**Asfiled with the Securities and Exchange Commission on August 14, 2003**

 

 

**UNITED STATESSECURI**TIES AND EXCHANGE COMMISSION

**WASHINGTON,D. C.  20549**

 

# ****

# ** **

**FORM 10-Q**

**(Mark One)**

 

**ý****        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934.**

 

**For the quarterly period ended June 30, 2003**

 

**or**

 

**o****        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934.**

 

**For the transition periodfrom         to         **

 

**CommissionFile Number:  1-15177**

 

**DIGITAL ANGEL CORPORATION**

(Exact name of registrant asspecified in its charter)

 

| **DELAWARE**                                                     |   | **52-1233960**                     |
|------------------------------------------------------------------|--------|------------------------------------|
| (State or other jurisdiction  of  incorporation or organization) |   | (IRS Employer  Identification No.) |
|                                                             |   |                               |
| **490 Villaume Avenue, South Saint Paul, Minnesota, 55075**      |
| (Address of registrant’s  principal executive offices)      |
|                                                             |   |                               |
| **(651)  455-1621**                                              |
| (Registrant’s telephone  number, including area code)       |

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes     ý    No     o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule12b-2 of the Exchange Act).Yes  o    No  ý

 

As of the close of business on August 1, 2003, therewere 26,951,989 shares outstanding of the issuer’s $0.005 per share par valuecommon stock.

 

 

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**DIGITAL ANGEL CORPORATION**

 

TABLE OF CONTENTS

 
| **Item**          |   | **Description**                                                                             |
|-------------------|--------|---------------------------------------------------------------------------------------------|
|              |   |                                                                                        |
|              |   | PART I –  FINANCIAL INFORMATION                                                        |
|              |   |                                                                                        |
| 1.                |   | Financial  Statements                                                                       |
| 2.                |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
| 3.                |   | Quantitative  and Qualitative Disclosures About Market Risk                                 |
| 4.                |   | Controls  and Procedures                                                                    |
|              |   |
|              |   | PART II  – OTHER INFORMATION                                                           |
|              |   |                                                                                        |
| 1.                |   | Legal  Proceedings                                                                          |
| 6.                |   | Exhibits  and Reports on Form 8-K                                                           |
|              |   |                                                                                        |
| SIGNATURE         |
| INDEX TO EXHIBITS |
|                   |        |                                                                                             |  |

 

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**PART I****    FINANCIAL INFORMATION**

Item 1.             Financial Statements.

 

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS**

(In thousands, except par value)

 
|                                                                                                                                                                                    |   | **June 30,  2003** |       | **December 31,  2002** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|------------------------|------------|
|                                                                                                                                                                                    |   | **(Unaudited)**    |       |                   |       |
| **Assets**                                                                                                                                                                              |   |               |       |                   |       |
| **Current Assets**                                                                                                                                                                      |   |               |       |                   |       |
| Cash and cash equivalents                                                                                                                                                               |   | **$**              | —     |                   | $          | 214 |   |
| Accounts receivable and unbilled  receivables (net of allowance for doubtful accounts of $238 in 2003 and $296  in 2002)                                                                |   | **5,166**          |       | 4,126                  |       |
| Inventories                                                                                                                                                                             |   | **6,670**          |       | 4,945                  |       |
| Other current assets                                                                                                                                                                    |   | **2,331**          |       | 1,478                  |       |
| **Total Current  Assets**                                                                                                                                                               |   | **14,167**         |       | 10,763                 |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Property And  Equipment, net**                                                                                                                                                        |   | **7,623**          |       | 7,769                  |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Goodwill and Other  Intangible Assets, net**                                                                                                                                          |   | **48,740**         |       | 48,893                 |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Other Assets, net**                                                                                                                                                                   |   | **342**            |       | 373                    |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
|                                                                                                                                                                                    |   | **$**              | **70,872** |                   | $          | 67,798 |   |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                           |   |               | ** ** |                   | ** ** |
| **Current Liabilities**                                                                                                                                                                 |   |               |       |                   |       |
| Line of credit and current maturities of  long-term debt                                                                                                                                |   | **$**              | **3,210**  |                   | $          | 816 |   |
| Accounts payable                                                                                                                                                                        |   | **6,352**          |       | 4,142                  |       |
| Accrued expenses and other current  liabilities                                                                                                                                         |   | **4,229**          |       | 3,704                  |       |
| Due to Applied Digital Solutions, Inc.                                                                                                                                                  |   | **415**            |       | 462                    |       |
| **Total Current  Liabilities**                                                                                                                                                          |   | **14,206**         |       | 9,124                  |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Long-Term Debt And  Notes Payable**                                                                                                                                                   |   | **3,289**          |       | 3,314                  |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Deferred Revenue**                                                                                                                                                                    |   | **140**            |       | 50                     |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Total Liabilities**                                                                                                                                                                   |   | **17,635**         |       | 12,488                 |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Commitments And  Contingencies**                                                                                                                                                      |   |               |       |                   |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Minority Interest**                                                                                                                                                                   |   | **188**            |       | 298                    |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
| **Stockholders’  Equity (See Note 1)**                                                                                                                                             |   |               |       |                   |       |
| Preferred stock: Authorized 1,000 in 2002,  of $1.75 par value, no shares issued or outstanding                                                                                         |   | **—**         | ** ** | **—**             | ** ** |
| Common stock: Authorized 95,000 shares, of  $.005 par value; 26,946 shares issued and 26,896 shares outstanding in 2003  and  26,568 shares issued and 26,518  outstanding in 2002 |   | **134**            |       | 133                    |       |
| Additional paid-in capital                                                                                                                                                              |   | **167,620**        |       | 167,365                |       |
| Accumulated deficit                                                                                                                                                                     |   | **(116,326**       | )          | (114,059               | )          |
| Common stock warrants                                                                                                                                                                   |   | **1,801**          |       | 1,801                  |       |
| Treasury stock (carried at cost, 50 shares)                                                                                                                                             |   | **(43**            | )          | (43                    | )          |
| Accumulated other comprehensive loss                                                                                                                                                    |   | **(137**           | )          | (185                   | )          |
| Total Stockholders’ Equity                                                                                                                                                         |   | **53,049**         |       | 55,012                 |       |
|                                                                                                                                                                                    |   |               |       |                   |       |
|                                                                                                                                                                                    |   | **$**              | **70,872** |                   | $          | 67,798 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

1

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

(In thousands, except per share data)

(Unaudited)

 

 
|                                                                                         |   | **For the Three Months  Ended June 30,** |       | **For the Six Months  Ended June 30,** |       |
|----------------------------------------------------------------------------------------------|--------|------------------------------------------|------------|----------------------------------------|------------|
|                                                                                         |   | **2003**                                 |       | **2002**                               |       | **2003** |   | **2002** |   |
|                                                                                         |   |                                     |       |                                   |       |   |   |   |   |
| Product revenue                                                                              |   | **$**                                    | **8,118**  |                                   | $          | 8,506 | ** ** | **$** | **18,983** |   | $ | 15,957 |   |
| Service revenue                                                                              |   | **242**                                  |       | 733                                    | ** ** | **775** |   | 1,036 |   |
| Total net revenue                                                                            |   | **8,360**                                |       | 9,239                                  | ** ** | **19,758** |   | 16,993 |   |
|                                                                                         |   |                                     |       |                                   |       |   |   |   |   |
| Cost of products sold                                                                        |   | **5,064**                                |       | 4,795                                  | ** ** | **10,703** |   | 9,095 |   |
| Cost of services sold                                                                        |   | **254**                                  |       | 389                                    | ** ** | **649** |   | 640 |   |
|                                                                                         |   |                                     |       |                                   |       |   |   |   |   |
| Gross profit                                                                                 |   | **3,042**                                |       | 4,055                                  | ** ** | **8,406** |   | 7,258 |   |
|                                                                                         |   |                                     |       |                                   |       |   |   |   |   |
| Selling, general and administrative  expenses                                                |   | **4,175**                                |       | 4,831                                  | ** ** | **8,455** |   | 27,589 |   |
| Management fees - Applied Digital  Solutions, Inc.                                           |   | —                                   |       | —                                 |       | — |   | 193 |   |
| Research and development expenses                                                            |   | **1,172**                                |       | 657                                    | ** ** | **2,083** |   | 1,306 |   |
| Interest expense - Applied Digital  Solutions, Inc.                                          |   | —                                   |       | —                                 |       | — |   | 1,806 |   |
| Interest expense - others                                                                    |   | **191**                                  | ** ** | 67                                     | ** ** | **329** |   | 125 |   |
| Other income                                                                                 |   | **(42**                                  | **)**      | —                                 | ** ** | **(84** | **)** | — |   |
|                                                                                         |   |                                     | ** ** |                                   |       |   | ** ** |   |   |
| Loss before minority interest share of  losses and equity in net loss of MAS prior to merger |   | **(2,454**                               | **)**      | (1,500                                 | )          | **(2,377** | **)** | (23,761 | ) |
|                                                                                         |   |                                     | ** ** |                                   |       |   | ** ** |   |   |
| Minority interest share of losses                                                            |   | **77**                                   |       | 2                                      |       | **110** |   | 43 |   |
|                                                                                         |   |                                     | ** ** |                                   |       |   | ** ** |   |   |
| Equity in net loss of MAS prior to merger                                                    |   | —                                   | ** ** | —                                 |       | — | ** ** | (291 | ) |
|                                                                                         |   |                                     | ** ** |                                   |       |   | ** ** |   |   |
| Net loss                                                                                     |   | **$**                                    | **(2,377** | **)**                                  | $          | (1,498 | ) | **$** | **(2,267** | **)** | $ | (24,009 | ) |
|                                                                                         |   |                                     | ** ** |                                   |       |   | ** ** |   |   |
| Net loss per common share - basic and  diluted                                               |   | **$**                                    | **(0.09**  | **)**                                  | $          | (0.06 | ) | **$** | **(0.09** | **)** | $ | (1.06 | ) |
|                                                                                         |   |                                     | ** ** |                                   |       |   | ** ** |   |   |
| Weighted average number of common shares  outstanding - basic and diluted                    |   | **26,856**                               | ** ** | 26,169                                 |       | **26,760** | ** ** | 22,616 |   |

 

See the accompanying notes to condensed consolidated financial statements.

 

2

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITY**

**For The Six Months Ended June 30, 2003**

(In Thousands)

(Unaudited)

 
|                                                  |   |                                 |   |                            |   |                     |   |                      |   |                |     |                                      |   |   |   |   |   |
|-------------------------------------------------------|--------|--------------------------------------|--------|---------------------------------|--------|--------------------------|--------|---------------------------|--------|---------------------|----------|-------------------------------------------|--------|--------|--------|--------|--------|
|                                                  |   |                                 |   | **Additional  Paid-In Capital** |   | **Accumulated  Deficit** |   | **CommonStock  Warrants** |   | **Treasury  Stock** |     | **Accumulated  Other Comprehensive Loss** |   |   |   |
|                                                  |   | **Total  Stockholders’ Equity** |   |
| **Common  Stock**                                     |
| **Number**                                            |   | **Amount**                           |
|                                                  |   |                                 |   |                            |   |                     |   |                      |   |                |     |                                      |   |   |   |   |   |
| **Balance —  December 31, 2002**                 |   | 26,568                               |   | $                               | 133    |                     | $      | 167,365                   |   | $                   | (114,059 | )                                         | $      | 1,801  |   | $      | (43    | ) | $ | (185 | ) | $ | 55,012 |   |
| Net loss                                              |   | —                               |   | —                          |   | —                   |   | (2,267                    | )      | —              |     | —                                    |   | — |   | (2,267 | )      |
| Comprehensive loss —Foreign currency translation |   | —                               |   | —                          |   | —                   |   | —                    |   | —              |     | —                                    |   | 48     |   | 48     |   |
| Total comprehensive income (loss)                     |   | —                               |   | —                          |   | —                   |   | (2,267                    | )      | —              |     | —                                    |   | 48     |   | (2,219 | )      |
| Exercise of stock options                             |   | 378                                  |   | 1                               |   | 230                      |   | —                    |   | —              |     | —                                    |   | — |   | 231    |   |
| Stock option repricing                                |   | —                               |   | —                          |   | 25                       |   | —                    |   | —              |     | —                                    |   | — |   | 25     |   |
|                                                  |   |                                 |   |                            |   |                     |   |                      |   |                |     |                                      |   |   |   |   |   |
| **Balance —  June 30, 2003**                     |   | 26,946                               |   | $                               | 134    |                     | $      | 167,620                   |   | $                   | (116,326 | )                                         | $      | 1,801  |   | $      | (43    | ) | $ | (137 | ) | $ | 53,049 |   |
|                                                  |   |                                 |   |                            |   |                     |   |                      |   |                |     |                                      |   |   |   |   |   |   |   |   |   |   |   |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

3

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

(In thousands)

(Unaudited)

 
|                                                                            |   | **For the Six Months  Ended June 30,** |       |
|---------------------------------------------------------------------------------|--------|----------------------------------------|------------|
|                                                                            |   | **2003**                               |       | **2002** |   |
| **Cash Flows From  Operating Activities**                                       |   |                                   |       |   |   |
| Net loss                                                                        |   | **$**                                  | **(2,267** | **)** | $ | (24,009 | ) |
|                                                                            |   |                                   | ** ** |   |   |
| Adjustments to reconcile net loss to net  cash used in operating activities:    |   |                                   | ** ** |   |   |
| Equity-based compensation                                                       |   | **25**                                 | ** ** | 18,877 |   |
| Interest allocated by ADS and contributed  to capital                           |   | —                                 | ** ** | 1,806 |   |
| Depreciation and amortization                                                   |   | **869**                                | ** ** | 1,830 |   |
| Minority interest                                                               |   | **(110**                               | **)**      | (43 | ) |
| Equity in net loss of affiliate                                                 |   | —                                 | ** ** | 291 |   |
| Loss on disposal of equipment                                                   |   | **16**                                 | ** ** | 7 |   |
| Change in assets and liabilities:                                               |   |                                   | ** ** |   |   |
| (Increase) decrease in accounts receivable                                      |   | **(1,097**                             | **)**      | 1,181 |   |
| (Increase) decrease in inventories                                              |   | **(1,725**                             | **)**      | 312 |   |
| Increase in other current assets                                                |   | **(842**                               | **)**      | (545 | ) |
| (Decrease) increase in due to ADS                                               |   | **(47**                                | **)**      | 153 |   |
| Increase (decrease) in accounts payable,  accrued expenses and deferred revenue |   | **2,885**                              | ** ** | (891 | ) |
| **Net Cash Used In  Operating Activities**                                      |   | **(2,293**                             | **)**      | (1,031 | ) |
|                                                                            |   |                                   | ** ** |   |   |
| **Cash Flows From  Investing Activities**                                       |   |                                   | ** ** |   |   |
| (Increase) decrease in other assets                                             |   | **(7**                                 | **)**      | 63 |   |
| Payments for property and equipment                                             |   | **(516**                               | **)**      | (673 | ) |
| Proceeds from sale of equipment                                                 |   | —                                 | ** ** | 23 |   |
| Cash acquired through acquisition, net of  acquisition costs                    |   | —                                 | ** ** | 40 |   |
| **Net Cash Used In  Investing Activities**                                      |   | **(523**                               | **)**      | (547 | ) |
|                                                                            |   |                                   | ** ** |   |   |
| **Cash Flows From  Financing Activities**                                       |   |                                   | ** ** |   |   |
| Amounts borrowed on line of credit                                              |   | **17,285**                             | ** ** | — |   |
| Amounts paid on line of credit                                                  |   | **(14,876**                            | **)**      | — |   |
| Net amounts borrowed on notes payable                                           |   | —                                 | ** ** | 136 |   |
| Payments on long-term debt                                                      |   | **(38**                                | **)**      | (32 | ) |
| Exercise of stock options                                                       |   | **231**                                | ** ** | 601 |   |
| Capital contribution by Applied Digital  Solutions, Inc.                        |   | —                                 | ** ** | 684 |   |
| **Net Cash Provided  By Financing Activities**                                  |   | **2,602**                              | ** ** | 1,389 |   |
|                                                                            |   |                                   | ** ** |   |   |
| **Effect of Exchange Rate Changes on Cash**                                     |   | —                                 | ** ** | 177 |   |
|                                                                            |   |                                   | ** ** |   |   |
| **Net Decrease In  Cash and Cash Equivalents**                                  |   | **(214**                               | **)**      | (12 | ) |
|                                                                            |   |                                   | ** ** |   |   |
| **Cash And Cash  Equivalents - Beginning Of Period**                            |   | **214**                                | ** ** | 596 |   |
|                                                                            |   |                                   | ** ** |   |   |
| **Cash And Cash  Equivalents - End Of Period**                                  |   | **$**                                  | —     | ** ** | $ | 584 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

4

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**DIGITAL ANGEL CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(Dollars in thousands)**

**(Unaudited)**

 

**1.**                                   Basisof Presentation

 

On March 27, 2002, Digital Angel Acquisition Co. (“Acquisition”), thena wholly-owned subsidiary of Medical Advisory Systems, Inc. (“MAS”), mergedwith and into Digital Angel Corporation, which was then a 93% owned subsidiaryof Applied Digital Solutions, Inc. (“ADS”). In the merger, the corporate existenceof Acquisition ceased, Digital Angel Corporation became a wholly-ownedsubsidiary of MAS and was renamed Digital Angel Technology Corporation(“DATC”), and MAS was renamed “Digital Angel Corporation.” In connection withthe merger 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 two subsidiaries, along with DATC, comprised theAdvanced Wireless Group (“AWG”). As a result of this contribution by ADS,Timely Technology Corp. became a wholly-owned subsidiary of the Company andSignature Industries, Limited became an 85% subsidiary. Prior to the mergerwith DATC, ADS owned 850,000 shares of MAS stock, representing approximately 16.3%of the outstanding stock of MAS. (Unless the context otherwise requires, theterm “Company” means Digital Angel Corporation and its subsidiaries). In themerger, the shares of DATC owned by ADS were converted into a total of18,750,000 shares of MAS common stock. As a result of the merger, ADS owned19,600,000 shares or 77.15% of the Company’s common stock. The merger wastreated as a reverse acquisition for accounting purposes, with AWG treated asthe accounting acquirer.

