**As filed with the Securities and Exchange Commissionon November 12, 2002**

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C.  20549**

 

# ****

# ** **

# **FORM 10-Q**

**(MarkOne)**

 

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

 

**Forthe quarterly period ended September 30, 2002**

 

**or**

 

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

 

**Forthe transition periodfrom         to         **

 

**Commission File Number:  1-15177**

 

**DIGITAL ANGELCORPORATION**

(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**            |
| (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

 

As of the close ofbusiness on November 7, 2002, there were 26,470,076 shares outstanding of theissuer’s $0.005 per share par value common stock.

 

 

----

 

**DIGITALANGEL CORPORATION**

 

TABLE OF CONTENTS

 
| Item           | Description                                                                                                     |
|----------------|-----------------------------------------------------------------------------------------------------------------|
|           |                                                                                                            |
|           | PART  I – FINANCIAL INFORMATION                                                                            |
|           |                                                                                                            |
| 1.             | Financial  Statements                                                                                           |
|           | Condensed  Balance Sheets as of September 30, 2002 (unaudited) and December 31, 2001                            |
|           | Condensed  Statements of Operations (unaudited) - for the three and nine months ended  September, 2002 and 2001 |
|           | Condensed  Statement of Stockholders’ Equity (unaudited) - for the nine months ended  September 30, 2002   |
|           | Condensed  Statements of Cash Flows (unaudited) - for the nine months ended September  30, 2002 and 2001        |
|           | Notes  to Condensed Financial Statements                                                                        |
| 2.             | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                     |
| 3.             | Quantitative  and Qualitative Disclosures About Market Risk                                                     |
| 4.             | Controls and Procedures                                                                                         |
|           |                                                                                                            |
|           |                                                                                                            |
|           | PART  II – OTHER INFORMATION                                                                               |
|           |                                                                                                            |
| 1.             | Legal Proceedings                                                                                               |
| 2.             | Changes  in Securities and Use of Proceeds                                                                      |
|           |                                                                                                            |
|           |                                                                                                            |
| 6.             | Exhibits and  Reports on Form 8-K                                                                               |
|           |                                                                                                            |
| SIGNATURE      |
| CERTIFICATIONS |
| EXHIBITS       |

 

2

----

 

PART I    FINANCIAL INFORMATION

Item 1.   Financial Statements.

 

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED BALANCE SHEETS**

(Inthousands, except par value)

 
|                                                                                                                                                                               |   | **Digital Angel  Corporation and  Subsidiaries  (Consolidated)  September 30,  2002** |        | **Advanced  Wireless  Group  (Combined****)****December 31,  2001** |       |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------|-------------|---------------------------------------------------------------------|------------|
|                                                                                                                                                                               |   | **(Unaudited)**                                                                       |        |                                                                |       |
| **Assets**                                                                                                                                                                         |   |                                                                                  |        |                                                                |       |
| **Current Assets**                                                                                                                                                                 |   |                                                                                  |        |                                                                |       |
| Cash and cash  equivalents                                                                                                                                                         |   | **$**                                                                                 | **480**     |                                                                | $          | 596 |   |
| Accounts  receivable and unbilled receivables (net of allowance for doubtful accounts  of $294 in 2002 and $296 in 2001)                                                           |   | **6,369**                                                                             |        | 5,402                                                               |       |
| Inventories                                                                                                                                                                        |   | **5,065**                                                                             |        | 5,819                                                               |       |
| Other current  assets                                                                                                                                                              |   | **1,883**                                                                             |        | 733                                                                 |       |
| **Total Current Assets**                                                                                                                                                           |   | **13,797**                                                                            |        | 12,550                                                              |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Property And Equipment, net**                                                                                                                                                    |   | **14,464**                                                                            |        | 14,476                                                              |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Goodwill and Other Intangible  Assets, net**                                                                                                                                     |   | **106,246**                                                                           |        | 72,876                                                              |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Investment In Affiliates**                                                                                                                                                       |   | **256**                                                                               |        | 6,779                                                               |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Other Assets, net**                                                                                                                                                              |   | **612**                                                                               |        | 698                                                                 |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
|                                                                                                                                                                               |   | **$**                                                                                 | **135,375** |                                                                | $          | 107,379 |   |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                     |   |                                                                                  | ** **  |                                                                | ** ** |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Current Liabilities**                                                                                                                                                            |   |                                                                                  |        |                                                                |       |
| Line of credit  and current maturities of long-term debt                                                                                                                           |   | **$**                                                                                 | **214**     |                                                                | $          | 82,802 |   |
| Accounts payable                                                                                                                                                                   |   | **4,568**                                                                             |        | 3,598                                                               |       |
| Accrued expenses  and other current liabilities                                                                                                                                    |   | **3,949**                                                                             |        | 2,044                                                               |       |
| Due to Applied  Digital Solutions, Inc.                                                                                                                                            |   | **672**                                                                               |        | —                                                              |       |
| **Total Current Liabilities**                                                                                                                                                      |   | **9,403**                                                                             |        | 88,444                                                              |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Long-Term Debt And Notes Payable**                                                                                                                                               |   | **3,355**                                                                             |        | 2,425                                                               |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Other Long-Term Liabilities**                                                                                                                                                    |   | **500**                                                                               |        | —                                                              |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Total Liabilities**                                                                                                                                                              |   | **13,258**                                                                            |        | 90,869                                                              |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Commitments And Contingencies**                                                                                                                                                  |   |                                                                                  |        |                                                                |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **Minority Interest**                                                                                                                                                              |   | **320**                                                                               |        | 394                                                                 |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
| **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 in 2002, of $.005 par value; 26,508 shares issued  and 26,458 shares outstanding in 2002 and 18,750 shares issued and  outstanding in 2001 |   | **132**                                                                               |        | 94                                                                  |       |
| Additional  paid-in capital                                                                                                                                                        |   | **167,015**                                                                           |        | 37,929                                                              |       |
| Accumulated  deficit                                                                                                                                                               |   | **(46,654**                                                                           | )           | (21,700                                                             | )          |
| Common stock  warrants                                                                                                                                                             |   | **1,638**                                                                             |        | 300                                                                 |       |
| Treasury stock  (carried at cost, 50 shares in 2002)                                                                                                                               |   | **(43**                                                                               | )           | —                                                              |       |
| Accumulated  other comprehensive loss                                                                                                                                              |   | **(291**                                                                              | )           | (507                                                                | )          |
| Total Stockholders’ Equity                                                                                                                                                    |   | **121,797**                                                                           |        | 16,116                                                              |       |
|                                                                                                                                                                               |   |                                                                                  |        |                                                                |       |
|                                                                                                                                                                               |   | **$**                                                                                 | **135,375** |                                                                | $          | 107,379 |   |

 

See the accompanying notes to condensed financial statements.

 

3

----

 

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED STATEMENTS OF OPERATIONS**

(In thousands, except pershare data)

(Unaudited)

 
|                                                                                                |   | **Digital Angel  Corporation and  Subsidiaries  (Consolidated)** |       | **Advanced  Wireless  Group  (Combined)**    |       | **Digital Angel  Corporation and  Subsidiaries  (Consolidated)** |        | **Advanced  Wireless  Group  (Combined)** |        |
|-----------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------------|-------------|-------------------------------------------|-------------|
|                                                                                                |   | **For the Three Months  Ended September 30,**                    |       | **For the Nine Months  Ended September 30,** |       |
|                                                                                                |   | **2002**                                                         |       | **2001**                                     |       | **2002**                                                         |        | **2001**                                  |        |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Product revenue                                                                                     |   | **$**                                                            | **9,004**  |                                         | $          | 8,416                                                            | ** **  | **$**                                     | **25,117**  |   | $ | 25,168 |   |
| Service revenue                                                                                     |   | **335**                                                          |       | 881                                          | ** ** | **1,215**                                                        |        | 2,803                                     |        |
| Total net revenue                                                                                   |   | **9,339**                                                        |       | 9,297                                        | ** ** | **26,332**                                                       |        | 27,971                                    |        |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Cost of products sold                                                                               |   | **4,680**                                                        |       | 5,255                                        | ** ** | **13,815**                                                       |        | 15,216                                    |        |
| Cost of services sold                                                                               |   | **264**                                                          |       | 599                                          | ** ** | **762**                                                          |        | 1,627                                     |        |
|                                                                                                |   | **4,944**                                                        | ** ** | 5,854                                        |       | **14,577**                                                       |        | 16,843                                    |        |
| Gross profit                                                                                        |   | **4,395**                                                        |       | 3,443                                        | ** ** | **11,755**                                                       |        | 11,128                                    |        |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Selling, general and administrative expenses                                                        |   | **4,688**                                                        |       | 5,672                                        | ** ** | **32,140**                                                       |        | 15,823                                    |        |
| Management fees - Applied Digital Solutions, Inc.                                                   |   | **—**                                                       |       | 185                                          | ** ** | **193**                                                          |        | 556                                       |        |
| Research and development expenses                                                                   |   | **614**                                                          |       | 1,332                                        | ** ** | **2,159**                                                        |        | 3,742                                     |        |
| Interest income                                                                                     |   | **(2**                                                           | **)**      | (3                                           | )          | **(2**                                                           | **)**       | (14                                       | )           |
| Interest expense - Applied Digital Solutions, Inc.                                                  |   | **—**                                                       |       | **—**                                   | ** ** | **1,806**                                                        |        | **—**                                |        |
| Interest expense - others                                                                           |   | **71**                                                           |       | 206                                          | ** ** | **196**                                                          |        | 357                                       |        |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Loss before  taxes, minority interest share of losses and equity in net loss (income) of  affiliate |   | **(976**                                                         | )          | (3,949                                       | )          | **(24,737**                                                      | **) ** | (9,336                                    | )           |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Provision (benefit) for income taxes                                                                |   | **—**                                                       |       | (52                                          | )          | **—**                                                       |        | 55                                        |        |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Loss before  minority interest share of losses and equity in net loss (income) of  affiliate        |   | **(976**                                                         | **)**      | (3,897                                       | )          | **(24,737**                                                      | **)**       | (9,391                                    | )           |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Minority interest share of losses                                                                   |   | **(31**                                                          | **)**      | (27                                          | )          | **(74**                                                          | **)**       | (54                                       | )           |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Equity in net loss (income) of affiliate                                                            |   | **—**                                                       |       | 51                                           | ** ** | **291**                                                          |        | 118                                       |        |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Net loss                                                                                            |   | **$**                                                            | **(945**   | **)**                                        | $          | (3,921                                                           | )           | **$**                                     | **(24,954** | **)** | $ | (9,455 | ) |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Net loss per common share - basic and diluted                                                       |   | **$**                                                            | **(0.04**  | **)**                                        | $          | (0.21                                                            | )           | **$**                                     | **(1.04**   | **)** | $ | (0.50 | ) |
|                                                                                                |   |                                                             |       |                                         |       |                                                             |        |                                      |        |
| Weighted average  number of common shares outstanding - basic and diluted                           |   | **26,439**                                                       |       | 18,750                                       | ** ** | **23,910**                                                       |        | 18,750                                    |        |

 

See the accompanying notes to condensed financial statements.

 

4

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED STATEMENT OF STOCKHOLDERS’EQUITY**

**For TheNine Months Ended September 30, 2002**

(In Thousands)

(Unaudited)

 
|                                                   |   |       |       | **Additional  Paid-In  Capital** |       | **Accumulated  Deficit** |       | **Common  Stock  Warrants** |       | **Treasury  Stock** |        | **Accumulated  Other Comprehensive  Loss** |       | **Total  Stockholders’  Equity** |       |
|--------------------------------------------------------|--------|------------|------------|----------------------------------|------------|--------------------------|------------|-----------------------------|------------|---------------------|-------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Common Stock**                                       |
| **Number**                                             |   | **Amount** |       |
|                                                   |   |       | ** ** |                             | ** ** |                     | ** ** |                        | ** ** |                | ** **  |                                       | ** ** |                                  | ** ** |   | ** ** |
| **Balance - December 31, 2001**                        |   | 18,750     |       | $                                | 94         |                     | $          | 37,929                      |       | $                   | (21,700     | )                                          | $          | 300                                   |       | $ | — |   | $ | (507 | ) | $ | 16,116 |   |
| Net loss                                               |   | —     |       | —                           |       | —                   |       | (24,954                     | )          | —              |        | —                                     |       | —                                |       | (24,954 | ) |
| Comprehensive  loss - Foreign currency translation     |   | —     |       | —                           |       | —                   |       | —                      |       | —              |        | —                                     |       | 216                                   |       | 216 |   |
| Total  comprehensive loss                              |   | —     |       | —                           |       | —                   |       | (24,954                     | )          | —              |        | —                                     |       | 216                                   |       | (24,738 | ) |
| Transfer of MAS  common shares to ADS                  |   | —     |       | —                           |       | (6,488                   | )          | —                      |       | —              |        | —                                     |       | —                                |       | (6,488 | ) |
| Contribution by  ADS                                   |   | —     |       | —                           |       | 6,433                    |       | —                      |       | —              |        | —                                     |       | —                                |       | 6,433 |   |
| Exercise of  stock options                             |   | 2,452      |       | 12                               |       | 619                      |       | —                      |       | —              |        | —                                     |       | —                                |       | 631 |   |
| Shares to be  issued in settlement of liability        |   | 38         |       | —                           |       | 225                      |       | —                      |       | —              |        | —                                     |       | —                                |       | 225 |   |
| Merger  consideration - Medical Advisory Systems, Inc. |   | 5,268      |       | 26                               |       | 28,163                   |       | —                      |       | 272                 |        | (43                                        | )          | —                                |       | 28,418 |   |
| Assumption of  debt by ADS                             |   | —     |       | —                           |       | 81,383                   |       | —                      |       | —              |        | —                                     |       | —                                |       | 81,383 |   |
| Stock options  remeasured in connection with merger    |   | —     |       | —                           |       | 18,681                   |       | —                      |       | —              |        | —                                     |       | —                                |       | 18,681 |   |
| Stock option  extension                                |   | —     |       | —                           |       | 70                       |       | —                      |       | —              |        | —                                     |       | —                                |       | 70 |   |
| Warrants  remeasured in connection with merger         |   | —     |       | —                           |       | —                   |       | —                      |       | 1,066               |        | —                                     |       | —                                |       | 1,066 |   |
|                                                   |   |       |       |                             |       |                     |       |                        |       |                |        |                                       |       |                                  |       |   |   |
| **Balance - September 30, 2002**                       |   | **26,508** | ** ** | **$**                            | **132**    | ** **               | **$**      | **167,015**                 | ** ** | **$**               | **(46,654** | **)**                                      | **$**      | **1,638**                             | ** ** | **$** | **(43** | **)** | **$** | **(291** | **)** | **$** | **121,797** | ** ** |

 

See the accompanying notes to condensed financial statements.

