** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C.  20549**

 

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# ** **

# **FORM 10-Q**

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

 

**DIGITAL ANGEL CORPORATION**

(Exact name of registrant as specified in its charter)

 

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

 

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

(Address of registrant’s principal executive offices)

 

**(651) 455-1621**

(Registrant’s telephone number, including area code)

 

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

 

Yes     ý    No     o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule12b-2 of the Exchange Act).

 

Yes     o    No     ý

 

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

 

Yes     o    No     ý

 

As ofthe close of business on October 28, 2005, there were 43,847,314 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                                                                           | ** ** |       |
| 6.                                        |       | Exhibits                                                                                    | ** ** |       |
| ** **                                | ** ** |                                                                                        |       |       |
| SIGNATURE                                 |       |                                                                                        |
| CERTIFICATIONS                            |       |                                                                                        |
| EXHIBITS                                  |       |                                                                                        |

 

2

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**PART I    FINANCIAL INFORMATION**

Item 1.    Financial Statements.

**DIGITAL ANGEL CORPORATION ANDSUBSIDIARIES**

 

**CONDENSEDCONSOLIDATED BALANCE SHEETS**(In thousands,except par value)

 
| ** **                                                                                                                                                                       | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                                       |       |                         |       |                        |       |
| **Current Assets**                                                                                                                                                               |       |                         |       |                        |       |
| Cash                                                                                                                                                                             | ** ** | **$**                        | **12,117** |                        | $          | 17,492 |   |
| Restricted cash                                                                                                                                                                  | ** ** | **—**                   |       | 327                         |       |
| Accounts receivable (net  of allowance for doubtful accounts of $216 in 2005 and $241 in 2004)                                                                                   | ** ** | **8,712**                    |       | 7,641                       |       |
| Inventories                                                                                                                                                                      | ** ** | **8,381**                    |       | 6,232                       |       |
| Other current assets                                                                                                                                                             | ** ** | **1,277**                    |       | 1,235                       |       |
| Net assets from  discontinued operations                                                                                                                                         | ** ** | **—**                   |       | 6                           |       |
| **Total Current Assets**                                                                                                                                                         | ** ** | **30,487**                   |       | 32,933                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Property and Equipment, net**                                                                                                                                                  | ** ** | **8,347**                    |       | 5,947                       |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Goodwill**                                                                                                                                                                     | ** ** | **53,563**                   |       | 48,997                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Other Intangible Assets, net**                                                                                                                                                 | ** ** | **3,468**                    |       | 4,011                       |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Other Assets, net**                                                                                                                                                            | ** ** | **769**                      |       | 785                         |       |
| ** **                                                                                                                                                                       |       | **$**                        | **96,634** |                        | $          | 92,673 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                   |       |                         |       |                        |       |
| **Current Liabilities**                                                                                                                                                          |       |                         |       |                        |       |
| Line of credit and current  maturities of long-term debt                                                                                                                         | ** ** | **$**                        | **2,236**  |                        | $          | 99 |   |
| Accounts payable                                                                                                                                                                 | ** ** | **5,107**                    |       | 3,936                       |       |
| Accrued expenses and other  current liabilities                                                                                                                                  | ** ** | **3,267**                    |       | 4,394                       |       |
| Deferred revenue                                                                                                                                                                 | ** ** | **1,452**                    |       | 1,204                       |       |
| Net liabilities from  discontinued operations                                                                                                                                    | ** ** | **94**                       |       | —                      |       |
| **Total Current Liabilities**                                                                                                                                                    | ** ** | **12,156**                   |       | 9,633                       |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Long-Term Debt And Notes Payable**                                                                                                                                             | ** ** | **3,696**                    |       | 2,285                       |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Deferred Revenue**                                                                                                                                                             | ** ** | **642**                      |       | 744                         |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Total Liabilities**                                                                                                                                                            | ** ** | **16,494**                   |       | 12,662                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Commitments And Contingencies (See Note 10)**                                                                                                                                  |       |                         |       |                        |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Minority Interest**                                                                                                                                                            | ** ** | **626**                      |       | 249                         |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Stockholders’ Equity**                                                                                                                                                    |       |                         |       |                        |       |
| Preferred stock:  Authorized 1,000 shares, of $1.75 par value, none outstanding in 2005 and 1  outstanding in 2004                                                               | ** ** | **—**                   |       | 1                           |       |
| Common stock: Authorized  95,000 shares, of $.005 par value; 44,225 shares issued and 43,847 shares  outstanding in 2005 and 43,425 shares issued and 43,375 outstanding in 2004 | ** ** | **222**                      | ** ** | 217                         |       |
| Additional paid-in capital                                                                                                                                                       | ** ** | **211,957**                  | ** ** | 207,875                     |       |
| Accumulated deficit                                                                                                                                                              | ** ** | **(130,842**                 | **)**      | (128,474                    | )          |
| Treasury stock (carried at  cost, 378 shares in 2005 and 50 shares in 2004)                                                                                                      | ** ** | **(1,580**                   | **)**      | (43                         | )          |
| Accumulated other  comprehensive (loss) income                                                                                                                                   | ** ** | **(243**                     | **)**      | 186                         |       |
| **Total Stockholders’ Equity**                                                                                                                                              | ** ** | **79,514**                   |       | 79,762                      |       |
| ** **                                                                                                                                                                       |       | **$**                        | **96,634** |                        | $          | 92,673 |   |
|                                                                                                                                                                                  |            |                              |            |                             |            |  |  |  |  |

 

See the accompanying notes to condensed consolidatedfinancial statements.

 

3

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

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

(Unaudited)

 
| ** **                                                                | ** ** | **For the Three Months  Ended September 30,** | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                | ** ** | **2005**                                           | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                      |       |                                               |       |                                              |       |   |   |   |   |
| Product revenue                                                           | ** ** | **$**                                              | **13,217** | ** **                                        | $          | 10,668 | ** ** | **$** | **40,161** | ** ** | $ | 30,582 |   |
| Service revenue                                                           | ** ** | **541**                                            | ** ** | 512                                               | ** ** | **1,860** | ** ** | 1,439 |   |
| Total net revenue                                                         | ** ** | **13,758**                                         | ** ** | 11,180                                            | ** ** | **42,021** | ** ** | 32,021 |   |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Cost of products sold                                                     | ** ** | **7,538**                                          | ** ** | 5,871                                             | ** ** | **22,559** | ** ** | 17,479 |   |
| Cost of services sold                                                     | ** ** | **284**                                            | ** ** | 293                                               | ** ** | **891** | ** ** | 841 |   |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Gross profit                                                              | ** ** | **5,936**                                          | ** ** | 5,016                                             | ** ** | **18,571** | ** ** | 13,701 |   |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Selling, general and administrative expenses                              | ** ** | **5,756**                                          | ** ** | 4,435                                             |       | **17,202** | ** ** | 13,162 |   |
| Research and development expenses                                         | ** ** | **1,165**                                          | ** ** | 731                                               |       | **3,370** | ** ** | 2,250 |   |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Operating loss                                                            | ** ** | **(985**                                           | **)**      | (150                                              | )          | **(2,001** | **)** | (1,711 | ) |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Interest income                                                           | ** ** | **89**                                             | ** ** | 9                                                 |       | **248** | ** ** | 25 |   |
| Interest expense                                                          | ** ** | **(98**                                            | **)**      | (254                                              | )          | **(278** | **)** | (757 | ) |
| Realized and unrealized  losses on Applied Digital common stock           | ** ** | **—**                                         | ** ** | (279                                              | )          | **—** | ** ** | (2,891 | ) |
| Other income                                                              | ** ** | **12**                                             | ** ** | 25                                                |       | **45** | ** ** | 83 |   |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Loss before taxes, minority interest and discontinued operations          | ** ** | **(982**                                           | **)**      | (649                                              | )          | **(1,986** | **)** | (5,251 | ) |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Income taxes                                                              | ** ** | **(24**                                            | **)**      | **—**                                        |       | **(110** | **)** | **—** | ** ** |
| Minority interest share of income                                         | ** ** | **(63**                                            | **)**      | (133                                              | )          | **(357** | **)** | (136 | ) |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Net loss from continuing  operations                                      | ** ** | **(1,069**                                         | **)**      | (782                                              | )          | **(2,453** | **)** | (5,387 | ) |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Income (loss) from  discontinued operations                               | ** ** | **85**                                             | ** ** | 255                                               |       | **85** | ** ** | (873 | ) |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Net loss                                                                  | ** ** | **$**                                              | **(984**   | **)**                                             | $          | (527 | ) | **$** | **(2,368** | **)** | $ | (6,260 | ) |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Loss per common  share-basic and diluted:                                 |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Loss from continuing  operations                                          | ** ** | **(0.02**                                          | **)**      | (0.02                                             | )          | **(0.05** | **)** | (0.17 | ) |
| Income (loss) from discontinued operations                                | ** ** | **—**                                         | ** ** | 0.01                                              |       | **—** | ** ** | (0.03 | ) |
| Net loss per common share —basic and diluted                         | ** ** | **$**                                              | **(0.02**  | **)**                                             | $          | (0.01 | ) | **$** | **(0.05** | **)** | $ | (0.20 | ) |
|                                                                      |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Weighted average number of common shares outstanding - basic and  diluted | ** ** | **43,847**                                         | ** ** | 32,892                                            |       | **43,811** | ** ** | 32,036 |   |
|                                                                           |            |                                                    |            |                                                   |            |  |  |  |  |  |  |  |  |  |  |

