**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C. 20549**

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# **FORM 10-Q**

| **x**                                                  | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF**  |
|--------------------------------------------------------|------------|---------------------------------------------------------------------|
| ** **                                             | ** ** | **THE SECURITIES EXCHANGE ACT OF  1934.**                           |
| ** **                                             | ** ** | ** **                                                          |
| **For the quarterly period ended  September 30, 2006** |
| ** **                                             |
| **Or**                                                 |
| ** **                                             |
| **o**                                                  | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF** |
| ** **                                             | ** ** | **THE SECURITIES EXCHANGE ACT OF  1934.**                           |
|                                                        |            |                                                                     |  |

 

**Forthe transition period from               to                 **

**CommissionFile Number: 1-15177**

**DIGITALANGEL CORPORATION**

(Exact name of registrant as specified in its charter)
| **DELAWARE**                                                    | ** ** | **52-1233960**                     |
|-----------------------------------------------------------------|------------|------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (IRS Employer  Identification No.) |

 

**490 Villaume Avenue, South SaintPaul, Minnesota, 55075**

(Address of registrant’s principal executive offices)

**(651) 455-1621**

(Registrant’s telephone number, including area code)

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

Yes  x  No  o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule12b-2 of the Exchange Act.

Large accelerated filer  o  Acceleratedfiler  o  Non-acceleratedfiler  x

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  o  No  x

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date.
| **Class**                               | ** ** | **Outstanding at November  6, 2006** |
|-----------------------------------------|------------|-----------------------------------------------------|
| Common Stock, $.005 par value per share |       | 44,515,823 shares                                   |

 

 

 

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**DIGITAL ANGEL CORPORATION**

TABLE OF CONTENTS
| Item                                 | ** ** | **Description**                                                                             | ** ** |
|--------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
|                                 |       |                                                                                        |
| PART  I — FINANCIAL INFORMATION |       |
|                                 |       |                                                                                        |
| 1.                                   |       | Financial  Statements                                                                       |       |
| 2.                                   |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       |
| 3.                                   |       | Quantitative and Qualitative Disclosures About Market  Risk                                 |       |
| 4.                                   |       | Controls and Procedures                                                                     |       |
|                                 |       |                                                                                        |       |
| PART  II — OTHER INFORMATION    |       |
|                                 |       |                                                                                        |       |
| 1.                                   |       | Legal  Proceedings                                                                          |       |
| 1A.                                  |       | Risk Factors                                                                                |       |
| 6.                                   |       | Exhibits                                                                                    |       |
|                                 |       |                                                                                        |       |
| SIGNATURE                            |       |
| CERTIFICATIONS                       |       |
| EXHIBITS                             |       |

 

 

2

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**PART IFINANCIAL INFORMATION**

Item1.    Financial Statements.

**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**(In thousands, except par value)
| ** **                                                                                                                                                                            | ** ** | **September 30,  2006**            | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                            | ** ** | **  (Unaudited)  ** | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                                            | ** ** | ** **                              | ** ** | ** **                  | ** ** |
| **Current Assets**                                                                                                                                                                    |       |                                    |       |                        |       |
| Cash                                                                                                                                                                                  | ** ** | **$**                                   | **3,871**  |                        | $          | 10,049 |   |
| Restricted cash                                                                                                                                                                       | ** ** | **140**                                 |       | 310                         |       |
| Accounts receivable (net of allowance for doubtful  accounts of $203 in 2006 and $212 in 2005)                                                                                   | ** ** | **8,268**                               |       | 10,152                      |       |
| Accounts receivable from VeriChip Corporation                                                                                                                                         | ** ** | **263**                                 |       | 232                         |       |
| Inventories                                                                                                                                                                           | ** ** | **11,008**                              |       | 8,657                       |       |
| Other current assets                                                                                                                                                                  | ** ** | **2,312**                               |       | 1,418                       |       |
| **Total Current Assets**                                                                                                                                                              | ** ** | **25,862**                              |       | 30,818                      |       |
|                                                                                                                                                                                  |       |                                    |       |                        |       |
| **Property and Equipment, net**                                                                                                                                                       | ** ** | **9,227**                               |       | 8,602                       |       |
| ** **                                                                                                                                                                            | ** ** | ** **                              | ** ** | ** **                  | ** ** |
| **Goodwill**                                                                                                                                                                          | ** ** | **51,210**                              |       | 48,491                      |       |
| ** **                                                                                                                                                                            | ** ** | ** **                              | ** ** | ** **                  | ** ** |
| **Other Intangible Assets, net**                                                                                                                                                      | ** ** | **1,678**                               |       | 1,813                       |       |
|                                                                                                                                                                                  |       |                                    |       |                        |       |
| **Other Assets, net**                                                                                                                                                                 | ** ** | **462**                                 |       | 483                         |       |
| ** **                                                                                                                                                                            | ** ** | **$**                                   | **88,439** |                        | $          | 90,207 |   |
| **Liabilities and Stockholders’  Equity**                                                                                                                                        | ** ** | ** **                              | ** ** | ** **                  | ** ** |
| **Current Liabilities**                                                                                                                                                               |       |                                    |       |                        |       |
| Line of credit and current maturities of long-term debt  and notes payable                                                                                                            | ** ** | **$**                                   | **3,536**  |                        | $          | 2,380 |   |
| Accounts payable                                                                                                                                                                      | ** ** | **4,970**                               |       | 5,381                       |       |
| Accrued expenses and other current liabilities                                                                                                                                        | ** ** | **2,391**                               |       | 3,232                       |       |
| Deferred revenue                                                                                                                                                                      | ** ** | **1,109**                               |       | 1,324                       |       |
| Net liabilities from discontinued operations                                                                                                                                          | ** ** | **60**                                  |       | 84                          |       |
| **Total Current Liabilities**                                                                                                                                                         | ** ** | **12,066**                              |       | 12,401                      |       |
|                                                                                                                                                                                  |       |                                    |       |                        |       |
| **Long-Term Debt And Notes Payable**                                                                                                                                                  | ** ** | **3,498**                               |       | 3,656                       |       |
|                                                                                                                                                                                  |       |                                    |       |                        |       |
| **Other Long Term Liabilities**                                                                                                                                                       | ** ** | **1,520**                               |       | 1,086                       |       |
|                                                                                                                                                                                  |       |                                    |       |                        |       |
| **Total Liabilities**                                                                                                                                                                 | ** ** | **17,084**                              |       | 17,143                      |       |
|                                                                                                                                                                                  |       |                                    |       |                        |       |
| **Commitments And Contingencies (See Note 10)**                                                                                                                                       |       |                                    |       |                        |       |
|                                                                                                                                                                                  |       |                                    |       |                        |       |
| **Minority Interest**                                                                                                                                                                 | ** ** | **556**                                 |       | 618                         |       |
|                                                                                                                                                                                  |       |                                    |       |                        |       |
| **Stockholders’ Equity**                                                                                                                                                         |       |                                    |       |                        |       |
| Preferred stock: Authorized 1,000 shares, of $1.75 par  value, none outstanding                                                                                                       | ** ** | **—**                              | ** ** | **—**                  | ** ** |
| Common stock: Authorized 95,000 shares, of $.005 par  value; 44,894 shares issued and 44,516 shares outstanding in 2006 and 44,225  shares issued and 43,847 outstanding in 2005 | ** ** | **225**                                 |       | 223                         |       |
| Additional paid-in capital                                                                                                                                                            | ** ** | **214,210**                             |       | 212,083                     |       |
| Accumulated deficit                                                                                                                                                                   | ** ** | **(142,095**                            | **)**      | (137,950                    | )          |
| Treasury stock (carried at cost, 378 shares)                                                                                                                                          | ** ** | **(1,580**                              | **)**      | (1,580                      | )          |
| Accumulated other comprehensive income (loss)                                                                                                                                         | ** ** | **39**                                  |       | (330                        | )          |
| **Total Stockholders’ Equity**                                                                                                                                                   | ** ** | **70,799**                              |       | 72,446                      |       |
| ** **                                                                                                                                                                            | ** ** | **$**                                   | **88,439** |                        | $          | 90,207 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

3

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** **

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

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

(Unaudited)
| ** **                                                                 | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                               | ** ** | **2005**                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Product revenue                                                            | ** ** | **$**                                                                  | **12,666** |                                                                  | $          | 13,217 | ** ** | **$** | **40,311** |   | $ | 40,161 |   |
| Service revenue                                                            | ** ** | **525**                                                                |       | 541                                                                   | ** ** | **1,658** |   | 1,860 |   |
| Total net  revenue                                                         | ** ** | **13,191**                                                             |       | 13,758                                                                | ** ** | **41,969** |   | 42,021 |   |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Cost of products  sold                                                     | ** ** | **7,210**                                                              |       | 7,538                                                                 | ** ** | **23,595** |   | 22,559 |   |
| Cost of services  sold                                                     | ** ** | **341**                                                                |       | 284                                                                   | ** ** | **896** |   | 891 |   |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Gross profit                                                               | ** ** | **5,640**                                                              |       | 5,936                                                                 | ** ** | **17,478** |   | 18,571 |   |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Selling, general  and administrative expenses                              | ** ** | **5,946**                                                              |       | 5,756                                                                 | ** ** | **18,181** |   | 17,202 |   |
| Research and  development expenses                                         | ** ** | **1,098**                                                              |       | 1,165                                                                 | ** ** | **3,439** |   | 3,370 |   |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Operating loss                                                             | ** ** | **(1,404**                                                             | **)**      | (985                                                                  | )          | **(4,142** | **)** | (2,001 | ) |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Interest income                                                            | ** ** | **64**                                                                 |       | 89                                                                    | ** ** | **239** |   | 248 |   |
| Interest expense                                                           | ** ** | **(117**                                                               | **)**      | (98                                                                   | )          | **(323** | **)** | (278 | ) |
| Other income                                                               | ** ** | **27**                                                                 |       | 12                                                                    | ** ** | **72** |   | 45 |   |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Loss before  taxes and minority interest                                   | ** ** | **(1,430**                                                             | **)**      | (982                                                                  | )          | **(4,154** | **)** | (1,986 | ) |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Income tax (provision) benefit                                             | ** ** | **(4**                                                                 | **)**      | (24                                                                   | )          | **68** |   | (110 | ) |
| Minority  interest share of income                                         | ** ** | **(1**                                                                 | **)**      | (63                                                                   | )          | **(59** | **)** | (357 | ) |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net loss from  continuing operations                                       | ** ** | **(1,435**                                                             | **)**      | (1,069                                                                | )          | **(4,145** | **)** | (2,453 | ) |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Income from  discontinued operations                                       | ** ** | **—**                                                             |       | 85                                                                    | ** ** | **—** |   | 85 |   |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net loss                                                                   | ** ** | **$**                                                                  | **(1,435** | **)**                                                                 | $          | (984 | ) | **$** | **(4,145** | **)** | $ | (2,368 | ) |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net loss per common share-basic and diluted                                | ** ** | **$**                                                                  | **(0.03**  | **)**                                                                 | $          | (0.02 | ) | $ | (0.09 | ) | $ | (0.05 | ) |
|                                                                       |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Weighted average number  of common shares outstanding - basic  and diluted | ** ** | **44,516**                                                             |       | 43,847                                                                | ** ** | **44,238** |   | 43,811 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

