**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C. 20549**

 

# ****

# ** **

# **FORM 10-Q**

**(Mark One)**

 

| **ý**                                                                                                                | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934.**  |
|---------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                | ** **                                                                                                |
| **For the quarterly period ended March 31, 2005**                                                                    |
| ** **                                                                                                                | ** **                                                                                                |
| ** **                                                                                                                | **Or**                                                                                                    |
| ** **                                                                                                                | ** **                                                                                                |
| **o**                                                                                                                     | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934.** |
| ** **                                                                                                                | ** **                                                                                                |
| **For the transition period  from       to       ** |
| ** **                                                                                                                | ** **                                                                                                |
| **Commission File Number:  1-15177**                                                                                 |

 

**DIGITALANGEL CORPORATION**

(Exact name of registrant as specified in its charter)

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

 

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

Yes     ý    No     o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule12b-2of the Exchange Act).

Yes     o    No     ý

 

Asof the close of business on April 29, 2005, there were 43,931,314 sharesoutstanding of the issuer’s $0.005 per share par value common stock.

 

 

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**DIGITAL ANGEL CORPORATION**

 

TABLE OF CONTENTS

 
| **Item**                                  | ** ** | **Description**                                                                             | ** ** |
|-------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
|                                      |       |                                                                                        |       |
| PART I –  FINANCIAL INFORMATION |       |
|                                      |       |                                                                                        |       |
| 1.                                        |       | Financial  Statements                                                                       |       |
| 2.                                        |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |       |
| 3.                                        |       | Quantitative and Qualitative  Disclosures About Market Risk                                 |       |
| 4.                                        |       | Controls and Procedures                                                                     |       |
|                                      |       |                                                                                        |       |
| PART II – OTHER  INFORMATION    |       |
|                                      |       |                                                                                        |       |
| 1.                                        |       | Legal Proceedings                                                                           |       |
| 2.                                        |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                |       |
| 5.                                        |       | Other Information                                                                           |       |
| 6.                                        |       | Exhibits                                                                                    |       |
|                                      |       |                                                                                        |       |
| SIGNATURE                                 |       |
| CERTIFICATIONS                            |       |
| EXHIBITS                                  |       |

 

2

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**PART I    FINANCIAL INFORMATION**

 

Item1.             FinancialStatements.

 

**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(In thousands, except par value)

 
| ** **                                                                                                                                                                       | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **(Unaudited)**          | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                                       |       |                     |       |                        |       |
| **Current Assets**                                                                                                                                                               |       |                     |       |                        |       |
| Cash                                                                                                                                                                             |       | **$**                    | **14,872** | ** **                  | $          | 17,492 |   |
| Restricted cash                                                                                                                                                                  |       | **182**                  | ** ** | 327                         |       |
| Accounts receivable (net of allowance for doubtful accounts of $447  in 2005 and $241 in 2004)                                                                                   |       | **8,556**                | ** ** | 7,641                       |       |
| Inventories                                                                                                                                                                      |       | **7,955**                | ** ** | 6,232                       |       |
| Other current assets                                                                                                                                                             |       | **1,221**                | ** ** | 1,235                       |       |
| Due from Applied Digital Solutions, Inc.                                                                                                                                    |       | **388**                  | ** ** | **—**                  |       |
| Net assets from discontinued operations                                                                                                                                          |       | **—**               | ** ** | 6                           |       |
| **Total Current Assets**                                                                                                                                                         |       | **33,174**               | ** ** | 32,933                      |       |
|                                                                                                                                                                             |       | ** **               | ** ** |                        |       |
| **Property and Equipment, net**                                                                                                                                                  |       | **8,522**                | ** ** | 5,947                       |       |
| ** **                                                                                                                                                                       |       | ** **               | ** ** |                        |       |
| **Goodwill and Other Intangible Assets, net**                                                                                                                                    |       | **57,365**               | ** ** | 53,008                      |       |
| ** **                                                                                                                                                                       |       | ** **               | ** ** |                        |       |
| **Other Assets, net**                                                                                                                                                            |       | **623**                  | ** ** | 785                         |       |
| ** **                                                                                                                                                                       |       | **$**                    | **99,684** | ** **                  | $          | 92,673 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                   |       | ** **               | ** ** |                        |       |
| **Current Liabilities**                                                                                                                                                          |       | ** **               | ** ** |                        |       |
| Line of credit and current maturities of long-term debt                                                                                                                          |       | **$**                    | **2,105**  | ** **                  | $          | 99 |   |
| Accounts payable                                                                                                                                                                 |       | **5,518**                | ** ** | 3,936                       |       |
| Accrued expenses and other current liabilities                                                                                                                                   |       | **3,110**                | ** ** | 4,371                       |       |
| Deferred revenue                                                                                                                                                                 |       | **1,129**                | ** ** | 1,204                       |       |
| Due to Applied Digital Solutions, Inc.                                                                                                                                      |       | **—**               | ** ** | 23                          |       |
| Net liabilities from discontinued operations                                                                                                                                     |       | **79**                   | ** ** | —                      |       |
| **Total Current Liabilities**                                                                                                                                                    |       | **11,941**               | ** ** | 9,633                       |       |
| ** **                                                                                                                                                                       |       | ** **               | ** ** |                        |       |
| **Long-Term Debt And Notes Payable**                                                                                                                                             |       | **3,944**                | ** ** | 2,285                       |       |
| ** **                                                                                                                                                                       |       | ** **               | ** ** |                        |       |
| **Deferred Revenue**                                                                                                                                                             |       | **639**                  | ** ** | 744                         |       |
| ** **                                                                                                                                                                       |       | ** **               | ** ** |                        |       |
| **Total Liabilities**                                                                                                                                                            |       | **16,524**               | ** ** | 12,662                      |       |
| ** **                                                                                                                                                                       |       | ** **               | ** ** |                        |       |
| **Commitments And Contingencies (See Note 10)**                                                                                                                                  |       | ** **               | ** ** |                        |       |
| ** **                                                                                                                                                                       |       | ** **               | ** ** |                        |       |
| **Minority Interest**                                                                                                                                                            |       | **357**                  | ** ** | 249                         |       |
| ** **                                                                                                                                                                       |       | ** **               | ** ** |                        |       |
| **Stockholders’ Equity**                                                                                                                                                    |       | ** **               | ** ** |                        |       |
| Preferred stock: Authorized 1,000 shares, of $1.75 par value, 0  outstanding in 2005 and 1 outstanding in 2004                                                                   |       | **—**               | ** ** | 1                           |       |
| Common stock: Authorized 95,000 shares, of $.005 par value; 44,268  shares issued and 44,218 shares outstanding in 2005 and 43,475 shares issued  and 43,425 outstanding in 2004 |       | **222**                  | ** ** | 217                         |       |
| Additional paid-in capital                                                                                                                                                       |       | **211,729**              | ** ** | 207,875                     |       |
| Accumulated deficit                                                                                                                                                              |       | **(128,967**             | **)**      | (128,474                    | )          |
| Treasury stock (carried at cost, 100 in 2005 and 50 in 2004)                                                                                                                     |       | **(274**                 | **)**      | (43                         | )          |
| Accumulated other comprehensive income                                                                                                                                           |       | **93**                   | ** ** | 186                         |       |
| **Total Stockholders’ Equity**                                                                                                                                              |       | **82,803**               | ** ** | 79,762                      |       |
|                                                                                                                                                                             |       | **$**                    | **99,684** | ** **                  | $          | 92,673 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

3

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**DIGITALANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

(In thousands, except pershare data)

(Unaudited)

 
| ** **                                                                           | ** ** | **For the  Three Months  Ended March 31,** | ** **  |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------------|-------------|
| ** **                                                                           | ** ** | **2005**                                        | ** **  | **2004** | ** ** |
|                                                                                 |       |                                            |        |   |   |
| Product revenue                                                                      |       | **$**                                           | **12,697**  | ** ** | $ | 10,512 |   |
| Service revenue                                                                      |       | **706**                                         | ** **  | 259 |   |
| Total net revenue                                                                    |       | **13,403**                                      | ** **  | 10,771 |   |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Cost of products sold                                                                |       | **7,103**                                       | ** **  | 6,129 |   |
| Cost of services sold                                                                |       | **305**                                         | ** **  | 113 |   |
|                                                                                 |       | ** **                                      |        |   | ** ** |
| Gross profit                                                                         |       | **5,995**                                       | ** **  | 4,529 |   |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Selling, general and administrative expenses                                         |       | **5,328**                                       | ** **  | 4,424 |   |
| Research and development expenses                                                    |       | **1,086**                                       | ** **  | 669 |   |
| Operating loss                                                                       |       | **(419**                                        | **)**       | (564 | ) |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Interest income                                                                      |       | **76**                                          | ** **  | 8 |   |
| Interest expense                                                                     |       | **(101**                                        | **)**       | (257 | ) |
| Realized and unrealized losses on Applied Digital Solutions, Inc.  common stock |       | **—**                                      | ** **  | (2,586 | ) |
| Other income                                                                         |       | **26**                                          | ** **  | 40 |   |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Loss before minority interest share of income and discontinued operations            |       | **(418**                                        | **)**       | (3,359 | ) |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Minority interest share of income                                                    |       | **(75**                                         | **) ** | (6 | ) |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Net loss from continuing operations                                                  |       | **(493**                                        | **)**       | (3,365 | ) |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Loss from discontinued operations                                                    |       | **—**                                      | ** **  | (379 | ) |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Net loss                                                                             |       | **$**                                           | **(493**    | **)** | $ | (3,744 | ) |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Loss per common share - basic and diluted                                            |       | ** **                                      | ** **  |   |   |
| Net loss from continuing operations                                                  |       | **$**                                           | **(0.01**   | **)** | $ | (0.11 | ) |
| Net loss from discontinued operations                                                |       | **—**                                      | ** **  | (0.01 | ) |
| Net loss per common share - basic and diluted                                        |       | **$**                                           | **(0.01**   | **)** | $ | (0.12 | ) |
|                                                                                 |       | ** **                                      | ** **  |   |   |
| Weighted average number of common shares outstanding – basic and  diluted       |       | **43,666**                                      | ** **  | 30,468 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