 

At the time of the merger, ADS transferred to the Digital Angel ShareTrust (“Digital Angel Share Trust” or “Trust”), a newly created Delawarebusiness trust, all shares of the Company’s common stock beneficially owned byADS. Following the merger, the Trust was the owner of and, through its AdvisoryBoard, voted all these 19,600,000 shares of the Company and had the ability toelect the Board of Directors of the Company. The Trust arose as a condition ofthe merger. In the event of a default of certain obligations of Applied DigitalSolutions to IBM Credit Corporation (IBM Credit), the shares owned by theDigital Angel Share Trust could be sold or otherwise disposed of to satisfysuch obligations.  On March 7, 2003 IBMCredit notified ADS that an event of default had occurred and IBM Credit wouldimmediately exercise any and/or all of its right and remedies it had under theIBM credit agreement and applicable law.

 

Effective April 1, 2003, ADS entered into a Forbearance Agreement withIBM Credit. Under the terms of the Forbearance Agreement, ADS acquired theright to purchase all of its outstanding debt obligations to IBM Credit,totaling approximately $99.0 million (including accrued interest), if ADS paidIBM Credit $30.0 million in cash by June 30, 2003.  As of June 30, 2003, ADS had made cash payments to IBM Credittotaling $30.0 million and had satisfied in full its debt obligations to IBMCredit.  In connection with satisfactionof ADS’s debt obligations to IBM Credit, the 19,600,000 shares of the Company’sstock beneficially owned by ADS were released to ADS from the Digital AngelShare Trust.

 

The accompanying unaudited condensed consolidated financial statementsof Digital Angel Corporation and subsidiaries as of June 30, 2003 and for thethree and six month periods ended June 30, 2003 and 2002 have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial information and with the instructions to Form10-Q and Article 10 of Regulation S-X under the Securities Exchange Act of1934.  Accordingly, they do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States of America for complete financialstatements.  In the opinion of theCompany’s management, all adjustments (including normal recurring adjustments)considered necessary to present fairly the financial statements have been made.

 

The consolidated statements of operations for the three and six monthsended June 30, 2003 and 2002 are not necessarily indicative of the results thatmay be expected for the entire year. These statements should be read in conjunction with the Digital

 

5

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Angel Corporation’s audited consolidated financialstatements and related notes thereto for the year ended December 31, 2002 whichare included in the Company’s Annual Report on Form 10-K.

 

Certain items in the condensed consolidated financial statements forthe 2002 periods have been reclassified for comparative purposes.

 

The financial information in these financial statements includes anallocation of expenses incurred by ADS on behalf of the Company as discussed inNote 12.  However, these financialstatements may not necessarily be indicative of the results that may haveoccurred had the Company been a separate, independent entity during the periodspresented or of future results of the Company.

 

The Company is engaged in the business of developing and bringing tomarket proprietary technology used to identify, locate and monitor people,animals and objects. Prior to March 27, 2002, the Company operated in foursegments: Animal Tracking, Digital Angel Technology, Digital Angel DeliverySystem and Radio Communications and Other. With the acquisition of MAS in March 2002,the Company reorganized into four segments: Animal Applications, Wireless andMonitoring, GPS and Radio Communications and Medical Systems. AnimalApplications is the name of the segment previously identified as AnimalTracking.  The Digital Angel Technologysegment and the Digital Angel Delivery System segment were combined to form theWireless and Monitoring segment, which is now managed as a single businessunit. GPS and Radio Communications is the name of the segment previouslyidentified as Radio Communications and Other and represents the activity ofSignature Industries, which is located in the United Kingdom. Medical Systemsreflects the MAS business, which was acquired on March 27, 2002.

 

*Animal Applications*—develops,manufactures, and markets a broad line of electronic and visual identificationdevices for the companion animal, livestock, laboratory animal, fish andwildlife markets worldwide. The tracking of cattle and hogs are crucial bothfor asset management and for disease control and food safety. The principaltechnologies employed by Animal Applications are electronic ear tags andimplantable microchips that use radio frequency transmission.

 

*Wireless and Monitoring*—developsand markets advanced technology to gather location and local sensory data andto communicate that data to an operations center. This segment is continuouslydeveloping its technology, which it refers to as its “Digital AngelTMtechnology.” The Digital AngelTM technology is the integration andminiaturization into marketable products of three technologies: wirelesscommunications (such as cellular), sensors (including bio-sensors) and positionlocation technology (including global positioning systems (GPS) and othersystems).

 

*GPS and Radio Communications*—consistsof the design, manufacture and support of secure GPS enabled search and rescueequipment and intelligent communications products and services for telemetry,mobile data and radio communications applications serving commercial andmilitary markets. In addition, it designs, manufactures and distributesintrinsically safe sounders (horn alarms) for industrial use and otherelectronic components.

 

*Medical Systems*—isthe MAS business which was acquired on March 27, 2002. A staff oflogistics specialists and physicians provide medical assistance services andinteractive medical information services to people traveling anywhere in theworld. It also sells a variety of kits containing pharmaceutical and medicalsupplies.

 

**2.**                                   CreditFacility, Debt Covenant Compliance and Liquidity

 

Effective October 30, 2002, the Company entered into a Credit andSecurity Agreement with Wells Fargo Business Credit, Inc. (“Wells Fargo”). TheCompany’s credit facility provides for borrowings up to 80% of eligiblereceivables, as defined, and up to a maximum of $5,000,000 under the terms ofthe Credit and Security Agreement.  AtJune 30, 2003, the annual interest rate on the credit facility wasapproximately 10.2%. The credit facility requires that the total amount ofinterest paid per year must be at least $120,000. The credit facility willexpire on October 30, 2005, at which time the entire outstanding balance of thecredit facility will become due and payable. Amounts borrowed under the creditfacility are secured by a first priority lien on substantially all of theCompany’s assets, including accounts receivable, patents and other intellectualproperty relating to the Digital AngelTM products. As of June 30, 2003, theCompany had $292,000 of borrowing availability and $1.9 million outstandingunder its credit facility.

 

The credit facility contains certain financial covenants, including amonthly minimum book net worth and monthly minimum earnings before taxes, andit limits capital expenditures during 2003. Any breach of the financialcovenants by the Company will constitute an event of default under the Creditand Security Agreement unless waived by Wells Fargo. In addition, any change ofcontrol of the Company will be an event of default under the Credit andSecurity Agreement. As defined in the Credit and Security Agreement, a changeof control includes the future acquisition by any person or group of persons ofmore than 25% of the voting power of all classes of the Company’s common stockor the Company’s current President and Chief Executive Officer ceases toactively manage the Company’s day-to-day business activities. As of June 30,2003, the Company was out of compliance with the minimum book net worth andmonthly minimum earnings before taxes covenants. The Company has obtained awaiver from Wells Fargo for these covenant violations. As a result of theCompany’s covenant violations in the first quarter of 2003, Wells Fargo isexercising its right to charge interest at the default rate, which wasapproximately 10.2% at June 30, 2003.

 

6

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ADS had a term and revolving credit agreement (IBM Credit Agreement)with IBM Credit. Effective April 1, 2003, ADS entered into a ForbearanceAgreement with IBM Credit.  Under theterms of the Forbearance Agreement, ADS acquired the right to purchase all ofits outstanding debt obligations to IBM Credit, totaling $99.0 million(including accrued interest), if ADS paid IBM Credit $30.0 million by June 30,2003.  As of June 30, 2003, ADS had madecash payments to IBM Credit Corporation totaling $30.0 million and hadsatisfied in full its debt obligations to IBM Credit Corporation under theForbearance Agreement.

 

Funding forthe $30.0 million payment to IBM Credit included $10.0 million in net proceedsfrom the issuance by ADS of 8.5% Convertible Exchangeable Debentures.  These debentures are convertible into sharesof ADS common stock or exchangeable for shares of our common stock owned byADS, or a combination thereof, at anytime at the purchasers’ option.  ADS owned 19.6 million shares, orapproximately 72.9%, of our issued and outstanding common stock, as of June 30,2003.  The exchange price for our commonstock subject to purchase pursuant to the debentures is $2.20 per share as tothe first 50.0% of the original principal amount of the debentures and $4.25per share as to the remaining 50.0% of the original principal amount, subjectto anti-dilution provisions.  Of the19,600,000 shares of our common stock owned by ADS, it has pledged 15,000,000shares to the debenture holders as collateral.

 

The debenturesrequire that ADS pay interest to each debenture holder at the rate of 8.5% perannum, payable on a quarterly basis beginning September 1, 2003 and, beginningon November 1, 2003, on a monthly basis, as to the principal amount required tobe redeemed each month. A final interest payment is due on the maturity date.Interest payments may be made in either cash or in shares of our common stock,or a combination thereof at ADS’s option, subject to certain restrictions. Theinterest conversion rate for our common stock is calculated based upon 90.0% ofthe average of the lowest 10 of the 20 volume-weighted average stock pricesimmediately prior to the applicable interest payment date, subject to a latepayment adjustment.  Principalredemption payments of $0.4 million are due monthly beginning November 1,2003.  The principal redemption paymentsmay be made in cash, in ADS common stock or our common stock at ADS’s option,subject to certain limitations regarding the average market value and tradingvolume of our common stock. The conversion prices are based upon the lesser of(a) 90.0% of the lowest 10 of the 20 volume-weighted average stock prices priorto the redemption date, and (b) the set prices as defined in the purchaseagreement. The set prices are based upon the market prices of ADS common stockand our common stock on the date of the transaction.

 

ADS has alsogranted to the debenture holders warrants to purchase approximately 5.35million shares of ADS common stock or 0.95 million shares of our common stockcurrently owned by ADS, or a combination of shares from both companies, at eachpurchaser’s option.  The exercise pricewith respect to our common stock issuable pursuant to the warrants is $3.178per share.  The warrants are subject toanti-dilution provisions, vest immediately and are exercisable through June 30,2007.

 

*Possible Consequences of Exchange of the ADSDebentures, Exercise of the ADS Warrants or Foreclosure of Pledged Shares*

 

Employment Agreement with Randolph K. Geissler. Under the terms of the employment agreement dated March 8, 2002, as amended, byand between the Company and Randolph K. Geissler (the President and ChiefExecutive Officer of the Company), a “change in control” occurs under that employmentagreement if any person becomes the “beneficial owner” (as defined in Rule13d-3 under the Securities Exchange Act of 1934), directly or indirectly, ofsecurities of the Company representing 20% or more of the combined voting powerof the Company’s then outstanding shares of common stock. ADS has issued8.5% Convertible Exchangeable Debentures which are convertible into shares ofADS common stock or exchangeable for shares of our common stock owned by ADS,or a combination thereof, at the purchasers’ option.  ADS has also granted the debenture purchasers warrants topurchase ADS common stock, shares our common stock owned by ADS, or acombination thereof, at the purchasers’ option.  In addition, to secure its obligations under the debentures, ADSpledged 15,000,000 of our shares to the debenture holders.  If the exchange of the debentures, theexercise of the warrants, any foreclosure of ADS’s pledge to the debentureholders, or any combination of these events, results in another person or groupof persons owning, in the aggregate, 20% or more of our common stock, suchtransaction  could constitute a changein control under the employment agreement with Mr. Geissler. Upon theoccurrence of a change in control, Mr. Geissler, at his sole option and discretion,may terminate his employment with the Company at any time within one year aftersuch change in control upon 15 days’ notice. In the event of suchtermination, the employment agreement provides that the Company must pay to Mr.Geissler a severance payment equal to three times the base amount as defined inSection 280G(b)(3) of the Internal Revenue Code of 1986, as amended (“Code”),minus $1.00 (currently a total of approximately $750,000), which would bepayable no later than one month after the effective date of Mr. Geissler’stermination of employment.

 

The employmentagreement also provides that (i) upon a change of control, (ii) upon thetermination of Mr. Geissler’s employment for any reason other than due to hismaterial default under the employment agreement, or (iii) if he ceases to bethe Company’s President and Chief Executive Officer for any reason other thantermination due to his material default under the employment agreement, within10 days of the occurrence of any such events, the Company is to pay to Mr.Geissler $4,000,000. The Company may pay such amount in cash or in theCompany’s common stock or with a combination of cash and common stock. Theemployment agreement also provides that if the $4,000,000 is paid in cash andstock, the amount of cash paid must be sufficient to cover the tax liabilityassociated with such payment, and such payment shall otherwise be structured tomaximize tax efficiencies to both the Company and Mr. Geissler.

 

7

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Credit and Security Agreement with WellsFargo Business Credit, Inc.  The Credit andSecurity Agreement provides that a “change in control” under that agreementresults in a default. A change in control is defined as either Mr.Geissler ceasing to actively manage the Company’s day-to-day businessactivities or the transfer of at least 25% of the outstanding shares of commonstock of the Company. Also, if the Company owes to Mr. Geissler $4,000,000under his employment agreement as described above, the obligation would mostlikely result in a breach of the Company’s financial covenants under the Creditand Security Agreement. If these defaults occurred and were not waived byWells Fargo, and if Wells Fargo were to enforce their rights under the terms ofthe Credit and Security Agreement and related agreements, the Company’sbusiness and financial condition would be materially and adversely affected,and it may force the Company to cease operations.

 

**3.**                                   Principlesof Consolidation and Combination

 

The June 30, 2003 and 2002 condensed consolidated financial statementsinclude the accounts of the Company and its wholly-owned and majority-ownedsubsidiaries from the date of acquisition. All significant intercompany accounts and transactions have been eliminatedin consolidation.

