**As filed with the Securities and ExchangeCommission on August 3, 2004**

 

 

**UNITEDSTATESSECURI**TIES AND EXCHANGE COMMISSION

**WASHINGTON, D. C.  20549**

 

# ****

 

**FORM10-Q**

**(Mark One)**

 

**ý****          ****QUARTERLY REPORT PURSUANT TO SECTION13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934.**

 

**For the quarterly period ended June 30, 2004**

 

**or**

 

**o****          ****TRANSITION REPORT PURSUANT TO SECTION13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934.**

 

**For the transition periodfrom         to         **

 

**Commission File Number:  1-15177**

 

**DIGITALANGEL CORPORATION**

(Exact name of registrant as specified in its charter)

 

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

 

Indicate by checkmark whether 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

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule12b-2 ofthe Exchange Act).

Yes  o    No  ý

 

As of the close ofbusiness on July 30, 2004, there were 32,820,511 shares outstanding of theissuer’s $0.005 per share par value common stock.

 

 

----

 

**DIGITAL ANGEL CORPORATION**

 

TABLE OF CONTENTS

 
| **Item**                            | ** ** | **Description**                                                                             | ** ** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|------------|
|                                |       |                                                                                        |
| PART I – FINANCIAL INFORMATION |       |                                                                                        |
|                                |       |                                                                                        |       |       |
| 1.                                  |       | Financial Statements                                                                        |       |       |
| 2.                                  |       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |       |       |
| 3.                                  |       | Quantitative and Qualitative Disclosures  About Market Risk                                 |       |       |
| 4.                                  |       | Controls and Procedures                                                                     |       |       |
|                                |       |                                                                                        |       |       |
| PART II – OTHER INFORMATION    |       |                                                                                        |
|                                |       |                                                                                        |       |       |
| 1.                                  |       | Legal Proceedings                                                                           |       |       |
| 2.                                  |       | Changes in Securities, Use of Proceeds and  Issuer Purchases of Equity Securities           |       |       |
| 4.                                  |       | Submission of Matters to A Vote of Securityholders                                          |       |       |
| 6.                                  |       | Exhibits and Reports on Form 8-K                                                            |       |       |
|                                |       |                                                                                        |       |       |
| SIGNATURE                           |       |                                                                                        |
| CERTIFICATIONS                      |       |                                                                                        |
| EXHIBITS                            |       |                                                                                        |

 

----

 

**PARTI    FINANCIAL INFORMATION**

Item 1.    Financial Statements.

 

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

(Inthousands, except par value)

 
| ** **                                                                                                                                                                              | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **(Unaudited)**    | ** ** | ** **             | ** ** |
| **Assets**                                                                                                                                                                              |       |               |       |                   |       |
| **Current Assets**                                                                                                                                                                      |       |               |       |                   |       |
| Cash                                                                                                                                                                                    |       | **$**              | **670**    |                   | $          | 894 |   |
| Restricted cash                                                                                                                                                                         |       | **777**            |       | 765                    |       |
| Applied Digital common stock                                                                                                                                                            |       | **2,621**          |       | —                 |       |
| Accounts receivable and unbilled  receivables (net of allowance for doubtful accounts of $236 in 2004 and $212  in 2003)                                                                |       | **5,144**          |       | 3,400                  |       |
| Inventories                                                                                                                                                                             |       | **6,269**          |       | 6,543                  |       |
| Deferred costs                                                                                                                                                                          |       | **132**            |       | —                 |       |
| Other current assets                                                                                                                                                                    |       | **1,165**          |       | 785                    |       |
| Net assets from discontinued operations                                                                                                                                                 |       | **26**             |       | 1,251                  |       |
| **Total Current Assets**                                                                                                                                                                |       | **16,804**         |       | 13,638                 |       |
| ** **                                                                                                                                                                              |       | ** **         |       |                   |       |
| **Property And Equipment, net**                                                                                                                                                         |       | **6,198**          |       | 6,528                  |       |
| ** **                                                                                                                                                                              |       | ** **         |       |                   |       |
| **Goodwill and Other Intangible Assets, net**                                                                                                                                           |       | **53,297**         |       | 45,119                 |       |
| ** **                                                                                                                                                                              |       | ** **         |       |                   |       |
| **Other Assets, net**                                                                                                                                                                   |       | **1,097**          |       | 942                    |       |
|                                                                                                                                                                                    |       | ** **         |       |                   |       |
|                                                                                                                                                                                    |       | **$**              | **77,396** |                   | $          | 66,227 |   |
|                                                                                                                                                                                    |       | ** **         |       |                   |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                           |       | ** **         |       |                   |       |
| **Current Liabilities**                                                                                                                                                                 |       | ** **         |       |                   |       |
| Line of credit and current maturities of  long-term debt and notes payable                                                                                                              |       | **$**              | **4,363**  |                   | $          | 5,008 |   |
| Accounts payable                                                                                                                                                                        |       | **4,465**          |       | 5,226                  |       |
| Accrued expenses and other current  liabilities                                                                                                                                         |       | **3,799**          |       | 3,201                  |       |
| Deferred revenue                                                                                                                                                                        |       | **1,505**          |       | 1,144                  |       |
| Due to Applied Digital                                                                                                                                                                  |       | **96**             |       | 347                    |       |
| **Total Current Liabilities**                                                                                                                                                           |       | **14,228**         |       | 14,926                 |       |
| ** **                                                                                                                                                                              |       | ** **         |       |                   |       |
| **Long-Term Debt And Notes Payable**                                                                                                                                                    |       | **1,975**          |       | 2,818                  |       |
| ** **                                                                                                                                                                              |       | ** **         |       |                   |       |
| **Deferred Revenue**                                                                                                                                                                    |       | **599**            |       | —                 |       |
| ** **                                                                                                                                                                              |       | ** **         |       |                   |       |
| **Total Liabilities**                                                                                                                                                                   |       | **16,802**         |       | 17,744                 |       |
|                                                                                                                                                                                    |       | ** **         |       |                   |       |
| **Commitments And Contingencies**                                                                                                                                                       |       | ** **         |       |                   |       |
| ** **                                                                                                                                                                              |       | ** **         |       |                   |       |
| **Minority Interest**                                                                                                                                                                   |       | **3**              |       | —                 |       |
|                                                                                                                                                                                    |       | ** **         |       |                   |       |
| **Stockholders’ Equity (See Note 1)**                                                                                                                                              |       | ** **         |       |                   |       |
| Preferred stock: Authorized 1,000 in 2002,  of $1.75 par value, 100 shares issued and outstanding in 2004 and 0 issued  and outstanding in 2003                                         |       | **175**            |       | —                 |       |
| Common stock: Authorized 95,000 shares, of  $.005 par value;  32,871 shares issued  and 32,821 shares outstanding in 2004 and 28,891 shares issued and 28,841  outstanding in 2003 |       | **164**            |       | 144                    |       |
| Additional paid-in capital                                                                                                                                                              |       | **189,543**        |       | 171,909                |       |
| Accumulated deficit                                                                                                                                                                     |       | **(129,250**       | )          | (123,517               | )          |
| Treasury stock (carried at cost, 50 shares)                                                                                                                                             |       | **(43**            | )          | (43                    | )          |
| Accumulated other comprehensive loss                                                                                                                                                    |       | **2**              |       | (10                    | )          |
| Total Stockholders’ Equity                                                                                                                                                         |       | **60,591**         |       | 48,483                 |       |
|                                                                                                                                                                                    |       | ** **         |       |                   |       |
|                                                                                                                                                                                    |       | **$**              | **77,396** |                   | $          | 66,227 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

1

----

 

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

(In thousands, except per share data)

(Unaudited)

 
| ** **                                                                          | ** ** | **For the Three Months  Ended June 30,** | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                          | ** ** | **2004**                                 | ** ** | **2003**                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                |       |                                     |       |                                   |       |   |   |   |   |
| Product revenue                                                                     |       | **$**                                    | **9,403**  | ** **                             | $          | 7,554 |   | **$** | **19,914** | ** ** | $ | 17,729 |   |
| Service revenue                                                                     |       | **667**                                  | ** ** | 347                                    |       | **927** | ** ** | 826 |   |
| Total net revenue                                                                   |       | **10,070**                               | ** ** | 7,901                                  |       | **20,841** | ** ** | 18,555 |   |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Cost of products sold                                                               |       | **5,479**                                | ** ** | 4,969                                  |       | **11,608** | ** ** | 10,445 |   |
| Cost of services sold                                                               |       | **435**                                  | ** ** | 1                                      |       | **548** | ** ** | 56 |   |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Gross profit                                                                        |       | **4,156**                                | ** ** | 2,931                                  |       | **8,685** | ** ** | 8,054 |   |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Selling, general and administrative  expenses                                       |       | **4,303**                                | ** ** | 3,850                                  |       | **8,727** | ** ** | 7,799 |   |
| Research and development expenses                                                   |       | **850**                                  | ** ** | 1,172                                  |       | **1,519** | ** ** | 2,083 |   |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Operating loss                                                                      |       | **(997**                                 | **)**      | (2,091                                 | )          | **(1,561** | **)** | (1,828 | ) |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Interest income                                                                     |       | **8**                                    | ** ** | —                                 |       | **16** | ** ** | — |   |
| Interest expense                                                                    |       | **(247**                                 | **)**      | (154                                   | )          | **(503** | **)** | (254 | ) |
| Realized and unrealized losses on Applied  Digital common stock                     |       | **(26**                                  | **)**      | —                                 |       | **(2,612** | **)** | — |   |
| Other income                                                                        |       | **20**                                   | ** ** | 39                                     |       | **58** | ** ** | 78 |   |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Loss before minority interest share of  losses (income) and discontinued operations |       | **(1,242**                               | **)**      | (2,206                                 | )          | **(4,602** | **)** | (2,004 | ) |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Minority interest share of losses (income)                                          |       | **3**                                    | ** ** | 77                                     |       | **(3** | **)** | 110 |   |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Net loss from continuing operations                                                 |       | **(1,239**                               | **)**      | (2,129                                 | )          | **(4,605** | **)** | (1,894 | ) |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Loss from discontinued operations                                                   |       | **(750**                                 | **)**      | (248                                   | )          | **(1,128** | **)** | (373 | ) |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Net loss                                                                            |       | **$**                                    | **(1,989** | **)**                                  | $          | (2,377 | ) | **$** | **(5,733** | **)** | $ | (2,267 | ) |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Loss per common share-basic and diluted:                                            |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Loss from continuing operations                                                     |       | **(0.04**                                | **)**      | (0.08                                  | )          | **(0.15** | **)** | (0.07 | ) |
| Loss from discontinued operations                                                   |       | **(0.02**                                | **)**      | (0.01                                  | )          | **(0.03** | **)** | (0.01 | ) |
| Net loss per common share –basic and  diluted                                  |       | **$**                                    | **(0.06**  | **)**                                  | $          | (0.09 | ) | **$** | **(0.18** | **)** | $ | (0.08 | ) |
|                                                                                |       | ** **                               | ** ** |                                   |       | ** ** | ** ** |   |   |
| Weighted average number of common shares  outstanding - basic and diluted           |       | **32,691**                               | ** ** | 26,856                                 |       | **31,604** | ** ** | 26,760 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

2

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’EQUITY**

**For The Six Months Ended June 30, 2004**

(In Thousands)

(Unaudited)

 
| ** **                                            | ** ** | ** **          | ** ** | ** **       | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | ** **        | ** ** | ** **             | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------|------------|-----------------|------------|----------------|------------|-------------------|------------|------------------------|------------|-----------------|------------|------------|------------|
| ** **                                            | ** ** | ** **          | ** ** | ** **       | ** ** | ** **  | ** ** | ** **      | ** ** | **Additional** | ** ** | ** **        | ** ** | ** **             | ** ** | **Other**       | ** ** | **Total**  | ** ** |
| ** **                                            | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Treasury**   | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                            | ** ** | **Number**          | ** ** | **Amount**       | ** ** | **Number**  | ** ** | **Amount**      | ** ** | **Capital**    | ** ** | **Deficit**       | ** ** | **Stock**              | ** ** | **Loss**        | ** ** | **Equity** | ** ** |
| ** **                                            | ** ** | ** **          | ** ** | ** **       | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | ** **        | ** ** | ** **             | ** ** | ** **      | ** ** | ** ** | ** ** |
| **Balance — December 31, 2003**                  |       | —              |       | $                | —     |        | 28,891     |            | $          | 144            |       | $                 | 171,909    |                   | $          | (123,517        | )          | $          | (43        | ) | $ | (10 | ) | $ | 48,483 |   |
| Net loss                                              |       | —              |       | —           |       | —      |       | —          |       | —         |       | (5,733            | )          | —                 |       | —          |       | (5,733     | )          |
| Comprehensive loss —Foreign currency translation |       |                |       |             |       | —      |       | —          |       | —         |       | —            |       | —                 |       | 12              |       | 12         |       |
| Total comprehensive income (loss)                     |       | —              |       | —           |       | —      |       | —          |       | —         |       | (5,733            | )          | —                 |       | 12              |       | (5,721     | )          |
| Merger consideration-OuterLink Corporation            |       | 100                 |       | 175              |       | —      |       | —          |       | 8,125          |       | —            |       | —                 |       | —          |       | 8,300      |       |
| Issuance of common stock to Applied Digital           |       | —              |       | —           |       | 3,000       |       | 15              |       | 7,905          |       | —            |       | —                 |       | —          |       | 7,920      |       |
| Conversion of debt into stock                         |       | —              |       |             |       | 250         |       | 1               |       | 582            |       | —            |       | —                 |       | —          |       | 583        |       |
| Shares cancelled on settlement with vendor            |       | —              |       | —           |       | (23         | )          | —          |       | —         |       | —            |       | —                 |       | —          |       | —     |       |
| Issuance of stock for services                        |       | —              |       | —           |       | 10          |       | —          |       | 31             |       | —            |       | —                 |       | —          |       | 31         |       |
| Exercise of stock options                             |       | —              |       | —           |       | 743         |       | 4               |       | 991            |       | —            |       | —                 |       | —          |       | 995        |       |
|                                                  |       |                |       |             |       |        |       |            |       |           |       |              |       |                   |       |            |       |       |       |
| **Balance — June 30, 2004**                      |       | 100                 |       | $                | 175        |        | 32,871     |            | $          | 164            |       | $                 | 189,543    |                   | $          | (129,250        | )          | $          | (43        | ) | $ | 2 |   | $ | 60,591 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

3

----

 