 

Seethe accompanying notes to condensed consolidated financial statements.

 

4

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITYFor The Nine Months Ended September 30, 2005**(In Thousands)(Unaudited)

 
| ** **                                                        | ** ** | ** **          | ** ** | ** **       | ** ** | ** **  | ** ** | ** **      | ** ** | ** **     | ** ** | ** **        | ** ** | ** **             | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|---------------------|------------|------------------|------------|-------------|------------|-----------------|------------|----------------|------------|-------------------|------------|------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                        | ** ** | ** **          | ** ** | ** **       | ** ** | ** **  | ** ** | ** **      | ** ** | **Additional** | ** ** | ** **        | ** ** | ** **             | ** ** | **Other**         | ** ** | **Total**  | ** ** |
| ** **                                                        | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated** | ** ** | **Treasury**   | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                        | ** ** | **Number**          | ** ** | **Amount**       | ** ** | **Number**  | ** ** | **Amount**      | ** ** | **Capital**    | ** ** | **Deficit**       | ** ** | **Stock**              | ** ** | **Income (Loss)** | ** ** | **Equity** | ** ** |
| **Balance - December 31, 2004**                              |       | —              |       | $                | 1          |        | 43,425     |            | $          | 217            |       | $                 | 207,875    |                   | $          | (128,474          | )          | $          | (43        | ) | $ | 186 |   | $ | 79,762 |   |
| Net loss                                                          |       | —              |       | —           |       | —      |       | —          |       | —         |       | (2,368            | )          | —                 |       | —            |       | (2,368     | )          |
| Comprehensive loss - Foreign currency translation                 |       | —              |       | —           |       | —      |       | —          |       | —         |       | —            |       | —                 |       | (429              | )          | (429       | )          |
| Total comprehensive loss                                          |       | —              |       | —           |       | —      |       | —          |       | —         |       | (2,368            | )          | —                 |       | (429              | )          | (2,797     | )          |
| Purchase of treasury stock                                        |       | —              |       | —           |       | —      |       | —          |       | —         |       | —            |       | (1,537                 | )          | —            |       | (1,537     | )          |
| 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        |       |
| Stock grant to former employee                                    |       | —              |       | —           |       | 7           |       | —          |       | 35             |       | —            |       | —                 |       | —            |       | 35         |       |
| Restricted stock issued to employees                              |       | —              |       | —           |       | —      |       | —          |       | 193            |       | —            |       | —                 |       | —            |       | 193        |       |
| **Balance — September 30, 2005**                             |       | —              |       | $                | —     |        | 44,225     |            | $          | 222            |       | $                 | 211,957    |                   | $          | (130,842          | )          | $          | (1,580     | ) | $ | (243 | ) | $ | 79,514 |   |

 

See the accompanying notes to condensed consolidatedfinancial statements.

 

5

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**DIGITALANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**(In thousands)(Unaudited)
| ** **                                                                   | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                          | ** ** | **2004** | ** ** |
| **Cash Flows From Operating  Activities**                                    |       |                                              |       |   |   |
| Net loss from continuing operations                                          | ** ** | **$**                                             | **(2,453** | **)** | $ | (5,387 | ) |
|                                                                         |       |                                              | ** ** |   |   |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                                              | ** ** |   |   |
| Income (loss) from discontinued operations                                   | ** ** | **85**                                            | ** ** | (873 | ) |
| Proceeds from sale of Applied Digital common stock                           | ** ** | **—**                                        | ** ** | 2,687 |   |
| Equity-based compensation                                                    | ** ** | **228**                                           | ** ** | 31 |   |
| Amortization of debt discount and deferred financing costs                   | ** ** | **—**                                        | ** ** | 276 |   |
| Depreciation and amortization                                                | ** ** | **1,829**                                         | ** ** | 1,501 |   |
| Minority interest                                                            | ** ** | **357**                                           | ** ** | 136 |   |
| Loss on Applied Digital common stock                                         | ** ** | **—**                                        | ** ** | 2,891 |   |
| Loss on disposal of equipment                                                | ** ** | **8**                                             | ** ** | 1 |   |
| Change in assets and liabilities:                                            |       |                                              | ** ** |   |   |
| Decrease in restricted cash                                                  | ** ** | **327**                                           | ** ** | 53 |   |
| Decrease (increase) in accounts receivable                                   | ** ** | **520**                                           | ** ** | (1,539 | ) |
| (Increase) decrease in inventories                                           | ** ** | **(1,072**                                        | **)**      | 5 |   |
| Increase in other current assets                                             | ** ** | **(69**                                           | **)**      | (364 | ) |
| Decrease in accounts payable, accrued expenses and deferred revenue          | ** ** | **(1,478**                                        | **)**      | (286 | ) |
| Net cash provided by discontinued operations                                 | ** ** | **100**                                           | ** ** | 154 |   |
| **Net Cash Used In Operating  Activities**                                   | ** ** | **(1,618**                                        | **)**      | (714 | ) |
|                                                                         |       |                                              | ** ** |   |   |
| **Cash Flows From Investing  Activities**                                    |       |                                              | ** ** |   |   |
| (Increase) decrease in other assets                                          | ** ** | **37**                                            | ** ** | (270 | ) |
| Proceeds from the sale of assets                                             | ** ** | **—**                                        | ** ** | 18 |   |
| Payments for property and equipment                                          | ** ** | **(1,319**                                        | **)**      | (369 | ) |
| Cash used in acquisition, net of cash acquired                               | ** ** | **(1,286**                                        | **)**      | (27 | ) |
| Net cash provided by discontinued operations                                 | ** ** | **—**                                        | ** ** | 1,730 |   |
| **Net Cash (Used In) Provided By  Investing Activities**                     | ** ** | **(2,568**                                        | **)**      | 1,082 |   |
|                                                                         |       |                                              | ** ** |   |   |
| **Cash Flows From Financing  Activities**                                    |       |                                              | ** ** |   |   |
| Amounts borrowed on line of credit                                           | ** ** | **3,179**                                         | ** ** | 28,295 |   |
| Amounts paid on line of credit                                               | ** ** | **(3,048**                                        | **)**      | (28,927 | ) |
| Payments on notes payable and long-term debt                                 | ** ** | **(339**                                          | **)**      | (398 | ) |
| Proceeds from notes payable and long-term debt                               | ** ** | **339**                                           | ** ** | — |   |
| Exercise of stock options and warrants                                       | ** ** | **358**                                           | ** ** | 1,090 | ** ** |
| Purchase of treasury stock                                                   | ** ** | **(1,537**                                        | **)**      | **—** | ** ** |
| Payments for financing costs                                                 | ** ** | **—**                                        | ** ** | (101 | ) |
| Net cash used in discontinued operations                                     | ** ** | **—**                                        | ** ** | (910 | ) |
| **Net Cash Used In Financing  Activities**                                   | ** ** | **(1,048**                                        | **)**      | (951 | ) |
|                                                                         |       |                                              | ** ** |   |   |
| **Effect of Exchange Rate Changes on Cash**                                  | ** ** | **(141**                                          | **)**      | (4 | ) |
|                                                                         |       |                                              | ** ** |   |   |
| **Net Decrease In Cash**                                                     | ** ** | **(5,375**                                        | **)**      | (587 | ) |
|                                                                         |       |                                              | ** ** |   |   |
| **Cash - Beginning Of Period**                                               | ** ** | **17,492**                                        | ** ** | 894 |   |
|                                                                         |       |                                              | ** ** |   |   |
| **Cash - End Of Period**                                                     | ** ** | **$**                                             | **12,117** | ** ** | $ | 307 |   |
|                                                                              |            |                                                   |            |  |  |  |  |  |