 

**4.**                                   RevenueRecognition

** **

Forproduct sales, the Company recognizes revenue at the time products are shippedand title has transferred, provided that a purchase order has been received ora contract has been executed, there are no uncertainties regarding customeracceptance, the sales price is fixed and determinable and collectability isdeemed probable. If uncertainties regarding customer acceptance exists, revenueis recognized when such uncertainties are resolved. There are no significantpost-contract support obligations at the time of revenue recognition. TheCompany’s accounting policy regarding vendor and post-contract supportobligations is based on the terms of the customers’ contracts, billable uponthe occurrence of the post-sale support. Costs of goods sold are recorded asthe related revenue is recognized. The Company does not offer a warranty policyfor services to customers. For software consulting and development services,the Company recognizes revenue based on the percent complete for fixed feecontracts, with the percent complete being calculated as either the number ofdirect labor hours in the project to date divided by the estimated total directlabor hours or based upon the completion of specific task orders. It is theCompany’s policy to record contract losses in their entirety in the period inwhich such losses are foreseeable. For non-fixed fee jobs, revenue isrecognized based on the actual direct labor hours in the job multiplied by thestandard billing rate and adjusted to realizable value, if necessary. Revenuesfrom contracts that provide services are recognized ratably over the term ofthe contract. Fixed fee revenues from contracts for services are recorded whenearned and exclude reimbursable costs. Reimbursable costs incurred inperforming such services are presented on a net basis and includetransportation, medical and communication costs. Other revenues are recognizedat the time services or goods are provided.

 

**5.**                                   Stock-BasedCompensation

 

TheCompany applies APB Opinion No. 25 and related Interpretations in accountingfor all its stock option plans. Accordingly, no compensation cost has been recognized under these stockoption plans.  The Company has adoptedthe disclosure-only provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation” and SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure,” which was released in December 2002 asan amendment to SFAS No. 123.  Thefollowing table illustrates the effect on net loss and loss per share if thefair value based method had been applied to all awards (in thousands, exceptper share data):

 
|                                                                                                                     |   | **Three Months Ended June 30,** |       | **Six Months Ended June 30,** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------|------------|-------------------------------|--------|
|                                                                                                                     |   | **2003**                        |       | **2002**                      |   | **2003** |   | **2002** |   |
| Reported net loss                                                                                                        |   | **$**                           | **(2,377** | **)**                         | $      | (1,498 | ) | **(2,267** | **)** | $ | (24,009 | ) |
| Stock-based employee compensation expense  in reported net loss, net of related tax effects                              |   | **(61**                         | **)**      | 196                           |   | **25** | ** ** | 13,410 |   |
| **Stock-based employee compensation  expense determined under the fair value based method, net of related tax  effects** |   | **(1,695**                      | **)**      | **(62**                       | **)**  | **(3,358** | **)** | **(13,636** | **)** |
| Pro forma  net loss                                                                                                      |   | **$**                           | **(4,133** | **)**                         | $      | (1,364 | ) | **$** | **(5,600** | **)** | $ | (24,235 | ) |
|                                                                                                                     |   |                            | ** ** |                          |   |   | ** ** |   |   |
| Loss per  share -basic and diluted                                                                                       |   |                            | ** ** |                          |   |   | ** ** |   |   |
| As  reported                                                                                                             |   | **$**                           | **(0.09**  | **)**                         | $      | (0.06 | ) | **$** | **(0.09** | **)** | $ | (1.06 | ) |
| Pro forma                                                                                                                |   | **$**                           | **(0.15**  | **)**                         | $      | (0.05 | ) | **$** | **(0.21** | **)** | $ | (1.07 | ) |

 

8

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**6.**                                   Inventory(in thousands)

 
|                                  |   | **June 30,  2003** |   | **December  31,  2002** |   |
|---------------------------------------|--------|--------------------|--------|-------------------------|--------|
| Raw  materials                        |   | $                  | 1,747  |                    | $      | 1,725 |   |
| Work in process                       |   | 135                |   | 128                     |   |
| Finished goods                        |   | 6,255              |   | 4,474                   |   |
|                                  |   | 8,137              |   | 6,327                   |   |
| Allowance for excess and obsolescence |   | (1,467             | )      | (1,382                  | )      |
| Net inventory                         |   | $                  | 6,670  |                    | $      | 4,945 |   |

 

**7.**                                   Loss Per Share

 

The following is a reconciliation of the numerator and denominator ofbasic and diluted loss per share (in thousands, except per share data):

 
|                                        |   | **Three Months  Ended June 30,** |       | **Six Months  Ended June 30,** |       |
|---------------------------------------------|--------|----------------------------------|------------|--------------------------------|------------|
|                                        |   | **2003**                         |       | **2002**                       |       | **2003** |   | **2002** |   |
| **Numerator:**                              |   |                             | ** ** |                           |       |   |   |   |   |
| Net loss                                    |   | **$**                            | **(2,377** | **)**                          | $          | (1,498 | ) | **$** | **(2,267** | **)** | $ | (24,009 | ) |
| **Denominator:**                            |   |                             | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| Denominator  for basic loss per share -     |   |                             |       |                           |       |   | ** ** |   |   |
| Weighted-average shares                     |   | **26,856**                       |       | 26,169                         | ** ** | **26,760** | ** ** | 22,616 |   |
| Denominator for diluted loss per share (1)- |   | **26,856**                       |       | 26,169                         | ** ** | **26,760** | ** ** | 22,616 |   |
| **Basic and  diluted loss per share**       |   | **$**                            | **(0.09**  | **)**                          | **$**      | **(0.06** | **)** | **$** | **(0.09** | **)** | **$** | **(1.06** | **)** |

 

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(1)     Potentiallydilutive securities are excluded from the computation of diluted loss per sharebecause to do so would have been anti-dilutive.

 

**8.**                                   SegmentInformation

 

The Company is engaged in the business of developing and bringing tomarket proprietary technologies used to identify, locate and monitor people,animals and objects. With the acquisition of MAS in March 2002, the Companyre-organized into four segments:  AnimalApplications, Wireless and Monitoring, GPS and Radio Communications, andMedical Systems. Prior period segment information has been restated to reflectthe Company’s current segment structure.

 

It is on this basis that management utilizes the financial informationto assist in making internal operating decisions.  The Company evaluates performance based on stand-alone segmentoperating income.

 

Following is the selected segment data as of and forthe three months ended June 30, 2003 (in thousands):

 
|                                          |   | **Animal  Applications** |       | **Wireless  and  Monitoring** |       | **GPS and  Radio  Communications** |       | **Medical  Systems** |       | **Corporate  /  Unallocated** |       | **Consolidated** |       |
|-----------------------------------------------|--------|--------------------------|------------|-------------------------------|------------|------------------------------------|------------|----------------------|------------|-------------------------------|------------|------------------|------------|
|                                          |   |                     | ** ** |                          | ** ** |                               | ** ** |                 | ** ** |                          | ** ** |             | ** ** |
| Net revenue from external customers:          |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
|                                          |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
| Product                                       |   | $                        | 5,188      |                          | $          | —                             |       | $                    | 2,708      |                          | $          | 222              |       | $ | — |   | $ | 8,118 |   |
| Service                                       |   | —                   |       | 5                             |       | —                             |       | 237                  |       | —                        |       | 242              |       |
| Total revenue                                 |   | $                        | 5,188      |                          | $          | 5                                  |       | $                    | 2,708      |                          | $          | 459              |       | $ | — |   | $ | 8,360 |   |
|                                          |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
| Loss before minority interest share of losses |   | $                        | (938       | )                             | $          | (755                               | )          | $                    | (513       | )                             | $          | (248             | )          | $ | — |   | $ | (2,454 | ) |
|                                          |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
| Total assets                                  |   | $                        | 58,821     |                          | $          | 664                                |       | $                    | 6,910      |                          | $          | 4,477            |       | $ | — |   | $ | 70,872 |   |

 

In the three month period ended June 30, 2003, two customers accountedfor approximately 21.8% and 16.7% of our Animal Applications revenue.

 

Following is the selected segment data as of and for the six monthsended June 30, 2003 (in thousands):

 

9

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|                                                    |   | **Animal  Applications** |   | **Wireless  and  Monitoring** |   | **GPS and  Radio  Communications** |   | **Medical  Systems** |   | **Corporate  /  Unallocated** |   | **Consolidated** |   |
|---------------------------------------------------------|--------|--------------------------|--------|-------------------------------|--------|------------------------------------|--------|----------------------|--------|-------------------------------|--------|------------------|--------|
|                                                    |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Net revenue from external customers:                    |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
|                                                    |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Product                                                 |   | $                        | 12,989 |                          | $      | —                             |   | $                    | 5,407  |                          | $      | 587              |   | $ | — |   | $ | 18,983 |   |
| Service                                                 |   | —                   |   | 159                           |   | —                             |   | 616                  |   | —                        |   | 775              |   |
| Total revenue                                           |   | $                        | 12,989 |                          | $      | 159                                |   | $                    | 5,407  |                          | $      | 1,203            |   | $ | — |   | $ | 19,758 |   |
|                                                    |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Income (loss) before minority interest  share of losses |   | $                        | 521    |                          | $      | (1,790                             | )      | $                    | (735   | )                             | $      | (373             | )      | $ | — |   | $ | (2,377 | ) |
|                                                    |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Total assets                                            |   | $                        | 58,821 |                          | $      | 664                                |   | $                    | 6,910  |                          | $      | 4,477            |   | $ | — |   | $ | 70,872 |   |

 

In the six month period ended June 30, 2002, four customers accountedfor approximately 15.4%, 11.6%, 10.9% and 10.2% of our Animal Applicationsrevenue.  We buy most of our syringeinjectible microchips that are used in our electronic identification productsfrom one supplier.

 

Following is the selected segment data as of and for the three monthsended June 30, 2002 (in thousands):

 
|                                                    |   | **Animal  Applications** |       | **Wireless  and  Monitoring** |       | **GPS and  Radio  Communications** |       | **Medical  Systems** |       | **Corporate  /  Unallocated** |       | **Consolidated** |       |
|---------------------------------------------------------|--------|--------------------------|------------|-------------------------------|------------|------------------------------------|------------|----------------------|------------|-------------------------------|------------|------------------|------------|
|                                                    |   |                     | ** ** |                          | ** ** |                               | ** ** |                 | ** ** |                          | ** ** |             | ** ** |
| Net revenue from external customers:                    |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
|                                                    |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
| Product                                                 |   | $                        | 5,612      |                          | $          | —                             |       | $                    | 2,480      |                          | $          | 414              |       | $ | — |   | $ | 8,506 |   |
| Service                                                 |   | —                   |       | 577                           |       | —                             |       | 156                  |       | —                        |       | 733              |       |
| Total  revenue                                          |   | $                        | 5,612      |                          | $          | 577                                |       | $                    | 2,480      |                          | $          | 570              |       | $ | — |   | $ | 9,239 |   |
|                                                    |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
| Income (loss) before minority interest  share of losses |   | $                        | 122        |                          | $          | (1,357                             | )          | $                    | (25        | )                             | $          | (240             | )          | $ | — |   | $ | (1,500 | ) |
|                                                    |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
| Total assets                                            |   | $                        | 79,037     |                          | $          | 16,978                             |       | $                    | 5,513      |                          | $          | 32,293           |       | $ | — |   | $ | 133,821 |   |

 

In the three month period ended June 30, 2002, two customers accountedfor approximately 15.8% and 15.1% of our Animal Applications revenue and onecustomer accounted for 49.2% of our Wireless and Monitoring revenue.

 

10

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Following is the selected segment data as of and for the six monthsended June 30, 2002 (in thousands):

 
|                                                                                                  |   | **Animal  Applications** |   | **Wireless  and  Monitoring** |   | **GPS and  Radio  Communications** |   | **Medical  Systems** |   | **Corporate  /  Unallocated** |   | **Consolidated** |   |
|-------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-------------------------------|--------|------------------------------------|--------|----------------------|--------|-------------------------------|--------|------------------|--------|
|                                                                                                  |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Net revenue from external customers:                                                                  |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
|                                                                                                  |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Product                                                                                               |   | $                        | 10,427 |                          | $      | —                             |   | $                    | 5,116  |                          | $      | 414              |   | $ | — |   | $ | 15,957 |   |
| Service                                                                                               |   | —                   |   | 880                           |   | —                             |   | 156                  |   | —                        |   | 1,036            |   |
| Total  revenue                                                                                        |   | $                        | 10,427 |                          | $      | 880                                |   | $                    | 5,116  |                          | $      | 570              |   | $ | — |   | $ | 16,993 |   |
|                                                                                                  |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Income (loss) before minority interest  share of losses and equity in net loss of MAS prior to merger |   | $                        | 401    |                          | $      | (3,147                             | )      | $                    | (288   | )                             | $      | (240             | )      | $ | (20,487 | )(1) | $ | (23,761 | ) |
|                                                                                                  |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Total assets                                                                                          |   | $                        | 79,037 |                          | $      | 16,978                             |   | $                    | 5,513  |                          | $      | 32,293           |   | $ | — |   | $ | 133,821 |   |

 

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(1)  Consists of $18,681,000non-cash compensation expense associated with Digital Angel options convertedinto options to acquire Digital Angel Corporation stock and $1,806,000 interestexpense associated with ADS obligations to IBM Credit Corporation.

 

In the six month period ended June 30, 2002, three customers accountedfor approximately 15.0%, 12.4% and 10.8% of our Animal Applicationsrevenue.  We buy most of oursyringe-injectable microchips that are used in our electronic identificationproducts from one supplier.  In the sixmonth period ended June 30, 2002, one customer accounted for approximately57.1% of our Wireless and Monitoring revenue.

 

**9.**                                   Acquisitions

 

The following describes the acquisitions by the Company (in thousands):

 
| **Company Acquired**            |   | **Date  Acquired** |   | **Acquisition  Price** |   | **Value of  Shares,  Warrants &  Options  Issued or  Issuable** |   | **Common  Shares  Issued (Net)** |   | **Goodwill  and Other  Intangibles  Acquired** |   | **Other Net  Assets and  Liabilities** |   | **Business  Description** |   |
|---------------------------------|--------|--------------------|--------|------------------------|--------|---------------------------------------------------------------------|--------|----------------------------------|--------|------------------------------------------------|--------|----------------------------------------|--------|---------------------------|--------|
| Medical  Advisory Systems, Inc. |   | 03/27/02           |   | $                      | 31,956 |                                                                | $      | 28,418                           |   | 5,218                                          |   | $                                      | 30,005 |                      | $      | 1,951 |   | Provider of medical assistance  and technical products and services |   |
|                                 |        |                    |        |                        |        |                                                                     |        |                                  |        |                                                |        |                                        |        |                           |        |  |  |  |  |

 

On March 27, 2002, DATC (formerly a part of ADS’s AWG) merged with awholly-owned subsidiary of MAS.  Foraccounting purposes, AWG is treated as the acquirer, and the acquisition of MASwas recorded at fair value under the purchase method of accounting.  The excess of purchase price over the fairvalue of the assets and liabilities of MAS have been recorded as goodwill.

 

The cost of the March 27, 2002 acquisition consisted of 5.268 millionshares of common stock valued at $25.0 million, including 50,000 shares oftreasury stock, options to purchase 1.2 million shares and warrants to purchase75,000 shares together valued at $3.4 million, and acquisition costs of $3.6million.  The valuation of the stock isbased on the value of the shares of MAS held by stockholders other than ADSprior to the acquisition.  The cost ofthe acquisition includes all payments according to the acquisition agreementplus costs for investment banking services and legal and accounting servicesthat were direct costs of acquiring these assets.  Included in the acquisition costs are certain severanceliabilities of $2.5 million related to employment agreements of two

 

11

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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 the benefits of a merger of AWG and MAS, the managementof AWG recognized the strategic advantage of combining the advanced wirelesstechnologies being developed by AWG with the physician-staffed call centerinfrastructure of MAS.  One of theprincipal benefits of such a combination is the ability of the Company to offera complete “end-to-end solution” to the various vertical markets for DigitalAngelTM products.

