                                                            |   | **11,173**          |        | 90,869            |       |
|                                                                                                                                                                             |   |                |        |              |       |
| **Commitments And Contingencies**                                                                                                                                                |   | **-**               |        | -                 |       |
|                                                                                                                                                                             |   |                |        |              |       |
| **Minority Interest**                                                                                                                                                            |   | **353**             |        | 394               |       |
|                                                                                                                                                                             |   |                |        |              |       |
| **Stockholders’ Equity (See Note 1)**                                                                                                                                       |   |                |        |              |       |
| Preferred shares: Authorized 1,000 in 2002, of $1.75 par value, no  shares issued or outstanding                                                                                 |   | **-**               |        | -                 |       |
| Common shares: Authorized 95,000 shares in 2002, of $.005 parvalue; 25,493 shares issued and 25,443 shares  outstanding in 2002and 18,750  shares issued and outstanding in 2001 |   | **127**             |        | 94                |       |
| Additional paid-in capital                                                                                                                                                       |   | **162,770**         |        | 37,929            |       |
| Accumulated deficit                                                                                                                                                              |   | **(44,211**         | )           | (21,700           | )          |
| Common stock warrants                                                                                                                                                            |   | **1,638**           |        | 300               |       |
| Treasury stock (carried at cost, 50 shares in 2002)                                                                                                                              |   | **(43**             | )           | -                 |       |
| Accumulated other comprehensive loss                                                                                                                                             |   | **(513**            | )           | (507              | )          |
| Total Stockholders’ Equity                                                                                                                                                  |   | **119,768**         |        | 16,116            |       |
|                                                                                                                                                                             |   |                |        |              |       |
|                                                                                                                                                                             |   | **$**               | **131,294** |              | $          | 107,379 |   |

 

 

See theaccompanying notes to condensed financial statements.

 

 

5

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**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES****CONDENSED STATEMENTS OF OPERATIONS**

(In thousands, except per share data)

(Unaudited)

 
|                                                                      |   | **Digital Angel**               |      | **Advanced**     |   |
|---------------------------------------------------------------------------|--------|---------------------------------|-----------|------------------|--------|
|                                                                      |   | **Corporation and**             |      | **Wireless**     |   |
|                                                                      |   | **Subsidiaries**                |      | **Group**        |   |
|                                                                      |   | **(Consolidated)**              |      | **(Combined)**   |   |
|                                                                      |   | **(As Restated**                |      | **(As Restated** |   |
|                                                                      |   | **See Note 1)**                 |      | **See Note 1)**  |   |
|                                                                      |   | **For the Three   Months** |      |
|                                                                      |   | **Ended March 31,**             |      |
|                                                                      |   | **2002**                        |      | **2001**         |   |
|                                                                      |   |                            |      |             |   |
| Product revenue                                                           |   | **$**                           | **7,451** |             | $      | 9,134 |   |
| Service revenue                                                           |   | **303**                         |      | 1,070            |   |
| Total net revenue                                                         |   | **7,754**                       |      | 10,204           |   |
|                                                                      |   |                            |      |             |   |
| Cost of products sold                                                     |   | **4,300**                       |      | 5,361            |   |
| Cost of services sold                                                     |   | **251**                         |      | 549              |   |
|                                                                      |   |                            |      |             |   |
| Gross profit                                                              |   | **3,203**                       |      | 4,294            |   |
|                                                                      |   |                            |      |             |   |
| Selling, general and administrative expenses                              |   | **21,341**                      |      | 2,501            |   |
| Management fees - Applied Digital Solutions, Inc.                         |   | **193**                         |      | 193              |   |
| Research and development expenses                                         |   | **1,331**                       |      | 1,084            |   |
| Depreciation and amortization                                             |   | **735**                         |      | 2,359            |   |
| Interest income                                                           |   | **-**                           |      | (3               | )      |
| Interest expense - Applied Digital Solutions, Inc.                        |   | **1,806**                       |      | -                |   |
| Interest expense - others                                                 |   | **58**                          |      | 59               |   |
|                                                                      |   |                            |      |             |   |
| Loss before taxes, minority interestand equity in net loss of affiliate   |   | **(22,261**                     | )         | (1,899           | )      |
|                                                                      |   |                            |      |             |   |
| Provision for income taxes                                                |   | **-**                           |      | 115              |   |
|                                                                      |   |                            |      |             |   |
| Loss before minority interest,and equity in net loss of affiliate         |   | **(22,261**                     | )         | (2,014           | )      |
|                                                                      |   |                            |      |             |   |
| Minority interest                                                         |   | **(41**                         | )         | (21              | )      |
|                                                                      |   |                            |      |             |   |
| Equity in net loss of affiliate                                           |   | **291**                         |      | 18               |   |
|                                                                      |   |                            |      |             |   |
| Net loss                                                                  |   | **(22,511**                     | )         | (2,011           | )      |
|                                                                      |   |                            |      |             |   |
| Net loss per common share - basic and diluted                             |   | **$**                           | **(1.18** | )                | $      | (0.11 | ) |
|                                                                      |   |                            |      |             |   |
| Weighted average number of common shares outstanding - basic and  diluted |   | **19,063**                      |      | 18,750           |   |

 

See the accompanying notes to condensed financialstatements.

 

 

6

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**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES**

 

**CONDENSED STATEMENT OFSTOCKHOLDERS’ EQUITYAs Restated See Note 1For The Three Months Ended March 31, 2002**(In Thousands)(Unaudited)

 

 
|                                                 |   |             |       |        |    |            |   |        |       |         |        |              |   | **Accumulated**   |       |       |    |
|------------------------------------------------------|--------|------------------|------------|-------------|---------|-----------------|--------|-------------|------------|--------------|-------------|-------------------|--------|-------------------|------------|------------|---------|
|                                                 |   |             |       |        |    | **Additional**  |   |        |       | **Common**   |        |              |   | **Other**         |       | **Total**  |    |
|                                                 |   | **Common Stock** |       | **Paid-In** |    | **Accumulated** |   | **Stock**   |       | **Treasury** |        | **Comprehensive** |   | **Stockholders'** |       |
|                                                 |   | **Number**       |       | **Amount**  |    | **Capital**     |   | **Deficit** |       | **Warrants** |        | **Stock**         |   | **Loss**          |       | **Equity** |    |
|                                                 |   |             |       |        |    |            |   |        |       |         |        |              |   |              |       |       |    |
| **Balance - December 31, 2001**                      |   | 18,750           |       | $           | 94      |            | $      | 37,929      |       | $            | (21,700     | )                 | $      | 300               |       | $          | -       |   | $ | (507 | ) | $ | 16,116 |   |
| Net loss                                             |   | -                |       | -           |    | -               |   | (22,511     | )          | -            |        | -                 |   | -                 |       | (22,511    | )       |
| Comprehensive loss -Foreign currency translation     |   | -                |       | -           |    | -               |   | -           |       | -            |        | -                 |   | (6                | )          | (6         | )       |
| Total comprehensive loss                             |   | -                |       | -           |    | -               |   | (22,511     | )          | -            |        | -                 |   | (6                | )          | (22,517    | )       |
| Transfer of MAS common shares to ADS                 |   | -                |       | -           |    | (6,488          | )      | -           |       | -            |        | -                 |   | -                 |       | (6,488     | )       |
| Contribution by ADS                                  |   | -                |       | -           |    | 2,789           |   | -           |       | -            |        | -                 |   | -                 |       | 2,789      |    |
| Exercise of stock options                            |   | 1,437            |       | 7           |    | 88              |   | -           |       | -            |        | -                 |   | -                 |       | 95         |    |
| Shares to be issued in settlement of liability       |   | 38               |       | -           |    | 225             |   | -           |       | -            |        | -                 |   | -                 |       | 225        |    |
| Merger consideration - MedicalAdvisory Systems, Inc. |   | 5,268            |       | 26          |    | 28,163          |   | -           |       | 272          |        | (43               | )      | -                 |       | 28,418     |    |
| Assumption of debt by ADS                            |   | -                |       | -           |    | 81,383          |   | -           |       | -            |        | -                 |   | -                 |       | 81,383     |    |
| Stock options remeasured in connectionwith merger    |   | -                |       | -           |    | 18,681          |   | -           |       | -            |        | -                 |   | -                 |       | 18,681     |    |
| Warrants remeasured in connectionwith merger         |   | -                |       | -           |    | -               |   | -           |       | 1,066        |        | -                 |   | -                 |       | 1,066      |    |
|                                                 |   |             |       |        |    |            |   |        |       |         |        |              |   |              |       |       |    |
| **Balance - March 31, 2002**                         |   | **25,493**       | ** ** | **$**       | **127** | ** **      | **$**  | **162,770** | ** ** | **$**        | **(44,211** | **)**             | **$**  | **1,638**         | ** ** | **$**      | **(43** | **)** | **$** | **(513** | **)** | **$** | **119,768** | ** ** |
|                                                      |        |                  |            |             |         |                 |        |             |            |              |             |                   |        |                   |            |            |         |  |  |  |  |  |  |  |  |  |

 

 

See theaccompanying notes to condensed financial statements.