 

5

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED STATEMENTS OF CASH FLOWS**

(In thousands)

(Unaudited)

 
|                                                                         |   | **Digital Angel  Corporation and  Subsidiaries  (Consolidated)** |        | **Advanced  Wireless  Group  (Combined)** |   |
|------------------------------------------------------------------------------|--------|------------------------------------------------------------------|-------------|-------------------------------------------|--------|
|                                                                         |   | **For the Nine Months  Ended September 30,**                     |        |
|                                                                         |   | **2002**                                                         |        | **2001**                                  |   |
| **Cash Flows From Operating  Activities**                                    |   |                                                             |        |                                      |   |
| Net loss                                                                     |   | **$**                                                            | **(24,954** | **)**                                     | $      | (9,455 | ) |
|                                                                         |   |                                                             |        |                                      |   |
| Adjustments to  reconcile net loss to net cash used in operating activities: |   |                                                             |        |                                      |   |
| Non-cash  compensation and administrative expense                            |   | **18,952**                                                       |        | —                                    |   |
| Interest  allocated by ADS and contributed to capital                        |   | **1,806**                                                        |        | —                                    |   |
| Depreciation and  amortization                                               |   | **2,750**                                                        |        | 8,752                                     |   |
| Minority  interest                                                           |   | **(74**                                                          | **)**       | (54                                       | )      |
| Equity in net  loss of affiliate                                             |   | **291**                                                          |        | 118                                       |   |
| Loss on sale of  equipment                                                   |   | **7**                                                            |        | —                                    |   |
| Change in assets  and liabilities:                                           |   |                                                             |        |                                      |   |
| Increase in  accounts receivable                                             |   | **(695**                                                         | **)**       | (930                                      | )      |
| Decrease  (increase) in inventories                                          |   | **821**                                                          |        | (978                                      | )      |
| (Increase)  decrease in other current assets                                 |   | **(1,271**                                                       | **)**       | 152                                       |   |
| Increase in due  to ADS                                                      |   | **672**                                                          |        | —                                    |   |
| Increase in  accounts payable and accrued expenses                           |   | **580**                                                          |        | 444                                       |   |
| **Net Cash Used In Operating  Activities**                                   |   | **(1,115**                                                       | **)**       | (1,951                                    | )      |
|                                                                         |   |                                                             |        |                                      |   |
| **Cash Flows From Investing  Activities**                                    |   |                                                             |        |                                      |   |
| Decrease in  other assets                                                    |   | **79**                                                           |        | 145                                       |   |
| Payments for  property and equipment                                         |   | **(984**                                                         | **)**       | (1,509                                    | )      |
| Proceeds from  sale of property and equipment                                |   | **23**                                                           |        | —                                    |   |
| Acquisition  costs, net of cash acquired through acquisition                 |   | **(73**                                                          | **)**       | —                                    |   |
| **Net Cash Used In Investing  Activities**                                   |   | **(955**                                                         | **)**       | (1,364                                    | )      |
|                                                                         |   |                                                             |        |                                      |   |
| **Cash Flows From Financing  Activities**                                    |   |                                                             |        |                                      |   |
| Amounts paid on  notes payable and line of credit                            |   | **(40**                                                          | **)**       | (71                                       | )      |
| Amounts borrowed  on long-term debt, net of repayments                       |   | **757**                                                          |        | —                                    |   |
| Exercise of  stock options                                                   |   | **631**                                                          |        | —                                    |   |
| Payments for  other financing costs                                          |   | **(78**                                                          | **)**       | —                                    |   |
| Net transactions  with Applied Digital Solutions, Inc.                       |   | **684**                                                          |        | 3,185                                     |   |
| **Net Cash Provided By Financing  Activities**                               |   | **1,954**                                                        |        | 3,114                                     |   |
|                                                                         |   |                                                             |        |                                      |   |
| **Net Decrease In Cash And Cash  Equivalents**                               |   | **(116**                                                         | )           | (201                                      | )      |
|                                                                         |   |                                                             |        |                                      |   |
| **Cash And Cash Equivalents -  Beginning Of Period**                         |   | **596**                                                          |        | 206                                       |   |
|                                                                         |   |                                                             |        |                                      |   |
| **Cash And Cash Equivalents - End Of  Period**                               |   | **$**                                                            | **480**     |                                      | $      | 5 |   |

 

See the accompanying notes to condensed financial statements.

 

6

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** **

**DIGITAL ANGEL CORPORATION**

**NOTES TO CONDENSED FINANCIALSTATEMENTS**

**(Dollarsin thousands)**

**(Unaudited)**

** **

**1.**                                      Basis ofPresentation

 

On March 27, 2002, Digital Angel Acquisition Co.(“Acquisition”), then a wholly-owned subsidiary of Medical Advisory Systems,Inc. (“MAS”), merged with and into Digital Angel Corporation, which was then a93% owned subsidiary of Applied Digital Solutions, Inc. (“ADS”).  In the merger, the corporate existence ofAcquisition ceased, Digital Angel Corporation became a wholly-owned subsidiaryof MAS and was renamed Digital Angel Technology Corporation (“DATC”), and MASwas renamed “Digital Angel Corporation”. In connection with the merger transaction, ADS contributed to MAS all ofits stock in Timely Technology Corp., a wholly-owned subsidiary, and SignatureIndustries, Limited, an 85% owned subsidiary. These two subsidiaries, along with DATC, comprised the Advanced WirelessGroup (“AWG”).   As a result of thiscontribution by ADS, Timely Technology Corp. became a wholly-owned subsidiaryof the Company and Signature Industries, Limited became an 85% subsidiary.  Prior to the merger with DATC, ADS owned850,000 shares of MAS stock representing approximately 16.6% of the outstandingstock of MAS.  (Unless the contextotherwise requires, the term “Company” means Digital Angel Corporation and itssubsidiaries.)  In the merger, theshares of DATC owned by ADS were converted into a total of 18,750,000 shares ofMAS common stock.  As a result of the merger,ADS owned 19,600,000 shares or 77.15% of the Company’s common stock.  In connection with the merger, ADStransferred to the Digital Angel Share Trust (the “Trust”) all shares of theCompany’s common stock owned by ADS. The Trust is the owner of and, through its Advisory Board, votes allshares of the Company owned by ADS, including all shares issued to ADS in themerger, and has the ability to elect the Board of Directors of theCompany.  The Trust arose as a conditionof the merger.  In connection withcertain obligations of ADS the shares owned by the Trust may be sold or otherwisedisposed of to satisfy such obligations. Additionally, the Company has certain covenant obligations in connectionwith the ADS obligations (see Note 9).

 

The merger has been treated as a reverse acquisitionfor accounting purposes, with AWG treated as the accounting acquirer.  The historical combined financial statementsof AWG became those of the Company, and the acquisition of MAS was accountedfor under the purchase method of accounting. Accordingly, the equity accounts of AWG have been restated based on thecommon shares received by the former shareholders of AWG in the merger.

 

On March 27, 2002, ADS amended and restated its debtagreement with IBM Credit Corporation, which, among other amendments, providedfor a release of AWG from the responsibility to repay an existing obligation.Accordingly, ADS assumed this obligation, which resulted in an increase toadditional paid-in capital of $81.4 million net of deferred financing fees ofapproximately $1.1 million on March 27, 2002.

 

Pursuant to the terms of the merger agreement, optionsto acquire shares of DATC common stock were converted into options to acquireshares of MAS common stock effective March 27, 2002. The conversion resulted ina new measurement date for the options and, as a result, the Company recorded acharge of approximately $18.7 million in non-cash compensation expense duringthe three months ended March 31, 2002. For current employees of the Company,these options are considered fixed awards under APB Opinion No. 25, and expensewas recorded for the intrinsic value of the options converted.  For all others, expense was recorded for thefair value of the options converted using the Black-Scholes option-pricingmodel.

 

The accompanying unaudited condensed consolidatedfinancial statements of Digital Angel

 

7

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Corporation andsubsidiaries as of and for three and nine month periods ended September 30,2002 and the combined financial statements of AWG as of December 31, 2001 andfor the three and nine month periods ended September 30, 2001 (unaudited) havebeen prepared in accordance with accounting principles generally accepted inthe United States of America for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X under the SecuritiesExchange Act of 1934.

 

Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements.  In the opinion of the Company’s management,all adjustments (including normal recurring adjustments) considered necessaryto present fairly the financial statements have been made.

 

The consolidated statements of operations for thethree and nine months ended September 30, 2002 are not necessarily indicativeof the results that may be expected for the entire year.  These statements should be read inconjunction with the AWG’s combined financial statements and related notesthereto for the year ended December 31, 2001 included as an exhibit to our Form8-K/A filed with the Securities and Exchange Commission on July 19, 2002.

 

Certain items in the combined financial statements forthe 2001 period have been reclassified for comparative purposes.

 

The financial information in these financialstatements includes an allocation of expenses incurred by ADS on behalf of theCompany as discussed in Note 9. However, these financial statements may not necessarily be indicative ofthe results that may have occurred had AWG been a separate, independent entityduring the periods presented or of future results of the Company.

 

**AccountingChanges**

 

Effective January 1, 2002, the Company adoptedStatement of Financial Accounting Standard No. 142, Goodwill and Other IntangibleAssets (FAS 142).  FAS 142 requires thatgoodwill and certain intangibles no longer be amortized but instead tested forimpairment at least annually.  

 

The Company will assess the fair value of its goodwillannually or between annual tests if events occur or circumstances change thatwould more likely than not reduce the fair value of its goodwill below itscarrying value.  If the Companydetermines that significant impairment has occurred, the Company would berequired to write-off the impaired portion of goodwill.  It is possible that an impairment charge, ifany, could have a material adverse effect on our financial condition andresults of operations.  

 

8

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The following table presents the impact of FAS 142 onnet loss and net loss per share had the standard been in effect for the threemonths and nine months ended September 30, 2001:

 
|                                               |   | **Three  Months Ended  September 30, 2001** |   | **Nine  Months Ended  September 30, 2001** |   |
|----------------------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
|                                               |   |                                        |   |                                       |   |
| **Net  loss:**                                     |   |                                        |   |                                       |   |
| Net loss as reported                               |   | $                                           | (3,921 | )                                          | $      | (9,455 | ) |
| Goodwill amortization                              |   | 2,300                                       |   | 6,259                                      |   |
| Equity method investment amortization              |   | 363                                         |   | 812                                        |   |
| Adjusted net loss                                  |   | $                                           | (1,258 | )                                          | $      | (2,384 | ) |
|                                               |   |                                        |   |                                       |   |
| **Basic  and diluted loss per share:**             |   |                                        |   |                                       |   |
| Net loss per share, basic and diluted, as reported |   | $                                           | (0.21  | )                                          | $      | (0.50 | ) |
| Goodwill amortization                              |   | 0.12                                        |   | 0.33                                       |   |
| Equity method investment amortization              |   | 0.02                                        |   | 0.04                                       |   |
| Adjusted net loss per  share, basic and diluted    |   | $                                           | (0.07  | )                                          | $      | (0.13 | ) |

 

Amortization expense ofother intangible assets totaled $335 and $141 for the nine months endedSeptember 30, 2002 and 2001, respectively.

 

**2.             Principlesof Consolidation and Combination**

 

The September 30, 2002 condensed consolidatedfinancial statements include the accounts of the Company and its wholly-owned andmajority-owned subsidiaries from the date of acquisition.  The combined financial statements atDecember 31, 2001 and for the three and nine months ended September 30, 2001include the accounts of AWG entities under common control.  All significant intercompany accounts andtransactions have been eliminated in consolidation and combination.  AWG used the equity method of accounting forits investments which are less than majority owned, but over which it had significantinfluence.

 

**3.             RevenueRecognition**

** **

**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 the Company’s policy to recordcontract losses in their entirety in the period in which such losses areforeseeable.  For non-fixed fee jobs,revenue is recognized based on the actual direct labor hours in the job timesthe standard billing rate and adjusted to realizable value, if necessary.  For product sales, the Company recognizesrevenue at the time products**

** **

9

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**are shipped and title has transferred, provided that apurchase order has been received or a contract has been executed, there are nouncertainties regarding customer acceptance, the sales price is fixed anddeterminable and collectability is deemed probable.  If uncertainties regarding customer acceptance exists, revenue isrecognized when such uncertainties are resolved.  There are no significant post-contract support obligations at thetime of revenue recognition.  TheCompany’s accounting policy regarding vendor and post-contract supportobligations is based on the terms of the customers’ contract, billable upon theoccurrence of the post-sale support. Costs of goods sold are recorded as the related revenue isrecognized.  The Company does not offera warranty policy for services to customers. Revenues from contracts thatprovide unlimited services are recognized ratably over the term of thecontract.  Fixed fee revenues fromcontracts for services are recorded when earned and exclude reimbursablecosts.  Reimbursable costs incurred inperforming such services are presented on a net basis and includetransportation, medical and communication costs.  Other revenues are recognized at the time services or goods areprovided.**

** **

**4.             Inventory**

 
|                                   |   | **September 30,  2002** |   | **December 31,  2001** |   |
|----------------------------------------|--------|-------------------------|--------|------------------------|--------|
| Raw materials                          |   | $                       | 1,577  |                   | $      | 1,474 |   |
| Work in process                        |   | 216                     |   | 176                    |   |
| Finished goods                         |   | 4,400                   |   | 5,611                  |   |
|                                   |   | 6,193                   |   | 7,261                  |   |
| Allowance for excess  and obsolescence |   | (1,128                  | )      | (1,442                 | )      |
| Net inventory                          |   | $                       | 5,065  |                   | $      | 5,819 |   |

 

10

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**5.**             **Loss Per Share**

 

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

 
|                                       |   | **Three Months  Ended September 30,** |       | **Nine Months  Ended September 30,** |       |
|--------------------------------------------|--------|---------------------------------------|------------|--------------------------------------|------------|
|                                       |   | **2002**                              |       | **2001**                             |       | **2002** |   | **2001** |   |
| **Numerator:**                             |   |                                  | ** ** |                                 |       |   | ** ** |   |   |
| Net loss                                   |   | **$**                                 | **(945**   | **)**                                | $          | (3,921 | ) | $ | **(24,954** | **)** | $ | (9,455 | ) |
| **Denominator:**                           |   |                                  | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| Denominator for basic loss per share -     |   |                                  |       |                                 |       |   |   |   |   |
| Weighted-average shares                    |   | **26,439**                            |       | 18,750                               |       | **23,910** |   | 18,750 |   |
| Denominator for diluted  loss per share(1) |   | **26,439**                            |       | 18,750                               |       | **23,910** |   | 18,750 |   |
| **Basic and diluted loss per share:**      |   | **$**                                 | **(0.04**  | **)**                                | **$**      | **(0.21** | **)** | **$** | **(1.04** | **)** | **$** | **(0.50** | **)** |

 

----

(1)  Potentially dilutive securities excluded fromthe computation of diluted loss per share because to do so would have beenanti-dilutive.

 
|                   |   | **Three Months   Ended September 30,****2002** |   | **Nine Months   Ended September 30,****2002** |   |
|------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|--------|
| Employee stock options |   | 7,817                                          |   | 7,817                                         |   |
| Warrants               |   | 1,289                                          |   | 1,289                                         |   |
|                   |   | 9,106                                          |   | 9,106                                         |   |

** **

11

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**6.             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.  Prior to March 27,2002, the Company operated in four segments — Animal Tracking, Digital AngelTechnology, Digital Angel Delivery System, and Radio Communications andOther.  With the acquisition of MedicalAdvisory Systems, Inc. in March 2002, the Company re-organized into foursegments:  Animal Applications, DigitalAngel Systems, GPS and Radio Communications, and Physician Call Center andOther.  Animal Applications is the newname of our segment previously identified as Animal Tracking.  We combined our Digital Angel Technologysegment with our Digital Angel Delivery Systems segment to form the new DigitalAngel Systems segment, which is now managed as a single business unit.  GPS and Radio Communications is the new nameof our segment previously identified as Radio Communications and Other andrepresents the activity of Signature Industries Limited, which is located inthe United Kingdom.  Physician CallCenter and Other reflects the newly acquired Medical Advisory Systems, Inc.business.  Prior period segmentinformation has been restated to reflect our current segment structure.

