**As filed with the Securities and Exchange Commissionon May 8, 2003**

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C.  20549**

 

# ****

# ** **

# **FORM 10-Q**

**(MarkOne)**

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

 

**Forthe quarterly period ended March 31, 2003**

 

**or**

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

 

**Forthe transition periodfrom         to**

 

**Commission File Number:  1-15177**

 

**DIGITAL ANGELCORPORATION**

(Exact name of registrant asspecified in its charter)

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

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes     ý    No     o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule12b-2 of the Exchange Act).

Yes     o    No     ý

 

As of the close ofbusiness on May 5, 2003, there were 26,821,839 shares outstanding of theissuer’s $0.005 per share par value common stock.

 

 

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**DIGITALANGEL CORPORATION**

 

TABLE OF CONTENTS

 
| Item           | Description                                                                                 |   |
|----------------|---------------------------------------------------------------------------------------------|--------|
|           |                                                                                        |   |
|           | PART I – FINANCIAL  INFORMATION                                                        | 3      |
|           |                                                                                        |   |
| 1.             | Financial  Statements                                                                       | 3      |
| 2.             | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 16     |
| 3.             | Quantitative  and Qualitative Disclosures About Market Risk                                 | 29     |
| 4.             | Controls  and Procedures                                                                    | 29     |
|           |                                                                                        |   |
|           | PART II – OTHER  INFORMATION                                                           | 30     |
|           |                                                                                        |   |
| 1.             | Legal Proceedings                                                                           | 30     |
| 6.             | Exhibits and Reports  on Form 8-K                                                           | 31     |
|           |                                                                                        |   |
| SIGNATURE      | 31                                                                                          |
| CERTIFICATIONS | 32                                                                                          |
| EXHIBITS       | 34                                                                                          |

 

2

----

 

**PARTI    FINANCIAL INFORMATION**

 

Item 1.             Financial Statements.

 

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

(Inthousands, except par value)

 
|                                                                                                                                                                                    |   | **March 31,  2003** |       | **December 31,   2002** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|-------------------------|------------|
|                                                                                                                                                                                    |   | **(Unaudited)**     |       |                    |       |
| **Assets**                                                                                                                                                                              |   |                |       |                    |       |
| **Current Assets**                                                                                                                                                                      |   |                |       |                    |       |
| Cash and cash  equivalents                                                                                                                                                              |   | **$**               | **—** |                    | $          | 214 |   |
| Accounts  receivable and unbilled receivables (net of allowance for doubtful accounts  of $197 in 2003 and $296 in 2002)                                                                |   | **7,676**           |       | 4,126                   |       |
| Inventories                                                                                                                                                                             |   | **5,919**           |       | 4,945                   |       |
| Other current  assets                                                                                                                                                                   |   | **1,109**           |       | 1,478                   |       |
| **Total Current Assets**                                                                                                                                                                |   | **14,704**          |       | 10,763                  |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Property And Equipment, net**                                                                                                                                                         |   | **7,656**           |       | 7,769                   |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Goodwill and Other Intangible  Assets, net**                                                                                                                                          |   | **48,808**          |       | 48,893                  |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Other Assets, net**                                                                                                                                                                   |   | **357**             |       | 373                     |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
|                                                                                                                                                                                    |   | $                   | **71,525** |                    | $          | 67,798 |   |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                          |   |                | ** ** |                    | ** ** |
| **Current Liabilities**                                                                                                                                                                 |   |                |       |                    |       |
| Line of credit  and current maturities of long-term debt                                                                                                                                |   | $                   | **3,809**  |                    | $          | 816 |   |
| Accounts payable                                                                                                                                                                        |   | **4,880**           |       | 4,142                   |       |
| Accrued expenses  and other current liabilities                                                                                                                                         |   | **3,496**           |       | 3,704                   |       |
| Due to Applied  Digital Solutions, Inc.                                                                                                                                                 |   | **323**             |       | 462                     |       |
| **Total Current Liabilities**                                                                                                                                                           |   | **12,508**          |       | 9,124                   |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Long-Term Debt And Notes Payable**                                                                                                                                                    |   | **3,303**           |       | 3,314                   |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Deferred Revenue**                                                                                                                                                                    |   | **104**             |       | 50                      |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Total Liabilities**                                                                                                                                                                   |   | **15,915**          |       | 12,488                  |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Commitments And Contingencies**                                                                                                                                                       |   |                |       |                    |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Minority Interest**                                                                                                                                                                   |   | **265**             |       | 298                     |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
| **Stockholders’ Equity (See Note 1)**                                                                                                                                              |   |                |       |                    |       |
| Preferred stock:  Authorized 1,000 in 2002, of $1.75 par value, no shares issued or outstanding                                                                                         |   | **—**          |       | **—**              |       |
| Common stock:  Authorized 95,000 shares, of $.005 par value; 26,856 shares issued and 26,806  shares outstanding in 2003 and  26,568  shares issued and 26,518 outstanding in 2002 |   | **134**             |       | 133                     |       |
| Additional  paid-in capital                                                                                                                                                             |   | **167,625**         |       | 167,365                 |       |
| Accumulated  deficit                                                                                                                                                                    |   | **(113,949**        | **)**      | (114,059                | )          |
| Common stock  warrants                                                                                                                                                                  |   | **1,801**           |       | 1,801                   |       |
| Treasury stock  (carried at cost, 50 shares)                                                                                                                                            |   | **(43**             | **)**      | (43                     | )          |
| Accumulated  other comprehensive loss                                                                                                                                                   |   | **(223**            | **)**      | (185                    | )          |
| Total Stockholders’ Equity                                                                                                                                                         |   | **55,345**          |       | 55,012                  |       |
|                                                                                                                                                                                    |   |                |       |                    |       |
|                                                                                                                                                                                    |   | **$**               | **71,525** |                    | $          | 67,798 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

3

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

(In thousands, except pershare data)

(Unaudited)

 
|                                                                                                          |   | **For the Three Months  Ended March 31,** |       |
|---------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|
|                                                                                                          |   | **2003**                                  |       | **2002** |   |
|                                                                                                          |   |                                      |       |   |   |
| Product revenue                                                                                               |   | **$**                                     | **10,865** |   | $ | 7,451 |   |
| Service revenue                                                                                               |   | **533**                                   |       | 303 | ** ** |
| Total net revenue                                                                                             |   | **11,398**                                |       | 7,754 | ** ** |
|                                                                                                          |   |                                      |       |   |   |
| Cost of products sold                                                                                         |   | **5,639**                                 |       | 4,300 | ** ** |
| Cost of services sold                                                                                         |   | **395**                                   |       | 251 | ** ** |
|                                                                                                          |   | **6,034**                                 | ** ** | 4,551 |   |
| Gross profit                                                                                                  |   | **5,364**                                 |       | 3,203 | ** ** |
|                                                                                                          |   |                                      |       |   |   |
| Selling, general and administrative expenses                                                                  |   | **4,280**                                 |       | 22,758 | ** ** |
| Management fees - Applied Digital Solutions, Inc.                                                             |   | **—**                                |       | 193 | ** ** |
| Research and development expenses                                                                             |   | **911**                                   |       | 649 | ** ** |
| Interest expense - Applied Digital Solutions, Inc.                                                            |   | **—**                                |       | 1,806 | ** ** |
| Interest expense - others                                                                                     |   | **138**                                   |       | 58 | ** ** |
| Other income                                                                                                  |   | **(42**                                   | **)**      | **—** |   |
|                                                                                                          |   |                                      |       |   |   |
| Income (loss)  before taxes, minority interest share of losses and equity in net loss of MAS  prior to merger |   | **77**                                    |       | (22,261 | ) |
|                                                                                                          |   |                                      |       |   |   |
| Provision   for income taxes                                                                             |   | **—**                                |       | **—** |   |
|                                                                                                          |   |                                      |       |   |   |
| Income (loss)  before minority interest share of losses and equity in net loss of MAS prior  to merger        |   | **77**                                    |       | (22,261 | ) |
|                                                                                                          |   |                                      |       |   |   |
| Minority interest share of losses                                                                             |   | **33**                                    |       | 41 |   |
|                                                                                                          |   |                                      |       |   |   |
| Equity in net loss of MAS prior to merger                                                                     |   | **—**                                |       | (291 | )  |
|                                                                                                          |   |                                      |       |   |   |
| Net income (loss)                                                                                             |   | $                                         | **110**    |   | $ | (22,511 | ) |
|                                                                                                          |   |                                      |       |   |   |
| Net income (loss) per common share - basic                                                                    |   | $                                         | **—** |   | $ | (1.18 | ) |
| Net income (loss) per common share - diluted                                                                  |   | **—**                                |       | (1.18 | ) |
|                                                                                                          |   |                                      |       |   |   |
| Weighted average  number of common shares outstanding - basic                                                 |   | **26,663**                                |       | 19,063 |   |
| Weighted average  number of common shares outstanding   diluted                                          |   | **30,638**                                |       | 19,063 | ** ** |
|                                                                                                               |        |                                           |            |  |  |  |  |  |

 

See the accompanying notes to condensed consolidated financialstatements.

 

4

----

 

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

**For TheThree Months Ended March 31, 2003**

(In Thousands)

(Unaudited)

 
|                                             |   |       |       | **Additional  Paid-In  Capital** |       | **Accumulated  Deficit** |       | **Common  Stock  Warrants** |       | **Treasury  Stock** |         | **Accumulated  Other Comprehensive  Loss** |       | **Total  Stockholders’  Equity** |       |
|--------------------------------------------------|--------|------------|------------|----------------------------------|------------|--------------------------|------------|-----------------------------|------------|---------------------|--------------|--------------------------------------------|------------|---------------------------------------|------------|
| **Common Stock**                                 |
| **Number**                                       |   | **Amount** |       |
|                                             |   |       | ** ** |                             | ** ** |                     | ** ** |                        | ** ** |                | ** **   |                                       | ** ** |                                  | ** ** |   | ** ** |
| **Balance -  December 31, 2002**                 |   | 26,568     |       | $                                | 133        |                     | $          | 167,365                     |       | $                   | (114,059     | )                                          | $          | 1,801                                 |       | $ | (43 | )  | $ | (185 | ) | $ | 55,012 |   |
| Net income                                       |   | —     |       | —                           |       | —                   |       | 110                         |       | —              |         | —                                     |       | —                                |       | 110 |   |
| Comprehensive loss -Foreign currency translation |   | —     |       | —                           |       | —                   |       | —                      |       | —              |         | —                                     |       | (38                                   | )     | (38 | ) |
| Total comprehensive income (loss)                |   | —     |       | —                           |       | —                   |       | 110                         |       | —              |         | —                                     |       | (38                                   | )     | 72 |   |
| Exercise of stock options                        |   | 288        |       | 1                                |       | 174                      |       | —                      |       | —              |         | —                                     |       | —                                |       | 175 |   |
| Stock option repricing                           |   | —     |       | —                           |       | 86                       |       | —                      |       | —              |         | —                                     |       | —                                |       | 86 |   |
|                                             |   |       |       |                             |       |                     |       |                        |       |                |         |                                       |       |                                  |       |   |   |
| **Balance –  March 31, 2003**               |   | **26,856** | ** ** | **$**                            | **134**    |                     | **$**      | **167,625**                 | ** ** | **$**               | **(113,949** | **)**                                      | **$**      | **1,801**                             | ** ** | **$** | **(43** | **)** | **$** | **(223** | **)** | **$** | **55,345** | ** ** |
|                                                  |        |            |            |                                  |            |                          |            |                             |            |                     |              |                                            |            |                                       |            |  |  |  |  |  |  |  |  |  |  |

 

See the accompanying notes to condensed consolidated financialstatements.

 

5

----

 

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(In thousands)

(Unaudited)

 
|                                                                                  |   | **For the Three Months  Ended March 31,** |    |
|---------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                                                  |   | **2003**                                  |    | **2002** |   |
| **Cash Flows From Operating  Activities**                                             |   |                                      |    |   |   |
| Net income  (loss)                                                                    |   | **$**                                     | **110** |   | $ | (22,511 | ) |
|                                                                                  |   |                                      |    |   |   |
| Adjustments to  reconcile net income (loss) to net cash used in operating activities: |   |                                      |    |   |   |
| Equity-based  compensation                                                            |   | **86**                                    |    | 18,681 |   |
| Interest  allocated by ADS and contributed to capital                                 |   | —                                    |    | 1,806 |   |
| Depreciation and  amortization                                                        |   | **434**                                   |    | 735 |   |
| Minority  interest                                                                    |   | **(33**                                   | **)**   | (41 | ) |
| Equity in net loss  of affiliate                                                      |   | —                                    |    | 291 |   |
| Loss on disposal  of equipment                                                        |   | **8**                                     |    | 75 |   |
| Change in assets  and liabilities:                                                    |   |                                      |    |   |   |
| (Increase)  decrease in accounts receivable                                           |   | **(3,607**                                | **)**   | 1,086 |   |
| Increase in  inventories                                                              |   | **(974**                                  | )       | (53 | ) |
| Decrease  (increase) in other current assets                                          |   | **375**                                   |    | (716 | ) |
| Decrease in due  to ADS                                                               |   | **(139**                                  | )       | (108 | ) |
| Increase in  accounts payable, accrued expenses and deferred revenue                  |   | **651**                                   |    | 210 |   |
| **Net Cash Used In Operating  Activities**                                            |   | **(3,089**                                | **)**   | (545 | ) |
|                                                                                  |   |                                      |    |   |   |
| **Cash Flows From Investing  Activities**                                             |   |                                      |    |   |   |
| Decrease in  other assets                                                             |   | **9**                                     |    | 52 |   |
| Payments for  property and equipment                                                  |   | **(250**                                  | **)**   | (200 | ) |
| Cash acquired  through acquisition, net of acquisition costs                          |   | —                                    |    | 218 |   |
| **Net Cash (Used In) Provided by  Investing Activities**                              |   | **(241**                                  | **)**   | 70 |   |
|                                                                                  |   |                                      |    |   |   |
| **Cash Flows From Financing  Activities**                                             |   |                                      |    |   |   |
| Amounts borrowed  on line of credit                                                   |   | **8,677**                                 |    | — |   |
| Amounts paid on  line of credit                                                       |   | **(5,677**                                | **)**   | — |   |
| Net amounts  borrowed on notes payable                                                |   | —                                    |    | 7 |   |
| Payments on  long-term debt                                                           |   | **(20**                                   | **)**   | (17 | ) |
| Exercise of  stock options                                                            |   | **175**                                   |    | 95 |   |
| Capital  contribution by Applied Digital Solutions, Inc.                              |   | —                                    |    | 682 |   |
| **Net Cash Provided By Financing  Activities**                                        |   | **3,155**                                 |    | 767 |   |
|                                                                                  |   |                                      |    |   |   |
| **Effect of Exchange Rate Changes on Cash**                                           |   | **(39**                                   | **)**   | (6 | ) |
|                                                                                  |   |                                      |    |   |   |
| **Net (Decrease) Increase In Cash and  Cash Equivalents**                             |   | **(214**                                  | **)**   | 286 |   |
|                                                                                  |   |                                      |    |   |   |
| **Cash And Cash Equivalents -  Beginning Of Period**                                  |   | **214**                                   |    | 596 |   |
|                                                                                  |   |                                      |    |   |   |
| **Cash And Cash Equivalents - End Of  Period**                                        |   | **$**                                     | —  |   | $ | 882 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