4

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITYFor The Nine Months Ended September 30, 2006**(InThousands)(Unaudited)
| ** **                                                     | ** ** | ** **               | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | ** **        | ** ** | ** **             | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|----------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                     | ** ** | ** **               | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | **Additional** | ** ** | ** **        | ** ** | ** **             | ** ** | **Other**              | ** ** | **Total**  | ** ** |
| ** **                                                     | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Treasury**   | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                     | ** ** | **Number**               | ** ** | **Amount**            | ** ** | **Number**  | ** ** | **Amount**      | ** ** | **Capital**    | ** ** | **Deficit**       | ** ** | **Stock**              | ** ** | **(Loss) Income** | ** ** | **Equity** | ** ** |
| ** **                                                     | ** ** | ** **               | ** ** | ** **            | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | ** **        | ** ** | ** **             | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Balance-December 31,  2005**                            |       | —                   |       | $                     | —     |        | 44,225     |            | $          | 223            |       | $                 | 212,083    |                   | $          | (137,950               | )          | $          | (1,580     | ) | $ | (330 | ) | $ | 72,446 |   |
| Net loss                                                       |       | —                   |       | —                |       | —      |       | —          |       | —         |       | (4,145            | )          | —                 |       | —                 |       | (4,145     | )          |
| Comprehensive income-foreign currency translation              |       | —                   |       | —                |       | —      |       | —          |       | —         |       | —            |       | —                 |       | 369                    |       | 369        |       |
| Total comprehensive loss                                       |       | —                   |       | —                |       | —      |       | —          |       | —         |       | (4,145            | )          | —                 |       | 369                    |       | (3,776     | )          |
| Issuance of common stock as consideration for DSD  acquisition |       | —                   |       | —                |       | 282         |       | 1               |       | 999            |       | —            |       | —                 |       | —                 |       | 1,000      |       |
| Exercise of stock options                                      |       | —                   |       | —                |       | 320         |       | 1               |       | 562            |       | —            |       | —                 |       | —                 |       | 563        |       |
| Restricted stock issued                                        |       | —                   |       | —                |       | 67          |       | —          |       | —         |       | —            |       | —                 |       | —                 |       | —     |       |
|                                                           |       |                     |       |                  |       |        |       |            |       |           |       |              |       |                   |       |                   |       |       |       |
| Equity-based compensation                                      |       | —                   |       | —                |       | —      |       | —          |       | 566            |       | —            |       | —                 |       | —                 |       | 566        |       |
|                                                           |       |                     |       |                  |       |        |       |            |       |           |       |              |       |                   |       |                   |       |       |       |
| **Balance-September 30, 2006**                                 |       | —                   |       | $                     | —     |        | 44,894     |            | $          | 225            |       | $                 | 214,210    |                   | $          | (142,095               | )          | $          | (1,580     | ) | $ | 39 |   | $ | 70,799 |   |

 

See the accompanying notes to condensed consolidatedfinancial statements.

5

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**DIGITALANGEL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**(In thousands)(Unaudited)
| ** **                                                                   | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                                              | ** ** | **2005** | ** ** |
| **Cash  Flows From Operating Activities**                                    |       |                                                                  |       |   |   |
| Net loss from continuing operations                                          | ** ** | **$**                                                                 | **(4,145** | **)** | $ | (2,453 | ) |
|                                                                         |       |                                                                  |       |   |   |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |                                                                  |       |   |   |
| Income from discontinued operations                                          |       |                                                                  |       | 85 |   |
| Equity-based compensation                                                    | ** ** | **566**                                                               |       | 228 |   |
| Depreciation and amortization                                                | ** ** | **1,484**                                                             |       | 1,829 |   |
| Minority interest                                                            | ** ** | **59**                                                                |       | 357 |   |
| Loss on disposal of equipment                                                | ** ** | **6**                                                                 |       | 8 |   |
| Change in assets and liabilities:                                            |       |                                                                  |       |   |   |
| Decrease in restricted cash                                                  | ** ** | **187**                                                               |       | 327 |   |
| Decrease in accounts receivable                                              | ** ** | **2,084**                                                             |       | 520 |   |
| Increase in due from VeriChip Corporation                                    | ** ** | **(31**                                                               | **)**      | — |   |
| Increase in inventories                                                      | ** ** | **(2,030**                                                            | **)**      | (1,072 | ) |
| Increase in other current assets                                             | ** ** | **(912**                                                              | **)**      | (69 | ) |
| Decrease in accounts payable, accrued expenses and  deferred revenue         | ** ** | **(1,230**                                                            | **)**      | (1,478 | ) |
| Net cash (used in) provided by discontinued  operations                      | ** ** | **(24**                                                               | **)**      | 100 |   |
| **Net  Cash Used In Operating Activities**                                   | ** ** | **(3,986**                                                            | **)**      | (1,618 | ) |
|                                                                         |       |                                                                  |       |   |   |
| **Cash Flows From Investing Activities**                                     |       |                                                                  |       |   |   |
| Decrease in other assets                                                     | ** ** | **10**                                                                |       | 37 |   |
| Payments for property and equipment                                          | ** ** | **(1,901**                                                            | **)**      | (1,319 | ) |
| Payments for acquisition costs                                               | ** ** | **(1,000**                                                            | **)**      | (1,286 | ) |
| **Net  Cash Used in Investing Activities**                                   | ** ** | **(2,891**                                                            | **)**      | (2,568 | ) |
|                                                                         |       |                                                                  |       |   |   |
| **Cash  Flows From Financing Activities**                                    |       |                                                                  |       |   |   |
| Amounts borrowed on line of credit                                           | ** ** | **3,508**                                                             |       | 3,179 |   |
| Amounts paid on line of credit                                               | ** ** | **(2,678**                                                            | **)**      | (3,048 | ) |
| Payments on notes payable and long-term debt                                 | ** ** | **(579**                                                              | **)**      | (339 | ) |
| Proceeds from notes payable and long-term debt                               |       | —                                                                |       | 339 |   |
| Proceeds from exercise of stock options and warrants                         | ** ** | **563**                                                               |       | 358 |   |
| Payment of dividend to minority shareholder                                  | ** ** | **(140**                                                              | **)**      | — |   |
| Purchase of treasury stock                                                   |       | —                                                                |       | (1,537 | ) |
| **Net  Cash Provided by (Used in) Financing Activities**                     | ** ** | **674**                                                               |       | (1,048 | ) |
|                                                                         |       |                                                                  |       |   |   |
| **Effect of Exchange Rate Changes  on Cash**                                 | ** ** | **25**                                                                |       | (141 | ) |
|                                                                         |       |                                                                  |       |   |   |
| **Net  Decrease In Cash**                                                    | ** ** | **(6,178**                                                            | **)**      | (5,375 | ) |
|                                                                         |       |                                                                  |       |   |   |
| **Cash -  Beginning Of Period**                                              | ** ** | **10,049**                                                            |       | 17,492 |   |
|                                                                         |       |                                                                  |       |   |   |
| **Cash - End Of Period**                                                     | ** ** | **$**                                                                 | **3,871**  |   | $ | 12,117 |   |

 

Seethe accompanying notes to condensed consolidated financial statements.

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**DIGITAL ANGEL CORPORATIONNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Dollars in thousands)(Unaudited)**

**1.****            ****The Companyand Basis of Presentation**

DigitalAngel Corporation and its subsidiaries (“the Company”) develop and deploysensor 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 ofelectronic and visual identification devices for the companion animal,livestock, fish and wildlife markets worldwide. The Animal Applications segmentconsists of our operations located in Minnesota, DSD Holdings A/S and itswholly-owned subsidiaries, located in Denmark and Poland, and Digital AngelInternational, Inc. and its subsidiaries located in Argentina, Brazil, Chile,Paraguay and Uruguay. The positive identification and tracking of cattle andhogs are crucial for asset management and for disease control and food safety.In addition to the visual ear tags which have been sold by the Company sincethe late 1940’s, Animal Applications utilizes radio frequency transmission(“RFID”) technologies in its electronic ear tags and implantable microchips.

*GPS and Radio Communications—*consists of the design, manufacture and support of globalpositioning system (“GPS”) enabled equipment. The GPS and Radio Communicationssegment consists of the Company’s subsidiaries Signature Industries Limited(90.9% owned), located in the United Kingdom and OuterLink Corporation, locatedin Massachusetts. Applications for the segment’s products include locationtracking and message monitoring of vehicles, aircraft and people in remotelocations through systems that integrate geosynchronous satellitecommunications and GPS enabled equipment and intelligent communicationsproducts and services for telemetry, mobile data and radio communicationsapplications serving commercial and military markets. 

OnFebruary 28, 2005, the Company acquired Denmark-based DSD Holdings A/S and itswholly-owned subsidiaries Daploma International A/S and Digitag A/S, includingDaploma International A/S’s 70%-owned subsidiary, Daploma Polska. DSD HoldingsA/S became a wholly-owned subsidiary of Digital Angel Corporation. DSD HoldingsA/S produces visual and RFID tags. DSD Holdings A/S’s operations are includedfrom the date of acquisition.

As ofSeptember 30, 2006, Applied Digital Solutions, Inc. (“Applied Digital” or“ADS”) owned 24,573,788 shares or approximately 55.2% of the Company’s commonstock.

Theaccompanying unaudited condensed consolidated financial statements of theCompany as of September 30, 2006 and for the three and nine month periods endedSeptember 30, 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 requiredby accounting principles generally accepted in the United States of America forcomplete financial statements. In the opinion of the Company’s management, alladjustments (including normal recurring adjustments) considered necessary topresent fairly the unaudited condensed consolidated financial statements havebeen made.