4

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**DIGITALANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

**For TheThree Months Ended March 31, 2005**

(In Thousands)

(Unaudited)

 
| ** **                                                        | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Treasury  Stock** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Total  Stockholders’    Equity** | ** ** |
|-------------------------------------------------------------------|------------|------------------|------------|------------|------------|------------|------------|------------|------------|----------------------------------|------------|--------------------------|------------|---------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                        | ** ** | ** **       | ** ** | ** ** | ** ** | ** ** |
| **Preferred Stock**                                               | ** ** | **Common Stock** |
| **Number**                                                        | ** ** | **Amount**       | ** ** | **Number** | ** ** | **Amount** |
|                                                              |       |             |       |       |       |       |       |       |       |                             |       |                     |       |                |       |                                                      |       |                                         |       |
| **Balance -  December 31, 2004**                             |       | —           |       | $          | 1          |       | 43,425     |       | $          | 217                              |       | $                        | 207,875    |                | $          | (128,474                                                  | )          | $                                            | (43        | ) | $ | 186 |   | $ | 79,762 |   |
| Net loss                                                          |       |             |       |       |       | —     |       | —     |       | —                           |       | (493                     | )          | —              |       | —                                                    |       | (493                                         | )          |
| Comprehensive loss - Foreign  currency translation                |       | —           |       | —     |       | —     |       | —     |       | —                           |       | —                   |       | —              |       | (93                                                       | )     | (93                                          | )     |
| Total comprehensive income (loss)                                 |       | —           |       | —     |       | —     |       | —     |       | —                           |       | (493                     | )          | —              |       | (93                                                       | )     | (586                                         | )          |
| Purchase of treasury stock                                        |       | —           |       | —     |       | —     |       | —     |       | —                           |       | —                   |       | (231                | )     | —                                                    |       | (231                                         | )     |
| Issuance of common stock to  Applied Digital Solutions, Inc. |       | —           |       | —     |       | 644        |       | 3          |       | 3,497                            |       | —                   |       | —              |       | —                                                    |       | 3,500                                        |       |
| Conversion of Series A  Preferred Stock                      |       | —           |       | (1         | )          | 14         |       | 1          |       | —                           |       | —                   |       | —              |       | —                                                    |       | —                                       |       |
| Exercise of stock options                                         |       | —           |       | —     |       | 20         |       | —     |       | 55                               |       | —                   |       | —              |       | —                                                    |       | 55                                           |       |
| Exercise of warrants                                              |       | —           |       | —     |       | 115        |       | 1          |       | 302                              |       | —                   |       | —              |       | —                                                    |       | 303                                          |       |
| **Balance –  March 31, 2005**                           |       | —           |       | $          | —     |       | 44,218     |       | $          | 222                              |       | $                        | 211,729    |                | $          | (128,967                                                  | )          | $                                            | (274       | ) | $ | 93 |   | $ | 82,803 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

5

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**DIGITALANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

(In thousands)

(Unaudited)

 
| ** **                                                                            | ** ** | **For the  Three Months  Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                        | ** ** | **2004** | ** ** |
| **Cash Flows From Operating Activities**                                              |       |                                            |       |   |   |
| Net loss from continuing operations                                                   |       | **$**                                           | **(493**   | **)** | $ | (3,365 | ) |
|                                                                                  |       | ** **                                      | ** ** |   |   |
| Adjustments to reconcile net (loss) income to net cash used in  operating activities: |       | ** **                                      | ** ** |   |   |
| Loss from discontinued operations                                                     |       | —                                          | ** ** | (379 | ) |
| Amortization of debt discount and deferred financing charges                          |       | —                                          | ** ** | 86 |   |
| Depreciation and amortization                                                         |       | **502**                                         | ** ** | 486 |   |
| Minority interest                                                                     |       | **76**                                          | ** ** | 6 |   |
| Loss on ADS common stock                                                              |       | —                                          | ** ** | 2,586 |   |
| Change in assets and liabilities:                                                     |       | ** **                                      | ** ** |   |   |
| Decrease (increase) in restricted cash                                                |       | **129**                                         | ** ** | (20 | ) |
| Decrease (increase) in accounts receivable                                            |       | **229**                                         | ** ** | (2,115 | ) |
| (Increase) decrease in inventories                                                    |       | **(487**                                        | **)**      | 937 |   |
| Increase in deferred costs                                                            |       | —                                          | ** ** | (72 | ) |
| Increase in other current assets                                                      |       | **(15**                                         | **)**      | (140 | ) |
| Net increase in due from / due to ADS                                                 |       | **(411**                                        | **)**      | (232 | ) |
| Increase in other assets                                                              |       | **(26**                                         | **)**      | (126 | ) |
| Decrease in accounts payable, accrued expenses and deferred revenue                   |       | **(1,072**                                      | **)**      | (357 | ) |
| Net cash provided by discontinued operations                                          |       | **85**                                          | ** ** | 305 |   |
| **Net Cash Used In Operating Activities**                                             |       | **(1,483**                                      | **)**      | (2,400 | ) |
|                                                                                  |       | ** **                                      | ** ** |   |   |
| **Cash Flows From Investing Activities**                                              |       | ** **                                      | ** ** |   |   |
| Proceeds from sale of Applied Digital common stock                                    |       | —                                          | ** ** | 1,421 |   |
| Payments for property and equipment                                                   |       | **(375**                                        | **)**      | (100 | ) |
| Cash (used in) acquired through acquisition, net of acquisition costs                 |       | **(871**                                        | **)**      | 85 |   |
| **Net Cash (Used In) Provided by Investing  Activities**                              |       | **(1,246**                                      | **)**      | 1,406 |   |
|                                                                                  |       | ** **                                      | ** ** |   |   |
| **Cash Flows From Financing Activities**                                              |       | ** **                                      | ** ** |   |   |
| Amounts borrowed on line of credit                                                    |       | —                                          | ** ** | 8,640 |   |
| Amounts paid on line of credit                                                        |       | **(32**                                         | **)**      | (7,826 | ) |
| Net amounts borrowed on notes payable                                                 |       | —                                          | ** ** | 367 |   |
| Payments on long-term debt                                                            |       | **(54**                                         | **)**      | (323 | ) |
| Purchase of treasury stock                                                            |       | **(231**                                        | **)**      | — |   |
| Exercise of stock options and warrants                                                |       | **358**                                         | ** ** | 990 |   |
| **Net Cash Provided By Financing Activities**                                         |       | **41**                                          | ** ** | 1,848 |   |
|                                                                                  |       | ** **                                      | ** ** |   |   |
| **Effect of Exchange Rate Changes on Cash**                                           |       | **68**                                          | ** ** | (58 | ) |
| ** **                                                                            |       | ** **                                      | ** ** |   |   |
| **Net (Decrease) Increase In Cash**                                                   |       | **(2,620**                                      | **)**      | 796 |   |
| ** **                                                                            |       | ** **                                      | ** ** |   |   |
| **Cash - Beginning Of Period**                                                        |       | **17,492**                                      | ** ** | 894 |   |
| ** **                                                                            |       | ** **                                      | ** ** |   |   |
| **Cash - End Of Period**                                                              |       | **$**                                           | **14,872** | ** ** | $ | 1,690 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

6

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**DIGITALANGEL CORPORATION**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Dollars inthousands)**

**(Unaudited)**

 

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

 

DigitalAngel Corporation and subsidiaries (“the Company”) develops and deploys sensorand communications technologies that enable rapid and accurate identification,location tracking, and condition monitoring of high-value assets.  The Company operates in two segments: AnimalApplications and GPS and Radio Communications.

 

*AnimalApplications—* develops, manufactures, andmarkets a broad line of electronic and visual identification devices for thecompanion animal, livestock, laboratory animal, fish and wildlife marketsworldwide.  The positive identificationand tracking of cattle and hogs are crucial for asset management and for diseasecontrol and food safety. In addition to the visual ear tags, which have beensold by the Company since the late 1940’s, Animal Applications utilizes radiofrequency transmission technologies in its electronic ear tags and implantablemicrochips.

 

*GPS and RadioCommunications—*consists of the design, manufactureand support of GPS enabled equipment. Applications for the segment’s productsinclude location tracking and message monitoring of vehicles, aircraft andpeople in remote locations through systems that integrate GPS andgeosynchronous satellite communications and GPS enabled equipment andintelligent communications products and services for telemetry, mobile data andradio communications applications serving commercial and military markets. Technologydevelopment in this segment includes the integration and miniaturization intomarketable products of twotechnologies: wireless communications and position location technology(including global positioning systems (GPS) and other systems).

 

OnFebruary 28, 2005, the Company acquired Denmark-based DSDHoldings A/S and its wholly-owned subsidiaries Daploma International A/S andDigitag A/S.  DSD Holdings A/S became awholly-owned subsidiary of Digital Angel Corporation.  DSD Holdings A/S produces visual and radiofrequency identification (“RFID”) tags as well as tamper-proof seals forpacking and shipping applications.  DSDHoldings A/S’s operations are included from the date of acquisition.   

 

Asof March 31, 2005, Applied Digital Solutions, Inc. (“Applied Digital”or “ADS”) owned 24,291,673 shares or 55.1% of the Company’s common stock.

 

The accompanying unauditedcondensed consolidated financial statements of the Company as of March 31,2005 and for the three month periods ended March 31, 2005 and 2004 havebeen prepared in accordance with accounting principles generally accepted inthe United States of America for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-Xunder the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for complete financial statements. In the opinion of the Company’s management, all adjustments (includingnormal recurring adjustments) considered necessary to present fairly thefinancial statements have been made.

 

The consolidated statements ofoperations for the three months ended March 31, 2005 and 2004 are notnecessarily indicative of the results that may be expected for the entireyear.  These statements should be read inconjunction with the Digital Angel Corporation’s audited consolidated financialstatements and related notes thereto for the year ended December 31, 2004which are included in the Company’s Annual Report on Form 10-K.

 

Certainitems in the condensed consolidated financial statements for the 2004 periodshave been reclassified for comparative purposes.

