**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D. C. 20549**

 

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# **FORM 10-Q**

 

| **ý**                                         | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF**  |
|----------------------------------------------------|------------|---------------------------------------------------------------------|
| ** **                                         | ** ** | **THE SECURITIES EXCHANGE ACT OF  1934.**                           |
| ** **                                         | ** ** | ** **                                                          |
| **For the  quarterly period ended March 31, 2006** |
| ** **                                         |
| **Or**                                             |
| ** **                                         |
| **o**                                              | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF** |
| ** **                                         | ** ** | **THE SECURITIES EXCHANGE ACT OF  1934.**                           |
|                                                    |            |                                                                     |  |

 

**For the transition periodfrom       to       **

 

**Commission File Number: 1-15177**

 

**DIGITALANGEL CORPORATION**

(Exact name of registrant as specified in itscharter)

 

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

 

**490Villaume Avenue, South Saint Paul, Minnesota, 55075**

(Address of registrant’s principal executiveoffices)

 

**(651)455-1621**

(Registrant’s telephone number, includingarea code)

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.

Yes     ý    No     o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule12b-2 ofthe Exchange Act.

Large acceleratedfiler     o    Acceleratedfiler   o      Non-accelerated filer     ý

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12 b-2 of the Exchange Act).

Yes     o    No     ý

 

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date.

 

| **Class**                                | ** ** | **Outstanding at May 1, 2006** |
|------------------------------------------|------------|-----------------------------------------------|
| Common Stock, $.005 par  value per share |       | 44,191,708 shares                             |

 

 

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**DIGITALANGEL 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                                                                           |       |
| 1A.                                      |       | Risk Factors                                                                                |       |
| 5.                                       |       | Other  Information                                                                          |       |
| 6.                                       |       | Exhibits                                                                                    |       |
| ** **                               | ** ** |
| SIGNATURE                                |       |
| CERTIFICATIONS                           |       |
| EXHIBITS                                 |       |

 

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**PART I FINANCIAL INFORMATION**

Item 1.             Financial Statements.

**DIGITALANGEL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**(In thousands, exceptpar value)

 
| ** **                                                                                                                                                                        | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                        | ** ** | **(Unaudited)**     | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                                        | ** ** | ** **          | ** ** | ** **                  | ** ** |
| **Current Assets**                                                                                                                                                                | ** ** | ** **          | ** ** | ** **                  | ** ** |
| Cash                                                                                                                                                                              | ** ** | **$**               | **8,707**  |                        | $          | 10,049 |   |
| Restricted cash                                                                                                                                                                   | ** ** | **173**             |       | 310                         |       |
| Accounts  receivable (net of allowance for doubtful accounts of $204 in 2006 and $212  in 2005)                                                                                   | ** ** | **9,960**           |       | 10,152                      |       |
| Accounts  receivable from VeriChip Corporation                                                                                                                                    | ** ** | **358**             |       | 232                         |       |
| Inventories                                                                                                                                                                       | ** ** | **9,044**           |       | 8,657                       |       |
| Other current  assets                                                                                                                                                             | ** ** | **1,657**           |       | 1,418                       |       |
| **Total Current Assets**                                                                                                                                                          | ** ** | **29,899**          |       | 30,818                      |       |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Property and Equipment, net**                                                                                                                                                   | ** ** | **8,035**           |       | 8,602                       |       |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Goodwill**                                                                                                                                                                      | ** ** | **49,165**          |       | 48,491                      |       |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Other Intangible Assets, net**                                                                                                                                                  | ** ** | **1,768**           |       | 1,813                       |       |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Other Assets, net**                                                                                                                                                             | ** ** | **379**             |       | 483                         |       |
| ** **                                                                                                                                                                        | ** ** | **$**               | **89,246** |                        | $          | 90,207 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                     | ** ** | ** **          | ** ** | ** **                  | ** ** |
| **Current Liabilities**                                                                                                                                                           | ** ** | ** **          | ** ** | ** **                  | ** ** |
| Line of credit  and current maturities of long-term debt                                                                                                                          | ** ** | **$**               | **2,490**  |                        | $          | 2,380 |   |
| Accounts payable                                                                                                                                                                  | ** ** | **4,902**           |       | 5,381                       |       |
| Accrued expenses  and other current liabilities                                                                                                                                   | ** ** | **2,504**           |       | 3,232                       |       |
| Deferred revenue                                                                                                                                                                  | ** ** | **940**             |       | 1,324                       |       |
| Net liabilities  from discontinued operations                                                                                                                                     | ** ** | **78**              |       | 84                          |       |
| **Total Current Liabilities**                                                                                                                                                     | ** ** | **10,914**          |       | 12,401                      |       |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Long-Term Debt And Notes Payable**                                                                                                                                              | ** ** | **3,525**           |       | 3,656                       |       |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Other Long Term Liabilities**                                                                                                                                                   | ** ** | **1,575**           |       | 1,086                       |       |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Total Liabilities**                                                                                                                                                             | ** ** | **16,014**          |       | 17,143                      |       |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Commitments And Contingencies (See Note 11)**                                                                                                                                   | ** ** | ** **          | ** ** | ** **                  | ** ** |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Minority Interest**                                                                                                                                                             | ** ** | **662**             |       | 618                         |       |
|                                                                                                                                                                              |       |                |       |                        |       |
| **Stockholders’ Equity**                                                                                                                                                     | ** ** | ** **          | ** ** | ** **                  | ** ** |
| Preferred stock:  Authorized 1,000 shares, of $1.75 par value, none outstanding                                                                                                   | ** ** | **—**          | ** ** | **—**                  | ** ** |
| Common stock:  Authorized 95,000 shares, of $.005 par value; 44,570 shares issued and 44,192  shares outstanding in 2006 and 44,225 shares issued and 43,847 outstanding in  2005 | ** ** | **223**             |       | 223                         |       |
| Additional  paid-in capital                                                                                                                                                       | ** ** | **213,297**         |       | 212,564                     |       |
| Accumulated  deficit                                                                                                                                                              | ** ** | **(138,536**        | )          | (137,950                    | )          |
| Deferred  compensation                                                                                                                                                            | ** ** | **(565**            | )          | (481                        | )          |
| Treasury stock  (carried at cost, 378 shares)                                                                                                                                     | ** ** | **(1,580**          | )          | (1,580                      | )          |
| Accumulated other  comprehensive (loss) income                                                                                                                                    | ** ** | **(269**            | )          | (330                        | )          |
| **Total Stockholders’ Equity**                                                                                                                                               | ** ** | **72,570**          |       | 72,446                      |       |
| ** **                                                                                                                                                                        | ** ** | **$**               | **89,246** |                        | $          | 90,207 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

2

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**(In thousands, except per share data)

(Unaudited)

 
| ** **                                                                     | ** ** | **For the  Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                        | ** ** | **2005** | ** ** |
|                                                                           |       |                                            |       |   |   |
| Product revenue                                                                | ** ** | **$**                                           | **15,142** |   | $ | 12,697 |   |
| Service revenue                                                                | ** ** | **680**                                         |       | 706 |   |
| Total net revenue                                                              | ** ** | **15,822**                                      |       | 13,403 |   |
|                                                                           |       |                                            |       |   |   |
| Cost of products sold                                                          | ** ** | **8,767**                                       |       | 7,103 |   |
| Cost of services sold                                                          | ** ** | **279**                                         |       | 305 |   |
|                                                                           |       |                                            |       |   |   |
| Gross profit                                                                   | ** ** | **6,776**                                       |       | 5,995 |   |
|                                                                           |       |                                            |       |   |   |
| Selling, general and administrative  expenses                                  | ** ** | **6,232**                                       |       | 5,328 |   |
| Research and development expenses                                              | ** ** | **1,190**                                       |       | 1,086 |   |
| Operating loss                                                                 | ** ** | **(646**                                        | )          | (419 | ) |
|                                                                           |       |                                            |       |   |   |
| Interest income                                                                | ** ** | **93**                                          |       | 76 |   |
| Interest expense                                                               | ** ** | **(95**                                         | )          | (101 | ) |
| Other income                                                                   | ** ** | **17**                                          |       | 26 |   |
|                                                                           |       |                                            |       |   |   |
| Loss before income taxes and minority  interest                                | ** ** | **(631**                                        | )          | (418 | ) |
|                                                                           |       |                                            |       |   |   |
| Income tax benefit                                                             | ** ** | **84**                                          | ** ** | **—** | ** ** |
| Minority interest share of income                                              | ** ** | **(39**                                         | )          | (75 | ) |
|                                                                           |       |                                            |       |   |   |
| Net loss                                                                       | ** ** | **$**                                           | **(586**   | ) | $ | (493 | ) |
|                                                                           |       |                                            |       |   |   |
| Net loss per common share - basic and  diluted                                 | ** ** | **$**                                           | **(0.01**  | ) | $ | (0.01 | ) |
|                                                                           |       |                                            |       |   |   |
| Weighted average number of common shares  outstanding – basic and diluted | ** ** | **43,907**                                      |       | 43,666 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