6

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**DIGITAL ANGEL CORPORATION**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Dollarsin thousands)**

**(Unaudited)**

 

**1.**                                     Basisof Presentation

 

On March 27, 2002,Digital Angel Acquisition Co. (“Acquisition”), then a wholly-owned subsidiaryof Medical Advisory Systems, Inc. (“MAS”), merged with and into Digital AngelCorporation, which was then a 93% owned subsidiary of Applied DigitalSolutions, Inc. (“ADS”). In the merger, the corporate existence of Acquisitionceased, Digital Angel Corporation became a wholly-owned subsidiary of MAS andwas renamed Digital Angel Technology Corporation (“DATC”), and MAS was renamed“Digital Angel Corporation.” In connection with the merger transaction, ADScontributed to MAS all of its stock in Timely Technology Corp., a wholly-ownedsubsidiary, and Signature Industries, Limited, an 85% owned subsidiary. Thesetwo subsidiaries, along with DATC, comprised the Advanced Wireless Group(“AWG”). As a result of this contribution by ADS, Timely Technology Corp.became a wholly-owned subsidiary of the Company and Signature Industries,Limited became an 85% subsidiary. Prior to the merger with DATC, ADS owned850,000 shares of MAS stock, representing approximately 16.3% of theoutstanding stock of MAS. (Unless the context otherwise requires, the term“Company” means Digital Angel Corporation and its subsidiaries). In the merger,the shares of DATC owned by ADS were converted into a total of 18,750,000shares of MAS common stock. As a result of the merger, ADS owned 19,600,000shares or 77.15% of the Company’s common stock. Further, at the time of themerger, ADS transferred to the Digital Angel Share Trust (“Digital Angel ShareTrust” or “Trust”), a newly created Delaware business trust, all shares of theCompany’s common stock beneficially owned by ADS. The Trust is the owner ofand, through its Advisory Board, votes all these 19,600,000 shares of theCompany and has the ability to elect the Board of Directors of the Company. TheTrust arose as a condition of the merger. In the event of a default of certainobligations of ADS under ADS’s credit agreement with IBM Credit LLC (IBMCredit), the shares owned by the Trust may be sold or otherwise disposed of tosatisfy such obligations. Additionally, the Company had certain covenantobligations in connection with the ADS obligations (See Note 12).

 

The merger was treated as a reverse acquisition foraccounting purposes, with AWG treated as the accounting acquirer.

 

On March 27, 2002,ADS amended and restated its credit agreement with IBM Credit which, amongother amendments, provided for a release of AWG from the responsibility torepay an existing obligation. Accordingly, ADS assumed this obligation, whichresulted in an increase to additional paid-in capital of $81.4 million net ofdeferred financing fees of approximately $1.1 million on March 27, 2002 .

 

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

 

The accompanying unaudited condensed consolidatedfinancial statements of Digital Angel Corporation and subsidiaries as of andfor the three month periods ended March 31, 2003 and 2002 have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial information and with the instructions to Form10-Q and Article 10 of Regulation S-X under the Securities Exchange Act of1934.  Accordingly, they do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States of America for complete financialstatements.  In the opinion of theCompany’s management, all adjustments (including normal recurring adjustments)considered necessary to present fairly the financial statements have been made.

 

The consolidated statements of operations for thethree months ended March 31, 2003 and 2002 are not necessarily indicative ofthe results that may be expected for the entire year.  These statements should be read in conjunction with the DigitalAngel Corporation’s audited consolidated financial statements and related notesthereto for the year ended December 31, 2002 which are included in theCompany’s Annual Report on Form 10-K.

 

Certain items in the condensed consolidated financialstatements for the 2002 period have been reclassified for comparative purposes.

 

The financial information in these financialstatements includes an allocation of expenses incurred by ADS on behalf of theCompany as discussed in Note 12. However, these financial statements may not necessarily be indicative ofthe results that may have occurred had AWG been a separate, independent entityduring the periods presented or of future results of the Company.

 

7

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The Company isengaged in the business of developing and bringing to market proprietarytechnology used to identify, locate and monitor people, animals and objects.Prior to March 27, 2002, the Company operated in four segments: Animal Tracking,Digital Angel Technology, Digital Angel Delivery System and RadioCommunications and Other. With the acquisition of MAS in March 2002, theCompany reorganized into four segments: Animal Applications, Wireless andMonitoring, GPS and Radio Communications and Medical Systems. AnimalApplications is the new name of the segment previously identified as AnimalTracking.  The Digital Angel Technologysegment and the Digital Angel Delivery System segment were combined to form thenew Wireless and Monitoring segment, which is now managed as a single businessunit. GPS and Radio Communications is the new name of the segment previouslyidentified as Radio Communications and Other and represents the activity ofSignature Industries, which is located in the United Kingdom. Medical Systemsreflects the MAS business, which was acquired on March 27, 2002.

 

*AnimalApplications*—develops, manufactures, and markets a broad lineof electronic and visual identification devices for the companion animal,livestock, laboratory animal, fish and wildlife markets worldwide. The trackingof cattle and hogs are crucial both for asset management and for diseasecontrol and food safety. The principal technologies employed by AnimalApplications are electronic ear tags and implantable microchips that use radiofrequency transmission.

 

*Wirelessand Monitoring*—develops and markets advanced technology togather location and local sensory data and to communicate that data to anoperations center. This segment is continuously developing its technology,which it refers to as its “Digital AngelTM technology.” The Digital AngelTMtechnology is the integration and miniaturization into marketable products ofthree technologies: wireless communications (such as cellular), sensors(including bio-sensors) and position location technology (including globalpositioning systems (GPS) and other systems).

 

*GPS andRadio Communications*—consists of the design, manufacture andsupport of secure GPS enabled search and rescue equipment and intelligentcommunications products and services for telemetry, mobile data and radiocommunications applications serving commercial and military markets. Inaddition, it designs, manufactures and distributes intrinsically safe sounders(horn alarms) for industrial use and other electronic components.

 

*MedicalSystems*—is the MAS business which was acquired onMarch 27, 2002. A staff of logistics specialists and physicians providemedical assistance services and interactive medical information services topeople traveling anywhere in the world. It also sells a variety of kitscontaining pharmaceutical and medical supplies.

 

**2.****                                     CreditFacility, Debt Covenant Compliance and Liquidity**

 

Effective October 30, 2002, the Company entered into aCredit and Security Agreement with Wells Fargo Business Credit, Inc. (“WellsFargo”). The Company’s credit facility provides for borrowings up to 80% ofeligible receivables, as defined, and up to a maximum of $5,000,000 under theterms of the Credit and Security Agreement. At March 31, 2003, the annual interest rate on the credit facility wasapproximately 10.5%. The credit facility requires that the total amount ofinterest paid per year must be at least $120,000. The credit facility willexpire on October 30, 2005, at which time the entire outstanding balance of thecredit facility will become due and payable. Amounts borrowed under the creditfacility are secured by a first priority lien on substantially all of theCompany’s assets, including accounts receivable, patents and other intellectualproperty relating to the Digital AngelTM product. As of March 31, 2003, theCompany had $926,000 of borrowing availability under its credit facility.

 

The credit facility contains certain financialcovenants, including a monthly minimum book net worth and monthly minimumearnings before taxes, and it limits capital expenditures during 2003. Anybreach of the financial covenants by the Company will constitute an event ofdefault under the Credit and Security Agreement. In addition, any change ofcontrol of the Company will be an event of default under the Credit andSecurity Agreement. As defined in the Credit and Security Agreement, a changeof control includes the future acquisition by any person or group of persons ofmore than 25% of the voting power of all classes of the Company’s common stockor the Company’s current President and Chief Executive Officer ceases toactively manage the Company’s day-to-day business activities. As of March 31,2003, the Company was out of compliance with the minimum book net worth andmonthly minimum earnings before taxes covenants. As a result of the Company'scovenant violations, Wells Fargo is exercising its right to charge interest atthe default rate, which was approximately 10.5% at March 31, 2003, from January1, 2003, until the covenant violation is no longer outstanding. The Company hasobtained a waiver of these covenant violations from Wells Fargo.

 

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

 

ADS was not in compliance with certain financialcovenants of the IBM Credit Agreement as of December 31, 2000. The IBM CreditAgreement was amended and restated on October 17, 2000 and further amended onMarch 30, 2001, July 1, 2001, September 15, 2001, November 15, 2001, December31, 2001, January 31, 2002 and February 27, 2002. In connection with theamendment on March 30, 2001, IBM Credit was granted warrants to acquire sharesof DATC’s common stock, which were converted in the merger into warrants topurchase 1.6 million shares of the Company’s common stock, exercisable at $1.07and expiring on April 10, 2007.

 

8

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ADS continued to generate operating losses in 2001 andwas in default of various financial covenants under the amended IBM CreditAgreement. In the third quarter of fiscal 2001, it was determined that thereexisted substantial doubt about ADS’s ability to continue as a going concernand ADS did not have the funds available to repay the amounts borrowed underthe IBM Credit Agreement. ADS allocated the outstanding borrowings of $82.6million to AWG effective September 30, 2001. Interest associated with theborrowings was allocated to AWG for the period from September 30, 2001 to March27, 2002.

 

Under the terms of the agreement and plan of mergerwith MAS, the common stock and assets of the three AWG subsidiaries werereleased from all liens and security interests under the IBM Credit Agreement,and the shares of the Company’s common stock beneficially owned by ADS uponcompletion of the merger between Digital Angel Corporation and MAS weretransferred on March 27, 2002 to the Digital Angel Share Trust as collateralfor the debt. ADS assumed the debt, which was treated as a capital contributionresulting in an increase in additional paid-in capital of approximately $81.4million, net of deferred financing fees of approximately $1.1 million on March27, 2002.

 

On March 1, 2002, ADS, the Digital Angel Share Trustand IBM Credit entered into a Third Amended and Restated Term Credit Agreement.The new IBM Credit Agreement became effective on March 27, 2002, the effectivedate of the merger. Amounts outstanding under the new IBM Credit Agreement bearinterest at an annual rate of 17% and matured on February 28, 2003. If allamounts were not repaid by February 28, 2003, the unpaid amount accruesinterest at an annual rate of 25%, and if they are not repaid by February 28,2004, the annual interest rate increases to 35%.

 

The Digital Angel Share Trust is controlled by anadvisory board, which is independent of ADS. The Trust has voting rightswith respect to the Company’s common stock until ADS’s obligations to IBMCredit are repaid in full. The Trust may be obligated to liquidate theshares of the Company’s common stock owned by it for the benefit of IBM Creditif ADS fails to make payments, or otherwise defaults, under the IBM CreditAgreement.

 

The IBM Credit Agreement contains debt covenantsrelating to ADS’s financial position and performance, as well as the Company’sfinancial position and performance. In the absence of a waiver oramendment to such financial covenants, noncompliance would constitute an eventof default under the IBM Credit Agreement, and IBM Credit would be entitled toaccelerate the maturity of all amounts ADS owes it. On September 30 andNovember 1, 2002, the IBM Credit Agreement was amended. The amendmentreduced the Company’s current assets to current liabilities ratio and MinimumCumulative Modified EBITDA requirements as defined in the IBM Credit Agreementfor the quarters ended September 30, 2002 and December 31, 2002. As ofDecember 31, 2002 the Company was out of compliance with the amended debtcovenants. IBM did not provide a waiver for the noncompliance.

 

Under the terms of the IBM Credit Agreement, ADS wasrequired to repay $29.8 million of the $77.2 million outstanding principalbalance owed to IBM Credit, plus $16.4 million of accrued interest andexpenses, on or before February 28, 2003. ADS did not make such payment onFebruary 28, 2003. On March 3, 2003, IBM Credit notified ADS that it had untilMarch 6, 2003 to make the payment. ADS did not make the payment on March 6,2003 as required. ADS’s failure to comply with the payment terms imposed by IBMCredit and the Company’s failure to maintain compliance with the financialperformance covenant of the IBM Credit Agreement constitute events of default.On March 7, 2003, IBM Credit notified ADS that an event of default had occurredand IBM Credit would immediately commence exercising any and/or all of itsrights and remedies.

