As filed with theSecurities and Exchange Commission on May 20, 2002

** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D. C.  20549**

 

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**FORM 10–Q**

(Mark One)

 

**ý        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF 1934.**

For the quarterlyperiod ended **March 31, 2002**

or

**o        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF 1934.**

For the transitionperiodfrom         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  EmployerIdentification No.) |

** **

**490 Villaume Avenue**

**South Saint Paul, Minnesota 55075**

**(651) 455-1621**

(Address, including zip code, andtelephone number,

including area code, of registrant’s principal executive offices)

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

(Former name, former address and former fiscal year, if changed sincelast report)

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

Yes         ý            No           o

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

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

 

 

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**DIGITAL ANGEL CORPORATION**

 

TABLE OF CONTENTS

 
| Item              | Description                                                                                           |   |
|-------------------|-------------------------------------------------------------------------------------------------------|--------|
|              |                                                                                                  |   |
|              | PART I — FINANCIAL INFORMATION                                                                   |   |
|              |                                                                                                  |   |
| 1.                | Financial Statements (unaudited)                                                                      |   |
|              | Consolidated Balance Sheets as of March  31, 2002 and December 31, 2001                               | 3      |
|              | Consolidated  Statements of Operations — for the three months ended March 31, 2002 and 2001      | 4      |
|              | Consolidated  Statement of Stockholders’ Equity — for the three months ended March 31, 2002 | 5      |
|              | Consolidated Statements of Cash Flows — for  the three months ended March 31, 2002 and 2001      | 6      |
|              | Notes  to Consolidated Financial Statements                                                           | 7      |
| 2.                | Management’s Discussion and Analysis of  Financial Condition and Results of Operations           | 15     |
| 3.                | Quantitative and Qualitative Disclosures About Market  Risk                                           | 29     |
|              |                                                                                                  |   |
|              | PART II — OTHER INFORMATION                                                                      |   |
|              |                                                                                                  |   |
| 1.                | Legal  Proceedings                                                                                    | 31     |
| 2.                | Changes In  Securities and Use of Proceeds                                                            | 32     |
| 3.                | Defaults Upon Senior  Securities                                                                      | 32     |
| 4.                | Submission  of Matters to a Vote of Security Holders                                                  | 33     |
| 5.                | Other  Information                                                                                    | 33     |
| 6.                | Exhibits and Reports  on Form 8-K                                                                     | 34     |
|              |                                                                                                  |   |
| SIGNATURE         | 36                                                                                                    |
| INDEX TO EXHIBITS | 37                                                                                                    |

 

2

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PARTI   FINANCIAL INFORMATION

Item1.    Financial Statements.

 

**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES**

 

**BALANCESHEETS**

(In thousands, except par value)

(Unaudited)

** **

**Assets**

 
|                                                                                                                                                                                                       |   | **(Consolidated)********March 31,********2002** |        | **(Combined)********December 31,********2001** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------------|-------------|------------------------------------------------|--------|
| **Current Assets**                                                                                                                                                                                         |   |                                            |        |                                           |   |
| Cash and cash equivalents                                                                                                                                                                                  |   | **$**                                           | **882**     |                                           | $      | 596 |   |
| Accounts receivable and unbilled receivables (net of allowancefor doubtful accounts of  $403 in 2002 and $296 in 2001)                                                                                     |   | **5,684**                                       |        | 5,402                                          |   |
| Inventories                                                                                                                                                                                                |   | **5,798**                                       |        | 5,819                                          |   |
| Other current assets                                                                                                                                                                                       |   | **1,452**                                       |        | 1,168                                          |   |
| **Total Current Assets**                                                                                                                                                                                   |   | **13,816**                                      |        | 12,985                                         |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Property And Equipment, net**                                                                                                                                                                            |   | **15,333**                                      |        | 14,476                                         |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Goodwill, net**                                                                                                                                                                                          |   | **114,685**                                     |        | 73,168                                         |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Investment In Affiliates**                                                                                                                                                                               |   | **954**                                         |        | 6,779                                          |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Other Assets, net**                                                                                                                                                                                      |   | **644**                                         |        | 263                                            |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
|                                                                                                                                                                                                       |   | **$**                                           | 145,432     |                                           | $      | 107,671 |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                              |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Current Liabilities**                                                                                                                                                                                    |   |                                            |        |                                           |   |
| Notes payable and current maturities of long-term debt                                                                                                                                                     |   | **$**                                           | **247**     |                                           | $      | 82,643 |   |
| Accounts payable                                                                                                                                                                                           |   | **3,817**                                       |        | 3,757                                          |   |
| Accrued expenses                                                                                                                                                                                           |   | **6,448**                                       |        | 2,044                                          |   |
| **Total Current Liabilities**                                                                                                                                                                              |   | **10,512**                                      |        | 88,444                                         |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Long-Term Debt And Notes Payable**                                                                                                                                                                       |   | **2,436**                                       |        | 2,425                                          |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Total Liabilities**                                                                                                                                                                                      |   | **12,948**                                      |        | 90,869                                         |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Commitments And Contingencies**                                                                                                                                                                          |   | **—**                                      |        | —                                         |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Minority Interest**                                                                                                                                                                                      |   | **373**                                         |        | 392                                            |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
| **Stockholders’ Equity**                                                                                                                                                                              |   |                                            |        |                                           |   |
| Preferred shares: Authorized 1,000 in 2002, of $1.75 par value, no shares  issued or outstanding                                                                                                           |   |                                            |        |                                           |   |
| Common shares: Authorized 95,000 shares in 2002 and 10,000 2001, of  $.005 parvalue; 25,405 shares  issued and 25,355 shares outstanding in 2002and 20,187 shares issued  and outstanding in 2001 (Note 1) |   | **127**                                         |        | 101                                            |   |
| Additional paid-in capital                                                                                                                                                                                 |   | **175,542**                                     |        | 38,213                                         |   |
| Accumulated deficit                                                                                                                                                                                        |   | **(43,521**                                     | )           | (21,697                                        | )      |
| Common stock warrants                                                                                                                                                                                      |   | **572**                                         |        | 300                                            |   |
| Treasury stock (carried at cost, 50 shares in 2002)                                                                                                                                                        |   | **(43**                                         | )           | —                                         |   |
| Accumulated other comprehensive income (loss)                                                                                                                                                              |   | **(566**                                        | )           | (507                                           | )      |
| Total Stockholders’ Equity                                                                                                                                                                            |   | **132,111**                                     |        | 16,410                                         |   |
|                                                                                                                                                                                                       |   |                                            |        |                                           |   |
|                                                                                                                                                                                                       |   | **$**                                           | **145,432** |                                           | $      | 107,671 |   |

 

See the accompanying notes to consolidatedfinancial statements.

 

3

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**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES**

 

**STATEMENTSOF OPERATIONS**

(Inthousands, except per share data)

(Unaudited)

 
| ** **                                                                        |   | **For the Three  Months  Ended March 31,** |      |
|-----------------------------------------------------------------------------------|--------|-------------------------------------------------|-----------|
|                                                                              |   | **(Consolidated)**                              |      | **(Combined)** |   |
|                                                                              |   | **2002**                                        |      | **2001** |   |
| Product revenue                                                                   |   | **$**                                           | **7,451** |   | $ | 9,134 |   |
| Service revenue                                                                   |   | **303**                                         |      | 1,070 |   |
| Total revenue                                                                     |   | **7,754**                                       |      | 10,204 |   |
|                                                                              |   |                                            |      |   |   |
| Cost of products sold                                                             |   | **4,276**                                       |      | 5,361 |   |
| Cost of services sold                                                             |   | **251**                                         |      | 549 |   |
|                                                                              |   |                                            |      |   |   |
| Gross profit                                                                      |   | **3,227**                                       |      | 4,294 |   |
|                                                                              |   |                                            |      |   |   |
| Selling, general and administrative expenses                                      |   | **2,578**                                       |      | 2,595 |   |
| Research and development expenses                                                 |   | **1,331**                                       |      | 1,084 |   |
| Non-cash compensation expense                                                     |   | **18,509**                                      |      | — |   |
| Depreciation and amortization                                                     |   | **688**                                         |      | 2,359 |   |
| Interest income                                                                   |   | **—**                                      |      | (3 | ) |
| Interest expense                                                                  |   | **1,907**                                       |      | 59 |   |
|                                                                              |   |                                            |      |   |   |
| Income (loss) before taxes, minority interestand equity in net loss of  affiliate |   | **(21,786**                                     | **)**     | (1,800 | ) |
|                                                                              |   |                                            |      |   |   |
| Provision for income taxes                                                        |   | **—**                                      |      | 115 |   |
|                                                                              |   |                                            |      |   |   |
| Income (loss) before minority interest,and equity in net loss of  affiliate       |   | **(21,786**                                     | **)**     | (1,915 | ) |
|                                                                              |   |                                            |      |   |   |
| Minority interest                                                                 |   | **(19**                                         | **)**     | (21 | ) |
|                                                                              |   |                                            |      |   |   |
| Equity in net loss of affiliate                                                   |   | **57**                                          |      | 18 |   |
|                                                                              |   |                                            |      |   |   |
| Net income (loss)                                                                 |   | **(21,824**                                     | **)**     | (1,912 | ) |
|                                                                              |   |                                            |      |   |   |
| Net income (loss) per common share — basic                                   |   | **$**                                           | **(1.07** | **)** | $ | (0.09 | ) |
|                                                                              |   |                                            |      |   |   |
| Net income (loss) per common share — diluted                                 |   | **$**                                           | **(1.07** | **)** | $ | (0.09 | ) |
|                                                                              |   |                                            |      |   |   |
| Weighted average number of common shares outstanding — basic                 |   | **20,419**                                      |      | 20,187 |   |
| Weighted average number of common shares outstanding — diluted               |   | **20,419**                                      |      | 20,187 |   |

 

See the accompanying notes to consolidatedfinancial statements.