 

7

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

 

The March 31, 2005 and 2004condensed consolidated financial statements include the accounts of the Companyand its wholly-owned and majority-owned subsidiaries (DSD Holdings A/S from thedate of acquisition on February 28, 2005 and OuterLink Corporation fromthe date of acquisition on January 22, 2004).  All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

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

 

The Company, except for itssubsidiary OuterLink Corporation, recognizes product revenue at the time product is shipped and title hastransferred, provided that a purchase order has been received or a contract hasbeen executed, there are no uncertainties regarding customer acceptance, thesales price is fixed and determinable and collectibility is deemed probable. Ifuncertainties regarding customer acceptance exist, revenue is recognized whensuch uncertainties are resolved. There are no significant post-contract supportobligations at the time of revenue recognition. Digital Angel Corporation’saccounting policy regarding vendor and post contract support obligations isbased on the terms of the customers’ contracts, billable upon occurrence of thepost-sale support. Costs of products sold and services provided are recorded asthe related revenue is recognized. Digital Angel Corporation offers a warrantyon its products.  For non-fixed and fixedfee jobs, service revenue is recognized based on the actual direct labor hoursin the job multiplied by the standard billing rate and adjusted to netrealizable value, if necessary.  Otherrevenue is recognized at the time service or goods are provided.  It is the Company’s policy to record contractlosses in their entirety in the period in which such losses are foreseeable.

 

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

 

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

 

The Company applies APB Opinion No. 25and related Interpretations in accounting for all its stock option plans.  Accordingly, no compensation cost has beenrecognized under these plans.  TheCompany has adopted the disclosure-only provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation” and SFAS No. 148, “Accounting forStock-Based Compensation-Transition and Disclosure,” which was released in December 2002as an amendment to SFAS No. 123. The following table illustrates the effect on net 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,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Reported net loss                                                                                                   |       | **$**                                  | **(493**   | **)** | $ | (3,744 | ) |
| Stock-based employee compensation expense in reported net loss, net  of related tax effects                         |       | **—**                             | ** ** | **—** |   |
| Stock-based employee compensation expense determined under the fair  value based method, net of related tax effects |       | **(1,275**                             | **)**      | (1,501 | ) |
| Pro forma net loss                                                                                                  |       | **$**                                  | **(1,768** | **)** | $ | (5,245 | ) |
|                                                                                                                |       | ** **                             | ** ** |   |   |
| Loss per share (basic and diluted)                                                                                  |       | ** **                             | ** ** |   |   |
| As reported                                                                                                         |       | **$**                                  | **(0.01**  | **)** | $ | (0.12 | ) |
| Pro forma                                                                                                           |       | **$**                                  | **(0.04**  | **)** | $ | (0.17 | ) |

 

8

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In December 2004,  SFAS No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R) was issued.  SFAS123R replaced SFAS No. 123 and supercedes APB Opinion No. 25.  The Company is required to adopt SFAS 123Rbeginning January 1, 2006.  SFAS123R requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the financial statements based ontheir fair values.  The pro formadisclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. The Company has begun, but has not completed, evaluating the impact ofthe adoption of SFAS 123R on its results of operations.  In connection with evaluating the impact ofSFAS 123R, the Company is considering the potential implementation of differentvaluation methods to determine the fair value of share-based compensation.  The Company believes the adoption of SFAS123R will have a material impact on its results of operations, regardless ofthe valuation method used.

 

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

 
| ** **                            | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Raw materials                         |       | **$**                    | **4,179**  | ** **                  | $          | 3,115 |   |
| Work in process                       |       | **105**                  | ** ** | 137                         |       |
| Finished goods                        |       | **5,614**                | ** ** | 4,895                       |       |
|                                  |       | **9,898**                | ** ** | 8,147                       |       |
| Allowance for excess and obsolescence |       | **(1,943**               | **)**      | (1,915                      | )          |
| Net inventory                         |       | **$**                    | **7,955**  | ** **                  | $          | 6,232 |   |

 

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

 

On February 25, 2005, theCompany entered into aStock Purchase Agreement with Applied Digital. Pursuant to the agreement, the Company issued 644,140 shares of itscommon stock to Applied Digital.  TheCompany received 684,543 shares of Applied Digital common stock as consideration.  The value of the stock exchanged was $3.5million. The Applied Digital common stock received by the Company was used aspartial consideration for the acquisition of DSD Holdings A/S and itswholly-owned subsidiaries, Daploma International A/S and Digitag A/S, asdescribed more fully in note 9.

 

On March 1, 2004, the Companyissued 3,000,000 shares of its common stock to Applied Digital pursuant to theStock Purchase Agreement (“Stock Purchase Agreement”) with Applied Digitaldated August 14, 2003.  The StockPurchase Agreement provided for Applied Digital to purchase 3,000,000 shares ofthe Company’s common stock at a price of $2.64 per share and a warrant (the “AppliedDigital Warrant”) to purchase up to 1,000,000 shares of the Company’s commonstock, which is exercisable for five years beginning February 1, 2004, at aprice per share of $3.74 payable in cash or shares of common stock of AppliedDigital.  The consideration for the saleof the Company’s 3,000,000 shares and the warrant was 1,980,000 shares ofApplied Digital common stock.  As of March 31,2004, the Company had sold 530,000 shares of Applied Digital common stock.  The Company accounted for the Applied Digitalstock as a trading security under SFAS 115, “Accounting for Certain Investmentsin Debt and Equity Securities”.  In thequarter ended March 31, 2004, the Company recorded realized losses of$702,000 on the 530,000 shares of Applied Digital common stock sold and anunrealized loss of $1,884,000 on the remaining 1,450,000 shares held by theCompany.  Fair value of the AppliedDigital common stock was determined by quoted values reported on NASDAQ.  As of December 31, 2004, the Company hadsold all of the 1,980,000 shares of Applied Digital common stock for $6.4million.  In December 2004, AppliedDigital exercised its warrant for 1,000,000 shares of common stock.  Net proceeds to the Company upon exercise ofthe warrant were $3.74 million.    

 

9

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

 

In April 2004, ourBoard of Directors approved a plan to sell our Medical Systems segment. TheMedical Systems segment represented the business operations of Medical AdvisorySystems, Inc, which we acquired on March 27, 2002.  The Medical Systems segment was one of ourreporting units in accordance with SFAS 142, “Goodwill and Other IntangibleAssets”.  Accordingly, the financialcondition, results of operations and cash flows of our Medical Systems segmenthave been reported as discontinued operations for all periods presented. Thefollowing discloses the operating losses from discontinued operations for thethree months ended March 31, 2005 and 2004, consisting of lossesattributable to the Medical Systems segment:

 
| ** **                                    | ** ** | **Three-Months  Ended March 31,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                    | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Product revenue                               |       | $                                      | —     |   | $ | 165 |   |
| Service revenue                               |       | —                                 |       | 190 |   |
| Total revenue                                 |       | —                                 |       | 355 |   |
| Cost of products sold                         |       | —                                 |       | 66 |   |
| Cost of services sold                         |       | —                                 |       | 236 |   |
| Total cost of products and services sold      |       | —                                 |       | 302 |   |
| Gross profit                                  |       | —                                 |       | 53 |   |
| Selling, general and administrative  expenses |       | —                                 |       | 399 |   |
| Other expense                                 |       | —                                 |       | 33 |   |
| Loss from discontinued operations             |       | $                                      | —     |   | $ | (379 | ) |

 

The above results do notinclude any allocated or common overhead expenses.  No benefit has been provided for income taxeson the losses attributable to the Medical Systems division.  The Company does not anticipate the MedicalSystems division incurring additional losses in the future.  However, in accordance with SFAS 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”, any additional operatinglosses or changes in the values of assets or liabilities will be reflected inthe financial condition and results of operations as incurred.

 

The net (liabilities) assets of discontinued operations as March 31,2005 and December 31, 2004, were comprised of the following:

 
| ** **                                              | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|---------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                              | ** ** | **(in thousands)**      | ** ** |
| Assets                                                  |       |                    |       |                       |       |
| Accounts receivable, net                                |       | $                       | —     |                       | $          | — |   |
| Inventory                                               |       | —                  |       | —                     |       |
| Other current assets                                    |       | —                  |       | —                     |       |
| Property and equipment, net                             |       | —                  |       | —                     |       |
| Goodwill and other intangible assets, net               |       | —                  |       | —                     |       |
| Other assets                                            |       | 35                      |       | 135                        |       |
| Total Assets                                            |       | $                       | 35         |                       | $          | 135 |   |
|                                                    |       |                    |       |                       |       |
| Current Liabilities:                                    |       |                    |       |                       |       |
| Notes payable and current maturities of  long-term debt |       | $                       | —     |                       | $          | — |   |
| Accounts payable                                        |       | —                  |       | —                     |       |
| Accrued expenses and deferred revenue                   |       | 114                     |       | 129                        |       |
| Total Liabilities                                       |       | $                       | 114        |                       | $          | 129 |   |
|                                                    |       |                    |       |                       |       |
| Net (Liabilities) Assets                                |       | $                       | (79        | )                          | $          | 6 |   |

 

10

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**8.****                                     ****Segment Information**

 

The Company is an advanced technology company in the field of rapid andaccurate identification, location tracking, and condition monitoring of high-valueassets.  The Company’s operating segmentsare: Animal Applications and GPS and Radio Communications.  During 2004, Digital Angel Corporation soldsubstantially all the assets related to its Medical Systems segment’s medicalservices business.  

 

It is on this basis that managementutilizes the financial information to assist in making internal operatingdecisions.  The Company evaluatesperformance based on stand-alone segment operating income.