 

IBM Credit, ADS and the Company agreed to the terms ofa Forbearance Agreement dated March 24, 2003. Under the terms of the Forbearance Agreement, ADS has agreed to dismissa lawsuit it had filed against IBM Credit and IBM Corporation in Palm BeachCounty, Florida on March 6, 2003. Under the Forbearance Agreement, ADS mustretain an investment bank to sell the Company’s shares owned by the Trust.  The effective date of the Agreement is nolater than March 31, 2003, and ADS must hire an investment bank within 30 daysafter the effective date of the Agreement. On May 6, 2003 ADS hired an investment bank.  Under the Forbearance Agreement, the Company agreed to cooperatein selling the shares owned by the Trust. If such sales by the Trust result in another person or group of personsowning, in the aggregate, 25% or more of the Company’s common stock, such saleswill be deemed to constitute an event of default under the Company’s Credit andSecurity Agreement with Wells Fargo. The occurrence of an event of default under the Credit and SecurityAgreement would subject the Company to the risk of foreclosure on substantiallyall of its assets to the extent necessary to repay any amounts due under thecredit facility, including, but not limited to, principal, interest, penaltiesor other costs and expenses incurred.

 

*PaymentProvisions of the Forbearance Agreement*

 

The payment provisions of the Forbearance Agreementare as follows: the Tranche A Loan, consisting of $68.0 million plus accruedinterest, must be repaid in full no later than September 30, 2003, providedthat all but $3.0 million of the Tranche A Loan (the “Tranche A DeficiencyAmount”) will be deemed to be paid in full on such date if less than the fullamount of the Tranche A Loan is repaid but all of the cash proceeds of theCompany’s shares held in the Trust are applied to the repayment of the TrancheA Loan. The Tranche A Deficiency Amount (if any) must be repaid no later thanMarch 31, 2004.  The Tranche B Loan,consisting of $9.2 million plus accrued interest, must be repaid in full nolater than March 31, 2004.  EffectiveMarch 24, 2003, the Tranche B Loan will bear 

 

9

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interest at seven percent (7%) per annum.

 

*PurchaseRights of the Forbearance Agreement*

 

The Tranche A and B Loans may be repurchased under theterms of the Forbearance Agreement by or on behalf of ADS as follows: (i) theloans and all other obligations may be purchased on or before June 30, 2003 for$30.0 million in cash; (ii) the loans and all other obligations may bepurchased on or before September 30, 2003 for $50.0 million in cash; and (iii)the Tranche A Loan may be purchased on or before September 30, 2003 for $40.0million in cash with an additional $10.0 million cash payment in respect of theTranche A Deficiency Amount and the Tranche B Loan due before on or beforeDecember 31, 2003.

 

In addition, ADS agreed that the Digital Angel ShareTrust will engage an investment bank within 30 days of the effective date ofthe Forbearance Agreement to pursue the sale of the 19,600,000 shares of theCompany’s common stock that are currently held in the Trust. The ForbearanceAgreement is to become effective no later than March 31, 2003.  On May 6, 2003 ADS hired an investmentbank.  All proceeds from the sale of theCompany’s common stock will be applied to the loans and other obligations tosatisfy the loan payment provisions discussed above if ADS has not satisfiedits purchase rights by September 30, 2003.

 

At the end of the forbearance period, the provisionsof the Forbearance Agreement will become of no force and effect and IBM Creditshall be free to exercise and enforce, or to take steps to exercise andenforce, all rights, powers, privileges and remedies available to it under theIBM Credit Agreement, as a result of the payment and covenant defaults existingon March 24, 2003, or if ADS defaults on any of the provisions of theForbearance Agreement or the IBM Credit Agreement during the forbearanceperiod.

 

*Possible Consequences of Sales ofthe Company’s Shares*

 

Employment Agreement withRandolph K. Geissler.  Under the terms of the employmentagreement dated March 8, 2002, as amended, by and between the Company andRandolph K. Geissler (the President and Chief Executive Officer of theCompany), a “change in control” occurs under that employment agreement if anyperson becomes the “beneficial owner” (as defined in Rule 13d-3 under theSecurities Exchange Act of 1934), directly or indirectly, of securities of theCompany representing 20% or more of the combined voting power of the Company’sthen outstanding shares of common stock. Therefore, if the Trust were tosell more than approximately 5.3 million shares of the Company’s common stock,such sale could constitute a change in control under the employment agreementwith Mr. Geissler. Upon the occurrence of a change in control, Mr.Geissler, at his sole option and discretion, may terminate his employment withthe Company at any time within one year after such change in control upon 15days’ notice. In the event of such termination, the employment agreementprovides that the Company must pay to Mr. Geissler a severance payment equal tothree times the base amount as defined in Section 280G(b)(3) of the InternalRevenue Code of 1986, as amended (“Code”), minus $1.00 (currently a total ofapproximately $750,000), which would be payable no later than one month afterthe effective date of Mr. Geissler’s termination of employment. In addition,upon the occurrence of a change of control under the employment agreement, alloutstanding stock options held by Mr. Geissler would become fullyexercisable. As of March 31, 2003, Mr. Geissler owned options to purchase1,000,000 shares for $3.39 per share, none of which had vested, which wouldbecome exercisable upon the occurrence of such a change in control.

 

The employment agreement also provides that (i) upon achange of control, (ii) upon the termination of Mr. Geissler’s employment forany reason other than due to his material default under the employmentagreement, or (iii) if he ceases to be the Company’s President and ChiefExecutive Officer for any reason other than termination due to his materialdefault under the employment agreement, within 10 days of the occurrence of anysuch events, the Company is to pay to Mr. Geissler $4,000,000. The Companymay pay such amount in cash or in the Company’s common stock or with acombination of cash and common stock. The employment agreement alsoprovides that if the $4,000,000 is paid in cash and stock, the amount of cashpaid must be sufficient to cover the tax liability associated with suchpayment, and such payment shall otherwise be structured to maximize taxefficiencies to both the Company and Mr. Geissler.

 

Credit and SecurityAgreement with Wells Fargo Business Credit, Inc.  TheCredit and Security Agreement provides that a “change in control” under thatagreement results in a default. A change in control is defined as eitherMr. Geissler ceasing to actively manage the Company’s day-to-day businessactivities or the transfer of at least 25% of the outstanding shares of commonstock of the Company. Also, if the Company owes to Mr. Geissler $4,000,000under his employment agreement as described above, the obligation would mostlikely result in a breach of the Company’s financial covenants under the Creditand Security Agreement. If these defaults occurred and were not waived byWells Fargo, and if Wells Fargo were to enforce their rights under the terms ofthe Credit and Security Agreement and related agreements, the Company’sbusiness and financial condition would be materially and adversely affected,and it may force the Company to cease operations.

 

10

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**3.**                                     Principlesof Consolidation and Combination

 

The March 31, 2003 and 2002 condensed consolidatedfinancial statements include the accounts of the Company and its wholly-ownedand majority-owned subsidiaries from the date of acquisition.  All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

**4.**                                     RevenueRecognition

** **

For product sales, the Company recognizes revenue at the time productsare shipped and title has transferred, provided that a purchase order has beenreceived or a contract has been executed, there are no uncertainties regardingcustomer acceptance, the sales price is fixed and determinable andcollectability is deemed probable. If uncertainties regarding customeracceptance exists, revenue is recognized when such uncertainties are resolved.There are no significant post-contract support obligations at the time ofrevenue recognition. The Company’s accounting policy regarding vendor andpost-contract support obligations is based on the terms of the customers’contracts, billable upon the occurrence of the post-sale support. Costs ofgoods sold are recorded as the related revenue is recognized. The Company doesnot offer a warranty policy for services to customers. For software consultingand development services, the Company recognizes revenue based on the percentcomplete for fixed fee contracts, with the percent complete being calculated aseither the number of direct labor hours in the project to date divided by theestimated total direct labor hours or based upon the completion of specifictask orders. It is the Company’s policy to record contract losses in theirentirety in the period in which such losses are foreseeable. For non-fixed feejobs, revenue is recognized based on the actual direct labor hours in the jobmultiplied by the standard billing rate and adjusted to realizable value, ifnecessary. Revenues from contracts that provide services are recognized ratablyover the term of the contract. Fixed fee revenues from contracts for servicesare recorded when earned and exclude reimbursable costs. Reimbursable costsincurred in performing such services are presented on a net basis and includetransportation, medical and communication costs. Other revenues are recognizedat the time services or goods are provided.

 

**5.****                                    ****Stock-Based Compensation**

 

The Company applies APB Opinion No. 25 and related Interpretations inaccounting for all the plans. Accordingly, no compensation cost has been recognized under theseplans.  The Company has adopted thedisclosure-only provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation” and SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure,” which was released in December 2002 asan amendment to SFAS No. 123.  Thefollowing table illustrates the effect on net income (loss) and earnings pershare if the fair value based method had been applied to all awards (inthousands, except per share data):

 
|                                                                                                                    |   | **Three Months   Ended March 31,** |      |
|-------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------|-----------|
|                                                                                                                    |   | **2003**                           |      | **2002** |   |
| Reported net income (loss)                                                                                              |   | **$**                              | **110**   |   | $ | (22,511 | ) |
| Stock-based employee compensation expense in reported net income  (loss), net of related tax effects                    |   | **86**                             |      | 13,214 |   |
| **Stock-based  employee compensation expense determined under the fair value based  method,net of related tax effects** |   | **(702**                           | **)**     | **(13,566** | **)** |
| Pro forma net loss                                                                                                      |   | **$**                              | **(506**  | **)** | (22,863 | )  |
|                                                                                                                    |   |                               |      |   |   |
| Income (loss) per share (basic and diluted)                                                                             |   |                               |      |   |   |
| As reported                                                                                                             |   | **$**                              | —    |   | $ | (1.18 | ) |
| Pro forma                                                                                                               |   | **$**                              | **(0.02** | **)** | $ | (1.20 | ) |

** **

**6.**                                     Inventory(in thousands)

 
|                                   |   | **March 31,  2003** |   | **December 31,  2002** |   |
|----------------------------------------|--------|---------------------|--------|------------------------|--------|
| Raw materials                          |   | $                   | 1,821  |                   | $      | 1,725 |   |
| Work in process                        |   | 155                 |   | 128                    |   |
| Finished goods                         |   | 5,253               |   | 4,474                  |   |
|                                   |   | 7,229               |   | 6,327                  |   |
| Allowance for excess  and obsolescence |   | (1,310              | )      | (1,382                 | )      |
| Net inventory                          |   | $                   | 5,919  |                   | $      | 4,945 |   |

 

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**7.**                                     **Income(Loss) Per Share**

 

The following is a reconciliation of the numerator anddenominator of basic and diluted income (loss) per share (in thousands, exceptper share data):

 
|                                                                    |   | **Three Months  Ended March 31,** |       |
|-------------------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                                    |   | **2003**                          |       | **2002** |   |
| **Numerator:**                                                          |   |                              |       |   |   |
| Net income (loss)                                                       |   | **$**                             | **110**    |   | $ | (22,511 | ) |
| **Denominator:**                                                        |   |                              | ** ** |   | ** ** |
| Denominator for basic income (loss) per  share-                         |   |                              |       |   |   |
| Weighted-average shares                                                 |   | **26,663**                        |       | 19,063 |   |
| **Basic  income (loss) per share**                                      |   | **$**                             | —     | ** ** | **$** | (1.18 | ) |
| Denominator for diluted income (loss) per share-                        |   |                              |       |   |   |
| Weighted-average shares                                                 |   | **26,663**                        |       | 19,063 |   |
| Potentially dilutive securities, calculated on the treasury method  (1) |   | **3,975**                         |       | — |   |
| Denominator for diluted income (loss) per share                         |   | **30,638**                        |       | 19,063 |   |
| **Diluted income (loss) per share**                                     |   | **$**                             | **—** | ** ** | **$** | **(1.18** | **)** |

 

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(1)     Potentially dilutivesecurities are excluded from the computation of diluted loss per share for thethree months ended March 31, 2002 because to do so would have beenanti-dilutive.

 

**8.****                                     SegmentInformation**

 

The Company isengaged in the business of developing and bringing to market proprietarytechnologies used to identify, locate and monitor people, animals and objects.With the acquisition of MAS in March 2002, the Company re-organized into foursegments:  Animal Applications, Wirelessand Monitoring, GPS and Radio Communications, and Medical Systems. Prior periodsegment information has been restated to reflect the Company’s current segmentstructure.

 

It is on thisbasis that management utilizes the financial information to assist in makinginternal operating decisions.  TheCompany evaluates performance based on stand-alone segment operating income.

 

Following is the selected segment data as of and for the three monthsended March 31, 2003 (in thousands):

 
|                                                                     |   | **Animal  Applications** |       | **Wireless and Monitoring** |       | **GPS and Radio  Communications** |       | **Medical Systems** |       | **Corporate /  Unallocated** |       | **Consolidated** |       |
|--------------------------------------------------------------------------|--------|--------------------------|------------|-----------------------------|------------|-----------------------------------|------------|---------------------|------------|------------------------------|------------|------------------|------------|
|                                                                     |   |                     | ** ** |                        | ** ** |                              | ** ** |                | ** ** |                         | ** ** |             | ** ** |
| Net revenue from  external customers:                                    |   |                     |       |                        |       |                              |       |                |       |                         |       |             |       |
|                                                                     |   |                     |       |                        |       |                              |       |                |       |                         |       |             |       |
| Product                                                                  |   | $                        | 7,801      |                        | $          | —                            |       | $                   | 2,699      |                         | $          | 365              |       | $ | — |   | $ | 10,865 |   |
| Service                                                                  |   | —                   |       | 154                         |       | —                            |       | 379                 |       | —                       |       | 533              |       |
| Total revenue                                                            |   | $                        | 7,801      |                        | $          | 154                               |       | $                   | 2,699      |                         | $          | 744              |       | $ | — |   | $ | 11,398 |   |
|                                                                     |   |                     |       |                        |       |                              |       |                |       |                         |       |             |       |
| Income (loss) before  income taxes and minority interest share of losses |   | $                        | 1,459      |                        | $          | (1,035                            | )          | $                   | (222       | )                            | $          | (125             | )          | $ | — |   | $ | 77 |   |
|                                                                     |   |                     |       |                        |       |                              |       |                |       |                         |       |             |       |
| Total assets                                                             |   | $                        | 60,178     |                        | $          | 741                               |       | $                   | 5,721      |                         | $          | 4,885            |       | $ | — |   | $ | 71,525 |   |

 

Three customers accounted for approximately 14.2%, 13.5% and 11.3% ofour Animal Applications revenue.