 

4

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**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES**

 

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

**For The Three Months Ended March 31, 2002**

(InThousands)

(Unaudited)

 
| ** **                                                    |   | **Common Stock** |   | **Additional********Paid-In** |    | **Accumulated** |   | **Common********Stock** |   | **Treasury** |        | **Accumulated********Other********Comprehensive** |   | **Total********Stockholders’** |   |
|---------------------------------------------------------------|--------|------------------|--------|-------------------------------|---------|-----------------|--------|-------------------------|--------|--------------|-------------|---------------------------------------------------|--------|-------------------------------------|--------|
|                                                          |   | **Number**       |   | **Amount**                    |    | **Capital**     |   | **Deficit**             |   | **Warrants** |        | **Stock**                                         |   | **Income (Loss)**                   |   | **Equity** |   |
|                                                          |   |             |   |                          |    |            |   |                    |   |         |        |                                              |   |                                |   |   |   |
| **Balance — December 31, 2001**                          |   | 20,187           |   | $                             | 101     |            | $      | 38,213                  |   | $            | (21,697     | )                                                 | $      | 300                                 |   | $ | — |   | $ | (507 | ) | $ | 16,410 |   |
| Net loss                                                      |   | —           |   | —                        |    | —          |   | (21,824                 | )      | —       |        | —                                            |   | (59                                 | )      | (21,883 | ) |
| Comprehensive loss —  Foreign  currency translation |   | —           |   | —                        |    | —          |   | —                  |   | —       |        | —                                            |   | —                              |   | — |   |
| Total comprehensive loss                                      |   | —           |   | —                        |    | —          |   | (21,824                 | )      | —       |        | —                                            |   | (59                                 | )      | (21,824 | ) |
| Merger consideration — MedicalAdvisory Systems, Inc.     |   | 5,218            |   | 26                            |    | 36,264          |   | —                  |   | 272          |        | (43                                               | )      | —                              |   | 36,519 |   |
| Derecognition of debt of ADS                                  |   | —           |   | —                        |    | 82,556          |   | —                  |   | —       |        | —                                            |   | —                              |   | 82,556 |   |
| Stock options issued in connectionwith merger with MAS        |   | —           |   | —                        |    | 18,509          |   | —                  |   | —       |        | —                                            |   | —                              |   | 18,509 |   |
|                                                          |   |             |   |                          |    |            |   |                    |   |         |        |                                              |   |                                |   |   |   |
| **Balance — March 31, 2002**                             |   | **25,405**       |   | **$**                         | **127** |            | **$**  | **175,542**             |   | **$**        | **(43,521** | **)**                                             | **$**  | **572**                             |   | **$** | **(43** | **)** | **$** | **(566** | **)** | **$** | **132,111** |   |

 

See the accompanying notes to consolidatedfinancial statements.

 

5

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**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES**

 

**STATEMENTS OF CASHFLOWS**

(Inthousands)

(Unaudited)

 
| ** **                                                                  |   | **For The Three Months********Ended March 31,** |        |
|-----------------------------------------------------------------------------|--------|-------------------------------------------------|-------------|
|                                                                        |   | **(Consolidated)**                              |        | **(Combined)** |   |
|                                                                        |   | **2002**                                        |        | **2001** |   |
| **Cash Flows From Operating Activities**                                    |   |                                            |        |   |   |
| Net loss                                                                    |   | **$**                                           | **(21,824** | **)** | $ | (1,912 | ) |
|                                                                        |   |                                            |        |   |   |
| Adjustments to reconcile net loss to net cashused in operating  activities: |   |                                            |        |   |   |
| Non-cash compensation expense                                               |   | **18,509**                                      |        | — |   |
| Deferred income taxes                                                       |   | **89**                                          |        | 34 |   |
| Depreciation and amortization                                               |   | **688**                                         |        | 2,359 |   |
| Minority interest                                                           |   | **(30**                                         | **)**       | (21 | ) |
| Equity in net loss of affiliate                                             |   | **57**                                          |        | 18 |   |
| Loss on sale of equipment                                                   |   | **75**                                          |        | 7 |   |
| Change in assets and liabilities:                                           |   |                                            |        |   |   |
| Increase in accounts receivable                                             |   | **(4**                                          | **)**       | (485 | ) |
| Decrease (increase) in inventories                                          |   | **88**                                          |        | (418 | ) |
| Increase in other current assets                                            |   | **(738**                                        | **)**       | (221 | ) |
| Increase in accounts payable andaccrued expenses                            |   | **1,056**                                       |        | 472 |   |
| **Net Cash Used In Operating Activities**                                   |   | **(2,034**                                      | **)**       | (167 | ) |
|                                                                        |   |                                            |        |   |   |
| **Cash Flows From Investing Activities**                                    |   |                                            |        |   |   |
| Decrease in other assets                                                    |   | **12**                                          |        | 254 |   |
| Payments for property and equipment                                         |   | **(200**                                        | **)**       | (653 | ) |
| Cash acquired through acquisition, netof acquisition costs                  |   | **297**                                         |        | — |   |
| **Net Cash Provided By (Used In) Investing Activities**                     |   | **109**                                         |        | (399 | ) |
|                                                                        |   |                                            |        |   |   |
| **Cash Flows From Financing Activities**                                    |   |                                            |        |   |   |
| Net amounts borrowed on notes payable                                       |   | **7**                                           |        | 36 |   |
| Payments on long-term debt                                                  |   | **(17**                                         | **)**       | — |   |
| Other financing costs                                                       |   | **—**                                      |        | (10 | ) |
| Net transactions with Applied Digital Solutions, Inc.                       |   | **2,221**                                       |        | 362 |   |
| **Net Cash Provided By Financing Activities**                               |   | **2,211**                                       |        | 388 |   |
|                                                                        |   |                                            |        |   |   |
| **Net Increase (Decrease) In Cash And Cash Equivalents**                    |   | **286**                                         |        | (178 | ) |
|                                                                        |   |                                            |        |   |   |
| **Cash And Cash Equivalents — Beginning Of Period**                    |   | **596**                                         |        | 206 |   |
|                                                                        |   |                                            |        |   |   |
| **Cash And Cash Equivalents — End Of Period**                          |   | **$**                                           | **882**     |   | $ | 28 |   |

 

See the accompanying notes to consolidatedfinancial statements.

 

6

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**DIGITALANGEL CORPORATION**

**NOTES TO CONSOLIDATED****FINANCIAL STATEMENTS**

**(Inthousands, except per share data)**

**(Unaudited)**

** **

**1.          Basis of Presentation**

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 (“Digital Angel”),which was then a 93% owned subsidiary of Applied Digital Solutions, Inc.(“ADS”).  In the merger, the corporateexistence of Acquisition ceased, Digital Angel became a wholly-owned subsidiaryof MAS, and MAS was renamed “Digital Angel Corporation” (the “Company” or the“Registrant”).  In connection with themerger transaction, the Company acquired from ADS its Advanced Wireless Group(“AWG”), consisting of Digital Angel, Timely Technology Corp. and SignatureIndustries, Limited, and ADS contributed to MAS all of its stock in TimelyTechnology Corp., a wholly-owned subsidiary, and Signature Industries, Limited,an 85% owned subsidiary.  As a result ofthis contribution by ADS, Timely Technology Corp. became a wholly-ownedsubsidiary of the Company and Signature Industries, Limited became an 85%subsidiary.  (The terms “Company” and“Registrant” mean Digital Angel Corporation and its subsidiaries.)  In the merger, the shares of Digital Angelowned by ADS were converted into a total of 18,750,000 shares of MAS commonstock, or approximately 77% of the stock of MAS.  After the merger, ADS transferred to Digital Angel Share Trust,which is controlled by an advisory board, all shares of the MAS common stockowned by ADS.

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 Registrant, and the assets and liabilities of MASwere accounted for as required under the purchase method of accounting.  Although the equity accounts of AWG survivethe merger, the capital structure of MAS survives the merger.  Accordingly, the equity accounts of AWG havebeen restated based on the common shares received by the former shareholders ofAWG in the merger.

Prior to March 27, 2002, AWG recorded a liability forADS’s debt to IBM Credit Corporation, due to ADS being in default on the loanagreement.  On March 27, 2002, ADSamended and restated its debt agreement with IBM Credit Corporation, which,among other amendments, provided for a release of AWG from the responsibilityto repay this debt.  Accordingly, AWGderecognized this debt, which resulted in an increase to additional paid-incapital of $82.5 million on March 27, 2002.

Pursuant to the terms ofthe merger agreement, options to acquire shares of Digital Angel common stockwere converted into options to acquire shares of MAS common stock effectiveMarch 27, 2002. The conversion resulted in a new measurement date for theoptions and, as a result, the Company recorded a one-time, non-recurring chargeof approximately $18.5 million in non-cash compensation expense during the threemonths ended March 31, 2002. For current employees of the Company, theseoptions are considered fixed awards under APB Opinion No. 25, and expense wasrecorded for the intrinsic value of the options converted. For all others,expense was recorded for the fair value of the options converted in accordancewith FAS 123. Fair value was determined by using the Black-Scholesoption-pricing model.