 

Following is the selected segmentdata as of and for the three months ended March 31, 2005 (in thousands):

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

 

Following is the selected segmentdata as of and for the three months ended March 31, 2004 (in thousands):

 
| ** **                                                                 | ** ** | **Animal  Applications** | ** ** | **GPS and  Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------------|------------|------------------------------|------------|------------------|------------|
|                                                                       |       |                     |       |                               |       |                         |       |             |       |
| Net revenue from external customers:                                       |       |                     |       |                               |       |                         |       |             |       |
|                                                                       |       |                     |       |                               |       |                         |       |             |       |
| Product                                                                    |       | $                        | 7,009      |                               | $          | 3,503                        |       | $                | —     |   | $ | 10,512 |   |
| Service                                                                    |       | 63                       |       | 196                                |       | —                       |       | 259              |       |
| Total revenue                                                              |       | $                        | 7,072      |                               | $          | 3,699                        |       | $                | —     |   | $ | 10,771 |   |
|                                                                       |       |                     |       |                               |       |                         |       |             |       |
| Loss before minority interest share of income and discontinued  operations |       | $                        | (2,642     | )                                  | $          | (717                         | )          | $                | —     |   | $ | (3,359 | ) |
|                                                                       |       |                     |       |                               |       |                         |       |             |       |
| Total assets                                                               |       | $                        | 65,320     |                               | $          | 16,498                       |       | $                | 564        |   | $ | 82,382 |   |

 

11

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

 

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

 
| **Company  Acquired** | ** ** | **Date  Acquired** | ** ** | **Acquisition  Price** | ** ** | **Goodwill  and  Other Intangibles  Acquired** | ** ** | **Other Net  Assets and  Liabilities** | ** ** | **Business  Description** | ** ** |
|-----------------------|------------|--------------------|------------|------------------------|------------|------------------------------------------------|------------|----------------------------------------|------------|---------------------------|------------|
| DSD Holdings A/S      |       | 2/28/05            |       | $                      | 3,697      |                                           | $          | 4,544                                  |       | $                         | (847       | ) | Manufactures and  markets visual and electronic RFID tags for livestock. |   |
| OuterLink Corporation |       | 1/22/04            |       | $                      | 8,501      |                                           | $          | 8,522                                  |       | $                         | (21        | ) | Provider of  real-time, satellite-based automated tracking, wireless data transfer and  two-way messaging with large fleets of vehicles. |   |

 

On February 28, 2005, theCompany acquired DSD Holdings A/S and its wholly-owned subsidiaries DaplomaInternational A/S and Digitag A/S.  DSDHoldings A/S became a wholly-owned subsidiary of Digital Angel Corporation.  The acquisition was accounted for under the purchasemethod of accounting.   The excess ofpurchase price over the fair value of the assets and liabilities of DSDHoldings A/S has been recorded as goodwill. The acquisition of DSD Holdings A/S has been recorded based onpreliminary estimates as of the date of acquisition.  Any changes to the preliminary estimatesduring the allocation period will be reflected as an adjustment togoodwill.  

 

Under theterms of the DSD Holdings A/S acquisition, the Company purchased all of theoutstanding capital stock of DSD Holdings A/S in consideration for a purchaseprice of seven times DSD Holdings A/S’s average annual EBITDA over the nextthree years less outstanding indebtedness at the end of the time period andless 30% of the total compensation paid to Lasse Nordfjeld, CEO of DSD HoldingsA/S.  An initial payment of $3.5 millionwas made at closing through the delivery of Applied Digital common stock valuedat $3.5 million which the Company acquired from Applied Digital in exchange for$3.5 million of Digital Angel Corporation common stock.

 

In addition,Digital Angel entered into employment agreements with the CEO of DSD HoldingsA/S and its subsidiaries, Lasse Nordfjeld and his son, the President ofDaploma, Torsten Nordfjeld.

 

Denmark-basedDSD Holdings A/S through its subsidiaries manufactures and markets visual andelectronic RFID tags for livestock as well as tamper-proof seals for packing andshipping applications.  The company has been in business formore than 30 years and has successfully developed markets in the Middle East,Japan, Australia and throughout Europe, particularly in Eastern Europe wherenew European Union entrants have to meet strict livestock tagging and trackingstandards.

 

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

 

12

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On January 22, 2004, the Companyacquired OuterLink Corporation, which became a wholly-owned subsidiary ofDigital Angel Corporation.  Theacquisition was accounted for under the purchase method of accounting.   The excess of purchase price over the fairvalue of the assets and liabilities of OuterLink Corporation was recorded asgoodwill of $3.8 million and intangible assets of $4.7 million. The intangibleassets are customer relationships, trademarks and core technology.  The customer relationships and coretechnology are being amortized over periods ranging from 4 to 8 years.  Amortization recorded in the three monthsended March 31, 2005 and 2004 was $0.2 million and $0.1 million,respectively.  The trademark has anindefinite life.

 

The cost of the acquisition consisted of100,000 shares of Series A preferred stock valued at $8.3 million andacquisition costs of $0.2 million.  The Series Apreferred stock became convertible into four million shares of the Company’scommon stock when the volume weighted average price of the Company’s commonstock equals or exceeds $4.00 per share for ten consecutive trading days.  As of March 31, 2005, 99,976 preferredshares had been converted into 3.9 million shares of the Company’s commonstock.

 

The valuation of the stock was primarilybased on historical trading history and stock prices of the Company’s commonstock and a marketability discount of 30%. The acquisition costs consist of legal and accounting related servicesthat were direct costs of the acquisition.

 

In considering the benefits of the OuterLinkCorporation acquisition, the management of Digital Angel Corporation recognizedthe strategic complement of OuterLink Corporation’s technologies and customerbase with Digital Angel Corporation’s existing animal applications and militaryGPS business lines.  This complementprovides for a strong platform for further development of Digital AngelCorporation’s capabilities in the area of high-value asset identification,tracking and condition monitoring.

 

The results of DSD Holdings A/S andOuterLink Corporation have been included in the consolidated financialstatements since their dates of acquisition, February 28, 2005 and January 22,2004, respectively.  Unaudited pro formaresults of operations for the three months ended March 31, 2005 and 2004are included below.  Such pro formainformation assumes that the above acquisitions had occurred as of January 1,2005 and 2004, and revenue is presented in accordance with the Company’saccounting policies.  This summary is notnecessarily indicative of what the results of operations of the Company wouldhave been had it been a combined entity during such periods, nor does itpurport to represent results of operations for any future periods.

 
| ** **                                    | ** ** | **For the  three months ended March 31,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------|------------|
| **(In thousands)**                            | ** ** | **2005**                                       | ** ** | **2004** | ** ** |
| Net revenue                                   |       | $                                              | 14,286     |   | $ | 11,811 |   |
| Net loss                                      |       | $                                              | (524       | ) | $ | (4,616 | ) |
| Net loss per common share - basic and diluted |       | $                                              | (0.01      | ) | $ | (0.15 | ) |

 

 

**10.****                              ****Contingencies**

 

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

 

On October 20,2004, the Company commenced an action in the United Stated District Court forthe District of Minnesota against AllFlex USA, Inc. and Pet HealthServices (USA), Inc.  This suitclaims that Allflex is marketing and selling a syringe implantableidentification transponder that infringes a 1993 patent granted to the Companyfor syringe implantable identification transponders previously found by theUnited States District Court for the District of Colorado to beenforceable.  The suit also claims thatPetHealth is using, selling and/or distributing the same transponder inviolation of the Company’s patent.  Thesuit seeks, among other things, an adjudication of infringement and that theinfringing parties be enjoined from further improper action.  The suit also seeks actual damages, punitivedamages and interest, costs and attorneys’ fees.  The Company believes that the suit iswell-grounded in law and fact.  Allflexhas asserted a counterclaim for breach of contract of an existing licenseagreement between the Company and Allflex and asserted a counterclaim seeking adeclaration of the parties’ rights and obligations under the licenseagreement.  Allflex has also moved for ajudgment on the pleadings, asserting that the license agreement should act as abar to a case for infringement.  TheCompany has contested the motion on the ground that Allflex’s actions exceedthe scope of the license and constitute an impermissible infringement of thepatent.  A hearing on this motion washeld on March 22, 2005, but the court has not yet ruled on themotion.  Discovery in the action has beencommenced and is continuing.

 

13

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

 

On October 20,2004, the Company commenced an action in the United States District Court forthe District of Minnesota against Datamars, Inc., Datamars, S.A., TheCrystal Import Corporation, and Medical Management International, Inc. (“Banfield”).  This suit claims that the defendants aremarketing and selling syringe implantable identification transpondersmanufactured by Datamars that infringe the Company’s 1993 patent for syringeimplantable identification transponders previously found by the United StatesDistrict Court for the District of Colorado to be enforceable.  Certain of the locations in which theinfringing transponders are sold, include, but are not limited to, “Banfield,The Pet Hospital” of which certain locations are associated with PetSmartstores.  The suit seeks, among otherthings, an adjudication of infringement and that the infringing parties beenjoined from further improper action. The suit also seeks actual damages, punitive damages and interest, costsand attorneys’ fees.  The Companybelieves that the suit is well-grounded in law and fact.  Discovery in the action has been commencedand is continuing.

 

*Crystal v. Digital Angel, et al.*

 

On or about December 29,2004 The Crystal Import Corporation filed an action against AVID IdentificationSystems, Inc. and Digital Angel in the United States District Court forthe Northern District of Alabama. Crystal’s complaint primarily asserts federal and state antitrust andrelated claims against AVID, though it also asserts similar claims againstDigital Angel.  Given the uncertaintiesassociated with all litigation and given that this case was not commencedagainst Digital Angel until February 2, 2005, the Company is unable tooffer any assessment on the potential liability exposure, if any, to DigitalAngel from this lawsuit.  The Company hasfiled a motion to dismiss the action for failure to state a claim on whichrelief could be granted, or in the alternative, to have the action transferredto the United States District Court for the District of Minnesota forconsolidation with the Datamars patent infringement action referred to above orto have the action stayed until the completion of the Datamars action.  The parties have filed briefs on the motion,but an oral argument has not been held, and no ruling on the motion has beenmade.  Discovery in the action has beencommenced and is continuing.