 

The results of MAShave been included in the consolidated financial statements since the date ofacquisition.  Unaudited pro formaresults of operations for the six months ended June 30, 2002 are includedbelow.  Such pro forma informationassumes that the above acquisition had occurred as of January 1, 2002, andrevenue is presented in accordance with the Company’s accounting policies.  This summary is not necessarily indicativeof what the result of operations of the Company would have been had it been acombined entity during such periods, nor does it purport to represent resultsof operations for any future periods.

 
| **(In thousands)**                             |   | **2002** |    |
|------------------------------------------------|--------|----------|---------|
| Net operating revenue                          |   | $        | 17,543  |   |
| Net loss                                       |   | $        | (25,463 | ) |
| Net loss per common share - basic and  diluted |   | $        | (1.02   | ) |

 

**10.**                            Contingencies

 

**Silva, et al. v. Customized ServicesAdministrators, Incorporated, dba CSA Travel Protection, Inc. et al., No.CV798528 (Santa Clara County Superior Court)**

 

On May 29, 2001, Janet Silva, individually and as Guardian *ad litem* for Jonathan Silva, a minor, andthe Estate of Clarence William Silva, Jr. filed suit against CustomizedServices Administrators, Incorporated (CSA), Pricesmart, Inc., CommercialUnion Insurance Company, CGU Insurance Group, and us in the Superior Court ofthe State of California in and for the County of Santa Clara. The allegationsof the complaint arise from a vacation guarantee insurance policy allegedlypurchased by the plaintiffs from the defendants on March 6, 2000. Thecomplaint alleges, among other things, that the defendants breached the termsof the insurance policy, defrauded plaintiffs, acted in bad faith and engagedin deceptive and unlawful business practices, resulting in the wrongful deathof Clarence William Silva, Jr. and the intentional infliction of emotionaldistress on plaintiffs. The complaint seeks the cost of funeral and burialexpenses of Mr. Silva and amounts constituting the loss of financialsupport of Mr. Silva, general damages, attorneys’ fees and costs, andexemplary damages.

 

CSA outsourced its travel assistance services to Medical AdvisorySystems. CSA filed a cross-claim against us alleging that we should be heldliable for any liability that CSA may have to the plaintiffs in this case. Wehave denied the allegations of the complaint and the CSA cross-claim and arevigorously contesting all aspects of this action.

 

We filed motions for summary judgment/adjudication, which were heard bythe Court on June 10, 2003. Our motions for summary adjudication ofplaintiffs’ causes of action for fraud, insurance, bad faith and unlawfulbusiness practices were granted. Our motion for summary adjudication onplaintiffs’ cause of action for breach of insurance contract also was granted.However, the Court gave the plaintiffs permission to amend their complaint onor before June 13, 2003 with respect to this cause of action. Our motionfor summary adjudication of plaintiffs’ cause of action for intentionalinfliction of emotional distress was taken under submission. Our motions forsummary adjudication of plaintiffs’ cause of action for wrongful death andprayer for punitive damages were denied, but the plaintiffs agreed that thepunitive damages claim applied only to their cause of action for intentionalinfliction of emotional distress. Therefore, if the Court grants our motion forsummary adjudication of this cause of action, the punitive damage claim shouldbe stricken in its entirety. The Court has set a Mandatory SettlementConference for August 20, 2003 and has set the case for trial onAugust 25, 2003 in the Santa Clara County Superior Court. We believe thislawsuit is defensible, and we intend to defend this matter vigorously. However,if there is an unfavorable outcome of this matter, we believe that our exposurecould be in excess of what we have been advised to be the applicable limits ofinsurance.

 

**11.**                            SupplementalCash Flow Information (in thousands)

 
|                                                |   | **Six Months  Ended June 30,** |       |
|-----------------------------------------------------|--------|--------------------------------|------------|
|                                                |   | **2003**                       |       | **2002** |   |
| Interest paid                                       |   | **$**                          | **254**    |   | $ | 171 |   |
| **Non-cash financing activities:**                  |   |                           |       |   | ** ** |
| **Shares to be issued in settlement  of liability** |   | **—**                     | ** ** | **225** |   |
|                                                     |        |                                |            |  |  |  |  |

 

12

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**12.**                            RelatedParty Activity

 

Prior to the merger, ADS provided certain general and administrativeservices to the Company, including finance, legal, benefits and otherservices.  The costs of these servicesare included in the Company’s Statements of Operations as management fees andare based on utilization, which management believes to be reasonable.  Costs of these services were $0.0 and $0.2million for the three and six month periods ended June 30, 2002.  ADS also charged the Company $1.8 million ofinterest expense in 2002, for which the liability was converted to a capitalcontribution.  In addition, accruedexpenses of $0.3 million were relieved and contributed to capital by ADS.  We continue to be charged by ADSapproximately $30,000 a month to support ADS’s research group.  Additionally, we were charged by ADS forproduct liability insurance through September 2002 and directors and officersinsurance through June 2003.  Thesetransactions resulted in a due to ADS of $0.3 million at June 30, 2003.

 

ADS acquired Timely Technology Corp., a part of AWG, in 2000, and themerger agreement included an earnout provision based on performance throughJune 30, 2002.  During the quarter endedJune 30, 2002, ADS paid the selling shareholder of Timely Technology Corp. $3.6million, payable in shares of ADS stock, as the final payment under the earnoutprovision.  This payout has beenreflected in the accompanying financial statements as a capital contribution byADS and an increase to goodwill and other intangibles.

 

The Company has executed an exclusive eleven year Distribution andLicensing Agreement dated March 4, 2002 with Verichip Corporation (Verichip), awholly-owned subsidiary of ADS, covering the manufacturing, purchasing anddistribution of Verichip’s implantable microchip and the maintenance of theVerichip Registry by the Company.  Theagreement includes a license for the use of the Company’s technology inVerichip’s identified markets.  TheCompany will be the sole manufacturer and supplier to Verichip.  Revenue recognized under the Distributionand Licensing Agreement was $87,000 and $29,000 for the six months ended June30, 2003 and 2002, respectively.

 

**13.**                            SubsequentEvents

 

Securities Purchase Agreement with LaurusMaster Fund, Ltd. On July 31, 2003, the Company entered into a Securities PurchaseAgreement (Purchase Agreement) to sell securities to Laurus Master Fund, Ltd.(Laurus).

 

Effective July31, 2003, under the Purchase Agreement, the Company issued and sold to Laurus atwo-year Secured Convertible Note (the Note) in the original principal amountof $2,000,000 and a Common Stock Purchase Warrant (the Laurus Warrant) topurchase up to 125,000 shares of the Company’s common stock.  The Note is convertible, at Laurus’s option,into shares of the Company’s common stock at a per share price of $2.33.  However, Laurus is not entitled to convertthe amount evidenced by the Note into a number of shares of common stock whichwould exceed the difference between the number of shares of common stockbeneficially owned by Laurus and 4.99% of the outstanding shares of commonstock of the Company.  The Note accruesinterest at an annual rate equal to the prime rate plus 1.75% but shall not beless than 6% per annum.

 

Under theLaurus Warrant, Laurus has the right, for a period of five years from the dateof such Laurus Warrant, to purchase a total of 125,000 shares of the Company’scommon stock.  The per share exerciseprice of the Laurus Warrant is $2.68 for 75,000 shares subject to the LaurusWarrant, $2.91 for 35,000 shares, and $3.38 for 15,000 shares.

 

In connectionwith the Note, the Company and Laurus entered into a Security Agreementgranting to Laurus a lien and security interest in the Company’s assets, whichis subject to a lien and security interest held by Wells Fargo Business Credit,Inc.

 

Under the RegistrationRights Agreement dated July 31, 2003 between the Company and Laurus, theCompany is obligated to file a Registration Statement on Form S-3 within30 days following the closing date and to cause such Registration Statement tobecome effective within 90 days following the closing date.  The Registration Statement will cover theresale of the shares of common stock underlying the Note and the Warrant.

 

Stock Purchase Agreement with Applied DigitalSolutions. On August 14, 2003, the Company enteredinto a Stock Purchase Agreement (Stock Purchase Agreement) with ADS as astrategic investment to increase ADS's ownership of the Company. The StockPurchase Agreement provides that the Company is to issue and sell to ADS3,000,000 shares of the Company's common stock at $2.64 per share and a warrant(the ADS warrant) to purchase up to 1,000,000 shares of the Company's stock.The aggregate purchase price for the sale of the Company's 3,000,000 shares ispayable in ADS common stock (ADS Exchange Shares) equal to the purchase pricedivided by the average of ADS's volume weighted average price for the tentrading days immediately preceeding the closing date (ADS Per Share ExchangePrice).  If the ADS Per Share ExchangePrice is less than $0.40, then ADS shall have the option to postpone theclosing date for a period not to exceed thirty calendar days or terminate theStock Purchase Agreement.

 

The ADS warrant provides ADS the right, for a period of five years fromFebruary 1, 2004, to purchase a total of 1,000,000 shares of the Company'scommon stock,. The exercise price of the ADS warrant will be equal to the dailyvolume weighted average price of our common stock for the first 10 consecutivedays of 2004 starting on January 2, 2004.

 

As part ofthis transaction, ADS is in negotiations with the holders of the ADS 8.5%Convertible Exchangeable Debentures (the Debenture Holders), which may resultin the Company issuing warrants to the Debenture Holders to acquire up to500,000 shares of its common stock.

 

 

13

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**Item 2****.****                              Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

The following discussion and analysis of our financialcondition and results of operations should be read in conjunction with theaccompanying financial statements and related notes thereto.

 

We consist of Digital AngelCorporation and its three subsidiaries — Digital Angel Technology Corporation(“DATC”), Timely Technology Corp. and Signature Industries, Limited. These three subsidiaries were previously known as the Advanced Wireless Group(“AWG”) of Applied Digital Solutions, Inc. (“ADS”).  DATC is engaged inthe business of developing and bringing to market proprietary technologies usedto identify, locate and monitor people, animals and objects.  DATC is theresult of the merger in September 2000 of Destron Fearing Corporation andDigital Angel.net Inc., which was then a wholly-owned subsidiary of ADS. BeforeMarch 27, 2002, the business of DATC was operated in four segments: Animal Tracking, Digital Angel Technology, Digital Angel Delivery System, andRadio Communications and Other.  With the acquisition of Medical AdvisorySystems, Inc. (“MAS”) in March 2002, the Company re-organized into foursegments:  Animal Applications, Wireless and Monitoring, GPS and RadioCommunications, and Medical Systems.  Animal Applications is the name ofour segment previously identified as Animal Tracking.  We combined ourDigital Angel Technology segment with our Digital Angel Delivery System segmentto form the Wireless and Monitoring segment, which is now managed as a singlebusiness unit.  GPS and Radio Communications is the name of our segmentpreviously identified as Radio Communications and Other.  Medical Systemsreflects the MAS business acquired March 27, 2002. Prior period segmentinformation has been restated to reflect our current segment structure.

 

 

**RESULTSOF OPERATIONS**

 

The following table summarizes our results ofoperations as a percentage of net operating revenue for the three and sixmonths ended June 30, 2003 and 2002 and is derived from the accompanyingconsolidated statements of operations included in this report.

 
|                                                                                         |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|----------------------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                                         |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                                                                         |   | **%**                            |   | **%**                          |   | **%** |   | **%** |   |
| Product revenue                                                                              |   | 97.1                             |   | 92.1                           |   | 96.1 |   | 93.9 |   |
| Service revenue                                                                              |   | 2.9                              |   | 7.9                            |   | 3.9 |   | 6.1 |   |
| Total net revenue                                                                            |   | 100.0                            |   | 100.0                          |   | 100.0 |   | 100.0 |   |
| Cost of products sold                                                                        |   | 60.6                             |   | 51.9                           |   | 54.2 |   | 53.5 |   |
| Cost of services sold                                                                        |   | 3.0                              |   | 4.2                            |   | 3.3 |   | 3.8 |   |
| Total cost of products and services sold                                                     |   | 63.6                             |   | 56.1                           |   | 57.5 |   | 57.3 |   |
| Gross profit                                                                                 |   | 36.4                             |   | 43.9                           |   | 42.5 |   | 42.7 |   |
| Selling, general and administrative expenses                                                 |   | 50.0                             |   | 52.3                           |   | 42.8 |   | 162.4 |   |
| Management fees - Applied Digital Solutions, Inc.                                            |   | —                           |   | —                         |   | — |   | 1.1 |   |
| Research and development expenses                                                            |   | 14.0                             |   | 7.1                            |   | 10.5 |   | 7.7 |   |
| Interest expense                                                                             |   | 2.3                              |   | 0.7                            |   | 1.7 |   | 11.4 |   |
| Other income                                                                                 |   | (0.5                             | )      | —                         |   | (0.4 | ) | — |   |
| Loss before minority interest share of losses and  equity in net loss of MAS prior to merger |   | (29.4                            | )      | (16.2                          | )      | (12.1 | ) | (139.9 | ) |
| Minority interest share of losses                                                            |   | 0.9                              |   | —                         |   | 0.6 |   | 0.3 |   |
| Equity in net loss of MAS prior to merger                                                    |   | —                           |   | —                         |   | — |   | (1.7 | ) |
| Net loss                                                                                     |   | (28.5                            | )      | (16.2                          | )      | (11.5 | ) | (141.3 | ) |

 

14

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**ThreeMonths Ended June 30, 2003 Compared to the Three Months Ended June 30, 2002**

 

**Revenue**

 

Revenue for the three months ended June 30, 2003decreased $0.9 million, or 9.5%, to $8.4 million when compared to $9.2 millionin revenue for the three months ended June 30, 2002.

 

Revenue for each of the operating segments was asfollows (in thousands):

 
|                          |   | **Three  Months  Ended June 30,  2003** |   | **Three  Months  Ended June 30,  2002** |   |
|-------------------------------|--------|-----------------------------------------|--------|-----------------------------------------|--------|
| Animal  Applications          |   | $                                       | 5,188  |                                    | $      | 5,612 |   |
| Wireless  and Monitoring      |   | 5                                       |   | 577                                     |   |
| GPS  and Radio Communications |   | 2,708                                   |   | 2,480                                   |   |
| Medical  Services             |   | 459                                     |   | 570                                     |   |
| Total                         |   | $                                       | 8,360  |                                    | $      | 9,239 |   |

 

The Animal Applications segment’s revenue decreased**$0.4 million, or 7.6%, in the threemonths ended June 30, 2003 compared to the three month period ended June 30,2002. The decrease is the result of unusually high sales in the second quarterof 2002 due to delays in the first quarter of 2002.

 

The Wireless and Monitoring segment’s revenuedecreased $0.6 million, or 99.1%, in the three months ended June 30, 2003 ascompared to the three month period ended June 30, 2002 due to the cancellationof a significant software contract in February 2003.

 

The GPS and Radio Communications segment’s revenueincreased $0.2  million, or 9.2%, in thethree months ended June 30, 2003 compared to the three month period ended June30, 2002 due to increases in the exchange rate.  In local currency, sales for the three months ended June 30, 2003are consistent with sales for the three months ended June 30, 2002.

 

MedicalServices segment’s revenue decreased $0.1 million, or 19.5%, in the three monthperiod ended June 30, 2003 compared to the three month period ended June 30,2002.  The majority of the increase wasdue to the cancellation of a service contract in January 2003 partially offsetby an increase in pharmaceutical sales.

 

**GrossProfit and Gross Profit Margin**

 

Gross profit for the three month period ended June 30,2003 was $3.0 million, a decrease**of$1.0 million, or 25.0%, compared to $4.0 million in the three month periodended June 30, 2002. As a percentage of revenue, the gross profit margin was36.4% and 43.9% for the three months ended June 30, 2003 and 2002,respectively.