 

The accounting policies of the operating segments are the same as thosedescribed in the summary of accounting policies in the Company’s auditedfinancial statements for the year ended December 31, 2001.  It is on this basis that management utilizesthe financial information to assist in making internal operatingdecisions.  The Company evaluatesperformance based on stand-alone segment operating income.

 

Following is the selected segment data as of and for the three monthsended September 30, 2002:

 
|                                                                                                                                        |   | **Animal  Applications** |       | **Digital Angel  Systems** |       | **GPS and Radio  Communications** |       | **Physician Call  Center and  Other** |       | **Corporate /  Unallocated** |       | **Consolidated** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|----------------------------|------------|-----------------------------------|------------|---------------------------------------|------------|------------------------------|------------|------------------|------------|
|                                                                                                                                        |   |                     | ** ** |                       | ** ** |                              | ** ** |                                  | ** ** |                         | ** ** |             | ** ** |
| Net revenue from  external customers:                                                                                                       |   |                     |       |                       |       |                              |       |                                  |       |                         |       |             |       |
|                                                                                                                                        |   |                     |       |                       |       |                              |       |                                  |       |                         |       |             |       |
| Product                                                                                                                                     |   | $                        | 5,887      |                       | $          | —                            |       | $                                     | 2,506      |                         | $          | 611              |       | $ | — |   | $ | 9,004 |   |
| Service                                                                                                                                     |   | —                   |       | 335                        |       | —                            |       | —                                |       | —                       |       | 335              |       |
| Total revenue                                                                                                                               |   | $                        | 5,887      |                       | $          | 335                               |       | $                                     | 2,506      |                         | $          | 611              |       | $ | — |   | $ | 9,339 |   |
|                                                                                                                                        |   |                     |       |                       |       |                              |       |                                  |       |                         |       |             |       |
| Income (loss) before  provision (benefit) for income taxes, minority interest share of losses and  equity in net loss (income) of affiliate |   | $                        | 850        |                       | $          | (1,450                            | )          | $                                     | (203       | )                            | $          | (173             | )          | $ | — |   | $ | (976 | ) |
|                                                                                                                                        |   |                     |       |                       |       |                              |       |                                  |       |                         |       |             |       |
| Total assets                                                                                                                                |   | $                        | 81,669     |                       | $          | 16,304                            |       | $                                     | 5,423      |                         | $          | 31,979           |       | $ | — |   | $ | 135,375 |   |

 

In the three month period ended September 30, 2002, two customersaccounted for 36.6% and 19.0% of our Animal Applications revenue two customersaccounted for 68.8% and 22.4% of our Digital Angel Systems revenue, and twocustomers accounted for 29.5% and 26.0% of our Physician Call Center and Otherrevenue.

 

12

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Following is the selected segment data as of and for the nine monthsended September 30, 2002:

 
|                                                                                                                                        |   | **Animal  Applications** |   | **Digital  Angel Systems** |   | **GPS and  Radio Communications** |   | **Physician  Call Center and Other** |   | **Corporate  / Unallocated** |   | **Consolidated** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|----------------------------|--------|-----------------------------------|--------|--------------------------------------|--------|------------------------------|--------|------------------|--------|
|                                                                                                                                        |   |                     |   |                       |   |                              |   |                                 |   |                         |   |             |   |
| Net revenue from  external customers:                                                                                                       |   |                     |   |                       |   |                              |   |                                 |   |                         |   |             |   |
|                                                                                                                                        |   |                     |   |                       |   |                              |   |                                 |   |                         |   |             |   |
| Product                                                                                                                                     |   | $                        | 16,314 |                       | $      | —                            |   | $                                    | 7,622  |                         | $      | 1,181            |   | $ | — |   | $ | 25,117 |   |
| Service                                                                                                                                     |   | —                   |   | 1,215                      |   | —                            |   | —                               |   | —                       |   | 1,215            |   |
| Total revenue                                                                                                                               |   | $                        | 16,314 |                       | $      | 1,215                             |   | $                                    | 7,622  |                         | $      | 1,181            |   | $ | — |   | $ | 26,332 |   |
|                                                                                                                                        |   |                     |   |                       |   |                              |   |                                 |   |                         |   |             |   |
| Income (loss)  before provision (benefit) for income taxes, minority interest share of  losses and equity in net loss (income) of affiliate |   | $                        | 1,251  |                       | $      | (4,597                            | )      | $                                    | (491   | )                            | $      | (413             | )      | $ | (20,487) | (1) | $ | (24,737 | ) |
|                                                                                                                                        |   |                     |   |                       |   |                              |   |                                 |   |                         |   |             |   |
| Total assets                                                                                                                                |   | $                        | 81,669 |                       | $      | 16,304                            |   | $                                    | 5,423  |                         | $      | 31,979           |   | $ | — |   | $ | 135,375 |   |

 

----

(1)  Consistsof $18,681,000 non-cash compensation expense associated with Digital Angeloptions converted into options to acquire Digital Angel Corporation stock and$1,806,000 interest expense associated with ADS obligations to IBM CreditCorporation.

 

In the nine month period ended September 30, 2002, two customersaccounted for 16.7% and 14.8% of our Animal Applications revenue, threecustomers accounted for 61.9%, 12.3% and 10.6% of our Digital Angel Systemsrevenue and two customers accounted for 26.8% and 25.5% of our Physician CallCenter and Other revenue.

 

 

Following is the selected segment data as of and for the three monthsended September 30, 2001:

 
|                                                                                                                               |   | **Animal  Applications** |   | **Digital Angel  Systems** |   | **GPS and Radio  Communications** |   | **Physician Call  Center and  Other** |   | **Combined** |   |
|------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|----------------------------|--------|-----------------------------------|--------|---------------------------------------|--------|--------------|--------|
| Net revenue from  external customers:                                                                                              |   |                     |   |                       |   |                              |   |                                  |   |         |   |
|                                                                                                                               |   |                     |   |                       |   |                              |   |                                  |   |         |   |
| Product                                                                                                                            |   | $                        | 5,501  |                       | $      | —                            |   | $                                     | 2,915  |         | $      | — |   | $ | 8,416 |   |
| Service                                                                                                                            |   | —                   |   | 881                        |   | —                            |   | —                                |   | 881          |   |
| Total revenue                                                                                                                      |   | $                        | 5,501  |                       | $      | 881                               |   | $                                     | 2,915  |         | $      | — |   | $ | 9,297 |   |
|                                                                                                                               |   |                     |   |                       |   |                              |   |                                  |   |         |   |
| Loss before provision  (benefit) for income taxes, minority interest share of losses and equity in  net loss (income) of affiliate |   | $                        | (968   | )                          | $      | (2,663                            | )      | $                                     | (318   | )            | $      | — |   | $ | (3,949 | ) |
|                                                                                                                               |   |                     |   |                       |   |                              |   |                                  |   |         |   |
| Total assets                                                                                                                       |   | $                        | 89,959 |                       | $      | 15,334                            |   | $                                     | 6,866  |         | $      | — |   | $ | 112,159 |   |

** **

**In the three month period ended September 30, 2001,two customers provided  20.5% and 18.8%of our Animal Applications revenue and two customers provided for 43.4% and14.6% of our Digital Angel Systems revenue.**

 

13

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**Following is the selected segment data as of and forthe nine months ended September 30, 2001:**

 
|                                                                                                                               |   | **Animal  Applications** |   | **Digital Angel  Systems** |   | **GPS and Radio  Communications** |   | **Physician Call  Center and  Other** |   | **Combined** |   |
|------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|----------------------------|--------|-----------------------------------|--------|---------------------------------------|--------|--------------|--------|
| Net revenue from  external customers:                                                                                              |   |                     |   |                       |   |                              |   |                                  |   |         |   |
|                                                                                                                               |   |                     |   |                       |   |                              |   |                                  |   |         |   |
| Product                                                                                                                            |   | $                        | 16,761 |                       | $      | —                            |   | $                                     | 8,407  |         | $      | — |   | $ | 25,168 |   |
| Service                                                                                                                            |   | —                   |   | 2,803                      |   | —                            |   | —                                |   | 2,803        |   |
| Total revenue                                                                                                                      |   | $                        | 16,761 |                       | $      | 2,803                             |   | $                                     | 8,407  |         | $      | — |   | $ | 27,971 |   |
|                                                                                                                               |   |                     |   |                       |   |                              |   |                                  |   |         |   |
| Loss before provision  (benefit) for income taxes, minority interest share of losses and equity in  net loss (income) of affiliate |   | $                        | (4,102 | )                          | $      | (4,691                            | )      | $                                     | (543   | )            | $      | — |   | $ | (9,336 | ) |
|                                                                                                                               |   |                     |   |                       |   |                              |   |                                  |   |         |   |
| Total assets                                                                                                                       |   | $                        | 89,959 |                       | $      | 15,334                            |   | $                                     | 6,866  |         | $      | — |   | $ | 112,159 |   |

** **

**In thenine month period ended September 30, 2001, two customers provided 18.1% and15.0% of our Animal Applications revenue and three customers provided 32.4%,18.7% and 18.4% of our Digital Angel Systems revenue.**

** **

14

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** **

**7.             Acquisitions**

 

The following describes the acquisitions by the Company during the ninemonth period ended September 30, 2002:

 
| **Company  Acquired**          |   | **Date  Acquired** |   | **Acquisition  Price** |   | **Acquisition  Costs** |   | **Value of  Shares,  Warrants &  Options  Issued or  Issuable** |   | **Common  Shares  Issued** |   | **Goodwill  and  Other  Intangibles  Acquired** |   | **Business  Description** |   |
|--------------------------------|--------|--------------------|--------|------------------------|--------|------------------------|--------|---------------------------------------------------------------------|--------|----------------------------|--------|-------------------------------------------------|--------|---------------------------|--------|
| Medical Advisory Systems, Inc. |   | 03/27/02           |   | $                      | 31,798 |                   | $      | 3,380                                                               |   | $                          | 28,418 |                                            | 5,218  |                      | $      | 29,976 |   | Provider  of medical assistance and technical products and services |   |
|                                |        |                    |        |                        |        |                        |        |                                                                     |        |                            |        |                                                 |        |                           |        |  |  |  |  |

 

On February 27, 2001, ADS acquired 16.6% of the capital stock of MAS(AMEX:DOC), a provider of medical assistance and technical products andservices, in a transaction valued at $8.3 million in consideration for 3.3million shares of ADS’s common stock. ADS controlled two of the seven seats on the Company’s Board ofDirectors and became the largest single shareholder.  This investment was accounted for under the equity method fromFebruary 27, 2001 through March 27, 2002. The excess of the purchase price over the estimated fair value of theshares acquired was approximately $6.8 million (goodwill) and through December31, 2001 was being amortized on a straight-line basis over five years.

 

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.  Identifiable intangible assets have beenrecorded based upon preliminary estimates as of the date of theacquisition.  Any changes to thepreliminary estimates during the allocation period will be reflected as anadjustment to goodwill. 

 

The cost of the March 27, 2002 acquisition consisted of 5.268 millionshares of common stock, including 50,000 shares of treasury stock, valued at$25.0 million, options to purchase 1.2 million shares and warrants to purchase75,000 shares valued at $3.4 million, and acquisition costs of $3.4million.  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, legal and accounting services thatwere direct costs of acquiring these assets. Included in the acquisition costs are certain severance liabilities of$2.5 million, related to employment agreements of two officers of MAS.  The value of the options and warrants isbased on the fair value of the options and warrants of MAS at the date ofacquisition.  The fair value wasdetermined using the Black-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 MAS have been included in theconsolidated financial statements since the date of acquisition.  Unaudited pro forma results of operationsfor the three and nine months ended September 30, 2002 and 2001 are includedbelow.  Such pro forma informationassumes that the above acquisition had occurred

 

15

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as of January 1,2002 and 2001, respectively, and revenue is presented in accordance with theCompany’s accounting policies.  Thissummary is not necessarily indicative of what the result of operations of theCompany would have been had it been a combined entity during such periods, nordoes it purport to represent results of operations for any future periods.

 
|                                           |   | **Three  Months Ended September 30,** | ** ** | **Nine  Months Ended September 30,** | ** ** |
|------------------------------------------------|--------|---------------------------------------|------------|--------------------------------------|------------|
|                                           |   | **2002**                              | ** ** | **2001**                             | ** ** | **2002** | ** ** | **2001** | ** ** |
| Net operating revenue                          |   | $                                     | 9,339      |                                 | $          | 10,076 |   | $ | 26,882 |   | $ | 30,741 |   |
| Net loss                                       |   | $                                     | (945       | )                                    | $          | (4,457 | ) | $ | (26,408 | ) | $ | (10,666 | ) |
| Net loss per common  share - basic and diluted |   | $                                     | (0.04      | )                                    | $          | (0.19 | ) | $ | (0.95 | ) | $ | (0.45 | ) |

 

**8.             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 asGuardian*ad Litem* for JonathanSilva, a minor, and the Estate of Clarence William Silva, Jr. (collectively,“Plaintiffs”) filed suit against Customized Services Administrators,Incorporated (“CSA”), Pricesmart, Inc. (“Pricesmart”), Commercial UnionInsurance Company (“Commercial Union”), CGU Insurance Group, and the Company(collectively the “Defendants”) in the Superior Court of the State ofCalifornia in and for the County of Santa Clara.  The allegations of the complaint arise from a vacation guaranteeinsurance policy (the “Insurance Contract”) allegedly purchased by Plaintiffsfrom Defendants on March 6, 2000.  Thecomplaint alleges, among other things, that Defendants breached the InsuranceContract, defrauded Plaintiffs, acted in bad faith, and engaged in deceptiveand unlawful business practices, resulting in the wrongful death of ClarenceWilliam Silva, Jr. (the “Deceased”) and the intentional infliction of emotionaldistress on Plaintiffs.  The complaintseeks the cost of funeral and burial expenses of the Deceased and amountsconstituting the loss of financial support of the Deceased, general damages,attorney’s fees and costs, and exemplary damages.