 

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

 
| ** **                                           | ** ** | **Three Months  Ended March 31,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                           | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Interest paid                                        |       | **$**                                  | **89**     |   | $ | 132 |   |
| Taxes paid                                           |       | —                                 |       | 9 |   |
| Non-cash activity:                                   |       | ** **                             |       |   |   |
| Issuance of preferred stock for business acquisition |       | **$**                                  | —     |   | 8,300 |   |
| Issuance of common stock for ADS common stock        |       | **3,500**                              |       | 7,920 |   |
|                                                      |            |                                        |            |  |  |  |  |

 

 

**12.****                              ****Related Party Activity**

 

The Company has executed anexclusive eleven year Distribution and Licensing Agreement dated March 4,2002 with Verichip Corporation (Verichip), a wholly-owned subsidiary of AppliedDigital, covering the manufacturing, purchasing and distribution of Verichip’simplantable microchip and the maintenance of the Verichip Registry by theCompany.  The agreement includes alicense for the use of the Company’s technology in Verichip’s identifiedmarkets.  The Company will be the solemanufacturer and supplier to Verichip. Revenue recognized under the Distribution and Licensing Agreement was$386,000 and $49,000 for the three months ended March 31, 2005 and 2004,respectively.  

 

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

 

14

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

 

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

 

Weconsist of Digital Angel Corporation and its six subsidiaries - Digital AngelTechnology Corporation (“DATC”), Timely Technology Corp., Signature IndustriesLimited, OuterLink Corporation, DSD Holdings A/S and Digital AngelInternational, Inc.

 

**RESULTS OFOPERATIONS**

 

Thefollowing table summarizes our results of operations as a percentage of netoperating revenue for the three months ended March 31, 2005 and 2004 andis derived from the accompanying consolidated statements of operations includedin this report.

 
| ** **                                                                 | ** ** | **Three Months  Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | **%**                                   | ** ** | **%** | ** ** |
| Product revenue                                                            |       | 94.7                                    |       | 97.6 |   |
| Service revenue                                                            |       | 5.3                                     |       | 2.4 |   |
| Total net revenue                                                          |       | 100.0                                   |       | 100.0 |   |
| Cost of products sold                                                      |       | 53.0                                    |       | 56.9 |   |
| Cost of services sold                                                      |       | 2.3                                     |       | 1.0 |   |
| Total cost of products and services sold                                   |       | 55.3                                    |       | 57.9 |   |
| Gross profit                                                               |       | 44.7                                    |       | 42.0 |   |
| Selling, general and administrative expenses                               |       | 39.8                                    |       | 41.1 |   |
| Research and development expenses                                          |       | 8.1                                     |       | 6.2 |   |
| Operating loss                                                             |       | (3.1                                    | )          | (5.2 | ) |
| Interest income                                                            |       | 0.6                                     |       | 0.1 |   |
| Interest expense                                                           |       | (0.8                                    | )          | (2.4 | ) |
| Realized and unrealized losses on Applied Digital common stock             |       | —                                  |       | (24.0 | ) |
| Other income                                                               |       | 0.2                                     |       | 0.4 |   |
| Loss before minority interest share of income and discontinued  operations |       | (3.1                                    | )          | (31.2 | ) |
| Minority interest share of income                                          |       | (0.6                                    | )          | (0.1 | ) |
| Net loss from continuing operations                                        |       | (3.7                                    | )          | (31.3 | ) |
| Loss from discontinued operations                                          |       | —                                  |       | (3.5 | ) |
| Net loss                                                                   |       | (3.7                                    | )          | (34.8 | ) |

 

**Three Months EndedMarch 31, 2005 Compared to the Three Months Ended March 31, 2004**

 

**Revenue**

 

Revenuefor the three months ended March 31, 2005 increased $2.6 million, or24.4%, to $13.4 million when compared to $10.8 million in revenue for the threemonths ended March 31, 2004.

 

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

 
| ** **                   | ** ** | **Three Months  Ended March 31,  2005** | ** ** | **Three Months  Ended March 31,  2004** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Animal Applications          |       | $                                            | 8,297      |                                         | $          | 7,072 |   |
| GPS and Radio Communications |       | 5,106                                        |       | 3,699                                        |       |
| Total                        |       | $                                            | 13,403     |                                         | $          | 10,771 |   |

 

15

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TheAnimal Applications segment’s revenue increased**$1.2 million, or 17.3%, in the three months ended March 31,2005 compared to the three month period ended March 31, 2004. The increasein revenue was principally due to an increase in microchip and visual productsales to livestock customers of $0.7, an increase in microchip sales to companionanimal customers of $0.1 million and the inclusion of $0.6 million of revenuefrom DSD Holdings A/S.  DSD Holdings A/Swas acquired on February 28, 2005.  Theincrease in sales is offset by a decrease in sales to fish and wildlife andother customers of $0.2 million.

 

TheGPS and Radio Communications segment’s revenue increased $1.4 million, or 38.0%to $5.1 million in the three months ended March 31, 2005 from $3.7 millionin the three months ended March 31, 2004. The increase primarily relates to increased revenue at our subsidiary,Signature Industries, related to shipments of the G2R pilot locator beacon tofulfill a contract with the government of India.

 

**Gross Profit andGross Profit Margin**

 

Grossprofit for the three month period ended March 31, 2005 was $6.0 million, anincrease**of $1.5 million, or 32.4%,compared to $4.5 million in the three month period ended March 31, 2004.As a percentage of revenue, the gross profit margin increased to 44.7% for thethree months ended March 31, 2005 from 42.0% for the three months endedMarch 31, 2004.

 

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

 
| ** **                   | ** ** | **Three Months  Ended March 31,  2005** | ** ** | **Three Months  Ended March 31,  2004** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Animal Applications          | ** ** | $                                            | 3,414      |                                         | $          | 2,806 | ** ** |
| GPS and Radio Communications |       | 2,581                                        |       | 1,723                                        |       |
| Total                        |       | $                                            | 5,995      |                                         | $          | 4,529 |   |

 

Grossprofit margin from operations for each operating segment was:

 
| ** **                   | ** ** | **Three Months  Ended March 31,  2005  %** | ** ** | **Three Months  Ended March 31,  2004  %** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal  Applications         |       | 41.1                                            |       | 39.7                                            |       |
| GPS and Radio Communications |       | 50.5                                            |       | 46.6                                            |       |

 

TheAnimal Applications segment’s gross profit increased $0.6 million, or 21.7%, inthe three month period ended March 31, 2005 compared to the three monthsended March 31, 2004.  We attribute$0.4 million of the increase to the previously mentioned sales increase and theinclusion of $0.2 million of gross profit from DSD Holdings A/S.  DSD Holdings A/S was acquired on February 28,2005.  The gross margin percentage increasedto 41.1% in the three month period ended March 31, 2005 as compared to 39.7%in the three month period ended March 31, 2004 due to high margin revenuein the first quarter of 2005 that did not occur in the first quarter of 2004.

 

TheGPS and Radio Communications segment’s gross profit increased $0.9 million, or 49.8%,in the three month period ended March 31, 2005 as compared to the threemonth period ended March 31, 2004. The gross margin percentage increased to 50.5% in the three month periodended March 31, 2005 as compared to 46.6% in the three month period endedMarch 31, 2004.  The increase ingross profit margin results primarily from higher margins at our SignatureIndustries, Ltd subsidiary related to shipments of the G2R pilot locatorbeacon.

 

16

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**Selling, Generaland Administrative Expenses**

 

Selling,general and administrative expenses increased $0.9 million, or 20.4%, in thethree month period ended March 31, 2005 as compared to the three monthperiod ended March 31, 2004. As a percentage of revenue, selling, generaland administrative expenses were 39.8% and 41.1% for the three months endedMarch 31, 2005 and 2004, respectively.

 

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

 
| ** **                   | ** ** | **Three Months  Ended March 31,  2005** | ** ** | **Three Months  Ended March 31,  2004** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Animal Applications          |       | $                                            | 2,783      |                                         | $          | 2,157 |   |
| GPS and Radio Communications |       | 2,545                                        |       | 2,267                                        |       |
| Total                        |       | $                                            | 5,328      |                                         | $          | 4,424 |   |

 

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

 
| ** **                   | ** ** | **Three Months  Ended March 31,  2005  %** | ** ** | **Three Months  Ended March 31,  2004  %** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal Applications          |       | 33.5                                            |       | 30.5                                            |       |
| GPS and Radio Communications |       | 49.8                                            |       | 61.3                                            |       |

 

TheAnimal Applications segment’s selling, general and administrative expensesincreased $0.6 million in the three month period ended March 31, 2005 ascompared to the three month period ended March 31, 2004 and as apercentage of revenue increased to 33.5% from 30.5% in the same respectiveperiod.  The increase in selling, generaland administrative expenses relates to increased legal and accounting expenseand $0.1 million of expense related to DSD Holding A/S.  DSD Holding A/S was acquired on February 28,2005.

 

TheGPS and Radio Communications segment’s selling, general and administrativeexpenses increased $0.3 million to $2.6 million in the three month period endedMarch 31, 2005 from $2.3 million in the three month period endedMarch 31, 2004.  The increase resultsfrom increased sales and marketing expenses at Signature Industries.  As a percentage of revenue, selling, generaland administrative expenses decreased to 49.8% in the three month period endedMarch 31, 2005 from 61.3% in the three month period ended March 31,2004 primarily due to the increase in sales in the current period.

 

**Research andDevelopment Expense**

 

Researchand development expense was $1.1 million in the three month period endedMarch 31, 2005, an increase of $0.4 million, or 62.3%, from $0.7 millionfor the three month period ended March 31, 2004.  As a percentage of revenue, research anddevelopment expense was 8.1% and 6.2% for the three months ended March 31,2005 and 2004, respectively.

 

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

 
| ** **                   | ** ** | **Three Months  Ended March 31,  2005** | ** ** | **Three Months  Ended March 31,  2004** | ** ** |
|------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| Animal Applications          |       | $                                            | 675        |                                         | $          | 523 |   |
| GPS and Radio Communications |       | 411                                          |       | 146                                          |       |
| Total                        |       | $                                            | 1,086      |                                         | $          | 669 |   |

 

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TheAnimal Applications segments research and development expense increased $0.1million in the three months ended March 31, 2005 as compared to the threemonths ended March 31, 2004.  Theincrease in research and development is related to the development of a radiofrequency identification (RFID) antenna detection system.  