 

Gross profit from operations for each operatingsegment was as follows (in thousands):

 
|                          |   | **Three  Months  Ended June 30,  2003** |   | **Three  Months  Ended June 30,  2002** |   |
|-------------------------------|--------|-----------------------------------------|--------|-----------------------------------------|--------|
| Animal  Applications          |   | $                                       | 1,704  |                                    | $      | 2,266 |   |
| Wireless  and Monitoring      |   | 5                                       |   | 330                                     |   |
| GPS  and Radio Communications |   | 1,221                                   |   | 1,246                                   |   |
| Medical  Services             |   | 112                                     |   | 213                                     |   |
| Total                         |   | $                                       | 3,042  |                                    | $      | 4,055 |   |

 

Gross profit margin from operations for each operatingsegment was:

 
|                          |   | **Three  Months  Ended June 30,  2003** |   | **Three  Months  Ended June 30,  2002** |   |
|-------------------------------|--------|-----------------------------------------|--------|-----------------------------------------|--------|
|                          |   | **%**                                   |   | **%**                                   |   |
| Animal  Applications          |   | 32.8                                    |   | 40.4                                    |   |
| Wireless  and Monitoring      |   | 100.0                                   |   | 57.2                                    |   |
| GPS  and Radio Communications |   | 45.1                                    |   | 50.2                                    |   |
| Medical  Services             |   | 24.4                                    |   | 37.4                                    |   |

 

The AnimalApplications segment’s gross profit decreased $0.6 million, or 24.8%, in thethree month period ended June 30, 2003 compared to the three months ended June30, 2002.  The decrease is**primarilydue to increased freight expenses. The gross margin percentage decreasedto 32.8% in the three month period ended June 30, 2003 as compared to 40.4% inthe three month period ended June 30, 2002 due to increased freight and labor costs, partially offset by lower materialcosts.

 

15

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The Wireless and Monitoring segment’s gross profit decreased $0.3million, or 98.5%, in the three month period ended June 30, 2003 as compared tothe three month period ended June 30, 2002. The decrease is due to the cancellation of a significant softwarecontract in February 2003.

 

The GPS and Radio Communications segment’s grossprofit decreased $0.02 million, or 2.0%, in the three month period ended June30, 2003 as compared to the three month period ended June 30, 2002.  The gross margin percentage decreased to45.1% in the three month period ended June 30, 2003 as compared to 50.2% in thethree month period ended June 30, 2002 due to an unfavorable shift in theproduct mix.

 

The Medical Services segment’s gross profit decreased$0.1 million, or 47.4%, for the three month period ended June 30, 2003.  The gross margin percentage decreased to24.4% in the three month period ended June 30, 2003 as compared to 37.4% in thethree month period ended June 30, 2002. The decrease is due to the shift in product mix arising from thetermination of a significant service contract and increased pharmaceuticalsales.  The shift in product mixresulted in increased material costs partially offset by lower labor andoverhead expenses.

 

**Selling,General and Administrative Expenses**

 

Selling, general and administrative expenses decreased$0.7 million, or 13.6%, in the three month period ended June 30, 2003 ascompared to the three month period ended June 30, 2002. As a percentage ofrevenue, selling, general and administrative expenses were 50.0% and 52.3% forthe three months ended June 30, 2003 and 2002, respectively.

 

Selling, general and administrative expenses for eachof the operating segments were as follows (dollars in thousands):

 
|                          |   | **Three  Months  Ended June 30,  2003** |   | **Three  Months  Ended June 30,  2002** |   |
|-------------------------------|--------|-----------------------------------------|--------|-----------------------------------------|--------|
| Animal  Applications          |   | $                                       | 1,844  |                                    | $      | 1,739 |   |
| Wireless  and Monitoring      |   | 495                                     |   | 1,390                                   |   |
| GPS  and Radio Communications |   | 1,511                                   |   | 1,251                                   |   |
| Medical  Services             |   | 325                                     |   | 451                                     |   |
| Total                         |   | $                                       | 4,175  |                                    | $      | 4,831 |   |

 

Selling, general and administrative expenses as apercentage of revenue for each of the operating segments were:

 
|                          |   | **Three  Months  Ended June 30,  2003** |   | **Three  Months  Ended June 30,  2002** |   |
|-------------------------------|--------|-----------------------------------------|--------|-----------------------------------------|--------|
|                          |   | **%**                                   |   | **%**                                   |   |
| Animal  Applications          |   | 35.5                                    |   | 31.0                                    |   |
| Wireless  and Monitoring      |   | 9900.0                                  |   | 240.9                                   |   |
| GPS  and Radio Communications |   | 55.8                                    |   | 50.4                                    |   |
| Medical  Services             |   | 70.8                                    |   | 79.1                                    |   |

 

The Animal Applications segment’s selling, general andadministrative expenses increased $0.1 million in the three monthperiod ended June 30, 2003 as compared to the three month period ended June 30,2002 and as a percentage of revenue increased to 35.5% from 31.0% in the samerespective period.  The increase as apercentage of revenue is primarily due to additional consulting expenses associatedwith the Verichip Distribution and Licensing Agreement.

 

The Wireless and Monitoring segment’s selling, generaland administrative expenses of $0.5 million decreased**$0.9 million in the three month periodended June 30, 2003 as compared $1.4 million in the three month period endedJune 30, 2002. The decrease is primarily due to the exclusion of amortizationexpense for a license to a digital encryption and distribution software systemthat the Company wrote off in the fourth quarter of 2002 and lower personnelcosts.  Included in the Wireless andMonitoring segment’s selling, general and administrative expense for the threemonths ended June 30, 2002 is $0.5 million of amortization expense for thesoftware.  Selling, general andadministrative expenses increased as a percentage of revenue to 9900.0% in thethree month period ended June 30, 2003 compared to 240.9% in the three monthperiod ended June 30, 2002 due to the significant decrease in revenue in 2003.

 

The GPS and Radio Communications segment’s selling,general and administrative expenses increased$0.3 million in the three month period ended June 30, 2003 as compared to thethree month period ended June 30, 2002 primarily due to an increase in salesand marketing expenses. As a percentage of revenue, selling, general andadministrative expenses increased to 55.8% in the three month period ended June30, 2003 from 50.4% in the three month period ended June 30, 2002.

 

16

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The Medical Services segment’s selling, general andadministrative expenses decreased $0.1 million, or 27.9% in the three monthperiod ended June 30, 2003.  As apercentage of revenue, selling, general and administrative expenses were 70.8%in the three month period ended June 30, 2003 from 79.1% in the three month periodended June 30, 2002. The decrease results from the elimination of certainadministrative expenses.

 

 

**Researchand Development Expense**

 

Research and development expense was $1.2 million inthe three month period ended June 30, 2003, an increase of $0.5 million, or78.4%, from $0.7 million for the three month period ended June 30, 2002.  As a percentage of revenue, research anddevelopment expense was 14.0% and 7.1% for the three months ended June 30, 2003and 2002, respectively.  Included inresearch and development expense for the three months ended June 30, 2003 arecharges by ADS of approximately $30,000 a month to support ADS’s researchgroup.

 

Research and development expense for each of theoperating segments was as follows (in thousands):

 
|                          |   | **Three Months  Ended June 30,  2003** |   | **Three  Months  Ended June 30,  2002** |   |
|-------------------------------|--------|----------------------------------------|--------|-----------------------------------------|--------|
| Animal  Applications          |   | $                                      | 691    |                                    | $      | 361 |   |
| Wireless  and Monitoring      |   | 263                                    |   | 296                                     |   |
| GPS  and Radio Communications |   | 218                                    |   | —                                  |   |
| Medical  Services             |   | —                                 |   | —                                  |   |
| Total                         |   | $                                      | 1,172  |                                    | $      | 657 |   |

 

The increase is due primarily to additional salary andconsulting expenses incurred for the development of the Animal Applicationsegment’s temperature-sensing implantable microchip and development expense forthe GPS and Radio Communications segment’s Sarbe (locator beacon) project.

 

**InterestExpense**

 

Interest expense was $0.2 million and $0.07 million for the three monthperiods ended June 30, 2003 and 2002, respectively.

 

**IncomeTaxes**

 

The Company had an effective income tax rate of 0.0% for the threemonth periods ended June 30, 2003 and 2002.  The Company accounts forincome taxes under the asset and liability approach.  Deferred tax assets and liabilities are recognized for theexpected future tax consequences attributed to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax basis.  Deferredtax assets and liabilities are measured using the enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to reverse.  A valuationallowance is provided against net deferred tax assets when it is more likelythan not that a tax benefit will not be realized.  Income taxes included U.S. and foreign taxes.

 

**SixMonths Ended June 30, 2003 Compared to the Six Months Ended June 30, 2002**

 

**Revenue**

 

Revenue for the six months ended June 30, 2003 increased $2.8 million,or 16.3%, to $19.8 million when compared to $17.0 million in revenue for thesix months ended June 30, 2002.

 

Revenue for each of the operating segments was as follows (inthousands):

 
|                          |   | **Six Months**

**Ended June  30,  2003** |   | **Six Months**

**Ended June  30,  2002** |   |
|-------------------------------|--------|-------------------------------------------|--------|-------------------------------------------|--------|
| Animal  Applications          |   | $                                         | 12,989 |                                      | $      | 10,427 |   |
| Wireless  and Monitoring      |   | 159                                       |   | 880                                       |   |
| GPS  and Radio Communications |   | 5,407                                     |   | 5,116                                     |   |
| Medical  Services             |   | 1,203                                     |   | 570                                       |   |
| Total                         |   | $                                         | 19,758 |                                      | $      | 16,993 |   |

 

17

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The Animal Applications segment’s revenue increased**$2.6 million, or 24.6%, in the six monthsended June 30, 2003 compared to the six month period ended June 30, 2002. Themajority of the increase was due to sales to fish and wildlife industrycustomers and companion animal microchip sales in North America and Europe.

 

The Wireless and Monitoring segment’s revenuedecreased $0.7 million, or 81.9%, in the six months ended June 30, 2003compared to the six month period ended June 30, 2002.  The decrease results from the cancellation of a significantsoftware contract in February 2003.

 

The GPS and Radio Communications segment's revenueincreased $0.3 million, or 5.7%, in the six months ended June 30, 2003 comparedto the six month period ended June 30, 2002. The increase results from increases in the exchange rate.  Sales in the local currency for the sixmonths ended June 30, 2003 when compared to sales in local currency for the sixmonths ended June 30, 2002 have decreased due to weak locator beacon andbattery replacement sales.

 

MedicalServices segment’s revenue increased $0.6 million, or 111.1% in the six monthperiod ended June 30, 2003 compared to the six month period ended June 30,2002.  The increase is due to theinclusion of six months of sales in 2003 compared to three months of sales in2002.  This segment became part of theCompany on March 27, 2002.

 

**GrossProfit and Gross Profit Margin**

 

Gross profit for the six month period ended June 30,2003 was $8.4 million, an increase**of$1.1 million, or 15.8%, compared to $7.3 million in the six month period endedJune 30, 2002. As a percentage of revenue, the gross profit margin was 42.5%and 42.7% for the six months ended June 30, 2003 and 2002, respectively.

 

Gross profit from operations for each operatingsegment was as follows (in thousands):

 
|                          |   | **Six Months  Ended June 30,  2003** |   | **Six Months  Ended June 30,  2002** |   |
|-------------------------------|--------|--------------------------------------|--------|--------------------------------------|--------|
| Animal  Applications          |   | $                                    | 5,364  |                                 | $      | 4,145 |   |
| Wireless  and Monitoring      |   | 104                                  |   | 382                                  |   |
| GPS  and Radio Communications |   | 2,586                                |   | 2,518                                |   |
| Medical  Services             |   | 352                                  |   | 213                                  |   |
| Total                         |   | $                                    | 8,406  |                                 | $      | 7,258 |   |

 

Gross profit margin from operations for each operatingsegment was:

 
|                          |   | **Six Months  Ended June 30,  2003** |   | **Six Months  Ended June 30,  2002** |   |
|-------------------------------|--------|--------------------------------------|--------|--------------------------------------|--------|
|                          |   | **%**                                |   | **%**                                |   |
| Animal  Applications          |   | 41.3                                 |   | 39.8                                 |   |
| Wireless  and Monitoring      |   | 65.4                                 |   | 43.4                                 |   |
| GPS  and Radio Communications |   | 47.8                                 |   | 49.2                                 |   |
| Medical  Services             |   | 29.3                                 |   | 37.4                                 |   |

 

The Animal Applicationssegment’s gross profit increased $1.2 million, or 29.4%, in the six monthperiod ended June 30, 2003 compared to the six months ended June 30, 2002 due to the previously mentioned salesincrease.  The gross marginpercentage increased to 41.3% in the six month period ended June 30, 2003 ascompared to 39.8% in the six month period ended June 30, 2002 due to lower material costs.

 

The Wireless and Monitoring segment’s gross profit decreased $0.3million, or 72.8%, in the six month period ended June 30, 2003 as compared tothe six month period ended June 30, 2002. Margins increased to 65.4% in the six month period ended June 30, 2003from 43.4% in the six month period ended June 30, 2002.  The gross margin percentage increase wasprimarily due to the termination of employees that worked exclusively on asoftware contract that was cancelled in February 2003.

 

The Medical Services segment’s gross profit increased$0.1 million, or 65.3%, for the six month period ended June 30, 2003 ascompared to the six month period ended June 30, 2002.  The gross margin percentage decreased to 29.3% in the six monthperiod ended June 30, 2003 as compared to 37.4% in the six month period endedJune 30, 2002.  The increase in grossprofit is due primarily to the inclusion of six months of operating resultsincluded in 2003 compared to three months of operating results included in2002.  This segment became part of theCompany on March 27, 2002.  The decreasein the gross margin percentage relates to the shift in product mix arising fromthe termination of a significant service

 

18

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contract and increased pharmaceutical sales.  The shift in product mix resulted inincreased material costs partially offset by lower labor and overhead expenses.

 

**Selling,General and Administrative Expenses**

 

Selling, general and administrative expenses decreased$19.1 million, or 69.4%, in the six month period ended June 30, 2003 ascompared to the six month period ended June 30, 2002. The decrease was causedprimarily by an $18.7 million charge included in selling, general andadministrative expenses in the six month period ended June 30, 2002 arisingfrom the remeasurement of options in connection with the merger.  Pursuant to the terms of the mergeragreement, options to acquire shares of DATC common stock were converted intooptions to acquire shares of MAS common stock effective March 27, 2002.  The conversion resulted in a new measurementdate for the options and, as a result, the Company recorded a charge ofapproximately $18.7 million in non-cash compensation expenses during the sixmonth period ended June 30, 2002.  Forcurrent employees of the Company, these options are considered fixed awardsunder APB Opinion No. 25, and expense was recorded for the fair value of theoption converted using the Black-Scholes option-pricing model.  As a percentage of revenue, selling, generaland administrative expenses were 42.8% and 162.4% for the six months ended June30, 2003 and 2002, respectively.

 

Selling, general and administrative expenses,excluding the $18.7 million charge, for each of the operating segments were asfollows (dollars in thousands):

 
|                          |   | **Six Months  Ended June 30,  2003** |   | **Six Months  Ended June 30,  2002** |   |
|-------------------------------|--------|--------------------------------------|--------|--------------------------------------|--------|
| Animal  Applications          |   | $                                    | 3,434  |                                 | $      | 2,849 |   |
| Wireless  and Monitoring      |   | 1,413                                |   | 2,827                                |   |
| GPS  and Radio Communications |   | 2,952                                |   | 2,781                                |   |
| Medical  Services             |   | 656                                  |   | 451                                  |   |
| Total                         |   | $                                    | 8,455  |                                 | $      | 8,908 |   |

 

Selling, general and administrative expenses as apercentage of revenue for each of the operating segments were:

 
|                          |   | **Six Months  Ended June 30,  2003** |   | **Six Months  Ended June 30,  2002** |   |
|-------------------------------|--------|--------------------------------------|--------|--------------------------------------|--------|
|                          |   | **%**                                |   | **%**                                |   |
| Animal  Applications          |   | 26.4                                 |   | 27.3                                 |   |
| Wireless  and Monitoring      |   | 888.7                                |   | 321.3                                |   |
| GPS  and Radio Communications |   | 54.6                                 |   | 54.4                                 |   |
| Medical  Services             |   | 54.5                                 |   | 79.1                                 |   |

 

The Animal Applications segment’s selling, general andadministrative expenses increased $0.6 million in the six monthperiod ended June 30, 2003 as compared to the six month period ended June 30,2002 and as a percentage of revenue decreased to 26.4% from 27.3% in the samerespective period.  The increase relatesprimarily to additional consulting expenses associated with the VerichipDistribution and Licensing Agreement and additional board of director relatedexpenses.