3

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITYFor The Three Months Ended March 31, 2006**(In Thousands)(Unaudited)

 
| ** **                                             | ** ** | **Preferred  Stock** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In** | ** ** | **Accumulated** | ** ** | **Deferred** | ** ** | **Treasury** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** |
|--------------------------------------------------------|------------|----------------------|------------|-------------------|------------|-------------------------|------------|-----------------|------------|--------------|------------|--------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                             | ** ** | **Number**           | ** ** | **Amount**        | ** ** | **Number**              | ** ** | **Amount**      | ** ** | **Capital**  | ** ** | **Deficit**  | ** ** | **Compensation**                      | ** ** | **Stock**                     | ** ** | **Loss** | ** ** | **Equity** | ** ** |
| ** **                                             | ** ** | ** **           | ** ** | ** **        | ** ** | ** **              | ** ** | ** **      | ** ** | ** **   | ** ** | ** **   | ** ** | ** **                            | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance-December 31, 2005**                     |       | —               |       | $                 | —     |                    | 44,225     |            | $          | 223          |       | $            | 212,564    |                                  | $          | (137,950                      | )          | $ | (481 | ) | $ | (1,580 | ) | $ | (330 | ) | $ | 72,446 |   |
| Net loss                                               |       | —               |       | —            |       | —                  |       | —          |       | —       |       | (586         | )          | —                                |       | —                        |       | — |   | (586 | ) |
| Comprehensive  loss-foreign currency translation       |       | —               |       | —            |       | —                  |       | —          |       | —       |       | —       |       | —                                |       | —                        |       | 61 |   | 61 |   |
| Total  comprehensive loss                              |       | —               |       | —            |       | —                  |       | —          |       | —       |       | (586         | )          | —                                |       | —                        |       | 61 |   | (525 | ) |
| Compensation  expense related to stock options granted |       | —               |       | —            |       | —                  |       | —          |       | 187          |       | —       |       | (187                                  | )          | —                        |       | — |   | — |   |
| Exercise of stock  options                             |       | —               |       | —            |       | 278                     |       | —          |       | 498          |       | —       |       | —                                |       | —                        |       | — |   | 498 |   |
| Restricted stock  issued                               |       | —               |       | —            |       | 67                      |       | —          |       | —       |       | —       |       | —                                |       | —                        |       | — |   | — |   |
| Amortization of  deferred compensation                 |       | —               |       | —            |       | —                  |       | —          |       | —       |       | —       |       | 103                                   |       | —                        |       | — |   | 103 |   |
| Issuance of stock  options to non-employees            |       | —               |       | —            |       | —                  |       | —          |       | 48           |       | —       |       | —                                |       | —                        |       | — |   | 48 |   |
|                                                   |       |                 |       |              |       |                    |       |            |       |         |       |         |       |                                  |       |                          |       |   |   |   |   |
| **Balance-March 31,  2006**                       |       | —               |       | $                 | —     |                    | 44,570     |            | $          | 223          |       | $            | 213,297    |                                  | $          | (138,536                      | )          | $ | (565 | ) | $ | (1,580 | ) | $ | (269 | ) | $ | 72,570 |   |

 

4

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**DIGITALANGEL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**(In thousands)(Unaudited)

 
| ** **                                                                   | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                  | ** ** | **2005** | ** ** |
| **Cash  Flows From Operating Activities**                                    | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Net loss                                                                     | ** ** | **$**                                     | **(586**   | ) | $ | (493 | ) |
|                                                                         |       |                                      |       |   |   |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                      |       |   |   |
| Equity-based compensation                                                    | ** ** | **151**                                   | ** ** | **—** | ** ** |
| Depreciation and amortization                                                | ** ** | **455**                                   |       | 502 |   |
| Minority interest                                                            | ** ** | **39**                                    |       | 75 |   |
| Loss on disposal of equipment                                                | ** ** | **15**                                    | ** ** | **—** | ** ** |
| Change in assets and liabilities:                                            |       |                                      |       |   |   |
| Decrease in restricted cash                                                  | ** ** | **137**                                   |       | 129 |   |
| Decrease in accounts receivable                                              | ** ** | **—**                                |       | 229 |   |
| Increase in due from VeriChip Corporation                                    | ** ** | **(126**                                  | **)**      | **—** | ** ** |
| Increase in inventories                                                      | ** ** | **(241**                                  | )          | (487 | ) |
| Increase in other current assets                                             | ** ** | **(174**                                  | )          | (15 | ) |
| Decrease in due to ADS                                                       | ** ** | **—**                                |       | (411 | ) |
| Increase in deferred taxes                                                   | ** ** | **(117**                                  | **)**      | **—** | ** ** |
| Decrease in accounts payable, accrued  expenses and deferred revenue         | ** ** | **(948**                                  | )          | (1,071 | ) |
| Net cash (used in) provided by discontinued  operations                      | ** ** | **(6**                                    | )          | 85 |   |
| **Net Cash  Used In Operating Activities**                                   | ** ** | **(1,401**                                | )          | (1,457 | ) |
|                                                                         |       |                                      |       |   |   |
| **Cash  Flows From Investing Activities**                                    | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Decrease (increase) in other assets                                          | ** ** | **101**                                   |       | (26 | ) |
| Payments for property and equipment                                          | ** ** | **(432**                                  | )          | (375 | ) |
| Payments for acquisition costs                                               | ** ** | **(8**                                    | )          | (871 | ) |
| **Net Cash  Used in Investing Activities**                                   | ** ** | **(339**                                  | )          | (1,272 | ) |
|                                                                         |       |                                      |       |   |   |
| **Cash  Flows From Financing Activities**                                    | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Amounts borrowed on line of credit                                           | ** ** | **997**                                   | ** ** | **—** | ** ** |
| Amounts paid on line of credit                                               | ** ** | **(943**                                  | )          | (32 | ) |
| Payments on notes payable and long-term  debt                                | ** ** | **(164**                                  | )          | (54 | ) |
| Exercise of stock options and warrants                                       | ** ** | **498**                                   |       | 358 |   |
| Purchase of treasury stock                                                   | ** ** | **—**                                |       | (231 | ) |
| **Net Cash  Provided by Financing Activities**                               | ** ** | **388**                                   |       | 41 |   |
|                                                                         |       |                                      |       |   |   |
| **Effect of Exchange Rate Changes on Cash**                                  | ** ** | **10**                                    |       | 68 |   |
|                                                                         |       |                                      |       |   |   |
| **Net  Decrease In Cash**                                                    | ** ** | **(1,342**                                | )          | (2,620 | ) |
|                                                                         |       |                                      |       |   |   |
| **Cash -  Beginning Of Period**                                              | ** ** | **10,049**                                |       | 17,492 |   |
|                                                                         |       |                                      |       |   |   |
| **Cash -  End Of Period**                                                    | ** ** | **$**                                     | **8,707**  |   | $ | 14,872 |   |

See the accompanying notes to condensed consolidated financialstatements.

 

5

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**DIGITAL ANGEL CORPORATION**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS(Dollars in thousands)(Unaudited)**

 

**1.****                                     ****The Company and Basis of Presentation**

 

DigitalAngel Corporation and its subsidiaries (“the Company”) develops and deployssensor and communications technologies that enable rapid and accurateidentification, location tracking, and condition monitoring of high-valueassets. The Company operates in two segments: (1) Animal Applications and (2)GPS and Radio Communications.

 

*Animal Applications—*develops, manufactures, and markets a broad line of electronic and visualidentification devices for the companion animal, livestock, laboratory animal,fish and wildlife markets worldwide. The Animal Applications segment consistsof our operations located in Minnesota and DSD Holdings A/S and itswholly-owned subsidiaries, located in Denmark. The positive identification andtracking of cattle and hogs are crucial for asset management and for diseasecontrol and food safety. In addition to the visual ear tags which have beensold by the Company since the late 1940’s, Animal Applications utilizes radiofrequency transmission (“RFID”) technologies in its electronic ear tags andimplantable microchips.

 

*GPS and Radio Communications—*consistsof the design, manufacture and support of global positioning system (“GPS”)enabled equipment. The GPS and Radio Communications segment consists of theCompany’s subsidiaries Signature Industries Limited (90.9% owned), located inthe United Kingdom and OuterLink Corporation, located in Massachusetts. Applicationsfor the segment’s products include location tracking and message monitoring ofvehicles, aircraft and people in remote locations through systems thatintegrate geosynchronous satellite communications and GPS enabled equipment andintelligent communications products and services for telemetry, mobile data andradio communications applications serving commercial and military markets.Technology development in this segment includes the integration andminiaturization into marketable products of two technologies: wireless communications and positionlocation technology (including GPS and other systems).

 

OnFebruary 28, 2005, the Company acquired Denmark-basedDSD Holdings A/S and its wholly-owned subsidiaries Daploma International A/S andDigitag A/S, including Daploma International A/S’s 70%-owned subsidiary,Daploma Polska. DSD Holdings A/S became a wholly-owned subsidiary of DigitalAngel Corporation. DSD Holdings A/S produces visual and RFID tags. DSD HoldingsA/S’s operations are included from the date of acquisition.

 

As ofMarch 31, 2006, Applied Digital Solutions, Inc. (“Applied Digital” or “ADS”)owned 24,291,673 shares or approximately 55.0% of the Company’s common stock.

 

Theaccompanying unaudited condensed consolidated financial statements of theCompany as of March 31, 2006 and for the three month periods endedMarch 31, 2006 and 2005 have been prepared in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial 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 the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements. In the opinion of the Company’s management, alladjustments (including normal recurring adjustments) considered necessary topresent fairly the financial statements have been made.

 

Theconsolidated statements of operations for the three months ended March 31,2006 and 2005 are not necessarily indicative of the results that may beexpected for the entire year. These statements should be read in conjunctionwith the Digital Angel Corporation’s audited consolidated financial statementsand related notes thereto for the year ended December 31, 2005 which areincluded in the Company’s Annual Report on Form 10-K.

 

6

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Certainitems in the condensed consolidated financial statements for the 2005 periodshave been reclassified for comparative purposes.