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

(In thousands)

(Unaudited)

 
| ** **                                                                      | ** ** | **For the Six Months  Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                      | ** ** | **2004**                               | ** ** | **2003** | ** ** |
| **Cash Flows From Operating Activities**                                        |       |                                   |       |   |   |
| Net loss from continuing operations                                             | ** ** | **$**                                  | **(4,605** | **)** | $ | (1,894 | ) |
|                                                                            |       |                                   | ** ** |   |   |
| Adjustments to reconcile net loss to net  cash used in operating activities:    |       |                                   | ** ** |   |   |
| Loss from discontinued operations                                               | ** ** | **(1,128**                             | **)**      | (373 | ) |
| Equity-based compensation                                                       | ** ** | **31**                                 | ** ** | 25 |   |
| Amortization of debt discount and deferred  financing costs                     |       | **124**                                | ** ** | 19 |   |
| Depreciation and amortization                                                   | ** ** | **1,157**                              | ** ** | 869 |   |
| Minority interest                                                               | ** ** | **3**                                  | ** ** | (110 | ) |
| Loss on Applied Digital common stock                                            |       | **2,612**                              | ** ** | — |   |
| Loss on disposal of equipment                                                   | ** ** | **39**                                 | ** ** | 16 |   |
| Change in assets and liabilities:                                               |       |                                   | ** ** |   |   |
| Increase in restricted cash                                                     | ** ** | **(74**                                | **)**      | — |   |
| Increase in accounts receivable                                                 | ** ** | **(1,169**                             | **)**      | (1,348 | ) |
| Decrease (increase) in inventories                                              | ** ** | **542**                                | ** ** | (1,728 | ) |
| Increase in deferred costs                                                      | ** ** | **(296**                               | **)**      | — |   |
| Increase in other current assets                                                | ** ** | **(259**                               | **)**      | (859 | ) |
| Decrease in due to Applied Digital                                              | ** ** | **(250**                               | **)**      | (47 | ) |
| (Decrease) increase in accounts payable,  accrued expenses and deferred revenue | ** ** | **(113**                               | **)**      | 3,017 |   |
| Net cash provided by  discontinued operations                                   | ** ** | **379**                                | ** ** | 120 |   |
| **Net Cash Used In Operating Activities**                                       | ** ** | **(3,007**                             | **)**      | (2,293 | ) |
|                                                                            |       |                                   | ** ** |   |   |
| **Cash Flows From Investing Activities**                                        |       |                                   | ** ** |   |   |
| Proceeds from sale of Applied Digital  common stock                             | ** ** | **2,687**                              | ** ** | — |   |
| Decrease in other assets                                                        | ** ** | **18**                                 | ** ** | — |   |
| Payments for property and equipment                                             | ** ** | **(235**                               | **)**      | (507 | ) |
| Cash acquired through acquisition, net of  acquisition costs                    |       | **(20**                                | **)**      | — |   |
| Net cash provided by (used in) discontinued  operations                         |       | **383**                                | ** ** | (16 | ) |
| **Net Cash Provided By (Used In) Investing  Activities**                        | ** ** | **2,833**                              | ** ** | (523 | ) |
|                                                                            |       |                                   | ** ** |   |   |
| **Cash Flows From Financing Activities**                                        |       |                                   | ** ** |   |   |
| Amounts borrowed on line of credit                                              | ** ** | **18,837**                             | ** ** | 17,285 |   |
| Amounts paid on line of credit                                                  | ** ** | **(19,510**                            | **)**      | (14,876 | ) |
| Payments on notes payable and long-term  debt                                   | ** ** | **(355**                               | **)**      | (20 | ) |
| Exercise of stock options                                                       | ** ** | **995**                                | ** ** | 231 |   |
| Payments for financing costs                                                    | ** ** | **(20**                                | **)**      | — |   |
| Net cash used in discontinued operations                                        | ** ** | —                                 | ** ** | (18 | ) |
| **Net Cash (Used In) Provided By Financing  Activities**                        | ** ** | **(53**                                | **)**      | 2,602 |   |
|                                                                            |       |                                   | ** ** |   |   |
| **Effect  of Exchange Rate Changes on Cash**                                    |       | **3**                                  | ** ** | — |   |
|                                                                            |       |                                   | ** ** |   |   |
| **Net Decrease In Cash**                                                        | ** ** | **(224**                               | **)**      | (214 | ) |
|                                                                            |       |                                   | ** ** |   |   |
| **Cash - Beginning Of Period**                                                  | ** ** | **894**                                | ** ** | 214 |   |
|                                                                            |       |                                   | ** ** |   |   |
| **Cash - End Of Period**                                                        | ** ** | **$**                                  | **670**    | ** ** | $ | — |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

4

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**DIGITAL ANGEL CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(Dollars in thousands)**

**(Unaudited)**

 

**1.**             Basis of Presentation

** **

On March 27, 2002,Digital Angel Acquisition Co. (“Acquisition”), then a wholly-owned subsidiaryof Medical Advisory Systems, Inc. (“MAS”), merged with and into Digital AngelCorporation, which was then a 93% owned subsidiary of Applied Digital. In themerger, the corporate existence of Acquisition ceased, Digital AngelCorporation became a wholly-owned subsidiary of MAS and was renamed DigitalAngel Technology Corporation (“DATC”), and MAS was renamed “Digital AngelCorporation.” In connection with the merger transaction, Applied Digitalcontributed to MAS all of its stock in Timely Technology Corp., a wholly-ownedsubsidiary, and Signature Industries, Limited, an 85% owned subsidiary. Thesetwo subsidiaries, along with DATC, comprised the Advanced Wireless Group(“AWG”). As a result of this contribution by Applied Digital, Timely TechnologyCorp. became a wholly-owned subsidiary of the Company and Signature Industries,Limited became an 85% subsidiary. Prior to the merger with DATC, AppliedDigital owned 850,000 shares of MAS stock, representing approximately 16.3% ofthe outstanding stock of MAS. (Unless the context otherwise requires, the term“Company” means Digital Angel Corporation and its subsidiaries). In the merger,the shares of DATC owned by Applied Digital were converted into a total of18,750,000 shares of MAS common stock. As a result of the merger, AppliedDigital owned 19,600,000 shares or 77.15% of the Company’s common stock. Themerger was treated as a reverse acquisition for accounting purposes, with AWGtreated as the accounting acquirer.

 

The accompanyingunaudited condensed consolidated financial statements of Digital AngelCorporation and subsidiaries as of June 30, 2004 and for the three and sixmonth periods ended June 30, 2004 and 2003 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 (including normal recurring adjustments) considered necessaryto present fairly the financial statements have been made.

 

The consolidatedstatements of operations for the three and six months ended June 30, 2004 and2003 are not necessarily indicative of the results that may be expected for theentire year.  These statements should beread in conjunction with the Digital Angel Corporation’s audited consolidatedfinancial statements and related notes thereto for the year ended December 31,2003 which are included in the Company’s Annual Report on Form 10-K.

 

Certain items in thecondensed consolidated financial statements for the 2003 periods have beenreclassified for comparative purposes.

 

TheCompany develops and deploys sensor and communications technologies that enablerapid and accurate identification, location tracking, and condition monitoringof high-value assets.  Prior toJanuary 22, 2004, the Company operated in four segments: AnimalApplications, Wireless and Monitoring, GPS and Radio Communications and MedicalSystems. With the acquisition of OuterLink Corporation in January 2004,the Company reorganized into three segments: Animal Applications, GPS and RadioCommunications and Medical Systems.  TheGPS and Radio Communications segment, the Wireless and Monitoring segment andthe OuterLink Corporation business, which was acquired on January 22,2004, were combined to form the new GPS and Radio Communications segment.  On April 19, 2004, Digital AngelCorporation sold certain assets of its Medical Systems segment’s medicalservices business.  Assets sold includeall of the tangible and intangible intellectual property developed for theoperation of the Medical Systems segment’s medical services business,pharmaceutical supplies and other inventory items, customer and suppliercontracts, computer software licenses, internet website and domain name andmailing lists and did not include the land and building used by thisoperation.  The Company sold the MedicalSystems segment’s land and buildings in a separate transaction on July 30, 2004for $1.5 million.  Net cash received on thesale, after paying off the related building mortgage, was approximately $0.4million.

 

*AnimalApplications—*develops, manufactures, and marketsa broad line of electronic and visual identification devices for the companionanimal, livestock, laboratory animal, fish and wildlife markets worldwide. Thetracking of cattle and hogs are crucial both for asset management and fordisease control and food safety. The principal technologies employed by AnimalApplications are electronic ear tags and implantable microchips that use radiofrequency transmission.

 

*GPS and RadioCommunications*-consists of the design,manufacture and support of GPS enabled equipment. Applications for thesegment’s products include location tracking and message monitoring ofvehicles, aircraft and people in remote locations through systems thatintegrate GPS and geosynchronous satellite communications and GPS enabledequipment and intelligent communications products and services for telemetry,mobile data and radio communications applications serving commercial andmilitary markets. Technology development in this segment includes theintegration and miniaturization into marketable products of

 

5

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three technologies: wireless communications (such as cellular), sensors(including bio-sensors) and position location technology (including globalpositioning systems (GPS) and other systems).

 

**2.****            ****Principles of Consolidation**

 

TheJune 30, 2004 and 2003 condensed consolidated financial statements include theaccounts of the Company and its wholly-owned and majority-owned subsidiaries(OuterLink Corporation from the date of acquisition on January 22, 2004).  All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

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

 

TheCompany, except for its subsidiary OuterLink Corporation, recognizes productrevenue at the time product is shipped and title has transferred, provided thata purchase order has been received or a contract has been executed, there areno uncertainties regarding customer acceptance, the sales price is fixed anddeterminable and collectibility is deemed probable. If uncertainties regardingcustomer acceptance exists, revenue is recognized when such uncertainties areresolved. There are no significant post-contract support obligations at thetime of revenue recognition. Digital Angel Corporation’s accounting policyregarding vendor and post contract support obligations is based on the terms ofthe customers’ contracts, billable upon occurrence of the post-sale support.Costs of products sold and services provided are recorded as the relatedrevenue is recognized. Digital Angel Corporation offers a warranty on itsproducts.  For non-fixed fee jobs,revenue is recognized based on the actual direct labor hours in the job multipliedby the standard billing rate and adjusted to net realizable value, ifnecessary. Revenues from contracts that provide services are recognized ratablyover the term of the contract. Fixed fee revenues from contracts for servicesare recorded when earned and exclude reimbursable costs. Reimbursable costsincurred in performing such services are presented on a net basis and includetransportation medical and communication costs. Other revenue is recognized atthe time service or goods are provided. It is the Company’s policy to record contract losses in their entiretyin the period in which such losses are foreseeable.

 

The Company’s subsidiary, OuterLinkCorporation, earns revenue from messaging services, which generally provide forservice on a month-to month basis and from the sale of related products tocustomers (communication terminals and software).  OuterLink Corporation’s messaging service isonly available through use of its products, such products have no alternativeuse.  Accordingly, service revenue isrecognized as the services are performed. OuterLink Corporation’s product revenue, for which title and risk ofloss transfers to the customer on shipment, is deferred upon shipment and isrecognized ratable over the estimated customer service period, currently 30months.

 

**4.**             Stock-BasedCompensation

** **

The Company applies APBOpinion No. 25 and related Interpretations in accounting for all its stockoption plans.  Accordingly, nocompensation cost has been recognized under these stock option plans.  The Company has adopted the disclosure-onlyprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and SFASNo. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,”which was released in December 2002 as an amendment to SFAS No. 123.  The following table illustrates the effect onnet loss and loss per share if the fair value based method had been applied toall awards (in thousands, except per share data):

 
| ** **                                                                                                          | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                          | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Reported net loss                                                                                                   |       | **$**                           | **(1,989** | **)**                         | $          | (2,377 | ) | **(5,733** | **)** | $ | (2,267 | ) |
| Stock-based employee compensation expense  in reported net loss, net of related tax effects                         |       | **31**                          | ** ** | (61                           | )          | **31** | ** ** | 25 |   |
| Stock-based employee compensation expense  determined under the fair value based method, net of related tax effects |       | **(2,111**                      | **)**      | (1,695                        | )          | **(3,611** | **)** | (3,358 | ) |
| Pro forma net loss                                                                                                  |       | **$**                           | **(4,069** | **)**                         | $          | (4,133 | ) | **$** | **(9,313** | **)** | $ | (5,600 | ) |
|                                                                                                                |       | ** **                      | ** ** |                          |       | ** ** | ** ** |   |   |
| Loss per share -basic and diluted                                                                                   |       | ** **                      | ** ** |                          |       | ** ** | ** ** |   |   |
| As reported                                                                                                         |       | **$**                           | **(0.06**  | **)**                         | $          | (0.09 | ) | **$** | **(0.18** | **)** | $ | (0.08 | ) |
| Pro forma                                                                                                           |       | **$**                           | **(0.12**  | **)**                         | $          | (0.15 | ) | **$** | **(0.30** | **)** | $ | (0.21 | ) |

 

6

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**5.**             Inventory (inthousands)

 
| ** **                            | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------|------------|--------------------|------------|------------------------|------------|
| Raw  materials                        | ** ** | $                  | 2,899      |                   | $          | 1,976 | ** ** |
| Work in process                       |       | 143                |       | 94                     |       |
| Finished goods                        |       | 5,342              |       | 6,294                  |       |
|                                  |       | 8,384              |       | 8,364                  |       |
| Allowance for excess and obsolescence |       | (2,115             | )          | (1,821                 | )          |
| Net inventory                         |       | $                  | 6,269      |                   | $          | 6,543 |   |

 

**6.****            ****Stock Exchange with Applied Digital**

 

On March 1,2004, the Company issued 3,000,000 shares of its common stock to AppliedDigital pursuant to the Stock Purchase Agreement (“Stock Purchase Agreement”)with Applied Digital dated August 14, 2003.   The Stock Purchase Agreement provided forApplied Digital to purchase 3,000,000 shares of the Company’s common stock at aprice of $2.64 per share and a warrant (the “Applied Digital Warrant”) topurchase up to 1,000,000 shares of the Company’s common stock, which isexercisable for five years beginning February 1, 2004, at a price pershare of $3.74 payable in cash or shares of common stock of Applied Digital.  The consideration for the sale of theCompany’s 3,000,000 shares and the warrant was 1,980,000 shares of AppliedDigital common stock.  The Companyexpects to sell the stock of Applied Digital to generate additional funds.  As of June 30, 2004, the Company has sold910,000 shares of Applied Digital common stock. The Company has accounted for the Applied Digital stock as a tradingsecurity under SFAS 115, “Accounting for Certain Investments in Debt and EquitySecurities”.   In the six months ended June30, 2004 the Company recorded realized losses of $955,000 on the 910,000 sharesof Applied Digital common stock sold and an unrealized loss of $1,657,000 onthe remaining 1,070,000 shares held by the Company.  Fair value of the Applied Digital common stockis determined by quoted values reported on NASDAQ.  