 

The Wireless and Monitoring segment’s selling, generaland administrative expenses of $1.4 million decreased**$1.4 million in the six month periodended June 30, 2003 as compared $2.8 million in the six month period ended June30, 2002. The decrease is primarily due to the exclusion of amortizationexpense for a license to a digital encryption and distribution software systemthat the Company wrote off in the fourth quarter of 2002.  Included in the Wireless and Monitoringsegment’s selling, general and administrative expense for the six months endedJune 30, 2002 is $1.0 million of amortization expense for this asset.  Selling, general and administrative expensesincreased as a percentage of revenue to 888.7 % in the six month period endedJune 30, 2003 compared to 321.3% in the six month period ended June 30, 2002due to the significant decline in revenue in 2003.

 

The GPS and Radio Communications segment’s selling,general and administrative expenses increased$0.2 million in the six month period ended June 30, 2003 as compared to the sixmonth period ended June 30, 2002 primarily due to an increase in marketing expenses.As a percentage of revenue, selling, general and administrative expensesincreased to 54.6% in the six month period ended June 30, 2003 from 54.4% inthe six month period ended June 30, 2002.

 

The Medical Services segment’s selling, general andadministrative expenses increased $0.2 million, or 45.5%, in the six monthperiod ended June 30, 2003 as compared to the six month period ended June 30,2002.  As a percentage of revenue,selling, general and administrative expenses were 54.5% in the six month periodended June 30, 2003 as compared to 79.1% in the six month period ended June 30,2002.  The increase in selling, generaland administrative expense is due primarily to the inclusion of six months ofexpense in 2003 compared to three months of expense in 2002.  This segment became part of the Company onMarch 27, 2002.

 

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**Researchand Development Expense**

 

Research and development expense was $2.1 million inthe six month period ended June 30, 2003, an increase of $0.8 million, or59.5%, from $1.3 million for the six month period ended June 30, 2002.  As a percentage of revenue, research anddevelopment expense was 10.5% and 7.7% for the six months ended June 30, 2003and 2002, respectively.  Included inresearch and development expense for the six months ended June 30, 2003 arecharges by ADS of approximately $30,000 a month to support ADS’s researchgroup.

 

Research and development expense for each of theoperating segments was as follows (in thousands):

 
|                          |   | **Six Months****Ended June 30,****2003** |   | **Six Months  Ended June 30,  2002** |   |
|-------------------------------|--------|------------------------------------------|--------|--------------------------------------|--------|
| Animal  Applications          |   | $                                        | 1,241  |                                 | $      | 605 |   |
| Wireless  and Monitoring      |   | 480                                      |   | 701                                  |   |
| GPS  and Radio Communications |   | 362                                      |   | —                               |   |
| Medical  Services             |   | —                                   |   | —                               |   |
| Total                         |   | $                                        | 2,083  |                                 | $      | 1,306 |   |

 

The increase is due primarily to additionaldevelopment expenses incurred for the Animal Application segment’stemperature-sensing implantable microchip and the GPS and Radio Communicationssegment’s Sarbe project and a change in accounting for the reimbursement of researchand development expenses.

 

**InterestExpense**

 

Interest expense was $0.3 million and $1.9 million for the six monthsperiod ended June 30, 2003 and 2002, respectively.  Included in the $1.9 million of interest expense for the sixmonths ended June 30, 2002 is $1.8 million of interest expense charged by ADS.

 

**IncomeTaxes**

 

The Company had an effective income tax rate of 0.0% for the six monthperiods ended June 30, 2003 and 2002.  The Company accounts forincome taxes under the asset and liability approach.  Deferred tax assets and liabilities are recognized for theexpected future tax consequences attributed to differences between thefinancial statement carrying amounts of existing assets and liabilities and theirrespective tax basis.  Deferred tax assetsand liabilities are measured using the enacted tax rates expected to apply totaxable income in the years in which those temporary differences are expectedto reverse.  A valuation allowance isprovided against net deferred tax assets when it is more likely than not that atax benefit will not be realized. Income taxes included U.S. and foreign taxes.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

As of June 30, 2003, the Company had cash and cashequivalents of $0.0 million compared to $0.2 million at December 31, 2002.  Cash used in operating activities totaled$2.3 million and $1.0 million in the first six months of 2003 and 2002,respectively.

 

In the first six months of 2003, the use of cash was due primarily tothe loss generated from operations and a significant increase in accountsreceivable and inventory.  Accountsreceivable, net of allowance for doubtful accounts, increased by $1.0 million,or 25.2%, to $5.1 million at June 30, 2003 from $4.1 million at December 31,2002.  This increase is primarily due tothe seasonality of our business. Offsetting these uses of cash were increases in accounts payable,accrued expenses and deferred revenue.

 

Inventory levels increased by $1.7 million to $6.6million at June 30, 2003 from $4.9 million at December 31, 2002 due to asignificant number of shipments in December 2002, resulting in a reduction ofinventory and the accumulation of inventory for anticipated sales in the secondhalf of 2003.

 

Accounts payable increased by $2.2 million to $6.3million at June 30, 2003 from $4.1 million at December 31, 2002.

 

Accrued expenses and other current liabilities increased by $0.5million, or 14.2%, to $4.2 million at June 30, 2003 from $3.7 million atDecember 31, 2002.

 

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Investing activities used cash of $0.5 million in thefirst six months of 2003 and 2002. During the first six months of 2003 and 2002, $0.5 million and $0.7million was spent to acquire property and equipment, respectively.

 

Financing activities provided cash of $2.6 million and$1.4 million in the first six months of 2003 and 2002, respectively.  In 2003, cash was provided primarily byborrowing on our line of credit.

 

*Debt, Covenant Compliance andLiquidity*

 

The following table summarizes the Company’s fixed cash obligations asof June 30, 2003 over various future periods (in thousands):

 
|                             |   |      |   | **Payments  Due by Period** |   |
|----------------------------------|--------|-----------|--------|-----------------------------|--------|
| **Contractual cash obligations** |   | **Total** |   | **Less than  1 Year**       |   | **1-3  Years** |   | **4-5  Years** |   | **After  5 Years** |   |
| Notes Payable and Long-Term Debt |   | $         | 3,374  |                        | $      | 91 |   | $ | 1,029 |   | $ | 117 |   | $ | 2,137 |   |
| Operating Leases                 |   | 13,572    |   | 584                         |   | 905 |   | 408 |   | 11,675 |   |
| Employment Contracts             |   | 3,213     |   | 1,217                       |   | 1,621 |   | 375 |   | — |   |
|                             |   | $         | 20,159 |                        | $      | 1,892 |   | $ | 3,555 |   | $ | 900 |   | $ | 13,812 |   |

 

Effective October 30, 2002, we entered into a Credit and SecurityAgreement with Wells Fargo Business Credit, Inc. (“Wells Fargo”). Our creditfacility provides for borrowings of up to 80% of eligible receivables, asdefined, and up to a maximum of $5,000,000 under the terms of the Credit andSecurity Agreement.  At June 30, 2003,the annual interest rate on the credit facility was approximately 10.2%. Thecredit facility requires that the total amount of interest paid per year mustbe at least $120,000. The credit facility will expire on October 30, 2005, atwhich time the entire outstanding balance of the credit facility will becomedue and payable. Amounts borrowed under the credit facility are secured by afirst priority lien on substantially all of our assets, including accountsreceivable, patents and other intellectual property relating to the Digital AngelTMproduct. As of June 30, 2003, we had $292,000 of borrowing availability underour credit facility.

 

The credit facility contains certain financial covenants, including amonthly minimum book net worth and monthly minimum earnings before taxes, andit limits our capital expenditures during 2003. Any breach of the financialcovenants by us will constitute an event of default under the Credit andSecurity Agreement unless waived by Wells Fargo. In addition, any change ofcontrol of the Company will be an event of default under the Credit andSecurity Agreement. As defined in the Credit and Security Agreement, a changeof control includes the future acquisition by any person or group of persons ofmore than 25% of the voting power of all classes of our common stock or ourcurrent President and Chief Executive Officer ceases to actively manage theCompany’s day-to-day business activities. As of June 30, 2003, we were out ofcompliance with the minimum book net worth and monthly minimum earnings beforetaxes covenants. We have obtained a waiver for these covenant violations fromWells Fargo.  As a result of ourcovenant violations in the first quarter of 2003, Wells Fargo is exercising itsright to charge interest at the default rate, which was approximately 10.2% atJune 30, 2003. There can be no assurance that we will continue to comply withthe financial covenants of our Credit and Security Agreement, that an event ofdefault will not occur, or that we can continue to obtain waivers of any eventsof default under the Credit and Security Agreement.

 

ADS had a term and revolving credit agreement (IBM Credit Agreement)with IBM Credit. Effective April 1, 2003, ADS entered into a ForbearanceAgreement with IBM Credit.  Under theterms of the Forbearance Agreement, ADS acquired the right to purchase all ofits outstanding debt obligations to IBM Credit, totaling $99.0 million(including accrued interest), if ADS paid IBM Credit $30.0 million by June 30,2003.  As of June 30, 2003, ADS had madecash payments to IBM Credit Corporation totaling $30.0 million and hadsatisfied in full its debt obligations to IBM Credit Corporation under theForbearance Agreement.

 

Funding forthe $30.0 million payment to IBM Credit included $10.0 million in net proceedsfrom the issuance by ADS of 8.5% Convertible Exchangeable Debentures.  These debentures are convertible into sharesof ADS common stock or exchangeable for shares of our common stock owned byADS, or a combination thereof, at anytime at the purchasers’ option.  ADS owned 19.6 million shares, orapproximately 72.9%, of our issued and outstanding common stock as of June 30,2003.  The exchange price for our commonstock subject to purchase pursuant to the debentures is $2.20 per share as tothe first 50.0% of the original principal amount of the debentures and $4.25per share as to the remaining 50.0% of the original principal amount, subjectto anti-dilution provisions.  Of the19,600,000 shares of our common stock owned by ADS, it has pledged 15,000,000shares to the debenture holders as collateral.

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The debenturesrequire that ADS pay interest to each debenture holder at the rate of 8.5% perannum, payable on a quarterly basis beginning September 1, 2003 and, beginningon November 1, 2003, on a monthly basis, as to the principal amount required tobe redeemed each month. A final interest payment is due on the maturity date.Interest payments may be made in either cash or in shares of our common stock,or a combination thereof at ADS’s option, subject to certain restrictions. Theinterest conversion rate for our common stock is calculated based upon 90.0% ofthe average of the lowest 10 of the 20 volume-weighted average stock pricesimmediately prior to the applicable interest payment date, subject to a latepayment adjustment.  Principalredemption payments of $0.4 million are due monthly beginning November 1,2003.  The principal redemption paymentsmay be made in cash, in ADS common stock or our common stock at ADS’s option,subject to certain limitations regarding the average market value and tradingvolume of our common stock. The conversion prices are based upon the lesser of(a) 90.0% of the lowest 10 of the 20 volume-weighted average stock prices priorto the redemption date, and (b) the set prices as defined in the purchaseagreement. The set prices are based upon the market prices of ADS common stockand our common stock on the date of the transaction.

 

ADS has alsogranted to the debenture holders warrants to purchase approximately 5.35million shares of ADS common stock or 0.95 million shares of our common stockcurrently owned by ADS, or a combination of shares from both companies, at eachpurchaser’s option.  The exercise pricewith respect to our common stock issuable pursuant to the warrants is $3.178per share.  The warrants are subject toanti-dilution provisions, vest immediately and are exercisable through June 30,2007.

 

*Possible Consequences of Exchange of the ADSDebentures, Exercise of the ADS Warrants or Foreclosure of Pledge Shares*

 

Employment Agreement with Randolph K.Geissler.  Under the terms of the employmentagreement dated March 8, 2002, as amended, by and between the Company andRandolph K. Geissler (the President and Chief Executive Officer of theCompany), a “change in control” occurs under that employment agreement if anyperson becomes the “beneficial owner” (as defined in Rule 13d-3 under theSecurities Exchange Act of 1934), directly or indirectly, of securities of theCompany representing 20% or more of the combined voting power of the Company’sthen outstanding shares of common stock. ADS has issued 8.5% ConvertibleExchangeable Debentures which are convertible into shares of ADS common stockor exchangeable for shares of our common stock owned by ADS, or a combinationthereof, at the purchasers’ option.  ADShas also granted the debenture purchasers warrants to purchase ADS commonstock, shares our common stock owned by ADS, or a combination thereof, at thepurchasers’ option.  In addition, tosecure its obligations under the debentures, ADS pledged 15,000,000 of ourshares to the debenture holders.  If theexchange of the debentures, the exercise of the warrants, any foreclosure ofADS’s pledge to the debenture holders, or any combination of these events,results in another person or group of persons owning, in the aggregate, 20% ormore of our common stock, such transaction could constitute a change in control under the employment agreement withMr. Geissler. Upon the occurrence of a change in control, Mr. Geissler, athis sole option and discretion, may terminate his employment with the Companyat any time within one year after such change in control upon 15 days’notice. In the event of such termination, the employment agreement providesthat the Company must pay to Mr. Geissler a severance payment equal to threetimes the base amount as defined in Section 280G(b)(3) of the Internal RevenueCode of 1986, as amended (“Code”), minus $1.00 (currently a total ofapproximately $750,000), which would be payable no later than one month afterthe effective date of Mr. Geissler’s termination of employment.

 

The employment agreement also provides that (i) upon a change ofcontrol, (ii) upon the termination of Mr. Geissler’s employment for any reasonother than due to his material default under the employment agreement, or (iii)if he ceases to be the Company’s President and Chief Executive Officer for anyreason other than termination due to his material default under the employmentagreement, within 10 days of the occurrence of any such events, the Company isto pay to Mr. Geissler $4,000,000. The Company may pay such amount in cashor in the Company’s common stock or with a combination of cash and commonstock. The employment agreement also provides that if the $4,000,000 ispaid in cash and stock, the amount of cash paid must be sufficient to cover thetax liability associated with such payment, and such payment shall otherwise bestructured to maximize tax efficiencies to both the Company and Mr. Geissler.

 

Credit and Security Agreement with WellsFargo Business Credit, Inc.  The Credit andSecurity Agreement provides that a “change in control” under that agreementresults in a default. A change in control is defined as either Mr.Geissler ceasing to actively manage the Company’s day-to-day businessactivities or the transfer of at least 25% of the outstanding shares of commonstock of the Company. Also, if the Company owes to Mr. Geissler $4,000,000under his employment agreement as described above, the obligation would mostlikely result in a breach of the Company’s financial covenants under the Creditand Security Agreement. If these defaults occurred and were not waived byWells Fargo, and if Wells Fargo were to enforce their rights under the terms ofthe Credit and Security Agreement and related agreements, the Company’sbusiness and financial condition would be materially and adversely affected,and it may force the Company to cease operations.

 

**Forward****– LookingStatements and Associated Risk**

 

This Form 10-Q contains forward-looking statementswithin the “safe harbor” provisions of the Private Securities Litigation ReformAct of 1995 with respect to our financial condition, results of operations andbusiness, and it includes statements relating to:

 

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

 

•                  anticipatedtrends in our business and demographics;

 

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

 

•                  ourfuture profitability and liquidity; and

 

•                  regulatory,competitive or other economic influences.

 

Words such as “anticipates,” “expects,” “intends,”“plans,” “believes,” “seeks,” “estimates” and similar expressions also identifyforward-looking statements.  Theseforward-looking statements are not guarantees of future performance and aresubject to risks and uncertainties that could cause actual results to differmaterially from estimates or forecasts contained in the forward-lookingstatements.  Some of these risks anduncertainties are beyond our control.

 

**RiskFactors**

 

You should carefully consider the risk factors listedbelow.  These risk factors may cause ourfuture earnings to be less or our financial condition to be less favorable thanwe expect.  You should read this sectiontogether with the other information contained herein.