 

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

 

The March31, 2006 and 2005 condensed consolidated financial statements include theaccounts of the Company and its wholly-owned and majority-owned subsidiaries(DSD Holdings A/S operations are included from the date of acquisition,February 28, 2005). All significant intercompany accounts and transactions havebeen 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 exist, 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 and fixed fee jobs, service revenue is recognized basedon the actual direct labor hours in the job multiplied by the standard billingrate and adjusted to net realizable value, if necessary. Other revenue isrecognized at the time service or goods are provided. It is the Company’spolicy to record contract losses in their entirety in the period in which suchlosses are foreseeable.

 

TheCompany’s subsidiary, OuterLink Corporation, earns revenue from messagingservices and from the sale of related products to customers (communicationterminals and software). OuterLink Corporation’s messaging service is onlyavailable through use of its products and such products have no alternative use.Accordingly, service revenue is recognized as the services are performed. OuterLinkCorporation’s product revenue, for which title and risk of loss transfers tothe customer on shipment, is deferred upon shipment and is recognized ratablyover the estimated customer service period of 42 months in the three monthperiod ended March 31, 2006 and 30 months in the three month period ended March31, 2005.

 

TheCompany records a liability for product warranties at the time it is probablethat a warranty liability has been incurred and the amount of loss can bereasonably estimated. The Company’s warranty liability was $34,000 as of March31, 2006. Following is a reconciliation of the Company’s product warranties (inthousands):

 
| ** **                                                                    | ** ** | **Amount of  Liability** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------|------------|
|                                                                          |       |                     |       |
| Balance as  of December 31, 2005                                         |       | $                        | 34         |   |
| Accruals for  warranties issued during the period                             |       | —                   |       |
| Accruals  related to pre-existing warranties (including changes in estimates) |       | —                   |       |
| Settlements  made (in cash or in kind) during the period                      |       | —                   |       |
| Balance as  of March 31, 2006                                            |       | $                        | 34         |   |

 

**4.****                                     ****Stock-Based Compensation**

 

On January 1, 2006 we adopted SFAS No. 123(revised 2004), “Share-Based Payment” (SFAS 123R). SFAS 123R replaced SFAS No. 123and supercedes APB Opinion No. 25. SFAS 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values. The proforma disclosures previously permitted under SFAS 123 are no longer analternative to financial statement recognition. We adopted SFAS 123R using themodified prospective method 

 

7

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which requires the application of the accountingstandard as of January 1, 2006. Our consolidated financial statements as of andfor the quarter ended March 31, 2006 reflect the impact of adopting SFAS 123R. Inaccordance with the modified prospective method, the consolidated financialstatements for prior periods have not been restated to reflect, and do notinclude, the impact of SFAS 123R. See Note 8, Stock Options and RestrictedStock for further details.

 

**5.****                                     ****Inventory (in thousands)**

 
| ** **                            | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Raw materials                         | ** ** | **$**                    | **3,617**  |                        | $          | 3,198 |   |
| Work in process                       | ** ** | **121**                  |       | 122                         |       |
| Finished goods                        | ** ** | **6,993**                |       | 7,006                       |       |
|                                  | ** ** | **10,731**               |       | 10,326                      |       |
| Allowance for excess and obsolescence | ** ** | **(1,687**               | )          | (1,669                      | )          |
| Net inventory                         | ** ** | **$**                    | **9,044**  |                        | $          | 8,657 |   |

 

**6.****                                     ****Stock Exchange with Applied Digital Solutions, Inc.**

 

OnFebruary 25, 2005, the Company entered into a Stock Purchase Agreement with Applied Digital. Thepurpose of the stock exchange was to use the shares as partial considerationfor the acquisition of DSD Holdings A/S and its wholly-owned subsidiaries,Daploma International A/S and Digitag A/S, including Daploma International A/S’s70%-owned subsidiary, Daploma Polska, as described more fully in Note 10. TheCompany and Applied Digital entered into the share exchange because of theselling shareholders’ desire, at the time the transaction was negotiated, toreceive their consideration in Applied Digital common stock as opposed to theCompany’s common stock. In addition, the stock purchase represented a strategicinvestment by Applied Digital whereby Applied Digital could increase itsownership interest in the Company. Pursuantto the agreement, the Company issued 644,140 shares of its common stock toApplied Digital. The Company received 684,543 shares of Applied Digital commonstock as consideration. The exchange ratio of shares was based upon theaverage of the volume-weighted-average price of the Company’s common stock andApplied Digital’s common stock for the ten trading days immediately preceding,and not including, the transaction closing date which was $5.434 for the Company’scommon stock and $5.113 for Applied Digital’s common stock. The value of the stock exchanged was $3.5million.

 

**7.**                                      **Discontinued Operations**

 

InApril 2004, our Board of Directors approved a plan to sell our MedicalSystems segment. The Medical Systems segment represented the businessoperations of Medical Advisory Systems, Inc, which we acquired onMarch 27, 2002. The Medical Systems segment was one of our reporting unitsin accordance with SFAS 131, “Disclosures about Segments of an Enterprise andRelated Information”. Accordingly, the financial condition, results ofoperations and cash flows of our Medical Systems segment have been reported asdiscontinued operations for all periods presented. For the three months endedMarch 31, 2006 and 2005, there were no losses attributable to the MedicalSystems segment. The Company does not anticipate the Medical Systems divisionincurring additional losses in the future. However, in accordance with SFAS144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, anyadditional operating losses or changes in the values of assets or liabilitieswill be reflected in the financial condition and results of operations asincurred.

 

The net liabilities of discontinued operations as of March 31,2006 and December 31, 2005, were comprised of accrued expenses aggregating$78,000 and $84,000, respectively.

 

8

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**8.****                                     ****Stock Options and Restricted Stock**

 

*StockOption Plans*

 

As of March 31, 2006 the Company maintains the AmendedAnd Restated Digital Angel Corporation Transition Stock Option Plan (“DAC StockOption Plan”), which is described below, and has outstanding stock optionswhich were issued pursuant to another plan which was terminated on February 23,2006. On January 1, 2006 we adopted SFAS 123R, using the modified prospectivetransition method. Accordingly, during the three month period ended March 31,2006 we recorded stock-based compensation expense for awards granted prior to,but not yet vested as of January 1, 2006, as if the fair value method requiredfor pro forma disclosure under SFAS 123 were in effect for expense recognitionpurposes. Upon adoption of SFAS 123R we elected to continue using theBlack-Scholes option pricing and we have recognized compensation expense usinga straight-line amortization method. During the three months ended March 31,2006 we recorded $151,000 (this amount reflects compensation for optionsgranted to non-employees and for restricted stock grants) in stock-basedemployee compensation expense.

 

As of March 31, 2006, the DAC Stock Option Plan,which is stockholder-approved, has 18,195,312 shares of common stock reservedfor issuance, of which 15,601,516 shares have been issued and 2,593,796 remainavailable for issuance.  As of March 31, 2006 awards consisting of optionsto purchase 7,645,196 shares were outstanding under the DAC Stock Option Planand awards consisting of options to purchase 476,820 shares were outstandingunder the Company’s terminated stock option plan. Additionally, restrictedstock awards for 154,230 shares of common stock have been granted under the DACStock Option Plan. Option awards are generally granted with an exercise priceequal to 110% the market price of the Company’s stock at the date of grant;those option awards generally vest over 3 years and have 10-year contractualterms. Certain option and share awards provide for accelerated vesting if thereis a change in control (as defined in the DAC Stock Option Plan).

 

*StockOption Activity*

 

The fair value of each option award is estimated onthe date of grant using a Black-Scholes valuation model. The followingassumptions were used for options granted in the three month period ended March31, 2005. There were no options granted in the three month period ended March31, 2006.  

 
| ** **                   | ** ** | **For the Three Months  Ended March 31,** | ** ** |
|------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                   | ** ** | **2005**                                                           | ** ** |
| Risk-free  interest rate     |       | 3.81                                                               | %          |
| Expected life (in  years)    |       | 5                                                                  |       |
| Dividend yield               |       | 0                                                                  | %          |
| Expected  volatility         |       | 106.09%-109.70                                                     | %          |
| Weighted-average  volatility |       | 108.54                                                             | %          |

 

Priorto 2006, our computation of expected volatility was determined based onhistorical volatility. Our computation of expected life in 2005 was determinedbased on historical experience of similar awards, giving consideration to thecontractual terms of the stock-based awards, vesting schedules and expectationsof future employee behavior. The interest rate is based on the U.S. Treasuryyield curve in effect at the time of grant.

 

Asummary of option activity under the Company’s option plans (the DAC StockOption Plan and the Company’s terminated plan) as of March 31, 2006, andchanges during the quarter then ended is presented below (in thousands, exceptper share amounts):

 
| ** **                      | ** ** | **Stock  Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|---------------------------------|------------|--------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|-------------------------------------|------------|
|                            |       |               |       |                                       |       |                                     |       |                                |       |
| Outstanding at  January 1, 2006 |       | 8,455              |       | $                                          | 3.97       |                                     |       |                                |       |   |
| Granted                         |       | —             |       | —                                     |       |                                     |       |                                |       |
| Exercised                       |       | (278               | )          | 1.80                                       |       |                                     |       |                                |       |
| Forfeited or  Expired           |       | (55                | )          | 4.49                                       |       |                                     |       |                                |       |
| Outstanding at  March 31, 2006  |       | 8,122              |       | $                                          | 4.04       |                                     | 7.85       |                                | $          | 5,331 | * |
| Exercisable at  March 31, 2006  |       | 7,922              |       | $                                          | 4.05       |                                     | 7.81       |                                | $          | 5,191 | * |

 

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*The intrinsic value of a stock option is the amount by which the market valueof the underlying stock exceeds the exercise price of the option. The marketvalue of our stock was $4.30 at March 31, 2006.