Theconsolidated statements of operations for the three and nine months ended September30, 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.

7

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**2.****            ****Principlesof Consolidation**

TheSeptember 30, 2006 and 2005 condensed consolidated financial statements includethe accounts of the Company and its wholly-owned and majority-ownedsubsidiaries (DSD Holdings A/S operations are included from the date ofacquisition, February 28, 2005). All significant intercompany accounts andtransactions have been eliminated in consolidation.

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

TheCompany, except for its subsidiary OuterLink Corporation, recognizes productrevenue at the time product is shipped and title has transferred, provided thata purchase order has been received or a contract has been executed, there areno uncertainties regarding customer acceptance, the sales price is fixed anddeterminable and collectibility is deemed probable. If uncertainties regardingcustomer acceptance 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 services 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 alternativeuse. Accordingly, service revenue is recognized as the services are performed.OuterLink Corporation’s product revenue, for which title and risk of losstransfers to the customer on shipment, is deferred upon shipment and isrecognized ratably over the estimated customer service period of 42 months inthe nine month period ended September 30, 2006 and 30 months in the nine monthperiod ended September 30, 2005.

The Companyrecords a liability for product warranties at the time it is probable that awarranty liability has been incurred and the amount of loss can be reasonablyestimated. The Company’s warranty liability was $34,000 as of September 30,2006. 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 September  30, 2006                                             |       | $                             | 34         |   |

 

**4.****            ****Stock-BasedCompensation**

On January 1, 2006 we adopted SFAS No. 123 (revised 2004),“Share-Based Payment” (SFAS 123R). SFAS 123R replaced SFAS No. 123 andsupercedes APB Opinion No. 25. SFAS 123R requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their fair values. The pro forma disclosurespreviously permitted under SFAS 123 are no longer an alternative to financialstatement recognition. We adopted SFAS 123R using the modified prospectivemethod which required the application of the accounting standard as of January1, 2006. Our consolidated financial statements as of and for the three and ninemonth periods ended September 30, 2006 reflect the impact of adopting SFAS123R. In accordance 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 7, Stock Options and RestrictedStock for further details.

8

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

|                                       | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw materials                         | ** ** | **$**                        | **3,113**  |                        | $          | 3,198 |   |
| Work in process                       | ** ** | **207**                      |       | 122                         |       |
| Finished goods                        | ** ** | **8,591**                    |       | 7,006                       |       |
|                                  | ** ** | **11,911**                   |       | 10,326                      |       |
| Allowance for excess and obsolescence | ** ** | **(903**                     | **)**      | (1,669                      | )          |
| Net inventory                         | ** ** | **$**                        | **11,008** |                        | $          | 8,657 |   |

 

**6.****            ****StockExchange with Applied Digital Solutions, Inc.**

OnFebruary 25, 2005, the Company entered into a Stock PurchaseAgreement with Applied Digital. The purpose of the stock exchange was to usethe Applied Digital shares as partial consideration for the acquisition of DSDHoldings 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, as described more fully in Note 9. The Company and AppliedDigital entered into the share exchange because of the selling shareholders’desire, at the time the transaction was negotiated, to receive theirconsideration in Applied Digital common stock as opposed to the Company’scommon stock. In addition, the stock purchase represented a strategic investmentby Applied Digital whereby Applied Digital could increase its ownershipinterest in the Company. Pursuant to the agreement, the Company issued 644,140shares of its common stock to Applied Digital. The Company received 684,543shares of Applied Digital common stock as consideration. The exchange ratio ofshares was based upon the average of the volume-weighted-average price of theCompany’s common stock and Applied Digital’s common stock for the ten tradingdays immediately preceding, and not including, the transaction closing date,which prices were $5.434 for the Company’s common stock and $5.113 for AppliedDigital’s common stock. The value of the stock exchanged was $3.5 million.

**7.****            ****StockOptions and Restricted Stock**

*StockOption Plans*

As of September 30, 2006, the Company maintains theAmended and Restated Digital Angel Corporation Transition Stock Option Plan(“DAC Stock Option Plan”), which is described below, and has outstanding stockoptions which were issued pursuant to another plan that was terminated onFebruary 23, 2006. On January 1, 2006 we adopted SFAS 123R, using the modifiedprospective transition method. Accordingly, during the nine month period endedSeptember 30, 2006 we recorded stock-based compensation expense for awardsgranted in 2006 and awards granted prior to, but not yet vested as of January1, 2006, as if the fair value method required for pro forma disclosure underSFAS 123 were in effect for expense recognition purposes. Upon adoption of SFAS123R, we elected to continue using the Black-Scholes option pricing and we haverecognized compensation expense using a straight-line amortization method.During the three and nine months ended September 30, 2006 we recorded, $0.3million and $0.6 million, respectively (this amount includes compensation foroptions granted to non-employees and for restricted stock grants), instock-based employee compensation expense.

9

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As of September 30, 2006, the DAC Stock Option Plan,which is stockholder-approved, has 18,195,312 shares of common stock reserved forissuance, of which 17,601,516 shares have been issued and 593,796 remain availablefor issuance.  As of September 30, 2006, awards consisting of options topurchase 9,603,196 shares were outstanding under the DAC Stock Option Plan andawards consisting of options to purchase 476,820 shares were outstanding underthe Company’s terminated stock option plan. Additionally, restricted stockawards for 154,230 shares of common stock have been granted under the DAC StockOption Plan. Option awards are generally granted with exercise prices betweenmarket price and 110% of the market price of the Company’s stock at the date ofgrant; option awards generally vest over 3 to 9 years and have 10-yearcontractual terms. Certain option and share awards provide for acceleratedvesting if there is a change in control (as defined in the DAC Stock OptionPlan).

*StockOption Activity*

The fair value of each option award is estimated onthe date of grant using a Black-Scholes valuation model. The following assumptionswere used for options granted in the three and nine month periods endedSeptember 30, 2006 and 2005.
| ** **                  | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|-----------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                                               | ** ** | **2005**                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Risk-free interest rate     |       | 4.8%                                                                   |       | 3.81%                                                                 |       | 5.03% |   | 3.81% |   |
| Expected life (in years)    |       | 5.0                                                                    |       | 5.0                                                                   |       | 8.41 |   | 5.0 |   |
| Dividend yield              |       | 0.0%                                                                   |       | 0.0%                                                                  |       | 0.0% |   | 0.0% |   |
| Expected volatility         |       | 85.7%                                                                  |       | 111.95%-113.3%                                                        |       | 85.7%-87.2% |   | 106.1%-113.3% |   |
|                        |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Weighted-average volatility |       | 85.7%                                                                  |       | 112.4%                                                                |       | 87.1% |   | 108.8% |   |

 

Ourcomputation of expected volatility is determined based on historicalvolatility. Our computation of expected life is determined based on historicalexperience of similar awards, giving consideration to the contractual terms ofthe stock-based awards, vesting schedules and expectations of future employeebehavior. The risk-free interest rate is based on the U.S. Treasury yield curvein effect at the time of grant.

Asummary of the Company’s stock option activity as of September 30, 2006, andchanges during the nine months then ended is presented below (in thousands,except per share amounts):
| ** **                        | ** ** | **Stock  Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-----------------------------------|------------|--------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|-------------------------------------|------------|
| ** **                        | ** ** | ** **         | ** ** | ** **                                 | ** ** | ** **                               | ** ** | ** **                          | ** ** |
| Outstanding at January 1, 2006    |       | 9,955              |       | $                                          | 3.94       |                                     |       |                                |       |   |
| Granted                           |       | 2,200              |       | 3.23                                       |       |                                     |       |                                |       |
| Exercised                         |       | (320               | )          | 1.80                                       |       |                                     |       |                                |       |
| Forfeited or Expired              |       | (255               | )          | 4.61                                       |       |                                     |       |                                |       |
| Outstanding at September 30, 2006 |       | 11,580             |       | $                                          | 3.85       |                                     | 7.82       |                                | $          | 1,458 | * |
| Exercisable at September 30, 2006 |       | 9,213              |       | $                                          | 4.00       |                                     | 7.35       |                                | $          | 1,458 | * |

----

* The intrinsicvalue of a stock option is the amount by which the market value of theunderlying stock exceeds the exercise price of the option. The market value ofour stock was $2.60 at September 30, 2006.

10

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Theweighted-average grant-date fair value of options granted during the nine-monthperiods ended September 30, 2006 and 2005 were $2.69 and $3.59 respectively.The total intrinsic value of options exercised during the nine-month periodsended September 30, 2006 and 2005 was $644,000 and $72,000, respectively.

A summaryof the status of the Company’s nonvested stock options as of September 30, 2006,and changes during the nine month period ended September 30, 2006, is presentedbelow (in thousands, except per share amounts):

|                                  | ** ** | **Stock Options** | ** ** | **Weighted Average  Grant-Date  Fair Value** | ** ** |
|----------------------------------|------------|------------------------|------------|--------------------------------------------------------|------------|
| ** **                       | ** ** | ** **             | ** ** | ** **                                             | ** ** |
| Nonvested at  January 1, 2006    |       | 217                    |       | $                                                      | 2.42       |   |
| Granted                          |       | 2,200                  |       | 2.69                                                   |       |
| Vested                           |       | (50                    | )          | 2.36                                                   |       |
| Nonvested at September  30, 2006 |       | 2,367                  |       | $                                                      | 2.66       |   |

 

As ofSeptember 30, 2006, there was $4,594,000 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 6.3 years.  The total fair value of sharesvested during the nine months ended September 30, 2006, was $118,000.

Cashreceived from option exercise under all share-based payment arrangements forthe nine-month periods ended September 30, 2006 and 2005, was $563,000 and $358,000,respectively.

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 andapproved by the Company’s shareholders on May 6, 2004. The option becameexercisable on December 30, 2005. As of September 30, 2006, the optionremains 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 andapproved by the Company’s shareholders on May 6, 2004. The option becameexercisable on February 18, 2005. As of September 30, 2006, the optionremains outstanding.

*Restricted Stock*

In March 2005, theCompany granted its Chairman of the Board 100,000 shares of the Company’srestricted stock. The restricted stock vested 50% on March 7, 2006 andwill vest 50% on March 7, 2007. The Company determined the value of thestock to be $506,000 based on the closing price of the Company’s stock on thedate of grant. 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 nine month period ended September 30, 2006, $190,000 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 vested 30% on February 25, 2006, will vest 30% onFebruary 25, 2007 and 40% on February 25, 2008. 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 nine month period ended September 30,2006, $56,000 was recognized as compensation expense in the Company’s resultsof operations.