 

 

7

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**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES**

 

**CONDENSED STATEMENTS OF CASH FLOWS**

(In thousands)(Unaudited)

 
|                                                                       |   | **Digital Angel**               |        | **Advanced**     |   |
|----------------------------------------------------------------------------|--------|---------------------------------|-------------|------------------|--------|
|                                                                       |   | **Corporation and**             |        | **Wireless**     |   |
|                                                                       |   | **Subsidiaries**                |        | **Group**        |   |
|                                                                       |   | **(Consolidated)**              |        | **(Combined)**   |   |
|                                                                       |   | **(As Restated**                |        | **(As Restated** |   |
|                                                                       |   | **See Note 1)**                 |        | **See Note 1)**  |   |
|                                                                       |   | **For the Three   Months** |        |
|                                                                       |   | **Ended March 31,**             |        |
|                                                                       |   | **2002**                        |        | **2001**         |   |
| **Cash Flows From Operating Activities**                                   |   |                            | ** **  |             |   |
| Net loss                                                                   |   | **$**                           | **(22,511** | **)**            | $      | (2,011 | ) |
|                                                                       |   |                            | ** **  |             |   |
| Adjustments to reconcile net loss to net cashused in operating activities: |   |                            | ** **  |             |   |
| Non-cash compensation expense                                              |   | **18,681**                      | ** **  | -                |   |
| Interest allocated by ADS and contributed to capital                       |   | **1,806**                       | ** **  | -                |   |
| Deferred income taxes                                                      |   | **-**                           | ** **  | 34               |   |
| Depreciation and amortization                                              |   | **735**                         | ** **  | 2,359            |   |
| Minority interest                                                          |   | **(41**                         | **)**       | (21              | )      |
| Equity in net loss of affiliate                                            |   | **291**                         | ** **  | 18               |   |
| Loss on sale of equipment                                                  |   | **75**                          | ** **  | 7                |   |
| Change in assets and liabilities:                                          |   |                            | ** **  |             |   |
| Decrease (increase) in accounts receivable                                 |   | **1,086**                       | ** **  | (485             | )      |
| Increase in inventories                                                    |   | **(53**                         | **)**       | (418             | )      |
| Increase in other current assets                                           |   | **(716**                        | **)**       | (221             | )      |
| Increase in due from ADS                                                   |   | **(108**                        | **)**       |             |   |
| Increase in accounts payable andaccrued expenses                           |   | **204**                         |        | 768              |   |
| **Net Cash (Used In) Provided By Operating Activities**                    |   | **(551**                        | **)**       | 30               |   |
|                                                                       |   |                            | ** **  |             |   |
| **Cash Flows From Investing Activities**                                   |   |                            | ** **  |             |   |
| Decrease in other assets                                                   |   | **52**                          | ** **  | 143              |   |
| Payments for property and equipment                                        |   | **(200**                        | **)**       | (653             | )      |
| Cash acquired through acquisition, netof acquisition costs                 |   | **218**                         | ** **  | -                |   |
| **Net Cash Provided By (Used In) Investing Activities**                    |   | **70**                          | ** **  | (510             | )      |
|                                                                       |   |                            | ** **  |             |   |
| **Cash Flows From Financing Activities**                                   |   |                            | ** **  |             |   |
| Net amounts borrowed on notes payable                                      |   | **7**                           | ** **  | 36               |   |
| Payments on long-term debt                                                 |   | **(17**                         | **)**       | -                |   |
| Other financing costs                                                      |   | **-**                           | ** **  | (10              | )      |
| Exercise of stock options                                                  |   | **95**                          |        |             |   |
| Net transactions with Applied Digital Solutions, Inc.                      |   | **682**                         | ** **  | 276              |   |
| **Net Cash Provided By Financing Activities**                              |   | **767**                         | ** **  | 302              |   |
|                                                                       |   |                            |        |             |   |
| **Net Increase (Decrease) In Cash And Cash Equivalents**                   |   | **286**                         |        | (178             | )      |
|                                                                       |   |                            |        |             |   |
| **Cash And Cash Equivalents - Beginning Of Period**                        |   | **596**                         |        | 206              |   |
|                                                                       |   |                            |        |             |   |
| **Cash And Cash Equivalents - End Of Period**                              |   | **$**                           | **882**     |             | $      | 28 |   |

 

 

See the accompanying notes to condensedconsolidated financial statements.

 

 

8

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**DIGITAL ANGEL CORPORATIONNOTES TO FINANCIAL STATEMENTS(In thousands, except per share data)(Unaudited)**

**1.         Basis of Presentation**

On March 27, 2002,Digital Angel Acquisition Co. (“Acquisition”), then a wholly-owned subsidiaryof Medical Advisory Systems, Inc. (“MAS”), merged with and into Digital AngelCorporation (“Digital Angel”), which was then a 93% owned subsidiary of AppliedDigital Solutions, Inc. (“ADS”).  In themerger, the corporate existence of Acquisition ceased, Digital Angel became awholly-owned subsidiary of MAS, and MAS was renamed “Digital AngelCorporation”.  In connection with themerger transaction, ADS contributed to MAS all of its stock in TimelyTechnology Corp., a wholly-owned subsidiary, and Signature Industries, Limited,an 85% owned subsidiary.  These twosubsidiaries along with Digital Angel comprised the Advanced Wireless Group(“AWG”).  As a result of this contributionby ADS, Timely Technology Corp. became a wholly-owned subsidiary of the Companyand Signature Industries, Limited became an 85% subsidiary.  Prior to the merger with Digital Angel, ADSowned 850,000 shares of MAS stock representing approximately 16.6% of theoutstanding stock of MAS.  (The terms“Company” and “Registrant” mean Digital Angel Corporation and itssubsidiaries.)  In the merger, theshares of Digital Angel owned by ADS were converted into a total of 18,750,000shares of MAS common stock.  As a resultof the merger, ADS owned 19,600,000 shares or 77.15% of the Company’s commonstock.  In connection with the merger,ADS transferred to Digital Angel Share Trust all shares of the MAS common stockowned by ADS. The trust is the owner of and, through its Advisory Board, votesall shares of MAS owned by ADS, including all shares of MAS issued to ADS inconsideration of the MAS merger, and has the ability to elect the Board ofDirectors of the Company. The Trust arose as a condition of the merger. Inconnection with certain obligations of ADS the shares owned by the Trust may besold or otherwise disposed of to satisfy such obligations.  Additionally, the Company has certaincovenant obligations in connection with the ADS obligations (see Note 8).

The merger has beentreated as a reverse acquisition for accounting purposes, with AWG treated asthe accounting acquirer.  The historicalcombined financial statements of AWG became those of the Registrant, and theassets and liabilities of MAS were accounted for as required under the purchasemethod of accounting.  Although theequity accounts of AWG survive the merger, the capital structure of MASsurvives the merger.  Accordingly, theequity accounts of AWG have been restated based on the common shares receivedby the former shareholders of AWG in the merger.

On March 27, 2002, ADSamended and restated its debt agreement with IBM Credit Corporation, which,among other amendments, provided for a release of AWG from the responsibilityto repay an existing obligation. Accordingly, ADS assumed this obligation, which resulted in an increase toadditional paid-in capital of $81.3 million net of deferred financing fees ofapproximately $1.1 million on March 27, 2002.

Pursuant to the terms ofthe merger agreement, options to acquire shares of Digital Angel common stockwere converted into options to acquire shares of MAS common stock effectiveMarch 27, 2002. The conversion resulted in a new measurement date for theoptions and, as a result, the Company recorded a charge of approximately $18.7million in non-cash compensation expense during the three months ended March31, 2002. For current employees of the Company, these options are consideredfixed awards under APB Opinion No. 25, and expense was recorded for theintrinsic value of the options converted. For all others, expense was recorded for the fair value of the optionsconverted using the Black-Scholes option-pricing model.

The accompanying unaudited consolidated financial statements of DigitalAngel Corporation and subsidiaries as of and for the three months ended March31, 2002 and the combined financial statements of AWG as of December 31,2001 and for the three months ended March 31, 2001 (unaudited) have beenprepared in accordance with accounting principles generally accepted in theUnited States of America for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X under the SecuritiesExchange Act of 1934.

 

9

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Accordingly, theydo not include all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements.  In the opinion ofthe Company’s management, all adjustments (including normal recurringadjustments) considered necessary to present fairly the financial statementshave been made.

The consolidatedstatements of operations for the three months ended March 31, 2002 are notnecessarily indicative of the results that may be expected for the entireyear.  These statements should be readin conjunction with the AWG’s combined financial statements and related notesthereto for the year ended December 31, 2001 included as an exhibit to our Form8-K/A filed with the Securities and Exchange Commission on July 19, 2002.

Certain items inthe combined financial statements for the 2001 period have been reclassifiedfor comparative purposes.

Net loss previously reportedfor the three months ended March 31, 2001 was restated from a net loss of$1,912 to a net loss of $2,011 to reflect a revision in expenses of a foreignsubsidiary.

The Company hasmade certain adjustments to the quarter ending March 31, 2002 results fromthose previously reported.

The following discloses thedifferences between the originally filed Form 10-Q for the quarter ended March31, 2002 and the results reported on the amended Form 10-Q/A for the sameperiod.

 

 

|                                                     |   | **(In  thousands)** |    |
|----------------------------------------------------------|--------|---------------------|---------|
| Net loss as originally reported                          |   | $                   | (21,824 | ) |
| Equity in net loss of affiliate                          |   | (234                | )       |
| Miscellaneous accruals and inventory adjustment          |   | (299                | )       |
| Option valuation                                         |   | (172                | )       |
| Amortization of intangible                               |   | (47                 | )       |
| Allocation of interest from Parent and minority interest |   | 65                  |    |
| Net loss as amended                                      |   | $                   | (22,511 | ) |
|                                                     |   |                |    |   |
| Loss per share, as reported                              |   | $                   | (1.07   | ) |
| Change                                                   |   |                | (.11    | ) |
| Loss per share, amended                                  |   | $                   | (1.18   | ) |

 

The impact of the accountingchanges and adjustments on the condensed consolidated balance sheets is todecrease total assets from $145.4 million to $131.3 million, decrease totalliabilities from $12.9 million to $11.1million and to decrease stockholders’equity from $132.1 million to $119.8 million

 

The $14.1 million decreasein assets includes the $12.7 million decrease in goodwill, $0.9 milliondecrease in accounts receivable, and a $0.7 million decrease in investments inaffiliates   The $1.8 million decreasein liabilities includes a decrease in accounts payable and accruedexpenses.  The items described abovecause the $12.3 million decrease in stockholders’ equity.

 

                Theaccompanying consolidated financial statements have been prepared assuming thatthe Company will continue as a going concern. The Company has suffered significant losses from operations and has notgenerated positive cash flows from operations. Additionally, the Company does not have an available line ofcredit.  These factors raise substantialdoubt about the Company’s ability to continue as a going concern.  The consolidated financial statements do notinclude any adjustments that might result from the outcome of this uncertainty.  The Company has conducted discussions withseveral banks regarding a credit facility.

 

 

10

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Our capital requirements depend on a varietyof factors, including, but not limited to, the rate of increase or decrease inits existing business base; the success, timing, and amount of investmentrequired to bring new products on-line; revenue growth or decline; andpotential acquisitions. Providing we are successful in obtaining the creditfacility and in raising additional equity capital, of which there can be noassurance, management believes that we will have the financial resources tomeet its future business requirements for at least the next twelve months.

 

The financial information in these financialstatements includes an allocation of expenses incurred by ADS on behalf of theCompany as discussed in Note 8. However, these financial statements may not necessarily be indicative ofthe results that may have occurred had AWG been a separate, independent entityduring the periods presented or of future results of the Company.