 

9

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Theweighted-average grant-date fair value of options granted during the quarterended March 31, 2005 was $3.41. The total intrinsic value of options exercisedduring the quarters ended March 31, 2006 and 2005 was $534,000 and$72,000,  respectively.

 

Asummary of the status of the Company’s nonvested stock options as of March 31,2006, and changes during the three month period ended March 31, 2006, ispresented below (in thousands, except per share amounts):

 
| ** **                   | ** ** | **Stock Options** | ** ** | **Weighted Average  Grant-Date  Fair Value** | ** ** |
|------------------------------|------------|------------------------|------------|--------------------------------------------------------|------------|
| ** **                   | ** ** | ** **             | ** ** | ** **                                             | ** ** |
| Nonvested at January 1, 2006 |       | 216,667                |       | $                                                      | 2.42       |   |
| Granted                      |       | —                 |       | —                                                 |       |
| Vested                       |       | (16,667                | )          | 1.29                                                   |       |
| Nonvested at March 31, 2006  |       | 200,000                |       | $                                                      | 2.52       |   |

 

Asof March 31, 2006, there was $0.6 million of total unrecognized compensationcost related to nonvested share-based compensation arrangements granted underthe DAC Stock Option Plan.  That cost is expected to be recognized over aweighted-average period of 2.0 years.  The total fair value of sharesvested during the quarter ended March 31, 2006, was $17,000.

 

Cashreceived from option exercise under all share-based payment arrangements forthe three months ended March 31, 2006, was $0.5 million.

 

On January 13, 2004, the Company granted itsChief Executive Officer (CEO) aten-year option to purchase 1,000,000 shares of the Company’s common stock at$3.92 per share. This option was granted outside the Company’s stock plans. Theoption became exercisable on December 30, 2005. As of March 31, 2006 theoption remains outstanding.

 

On February 18, 2004, the Company granted itsChairman of the Board of Directors aten-year option to purchase 500,000 shares of the Company’s common stock at$3.43 per share. This option was granted outside the Company’s stock plans. Theoption became exercisable on February 18, 2005. As of March 31, 2006 theoption remains outstanding.

 

*Restricted Stock*

 

In March 2005, theCompany granted its Chairman of the Board 100,000 shares of the Company’srestricted stock. The restricted stock vests 50% on March 7, 2006 and 50%on March 7, 2007. The Company determined the value of the stock to be$506,000 based on the closing price of the Company’s stock on the date ofgrant. The value of the restricted stock has been recorded as deferredcompensation and is being amortized to compensation expense over the two yearvesting period. In the three month period March 31, 2006, $63,000 wasrecognized as compensation expense in the Company’s results of operations.

 

In February 2005, theCompany granted an employee 54,230 shares of the Company’s restricted stock.The restricted stock vests 30% on February 25, 2006, 30% onFebruary 25, 2006 and 40% on February 25, 2007. The Companydetermined the value of the stock to be $250,000 based on the closing price ofthe Company’s stock on the date of grant. The value of the restricted stock hasbeen recorded as deferred compensation and is being amortized to compensationexpense over the vesting period. In the three month period March 31, 2006 $17,000was recognized as compensation expense in the Company’s results of operations.

 

10

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*ProForma Information for Periods Prior to the Adoption of SFAS 123R*

 

Priorto the adoption of SFAS 123R, we provided the disclosures required under SFAS123 as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosures.” Employee stock-based compensation expenses recognized under SFAS 123Rwas not reflected in our results of operations for the three month period endedMarch 31, 2005 for employee stock option awards as all stock options weregranted with an exercise price greater than or equal to the market value of theunderlying common stock on the date of grant. Previously reported results havenot been restated.

 

Thepro forma information for the three months ended March 31, 2005 was as follows(in thousands, except per share amounts):

 
| Reported net loss                                                              |   | $      | (493   | ) |
|--------------------------------------------------------------------------------|--------|--------|--------|---|
| Stock-based  compensation expense in reported net loss                         |   | — |   |
| Stock-based  compensation expense determined under the fair value based method |   | (1,275 | )      |
| Pro forma net  loss                                                            |   | $      | (1,768 | ) |
|                                                                           |   |   |   |
| Loss per share  (basic and diluted)                                            |   |   |   |
| As reported                                                                    |   | $      | (0.01  | ) |
| Pro forma                                                                      |   | $      | (0.04  | ) |

 

**9.****                                     ****Segment Information**

 

The Company is an advanced technology companyin the field of rapid and accurate identification, location tracking, andcondition monitoring of high-value assets. The Company’s operating segmentsare: (1) Animal Applications and (2) GPS and Radio Communications.

 

It is onthe basis of segment reporting that management utilizes the financialinformation to assist in making internal operating decisions. The Companyevaluates performance based on stand-alone segment operating income.

 

Followingis the selected segment data for the three months ended March 31, 2006 (inthousands):

 
| ** **                                                      | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|-----------------------------------|------------|------------------|------------|
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Net revenue from  external customers:                           |       |                     |       |                                        |       |                              |       |             |       |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Product                                                         |       | $                        | 11,085     |                                        | $          | 4,057                             |       | $                | —     |   | $ | 15,142 |   |
| Service                                                         |       | 417                      |       | 263                                         |       | —                            |       | 680              |       |
| Total revenue                                                   |       | $                        | 11,502     |                                        | $          | 4,320                             |       | $                | —     |   | $ | 15,822 |   |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Operating loss                                                  |       | $                        | (96        | )                                           | $          | (550                              | )          | $                | —     |   | $ | (646 | ) |
|                                                            |       |                     |       |                                        |       |                              |       |             |       |
| Loss before  income taxes and minority interest share of income |       | $                        | (71        | )                                           | $          | (560                              | )          | $                | —     |   | $ | (631 | ) |
| Total assets                                                    |       | $                        | 80,288     |                                        | $          | 8,958                             |       | $                | —     |   | $ | 89,246 |   |

 

11

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Followingis the selected segment data as of and for the three months ended March 31,2005 (in thousands):

 
| ** **                                                                        | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|-----------------------------------|------------|------------------|------------|
|                                                                              |       |                     |       |                                        |       |                              |       |             |       |
| Net revenue from  external customers:                                             |       |                     |       |                                        |       |                              |       |             |       |
|                                                                              |       |                     |       |                                        |       |                              |       |             |       |
| Product                                                                           |       | $                        | 7,881      |                                        | $          | 4,816                             |       | $                | —     |   | $ | 12,697 |   |
| Service                                                                           |       | 416                      |       | 290                                         |       | —                            |       | 706              |       |
| Total revenue                                                                     |       | $                        | 8,297      |                                        | $          | 5,106                             |       | $                | —     |   | $ | 13,403 |   |
|                                                                              |       |                     |       |                                        |       |                              |       |             |       |
| Operating loss                                                                    |       | $                        | (44        | )                                           | $          | (375                              | )          | $                | —     |   | $ | (419 | ) |
|                                                                              |       |                     |       |                                        |       |                              |       |             |       |
| Loss before  taxes, minority interest share of income and discontinued operations |       | $                        | (21        | )                                           | $          | (397                              | )          | $                | —     |   | $ | (418 | ) |
| Total assets                                                                      |       | $                        | 84,761     |                                        | $          | 14,923                            |       | $                | —     |   | $ | 99,684 |   |

 

**10.****                              ****Acquisitions**

 

Thefollowing describes the acquisitions by the Company (in thousands) in the threemonths ended March 31, 2006 and the year ended December 31, 2005:

 
| **Company Acquired** | ** ** | **Date  |Acquired** | ** ** | **Acquisition  Price** | ** ** | **Goodwill  and  Other  Intangibles  Acquired** | ** ** | **Other Net  Assets and  Liabilities** | ** ** | **Business Description** | ** ** |
|---------------------------|------------|---------------------|------------|------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------|------------|
| DSD Holdings A/S          |       | 2/28/05             |       | $                      | 3,902      |                                            | $          | 6,008                                            |       | $                             | (2,106     | ) | Manufactures and markets visual and  electronic RFID tags for livestock. |   |
|                           |            |                     |            |                        |            |                                                 |            |                                                  |            |                               |            |  |  |  |

 

On February 28, 2005, theCompany acquired DSD Holdings A/S and its wholly-owned subsidiaries DaplomaInternational A/S and Digitag A/S, including Daploma International A/S’s70%-owned subsidiary. DSD Holdings A/S became a wholly-owned subsidiary ofDigital Angel Corporation. Denmark-based DSD Holdings A/S through itssubsidiaries manufactures and markets visual and electronic RFID tags forlivestock. Theacquisition was accounted for under the purchase method of accounting. Theexcess of purchase price over the fair value of the assets and liabilities ofDSD Holdings A/S has been recorded as goodwill of $4.0 million and intangibleassets of $2.0 million. The intangible assets are customer relationships,tradename, patents and a non-compete agreement. The customer relationships,patents and a non-compete agreement are being amortized over periods rangingfrom 3 to 15 years. Amortization recorded in the three months ended March 31,2006 was $45,000. The tradename has an indefinite life.