The accompanying unaudited consolidated financial statements of DigitalAngel Corporation and subsidiaries as of March 31, 2002 and the unauditedcombined financial statements of AWG as of December 31, 2001 and for thethree months ended March 31, 2002 and 2001 have been prepared in accordancewith accounting principles generally accepted in the United States of Americafor interim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X under the Securities Exchange Act of 1934.  Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements.  In the opinion of the Company’s management,all adjustments (consisting of only

 

7

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normal recurring adjustments) considered necessary topresent fairly the consolidated financial statements have been made.

The consolidatedstatements of operations for the three months ended March 31, 2002 are notnecessarily indicative of the results that may be expected for the 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 May 20, 2002.

On May 16, 2002,ADS filed a Notification of Late Filing on Form 12b-25 indicating that it had adisagreement with its former outside auditing firm Grant Thornton LLP,concerning the proper accounting treatment with respect to certain options and,as a result of this disagreement, Grant Thornton LLP communicated itsresignation in a letter to the Registrant dated May 14, 2002. Grant ThorntonLLP has advised the Registrant that it has not completed its review of theRegistrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 2002and should not be associated with that report in any way. Due to the timing ofthe resignation, the Registrant has not engaged an outside auditing firm toreplace Grant Thornton LLP. As a result of the foregoing, the interim financialstatements contained in the Registrant's Quarterly Report on Form 10-Q for thequarter ended March 31, 2002 have not been reviewed by an independent publicaccountant as required pursuant to Rule 70-01(d) of Regulation S-X. When weappoint our new auditors, they will complete the SAS 71 review of our firstquarter financial statements and we will file an amended Form 10-Q/A.

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

**Accounting Changes**

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

The followingtable presents the impact of FAS 142 on net income (loss) and net income (loss)per share had the standard been in effect for the three months ended March 31,2002:

| ** **                                         |   | **Three  Months Ended  March 31, 2001** |   |
|----------------------------------------------------|--------|-----------------------------------------|--------|
| **Net income (loss):**                             |   |                                    |   |
| Net loss as reported                               |   | $                                       | (1,912 | ) |
| Goodwill amortization                              |   | 1,935                                   |   |
| Equity method investment amortization              |   | 113                                     |   |
| Adjusted net income                                |   | $                                       | 136    |   |
|                                               |   |                                    |   |
| **Basis and diluted income (loss) per share:**     |   |                                    |   |
| Net loss per share, basis and diluted, as reported |   | $                                       | (0.09  | ) |
| Goodwill amortization                              |   | 0.10                                    |   |
| Equity method investment amortization              |   | 0.00                                    |   |
| Adjusted net income per share, basic and diluted   |   | $                                       | 0.01   |   |

 

Amortization expense ofother intangible assets totaled $17 and $10 for the three months ended March31, 2002 and 2001, respectively.

 

8

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**2.             Principlesof Consolidation and Combination**

The financialstatements include the accounts of the Company and its wholly owned andmajority owned subsidiaries.  Allsignificant intercompany accounts and transactions have been eliminated inconsolidation and combination.  Interestin less than majority owned entities are accounted for using the equity methodof accounting.

 

**3.             Inventory**

** **

|                                  |   | **March 31,  2002** |   | **December  31,  2001** |   |
|---------------------------------------|--------|---------------------|--------|-------------------------|--------|
| Raw materials                         |   | $                   | 1,356  |                    | $      | 1,474 |   |
| Work in process                       |   | 190                 |   | 176                     |   |
| Finished goods                        |   | 5,527               |   | 5,611                   |   |
|                                  |   | 7,073               |   | 7,261                   |   |
| Allowance for excess and obsolescence |   | (1,275              | )      | (1,442                  | )      |
| Net inventory                         |   | $                   | 5,798  |                    | $      | 5,819 |   |

 

9

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**4.**             **Earnings(Loss) Per Share**

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

 
|                                                                           |   | **Three Months Ended March 31,** |    |
|--------------------------------------------------------------------------------|--------|----------------------------------|---------|
|                                                                           |   | **2002**                         |    | **2001** |   |
| **Numerator:**                                                                 |   |                             |    |   |   |
| Net loss                                                                       |   | $                                | (21,824 | ) | $ | (1,912 | ) |
| **Denominator:**                                                               |   |                             |    |   |   |
| Denominator for basic earnings (loss) per share — Weighted-average shares |   | 20,419                           |    | 20,187 |   |
| Denominator for diluted earnings (loss) per share(1)                           |   | 20,419                           |    | 20,187 |   |
| **Basic earnings (loss) per share:**                                           |   | $                                | (1.07   | ) | $ | (0.09 | ) |
| **Diluted earnings (loss) per share:**                                         |   | $                                | (1.07   | ) | $ | (0.09 | ) |

----

(1) Dilutivesecurities have not been calculated for the three months ended March 31, 2001and the period from January 1, 2002 through March 27, 2002, because thepotentially dilutive securities of AWG (consisting of options and warrants topurchase shares of Digital Angel Corporation) did not have a publicmarket.  On March 27, 2002, thepotentially dilutive securites of Medical Advisory Systems, Inc. became thoseof the Company.  These weighted averageshares, listed below, were not included in the computation of diluted loss pershare because to do so would have been anti-dilutive.
|                   |   | **Three Months  Ended March 31,** |   |
|------------------------|--------|-----------------------------------|--------|
|                   |   | **2002**                          |   | **2001** |   |
| Employee stock options |   | 164                               |   | — |   |
| Warrants               |   | 42                                |   | — |   |
|                   |   | 206                               |   | — |   |

 

10

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**5.             SegmentInformation**

 

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

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

Following is the selectedsegment data as of and for the three months ended March 31, 2002:
|                                                                                                                     |   | **Animal  Applications** |   | **Digital Angel  Systems** |   | **GPS and Radio  Communications** |   | **Physician Call  Center and  Other** |   | **Corporate / Unallocated** |   | **Consolidated** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|----------------------------|--------|-----------------------------------|--------|---------------------------------------|--------|-----------------------------|--------|------------------|--------|
| Net revenue from  external customers:                                                                                    |   |                     |   |                       |   |                              |   |                                  |   |                        |   |             |   |   |   |   |   |   |   |
| Product                                                                                                                  |   | $                        | 4,815  |                       | $      | —                            |   | $                                     | 2,636  |                        | $      | —           |   | $ | — |   | $ | 7,451 |   |
| Service                                                                                                                  |   | —                   |   | 303                        |   | —                            |   | —                                |   | —                      |   | 303              |   |
| Total revenue                                                                                                            |   | $                        | 4,815  |                       | $      | 303                               |   | $                                     | 2,636  |                        | $      | —           |   | $ | — |   | $ | 7,754 |   |
|                                                                                                                     |   |                     |   |                       |   |                              |   |                                  |   |                        |   |             |   |
| Income (loss) from  operations before provision for income taxes, minority interest and equity in  net loss of affiliate |   | $                        | 445    |                       | $      | (1,791                            | )      | $                                     | (125   | )                           | $      | —           |   | $ | (20,315 | ) | $ | (21,786 | ) |
|                                                                                                                     |   |                     |   |                       |   |                              |   |                                  |   |                        |   |             |   |
| Total assets                                                                                                             |   | $                        | 80,302 |                       | $      | 14,448                            |   | $                                     | 5,635  |                        | $      | 45,047           |   | $ | — |   | $ | 145,432 |   |

 

11

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Following is the selected segment data as of and for the three monthsended March 31, 2001:

 
|                                                                                                                     |   | **Animal  Applications** |   | **Digital Angel  Systems** |   | **GPS and Radio  Communications** |   | **Physician Call  Center and Other** |   | **Combined** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|----------------------------|--------|-----------------------------------|--------|--------------------------------------|--------|--------------|--------|
| Net revenue from  external customers:                                                                               |   |                     |   |                       |   |                              |   |                                 |   |         |   |   |   |   |   |   |
| Product                                                                                                                  |   | $                        | 6,382  |                       | $      | —                            |   | $                                    | 2,752  |         | $      | — |   | $ | 9,134 |   |
| Service                                                                                                                  |   | —                   |   | 1,070                      |   | —                            |   | —                               |   | 1,070        |   |
| Total revenue                                                                                                            |   | $                        | 6,382  |                       | $      | 1,070                             |   | $                                    | 2,752  |         | $      | — |   | $ | 10,204 |   |
|                                                                                                                     |   |                     |   |                       |   |                              |   |                                 |   |         |   |
| Income (loss) from  operations before provision for income taxes, minority interest and equity in  net loss of affiliate |   | $                        | (1,040 | )                          | $      | (565                              | )      | $                                    | 195    |         | $      | — |   | $ | (1,800 | ) |
|                                                                                                                     |   |                     |   |                       |   |                              |   |                                 |   |         |   |
| Total assets                                                                                                             |   | $                        | 93,874 |                       | $      | 11,441                            |   | $                                    | 6,691  |         | $      | — |   | $ | 112,006 |   |

 

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**6.             Acquisitions**

 