 

**Accounting Changes**

Effective January1, 2002, the Company adopted Statement of Financial Accounting Standard No.142, Goodwill and Other Intangible Assets (FAS 142).  FAS 142 requires that goodwill and certain intangibles no longerbe amortized but instead tested for impairment at least annually.  There was no impairment of goodwill uponadoption of FAS 142.  However, there canbe no assurance that future goodwill impairment tests will not result inimpairment charges.

The followingtable presents the impact of FAS 142 on net income (loss) and net income (loss)per share had the standard been in effect for the three months ended March 31,2001:

|                                               |   | **Three**           |   |
|----------------------------------------------------|--------|---------------------|--------|
|                                               |   | **Months  Ended**   |   |
|                                               |   | **March 31,  2001** |   |
| **Net income (loss):**                             |   |                |   |
| Net loss as restated                               |   | $                   | (2,011 | ) |
| Goodwill amortization                              |   | 1,935               |   |
| Equity method investment amortization              |   | 113                 |   |
| Adjusted net income                                |   | $                   | 37     |   |
|                                               |   |                |   |
| **Basis and diluted income (loss) per share:**     |   |                |   |
| Net loss per share, basis and diluted, as reported |   | $                   | (0.11  | ) |
| Goodwill amortization                              |   | 0.10                |   |
| Equity method investment amortization              |   | 0.01                |   |
| Adjusted net income per share, basic and diluted   |   | $                   | 0.00   |   |

Amortization expense of other intangible assetstotaled $64 and $10 for the three months ended March 31, 2002 and 2001,respectively.

 

 

11

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**2.             Principlesof Consolidation and Combination and Other Matters**

The March 31, 2002consolidated financial statements include the accounts of the Company and itswholly-owned and majority-owned subsidiaries from the date of acquisition.  The combined financial statements ofDecember 31, 2001 and for the three months ended March 31, 2001 include theaccounts of AWG entities under common control. All significant intercompany accounts and transactions have beeneliminated in consolidation and combination. AWG used the equity method of accounting for its investments which areless than majority owned, but over which it had significant influence.

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

For softwareconsulting and development services, the Company recognizes revenue based onthe percent complete for fixed fee contracts, with the percent complete beingcalculated as either the number of direct labor hours in the project to datedivided by the estimated total direct labor hours or based upon the completionof specific task orders.  It is theCompany's policy to record contract losses in their entirety in the period inwhich such losses are foreseeable.  Fornon fixed fee jobs, revenue is recognized based on the actual direct laborhours in the job times the standard billing rate and adjusted to realizablevalue, if necessary.  For product sales,the Company recognizes revenue at the time products are shipped and title hastransferred, provided that a purchase order has been received or a contract hasbeen executed, there are no uncertainties regarding customer acceptance, thesales price is fixed and determinable and collectability is deemedprobable.  If uncertainties regardingcustomer acceptance exists, revenue is recognized when such uncertainties areresolved.  There are no significantpost-contract support obligations at the time of revenue recognition.  The Company's accounting policy regardingvendor and post-contract support obligations is based on the terms of thecustomers' contract, billable upon the occurrence of the post-salesupport.  Costs of goods sold arerecorded as the related revenue is recognized. The Company provides warranties on certain of its products.  Estimated warranty costs are accrued in thesame period in which the related revenue is recognized, based on anticipatedparts and labor cost and utilizing historical experience.  The Company does not offer a warranty policyfor services to customers.  Revenuesfrom contracts that provide unlimited services are recognized ratably over theterm of the contract.  Fixed feerevenues from contracts for services are recorded when earned and excludesreimbursable costs.  Reimbursable costsincurred in performing such services are presented on a net basis and includetransportation, medical and communication costs.  Other revenues are recognized at the time services or goods areprovided.

**4.             Inventory**

|                                  |   | **March 31,  2002** |   | **December  31,  2001** |   |
|---------------------------------------|--------|---------------------|--------|-------------------------|--------|
| Raw materials                         |   | $                   | 1,356  |                    | $      | 1,474 |   |
| Work in process                       |   | 190                 |   | 176                     |   |
| Finished goods                        |   | 5,668               |   | 5,611                   |   |
|                                  |   | 7,214               |   | 7,261                   |   |
| Allowance for excess and obsolescence |   | (1,275              | )      | (1,442                  | )      |
| Net inventory                         |   | $                   | 5,939  |                    | $      | 5,819 |   |

**5.**             **Loss PerShare**

The following is a reconciliation of the numerator anddenominator of basic and diluted loss per share:

 

 

12

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|                                         |   | **Three Months Ended March 31,** |    |
|----------------------------------------------|--------|----------------------------------|---------|
|                                         |   | **2002**                         |    | **2001** |   |
| **Numerator:**                               |   |                             |    |   |   |
| Net loss                                     |   | $                                | (22,511 | ) | $ | (2,011 | ) |
|                                         |   |                             |    |   |   |
| **Denominator:**                             |   |                             |    |   |   |
| Denominator for basic  loss per share — |   |                             |    |   |   |
| Weighted-average shares                      |   | 19,063                           |    | 18,750 |   |
| Denominator for diluted loss per share(1)    |   | 19,063                           |    | 18,750 |   |
| **Basic and diluted loss per share:**        |   | $                                | (1.18   | ) | $ | (0.11 | ) |

----

(1) Potentially dilutivesecurities excluded from the computation of diluted loss per share because todo so would have been anti-dilutive are as follows.

|                   |   | **Three Months Ended March 31,** |   |
|------------------------|--------|----------------------------------|--------|
|                   |   | **2002**                         |   |
| Employee stock options |   | 4,923                            |   |
| Warrants               |   | 1,239                            |   |
|                   |   | 6,162                            |   |

 

 

 

13

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**6.**                                      Segment Information

The Company is engaged inthe business of developing and bringing to market proprietary technologies usedto identify, locate and monitor people, animals and objects.  Prior to March 27, 2002, the Companyoperated in four segments — Animal Tracking, Digital Angel Technology, DigitalAngel Delivery System, and Radio Communications and Other.  With the acquisition of Medical AdvisorySystems, Inc. in March 2002, the Company re-organized into four segments:  Animal Applications, Digital Angel Systems,GPS and Radio Communications, and Physician Call Center and Other.  Animal Applications is the new name of oursegment previously identified as Animal Tracking.  We combined our Digital Angel Technology Segment with our DigitalAngel Delivery System segment to form the new Digital Angel Systems segment,which is now managed as a single business unit.  GPS and Radio Communications is the new name of our segmentpreviously identified as Radio Communications and Other.  Physician Call Center and Other reflects thenewly acquired Medical Advisory Systems, Inc. business.  Prior period segment information has beenrestated to reflect our current segment structure.

The accounting policiesof the operating segments are the same as those described in the summary ofaccounting policies in the Company’s audited financial statements for the yearended December 31, 2001.  It is on thisbasis that management utilizes the financial information to assist in makinginternal operating decisions.  TheCompany evaluates performance based on stand-alone segment operating income.

Following is the selected segment data as of and forthe three months ended March 31, 2002:
|                                                                                                                     |   | **Animal Applications** |   | **Digital Angel Systems** |   | **GPS and Radio Communications** |   | **Physician Call Center and Other** |   | **Corporate / Unallocated** |   | **Consolidated** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|---------------------------|--------|----------------------------------|--------|-------------------------------------|--------|-----------------------------|--------|------------------|--------|
| Net revenue from  external customers:                                                                                    |   |                    |   |                      |   |                             |   |                                |   |                        |   |             |   |
| Product                                                                                                                  |   | $                       | 4,815  |                      | $      | —                           |   | $                                   | 2,636  |                        | $      | —           |   | $ | — |   | $ | 7,451 |   |
| Service                                                                                                                  |   | —                  |   | 303                       |   | —                           |   | —                              |   | —                      |   | 303              |   |
| Total revenue                                                                                                            |   | $                       | 4,815  |                      | $      | 303                              |   | $                                   | 2,636  |                        | $      | —           |   | $ | — |   | $ | 7,754 |   |
|                                                                                                                     |   |                    |   |                      |   |                             |   |                                |   |                        |   |             |   |
| Income (loss)  from operations before provision for income taxes, minority interest and  equity in net loss of affiliate |   | $                       | 288    |                      | $      | (1,791                           | )      | $                                   | (271   | )                           | $      | —           |   | $ | (20,487 | )(1) | $ | (22,261 | ) |
|                                                                                                                     |   |                    |   |                      |   |                             |   |                                |   |                        |   |             |   |
| Total assets                                                                                                             |   | $                       | 79,559 |                      | $      | 14,448                           |   | $                                   | 5,587  |                        | $      | 31,700           |   | $ | — |   | $ | 131,294 |   |

----

Two customers accounted for approximately 13.4% and 12.5% of our AnimalApplications revenue.  We buy most ofour syringe injectible microchips that are used in our electronicidentification products from one supplier.

 

(1)  Consists of $18,681non-cash compensation expense associated with Digital Angel options convertedinto options to acquire MAS stock and $1,806 interest expense associated withADS obligations to IBM Credit Corporation.