*Pro FormaInformation 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 123 werenot reflected in our results of operations for the three and nine month periodsended September 30, 2005 for employee stock option awards as all stock optionswere granted with an exercise price greater than or equal to the market valueof the underlying common stock on the date of grant. Previously reportedresults have not been restated.

11

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Thepro forma information for the three and nine months ended September 30, 2005was as follows (in thousands, except per share amounts):

|                                                                                | ** ** | **For the Three  Months Ended  September 30,  2005** | ** ** | **For the Nine  Months Ended  September 30,  2005** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Reported net loss                                                              |       | $                                                                        | (984       | )                                                                       | $          | (2,368 | ) |
| Stock-based  compensation expense in reported net loss                         |       | 83                                                                       |       | 228                                                                     |       |
| Stock-based  compensation expense determined under the fair value based method |       | (1,341                                                                   | )          | (4,113                                                                  | )          |
| Pro forma net loss                                                             |       | $                                                                        | (2,242     | )                                                                       | $          | (6,253 | ) |
|                                                                           |       |                                                                     |       |                                                                    |       |
| Loss per share (basic and diluted)                                             |       |                                                                     |       |                                                                    |       |
| As  reported                                                                   |       | $                                                                        | (0.02      | )                                                                       | $          | (0.05 | ) |
| Pro forma                                                                      |       | $                                                                        | (0.05      | )                                                                       | $          | (0.14 | ) |

 

**8.****            ****SegmentInformation**

The Company is an advanced technology company in thefield of rapid and accurate identification, location tracking, and conditionmonitoring of high-value assets. The Company’s operating segments are: (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 as of and for the three months ended September 30,2006 (in thousands):

|                                                         | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|------------------|------------|
|                                                    |       |                     |       |                                        |       |             |       |
| Net revenue from external customers:                    |       |                     |       |                                        |       |             |       |
|                                                    |       |                     |       |                                        |       |             |       |
| Product                                                 |       | $                        | 8,254      |                                        | $          | 4,412            |       | $ | 12,666 |   |
| Service                                                 |       | —                   |       | 525                                         |       | 525              |       |
| Total revenue                                           |       | $                        | 8,254      |                                        | $          | 4,937            |       | $ | 13,191 |   |
|                                                    |       |                     |       |                                        |       |             |       |
| Operating loss                                          |       | $                        | (932       | )                                           | $          | (472             | )          | $ | (1,404 | ) |
|                                                    |       |                     |       |                                        |       |             |       |
| Loss before taxes and minority interest share of income |       | $                        | (944       | )                                           | $          | (486             | )          | $ | (1,430 | ) |
|                                                    |       |                     |       |                                        |       |             |       |
| Total assets                                            |       | $                        | 78,041     |                                        | $          | 10,398           |       | $ | 88,439 |   |

 

12

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Followingis the selected segment data as of and for the three months ended September 30,2005 (in thousands):

|                                                                   | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|------------------|------------|
|                                                              |       |                     |       |                                        |       |             |       |
| Net revenue from external customers:                              |       |                     |       |                                        |       |             |       |
|                                                              |       |                     |       |                                        |       |             |       |
| Product                                                           |       | $                        | 8,448      |                                        | $          | 4,769            |       | $ | 13,217 |   |
| Service                                                           |       | 321                      |       | 220                                         |       | 541              |       |
| Total revenue                                                     |       | $                        | 8,769      |                                        | $          | 4,989            |       | $ | 13,758 |   |
|                                                              |       |                     |       |                                        |       |             |       |
| Operating loss                                                    |       | $                        | (612       | )                                           | $          | (373             | )          | $ | (985 | ) |
|                                                              |       |                     |       |                                        |       |             |       |
| Loss before taxes, minority interest and discontinued  operations |       | $                        | (601       | )                                           | $          | (381             | )          | $ | (982 | ) |
|                                                              |       |                     |       |                                        |       |             |       |
| Total assets                                                      |       | $                        | 82,144     |                                        | $          | 14,490           |       | $ | 96,634 |   |

 

13

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Followingis the selected segment data as of and for the nine months ended September 30,2006 (in thousands):

|                                                         | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|------------------|------------|
|                                                    |       |                     |       |                                        |       |             |       |
| Net revenue from external customers:                    |       |                     |       |                                        |       |             |       |
|                                                    |       |                     |       |                                        |       |             |       |
| Product                                                 |       | $                        | 27,542     |                                        | $          | 12,769           |       | $ | 40,311 |   |
| Service                                                 |       | 589                      |       | 1,069                                       |       | 1,658            |       |
| Total revenue                                           |       | $                        | 28,131     |                                        | $          | 13,838           |       | $ | 41,969 |   |
|                                                    |       |                     |       |                                        |       |             |       |
| Operating loss                                          |       | $                        | (2,441     | )                                           | $          | (1,701           | )          | $ | (4,142 | ) |
|                                                    |       |                     |       |                                        |       |             |       |
| Loss before taxes and minority interest share of income |       | $                        | (2,419     | )                                           | $          | (1,735           | )          | $ | (4,154 | ) |
|                                                    |       |                     |       |                                        |       |             |       |
| Total assets                                            |       | $                        | 78,041     |                                        | $          | 10,398           |       | $ | 88,439 |   |

 

Following is the selected segment data as of and for thenine months ended September 30, 2005 (in thousands):

|                                                         | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------|------------|------------------|------------|
|                                                    |       |                     |       |                                        |       |             |       |
| Net revenue from external customers:                    |       |                     |       |                                        |       |             |       |
|                                                    |       |                     |       |                                        |       |             |       |
| Product                                                 |       | $                        | 24,365     |                                        | $          | 15,796           |       | $ | 40,161 |   |
| Service                                                 |       | 1,037                    |       | 823                                         |       | 1,860            |       |
| Total revenue                                           |       | $                        | 25,402     |                                        | $          | 16,619           |       | $ | 42,021 |   |
|                                                    |       |                     |       |                                        |       |             |       |
| Operating loss                                          |       | $                        | (1,734     | )                                           | $          | (267             | )          | $ | (2,001 | ) |
|                                                    |       |                     |       |                                        |       |             |       |
| Loss before taxes and minority interest share of income |       | $                        | (1,703     | )                                           | $          | (283             | )          | $ | (1,986 | ) |
|                                                    |       |                     |       |                                        |       |             |       |
| Total assets                                            |       | $                        | 82,144     |                                        | $          | 14,490           |       | $ | 96,634 |   |

 

**9.****            ****Acquisitions**

Thefollowing describes the acquisitions by the Company (in thousands) in the ninemonths ended September 30, 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            |       | $                      | 5,902      |                                            | $          | 8,008                                            |       | $                             | (2,106     | ) | Manufactures and markets visual and electronic RFID tags  for livestock. |   |
|                           |            |                    |            |                        |            |                                                 |            |                                                  |            |                               |            |  |  |  |

 

14

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OnFebruary 28, 2005, the Company acquired DSD Holdings A/S and itswholly-owned subsidiaries Daploma International A/S and Digitag A/S, includingDaploma International A/S’s 70%-owned subsidiary. DSD Holdings A/S became awholly-owned subsidiary of Digital Angel Corporation. Denmark-based DSDHoldings A/S through its subsidiaries manufactures and markets visual andelectronic RFID tags for livestock. The acquisition was accounted for under thepurchase method of accounting. The excess of purchase price over the fair valueof the assets and liabilities of DSD Holdings A/S has been recorded as goodwillof $6.0 million and intangible assets of $2.0 million. The intangible assetsare customer relationships, tradename, patents and a non-compete agreement. Thecustomer relationships, patents and a non-compete agreement are being amortizedover periods ranging from 3 to 15 years. Amortization recorded in the ninemonths ended September 30, 2006 and 2005 was $135,000 and $175,000,respectively.

Under the terms of theDSD Holdings A/S acquisition, the Company purchased all of the outstandingcapital stock of DSD Holdings A/S in consideration for a purchase price ofseven times DSD Holdings A/S’s average annual EBITDA over the next three yearsless outstanding indebtedness at the end of the time period. An initial paymentof $3.5 million was made at closing through the delivery of Applied Digitalcommon stock valued at $3.5 million which the Company acquired from AppliedDigital in exchange for $3.5 million of Digital Angel Corporation common stock.To account for pre-closing pricing fluctuations the Company paid additionalconsideration of $195,000 to the shareholders of DSD Holdings A/S onJune 7, 2005.

In addition, on February 28, 2005 Digital Angelentered into employment agreements with the Chief Executive Officer of DSDHoldings A/S and its subsidiaries, Lasse Nordfjeld and his son, the Presidentof Daploma, Torsten Nordfjeld.

Pursuant to the terms of the stock purchase agreement,at any time between the closing date of the acquisition and December 31, 2006the Company had the right to buyout the remaining purchase price.  On April 13, 2006, Digital Angel exercisedits right to buyout the remaining purchase price by electing to pay the setamount of $2.0 million. The $2.0 million buyout price was satisfied by a cashpayment of $1.0 million made on April 13, 2006 and the issuance on June 8, 2006of $1.0 million worth of Digital Angel’s unregistered common stock, or 282,115shares. The number of shares of Digital Angel’s common stock that wereexchanged was determined based upon the average of the volume-weighted-averageprice of Digital Angel’s common stock for the 10 trading days prior to theclosing date of the share exchange agreement, or $3.545 per share.  LANO Holdings Aps, wholly owned by LasseNordfjeld, and Torsten Nordfjeld received 174,403 shares and 28,268 shares,respectively, of the 282,115 shares issued to the former shareholders ofDSD.  The $2.0 million buyout price wasrecorded as additional goodwill.

Applied Digital and theformer shareholders of DSD agreed to exchange, per the terms of a shareexchange agreement dated April 12, 2006, registered shares of Applied Digital’scommon stock for the unregistered shares of the Company’s common stock paid bythe Company to the former shareholders of DSD pursuant to the buyout agreement.Pursuant to the share exchange agreement, Applied Digital issued to the formershareholders of DSD 454,545 shares of Applied Digital’s common stock, valued at$972,249, plus $27,751 in cash in exchange for the 282,115 shares of DigitalAngel common stock that the former shareholders of DSD received from theCompany in partial payment of the buyout, as more fully discussed above. Thenumber of shares of Applied Digital common stock that were exchanged wasdetermined based upon the average of the volume-weighted-average price of ourcommon stock for the two trading days immediately preceding, and not including,the transaction closing date of June 8, 2006, which was $2.14 per share.