The following describesthe acquisition by the Company during the quarter ended March 31, 2002:
| **Company  Acquired**                              |   | **Date  Acquired** |   | **Percent  Acquired** |   | **Acquisition  Price** |   | **Cash  Consid-eration** |   | **Value of  Shares,  Warrants &  Options Issued or  Issuable** |   | **Common/  Preferred  Shares Issued** |   | **Goodwill  Acquired** |   | **Business  Description** |   |
|----------------------------------------------------|--------|--------------------|--------|-----------------------|--------|------------------------|--------|--------------------------|--------|--------------------------------------------------------------------|--------|---------------------------------------|--------|------------------------|--------|---------------------------|--------|
| 2002  Acquisition:  Medical Advisory Systems, Inc. |   | 03/27/02           |   | 83.4                  | %      | $                      | 44,206 |                     | $      | 1,249                                                              |   | 42,957                                |   | 5,218                  |   | 41,517                    |   | Provider of medical  assistance and technical products and services |   |
|                                                    |        |                    |        |                       |        |                        |        |                          |        |                                                                    |        |                                       |        |                        |        |                           |        |  |  |

 

On February 27, 2001, ADSacquired approximately 16.5% of the capital stock of MAS (AMEX:DOC), a providerof medical assistance and technical products and services, in a transactionvalued at approximately $8.3 million in consideration for 3.3 million shares ofADS’s common stock.  ADS controls two ofthe seven seats on the Company’s Board of Directors and became the largestsingle shareholder.  This investment wasaccounted for under the equity method from February 27, 2001 through March 27,2002.  The excess of the purchase priceover the estimated fair value of the shares acquired was approximately $7.0million (goodwill) and was being amortized on a straight-line basis over fiveyears, through December 31, 2001.

On March 27, 2002,Digital Angel Corporation merged with a wholly-owned subsidiary of MAS.  For accounting purposes, Digital AngelCorporation is treated as the acquirer, and the assets and liabilities of MASwere recorded at fair value under the purchase method of accounting to theextent acquired, 83.4%.  The consolidatedfinancial statements reflect the results of operations of MAS from the date ofacquisition.  The costs of acquisitionsinclude all payments according to the acquisition agreements plus costs forinvestment banking services, legal and accounting services that were directcosts of acquiring these assets.

Unaudited pro formaresults of operations for the three months ended March 31, 2002 and 2001 areincluded below.  Such pro formainformation assumes that the above acquisition had occurred as of January 1,2002 and 2001, respectively.

 

|                                                 |   | **Three  Months  Ended  March 3l,** |   | **Three  Months  Ended  March 3l,** |   |
|------------------------------------------------------|--------|-------------------------------------|--------|-------------------------------------|--------|
|                                                 |   | **2002**                            |   | **2001**                            |   |
| Net operating revenue                                |   | $                                   | 8,639  |                                | $      | 11,802 |   |
| Loss from operations                                 |   | (22,109                             | )      | (2,247                              | )      |
| Loss per common share from operations — basic   |   | $                                   | (1.08  | )                                   | $      | (0.11 | ) |
| Loss per common share from operations — diluted |   | $                                   | (1.08  | )                                   | $      | (0.11 | ) |

 

13

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**7.             LegalProceedings**

** **

The Company is party tovarious legal proceedings.  In theopinion of management, these proceedings are not likely to have a materialadverse effect on the financial position, cash flows or overall trends inresults of the Company.  The estimate ofpotential impact on the Company’s financial position, overall results ofoperations or cash flows for the above legal proceedings could change in thefuture.

**8.             RelatedParty Activity**

** **

ADS provides certain general and administrative services to the Companyincluding finance, legal, benefits and other miscellaneous items.  The cost of these services are included inthe Company’s Combined Statement of Operations based on utilization, whichmanagement believes to be reasonable. Cost of these services were $0.2 million and $0.2 million for the threemonths ended March 31, 2002 and 2001, respectively.

 

14

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**Item 2****.****                                  ****Management’s Discussion and Analysis of Financial Conditionand Results of Operations.**

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

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

 

15

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        **RESULTS OF OPERATIONS**

The following tablesummarizes our results of operations as a percentage of net operating revenuefor the three months ended March 31, 2002 and 2001 and is derived from theaccompanying consolidated and combined statements of operations included inthis report.
|                                                                                                           |   | **Three Months Ended March 31,** |   |
|----------------------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                                                           |   | **2002**                         |   | **2001** |   |
|                                                                                                           |   | **%**                            |   | **%** |   |
| Product revenue                                                                                                |   | 96.1                             |   | 89.5 |   |
| Service revenue                                                                                                |   | 3.9                              |   | 10.5 |   |
| Total revenue                                                                                                  |   | 100.0                            |   | 100.0 |   |
| Cost of products  sold                                                                                         |   | 55.1                             |   | 52.5 |   |
| Cost of services  sold                                                                                         |   | 3.2                              |   | 5.4 |   |
| Total cost of  products and services sold                                                                      |   | 58.4                             |   | 57.9 |   |
| Gross profit                                                                                                   |   | 41.6                             |   | 42.1 |   |
| Selling, general and administrative expenses                                                                   |   | 33.2                             |   | 25.4 |   |
| Research and development expenses                                                                              |   | 17.2                             |   | 10.6 |   |
| Non-cash compensation expense                                                                                  |   | 238.7                            |   | — |   |
| Depreciation and amortization                                                                                  |   | 8.9                              |   | 23.1 |   |
| Interest income                                                                                                |   | (0.0                             | )      | (0.0 | ) |
| Interest expense                                                                                               |   | 24.6                             |   | 0.6 |   |
| Loss from operations before provision for income  taxes, minority interest and equity in net loss of affiliate |   | (281.0                           | )      | (17.6 | ) |
| Provision for  income taxes                                                                                    |   | 0.0                              |   | 1.1 |   |
| Loss from  operations before minority interest and equity in net loss of affiliate                             |   | (281.0                           | )      | (18.7 |   |
| Minority interest                                                                                              |   | (0.2                             | )      | (0.2 | ) |
| Equity in net  loss of affiliate                                                                               |   | 0.7                              |   | 0.2 |   |
| Net loss                                                                                                       |   | (281.5                           | )      | (18.7 | ) |

 

16

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**Revenue**

Revenue from operationsfor the three months ended March 31, 2002 was $7.8 million, a decrease of $2.4million, or 23.5%, from $10.2 million in the three months ended March 31, 2001.

Revenue for each of theoperating segments was:

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

 

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

The Digital Angel Systemssegment’s revenue decreased $1.1 million, or 71.7%, in the first three monthsof 2002 from the first three months of 2001 due to completed client assignmentsthat were not replaced.

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

**Gross Profit and Gross Profit Margin**

Gross profit for thethree months ended March 31, 2002 was $3.2 million, a decrease of $1.1 million,or 25.6%, from $4.3 million in the three months ended March 31, 2001.  As a percentage of revenue, the gross profitmargin was 41.6% and 42.1% for the three months ended March 31, 2002 and 2001,respectively.

Gross profit fromoperations for each operating segment was:

|                                        |   | **Three Months Ended March 31,** |   | **Three Months Ended March 31,** |   |
|---------------------------------------------|--------|----------------------------------|--------|----------------------------------|--------|
|                                        |   | **2002**                         |   | **2001**                         |   |
| Animal Applications — Product          |   | $                                | 1,903  |                             | $      | 2,491 |   |
| Digital Angel Systems — Service        |   | 52                               |   | 522                              |   |
| GPS and Radio Communications — Product |   | 1,272                            |   | 1,281                            |   |
| Total                                       |   | $                                | 3,227  |                             | $      | 4,294 |   |

 

Gross profit margin fromoperations for each operating segment was:

|                                        |   | **Three Months Ended March 31,** |   | **Three Months Ended March 31,** |   |
|---------------------------------------------|--------|----------------------------------|--------|----------------------------------|--------|
|                                        |   | **2002**                         |   | **2001**                         |   |
|                                        |   | **%**                            |   | **%**                            |   |
| Animal Applications — Product          |   | 39.5                             |   | 39.0                             |   |
| Digital Angel Systems — Service        |   | 17.2                             |   | 48.8                             |   |
| GPS and Radio Communications — Product |   | 48.3                             |   | 46.5                             |   |
| Total                                       |   | 41.6                             |   | 42.1                             |   |

 

The Animal Applications segment’s gross profitdecreased $0.6 million in the first three months of 2002 from the first threemonths of 2001 due to the previously mentioned sales decrease.  Margins 

 

17

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increased to 39.5% in thefirst three months of 2002 from 39.0% in the first three months of 2001 due tothe product mix.

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

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

**Selling, General and AdministrativeExpenses**

Selling, general andadministrative expenses from operations remained constant at $2.6 million inthe three months ended March 31, 2002 and March 31, 2001.  As a percentage of revenue, selling, generaland administrative expenses were 33.2% and 25.4% for the three months endedMarch 31, 2002 and 2001, respectively.