 

TheGPS and Radio Communications segment’s research and development expenseincreased $0.3 million in the three months ended March 31, 2005 as compared tothe three months ended March 31, 2004. The increase is related to our Outerlink Corporation subsidiary. 

 

**Interest Expense**

 

Interestexpense was $0.1 million and $0.3 million for the three month periods endedMarch 31, 2005 and 2004, respectively. The decrease relates to a $2.8 million reduction in total debt from $8.8million as of March 31, 2004 to $6.0 million as of March 31, 2005.  $3.8 million of debt was assumed in theacquisition of DSD Holdings A/S on February 28, 2005.

 

**Loss on AppliedDigital Common Stock**

** **

OnMarch 1, 2004, Digital Angel Corporation issued 3,000,000 shares of itscommon stock and a warrant to purchase up to 1,000,000 shares of the Company’scommon stock to Applied Digital in exchange for 1,980,000 shares of AppliedDigital’s common stock, exclusive of warrant proceeds.  In the quarter ended March 31, 2004, theCompany recorded realized and unrealized losses of $2,586,000 related to the stockexchange with Applied Digital.  As ofDecember 31, 2004, the Company had sold all of the 1,980,000 shares of AppliedDigital common stock for $6.4 million. In December 2004, Applied Digital exercised its warrant for 1,000,000shares of our common stock.  Net proceedsto the Company upon exercise of the warrant were $3.74 million.    

 

**Income Taxes**

 

TheCompany had an effective income tax rate of 0.0% for the three month periodsended March 31, 2005 and 2004.  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 foreign taxes.

 

**Discontinued Operations**

** **

During 2004, the Company sold substantiallyall the assets of its Medical Systems segment’s medical services business.

 

The following disclosesthe operating losses from discontinued operations for the three months ended March31, 2005 and 2004, consisting of losses attributable to the Medical Systemssegment:

 
| ** **                                    | ** ** | **Three-Months  Ended March 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|
| ** **                                    | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Product revenue                               |       | $                                 | —     |   | $ | 165 |   |
| Service revenue                               |       | —                            |       | 190 |   |
| Total revenue                                 |       | —                            |       | 355 |   |
| Cost of products sold                         |       | —                            |       | 66 |   |
| Cost of services sold                         |       | —                            |       | 236 |   |
| Total cost of products and services sold      |       | —                            |       | 302 |   |
| Gross profit                                  |       | —                            |       | 53 |   |
| Selling, general and administrative  expenses |       | —                            |       | 399 |   |
| Other expense                                 |       | —                            |       | 33 |   |
| Loss from discontinued operations             |       | $                                 | —     |   | $ | (379 | ) |

 

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**LIQUIDITY ANDCAPITAL RESOURCES**

 

Asof March 31, 2005, the Company had cash, excluding restricted cash, of $14.9million compared to $17.5 million at December 31, 2004.  Cash used in operating activities totaled $1.5million and $2.4 million in the first three months of 2005 and 2004,respectively.

 

Inthe first three months of 2005, the use of cash was due primarily to the lossfrom continuing operations of $0.5 million, an increase in inventory of $0.5million and a decrease in accounts payable and accrued expenses of $1.1million.  Offsetting these uses of cash wasdepreciation and amortization of $0.5 million.

 

Accountsreceivable, net of allowance for doubtful accounts, increased by $0.9 million,or 12.0%, to $8.5 million at March 31, 2005 from $7.6 million atDecember 31, 2004.  The increase includes$1.1 million of accounts receivable acquired in the acquisition of DSD HoldingsA/S.

 

Inventorylevels increased by $1.7 million to $7.9 million at March 31, 2005 from$6.2 million at December 31, 2004 due to an increase in inventory at ourAnimal Applications segment and $1.4 million of acquired inventory in theacquisition of DSD Holdings A/S.

 

Accountspayable increased by $1.6 million to $5.5 million at March 31, 2005 from $3.9million at December 31, 2004.  Theincrease relates to an increase in accounts payable at our Animal Applicationssegment and $1.1 million of accounts payable acquired in the acquisition of DSDHoldings A/S.

 

Accrued expenses and other currentliabilities decreased by $1.3 million, or 28.8%, to $3.1 million atMarch 31, 2005 from $4.4 million at December 31, 2004.  

 

Investingactivities used cash of $1.2 million in the first quarter of 2005 and providedcash of $1.4 million in the first quarter of 2004. In the first quarter of 2005,cash used was primarily for the acquisition of DSD Holdings A/S andexpenditures for plant property and equipment of $0.3 million.

 

Financingactivities provided cash of $0.0 million and $1.8 million in the first threemonths of 2005 and 2004, respectively.  

 

TheCompany expects that current funds available and cash from operations willadequately fund the Company’s operations for the next twelve months.

 

*Debt, CovenantCompliance and Liquidity*

 

*Invoice Discounting Agreement*  On April 9, 2003, Signature Industries Ltd.entered into a two-year Invoice Discounting Agreement with The Royal Bank ofScotland Commercial Services Limited (“RBS”). The Invoice Discounting Agreement, as amended October 28, 2003, providesfor Signature to sell with full title guarantee most of its receivables, asdefined in the Invoice Discounting Agreement, as amended.  RBS prepays 80% of the receivables sold, notto exceed an outstanding balance of £750,000 ($1,410,000 at March 31, 2005) atany given time.  RBS pays Signature theremainder of the receivable upon collection of the receivable.  Receivables which remain outstanding 90 daysfrom the end of the invoice month become ineligible and RBS may requireSignature to repurchase the receivable back. The discounting charge accrues daily at an annual rate 2.25% above thebase rate, as defined in the amended Invoice Discounting Agreement (7.0% atMarch 31, 2005).  Signature pays acommission charge to RBS of 0.2% of each receivable balance sold.  The Invoice Discounting Agreement, asamended, requires a minimum commission charge of £833 per month.  Discounting charges of $11,000 and $32,000are included in interest expense for the three months ended March 31, 2005 and2004, respectively.

 

*Credit Facility*Asof March 31, 2005, DSD Holdings is party to a credit agreement with Danske Bank.  The credit facility provides for borrowingsup to DKK 12 million ($2,124,000 at March 31, 2005).  At March 31, 2005, the annual interest rateon the facility was 4.25%.  Borrowingavailability under the facility as of March 31, 2005 was approximately$330,000.

 

*Stock issuances to AppliedDigital* On February 25, 2005, the Company entered into a Stock Purchase Agreement withApplied Digital.  Pursuant to theagreement the Company issued 644,140 shares of its common stock to AppliedDigital.  The Company received 684,543shares of Applied Digital common stock as consideration.  The value of the stock exchanged was $3.5million. The Applied Digital common stock received by the Company was used aspartial consideration for the acquisition of DSD Holdings A/S and itswholly-owned subsidiaries, Daploma International A/S and Digitag A/S.

 

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*Stock Repurchase*On March 29, 2005, the Company’s Board of Directors approved the repurchase ofup to 1.5 million shares of its common stock over a ninety day periodcommencing on March 30, 2005.  As ofMarch 31, 2005, the Company purchased 50,000 shares for a total of $0.2 million.

 

The following table summarizes theCompany’s fixed cash obligations as of March 31, 2005 over various futureyears (in thousands):

 
| ** **                       | ** ** | ** ** | ** ** | **Payments Due  by Period** | ** ** |
|----------------------------------|------------|------------|------------|-----------------------------|------------|
| **Contractual cash obligations** | ** ** | **Total**  | ** ** | **Less than  1 Year**       | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **After  5 Years** | ** ** |
| Notes Payable and Long-Term Debt |       | $          | 6,049      |                        | $          | 2,105 |   | $ | 1,240 |   | $ | 687 |   | $ | 2,017 |   |
| Operating Leases                 |       | 19,400     |       | 746                         |       | 1,257 |   | 1,115 |   | 16,282 |   |
| Employment Contracts             |       | 1,476      |       | 1,219                       |       | 257 |   | — |   | — |   |
|                             |       | $          | 26,925     |                        | $          | 4,070 |   | $ | 2,754 |   | $ | 1,802 |   | $ | 18,299 |   |

 

**IMPACT OF RECENTLYISSUED ACCOUNTING STANDARDS**

 

InDecember 2004, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R), which replaces SFAS No. 123, “Accounting for Stock-BasedCompensation,” (SFAS 123) and supercedes APB Opinion No. 25, “Accounting forStock Issued to Employees.” SFAS 123R requires all share-based payments toemployees, including grants of employee stock options, to be recognized in thefinancial statements based on their fair values beginning with fiscal yearsafter June 15, 2005, with early adoption encouraged. The pro formadisclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. The Company is required toadopt SFAS 123R beginning January 1, 2006. Under SFAS 123R, the Companymust determine the appropriate fair value model to be used for valuingshare-based payments, the amortization method for compensation cost and the transitionmethod to be used at date of adoption. The transition methods includeprospective and retroactive adoption options. The Company has begun, but hasnot completed, evaluating the impact of the adoption of SFAS 123R on itsresults of operations. In connection with evaluating the impact ofSFAS 123R, the Company is considering the potential implementation ofdifferent valuation methods to determine the fair value of share-basedcompensation.  The Company believes theadoption of SFAS 123R will have a material impact on our results ofoperations, regardless of the valuation method used.

 

InNovember 2004, the FASB issued SFAS No. 151, “Inventory Costs, anamendment of ARB No. 43, Chapter 4.” SFAS No. 151 amends AccountingResearch Bulletin (“ARB”) No. 43, Chapter 4, to clarify that abnormalamounts of idle facility expense, freight, handling costs and wasted materials(spoilage) should be recognized as current-period charges. In addition, SFASNo. 151 requires that allocation of fixed production overhead to inventorybe based on the normal capacity of the production facilities. The Company isrequired to adopt SFAS 151 beginning January 1, 2006. The Company believesthe adoption of SFAS 151 will not have a material impact on the results of itsoperations, financial position or cash flows.

 

**Forward - LookingStatements and Associated Risk**

 

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

 

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

•                  anticipatedtrends in our business and demographics;

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

•                  ourfuture profitability and liquidity; and

•                  regulatory,competitive or other economic influences.