 

Seethe accompanying notes to condensed consolidated financial statements.

 

6

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**DIGITAL ANGEL CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS(Dollars in thousands)(Unaudited)**

 

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

 

Digital Angel Corporation and itssubsidiaries (“the Company”) develops and deploys sensor and communications technologiesthat enable rapid and accurate identification, location tracking, and conditionmonitoring of high-value assets.  TheCompany operates in two segments: (1) Animal Applications and (2) GPS and RadioCommunications.

 

*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 fordisease control and food safety. In addition to the visual ear tags, which havebeen sold by the Company since the late 1940’s, Animal Applications utilizesradio frequency transmission (“RFID”) technologies in its electronic ear tagsand implantable microchips.

 

*GPS and RadioCommunications—*consists of the design, manufactureand support of global positioning system (“GPS”) enabled equipment.Applications for the segment’s products include location tracking and messagemonitoring of vehicles, aircraft and people in remote locations through systemsthat integrate GPS and geosynchronous satellite communications and GPS enabledequipment and intelligent communications products and services for telemetry,mobile data and radio communications applications serving commercial andmilitary markets. Technology development in this segment includes theintegration and miniaturization into marketable products of two technologies: wireless communications and positionlocation technology (including GPS and other systems).

 

On February 28, 2005, theCompany 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.

 

As of September 30, 2005,Applied Digital Solutions, Inc. (“Applied Digital” or “ADS”) owned24,291,673 shares or 55.4% of the Company’s common stock.

 

The accompanying unauditedcondensed consolidated financial statements of the Company as ofSeptember 30, 2005 and for the three and nine month periods endedSeptember 30, 2005 and 2004 have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X under the Securities Exchange Act of1934.  Accordingly, they do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States of America for complete financialstatements.  In the opinion of theCompany’s management, all adjustments (including normal recurring adjustments)considered necessary to present fairly the financial statements have been made.

 

The consolidated statements ofoperations for the three and nine months ended September 30, 2005 and 2004are not necessarily indicative of the results that may be expected for theentire year.  These statements should beread in conjunction with the Digital Angel Corporation’s audited consolidatedfinancial statements and related notes thereto for the year endedDecember 31, 2004 which are included in the Company’s Annual Report onForm 10-K.

 

Certain items in the condensedconsolidated financial statements for the 2004 periods have been reclassifiedfor comparative purposes.

 

7

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

 

The September 30, 2005 and2004 condensed consolidated financial statements include the accounts of theCompany and its wholly-owned and majority-owned subsidiaries (DSD Holdings A/Sand OuterLink Corporation operations are included from the date of acquisition:February 28, 2005 and January 22, 2004, respectively).  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 timeproduct is shipped and title has transferred, provided that a purchase orderhas been received or a contract has been executed, there are no uncertaintiesregarding customer acceptance, the sales price is fixed and determinable andcollectibility is deemed probable. If uncertainties regarding customeracceptance exist, revenue is recognized when such uncertainties are resolved.There are no significant post-contract support obligations at the time ofrevenue recognition. Digital Angel Corporation’s accounting policy regardingvendor and post contract support obligations is based on the terms of thecustomers’ contracts, billable upon occurrence of the post-sale support. Costsof products sold and services provided are recorded as the related revenue isrecognized. Digital Angel Corporation offers a warranty on its products.  For non-fixed and fixed fee jobs, servicerevenue is recognized based on the actual direct labor hours in the jobmultiplied by the standard billing rate and adjusted to net realizable value,if necessary.  Other revenue isrecognized 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 and from the sale of relatedproducts to customers (communication terminals and software).  OuterLink Corporation’s messaging service isonly available through use of its products and such products have noalternative use.  Accordingly, servicerevenue is recognized as the services are performed.  OuterLink Corporation’s product revenue, forwhich title and risk of loss transfers to the customer on shipment, is deferredupon shipment and is recognized ratably over the estimated customer serviceperiod of 30 months.

 

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

 

The Company applies APB OpinionNo. 25 and related Interpretations in accounting for all its stock optionplans.  Accordingly, no compensation costhas been recognized under these plans. The Company has adopted the disclosure-only provisions of SFASNo. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure,” which was released inDecember 2002 as an amendment to SFAS No. 123.  The following table illustrates the effect onnet loss and earnings per share if the fair value based method had been appliedto all awards (in thousands, except per share data):

 
| ** **                                                                                                          | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Reported net loss                                                                                                   | ** ** | **$**                                     | **(984**   | **)**                                    | $          | (527 | ) | **(2,368** | **)** | $ | (6,260 | ) |
| Stock-based employee compensation expense in reported net loss, net  of related tax effects                         | ** ** | **83**                                    | ** ** | **—**                               |       | **228** | ** ** | 31 |   |
| Stock-based employee compensation expense determined under the fair  value based method, net of related tax effects | ** ** | **(1,341**                                | **)**      | (2,024                                   | )          | **(4,113** | **)** | (5,647 | ) |
| Pro forma net loss                                                                                                  | ** ** | **$**                                     | **(2,242** | **)**                                    | $          | (2,551 | ) | **$** | **(6,253** | **)** | $ | (11,876 | ) |
|                                                                                                                |       |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Loss per share -basic and  diluted                                                                                  |       |                                      | ** ** |                                     |       |   | ** ** |   |   |
| As reported                                                                                                         | ** ** | **$**                                     | **(0.02**  | **)**                                    | $          | (0.01 | ) | **$** | **(0.05** | **)** | $ | (0.20 | ) |
| Pro forma                                                                                                           | ** ** | **$**                                     | **(0.05**  | **)**                                    | $          | (0.08 | ) | **$** | **(0.14** | **)** | $ | (0.37 | ) |

 

InDecember 2004, SFAS No. 123 (revised 2004), “Share-Based Payment”(SFAS 123R) was issued.  SFAS 123Rreplaced 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.