Selling, general and administrative expenses for each of the operatingsegments were:

 

|                         |   | **Three Months Ended March 31,** |   | **Three Months Ended March 31,** |   |
|------------------------------|--------|----------------------------------|--------|----------------------------------|--------|
|                         |   | **2002**                         |   | **2001**                         |   |
| Animal Applications          |   | $                                | 1,031  |                             | $      | 1,067 |   |
| Digital Angel Systems        |   | 229                              |   | 214                              |   |
| GPS and Radio Communications |   | 1,318                            |   | 1,314                            |   |
| Total                        |   | $                                | 2,578  |                             | $      | 2,595 |   |

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

|                         |   | **Three Months Ended March 31,** |   | **Three Months Ended March 31,** |   |
|------------------------------|--------|----------------------------------|--------|----------------------------------|--------|
|                         |   | **2002**                         |   | **2001**                         |   |
|                         |   | **%**                            |   | **%**                            |   |
| Animal Applications          |   | 21.4                             |   | 16.7                             |   |
| Digital Angel Systems        |   | 75.6                             |   | 20.0                             |   |
| GPS and Radio Communications |   | 50.0                             |   | 47.7                             |   |
| Total                        |   | 33.2                             |   | 25.4                             |   |

 

The Animal Applicationssegment’s selling, general and administrative expenses decreased $0.1 millionin the first three months of 2002 compared to the first three months of 2001and as a percentage of revenue increased to 21.4% from 16.7% in the samerespective periods.  The decrease in thedollars was due to workforce cost reductions, partially offset by significantincreases in non-personnel expenses.

The Digital AngelSystems segment’s selling, general and administrative expenses remainedconstant at $0.2 million in the first three months of 2002 compared to thefirst three months of 2001.  Selling,general and administrative expenses increased as a percentage of revenue to75.6% in the first three months of 2002 compared to 20.0% in the first threemonths of 2001 as a result of lower revenues as previously discussed.

The GPS and Radio Communications segment’s selling,general and administrative expenses were essentially unchanged in the first threemonths of 2002 from the first three months of 2001.  As a 

 

18

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percentageof revenue, selling, general and administrative expenses increased to 50.0% inthe first three months of 2002 from 47.7% in the first three months of 2001 asa result of lower revenues as previously discussed.

**Research and Development Expense**

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

Research and developmentexpense for each of the operating segments was:

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

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

**Non-cash Compensation Expense**

Pursuant to the terms ofthe merger agreement, options to acquire shares of Digital Angel common stockwere converted into options to acquire shares of MAS common stock effectiveMarch 27, 2002. The conversion resulted in a new measurement date for theoptions and, as a result, the Company recorded a one-time, non-recurring chargeof approximately $18.5 million in non-cash compensation expense during thethree months ended March 31, 2002. For current employees of the Company, theseoptions are considered fixed awards under APB Opinion No. 25, and expense wasrecorded for the intrinsic value of the options converted. For all others,expense was recorded for the fair value of the options converted in accordancewith FAS 123. Fair value was determined by using the Black-Scholesoption-pricing model.

**Depreciation and Amortization**

Depreciation andamortization expense from operations was $0.7 million in the three months endedMarch 31, 2002, a decrease of $1.7 million, or 70.8%, from $2.4 million in thethree months ended March 31, 2001.  As apercentage of revenue, the depreciation and amortization expense was 8.9% and23.1% for the three months ended March 31, 2002 and 2001, respectively.

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

Depreciation andamortization expense for each of the operating segments was:

|                         |   | **Three Months Ended March 31,** |   | **Three Months Ended March 31,** |   |
|------------------------------|--------|----------------------------------|--------|----------------------------------|--------|
|                         |   | **2002**                         |   | **2001**                         |   |
| Animal Applications          |   | $                                | 95     |                             | $      | 2,110 |   |
| Digital Angel Systems        |   | 527                              |   | 93                               |   |
| GPS and Radio Communications |   | 66                               |   | 156                              |   |
| Total                        |   | $                                | 688    |                             | $      | 2,359 |   |

 

The increase in the Digital Angel Systems segment’s depreciation andamortization during the 

 

19

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first three monthsof 2002 compared to the first three months of 2001 is a result of increasedamortization related to amortization on purchased software associated with theDigital Angel Delivery System that was placed in service in April 2001.

**Interest Expense**

Interest expense was $1.9million and $59 thousand for the first three months of 2002 and 2001,respectively.  Interest expense in thefirst three months of 2002 includes interest expense of $1.8 million on thedebt owed to IBM Credit Corporation by Applied Digital Solutions, Inc.  As discussed in Note 1 to the financialstatements, this debt was recognized by AWG due to ADS’s default on the loanagreement.  On March 27, 2002, ADS restructuredits loan agreement with IBM Credit Corporation.  The provisions of this restructuring included AWG being releasedfrom responsibility to repay this debt. Accordingly, AWG derecognized this liability on March 27, 2002.

**Income Taxes**

AWG had effective incometax rates of 0.0% and a negative 6.4% for the first three months of 2002 and2001, respectively.  Differences in theeffective income tax rates from the statutory federal income tax rate in 2002arise primarily from valuation allowances recorded on deferred net operatinglosses and in 2001 arise primarily from valuation allowances recorded ondeferred net operating losses, non-deductible goodwill amortization associatedwith acquisitions and state taxes net of federal benefits. The U.S. companiesin AWG were included in ADS’s consolidated federal income tax return throughMarch 27, 2002.  MAS and itssubsidiaries file a separate consolidated federal income tax return.  After March 27, 2002, AWG’s U.S.subsidiaries will file a consolidated federal tax return with MAS.

**LIQUIDITYAND CAPITAL RESOURCES FROM OPERATIONS**

As of March 31,2002, cash and cash equivalents totaled $0.9 million, a decrease of $0.3million, or 50.0%, from $0.6 million at December 31, 2001.  Through March 27, 2002, AWG used a cashmanagement system to apply excess cash on hand against advances due toADS.  Cash used in operating activitiestotaled $2.0 million and $.2 million in the first three months of 2002 and2001, respectively.  In the first threemonths of 2002, the use of cash was due to the net loss, after adjusting fornon-cash charges, and increases in other current assets.  Partially offsetting these uses of cash wereincreases in cash from increases in accounts payable and accrued expenses.  In the first three months of 2001, the useof cash was due to the net loss, after adjusting for non-cash charges, andincreases in accounts receivable, inventory, and other current assets.Partially offsetting these uses of cash were increases in cash from accountspayable and accrued expenses.

Accountsreceivable, net of allowance for doubtful accounts, increased by $0.3 million,or 5.6%, to $5.7 million at March 31, 2002 from $5.4 million at December 31,2001.  This increase was primarily as aresult of our acquisition of MAS.

Inventory levelsremained relatively constant at $5.8 million at March 31, 2002 and December 31,2001.  Inventory acquired from ouracquisition of MAS was not material.

Property andequipment increased by $0.8 million, or 5.5%, to $15.3 million at March 31, 2002compared to $14.5 million at December 31, 2001.  This increase was due primarily to property and equipmentacquired from our acquisition from MAS, plus capital expenditures of $0.2million.  This was offset withdepreciation expense for the three months ended March 31, 2002.

Goodwill increased to $114.7 million at March 31, 2002compared to $73.2 million at December 31, 2001 due to our acquisition of MAS.

 

20

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Investment inaffiliates decreased by $5.8 million, or 85.3%, to $1.0 million at March 31,2002 compared to $6.8 million at December 31, 2001.  This decrease was due to MAS now being consolidated, whereas theprevious 16.5% interest was treated as an equity method investment at December31, 2001.  This decrease was partiallyoffset by equity method investments held by MAS that were acquired as part ofthe acquisition of MAS.

Accounts payableremained stable at $3.8 million at March 31, 2002 and December 31, 2001. Thiswas due to payments on accounts payable, offset by payables acquired from theacquisition of MAS.

Accrued expensesincreased by $4.4 million, or 220.0%, to $6.4 million at March 31, 2002 from$2.0 million at December 31, 2001.  Theincrease was due to accrued acquisition costs, and accrued expenses acquiredfrom the acquisition of MAS.

Investingactivities provided cash of $0.1 million in the first three months of 2002, andused cash of  $0.4 million in the firstthree months of 2001.  During the firstthree months of 2002 and 2001, $0.2 million and $0.7 million, respectively, wasspent to acquire property and equipment. This was offset in the first threemonths of 2002 by cash acquired, net of acquisition costs, from the acquisitionof MAS.

Financingactivities provided cash of $1.8 million and $0.4 million in the first threemonths of 2002 and 2001, respectively. During the first three months of 2002and 2001, cash was provided primarily by additional investments from ADS.

*Debt,Covenant Compliance and Liquidity*

ADS maintains a term and revolving credit agreementwith IBM Credit (IBM Credit). Under the credit agreement in effect throughMarch 27, 2002, IBM Credit maintained liens and security interests in theoutstanding capital stock of the three AWG subsidiaries and on their assets tocollateralize ADS’s obligations to IBM Credit under the IBM credit agreement.

 

ADS generated a significant loss from operations in2000. As a result, ADS was not in compliance with certain financial covenantsof the IBM credit agreement as of December 31, 2000. The IBM credit agreementwas amended and restated on October 17, 2000 and further amended on March 30,2001. In connection with the amendment on March 30, 2001, Digital Angel grantedIBM Credit Corporation warrants to acquire 1.2 million shares of DigitalAngel’s common stock valued at $0.3 million. As of the March 30, 2001amendment, ADS was in compliance with the revised covenants.