 

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

 

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**Risk Factors**

 

Youshould carefully consider the risk factors listed below.  These risk factors may cause our futureearnings to be less or our financial condition to be less favorable than weexpect.  These factors may also affectthe trading price of our common stock. You should read this section together with the other informationcontained herein.

 

**As ofMarch 31, 2005, our majority stockholder, Applied Digital Solutions, owns 55.1%of our common stock, is able to completely control the board of directors andmay support actions that conflict with the interests of the other stockholders.**

 

As of March 31, 2005, AppliedDigital Solutions is the beneficial owner of 55.1% of our common stock, and itcontrols us with respect to all matters upon which our stockholders may vote,including the selection of the Board of Directors, mergers, acquisitions andother significant corporate transactions. There can be no assurance as to how Applied Digital Solutions maysupport actions that are contrary to or conflict with the interests of theother stockholders.

 

**Newaccounting pronouncements may impact our future results of operations.**

** **

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) No. 123R “Share-BasedPayment.” This statement, which will be effective in our first quarter of 2006,will change how we account for share-based compensation, and may have asignificant impact on our future results of operations.

 

We currentlyaccount for share-based payments to employees and directors using the intrinsicvalue method. Under this method, we generally do not recognize any compensationrelated to stock option grants we issue under our stock option plans.

 

SFAS 123R willrequire us to recognize share-based compensation as compensation expense in thestatement of operations based on the fair values of such equity on the date ofthe grant, with the compensation expense recognized over the period in whichthe recipient is required to provide service in exchange for the equity award.This statement will also require us to adopt a fair value-based method formeasuring the compensation expense related to share-based compensation. We havebegun, but have not completed, evaluating the impact of the adoption ofSFAS 123R on our results of operations. In connection with evaluating theimpact of SFAS 123R, we are considering the potential implementation ofdifferent valuation methods to determine the fair value of share-basedcompensation. We believe the adoption of SFAS 123R will have a materialimpact on our results of operations, regardless of the valuation method used.

 

**We may continue toincur losses.**

 

We incurred a net loss of $0.5million for the quarter ended March 31, 2005. We also recorded a net lossof $5.0 million, $9.5 million and $92.4 million for the years endedDecember 31, 2004, 2003 and 2002, respectively. Included in the $92.4million loss for the year ended December 31, 2002 is a goodwill impairmentcharge of $57.4 million, an asset impairment charge of $6.4 million, and a$18.7 million charge arising from the remeasurement of options in connectionwith the 2002 merger between Digital Angel Acquisition Company, which was thena wholly-owned subsidiary of Medical Advisory Systems, and Digital AngelCorporation, which was then a 93% owned subsidiary of Applied Digital Solutions. No assurance can be given as to whetherwe will achieve profitability, if at all. Profitability depends on manyfactors, including the success of marketing programs, the maintenance andreduction of expenses, and the ability to coordinate successfully theoperations of our business units. If we fail to achieve and maintain sufficientprofitability within the time frame expected by investors, the market price ofour common stock may be adversely affected.

 

**Infringement bythird parties on our intellectual property or development of substantiallyequivalent proprietary technology by our competitors could negatively affectour business.**

 

Our success depends significantlyon our ability to maintain patent and trade secret protection, to obtain futurepatents and licenses, and to operate without infringing on the proprietaryrights of third parties. There can be no assurance that the measures we havetaken to protect our intellectual property will prevent its misappropriation orcircumvention.  In addition, there can beno assurance 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 rely toa lesser extent on unpatented proprietary technology, and no assurance can begiven 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.

 

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

 

The electronic animalidentification market can be negatively affected by such factors as food safetyconcerns, consumer perceptions regarding cost and efficacy, internationaltechnology standards, national infrastructures, and slaughterhouse removal ofmicrochips.

 

We are also subject to federal,state and local regulation in the United States, including regulation by theFDA, FCC and the USDA, and in other countries. We cannot predict the extent to which we may be affected by furtherlegislative and regulatory developments concerning our products andmarkets.  We are required to obtainregulatory 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 under development.  Regulatory authorities also have theauthority to revoke approval of previously approved products for cause, torequest recalls of products and to close manufacturing plants in response toviolations.  Any such regulatory action,including the failure to obtain such approval, could prevent us from selling,or materially impair our ability to sell, our products in certain markets and couldnegatively affect our business.

 

**We rely heavily onsales to government contractors of our animal identification products, and anydecline in the demand by these customers for our products could negativelyaffect our business.**

 

Certain customers for electronicidentification devices for fish are government contractors that rely on fundingfrom the United States government.  Sincethese contractors rely heavily on government funds, any decline in theavailability of such funds could result in a decreased demand by thesecontractors for our products.  Anydecrease in demand by such customers could have a material adverse effect onour financial condition and results of operations and result in a decline inthe market value of our common stock.

 

**We depend on asingle production arrangement with Raytheon Microelectronics Espana, SA for ourpatented syringe-injectable microchips, and the loss of or any significantreduction in the production could have an adverse effect on our business.**

 

We rely solely on a productionarrangement with Raytheon Microelectronics Espana, SA for the manufacture ofour patented syringe-injectable microchips that are used in all of ourimplantable electronic identification products. In addition, we have no formalwritten agreement with Raytheon for the production of our microchips. Raytheonutilizes our proprietary technology and our equipment in the production of oursyringe-injectable microchips. The termination, or any significant reduction,by Raytheon of the assembly of our microchips or a material increase in the pricecharged by Raytheon for the assembly of our microchips could have an adverseeffect on our financial condition and results of operations.  In addition, Raytheon may not be able toproduce sufficient quantities of the microchips to meet any significant increaseddemand for our products or to meet any such demand on a timely basis.  Any inability or unwillingness of Raytheon tomeet our demand for microchips would require us to utilize an alternativeproduction arrangement and remove our automated assembly production machineryfrom the Raytheon facility, which would be costly and could delayproduction.  Moreover, if Raytheonterminates our production arrangement, we cannot ensure that the assembly ofour microchips from another source would be on comparable or acceptableterms.  The failure to make such analternative production arrangement could have an adverse effect on ourbusiness.

 

**We depend onprincipal customers.**

 

Our four largest customers, inaggregate, accounted for 21.7% of our consolidated revenue in the quarter endedMarch 31, 2005. Our subsidiary, Signature Industries, Ltd. is heavilydependent on contracts with domestic government agencies and foreigngovernments, including India and the United Kingdom, primarily relating tomilitary applications. The loss of, or a significant reduction in, orders fromthese or our other major customers could have a material adverse effect on ourfinancial condition and results of operations.

 

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**We compete with othercompanies in the visual and electronic identification and pilot locator beaconmarkets, and the products sold by our competitors could become more popularthan our products or render our products obsolete.**

 

The market for visual andelectronic identification and pilot locator beacon products is highlycompetitive. We believe that our principal competitors in the visualidentification market for livestock are AllFlex USA and Y-Tex Corporation andthat our principal competitors in the electronic identification market areAllFlex USA, Datamars SA and Avid Identification Systems, Inc. and that ourprincipal competitors in the pilot locator beacon market are Boeing NorthAmerican Inc., General Dynamics Decision Systems and Tadiran Spectralink Ltd.

 

In addition, other companies couldenter this line of business in the future. Certain of our competitors have substantially greater financial andother resources than us. We may not be able to compete successfully with thesecompetitors, and those competitors may develop or market technologies andproducts that are more widely accepted than ours or that would render ourproducts obsolete or noncompetitive.

 

**Our earnings willdecline if we write off goodwill and other intangible assets.**

 

As of March 31, 2005, we hadrecorded goodwill of $53.5 million. On January 1, 2002, we adopted SFASNo. 142, “Goodwill and Other Intangible Assets.”  SFAS No. 142 requires that goodwill andcertain intangibles no longer be amortized but instead be tested for impairmentat least annually by applying a fair value based test. During the fourthquarter of 2003, the Company performed the annual impairment test for goodwillusing a fair value based approach, primarily discounted cash flows. Anevaluation of the Medical Systems reporting unit indicated that $2.4 million ofgoodwill was impaired. Additionally, management estimated that certainintangible assets at our Medical Systems reporting unit were impaired by $0.6million.  Accordingly, the Companyrecorded an impairment charge of $3.0 million in the fourth quarter of 2003,which is included in asset impairment in the 2003 statement of operations.  During the fourth quarter of 2002, werecorded an impairment charge of $57.4 million for goodwill at our GPS andRadio Communications and Medical Systems reporting units.

 

We will assess the fair value ofour goodwill annually or earlier if events occur or circumstances change thatwould more likely than not reduce the fair value of our goodwill below itscarrying value. These events or circumstances would include a significantchange in business climate, including a significant, sustained decline in anentity’s market value, legal factors, operating performance indicators,competition, sale or disposition of a significant portion of the business, orother factors. If we determine that significant impairment has occurred, wewould be required to write off the impaired portion of goodwill. Impairmentcharges could have a material adverse effect on our financial condition andresults of operations.

 

**The exercise ofoptions and warrants outstanding and available for issuance may adverselyaffect the market price of our common stock*.***

 

As of March 31, 2005, we had9,896,000 options and 605,000 warrants outstanding to purchase from us a totalof 10,501,000 shares of common stock at exercise prices ranging from $0.05 to$10.50 per share. In addition, we are requesting our stockholders approve anamendment to one of our stock plans at our May 3, 2005 Annual Meeting whichwould allow for 2,000,000 additional shares of common stock which may be issuedin the future under our stock option plans. The exercise of outstanding optionsand warrants and the sale in the public market of the shares purchased uponsuch exercise may adversely affect the market price of our common stock.

 

**Currency exchangerate fluctuations could have an adverse effect on our sales and financialresults.**

 

We generate a portion of our salesand incur a portion of 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 asmall team of senior management, and we may have difficulty attracting andretaining additional personnel.**

 

Our future success will depend inlarge part upon the continued services and performance of senior management andother key personnel.  If we lose theservices of any member of our senior management team, our overall operationscould be materially and adversely affected. In addition, 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 areneeded.  Competition for theseindividuals is intense.  We cannot ensurethat we will be able to successfully attract, integrate or retain sufficientlyqualified personnel when the need arises. Any failure to attract and retain the necessary technical, managerial,marketing, purchasing and customer service personnel could have a materialadverse effect on our financial condition and results of operations.