 

**7.**             Discontinued Operations

** **

In April 2004, our Boardof Directors approved a plan to sell our Medical Systems segment. The MedicalSystems segment represented the business operations of Medical AdvisorySystems, Inc, which we acquired on March 27, 2002.  The Medical Systems segment was one of ourreporting units in accordance with SFAS 142, “Goodwill and Other IntangibleAssets”.  Accordingly, the financialcondition, results of operations and cash flows of our Medical Systems segmenthave been reported as discontinued operations for all periods presented. Thefollowing discloses the operating losses from discontinued operations for thethree and six-months ended June 30, 2004 and 2003, consisting of lossesattributable to the Medical Systems segment:

 
| ** **                                    | ** ** | **Three-Months  Ended June 30,** | ** ** | **Six-Months  Ended June 30,** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                    | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Product revenue                               |       | $                                | 40         |                           | $          | 222 |   | $ | 204 |   | $ | 587 |   |
| Service revenue                               |       | 32                               |       | 237                            |       | 223 |   | 616 |   |
| Total revenue                                 |       | 72                               |       | 459                            |       | 427 |   | 1,203 |   |
| Cost of products sold                         |       | 20                               |       | 95                             |       | 87 |   | 258 |   |
| Cost of services sold                         |       | 82                               |       | 252                            |       | 317 |   | 593 |   |
| Total cost of products and services sold      |       | 102                              |       | 347                            |       | 404 |   | 851 |   |
| Gross profit                                  |       | (30                              | )          | 112                            |       | 23 |   | 352 |   |
| Selling, general and administrative  expenses |       | 648                              |       | 325                            |       | 1,046 |   | 656 |   |
| Other income and expense                      |       | 72                               |       | 35                             |       | 105 |   | 69 |   |
| Loss from discontinued operations             |       | $                                | (750       | )                              | $          | (248 | ) | $ | (1,128 | ) | $ | (373 | ) |

 

The above results do notinclude any allocated or common overhead expenses.  We have not provided a benefit for incometaxes on the losses attributable to the Medical Systems division.  We do not anticipate the Medical Systemsdivision incurring additional losses in the future.  However, in accordance with SFAS 144,“Accounting for the Impairment or Disposal of Long-Lived Assets”,  any additional operating losses or changes inthe values of assets or liabilities will be reflected in our financialcondition and results of operations as incurred.

 

The net assetsof discontinued operations as of June 30, 2004 and December 31, 2003, werecomprised of the following:

 

7

----

 
| ** **                                              | ** ** | **June 30, 2004**  | ** ** | **December 31, 2003** | ** ** |
|---------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                              | ** ** | **(in thousands)** | ** ** |
| Assets                                                  |       |               |       |                  |       |
| Cash                                                    |       | $                  | —     |                  | $          | — |   |
| Accounts receivable, net                                |       | 66                 |       | 453                   |       |
| Inventory                                               |       | —             |       | 46                    |       |
| Other current assets                                    |       | 1                  |       | 43                    |       |
| Property and equipment, net                             |       | 1,050              |       | 1,137                 |       |
| Goodwill and other intangible assets, net               |       | —             |       | 489                   |       |
| Other assets                                            |       | 144                |       | 163                   |       |
| Total Assets                                            |       | $                  | 1,261      |                  | $          | 2,331 |   |
|                                                    |       |               |       |                  |       |
| Current Liabilities:                                    |       |               |       |                  |       |
| Notes payable and current maturities of  long-term debt |       | $                  | (910       | )                     | $          | (910 | ) |
| Accounts payable                                        |       | (27                | )          | (71                   | )          |
| Accrued expenses and deferred revenue                   |       | (298               | )          | (99                   | )          |
| Total Liabilities                                       |       | $                  | (1,235     | )                     | $          | (1,080 | ) |
|                                                    |       |               |       |                  |       |
| Net Assets                                              |       | $                  | 26         |                  | $          | 1,251 |   |

 

**8.****             Loss Per Share**

 

The following is a reconciliationof the numerator and denominator of basic and diluted loss per share (inthousands, except per share data):

 
| ** **                                  | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                  | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Numerator:**                              |       |                             | ** ** |                           |       |   |   |   |   |
| Net loss                                    | ** ** | **$**                            | **(1,989** | **)**                          | $          | (2,377 | ) | **$** | **(5,733** | **)** | $ | (2,267 | ) |
| **Denominator:**                            | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Denominator for basic loss per  share -     |       |                             |       |                           |       | ** ** | ** ** |   |   |
| Weighted-average shares                     | ** ** | **32,691**                       |       | 26,856                         | ** ** | **31,604** | ** ** | 26,760 |   |
| Denominator for diluted loss per share (1)- | ** ** | **32,691**                       |       | 26,856                         | ** ** | **31,604** | ** ** | 26,760 |   |
| **Basic and diluted loss  per share**       | ** ** | **$**                            | **(0.06**  | **)**                          | **$**      | **(0.09** | **)** | **$** | **(0.18** | **)** | **$** | **(0.08** | **)** |

 

----

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

 

**9.**             Segment Information

** **

The Company is an advanced technology company in the field of rapid andaccurate identification, location tracking, and condition monitoring ofhigh-value assets.  Prior to January 22,2004, the Company operated in four segments: Animal Applications, Wireless andMonitoring, GPS and Radio Communications and Medical Systems.  With the acquisition of OuterLink Corporationin January 2004, the Company reorganized into three segments: AnimalApplication, GPS and Radio Communications and Medical Systems.  The GPS and Radio Communications segment, theWireless and Monitoring segment and the OuterLink Corporation business, whichwas acquired on January 22, 2004, were combined to form the new GPS and RadioCommunications segment.  Prior periodsegment information has been restated to reflect the Company’s current segmentstructure. On April 19, 2004, Digital Angel Corporation sold certain assets ofits Medical Systems segment’s medical services business.  Assets sold include all of the tangible andintangible intellectual property developed for the operation of the MedicalSystems segment’s medical services business, pharmaceutical supplies and otherinventory items, customer and supplier contracts, computer software licenses,internet website and domain name and mailing lists and did not include the landand building used by this operation.  TheCompany sold the Medical Systems segment’s land and buildings in a separatetransaction on July 30, 2004 for $1.5 million. Net cash received on the sale, after paying off the related buildingmortgage, was approximately $0.4 million.

 

8

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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 June 30, 2004 (in thousands):

 

 
| ** **                                                                                   | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------------|------------|------------------------------|------------|------------------|------------|
| ** **                                                                                   | ** ** | ** **               | ** ** | ** **                        | ** ** | ** **                   | ** ** | ** **       | ** ** |
| Net revenue from external customers:                                                         |       |                     |       |                              |       |                         |       |             |       |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Product                                                                                      |       | $                        | 5,779      |                              | $          | 3,624                        |       | $                | —     |   | $ | 9,403 |   |
| Service                                                                                      |       | 334                      |       | 333                               |       | —                       |       | 667              |       |
| Total  revenue                                                                               |       | $                        | 6,113      |                              | $          | 3,957                        |       | $                | —     |   | $ | 10,070 |   |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Income (loss) before minority interest  share of losses (income) and discontinued operations |       | $                        | (439       | )                                 | $          | (803                         | )          | $                | —     |   | $ | (1,242 | ) |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Total assets                                                                                 |       | $                        | 60,303     |                              | $          | 17,067                       |       | $                | 26         |   | $ | 77,396 |   |

 

In the three month period endedJune 30, 2004, two customers accounted for approximately 22.9%, and 11.1% ofour Animal Applications revenue.

 

Following is the selectedsegment data as of and for the six months ended June 30, 2004 (in thousands):

 
| ** **                                                                                   | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------------|------------|------------------------------|------------|------------------|------------|
| ** **                                                                                   | ** ** | ** **               | ** ** | ** **                        | ** ** | ** **                   | ** ** | ** **       | ** ** |
| Net revenue from external customers:                                                         |       |                     |       |                              |       |                         |       |             |       |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Product                                                                                      |       | $                        | 12,788     |                              | $          | 7,126                        |       | $                | —     |   | $ | 19,914 |   |
| Service                                                                                      |       | 397                      |       | 530                               |       | —                       |       | 927              |       |
| Total  revenue                                                                               |       | $                        | 13,185     |                              | $          | 7,656                        |       | $                | —     |   | $ | 20,841 |   |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Income (loss) before minority interest  share of losses (income) and discontinued operations |       | $                        | (3,082     | )                                 | $          | (1,520                       | )          | $                | —     |   | $ | (4,602 | ) |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Total assets                                                                                 |       | $                        | 60,303     |                              | $          | 17,067                       |       | $                | 26         |   | $ | 77,396 |   |

 

 

In the six month period endedJune 30, 2004, two customers accounted for approximately 18.2%, and 12.0% ofour Animal Applications revenue.

 

Following is the selectedsegment data as of and for the three months ended June 30, 2003 (in thousands):

 

 
| ** **                                                                                   | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------------|------------|------------------------------|------------|------------------|------------|
| ** **                                                                                   | ** ** | ** **               | ** ** | ** **                        | ** ** | ** **                   | ** ** | ** **       | ** ** |
| Net revenue from external customers:                                                         |       |                     |       |                              |       |                         |       |             |       |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Product                                                                                      |       | $                        | 4,846      |                              | $          | 2,708                        |       | $                | —     |   | $ | 7,554 |   |
| Service                                                                                      |       | 342                      |       | 5                                 |       | —                       |       | 347              |       |
| Total  revenue                                                                               |       | $                        | 5,188      |                              | $          | 2,713                        |       | $                | —     |   | $ | 7,901 |   |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Income (loss) before minority interest  share of losses (income) and discontinued operations |       | $                        | (938       | )                                 | $          | (1,268                       | )          | $                | —     |   | $ | (2,206 | ) |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Total assets                                                                                 |       | $                        | 57,872     |                              | $          | 7,574                        |       | $                | 4,199      |   | $ | 69,645 |   |

 

9

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In the three month period endedJune 30, 2003, two customers accounted for approximately 21.8% and 16.7% of ourAnimal Applications revenue.

 

Following is the selectedsegment data as of and for the six months ended June 30, 2003 (in thousands):

 
| ** **                                                                                   | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------------|------------|------------------------------|------------|------------------|------------|
| ** **                                                                                   | ** ** | ** **               | ** ** | ** **                        | ** ** | ** **                   | ** ** | ** **       | ** ** |
| Net revenue from external customers:                                                         |       |                     |       |                              |       |                         |       |             |       |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Product                                                                                      |       | $                        | 12,322     |                              | $          | 5,407                        |       | $                | —     |   | $ | 17,729 |   |
| Service                                                                                      |       | 667                      |       | 159                               |       | —                       |       | 826              |       |
| Total  revenue                                                                               |       | $                        | 12,989     |                              | $          | 5,566                        |       | $                | —     |   | $ | 18,555 |   |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Income (loss) before minority interest  share of losses (income) and discontinued operations |       | $                        | 521        |                              | $          | (2,525                       | )          | $                | —     |   | $ | (2,004 | ) |
|                                                                                         |       |                     |       |                              |       |                         |       |             |       |
| Total assets                                                                                 |       | $                        | 57,872     |                              | $          | 7,574                        |       | $                | 4,199      |   | $ | 69,645 |   |

 

In the six month period endedJune 30, 2003, four customers accounted for approximately 17.1%, 11.6%, 10.9%,and 10.3% of our Animal Applications revenue.

 

**10.****         ****Acquisition**

 

Thefollowing describes the acquisition by the Company (in thousands):

 
| **Company  Acquired**  | ** ** | **Date  Acquired** | ** ** | **Acquisition  Price** | ** ** | **Value of  Series A  Preferred  Stock** | ** ** | **Series A  Preferred  Shares  Issued** | ** ** | **Goodwill  and  Other  Intangibles  Acquired** | ** ** | **Other Net  Assets and  Liabilities** | ** ** | **Business  Description** | ** ** |
|------------------------|------------|--------------------|------------|------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------------------|------------|----------------------------------------|------------|---------------------------|------------|
| OuterLink  Corporation |       | 1/22/04            |       | $                      | 8,501      |                                     | $          | 8,300                                   |       | 100                                             |       | $                                      | 8,522      |                      | $          | (21 | ) | Provider of real-time, satellite-based  automated tracking, wireless data transfer and two-way messaging with large  fleets of vehicles. |   |
|                        |            |                    |            |                        |            |                                          |            |                                         |            |                                                 |            |                                        |            |                           |            |  |  |  |  |

 

OnJanuary 22, 2004, the Company acquired OuterLink Corporation.  OuterLink Corporation became a wholly-owned subsidiaryof Digital Angel Corporation.  Theacquisition was accounted for under the purchase method of accounting.   The excess of purchase price over the fairvalue of the assets and liabilities of OuterLink Corporation was recorded asgoodwill of $3.8 million and intangible assets of $4.7 million.  

 

Thecost of the acquisition consisted of 100,000 shares of Series A preferred stockvalued at $8.3 million and acquisition costs of $0.2 million.  The Series A preferred stock is convertibleinto four million shares of the Company’s common stock when the volume weightedaverage price of the Company’s common stock equals or exceeds $4.00 per sharefor ten consecutive trading days.

 

10

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The valuation of the stock is primarily based on historical tradinghistory and stock prices of the Company’s common stock and a marketabilitydiscount of 30%.  The cost of theacquisition consists of legal and accounting related services that were directcosts of acquiring these assets.

 

Inconsidering the benefits the OuterLink Corporation acquisition, the managementof Digital Angel Corporation recognized the strategic complement of OuterLinkCorporation’s technologies and customer base with Digital Angel Corporation’sexisting animal applications and military GPS business lines.  This complement provides for a strongplatform for further development of Digital Angel Corporation’s capabilities inthe area of high-value asset identification, tracking and condition monitoring.