 

CSA has filed a cross-claim against the Companyalleging that the Company should be held liable for any liability that CSA mayhave to Plaintiffs.  The Company hasdenied the allegations of the complaint and the CSA cross-claim and isvigorously contesting all aspects of this action.

 

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

 

16

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**9.             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 $0.2 millionfor the three months ended September 30, 2001, and $0.2 million and $0.6million for the nine months ended September 30, 2002 and 2001, respectively.  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 $42,000 a month to support ADS’ research group.  Additionally, we are charged by ADS forproduct liability insurance through September 2002 and directors and officersinsurance through June 2003.  Thesetransactions resulted in a due to ADS of $0.7 million at September 30, 2002.

 

ADS acquired Timely Technology Corp., a part of AWG, in 2000 and themerger agreement included an earnout provision based on performance throughJune 30, 2002.  ADS has agreed to paythe selling shareholder of Timely Technology Corp. $3.6 million, payable inshares of ADS stock, as the final payment under the earnout provision.  This obligation has been reflected in theaccompanying financial statements as a capital contribution by ADS and anincrease to goodwill and other intangibles.

 

The Company hasexecuted an exclusive eleven year Distribution and Licensing Agreement datedMarch 4, 2002 with Verichip Corporation (Verichip), a wholly-owned subsidiaryof ADS, covering the manufacturing, purchasing and distribution of Verichip’simplantable microchip and the maintenance of the Verichip Registry by theCompany.  The agreement includes alicense for the use of the Company’s technology in Verichip’s identifiedmarkets.  The Company will be the solemanufacturer and supplier to Verichip. Revenue recognized under the Distribution and Licensing Agreement was$62,000 for the nine months ended September 30, 2002.  

 

In connection with certain obligations of ADS, theCompany has financial covenants.  OnSeptember 30, 2002, the debt covenants were amended for the remainder of2002.  The amendment reduced theCompany’s current assets to current liabilities ratio and Minimum CumulativeModified EBITDA requirements for the quarters ended September 30, 2002 andDecember 31, 2002.  The Company was incompliance with the amended debt covenants on September 30, 2002.  Minimum Cumulative Modified EBITDA, asdefined in the credit agreement, excludes non-cash compensation expense,one-time charges, impairment losses or any liability or claim that will besatisfied by issuance of the Company’s common stock.  The debt covenants, as amended on September 30, 2002, are asfollows:

 
| **COVENANT**                           |   | **COVENANTS  REQUIREMENT** |   |
|----------------------------------------|--------|----------------------------|--------|
| Current Assets to  Current Liabilities |   | September 30, 2002         |   | 1.05:1 |   |
|                                   |   | December 31, 2002          |   | 1.09:1 |   |
|                                   |   |                       |   |   |   |
| Minimum Cumulative  Modified EBITDA    |   | September 30, 2002         |   | $ | 0 |   |
|                                   |   | December 31, 2002          |   | $ | 1,001,000 |   |

 

**10.          Investmentin Affiliates**

 

**The change in the Company’s investment in affiliatesis as follows:**

** **
| **Balance  December 31, 2001**                        |   | **$**      | **6,779**  |   |
|-------------------------------------------------------|--------|------------|------------|--------|
| **Equity  in net loss of affiliate**                  |   | **(291**   | **)**      |
| **MAS  common shares transferred to ADS**             |   | **(6,488** | **)**      |
| **MAS  affiliates obtained through merger (at cost)** |   | **256**    | ** ** |
| **Balance  September 30, 2002**                       |   | **$**      | **256**    |   |

 

**11.          OptionGrant**

** **

The Company adopted the Amended and Restated DigitalAngel Corporation Transition Stock Option Plan which, as amended, provides for11,195,312 shares of common stock for which options and other awards may begranted.

 

On June 27, 2002, the Company's Board of Directorsgranted options to purchase 3,910,000 shares to officers, employees anddirectors of the Company.  The optionshave an exercise price of $3.39, the market price of the Company’s common stockon the date of grant, and expire in ten years. Options to purchase 3,000,000 shares vest one year from the date ofgrant, and the remaining options

 

17

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vest one-third annually,beginning on the first anniversary of the grant date.  Pursuant to an amendment to the Company's Certificate ofIncorporation, required by the terms of the Digital Angel Share TrustAgreement, the option grant requires the approval of at least two-thirds of theCompany's stockholders.  Approval of thegrant was obtained on August 29, 2002. In addition, the grant of the options must be approved by the Trust,which approval the Company obtained. 

 

**12.**          **Subsequent Events**

** **

On October 30, 2002, we signed a credit and securityagreement and related agreements with Wells Fargo Business Credit, Inc. that,among other things, permit us to borrow up to $5,000,000 from Wells FargoBusiness Credit from time to time under the terms of the credit and securityagreement.  Amounts borrowed under thecredit facility are general obligations of the Company secured by a firstpriority lien on substantially all of the Company’s assets, including ouraccounts receivable and our patents and other intellectual property relating tothe Digital AngelTM product.  Theoutstanding principal balance of the credit facility bears interest at anannual rate equal to the rate of interest publicly announced from time to timeby Wells Fargo Bank National Association as its “prime rate” plus threepercentage points.  However, the creditand security agreement requires that the total amount of interest paid to WellsFargo Business Credit per year must be at least $120,000.  The credit facility will expire on October30, 2005, at which time the entire outstanding balance of the credit facilitywill become due and payable.

 

The credit and security agreement requires us to meetcertain financial covenants, including a monthly minimum book net worth andmonthly minimum earnings before taxes, and it limits our capital expendituresduring 2003.  Any breach of thefinancial covenants by us will constitute an event of default under the creditand security agreement.  The credit andsecurity agreement also provides that any change of control of the Company willbe an event of default under the credit and security agreement.  As defined in the credit and securityagreement, a change of control includes the future acquisition by any person orgroup of persons of more than 25% of the voting power of all classes of ourcommon stock.  If ADS defaults under theIBM credit agreement, the Trust will be obligated, upon the request of IBMCredit Corporation, to sell all or a portion of our common stock held by the Trust.  If such sales by the Trust result in aperson or group of persons owning, in the aggregate, 25% or more of our commonstock, such sales will be deemed to constitute an event of default under thecredit and security agreement. 

 

On November 1,2002 we filed a Registration Statement on Form S-1 with the Securities andExchange Commission.  The RegistrationStatement is for the sale of up to 3,000,000 shares of our common stock and thesale by certain of our existing stockholders of up to 22,348,720 shares oftheir common stock of the Company.  Theexisting stockholders’ 22,348,720 shares are being registered to permit thestockholders to sell their shares of the Company’s common stock from time totime in the public market.  The Companywill not receive any proceeds from the sale of the common stock by the sellingstockholders.  The RegistrationStatement on Form S-1 is subject to review by the Securities and ExchangeCommission.

 

18

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**Item2.****                              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 Angel Corporation and its three subsidiaries –Digital Angel Technology Corporation (“DATC”), Timely Technology Corp. andSignature Industries, Limited.  Thesethree subsidiaries were known as the Advanced Wireless Group (“AWG”).  DATC is engaged in the business ofdeveloping and bringing to market proprietary technologies used to identify,locate and monitor people, animals and objects.  DATC is the result of the merger in September 2000 of DestronFearing Corporation and Digital Angel.net Inc., which was then a wholly-ownedsubsidiary of ADS. Before March 27, 2002, the business of DATC was operated infour segments:  Animal Tracking, DigitalAngel Technology, Digital Angel Delivery System, and Radio Communications andOther.  With the acquisition of MAS inMarch 2002, the Company re-organized into four segments:  Animal Applications, Digital Angel Systems,GPS and Radio Communications, and Physician Call Center and Other.  Animal Applications is the new name of oursegment previously identified as Animal Tracking.  We combined our Digital Angel Technology segment with our DigitalAngel Delivery System segment to form the new Digital Angel Systems segment,which is now managed as a single business unit.  GPS and Radio Communications is the new name of our segment previouslyidentified as Radio Communications and Other. Physician Call Center and Other reflects the newly acquired MASbusiness.  Prior period segmentinformation has been restated to reflect our current segment structure.

 

19

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**RESULTS OF OPERATIONS**

 

The following table summarizes our results ofoperations as a percentage of net operating revenue for the three and ninemonths ended September 30, 2002 and 2001 and is derived from the accompanyingconsolidated and combined statements of operations included in this report.

 
|                                                                                                                               |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                                                                                               |   | **2002**                              |   | **2001**                             |   | **2002** |   | **2001** |   |
|                                                                                                                               |   | **%**                                 |   | **%**                                |   | **%** |   | **%** |   |
| Product revenue                                                                                                                    |   | 96.4                                  |   | 90.5                                 |   | 95.4 |   | 90.0 |   |
| Service revenue                                                                                                                    |   | 3.6                                   |   | 9.5                                  |   | 4.6 |   | 10.0 |   |
| Total net  revenue                                                                                                                 |   | 100.0                                 |   | 100.0                                |   | 100.0 |   | 100.0 |   |
| Cost of products  sold                                                                                                             |   | 50.1                                  |   | 56.5                                 |   | 52.5 |   | 54.4 |   |
| Cost of services  sold                                                                                                             |   | 2.8                                   |   | 6.5                                  |   | 2.9 |   | 5.8 |   |
| Total cost of  products and services sold                                                                                          |   | 52.9                                  |   | 63.0                                 |   | 55.4 |   | 60.2 |   |
| Gross profit                                                                                                                       |   | 47.1                                  |   | 37.0                                 |   | 44.6 |   | 39.8 |   |
| Selling, general  and administrative expenses                                                                                      |   | 50.2                                  |   | 61.0                                 |   | 122.1 |   | 56.6 |   |
| Management fees  - Applied Digital Solutions, Inc.                                                                                 |   | 0.0                                   |   | 2.0                                  |   | 0.7 |   | 2.0 |   |
| Research and  development expenses                                                                                                 |   | 6.6                                   |   | 14.3                                 |   | 8.2 |   | 13.4 |   |
| Interest income                                                                                                                    |   | 0.0                                   |   | 0.0                                  |   | 0.0 |   | (0.1 | ) |
| Interest expense                                                                                                                   |   | 0.8                                   |   | 2.2                                  |   | 7.6 |   | 1.3 |   |
| Loss before provision  (benefit) for income taxes, minority interest share of losses and equity in  net loss (income) of affiliate |   | (10.5                                 | )      | (42.5                                | )      | (94.0 | ) | (33.4 | ) |
| Provision  (benefit) for income taxes                                                                                              |   | 0.0                                   |   | (0.6                                 | )      | 0.0 |   | 0.2 |   |
| Loss before minority  interest share of losses and equity in net loss (income) of affiliate                                        |   | (10.5                                 | )      | (41.9                                | )      | (94.0 | ) | (33.6 | ) |
| Minority  interest share of losses                                                                                                 |   | (0.4                                  | )      | (0.3                                 | )      | (0.3 | ) | (0.2 | ) |
| Equity in net  loss (income) of affiliate                                                                                          |   | 0.0                                   |   | 0.5                                  |   | 1.1 |   | 0.4 |   |
| Net loss                                                                                                                           |   | (10.1                                 | )      | (42.1                                | )      | (94.8 | ) | (33.8 | ) |

 

**ThreeMonths Ended September 30, 2002 Compared to the Three Months Ended September30, 2001**

 

**Revenue**

Revenue from operations for the three months ended September 30, 2002remained constant at $9.3 million when compared to the three months endedSeptember 30, 2001.

 

20

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Revenue for each of the operating segments was:

 
|                             |   | **Three  Months Ended  September 30,  2002** |   | **Three  Months  Ended September 30,  2001** |   |
|----------------------------------|--------|----------------------------------------------|--------|----------------------------------------------|--------|
| Animal Applications              |   | $                                            | 5,887  |                                         | $      | 5,501 |   |
| Digital Angel Systems            |   | 335                                          |   | 881                                          |   |
| GPS and Radio  Communications    |   | 2,506                                        |   | 2,915                                        |   |
| Physician Call Center  and Other |   | 611                                          |   | —                                       |   |
| Total                            |   | $                                            | 9,339  |                                         | $      | 9,297 |   |

 

The Animal Applications segment’s revenue increased**$0.4 million, or 7.0%, in the threemonths ended September 30, 2002 compared to the three month period endedSeptember 30, 2001.  The increase is dueprimarily to sales of transponders to the fisheries industry customers.

 

The Digital Angel Systems segment’s revenue decreased$0.5 million, or 62.0%, in the three month period ended September 30, 2002compared to the three monthperiod ended September 30, 2001primarily due to a shift in emphasis to the Digital AngelTM products, which arein the initial stages of development.

 

The GPS and Radio Communications segment’s revenuedecreased $0.4 million, or 14.0%, in the three month period ended September 30,2002 compared to threemonth period ended September 30, 2001 primarilyas a result of order fluctuations.

 

PhysicianCall Center and Other segment’s revenue was $0.6 million in the three monthperiod ended September 30, 2002.  Thesegment became part of the Company on March 27, 2002.

 

**GrossProfit and Gross Profit Margin**

 

Gross profit for the three month period endedSeptember 30, 2002 was $4.4 million, an increase**of $1.0 million, or 27.7%, compared to $3.4 million in thethree month period ended September 30, 2001. As a percentage of revenue, thegross profit margin was 47.1% and 37.0% for the three months ended September30, 2002 and 2001, respectively.