 

Under theterms of the DSD Holdings A/S acquisition, the Company purchased all of theoutstanding capital stock of DSD Holdings A/S in consideration for a purchaseprice of seven times DSD Holdings A/S’s average annual EBITDA over the nextthree years less outstanding indebtedness at the end of the time period. An initialpayment of $3.5 million was made at closing through the delivery of AppliedDigital common stock valued at $3.5 million which the Company acquired fromApplied Digital in exchange for $3.5 million of Digital Angel Corporationcommon stock. To account for pre-closing pricing fluctuations the Company paidadditional consideration of $195,000 to the shareholders of DSD Holdings A/S onJune 7, 2005. Pursuant to the terms of the stock purchase agreement, atany time between the closing date of the acquisition and December 31, 2006 theCompany had the right to buyout the remaining purchase price. On April 13, 2006the Company exercised its right to buyout the remaining purchase price byelecting to pay the set amount, as defined in the agreement, of $2 million. The$2 million buyout price will be satisfied by a cash payment of $1 million andshares of the Company’s unregistered common stock valued at $1 million. The $1million cash payment was made on April 13, 2006.

 

In addition, Digital Angel entered into employmentagreements with the Chief Executive Officer of DSD Holdings A/S and itssubsidiaries, Lasse Nordfjeld and his son, the President of Daploma, TorstenNordfjeld.

 

12

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Digital Angel Corporation operates DSDHoldings A/S and its operating subsidiaries from their current headquartersnear Copenhagen, Denmark.

 

Theresults of DSD Holdings A/S have been included in the consolidated financialstatements since its date of acquisition. Unaudited pro forma results ofoperations for the three months ended March 31, 2005 are included below. Suchpro forma information assumes that the above acquisition had occurred as ofJanuary 1, 2005, and revenue is presented in accordance with the Company’saccounting policies. This summary is not necessarily indicative of what theresults of operations of the Company would have been had it been a combinedentity during such periods, nor does it purport to represent results ofoperations for any future periods.

 
| ** **                                     | ** ** | **For the Three  Months  Ended March 31,** | ** ** |
|------------------------------------------------|------------|----------------------------------------------------------------|------------|
| **(In thousands)**                        | ** ** | **2005**                                                       | ** ** |
| Net revenue                                    |       | $                                                              | 14,286     |   |
| Net loss                                       |       | $                                                              | (524       | ) |
| Net loss per  common share - basic and diluted |       | $                                                              | (0.01      | ) |

 

**11.****                              ****Litigation**

 

*Digital Angel Corporation vs.Allflex USA, Inc and Pet Health Services (USA), Inc.*

 

On October 20, 2004, the Company commenced anaction in the United Stated District Court for the District of Minnesotaagainst AllFlex USA, Inc. and Pet Health Services (USA), Inc. Thissuit claimed that Allflex was marketing and selling a syringe implantableidentification transponder that infringed a 1993 patent granted to the Companyfor syringe implantable identification transponders previously found by theUnited States District Court for the District of Colorado to be enforceable.The suit also claimed that PetHealth was using, selling and/or distributing thesame transponder in violation of the Company’s patent. The suit sought, amongother things, an adjudication of infringement and that the infringing partiesbe enjoined from further improper action. The suit sought actual damages,punitive damages and interest, costs and attorneys’ fees. Allflex asserted acounterclaim for breach of contract of an existing license agreement betweenthe Company and Allflex and asserted a counterclaim seeking a declaration ofthe parties’ rights and obligations under the license agreement. Allflex alsomoved for a judgment on the pleadings, asserting that the license agreementshould act as a bar to a case for infringement. The Company contested themotion on the ground that Allflex’s actions exceed the scope of the license andconstituted an impermissible infringement of the patent and asked the Court forleave to amend the complaint to assert a claim for infringement of a separatepatent licensed exclusively to the Company by Bio Medic Data Systems. OnJune 23, 2005, the Court issued a ruling granting the Defendant’s motionfor judgment on the pleadings and denying the Company’s motion for leave toamend.

 

On July 21, 2005, Allflex filed an action inthe United Stated District Court for the Northern District of Texas seeking adeclaratory judgment that it did not infringe the Bio Medic patent. The Companyhas not been served with this complaint and Allflex agreed to withdraw thecomplaint without prejudice.

 

On September 28, 2005, Allflex sought an awardof attorneys fees and costs based on a fee-shifting clause in the licenseagreement and under 35 U.S.C. §285, which provides for an award of attorneysfees and costs in exceptional cases. The Company contested this motion, and onOctober 6, 2005, the Court denied the motion in its entirety. Finaljudgment in the action was entered on February 21, 2006. On March 20,2006, the Company filed a notice of appeal with the Federal Circuit Court of Appealsin Washington, D.C. The appeal is presently pending.

 

*Digital Angel Corporation vs. Datamars, Inc., Datamars, S.A., TheCrystal Import Corporation and Medical Management International, Inc.*

 

On October 20, 2004, the Company commenced anaction in the United States District Court for the District of Minnesotaagainst Datamars, Inc., Datamars, S.A., The Crystal Import Corporation,and Medical

 

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Management International, Inc.(“Banfield”). This suit claims that the defendants are marketing and sellingsyringe implantable identification transponders manufactured by Datamars thatinfringe the Company’s 1993 patent for syringe implantable identificationtransponders previously found by the United States District Court for theDistrict of Colorado to be enforceable. Certain of the locations in which theinfringing transponders are or have been sold, include, but are not limited to,“Banfield, The Pet Hospital” of which certain locations are associated withPetSmart stores. The suit seeks, among other things, an adjudication ofinfringement and that the infringing parties be enjoined from further improperaction. The suit also seeks actual damages, punitive damages and interest,costs and attorneys’ fees. The Company believes that the suit is well-groundedin law and fact. Discovery in the action has been commenced and is continuing.On February 28, 2006, the Court conducted a hearing (the “MarkmanHearing”) in which each of the parties presented the Court with their viewsregarding the scope of the claims set forth in the subject patent. Followingthe hearing, the Court took the matter under advisement, and indicated that aruling on the scope of the claims would be issued in the ordinary course. As ofthe date of this filing, no ruling has been received by the Company.

 

*Crystal Import Corporation v. Digital Angel, et al.*

 

On or about December 29, 2004, The CrystalImport Corporation filed an action against AVID IdentificationSystems, Inc. and the Company in the United States District Court for theNorthern District of Alabama. Crystal’s complaint primarily asserted federaland state antitrust and related claims against AVID, though it also assertedsimilar claims against the Company. The Company filed a motion to dismiss theaction for failure to state a claim on which relief could be granted, or in thealternative, to have the action transferred to the United States District Courtfor the District of Minnesota. On October 12, 2005, the Alabama Court deniedthe Company’s motion to dismiss the complaint, but granted the Company’s motionto transfer the action to Minnesota. Following the docketing of the action inMinnesota, the Company and AVID filed a motion seeking to stay the case untilthe corresponding patent infringement actions have been resolved. This motionhas been scheduled for hearing in May, 2006. Given the uncertainties associatedwith all litigation and given the early stage of this proceeding, the Companyis unable to offer any assessment on the potential liability exposure, if any,to the Company from this lawsuit.

 

*Digital Angel Corporation v. Corporativo SCM, S.A. de C.V.*

 

On or about June 2, 2005, the Company filed adeclaratory judgment action in the U.S. District Court for the District of Minnesotaseeking to have the Court determine the rights and liabilities of the Companyunder a 2002 distribution agreement with Corporativo SCM, S.A. de C.V., aMexican company which entered into a distribution agreement for a product thatwas then under development by the Company but the development of which wassubsequently abandoned. Although the distribution agreement required that anyactions arising out of or related to the agreement be filed within two years ofthe occurrence of the events giving rise to the claim, the Company received aletter in 2005 from the defendant threatening to assert a claim notwithstandingthe two year limit set forth in the agreement. The defendant accordingly fileda motion to dismiss the declaratory judgment action, which the Court denied. Onor about January 10, 2006, the defendant filed an answer and asserted acounterclaim against the Company for fraud seeking damages in an amount inexcess of $75,000. The Company filed a response denying the allegations of thecounterclaim, and has asked that the Court dismiss the claim both because theclaim was not timely filed in accordance with the provisions of the agreementand because the counterclaim was not plead with the specificity required by theapplicable rules of Civil Procedure. The defendant filed a responsivebrief and, in addition, filed an amended complaint repleading its claims andadding a counterclaim for fraud in the inducement. Arguments on the Company’smotion to dismiss were heard on March 22, 2006. The Court took the matter underadvisement, and as of the date of the filing of this quarterly report, theCourt has not ruled on the merits of the motion. Given the uncertaintiesassociated with all litigation and given the early stage of this proceeding,the Company is unable to offer any assessment on the potential liabilityexposure, if any, to the Company from this lawsuit.