 

Theresults of OuterLink Corporation have been included in the consolidatedfinancial statements since the date of acquisition of January 22, 2004.  Unaudited pro forma results of operations forthe three months ended June 30, 2003 and the six months ended June 30, 2004 and2003 are included below.  Such pro formainformation assumes that the above acquisition had occurred as ofJanuary 1, 2004 and 2003, and revenue is presented in accordance with theCompany’s accounting policies.  Thissummary is not necessarily indicative of what the result of operations of theCompany would have been had it been a combined entity during such periods, nordoes it purport to represent results of operations for any future periods.

 
| ** **                                     | ** ** | ** ** | ** ** | **For the  three-months  ended June 30,** | ** ** |
|------------------------------------------------|------------|------------|------------|-------------------------------------------|------------|
| **(In thousands)**                             | ** ** | ** ** | ** ** | **2003**                                  | ** ** |
| Net revenue                                    |       |       |       | $                                         | 8,235      |   |
| Net loss                                       |       |       |       | $                                         | (3,300     | ) |
| Net loss per  common share - basic and diluted |       |       |       | $                                         | (0.12      | ) |

 
| ** **                                     | ** ** | **For the  six-months ended June 30,** | ** ** |
|------------------------------------------------|------------|----------------------------------------|------------|
| **(In thousands)**                             | ** ** | **2004**                               | ** ** | **2003** | ** ** |
| Net revenue                                    |       | $                                      | 20,928     |   | $ | 19,149 |   |
| Net loss                                       |       | $                                      | (6,436     | ) | $ | (4,281 | ) |
| Net loss per  common share - basic and diluted |       | $                                      | (0.20      | ) | $ | (0.16 | ) |

 

**11.**          Contingencies

** **

*Wurts Litigation*

 

InFebruary 2003, an action was filed in the Middlesex County Superior Courtin the Commonwealth of Massachusetts. The Company’s subsidiary, OuterLink Corporation, as well as asignificant stockholder of OuterLink and a principal of the significantstockholder were named as defendants. The complaint alleged breach of an August 25, 1999 employment contract.  The plaintiff was President and CEO ofOuterLink Corporation from July 1999 through August 2002.  The Complaint sought damages based principally on acontractual severance provision that allegedly provided for four months ofcompensation for every year or fraction thereof served prior to termination.  This matter was settled in July 2004 inconsideration for a cash payment of $250,000.

 

*E-Research Litigation*

 

InJune, 2002, eResearch Technology, Inc. f/k/a Premier Research Worldwide, Ltd.(“ERT”) commenced a proceeding against U.S. Bank National Association (“USBank”), subsequently intervened in by the Company in the New Jersey state courtand subsequently removed to the United States District Court for the Districtof New Jersey.  This suit was commencedto pursue alleged damages of approximately $350,000 due to the Company’s and USBank’s alleged failure to register transfers of restricted Digital Angel sharessold by ERT in May 2002.  This matter wassettled prior to trial without either party paying any amounts to the otherparty. 

 

*Electronic Identification Devices Litigation*

 

InFebruary 2004, Electronic Identification Devices, Ltd. (“EID”) commenced aDeclaratory Judgment Action against the Company in the United States DistrictCourt for the Western District of Texas. This action seeks a declaration of patent non-infringement relating tothe Company’s patented syringe implantable identification transponder.  The lawsuit alleges that EID has developed anew transponder that it believes does not infringe on the Company’spatent.  The lawsuit acknowledges thatthe Company obtained a Judgment of infringement and two contempt orders againstEID based on selling certain systems that infringed the Company’s patent in1997, 1998 and 1999.  On March 10,2004 the Company filed a motion seeking the dismissal of the DeclaratoryJudgment Complaint or, in the alternative, that the action be transferred toMinnesota.  The Court has not yet ruledon the Company’s motion. Given the very early stage of this matter, theultimate outcome of this proceeding cannot be predicted at this time.  The

 

11

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Company is currently unable to determine the potential effect of thislitigation on its consolidated financial position, results of operation or cashflows.

 

*John Fernandez vs. United States of America vs. Medical AdvisorySystems, Inc.*

* *

OnDecember 29, 2003, John Fernandez filed a lawsuit in the Orlando Division ofthe United States District Court for the Middle District of Florida.  The plaintiff filed the lawsuit against theUnites States of America as the operator of the ship on which the plaintiffserved.  He alleged that the UnitedStates had contracted with Medical Advisory Systems to provide medical adviceand that the physician at Medical Advisory Systems had rendered an incorrectlong-distance diagnosis, resulting to injury to the plaintiff.  Mr. Fernandez asserted against the UnitedStates claims of negligence under the Jones Act, unseaworthiness andmaintenance and cure. He alleged damages in excess of $75,000, plus prejudgmentand post-judgment interest at the legal rate and costs and disbursements of theaction.  On April 14, 2004, the UnitedStates served Medical Advisory Systems with a third part complaint in Admiralityin which it alleged that Medical Advisory Systems is liable to it for all orpart of the plaintiff’s claim in that Medical Advisory Systems and/or itsemployee/physician rendering the medical advice was negligent.  In response, on May 12, 2004, MedicalAdvisory Systems filed a motion to dismiss the third party complaint.  Given the very early stage of the lawsuit,the ultimate outcome of this proceeding cannot be predicted at this time.  The Company is currently unable to determinethe potential effect of this litigation on our consolidated financial position,results of operations or cash flows. 

 

**12.****          Supplemental Cash FlowInformation (in thousands)**

 
| ** **                                                 | ** ** | **Six Months  Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Interest paid                                              |       | **$**                               | **281**    |   | $ | 254 |   |
| Non-cash  activity:                                        |       | ** **                          |       |   |   |
| Issuance of  preferred stock for business acquisition      |       | **$**                               | **8,300**  |   | — |   |
| Issuance of  common stock for Applied Digital common stock |       | **7,920**                           |       | — |   |
| Conversion of  debt into common stock                      |       | **583**                             |       | — |   |
|                                                            |            |                                     |            |  |  |  |  |

 

**13.****          Related Party Activity**

 

In 2003,Applied Digital charged the Company for research expenses and directors andofficers insurance.  Amounts due toApplied Digital were offset by receivables due from Applied Digital resultingfrom the Distribution and Licensing Agreement with Verichip Corporation, awholly-owned subsidiary of Applied Digital. At June 30, 2004, these transactions resulted in a net amount due toApplied Digital of $0.1 million. 

 

The Companyhas executed an exclusive eleven year Distribution and Licensing Agreementdated March 4, 2002 with Verichip Corporation (Verichip), a wholly-owned subsidiaryof Applied Digital, covering the manufacturing, purchasing and distribution ofVerichip’s implantable microchip and the maintenance of the Verichip Registryby the Company.  The agreement includes alicense for the use of the Company’s technology in Verichip’s identifiedmarkets.  The Company will be the solemanufacturer and supplier to Verichip. Revenue recognized under the Distribution and Licensing Agreement was$57,000 and $87,000 for the six months ended June 30, 2004 and 2003,respectively.

 

12

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**Item 2.****          Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

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

 

Weconsist of Digital Angel Corporation and its four subsidiaries — Digital AngelTechnology Corporation (“DATC”), Timely Technology Corp., Signature Industries,Limited, and OuterLink Corporation

 

**RESULTSOF OPERATIONS**

 

The followingtable summarizes our results of operations as a percentage of net operatingrevenue for the three and six months ended June 30, 2004 and 2003 and isderived from the accompanying consolidated statements of operations included inthis report.

 
| ** **                                                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                 | ** ** | **%**                            | ** ** | **%**                          | ** ** | **%** | ** ** | **%** | ** ** |
| Product revenue                                                            |       | 93.4                             |       | 95.6                           |       | 95.5 |   | 95.5 |   |
| Service revenue                                                            |       | 6.6                              |       | 4.4                            |       | 4.5 |   | 4.5 |   |
| Total net revenue                                                          |       | 100.0                            |       | 100.0                          |       | 100.0 |   | 100.0 |   |
| Cost of products sold                                                      |       | 54.4                             |       | 62.9                           |       | 55.7 |   | 56.3 |   |
| Cost of services sold                                                      |       | 4.3                              |       | 0.0                            |       | 2.6 |   | 0.3 |   |
| Total cost of products and services sold                                   |       | 58.7                             |       | 62.9                           |       | 58.3 |   | 56.6 |   |
| Gross profit                                                               |       | 41.3                             |       | 37.1                           |       | 41.7 |   | 43.4 |   |
| Selling, general and administrative  expenses                              |       | 42.7                             |       | 48.8                           |       | 41.9 |   | 42.0 |   |
| Research and development expenses                                          |       | 8.4                              |       | 14.8                           |       | 7.3 |   | 11.2 |   |
| Operating loss                                                             |       | (9.8                             | )          | (26.5                          | )          | (7.5 | ) | (9.8 | ) |
| Interest income                                                            |       | 0.1                              |       | 0.0                            |       | 0.1 |   | 0.0 |   |
| Interest expense                                                           |       | (2.5                             | )          | (1.9                           | )          | (2.4 | ) | (1.4 | ) |
| Loss on Applied Digital common stock                                       |       | (0.3                             | )          | 0.0                            |       | (12.6 | ) | 0.0 |   |
| Other income                                                               |       | 0.2                              |       | 0.4                            |       | 0.3 |   | 0.4 |   |
| Loss before minority interest share of  losses and discontinued operations |       | (12.3                            | )          | (28.0                          | )          | (22.1 | ) | (10.8 | ) |
| Minority interest share of losses                                          |       | 0.0                              |       | 1.0                            |       | 0.0 |   | 0.6 |   |
| Net loss from continuing operations                                        |       | (12.3                            | )          | (27.0                          | )          | (22.1 | ) | (10.2 | ) |
| Loss from discontinued operations                                          |       | (7.4                             | )          | (3.1                           | )          | (5.4 | ) | (2.0 | ) |
| Net loss                                                                   |       | (19.7                            | )          | (30.1                          | )          | (27.5 | ) | (12.2 | ) |

 

13

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**ThreeMonths Ended June 30, 2004 Compared to the Three Months Ended June 30, 2003**

 

**Revenue**

 

Revenue for thethree months ended June 30, 2004 increased $2.2 million, or 27.5%, to $ 10.1million when compared to $7.9 million in revenue for the three months endedJune 30, 2003.

 

Revenue for eachof the operating segments was as follows (in thousands):

 

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2004** | ** ** | **Three Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| Animal Applications          |       | $                                      | 6,113      |                                   | $          | 5,188 |   |
| GPS and Radio Communications |       | 3,957                                  |       | 2,713                                  |       |
| Total                        |       | $                                      | 10,070     |                                   | $          | 7,901 |   |

 

The AnimalApplications segment’s revenue increased**$0.9million, or 17.8%, in the three months ended June 30, 2004 compared to thethree month period ended June 30, 2003. The increase is the result of increasedsales to our livestock customers of $0.3 million, fish and wildlife customersof $0.3 million, and companion animal customers of $0.3 million.

 

The GPS and RadioCommunications segment’s revenue increased $1.2 million, or 45.9%, in the threemonths ended June 30, 2004 compared to the three month period ended June 30,2003.  The increase is primarily due toincreased revenues of $0.8 million at our subsidiary, Signature Industries,located in the United Kingdom.   Theincrease in revenue at Signature Industries relates to initial shipments of theG2R pilot locator beacon and increased sales in Signature’s Clifford and Snelldivision.  OuterLink Corporation revenuewas $0.4 million for the three months ended June 30, 2004.  OuterLink Corporation was acquired on January22, 2004 and is not included in our results for the three months ended June 30,2003.  

 

**GrossProfit and Gross Profit Margin**

 

Gross profit forthe three month period ended June 30, 2004 was $4.2 million, an increase**of $1.2 million, or 41.8%, compared to$3.0 million in the three month period ended June 30, 2003. As a percentage ofrevenue, the gross profit margin was 41.3% and 37.1% for the three months endedJune 30, 2004 and 2003, respectively.

 

Gross profit fromoperations for each operating segment was as follows (in thousands):

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2004** | ** ** | **Three Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| Animal Applications          |       | $                                      | 2,328      |                                   | $          | 1,705 |   |
| GPS and Radio Communications |       | 1,828                                  |       | 1,226                                  |       |
| Total                        |       | $                                      | 4,156      |                                   | $          | 2,931 |   |

 

 

Gross profitmargin from operations for each operating segment was:

 

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2004** | ** ** | **Three Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **                   | ** ** | **%**                                  | ** ** | **%**                                  | ** ** |
| Animal Applications          |       | 38.1                                   |       | 32.9                                   |       |
| GPS and Radio Communications |       | 46.2                                   |       | 45.2                                   |       |

 

The AnimalApplications segment’s gross profit increased $0.6 million, or 36.5%, in thethree month period ended June 30, 2004 compared to the three months ended June30, 2003.  The increase is**primarilydue to the increase in sales as mentioned above and lower freight costs in the2004 period. The gross margin percentage increased to 38.1% in the threemonth period ended June 30, 2004 as compared to 32.9% in the three month periodended June 30, 2003.  The gross marginpercentage increase is the primarily the result of lower freight costs and fixed costs remaining constant asrevenue increased. 

 

The GPS andRadio Communications segment’s gross profit increased $0.6 million, or 49.1%,in the three month period ended June 30, 2004 as compared to the three monthperiod ended June 30, 2003.  The GPS andRadio Communications segment’s gross profit is attributable increased grossprofit at our subsidiary Signature Industries of $0.5 million. The gross marginpercentage increased to 46.2% in the three month period ended June 30, 2004 ascompared to 45.2% in the three month period ended June 30, 2003 primarily dueto lower material costs at Signature Industries.  OuterLink Corporation gross profit was $0.1million in the three

 

14

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months ended June 30, 2004.OuterLink Corporation was acquired in January 2004.

 

**Selling,General and Administrative Expenses**

 

Selling, generaland administrative expenses increased $0.5 million, or 11.8%, in the threemonth period ended June 30, 2004 as compared to the three month period endedJune 30, 2003. As a percentage of revenue, selling, general and administrativeexpenses were 42.7% and 48.8% for the three months ended June 30, 2004 and2003, respectively.