 

Gross profit from operations for each operatingsegment was:

 
|                             |   | **Three  Months  Ended September 30,  2002** |   | **Three  Months  Ended September 30,  2001** |   |
|----------------------------------|--------|----------------------------------------------|--------|----------------------------------------------|--------|
| Animal Applications              |   | $                                            | 2,828  |                                         | $      | 1,976 |   |
| Digital Angel Systems            |   | 71                                           |   | 282                                          |   |
| GPS and Radio  Communications    |   | 1,251                                        |   | 1,185                                        |   |
| Physician Call Center  and Other |   | 245                                          |   | —                                       |   |
| Total                            |   | $                                            | 4,395  |                                         | $      | 3,443 |   |

 

Gross profit margin from operations for each operatingsegment was:

 
|                             |   | **Three  Months  Ended September 30,  2002** |       | **Three  Months  Ended September 30,  2001** |       |
|----------------------------------|--------|----------------------------------------------|------------|----------------------------------------------|------------|
|                             |   | **%**                                        | ** ** | **%**                                        | ** ** |
| Animal Applications              |   | 48.0                                         |       | 35.9                                         |       |
| Digital Angel Systems            |   | 21.2                                         |       | 32.0                                         |       |
| GPS and Radio  Communications    |   | 49.9                                         |       | 40.7                                         |       |
| Physician Call Center  and Other |   | 40.1                                         |       | —                                       |       |
| Total                            |   | 47.1                                         |       | 37.0                                         |       |

 

21

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The Animal Applicationssegment’s gross profit increased $0.9 million in the three month period endedSeptember 30, 2002 compared to the three months ended September 30, 2001**due to the previously mentioned salesincrease.  The gross margin percentage increasedto 48.0% in the three month period ended September 30, 2002 as compared to35.9% in the three month period ended September 30, 2001 due to highermargin product mix.

 

The Digital Angel Systemssegment’s gross profit decreased $0.2 million, or 74.8 %, in the three monthperiod ended September 30, 2002 as compared to the three month period endedSeptember 30, 2001.  Margins decreasedto 21.2% in the three month period ended September 30, 2002 from 32.0% in thethree month period ended September 30, 2001*. *The gross profit decrease was primarilydue to a shift to lower margin contracts.

 

The GPS and RadioCommunications segment’s gross profit increased $0.07 million, or 5.6%, in thethree month period ended September 30, 2002 as compared to the three monthperiod ended September 30, 2001.  Thegross margin percentage increased to 49.9% in the three month period endedSeptember 30, 2002 as compared to 40.7% in the three month period endedSeptember 30, 2001 due to a favorable shift in the product mix.

 

The Physician Call Centerand Other segment’s gross profit was $0.2 million for the three month periodended September 30, 2002.  The grossmargin was 40.1% in the three month period ended September 30, 2002.  This segment became part of the Company onMarch 27, 2002.

 

**Selling, General and AdministrativeExpenses**

 

Selling, general andadministrative expenses from operations decreased $1.0 million, or 17.3%, inthe three month period ended September 30, 2002 as compared to thethree month period ended September 30, 2001. As a percentage of revenue, selling, general and administrative expenseswere 50.2% and 61.0% for the three months ended September 30, 2002 and 2001,respectively.

 

Selling, general andadministrative expenses for each of the operating segments were:

 
|                             |   | **Three  Months  Ended September 30,  2002** |   | **Three  Months  Ended September 30,  2001** |   |
|----------------------------------|--------|----------------------------------------------|--------|----------------------------------------------|--------|
| Animal Applications              |   | $                                            | 1,746  |                                         | $      | 3,181 |   |
| Digital Angel Systems            |   | 1,219                                        |   | 1,011                                        |   |
| GPS and Radio  Communications    |   | 1,309                                        |   | 1,480                                        |   |
| Physician Call Center  and Other |   | 414                                          |   | —                                       |   |
| Total                            |   | $                                            | 4,688  |                                         | $      | 5,672 |   |

 

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

 
|                             |   | **Three  Months  Ended September 30,  2002** |   | **Three  Months  Ended September 30,  2001** |       |
|----------------------------------|--------|----------------------------------------------|--------|----------------------------------------------|------------|
|                             |   | **%**                                        |   | **%**                                        | ** ** |
| Animal Applications              |   | 29.7                                         |   | 57.8                                         |       |
| Digital Angel Systems            |   | 363.9                                        |   | 114.8                                        |       |
| GPS and Radio  Communications    |   | 52.2                                         |   | 50.8                                         |       |
| Physician Call Center  and Other |   | 67.8                                         |   | —                                       |       |
| Total                            |   | 50.2                                         |   | 61.0                                         |       |

 

The Animal Applicationssegment’s selling, general and administrative expenses decreased $1.4million in the three month period ended September 30, 2002 as compared to thethree month period ended September 30, 2001 and as a percentage of revenuedecreased to 29.7% from 57.8% in the same respective periods.

 

22

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The decrease is primarily due to the adoption of FAS142, which took effect January 1, 2002. The adoption of FAS 142 requires the testing of goodwill for impairmentat least annually, eliminating the need for monthly amortization of goodwill.  Accordingly, goodwill amortization was notrecorded during the three months ended September 30, 2002.

 

The Digital Angel Systemssegment’s selling, general and administrative expenses of $1.2 million increased**$0.2 million in the three month periodended September 30, 2002 as compared $1.0 million in the three month periodended September 30, 2001.  Selling,general and administrative expenses increased as a percentage of revenue to 363.9% in the three month period endedSeptember 30, 2002 compared to 114.8% in the three month period ended September30, 2001 primarily as a result ofsoftware amortization expenses.

 

The GPS and RadioCommunications segment’s selling, general and administrative expenses decreased $0.2 million in the three monthperiod ended September 30, 2002 as compared to the three month period endedSeptember 30, 2001 primarily due to administrative cost reductions. As apercentage of revenue, selling, general and administrative expenses increasedto 52.2% in the three month period ended September 30, 2002 from 50.8% in thethree month period ended September 30, 2001.

 

The Physician Call Centersegment’s selling, general and administrative expenses were $0.4 million in thethree month period ended September 30, 2002. As a percentage of revenue, selling, general and administrative expenseswere 67.8% in the three month period ended September 30, 2002.  This segment became part of the Company onMarch 27, 2002.

** **

**ManagementFees**–**Applied DigitalSolutions, Inc.**

 

Management fees chargedby ADS amounted to $0.2 million for the three months ended September 30,2001.  These fees were for general andadministrative services performed for us. After March 27, 2002, we no longer pay a management fee to ADS.

** **

**Research and Development Expense**

 

Research and developmentexpense from operations was $0.6 million in the three month period endedSeptember 30, 2002, a decrease of $0.7 million, or 53.9%, from $1.3 million forthe three month period ended September 30, 2001.  As a percentage of revenue, research and development expense was6.6% and 14.3% for the three months ended September 30, 2002 and 2001,respectively.  Included in research anddevelopment expense are charges by ADS of approximately $42,000 a month tosupport ADS’ research group.  

 

Research and developmentexpense for each of the operating segments was:

 
|                             |   | **Three  Months  Ended September 30,  2002** |   | **Three  Months  Ended September 30,  2001** |   |
|----------------------------------|--------|----------------------------------------------|--------|----------------------------------------------|--------|
| Animal Applications              |   | $                                            | 186    |                                         | $      | 218 |   |
| Digital Angel Systems            |   | 294                                          |   | 1,114                                        |   |
| GPS and Radio  Communications    |   | 134                                          |   | —                                       |   |
| Physician Call Center  and Other |   | —                                       |   | —                                       |   |
| Total                            |   | $                                            | 614    |                                         | $      | 1,332 |   |

 

The significant decreaseis due primarily to a reduction in basic research and development expenses associatedwith the Digital AngelTM product.  Sincethe fundamental technology has now been developed, research expenses havedeclined and expenses are now focused on development for specific verticalmarkets.

 

23

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**Interest Expense**

 

Interest expense was $0.07 million and $0.2 million for the threemonths period ended September 30, 2002 and 2001, respectively. 

** **

**Income Taxes**

 

The Company and AWG had effective income tax rates of 0.0% and a (1.3)%for the three month period ended September 30, 2002 and 2001, respectively. Differences in the effective income tax rates from the statutory federalincome tax rate in 2002 arise primarily from valuation allowances recorded ondeferred tax assets resulting from net operating losses.  The differences in 2001 arise primarily fromvaluation allowances recorded on deferred tax assets resulting from netoperating losses, non-deductible goodwill amortization associated withacquisitions and state taxes net of federal benefits. The U.S. companies in AWGwere included in ADS’s consolidated federal income tax return through March 27,2002.  MAS and its subsidiaries file aseparate consolidated federal income tax return.  After March 27, 2002, AWG’s U.S. subsidiaries will file a consolidatedfederal tax return with MAS.

 

**NineMonths Ended September 30, 2002 Compared to the Nine Months Ended September 30,2001**

 

**Revenue**

 

Revenue from operationsfor the nine months ended September 30, 2002 was $26.3 million, a decrease of$1.6 million, or 5.9%, from $28.0 million in the nine months ended September30, 2001.

 

Revenue for each of theoperating segments was:

 
|                             |   | **Nine Months****Ended September 30,  2002** |   | **Nine Months****Ended September 30,2001** |   |
|----------------------------------|--------|----------------------------------------------|--------|--------------------------------------------|--------|
| Animal Applications              |   | $                                            | 16,314 |                                       | $      | 16,761 |   |
| Digital Angel Systems            |   | 1,215                                        |   | 2,803                                      |   |
| GPS and Radio  Communications    |   | 7,622                                        |   | 8,407                                      |   |
| Physician Call Center  and Other |   | 1,181                                        |   | —                                     |   |
| Total                            |   | $                                            | 26,332 |                                       | $      | 27,971 |   |

 

24

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The Animal Applicationssegment’s revenue decreased $0.4 million, or 2.7%, in the nine month periodended September 30, 2002 as compared to the nine month period ended September30, 2001.  The decline is due primarilyto the higher sales in the first quarter of 2001 to a large customer to preparefor the launch of the pet identification product in France.

 

The Digital Angel Systemssegment’s revenue decreased $1.6 million, or 56.7%, in the nine month periodended September 30, 2002 as compared to the nine month period ended September 30, 2001 due to completed client assignments thatwere not replaced and a shift in emphasis to the Digital AngelTM products whichare in the initial stages of development.

 

The GPS and RadioCommunications segment’s revenue decreased** $0.8 million, or 9.3%, in the nine monthperiod ended September 30, 2002 as compared to the nine month period ended September 30, 2001 primarily as a result of order fluctuations.

 

The Physician Call Centerand Other revenue was $1.2 million for the nine months ended September 30,2002.  This segment became part of theCompany on March 27, 2002.

 

**Gross Profit and Gross Profit Margin**

 

Gross profit for the ninemonths ended September 30, 2002 was $11.8 million, a decrease of $0.6 million,or 5.6%, from $11.1 million in the nine months ended September 30, 2001.  As a percentage of revenue, the gross profitmargin was 44.6 % and 39.8% for the nine months ended September 30, 2002 and2001, respectively.

 

Gross profit fromoperations for each operating segment was:

 
|                             |   | **Nine  Months   Ended September 30,  2002** |   | **Nine  Months  Ended September 30,  2001** |   |
|----------------------------------|--------|----------------------------------------------|--------|--------------------------------------------------|--------|
| Animal Applications              |   | $                                            | 6,973  |                                             | $      | 6,147 |   |
| Digital Angel Systems            |   | 453                                          |   | 1,176                                            |   |
| GPS and Radio  Communications    |   | 3,871                                        |   | 3,805                                            |   |
| Physician Call Center  and Other |   | 458                                          |   | —                                           |   |
| Total                            |   | $                                            | 11,755 |                                             | $      | 11,128 |   |

 

Gross profit margin fromoperations for each operating segment was:

 
|                             |   | **Nine  Months  Ended September 30,  2002** |   | **Nine  Months  Ended September 30,  2001** |   |
|----------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|--------|
|                             |   | **%**                                       |   | **%**                                       |   |
| Animal Applications              |   | 42.7                                        |   | 36.7                                        |   |
| Digital Angel Systems            |   | 37.3                                        |   | 42.0                                        |   |
| GPS and Radio  Communications    |   | 50.8                                        |   | 45.3                                        |   |
| Physician Call Center  and Other |   | 38.8                                        |   | —                                      |   |
| Total                            |   | 44.6                                        |   | 39.8                                        |   |

 

The Animal Applicationssegment’s gross profit of $7.0 million in the nine months ended September 30,2002 increased $0.8 million compared to $6.2 million in the nine month periodended September 30, 2001*. *The gross profit margin increasedto 42.7% in the nine month period ended September 30, 2002 as compared to 36.7%in the nine months ended September 30, 2001 due to a more favorable productmix.

 

The Digital Angel Systemssegment’s gross profit decreased $0.7 million, or 61.5%, in the nine monthsended September 30, 2002 as compared to the nine months ended September 30,2001.  Margins decreased to 37.3% in thenine months ended September 30, 2002 from 42.0% in the nine months endedSeptember 30, 2001.  The gross profit decrease was primarily dueto the sales decline.  The margin percentage declined due to the retention of personnel as resources were shifted tosupport the Digital AngelTM products.

 

25

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The GPS and RadioCommunications segment’s gross profit increased $0.07 million or 1.7% in thenine months ended September 30, 2002 as compared to the nine months endedSeptember 30, 2001.  The gross marginpercentage increased**to 50.8% inthe nine months ended September 30, 2002 compared to 45.3% in the nine months ended September 30, 2001 due to a favorable shift in the product mix.

 

The Physician Call Centerand Other segment’s gross profit was $0.5 million for the nine months endedSeptember 30, 2002.  The gross marginwas 38.8% in the nine months ended September 30, 2002.  This segment became part of the Company onMarch 27, 2002.

 

**Selling, General and AdministrativeExpenses**

 

Selling, general andadministrative expenses from operations increased$16.3 million, or 103.1%, in the nine months ended September 30, 2002 ascompared to the nine months ended September 30, 2001.  This increase was caused primarily by an $18.7 million chargearising from the remeasurement of options in connection with the merger.  Pursuant to the terms of the merger agreement,options to acquire shares of DATC common stock were converted into options toacquire 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 expense during the threemonths ended March 31, 2002.  Forcurrent employees of the Company, these options are considered fixed awardsunder APB Opinion No. 25, and expense was recorded for the intrinsic value ofthe options converted.  For all others,expense was recorded for the fair value of the options converted using theBlack-Scholes option-pricing model. 

 

Offsetting the non-cashcompensation expense is the decrease in amortization expense due to theadoption of FAS 142, which took effect January 1, 2002.  The adoption of FAS 142 requires the testingof goodwill for impairment at least annually, eliminating the need for monthlyamortization of goodwill.  Accordingly,goodwill amortization was not recorded during the first nine months of 2002.

 

As a percentage ofrevenue, selling, general and administrative expenses were 122.1% and 56.6% forthe nine months ended September 30, 2002 and 2001, respectively.