 

 

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Following is the selectedsegment data as of and for the three months ended March 31, 2001:

 
|                                                                                                                    |   |             |   |               |   |               |   | **Physician  Call** |   |         |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|------------------|--------|--------------------|--------|--------------------|--------|---------------------|--------|--------------|--------|
|                                                                                                                    |   | **Animal**       |   | **Digital  Angel** |   | **GPS and  Radio** |   | **Center and**      |   |         |   |
|                                                                                                                    |   | **Applications** |   | **Systems**        |   | **Communications** |   | **Other**           |   | **Combined** |   |
| Net revenue from external customers:                                                                                    |   |             |   |               |   |               |   |                |   |         |   |
| Product                                                                                                                 |   | $                | 6,382  |               | $      | -                  |   | $                   | 2,752  |         | $      | - |   | $ | 9,134 |   |
| Service                                                                                                                 |   | -                |   | 1,070              |   | -                  |   | -                   |   | $            | 1,070  |   |
| Total revenue                                                                                                           |   | $                | 6,382  |               | $      | 1,070              |   | $                   | 2,752  |         | $      | - |   | $ | 10,204 |   |
| Income (loss) from operations before  provision for income taxes, minority interest and equity in net loss of affiliate |   | $                | (1,040 | )                  | $      | (565               | )      | $                   | (294   | )            | $      | - |   | $ | (1,899 | ) |
| Total assets                                                                                                            |   | $                | 93,874 |               | $      | 11,441             |   | $                   | 6,691  |         | $      | - |   | $ | 112,006 |   |

** **

**Three customers provided forapproximately 17%, 14% and 13% of our Animal Applications revenue.**

** **

** **

**15**

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**7.             Acquisitions**

The following describesthe acquisition by the Company during the quarter ended March 31, 2002:
| **Company Acquired**            |   | **Date  Acquired** |   | **Acquisition  Price** |   | **Acquisition  Costs** |   | **Value of  Shares, Warrants & Options Issued or Issuable** |   | **Common/  Preferred Shares Issued** |   | **Goodwill  and Other  Intangibles  Acquired** |   | **Business  Description**                                           |   |
|---------------------------------|--------|--------------------|--------|------------------------|--------|------------------------|--------|-----------------------------------------------------------------|--------|--------------------------------------|--------|------------------------------------------------|--------|---------------------------------------------------------------------|--------|
| 2002 Acquisition:               |   | 03/27/02           |   | $31,208                |   | $2,790                 |   | $28,418                                                         |   | 5,218                                |   | $29,386                                        |   | Provider  of medical assistance and technical products and services |   |
| Medical Advisory Systems,  Inc. |   |               |   |                   |   |                   |   |                                                            |   |                                 |   |                                           |   |                                                                |

 

On February 27, 2001, ADSacquired approximately 16.6% of the capital stock of MAS (AMEX:DOC), a providerof medical assistance and technical products and services, in a transactionvalued at approximately $8.3 million in consideration for 3.3 million shares ofADS’s common stock.  ADS controlled twoof the seven seats on the Company’s Board of Directors and became the largestsingle shareholder.  This investment wasaccounted for under the equity method from February 27, 2001 through March 27,2002.  The excess of the purchase priceover the estimated fair value of the shares acquired was approximately $6.8million (goodwill) and was being amortized on a straight-line basis over fiveyears, through December 31, 2001.

On March 27, 2002,Digital Angel Corporation merged with a wholly-owned subsidiary of MAS.  For accounting purposes, AWG is treated asthe acquirer, and the assets and liabilities of MAS were recorded at fair valueunder the purchase method of accounting. The consolidated financial statements reflect the results of operationsof MAS from the date of acquisition. The costs of acquisitions include all payments according to theacquisition agreements plus costs for investment banking services, legal andaccounting services that were direct costs of acquiring these assets.

The cost of theMarch 27, 2002 acquisition consisted of 5.218 million shares of common stockvalued at $25.0 million, 1.2 million options and 75,000 warrants valued at $3.4million, and acquisition costs of $2.8 million.  The valuation of the stock is based on the fair value of theshares of MAS held by stockholders other than Applied Digital Solutions priorto the acquisition.  Included in theacquisition costs are certain severance liabilities of $2.5 million, related toemployment agreements of two officers of MAS. The value of the options and warrants is based on the fair value of theoptions and warrants of MAS at the date of acquisition.  The fair value was determined using theBlack-Scholes option pricing model.

In considering thebenefits of a merger of AWG and MAS, the management of AWG recognized thestrategic advantage of combining the advanced wireless technologies beingdeveloped by AWG with the physician staffed call center of relatedinfrastructure of MAS.  One of the principalbenefits of such a combination would be the ability of AWG to offer a complete“end-to-end solution” to the various vertical markets for Digital AngelTMproducts.

 

 

16

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Unaudited pro formaresults of operations for the three months ended March 31, 2002 and 2001 areincluded below.  Such pro formainformation assumes that the above acquisition had occurred as of January 1,2002 and 2001, respectively, and revenue is presented in accordance with the Company'saccounting policies.

 
|                                               |   | **Three  Months Ended   March 3l,** |    | **Three  Months Ended  March 3l,** |   |
|----------------------------------------------------|--------|-------------------------------------|---------|------------------------------------|--------|
|                                               |   | **2002**                            |    | **2001**                           |   |
| Net operating revenue                              |   | $                                   | 8,304   |                               | $      | 11,278 |   |
| Net Loss                                           |   | $                                   | (23,965 | )                                  | $      | (2,346 | ) |
| Net Loss per common share — basic and diluted |   | $                                   | (1.00   | )                                  | $      | (0.10 | ) |
|                                                    |        |                                     |         |                                    |        |  |  |  |  |

 

 

**8.             Contingencies**

**Silva, et al. v. Customized Services Administrators,Incorporated, dba CSA Travel Protection, Inc. et al., No. CV798528 (Santa ClaraCounty Superior Court)**

OnMay 29, 2001, Janet Silva, individually and as Guardian*ad Litem* for Jonathan Silva, a minor, andthe Estate of Clarence William Silva, Jr. (collectively, “Plaintiffs”) filedsuit against Customized Services Administrators, Incorporated (“CSA”),Pricesmart, Inc. (“Pricesmart”), Commercial Union Insurance Company(“Commercial Union”), CGU Insurance Group, and the Company (collectively the“Defendants”) in the Superior Court of the State of California in and for theCounty of Santa Clara.  The allegationsof the complaint arise from a vacation guarantee insurance policy (the“Insurance Contract”) allegedly purchased by Plaintiffs from Defendants onMarch 6, 2000.  The complaint alleges,among other things, that Defendants breached the Insurance Contract, defraudedPlaintiffs, acted in bad faith, engaged in deceptive and unlawful businesspractices, resulting in the wrongful death of Clarence William Silva, Jr. (the“Deceased”) and the intentional infliction of emotional distress onPlaintiffs.  The complaint seeks thecost of funeral and burial expenses of the Deceased and amounts constitutingthe loss of financial support of the Deceased, general damages, attorney’s feesand costs, and exemplary damages.

 

CSA has filed a cross-claimagainst the Company alleging that the Company should be held liable for anyliability that CSA may have to Plaintiffs. The Company has denied the allegations of the complaint and the CSAcross-claim and is vigorously contesting all aspects of this action.

 

The Company is party to various other legal proceedings.  In the opinion of management, theseproceedings are not likely to have a material adverse effect on the financialposition, cash flows or overall trends in results of the Company.  The estimate of potential impact on theCompany’s financial position, overall results of operations or cash flows forthe above legal proceedings could change in the future.

 

 

17

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** **

**9.             Related Party Activity**

                ADS provides certain general andadministrative services to the Company including finance, legal, benefits andother miscellaneous items.  The cost ofthese services are included in the Company’s Statements of Operations based onutilization, which management believes to be reasonable.  Cost of these services were $0.2 million and$0.2 million for the three months ended March 31, 2002 and 2001,respectively.  ADS also charged theCompany $1.8 million of interest expense in 2002, for which the liability wasconverted to a capital contribution.  Inaddition, accrued expenses of $302,000 were relieved and contributed to capitalby ADS.  Other transactions resulted ina due from ADS of $0.1 million at March 31, 2002.

In connection withcertain obligations of ADS, the Company has the following convenants.  Minimum Cumulative EBITDA, as defined, inthe credit agreement, excludes non-cash compensation expense, one-time charges,impairment losses and any liability or claim that will be satisfied by issuanceof the Company's common stock.
| **COVENANT**                          |   | **COVENANTS REQUIREMENT** |   |
|---------------------------------------|--------|---------------------------|--------|
|                                  |   |                      |   |
| Current Assets to Current Liabilities |   | June 30, 2002             |   | 1.8:1 |   |
|                                  |   | September 30, 2002        |   | 1.8:1 |   |
|                                  |   | December 31, 2002         |   | 2.0:1 |   |
|                                  |   |                      |   |   |   |
| Minimum Cumulative Modified EBITDA    |   | June 30, 2002             |   | 577,000 |   |
|                                  |   | September 30, 2002        |   | 1,547,000 |   |
|                                  |   | December 31, 2002         |   | 3,329,000 |   |

 

The Companybelieves that when the second quarter results are finalized, it may not be incompliance with certain of the covenants. Although ADS will request a waiver from its lender, there can be noassurances that a waiver will be obtained.

**10.          Investmentin Affiliates**

                Thechange in the Company's investment in affiliates is as follows:
|                                             |   |   |   |
|--------------------------------------------------|--------|--------|--------|
| Balance December 31, 2001                        |   | 6,779  |   |
|                                             |   |   |   |
| Equity in net loss of affiliate                  |   | (291   | )      |
|                                             |   |   |   |
| MAS common shares transferred to ADS             |   | (6,488 | )      |
|                                             |   |   |   |
| MAS affiliates obtained through merger (at cost) |   | 256    |   |
|                                             |   |   |   |
| Balance March 31, 2002                           |   | 256    |   |

**11.          SubsequentEvents**

On June 27, 2002, theCompany granted 3,910,000 options to employees and directors of theCompany.  The options have an exerciseprice of $3.39, the fair value of the Company’s common stock on the date ofgrant, and expire in 10 years. 3,000,000 of the options vest one year from the date of grant and theremaining vest one-third annually beginning on the first anniversary of thegrant date.

The Company adopted the Digital Angel Corporation Transition StockOption Plan, which as amended, provides for 11.2 million shares of common stockfor which options and other grants may be granted.

 

 

18

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**Item2.****                                  ****Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

The following discussionand analysis of our financial condition and results of operations should beread in conjunction with the accompanying financial statements and relatednotes thereto.

We consist of MAS and its three subsidiaries, which formerly weresubsidiaries of Applied Digital Solutions, Inc. (“ADS”) — Digital AngelCorporation (“DAC”), Timely Technology Corp. and Signature Industries,Limited.  These three subsidiaries wereknown as the Advanced Wireless Group (“AWG”). DAC is engaged in the business of developing and bringing to marketproprietary technologies used to identify, locate and monitor people, animalsand objects.  DAC is the result of themerger in September 2000 of Destron Fearing Corporation and Digital Angel.netInc., which was then a wholly-owned subsidiary of ADS. Before March 27, 2002,the business of DAC was operated in four segments:  Animal Tracking, Digital Angel Technology, Digital Angel DeliverySystem, and Radio Communications and Other. With the acquisition of MAS in March 2002, the Company re-organized intofour segments:  Animal Applications,Digital Angel Systems, GPS and Radio Communications, and Physician Call Centerand Other.  Animal Applications is thenew name of our segment previously identified as Animal Tracking.  We combined our Digital Angel TechnologySegment with our Digital Angel Delivery System segment to form the new DigitalAngel Systems segment, which is now managed as a single business unit.  GPS and Radio Communications is the new nameof our segment previously identified as Radio Communications and Other.  Physician Call Center and Other reflects thenewly acquired MAS business.  Priorperiod segment information has been restated to reflect our current segmentstructure.