 

Selling, generaland administrative expenses for each of the operating segments were as follows(dollars in thousands):

 

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2004** | ** ** | **Three Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| Animal Applications          |       | $                                      | 1,909      |                                   | $          | 1,844 |   |
| GPS and Radio Communications |       | 2,394                                  |       | 2,006                                  |       |
| Total                        |       | $                                      | 4,303      |                                   | $          | 3,850 |   |

 

 

Selling, generaland administrative expenses as a percentage of revenue for each of theoperating segments were:

 

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2004** | ** ** | **Three Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **                   | ** ** | **%**                                  | ** ** | **%**                                  | ** ** |
| Animal Applications          |       | 31.2                                   |       | 35.5                                   |       |
| GPS and Radio Communications |       | 60.5                                   |       | 73.9                                   |       |

 

The AnimalApplications segment’s selling, general and administrative expenses increased $0.07million in the three month period ended June 30, 2004 as compared to the threemonth period ended June 30, 2003 and as a percentage of revenue decreased to31.2% from 35.5% in the same respective period. The increase in selling, general and administrative expense is primarilydue to additional consulting expenses associated with the preparation of the510K application for FDA approval of the Verichip product in the prior period. 

 

The GPS and RadioCommunications segment’s selling, general and administrative expenses increased $0.4 million in the threemonth period ended June 30, 2004 as compared to the three month period endedJune 30, 2003.  The increase of $0.4million results from increased expenses of $0.2 million at SignatureIndustries, $0.5 million of expense at OuterLink, which was acquired in January2004, offset by a decrease of $0.3 million related to the scaleback of theDigital Angel TM technology development. As a percentage of revenue,selling, general and administrative expenses decreased to 60.5% in the threemonth period ended June 30, 2004 from 73.9% in the three month period endedJune 30, 2003. 

 

**Researchand Development Expense**

 

Research anddevelopment expense was $0.9 million in the three month period ended June 30,2004, a decrease of $0.3 million, or 27.5%, from $1.2 million for the threemonth period ended June 30, 2003.  As apercentage of revenue, research and development expense was 8.4% and 14.8% forthe three months ended June 30, 2004 and 2003, respectively.  

 

Research anddevelopment expense for each of the operating segments was as follows (inthousands):

 
| ** **                   | ** ** | **Three Months  Ended June 30,  2004** | ** ** | **Three Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| Animal Applications          |       | $                                      | 653        |                                   | $          | 691 |   |
| GPS and Radio Communications |       | 197                                    |       | 481                                    |       |
| Total                        |       | $                                      | 850        |                                   | $          | 1,172 |   |

 

The decrease inresearch and development expense is due primarily to the continued scaleback ofresearch and development on the Digital AngelTM technology and completionof development on Signature Industries’ pilot locator beacon. 

 

**InterestExpense**

 

Interest expense was $0.2million for the three month periods ended June 30, 2004 and 2003,respectively.  

 

15

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**Loss on Applied Digital Common Stock**

 

On March 1,2004, Digital Angel Corporation issued 3,000,000 shares of its common stock anda warrant to purchase up to 1,000,000 shares of the Company’s common stock toApplied Digital in exchange for 1,980,000 shares of Applied Digital’s commonstock, exclusive of the proceeds which may be received when the warrant isexercised. The Company has accounted for the Applied Digital stock as a tradingsecurity under SFAS 115, “Accounting for Certain Investments in Debt and EquitySecurities”.  In the quarter ended June30, 2004, the Company sold approximately 380,000 shares of Applied Digitalcommon stock sold.  The Company recordedrealized losses of $253,000 and unrealized gains of $227,000 in the quarterended June 30, 2004.  Fair value of theApplied Digital common stock is determined by quoted values reported on theNASDAQ. 

 

**IncomeTaxes**

 

The Company had aneffective income tax rate of 0.0% for the three month periods ended June 30,2004 and 2003.  The Company accounts for income taxes underthe asset and liability approach. Deferred tax assets and liabilities are recognized for the expectedfuture tax consequences attributed to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax basis.  Deferred taxassets and liabilities are measured using the enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to reverse.  A valuationallowance is provided against net deferred tax assets when it is more likelythan not that a tax benefit will not be realized.  Income taxes included U.S. and foreign taxes.

 

**Discontinued Operations**

** **

On April 19, 2004, the Companysold certain assets of its Medical Systems segment’s medical services businesspursuant to an Asset Purchase Agreement dated April 8, 2004 by and betweenDigital Angel Corporation and MedAire, Inc. Assets sold include all of the tangible and intangible intellectualproperty developed for the operation of the Medical Systems segment’s medicalservices business, pharmaceutical supplies and other inventory items, customerand supplier contracts, computer software licenses, internet website and domainname and mailing lists.

 

Under the terms of the agreement,the purchase price, in addition to MedAire, Inc.’s assumption of certainliabilities was $420,000 plus any prepaid deposits and the cost of thepharmaceutical inventory and supplies reduced by any pre-billing to or pro-rataprepayment by the Company’s customers.

 

In connection with exiting thisactivity, the Company recognized obligations and recorded a loss ofapproximately $0.5 million in the three months ended June 30, 2004.  In addition, the Company sold theMedical Systems segment’s land and buildings in a separate transaction on July30, 2004 for $1.5 million.  Net cashreceived on the sale, after paying off the related building mortgage, wasapproximately $0.4 million.

 

The following disclosesthe operating losses from discontinued operations for the three-months endedJune 30, 2004 and 2003, consisting of losses attributable to the MedicalSystems segment:

 
| ** **                                    | ** ** | **Three-Months  Ended June 30,** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| Product revenue                               |       | $                                | 40         |   | $ | 222 |   |
| Service revenue                               |       | 32                               |       | 237 |   |
| Total revenue                                 |       | 72                               |       | 459 |   |
| Cost of products sold                         |       | 20                               |       | 95 |   |
| Cost of services sold                         |       | 82                               |       | 252 |   |
| Total cost of products and services sold      |       | 102                              |       | 347 |   |
| Gross (loss) profit                           |       | (30                              | )          | 112 |   |
| Selling, general and administrative  expenses |       | 648                              |       | 325 |   |
| Other income and expense                      |       | 72                               |       | 35 |   |
| Loss from discontinued operations             |       | $                                | (750       | ) | $ | (248 | ) |

 

**SixMonths Ended June 30, 2004 Compared to the Six Months Ended June 30, 2003**

 

**Revenue**

 

Revenue for the sixmonths ended June 30, 2004 increased $2.3 million, or 12.3%, to $20.8 millionwhen compared to $18.6

 

16

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million in revenue for the sixmonths ended June 30, 2003.

 

Revenue for each of theoperating segments was as follows (in thousands):

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2004** | ** ** | **Six Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| Animal Applications          |       | $                                    | 13,185     |                                 | $          | 12,989 |   |
| GPS and Radio Communications |       | 7,656                                |       | 5,566                                |       |
| Total                        |       | $                                    | 20,841     |                                 | $          | 18,555 |   |

 

The AnimalApplications segment’s revenue increased**$0.2million, or 1.5%, in the six months ended June 30, 2004 compared to the sixmonth period ended June 30, 2003. The increase is due to increased sales in thesix months ended June 30, 2004 to companion animal customers of $0.3 millionand livestock customers of $0.7 million, offset by decreased sales to our fishand wildlife customers of $0.8 million.  

 

The GPS and RadioCommunications segment’s revenue increased $2.1 million, or 37.5%, in the sixmonths ended June 30, 2004 compared to the six month period ended June 30,2003.  The increase primarily relates toincreased revenue at our subsidiary, Signature Industries, related to theinitial shipments of the G2R pilot locator beacon and increased sales inSignature’s Clifford and Snell division. OuterLink Corporation revenue was $0.7million for the six months ended June 30, 2004.  OuterLink Corporation was acquired on January22, 2004 and is not included in our results for the six months ended June 30,2003.  

 

**GrossProfit and Gross Profit Margin**

 

Gross profit forthe six month period ended June 30, 2004 was $8.7 million, an increase**of $0.6 million, or 7.8%, compared to$8.1 million in the six month period ended June 30, 2003. As a percentage ofrevenue, the gross profit margin was 41.7% and 43.4% for the six months endedJune 30, 2004 and 2003, respectively.

 

Gross profit foreach operating segment was as follows (in thousands):

 

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2004** | ** ** | **Six Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| Animal Applications          |       | $                                    | 5,134      |                                 | $          | 5,364 |   |
| GPS and Radio Communications |       | 3,551                                |       | 2,690                                |       |
| Total                        |       | $                                    | 8,685      |                                 | $          | 8,054 |   |

 

Gross profitmargin for each operating segment was:

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2004** | ** ** | **Six Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **%**                                | ** ** | **%**                                | ** ** |
| Animal Applications          |       | 38.9                                 |       | 41.3                                 |       |
| GPS and Radio Communications |       | 46.4                                 |       | 48.3                                 |       |

 

The Animal Applicationssegment’s gross profit decreased $0.2 million, or 4.3%, in the six month periodended June 30, 2004 compared to the six months ended June 30, 2003 due to increased material cost slightlyoffset by lower freight costs in 2004.  Thegross margin percentage decreased to 38.9% in the six month period ended June30, 2004 as compared to 41.3% in the six month period ended June 30, 2003 due primarily due to increased materialcosts.

 

The GPS and RadioCommunications segment’s gross profit increased $0.9 million, or 32.0%, in thesix month period ended June 30, 2004 compared to the six months ended June 30,2003 due to increased gross profit of$0.8 million at Signature Industries and $0.1 million at OuterLink.  OuterLink was acquired in January 2004.  The gross margin percentage decreasedto 46.4% in the six month period ended June 30, 2004 as compared to 48.3% inthe six month period ended June 30, 2003 dueto lower margins on the OuterLink revenue.

 

**Selling,General and Administrative Expenses**

 

Selling, generaland administrative expenses increased $0.9 million, or 11.9%, in the six monthperiod ended June 30, 2004 as compared to the six month period ended June 30,2003.  As a percentage of revenue,selling, general and administrative expenses were

 

17

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41.9% and 42.0% for the sixmonths ended June 30, 2004 and 2003, respectively.

 

Selling, generaland administrative expenses were as follows (dollars in thousands):

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2004** | ** ** | **Six Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| Animal Applications          |       | $                                    | 4,066      |                                 | $          | 3,434 |   |
| GPS and Radio Communications |       | 4,661                                |       | 4,365                                |       |
| Total                        |       | $                                    | 8,727      |                                 | $          | 7,799 |   |

 

Selling, generaland administrative expenses as a percentage of revenue for each of theoperating segments were:

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2004** | ** ** | **Six Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **%**                                | ** ** | **%**                                | ** ** |
| Animal Applications          |       | 30.8                                 |       | 26.4                                 |       |
| GPS and Radio Communications |       | 60.9                                 |       | 78.4                                 |       |

** **

The AnimalApplications segment’s selling, general and administrative expenses increased $0.6million in the six month period ended June 30, 2004 as compared to the sixmonth period ended June 30, 2003 and as a percentage of revenue increased to30.8% from 26.4% in the same respective period. The increase relates primarily to additional legal, accounting andinvestor relation expenses in the six months ended June 30, 2004.

 

The GPS and RadioCommunications segment’s selling, general and administrative expenses increased $0.3 million in the sixmonth period ended June 30, 2004 as compared to the six month period ended June30, 2003.  This increase is primarily dueto $0.9 million of OuterLink expense, $0.4 million of increased expense at oursubsidiary, Signature Industries, offset by a decrease of $1.0 million relatedto the scaleback of Digital Angel TM technology development.OuterLink was acquired in January 2004. As a percentage of revenue, selling,general and administrative expenses decreased to 60.9% in the six month periodended June 30, 2004 from 78.4% in the six month period ended June 30, 2003.

 

**Researchand Development Expense**

 

Research anddevelopment expense was $1.5 million in the six month period ended June 30,2004, a decrease of $0.6 million, or 27.1%, from $2.1 million for the six monthperiod ended June 30, 2003.  As apercentage of revenue, research and development expense was 7.3% and 11.2% forthe six months ended June 30, 2004 and 2003, respectively.  

 

Research anddevelopment expense for each of the operating segments was as follows (inthousands):

 
| ** **                   | ** ** | **Six Months  Ended June 30,  2004** | ** ** | **Six Months  Ended June 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| Animal Applications          |       | $                                    | 1,176      |                                 | $          | 1,241 |   |
| GPS and Radio Communications |       | 343                                  |       | 842                                  |       |
| Total                        |       | $                                    | 1,519      |                                 | $          | 2,083 |   |

 

The decrease inresearch and development expense is due primarily to the continued scaleback ofresearch and development on the Digital AngelTM technology andcompletion of development on Signature Industries’ pilot locator beacon. 

 

**InterestExpense**

 

Interest expense was $0.5million and $0.3 million for the six months period ended June 30, 2004 and2003, respectively. The increase relates to the amortization of deferredfinancing costs related to the financings in July and August of 2003. 

 

**IncomeTaxes**

 

The Company had aneffective income tax rate of 0.0% for the six month periods ended June 30, 2004and 2003.  The Company accounts for income taxes underthe asset and liability approach. Deferred tax assets and liabilities are recognized for the expectedfuture tax consequences attributed to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax basis.  Deferred taxassets and liabilities are measured using the enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to reverse.  A valuationallowance is provided against net deferred tax assets when it is more likelythan not that a tax benefit will not be realized.  Income taxes included U.S. and foreign taxes.

 

18

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**Loss on Applied Digital Common Stock**

** **

On March 1,2004, Digital Angel Corporation issued 3,000,000 shares of its common stock anda warrant to purchase up to 1,000,000 shares of the Company’s common stock toApplied Digital in exchange for 1,980,000 shares of Applied Digital’s commonstock, exclusive of the proceeds which may be received when the warrant isexercised.  As of June 30, 2004, theCompany has sold approximately 910,000 shares of Applied Digital commonstock.  The Company has accounted for theApplied Digital stock as a trading security under SFAS 115, “Accounting forCertain Investments in Debt and Equity Securities”.  In the quarter ended June 30, 2004, theCompany recorded realized losses of $955,000 on the approximately 910,000shares of Applied Digital common stock sold and unrealized losses of $1,657,000on the 1,070,000 shares held by the Company. Fair value of the Applied Digital common stock is determined by quotedvalues reported on the NASDAQ. 

 

**Discontinued Operations**

** **

On April 19, 2004, the Companysold certain assets of its Medical Systems segment’s medical services businesspursuant to an Asset Purchase Agreement dated April 8, 2004 by and betweenDigital Angel Corporation and MedAire, Inc. Assets sold include all of the tangible and intangible intellectualproperty developed for the operation of the Medical Systems segment’s medicalservices business, pharmaceutical supplies and other inventory items, customerand supplier contracts, computer software licenses, internet website and domainname and mailing lists.