Digital Angel Corporation operates DSD Holdings A/Sand its operating subsidiaries from their current headquarters near Copenhagen,Denmark.

The resultsof DSD Holdings A/S have been included in the consolidated financial statementssince its date of acquisition. Unaudited pro forma results of operations forthe nine months ended September 30, 2005 are included below. Such pro formainformation 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.

15

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|                                                                       | ** ** | **For the Nine  Months  Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| **(In thousands, except per share amounts)** | ** ** | **2005**                                                      | ** ** |
| Net revenue                                                           |       | $                                                             | 42,904     |   |
| Net loss                                                              |       | $                                                             | (2,399     | ) |
| Net loss per common share – basic and diluted                    |       | $                                                             | (0.06      | ) |

 

**10.****         ****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.

Final judgment in the action was entered onFebruary 21, 2006. On March 20, 2006, the Company filed a notice of appealof the final judgment with the Federal Circuit Court of Appeals in Washington,D.C. The appeal is presently pending.

*Digital Angel Corporation vs. Datamars, Inc.,Datamars, S.A., The Crystal Import Corporation and Medical ManagementInternational, Inc.*

On October 20, 2004, the Company commenced anaction in the United States District Court for the District of Minnesota againstDatamars, Inc., Datamars, S.A., The Crystal Import Corporation, andMedical Management International, Inc. (“Banfield”). This suit claims thatthe defendants are marketing and selling syringe implantable identificationtransponders manufactured by Datamars that infringe the Company’s 1993 patentfor syringe implantable identification transponders previously found by theUnited States District Court for the District of Colorado to be enforceable.Certain of the locations in which the infringing transponders are or have beensold, include, but are not limited to, “Banfield, The Pet Hospital” of whichcertain locations are associated with PetSmart stores. The suit seeks, amongother things, an adjudication of infringement and that the infringing parties beenjoined from further improper action. The suit also seeks actual damages,punitive damages and interest, costs and attorneys’ fees. The Company believesthat the suit is well-grounded in law and fact. Discovery in the action hasbeen commenced and is continuing. On February 28, 2006, the Courtconducted a hearing (the “Markman Hearing”) in which each of the partiespresented the Court with their views regarding the scope of the claims setforth in the subject patent. On May 22, 2006, the Court issued its order on theMarkman Hearing, largely adopting Digital Angel’s views on the scope of theclaims in the subject patent.  Theparties are continuing discovery in light of that order.

16

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*CrystalImport Corporation v. Digital Angel, et al.*

On or about December 29, 2004, The Crystal ImportCorporation filed an action against AVID Identification Systems, Inc. andthe Company in the United States District Court for the Northern District ofAlabama. Crystal’s complaint primarily asserted federal and state antitrust andrelated claims against AVID, though it also asserted similar claims against theCompany. The Company filed a motion to dismiss the action for failure to statea claim on which relief could be granted, or in the alternative, to have theaction transferred to the United States District Court for the District ofMinnesota. On October 11, 2005, the Alabama Court denied the Company’smotion to dismiss the complaint, but granted the Company’s motion to transferthe action to Minnesota. Following the docketing of the action in Minnesota,the Company and AVID filed a motion seeking to stay the case until thecorresponding patent infringement actions have been resolved. Prior to thehearing on the motion, an agreement was reached pursuant to which the Court enteredan order on July 12, 2006 staying the action for 90 days with permission toseek an additional stay thereafter.  Thestay having expired on October 10, 2006 the Company and Avid re-filed theirmotion seeking to stay the case until the corresponding patent infringementactions have been resolved.  The hearingon the motion is scheduled to take place on November 20, 2006.  Given the uncertainties associated with alllitigation and given the early stage of this proceeding, the Company is unableto offer any assessment on the potential liability exposure, if any, to theCompany from this lawsuit.

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

On or about June2, 2005, the Company filed a declaratory judgment action in the U.S. DistrictCourt for the District of Minnesota seeking to have the Court determine therights and liabilities of the Company under a 2002 distribution agreement withCorporativo SCM, S.A. de C.V., a Mexican company which entered into adistribution agreement for a product that was then under development by theCompany but the development of which was subsequently abandoned.  The defendant filed a motion to dismiss thedeclaratory judgment action, which the Court denied. On or about January 10,2006, the defendant filed an answer and asserted a counterclaim against theCompany for fraud seeking damages in an amount in excess of $75,000. TheCompany filed a response denying the allegations of the counterclaim,and moved to dismiss the counterclaim because it was not timely andfailed to plead fraud with particularlity. The Court deniedthe Company’s motion to dismiss on May 8, 2006 and the Company filedan Answer to the Amended Counterclaim that, among other things,denies the allegations of the Amended Counterclaim and asserts affirmativedefenses.  The case is in the initial discovery stages.  Given theuncertainties associated with all litigation and given the early stage of thisproceeding, the Company is unable to offer any assessment on the potentialliability exposure, if any, to the Company from this lawsuit.

**11.****         ****SupplementalCash Flow Information (in thousands)**
|                                                                      | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                           | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Interest paid                                                        | ** ** | **$**                                               | **316**    |   | $ | 291 |   |
| Taxes paid                                                           | ** ** | **80**                                              |       | 11 |   |
| Non-cash activity:                                                   |       |                                                |       |   |   |
| Issuance  of common stock for ADS common stock                       |       | —                                              |       | 3,500 |   |
| Issuance  of common stock to former shareholders of DSD Holdings A/S | ** ** | **1,000**                                           |       | — |   |
| Financing of equipment through capital lease                         | ** ** | **440**                                             |       | — |   |
|                                                                      |            |                                                     |            |  |  |  |  |

 

**12.****         ****RelatedParty Activity**

The Company has an eleven-year Distribution and LicensingAgreement dated March 4, 2002, amended December 28, 2005, withVeriChip Corporation (VeriChip), a wholly-owned subsidiary of Applied Digital,covering the manufacturing, purchasing and distribution of the Company’simplantable microchip and the maintenance of the VeriChip Registry by theCompany. The amended agreement contains, among other things, minimum purchaserequirements in order to maintain exclusivity, whereby VeriChip is required topurchase $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 its terms.The Distribution and Licensing agreement includes a license for the use of theCompany’s technology in VeriChip’s identified markets. Under the Distributionand Licensing Agreement, the Company is the sole manufacturer and supplier toVeriChip. The existing terms with the Company’s sole supplier of implantablemicrochips, Raytheon Microelectronics Espana, SA, expire on June 30, 2010.

17

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Revenuerecognized under the Distribution and Licensing Agreement was $194,000 and$466,000 for the nine months ended September 30, 2006 and 2005, respectively.

Amounts duefrom VeriChip as of September 30, 2006 and December 31, 2005 were $263,000 and$232,000, respectively.

See Note 6for a description of the stock exchange transactions with Applied Digital.

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

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

We consistof Digital Angel Corporation and our subsidiaries - Digital Angel TechnologyCorporation (“DATC”), Fearing Manufacturing, Inc., Timely Technology Corp.,Signature Industries Limited (90.9% owned subsidiary), OuterLink Corporation,DSD Holdings A/S and its subsidiaries Daploma International A/S (including its70%-owned subsidiary, Daploma Polska) and Digitag A/S, Digital Angel Holdings,LLC and Digital Angel International, Inc. and its subsidiaries DigitalAngel S.A., Digital Angel do Brasil Produtos de Informatica LTDA, Digital AngelChile S.A., Digital Angel Paraguay S.A., and Digital Angel Uruguay S.A.

**RESULTS OF OPERATIONS**

Thefollowing table summarizes our results of operations as a percentage of netoperating revenue for the three and nine months ended September 30, 2006 and2005 and is derived from the accompanying consolidated statements of operationsincluded in this report.
| ** **                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                        | ** ** | **%**                                                | ** ** | **%**                                               | ** ** | **%** | ** ** | **%** | ** ** |
| Product revenue                                                   |       | 96.0                                                 |       | 96.1                                                |       | 96.0 |   | 95.6 |   |
| Service revenue                                                   |       | 4.0                                                  |       | 3.9                                                 |       | 4.0 |   | 4.4 |   |
| Total net  revenue                                                |       | 100.0                                                |       | 100.0                                               |       | 100.0 |   | 100.0 |   |
| Cost of products  sold                                            |       | 54.7                                                 |       | 54.8                                                |       | 56.2 |   | 53.7 |   |
| Cost of services  sold                                            |       | 2.6                                                  |       | 2.1                                                 |       | 2.2 |   | 2.1 |   |
| Total cost of  products and services sold                         |       | 57.3                                                 |       | 56.9                                                |       | 58.4 |   | 55.8 |   |
| Gross profit                                                      |       | 42.7                                                 |       | 43.1                                                |       | 41.6 |   | 44.2 |   |
| Selling, general  and administrative expenses                     |       | 45.1                                                 |       | 41.8                                                |       | 43.3 |   | 40.9 |   |
| Research and  development expenses                                |       | 8.2                                                  |       | 8.5                                                 |       | 8.2 |   | 8.1 |   |
| Operating loss                                                    |       | (10.6                                                | )          | (7.2                                                | )          | (9.9 | ) | (4.8 | ) |
| Interest income                                                   |       | 0.5                                                  |       | 0.6                                                 |       | 0.6 |   | 0.6 |   |
| Interest expense                                                  |       | (0.9                                                 | )          | (0.6                                                | )          | (0.8 | ) | (0.7 | ) |
| Other income                                                      |       | 0.1                                                  |       | 0.1                                                 |       | 0.2 |   | 0.1 |   |
| Loss before  taxes, minority interest and discontinued operations |       | (10.9                                                | )          | (7.1                                                | )          | (9.9 | ) | (4.8 | ) |
| Income tax  expense                                               |       | (0.0                                                 | )          | (0.2                                                | )          | 0.2 |   | (0.3 | ) |
| Minority  interest share of income                                |       | (0.0                                                 | )          | (0.5                                                | )          | (0.2 | ) | (0.7 | ) |
| Net loss from  continuing operations                              |       | (10.9                                                | )          | (7.8                                                | )          | (9.9 | ) | (5.8 | ) |
| Income from  discontinued operations                              |       | 0.0                                                  |       | 0.6                                                 |       | 0.0 |   | 0.2 |   |
| Net loss                                                          |       | (10.9                                                | )          | (7.2                                                | )          | (9.9 | ) | (5.6 | ) |

 

**Three Months EndedSeptember 30, 2006 Compared to the Three Months Ended September 30, 2005**

**Revenue**

Totalrevenue for the three months ended September 30, 2006 was $13.2 million, adecrease of $0.6 million, or 4.1%, compared to $13.8 million in revenue for thethree months ended September 30, 2005.