 

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Following is the selected segment data as of and for the three monthsended March 31, 2002 (in thousands):

 
|                                                                                                                 |   | **Animal  Applications** |   | **Wireless  and  Monitoring** |   | **GPS and  Radio  Communications** |   | **Medical   Systems** |   | **Corporate  /   Unallocated** |   | **Consolidated** |   |
|----------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-------------------------------|--------|------------------------------------|--------|-----------------------|--------|--------------------------------|--------|------------------|--------|
|                                                                                                                 |   |                     |   |                          |   |                               |   |                  |   |                           |   |             |   |
| Net revenue from  external customers:                                                                                |   |                     |   |                          |   |                               |   |                  |   |                           |   |             |   |
|                                                                                                                 |   |                     |   |                          |   |                               |   |                  |   |                           |   |             |   |
| Product                                                                                                              |   | $                        | 4,815  |                          | $      | —                             |   | $                     | 2,636  |                           | $      | —           |   | $ | — |   | $ | 7,451 |   |
| Service                                                                                                              |   | —                   |   | 303                           |   | —                             |   | —                |   | —                         |   | 303              |   |
| Total revenue                                                                                                        |   | $                        | 4,815  |                          | $      | 303                                |   | $                     | 2,636  |                           | $      | —           |   | $ | — |   | $ | 7,754 |   |
|                                                                                                                 |   |                     |   |                          |   |                               |   |                  |   |                           |   |             |   |
| Income (loss)  before income taxes, minority interest share of losses and equity in net loss  of MAS prior to merger |   | $                        | 288    |                          | $      | (1,791                             | )      | $                     | (271   | )                              | $      | —           |   | $ | (20,487 | ) (1) | $ | (22,261 | ) |
|                                                                                                                 |   |                     |   |                          |   |                               |   |                  |   |                           |   |             |   |
| Total assets                                                                                                         |   | $                        | 79,559 |                          | $      | 14,448                             |   | $                     | 5,587  |                           | $      | 31,700           |   | $ | — |   | $ | 131,294 |   |

 

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

 

Two customers accounted for approximately 13.4% and12.5% of our Animal Applications revenue.  We buy most of our syringe injectible microchips that are used in ourelectronic identification products from one supplier.

 

** **

**9.**                                     Acquisitions

 

The following describes the acquisitions by the Company (in thousands):

 
| **Company  Acquired**          |   | **Date  Acquired** |   | **Acquisition  Price** |   | **Value of  Shares,  Warrants &  Options  Issued or  Issuable** |   | **Common  Shares  Issued (Net)** |   | **Goodwill  and  Other  Intangibles  Acquired** |   | **Other Net  Assets and Liabilities** |   | **Business  Description** |   |
|--------------------------------|--------|--------------------|--------|------------------------|--------|---------------------------------------------------------------------|--------|----------------------------------|--------|-------------------------------------------------|--------|---------------------------------------|--------|---------------------------|--------|
| Medical Advisory Systems, Inc. |   | 03/27/02           |   | $                      | 31,956 |                                                                | $      | 28,418                           |   |                                            | 5,218  |                                  | $      | 30,005                    |   | $ | 1,951 |   | Provider of medical  assistance and technical products and services |   |
|                                |        |                    |        |                        |        |                                                                     |        |                                  |        |                                                 |        |                                       |        |                           |        |  |  |  |  |  |

 

On March 27, 2002, DATC (formerly a part of ADS’s AWG) merged with awholly-owned subsidiary of MAS.  Foraccounting purposes, AWG is treated as the acquirer, and the acquisition of MASwas recorded at fair value under the purchase method of accounting.   The excess of purchase price over the fairvalue of the assets and liabilities of MAS have been recorded as goodwill.  Identifiable intangible assets have beenrecorded based upon preliminary estimates as of the date of theacquisition.  Any changes to thepreliminary estimates during the allocation period will be reflected as anadjustment to goodwill.

 

The cost of the March 27, 2002 acquisition consisted of 5.268 millionshares of common stock valued at $25.0 million, including 50,000 shares oftreasury stock, options to purchase 1.2 million shares and warrants to purchase75,000 shares together valued at $3.4 million, and acquisition costs of $3.6million.  The valuation of the stock isbased on the value of the shares of MAS held by stockholders other than ADSprior to the acquisition.  The cost ofthe acquisition includes all payments according to the acquisition agreementplus costs for investment banking services and legal and accounting servicesthat were direct costs of acquiring these assets.  Included in the acquisition costs are certain severance liabilitiesof $2.5 million related to employment agreements of two officers of MAS.  The value of the options and warrants isbased on the fair value of the options and warrants of MAS at the date ofacquisition.  The fair value wasdetermined using the Black-Scholes option pricing model.

 

In considering the benefits of a merger of AWG and MAS, the managementof AWG recognized the strategic advantage of 

 

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combining the advanced wireless technologies being developed by AWGwith the physician-staffed call center infrastructure of MAS.  One of the principal benefits of such acombination is the ability of the Company to offer a complete “end-to-endsolution” to the various vertical markets for Digital AngelTM products.

 

The results of MAS have been included in theconsolidated financial statements since the date of acquisition.  Unaudited pro forma results of operationsfor the three months ended March 31, 2002 are included below.  Such pro forma information assumes that theabove acquisition had occurred as of January 1, 2002, and revenue is presentedin accordance with the Company’s accounting policies.  This summary is not necessarily indicative of what the result ofoperations of the Company would have been had it been a combined entity duringsuch periods, nor does it purport to represent results of operations for anyfuture periods.

 
| **(In thousands)**                             |   | **2002** | ** ** |
|------------------------------------------------|--------|----------|------------|
| Net operating revenue                          |   | $        | 8,304      |   |
| Net loss                                       |   | $        | (23,965    | ) |
| Net loss per common  share - basic and diluted |   | $        | (1.00      | ) |

 

**10.**                               Contingencies

 

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

 

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

 

CSA outsourced its travel assistance services toMAS.  CSA has filed a cross-claimagainst the Company alleging that the Company should be held liable for anyliability that CSA may have to Plaintiffs. The Company has denied the allegations of the complaint and the CSAcross-claim and is vigorously contesting all aspects of this action.

 

The Company is party to various other legal proceedings.  In the opinion of management, theseproceedings, either alone or in the aggregate, are not likely to have amaterial adverse effect on the financial position, cash flows or overall trendsin results of the Company.  The estimateof potential impact on the Company’s financial position, overall results ofoperations or cash flows for the above legal proceedings could change in thefuture.

 

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

 
|                                                                         |   | **Three Months  Ended March 31,** |    |
|------------------------------------------------------------------------------|--------|-----------------------------------|---------|
|                                                                         |   | **2003**                          |    | **2002** |   |
| Interest paid                                                                |   | **$**                             | **128** |   | $ | 92 |   |
| Non-cash financing activities:Shares to be issued in settlement of liability |   | —                            |    | **225** |   |
|                                                                              |        |                                   |         |  |  |  |  |

 

**12.**                              RelatedParty Activity

 

Prior to the merger, ADS provided certain general and administrativeservices to the Company, including finance, legal, benefits and otherservices.  The costs of these servicesare included in the Company’s Statements of Operations as management fees andare based on utilization, which management believes to be reasonable.  Costs of these services were $0.2 millionfor the three months ended March 31, 2002. ADS also charged the Company $1.8 million of interest expense in 2002,for which the liability was converted to a capital contribution.  In addition, accrued expenses of $0.3million were relieved and contributed to capital by ADS.  We continue to be charged by ADSapproximately $42,000 a month to support ADS’ s research group.  Additionally, we were charged by ADS forproduct liability insurance through September 2002 and continue to be chargedfor directors and officers insurance through June 2003.  These transactions resulted in a due to ADSof $0.3 million at March 31, 2003.

 

14

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ADS acquired Timely Technology Corp., a part of AWG, in 2000, and themerger agreement included an earnout provision based on performance throughJune 30, 2002.  During the quarter endedJune 30, 2002, ADS paid the selling shareholder of Timely Technology Corp. $3.6million, payable in shares of ADS stock, as the final payment under the earnoutprovision.  This payout has beenreflected in the accompanying financial statements as a capital contribution byADS and an increase to goodwill and other intangibles.

 

The Company hasexecuted an exclusive eleven year Distribution and Licensing Agreement datedMarch 4, 2002 with Verichip Corporation (Verichip), a wholly-owned subsidiaryof ADS, covering the manufacturing, purchasing and distribution of Verichip’simplantable microchip and the maintenance of the Verichip Registry by the Company.  The agreement includes a license for the useof the Company’s technology in Verichip’s identified markets.  The Company will be the sole manufacturerand supplier to Verichip.  Revenuerecognized under the Distribution and Licensing Agreement was $108,000 and$6,000 for the three months ended March 31, 2003 and 2002, respectively.

 

15

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

 

The following discussion and analysis of our financialcondition and results of operations should be read in conjunction with theaccompanying financial statements and related notes thereto.

 

Weconsist of Digital Angel Corporation and its three subsidiaries — Digital AngelTechnology Corporation (“DATC”), Timely Technology Corp. and SignatureIndustries, Limited.  These three subsidiaries were previously known asthe Advanced Wireless Group (“AWG”) of Applied Digital Solutions, Inc.(“ADS”).  DATC is engaged in the business of developing and bringing tomarket proprietary technologies used to identify, locate and monitor people,animals and objects.  DATC is the result of the merger in September 2000of Destron Fearing Corporation and Digital Angel.net Inc., which was then awholly-owned subsidiary of ADS. Before March 27, 2002, the business of DATC wasoperated in four segments:  Animal Tracking, Digital Angel Technology,Digital Angel Delivery System, and Radio Communications and Other.  Withthe acquisition of Medical Advisory Systems, Inc. (“MAS”) in March 2002, theCompany re-organized into four segments:  Animal Applications, Wirelessand Monitoring, GPS and Radio Communications, and Medical Systems.  AnimalApplications is the new name of our segment previously identified as AnimalTracking.  We combined our Digital Angel Technology segment with ourDigital Angel Delivery System segment to form the new Wireless and Monitoringsegment, which is now managed as a single business unit.  GPS and RadioCommunications is the new name of our segment previously identified as RadioCommunications and Other.  Medical Systems reflects the newly acquired MASbusiness.  Prior period segment information has been restated to reflectour current segment structure.

 

**RESULTSOF OPERATIONS**

 

The following table summarizes our results ofoperations as a percentage of net operating revenue for the three months endedMarch 31, 2003 and 2002 and is derived from the accompanying consolidatedstatements of operations included in this report.

 
|                                                                                                                                         |   | **Three Months Ended  March 31,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                                                                                         |   | **2003  %**                       |   | **2002  %** |   |
| Product revenue                                                                                                                              |   | 95.3                              |   | 96.1 |   |
| Service revenue                                                                                                                              |   | 4.7                               |   | 3.9 |   |
| Total net  revenue                                                                                                                           |   | 100.0                             |   | 100.0 |   |
| Cost of products  sold                                                                                                                       |   | 49.5                              |   | 55.5 |   |
| Cost of services  sold                                                                                                                       |   | 3.5                               |   | 3.2 |   |
| Total cost of  products and services sold                                                                                                    |   | 53.0                              |   | 58.7 |   |
| Gross profit                                                                                                                                 |   | 47.0                              |   | 41.3 |   |
| Selling, general  and administrative expenses                                                                                                |   | 37.5                              |   | 293.5 |   |
| Management fees  - Applied Digital Solutions, Inc.                                                                                           |   | 0.0                               |   | 2.5 |   |
| Research and  development expenses                                                                                                           |   | 8.0                               |   | 8.4 |   |
| Interest expense                                                                                                                             |   | 1.2                               |   | 24.0 |   |
| Other income                                                                                                                                 |   | (0.4                              | )      | 0.0 |   |
| Income (loss) before  provision (benefit) for income taxes, minority interest share of losses and  equity in net loss of MAS prior to merger |   | 0.7                               |   | (287.1 | ) |
| Provision for  income taxes                                                                                                                  |   | 0.0                               |   | 0.0 |   |
| Income (loss) before  minority interest share of losses and equity in net loss of MAS prior to  merger                                       |   | 0.7                               |   | (287.1 | ) |
| Minority  interest share of losses                                                                                                           |   | 0.3                               |   | 0.6 |   |
| Equity in net  loss of MAS prior to merger                                                                                                   |   | 0.0                               |   | (3.8 | ) |
| Net income  (loss)                                                                                                                           |   | 1.0                               |   | (290.3 | ) |

 

16

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**ThreeMonths Ended March 31, 2003 Compared to the Three Months Ended March 31, 2002**

 

**Revenue**

 

Revenue from operations for the three months ended March 31, 2003increased $3.6 million, or 47.0%, to $11.4 million when compared to $7.8million in revenue for the three months ended March 31, 2002.