 

The IBM credit agreement contains certain quarterlyfinancial covenants, which became more restrictive during 2001. ADS anticipatedthat it would continue to comply in 2001 with the quarterly financial covenantsin the IBM credit agreement. However, ADS was not in compliance with itsminimum EBITDA (as defined in the IBM credit agreement) or collateral shortfallcovenants at June 30, 2001. ADS was also not in compliance with the minimumEBITDA, Tangible Net Worth and Current Assets to Current Liabilities covenantrequirements at September 30, 2001 and it again had a collateralshortfall.  As of December 31, 2001, ADSwas not incompliance with various financial covenants, including minimumTangible Net Worth, EBITDA, the ratio of Current Assets to Current Liabilities,and collateral. The IBM credit agreement was amended and restated on July 1,2001, September 15, 2001, November 15, 2001, December 31, 2001, January 31,2002 and February 27, 2002.  Theseamendments extended the due dates of principal and interest payments under thecredit agreement until April 2, 2002.

 

At December 31, 2001, ADS’s outstanding borrowingsunder the IBM credit agreement totaled $82.6 million. At that time, ADS did nothave the funds to repay the borrowings under the IBM credit 

 

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agreement. Accordingly, the $82.6 million of outstanding borrowings wasallocated to AWG effective as of September 30, 2001 and was reflected as acurrent obligation in the December 31, 2001 combined balance sheet. Interestassociated with the borrowings was allocated to AWG for the period fromSeptember 30, 2001 to March 27, 2002. Under the terms of the agreement and plan of merger with MAS, the commonstock and assets of the three AWG subsidiaries were released from all liens andsecurity interests under the IBM credit agreement, and the shares of the AWGsubsidiaries common stock beneficially owned by ADS upon completion of themerger were pledged to IBM as collateral for the debt.  Since AWG’s assets were released from allliens and security interests on March 27, 2002, we derecognized the amountsowed to IBM by ADS on that date.  Thisresulted in an increase in additional paid-in capital of approximately $83million.

 

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

ADS’s new creditagreement contains debt covenants made by ADS relating to its financialposition and performance, as well as the Company’s financial position andperformance.  The Company currentlyexpects that its financial performance will meet and be in compliance throughout2002 with covenants in the new credit agreement that apply to the Company.  However, if business conditions are otherthan as anticipated or other unforeseen events or circumstances occur, thesemay impact the ability of ADS and the Company to remain in compliance with thecovenants.  In the absence of waiver oramendment to such financial covenants, such noncompliance would constitute anevent of default under the new credit agreement, and IBM Credit would beentitled to accelerate the maturity of all amounts ADS owes it.  If such noncompliance appears likely, oroccurs, ADS may seek to renegotiate the covenants and/or obtain waivers, asrequired.  There can be no assurance,however, that ADS would be successful in negotiating such amendments or obtainingsuch waivers.

On March 27, 2002,upon completion of the merger between Digital Angel and MAS, in satisfaction ofa condition to the consent to the merger by IBM Credit, ADS transferred to aDelaware business trust controlled by an advisory board all of the shares ofour common stock owned by it and, as a result, the trust has legal title toapproximately 77.46% of our common stock. The trust has voting rights with respect to our common stock until ADS’sobligations to IBM Credit are repaid in full. The trust may be obligated to liquidate the shares of our common stockowned by it for the benefit of IBM Credit if ADS fails to make payments, orotherwise defaults, under its new credit agreement with IBM Credit.

To date, financing from acquisitions, ADS’s advancesand revenue generated from operations have been our primary sources of funding.However, we do not anticipate receiving additional advances from ADS.  We estimate that we will need to obtainapproximately $5 million to $7 million in additional funding over the nexttwelve months in order to continue our efforts to implement our business plan.As a result, we will need to obtain additional capital in the near future. Asof the date of these statements, we 

 

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have held discussions with several banks and an asset based lenderregarding a credit facility. Our capital requirements depend on a variety offactors, including, but not limited to, the rate of increase or decrease in ourexisting business base; the success, timing, and amount of investment requiredto bring new products on-line; revenue growth or decline; and potentialacquisitions. If we are successful in obtaining the credit facility and inraising additional equity capital, of which there can be no assurance,management believes that we will have the financial resources to meet itsfuture business requirements for at least the next twelve months. See “RISKFACTORS — We Will Need Additional Financing.”

 

**FORWARDLOOKING STATEMENTS AND ASSOCIATED RISKS**

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

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

•                      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.

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

**RiskFactors**

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.

***As a Result of the Merger and the Transfer of Shares of OurCommon Stock to the Digital Angel Share Trust, There is Uncertainty as to theFuture Control of Our Company.***

 

After the merger, in satisfaction of a condition tothe consent to the merger of IBM Credit Corporation, ADS transferred to theDigital Angel Share Trust (the “Trust”) all shares of our common stock owned byADS.  As a result, the Trust is thebeneficial owner of approximately 77% of our common stock, and it controls uswith respect to all matters upon which our stockholders may vote, including theselection of the Board of Directors and mergers, acquisitions and othersignificant corporate transactions. There can be no assurance as to how the Trust will exercise control overour Company.

 

Upon the request of IBM Credit Corporation, the Trustwill be obligated to sell the shares of our 

 

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

 

***Sales of Our Common Stock by the Trust May Cause a Reductionin the Market Value of Our Common Stock.***

 

If amounts due to IBM Credit Corporation by ADS arenot paid when due, including at least $33 million on February 28, 2003, plusaccrued interest and expenses, or if ADS is otherwise in default under itscredit agreement and its obligations are accelerated, IBM Credit Corporationwill have the right to require shares of our common stock held in the Trust tobe sold to provide funds to satisfy the obligations of ADS. It is unlikely thatADS will have the funds required for payment of such obligations. The sale of asignificant amount of shares of our common stock owned by the Trust in a singletransaction or in a series of transactions over a short period of time couldresult in a significant decline in the market value of our common stock.

 

***We May Face Operational and Strategic Challenges That MayPrevent Us From Successfully Integrating The MAS Business.***

 

The operation of our Company after the merger involvesrisks related to the integration and management of acquired properties andoperations. We may encounter substantial difficulties, costs and delays inintegrating the operations of our subsidiaries with our business, including:

 

• perceived adverse changes in business focus;

 

• potential conflicts inmarketing or other important relationships;

 

• loss of key employees or customers;

 

• possibleinconsistencies in standards, controls, procedures and policies among thecompanies and the need to implement and harmonize company-wide financial,accounting, information and other systems;

 

• failure to maintain thequality of products and services that such companies have historicallyprovided;

 

• the need to coordinategeographically diverse organizations; and

 

• the diversion ofmanagement’s attention from the day-to-day operations.

 

If we fail to integrate these businesses successfullyand/or if we fail to realize the intended benefits of the merger, our financialcondition and results of operations could be adversely affected and the marketprice of our common stock could decline from its current market price.

 

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

 

We incurred a net loss of $21.8 million for thethree-month period ended March 31, 2002. We also recorded a net loss of $17.4million and $3.9 million for the years ended December 31, 2001 and 2000, respectively.No assurance can be given as to whether or when we will be profitable.Profitability depends on many factors, including the success of marketingprograms, the maintenance and reduction of expenses and the ability tocoordinate successfully the operations of business units. If we becomeprofitable, of which there is no assurance, it may not be able to sustain orincrease profitability. If we fail to achieve and maintain profitability withinthe time frame expected by investors, the market price of our common stock maybe adversely affected.

 

***We Depend on the Protection of Our Proprietary Technology.***

 

Our success depends partly on our ability to maintainpatent and trade secret protection, to obtain future patents and licenses, andto operate without infringing on the proprietary rights of third parties. Therecan be no assurance that the measures we have taken to protect our intellectualproperty, including those relating to the Digital Angel Systems, will preventits misappropriation or circumvention. In addition, there can be no assurancethat any patent application, when filed, will result in an issued patent, orthat our existing patents, or any patents that may be issued in the future,will provide us with significant protection against competitors. Moreover,there can be no assurance that any patents issued to or licensed by us will notbe infringed upon or circumvented by others. Litigation to establish thevalidity of patents, to assert infringement claims against others, and todefend against patent infringement claims can be expensive and time-consuming,even if the outcome is in our favor. We also rely to a lesser extent onunpatented proprietary technology, and no assurance can be given that otherswill not independently develop substantially equivalent proprietaryinformation, techniques or processes or that we can meaningfully protect ourrights to such unpatented proprietary technology.

 

***Many Factors Can Negatively Affect the Animal IdentificationMarket.***

 

The electronic animal identification market can benegatively affected by such factors as food safety concerns, consumerperceptions regarding cost and efficacy, international technology standards,national infrastructures, United States Food and Drug Administration (FDA)reviews, United States Federal Communications Commission (FCC) approvals, andslaughterhouse removal of microchips. In addition, certain foreign governmentalstandards that require specific codes may limit our ability to sell microchipsfrom our current inventory in such countries. Many of the principal customersfor fish electronic identification devices are government contractors that relyon funding from the United States government, and this market could beadversely affected by any decline in the availability of government funds. Wemay be adversely affected by these and other factors affecting the animalidentification market, which could have an adverse effect on our financialcondition and results of operations.

 

***We Depend on a Single Supplier For Our Electronic IdentificationProducts.***

 

We rely largely on a production arrangement withRaytheon Corporation for the manufacture of our syringe-injectable microchipsthat are used in all of our electronic identification products. Thetermination, or any significant reduction, by Raytheon of its production ofthese microchips could have a material adverse effect on our financialcondition and results of operations. In addition, Raytheon may not be able toproduce sufficient quantities to meet any significant increased demand for ourproducts or to meet any such demand on a timely basis. Any inability orunwillingness of Raytheon to meet potentially increased demand for our productcould have a material adverse effect on our financial condition and results ofoperations.  The Company also has itsown microchip production operations located in another contract facility thatwe intend to use more intensively to meet additional product demand.