 

Selling, general andadministrative expenses for each of the operating segments excluding the $18.7million charge were:

 
|                             |   | **Nine  Months  Ended September 30,  2002** |   | **Nine  Months  Ended September 30,  2001** |   |
|----------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|--------|
| Animal Applications              |   | $                                           | 4,595  |                                        | $      | 9,413 |   |
| Digital Angel Systems            |   | 4,046                                       |   | 2,085                                       |   |
| GPS and Radio  Communications    |   | 3,953                                       |   | 4,325                                       |   |
| Physician Call Center  and Other |   | 865                                         |   | —                                      |   |
| Total                            |   | $                                           | 13,459 |                                        | $      | 15,823 |   |

 

Selling, general andadministrative expenses as a percentage of revenue for each of the operatingsegments excluding the $18.7 million charge were:

 
|                             |   | **Nine  Months  Ended September 30,  2002** |   | **Nine  Months  Ended September 30,  2001** |   |
|----------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|--------|
|                             |   | **%**                                       |   | **%**                                       |   |
| Animal Applications              |   | 28.2                                        |   | 56.2                                        |   |
| Digital Angel Systems            |   | 333.0                                       |   | 74.4                                        |   |
| GPS and Radio  Communications    |   | 51.9                                        |   | 51.4                                        |   |
| Physician Call Center  and Other |   | 73.2                                        |   | —                                      |   |
| Total                            |   | 51.1                                        |   | 56.6                                        |   |

 

The Animal Applicationssegment’s selling, general and administrative expenses decreased $4.8 millionin the nine months ended September 30, 2002 compared to the nine monthsSeptember 30, 2001 and as a percentage of revenue decreased to 28.2% from 56.2%in the same respective periods.  Thedecrease is due primarily to the adoption of FAS 142, which took effect onJanuary 1, 2002.  The adoption of FAS 142requires the testing of goodwill for impairment at least annually, eliminatingthe need for monthly amortization of goodwill. The decrease was offset byincreased legal, accounting, and investor relations expenses.

 

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The Digital Angel Systemssegment’s selling, general and administrative expenses increased**$2.0 million in the nine months endedSeptember 30, 2002 as compared to the nine months ended September 30,2001.  Selling, general andadministrative expenses increased**as apercentage of revenue to 333.0% in the nine months ended September 30, 2002compared to 74.4% in the nine months ended September 30, 2001 as a result ofthe scale up of marketing personnel, advertising and media programs, andinfrastructure to support the introduction of Digital AngelTMproducts.

 

The GPS and RadioCommunications segment’s selling, general and administrative expenses decreased$0.4 million in the nine months ended September 30, 2002 as compared to thenine months ended September 30, 2001 due to a reduction in salespersonnel.  As a percentage of revenue,selling, general and administrative expenses increased to 51.9% in the firstnine months of 2002 from 51.4% in the first nine months of 2001.

 

The Physician Call Centerand Other segment’s selling, general and administrative expenses were $0.9 millionin the nine months ended September 30, 2002. This segment became part of the Company on March 27, 2002.

 

**ManagementFees**–**Applied DigitalSolutions, Inc.**

 

Management fees chargedby ADS amounted to $0.2 million and $0.6 million for the nine months endedSeptember 30, 2002 and 2001, respectively. These fees were for general and administrative services performed forus.  After March 27, 2002, we no longerpay a management fee to ADS.

 

**Research and Development Expense**

 

Research and developmentexpense from operations was $2.2 million in the nine months ended September 30,2002, a decrease of $1.6 million, or 42.3%, from $3.7 million for the ninemonths ended September 30, 2001.  As apercentage of revenue, research and development expense was 8.2% and 13.4% forthe nine months ended September 30, 2002 and 2001, respectively.  Included in research and development expenseare charges by ADS of approximately $42,000 a month to support ADS’ researchgroup.  

 

Research and developmentexpense for each of the operating segments was:

 
|                             |   | **Nine  Months  Ended September 30,  2002** |   | **Nine  Months  Ended September 30,  2001** |   |
|----------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|--------|
| Animal Applications              |   | $                                           | 791    |                                        | $      | 773 |   |
| Digital Angel Systems            |   | 995                                         |   | 2,969                                       |   |
| GPS and Radio  Communications    |   | 373                                         |   | —                                      |   |
| Physician Call Center  and Other |   | —                                      |   | —                                      |   |
| Total                            |   | $                                           | 2,159  |                                        | $      | 3,742 |   |
|                                  |        |                                             |        |                                             |        |  |  |  |  |

 

The decrease in expenseis primarily due to the completion of some Digital AngelTMtechnology development.

 

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** **

**Interest Expense**

 

Interest expense was $2.0 million and $0.4 million forthe first nine months of 2002 and 2001, respectively.  Interest expense in the first nine months of 2002 includesinterest expense of $1.8 million on the debt owed to IBM Credit Corporation byADS.  As discussed in Note 1 to thefinancial statements, this debt was recognized by AWG due to ADS’s default onthe loan agreement.  On March 27, 2002,ADS restructured its loan agreement with IBM Credit Corporation.  The provisions of this restructuringincluded AWG being released from responsibility to repay this debt.  Accordingly, ADS assumed this liability onMarch 27, 2002.

 

**Income Taxes**

 

The Company and AWG had effective income tax rates of0.0% and 0.6% for the first nine months of 2002 and 2001, respectively. Differences in the effective incometax rates from the statutory federal income tax rate in 2002 arise primarilyfrom valuation allowances recorded on deferred tax assets resulting from netoperating losses.  Differences in 2001arise primarily from valuation allowances recorded on deferred tax assetsresulting from net operating losses, non-deductible goodwill amortizationassociated with acquisitions and state taxes net of federal benefits. The U.S.companies in AWG were included in ADS’s consolidated federal income tax returnthrough March 27, 2002.  MAS and itssubsidiaries file a separate consolidated federal income tax return.  After March 27, 2002, AWG’s U.S.subsidiaries will file a consolidated federal tax return with MAS.

 

**LIQUIDITY AND CAPITAL RESOURCES FROMOPERATIONS**

 

As of September 30, 2002,cash and cash equivalents totaled $0.5 million as compared to $0.6 million atDecember 31, 2001.  Through March 27,2002, AWG used a cash management system to apply excess cash on hand againstadvances due to ADS.  Cash used inoperating activities totaled $1.1 million and $2.0 million in the first ninemonths of 2002 and 2001, respectively. In the first nine months of 2002, the use of cash was due to the netloss, after adjusting for non-cash charges, increases in other current assets andaccounts receivable.  Accounts receivable, net of allowance fordoubtful accounts, increased by $1.0 million, or 17.9%, to $6.4 million atSeptember 30, 2002 from $5.4 million at December 31, 2001.  This increase is due to a large contractcompletion for a fishery industry customer in September 2002.  Partially offsetting these uses ofcash were increases in cash from decreases in inventory and increases inaccounts payable and accrued expenses.  

 

Inventory levelsdecreased by $0.7 million to $5.1 million at September 30, 2002 from $5.8million at December 31, 2001 due to more detailed management of inventorylevels.  Inventory acquired from ouracquisition of MAS amounted to $0.1 million.

 

Accounts payableincreased by $1.0 million to $4.6 million at September 30, 2002 from $3.6million at December 31, 2001.  

 

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Accrued expensesand other current liabilities increased by $1.9 million, or 93.2%, to $3.9million at September 30, 2002 from $2.0 million at December 31, 2001.  The increase was due to accrued acquisitioncosts and accrued expenses acquired from the acquisition of MAS.

 

Investing activities usedcash of $1.0 million in the first nine months of 2002 and $1.4 million in thefirst nine months of 2001.  During thefirst nine months of 2002 and 2001, $1.0 million and $1.5 million,respectively, were spent to acquire property and equipment.

 

Financing activitiesprovided cash of $2.0 million and $3.1 million in the first nine months of 2002 and 2001, respectively.  Cash was provided primarily by stock optionexercises and the refinancing of our mortgage on our physician call centerfacilities in 2002 and additional investments by Applied Digital Solutions,Inc. in the nine months ended September 30, 2002 and 2001.

 

*Debt, Covenant Compliance andLiquidity*

 

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

 

ADS generated asignificant loss from operations in 2000. As a result, ADS was not incompliance with certain financial covenants of the IBM credit agreement as ofDecember 31, 2000. The IBM credit agreement was amended and restated on October17, 2000 and further amended on March 30, 2001. In connection with theamendment on March 30, 2001, Digital Angel granted IBM Credit Corporationwarrants to acquire 1.2 million shares of DATC’s common stock valued at $0.3million. As of the March 30, 2001 amendment, ADS was in compliance with therevised covenants.

 

The IBM credit agreementcontains certain quarterly financial covenants, which became more restrictiveduring 2001. ADS anticipated that it would continue to comply in 2001 with thequarterly financial covenants in the IBM credit agreement. However, ADS was notin compliance with its minimum EBITDA (as defined in the IBM credit agreement)or collateral shortfall covenants at June 30, 2001. ADS was also not incompliance with the minimum EBITDA, Tangible Net Worth and Current Assets toCurrent Liabilities covenant requirements at September 30, 2001 and it againhad a collateral shortfall.  As ofDecember 31, 2001, ADS was not in compliance with various financial covenants,including minimum Tangible Net Worth, EBITDA, the ratio of Current Assets toCurrent Liabilities, and collateral. The IBM credit agreement was amended andrestated on July 1, 2001, September 15, 2001, November 15, 2001, December 31,2001, January 31, 2002 and February 27, 2002. These amendments extended the due dates of principal and interest paymentsunder the credit agreement until April 2, 2002.

 

At December 31, 2001,ADS’s outstanding borrowings under the IBM credit agreement totaled $82.6million. At that time, ADS did not have the funds to repay the borrowings underthe IBM credit agreement. Accordingly, the $82.6 million of outstandingborrowings was allocated to AWG effective as of September 30, 2001 and wasreflected as a current obligation in the December 31, 2001 combined balancesheet. Interest associated with the borrowings was allocated to AWG for theperiod from September 30, 2001 to March 27, 2002.  Under the terms of the agreement and plan of merger with MAS, thecommon stock and assets of the three AWG subsidiaries were released from allliens and security interests under the IBM credit agreement, and the shares ofthe Company’s common stock beneficially owned by ADS upon completion of themerger were transferred to the Digital Angel Share Trust as

 

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collateral for thedebt.  ADS assumed the debt, which wastreated as a capital contribution resulting in an increase in additionalpaid-in capital of approximately $81.4 million.

 

On March 1, 2002, ADS and Digital Angel Share Trust, anewly created Delaware business trust, and IBM Credit entered into a ThirdAmended and Restated Term Credit Agreement. The new credit agreement becameeffective on March 27, 2002, the effective date of the merger between DigitalAngel and MAS. Amounts outstanding under the new credit agreement bear interestat an annual rate of 17% and mature on February 28, 2003.  No principal or interest payments are dueuntil the maturity date. However, the maturity date will be extended forconsecutive one-year periods if ADS repays at least 40% of the originalprincipal amount outstanding plus accrued interest and expenses prior toFebruary 28, 2003, and an additional 40% of the original principal amountoutstanding plus accrued interest and expenses prior to February 28, 2004.  In any event, all amounts outstanding willbe required to be repaid by August 15, 2005. If all amounts are not repaid by February 28, 2003, the unpaid amountwill accrue interest at an annual rate of 25%, and it they are not repaid byFebruary 28, 2004, the annual interest rate increases to 35%.

 

ADS’s new credit agreement contains debt covenantsmade by ADS relating to its financial position and performance, as well as theCompany’s financial position and performance. The Company’s ability to meet its financial performance requirements andbe in compliance throughout 2002 with covenants in the new credit agreementthat apply to the Company cannot be assured. If business conditions are other than as anticipated or other unforeseenevents or circumstances occur, these may impact the ability of ADS and theCompany to remain in compliance with the covenants.  In the absence of a waiver or amendment to such financialcovenants, such noncompliance would constitute an event of default under thenew credit agreement, and IBM Credit would be entitled to accelerate thematurity of all amounts ADS owes it.  OnSeptember 30, 2002 the new credit agreement was amended.  The amendment reduced the Company’s currentassets to current liabilities ratio and Minimum Cumulative Modified EBITDArequirement, as defined, in the credit agreement, for the quarters endedSeptember 30, 2002 and December 31, 2002. The Company was in compliance with the amended debt covenants onSeptember 30, 2002. 

 

On March 27, 2002, upon completion of the mergerbetween Digital Angel and MAS, in satisfaction of a condition to the consent tothe merger by IBM Credit, ADS transferred to the Digital Angel Share Trustcontrolled by an advisory board all of the shares of our common stock owned byit and, as a result, the Trust has legal title to 77.15% of our common stock.  The Trust has voting rights with respect toour common stock until ADS’s obligations to IBM Credit are repaid in full.  The Trust may be obligated to liquidate theshares of our common stock owned by it for the benefit of IBM Credit if ADSfails to make payments, or otherwise defaults, under its new credit agreementwith IBM Credit.

 

To date, financingfrom acquisitions, ADS’s advances and revenue generated from operations havebeen our primary sources of funding. However, we do not anticipate receiving additional advances from ADS andwe have not been able to generate positive cash flows from operations.

 

On October 30, 2002, we signed a credit and securityagreement and related agreements with Wells Fargo Business Credit, Inc. that,among other things, permits us to borrow up to $5,000,000 from Wells FargoBusiness Credit from time to time under the terms of the credit and securityagreement.  Amounts borrowed under thecredit facility are general obligations of the Company secured by a firstpriority lien on substantially all of the Company’s assets, including ouraccounts receivable and our patents and other intellectual property relating tothe Digital AngelTM product.  Theoutstanding principal balance of the credit facility bears interest at anannual rate equal to the rate of interest publicly announced from time to timeby Wells Fargo Bank National Association as its “prime rate” plus threepercentage points.  However, the creditand security agreement requires that the total amount of interest paid to WellsFargo Business Credit per year must be at least $120,000.  The credit facility will expire on October30, 2005, at which time the entire outstanding balance of the credit facilitywill become due and payable. 

 

The credit and security agreement requires us to meetcertain financial covenants, including a monthly minimum book net worth andmonthly minimum earnings before taxes, and it limits our capital expendituresduring 2003.  Any breach of thefinancial covenants by us will constitute an event of default under the creditand security agreement.  The credit andsecurity agreement also provides that any change of control of the Company willbe an event of default under the credit and security agreement.  As defined in the credit and securityagreement, a change of control includes the acquisition by any person or groupof persons of more than 25% of the voting power of all classes of our commonstock.  If Applied Digital Solutionsdefaults under the IBM credit agreement, the Digital Angel Share Trust will beobligated, upon the request of IBM Credit Corporation, to sell all or a portionof our common stock held by the Trust. If such sales by the Trust result in a person or group of personsowning, in the aggregate, 25% or more of our common stock, such sales will bedeemed to constitute an event of default under the credit and securityagreement. 

 

The occurrence of an event of default under the creditand security agreement would subject us to the risk of foreclosure onsubstantially all of our assets to the extent necessary to repay any amountsdue under the credit facility, including, but not limited to, principal,interest, penalties or other costs and expenses incurred.  There can be no assurance that we willcontinue to comply with the financial covenants of the credit and securityagreement or that an event of default will not occur.