 

Revenue for each of the operating segments was as follows (inthousands):

 
|                          |   | **Three  Months  Ended March 31,  2003** |   | **Three  Months  Ended March 31,  2002** |   |
|-------------------------------|--------|------------------------------------------|--------|------------------------------------------|--------|
| Animal Applications           |   | $                                        | 7,801  |                                     | $      | 4,815 |   |
| Wireless and Monitoring       |   | 154                                      |   | 303                                      |   |
| GPS and Radio  Communications |   | 2,699                                    |   | 2,636                                    |   |
| Medical Services              |   | 744                                      |   | —                                   |   |
| Total                         |   | $                                        | 11,398 |                                     | $      | 7,754 |   |

 

The Animal Applications segment’s revenue increased**$3.0 million, or 62.0%, in the threemonths ended March 31, 2003 compared to the three month period ended March 31,2002. The majority of the increase was due to sales to fishery industrycustomers.  Sales to fishery industry customers were lower in the firstquarter of 2002 when compared to sales in the first quarter of 2003. Additionally, companion animal microchip sales increased in North America andEurope.

 

MedicalServices segment’s revenue was $0.7 million in the three month period endedMarch 31, 2003.  The segment became partof the Company on March 27, 2002.

 

**GrossProfit and Gross Profit Margin**

 

Gross profit for the three month period ended March31, 2003 was $5.4 million, an increase**of$2.2 million, or 67.5%, compared to $3.2 million in the three month periodended March 31, 2002. As a percentage of revenue, the gross profit margin was47.0% and 41.3% for the three months ended March 31, 2003 and 2002,respectively.

 

Gross profit from operations for each operatingsegment was as follows (in thousands):

 
|                          |   | **Three  Months  Ended March 31,  2003** |   | **Three  Months  Ended March 31,  2002** |   |
|-------------------------------|--------|------------------------------------------|--------|------------------------------------------|--------|
| Animal Applications           |   | $                                        | 3,660  |                                     | $      | 1,879 |   |
| Wireless and Monitoring       |   | 99                                       |   | 52                                       |   |
| GPS and Radio  Communications |   | 1,365                                    |   | 1,272                                    |   |
| Medical Services              |   | 240                                      |   | —                                   |   |
| Total                         |   | $                                        | 5,364  |                                     | $      | 3,203 |   |

 

Gross profit margin from operations for each operatingsegment was:

 
|                          |   | **Three  Months  Ended March 31,  2003  %** |   | **Three  Months  Ended March 31,  2002  %** |   |
|-------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|--------|
| Animal Applications           |   | 46.9                                        |   | 39.0                                        |   |
| Wireless and Monitoring       |   | 64.3                                        |   | 17.2                                        |   |
| GPS and Radio  Communications |   | 50.6                                        |   | 48.3                                        |   |
| Medical Services              |   | 32.3                                        |   | —                                      |   |
| Total                         |   | 47.0                                        |   | 41.3                                        |   |

 

The Animal Applicationssegment’s gross profit increased $1.8 million, or 94.8%, in the three monthperiod ended March 31, 2003 compared to the three months ended March 31, 2002**dueto the previously mentioned sales increase. The gross margin percentage increased to 46.9% in the three monthperiod ended March 31, 2003 as compared to 39.0% in the three month periodended March 31, 2002 due to lowerlabor costs in 2003.

 

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The Wireless and Monitoring segment’s gross profitincreased $0.05 million, or 90.4%, in the three month period ended March 31,2003 as compared to the three month period ended March 31, 2002.  Margins increased to 64.3% in the threemonth period ended March 31, 2003 from 17.2% in the three month period endedMarch 31, 2002.  The gross marginpercentage increase was primarily due to the termination of employees thatworked exclusively on a software contract that was cancelled in February 2003.

 

The GPS and RadioCommunications segment’s gross profit increased $0.09 million, or 7.3%, in thethree month period ended March 31, 2003 as compared to the three month periodended March 31, 2002.  The gross marginpercentage increased to 50.6% in the three month period ended March 31, 2003 ascompared to 48.3% in the three month period ended March 31, 2002 due to afavorable shift in the product mix.

 

The Medical Servicessegment’s gross profit was $0.2 million for the three month period ended March31, 2003.  The gross margin was 32.3% inthe three month period ended March 31, 2003. This segment became part of the Company on March 27, 2002.

 

**Selling, General and AdministrativeExpenses**

 

Selling, general andadministrative expenses decreased $18.5 million, or 81.2%, in the three monthperiod ended March 31, 2003 as compared to the three month period ended March31, 2002. The decrease was caused primarily by an $18.7 million charge includedin selling, general and administrative expenses in the three month period endedMarch 31, 2002 arising from the remeasurement of options in connection with themerger.  Pursuant to the terms of themerger agreement, options to acquire shares of DATC common stock were convertedinto options to acquire shares of MAS common stock effective March 27, 2002.  The conversion resulted in a new measurementdate for the options and, as a result, the Company recorded a charge ofapproximately $18.7 million in non-cash compensation expense during the threemonth period ended March 31, 2002.  Forcurrent employees of the Company, these options are considered fixed awards underAPB Opinion No. 25, and expense was recorded for the fair value of the optionsconverted using the Black-Scholes option-pricing model.  As a percentage of revenue, selling, generaland administrative expenses were 37.5% and 293.5% for the three months endedMarch 31, 2003 and 2002, respectively.

 

Selling, general andadministrative expenses, excluding the $18.7 million charge, for each of theoperating segments were as follows (dollars in thousands):

 
|                          |   | **Three  Months  Ended March 31,  2003** |   | **Three  Months  Ended March 31,  2002** |   |
|-------------------------------|--------|------------------------------------------|--------|------------------------------------------|--------|
| Animal Applications           |   | $                                        | 1,590  |                                     | $      | 1,110 |   |
| Wireless and Monitoring       |   | 918                                      |   | 1,437                                    |   |
| GPS and Radio  Communications |   | 1,441                                    |   | 1,530                                    |   |
| Medical Services              |   | 331                                      |   | —                                   |   |
| Total                         |   | $                                        | 4,280  |                                     | $      | 4,077 |   |

 

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

 
|                          |   | **Three  Months  Ended March 31,  2003  %** |   | **Three  Months  Ended March 31,  2002  %** |   |
|-------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|--------|
| Animal Applications           |   | 20.4                                        |   | 23.1                                        |   |
| Wireless and Monitoring       |   | 596.1                                       |   | 474.3                                       |   |
| GPS and Radio  Communications |   | 53.4                                        |   | 58.0                                        |   |
| Medical Services              |   | 44.5                                        |   | —                                      |   |
| Total                         |   | 37.5                                        |   | 52.6                                        |   |

 

The Animal Applicationssegment’s selling, general and administrative expenses increased $0.5million in the three month period ended March 31, 2003 as compared to the threemonth period ended March 31, 2002 and as a percentage of revenue decreased to20.4% from 23.1% in the same respective period.  The decrease as a percentage of revenue is primarily due tocertain fixed costs remained constant while sales increased in 2003 whencompared to 2002.

 

The Wireless andMonitoring segment’s selling, general and administrative expenses of $0.9million decreased**$0.5million in the three month period ended March 31, 2003 as compared $1.4 millionin the three month period ended March 31, 2002. The decrease is primarily dueto the exclusion of amortization expense for a license to a digital encryptionand distribution software system that the Company wrote off in the fourthquarter of 2002.  Included in theWireless and Monitoring segment’s selling, general and administrative expensefor the three months ended March 31, 2002 is $0.5 million of amortizationexpense for this asset.   Selling,

 

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general and administrative expenses increased as a percentage ofrevenue to 596.1% in the three month period ended March 31, 2003 compared to474.3% in the three month period ended March 31, 2002.

 

The GPS and RadioCommunications segment’s selling, general and administrative expenses decreased $0.09 million in the threemonth period ended March 31, 2003 as compared to the three month period endedMarch 31, 2002 primarily due to a reduction in personnel costs. As a percentageof revenue, selling, general and administrative expenses decreased to 53.4% inthe three month period ended March 31, 2003 from 58.0% in the three monthperiod ended March 31, 2002.

 

The Medical Servicessegment’s selling, general and administrative expenses were $0.3 million in thethree month period ended March 31, 2003. As a percentage of revenue, selling, general and administrative expenseswere 44.5% in the three month period ended March 31, 2003.  This segment became part of the Company onMarch 27, 2002.

 

**ManagementFees – Applied Digital Solutions, Inc.**

 

Management fees chargedby ADS amounted to $0.2 million for the three months ended March 31, 2002.  These fees were for general andadministrative services performed for us. After March 27, 2002, we no longer pay a management fee to ADS.

 

**Research and Development Expense**

 

Research and developmentexpense was $0.9 million in the three month period ended March 31, 2003, anincrease of $0.3 million, or 40.4%, from $0.6 million for the three monthperiod ended March 31, 2002.  As a percentageof revenue, research and development expense was 8.0% and 8.4% for the threemonths ended March 31, 2003 and 2002, respectively.  Included in research and development expense for the three monthsended March 31, 2003 are charges by ADS of approximately $42,000 a month tosupport ADS’s research group.

 

Research and developmentexpense for each of the operating segments was as follows (in thousands):

 
|                          |   | **Three  Months  Ended March 31,  2003** |   | **Three  Months  Ended March 31,  2002** |   |
|-------------------------------|--------|------------------------------------------|--------|------------------------------------------|--------|
| Animal Applications           |   | $                                        | 550    |                                     | $      | 244 |   |
| Wireless and Monitoring       |   | 217                                      |   | 405                                      |   |
| GPS and Radio  Communications |   | 144                                      |   | —                                   |   |
| Medical Services              |   | —                                   |   | —                                   |   |
| Total                         |   | $                                        | 911    |                                     | $      | 649 |   |

 

The increase is dueprimarily to additional development expenses incurred for the AnimalApplication segment’s temperature-sensing implantable microchip and the GPS andRadio Communications segment’s Sarbe project.

 

**Interest Expense**

 

Interest expense was $0.1 million and $1.9 million for the three monthsperiod ended March 31, 2003 and 2002, respectively.   Interest expense in the first three months of 2002 includesinterest expense of $1.8 million on the debt owed to IBM Credit Corporation byADS.  As discussed in Note 1 to thefinancial statements, on March 27, 2002, ADS restructured its loan agreementwith IBM Credit Corporation.  Theprovisions of this restructuring included AWG being released fromresponsibility to repay this debt.

 

**Income Taxes**

 

The Company had an effective income tax rate of 0.0% for the threemonth periods ended March 31, 2003 and 2002.  TheCompany accounts for income taxes under 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 liabilities are measured using the enacted taxrates expected to apply to taxable income in the years in which those temporarydifferences 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.  Income taxes included U.S. and foreigntaxes.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

As of March 31, 2003, theCompany had cash and cash equivalents of $0.0 million compared to $0.2 millionat December 31, 2002.  Cash used inoperating activities totaled $3.1 million and $0.6 million in the first threemonths of 2003 and 2002, respectively. 

 

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In the first three months of 2003, the use of cash was due primarily toa significant increase in accounts receivable. Accounts receivable, net of allowance for doubtful accounts, increasedby $3.6 million, or 86.0%, to $7.7 million at March 31, 2003 from $4.1 millionat December 31, 2002.  This increase isdue to a significant number of shipments in March 2003.   Offsetting these uses of cash wereincreases in accounts payable, accrued expenses and deferred revenue anddecreases in other current assets.

 

Inventory levelsincreased by $1.0 million to $5.9 million at March 31, 2003 from $4.9 millionat December 31, 2002 due to a significant number of shipments in December 2002,resulting in a reduction of inventory and the accumulation of inventory foranticipated sales in 2003.  Inventoryacquired from our acquisition of MAS amounted to $0.1 million.

 

Accounts payableincreased by $0.8 million to $4.9 million at March 31, 2003 from $4.1 millionat December 31, 2002.

 

Accrued expenses and other current liabilities decreased by $0.2 million,or 5.6%, to $3.5 million at March 31, 2003 from $3.7 million at December 31,2002.  The decrease was due primarily topayment of accrued acquisition costs.

 

Investing activities usedcash of $0.2 million in the first three months of 2003 and provided cash of$0.07 million in the first three months of 2002.  During each of the first three months of 2003 and 2002, $0.2million was spent to acquire property and equipment.

 

Financing activitiesprovided cash of $3.2 million and $0.8 million in the first three months of2003 and 2002, respectively.  Cash wasprovided primarily by borrowing on our line of credit.

 

*Debt,Covenant Compliance and Liquidity*

 

The following table summarizes the Company’s fixedcash obligations as of March 31, 2003 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 |   | $         | 3,401                       |                  | 98 |   | 1,035 |   | 115 |   | 2,153 |   |
| Operating Leases                  |   | 13,482    |                        | 612                   |   | 587 |   | 720 |   | 11,563 |   |
| Employment  Contracts             |   | 3,504     |                        | 1,277                 |   | 1,665 |   | 562 |   | — |   |
|                              |   | $         | 20,387                      |                  | $ | 1,987 |   | $ | 3,287 |   | $ | 1,397 |   | $ | 13,716 |   |
|                                   |        |           |                             |                       |  |  |  |  |  |  |  |  |  |  |  |  |

 

Effective October 30, 2002, we entered into a Creditand Security Agreement with Wells Fargo Business Credit, Inc. (“Wells Fargo”).Our credit facility provides for borrowings up to 80% of eligible receivables,as defined, and up to a maximum $5,000,000 under the terms of the Credit andSecurity Agreement.  At March 31, 2003,the annual interest rate on the credit facility was approximately 10.5%. Thecredit facility requires that the total amount of interest paid per year mustbe at least $120,000. The credit facility will expire on October 30, 2005, atwhich time the entire outstanding balance of the credit facility will become dueand payable. Amounts borrowed under the credit facility are secured by a firstpriority lien on substantially all of our assets, including accountsreceivable, patents and other intellectual property relating to the DigitalAngelTM product. As of March 31, 2003, we had $926,000 of borrowing availabilityunder our credit facility.