 

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

 

For the three months ended March 31, 2002, we hadthree customers of our Animal Applications segment that accounted for a largeportion of our gross revenue.  Biomark,Pacific States Marine, and Schering-Plough Pharmaceutical accounted forapproximately 12.5%, 13.4%, and 8.7% of our gross revenues, respectively. Inaddition, the GPS and Radio Communications segment is heavily dependent oncontracts with domestic government agencies and foreign governments, includingthe United Kingdom, primarily relating to military applications. The loss of,or a significant reduction in, orders from these or our other major customerscould have a material adverse effect on our financial condition and results ofoperations.

 

***Significant Competition Exists in the Visual and ElectronicIdentification Markets.***

 

The market for visual and electronic identificationfor companion animals and livestock is highly competitive. We believe that ourprincipal competitors in the visual identification market for livestock areAllFlex and Y-Tex, and our principal competitor in the electronicidentification market that has developed permanent electronic identificationdevices for the companion animal market is AllFlex. In addition, othercompanies could enter this line of business in the future. Certain of ourcompetitors have substantially greater financial and other resources than wedo. We cannot ensure that we will compete successfully or that our competitorswill not succeed in developing or marketing technologies and products that are morewidely accepted than those being developed by us or that would render ourproducts obsolete or noncompetitive. We are not aware of competitors currentlymarketing products that would compete with the Digital Angel technology.However, we are aware of several potential competitors that have expressed aninterest in similar technologies. If such competitors enter the market andcompete with the Digital Angel technology, such competition could have amaterial adverse effect on our financial condition and results of operations.

 

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

 

We are subject to federal, state and local regulationin the United States and other countries, and we cannot predict the extent towhich we may be affected by future legislative and other regulatorydevelopments concerning our products and markets. We are required to obtainregulatory approval before marketing most of our products. Our products aresubject to FCC regulations governing electromagnetic emissions, and ourinsecticide products have been approved by the United States EnvironmentalProtection Agency (EPA) and are produced in accordance with EPA regulations.Sales of insecticide products are incidental to our primary business and do notrepresent a material part of our operations. Our products also are subject tocompliance with foreign government agency requirements. Our contracts with ourdistributors generally require the distributor to obtain all necessaryregulatory approvals from the governments of the countries in which the distributorsells our products. However, any such approval may be subject to significantdelays. Some regulators also have the authority to revoke approval ofpreviously approved products for cause, to request recalls of products and toclose manufacturing plants in response to violations. Any actions by theseregulators could have a material adverse effect on our business, financialcondition and results of operations.

 

***The Digital Angel Systems Segment is a Development StageEnterprise.***

 

The Digital Angel Systems segment is in the initialstage of operations and is a development stage enterprise. As a result, it hasno operating history upon which to base an evaluation of its current businessand future prospects. The first Digital Angel product was introduced inNovember 2001. Accordingly, this segment has generated no substantial revenues.Moreover, this segment does not

 

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currently have any contracts in place that will provide any significantrevenue. In addition, because of this segment’s lack of an operating history,management has limited insight into trends that may emerge and could materiallyadversely affect its business. This segment’s prospects must be considered inlight of the risks, expenses and difficulties frequently encountered bycompanies in new and rapidly evolving markets. Stockholders should consider therisks and difficulties the Digital Angel Systems segment may encounter in itsnew and rapidly evolving market, especially given the segment’s lack ofoperating history. These risks include the Digital Angel Technology segment’sability to:

 

• develop and market theDigital Angel technology by integrating and miniaturizing new technologies intomarketable products and services;

 

• build a customer base;

 

• generate revenues;

 

• compete favorably in a highly competitive market;

 

• access sufficient capital to support growth;

 

• recruit and retain qualified employees;

 

• introduce new products and services; and

 

• build technology and support systems.

 

***The Digital AngelTM Technology Is Not Proven AndWe May Not Be Able To Develop Products From This Unproven Technology.***

 

The Digital AngelTM Systems segment dependson the development, integration, miniaturization and successful marketing ofseveral pieces of advanced technology that have not previously been integratedor used as anticipated by this segment. The Digital AngelTM Systemssegment depends upon advanced technology, including: wireless communication,biosensors, motion determination and global positioning system capabilities.Many of these technologies are unproven or relatively new. In addition, thesetechnologies have not been previously integrated or miniaturized into acommercial product. No assurances can be given as to when or if the DigitalAngelTM technology will be successfully marketed. Our ability todevelop and commercialize products based on our proprietary technology willdepend on our ability to develop our products internally on a timely basis orto enter into arrangements with third parties to provide these functions. If wefail to develop and commercialize products successfully, it could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

***The Digital Angel Systems Segment Expects to Incur FutureLosses and May Not Achieve Profitability.***

 

From the period from January 2000 until March 31,2002, approximately $7.7 million has been invested in research and developmentrelating to the Digital AngelTM technology. Our management expects theDigital Angel Systems segment to incur additional development, sales andmarketing, and other general expenses. As a result, the Digital Angel Systemssegment may incur losses for the foreseeable future and will need to generaterevenues to achieve profitability. Even if the segment achieves profitability,it may not be able to sustain it.

 

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***We Depend on a Small Team of Senior Management and We MayHave Difficulty Attracting and Retaining Additional Personnel.***

 

Our future success is highly dependent upon thecontinued services and performance of senior management and other keypersonnel.  If we lose the services ofany member of our senior management team, our overall operations could beadversely affected. In addition, our future success will depend on our abilityto identify, attract, hire, train, retain and motivate other highly skilledtechnical, managerial, marketing, purchasing and customer service personnelwhen they are needed. Competition for these individuals is intense. We cannotensure that it will be able successfully to attract, integrate or retainsufficiently qualified personnel when the need arises. Any failure to attractand retain the necessary technical, managerial, marketing, purchasing andcustomer service personnel could have a material adverse effect on ourfinancial condition and results of operations.

 

***We Will Need Additional Financing***

 

Our company, especially the Digital Angel Systemssegment, currently relies upon the revenue generated by our Animal Applicationssegment.  We estimate that we will needto obtain approximately $5.0 million to $7.0 million in additional funding overthe next twelve months in order to continue our efforts to implement ourbusiness plan. As of the date of these financial statements, we have helddiscussions with several banks and an asset based lender regarding creditagreements.

Our actual capital needs will depend on operatinglosses, development expenses, working capital needs and other factors. Forecastsof such factors are inherently uncertain, and any variation in those factorsfrom the levels used in current forecasts could result in us needing morecapital, or capital earlier, than projected. Capital can be difficult andexpensive to obtain, and there can be no assurance that we will be able toobtain additional financing. If this capital is not raised, we may not be ableto execute our business plan, may not be able successfully to develop andmarket the Digital AngelTM technology and our financial conditionand results of operations may be materially adversely affected. To date, wehave not been able to obtain this capital. No assurance can be given that wewill be able to raise this additional necessary capital.

 

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

 

Moreover, we may issue additional shares:

 

• to employees;

 

• in connection with acquisitions and corporatealliances; and

 

• to raise capital.

 

Pursuant to a registration rights agreement, the Digital Angel ShareTrust and any of its transferees of our common stock, subject to certain termsand conditions, have the right to require us to register shares of our commonstock beneficially owned by them upon demand and any other time we register stockfor 

 

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sale.

 

In addition, IBM Credit Corporation currently holds awarrant to acquire 1,163,906 shares of our common stock. The warrant isexercisable for five years beginning on April 5, 2002, or earlier under certaincircumstances. Under the warrant, IBM Credit Corporation, subject to certainterms and conditions, has the right to require us to register shares of ourcommon stock subject to the warrant.

 

**IMPACT OF RECENTLY ISSUED ACCOUNTINGSTANDARDS**

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

In August 2001, the FASBissued FAS 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*.  This standard supersedes FAS 121, *Accountingfor the Impairment of Long-Lived Assets to Be Disposed Of*, andprovides a single accounting model for long-lived assets to be disposed of.This standard 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 supercede the provisions of APB Opinion 30, *Reporting the Results ofOperations-Reporting the Effects of Disposal of a Segment of a Business, andExtraordinary, Unusual and Infrequently Occurring Events and Transactions*,with regard to reporting the effects of a disposal of a segment of a businessand will require expected future operating losses from Discontinued Operationsto be displayed in Discontinued Operations in the period in which the lossesare incurred, rather than as of the measurement date as presently required byAPB 30. This statement is effective for fiscal years beginning after December15, 2001. We adopted this statement on January 1, 2002. The adoption of FAS 144did not have a material impact on our operations or financial position.

 

**Item 3.****                                                          ****Quantitative and Qualitative Disclosures About Market Risk**

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

 

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We presently donot use any derivative financial instruments to hedge our exposure to adversefluctuations in interest rates, foreign exchange rates, fluctuations incommodity prices or other market risks, nor do we invest in speculativefinancial 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.