 

**Historical losses and negative cashflows from operations raise doubt about our ability to continue as a going concern.**

 

Historically, the Company has suffered losses and has not generatedpositive cash flows from operations. This raises substantial doubt about the Company’s ability to continue asa going concern.  The audit reports ofEisner LLP for the year ended December 31, 2002 for the Company’s financialstatements and PricewaterhouseCoopers LLP for each of the two years endedDecember 31, 2001 and 2000 for AWG’s financial statements, which became ourhistorical financial statements in the merger, contained an explanatoryparagraph expressing doubt about the Company’s and AWG’s ability to continue as a going concern.

 

**The Company’s majority stockholder, Applied Digital Solutions, Inc.,owns 72.9% of the Company’s common stock, is able to completely control the boardof directors and may support actions that conflict with the interests of theother stockholders.**

 

ADS is the beneficial owner of 72.9% of our common stock, and itcontrols us with respect to all matters upon which our stockholders may vote,including the selection of the Board of Directors, mergers, acquisitions andother significant corporate transactions. There can be no assurance as to how ADS will exercise control overus.  ADS may support actions that arecontrary to or conflict with the interests of the other stockholders.

 

 

**Any sales of ourcommon stock acquired in the exchange of the ADS debentures, the exercise ofthe ADS warrants, or any foreclosure of the pledge of our shares by ADS to thedebenture holders may cause a reduction in the market value of our commonstock.**

 

Of the19,600,000 shares of our common stock owned by ADS, it has pledged 15,000,000shares as collateral in connection with the issuance by ADS of the 8.5%Convertible Exchangeable Debentures. The debentures are convertible into shares of ADS common stock orexchangeable for shares of our common stock owned by ADS, or a combinationthereof, at the purchasers’ option.  Inaddition, the debentures provide for the payment of interest by ADS to eachdebenture holder at the rate of 8.5% per annum.  Interest payments may be made in either cash, shares of ourcommon stock or a combination thereof, at ADS’s option, subject to certainrestrictions.  The principal redemptionpayments may be made in cash, ADS common stock or our common stock at ADS’soption, subject to certain limitations regarding the average market value andtrading volume of our common stock.

 

ADS has alsogranted to the debenture holders warrants to acquire approximately 5.35 millionshares of ADS common stock, or 0.95 million shares of our common stockcurrently owned by ADS, or a combination of shares from both companies, at eachpurchaser’s option.  These warrants aresubject to anti-dilution provisions, vest immediately and are exercisablethrough June 30, 2007.

 

Exchange ofthe debentures, exercise of the warrants, foreclosure of the pledge, or anycombination of these events, could result in the transfer of a significantnumber of shares of our common stock to one or more persons. There can be noassurance that any shares transferred in any debenture exchange, warrantexercise, or pledge will be held for any period of time by the debentureholders upon such exchange or exercise. The debenture holders may elect to sell our shares in privatetransactions or in the public market. In the event our shares are sold by the debenture holders, we will havelittle or no control over such sales. We can give no assurance as to how these shares of our common stock willbe sold, who will purchase such shares or the number of shares that will besold at any

 

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given time.  The sale of a significant number of sharesof our common stock in a single transaction or in a series of transactions overa short period of time could result in a significant decline in the marketvalue of our common stock.

 

**Theterms of our credit facility subject us to the risk of foreclosure onsubstantially all of our assets*.***

 

Effective October 30, 2002, we entered into a Credit and SecurityAgreement with Wells Fargo Business Credit, Inc. (“Wells Fargo”). Our creditfacility provides for borrowings up to 80% of eligible receivable, as defined,and up to a maximum of $5,000,000 under the terms of the Credit and SecurityAgreement.  At June 30, 2003, the annualinterest rate on the credit facility was approximately 10.2%. The creditfacility requires that the total amount of interest paid per year must be atleast $120,000. The credit facility will expire on October 30, 2005, at whichtime the entire outstanding balance of the credit facility will become due andpayable. Amounts borrowed under the credit facility are secured by a firstpriority lien on substantially all of our assets, including accountsreceivable, patents and other intellectual property relating to the DigitalAngelTM product. As of June 30, 2003, we had $292,000 of borrowing availabilityand $1.9 million outstanding under our credit facility.

 

The credit facility contains certain financial covenants, including amonthly minimum book net worth and monthly minimum earnings before taxes, andit limits our capital expenditures during 2003. Any breach of the financialcovenants by us will constitute an event of default under the Credit andSecurity Agreement unless waived by Wells Fargo. In addition, any change ofcontrol of the Company will be an event of default under the Credit andSecurity Agreement. As defined in the Credit and Security Agreement, a changeof control includes the future acquisition by any person or group of persons ofmore than 25% of the voting power of all classes of our common stock or ourcurrent President and Chief Executive Officer ceases to actively manage theCompany’s day-to-day business activities. As of June 30, 2003, we were out ofcompliance with the minimum book net worth and monthly minimum earnings beforetaxes covenants.  We have obtained awaiver for these covenant violations from Wells Fargo.  As a result of our covenant violations inthe first quarter of 2003, Wells Fargo is exercising its right to charge interestat the default rate, which was approximately 10.2% at June 30, 2003. There canbe no assurance that we will continue to comply with the financial covenants ofour Credit and Security Agreement, that an event of default will not occur orthat we can continue to obtain waivers of any events of default.

 

The credit facility will expire on October 30, 2005, at which time theentire outstanding balance of the credit facility will become due andpayable.  We may not have sufficientfunds to repay the outstanding balance on the credit facility upon itsmaturity.  Accordingly, we may berequired to obtain the funds necessary to repay the credit facility eitherthrough refinancing the credit facility, the issuance of additional equity ordebt securities or the sale of assets. There can be no assurance that, if needed, we can obtain suchrefinancing, issue equity or debt securities, or sell assets under terms thatare acceptable to us, or at all.  If weare unable to obtain funds to repay this indebtedness on acceptable terms, orat all, we may be forced to dispose of assets or take other actions ondisadvantageous terms, which could result in losses to the Company and have amaterial adverse effect on our financial condition.  For these reasons, there can be no assurance that we will be ableto repay the credit facility upon its maturity.

 

As described above, ADS has issued debentures which are convertibleinto shares of ADS common stock or exchangeable for shares of our common stockowned by ADS, or a combination thereof, at the purchasers’ option.  In addition, ADS pledged 15,000,000 of ourshares to secure its obligations under the debentures.  If the exchange of the debentures, an exerciseof the warrants, a foreclosure of the pledge, or any combination thereof,results in another person or group of persons owning, in the aggregate, 25.0%or more of our common stock, such transaction will be deemed to constitute anevent of default under the Credit and Security Agreement with Wells Fargo.

 

The occurrence of any of the foregoing or any other events of defaultunder the Credit and Security Agreement would subject us to the risk offoreclosure by Wells Fargo on substantially all of our assets to the extentnecessary to repay any amounts due under the credit facility, including, butnot limited to, principal, interest, penalties or other costs and expensesincurred.  Any such default andresulting foreclosure could have a material adverse effect on our financialcondition.

 

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**Exchangeof the ADS debentures, exercise of the ADS warrants or foreclosure of thepledged shares may trigger “change in control” clauses under key agreementswhich may materially and adversely affect the Company’s business and financialcondition.**

 

Employment Agreement with Randolph K. Geissler. Under the terms of the employment agreement dated March 8, 2002, as amended, byand between the Company and Randolph K. Geissler (the President and ChiefExecutive Officer of the Company), a “change in control” occurs under thatemployment agreement if any person becomes the “beneficial owner” (as definedin Rule 13d-3 under the Securities Exchange Act of 1934), directly orindirectly, of securities of the Company representing 20% or more of thecombined voting power of the Company’s then outstanding shares of commonstock. ADS has issued 8.5% Convertible Exchangeable Debentures which areconvertible into shares of ADS common stock or exchangeable for shares of ourcommon stock owned by ADS, or a combination thereof, at the purchasers’option.  ADS has also granted thedebenture purchasers warrants to purchase ADS common stock, shares our commonstock owned by ADS, or a combination thereof, at the purchasers’ option.  In addition, to secure its obligations underthe debentures, ADS pledged 15,000,000 of our shares to the debentureholders.   If the exchange of thedebentures, the exercise of the warrants, any foreclosure of ADS’s pledge tothe debenture holders, or any combination of these events, results in anotherperson or group of persons owning, in the aggregate, 20% or more of our commonstock, such transaction  couldconstitute a change in control under the employment agreement with Mr.Geissler. Upon the occurrence of a change in control, Mr. Geissler, at hissole option and discretion, may terminate his employment with the Company atany time within one year after such change in control upon 15 days’notice. In the event of such termination, the employment agreementprovides that the Company must pay to Mr. Geissler a severance payment equal tothree times the base amount as defined in Section 280G(b)(3) of the InternalRevenue Code of 1986, as amended (“Code”), minus $1.00 (currently a total ofapproximately $750,000), which would be payable no later than one month afterthe effective date of Mr. Geissler’s termination of employment. 

 

The employmentagreement also provides that (i) upon a change of control, (ii) upon thetermination of Mr. Geissler’s employment for any reason other than due to hismaterial default under the employment agreement, or (iii) if he ceases to bethe Company’s President and Chief Executive Officer for any reason other thantermination due to his material default under the employment agreement, within10 days of the occurrence of any such events, the Company is to pay to Mr.Geissler $4,000,000. The Company may pay such amount in cash or in theCompany’s common stock or with a combination of cash and common stock. Theemployment agreement also provides that if the $4,000,000 is paid in cash andstock, the amount of cash paid must be sufficient to cover the tax liabilityassociated with such payment, and such payment shall otherwise be structured tomaximize tax efficiencies to both the Company and Mr. Geissler.

 

Credit and Security Agreement with Wells Fargo Business Credit, Inc. The Credit and Security Agreement provides that a “change in control” underthat agreement results in a default. A change in control is defined aseither Mr. Geissler ceasing to actively manage the Company’s day-to-daybusiness activities or the transfer of at least 25% of the outstanding sharesof common stock of the Company. Also, if the Company owes to Mr. Geissler$4,000,000 under his employment agreement as described above, the obligationwould most likely result in a breach of the Company’s financial covenants underthe Credit and Security Agreement. If these defaults occurred and were notwaived by Wells Fargo, and if Wells Fargo were to enforce their rights underthe terms of the Credit and Security Agreement and related agreements, theCompany’s business and financial condition would be materially and adverselyaffected, and it may force the Company to cease operations.

 

**Our earnings will decline if we writeoff additional goodwill and other intangible assets.**

 

As of June 30, 2003, we had recorded goodwill of $47.5 million. OnJanuary 1, 2002, we adopted SFAS No. 142, “Goodwill and Other IntangibleAssets.”  SFAS No. 142 requires thatgoodwill and certain intangibles no longer be amortized but instead tested forimpairment at least annually by applying a fair value based test. During thefirst quarter of 2002, we completed the transitional goodwill impairment testrequired by SFAS No. 142 and recorded no impairment of our goodwill.  During the fourth quarter of 2002, weperformed the annual impairment test for goodwill using a fair value basedapproach, primarily discounted cash flows. An evaluation of the Wireless and Monitoring and Medical Systemsreporting units indicated that $31.5 million and $25.9 million of goodwill,respectively, was impaired. Accordingly, we recorded an impairment charge of$57.4 million in the fourth quarter of 2002. Factors contributing to theimpairment charge were a longer than anticipated timeframe in developing the newDigital AngelTM technology for the Wireless and Monitoring reporting unit and achange in business focus for the Medical Systems reporting unit. We will assessthe fair value of our goodwill annually or earlier if events occur orcircumstances change that would more likely than not

 

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reduce the fair value of our goodwill below its carrying value.  These events or circumstances would includea significant change in business climate, including a significant, sustaineddecline in an entity’s market value, legal factors, operating performanceindicators, competition, sale or disposition of a significant portion of thebusiness, or other factors. If we determine that significant impairment hasoccurred, we would be required to write off the impaired portion of goodwill.Impairment charges could have a material adverse effect on our financialcondition and results of operations.

 

**The exercise of options and warrantsoutstanding and available for issuance may adversely affect the market price ofour common stock*.***

 

As of June 30, 2003, we had options and warrants outstanding topurchase a total of 8,552,000 shares of common stock at exercise prices rangingfrom $0.05 to $10.50 per share, with a weighted average exercise price of$1.64.  In addition, we had 2,545,000additional shares of common stock which may be issued in the future under ourstock option plans.  The exercise ofoutstanding options and warrants and the sale in the public market of theshares purchased upon such exercise may adversely affect the market price ofour common stock.

 

**We maycontinue to incur losses.**

 

We incurred net losses of $2.3 million, $92.4 million, $17.4 millionand $3.9 million in the six month period ended June 30, 2003 and the years endedDecember 31, 2002, 2001 and 2000, respectively.  No assurance can be given as to whether we will achieveprofitability, if at all. 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 wefail to achieve and maintain sufficient profitability within the time frameexpected by investors, the market price of our common stock may be adverselyaffected.

 

**The Wireless and Monitoring segment isexpected to incur future losses and may never achieve profitability*.***

 

We have invested approximately $14.0 million in the Digital Angeläproduct for the period from April 1998 through June 30, 2003.  We expect the Wireless and Monitoringsegment to incur additional development, sales and marketing, and other generalexpenses.  As a result, the Wireless andMonitoring segment is expected to incur losses for the foreseeable future andwill need to generate significant revenues to achieve profitability.  There can be no assurance that the segmentwill achieve profitability or, if profitability is achieved, that it will besustained.  The Wireless and Monitoringsegment’s failure to achieve or sustain profitability would have a materialadverse effect on the market value of our common stock.

 

The Wireless andMonitoring segment is the initial stage of operations and may encounterunforeseen difficulties that could negatively affect our business.  It has generated no substantial revenue. Asa result, it has minimal operating history upon which to base an evaluation ofits current business and future prospects. The first Digital Angel product wasintroduced in November 2001.  Moreover,this segment does not currently have any contracts in place that will provideany significant revenue.  Because ofthis segment’s lack of an operating history, management has limited insightinto trends that may emerge and could materially adversely affect its business.  This segment’s prospects must be consideredin light of the risks, expenses and difficulties frequently encountered bycompanies in new and rapidly evolving markets. This segment could encounter risks and difficulties in its new andrapidly evolving market, especially given its lack of operating history. Theserisks include the Wireless and Monitoring segment’s ability to:

 

•                  developand market Digital Angel products by integrating and miniaturizing newtechnologies into marketable products and services;

 

•                  builda customer base;

 

•                  generaterevenues;

 

•                  competesuccessfully in a highly competitive market;

 

•                  accesssufficient capital to support growth;

 

•                  recruitand retain qualified employees;

 

•                  introducenew products and services; and

 

•                  buildtechnology and support systems.

 

Each of these risks could lead to unforeseen expenses or losses, whichcould have a material adverse effect on our financial 

 

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condition and results ofoperations.

 

**Infringement by third parties on ourintellectual property or the development of substantially equivalentproprietary technology by our competitors could negatively affect our business.**

 

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

 

**Domestic and foreign governmentregulation and other factors could impair our ability to develop and sell ourproducts in certain markets.**

 

The electronic animal identification market can be negatively affectedby such factors as food safety concerns, consumer perceptions regarding costand efficacy, international technology standards, national infrastructures, andslaughterhouse removal of microchips.

 

We are also subject to federal, state and local regulation in theUnited States, including regulation by the U.S. Food and Drug Administration,the U.S. Federal Communications Commission and the U.S. Department ofAgriculture, and to regulation in other countries.  We cannot predict the extent to which we may be affected byfurther legislative and regulatory developments concerning our products andmarkets.  We are required to obtainregulatory approval before marketing most of our products.  The regulatory process can be verytime-consuming and costly, and there is no assurance that we will receive theregulatory approvals necessary to sell our products.  Regulatory authorities also have the authority to revoke approvalof previously approved products for cause, to request recalls of products andto close manufacturing plants in response to violations.  Any such regulatory action, including thefailure to obtain such approval, could prevent us from selling, or materiallyimpair our ability to sell, our products in certain markets and couldnegatively affect our business.