 

 

8

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

 
| ** **                            | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw materials                         | ** ** | **$**                        | **3,917**  |                        | $          | 3,115 |   |
| Work in process                       | ** ** | **57**                       |       | 137                         |       |
| Finished goods                        | ** ** | **6,385**                    |       | 4,895                       |       |
|                                  | ** ** | **10,359**                   |       | 8,147                       |       |
| Allowance for excess and obsolescence | ** ** | **(1,978**                   | **)**      | (1,915                      | )          |
| Net inventory                         | ** ** | **$**                        | **8,381**  |                        | $          | 6,232 |   |

 

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

 

On February 25, 2005, theCompany entered intoa Stock Purchase Agreement with Applied Digital.  The purpose of the stock exchange was to usethe shares as partial consideration for the acquisition of DSD Holdings A/S andits wholly-owned subsidiaries, Daploma International A/S and Digitag A/S, asdescribed more fully in note 9.  The Company andApplied Digital entered into the share exchange because of the sellingshareholders’ desire, at the time the transaction was negotiated, to receivetheir consideration in Applied Digital common stock as opposed to the Company’scommon stock.  In addition, the stockpurchase represented a strategic investment by Applied Digital whereby AppliedDigital could increase its ownership interest in the Company. Pursuant to the agreement, the Companyissued 644,140 shares of its common stock to Applied Digital.  The Company received 684,543 shares ofApplied Digital common stock as consideration. The exchange ratio of shares was based upon the average of thevolume-weighted-average price of the Company’s common stock and Applied Digital’scommon stock for the ten trading days immediately preceding, and not including,the transaction closing date which was $5.434 for the Company’s common stockand $5.113 for Applied Digital’s common stock. The value ofthe stock exchanged was $3.5 million.

 

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 dated August 14, 2003 was used as a method for theCompany to obtain and sell shares of Applied Digital in order to generate cashfor operations in a period of time when other capital was scarce or notavailable.  The Company believed theshare exchange with Applied Digital, as compared to selling shares of DigitalAngel, was beneficial because (i) the net yield on the sale was higher asthe Company did not have to pay an underwriting commission and (ii) theCompany believed the sale of Applied Digital shares was preferable to the saleof Digital Angel shares because (a) a larger number of Applied Digitalshares were outstanding in the hands of unaffiliated holders (b) AppliedDigital shares had a much larger volume of stock trading on a daily basis and(c) Applied Digital shares had lower stock price volatility than DigitalAngel shares.  In addition, the Companyand Applied Digital mutually agreed that the stock purchase represented astrategic investment by Applied Digital whereby Applied Digital could increaseits ownership interest in the Company.

 

The purchase price per share for the shares of theCompany’s stock was based on the closing price of the Company’s common stock onJune 30, 2003 of $2.64 per share. This price was used because the Company and Applied Digital determinedthat this was a fair price and because it reflected the fair value of thesecurities before any impact of the Applied Digital Debenture holderspotentially hedging their position in the Company’s common stock and therebyaffecting the market price of the stock. In connection with this transaction, the Company granted a five yearwarrant to the Applied Digital Debenture holders to acquire up to 500,000shares of the Company’s common stock at an exercise price of $2.64 pershare.  The warrant was issued inconsideration for a waiver from the Applied Digital Debenture holders allowingApplied Digital to register the shares being issued in connection with theStock Purchase Agreement.  The exerciseprice of the warrant was determined in negotiation with the Applied DigitalDebenture holders.  The purchase price ofthe Applied Digital common stock was based on the average of the volumeweighted average price of Applied Digital’s common stock for the ten tradingdays immediately preceding (and not including) the closing date.  In addition, as part of this transaction, theCompany granted a five year warrant to Applied Digital to purchase up to 1million shares of the Company’s common stock. The exercise price of the warrant, $3.74, was based on the daily volumeweighted average price of the Company’s common stock for the first 10consecutive trading days of 2004 starting on January 2, 2004.

 

The Company accounted for this transaction in amanner similar to a private placement whereby the Company issued common stockand warrants in exchange for common stock of Applied Digital.  The Company’s intention was to sell theshares of Applied Digital to generate cash for its operations.  Accordingly, the Company accounted for theApplied Digital stock as a trading security under SFAS 115, “Accounting forCertain Investments in Debt and Equity Securities.”

 

 In the nine months ended September 30,2004, the Company recorded realized losses of $1.0 million on the 910,000shares of Applied Digital common stock sold and an unrealized loss of $1.9million on the remaining 1,070,000 shares held by the Company.  Fair value of the Applied Digital commonstock 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 $6.7million.  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**

 

InApril 2004, our Board of Directors approved a plan to sell our MedicalSystems segment. The Medical Systems segment represented the businessoperations of Medical Advisory Systems, Inc, which we acquired onMarch 27, 2002.  The Medical Systemssegment was one of our reporting units in accordance with SFAS 131, “Disclosuresabout Segments of an Enterprise and Related Information”.  Accordingly, the financial condition, resultsof operations and cash flows of our Medical Systems segment have been reportedas discontinued operations for all periods presented. The following disclosesthe operating losses from discontinued operations for the three and nine monthsended September 30, 2005 and 2004, consisting of losses attributable tothe Medical Systems segment:

 
| ** **                                    | ** ** | **Three-Months  Ended September 30,** | ** ** | **Nine-Months  Ended September 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Product revenue                               |       | $                                          | —     |                                      | $          | — |   | $ | — |   | $ | 204 |   |
| Service revenue                               |       | —                                     |       | —                                    |       | — |   | 223 |   |
| Total revenue                                 |       | —                                     |       | —                                    |       | — |   | 427 |   |
| Cost of products sold                         |       | —                                     |       | —                                    |       | — |   | 87 |   |
| Cost of services sold                         |       | —                                     |       | —                                    |       | — |   | 317 |   |
| Total cost of products and  services sold     |       | —                                     |       | —                                    |       | — |   | 404 |   |
| Gross profit                                  |       | —                                     |       | —                                    |       | — |   | 23 |   |
|                                          |       |                                       |       |                                      |       |   |   |   |   |
| Selling, general and  administrative expenses |       | —                                     |       | 35                                        |       | — |   | 1,081 |   |
| Other expense (income)                        |       | (85                                        | )          | (290                                      | )          | (85 | ) | (185 | ) |
| Income (loss) from discontinued operations    |       | $                                          | 85         |                                      | $          | 255 |   | $ | 85 |   | $ | (873 | ) |

 

The above resultsdo not include 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.

 

Thenet (liabilities) assets of discontinued operations as September 30, 2005and December 31, 2004, were comprised of the following:

 
| ** **                                             | ** ** | **September 30, 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                                           |       | —                      |       | 135                        |       |
| Total Assets                                           |       | $                           | —     |                       | $          | 135 |   |
|                                                   |       |                        |       |                       |       |
| Liabilities:                                           |       |                        |       |                       |       |
| Notes payable and current maturities of long-term debt |       | $                           | —     |                       | $          | — |   |
| Accounts payable                                       |       | —                      |       | —                     |       |
| Accrued expenses and deferred revenue                  |       | 94                          |       | 129                        |       |
| Total Liabilities                                      |       | $                           | 94         |                       | $          | 129 |   |
|                                                   |       |                        |       |                       |       |
| Net (Liabilities) Assets                               |       | $                           | (94        | )                          | $          | 6 |   |

 

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

 

The Company is an advanced technology company in thefield of rapid and accurate identification, location tracking, and conditionmonitoring of high-value assets.  TheCompany’s operating segments are: (1) Animal Applications and (2) GPS and RadioCommunications.  During 2004, DigitalAngel Corporation sold substantially all the assets related to its MedicalSystems segment’s medical services business.