 

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**PARTII****OTHER INFORMATION**

**Item 1.    Legal Proceedings.**

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

On May 29, 2001, JanetSilva, individually and as Guardian*ad Litem*for Jonathan Silva, a minor, and the Estate of Clarence William Silva, Jr.(collectively, “Plaintiffs”) filed suit against Customized ServicesAdministrators, Incorporated (“CSA”), Pricesmart, Inc. (“Pricesmart”),Commercial Union Insurance Company (“Commercial Union”), CGU Insurance Group,and the Company (collectively the “Defendants”) in the Superior Court of theState of California in and for the County of Santa Clara.  The allegations of the complaint arise froma vacation guarantee insurance policy (the “Insurance Contract”) allegedlypurchased by Plaintiffs from Defendants on March 6, 2000.  The complaint alleges, among other things,that Defendants breached the Insurance Contract, defrauded Plaintiffs, acted inbad faith, engaged in deceptive and unlawful business practices, resulting inthe wrongful death of Clarence William Silva, Jr. (the “Deceased”) and theintentional infliction of emotional distress on Plaintiffs.  The complaint seeks the cost of funeral andburial expenses of the Deceased and amounts constituting the loss of financialsupport of the Deceased, general damages, attorney’s fees and costs, and exemplarydamages.

 

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 is vigorouslycontesting 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.    Changesin Securities and Use of Proceeds.**

RecentSales of Unregistered Securities

Thefollowing table lists all unregistered securities sold by the Company betweenJanuary 1, 2002 and March 31, 2002. These shares were issued in acquisition transactions to the persons orentities indicated. These shares were issued without registration in relianceupon the exemption provided by Section 4(2) of the Securities Act of 1933, asamended, and Rule 506 of Regulation D promulgated thereunder.
| **Name/Entity/Nature**           |   | **Number of Persons** |   | **Note** |   | **Issued For** |   | **Number of  Common  Shares** |   |
|----------------------------------|--------|-----------------------|--------|----------|--------|----------------|--------|-------------------------------|--------|
| Applied Digital  Solutions, Inc. |   | 1                     |   | 1        |   | Acquisition    |   | 18,750,000                    |   |
| Richard J. Sullivan              |   | 1                     |   | 2        |   | Acquisition    |   | 937,500                       |   |
| Garrett A. Sullivan              |   | 1                     |   | 2        |   | Acquisition    |   | 468,750                       |   |
| Evan C. McKeown                  |   | 1                     |   | 2        |   | Acquisition    |   | 30,468                        |   |
|                             |   |                  |   |     |   |           |   |                          |   |
| Total                            |   |                  |   |     |   |           |   | 20,186,718                    |   |

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1.               Representsshares issued in connection with the merger of Applied Digital Solutions,Inc.’s Advanced Wireless Group in exchange for shares of Digital AngelCorporation, which was a subsidiary of Applied Digital Solutions, Inc.  No cash was involved in the transaction.

2.               Representsshares issued to minority shareholders of Applied Digital Solutions, Inc.’sAdvanced Wireless Group to effect the merger transaction.  No cash was involved in the transaction.

** **

**Item 3.    DefaultsUpon Senior Securities.**

**       **Not applicable.

 

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**Item 4.    Submissionof Matters to a Vote of Security Holders.**

** **

At a special meeting of the stockholders of MAS heldon March 18, 2002, the following matters were submitted to the stockholders fora vote:

•                    The approval ofan Agreement and Plan of Merger, dated as of November 1, 2002, pursuant towhich Digital Angel Acquisition Co., a Delaware corporation and a wholly-ownedsubsidiary of MAS, would merge with and into Digital Angel Corporation, aDelaware corporation and a wholly-owned subsidiary of Applied Digital Systems,Inc. (3,396,247 shares voted for, 33,935 shares voted against, 14,120 sharesabstained from voting, and no broker non-votes);

•                    Amending MAS’sCertificate of Incorporation to change its name to “Digital Angel Corporation”and to authorize 85,000,000 additional shares of common stock, par value $0.005per share (4,243,419 shares voted for, 40,514 shares voted against, 10,369shares abstained from voting, and no broker non-votes); and

•                    To transactsuch other business as may properly come before the meeting or any adjournmentor postponement of the special meeting (4,246,403 shares voted for, 6,635shares voted against, 20,864 shares abstained from voting, and no brokernon-votes).

 

        The meeting did not involve the election of directors.

** **

**Item 5.    OtherInformation.**

None

 

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**Item 6.                    Exhibits and Reports on Form 8-K.**

** **
|    |   | **(a)           Exhibits**                                                                                                                                                                                                                                                                                  |
|---------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
|    |   | The following exhibits are  hereby incorporated into this Quarterly Report on Form 10-Q by reference to  the reports and schedules identified below filed with the Securities and  Exchange Commission (“Commission”)**:**                                                                                                                          |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 2.1     |   | Agreement and Plan of Merger by and between Applied  Digital Solutions, Inc., Digital Angel Corporation, Medical Advisory Systems,  Inc. and Acquisition Subsidiary, Inc. dated as of November 1, 2001  (incorporated herein by reference to Appendix A to final Proxy Statement filed  by MAS with the Commission on February 14, 2002).                     |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 2.2     |   | First Amendment to  Agreement and Plan of Merger by and among Applied Digital Solutions, Inc.,  Digital Angel Corporation, Medical Advisory Systems, Inc. and Digital Angel  Acquisition Co. dated as of March 26, 2002 (incorporated herein by reference to Exhibit 2.2 to  Current Report on Form 8-K filed by MAS with the Commission on April 11,  2002). |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 3.1     |   | Amended and Restated  Certificate of Incorporation of MAS (incorporated herein by reference to MAS’s  Registration Statement on Form S-18 (No. 2-98314) filed by MAS with the  Commission on June 7, 1985 and MAS’s Annual Report on Form 10-KSB filed by  MAS with the Commission on March 28, 1990).                                              |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 3.2     |   | Bylaws of MAS  (incorporated herein by reference to MAS’s Registration Statement on Form  S-18 (No. 2-98314) filed by MAS with the Commission on June 7, 1985).                                                                                                                                                                                          |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
|    |   | The following exhibits are  filed with this Quarterly Report on Form 10-Q:                                                                                                                                                                                                                                                                                    |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 3.3     |   | Amendment to Certificate  of Incorporation of MAS filed with the Delaware Secretary of State on March  27, 2002.                                                                                                                                                                                                                                              |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 3.4     |   | Amendment to Certificate  of Incorporation of Digital Angel Corporation filed with the Delaware  Secretary of State on May 14, 2002.                                                                                                                                                                                                                          |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 3.5     |   | Amendment to Bylaws of MAS  dated March 27, 2002.                                                                                                                                                                                                                                                                                                             |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 10.1    |   | Employment Agreement dated  as of March 8, 2002 by and between Randolph K. Geissler and the Company.                                                                                                                                                                                                                                                          |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 10.2    |   | Employment Agreement dated  as of April 1, 2002 by and between James P. Santelli and the Company.                                                                                                                                                                                                                                                             |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| 10.3    |   | Amendment to Employment  Agreement dated March 8, 2002 by and between Randolph K. Geissler and the  Company.                                                                                                                                                                                                                                                  |
|    |   |                                                                                                                                                                                                                                                                                                                                                          |
| **(b)** |   | **Reports on Form  8-K**                                                                                                                                                                                                                                                                                                                                      |

**                Thefollowing are the Current Reports on Form 10-Q filed by MAS or the Companyduring the quarter ended March 31, 2002 or during the period from March 31,2002 to the date of this Quarterly Report on Form 10-Q:**
| (i) |   | On April 11,  2002, we filed a Current Report on Form 8-K which disclosed a change in  control, an acquisition of assets, information |
|-----|--------|---------------------------------------------------------------------------------------------------------------------------------------|

 

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|   |   | regarding a  potential change in certifying accountants, and a change in fiscal year.                                      |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                       |
| (ii)   |   | On April 18,  2002, we filed a Current Report on Form 8-K which disclosed changes in our  Board of Directors and Officers. |
|   |   |                                                                                                                       |
| (iii)  |   | On April 25,  2002, we filed a Current Report on Form 8-K which disclosed a change in  certifying accountants.             |

 

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**SIGNATURE**

 

                Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.
|                | Digital  angel corporation  (Registrant) |
|---------------------|------------------------------------------|
|                |                                     |
| Dated: May 20, 2002 | By:                                      | /S/ JAMES P. SANTELLI |
|                |                                     | James P.  Santelli  Vice President — Finance, Chief  Financial Officer |

 

36

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**INDEX TO EXHIBITS**

 

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

 
| 3.3    |   | Amendment to  Certificate of Incorporation of MAS filed with the Delaware Secretary of  State on March 27, 2002.                     |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                 |
| 3.4    |   | Amendment to  Certificate of Incorporation of Digital Angel Corporation filed with the  Delaware Secretary of State on May 14, 2002. |
|   |   |                                                                                                                                 |
| 3.5    |   | Amendment to  Bylaws of MAS dated March 27, 2002.                                                                                    |
|   |   |                                                                                                                                 |
| 10.1   |   | Employment Agreement dated  as of March 8, 2002 by and between Randolph K. Geissler and the Company.                                 |
|   |   |                                                                                                                                 |
| 10.2   |   | Employment Agreement dated  as of April 1, 2002 by and between James P. Santelli and the Company.                                    |
|   |   |                                                                                                                                 |
| 10.3   |   | Amendment to Employment  Agreement dated March 8, 2002 by and between Randolph K. Geissler and the  Company.                         |

 

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