 

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**12.****                              ****Supplemental Cash Flow Information (in thousands)**

 
| ** **                                     | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Interest paid                                  | ** ** | **$**                                                | **93**     |   | $ | 89 |   |
| Taxes paid                                     | ** ** | **36**                                               |       | — |   |
| Non-cash  activity:                            |       |                                                 |       |   |   |
| Issuance of  common stock for ADS common stock |       | —                                               |       | 3,500 |   |
|                                                |            |                                                      |            |  |  |  |  |

 

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

 

The Company has an exclusive eleven-yearDistribution and Licensing Agreement dated March 4, 2002, amendedDecember 28, 2005,  with VeriChipCorporation (VeriChip), a wholly-owned subsidiary of Applied Digital, coveringthe manufacturing, purchasing and distribution of the Company’s implantablemicrochip and the maintenance of the VeriChip Registry by the Company. Theamended agreement contains, among other things, minimum purchase requirementsin order to maintain exclusivity, whereby VeriChip is required to purchase$875,000, $1,750,000 and $2,500,000 for each of 2007, 2008 and 2009,respectively, and $3,750,000 for 2010 and each year thereafter. The agreementcontinues until March 2013, and, as long as VeriChip continues to meet theminimum purchase requirements, will automatically renew annually under itsterms. The Distribution and Licensing agreement includes a license for the useof the Company’s technology in VeriChip’s identified markets. Under theDistribution and Licensing Agreement the Company is the sole manufacturer andsupplier to VeriChip. The existing terms with the Company’s sole supplier ofimplantable microchips, Raytheon Microelectronics Espana, SA, expire on June30, 2010. TheDistributionand Licensing Agreement also includes indemnity and hold harmless provisions for VeriChip.Further, the agreement provides that the Company shall, at VeriChip’s option,furnish and operate a computer database to provide data collection, storage andrelated services for VeriChip’s customers for a fee.

 

Revenuerecognized under the Distribution and Licensing Agreement was $0.2 million and$0.4 million for the three months ended March 31, 2006 and 2005,respectively.

 

See Note6 for a description of the stock exchange transactions with Applied Digital.

 

Followingis a summary of amounts due from and amounts due to related parties as ofMarch 31, 2006 and December 31, 2005. (In thousands)

 
| ** **                     | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Due from VeriChip  Corporation | ** ** | **$**                    | **358**    |                        | $          | 232 |   |
| Due to Applied  Digital        |       | —                   |       | —                      |       |
|                                |            |                          |            |                             |            |  |  |

 

**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations.**

 

Thefollowing discussion and analysis of our financial condition and results ofoperations should be read in conjunction with the accompanying financialstatements and related notes thereto.

 

Weconsist of Digital Angel Corporation and our subsidiaries - Digital AngelTechnology Corporation (“DATC”), Fearing Manufacturing, Inc., Timely TechnologyCorp., Signature Industries Limited (90.9% owned subsidiary), OuterLinkCorporation, DSD Holdings A/S and its subsidiaries Daploma International A/S(including its 70%-owned subsidiary, Daploma Polska) and Digitag A/S, DigitalAngel Holdings, LLC and Digital Angel International, Inc. and itssubsidiaries Digital Angel S.A. and Digital Angel do Brasil Produtos deInformatica LTDA.

 

15

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**RESULTS OF OPERATIONS**

 

Thefollowing table summarizes our results of operations as a percentage of netoperating revenue for the three months ended March 31, 2006 and 2005 andis derived from the accompanying consolidated statements of operations includedin this report.

 
| ** **                                                      | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| ** **                                                      | ** ** | **%**                                            | ** ** | **%** | ** ** |
| Product revenue                                                 |       | 95.7                                             |       | 94.7 |   |
| Service revenue                                                 |       | 4.3                                              |       | 5.3 |   |
| Total net revenue                                               |       | 100.0                                            |       | 100.0 |   |
| Cost of products  sold                                          |       | 55.4                                             |       | 53.0 |   |
| Cost of services  sold                                          |       | 1.8                                              |       | 2.3 |   |
| Total cost of  products and services sold                       |       | 57.2                                             |       | 55.3 |   |
| Gross profit                                                    |       | 42.8                                             |       | 44.7 |   |
| Selling, general  and administrative expenses                   |       | 39.4                                             |       | 39.8 |   |
| Research and  development expenses                              |       | 7.5                                              |       | 8.0 |   |
| Operating loss                                                  |       | (4.1                                             | )          | (3.1 | ) |
| Interest income                                                 |       | 0.6                                              |       | 0.6 |   |
| Interest expense                                                |       | (0.6                                             | )          | (0.8 | ) |
| Other income                                                    |       | 0.1                                              |       | 0.2 |   |
| Loss before  income taxes and minority interest share of income |       | (4.0                                             | )          | (3.1 | ) |
| Income tax  benefit                                             |       | 0.5                                              |       | — |   |
| Minority interest  share of income                              |       | (0.2                                             | )          | (0.6 | ) |
| Net loss                                                        |       | (3.7                                             | )          | (3.7 | ) |

 

**ThreeMonths Ended March 31, 2006 Compared to the Three Months Ended March 31, 2005**

 

**Revenue**

 

Revenuefor the three months ended March 31, 2006 increased $2.4 million, or 18.0%, to$15.8 million when compared to $13.4 million in revenue for the three monthsended March 31, 2005.

 

Revenuefor each of the operating segments was as follows (in thousands):

 
| ** **                    | ** ** | **Three Months  Ended March 31,  2006** | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|-------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Animal  Applications          |       | $                                                      | 11,502     |                                                   | $          | 8,297 |   |
| GPS and Radio  Communications |       | 4,320                                                  |       | 5,106                                                  |       |
| Total                         |       | $                                                      | 15,822     |                                                   | $          | 13,403 |   |

 

TheAnimal Applications segment’s revenue increased**approximately $3.2million, or 38.6%, in the three months ended March 31, 2006 compared to thethree month period ended March 31, 2005. The increase in revenue wasprincipally due to an increase in electronic and visual product sales tolivestock customers of approximately $0.9 million, an increase in sales tocompanion animal customers of approximately $1.5 million, and an increase inrevenue of approximately $0.8 million at our subsidiary DSD Holdings A/S. Theincrease in sales at DSD Holdings A/S results primarily from the inclusion ofthree months of results in the three month period ended March 31, 2006 comparedto the inclusion of one month of results in the three month period ended March31, 2005. DSD Holdings A/S was acquired on February 28, 2005.

 

The GPSand Radio Communications segment’s revenue decreased approximately $0.8million, or 15.4% to approximately $4.3 million in the three months ended March31, 2006 from approximately $5.1 million in the three months ended March 31,2005. The decrease in revenue was principally due to a decrease in sales inSignature’s Sarbe Division of $1.0 million, a decrease in sales in Signature’sClifford and Snell division of $0.1 million offset by increases of $0.2 millionin each of Signature’s Control Products and Radio divisions. In the threemonths ended March 31, 2006 there were no shipments by Signature IndustriesLimited of the G2R Sarbe locator beacon under the contract with the governmentof India compared to approximately $0.9 million of shipments in the threemonths ended March 31, 2005. Signature completed shipments under the contractwith the government of India occurred in May 2005.

 

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**Gross Profit and Gross Profit Margin**

 

Grossprofit for the three month period ended March 31, 2006 was approximately $6.8million, an increase**ofapproximately $0.8 million, or 13.0%, compared to approximately $6.0 million inthe three month period ended March 31, 2005. As a percentage of revenue, thegross profit margin decreased to 42.8% for the three months ended March 31,2006 from 44.7% for the three months ended March 31, 2005.

 

Grossprofit from operations for each operating segment was as follows (inthousands):

 
| ** **                    | ** ** | **Three Months  Ended March 31,  2006** | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|-------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Animal  Applications          |       | $                                                      | 4,651      |                                                   | $          | 3,414 |   |
| GPS and Radio  Communications |       | 2,125                                                  |       | 2,581                                                  |       |
| Total                         |       | $                                                      | 6,776      |                                                   | $          | 5,995 |   |

 

Grossprofit margin from operations for each operating segment was:

 
| ** **                    | ** ** | **Three Months  Ended March 31,  2006** | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|-------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                    | ** ** | **%**                                                  | ** ** | **%**                                                  | ** ** |
| Animal  Applications          |       | 40.4                                                   |       | 41.1                                                   |       |
| GPS and Radio  Communications |       | 49.2                                                   |       | 50.5                                                   |       |

 

TheAnimal Applications segment’s gross profit increased approximately $1.2million, or 36.2%, in the three month period ended March 31, 2006 compared tothe three months ended March 31, 2005. We attribute approximately $0.4 millionof the increase to the previously mentioned sales increases and $0.4 million tothe inclusion of DSD Holdings A/S for an additional two months of operations inthree month period ended March 31, 2006. DSD Holdings A/S was acquired onFebruary 28, 2005. The gross margin percentage was 40.4% for the three monthperiod ended March 31, 2006 compared to 41.1% for the three month period endedMarch 31, 2005. The gross margin percentage decreased in the three month periodended March 31, 2006 due to increased freight, brokerage and customs expenses.

 

The GPSand Radio Communications segment’s gross profit decreased approximately $0.5million, or 17.7%, in the three month period ended March 31, 2006 as comparedto the three month period ended March 31, 2005. The decrease in gross profitrelates to the decrease in sales and decreased gross margin percentage. Thegross margin percentage decreased to 49.2% in the three month period endedMarch 31, 2006 as compared to 50.5% in the three month period endedMarch 31, 2005. The decrease in gross margin percentage relates primarilyto higher margins on G2R Sarbe locator beacons shipped under the contract withthe government of India in the first three months of 2005. Signature completedshipments under the contract with the government of India occurred in May 2005.

 

**Selling, General and Administrative Expenses**

 

Selling,general and administrative expenses increased approximately $0.9 million, or17.0%, in the three month period ended March 31, 2006 as compared to the threemonth period ended March 31, 2005. As a percentage of revenue, selling, generaland administrative expenses were 39.4% and 39.8% for the three months endedMarch 31, 2006 and 2005, respectively.