 

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

 

The principal customers for electronic identification devices for fishare government contractors that rely on funding from the United Statesgovernment.  Because these contractorsrely heavily on government funds, any decline in the availability of such fundscould result in a decreased demand by these contractors for our products.  Any decrease in demand by such customerscould have a material adverse effect on our financial condition and results ofoperations and result in a decline in the market value of our common stock.

 

**We depend on a single productionarrangement with Raytheon Corporation for our patented syringe-injectablemicrochips, and the loss of or any significant reduction in the production couldhave an adverse effect on our business.**

 

We rely solely on a production arrangement with Raytheon Corporation(“Raytheon”) for the manufacture of our patented syringe-injectable microchipsthat are used in all of our implantable electronic identificationproducts.  Raytheon utilizes ourproprietary technology and our equipment in the production of oursyringe-injectable microchips. The termination, or any significant reduction,by Raytheon of the assembly of our microchips or a material increase in the pricecharged by Raytheon for the assembly of our microchips could have an adverseeffect on our financial condition and results of operations.  In addition, Raytheon may not be able toproduce sufficient quantities of the microchips to meet any significantincreased demand for our products or to meet any such demand on a timelybasis.  Any inability or unwillingnessof Raytheon to meet our demand for microchips would require us to utilize analternative production arrangement and remove our automated assembly productionmachinery from the Raytheon facility, which would be costly and could delayproduction.  Moreover, if Raytheonterminates our production arrangement, we cannot ensure that the assembly ofour microchips from another source would be on comparable or acceptableterms.  The failure to make such analternative production arrangement could have an adverse effect on ourbusiness.

 

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**We depend onprincipal customers.**

 

For the six month period ended June 30, 2003, four customers — ScheringPlough, Biomark, Pacific States and Merial — together accounted for 31.7% ofour consolidated revenues. For the three month period ended June 30, 2003, thesame customers together accounted for 33.1% of our consolidated revenues.  In addition, the GPS and RadioCommunications segment is heavily dependent on contracts with domesticgovernment agencies and foreign governments, including the United Kingdom,primarily relating to military applications. The loss of, or a significantreduction in, orders from these or our other major customers could have amaterial adverse effect on our financial condition and results of operations.

 

**We compete with other companies inthe visual and electronic identification market, and the products sold by ourcompetitors could become more popular than our products or render our productsobsolete.**

 

The market for visual and electronic identification for companionanimals and livestock is highly competitive. We believe that our principal competitorsin the visual identification market for livestock are AllFlex USA and Y-TexCorporation, and that our principal competitors in the electronicidentification market that have developed permanent electronic identificationdevices for the companion animal market are AllFlex USA, Datamars SA and AvidPlc.  Neither Datamars nor Avid has beengranted a U.S. license to use implantable technology.

 

In addition, other companies could enter this line of business in thefuture.  Some of our competitors have substantiallygreater financial and other resources than us. We may not be able to competesuccessfully with these competitors, and those competitors may develop ormarket technologies and products that are more widely accepted than ours orthat would render our products obsolete or noncompetitive.  We are not aware of any other competitorscurrently marketing products that would compete with the Digital Angelproduct.  However, we are aware ofseveral potential competitors that have expressed an interest in similartechnologies.  We are unaware of anyactual sales of a competing product.  Ifsuch competitors enter the market and compete with the Digital Angel product,such competition could have a material adverse effect on our business.

 

**We are subject to risks as a resultof our foreign operations.**

 

We maintain operations outside of the United States, which subjects usto risks that are inherent in international operations, including the riskthat:

 

•                  itis more difficult to enforce agreements and collect receivables through manyforeign legal systems;

 

•                  foreigncustomers may have longer payment cycles than customers in the United States;

 

•                  taxrates in some foreign countries may exceed those in the United States, andforeign earnings may be subject to withholding requirements or the impositionof tariffs, exchange controls or other restrictions;

 

•                  generaleconomic and political conditions in countries where we operate may have anadverse effect on our operations or other presence in those countries;

 

•                  thedifficulties associated with managing a large organization spread throughoutvarious countries may adversely affect our business in those countries; and

 

•                  requiredcompliance with a variety of foreign laws and regulations may prove onerous andadversely affect our operations abroad.

 

As we continue to expand our business globally, our success willdepend, in part, on our ability to anticipate and effectively manage these andother risks.  These and other factorsmay have a material adverse effect on our international operations or ourbusiness as a whole.

 

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

 

We generate a portion of our sales and incur a portion of our expensesin currencies other than U.S. dollars. To the extent that we are unable to match revenues received in foreigncurrencies with costs paid in the same currency, exchange rate fluctuations inany such currency could have an adverse effect on our financial results.

 

**We depend on a small team of seniormanagement, and we may have difficulty attracting and retaining additionalpersonnel.**

 

Our future success will depend in large part upon the continuedservices and performance of senior management and other 

 

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key personnel.  If we lose theservices of any member of our senior management team, our overall operationscould be materially and adversely affected. In addition, our future success will depend on our ability to identify,attract, hire, train, retain and motivate other highly skilled technical,managerial, marketing, purchasing and customer service personnel when they areneeded.  Competition for theseindividuals is intense.  We cannotensure that we will be able to successfully attract, integrate or retainsufficiently qualified personnel when the need arises.  Any failure to attract and retain thenecessary technical, managerial, marketing, purchasing and customer servicepersonnel could have a material adverse effect on our financial condition andresults of operations.

 

We have employment agreements with certain key personnel, including ourPresident and Chief Executive Officer. The agreement with our President and Chief Executive Officer providesfor specific payments in the event of a change in control of the Company.

 

**The Digital AngelTM technology is notproven, and we may not be able to develop products from this unproventechnology.**

 

The Wireless and Monitoring segment depends on the development,integration, miniaturization and successful marketing of several advancedtechnologies that have not previously been integrated or used as anticipated bythis segment. The Wireless and Monitoring segment depends upon advancedtechnology, including wireless communication, biosensors, motion determinationand global positioning system capabilities. Many of these technologies areunproven or relatively new.  Noassurances can be given as to when or if the Digital Angel product will besuccessfully marketed. Our ability to develop and commercialize products basedon our proprietary technology will depend on our ability to develop ourproducts internally on a timely basis or to enter into arrangements with thirdparties to provide these functions.  Ourfailure to develop and commercialize products successfully could have amaterial adverse effect on our financial condition and results of operations.

 

**IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS**

 

In May 2003,the FASB issued SFAS No. 150, “Accounting for Certain Financial Instrumentswith characteristics of both Liabilities and Equity.”  SFAS No. 150 establishes standards for classifying and measuringcertain financial instruments with characteristics of both liabilities andequity.  SFAS No. 150 is effective forfinancial instruments entered into or modified after May 31, 2003.  The Company does not expect thispronouncement to have a material impact on its results of operations orfinancial condition.

 

In April 2003, the FASB issued SFAS No. 149, “Amendment of StatementNo. 133 on Derivative Instruments and Hedging Activities.”  Among other things, this Statement requiresthat contracts with comparable characteristics be accounted for similarly andclarifies under what circumstances a contract with an initial net investmentmeets the characteristics of a derivative. SFAS No. 149 is effective July 1, 2003. The Company does not expect this pronouncement to have a material impacton its results of operations or financial condition.

 

 

**Item 3****.****           Quantitativeand Qualitative Disclosures About Market Risk**

 

We have operations and sales in various regions of the world.Additionally, we may export and import to and from other countries.  Our operations may therefore be subject tovolatility because of currency fluctuations, inflation, and changes in politicaland economic conditions in these countries. Sales and expenses may bedenominated in local currencies and may be affected as currency fluctuationsaffect our product prices and operating costs or those of our competitors.

 

We presently do not use any derivative financial instruments to hedge ourexposure to adverse fluctuations in interest rates, foreign exchange rates,fluctuations in commodity prices or other market risks, nor do we invest inspeculative financial instruments.

 

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Due to the nature of our borrowings and our short-term investments, wehave concluded that there is no material market risk exposure and, therefore,no quantitative tabular disclosures are required.

 

**Item 4****.****           Controlsand Procedures**

 

At the end of the period covered by this report, the Company carriedout an evaluation, under the supervision and with the participation of theCompany’s management, including the Company’s Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of the design and operation of theCompany’s disclosure controls and procedures. Based upon that evaluation, Company’s management, including its ChiefExecutive Officer and Chief Financial Officer, concluded that the Company’sdisclosure controls and procedures were effective as of June 30, 2003. Therehave been no changes in the Company’s internal controls over financialreporting that occurred during the most recent fiscal quarter that havematerially affected, or are reasonably likely to affect, the Company’s internalcontrols over financial reporting.

 

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**PARTII****    OTHER INFORMATION**

 

**Item 1.**                                                           Legal Proceedings.

** **

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

 

On May 29, 2001, Janet Silva, individually and as Guardian *ad litem* for Jonathan Silva, a minor, andthe Estate of Clarence William Silva, Jr. filed suit against CustomizedServices Administrators, Incorporated (CSA), Pricesmart, Inc., CommercialUnion Insurance Company, CGU Insurance Group, and us in the Superior Court ofthe State of California in and for the County of Santa Clara. The allegationsof the complaint arise from a vacation guarantee insurance policy allegedlypurchased by the plaintiffs from the defendants on March 6, 2000. Thecomplaint alleges, among other things, that the defendants breached the termsof the insurance policy, defrauded plaintiffs, acted in bad faith and engagedin deceptive and unlawful business practices, resulting in the wrongful deathof Clarence William Silva, Jr. and the intentional infliction of emotionaldistress on plaintiffs. The complaint seeks the cost of funeral and burialexpenses of Mr. Silva and amounts constituting the loss of financialsupport of Mr. Silva, general damages, attorneys’ fees and costs, andexemplary damages.

 

CSA outsourced its travel assistance services to Medical AdvisorySystems. CSA filed a cross-claim against us alleging that we should be heldliable for any liability that CSA may have to the plaintiffs in this case. Wehave denied the allegations of the complaint and the CSA cross-claim and arevigorously contesting all aspects of this action.

 

We filed motions for summary judgment/adjudication, which were heard bythe Court on June 10, 2003. Our motions for summary adjudication ofplaintiffs’ causes of action for fraud, insurance, bad faith and unlawfulbusiness practices were granted. Our motion for summary adjudication ofplaintiffs’ cause of action for breach of insurance contract also was granted.However, the Court gave the plaintiffs permission to amend their complaint onor before June 13, 2003 with respect to this cause of action. Our motionfor summary adjudication of plaintiffs’ cause of action for intentionalinfliction of emotional distress was taken under submission. Our motions forsummary adjudication of plaintiffs’ cause of action for wrongful death andprayer for punitive damages were denied, but the plaintiffs agreed that thepunitive damages claim applied only to their cause of action for intentionalinfliction of emotional distress. Therefore, if the Court grants our motion forsummary adjudication of this cause of action, the punitive damage claim shouldbe stricken in its entirety. The Court has set a Mandatory SettlementConference for August 20, 2003 and has set the case for trial onAugust 25, 2003 in the Santa Clara County Superior Court. We believe thislawsuit is defensible, and we intend to defend this matter vigorously. However,if there is an unfavorable outcome of this matter, we believe that our exposurecould be in excess of what we have been advised to be the applicable limits ofinsurance.

 

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**Item 6**.                                                           Exhibitsand Reports on Form 8-K.

 
|   |   | **(a)****                                      Exhibits**                                                                        |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                      |
|   |   | The following exhibits are hereby  incorporated into this Quarterly Report on Form 10-Q by reference to the  reports and schedules identified below filed with the Securities and Exchange  Commission (“Commission”)**:**                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 3.1    |   | Amended and Restated  Certificate of Incorporation of MAS (incorporated herein by reference to  MAS’s Registration Statement  on Form S-18 (No. 2-98314) filed by MAS with the Commission on June 7, 1985  and MAS’s Annual Report on Form 10-KSB filed by MAS with the Commission on  March 28, 1990).         |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 3.2    |   | Bylaws of MAS (incorporated  herein by reference to MAS’s Registration Statement on Form S-18 (No.  2-98314) filed by MAS with the Commission on June 7, 1985).                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 10.1   |   | Forbearance Agreement dated March 24, 2003 by and among Applied  Digital Solutions, Inc. IBM Credit LLC, Digital Angel Corporation and the  other parties named therein (incorporated by herein reference to Exhibit 10.1  to the Annual Report on Form 10-K filed by the Company for the year ended  December 31, 2002). |
|   |   |                                                                                                                                                                                                                                                                                                                      |
|   |   | The following exhibits are filed with this  Quarterly Report on Form 10-Q:                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 10.2   |   | Securities Purchase Agreement dated as of July 31, 2003 by and  between Digital Angel Corporation and Laurus Master Fund, Ltd.                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 10.3   |   | Secured Convertible Note dated as of July 31, 2003 by Digital Angel  Corporation to Laurus Master Fund, Ltd.                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 10.4   |   | Common Stock Purchase Warrant for Right to Purchase 125,000 Shares of  Common Stock of Digital Angel Corporation                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 10.5   |   | Registration Rights Agreement dated as of July 31, 2003 by and  between Digital Angel Corporation and Laurus Master Fund, Ltd.                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 31.1   |   | Certification of Chief Executive Officer under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 31.2   |   | Certification of Chief Financial Officer under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 32.1   |   | Certification of Chief Executive  Officer Pursuant to 18 U.S.C Section 1350, as Adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                      |
| 32.2   |   | Certification of Chief Financial Officer Pursuant to 18 U.S.C Section  1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                      |
|   |   | **(b)**                                                                                                                                                                                                                                                                                                                   | **Reports  on Form 8-K** |
|   |   |                                                                                                                                                                                                                                                                                                                      |   |
|   |   | **The Company furnished the following Current  Reports on Form 8-K during the quarter ended June 30, 2003:**                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                      |
|   |   | (i)                                                                                                                                                                                                                                                                                                                       | Form 8-K furnished on April 3, 2003 regarding 2002 financial results,  and |
|   |   |                                                                                                                                                                                                                                                                                                                      |   |
|   |   | (ii)                                                                                                                                                                                                                                                                                                                      | Form 8-K furnished on May 9, 2003 regarding financial results for  quarter ended March 31, 2003 |

 

**SIGNATURE**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                    | DIGITAL ANGEL CORPORATION                             |
|-------------------------|-------------------------------------------------------|
|                    | (Registrant)                                          |
|                    |                                                  |
| Dated: August 14 , 2003 |                                                  | By: | /s/ JAMES P. SANTELLI |   |
|                    | James P. Santelli                                     |   |
|                    | Vice President - Finance and Chief  Financial Officer |   |
|                         |                                                       |  |  |  |

 

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**INDEX TO EXHIBITS**

 

The following exhibits are filed with this QuarterlyReport on Form 10-Q:

 

 
| 10.2   |   | Securities Purchase Agreement dated as of July 31, 2003 by and  between Digital Angel Corporation and Laurus Master Fund, Ltd.                       |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                 |
| 10.3   |   | Secured Convertible Note dated as of July 31, 2003 by Digital Angel  Corporation to Laurus Master Fund, Ltd.                                         |
|   |   |                                                                                                                                                 |
| 10.4   |   | Common Stock Purchase Warrant for Right to Purchase 125,000 Shares of  Common Stock of Digital Angel Corporation                                     |
|   |   |                                                                                                                                                 |
| 10.5   |   | Registration Rights Agreement dated as of July 31, 2003 by and  between Digital Angel Corporation and Laurus Master Fund, Ltd.                       |
|   |   |                                                                                                                                                 |
| 31.1   |   | Certification of Chief Executive Officer under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                       |
|   |   |                                                                                                                                                 |
| 31.2   |   | Certification of Chief Financial Officer under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                       |
|   |   |                                                                                                                                                 |
| 32.1   |   | Certification of Chief Executive Officer Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |
|   |   |                                                                                                                                                 |
| 32.2   |   | Certification of Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |

 

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