 

 

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        **RESULTS OF OPERATIONS**

The following tablesummarizes our results of operations as a percentage of net operating revenuefor the three months ended March 31, 2002 and 2001 and is derived from theaccompanying consolidated and combined statements of operations included inthis report.
|                                                                                                            |   | **Three Months Ended  March 31,** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                                            |   | **2002**                          |   | **2001** |   |
|                                                                                                            |   | **%**                             |   | **%** | ** ** |
| Product revenue                                                                                                 |   | 96.1                              |   | 89.5 |   |
| Service revenue                                                                                                 |   | 3.9                               |   | 10.5 |   |
| Total revenue                                                                                                   |   | 100.0                             |   | 100.0 |   |
| Cost of products sold                                                                                           |   | 55.5                              |   | 52.5 |   |
| Cost of services sold                                                                                           |   | 3.2                               |   | 5.4 |   |
| Total cost of products and services sold                                                                        |   | 58.7                              |   | 57.9 |   |
| Gross profit                                                                                                    |   | 41.3                              |   | 42.1 |   |
| Selling,  general and administrative expenses                                                                   |   | 34.3                              |   | 24.5 |   |
| Management  fees — Applied Digital Solutions, Inc.                                                         |   | 2.5                               |   | 1.9 |   |
| Research  and development expenses                                                                              |   | 17.2                              |   | 10.6 |   |
| Non-cash  compensation expense                                                                                  |   | 240.9                             |   | — |   |
| Depreciation  and amortization                                                                                  |   | 9.5                               |   | 23.1 |   |
| Interest income                                                                                                 |   | (0.0                              | )      | (0.0 | ) |
| Interest  expense                                                                                               |   | 24.0                              |   | 0.6 |   |
| Loss  from operations before provision for income taxes, minority interest and  equity in net loss of affiliate |   | (287.1                            | )      | (18.6 | ) |
| Provision for income taxes                                                                                      |   | 0.0                               |   | 1.1 |   |
| Loss from operations before minority interest and equity in net loss  of affiliate                              |   | (287.1                            | )      | (19.7 | ) |
| Minority interest                                                                                               |   | (0.6                              | )      | (0.2 | ) |
| Equity in net loss of affiliate                                                                                 |   | 3.8                               |   | 0.2 |   |
| Net loss                                                                                                        |   | (290.3                            | )      | (19.7 | ) |

 

 

20

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**Revenue**

Revenue from operationsfor the three months ended March 31, 2002 was $7.8 million, a decrease of $2.4million, or 24%, from $10.2 million in the three months ended March 31, 2001.

Revenue for each of theoperating segments was:

|                                        |   | **Three Months Ended   March 31,** |   | **Three Months Ended   March 31,** |   |
|---------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                        |   | **2002**                           |   | **2001**                           |   |
| Animal Applications — Product          |   | $                                  | 4,815  |                               | $      | 6,382 |   |
| Digital Angel Systems — Service        |   | 303                                |   | 1,070                              |   |
| GPS and Radio Communications — Product |   | 2,636                              |   | 2,752                              |   |
| Total                                       |   | $                                  | 7,754  |                               | $      | 10,204 |   |

 

The Animal Applicationssegment’s revenue decreased $1.6 million, or 24.6%, in the first three monthsof 2002 from the first three months of 2001. The decline is due primarily to the timing of sales of transponders tothe fisheries industry customers, as well as higher sales in the first quarterof 2001 to a large customer to prepare for the launch of the pet identificationproduct in France.

The Digital Angel Systemssegment’s revenue decreased $0.8 million, or 71.7%, in the first three monthsof 2002 from the first three months of 2001 due to completed client assignmentsthat were not replaced.

The GPS and RadioCommunications segment’s revenue decreased $0.1 million, or 4.2 %, in the firstthree months of 2002 compared to the first three months of 2001 primarily as aresult of seasonal order fluctuations.

**Gross Profit and Gross Profit Margin**

Gross profit for thethree months ended March 31, 2002 was $3.2 million, a decrease of $1.1 million,or 25.4%, from $4.3 million in the three months ended March 31, 2001.  As a percentage of revenue, the gross profitmargin was 41.3% and 42.1% for the three months ended March 31, 2002 and 2001,respectively.

Gross profit fromoperations for each operating segment was:

|                                        |   | **Three Months Ended   March 31,** |   | **Three Months Ended   March 31,** |   |
|---------------------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                                        |   | **2002**                           |   | **2001**                           |   |
| Animal Applications — Product          |   | $                                  | 1,879  |                               | $      | 2,491 |   |
| Digital Angel Systems — Service        |   | 52                                 |   | 522                                |   |
| GPS and Radio Communications — Product |   | 1,272                              |   | 1,281                              |   |
| Total                                       |   | $                                  | 3,203  |                               | $      | 4,294 |   |

 

Gross profit margin fromoperations for each operating segment was:

|                                        |   | **Three Months Ended   March 31,** |   | **Three Months Ended   March 31,** |       |
|---------------------------------------------|--------|------------------------------------|--------|------------------------------------|------------|
|                                        |   | **2002**                           |   | **2001**                           |       |
|                                        |   | **%**                              |   | **%**                              | ** ** |
| Animal Applications — Product          |   | 39.0                               |   | 39.0                               |       |
| Digital Angel Systems — Service        |   | 17.2                               |   | 48.8                               |       |
| GPS and Radio Communications — Product |   | 48.3                               |   | 46.5                               |       |
| Total                                       |   | 41.3                               |   | 42.1                               |       |

 

 

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The AnimalApplications segment’s gross profit decreased $0.6 million in the first threemonths of 2002 from the first three months of 2001 due to the previouslymentioned sales decrease.  Marginsremained constant at 39.0%.

The Digital AngelSystems segment’s gross profit decreased $0.5 million, or 90.0%, in the firstthree months of 2002 as compared to the first three months of 2001.  Margins decreased to 17.2% in the firstthree months of 2002 from 48.8% in the first three months of 2001.  The gross profit decrease was primarily dueto the sales decline.  The marginpercentage declined due to the retention of personnel subsequent to the salesclient contract completion as resources were shifted to support the DigitalAngelTM products.

The GPS and RadioCommunications segment’s gross profit was $1.3 million for the first threemonths of 2002 and the first three months of 2001.  The gross margin percentage increased to 48.3% in the first threemonths of 2002 compared to 46.5% in the first three months of 2001 due to afavorable shift in the product mix.

**Selling, General and AdministrativeExpenses**

Selling general andadministrative expenses from operations increased $18.8 million, or 724.9% inthe first three months of 2002 as compared to the first three months of2001.  The increase was caused primarilyby an $18.7 million charge arising from the remeasurement of options inconnection with the merger.  Pursuant tothe terms of the merger agreement, options to acquire shares of Digital Angelcommon stock were converted into options to acquire shares of MAS common stockeffective March 27, 2002. The conversion resulted in a new measurement date forthe options and, as a result, the Company recorded a charge of approximately$18.7 million in non-cash compensation expense during the three months endedMarch 31, 2002. For current employees of the Company, these options areconsidered fixed awards under APB Opinion No. 25, and expense was recorded forthe intrinsic value of the options converted. For all others, expense was recorded for the fair value of the optionsconverted using the Black-Scholes option-pricing model.  As a percentage of revenue, selling, generaland administrative expenses were 275.2% and 23.5% for the three months endedMarch 31, 2002 and 2001, respectively.

Selling, general and administrative expenses for eachof the operating segments excluding the $18.7 million charge were:

|                         |   | **Three Months Ended   March 31,** |   | **Three Months Ended   March 31,** |   |
|------------------------------|--------|------------------------------------|--------|------------------------------------|--------|
|                         |   | **2002**                           |   | **2001**                           |   |
| Animal Applications          |   | $                                  | 1,015  |                               | $      | 874 |   |
| Digital Angel Systems        |   | 228                                |   | 214                                |   |
| GPS and Radio Communications |   | 1,417                              |   | 1,413                              |   |
| Total                        |   | $                                  | 2,660  |                               | $      | 2,501 |   |

Selling, general andadministrative expenses as a percentage of revenue for each of the operatingsegments were:

|                         |   | **Three Months Ended   March 31,** |   | **Three Months Ended   March 31,** |       |
|------------------------------|--------|------------------------------------|--------|------------------------------------|------------|
|                         |   | **2002**                           |   | **2001**                           |       |
|                         |   | **%**                              |   | **%**                              | ** ** |
| Animal Applications          |   | 21.1                               |   | 13.7                               |       |
| Digital Angel Systems        |   | 75.2                               |   | 20.0                               |       |
| GPS and Radio Communications |   | 53.8                               |   | 53.6                               |       |
| Total                        |   | 34.3                               |   | 24.5                               |       |

 

The Animal Applicationssegment’s selling, general and administrative expenses increased $0.1 millionin the first three months of 2002 compared to the first three months of 2001and as a percentage of revenue increased to 21.1% from 13.7% in the samerespective periods.  The increase in thedollars was due to significant increases in non-personnel expenses, partiallyoffset by workforce cost reductions.

The Digital Angel Systems segment’s selling, generaland administrative expenses remained constant at $0.2 million in the firstthree months of 2002 compared to the first three months of 2001.  Selling, general and administrative expensesincreased as a percentage of revenue to 75.2% in the first three months of 2002compared to 20.0% in the first three months of 2001 as a result of lowerrevenues as previously discussed.

 

 

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The GPS and RadioCommunications segment’s selling, general and administrative expenses remainedapproximately the same in the first three months of 2002 compared to the firstthree months of 2001.    As a percentageof revenue, selling, general and administrative expenses increased to 53.8% inthe first three months of 2002 from 53.6% in the first three months of 2001.

**ManagementFees — Applied Digital Solutions, Inc.**

Managementfees charged by Applied Digital Solutions, Inc. amounted to $0.2 million forthe three months ended March 31, 2002 and 2001.  These fees were for general and administrative services performedfor us.  After March 31, 2002, we willno longer pay a management fee to ADS.