 

The credit facility contains certain financialcovenants, including a monthly minimum book net worth and monthly minimumearnings before taxes, and it limits our capital expenditures during 2003. Anybreach of the financial covenants by us will constitute an event of defaultunder the Credit and Security Agreement. In addition, any change of control ofthe Company will be an event of default under the Credit and Security Agreement.As defined in the Credit and Security Agreement, a change of control includesthe future acquisition by any person or group of persons of more than 25% ofthe voting power of all classes of our common stock or our current Presidentand Chief Executive Officer ceases to actively manage the Company’s day-to-daybusiness activities. As of March 31, 2003, we were out of compliance with theminimum book net worth and monthly minimum earnings before taxes covenants. Asa result of our covenant violations, Wells Fargo is exercising its right tocharge interest at the default rate, which was approximately 10.5% at March 31,2003, from January 1, 2003, until the covenant violation is no longeroutstanding. We have obtained a waiver of these covenant violations from WellsFargo. There can be no assurance that we will continue to comply with thefinancial covenants of our Credit and Security Agreement, that an event ofdefault will not occur, or that we can continue to obtain waivers of any eventsof default under the Credit and Security Agreement.

 

Management believes that we will need to obtainapproximately $3 to $5 million to meet our capital requirements for the next 12months. Management is currently exploring capital sources, in addition to thecredit facility, which together will sufficiently meet our capitalrequirements. Our capital requirements will depend upon a variety of factors,including, but not limited to, the rate of increase or decrease in our existingbusiness base; the success, timing and amount of investment required to bringnew products to market; revenue growth or decline; and potentialacquisitions.  There can be no assurance that we will be able to obtainfuture financing in an amount sufficient to implement our business plan.

 

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On November 27, 2002, we filed a RegistrationStatement on Form S-1 with the Securities and Exchange Commission, which becameeffective on January 22, 2003.  The Registration Statement registers thesale by certain of our existing stockholders of up to 22,348,720 shares oftheir common stock of the Company.  The sale of the existing stockholders’22,348,720 shares is being registered to permit the stockholders to sell theirshares of the Company’s common stock from time to time in the publicmarket.  We will not receive any proceeds from the sale of the commonstock by the selling stockholders.

 

ADS has a term and revolving credit agreement (IBMCredit Agreement) with IBM Credit LLC (IBM Credit). Under the IBM Credit Agreementin effect through March 27, 2002, IBM Credit maintained liens and securityinterests in the outstanding capital stock of the three AWG subsidiaries and ontheir assets to collateralize ADS’s obligations to IBM Credit under the IBMCredit Agreement.

 

ADS was not in compliance with certain financialcovenants of the IBM Credit Agreement as of December 31, 2000. The IBM CreditAgreement was amended and restated on October 17, 2000 and further amended onMarch 30, 2001, July 1, 2001, September 15, 2001, November 15, 2001, December31, 2001, January 31, 2002 and February 27, 2002. In connection with theamendment on March 30, 2001, IBM Credit was granted warrants to acquire 1.16million shares of Digital Angel’s common stock exercisable at $1.07 and expiringon April 10, 2007.

 

ADS continued to generate operating losses in 2001 andwas in default of various financial covenants under the amended IBM CreditAgreement. In the third quarter of fiscal 2001, it was determined that thereexisted substantial doubt about ADS’s ability to continue as a going concernand ADS did not have the funds available to repay the amounts borrowed underthe IBM Credit Agreement. ADS allocated the outstanding borrowings of $82.6million to AWG effective September 30, 2001. Interest associated with theborrowings was allocated to AWG for the period from September 30, 2001 to March27, 2002.

 

Under the terms of the agreement and plan of mergerwith MAS, the common stock and assets of the three AWG subsidiaries werereleased from all liens and security interests under the IBM Credit Agreement,and the shares of our common stock beneficially owned by ADS upon completion ofthe merger between DATC and MAS were transferred on March 27, 2002 to theDigital Angel Share Trust as collateral for the debt. ADS assumed thedebt, which was treated as a capital contribution, resulting in an increase inadditional paid-in capital of approximately $81.4 million, net of deferredfinancing fees of approximately $1.1 million on March 27, 2002.

 

On March 1, 2002, ADS, the Digital Angel Share Trustand IBM Credit entered into a Third Amended and Restated Term Credit Agreement.The new IBM Credit Agreement became effective on March 27, 2002, the effectivedate of the merger. Amounts outstanding under the new IBM Credit Agreement bearinterest at an annual rate of 17% and matured on February 28, 2003. If allamounts were not repaid by February 28, 2003, the unpaid amount accruesinterest at an annual rate of 25%, and if they are not repaid by February 28,2004, the annual interest rate increases to 35%.

 

The Digital Angel Share Trust is controlled by anadvisory board, which is independent of ADS. The Trust has voting rightswith respect to our common stock until ADS’s obligations to IBM Credit arerepaid in full.

 

The IBM Credit Agreement contains debt covenantsrelating to ADS’ financial position and performance, as well as our financialposition and performance. In the absence of a waiver or amendment to suchfinancial covenants, noncompliance would constitute an event of default underthe IBM Credit Agreement, and IBM Credit would be entitled to accelerate thematurity of all amounts ADS owes it. On September 30 and November 1, 2002,the IBM Credit Agreement was amended. The amendment reduced our current assetsto current liabilities ratio and Minimum Cumulative Modified EBITDArequirements as defined in the IBM Credit Agreement for the quarters endedSeptember 30, 2002 and December 31, 2002. As of December 31, 2002, we wereout of compliance with the amended debt covenants. IBM did not provide a waiverfor the noncompliance.

 

Under the terms of the IBM Credit Agreement, ADS wasrequired to repay $29.8 million of the $77.2 million outstanding principalbalance owed to IBM Credit, plus $16.4 million of accrued interest andexpenses, on or before February 28, 2003. ADS did not make such payment onFebruary 28, 2003. On March 3, 2003, IBM Credit notified ADS that it had untilMarch 6, 2003 to make the payment. ADS did not make the payment on March 6,2003 as required. ADS’s failure to comply with the payment terms imposed by IBMCredit and our failure to maintain compliance with the financial performancecovenant of the IBM Credit Agreement constitute events of default. On March 7,2003, IBM Credit notified ADS that an event of default had occurred and IBMCredit would immediately commence exercising any and/or all of its rights andremedies.

 

IBM Credit, ADS and the Company agreed to the terms ofa Forbearance Agreement dated March 24, 2003. Under the Forbearance Agreement,ADS has agreed to dismiss a lawsuit it had filed against IBM Credit and IBMCorporation in Palm Beach County, Florida on March 6, 2003. Under theForbearance Agreement, ADS must retain an investment bank to sell the Company’sshares owned by the Trust.  Theeffective date of the Forbearance Agreement is no later than March 31, 2003,and ADS must hire the investment bank within 30 days after the effective dateof the Forbearance Agreement. On May 6, 2003 ADS hired an investment bank.  Under the Forbearance Agreement, we agreedto cooperate in selling the shares owned by the Trust. If such sales by theTrust result in another person or group of persons owning, in 

 

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the aggregate, 25% or more of our common stock, such sales will bedeemed to constitute an event of default under our Credit and SecurityAgreement with Wells Fargo. The occurrence of an event of default under theCredit and Security Agreement would subject us to the risk of foreclosure onsubstantially all of our assets to the extent necessary to repay any amountsdue under the credit facility, including, but not limited to, principal,interest, penalties or other costs and expenses incurred.

 

*PaymentProvisions of the Forbearance Agreement*

 

The payment provisions of the Forbearance Agreementare as follows: the Tranche A Loan, consisting of $68.0 million plus accruedinterest, must be repaid in full no later than September 30, 2003, providedthat all but $3.0 million of the Tranche A Loan (the “Tranche A DeficiencyAmount”) will be deemed to be paid in full on such date if less than the fullamount of the Tranche A Loan is repaid but all of the cash proceeds of theCompany’s shares held in the Trust are applied to the repayment of the TrancheA Loan. The Tranche A Deficiency Amount (if any) must be repaid no later thanMarch 31, 2004. The Tranche B Loan, consisting of $9.2 million plus accruedinterest, must be repaid in full no later than March 31, 2004.  Effective March 24, 2003, the Tranche B Loanwill bear interest at seven percent (7%) per annum.

 

*PurchaseRights of the Forbearance Agreement*

 

The Tranche A and B Loans may be repurchased under theterms of the Forbearance Agreement by or on behalf of ADS as follows: (i) theloans and all other obligations may be purchased on or before June 30, 2003 for$30.0 million in cash; (ii) the loans and all other obligations may bepurchased on or before September 30, 2003 for $50.0 million in cash; and (iii)the Tranche A Loan may be purchased on or before September 30, 2003 for $40.0million in cash with an additional $10.0 million cash payment in respect of theTranche A Deficiency Amount and the Tranche B Loan due before on or beforeDecember 31, 2003.

 

In addition, ADS agreed that the Digital Angel ShareTrust will engage an investment bank within 30 days of the effective date ofthe Forbearance Agreement to pursue the sale of the 19,600,000 shares of ourcommon stock that are currently held in the Trust. On May 6, 2003 ADS hired aninvestment bank.  All proceeds from thesale of our common stock will be applied to the loans and other obligations tosatisfy the loan payment provisions discussed above if ADS has not satisfiedits purchase rights by September 30, 2003.

 

At the end of the forbearance period, the provisionsof the Forbearance Agreement will become of no force and effect and IBM Creditshall be free to exercise and enforce, or to take steps to exercise andenforce, all rights, powers, privileges and remedies available to it under the IBMCredit Agreement, as a result of the payment and covenant defaults existing onMarch 24, 2003, or if ADS defaults on any of the provisions of the forbearanceagreement or the IBM Credit Agreement during the forbearance period.

 

*PossibleConsequences of Sales of the Company’s Shares*

 

Employment Agreement withRandolph K. Geissler.  Under the terms of the employmentagreement dated March 8, 2002, as amended, by and between the Company andRandolph K. Geissler (the President and Chief Executive Officer of theCompany), a “change in control” occurs under that employment agreement if anyperson becomes the “beneficial owner” (as defined in Rule 13d–3 under theSecurities Exchange Act of 1934), directly or indirectly, of securities of theCompany representing 20% or more of the combined voting power of the Company’sthen outstanding shares of common stock. Therefore, if the Trust were tosell more than approximately 5.3 million shares of the Company’s common stock,such sale could constitute a change in control under the employment agreementwith Mr. Geissler. Upon the occurrence of a change in control, Mr.Geissler, at his sole option and discretion, may terminate his employment withthe Company at any time within one year after such change in control upon 15 days’notice. In the event of such termination, the employment agreementprovides that the Company must pay to Mr. Geissler a severance payment equal tothree times the base amount as defined in Section 280G(b)(3) of the InternalRevenue Code of 1986, as amended (“Code”), minus $1.00 (currently a total ofapproximately $750,000), which would be payable no later than one month afterthe effective date of Mr. Geissler’s termination of employment. Inaddition, upon the occurrence of a change of control under the employmentagreement, all outstanding stock options held by Mr. Geissler would becomefully exercisable. As of December 31, 2002, Mr. Geissler owned options topurchase 1,000,000 shares for $3.39 per share, none of which had vested, whichwould become exercisable upon the occurrence of such a change in control.

 

The employment agreement also provides that (i) upon achange of control, (ii) upon the termination of Mr. Geissler’s employmentfor any reason other than due to his material default under the employmentagreement, or (iii) if he ceases to be the Company’s President and ChiefExecutive Officer for any reason other than termination due to his materialdefault under the employment agreement, within 10 days of the occurrence of anysuch events, the Company is to pay to Mr. Geissler $4,000,000. The Companymay pay such amount in cash or in the Company’s common stock or with acombination of cash and common stock. The employment agreement alsoprovides that if the $4,000,000 is paid in cash and stock, the amount of cashpaid must be sufficient to 

 

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cover the tax liability associated with such payment, and such paymentshall otherwise be structured to maximize tax efficiencies to both the Companyand Mr. Geissler.

 

Credit and SecurityAgreement with Wells Fargo Business Credit, Inc.  TheCredit and Security Agreement provides that a “change in control” under thatagreement results in a default. A change in control is defined as eitherMr. Geissler ceasing to actively manage the Company’s day-to-day businessactivities or the transfer of at least 25% of the outstanding shares of commonstock of the Company. Also, if the Company owes to Mr. Geissler $4,000,000under his employment agreement as described above, the obligation would mostlikely result in a breach of the Company’s financial covenants under the Creditand Security Agreement as described above. If these defaults occurred andwere not waived by Wells Fargo, and if Wells Fargo were to enforce their rightsunder the terms of the Credit and Security Agreement and related agreements,the Company’s business and financial condition would be materially andadversely affected, and it may force the Company to cease operations.

 

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

 

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

 

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

 

•                  anticipated trends in our businessand demographics;

 

•                  our ability to successfully integratethe business operations of recently acquired companies;

 

•                  our future profitability andliquidity; and

 

•                  regulatory, competitive or othereconomic influences.

 

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

 

**Risk Factors**

 

You should carefullyconsider the risk factors listed below. These risk factors may cause our future earnings to be less or ourfinancial condition to be less favorable than we expect.  You should read this section together withthe other information contained herein.

 

**Historical losses and negative cashflows from operations raise doubt about our ability to continue as a goingconcern.**

 

Historically, the Company has suffered losses and hasnot generated positive cash flows from operations.  This raises substantial doubt about the Company’s ability tocontinue as a going concern.  The auditreports of Eisner LLP for the year ended December 31, 2002 for the Company’sfinancial statements and PricewaterhouseCoopers LLP for each of the two yearsended December 31, 2001 and 2000 for AWG’s financial statements, which becameour historical financial statements in the merger, contained an explanatoryparagraph expressing doubt about the Company’s and AWG’s ability to continue as a going concern.  We believe that we will need to obtainapproximately $3 to $5 million to meet our capital requirements for the next 12months. Management is currently exploring capital sources, in addition to thecredit facility, which together will sufficiently meet our capitalrequirements.