 

Under the terms of the agreement, thepurchase price, in addition to MedAire, Inc.’s assumption of certainliabilities was $420,000 plus any prepaid deposits and the cost of thepharmaceutical inventory and supplies reduced by any pre-billing to or pro-rataprepayment by the Company’s customers.

 

In connection with exiting thisactivity, the Company recognized obligations and recorded a loss ofapproximately $0.6 million in the six months ended June 30, 2004.  In addition, on July 30, 2004, the Companysold the Medical Systems segment’s land and building for an amount in excess ofour carrying basis. In addition, the Company sold the Medical Systemssegment’s land and buildings in a separate transaction on July 30, 2004 for$1.5 million.  Net cash received on thesale, after paying off the related building mortgage, was approximately $0.4million.  

 

The following disclosesthe operating losses from discontinued operations for the six-months ended June30, 2004 and 2003, consisting of losses attributable to the Medical Systemssegment:

 
| ** **                                    | ** ** | **Six-Months  Ended June 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------|------------|
| ** **                                    | ** ** | **2004**                       | ** ** | **2003** | ** ** |
| Product revenue                               |       | $                              | 204        |   | $ | 587 |   |
| Service revenue                               |       | 223                            |       | 616 |   |
| Total revenue                                 |       | 427                            |       | 1,203 |   |
| Cost of products sold                         |       | 87                             |       | 258 |   |
| Cost of services sold                         |       | 317                            |       | 593 |   |
| Total cost of products and services sold      |       | 404                            |       | 851 |   |
| Gross profit                                  |       | 23                             |       | 352 |   |
| Selling, general and administrative  expenses |       | 1,046                          |       | 656 |   |
| Other income and expense                      |       | 105                            |       | 69 |   |
| Loss from discontinued operations             |       | $                              | (1,128     | ) | $ | (373 | ) |

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

As of June 30,2004, the Company had cash of $0.7 million compared to $0.9 million at December31, 2003.  In addition, at June 30, 2004we held Applied Digital common stock of $2.6 million compared to $0.0 millionat December 31, 2003.  Cash used inoperating activities totaled $3.0 million and $2.3 million in the first sixmonths of 2004 and 2003, respectively.

 

In the firstsix months of 2004, the use of cash was due primarily to the loss generatedfrom operations and a significant increase in accounts receivable.  Accounts receivable, net of allowance fordoubtful accounts, increased by $1.7 million, or 51.3%, to $5.1 million at June30, 2004 from $3.4 million at December 31, 2003.  Approximately $0.5 million of the increasewas accounts receivable acquired in the acquisition of OuterLink Corporation inJanuary 2004.  Offsetting these uses ofcash was a decrease in inventory, depreciation and amortization of $1.2 millionand realized and unrealized losses on Applied Digital common stock of $2.6million. 

 

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Inventory levelsdecreased by $0.2 million to $6.3 million at June 30, 2004 from $6.5 million atDecember 31, 2003 due to an accumulation of inventory in December 2003 offsetby inventory acquired in the OuterLink Corporation acquisition. 

 

Accounts payabledecreased by $0.7 million to $4.5 million at June 30, 2004 from $5.2 million atDecember 31, 2003.

 

Accrued expenses andother current liabilities increased by $0.6 million, or 18.7%, to $3.8 millionat June 30, 2004 from $3.2 million at December 31, 2003.  Accrued expenses acquired in the OuterLinkacquisition totaled $0.6 million.

 

Investingactivities provided cash of $2.8 million in the first six months of 2004 andused cash of $0.5 million in the first six months of 2003.  In the first six months of 2004, cashprovided was primarily from the sale of Applied Digital common stock and thesale of the Medical Systems segment’s assets. During the first six months of2004 and 2003, $0.2 million and $0.5 million was spent to acquire property andequipment, respectively.

 

Financingactivities used cash of $0.05 million in the first six months of 2004 andprovided cash of $2.6 million in the first six months of 2003.  In the six months ended June 30, 2004, cashwas used primarily for payments on our debt and line of credit of $1.0 millionoffset by proceeds from stock option exercises of $1.0 million.

 

*Debt andLiquidity*

 

The followingtable summarizes the Company’s fixed cash obligations as of June 30, 2004 overvarious future periods (in thousands):

 

 
| ** **                       | ** ** | ** ** | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------|------------|------------|------------|----------------------------|------------|
| **Contractual cash obligations** | ** ** | **Total**  | ** ** | **Less than  1 Year**      | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **After  5 Years** | ** ** |
| Notes Payable and Long-Term Debt |       | $          | 7,422      |                       | $          | 5,080 |   | $ | 144 |   | $ | 127 |   | $ | 2,071 |   |
| Operating Leases                 |       | 17,745     |       | 811                        |       | 1,284 |   | 1,129 |   | 15,521 |   |
| Employment Contracts             |       | 1,778      |       | 865                        |       | 913 |   | — |   | — |   |
|                             |       | $          | 26,945     |                       | $          | 6,756 |   | $ | 2,341 |   | $ | 1,256 |   | $ | 17,592 |   |

 

*ConvertibleNote. *OnJuly 31, 2003, we entered into a Securities Purchase Agreement (“PurchaseAgreement”) to sell to Laurus Master Fund, Ltd. (“Laurus”) a two-year SecuredConvertible Note (the “Convertible Note”) in the original principal amount of$2,000,000 and a five-year warrant to purchase up to 125,000 shares of ourcommon stock.  The per share exerciseprice of the warrant is $2.68 for 75,000 shares, $2.91 for 35,000 shares and$3.38 for 15,000 shares. The Convertible Note is convertible, at Laurus’soption, into shares of our common stock at a per share price of $2.33.  Laurus is not entitled to convert the amountevidenced by the Convertible Note into a number of shares of common stock whichwould exceed the difference between the number of shares of common stockbeneficially owned by Laurus and 4.99% of the outstanding shares of our commonstock.  However, Laurus may acquire morethan 4.99% of our outstanding common stock upon 75 days notice to the Company.Through June 30, 2004, Laurus has converted $582,500 into 250,000 shares of ourcommon stock.  In accordance with theletter agreement dated June 1, 2004, between us, Applied Digital and Laurus,Laurus sold 150,000 of the common shares to Applied Digital.  As of June 30, 2004 the principal balance ofthe Convertible Note was $846,000.  TheConvertible Note accrues interest at an annual rate equal to the higher of theprime rate plus 1.75% or 6% per annum. We allocated $143,000 of the proceeds to the warrant issued.  The amount allocated represents the fairvalue of the warrant calculated under the Black-Scholes method.  The value of the warrant is included inadditional paid-in capital and is being amortized to interest expense over thelife of the Convertible Note.

 

In connectionwith the Convertible Note, we entered into a Security Agreement with Laurusgranting to Laurus a lien and security interest in our assets.  Additionally, the Securities PurchaseAgreement includes default provisions should an Event of Default (as defined inthe agreement) occur.  Furthermore, undera related registration rights agreement, the common stock underlying theConvertible Note is registered with the Securities and Exchange Commission.

 

*RevolvingNote and Minimum Borrowing Note*.  On August 28, 2003, we entered into aSecurity Agreement with Laurus under which we may borrow from Laurus the lesserof $5,000,000 or an amount that is determined based on percentages of oureligible accounts receivable and inventory as prescribed by the terms of theSecurity Agreement.  Under the SecurityAgreement, we issued to Laurus a three-year Secured Revolving Convertible Note(“Revolving Note”) in the original principal amount of $3,500,000 and athree-year Secured Minimum Borrowing Convertible Note (“Minimum BorrowingNote”) in the original principal amount of $1,500,000. We used proceeds fromthe Revolving Note and Minimum Borrowing Note to satisfy in full our creditfacility from Wells Fargo Business Credit. The Revolving Note and Minimum Borrowing Note accrue interest at anannual rate equal to the prime rate plus 2.5%. The availability under theRevolving Note was $2.1 million at June 30, 2004.

 

Beginning May 28, 2004,the Minimum Borrowing Note and the Revolving Note are convertible, at Laurus’soption, into shares of our common stock at a per price share of $2.64 (the“Fixed Conversion Price”).  The FixedConversion Price is adjusted

 

20

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upward following eachconversion of $2,000,000, as defined. Laurus is not entitled to convert the amount evidenced by the MinimumBorrowing Note and the Revolving Note into a number of shares of common stockwhich would exceed the difference between the number of shares of ourcommon stock beneficially owned by Laurus or issuable upon the exercise ofwarrants held by Laurus and 4.99% of our outstanding shares of our commonstock.  However, Laurus may acquire morethan 4.99% of our outstanding common stock upon 75 days’ notice to us.  Additionally, the Securities PurchaseAgreement includes default provisions should an Event of Default (as defined inthe agreement) occur.  Furthermore, undera related registration rights agreement, the common stock underlying theRevolving Note and Minimum Borrowing Note has been registered with theSecurities and Exchange Commission.

 

We also issued to Laurus afive-year warrant to purchase up to 115,000 shares of our common stock. The pershare exercise price of the warrant is $2.55 for 70,000 shares, $2.75 for35,000 shares, and $2.95 for 10,000 shares. We allocated $133,000 of theproceeds to the warrant issued.   Theamount allocated represents the fair value of the warrant calculated under theBlack-Scholes method.  The value of thewarrant is included in additional paid-in capital and is being amortized tointerest expense over the life of the Revolving Note and Minimum BorrowingNote.

 

On June 1, 2004, we executeda letter agreement with Laurus and Applied Digital that amended certain termsof various transaction documents executed by us and Laurus in connection withthe issuance by us of the Convertible Note, Revolving Note and MinimumBorrowing Note to Laurus.  The letteragreement provides that:

 

•      We agreed to not prepay anyoutstanding principal amounts evidenced by the Revolving Note and MinimumBorrowing Note.

 

•      Laurus agreed to waive anyand all fees allegedly due to Laurus from us as a result of our failure totimely cause the shares underlying the Revolving Note and Minimum BorrowingNote to be registered. 

 

•      Laurus shall convert theportion of the Revolving Note equal to 150,000 shares of our common stock a thefixed conversion price set forth in the Convertible Note and, as promptly aspracticable following such conversion, Applied Digital shall purchase suchshares at a purchase price equal to the volume weighted average price of ourcommon stock for the three trading days prior to Laurus’ conversion.

 

•      Laurus shall not convert anyof the outstanding principal balance on the Revolving Note, the MinimumBorrowing Note or any other obligation issued by us to Laurus in an amount thatexceeds 25% of the aggregate dollar trading volume of our common stock for thethirty day trading period immediately preceding the delivery of a notice ofconversion by Laurus to us. 

 

•      Upon conversion of any ofthe outstanding principal balance on the Revolving Note, the Minimum BorrowingNote or any other obligations issued by us to Laurus, we and Applied Digitalshall have the right to purchase all of the shares acquired by Laurus in suchconversion at a price per share equal to the volume weighted average price ofour common stock for the three trading days prior to Laurus’ conversion; and 

 

•      Laurus shall not convert anyportion of the Minimum Borrowing Note prior to repayment in full of allobligations outstanding under the Revolving Note.

 

*WorkingCapital Loan. *OnMarch 7, 2003, Signature Industries Ltd., our subsidiary in the UnitedKingdom, entered into a Loan Agreement with The Royal Bank of Scotland for £500,000 to finance the workingcapital requirements of their Indian Air Force contract.  The loan bears interest at an annual rateequal to 2.25% above the base rate, as defined in the agreement (6.75% at June30, 2004).  The base rate may vary fromtime to time.  On January 22, 2004, theagreement was amended to increase the loan amount to £1,000,000 ($1,807,000 as of June 30, 2004).  On June 10, 2004, the repayment terms of theAgreement were amended.  As amended,repayments shall be £200,000 due onJuly 31, 2004, £350,000 on August 31, 2004, £350,000 on September 30,2004, and £100,000 on October 31, 2004.  

 

*InvoiceDiscounting Agreement. *On April 9, 2003, Signature Industries Ltd. entered into atwo-year Invoice Discounting Agreement with The Royal Bank of ScotlandCommercial Services Limited (“RBS”).  TheInvoice Discounting Agreement, as amended October 28, 2003, provides forSignature to sell with full title guarantee most of its receivables, as definedin the Invoice Discounting Agreement. RBS prepays 80% of the receivables sold, not to exceed an outstandingbalance of £750,000 ($1,355,000as of June ) at any given time.  RBS paysSignature the remainder of the receivables upon their collection.  Receivables which remain outstanding 90 daysfrom the end of the invoice month become ineligible, and RBS may requireSignature to repurchase these receivables. The discounting charge accrues daily at an annual rate equal to 2.25%above the base rate, as defined in the amended Invoice Discounting Agreement(6.75% at June 30, 2004).  Signature paysa commission charge to RBS of 0.2% of each receivable balance sold.  The Invoice Discounting Agreement, asamended, requires a minimum commission charge of £833 per month.  Discounting charges of $32,000 are includedin interest expense in the statement of operations for the six months endedJune 30, 2004. The amount of receivables financed at June 30, 2004 was $0.7 million.

 

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*StockIssuance to Applied Digital. *On March 1, 2004, we issued 3,000,000shares of our common stock to Applied Digital pursuant to the stock purchaseagreement with Applied Digital dated August 14, 2003.   The stock purchase agreement provided forApplied Digital to purchase 3,000,000 shares of our common stock at a price of$2.64 per share and a warrant to purchase up to 1,000,000 shares of our commonstock.  The warrant is exercisable for fiveyears beginning February 1, 2004 at an exercise price per share of $3.74payable in cash or shares of common stock of Applied Digital.  The purchase price for the sale of our3,000,000 shares and the warrant was payable in shares of Applied Digital commonstock having an aggregate value of $7.92 million.  The number of shares of Applied Digitalcommon stock received by Digital Angel Corporation as payment of the purchaseprice was 1,980,000 shares (as adjusted for a subsequent one-for-10 reversestock split of Applied Digital’s common stock), exclusive of the proceeds onexercise of the warrant.   We expect togenerate cash by selling the shares of Applied Digital common stock.  In the six months ended June 30, 2004, we hadsold 910,000 shares of Applied Digital common stock, resulting in aggregate netproceeds of approximately $2.7 million.

 

As part ofthis transaction , we issued five-year warrants to purchase up to 500,001shares of our common stock at an exercise price of $2.64 per share anytime onor after February 1, 2004 to the holders of the Applied Digital 8.5%Convertible Exchangeable Debentures.

 

During the sixmonths ended June 30, 2004, we received aggregate proceeds of $1.0 millionon the exercise of stock options.