**Research and Development Expense**

Research and developmentexpense from operations was $1.3 million in the three months ended March 31,2002, an increase of $0.2 million, or 18.2%, from $1.1 million for the threemonths ended March 31, 2001.  As apercentage of revenue, research and development expense was 17.2% and 10.6% forthe three months ended March 31, 2002 and 2001, respectively.

Research and development expense for each of theoperating segments was:

|                         |   | **Three Months Ended March 31,** |   | **Three Months Ended March 31,** |   |
|------------------------------|--------|----------------------------------|--------|----------------------------------|--------|
|                         |   | **2002**                         |   | **2001**                         |   |
| Animal Applications          |   | $                                | 244    |                             | $      | 302 |   |
| Digital Angel Systems        |   | 1,087                            |   | 782                              |   |
| GPS and Radio Communications |   | —                           |   | —                           |   |
| Total                        |   | $                                | 1,331  |                             | $      | 1,084 |   |

Thesignificant increase is due to research and development activities associatedwith the Digital AngelTM product.

**Depreciation and Amortization**

Depreciation andamortization expense from operations was $0.7 million in the three months endedMarch 31, 2002, a decrease of $1.7 million, or 70.8%, from $2.4 million in thethree months ended March 31, 2001.  As apercentage of revenue, the depreciation and amortization expense was 9.5% and23.1% for the three months ended March 31, 2002 and 2001, respectively.

The decrease wasprimarily due to the adoption of FAS 142, which took effect January 1,2002.  The adoption of FAS 142 requiresthe testing of goodwill for impairment at least annually, eliminating the needfor monthly amortization of goodwill. Accordingly, goodwill amortization was not recorded during the firstthree months of 2002.

Depreciation and amortization expense for each of the operatingsegments was:

 

 

23

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|                         |   | **Three Months Ended March 31,** |   | **Three Months Ended March 31,** |   |
|------------------------------|--------|----------------------------------|--------|----------------------------------|--------|
|                         |   | **2002**                         |   | **2001**                         |   |
| Animal Applications          |   | $                                | 95     |                             | $      | 2,110 |   |
| Digital Angel Systems        |   | 527                              |   | 93                               |   |
| GPS and Radio Communications |   | 113                              |   | 156                              |   |
| Total                        |   | $                                | 735    |                             | $      | 2,359 |   |

 

The increase in theDigital Angel Systems segment’s depreciation and amortization during the firstthree months of 2002 compared to the first three months of 2001 is a result ofincreased amortization related to amortization on purchased software associatedwith the Digital Angel Delivery System that was placed in service in April2001.

**InterestExpense**

Interest expense was $1.9million and $59 thousand for the first three months of 2002 and 2001,respectively.  Interest expense in thefirst three months of 2002 includes interest expense of $1.8 million on thedebt owed to IBM Credit Corporation by Applied Digital Solutions, Inc.  As discussed in Note 1 to the financial statements,on March 27, 2002, ADS restructured its loan agreement with IBM CreditCorporation.  The provisions of thisrestructuring included AWG being released from responsibility to repay thisdebt.  Accordingly, ADS assumed thisliability on March 27, 2002.

**Income Taxes**

AWG had effective income taxrates of 0.0% and a negative 6.4% for the first three months of 2002 and 2001,respectively.  Differences in theeffective income tax rates from the statutory federal income tax rate in 2002arise primarily from valuation allowances recorded on deferred net operatinglosses and in 2001 arise primarily from valuation allowances recorded ondeferred net operating losses, non-deductible goodwill amortization associatedwith acquisitions and state taxes net of federal benefits. The U.S. companiesin AWG were included in ADS’s consolidated federal income tax return throughMarch 27, 2002.  MAS and itssubsidiaries file a separate consolidated federal income tax return.  After March 27, 2002, AWG’s U.S.subsidiaries will file a consolidated federal tax return with MAS.

**LIQUIDITYAND CAPITAL RESOURCES FROM OPERATIONS**

As of March 31,2002, cash and cash equivalents totaled $0.9 million, an increase of $0.3million, or 50.0%, from $0.6 million at December 31, 2001.  Through March 27, 2002, AWG used a cashmanagement system to apply excess cash on hand against advances due toADS.  Cash (used in) and provided byoperating activities totaled ($0.6) million and $30 thousand in the first threemonths of 2002 and 2001, respectively. In the first three months of 2002, the use of cash was due to the netloss, after adjusting for non-cash charges and increases in other currentassets.  Partially offsetting these usesof cash were increases in cash from decreases in accounts receivable andincreases in accounts payable and accrued expenses. 

Accounts receivable, net of allowance for doubtfulaccounts, decreased by $0.8 million, or 14.8%, to $4.6 million at March 31,2002 from $5.4 million at December 31, 2001. This decrease was due to a seasonal reduction in sales from the threemonths ended December 31, 2001 to the three months ended March 31, 2002,partially offset by an increase as a result of our acquisition of MAS.

 

 

24

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Inventory levelsincreased by $0.1 million to $5.9 million at March 31, 2002 from  $5.8 million at December 31, 2001.  Inventory acquired from our acquisition ofMAS amounted to $0.1 million.

Investment inaffiliates decreased by $6.5 million, or 95.6%, to $0.3 million at March 31,2002 compared to $6.8 million at December 31, 2001.  This decrease was due to our transferring the shares representingour 16.5% ownership in MAS to ADS.  Thisdecrease was partially offset by equity method investments held by MAS thatwere acquired as part of the acquisition of MAS.

Accounts payableincreased by $0.3 million to $4.1 million at March 31, 2002 from $3.8 millionat December 31, 2001.   This was due topayables acquired from the acquisition of MAS.

Accrued expensesincreased by $2.4 million, or 120.0%, to $4.4 million at March 31, 2002 from$2.0 million at December 31, 2001.  Theincrease was due to accrued acquisition costs, and accrued expenses acquiredfrom the acquisition of MAS.

Investingactivities provided cash of $0.1 million in the first three months of 2002, andused cash of  $0.5 million in the firstthree months of 2001.  During the firstthree months of 2002 and 2001, $0.2 million and $0.7 million, respectively,were spent to acquire property and equipment. This was offset in the firstthree months of 2002 by cash acquired, net of acquisition costs, from theacquisition of MAS.

Financingactivities provided cash of $0.4 million and $0.7 million in the first threemonths of 2002 and 2001, respectively. During the first three months of 2002and 2001, cash was provided primarily by additional investments from ADS.

*Debt,Covenant Compliance and Liquidity*

ADS maintains a term andrevolving credit agreement with IBM Credit (IBM Credit). Under the creditagreement in effect through March 27, 2002, IBM Credit maintained liens andsecurity interests in the outstanding capital stock of the three AWGsubsidiaries and on their assets to collateralize ADS’s obligations to IBMCredit under the IBM credit agreement.

 

ADS generated a significantloss from operations in 2000. As a result, ADS was not in compliance withcertain financial covenants of the IBM credit agreement as of December 31,2000. The IBM credit agreement was amended and restated on October 17, 2000 andfurther amended on March 30, 2001. In connection with the amendment on March30, 2001, Digital Angel granted IBM Credit Corporation warrants to acquire 1.2million shares of Digital Angel’s common stock valued at $0.3 million. As ofthe March 30, 2001 amendment, ADS was in compliance with the revised covenants.

 

The IBM credit agreementcontains certain quarterly financial covenants, which became more restrictiveduring 2001. ADS anticipated that it would continue to comply in 2001 with thequarterly financial covenants in the IBM credit agreement. However, ADS was notin compliance with its minimum EBITDA (as defined in the IBM credit agreement)or collateral shortfall covenants at June 30,

 

 

25

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2001. ADS was also not in compliance with theminimum EBITDA, Tangible Net Worth and Current Assets to Current Liabilitiescovenant requirements at September 30, 2001 and it again had a collateralshortfall.  As of December 31, 2001, ADSwas not in compliance with various financial covenants, including minimumTangible Net Worth, EBITDA, the ratio of Current Assets to Current Liabilities,and collateral. The IBM credit agreement was amended and restated on July 1,2001, September 15, 2001, November 15, 2001, December 31, 2001, January 31,2002 and February 27, 2002.  Theseamendments extended the due dates of principal and interest payments under thecredit agreement until April 2, 2002.

 

At December 31, 2001, ADS’soutstanding borrowings under the IBM credit agreement totaled $82.6 million. Atthat time, ADS did not have the funds to repay the borrowings under the IBMcredit agreement. Accordingly, the $82.6 million of outstanding borrowings wasallocated to AWG effective as of September 30, 2001 and was reflected as acurrent obligation in the December 31, 2001 combined balance sheet. Interestassociated with the borrowings was allocated to AWG for the period fromSeptember 30, 2001 to March 27, 2002. Under the terms of the agreement and plan of merger with MAS, the commonstock and assets of the three AWG subsidiaries were released from all liens andsecurity interests under the IBM credit agreement, and the shares of theCompany's common stock beneficially owned by ADS upon completion of the mergerwere transferred to the Digital Angel Share Trust as collateral for thedebt.  ADS assumed the debt which wastreated as a capital contribution resulting in an increase in additionalpaid-in capital of approximately $81.4 million.

 

On March 1, 2002, ADS andDigital Angel Share Trust, a newly created Delaware business trust, and IBMCredit entered into a Third Amended and Restated Term Credit Agreement. The newcredit agreement became effective on March 27, 2002, the effective date of themerger between Digital Angel and MAS. Amounts outstanding under the new creditagreement bear interest at an annual rate of 17% and mature on February 28,2003.  No principal or interest paymentsare due until the maturity date. However, the maturity date will be extendedfor consecutive one-year periods if ADS repays at least 40% of the originalprincipal amount outstanding plus accrued interest and expenses prior toFebruary 28, 2003 and an additional 40% of the original principal amountoutstanding plus accrued interest and expenses prior to February 28, 2004.  In any event, all amounts outstanding willbe required to be repaid by August 15, 2005. If all amounts are not repaid by February 28, 2003, the unpaid amountwill accrue interest at an annual rate of 25%, and if they are not repaid byFebruary 28, 2004, the interest rate increases to 35%.