 

17

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

 
| ** **                    | ** ** | **Three Months  Ended March 31,  2006** | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|-------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Animal  Applications          |       | $                                                      | 3,952      |                                                   | $          | 2,783 |   |
| GPS and Radio  Communications |       | 2,280                                                  |       | 2,545                                                  |       |
| Total                         |       | $                                                      | 6,232      |                                                   | $          | 5,328 |   |

 

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

 
| ** **                    | ** ** | **Three Months  Ended March 31,  2006** | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|-------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                    | ** ** | **%**                                                  | ** ** | **%**                                                  | ** ** |
| Animal  Applications          |       | 34.4                                                   |       | 33.5                                                   |       |
| GPS and Radio  Communications |       | 52.8                                                   |       | 49.8                                                   |       |

 

TheAnimal Applications segment’s selling, general and administrative expensesincreased approximately $1.2 million in the three month period ended March 31,2006 as compared to the three month period ended March 31, 2005 and selling,general and administrative expense as a percentage of revenue increased to 34.4%from 33.5% in the same respective periods. The increase in selling, general andadministrative expense relates primarily to a charge of approximately $0.2million in acquisition expenses, approximately $0.6 million of increasedcompensation expense, and approximately $0.3 million of expense related to DSDHolding A/S. DSD Holding A/S was acquired on February 28, 2005. Theincrease in compensation expense relates primarily to increased bonus expenseof $0.3 million, increased salaries of $0.2 and increased stock basedcompensation expense of $0.1 related to options granted to non-employees andrestricted stock granted to in 2005. All of the Company’s out-of-the-money,unvested stock options issued to current employees, officers and directorsprior to November 15, 2005 were vested on December 30, 2005 and nostock options were granted in the first quarter of 2006, therefore equity basedcompensation expense related to unvested stock options was immaterial in thethree month period ended March 31, 2006.

 

The GPSand Radio Communications segment’s selling, general and administrative expensesdecreased approximately $0.3 million to approximately $2.3 million in the threemonth period ended March 31, 2006 from approximately $2.6 million in the threemonth period ended March 31, 2005. The decrease in selling, general andadministrative expense relates primarily to reduced salary expense andintangible amortization expense at our subsidiary, OuterLink Corporation. As apercentage of revenue, selling, general and administrative expenses increasedto 52.8% in the three month period ended March 31, 2006 from 49.8% in the threemonth period ended March 31, 2005. The increase in selling, general and administrativeexpense as a percentage of sales resulted primarily from the decrease in salesin the current period.

 

**Research and Development Expense**

 

Researchand development expense was approximately $1.2 million in the three monthperiod ended March 31, 2006, an increase of approximately $0.1 million, or9.6%, from approximately $1.1 million for the three month period ended March31, 2005. As a percentage of revenue, research and development expense was 7.5%and 8.0% for the three months ended March 31, 2006 and 2005, respectively.

 

Researchand development expense for each of the operating segments was as follows (inthousands):

 
| ** **                    | ** ** | **Three Months  Ended March 31,  2006** | ** ** | **Three Months  Ended March 31,  2005** | ** ** |
|-------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Animal  Applications          |       | $                                                      | 795        |                                                   | $          | 675 |   |
| GPS and Radio  Communications |       | 395                                                    |       | 411                                                    |       |
| Total                         |       | $                                                      | 1,190      |                                                   | $          | 1,086 |   |

 

TheAnimal Applications segment’s research and development expense wasapproximately $0.8 million

 

18

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inthe three month period ended March 31, 2006, an increase of approximately $0.1million, or 17.8%, from approximately $0.7 million for the three month periodended March 31, 2005. The increase is primarily related to new productdevelopment.

 

The GPSand Radio Communications segment’s research and development expense wasapproximately $0.4 million in the three month periods ended March 31, 2006 and2005. Research and development in the three month period ended March 31, 2006relates to the continued development of OuterLink Corporation’s next generationof communication system hardware.

 

**Interest Expense**

 

Interestexpense was approximately $0.1 million for the three month periods ended March31, 2006 and 2005.

 

**Income Taxes**

 

TheCompany recorded an income tax benefit of $0.1 million in the three monthperiod ended March 31, 2006 and no tax provision for the three month periodended March 31, 2005. The income tax benefit for the three month period endedMarch 31, 2006 relates to deferred taxes amounting to $117,000 associated withintangible assets at our Daploma International A/S subsidiary offset by currentincome taxes of $33,000 related to income at a subsidiary of DaplomaInternational A/S. The Company accounts for income taxes under the asset andliability approach. Deferred tax assets and liabilities are recognized for theexpected future tax consequences attributed to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax basis. Deferred tax assets and liabilities are measuredusing the enacted tax rates expected to apply to taxable income in the years inwhich those temporary differences are expected 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.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

As ofMarch 31, 2006, the Company had cash of $8.7 million. Cash used in operatingactivities totaled $1.4 million in the first three months of 2006 and 2005,respectively.

 

In thefirst three months of 2006, the use of cash was due primarily to an increase ininventory of $0.2 million, an increase of $0.2 million in current assets and adecrease in accounts payable, accrued expenses and deferred revenue of $0.9million. Offsetting these uses of cash was depreciation and amortization of$0.5 million and non-cash equity based compensation of $0.2 million.

 

Investingactivities used cash of $0.3 million and $1.3 million in the first three monthsof 2006 and 2005, respectively. The Company purchased $0.4 million of propertyand equipment in the first three months of 2006.

 

Financingactivities provided cash of $0.4 million and $41,000 in the first three monthsof 2006 and 2005. In the first three months of 2006, proceeds to the Companyrelated to stock option exercises were $0.5 million.

 

On April 13,2006 the Company exercised its right to buyout the remaining purchase price byelecting to pay the set amount, as defined in the agreement, of $2 million. The$2 million buyout price will be satisfied by a cash payment of $1 million and$1 million worth of the Company’s unregistered common stock.

 

TheCompany expects that current available funds will adequately fund the Company’soperations for the next twelve months.

 

*Debt,Covenant Compliance and Liquidity*

 

*InvoiceDiscounting Agreement* On April 9, 2003,Signature Industries Limited entered into a two-year

 

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Invoice Discounting Agreementwith The Royal Bank of Scotland Commercial Services Limited (“RBS”). TheInvoice Discounting Agreement, as amended October 28, 2003 andJune 21, 2005, provides for Signature to sell with full title guaranteemost of its receivables, as defined in the Invoice Discounting Agreement, asamended. RBS prepays 80% of the receivables sold in the United Kingdom and 75%of the receivables sold in the rest of the world, not to exceed an outstandingbalance of £750,000 ($1.3 million at March 31, 2006) at any given time. RBSpays Signature the remainder of the receivable upon collection of the receivable.Receivables which remain outstanding 90 days from the end of the invoice monthbecome ineligible and RBS may require Signature to repurchase the receivableback. The discounting charge accrues daily at an annual rate of 1.85% above thebase rate, as defined in the amended Invoice Discounting Agreement (6.35% atMarch 31, 2006). Signature pays a commission charge to RBS of 0.16% of eachreceivable balance sold. The Invoice Discounting Agreement, as amended,requires a minimum commission charge of £833 per month. Discounting charges of$10,000 and $11,000 are included in interest expense for the three months endedMarch 31, 2006 and 2005, respectively. As of March 31, 2006, $0.4 million ofreceivables were financed under the Invoice Discounting Agreement.

 

*Equipment Loans-DSD Holdings*  DSDHoldings is party to equipment loans which are collateralized by productionequipment. Principal and interest payments totaling approximately DKK 0.5million ($73,800 USD at March 31, 2006) are payable quarterly. Payments are duethrough January 2010. The interest rates on the loans are variable andrange from 4.55% to 7.06% as of March 31, 2006. As of March 31, 2006, theamount outstanding under the equipment loans was $1.1 million

 

*Line of Credit-DSD Holdings*  As ofMarch 31, 2006, DSD Holdings is party to a credit agreement with DanskeBank. The credit facility provides for borrowings up to DKK 12 million ($1.9million USD at March 31, 2006). As of March 31, 2006 the amountoutstanding under the credit agreement was $1.8 million. The interest isdetermined quarterly and is based on the international rates Danske Bankcan establish on a loan in the same currency on the internationalmarket plus 2.0%. At March 31, 2006, the annual interest rate on thefacility was 4.95%. Borrowing availability under the credit facility considersguarantees outstanding. The borrowing availability on the credit agreement was$15,000 at March 31, 2006. The credit agreement shall remain effective untilfurther notice. DSD Holdings can terminate the credit agreement and pay theoutstanding balance or Danske Bank may demand the credit line be settledimmediately at any given time, without prior notice.

 

*Note Payable-DSD Holdings*  As ofMarch 31, 2006, DSD Holdings is party to a note payable with Danske Bank.Principal and interest payments of DKK 0.3 million ($49,000 USD at March 31,2006) plus interest are payable quarterly through December 15, 2008. Theinterest rate on the note is calculated based on the international rates DanskeBank can establish on a loan in DKK in the international market plus 2.0%. Theinterest rate on the note payable was 4.52% at March 31, 2006. As of March31, 2006, the amount outstanding under the note payable was $0.5 million.

 

*MortgageNotes Payable* The Company is party to a mortgage notes payable collateralized by landand building. Principal and interest payments totaling approximately $30,000are payable monthly through October 2010. The final payment of $2.0 million isdue in November of 2010. The interest rate on the note is fixed at 8.18%. As ofMarch 31, 2006, the amount outstanding under the mortgage note payable was $2.2million.

 

*Stock Issuances to Applied Digital*On February 25, 2005, the Company entered into a Stock Purchase Agreement with Applied Digital. Pursuantto the agreement the Company issued 644,140 shares of its common stock toApplied Digital. The Company received 684,543 shares of Applied Digital commonstock as consideration. The value of the stock exchanged was $3.5 million. TheApplied Digital common stock received by the Company was used as partialconsideration for the acquisition of DSD Holdings A/S and its wholly-ownedsubsidiaries, Daploma International A/S and Digitag A/S.