 

**Forward****– Looking Statements and Associated Risk**

 

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

 

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

 

•      anticipated trends in our business anddemographics;

 

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

 

•      our future profitability and liquidity; and

 

•      regulatory, competitive or other economicinfluences.

 

Words such as“anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates”and similar expressions also identify forward-looking statements.  These forward-looking statements are notguarantees of future performance and are subject to risks and uncertaintiesthat could cause actual results to differ materially from estimates orforecasts contained in the forward-looking statements.  Some of these risks and uncertainties arebeyond our control.

 

**RiskFactors**

** **

You shouldcarefully consider the risk factors listed below.  These risk factors may cause our 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. 

 

**Recentchanges in our senior management could have an adverse effect on our financialresults.**

** **

We have recentlyexperienced numerous changes with respect to our senior management. OnSeptember 4, 2003, Randolph K. Geissler resigned as Chief ExecutiveOfficer of Digital Angel Corporation after serving in such position since theMarch 2002 merger between Digital Angel Corporation and Medical AdvisorySystems. From September 2000 until March 2002, Mr. Geisslerserved as Chief Executive Officer of Digital Angel Corporation, one of thepredecessor corporations to our Company. 

 

FollowingMr. Geissler’s resignation, our Board appointed Kevin McLaughlin as theinterim Chief Executive Officer of Digital Angel Corporation while we conducteda formal search for a permanent Chief Executive Officer. At the time of hisappointment as interim Chief Executive Officer, Mr. McLaughlin was servingas President and Chief Operating Officer of Applied Digital. OnNovember 3, 2003, we announced that we had agreed to appoint Van Chu asChief Executive Officer. At the time of this announcement, Mr. Chu wasChief Executive Officer of OuterLink Corporation, a company that was acquiredby Digital Angel Corporation in a merger on January 22, 2004. Mr. Chuassumed his duties as our Chief Executive Officer on November 7, 2003. 

 

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Mr. Chu wasterminated as Chief Executive Officer of the Company on January 12, 2004, theCompany’s board of directors appointed Kevin N. McGrath as President and ChiefExecutive Officer of the Company. 

 

Because wedepend heavily on the skills of those persons holding senior managementpositions, the loss of any senior executive could materially adversely affectour financial results. These senior executives, in many cases, have strongrelationships with our customers and suppliers. Therefore, the loss of theservices of such senior executives or any general instability in the compositionof our senior management could have a negative impact on our relationship withthese customers and suppliers. We cannot ensure that we will be able to retainour senior executives and this uncertainty could have a material negativeimpact on our business. 

 

**Asof June 30, 2004, our majority stockholder, Applied Digital owned 68.4% of ourcommon stock. Thus, it is able to completely control the board of directors andmay support actions that conflict with the interests of the other stockholders.**

** **

As of June 30,2004, Applied Digital was the beneficial owner of 68.4% of our common stock. Itcontrols us with respect to all matters upon which our stockholders may vote,including the selection of the Board of Directors, mergers, acquisitions andother significant corporate transactions. Applied Digital has the ability toexercise control over us. Applied Digital may support actions that are contraryto or conflict with the interests of the other stockholders. 

 

**Ourstockholders will experience dilution if Laurus Master Fund exercises its rightto convert certain debt owed by us into shares of our common stock.**

** **

OnJuly 31, 2003, we issued to Laurus Master Fund a two-year securedconvertible note in the original principal amount of $2,000,000. The securedconvertible note is convertible, at Laurus Master Fund’s option, into shares ofour common stock at a per share price of $2.33. In connection with the issuanceof the secured convertible note, we also issued to Laurus Master Fund afive-year warrant to purchase 125,000 shares of our common stock at exerciseprices ranging from $2.68 to $3.38 per share. 

 

OnAugust 28, 2003, we issued a three-year secured revolving convertible notein the principal amount of $3,500,000 and a three-year secured minimumborrowing convertible note in the principal amount of $1,500,000 to LaurusMaster Fund. When the two-year secured convertible note is repaid in full,either in cash or by conversion into our common stock, each of these notes willbe convertible, at Laurus Master Fund’s option, into shares of our common stockat $2.64 per share. In connection with the issuance of these notes, LaurusMaster Fund also acquired a five-year warrant to purchase 115,000 shares of ourcommon stock at exercise prices ranging from $2.55 to $2.95 per share. 

 

Through June30, 2004, Laurus Master Fund had converted $582,500 in principal amount of thetwo-year secured convertible note dated July 31, 2003 into 383,000 sharesof our common stock. Our issuance of shares to Laurus Master Fund upon any otherconversion of these notes or any exercise of the warrants may result insubstantial dilution to other Digital Angel Corporation stockholders. Inaddition, Laurus Master Fund may offer and sell any and all of the shares ofour common stock received in connection with conversion of the notes orexercise of the warrants at prices and times to be determined in its solediscretion. There is no independent or third-party underwriter involved in theoffering of the shares of our common stock acquired by Laurus Master Fund, andthere can be no guarantee that any disposition of those shares will becompleted in a manner that is not disruptive to the trading market for ourcommon stock. 

 

**Ourstockholders will experience dilution upon conversion of the Series A PreferredStock issued by us in the OuterLink Corporation acquisition.**

** **

OnJanuary 22, 2004, we acquired OuterLink Corporation of Concord,Massachusetts, in a merger. As consideration for the merger, we issued 100,000shares of our Series A Preferred Stock in exchange for all of the issuedand outstanding shares of OuterLink’s capital stock. The Series APreferred Stock is convertible into 4,000,000 shares of our common stock whenthe volume-weighted average price of our common stock equals or exceeds $4.00 pershare for 10 consecutive trading days. The issuance of our common stock uponany conversion of the Series A Preferred Stock issued to the OuterLinkstockholders would result in dilution to our current stockholders. 

 

**Theterms of our debt obligations to Laurus Master Fund subject us to the risk offoreclosure on substantially all of our assets.**

** **

We may nothave sufficient funds to repay Laurus Master Fund when the obligations on theconvertible note, minimum borrowing note and revolving note mature. Accordingly,we may be required to obtain the funds necessary to repay these obligationseither through refinancing, the issuance of additional equity or debtsecurities or the sale of assets. There can be no assurance that we can obtainthe funds needed, if any, to repay the obligations from any one or more ofthese other sources on favorable economic terms or at all. If we are unable toobtain funds to repay this indebtedness, we may be forced to dispose of assetsor take other actions on disadvantageous terms, which could result in losses toDigital Angel Corporation and could have a material adverse effect on ourfinancial condition. 

 

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To secure thepayment of all debts, liabilities and obligations owed to Laurus Master Fund,we have granted to Laurus Master Fund a security interest in and lien upon allof our property and assets, whether real or personal, tangible or intangible,whether now owned or hereafter acquired, or in which we now have, or at any timein the future may acquire, any right, title or interest. The occurrence of anevent of default under the convertible note, minimum borrowing note orrevolving note would subject us to foreclosure by Laurus Master Fund onsubstantially all of our assets to the extent necessary to repay any amountsdue. Any such default and resulting foreclosure will have a material adverseeffect on our financial condition.

 

**Ourearnings will decline if we write off additional goodwill and other intangibleassets.**

** **

As of June 30,2004, we had goodwill of $49.0 million. On January 1, 2002, we adoptedSFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142requires that goodwill and certain intangibles no longer be amortized butinstead tested for impairment at least annually by applying a fair value basedtest. During the fourth quarter of 2003, we performed the annual impairmenttest for goodwill using a fair value based approach, primarily discounted cashflows. An evaluation of the Medical Systems reporting unit indicated that$2.4 million of goodwill was impaired. Additionally, management estimatedthat certain intangible assets at our Medical Systems reporting unit wereimpaired by $0.6 million. Accordingly, we recorded an impairment charge of$3.0 million in the fourth quarter of 2003, which is included as an assetimpairment charge in the 2003 statement of operations. During the fourthquarter of 2002, we recorded an impairment charge of $57.4 million forgoodwill at our GPS and Radio Communications and Medical Systems reportingunits. 

 

We will assessthe fair value of our goodwill annually or earlier if events occur orcircumstances change that would more likely than not reduce the fair value ofour goodwill below its carrying value. These events or circumstances wouldinclude a significant change in business climate, including a significant,sustained decline in an entity’s market value, legal factors, operatingperformance indicators, competition, sale or disposition of a significantportion of the business, or other factors. If we determine that significantimpairment has occurred, we would be required to write off the impaired portionof goodwill. Impairment charges could have a material adverse effect on ourfinancial condition and results of operations. 

 

**Theexercise of outstanding options and warrants may adversely affect the marketprice of our common stock.**

** **

As of June 30,2004, we had 10,142,000 options and 3,029,000 warrants outstanding to purchasefrom us a total of 13,171,000 shares of common stock at exercise prices rangingfrom $0.50 to $10.50 per share. In addition, as of June 30, 2004, we had4,479,000 additional shares of common stock which may be issued in the futureunder our stock option plans. The exercise of outstanding options and warrantsand the sale in the public market of the shares purchased upon such exercisemay adversely affect the market price of our common stock. 

 

**Wemay continue to incur losses.**

** **

We incurred anet loss of $5.7 million for the six months ended June 30, 2004.  In addition, we incurred net losses of$9.5 million, $92.4 million, $17.4 million in the years endedDecember 31, 2003, 2002 and 2001, respectively. Included in the$92.4 million loss for the year ended December 31, 2002 is a goodwillimpairment charge of $57.4 million, an asset impairment charge of$6.4 million, and an $18.7 million charge arising from theremeasurement of options in connection with the merger. No assurance can begiven as to when we will achieve profitability, if at all. Profitability dependson many factors, including the success of our marketing programs, ourmaintenance and reduction of expenses, and the ability to coordinatesuccessfully the operations of our business units. If we fail to achieve andmaintain sufficient profitability within the time frame expected by investors,the market price of our common stock may be adversely affected. 

 

**Infringementby third parties on our intellectual property or the development ofsubstantially equivalent proprietary technology by our competitors couldnegatively affect our business.**

** **

Our successdepends significantly on our ability to maintain patent and trade secretprotection, to obtain future patents and licenses, and to operate withoutinfringing on the proprietary rights of third parties. There can be noassurance that the measures we have taken to protect our intellectual property,including those relating to the Digital Angel technology, will prevent themisappropriation or circumvention of our intellectual property. In addition,there can be no assurance that any patent application, when filed, will resultin an issued patent, or that our existing patents, or any patents that may beissued in the future, will provide us with significant protection againstcompetitors. Moreover, there can be no assurance that any patents issued to orlicensed by us will not be infringed upon or circumvented by others. Litigationto establish the validity of patents, to assert infringement claims againstothers, and to defend against patent infringement claims can be expensive andtime-consuming, even if the outcome is in our favor. We also rely to a lesserextent on unpatented proprietary technology, and no assurance can be given thatothers will not independently develop substantially equivalent proprietary information,techniques or processes or that we can meaningfully protect our rights to suchunpatented proprietary technology.

 

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Infringement on ourintellectual property or the development of substantially equivalent technologyby our competitors could have a material adverse effect on our business. 

 

**Domesticand foreign government regulation and other factors could impair our ability todevelop and sell our products in certain markets.**

** **

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

 

We are alsosubject to federal, state and local regulation in the United States, includingregulation by the U.S. Food and Drug Administration, the U.S. FederalCommunications Commission, the Federal Aviation Authority and the U.S.Department of Agriculture, and to regulation in other countries. We cannotpredict the extent to which we may be affected by further legislative andregulatory developments concerning our products and markets. We are required toobtain regulatory approval before marketing most of our products. Theregulatory process can be very time-consuming and costly, and there is noassurance that we will receive the regulatory approvals necessary to sell ourproducts. Regulatory authorities 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 such regulatoryaction, including the failure to obtain such approval, could prevent us fromselling, or materially impair our ability to sell, our products in certainmarkets and could negatively affect our business. 

 

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

** **

The principalcustomers for electronic identification devices for fish are governmentcontractors that rely on funding from the United States government. Becausethese contractors rely heavily on government funds, any decline in theavailability of such funds could result in a decreased demand by thesecontractors for our products. Any decrease in demand by such customers couldhave a material adverse effect on our financial condition and results ofoperations and result in a decline in the market value of our common stock. 

 

**Wedepend on a single production arrangement with Raytheon MicroelectronicsEspana, SA for our patented syringe-injectable microchips, and the loss of orany significant reduction in the production could have an adverse effect on ourbusiness.**

** **

We rely solelyon a production arrangement with Raytheon Microelectronics Espana, SA for themanufacture of our patented syringe-injectable microchips that are used in allof our implantable electronic identification products. Raytheon utilizes ourproprietary technology and our equipment in the production of oursyringe-injectable microchips. The termination, or any significant reduction,by Raytheon of the assembly of our microchips or a material increase in the pricecharged by Raytheon for the assembly of our microchips could have an adverseeffect on our financial condition and results of operations. In addition,Raytheon may not be able to produce sufficient quantities of the microchips tomeet any significant increased demand for our products or to meet any suchdemand on a timely basis. Any inability or unwillingness of Raytheon to meetour demand for microchips would require us to utilize an alternative productionarrangement and remove our automated assembly production machinery from theRaytheon facility, which would be costly and could delay production. Moreover,if Raytheon terminates our production arrangement, we cannot assure that theassembly of our microchips from another source would be on comparable or acceptableterms. The failure to make such an alternative production arrangement couldhave an adverse effect on our business. 

 

**Wedepend on principal customers.**

** **

For the sixmonths ended June 30, 2004, we had one customer which accounted for 11.5% ofour consolidated revenue, and our four largest customers, in the aggregate,accounted for 30.2% of our consolidated revenue. For the year ended December31, 2003, we had one customer that accounted for 11.8% of our consolidatedrevenues, and our four largest customers accounted for, in the aggregate, 30.9%of our consolidated revenues.  Oursubsidiary, Signature Industries, Ltd., is heavily dependent on contracts withdomestic government agencies and foreign governments, including the UnitedKingdom, primarily relating to military applications. The loss of, or asignificant reduction in, orders from these or our other major customers couldhave a material adverse effect on our financial condition and results ofoperations. 

 

**Wecompete with other companies in the visual and electronic identificationmarket, and the products sold by our competitors could become more popular thanour products or render our products obsolete.**

** **

The market forvisual and electronic identification for companion animals and livestock ishighly competitive. We believe that our principal competitors in the visualidentification market for livestock are AllFlex USA and Y-Tex Corporation andthat our principal competitors in the electronic identification market areAllFlex USA, Datamars SA and Avid Identification Systems, Inc. 