ADS’s new creditagreement contains debt covenants made by ADS relating to its financialposition and performance, as well as the Company’s financial position andperformance.  The Company's ability tomeet its financial performance requirements and be in compliance throughout2002 with covenants in the new credit agreement that apply to the Companycannot be assured.  If businessconditions are other than as anticipated or other unforeseen events orcircumstances occur, these may impact the ability of ADS and the Company tomaintain compliance with the covenants. In the absence of waiver or amendment to such financial covenants, suchnoncompliance would constitute an event of default under the new credit agreement,and IBM Credit would be entitled to accelerate the maturity of all amounts ADSowes it.  If such noncompliance appearslikely, or occurs, ADS may seek to renegotiate the covenants and/or obtainwaivers, as required.  There can be noassurance, however, that ADS would be successful in negotiating such amendmentsor obtaining such waivers.

On March 27, 2002,upon completion of the merger between Digital Angel and MAS, in satisfaction ofa condition to the consent to the merger by IBM Credit, ADS transferred to aDelaware business trust controlled by an advisory board all of the shares ofour common stock owned by it and, as

 

 

26

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a result, the trust has legal title to approximately 77.15% of ourcommon stock.  The trust has votingrights with respect to our common stock until ADS’s obligations to IBM Creditare repaid in full.  The trust may beobligated to liquidate the shares of our common stock owned by it for thebenefit of IBM Credit if ADS fails to make payments, or otherwise defaults,under its new credit agreement with IBM Credit.

To date, financing fromacquisitions, ADS’s advances and revenue generated from operations have beenour primary sources of funding. However, we do not anticipate receivingadditional advances from ADS.  Weestimate that we will need to obtain approximately $5 million to $7 million inadditional funding over the next twelve months in order to continue our effortsto implement our business plan. As a result, we will need to obtain additionalcapital in the near future. As of the date of these statements, we have helddiscussions with several banks and an asset based lender regarding a creditfacility. Our capital requirements depend on a variety of factors, including,but not limited to, the rate of increase or decrease in our existing businessbase; the success, timing, and amount of investment required to bring newproducts on-line; revenue growth or decline; and potential acquisitions. If weare successful in obtaining the credit facility and in raising additional equitycapital, of which there can be no assurance, management believes that we willhave the financial resources to meet its future business requirements for atleast the next twelve months. See “RISK FACTORS — We Will Need AdditionalFinancing.”

 

**FORWARDLOOKING STATEMENTS AND ASSOCIATED RISKS**

**Forward—Looking Statements and Associated Risk**.

ThisForm 10-Q/A 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 includestatements relating to:

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

•                    anticipated trends in our business and demographics;

•                    our ability to successfully integrate the businessoperations of recently acquired companies;

•                   our future profitability and liquidity; and

•                    regulatory, competitive or other economic influences.

Wordssuch as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,”“estimates” and similar expressions also identify forward-lookingstatements.  These forward-lookingstatements are not guarantees of future performance and are subject to risksand uncertainties that could cause actual results to differ materially fromestimates or forecasts contained in the forward-looking statements.  Some of these risks and uncertainties arebeyond our control.

**RiskFactors**

You shouldcarefully consider the risk factors listed below.  These risk factors may cause our future earnings to be less orour financial condition to be less favorable than we expect.  You should read this section together withthe other information contained herein.

 

 

27

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***As a Result of the Merger and the Transferof Shares of Our Common Stock to the Digital Angel Share Trust, There isUncertainty as to the Future Control of Our Company.***

 

After the merger, insatisfaction of a condition to the consent to the merger of IBM CreditCorporation, ADS transferred to the Digital Angel Share Trust (the “Trust”) allshares of our common stock owned by ADS. As a result, the Trust is the beneficial owner of approximately 77% ofour common stock, and it controls us with respect to all matters upon which ourstockholders may vote, including the selection of the Board of Directors andmergers, acquisitions and other significant corporate transactions.  There can be no assurance as to how theTrust will exercise control over our Company.

 

Upon the request of IBMCredit Corporation, the Trust will be obligated to sell the shares of ourcommon stock owned by ADS for the benefit of IBM Credit Corporation if ADSfails to make payments to IBM Credit Corporation beginning on February 28, 2003or at such time ADS otherwise defaults under the agreement. Such sales may bein private transactions or in the public market. We can give no assurance as towhen or how shares of our common stock will be sold, as to who will purchasesuch shares, or as to the number of shares that may be sold at any given time.As a result, duration of the Trust’s control over us and the identity of anyparties which may acquire control of us if and when such sales commence isuncertain.

 

***Sales of Our Common Stock by the Trust MayCause a Reduction in the Market Value of Our Common Stock.***

 

If amounts due to IBM CreditCorporation by ADS are not paid when due, including at least $33 million onFebruary 28, 2003, plus accrued interest and expenses, or if ADS or the Companyis otherwise in default under its credit agreement and its obligations areaccelerated, IBM Credit Corporation will have the right to require shares ofour common stock held in the Trust to be sold to provide funds to satisfy theobligations of ADS. It is unlikely that ADS will have the funds required forpayment of such obligations. The sale of a significant amount of shares of ourcommon stock owned by the Trust in a single transaction or in a series oftransactions over a short period of time could result in a significant declinein the market value of our common stock.

 

***We May Face Operational and StrategicChallenges That May Prevent Us From Successfully Integrating The MAS Business.***

 

The operation of our Companyafter the merger involves risks related to the integration and management ofacquired properties and operations. We may encounter substantial difficulties,costs and delays in integrating the operations of our subsidiaries with ourbusiness, including:

 

•                      perceived adverse changes in businessfocus;

 

•                      potential conflicts in marketing or otherimportant relationships;

 

•                      loss of key employees or customers;

 

•                      possible inconsistencies in standards,controls, procedures and policies among the companies and the need to implementand harmonize company-wide financial, accounting, information and othersystems;

 

•                      failure to maintain the quality ofproducts and services that such companies have historically provided;

 

 

28

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•                      the need to coordinate geographicallydiverse organizations; and

 

•                      the diversion of management’s attentionfrom the day-to-day operations.

 

 

If we fail to integratethese businesses successfully and/or if we fail to realize the intendedbenefits of the merger, our financial condition and results of operations couldbe adversely affected and the market price of our common stock could declinefrom its current market price.

 

***We May Continue to Incur Losses.***

 

We incurred a net loss of$22.5 million for the three-month period ended March 31, 2002. We also recordeda net loss of $17.4 million and $3.9 million for the years ended December 31,2001 and 2000, respectively. No assurance can be given as to whether or when wewill be profitable. Profitability depends on many factors, including thesuccess of marketing programs, the maintenance and reduction of expenses andthe ability to coordinate successfully the operations of business units. If webecome profitable, of which there is no assurance, we may not be able tosustain or increase profitability. If we fail to achieve and maintainprofitability within the time frame expected by investors, the market price ofour common stock may be adversely affected.

 

***We Depend on the Protection of OurProprietary Technology.***

 

Our success depends partlyon our ability to maintain patent and trade secret protection, to obtain futurepatents and licenses, and to operate without infringing on the proprietaryrights of third parties. There can be no assurance that the measures we havetaken to protect our intellectual property, including those relating to theDigital Angel Systems, will prevent its misappropriation or circumvention. Inaddition, there can be no assurance that any patent application, when filed,will result in an issued patent, or that our existing patents, or any patentsthat may be issued in the future, will provide us with significant protectionagainst competitors. Moreover, there can be no assurance that any patentsissued to or licensed by us will not be infringed upon or circumvented byothers. Litigation to establish the validity of patents, to assert infringementclaims against others, and to defend against patent infringement claims can beexpensive and time-consuming, even if the outcome is in our favor. We also relyto a lesser extent on unpatented proprietary technology, and no assurance canbe given that others will not independently develop substantially equivalentproprietary information, techniques or processes or that we can meaningfullyprotect our rights to such unpatented proprietary technology.

 

***Many Factors Can Negatively Affect theAnimal Identification Market.***

 

The electronic animalidentification market can be negatively affected by such factors as food safetyconcerns, consumer perceptions regarding cost and efficacy, internationaltechnology standards, national infrastructures, United States Food and DrugAdministration (FDA) reviews, United States Federal Communications Commission(FCC) approvals, and slaughterhouse removal of microchips. In addition, certainforeign governmental standards that require specific codes may limit ourability to sell microchips from our current inventory in such countries. Manyof the principal customers for fish electronic identification devices aregovernment contractors that rely on funding from the United States government,and this market could be adversely affected by any decline in the availabilityof government funds. We may be adversely affected by these and other factorsaffecting the animal identification market, which could have an adverse effecton our financial condition and results of operations.

 

 

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***We Depend on a Single Supplier For OurElectronic Identification Products.***

 

We rely largely on aproduction arrangement with Raytheon Corporation for the manufacture of oursyringe-injectable microchips that are used in all of our electronicidentification products. The termination, or any significant reduction, byRaytheon of its production of these microchips could have a material adverseeffect on our financial condition and results of operations. In addition,Raytheon may not be able to produce sufficient quantities to meet anysignificant increased demand for our products or to meet any such demand on atimely basis. Any inability or unwillingness of Raytheon to meet potentiallyincreased demand for our product could have a material adverse effect on ourfinancial condition and results of operations. The Company also has its own microchip production operations located inanother contract facility that we intend to use more intensively to meetadditional product demand.

 

***We Depend on Principal Customers.***

 

For the three months endedMarch 31, 2002, we had three customers of our Animal Applications segment thataccounted for a large portion of our gross revenue.  Biomark, Pacific States Marine, and Schering-PloughPharmaceutical accounted for approximately 12.5%, 13.4%, and 8.7% of our grossrevenues, respectively. In addition, the GPS and Radio Communications segmentis heavily dependent on contracts with domestic government agencies and foreigngovernments, including the United Kingdom, primarily relating to militaryapplications. The loss of, or a significant reduction in, orders from these orour other major customers could have a material adverse effect on our financialcondition and results of operations.

 

***Significant Competition Exists in theVisual and Electronic Identification Markets.***

 

The market for visual andelectronic identification for companion animals and livestock is highlycompetitive. We believe that our principal competitors in the visualidentification market for livestock are AllFlex and Y-Tex, and our principalcompetitor in the electronic identification market that has developed permanentelectronic identification devices for the companion animal market is AllFlex.In addition, other companies could enter this line of business in the future.Certain of our competitors have substantially greater financial and otherresources than we do. We cannot ensure that we will compete successfully orthat our competitors will not succeed in developing or marketing technologiesand products that are more widely accepted than those being developed by us orthat would render our products obsolete or noncompetitive. We are not aware ofcompetitors currently marketing products that would compete with the DigitalAngel technology. However, we are aware of several potential competitors thathave expressed an interest in similar technologies. If such competitors enterthe market and compete with the Digital Angel technology, such competitioncould have a material adverse effect on our financial condition and results ofoperations.