 

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Managementbelieves that the amount available under the credit facility will be sufficientto meet our capital requirements for at least the next twelve months.  However, we may need to obtain additionalcapital in the future.  Our futurecapital requirements will depend upon a variety of factors, including, but notlimited to, the rate of increase or decrease in our existing business base; thesuccess, timing and amount of investment required to bring new products tomarket; revenue growth or decline; and potential acquisitions.  There can be no assurance that we will beable to obtain future financing in an amount sufficient to implement ourbusiness plan.

 

On November 1, 2002 we filed a Registration Statementon Form S-1 with the Securities and Exchange Commission.  The Registration Statement is for the saleof up to 3,000,000 shares of our common stock and the sale by certain of ourexisting stockholders of up to 22,348,720 shares of their common stock of theCompany.  The existing stockholders’22,348,720 shares are being registered to permit the stockholders to sell theirshares of the Company’s common stock from time to time in the publicmarket.  We do not currently havespecific plans for the use of net proceeds from our sale of our commonstock.  We anticipate that any netproceeds will be used for general corporate purposes, which may include, butnot limited to, working capital, capital expenditures, repayment ofindebtedness, investments and acquisitions. The Company will not receive any proceeds from the sale of the commonstock by the selling stockholders. The Registration Statement on Form S-1 issubject to review by the Securities and Exchange Commission. 

 

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**FORWARDLOOKING STATEMENTS AND ASSOCIATED RISKS**

 

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

 

This Form 10-Q containsforward-looking statements within the “safe harbor” provisions of the PrivateSecurities Litigation Reform Act of 1995 with respect to our financialcondition, results of operations and business, and includes statements relatingto:

 

•    our growth strategies including, withoutlimitation, our ability to deploy**new products and services;

 

•    anticipated trends in our business anddemographics;

 

•    our ability to successfully integrate thebusiness operations of recently acquired companies;

 

•    our future profitability and liquidity; and

 

•    regulatory, competitive or other economicinfluences.

 

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**

 

Youshould carefully consider the risk factors listed below.  These risk factors may cause our futureearnings to be less or our financial condition to be less favorable than weexpect.  You should read this sectiontogether with the other information contained herein.

 

***The Company’s majority stockholder, DigitalAngel Share Trust, owns 74.1% of the Company’s common stock, is able tocompletely control the board of directors and may support actions that conflictwith the interests of the other stockholders.***

 

After the merger,in satisfaction of a condition to the consent to the merger of IBM CreditCorporation, ADS transferred to the Digital Angel Share Trust all shares of ourcommon stock owned by ADS.  As a result,the Trust is the beneficial owner of 74.1% of our common stock, and it controlsus with respect to all matters upon which our stockholders may vote, includingthe selection of the Board of Directors and mergers, acquisitions and othersignificant corporate transactions.

 

The Trust iscontrolled by an independent advisory board, and there can be no assurance asto how the advisory board and the Trust will exercise control over us.  The Trust and the advisory board may supportactions that are contrary to or conflict with the interests of the otherstockholders.

 

Upon the requestof IBM Credit Corporation, the Trust is obligated to sell the shares of ourcommon stock owned by the Trust for the benefit of IBM Credit Corporation ifADS fails to make payments to IBM Credit Corporation beginning on February 28,2003 or at such other time ADS defaults under the credit agreement with IBMCredit Corporation. Such sales may be in private transactions or in the publicmarket. We can give no assurance as to when or how shares of our common stockwill be sold, as to who will purchase such shares, or as to the number ofshares that may be sold at any given time. As a result, the duration of theTrust’s control over us, the identity of any parties which may acquire controlof us and the market price of our stock if and when such sales commence isuncertain.

 

At June 30, 2002,ADS was out of compliance with some of the covenants of the IBM creditagreement.  In addition, as of June 30,2002, the Company had not complied with some of the financial covenants in theIBM credit agreement that we were required to meet to prevent ADS’s defaultunder the IBM credit agreement.  IBMCredit Corporation waived such noncompliance at June 30, 2002.

 

On September 30,2002, the debt covenants in the IBM credit agreement were amended for theremainder of 2002.  The amendmentreduced the Company’s current ratio and Minimum Cumulative Modified EBITDArequirements, as those terms are defined in the IBM credit agreement, for the quartersended September 30 and December 31, 2002. The Company is in compliance with its debt covenants at September 30,2002. 

 

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***The terms of our credit facility subject us to the risk offoreclosure on substantially all of our assets.***

 

On October 30, 2002, we signed a credit and securityagreement and related agreements with Wells Fargo Business Credit, Inc. that,among other things, permit us to borrow up to $5,000,000 from Wells FargoBusiness Credit from time to time under the terms of the credit and securityagreement.  Amounts borrowed under thecredit facility are general obligations of the Company secured by a firstpriority lien on substantially all of the Company’s assets, including ouraccounts receivable and our patents and other intellectual property relating tothe Digital AngelTM product.  The creditfacility will expire on October 30, 2005, at which time the entire outstandingbalance of the credit facility will become due and payable.  There can be no assurance that we will beable to pay amounts owed under the credit facility when they become due.

 

The credit and security agreement requires us tocomply with certain financial covenants, including a monthly minimum book networth and monthly minimum earnings before taxes, and it limits our capitalexpenditures during 2003.  There can beno assurance that we will continue to meet the financial covenants.  Any breach of the financial covenants by uswill constitute an event of default under the credit and securityagreement.  The credit and securityagreement also provides that any change of control of the Company will be anevent of default under the credit and security agreement.  As defined in the credit and securityagreement, a change of control includes the acquisition by any person or groupof persons of more than 25% of the voting power of all classes of our commonstock.  If Applied Digital Solutionsdefaults under the IBM credit agreement, the Digital Angel Share Trust will beobligated, upon the request of IBM Credit Corporation, to sell all or a portionof our common stock held by the Trust. If such sales by the Trust result in a person or group of personsowning, in the aggregate, 25% or more of our common stock, such sales will bedeemed to be an event of default under the credit and security agreement.  There can be no assurance that AppliedDigital Solutions will not default under the IBM credit agreement or that, uponany such default, IBM Credit Corporation will not cause the sale of more than25% of our common stock to any person or group of persons.

 

The credit facility will expire on October 30, 2005,at which time the entire outstanding balance of the credit facility will becomedue and payable.  We may not havesufficient funds to repay the outstanding balance on the credit facility uponits maturity.  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, or atall, 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.  

 

The occurrence of any of the foregoing, or any otherevents of default, under the credit and security agreement would subject us tothe risk of foreclosure by Wells Fargo Business Credit on substantially all ofour assets to the extent necessary to repay any amounts due under the creditfacility, including, but not limited to, principal, interest, penalties orother costs and expenses incurred.  Anysuch default and resulting foreclosure could have a material adverse effect onour financial condition.

 

***Sales of our common stock by the Trust may cause a reductionin the market value of our common stock.***

 

If amounts due toIBM Credit Corporation by ADS are not paid when due, or if ADS or the Companyotherwise defaults under its credit agreement and ADS’s obligations areaccelerated, IBM Credit Corporation will have the right to require the Trust tosell shares of our common stock to provide funds to satisfy the obligations ofADS to IBM Credit Corporation.  It isunlikely that ADS will have the funds required for payment of such obligationswhen due. The sale of a significant number of shares of our common stock ownedby the Trust in a single transaction or in a series of transactions over ashort period of time could result in a significant decline in the market valueof our common stock.

 

***Historical losses and negative cash flows from operationsraise doubt about our ability to continue as a going concern.***

 

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 report ofPricewaterhouseCoopers LLP for each of the years ended December 31, 2001 and2002 for the AWG financial statements, which became the Company’s historicalfinancial statements in the merger, contained an explanatory paragraphexpressing doubt about AWG’s ability to continue as a going concern.  The Company’s condensed consolidatedfinancial statements as of and for the nine months ended September 30, 2002included in this Form 10-Q do not include adjustments that might be required asa result of this uncertainty.  Webelieve that we have the financial resources to meet our future businessrequirements for at least the next twelve months.

*** ***

***Our earnings will decline if we write off goodwill.***

 

As of September 30, 2002, we recorded goodwill of$106.2 million.  Due to a new accountingstandard that went into effect on January 1, 2002, goodwill and other intangibleassets with indefinite lives are not amortized but rather tested for impairment

 

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annually.  There was no impairment of goodwill uponadoption of this standard.  As a result,we will assess the fair value of our goodwill annually or between annual testsif events occur or circumstances change that would more likely than not reducethe fair value of our goodwill below its carrying value.  If we ever determine that significantimpairment has occurred, we would be required to write off the impaired portionof goodwill.  Any impairment chargecould have a material adverse effect on our financial condition and results ofoperations.

 

***The exercise ofoptions and warrants outstanding and available for issuance may adverselyaffect the market price of our common stock.***

 

As of September 30, 2002, we had options and warrantsoutstanding to purchase a total of 9,106,319 shares of common stock at exerciseprices ranging from $0.05 to $10.50 per share. In addition, we had 5,027,899 additional shares of common stock whichmay be issued in the future under our stock option plans.  The exercise of outstanding options andwarrants and the sale in the public market of the shares purchased upon suchexercise may adversely affect the market price of our common stock. 

 

***We may continue to incur losses.***

 

We incurred a netloss of $25.0 million for the nine month period ended September 30, 2002. Wealso recorded a net loss of $17.4 million and $3.9 million for the years endedDecember 31, 2001 and 2000, respectively. No assurance can be given as towhether or when we will be profitable. Profitability depends on many factors,including the success of marketing programs, the maintenance and reduction ofexpenses, and the ability to coordinate successfully the operations of businessunits. If we become profitable, of which there is no assurance, we may not beable to sustain or increase profitability. If we fail to achieve and maintainprofitability within the time frame expected by investors, the market price ofour common stock may be adversely affected.

 

***The Digital Angel Systems segment is expected to incurfuture losses and may not achieve profitability.***

 

We have investedapproximately $14.0 million in the Digital Angelä product for theperiod from April 1998 through September 30, 2002.  We expect the Digital Angel Systems segment to incur additionaldevelopment, sales and marketing, and other general expenses.  As a result, the Digital Angel Systemssegment is expected to incur losses for the foreseeable future and will need togenerate 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 Digital Angel Systemssegment’s failure to achieve or sustain profitability would have a materialadverse effect on the market value of our common stock.

 

***The Digital AngelSystems segment is the initial stage of operations and may encounter unforeseendifficulties that could negatively affect our business.***

 

The Digital AngelSystems segment is in the initial stage of operations and has generated nosubstantial revenue. As a result, it has minimal operating history upon whichto base an evaluation of its current business and future prospects. The firstDigital Angel product was introduced in November 2001.  Moreover, this segment does not currentlyhave any contracts in place that will provide any significant revenue.  Because of this segment’s lack of anoperating history, management has limited insight into trends that may emergeand could materially adversely affect its business.  This segment’s prospects must be considered in light of therisks, expenses and difficulties frequently encountered by companies in new andrapidly evolving markets.  This segmentcould encounter risks and difficulties in its new and rapidly evolving market,especially given its lack of operating history. These risks include the DigitalAngel Technology segment’s ability to:

 

•                       develop andmarket the Digital Angel product by integrating and miniaturizing newtechnologies into marketable products and services;

 

•                       build acustomer base;

 

•                       generaterevenues;

 

•                       competesuccessfully in a highly competitive market;

 

•                       accesssufficient capital to support growth;

 

•                       recruit andretain qualified employees;

 

•                       introducenew products and services; and

 

•                       buildtechnology and support systems.

 

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Each of theserisks could lead to unforeseen expenses or losses, which could have a materialadverse effect on our financial condition and results of operations.

 

***Infringement by third parties on our intellectual propertyor development of substantially equivalent proprietary technology by ourcompetitors could negatively affect our business.***

 

Our successdepends significantly on our ability to maintain patent and trade secretprotection, to obtain future patents and licenses, and to operate withoutinfringing 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 itsmisappropriation 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 proprietary information,techniques or processes or that we can meaningfully protect our rights to suchunpatented proprietary technology. Infringement on our intellectual property or the development ofsubstantially equivalent technology by our competitors could have a materialadverse effect on our business.

 

***Domestic and foreign government regulation and other factorscould impair our ability to develop and sell our products in certain markets.***

 

The electronicanimal identification market can be negatively affected by such factors as foodsafety concerns, consumer perceptions regarding cost and efficacy,international technology standards, national infrastructures, andslaughterhouse removal of microchips. 

 

We are alsosubject to federal, state and local regulation in the United States, includingregulation by the United States Food and Drug Administration (FDA), UnitedStates Federal Communications Commission (FCC) and the United States Departmentof Agriculture (USDA), and in other countries. We cannot predict the extent to which we may be affected by furtherlegislative and regulatory developments concerning our products andmarkets.  We are required to obtainregulatory approval before marketing most or 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 rely heavily onsales to government contractors of our animal identification products, and anydecline in the demand by these customers for our products could negativelyaffect our business.***

 

Many of theprincipal customers for electronic identification devices for fish aregovernment contractors that rely on funding from the United Statesgovernment.  Since 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 production arrangement for our animalidentification products, and the loss of or any significant reduction in theproduction could have an adverse effect on our business.***

 

We rely solely on a production arrangement withRaytheon Corporation for the assembly of our patented syringe-injectablemicrochips that are used in all of our implantable electronic identificationproducts. Raytheon utilizes our proprietary technology and our equipment in theproduction of our syringe-injectable microchips. The termination, or anysignificant reduction, by Raytheon of the assembly of our microchips or amaterial increase in the price charged by Raytheon for the assembly of ourmicrochips could have an adverse effect on our financial condition and resultsof operations.  In addition, Raytheonmay not be able to produce sufficient quantities of the microchips to meet anysignificant increased demand for our products or to meet any such demand on atimely basis.  Any inability orunwillingness of Raytheon to meet our demand for microchips would require us toutilize an alternative production arrangement and remove our automated assemblyproduction machinery from the Raytheon facility.  Moreover, if Raytheon terminates our production arrangement, wecannot ensure that the assembly of our microchips from another source would beon comparable or acceptable terms.  Thefailure to make such an alternative production arrangement could have anadverse effect on our business.

 

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***We depend on principal customers.***

 

For the ninemonths ended September 30, 2002, two customers of our Animal Applicationssegment accounted for a large portion of our gross revenue.  USAED and Schering-Plough Pharmaceuticalaccounted for 16.7% and 14.8% of our gross Animal Applications revenues,respectively. In addition, the GPS and Radio Communications segment is heavilydependent on contracts with domestic government agencies and foreigngovernments, including the United Kingdom, primarily relating to militaryapplications. The loss of, or a significant reduction in, orders from these orour other major customers could have a material adverse effect on our financialcondition and results of operations.