 

*Stock Repurchase* On March 29, 2005, theCompany’s Board of Directors approved the repurchase of up to 1.5 millionshares of its common stock over a ninety day period commencing onMarch 30, 2005. The Company purchased 328,000 shares for a total of $1.5million.

 

20

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The followingtable summarizes the Company’s fixed cash obligations as of March 31, 2006 overvarious future years (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          |       | $          | 6,015      |                                      | $          | 2,490 |   | $ | 1,091 |   | $ | 2,434 | ** ** | **$** | **—** | ** ** |
| Operating Leases                           |       | 17,548     |       | 706                                       |       | 1,244 |   | 958 |   | 14,640 |   |
| Employment  Contracts                      |       | 1,782      |       | 1,372                                     |       | 410 | ** ** | **—** | ** ** | **—** | ** ** |
|                                       |       | $          | 25,345     |                                      | $          | 4,568 |   | $ | 2,745 |   | $ | 3,392 |   | $ | 14,640 |   |

 

**IMPACT OFRECENTLY ISSUED ACCOUNTING STANDARDS**

 

InDecember 2004, SFAS No. 123 (revised 2004), “Share-Based Payment”(SFAS 123R) was issued. SFAS 123R replaced SFAS No. 123 and supercedes APBOpinion No. 25. SFAS 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values. The pro forma disclosures previouslypermitted under SFAS 123 are longer an alternative to financial statementrecognition.

 

OnJanuary 1, 2006 we adopted the provisions of SFAS 123R, using the modifiedprospective transition method. Accordingly, during the three months ended March31, 2006 we recorded stock-based compensation expense for awards granted priorto , but not vested as of January 1, 2006, as if the fair value method requiredfor pro forma disclosure under SFAS 123 were in effect for expense recognitionpurposes. In accordance with modified prospective transition method priorperiods have not been restated. However, the pro forma effects of recognizingthe estimated fair value of stock based compensation for the first quarter of2005 are disclosed in Note 8 of the Notes to our Condensed ConsolidatedFinancial Statements. Upon adoption of SFAS 123R we elected to continue usingthe Black-Scholes option pricing model and have recognized compensation expenseusing a straight-line amortization method.

 

Allof the Company’s out-of-the-money, unvested stock options issued to currentemployees, officers and directors prior to November 15, 2005 were vestedon December 30, 2005, and, therefore, the initial adoption of SFAS 123Rdid not have a material impact on our consolidated results of operations andearnings (loss) per share. The purpose of the accelerated vesting was to enablethe Company to avoid recognizing in our statements of operations non-cashcompensation expense associated with the options in future periods. As a resultof the acceleration, we avoided recognition of approximately $8.6 million ofcompensation expense in our statement of operations over the course of theoriginal vesting periods. Such expense was included in our pro formastock-based compensation footnote disclosure for the quarter endedDecember 31, 2005. The majority of the accelerated options, absent theacceleration, would have been vested in 2006, with a smaller percentage vestingover the next 30 months. As of March 31, 2006, there was $0.6 million of totalunrecognized compensation cost related to nonvested share-based compensationarrangements granted under the DAC Stock Option Plan.  That cost isexpected to be recognized over a weighted-average period of 2.0 years.

 

Althoughthe initial adoption of SFAS 123R did not have a material impact on ourconsolidated results of operations and earnings (loss) per share, as we grantmore options or other share based compensation to employees, we expect that theimpact may be material.

 

In November 2004, the FASB issued SFASNo. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.”SFAS No. 151 amends Accounting Research Bulletin (“ARB”) No. 43,Chapter 4, to clarify that abnormal amounts of idle facility expense, freight,handling costs and wasted materials (spoilage) should be recognized ascurrent-period charges. In addition, SFAS No. 151 requires that allocationof fixed production overhead to inventory be based on the normal capacity ofthe production facilities. The Company is required to adopt SFAS 151 beginningJanuary 1, 2006. The adoption of SFAS 151 did not have a material impacton the results of its operations, financial position or cash flows.

 

InDecember 2004, the FASB issued SFAS No. 153, “Exchanges ofNonmonetary Assets” (SFAS 153). This Statement amends Opinion 29 to eliminatethe exception for nonmonetary exchanges of similar productive assets andreplaces it with a general exception for exchanges of nonmonetary assets thatdo not have commercial substance. A nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. SFAS 153 is effective fornonmonetary asset exchanges 

 

21

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occurring in fiscal periodsbeginning after June 15, 2005. The adoption of SFAS 153 did not have amaterial impact on the results of its operations or financial position.

 

InMay 2005, the FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections a replacement of APB No. 20 and FAS No. 3” (SFAS 154).SFAS 154 changes the requirements for the accounting for and reporting of achange in accounting principle. SFAS 154 also applies to all voluntarychanges in accounting principle. It also applies to changes required by anaccounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. When a pronouncement includesspecific transition provisions, those provisions should be followed. SFAS 154is effective for all accounting changes and corrections of errors made infiscal years beginning after December 15, 2005. The adoption of SFAS 154did not have a material impact on the results of its operations or financialposition.

 

**Forward-Looking Statements and Associated Risks**

 

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

 

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

 

•                  anticipatedtrends in our business and demographics;

 

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

 

•                  ourfuture profitability and liquidity; and

 

•                  regulatory,competitive or other economic influences.

 

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

 

Ouractual results might differ materially from historical performance or currentexpectation. We do not undertake any obligation to update or revise publiclyany forward-looking statement, whether as a result of new information, futureevent or otherwise.

 

**Item 3. Quantitative and Qualitative Disclosures About MarketRisk**

 

We haveoperations and sales in various regions of the world. Additionally, we mayexport and import to and from other countries. Our operations may therefore besubject to volatility because of currency fluctuations, inflation, and changesin political and economic conditions in these countries. Sales and expenses maybe denominated in local currencies and may be affected as currency fluctuationsaffect our product prices and operating costs or those of our competitors. Wedo not believe that any changes in currency fluctuations, inflation, andchanges in political and economic conditions would have a material affect onour business or our results of operations.

 

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.

 

**Item 4. Controls and Procedures**

 

As of theend of the period covered by this Form 10-Q, we carried out an evaluation,under the 

 

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supervisionand with the participation of our management, including the Chief ExecutiveOfficer and the Chief Financial Officer, of the effectiveness of the design andoperation of our disclosure controls and procedures. Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective.

 

During the period covered by the Form 10-Q,there were no changes in our internal control over financial reporting thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PART II    OTHERINFORMATION**

 

**Item 1. Legal Proceedings.**

 

For information with respect to certain legalproceedings, see the information included under the caption entitled, “Litigation”(Note 11) of the “Notes to Condensed Consolidated Financial Statements” whichis incorporated herein by reference.

 

**Item 1A. Risk Factors**

 

There have been no material changes in our riskfactors from those disclosed in our 2005 Annual Report on From 10-K.

 

**Item 5. Other Information**

 

OnApril 28, 2006, the Company entered into an agreement with RaytheonMicroelectronics España, S.A. (“RME”), related to the manufacture anddistribution of glass-encapsulated, syringe-implantable transponders (“Product”).The agreement, which is effective as of April 26, 2006 and expires on June 30,2010, sets forth certain terms on which the Company acquires Product from RME. Theagreement also provides the Company and persons acquiring Product from theCompany with a license from RME and its affiliates regarding any intellectualproperty owned by RME and its affiliates which is related to the manufacture,distribution and use of the Product. The license is exclusive to the Companyfor animal and human applications provided that the Company satisfies certainminimum purchase obligations.

 

**Item 6. Exhibits**

 
| ** ** | ** ** | **(a)    Exhibits**                                                                                                                                                                                          |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                             |
| 3.1        |       | Amended and Restated Certificate of Incorporation  (incorporated by reference to Exhibit 3.1 to Amendment No. 1 to our  Registration Statement on Form S-3 (No. 333-110817) filed on  January 23, 2004) |
|       |       |                                                                                                                                                                                                                             |
| 3.2        |       | Bylaws (incorporated by reference to Exhibit 3.2 to  Amendment No. 1 to our Registration Statement on Form S-3   (No. 333-110817) filed on January 23, 2004)                                            |
|       |       |                                                                                                                                                                                                                             |
| 10.1       |       | Supply Agreement between Digital Angel Corporation and  Raytheon Microelectronics Espana dated April 26, 2006                                                                                                                    |
|       |       |                                                                                                                                                                                                                             |
| 31.1       |       | Certification of Chief Executive Officer under  Rules 13a-14(a)/15d-14(a) under the Securities and Exchange Act and  Section 302 of the Sarbanes-Oxley Act of 2002.                                               |
|       |       |                                                                                                                                                                                                                             |
| 31.2       |       | Certification of Chief Financial Officer under  Rules 13a-14(a)/15d-14(a) under the Securities and Exchange Act and  Section 302 of the Sarbanes-Oxley Act of 2002.                                               |
|       |       |                                                                                                                                                                                                                             |
| 32.1       |       | Certification of Chief Executive Officer Pursuant to 18  U.S.C Section 1350, as Adopted Pursuant to                                                                                                                         |

 

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

 

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**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: May 3, 2006 | By:                       | /s/ JAMES P. SANTELLI |
|               |                      | James P. Santelli |
|               |                      | Senior Vice President and  Chief Financial Officer |

 

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