 

10

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It is on the basis of segmentreporting that management utilizes the financial information to assist inmaking internal operating decisions.  TheCompany evaluates performance based on stand-alone segment operating income.

 

Following is the selected segment datafor the three months ended September 30, 2005 (in thousands):

 
| ** **                                                                        | ** ** | **Animal  Applications** | ** ** | **GPS and  Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------------|------------|------------------------------|------------|------------------|------------|
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Net revenue from external customers:                                              |       |                     |       |                               |       |                         |       |             |       |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Product                                                                           |       | $                        | 8,448      |                               | $          | 4,769                        |       | $                | —     |   | $ | 13,217 |   |
| Service                                                                           |       | 321                      |       | 220                                |       | —                       |       | 541              |       |
| Total revenue                                                                     |       | $                        | 8,769      |                               | $          | 4,989                        |       | $                | —     |   | $ | 13,758 |   |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Operating loss                                                                    |       | $                        | (612       | )                                  | $          | (373                         | )          | $                | —     |   | $ | (985 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Loss before taxes,  minority interest share of income and discontinued operations |       | $                        | (601       | )                                  | $          | (381                         | )          | $                | —     |   | $ | (982 | ) |
|                                                                                   |            |                          |            |                                    |            |                              |            |                  |            |  |  |  |  |  |

 

Following is the selected segmentdata as of and for the nine months ended September 30, 2005 (inthousands):

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

 

Following is the selected segmentdata for the three months ended September 30, 2004 (in thousands):

 
| ** **                                                                        | ** ** | **Animal  Applications** | ** ** | **GPS and  Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------------|------------|------------------------------|------------|------------------|------------|
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Net revenue from external customers:                                              |       |                     |       |                               |       |                         |       |             |       |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Product                                                                           |       | $                        | 5,303      |                               | $          | 5,365                        |       | $                | —     |   | $ | 10,668 |   |
| Service                                                                           |       | 212                      |       | 300                                |       | —                       |       | 512              |       |
| Total revenue                                                                     |       | $                        | 5,515      |                               | $          | 5,665                        |       | $                | —     |   | $ | 11,180 |   |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Operating income (loss)                                                           |       | $                        | (327       | )                                  | $          | 177                          |       | $                | —     |   | $ | (150 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Loss before taxes, minority  interest share of income and discontinued operations |       | $                        | (777       | )                                  | $          | 128                          |       | $                | —     |   | $ | (649 | ) |
|                                                                                   |            |                          |            |                                    |            |                              |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |

 

 

11

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Following is the selected segmentdata as of and  for the nine months endedSeptember 30, 2004 (in thousands):

 
| ** **                                                                        | ** ** | **Animal  Applications** | ** ** | **GPS and  Radio  Communications** | ** ** | **Corporate /  Unallocated** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------|------------|------------------------------------|------------|------------------------------|------------|------------------|------------|
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Net revenue from external customers:                                              |       |                     |       |                               |       |                         |       |             |       |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Product                                                                           |       | $                        | 18,091     |                               | $          | 12,491                       |       | $                | —     |   | $ | 30,582 |   |
| Service                                                                           |       | 609                      |       | 830                                |       | —                       |       | 1,439            |       |
| Total revenue                                                                     |       | $                        | 18,700     |                               | $          | 13,321                       |       | $                | —     |   | $ | 32,021 |   |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Operating loss                                                                    |       | $                        | (436       | )                                  | $          | (1,275                       | )          | $                | —     |   | $ | (1,711 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Loss before taxes,  minority interest share of income and discontinued operations |       | $                        | (3,859     | )                                  | $          | (1,392                       | )          | $                | —     |   | $ | (5,251 | ) |
|                                                                              |       |                     |       |                               |       |                         |       |             |       |
| Total assets                                                                      |       | $                        | 59,743     |                               | $          | 17,359                       |       | $                | 101        |   | $ | 77,203 |   |
|                                                                                   |            |                          |            |                                    |            |                              |            |                  |            |  |  |  |  |  |  |

 

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

 

The following describes theacquisitions by the Company (in thousands) in the nine months ended September30, 2005 and 2004:

 
| **Company Acquired**  | ** ** | **Date  Acquired** | ** ** | **Acquisition  Price** | ** ** | **Goodwill  and  Other  Intangibles  Acquired** | ** ** | **Other Net  Assets and  Liabilities** | ** ** | **Business  Description** | ** ** |
|-----------------------|------------|--------------------|------------|------------------------|------------|-------------------------------------------------|------------|----------------------------------------|------------|---------------------------|------------|
| DSD Holdings A/S      |       | 2/28/05            |       | $                      | 3,902      |                                            | $          | 4,743                                  |       | $                         | (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 AngelCorporation.  The acquisition was accountedfor under the purchase method of accounting.  The excess of purchase price over the fair value of the assets andliabilities of DSD Holdings A/S has been recorded as goodwill.  The acquisition of DSD Holdings A/S has beenrecorded based on preliminary estimates as of the date of acquisition.  Any changes to the preliminary estimatesduring the allocation period will be reflected as an adjustment to goodwill.

 

Under the terms of the DSD Holdings A/S acquisition,the Company purchased all of the outstanding capital stock of DSD Holdings A/Sin consideration for a purchase price of seven times DSD Holdings A/S’s averageannual EBITDA over the next three years less outstanding indebtedness at theend of the time period.  An initialpayment of $3.5 million was made at closing through the delivery of AppliedDigital common stock valued at $3.5 million which the Company acquired fromApplied Digital in exchange for $3.5 million of Digital Angel Corporationcommon stock.  To account for pre-closingpricing fluctuations the Company paid additional consideration of $195,000 tothe shareholders of DSD Holdings A/S on June 7, 2005.

 

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

 

Denmark-based DSD Holdings A/S through itssubsidiaries manufactures and markets visual and electronic RFID tags forlivestock.  In considering the benefits of the DSDacquisition, the management of Digital Angel recognized the synergies availablewith DSD’s highly automated andefficient manufacturing facility, as well as DSD’s presence in successfullydeveloped markets in Europe, the Middle East and Asia. The acquisition providesDigital Angel with immediate expansion of its existing business in the significantEuropean market for livestock tagging and tracking.

 

Digital AngelCorporation operates DSD Holdings A/S and its operating subsidiaries from theircurrent headquarters near Copenhagen, Denmark.

 

12

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On January 22,2004, the Company acquired OuterLink Corporation, which became a wholly-ownedsubsidiary of Digital Angel Corporation. The acquisition was accounted for under the purchase method ofaccounting.   The excess of purchaseprice over the fair value of the assets and liabilities of OuterLinkCorporation was recorded as goodwill of $3.8 million and intangible assets of$4.7 million. The intangible assets are customer relationships, trademarks andcore technology. The customer relationships and core technology are beingamortized over periods ranging from 4 to 8 years.  Amortization recorded in the three-monthsended September 30, 2005 and 2004 was $0.2 million and $0.1million,respectively.  Amortization recorded inthe nine-months ended September 30, 2005 and 2004 was $0.5 million and$0.5 million, respectively.  Thetrademark has an indefinite life.