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Revenue foreach of the operating segments was as follows (in thousands):
|                              | ** ** | **Three Months  Ended  September 30,  2006** | ** ** | **Three Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Animal Applications          |       | $                                                      | 8,254      |                                                   | $          | 8,769 |   |
| GPS and Radio Communications |       | 4,937                                                  |       | 4,989                                                  |       |
| Total                        |       | $                                                      | 13,191     |                                                   | $          | 13,758 |   |

 

The AnimalApplications segment’s revenue was $8.3 million in the three months endedSeptember 30, 2006, a decrease of $0.5 million, or 5.9%, compared to $8.8million in the three month period ended September 30, 2005. The decrease inrevenue was principally due to a decrease in sales to fish and wildlifecustomers of approximately $0.7 million and a decrease in sales to companionanimal customers of approximately $0.1 million. The decreases in the AnimalApplication segment were partially offset by an increase in sales to U.S.livestock customers of $0.3 million.

The GPS andRadio Communications segment’s revenue was $4.9 million in the three monthsended September 30, 2006, a decrease of $52,000, or 1.0%, compared to $5.0million in the three months ended September 30, 2005.  The decrease in revenue was due to a decreasein sales of Signature’s Sarbe products of $0.4 million, partially offset by anincrease in sales at Signature’s Radio Hire division of approximately $0.1million and an increase in sales at OuterLink Corporation of $0.2 million.

**Gross Profit and Gross Profit Margin**

Grossprofit for the three month period ended September 30, 2006 was approximately$5.6 million, a decrease**ofapproximately $0.3 million, or 5.0%, compared to approximately $5.9 million inthe three month period ended September 30, 2005. As a percentage of revenue,the gross profit margin decreased to 42.7% for the three months ended September30, 2006 from 43.1% for the three months ended September 30, 2005.

Grossprofit from operations for each operating segment was as follows (inthousands):
|                              | ** ** | **Three Months  Ended  September 30,  2006** | ** ** | **Three Months  Ended   September 30,  2005** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| Animal Applications          |       | $                                                      | 3,102      |                                                         | $          | 3,478 |   |
| GPS and Radio Communications |       | 2,538                                                  |       | 2,458                                                        |       |
| Total                        |       | $                                                      | 5,640      |                                                         | $          | 5,936 |   |

 

Grossprofit margin from operations for each operating segment was:
|                              | ** ** | **Three Months  Ended  September 30,  2006** | ** ** | **Three Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                                  | ** ** | **%**                                                  | ** ** |
| Animal Applications          |       | 37.6                                                   |       | 39.7                                                   |       |
| GPS and Radio Communications |       | 51.4                                                   |       | 49.3                                                   |       |

 

The AnimalApplications segment’s gross profit decreased approximately $0.4 million, or10.8%, in the three month period ended September 30, 2006 compared to the threemonths ended September 30, 2005. The gross margin percentage was 37.6% for thethree month period ended September 30, 2006 compared to 39.7% for the threemonth period ended September 30, 2005. We attribute the decrease in grossmargin and gross margin percentage to additional freight and importation dutiesassociated with providing inventory to South America from Denmark and the U.S. andproduct mix in the three months ended September 30, 2006 which yielded lowergross margin and gross margin percentage.

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The GPS andRadio Communications segment’s gross profit increased approximately $0.1million, or 3.3%, in the three month period ended September 30, 2006 ascompared to the three month period ended September 30, 2005.  In the three months ended September 30, 2006,OuterLink Corporation’s gross profit was up approximately $0.2 million offsetby a decrease in gross profit of $0.1 million at Signature IndustriesLimited.  The gross margin percentageincreased to 51.4% in the three month period ended September 30, 2006 ascompared to 49.3% in the three month period ended September 30, 2005. Theincrease in gross margin percentage relates primarily to lower material costsas a percentage of revenue at Signature Industries Limited and an increase insales at OuterLink at a greater rate than the increase in overhead costs.

**Selling, General and Administrative Expenses**

Selling,general and administrative expenses increased approximately $0.2 million, or3.3%, in the three month period ended September 30, 2006 as compared to thethree month period ended September 30, 2005. As a percentage of revenue,selling, general and administrative expenses were 45.1% and 41.8% for the threemonths ended September 30, 2006 and 2005, respectively.

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

|                              | ** ** | **Three Months  Ended  September 30,  2006** | ** ** | **Three Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Animal Applications          |       | $                                                      | 3,459      |                                                   | $          | 3,373 |   |
| GPS and Radio Communications |       | 2,487                                                  |       | 2,383                                                  |       |
| Total                        |       | $                                                      | 5,946      |                                                   | $          | 5,756 |   |

 

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

|                              | ** ** | **Three Months  Ended  September 30,  2006** | ** ** | **Three Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                                  | ** ** | **%**                                                  | ** ** |
| Animal Applications          |       | 41.9                                                   |       | 38.5                                                   |       |
| GPS and Radio Communications |       | 50.4                                                   |       | 47.8                                                   |       |

 

The AnimalApplications segment’s selling, general and administrative expenses increasedapproximately $0.1 million in the three month period ended September 30, 2006as compared to the three month period ended September 30, 2005 and selling,general and administrative expense as a percentage of revenue increased to41.9% from 38.5% in the same respective periods.  The increase in selling, general andadministrative expense as a percentage of revenue primarily relates to thedecrease in sales, as mentioned above.

The GPS andRadio Communications segment’s selling, general and administrative expensesincreased approximately $0.1 million to approximately $2.5 million in the threemonth period ended September 30, 2006 from approximately $2.4 million in thethree month period ended September 30, 2005. In the three months endedSeptember 30, 2006, decreased amortization expense at our subsidiary, OuterLinkCorporation, was partially offset by increased salary expense at oursubsidiary, Signature Industries Limited. As a percentage of revenue, selling, general and administrative expensesincreased to 50.4% in the three month period ended September 30, 2006 from47.8% in the three month period ended September 30, 2005. The increase inselling, general and administrative expense as a percentage of sales resultedprimarily from an increase in expenses while sales remained constant.

All of theCompany’s out-of-the money, unvested stock options issued to current employees,officers and directors prior to November 15, 2005 were vested on December 30,2005, therefore equity based compensation expense related to stock optionsgranted prior to the adoption of SFAS 123R was immaterial.  In the nine months ended September 30, 2006the Company granted 2.2 million stock options to employees and directors ofDigital Angel Corporation.  As ofSeptember 30, 2006 the Company’s unrecognized compensation expense associatedwith its stock options is estimated to be $4.6 million and is expected to berecognized over a weighted average 6.3 years.  The Company expects approximately 90% of this expense to be included inselling, general and administrative expense.

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**Research and Development Expense**

Researchand development expense was approximately $1.1 million in the three monthperiod ended September 30, 2006 compared to approximately $1.2 million for thethree month period ended September 30, 2005. As a percentage of revenue,research and development expense was 8.2% and 8.5% for the three months endedSeptember 30, 2006 and 2005, respectively.

Researchand development expense for each of the operating segments was as follows (inthousands):
|                              | ** ** | **Three Months  Ended  September 30,  2006** | ** ** | **Three Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Animal Applications          |       | $                                                      | 576        |                                                   | $          | 717 |   |
| GPS and Radio Communications |       | 522                                                    |       | 448                                                    |       |
| Total                        |       | $                                                      | 1,098      |                                                   | $          | 1,165 |   |

 

The AnimalApplications segment’s research and development expense decreased approximately$0.1 million to $0.6 million in the three month period ended September 30, 2006compared to $0.7 million in the three month period ended September 30,2005.  Research and development in thethree month period ended September 30, 2006 relates to continued product development.

The GPS andRadio Communications segment’s research and development expense increasedapproximately $0.1 million to $0.5 million in the three month period endedSeptember 30, 2006 compared to $0.4 million in the three month period endedSeptember 30, 2005.  Research anddevelopment in the three month period ended September 30, 2006 relates tocontinued product development of OuterLink Corporation’s next generation ofcommunication system hardware and development of the 406.6 MHz product familyat Signature Industries Limited.

**Interest Expense**

Interestexpense was approximately $0.1 million for the three month period endedSeptember 30, 2006 and approximately $0.1 million for the three month periodended September 30, 2005.

**Income Taxes**

The Companyrecorded an income tax provision of $4,000 in the three month period endedSeptember 30, 2006 compared to a tax provision of $24,000 for the three monthperiod ended September 30, 2005. The income tax provision for the three monthperiod ended September 30, 2006 relates to 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.

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**Nine Months EndedSeptember 30, 2006 Compared to the Nine Months Ended September 30, 2005**

**Revenue**

Revenue was$42.0 million for each of the nine months ended September 30, 2006 and 2005.

Revenue foreach of the operating segments was as follows (in thousands):
|                              | ** ** | **Nine Months  Ended  September 30,  2006** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Animal Applications          |       | $                                                     | 28,131     |                                                  | $          | 25,402 |   |
| GPS and Radio Communications |       | 13,838                                                |       | 16,619                                                |       |
| Total                        |       | $                                                     | 41,969     |                                                  | $          | 42,021 |   |

 

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The AnimalApplications segment’s revenue of approximately $28.1 million for the ninemonths ended September 30, 2006 represents an increase of approximately $2.7 million, or 10.7%, compared to $25.4million for the nine month period ended September 30, 2005. The increase inrevenue was principally due to an increase in electronic and visual product salesto livestock customers of approximately $1.7 million, an increase in sales tocompanion animal customers of approximately $1.9 million, an increase in salesof $0.5 million at DSD Holdings A/S ($0.8 million relates to two additionalmonths of sales in 2006 offset by decreased sales of $0.3 million), and anincrease in sales to customers in South America of $0.6 million.   The increases in the Animal Applicationsegment are partially offset by a decrease in sales to fish and wildlifecustomers of $1.7 million and a decrease in sales to VeriChip Corporation of$0.3 million.