 

**The Company’s majority stockholder, Digital Angel Share Trust, owns73.1% of the Company’s common stock, is able to completely control the board ofdirectors and may support actions that conflict with the interests of the otherstockholders.**

 

The Trust is the beneficial owner of 73.1% of ourcommon stock, and it controls us with respect to all matters upon which ourstockholders may vote, including the selection of the Board of Directors,mergers, acquisitions and other significant corporate transactions.

 

The Trust is controlled by an independent advisoryboard, and there can be no assurance as to how the advisory board and the Trustwill exercise control over us.  TheTrust and the advisory board may support actions that are contrary to orconflict with the interests of the other stockholders.

 

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Upon the request of IBM Credit LLC (IBM Credit), theDigital Angel Share Trust is obligated to sell the shares of our common stockowned by the Trust for the benefit of IBM Credit if ADS fails to make paymentsto IBM Credit or otherwise defaults under the credit agreement with IBM Credit.ADS was required to repay $29.8 million of the $77.2 million outstandingprincipal balance owed to IBM Credit, plus $16.4 million of accrued interestand expenses on or before February 28, 2003. ADS did not make such payment on February 28, 2003.  On March 3, 2003, IBM Credit notified ADSthat it had until March 6, 2003 to make the payment.  ADS  did not make thepayment on March 6, 2003 as required. In addition, ADS’s IBM Credit Agreement contains debt covenants made byADS relating to its financial position and performance, as well as ourfinancial position and performance.  Inthe absence of a waiver or amendment to such financial covenants, noncomplianceconstitutes an event of default under the IBM Credit Agreement, and IBM Creditwould be entitled to accelerate the maturity of all amounts ADS owes it.  On September 30 and November 1, 2002 the IBMCredit Agreement was amended. The amendment reduced our current assets tocurrent liabilities ratio and Minimum Cumulative Modified EBITDA requirementsas defined in the IBM Credit Agreement for the quarters ended September 30,2002 and December 31, 2002. As of December 31, 2002, we were out of compliancewith the amended debt covenants. IBM did not provide a waiver for thenoncompliance.

 

ADS’s failure to comply with the payment terms imposedby IBM Credit and our failure to maintain compliance with the debt covenants ofthe IBM Credit Agreement constitute events of default.  On March 7, 2003, IBM Credit notified ADSthat an event of default had occurred and IBM Credit would immediately commenceexercising any and/or all of its rights and remedies.  IBM Credit, ADS, the Company and other parties entered into aForbearance Agreement dated March 24, 2003 with respect to such defaults andADS’s obligations under the IBM Credit Agreement.  Under the Forbearance Agreement, ADS must retain an investmentbank to sell the Company’s shares owned by the Trust. The effective date of theAgreement is no later than March 31, 2003, and ADS must hire the investmentbank within 30 days after the effective date of the Agreement.  On May 6, 2003 ADS hired an investmentbank.  Under the Forbearance Agreement,we agreed to cooperate in selling the shares owned by the Trust. Such sales maybe in private transactions or in the public market. We will have little or nocontrol over any such sales.  We cangive no assurance as to when or how shares of our common stock will be sold, asto who will purchase such shares, or as to the number of shares that may besold at any given time. As a result, the duration of the Trust’s control overus, the identity of any parties which may acquire control of us and the marketprice of our stock if and when such sales commence is uncertain.

 

**The termsof our credit facility subject us to the risk of foreclosure on substantiallyall of our assets*.***

 

Effective October 30, 2002, we entered into a Creditand Security Agreement with Wells Fargo Business Credit, Inc. (“Wells Fargo”).Our credit facility provides for borrowings up to 80% of eligible receivable,as defined, and up to a maximum of $5,000,000 under the terms of the Credit andSecurity Agreement.  At March 31, 2003,the annual interest rate on the credit facility was approximately 10.5%. Thecredit facility requires that the total amount of interest paid per year mustbe at least $120,000. The credit facility will expire on October 30, 2005, atwhich time the entire outstanding balance of the credit facility will becomedue and payable. Amounts borrowed under the credit facility are secured by afirst priority lien on substantially all of our assets, including accountsreceivable, patents and other intellectual property relating to the DigitalAngelTM product. As of March 31, 2003, we had $926,000 of borrowing availabilityunder our credit facility.

 

The credit facility contains certain financialcovenants, including a monthly minimum book net worth and monthly minimumearnings before taxes, and it limits our capital expenditures during 2002 and2003. Any breach of the financial covenants by us will constitute an event ofdefault under the Credit and Security Agreement. In addition, any change ofcontrol of the Company will be an event of default under the Credit andSecurity Agreement. As defined in the Credit and Security Agreement, a changeof control includes the future acquisition by any person or group of persons ofmore than 25% of the voting power of all classes of our common stock or ourcurrent President and Chief Executive Officer ceases to actively manage theCompany’s day-to-day business activities. As of March 31, 2003, we were out ofcompliance with the minimum book net worth and monthly minimum earnings beforetaxes covenants. As a result of our covenant violations, Wells Fargo isexercising its right to charge interest at the default rate, which wasapproximately 10.5% at March 31, 2003, from January 1, 2003, until the covenantviolation is no longer outstanding. We have obtained a waiver of these covenantviolations from Wells Fargo. There can be no assurance that we will continue tocomply with the financial covenants of our Credit and Security Agreement, thatan event of default will not occur or that we can continue to obtain waivers ofany events of default.

 

The credit facility will expire on October 30, 2005,at which time the entire outstanding balance of the credit facility will becomedue and payable.  We may not havesufficient funds to repay the outstanding balance on the credit facility uponits maturity.  Accordingly, we may berequired to obtain the funds necessary to repay the credit facility either throughrefinancing the credit facility, the issuance of additional equity or debtsecurities or the sale of assets.  Therecan be no assurance that, if needed, we can obtain such refinancing, issueequity or debt securities, or sell assets under terms that are acceptable tous, or at all.  If we are unable toobtain funds to repay this indebtedness on acceptable terms, or at all, we maybe forced to dispose of assets or take other actions on disadvantageous terms,which could result in losses to the Company and have a material adverse effecton our financial condition.  For thesereasons, there can be no assurance that we will be able to repay the creditfacility upon its maturity.

 

As described above, in connection with defaults underthe IBM Credit Agreement, IBM Credit, ADS and the Company have entered into theForbearance Agreement under which ADS must retain an investment bank withinapproximately 30 days to sell the 

 

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shares owned by the Digital Angel Share Trust. If such sales by or onbehalf of the Trust result in another person or group of persons owning, in theaggregate, 25% or more of our common stock, such sales will be deemed toconstitute an event of default under our Credit and Security Agreement.

 

The occurrence of any of the foregoing or any otherevents of default under the Credit and Security Agreement would subject us tothe risk of foreclosure by Wells Fargo on substantially all of our assets tothe extent necessary to repay any amounts due under the credit facility,including, but not limited to, principal, interest, penalties or other costsand expenses incurred.  Any such defaultand resulting foreclosure could have a material adverse effect on our financialcondition.

 

**Sales of our common stock by theTrust may cause a reduction in the market value of our common stock.**

 

As described above, in connection with defaults underthe IBM Credit Agreement, IBM Credit, ADS and the Company have entered into theForbearance Agreement under which ADS must retain an investment bank withinapproximately 30 days to sell the shares owned by the Digital Angel ShareTrust. The sale of a significant number of shares of our common stock owned bythe Trust in a single transaction or in a series of transactions over a shortperiod of time could result in a significant decline in the market value of ourcommon stock.

 

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

 

As of March 31, 2003, we had recorded goodwill of $47.5million. On January 1, 2002, we adopted SFAS No. 142, “Goodwill and OtherIntangible Assets.”  SFAS No. 142requires that goodwill and certain intangibles no longer be amortized butinstead tested for impairment at least annually by applying a fair value basedtest. During the first quarter of 2002, we completed the transitional goodwillimpairment test required by SFAS No. 142 and recorded no impairment of ourgoodwill.  During the fourth quarter of2002, we performed the annual impairment test for goodwill using a fair valuebased approach, primarily discounted cash flows.  An evaluation of the Wireless and Monitoring and Medical Systemsreporting units indicated that $31.5 million and $25.9 million of goodwill,respectively, was impaired. Accordingly, we recorded an impairment charge of$57.4 million in the fourth quarter of 2002. Factors contributing to theimpairment charge were a longer than anticipated timeframe in developing thenew Digital AngelTM technology for the Wireless and Monitoring reporting unitand a change in business focus for the Medical Systems reporting unit. We willassess the fair value of our goodwill annually or earlier if events occur orcircumstances change that would more likely than not reduce the fair value ofour goodwill below its carrying value. These events or circumstances would include a significant change inbusiness climate, including a significant, sustained decline in an entity’smarket value, legal factors, operating performance indicators, competition,sale or disposition of a significant portion of the business, or other factors.If we determine that significant impairment has occurred, we would be requiredto write off the impaired portion of goodwill. Impairment charges could have amaterial adverse effect on our financial condition and results of operations.

 

**Theexercise of options and warrants outstanding and available for issuance mayadversely affect the market price of our common stock*.***

 

As of March 31, 2003, we had options and warrantsoutstanding to purchase a total of 8,643,000 shares of common stock at exerciseprices ranging from $0.05 to $10.50 per share, with a weighted average exerciseprice of $1.63.  In addition, we had2,545,000 additional shares of common stock which may be issued in the future underour stock option plans.  The exercise ofoutstanding options and warrants and the sale in the public market of theshares purchased upon such exercise may adversely affect the market price ofour common stock.

 

**We maycontinue to incur losses.**

 

We incurred net losses of $92.4 million, $17.4 millionand $3.9 million in the years ended December 31, 2002, 2001 and 2000,respectively.  Although we had netincome of $110,000 for the three months ended March 31, 2003, no assurance canbe given as to whether we will continue to be profitable or that we canincrease profitability. Profitability depends on many factors, including thesuccess of marketing programs, the maintenance and reduction of expenses, andthe ability to coordinate successfully the operations of business units. If wefail to achieve and maintain sufficient profitability within the time frameexpected by investors, the market price of our common stock may be adverselyaffected.

 

**The Wireless and Monitoring segmentis expected to incur future losses and may not achieve profitability*.***

 

We have invested approximately $13.3 million in theDigital Angelä product for theperiod from April 1998 through March 31, 2003. We expect the Wireless and Monitoring segment to incur additionaldevelopment, sales and marketing, and other general expenses.  As a result, the Wireless and Monitoringsegment is expected to incur losses for the foreseeable future and will need togenerate significant revenues to achieve profitability.  There can be no assurance that the segmentwill achieve profitability or, if profitability is achieved, that it will besustained.  The Wireless and Monitoringsegment’s failure to achieve or sustain profitability would have a materialadverse effect on the market value of our common stock.

 

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The Wireless andMonitoring segment is the initial stage of operations and may encounterunforeseen difficulties that could negatively affect our business.  It has generated no substantial revenue. Asa result, it has minimal operating history upon which to base an evaluation ofits current business and future prospects. The first Digital Angel product wasintroduced in November 2001.  Moreover,this segment does not currently have any contracts in place that will provideany significant revenue.  Because ofthis segment’s lack of an operating history, management has limited insightinto trends that may emerge and could materially adversely affect its business.  This segment’s prospects must be consideredin light of the risks, expenses and difficulties frequently encountered bycompanies in new and rapidly evolving markets. This segment could encounter risks and difficulties in its new andrapidly evolving market, especially given its lack of operating history. Theserisks include the Wireless and Monitoring segment’s ability to:

 

•                  develop and market Digital Angelproducts by integrating and miniaturizing new technologies into marketableproducts and services;

 

•                  build a customer base;

 

•                  generate revenues;

 

•                  compete successfully in a highlycompetitive market;

 

•                  access sufficient capital to supportgrowth;

 

•                  recruit and retain qualifiedemployees;

 

•                  introduce new products and services;and

 

•                  build technology and support systems.

 

Each of these risks could lead to unforeseen expensesor losses, which could have a material adverse effect on our financialcondition and results of operations.

 

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

 

Our success depends significantly on our ability tomaintain patent and trade secret protection, to obtain future patents andlicenses, and to operate without infringing on the proprietary rights of thirdparties. There can be no assurance that the measures we have taken to protectour intellectual property, including those relating to the Digital Angeltechnology, will prevent the misappropriation or circumvention of our intellectualproperty.  In addition, there can be noassurance that any patent application, when filed, will result in an issuedpatent, or that our existing patents, or any patents that may be issued in thefuture, will provide us with significant protection against competitors.Moreover, there can be no assurance that any patents issued to or licensed byus will not be infringed upon or circumvented by others.  Litigation to establish the validity ofpatents, to assert infringement claims against others, and to defend againstpatent infringement claims can be expensive and time-consuming, even if theoutcome is in our favor.  We also relyto a lesser extent on unpatented proprietary technology, and no assurance canbe given that others will not independently develop substantially equivalentproprietary information, techniques or processes or that we can meaningfullyprotect our rights to such unpatented proprietary technology.  Infringement on our intellectual property orthe development of substantially equivalent technology by our competitors couldhave a material adverse effect on our business.

 

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

 

The electronic animal identification market can benegatively affected by such factors as food safety concerns, consumerperceptions regarding cost and efficacy, international technology standards,national infrastructures, and slaughterhouse removal of microchips.