 

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** **

**Item 3****.  Quantitative andQualitative Disclosures About Market Risk**

 

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

 

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

 

Asof March 31, 2005, we had short term investments of $14.6 million.  The short-term investments consist of highlyliquid securities between three and twelve months.  Due to the nature of our borrowings and ourshort-term investments, we have concluded that there is no material market riskexposure and, therefore, no quantitative tabular disclosures are required.

 

**Item 4.****  Controls andProcedures**

 

Within the 90 days prior to thedate of this report, the Company carried out an evaluation, under thesupervision and with the participation of the Company’s management, includingthe Company’s Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand 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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**PART II    OTHERINFORMATION**

 

**Item 1****.  Legal Proceedings.**

 

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

 

On October 20,2004, the Company commenced an action in the United Stated District Court forthe District of Minnesota against AllFlex USA, Inc. and Pet Health Services(USA), Inc.  This suit claims thatAllflex is marketing and selling a syringe implantable identificationtransponder that infringes a 1993 patent granted to the Company for syringeimplantable identification transponders previously found by the United StatesDistrict Court for the District of Colorado to be enforceable.  The suit also claims that PetHealth is using,selling and/or distributing the same transponder in violation of the Company’spatent.  The suit seeks, among otherthings, an adjudication of infringement and that the infringing parties beenjoined from further improper action. The suit also seeks actual damages, punitive damages and interest, costsand attorneys’ fees.  The Companybelieves that the suit is well-grounded in law and fact.  Allflex has asserted a counterclaim forbreach of contract of an existing license agreement between the Company andAllflex and asserted a counterclaim seeking a declaration of the parties’rights and obligations under the license agreement.  Allflex has also moved for a judgment on thepleadings, asserting that the license agreement should act as a bar to a casefor infringement.  The Company hascontested the motion on the ground that Allflex’s actions exceed the scope ofthe license and constitute an impermissible infringement of the patent.  A hearing on this motion was held on March22, 2005, but the court has not yet ruled on the motion.  Discovery in the action has been commencedand is continuing.

 

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

 

On October 20,2004, the Company commenced an action in the United States District Court forthe District of Minnesota against Datamars, Inc., Datamars, S.A., The CrystalImport Corporation, and Medical Management International, Inc. (“Banfield”).  This suit claims that the defendants aremarketing and selling syringe implantable identification transpondersmanufactured by Datamars that infringe the Company’s 1993 patent for syringeimplantable identification transponders previously found by the United StatesDistrict Court for the District of Colorado to be enforceable.  Certain of the locations in which theinfringing transponders are sold, include, but are not limited to, “Banfield,The Pet Hospital” of which certain locations are associated with PetSmartstores.  The suit seeks, among otherthings, an adjudication of infringement and that the infringing parties beenjoined from further improper action. The suit also seeks actual damages, punitive damages and interest, costsand attorneys’ fees.  The Companybelieves that the suit is well-grounded in law and fact.  Discovery in the action has been commencedand is continuing.

 

*Crystal v. Digital Angel, et al.*

 

On or aboutDecember 29, 2004 The Crystal Import Corporation filed an action against AVIDIdentification Systems, Inc. and Digital Angel in the United States DistrictCourt for the Northern District of Alabama. Crystal’s complaint primarily asserts federal and state antitrust andrelated claims against AVID, though it also asserts similar claims againstDigital Angel.  Given the uncertaintiesassociated with all litigation and given that this case was not commencedagainst Digital Angel until February 2, 2005, the Company is unable to offerany assessment on the potential liability exposure, if any, to Digital Angelfrom this lawsuit.  The Company has fileda motion to dismiss the action for failure to state a claim on which reliefcould be granted, or in the alternative, to have the action transferred to theUnited States District Court for the District of Minnesota for consolidationwith the Datamars patent infringement action referred to above or to have theaction stayed until the completion of the Datamars action.  The parties have filed briefs on the motion,but an oral argument has not been held, and no ruling on the motion has beenmade.  Discovery in the action has beencommenced and is continuing.

 

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**Item 2.  Unregistered****Sales of Equity Securities and Use of Proceeds**

 

On February 25, 2005, the Companyentered into a Stock Purchase Agreement with Applied Digital Solutions.  Pursuant to the agreement the Company issued644,140 shares of its common stock to Applied Digital.  The Company received 684,543 shares ofApplied Digital common stock as consideration. The value of the stock exchanged was $3.5 million. The Applied Digitalcommon stock received by the Company was used as partial consideration for theacquisition of DSD Holdings A/S and its wholly-owned subsidiaries, DaplomaInternational A/S and Digitag A/S.

 

On March 1, 2004, the Companyissued 3,000,000 unregistered shares of its common stock, $0.005 par value, toits majority shareholder, Applied Digital Solutions, Inc. pursuant to apreviously announced transaction.  TheCompany exchanged 3,000,000 shares of its common stock, $0.005 par value, for1,980,000 shares of Applied Digital Solutions, Inc. common stock, $0.01 parvalue.  The shares received from AppliedDigital Solutions, Inc. were registered with the Securities and ExchangeCommission pursuant to a registration statement on Form S-1 that was declaredeffective February 17, 2004.  As ofDecember 31, 2004, the Company had sold all of the 1,980,000 shares of AppliedDigital common stock for $6.4 million.

 

During the first quarter 2005, theCompany granted restricted stock and options to purchase shares of its commonstock totaling 3,671,000 shares to certain employees and its directors. 

 

On March 29, 2005, the Company’sBoard of Directors approved the repurchase of up to 1.5 million shares of itscommon stock over a ninety day period commencing on March 30, 2005.  As of March 31, 2005, the Company purchased50,000 shares for a total of $0.2 million.

 

The following table illustratesissuer purchases of equity securities during the three months ended March 31,2005:

 

 
| **Period**                      | ** ** | **Total Number  of  Shares  Purchased** | ** ** | **Average  Price  Paid Per Share** | ** ** | **Total Number  of Shares  Purchased as  Part of Publicly  Announced  Plan** | ** ** | **Maximum  Number of  Shares that  May Yet Be  Purchased  Under the Plans** | ** ** |
|---------------------------------|------------|-----------------------------------------|------------|------------------------------------|------------|------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
|                            |       |                                    |       |                               |       |                                                                         |       |                                                                        |       |
| Month 1 (January 1 - 31, 2005)  |       | —                                  |       | $                                  | —     |                                                                         | —     |                                                                        | —     |   |
| Month 2 (February 1 - 28, 2005) |       | —                                  |       | —                             |       | —                                                                       |       | —                                                                      |       |
| Month 3 (March 1 - 31, 2005)    |       | 50,000                                  |       | 4.62                               |       | 50,000                                                                       |       | 1,450,000                                                                   |       |
| Total                           |       | 50,000                                  |       | $                                  | 4.62       |                                                                         | 50,000     |                                                                        | 1,450,000  |   |

** **

**Item 5.  Otherinformation**

** **

During March2005, the Company’s directors, except for Mr. McGrath, established plans inaccordance with Rule 10b5-1 of the General Rules and Regulations promulgated bythe Securities and Exchange Commission under the Securities Exchange Act of1934, as amended, to provide for predetermined sales of a portion of theirshares of Company common stock obtainable upon the exercise of stock options,subject to certain contingencies.  Inaddition, the Company’s Chief Financial Officer entered into Rule 10b5-1trading plans.

 

Under the Rule10b5-1 plans, the directors and the Chief Financial Officer will sell varyingamounts of Company common stock obtained upon the exercise of stock options atprice targets substantially above the current market price of the Company’scommon stock.  The number of shares to besold under the plans generally range from 30% to 60% of the respectivedirectors or officer’s outstanding option positions and the applicable pricetargets are set at $8.05 and higher.

 

These planswere adopted while the insiders were not in possession of material non-publicinformation and allow the insiders to trade on a predetermined basis,regardless of the receipt of any subsequent material non-publicinformation.  Such plans allow insidersto diversify their holdings and to minimize the market impact of stock sales byspreading them out over a period of time. Option exercises and/or stock sales made under the plan will be publiclydisclosed in accordance with applicable rules.

 

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**Item 6.  Exhibits**

 
|   | **(a)    Exhibits**                                                                                                                                                                      |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                         |
| 3.1    | Amended and Restated Certificate  of Incorporation (incorporated by reference to Exhibit 3.1 to Amendment No. 1  to our Registration Statement on Form S-3 (No. 333-110817) filed on  January 23, 2004) |
|   |                                                                                                                                                                                                         |
| 3.2    | Bylaws (incorporated by reference  to Exhibit 3.2 to Amendment No. 1 to our Registration Statement on Form S-3  (No. 333-110817) filed on January 23, 2004)                                             |
|   |                                                                                                                                                                                                         |
| 31.1   | Certification of Chief Executive  Officer under Rules 13a-14(a)/15d-14(a) under the Securities and Exchange Act  and Section 302 of the Sarbanes-Oxley Act of 2002.                                     |
|   |                                                                                                                                                                                                         |
| 31.2   | Certification of Chief Financial  Officer under Rules 13a-14(a)/15d-14(a) under the Securities and Exchange Act  and Section 302 of the Sarbanes-Oxley Act of 2002.                                     |
|   |                                                                                                                                                                                                         |
| 32.1   | Certification of Chief Executive  Officer Pursuant to 18 U.S.C Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                |
|   |                                                                                                                                                                                                         |
| 32.2   | Certification of Chief Financial  Officer Pursuant to 18 U.S.C Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                |

 

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**SIGNATURE**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|               |   | DIGITAL ANGEL CORPORATION |
|--------------------|--------|---------------------------|
|               |   | (Registrant)              |
|               |   |                      |   |
| Dated: May 2, 2005 |   | By:                       | /S/ JAMES P. SANTELLI |
|               |   |                      | James P. Santelli |
|               |   |                      | Vice President - Finance  and Chief  Financial Officer |

 

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