 

***We Are Subject to Government Regulation.***

 

We are subject to federal,state and local regulation in the United States and other countries, and wecannot predict the extent to which we may be affected by future legislative andother regulatory developments concerning our products and markets. We arerequired to obtain regulatory approval before marketing most of our products.Our products are subject to FCC regulations governing electromagneticemissions, and our insecticide products have been approved by the United StatesEnvironmental Protection Agency (EPA) and are produced in accordance with EPAregulations. Sales of insecticide products are incidental to our primarybusiness and do not represent a material part of our operations. Our productsalso are subject to compliance with foreign government agency requirements. Ourcontracts with our distributors generally require the distributor to obtain allnecessary regulatory approvals from the governments of the countries in whichthe distributor sells our products. However, any such approval 

 

 

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may be subject to significant delays. Someregulators also have the authority to revoke approval of previously approvedproducts for cause, to request recalls of products and to close manufacturingplants in response to violations. Any actions by these regulators could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

***The Digital Angel Systems Segment is aDevelopment Stage Enterprise.***

 

The Digital Angel Systemssegment is in the initial stage of operations and is a development stageenterprise. As a result, it has no operating history upon which to base anevaluation of its current business and future prospects. The first DigitalAngel product was introduced in November 2001. Accordingly, this segment hasgenerated no substantial revenues. Moreover, this segment does not currentlyhave any contracts in place that will provide any significant revenue. Inaddition, because of this segment’s lack of an operating history, managementhas limited insight into trends that may emerge and could materially adverselyaffect its business. This segment’s prospects must be considered in light ofthe risks, expenses and difficulties frequently encountered by companies in newand rapidly evolving markets. Stockholders should consider the risks anddifficulties the Digital Angel Systems segment may encounter in its new andrapidly evolving market, especially given the segment’s lack of operatinghistory. These risks include the Digital Angel Technology segment’s ability to:

 

•                    develop and market the Digital Angel technology byintegrating and miniaturizing new technologies into marketable products andservices;

 

•                    build a customer base;

 

•                    generate revenues;

 

•                    compete favorably in a highly competitive market;

 

•                    access sufficient capital to support growth;

 

•                    recruit and retain qualified employees;

 

•                    introduce new products and services; and

 

•                    build technology and support systems.

 

***The Digital AngelTM TechnologyIs Not Proven And We May Not Be Able To Develop Products From This UnprovenTechnology.***

 

The Digital AngelTMSystems segment depends on the development, integration, miniaturization andsuccessful marketing of several pieces of advanced technology that have notpreviously been integrated or used as anticipated by this segment. The DigitalAngelTM Systems segment depends upon advanced technology, including:wireless communication, biosensors, motion determination and global positioningsystem capabilities. Many of these technologies are unproven or relatively new.In addition, these technologies have not been previously integrated orminiaturized into a commercial product. No assurances can be given as to whenor if the Digital AngelTM technology will be successfully marketed.Our ability to develop and commercialize products based on our proprietarytechnology will depend on our ability to develop our products internally on atimely basis or to enter into arrangements with third parties to provide thesefunctions. If we fail to develop and commercialize products successfully, itcould have a material adverse effect on our business, financial condition andresults of operations.

 

 

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***The Digital Angel Systems Segment Expectsto Incur Future Losses and May Not Achieve Profitability.***

 

From the period from January2000 until March 31, 2002, approximately $7.7 million has been invested inresearch and development relating to the Digital AngelTM technology.Our management expects the Digital Angel Systems segment to incur additionaldevelopment, sales and marketing, and other general expenses. As a result, theDigital Angel Systems segment may incur losses for the foreseeable future andwill need to generate revenues to achieve profitability. Even if the segmentachieves profitability, it may not be able to sustain it.

 

 

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***We Depend on a Small Team of SeniorManagement and We May Have Difficulty Attracting and Retaining AdditionalPersonnel.***

 

Our future success is highlydependent upon the continued services and performance of senior management andother key personnel.  If we lose theservices of any member of our senior management team, our overall operationscould be adversely affected. In addition, our future success will depend on ourability to identify, attract, hire, train, retain and motivate other highlyskilled technical, managerial, marketing, purchasing and customer servicepersonnel when they are needed. Competition for these individuals is intense.We cannot ensure that we will be able successfully to attract, integrate or retainsufficiently qualified personnel when the need arises. Any failure to attractand retain the necessary technical, managerial, marketing, purchasing andcustomer service personnel could have a material adverse effect on ourfinancial condition and results of operations.

 

***We Will Need Additional Financing***

 

Our company, especially theDigital Angel Systems segment, currently relies upon the revenue generated byour Animal Applications segment.  Weestimate that we will need to obtain approximately $5.0 million to $7.0 millionin additional funding over the next twelve months in order to continue ourefforts to implement our business plan. As of the date of these financialstatements, we have held discussions with several banks and an asset basedlender regarding credit agreements.

Our actual capital needswill depend on operating losses, development expenses, working capital needsand other factors. Forecasts of such factors are inherently uncertain, and anyvariation in those factors from the levels used in current forecasts couldresult in us needing more capital, or capital earlier, than projected. Capitalcan be difficult and expensive to obtain, and there can be no assurance that wewill be able to obtain additional financing. If this capital is not raised, wemay not be able to execute our business plan, may not be able successfully todevelop and market the Digital AngelTM technology and our financialcondition and results of operations may be materially adversely affected. Todate, we have not been able to obtain this capital. No assurance can be giventhat we will be able to raise this additional necessary capital.

 

If funds are notavailable when required for working capital needs, our ability to carry out ourbusiness plan could be adversely affected and we may be required to scale backgrowth and operations to reflect the extent of available funding. Lendingarrangements will probably include limitations on our ability to incur otherindebtedness, pay dividends, create liens, sell or purchase shares of capitalstock, sell assets or make acquisitions or enter into other transactions. Suchrestrictions may adversely affect our ability to finance future operations orcapital needs or to engage in other business activities. If additional fundsare raised by issuing equity or convertible debt securities, the value of ourstockholders investment may be diluted. These securities may have rights,preferences or privileges senior to those of our common stockholders.

 

Moreover, we may issueadditional shares:

 

•        toemployees;

 

•        inconnection with acquisitions and corporate alliances; and

 

•        toraise capital.

 

Pursuant to a registration rights agreement,the Digital Angel Share Trust and any of its transferees of our common stock,subject to certain terms and conditions, have the right to require us toregister shares of our common stock beneficially owned by them upon demand andany other time we register stock for sale.

 

 

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In addition, IBM CreditCorporation currently holds a warrant to acquire 1,163,906 shares of our commonstock. The warrant is exercisable for five years beginning on April 5, 2002, orearlier under certain circumstances. Under the warrant, IBM Credit Corporation,subject to certain terms and conditions, has the right to require us toregister shares of our common stock subject to the warrant.

 

**IMPACT OF RECENTLY ISSUED ACCOUNTINGSTANDARDS**

In July 2001, the FASBissued FAS No. 141 *Business Combinations* and FAS No. 142 *Goodwill andOther Intangible Assets. *FAS141 requires business combinations initiated after June 30, 2001 to beaccounted for using the purchase method of accounting and broadens the criteriafor recording intangible assets separate from goodwill.  Recorded goodwill and intangibles will beevaluated against these new criteria and may result in certain intangiblesbeing included in goodwill, or alternatively, amounts initially recorded asgoodwill may be separately identified and recognized apart from goodwill.  FAS 142 requires the use of anon-amortization approach to account for purchased goodwill and certainintangibles.  Under a non-amortizationapproach, goodwill and certain intangibles will not be amortized into resultsof operations, but instead would be reviewed for impairment and written downand charged to results of operations only in the periods in which the recordedvalue of goodwill and certain intangibles is more than its fair value. Weadopted the provisions of each statement, which apply to goodwill and certainintangibles acquired prior to June 30, 2001, on January 1, 2002. The adoptionof these standards will have the impact of reducing our amortization ofgoodwill commencing January 1, 2002. There was no impairment of goodwill uponadoption of FAS 142.  Future impairmentreviews may result in periodic write-downs.

In August 2001, the FASB issued FAS 144, *Accounting for the Impairment orDisposal of Long-Lived Assets*. This standard supersedes FAS 121, *Accounting for the Impairment of Long-Lived Assets toBe Disposed Of*, and provides a single accounting model forlong-lived assets to be disposed of. This standard significantly changes thecriteria that would have to be met to classify an asset as held-for-sale. Thisdistinction is important because assets to be disposed of are stated at thelower of their fair values or carrying amounts and depreciation is no longerrecognized. The new rules will also supercede the provisions of APB Opinion 30,*Reportingthe Results of Operations-Reporting the Effects of Disposal of a Segment of aBusiness, and Extraordinary, Unusual and Infrequently Occurring Events andTransactions*, with regard to reporting the effects of a disposal ofa segment of a business and will require expected future operating losses fromDiscontinued Operations to be displayed in Discontinued Operations in theperiod in which the losses are incurred, rather than as of the measurement dateas presently required by APB 30. This statement is effective for fiscal yearsbeginning after December 15, 2001. We adopted this statement on January 1,2002. The adoption of FAS 144 did not have a material impact on our operationsor financial position.

 

 

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| **Item  6.** |   | **Exhibits**                                                              |
|--------------|--------|---------------------------------------------------------------------------|
|         |   |                                                                      |
| 99.1         |   | Certification  Pursuant to 18 U.S.C. Section 1350 of James P. Santelli    |
| 99.2         |   | Certification  Pursuant to 18 U.S.C. Section 1350 of Randolph K. Geissler |

 

 

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**SIGNATURE**

 

                Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.
|                  | Digital  angel corporation(Registrant) |
|-----------------------|----------------------------------------|
|                  |                                   |   |
| Dated: August 8, 2002 | By:                                    | /S/ JAMES P. SANTELLI |
|                  |                                   | James  P. Santelli   Vice President - Finance, Chief   Financial Officer |

 

 

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