 

The costof the acquisition consisted of 100,000 shares of Series A preferred stockvalued at $8.3 million and acquisition costs of $0.2 million.  The Series A preferred stock becameconvertible into four million shares of the Company’s common stock when thevolume weighted average price of the Company’s common stock was greater than orequal to $4.00 per share for ten consecutive trading days.  As of September 30, 2005, 99,976preferred shares had been converted into 3.9 million shares of the Company’scommon stock.

 

Thevaluation of the stock was primarily based on historical trading history andstock prices of the Company’s common stock and a marketability discount of30%.  The acquisition costs consist oflegal and accounting related services that were direct costs of theacquisition.

 

Inconsidering the benefits of the OuterLink Corporation acquisition, themanagement of Digital Angel Corporation recognized the strategic complement ofOuterLink Corporation’s technologies and customer base with Digital AngelCorporation’s existing animal applications and military GPS business lines.

 

The results of DSD Holdings A/S andOuterLink Corporation have been included in the consolidated financialstatements since their dates of acquisition, February 28, 2005 andJanuary 22, 2004, respectively. Unaudited pro forma results of operations for the three months ended September 30,2004 and the nine months ended September 30, 2005 and 2004 are includedbelow.  Such pro forma informationassumes that the above acquisitions had occurred as of January 1, 2005 and2004, and revenue is presented in accordance with the Company’s accountingpolicies.  This summary is not necessarilyindicative of what the results of operations of the Company would have been hadit been a combined entity during such periods, nor does it purport to representresults of operations for any future periods.

 
| ** **                                    | ** ** | **For the  three months  ended September 30,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|
| **(In thousands)**                            | ** ** | **2004**                                            | ** ** |
| Net revenue                                   |       | $                                                   | 12,129     |   |
| Net loss                                      |       | $                                                   | (643       | ) |
| Net loss per common share - basic and diluted |       | $                                                   | (0.02      | ) |

 
| ** **                                    | ** ** | **For the nine  months ended September 30,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------|------------|
| **(In thousands)**                            | ** ** | **2005**                                          | ** ** | **2004** | ** ** |
| Net revenue                                   |       | $                                                 | 42,904     |   | $ | 34,738 |   |
| Net loss                                      |       | $                                                 | (2,399     | ) | $ | (7,651 | ) |
| Net loss per common share - basic and diluted |       | $                                                 | (0.06      | ) | $ | (0.24 | ) |

 

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

 

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

 

On October 20, 2004, the Company commenced anaction in the United Stated District Court for the District of Minnesotaagainst AllFlex USA, Inc. and Pet Health Services (USA), Inc.  This suit claimed that Allflex is marketingand selling a syringe implantable identification transponder that infringes a1993 patent granted to the Company for syringe implantable identificationtransponders previously found by the United States District Court for theDistrict of Colorado to be enforceable. The suit also claimed that PetHealth is using, selling and/ordistributing the same transponder in violation of the Company’s patent.  The suit sought, among other things, anadjudication of infringement and that the infringing parties be enjoined fromfurther improper action.  The suit soughtactual damages, punitive damages and interest, costs and attorneys’ fees.  Allflex asserted a counterclaim for breach ofcontract of an existing license agreement between the Company and Allflex andasserted a counterclaim seeking a declaration of the parties’ rights andobligations under the license agreement. Allflex also moved for a judgment on the pleadings, asserting that thelicense agreement should act as a bar to a case for infringement.  The Company contested the motion on theground that Allflex’s actions exceed the scope of the license and constitutedan impermissible infringement of the patent and asked the Court for leave toamend the complaint to assert a claim against a separate patent licensedexclusively to the Company by Bio Medic Data Systems.   On June 23, 2005, the Court issued aruling granting the Defendant’s motion for judgment on the pleadings anddenying the Company’s motion for leave to amend.

 

13

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

 

On September 28, 2005, Allflex sought an award ofattorneys fees and costs based on a fee-shifting clause in the licenseagreement and under 35 U.S.C. §285, which provides for an award of attorneysfees and costs in exceptional cases.  TheCompany contested this motion, and on October 6, 2005, the Court denied themotion in its entirety.  Final judgmentin the action has not yet entered, and the Company is considering whether toappeal the Court’s ruling granting judgment on the pleadings.

 

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

 

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

 

On or about December 29, 2004 The CrystalImport Corporation filed an action against AVID IdentificationSystems, Inc. and the Company in the United States District Court for theNorthern District of Alabama.  Crystal’scomplaint primarily asserted federal and state antitrust and related claimsagainst AVID, though it also asserted similar claims against the Company.  The Company filed a motion to dismiss theaction for failure to state a claim on which relief could be granted, or in thealternative, to have the action transferred to the United States District Courtfor the District of Minnesota for consolidation with the Datamars patentinfringement action referred to above or to have the action stayed until thecompletion of the Datamars action.   OnOctober 12, 2005, the Alabama Court denied the Company’s motion to dismiss thecomplaint, but granted the Company’s motion to transfer the action toMinnesota, where the Company intends to seek to consolidate the action with thepatent infringement action.  Given theuncertainties associated with all litigation and given the early stage of thisproceeding, the Company is unable to offer any assessment on the potentialliability exposure, if any, to the Company from this lawsuit.

 

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

 
| ** **                                            | ** ** | **Nine Months  Ended September 30,** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| Interest paid                                         | ** ** | **$**                                     | **291**    |   | $ | 378 |   |
| Taxes paid                                            | ** ** | **111**                                   |       | — |   |
| Non-cash activity:                                    |       |                                      |       |   |   |
| Issuance of preferred  stock for business acquisition |       | —                                    |       | 8,300 |   |
| Issuance of common stock  for ADS common stock        | ** ** | **3,500**                                 |       | 7,920 |   |
| Conversion of debt into  common stock                 |       | —                                    |       | 699 |   |
|                                                       |            |                                           |            |  |  |  |  |

 

**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$0.5 million and $0.1 million for the nine months ended September 30, 2005and 2004, respectively.  Prior toJanuary 1, 2005 and pursuant to mutual agreement between the Company,Applied Digital and Verichip Corporation amounts due from Verichip Corporationwere offset against amounts the Company owed to Applied Digital for certaingeneral and administrative services, research and development services,directors and officers insurance and expense reimbursement.  Effective January 1, 2005, all amountsdue from Verichip Corporation are to be paid to the Company.

 

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

 

 

14

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Following is a summary of amountsdue from and amounts due to related parties as of September 30, 2005 andDecember 31, 2005. (In thousands)

 
| ** **                    | ** ** | **Nine Months  Ended September 30,** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
| ** **                    | ** ** | **September  30,  2005**                  | ** ** | **December 31,  2004** | ** ** |
| Due from Verichip Corporation | ** ** | **$**                                     | **7**      |   | $ | — |   |
| Due to Applied Digital        | ** ** | **16**                                    |       | 23 |   |
|                               |            |                                           |            |  |  |  |  |

 

 

**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations.**

 

The following discussion andanalysis of our financial condition and results of operations should be read inconjunction with the accompanying financial statements and related notesthereto.

 

We consist of Digital AngelCorporation and its seven subsidiaries - Digital Angel Technology Corporation (“DATC”),Timely Technology Corp., Signature Industries Limited (90.9% owned subsidiary),OuterLink Corporation, DSD Holdings A/S, Digital Angel Holdings, Inc. andDigital Angel International, Inc.