 

***We compete with other companies in the visual and electronicidentification market, and the products sold by our competitors could becomemore popular than our products or render our products obsolete.***

 

The market forvisual and electronic identification for companion animals and livestock ishighly competitive. We believe that our principal competitors in the visualidentification market for livestock are AllFlex USA and Y-Tex Corporation, andthat our principal competitors in the electronic identification market thathave developed permanent electronic identification devices for the companionanimal market are AllFlex USA, Datamars SA and Avid Plc.  Neither Datamars nor Avid has been granted aU.S. license to use our implantable technology.

 

In addition, othercompanies could enter this line of business in the future.  Certain of our competitors havesubstantially greater financial and other resources than us. We may not be ableto compete successfully with these competitors, and those competitors maydevelop or market technologies and products that are more widely accepted thanours or that 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 of severalpotential 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 result of our foreignoperations.***

 

Wemaintain operations outside of the United States, which subjects us to risksthat are inherent in international operations, including the risk that:

 

•                       it is moredifficult to enforce agreements and collect receivables through certain foreignlegal systems;

 

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

 

•                       tax ratesin some foreign countries may exceed those in the United States, and foreignearnings may be subject to withholding requirements or the imposition oftariffs, exchange controls or other restrictions;

 

•                       generaleconomic and political conditions in countries where we operate may have anadverse effect on our operations 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 toexpand our business globally, our success will depend, in part, on our abilityto anticipate and effectively manage these and other risks.  These and other factors may have a materialadverse effect on our international operations or our business as a whole.

 

***Currency exchange rate fluctuations could have an adverseeffect on our sales and financial results.***

 

We generate a portion of our sales and incur a portionof our expenses in currencies other than U.S. dollars.  To the extent that we are unable to matchrevenues received in foreign currencies with costs paid in the same currency,exchange rate fluctuations in any such currency could have an adverse effect onour financial results.

 

***We depend on asmall team of senior management, and we may have difficulty attracting andretaining additional personnel.***

 

Our future successwill depend in large part upon the continued services and performance of seniormanagement and other key personnel.  Ifwe lose the services of any member of our senior management team, our overalloperations could be materially and

 

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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 cannot ensurethat we will be able to successfully attract, integrate or retain sufficientlyqualified personnel when the need arises. Any failure to attract and retain the necessary technical, managerial,marketing, purchasing and customer service personnel could have a materialadverse effect on our financial condition and results of operations.

 

***The Digital AngelTM technologyis not proven, and we may not be able to develop products from this unproventechnology.***

 

The Digital AngelSystems segment depends on the development, integration, miniaturization andsuccessful marketing of several advanced technologies that have not previouslybeen integrated or used as anticipated by this segment. The Digital AngelSystems segment depends upon advanced technology, including: wirelesscommunication, biosensors, motion determination and global positioning systemcapabilities. Many of these technologies are unproven or relatively new.  These technologies have not been previouslyintegrated or miniaturized into a commercial product.  No assurances can be given as to when or if the Digital Angelproduct will be successfully marketed. Our ability to develop and commercializeproducts based on our proprietary technology will depend on our ability todevelop our products internally on a timely basis or to enter into arrangementswith third parties to provide these functions. Our failure to develop and commercialize products successfully couldhave a material adverse effect on our financial condition and results ofoperations.

 

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**IMPACT OF RECENTLY ISSUED ACCOUNTINGSTANDARDS**

 

In July 2001, the FASB issued FAS 141 *BusinessCombinations* and FAS 142 *Goodwill and Other Intangible Assets. *FAS 141 requires businesscombinations initiated after June 30, 2001 to be accounted for using thepurchase method of accounting and broadens the criteria for recordingintangible assets separate from goodwill. Recorded goodwill and intangibles will be evaluated against these newcriteria and may result in certain intangibles being included in goodwill, oralternatively, amounts initially recorded as goodwill may be separatelyidentified and recognized apart from goodwill. FAS 142 requires the use of a non-amortization approach to account forpurchased goodwill and certain intangibles. Under a non-amortization approach, goodwill and certain intangibles willnot be amortized into results of operations, but instead are reviewed forimpairment and written down and charged to results of operations only in theperiods in which the recorded value of goodwill and certain intangibles is morethan its fair value. We adopted the provisions of each statement, which applyto goodwill and certain intangibles acquired prior to June 30, 2001, on January1, 2002. The adoption of these standards have the impact of eliminating ouramortization of goodwill commencing January 1, 2002. There was no impairment ofgoodwill upon adoption of FAS 142. Future impairment reviews may result in periodic write-downs.

 

In August 2001, the FASB issued FAS 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets.*  Thisstandard supersedes FAS 121, *Accounting forthe Impairment of Long-Lived Assets to Be Disposed Of*, and providesa single accounting model for long-lived assets to be disposed of. Thisstandard significantly changes the criteria that would have to be met toclassify an asset as held-for-sale. This distinction is important becauseassets to be disposed of are stated at the lower of their fair values orcarrying amounts and depreciation is no longer recognized. The new rules willalso supersede the provisions of APB Opinion 30, *Reporting the Results of Operations-Reporting the Effects of Disposalof a Segment of a Business, and Extraordinary, Unusual and InfrequentlyOccurring Events and Transactions*, with regard to reporting theeffects of a disposal of a segment of a business and will require expectedfuture operating losses from Discontinued Operations to be displayed inDiscontinued Operations in the period in which the losses are incurred, ratherthan as of the measurement date as presently required by APB 30. This statementis effective for fiscal years beginning after December 15, 2001. We adoptedthis statement on January 1, 2002. The adoption of FAS 144 did not have amaterial impact on our operations or financial position.

 

In May 2002, theFASB issued FAS 145, *Rescission of FAS Statements 4, 44 and 64, Amendmentof FAS Statement 13 and Technical Corrections*.  FAS 145 eliminates Statement 4 (andStatement 64, as it amends Statement 4), which require gains and losses fromextinguishment of debt to be aggregated and, if material, classified as anextraordinary item, and thus, also the exception to applying Opinion 30 iseliminated as well.  This statement iseffective for fiscal years beginning after May 2002 for the provisions relatedto the rescission of Statements 4 and 64 and for all transactions entered intobeginning May 2002 for the provision related to the amendment of Statement 13.  The Company does not expect that adoption ofFAS 145 will have a material impact on its operations or financialposition.  

 

In June 2002, theFASB issued FAS 146, *Accounting for Costs Associated with Exit or DisposalActivities*.  FAS 146 requiresrecording costs associated with exit or disposal activities at their fairvalues when a liability has been incurred. Under previous guidance, certain exit costs were accrued uponmanagement’s commitment to an exit plan. We are required to adopt of FAS 146 on January 1, 2003.  The Company has not yet determined whatimpact the adoption of FAS 146 will have on its operations and financialpositions. 

 

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**Item3.    Quantitative and QualitativeDisclosures About Market Risk**

 

We have operations and sales in various regions of theworld. 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 inpolitical and 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 instrumentsto hedge our exposure to adverse fluctuations in interest rates, foreignexchange rates, fluctuations in commodity prices or other market risks; nor dowe invest in speculative financial instruments.

 

Due to the nature of our borrowings and our short-terminvestments, we have concluded that there is no material market risk exposureand, therefore, no quantitative tabular disclosures are required.

 

**Item 4.    Controls andProcedures**

 

Within the 90 daysprior to the date of this report, the Company carried out an evaluation, underthe supervision and with the participation of the Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer, ofthe effectiveness of the design and operation of the Company’s disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-14 under theSecurities Exchange Act of 1934.  Basedupon that evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that the Company’s disclosure controls and procedures are effectivein timely alerting them to material information relating to the Company(including its consolidated subsidiaries) required to be included in theCompany’s periodic SEC filings with the Securities and Exchange Commission.  Since the date of their evaluation, therehave been no significant changes in our internal controls or in other factorsthat could significantly affect the Company’s internal controls.

 

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**PART II      OTHER INFORMATION**

 

**Item 1.**                    LegalProceedings.

** **

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

 

On May 29, 2001, Janet Silva, individually and asGuardian*ad Litem* for JonathanSilva, a minor, and the Estate of Clarence William Silva, Jr. (collectively,“Plaintiffs”) filed suit against Customized Services Administrators,Incorporated (“CSA”), Pricesmart, Inc. (“Pricesmart”), Commercial UnionInsurance Company (“Commercial Union”), CGU Insurance Group, and the Company(collectively the “Defendants”) in the Superior Court of the State ofCalifornia in and for the County of Santa Clara.  The allegations of the complaint arise from a vacation guaranteeinsurance policy (the “Insurance Contract”) allegedly purchased by Plaintiffsfrom Defendants on March 6, 2000.  Thecomplaint alleges, among other things, that Defendants breached the InsuranceContract, defrauded Plaintiffs, acted in bad faith, and engaged in deceptiveand unlawful business practices, resulting in the wrongful death of ClarenceWilliam Silva, Jr. (the “Deceased”) and the intentional infliction of emotionaldistress on Plaintiffs.  The complaintseeks the cost of funeral and burial expenses of the Deceased and amountsconstituting the loss of financial support of the Deceased, general damages,attorney’s fees and costs, and exemplary damages.

 

CSA has filed a cross-claim against the Companyalleging that the Company should be held liable for any liability that CSA mayhave to Plaintiffs.  The Company hasdenied the allegations of the complaint and the CSA cross-claim and isvigorously contesting all aspects of this action.

 

We and our subsidiaries are party to various otherlegal actions as either a plaintiff or a defendant.  In our opinion, as of the date of this Form 10-Q, theseproceedings will not have a material adverse effect on our financial position,our cash flows or our overall trends in results. The estimate of the potentialimpact on our financial position, our overall results of operations or our cashflows for these proceedings could change in the future.

 

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**Item 2.**                    Changes in Securities and Use ofProceeds.

** **

Recent Sales of Unregistered Securities

 

The following table lists all unregistered securitiessold by the Company between July 1, 2002 and September 30, 2002.  These shares were issued withoutregistration in reliance upon the exemption provided by Section 4(2) of theSecurities Act of 1933, as amended, and Rule 506 of Regulation D promulgatedthereunder.

 
| **Name/Entity/Nature** |   | **Number of  Persons** |   | **Note** |   | **Issued For** |   | **Number of  Common  Shares** |   |
|------------------------|--------|------------------------|--------|----------|--------|----------------|--------|-------------------------------|--------|
|                   |   |                   |   |     |   |           |   |                          |   |
| Redington, Inc.        |   | 1                      |   | 1        |   | Services       |   | 50,000                        |   |
| Total                  |   |                   |   |     |   |           |   | 50,000                        |   |

 

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1.                    Represents awarrant to purchase 50,000 shares at $3.60 per share, which is exercisable forfive years beginning June 27, 2002.

 

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

** **

**(a)           Exhibits**

 

Thefollowing exhibits are hereby incorporated into this Quarterly Report on Form10-Q by reference to the reports and schedules identified below filed with theSecurities and Exchange Commission (“Commission”)**:**

 

2.1                               Agreementand Plan of Merger by and between Applied Digital Solutions, Inc., Digital AngelCorporation, Medical Advisory Systems, Inc. and Acquisition Subsidiary, Inc.dated as of November 1, 2001 (incorporated herein by reference to Appendix A tofinal Proxy Statement filed by MAS with the Commission on February 14, 2002).

 

2.2                               First Amendment to Agreement and Plan of Merger byand among Applied Digital Solutions, Inc., Digital Angel Corporation, Medical Advisory Systems, Inc. and Digital AngelAcquisition Co. dated as of March 26, 2002 (incorporated herein byreference to Exhibit 2.2 to Current Report on Form 8-K filed by MAS with theCommission on April 11, 2002).

 

3.1                               Amended and Restated Certificate of Incorporation ofMAS (incorporated herein by reference to MAS’s Registration Statement on Form S-18 (No. 2-98314) filed by MAS withthe Commission on June 7, 1985 and MAS’s Annual Report on Form 10-KSB filed byMAS with the Commission on March 28, 1990).

 

3.2                               Bylaws of MAS (incorporated herein by reference toMAS’s Registration Statement on Form S-18 (No. 2-98314) filed by MAS with theCommission on June 7, 1985).

 

Thefollowing exhibits are filed with this Quarterly Report on Form 10-Q:

 

99.1                         Certificationof Chief Executive OfficerPursuant to 18 U.S.C Section 1350, as Adopted Pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

99.2                         Certificationof Chief Financial Officer Pursuant to 18 U.S.C Section 1350, as AdoptedPursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

**(b)****                                  Reportson Form 8-K**

** **

On October 31, 2002, the Company filed a CurrentReport on Form 8-K dated October 30, 2002 in which the Company reported that itentered into a $5.0 million credit facility with Wells Fargo Business Credit,Inc. 

 

On November 4, 2002, the Company filed a CurrentReport on Form 8-K/A-1 dated October 30, 2002 to file the correct copy of Exhibit10.1 to the Form 8-K filed on October 31, 2002.

** **

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**SIGNATURE**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                      |   | DIGITAL  ANGEL CORPORATION |                             |
|---------------------------|--------|----------------------------|----------------------------------|
|                      |   | (Registrant)               |                             |
|                      |   |                       |                             |
| Dated: November 12,  2002 |   | By:                        | /S/ JAMES P. SANTELLI            |   |
|                      |   |                       | James P.  Santelli               |   |
|                      |   |                       | Vice President -  Finance, Chief |   |
|                      |   |                       | Financial  Officer               |   |

 

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**CERTIFICATIONS**

 

I, James P. Santelli,certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-Q of Digital Angel Corporation;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5)                                      Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6)                                      Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

Date:November 12, 2002

 
|   |   |   |   | /s/ JAMES P. SANTELLI     |   |   |
|--------|--------|--------|--------|---------------------------|--------|--------|
|   |   |   |   | James P. Santelli         |   |   |
|   |   |   |   | Chief Financial Officer   |   |   |
|   |   |   |   | Digital Angel Corporation |   |   |

 

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I, Randolph K. Geissler, certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-Q of Digital Angel Corporation;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)                                      designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

b)                                     evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)                                      presentedin this quarterly report our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)                                      allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                     anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

Date: November 12, 2002

 
|   |   |   |   | /s/ RANDOLPH K. GEISSLER  |   |   |
|--------|--------|--------|--------|---------------------------|--------|--------|
|   |   |   |   | Randolph K. Geissler      |   |   |
|   |   |   |   | Chief Executive Officer   |   |   |
|   |   |   |   | Digital Angel Corporation |   |   |
|        |        |        |        |                           |        |        |  |

 

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**INDEX TOEXHIBITS**

 

The followingexhibits are filed with this Quarterly Report on Form 10-Q:

 

99.1                           Certificationof Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as AdoptedPursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

99.2                           Certificationof Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as AdoptedPursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 

 

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