 

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In addition,other companies could enter this line of business in the future. Certain of ourcompetitors have substantially greater financial and other resources than us.We may not be able to compete successfully with these competitors, and thesecompetitors may develop or market technologies and products that are morewidely accepted than ours or that would render our products obsolete ornoncompetitive. 

 

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

** **

We generate aportion of our sales and incur a portion of our expenses in currencies otherthan U.S. dollars. To the extent that we are unable to match revenues receivedin foreign currencies with costs paid in the same currency, exchange ratefluctuations in any such currency could have an adverse effect on our financialresults. 

 

**Wedepend on a small team of senior management, and we may have difficulty attractingand retaining additional personnel.**

** **

Our futuresuccess will depend in large part upon the continued services and performanceof senior management and other key personnel. If we lose the services of anymember of our senior management team, our overall operations could bematerially and adversely affected. In addition, our future success will dependon our ability to identify, attract, hire, train, retain and motivate otherhighly skilled technical, managerial, marketing, purchasing and customer servicepersonnel when they are needed. Competition for these individuals is intense.We cannot ensure that we will be able to successfully attract, integrate orretain sufficiently qualified personnel when the need arises. Any failure toattract and retain the necessary technical, managerial, marketing, purchasingand customer service personnel could have a material adverse effect on ourfinancial condition and results of operations. 

 

**IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS**

 

InJune 2002, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards (SFAS) No. 146, “Accounting for Costs Associatedwith Exit or Disposal Activities.” SFAS No. 146 requires recording costsassociated with exit or disposal activities at their fair values when aliability has been incurred. Under previous guidance, certain exit costs wereaccrued upon management’s commitment to an exit plan. The Company adopted SFASNo. 146 on January 1, 2003. The adoption of SFAS No. 146 did not have amaterial impact on the results of operations or financial position.

 

EffectiveJanuary 1, 2003, the Company adopted the recognition and measurementprovisions of FASB Interpretation No. 45 (“Interpretation 45”), “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others.” This interpretation elaborates on thedisclosures to be made by a guarantor in interim and annual financialstatements about the obligations under certain guarantees. Interpretation 45 alsoclarifies that a guarantor is required to recognize, at the inception of aguarantee, a liability for the fair value of the obligation undertaken inissuing the guarantee. The initial recognition and initial measurementprovisions of this interpretation are applicable on a prospective basis toguarantees issued or modified after December 31, 2002. The Company doesnot currently provide significant guarantees on a routine basis. As a result,this interpretation has not had a material impact on the Company’s financialstatements.

 

InDecember 2003, the FASB issued FASB Interpretation No. 46 (revisedDecember 2003) (“Interpretation 46”), “Consolidation of Variable InterestEntities.” Application of this interpretation is required in the Company’sfinancial statements for interests in variable interest entities that areconsidered to be special-purpose entities for the year ended December 31,2003. The Company determined that it does not have any arrangements orrelationships with special-purpose entities.

 

Interpretation46 addresses the consolidation of business enterprises to which the usualcondition (ownership of a majority voting interest) of consolidation does notapply. This interpretation focuses on controlling financial interests that maybe achieved through arrangements that do not involve voting interests. Itconcludes that in the absence of clear control through voting interests, acompany’s exposure (variable interest) to the economic risks and potentialrewards from the variable interest entity’s assets and activities are the bestevidence of control. If an enterprise holds a majority of the variableinterests of an entity, it would be considered the primary beneficiary. Theprimary beneficiary is required to include assets, liabilities and the resultsof operations of the variable interest entity in its financial statements. Theadoption of FIN 46 did not have an impact on the financial position oroperations of the Company.

 

InMay 2003, the FASB issued SFAS 150, Accounting for Certain Financial Instrumentswith Characteristics of Both Liabilities and Equity (SFAS No. 150). SFAS No.150 establishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity. Itrequires that an issuer classify a financial instrument that is within itsscope as a liability (or an asset in some circumstances). Many of thoseinstruments were previously classified as equity. SFAS No. 150 is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003. It is to be implemented by reporting the cumulativeeffect of a change in accounting principle for financial instruments created beforethe issuance date of the statement and still existing at the beginning of theinterim period of adoption. Restatement is not permitted. The Company adoptedthe provisions of SFAS No.150 effective July 1, 2003. The adoption of SFASNo. 150 did not have an impact on the Company’s financial position or resultsof operations.

 

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

 

Wehave operations and sales in various regions of the world. Additionally, we mayexport and import to and from other countries. Our operations may therefore be subject to volatility because ofcurrency fluctuations, inflation, and changes in political and economic conditionsin these countries. Sales and expenses may be denominated in local currenciesand may be affected as currency fluctuations affect our product prices andoperating costs or those of our competitors.

 

Wepresently do not use any derivative financial instruments to hedge our exposureto adverse fluctuations in interest rates, foreign exchange rates, fluctuationsin commodity prices or other market risks, nor do we invest in speculativefinancial instruments.

 

Dueto the nature of our borrowings and our short-term investments, we haveconcluded that there is no material market risk exposure and, therefore, noquantitative tabular disclosures are required.

 

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

 

Withinthe 90 days prior to the date of this report, the Company carried out anevaluation, under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Exchange Act Rule 13a-14 underthe Securities Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that the Company’s disclosure controls andprocedures are effective in timely alerting them to material informationrelating to the Company (including its consolidated subsidiaries) required tobe included in the Company’s periodic SEC filings with the Securities andExchange Commission.  Since the date oftheir evaluation, there have been no significant changes in our internalcontrols or in other factors that could significantly affect the Company’sinternal controls.

 

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**PART II    OTHERINFORMATION**

 

**Item 1.****   ****LegalProceedings.**

 

*Wurts Litigation*

 

InFebruary 2003, an action was filed in the Middlesex County Superior Courtin the Commonwealth of Massachusetts. Our subsidiary, OuterLink Corporation, as well as a significantstockholder of OuterLink and a principal of the significant stockholder werenamed as defendants.  The complaintalleged breach of an August 25, 1999 employment contract.  The plaintiff was President and CEO ofOuterLink Corporation from July 1999 through August 2002.  The Complaint sought damages basedprincipally on a contractual severance provision that allegedly provided forfour months of compensation for every year or fraction thereof served prior totermination.  This matter was settled inJuly 2004 in consideration for a cash payment of $250,000.

 

*E-Research Litigation*

 

InJune, 2002, eResearch Technology, Inc. f/k/a Premier Research Worldwide, Ltd.(“ERT”) commenced a proceeding against U.S. Bank National Association (“USBank”), subsequently intervened in by us in the New Jersey state court andsubsequently removed to the United States District Court for the District ofNew Jersey.  This suit was commenced topursue alleged damages of approximately $350,000 due to alleged failure by usand US Bank’s alleged failure to register transfers of restricted Digital Angelshares sold by ERT in May 2002.  Thismatter was settled prior to trial without either party paying any amounts tothe other party. 

 

*Electronic Identification Devices Litigation*

 

InFebruary 2004, Electronic Identification Devices, Ltd. (“EID”) commenced aDeclaratory Judgment Action against us in the United States District Court forthe Western District of Texas. This action seeks a declaration of patentnon-infringement relating to our syringe implantable identificationtransponders.  The lawsuit alleges thatEID has developed a new transponder that it believes does not infringe on ourpatent.  The lawsuit acknowledges that weobtained a Judgment of infringement and two Contempt Orders against EID basedon selling certain systems that infringed our patent in 1997, 1998 and1999.  On March 10, 2004 the Companyfiled a motion seeking the dismissal of the Declaratory Judgment Complaint or,in the alternative, that the action be transferred to Minnesota.  The Court has not yet ruled on the Company’smotion. Given the very early stage of this matter, the ultimate outcome of thisproceeding cannot be predicted at this time. We are currently unable to determine the potential effect of thislitigation on its consolidated financial position, results of operation or cashflows.

 

*John Fernandez vs. United States of America vs. Medical AdvisorySystems, Inc.*

* *

OnDecember 29, 2003, John Fernandez filed a lawsuit in the Orlando Division ofthe United States District Court for the Middle District of Florida.  The plaintiff filed the lawsuit against theUnites States of America as the operator of the ship on which the plaintiffserved.  He alleged that the UnitedStates had contracted with Medical Advisory Systems to provide medical adviceand that the physician at Medical Advisory Systems had rendered an incorrectlong-distance diagnosis, resulting to injury to the plaintiff.  Mr. Fernandez asserted against the UnitedStates claims of negligence under the Jones Act, unseaworthiness andmaintenance and cure. He alleged damages in excess of $75,000, plus prejudgmentand post-judgment interest at the legal rate and costs and disbursements of theaction.  On April 14, 2004, the UnitedStates served Medical Advisory Systems with a third part complaint in Admiralityin which it alleged that Medical Advisory Systems is liable to it for all orpart of the plaintiff’s claim in that Medical Advisory Systems and/or itsemployee/physician rendering the medical advice was negligent.  In response, on May 12, 2004, MedicalAdvisory Systems filed a motion to dismiss the third party complaint.  Given the very early stage of the lawsuit,the ultimate outcome of this proceeding cannot be predicted at this time.  We are currently unable to determine thepotential effect of this litigation on our consolidated financial position,results of operations or cash flows. 

 

**Item 2.****   ****Changes inSecurities, Use of Proceeds and Issuer Purchases of Equity Securities**

 

On May 13,2004, the Company issued 10,000 shares of common stock to Mr. Ronald Dunbar forservices rendered in connection with recruiting Mr. Kevin N. McGrath to bedirector of the Company.  The shares wereissued in an exempt transaction under, among other exemptions, section 4(2) ofthe Securities Act of 1933, as amended. Mr. Dunbar received no other fee or compensation in connection with Mr.McGrath becoming a director of the Company.

 

On April 13,2004, the Company issued 15,309 shares of common stock to Mpact Communications,Inc.  The shares were issued in an exempttransaction under, among other exemptions, section 4(2) of the Securities Actof 1933, as amended and relate to services provided in April 2002 to supportthe initial launch of the first Digital Angel product

 

**Item 4****.    Submissionof Matters to A Vote****ofSecurityholders**

 

At the AnnualMeeting of Stockholders held on May 6, 2004, the following proposals wereadopted by the margins indicated:

 

**PROPOSAL1 – ELECTION OF DIRECTORS**

 

The followingpersons were elected as directors of the Company:

 
| Scott R. Silverman  |   | John R. Block        |
|---------------------|--------|----------------------|
| Kevin N. McGrath    |   | Kevin H. McLaughlin  |
| Howard S. Weintraub |   | Michael S. Zarriello |

 

No fewer than29,215,428 shares were voted in favor of, no more than 2,609,976 shares werevoted against and no shares abstained from voting on the proposed directors.

 

**PROPOSAL2 – APPROVAL OF AMENDMENT TO 2002 TRANSITION STOCK OPTION PLAN**

 

The followingis the result of the stockholders’ vote on the amendment to the 2002 TransitionStock Option Plan:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
|       |       |        |       |        |       |
| 24,532,183 |       | 1,035,289   |       | 16,705      |       |

 

**PROPOSAL3 – RATIFICATION OF OPTIONS GRANTED OUTSIDE OF 2002 TRANSITION STOCK OPTIONPLAN**

 

The following is the result of thestockholders’ vote on the ratification of options granted outside the 2002Transition Stock Option Plan:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** |   |
|------------|------------|-------------|------------|-------------|--------|
|       |       |        |       |        |   |
| 24,471,662 |       | 1,081,147   |       | 31,368      |   |

 

**PROPOSAL4 – RATIFICATION OF APPOINTMENT OF EISNER, LLP**

 

The following is the result of thestockholders’ vote on the ratification of the appointment of Eisner, LLP asindependent auditors:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** |   |
|------------|------------|-------------|------------|-------------|--------|
|       |       |        |       |        |   |
| 31,699,977 |       | 49,172      |       | 76,755      |   |

 

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

 

**(a)****          ****Exhibits**

 

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

 

3.1           Amended and RestatedCertificate of Incorporation (incorporated by reference to Exhibit 3.1 toAmendment No. 1 to our Registration Statement on Form S-3 (No. 333-110817)filed on January 23, 2004)

 

3.2           Bylaws (incorporated byreference to Exhibit 3.2 to Amendment No. 1 to our Registration Statement onForm S-3 (No. 333-110817) filed on January 23, 2004)

 

The following exhibits are filedwith this Quarterly Report on Form 10-Q:

 

31.1         Certification of ChiefExecutive Officer under Rules 13a-14(a)/15d-14(a) under the Securities andExchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.

 

31.2         Certification of ChiefFinancial Officer under Rules 13a-14(a)/15d-14(a) under the Securities andExchange Act and Section 302 of the Sarbanes-Oxley Act of 2002.

 

32.1         Certification of ChiefExecutive Officer Pursuant to 18 U.S.C Section 1350, as Adopted Pursuantto Section 906 of the Sarbanes-Oxley Act of 2002.

 

32.2         Certification of ChiefFinancial Officer Pursuant to 18 U.S.C Section 1350, as Adopted Pursuantto Section 906 of the Sarbanes-Oxley Act of 2002.

 

**(b)****          ****Reports on Form 8-K**

 

Duringthe three months ended March 31, 2004, the Company filed the followingCurrent Reports on Form 8-K:

 

(i)            OnJune 2, 2004 the Company filed a Current Report on Form 8-K dated June 1, 2004to report the execution of a Letter Agreement between the Company and LaurusMaster Fund . 

 

(ii)           On May 3, 2004 the Companyfiled a Current Report on Form 8-K dated May 3, 2004 to report the Company’sfirst quarter financial results.

 

(iii)          On April 23, 2004 theCompany filed a Current Report on Form 8-K dated April 19, 2004 to report thecompletion of the sale of certain assets of the Company’s Medical Systemssegment.

 

(iv)          On April 12, 2004 theCompany filed a Current Report on Form 8-K dated April 8, 2004 to announce thesale of certain assets of the Company’s Medical Systems segment.

 

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**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|                  |   | DIGITAL ANGEL CORPORATION |
|-----------------------|--------|---------------------------|
|                  |   | (Registrant)              |
|                  |   |                      |   |
| Dated: August 3, 2004 |   | By:                       | /S/ JAMES P. SANTELLI |
|                  |   |                      | James P. Santelli |
|                  |   |                      | Vice President - Finance and  Chief  Financial Officer |

 

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