 

**RESULTS OFOPERATIONS**

 

The following table summarizes ourresults of operations as a percentage of net operating revenue for the threeand nine months ended September 30, 2005 and 2004 and is derived from theaccompanying consolidated statements of operations included in this report.

 
| ** **                                                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                      | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                      | ** ** | **%**                                      | ** ** | **%**                                     | ** ** | **%** | ** ** | **%** | ** ** |
| Product revenue                                                 |       | 96.1                                       |       | 95.4                                      |       | 95.6 |   | 95.5 |   |
| Service revenue                                                 |       | 3.9                                        |       | 4.6                                       |       | 4.4 |   | 4.5 |   |
| Total net revenue                                               |       | 100.0                                      |       | 100.0                                     |       | 100.0 |   | 100.0 |   |
| Cost of products sold                                           |       | 54.8                                       |       | 52.5                                      |       | 53.7 |   | 54.6 |   |
| Cost of services sold                                           |       | 2.1                                        |       | 2.6                                       |       | 2.1 |   | 2.6 |   |
| Total cost of products and  services sold                       |       | 56.9                                       |       | 55.1                                      |       | 55.8 |   | 57.2 |   |
| Gross profit                                                    |       | 43.1                                       |       | 44.9                                      |       | 44.2 |   | 42.8 |   |
| Selling, general and  administrative expenses                   |       | 41.8                                       |       | 39.7                                      |       | 40.9 |   | 41.1 |   |
| Research and development  expenses                              |       | 8.5                                        |       | 6.5                                       |       | 8.1 |   | 7.0 |   |
| Operating loss                                                  |       | (7.2                                       | )          | (1.3                                      | )          | (4.8 | ) | (5.3 | ) |
| Interest income                                                 |       | 0.6                                        |       | 0.1                                       |       | 0.6 |   | 0.1 |   |
| Interest expense                                                |       | (0.6                                       | )          | (2.3                                      | )          | (0.7 | ) | (2.4 | ) |
| Loss on Applied Digital  common stock                           |       | 0.0                                        |       | (2.5                                      | )          | 0.0 |   | (9.0 | ) |
| Other income                                                    |       | 0.1                                        |       | 0.2                                       |       | 0.1 |   | 0.2 |   |
| Loss before tax, minority  interest and discontinued operations |       | (7.1                                       | )          | (5.8                                      | )          | (4.8 | ) | (16.4 | ) |
| Income tax expense                                              |       | (0.2                                       | )          | —                                    |       | (0.3 | ) | — |   |
| Minority interest share of  income                              |       | (0.5                                       | )          | (1.2                                      | )          | (0.7 | ) | (0.4 | ) |
| Net loss from continuing  operations                            |       | (7.8                                       | )          | (7.0                                      | )          | (5.8 | ) | (16.8 | ) |
| Income (loss) from  discontinued operations                     |       | 0.6                                        |       | 2.3                                       |       | 0.2 |   | (2.7 | ) |
| Net loss                                                        |       | (7.2                                       | )          | (4.7                                      | )          | (5.6 | ) | (19.5 | ) |

 

**Three Months Ended September 30, 2005Compared to the Three Months Ended September 30, 2004**

 

**Revenue**

 

Revenue for the three months endedSeptember 30, 2005 increased $2.6 million, or 23.1%, to $13.8 million whencompared to $11.2 million in revenue for the three months endedSeptember 30, 2004.

 

15

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Revenue for each of the operatingsegments was as follows (in thousands):

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2005** | ** ** | **Three Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Animal Applications          |       | $                                                | 8,769      |                                             | $          | 5,515 |   |
| GPS and Radio Communications |       | 4,989                                            |       | 5,665                                            |       |
| Total                        |       | $                                                | 13,758     |                                             | $          | 11,180 |   |

 

The Animal Applications segment’srevenue increased**approximately $3.3 million, or 59.0%,in the three months ended September 30, 2005 compared to the three monthperiod ended September 30, 2004. The increase in revenue was principallydue to an increase in sales to fish and wildlife customers of approximately$0.9 million, an increase in microchip and visual product sales to livestockcustomers of approximately $0.8 million, an increase in sales to companionanimal customers of approximately $0.5 million, and the inclusion ofapproximately $1.1 million of revenue from DSD Holdings A/S.  DSD Holdings A/S was acquired onFebruary 28, 2005.

 

The GPS and Radio Communicationssegment’s revenue decreased approximately $0.7 million, or 11.9% toapproximately $5.0 million in the three months ended September 30, 2005from approximately $5.7 million in the three months ended September 30,2004.  The decrease primarily relates todecreased revenue at our subsidiary, Signature Industries.   In the three months ended September 30, 2005there were no shipments by Signature Industries of the G2R Sarbe locator beaconunder the contract with the government of India compared to approximately $1.8million of shipments in the three months ended September 30, 2004. Signature’slast shipment under the contract with the government of India occurred in May2005. In the three months ended September 30, 2005 this decrease was offset byincreased shipments of Sarbe accessories to the United Kingdom Ministry ofDefence of approximately $0.6 million and increased sales of approximately $0.5million in Signature’s alarm and equipment leasing divisions.

 

**Gross Profit andGross Profit Margin**

 

Gross profit for the three monthperiod ended September 30, 2005 was approximately $5.9 million, anincrease**of approximately $0.9million, or 18.3%, compared to approximately $5.0 million in the three monthperiod ended September 30, 2004. As a percentage of revenue, the grossprofit margin decreased to 43.1% for the three months ended September 30,2005 from 44.9% for the three months ended September 30, 2004.

 

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

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2005** | ** ** | **Three Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Animal Applications          |       | $                                                | 3,478      |                                             | $          | 2,155 |   |
| GPS and Radio Communications |       | 2,458                                            |       | 2,861                                            |       |
| Total                        |       | $                                                | 5,936      |                                             | $          | 5,016 |   |

 

Gross profit margin from operationsfor each operating segment was:

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2005** | ** ** | **Three Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                            | ** ** | **%**                                            | ** ** |
| Animal Applications          |       | 39.7                                             |       | 39.1                                             |       |
| GPS and Radio Communications |       | 49.3                                             |       | 50.5                                             |       |

 

The Animal Applications segment’sgross profit increased approximately $1.3 million, or 61.4%, in the three monthperiod ended September 30, 2005 compared to the three months endedSeptember 30, 2004.  We attributeapproximately $1.0 million of the increase to the previously mentioned salesincrease and improved margins and the inclusion of approximately $0.3 millionof gross profit from DSD Holdings A/S. DSD Holdings A/S was acquired on February 28, 2005.  The gross margin percentage was 39.7% for thethree month period ended September 30, 2005 compared to 39.1% for thethree month period ended September 30, 2004.

 

The GPS and Radio Communicationssegment’s gross profit decreased approximately $0.4 million, or 14.1%, in the threemonth period ended September 30, 2005 as compared to the three monthperiod ended September 30, 2004. The decrease in gross profit relates tothe decrease in sales. The gross margin percentage decreased to 49.3% in thethree month period ended September 30, 2005 as compared to 50.5% in thethree month period ended September 30, 2004.

 

**Selling, Generaland Administrative Expenses**

 

Selling, general and administrativeexpenses increased approximately $1.3 million, or 29.8%, in the three monthperiod ended September 30, 2005 as compared to the three month periodended September 30, 2004. As a percentage of revenue, selling, general andadministrative expenses were 41.8% and 39.7% for the three months endedSeptember 30, 2005 and 2004, respectively.