The GPS andRadio Communications segment’s revenue of approximately $13.8 million in thenine months ended September 30, 2006 represents a decrease of approximately$2.8 million, or 16.7%, compared to $16.6 million for the nine months endedSeptember 30, 2005. The decrease in revenue was primarily due to anapproximately $3.6 million decrease in sales of Signature’s Sarbe products, partiallyoffset by an increase in sales at Signature’s Radio Hire division ofapproximately $0.5 million. We attribute $2.2 million of the Sarbe productsales decrease to the completion of the Indian government contract in May 2005and $1.4 million of the Sarbe product sales decrease to other Sarbe product customers,including the UK Ministry of Defence.

**Gross Profit and Gross Profit Margin**

Grossprofit for the nine month period ended September 30, 2006 was approximately$17.5 million, a decrease**ofapproximately $1.1 million, or 5.9%, compared to approximately $18.6 million inthe nine month period ended September 30, 2005. As a percentage of revenue, thegross profit margin decreased to 41.6% for the nine months ended September 30,2006 from 44.2% for the nine months ended September 30, 2005.

Grossprofit from operations for each operating segment was as follows (inthousands):
|                              | ** ** | **Nine Months  Ended  September 30,  2006** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Animal Applications          |       | $                                                     | 10,559     |                                                  | $          | 10,067 |   |
| GPS and Radio Communications |       | 6,919                                                 |       | 8,504                                                 |       |
| Total                        |       | $                                                     | 17,478     |                                                  | $          | 18,571 |   |

 

Grossprofit margin from operations for each operating segment was:
|                              | ** ** | **Nine Months  Ended  September 30,  2006** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                                 | ** ** | **%**                                                 | ** ** |
| Animal Applications          |       | 37.5                                                  |       | 39.6                                                  |       |
| GPS and Radio Communications |       | 50.0                                                  |       | 51.2                                                  |       |

 

The AnimalApplications segment’s gross profit increased approximately $0.5 million, or4.9%, in the nine month period ended September 30, 2006 compared to the ninemonths ended September 30, 2005. We attribute approximately $0.2 million of theincrease to the previously mentioned sales increases and $0.3 million to theinclusion of DSD Holdings A/S for an additional two months of operations in thenine month period ended September 30, 2006. DSD Holdings A/S was acquired onFebruary 28, 2005. The gross margin percentage was 37.5% for the ninemonth period ended September 30, 2006 compared to 39.6% for the nine monthperiod ended September 30, 2005. We attribute the decrease in gross marginpercentage to additional freight and importation duties associated withproviding inventory to South America from Denmark and the United States.

The GPS andRadio Communications segment’s gross profit decreased approximately $1.6million, or 18.6%, in the nine month period ended September 30, 2006 ascompared to the nine month period ended September 30, 2005. The decrease ingross profit relates to the decrease in sales and decreased gross marginpercentage. The gross margin percentage decreased to 50.0% in the nine monthperiod ended September 30, 2006 as compared to 51.2% in the nine month periodended September 30, 2005. The decrease in gross margin percentage relatesprimarily to higher margins on G2R Sarbe locator beacons shipped under thecontract with the government of India in the first six months of 2005.  Signature completed shipments under thecontract with the government of India in May 2005.

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**Selling, General and Administrative Expenses**

Selling,general and administrative expenses increased approximately $1.0 million, or5.7%, in the nine month period ended September 30, 2006 as compared to the ninemonth period ended September 30, 2005. As a percentage of revenue, selling,general and administrative expenses were 43.3% and 40.9% for the nine monthsended September 30, 2006 and 2005, respectively.

Selling,general and administrative expenses for each of the operating segments were asfollows (dollars in thousands):
|                              | ** ** | **Nine Months  Ended  September 30,  2006** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Animal Applications          |       | $                                                     | 10,905     |                                                  | $          | 9,714 |   |
| GPS and Radio Communications |       | 7,276                                                 |       | 7,488                                                 |       |
| Total                        |       | $                                                     | 18,181     |                                                  | $          | 17,202 |   |

 

Selling,general and administrative expenses as a percentage of revenue for each of theoperating segments were:
|                              | ** ** | **Nine Months  Ended  September 30,  2006** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                                 | ** ** | **%**                                                 | ** ** |
| Animal Applications          |       | 38.8                                                  |       | 38.2                                                  |       |
| GPS and Radio Communications |       | 52.6                                                  |       | 45.1                                                  |       |

 

The AnimalApplications segment’s selling, general and administrative expenses increasedapproximately $1.2 million in the nine month period ended September 30, 2006 ascompared to the nine month period ended September 30, 2005 and selling, generaland administrative expense as a percentage of revenue increased to 38.8% from38.2% in the same respective periods. The increase in selling, general andadministrative expenses relates primarily to a charge of approximately $0.2million in acquisition expenses, approximately $0.7 million in additionalcompensation expense, approximately $0.4 million of additional expense relatedto DSD Holding A/S and increased selling, general and administrative expensesin our South American subsidiaries of $0.3 million.  Such increases are partially offset bydecreased insurance expense of $0.3 million. The nine month period ended September30, 2005 includes seven months of results for DSD Holdings A/S compared to ninemonths of results in the nine month period ended September 30, 2006.  DSD Holdings A/S was acquired on February 28,2005.

The GPS andRadio Communications segment’s selling, general and administrative expensesdecreased approximately $0.2 million to approximately $7.3 million in the ninemonth period ended September 30, 2006 from approximately $7.5 million in thenine month period ended September 30, 2005. The decrease in selling, generaland administrative expense relates primarily to reduced intangible amortizationexpense at our subsidiary, OuterLink Corporation, partially offset by increasedselling, general and administrative expense at our subsidiary Signature IndustriesLimited.  As a percentage of revenue,selling, general and administrative expenses increased to 52.6% in the ninemonth period ended September 30, 2006 from 45.1% in the nine month period endedSeptember 30, 2005. The increase in selling, general and administrative expenseas a percentage of sales resulted primarily from the decrease in sales in thecurrent period.

All of theCompany’s out-of-the money, unvested stock options issued to current employees,officers and directors prior to November 15, 2005 were vested on December 30,2005, therefore equity based compensation expense related to stock optionsgranted prior to the adoption of SFAS 123R was immaterial.  In the nine months ended September 30, 2006,the Company granted 2.2 million stock options to employees and directors ofDigital Angel Corporation.  As ofSeptember 30, 2006 the Company’s unrecognized compensation expense associatedwith its stock options is estimated to be $4.6 million and is expected to berecognized over a weighted average 6.3 years.  The Company expects approximately 90% of this expense to be included inselling, general and administrative expense.

**Research and Development Expense**

Researchand development expense was approximately $3.4 million in each of the ninemonth periods ended September 30, 2006 and 2005. As a percentage of revenue,research and development expense was 8.2% and 8.1% for the nine months endedSeptember 30, 2006 and 2005, respectively.

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Research and development expense for each of the operatingsegments was as follows (in thousands):
|                              | ** ** | **Nine Months  Ended  September 30,  2006** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Animal Applications          |       | $                                                     | 2,097      |                                                  | $          | 2,087 |   |
| GPS and Radio Communications |       | 1,342                                                 |       | 1,283                                                 |       |
| Total                        |       | $                                                     | 3,439      |                                                  | $          | 3,370 |   |

 

The Animal Applicationssegment’s research and development expense was approximately $2.1 million ineach of the nine month periods ended September 30, 2006 and 2005. The researchand development primarily consists of new product development.

The GPS andRadio Communications segment’s research and development expense wasapproximately $1.3 million in the nine month periods ended September 30, 2006and 2005. Research and development in the nine month period ended September 30,2006 relates to the continued development of OuterLink Corporation’s nextgeneration of communication system hardware and the development of the 406.6MHz product family at Signature Industries Limited.

**Interest Expense**

Interestexpense was approximately $0.3 million in each of the nine month periods endedSeptember 30, 2006 and 2005.

**Income Taxes**

The Companyrecorded an income tax benefit of approximately $68,000 in the nine monthperiod ended September 30, 2006 and an income tax provision of approximately$110,000 for the nine month period ended September 30, 2005. The income taxbenefit for the nine month period ended September 30, 2006 relates to asubsidiary of Daploma International A/S. The Company accounts for income taxesunder the asset and liability approach. Deferred tax assets and liabilities arerecognized for the expected future tax consequences attributed to differencesbetween the financial statement carrying amounts of existing assets andliabilities and their respective tax basis. Deferred tax assets and liabilitiesare measured using the enacted tax rates expected to apply to taxable income inthe years in which those temporary differences are expected to reverse. Avaluation allowance is provided against net deferred tax assets when it is morelikely than not that a tax benefit will not be realized.

**LIQUIDITY AND CAPITAL RESOURCES**

As ofSeptember 30, 2006, the Company had cash of $3.9 million. Cash used inoperating activities totaled approximately $4.0 million and approximately $1.6million in the first nine months of 2006 and 2005, respectively.

In thefirst nine months of 2006, the use of cash was due primarily to the net loss ofapproximately $4.1 million, an increase in inventory of approximately $2.0million, and a decrease in accounts payable, accrued expenses and deferred revenueof approximately $1.2 million. Partially offsetting these uses of cash were adecrease in accounts receivable of $2.1 million, depreciation and amortizationof approximately $1.5 million and non-cash equity based compensation ofapproximately $0.6 million.

Investing activities used cash of approximately $2.9million and approximately $2.6 million in the first nine months of 2006 and2005, respectively. The Company purchased approximately $1.9 million of propertyand equipment in the first nine months of 2006 and $1.3 million in the firstnine months of 2005.  On April 13,2006 the Company exercised its right to buyout the remaining purchase price forthe acquisition of DSD Holdings. The $2.0 million buyout price was satisfied bya cash payment of $1.0 million paid in April 2006 and $1.0 million worth of theCompany’s unregistered common stock issued in June 2006.

Financingactivities provided cash of approximately $0.7 million in the first nine monthsof 2006 and used cash of approximately $1.0 million in the first nine months of2005. In the first nine months of 2006, proceeds to the Company related tostock option exercises were approximately $0.6 million.  In the first nine months of 2005,approximately $1.5 million of cash was used for the purchase of 328,100 sharesof treasury stock.

The Companyexpects that current available funds along with cash generated from operations willadequately fund the Company’s operations for the next twelve months.