 

We are also subject to federal, state and localregulation in the United States, including regulation by the U.S. Food and DrugAdministration, the U.S. Federal Communications Commission and the U.S.Department of Agriculture, and to regulation in other countries.  We cannot predict the extent to which we maybe affected by further legislative and regulatory developments concerning ourproducts and markets.  We are requiredto obtain regulatory approval before marketing most of our products.  The regulatory process can be verytime-consuming and costly, and there is no assurance that we will receive theregulatory approvals necessary to sell our products.  Regulatory authorities also have the authority to revoke approvalof previously approved products for cause, to request recalls of products andto close manufacturing plants in response to violations.  Any such regulatory action, including thefailure to obtain such approval, could prevent us from selling, or materiallyimpair our ability to sell, our products in certain markets

 

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and could negatively affect our business.

 

**We rely heavily on sales to government contractorsof our animal identification products, and any decline in the demand by thesecustomers for our products could negatively affect our business.**

 

The principal customers for electronic identificationdevices for fish are government contractors that rely on funding from theUnited States government.  Because thesecontractors rely heavily on government funds, any decline in the availabilityof such funds could result in a decreased demand by these contractors for ourproducts.  Any decrease in demand bysuch customers could have a material adverse effect on our financial conditionand results of operations and result in a decline in the market value of ourcommon stock.

 

**Wedepend on a single production arrangement with Raytheon Corporation for ourpatented syringe-injectable microchips, and the loss of or any significantreduction in the production could have an adverse effect on our business. Wehave no formal written agreement with Raytheon Corporation for the productionof our microchips.**

 

We rely solely on a production arrangement withRaytheon Corporation (“Raytheon”) for the manufacture of our patented syringe-injectablemicrochips that are used in all of our implantable electronic identificationproducts. In addition, we have no formal written agreement with Raytheon forthe production of our microchips. Raytheon utilizes our proprietary technologyand our equipment in the production of our syringe-injectable microchips. Thetermination, or any significant reduction, by Raytheon of the assembly of ourmicrochips or a material increase in the price charged by Raytheon for theassembly of our microchips could have an adverse effect on our financialcondition and results of operations.  Inaddition, Raytheon may not be able to produce sufficient quantities of themicrochips to meet any significant increased demand for our products or to meetany such demand on a timely basis.  Anyinability or unwillingness of Raytheon to meet our demand for microchips wouldrequire us to utilize an alternative production arrangement and remove ourautomated assembly production machinery from the Raytheon facility, which wouldbe costly and could delay production. Moreover, if Raytheon terminates our production arrangement, we cannotensure that the assembly of our microchips from another source would be oncomparable or acceptable terms.  Thefailure to make such an alternative production arrangement could have anadverse effect on our business.

 

**Wedepend on principal customers.**

 

For the three month period ended March 31, 2003, fivecustomers — Schering Plough, US Army Corp of Engineers, Biomark, Pacific Statesand US Department of Energy — accounted for 39.2% of our consolidated revenues.In addition, the GPS and Radio Communications segment is heavily dependent oncontracts with domestic government agencies and foreign governments, includingthe United Kingdom, primarily relating to military applications. The loss of,or a significant reduction in, orders from these or our other major customerscould have a material adverse effect on our financial condition and results ofoperations.  No individual customeraccounted for 10% or more of our revenues in the three month period ended March31, 2003.

 

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

 

The market for visual and electronic identificationfor companion animals and livestock is highly competitive. We believe that ourprincipal competitors in the visual identification market for livestock areAllFlex USA and Y-Tex Corporation, and that our principal competitors in theelectronic identification market that have developed permanent electronicidentification devices for the companion animal market are AllFlex USA,Datamars SA and Avid Plc.  NeitherDatamars nor Avid has been granted a U.S. license to use implantabletechnology.

 

In addition, other companies could enter this line ofbusiness in the future.  Certain of ourcompetitors have substantially greater financial and other resources than us.We may not be able to compete successfully with these competitors, and thosecompetitors may develop or market technologies and products that are morewidely accepted than ours or that would render our products obsolete ornoncompetitive.  We are not aware of anyother competitors currently marketing products that would compete with theDigital Angel product.  However, we areaware of several potential competitors that have expressed an interest insimilar technologies.  We are unaware ofany actual sales of a competing product. If such competitors enter the market and compete with the Digital Angelproduct, such competition could have a material adverse effect on our business.

 

**We aresubject to risks as a result of our foreign operations.**

 

We maintain operationsoutside of the United States, which subjects us to risks that are inherent ininternational operations, including the risk that:

 

•                  it is more difficult to enforceagreements and collect receivables through many foreign legal systems;

 

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•                  foreign customers may have longerpayment cycles than customers in the United States;

 

•                  tax rates in some foreign countriesmay exceed those in the United States, and foreign earnings may be subject towithholding requirements or the imposition of tariffs, exchange controls orother restrictions;

 

•                  general economic and politicalconditions in countries where we operate may have an adverse effect on ouroperations or other presence in those countries;

 

•                  the difficulties associated withmanaging a large organization spread throughout various countries may adverselyaffect our business in those countries; and

 

•                  required compliance with a variety offoreign laws and regulations may prove onerous and adversely affect ouroperations abroad.

 

As we continue to expand our business globally, oursuccess will depend, in part, on our ability to anticipate and effectivelymanage these and other risks.  These andother factors may have a material adverse effect on our internationaloperations or our business as a whole.

 

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

 

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

 

**We depend on a small team of seniormanagement, and we may have difficulty attracting and retaining additionalpersonnel.**

 

Our future success will depend in large part upon thecontinued services and performance of senior management and other keypersonnel.  If we lose the services ofany member of our senior management team, our overall operations could bematerially and adversely affected.  Inaddition, our future success will depend on our ability to identify, attract,hire, train, retain and motivate other highly skilled technical, managerial,marketing, purchasing and customer service personnel when they are needed.  Competition for these individuals isintense.  We cannot ensure that we willbe able to successfully attract, integrate or retain sufficiently qualifiedpersonnel when the need arises.  Anyfailure to attract and retain the necessary technical, managerial, marketing,purchasing and customer service personnel could have a material adverse effecton our financial condition and results of operations.

 

We have employment agreements with certain key personnel,including our President and Chief Executive Officer.  The agreement with our President and Chief Executive Officerprovides for specific payments in the event of a change in control of theCompany.

 

**The Digital AngelTMtechnology is not proven, and we may not be able to develop products from thisunproven technology.**

 

The Wireless and Monitoring segment depends on thedevelopment, integration, miniaturization and successful marketing of severaladvanced technologies that have not previously been integrated or used asanticipated by this segment. The Wireless and Monitoring segment depends uponadvanced technology, including wireless communication, biosensors, motiondetermination and global positioning system capabilities. Many of thesetechnologies are unproven or relatively new. No assurances can be given as to when or if the Digital Angel productwill be successfully marketed. Our ability to develop and commercializeproducts based on our proprietary technology will depend on our ability todevelop our products internally on a timely basis or to enter into arrangementswith third parties to provide these functions. Our failure to develop and commercialize products successfully couldhave a material adverse effect on our financial condition and results ofoperations.

 

**IMPACT OF RECENTLY ISSUED ACCOUNTINGSTANDARDS**

 

In April 2002, the FASB issued SFAS No. 145,“Rescission of FAS Statements 4, 44 and 64, Amendment of FAS Statement 13 andTechnical Corrections.” SFAS No. 145 eliminates Statement 4 (and Statement 64,as it amends Statement 4), which required gains and losses from extinguishmentof debt to be aggregated and, if material, classified as an extraordinary item,and thus, also the exception to applying Opinion 30 is eliminated as well. Thisstatement is effective for fiscal years beginning after May 2002 for theprovisions related to the rescission of Statements 4 and 64 and for alltransactions entered into beginning May 2002 for the provision related to theamendment of Statement 13. We do not expect that the adoption of SFAS No. 145will have a material impact on our results of operations or financial position.

 

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In June 2002, the FASB issued SFAS No. 146,“Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No.146 requires recording costs associated with exit or disposal activities attheir fair values when a liability has been incurred. Under previous guidance,certain exit costs were accrued upon management’s commitment to an exit plan.We are required to adopt SFAS No. 146 on January 1, 2003. We do not expect theadoption of SFAS No. 146 will have a material impact on our results ofoperations or financial position.

 

In December 2002, the FASB issued SFAS No. 148, “Accountingfor Stock-Based Compensation - Transition and Disclosure,” an amendment to SFASNo. 123 “Accounting for Stock-Based Compensation.”  Provisions of this statement provide two additional alternativetransition methods: modified prospective method and retroactive restatementmethod, for an entity that voluntary changes to the fair value based method ofaccounting for stock-based employee compensation.  The statement eliminates the use of the original SFAS No. 123prospective method of transition alternative for those entities that change tothe fair value based method in fiscal years beginning after December 15,2003.  It also amends the disclosureprovisions of SFAS No. 123 to require prominent annual disclosure about theeffects on reported net income in the Summary of Significant AccountingPolicies and also requires disclosure about these effects in interim financialstatements.  These provisions areeffective for financial statements for fiscal years ending after December 15,2002.  Accordingly, we adopted theapplicable disclosure requirements of this statement for year-endreporting.  The transition provisions ofthis statement apply upon the adoption of the SFAS No. 123 fair value basedmethod.  We did not change our method ofaccounting for employee stock-based compensation from the intrinsic method tothe fair value based alternative.

 

 

**Item 3.****           Quantitative and QualitativeDisclosures About Market Risk**

 

We have operations and sales in various regions of theworld. Additionally, we may export and import to and from other countries.  Our operations may therefore be subject tovolatility because of currency fluctuations, inflation, and changes inpolitical and economic conditions in these countries. Sales and expenses may bedenominated in local currencies and may be affected as currency fluctuationsaffect our product prices and operating costs or those of our competitors.

 

We presently do not use any derivative financialinstruments to hedge our exposure to adverse fluctuations in interest rates,foreign exchange rates, fluctuations in commodity prices or other market risks,nor do we invest in speculative financial instruments.

 

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

 

**Item 4.****           Controls and Procedures**

 

Within the 90 daysprior to the date of this report, the Company carried out an evaluation, underthe supervision and with the participation of the Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer, ofthe effectiveness of the design and operation of the Company’s disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-14 under the SecuritiesExchange Act of 1934.  Based upon thatevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat the Company’s disclosure controls and procedures are effective in timelyalerting them to material information relating to the Company (including itsconsolidated subsidiaries) required to be included in the Company’s periodicSEC filings with the Securities and Exchange Commission.  Since the date of their evaluation, therehave been no significant changes in our internal controls or in other factorsthat could significantly affect the Company’s internal controls.

 

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**PARTII    OTHER INFORMATION**

 

**Item 1.**                                    Legal Proceedings.

** **

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

 

On May 29, 2001, Janet Silva, individually and asGuardian*ad litem* for JonathanSilva, a minor, and the Estate of Clarence William Silva, Jr. (collectively, “Plaintiffs”)filed suit against Customized Services Administrators, Incorporated (“CSA”),Pricesmart, Inc. (“Pricesmart”), Commercial Union Insurance Company(“Commercial Union”), CGU Insurance Group, and the Company (collectively the“Defendants”) in the Superior Court of the State of California in and for theCounty of Santa Clara.  The allegationsof the complaint arise from a vacation guarantee insurance policy (the“Insurance Contract”) allegedly purchased by Plaintiffs from Defendants onMarch 6, 2000.  The complaint alleges,among other things, that Defendants breached the Insurance Contract, defraudedPlaintiffs, acted in bad faith, and engaged in deceptive and unlawful businesspractices, resulting in the wrongful death of Clarence William Silva, Jr. (the“Deceased”) and the intentional infliction of emotional distress onPlaintiffs.  The complaint seeks thecost of funeral and burial expenses of the Deceased and amounts constitutingthe loss of financial support of the Deceased, general damages, attorney’s feesand costs, and exemplary damages.

 

CSA outsourced its travel assistance services toMAS.  CSA has filed a cross-claimagainst the Company alleging that the Company should be held liable for anyliability that CSA may have to Plaintiffs. The Company has denied the allegations of the complaint and the CSAcross-claim and is vigorously contesting all aspects of this action.

 

We and our subsidiaries are party to various otherlegal actions as either a plaintiff or a defendant.  In our opinion, as of the date of this Form 10-Q, theseproceedings, either individually or in the aggregate, will not have a materialadverse effect on our financial position, our cash flows or our overall trendsin results. The estimate of the potential impact on our financial position, ouroverall results of operations or our cash flows for these proceedings couldchange in the future.

 

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

** **

**(a)**                                  Exhibits

 

The following exhibits are herebyincorporated into this Quarterly Report on Form 10-Q by reference to thereports and schedules identified below filed with the Securities and ExchangeCommission (“Commission”)**:**

 

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

 

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

 

10.1                          ForbearanceAgreement dated March 24, 2003 by and among Applied Digital Solutions, Inc. IBMCredit LLC, Digital Angel Corporation and the other parties named therein(incorporated by herein reference to Exhibit 10.1 to the Annual Report on Form10-K filed by the Company for the year ended December 31, 2002).

 

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

 

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

 

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

 

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

** **

During the three months ended March 31, 2003, theCompany filed a Current Report on Form 8-K dated March 6, 2003reporting the default by Applied Digital Solutions, Inc. under its CreditAgreement with IBM Credit LLC.

 

**SIGNATURE**

 

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

 
|               |   | DIGITAL  ANGEL CORPORATION |
|--------------------|--------|----------------------------|
|               |   | (Registrant)               |
|               |   |                       |   |
| Dated: May 8, 2003 |   | By:                        | /S/ JAMES P.  SANTELLI |   |
|               |   |                       | James P.  Santelli |   |
|               |   |                       | Vice President -  Finance and Chief Financial Officer |   |

 

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**CERTIFICATIONS**

 

I, James P. Santelli,certify that:

 

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

 

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

 

3.                                       Basedon my knowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Date: May 8, 2003

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

 

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I, Randolph K. Geissler, certify that:

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Date: May 8, 2003

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

 

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**INDEX TO EXHIBITS**

 

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

 

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

 

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

 

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