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*Debt, CovenantCompliance and Liquidity*

*Invoice Discounting Agreement*On April 9, 2003, Signature Industries Limited entered into a two-yearInvoice Discounting Agreement with The Royal Bank of Scotland CommercialServices Limited (“RBS”). The Invoice Discounting Agreement, as amendedOctober 28, 2003, June 21, 2005 and July 27, 2006, provides for Signatureto sell with full title guarantee most of its receivables, as defined in theInvoice Discounting Agreement, as amended. RBS prepays 80% of the receivables soldin the United Kingdom and 80% of the receivables sold in the rest of the world,not to exceed an outstanding balance of £1,000,000 (US $1.9 million atSeptember 30, 2006) at any given time. RBS pays Signature the remainder of thereceivable upon collection of the receivable. Receivables which remainoutstanding 90 days from the end of the invoice month become ineligible and RBSmay require Signature to repurchase the receivable. The discounting chargeaccrues daily at an annual rate of 1.5% above the base rate, as defined in theamended Invoice Discounting Agreement (6.25% at September 30, 2006). Signaturepays a commission charge to RBS of 0.16% of each receivable balance sold. TheInvoice Discounting Agreement, as amended, requires a minimum commission chargeof £833 per month. Discounting charges of $36,000 and $30,000 are included ininterest expense for the nine months ended September 30, 2006 and 2005,respectively. As of September 30, 2006, $1.0 million of receivables werefinanced under the Invoice Discounting Agreement.

*Equipment Loans-DSD Holdings*  DSD Holdings is party to equipment loanswhich are collateralized by production equipment. Principal and interestpayments totaling approximately DKK 0.4 million (US $69,000 at September 30,2006) are payable quarterly. Payments are due through January 2010. Theinterest rates on the loans are variable and range from 5.116% to 8.137% as ofSeptember 30, 2006. As of September 30, 2006, the amount outstanding under theequipment loans was $1.0 million.

*Line of Credit-DSD Holdings*  DSD Holdings and its wholly-owned subsidiary,Daploma International A/S, are party to a credit agreement with Danske Bank A/S.On June 1, 2006, DSD Holdings and Daploma International A/S amended theborrowing availability from DKK 12 million (US $2.0 million at September 30,2006) to DKK 18 million (US $3.1 million at September 30, 2006).  In connection with the amendment, DigitalAngel Corporation executed a Letter of Support which confirms that DigitalAngel Corporation shall maintain its holding of 100% of the share capitalof  Daploma, and that Digital Angel shallneither sell, nor pledge, nor in any other way dispose of any part of Daplomaor otherwise reduce its influence on Daploma without the prior consent ofDanske Bank.  As of September 30, 2006the amount outstanding under the credit agreement was $2.5 million. Theinterest is determined quarterly and is based on the internationalrates Danske Bank can establish on a loan in the same currency on theinternational market plus 2.0%. At September 30, 2006, the annualinterest rate on the facility was 5.1%. Borrowing availability under the creditfacility considers guarantees outstanding. At September 30, 2006 the borrowingavailability on the credit agreement was DKK 1.2 million (US $0.2 million atSeptember 30, 2006). The credit agreement shall remain effective until furthernotice. DSD Holdings can terminate the credit agreement and pay the outstandingbalance or Danske Bank may demand the credit line be settled immediatelyat any given time, without prior notice.

*Note Payable-DSD Holdings*  As of September 30, 2006, DSD Holdings isparty to a note payable with Danske Bank A/S. Principal payments of DKK 0.3million (US $51,000 at September 30, 2006) plus interest are payable quarterlythrough December 15, 2008. The interest rate on the note is calculatedbased on the international rates Danske Bank can establish on a loan in DKK inthe international market plus 2.0%. The interest rate on the note payable was5.07% at September 30, 2006. As of September 30, 2006, the amount outstandingunder the note payable was $0.5 million.

*Mortgage Notes Payable*  The Company is party to a mortgage notespayable collateralized by land and building. Principal and interest paymentstotaling approximately $20,000 are payable monthly through October 2010. Thefinal payment of $2.0 million is due in November of 2010. The interest rate onthe note is fixed at 8.18%. As of September 30, 2006, the amount outstandingunder the mortgage note payable was $2.2 million.

*StockIssuances to Applied Digital* On February 25, 2005, the Company entered intoa Stock Purchase Agreement with Applied Digital. Pursuant to the agreement theCompany issued 644,140 shares of its common stock to Applied Digital. The Companyreceived 684,543 shares of Applied Digital common stock as consideration. Thevalue of the stock exchanged was $3.5 million. The Applied Digital common stockreceived by the Company was used as partial consideration for the acquisitionof DSD Holdings A/S and its wholly-owned subsidiaries, Daploma InternationalA/S and Digitag A/S.

*StockRepurchase*On March 29, 2005, the Company’s Board of Directors approved therepurchase of up to 1.5 million shares of its common stock over a ninety dayperiod commencing on March 30, 2005. The Company purchased 328,000 sharesfor a total of $1.5 million.

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The following table summarizes the Company’s fixed cashobligations as of September 30, 2006 over various 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           |       | $          | 7,034      |                                      | $          | 3,536 |   | $ | 1,219 |   | $ | 2,279 | ** ** | **$** | **—** | ** ** |
| Operating Leases                           |       | 18,106     |       | 776                                       |       | 1,308 |   | 1,006 |   | 15,016 |   |
| Employment Contracts                       |       | 1,465      |       | 1,055                                     |       | 410 | ** ** | **—** | ** ** | **—** | ** ** |
|                                       |       | $          | 26,605     |                                      | $          | 5,367 |   | $ | 2,937 |   | $ | 3,285 |   | $ | 15,016 |   |

 

**IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS**

In June 2006, the Financial Accounting Standards Board (FASB) issuedInterpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretationof FAS No. 109” (FIN 48), which clarifies the accounting for uncertainty inincome taxes. Currently, the accounting for uncertainty in income taxes issubject to significant and varied interpretations that have resulted in diverseand inconsistent accounting practices and measurements. Addressing suchdiversity, FIN 48 prescribes a consistent recognition threshold and measurementattribute, as well as clear criteria for subsequently recognizing,derecognizing and measuring changes in such tax positions for financialstatement purposes. FIN 48 also requires expanded disclosure with respect tothe uncertainty in income taxes. FIN 48 is effective for fiscal years beginningafter December 15, 2006. The Company has not yet determined the impact of FIN 48on its consolidated financial position, results of operations, cash flows orfinancial statement disclosures.

In September 2006,FASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans—an amendment of FASB StatementsNo. 87, 88, 106, and 132(R),” which requires employers to:(a) recognize in its statement of financial position an asset for a plan’soverfunded status or a liability for a plan’s underfunded status;(b) measure a plan’s assets and its obligations that determine its fundedstatus as of the end of the employer’s fiscal year; and (c) recognizechanges in the funded status of a defined benefit postretirement plan in theyear in which the changes occur. Those changes will be reported in comprehensiveincome of a business entity. The requirement to recognize the funded status ofa benefit plan and the disclosure requirements are effective as of the end ofthe fiscal year ending after December 15, 2006, for entities with publiclytraded equity securities. The requirement to measure plan assets and benefitobligations as of the date of the employer’s fiscal year-end statement offinancial position is effective for fiscal years ending after December 15,2008. The Company has determined that the adoption of SFAS 158 will not have amaterial affect on its consolidatedfinancial position, results of operations, cash flows or financial statementdisclosures.

Also in September2006, FASB issued SFAS No. 157, “*FairValue Measurements’*” which defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements. This Statement iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007 and interim periods within those fiscal years. Earlierapplication is encouraged provided that the reporting entity has not yet issuedfinancial statements for that fiscal year including financial statements for aninterim period within that fiscal year. The Company is assessing SFASNo. 157 and has not determined yet the impact that the adoption of SFASNo. 157 will have on its result of operations or financial position. 

**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:

·                  our growth strategies including,without limitation, our ability to deploy**newproducts and services;

·                  anticipated trends in ourbusiness and demographics;

·                  our ability to successfullyintegrate the business operations of recently acquired companies;

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·                  our future profitability andliquidity; and

·                  regulatory, competitive orother economic influences.

Words suchas “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,”“estimates” and similar expressions also identify forward-looking statements.These forward-looking statements are not guarantees of future performance andare subject to risks and uncertainties that could cause actual results todiffer materially from estimates or forecasts contained in the forward-lookingstatements. Some of these risks and uncertainties are beyond our control. SeeItem 1A. Risk Factors included in our 2005 Annual Report on Form 10-K/A.

Our actualresults 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 Market Risk**

We haveoperations and sales in various regions of the world. Additionally, we may exportand import to and from other countries. Our operations may therefore be subjectto volatility because of currency fluctuations, inflation, and changes inpolitical and economic conditions in these countries. Sales and expenses may bedenominated in local currencies and may be affected as currency fluctuationsaffect our product prices and operating costs or those of our competitors. 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 supervision and with the participation of our management, includingthe Chief Executive Officer and the Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures. Based upon that evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures areeffective.

During theperiod covered by the Form 10-Q, there were no changes in our internalcontrol over financial reporting that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

**PART II    OTHER INFORMATION**

**Item 1. Legal Proceedings.**

For information with respect to certain legal proceedings, see theinformation included under the caption entitled, “Litigation” (Note 10) of the “Notesto Condensed Consolidated Financial Statements,” which is incorporated hereinby reference.

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**Item 1A. RiskFactors**

Information regarding risk factors appears in Management’s Discussion andAnalysis of Financial Condition and Results of Operations-Forward LookingStatements and Associated Risks in Part I, Item 2 of this Form 10-Q.  There have been no material changes in ourrisk factors from those disclosed in our 2005 Annual Report on Form 10-K/A.

**Item 6. Exhibits**
|        | ** ** | **(a)    Exhibits**                                                                                                                                             |
|--------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                                                                                                |
| 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 Financial Officer Pursuant to 18 U.S.C Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                        |
|   |       |                                                                                                                                                                                |
| 32.2   |       | Certification  of Chief Financial Officer Pursuant to 18 U.S.C Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                       |

 

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**SIGNATURE**

Pursuant to the requirements of the Securities Exchange Actof 1934, the Registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
|                         |   | DIGITAL  ANGEL CORPORATION |
|-------------------------|--------|----------------------------|
|                    |   | (Registrant)               |
|                    |   |                       |
| Dated: November 9, 2006 |   | By:                        |   | /s/ James  P. Santelli |
|                    |   |                       |   | James P.  Santelli |
|                    |   |                       |   | Senior  Vice President and Chief Financial Officer |

 

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