 

16

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Selling, general and administrativeexpenses for each of the operating segments were as follows (dollars inthousands):

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2005** | ** ** | **Three Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Animal Applications          |       | $                                                | 3,373      |                                             | $          | 1,944 |   |
| GPS and Radio Communications |       | 2,383                                            |       | 2,491                                            |       |
| Total                        |       | $                                                | 5,756      |                                             | $          | 4,435 |   |

 

Selling, general and administrativeexpenses as a percentage of revenue for each of the operating segments were:

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2005** | ** ** | **Three Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                            | ** ** | **%**                                            | ** ** |
| Animal Applications          |       | 38.5                                             |       | 35.2                                             |       |
| GPS and Radio Communications |       | 47.8                                             |       | 44.0                                             |       |

 

The Animal Applications segment’sselling, general and administrative expenses increased approximately $1.4million in the three month period ended September 30, 2005 as compared tothe three month period ended September 30, 2004 and selling, general andadministrative expense as a percentage of revenue increased to 38.5% from 35.2%in the same respective period.  The increasein selling, general and administrative expense relates primarily to a charge ofapproximately $0.4 million in legal expenses related to the protection of theCompany’s intellectual property, approximately $0.4 million of compensationexpense, and approximately $0.4 million of expense related to DSD HoldingA/S.  DSD Holding A/S was acquired onFebruary 28, 2005.

 

The GPS and Radio Communicationssegment’s selling, general and administrative expenses decreased approximately$0.1 million to approximately $2.4 million in the three month period endedSeptember 30, 2005 from approximately $2.5 million in the three monthperiod ended September 30, 2004.  Asa percentage of revenue, selling, general and administrative expenses increasedto 47.8% in the three month period ended September 30, 2005 from 44.0% inthe three month period ended September 30, 2004.  The increase in selling, general andadministrative expense as a percentage of sales resulted primarily from thedecrease in sales in the current period.

 

**Research andDevelopment Expense**

 

Research and development expensewas approximately $1.2 million in the three month period endedSeptember 30, 2005, an increase of approximately $0.4 million, or 59.4%,from approximately $0.7 million for the three month period endedSeptember 30, 2004.  As a percentageof revenue, research and development expense was 8.5% and 6.5% for the threemonths ended September 30, 2005 and 2004, respectively.

 

Research and development expensefor each of the operating segments was as follows (in thousands):

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2005** | ** ** | **Three Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Animal Applications          |       | $                                                | 717        |                                             | $          | 539 |   |
| GPS and Radio Communications |       | 448                                              |       | 192                                              |       |
| Total                        |       | $                                                | 1,165      |                                             | $          | 731 |   |

 

 

 

The Animal Applications segments researchand development expense was approximately $0.7 million in the three monthperiod ended September 30, 2005, an increase of approximately $0.2 million, or33.0%, from approximately $0.5 million for the three month period endedSeptember 30, 2004. The increase is related to the development of a large scaleradio frequency identification (RFID) antenna detection system for a fish andwildlife customer.

 

The GPS and Radio Communicationssegment’s research and development expense was approximately $0.4 million inthe three month period ended September 30, 2005, an increase of approximately$0.2 million, or 133.3%, from approximately $0.2 million in the three monthsended September 30, 2004.   Theincrease is primarily related to expenses at our OuterLink subsidiaryassociated with continued development of its next generation of communicationsystem hardware.

 

17

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**Interest Expense**

 

Interest expense was approximately$0.1 million and approximately $0.3 million for the three month periods endedSeptember 30, 2005 and 2004, respectively. Interest expense in the three months ended September 30, 2004included discount amortization and deferred debt cost amortization.

 

**Loss on AppliedDigital Common Stock**

 

On March 1, 2004, DigitalAngel Corporation issued 3,000,000 shares of its common stock and a warrant topurchase up to 1,000,000 shares of the Company’s common stock to AppliedDigital in exchange for 1,980,000 shares of Applied Digital’s common stock,exclusive of warrant proceeds.  In thequarter ended September 30, 2004, the Company recorded unrealized lossesof approximately $0.3 million related to the stock exchange with AppliedDigital.  As of December 31, 2004,the Company had sold all of the 1,980,000 shares of Applied Digital commonstock for approximately $6.7 million.

 

**Income Taxes**

 

The Company recorded an income taxprovision of $24,000 in the three month period ended September 30, 2005and no tax provision for the three month period ended September 30, 2004.  Income taxes for the three month period endedSeptember 30, 2005 relate to income earned by a subsidiary of DaplomaInternational A/S.  The Company accountsfor 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.

 

**DiscontinuedOperations**

 

During2004, the Company sold substantially all the assets of its Medical Systemssegment.

 

The followingdiscloses the operating losses from discontinued operations for the threemonths ended September 30, 2005 and 2004, consisting of lossesattributable to the Medical Systems segment:

 
| ** **                                    | ** ** | **Three-Months  Ended September 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Product revenue                               |       | $                                          | —     |   | $ | — |   |
| Service revenue                               |       | —                                     |       | — |   |
| Total revenue                                 |       | —                                     |       | — |   |
| Cost of products sold                         |       | —                                     |       | — |   |
| Cost of services sold                         |       | —                                     |       | — |   |
| Total cost of products and  services sold     |       | —                                     |       | — |   |
| Gross profit                                  |       | —                                     |       | — |   |
| Selling, general and  administrative expenses |       | —                                     |       | 35 |   |
| Other income                                  |       | (85                                        | )          | (290 | ) |
| Income from discontinued operations           |       | $                                          | 85         |   | $ | 255 |   |

 

 

 

**Nine Months Ended September 30, 2005Compared to the Nine Months Ended September 30, 2004**

 

**Revenue**

 

Revenue for the nine months endedSeptember 30, 2005 increased approximately $10.0 million, or 31.2%, toapproximately $42.0 million when compared to approximately $32.0 million in revenuefor the nine months ended September 30, 2004.

 

Revenue for each of the operatingsegments was as follows (in thousands):

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2005** | ** ** | **Nine Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal Applications          |       | $                                               | 25,402     |                                            | $          | 18,700 |   |
| GPS and Radio Communications |       | 16,619                                          |       | 13,321                                          |       |
| Total                        |       | $                                               | 42,021     |                                            | $          | 32,021 |   |

 

18

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The Animal Applications segment’srevenue increased approximately**$6.7million, or 35.8%, in the nine months ended September 30, 2005 compared tothe nine month period ended September 30, 2004. The increase in revenuewas principally due to an increase in microchip and visual product sales tolivestock customers of approximately $1.7 million, an increase in sales to fishand wildlife customers of approximately $0.9 million, an increase in sales tocompanion animal customers of approximately $0.5 million, an increase in salesto Verichip Corporation of approximately $0.4 million and the inclusion ofapproximately $3.2 million of revenue from DSD Holdings A/S.  DSD Holdings A/S was acquired onFebruary 28, 2005.

 

The GPS and Radio Communicationssegment’s revenue increased approximately $3.3 million, or 24.8% toapproximately $16.6 million in the nine months ended September 30, 2005from approximately $13.3 million in the nine months ended September 30,2004.  The increase was principally dueto increased sales of approximately $2.9 million at our subsidiary, SignatureIndustries, related to shipments of Sarbe accessories to the United KingdomMinistry of Defence and increased sales in Signature’s alarm and equipmentleasing divisions.  Additionally, salesat our subsidiary OuterLink Corporation increased approximately $0.4 million inthe nine months ended September 30, 2005 as compared to the nine monthsended September 30, 2004

 

**Gross Profit andGross Profit Margin**

 

Gross profit for the nine monthperiod ended September 30, 2005 was approximately $18.6 million, anincrease**of approximately $4.9million, or 35.5%, compared to approximately $13.7 million in the nine monthperiod ended September 30, 2004. As a percentage of revenue, the grossprofit margin increased to 44.2% for the nine months ended September 30,2005 from 42.8% for the nine months ended September 30, 2004.

 

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

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2005** | ** ** | **Nine Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal Applications          |       | $                                               | 10,067     |                                            | $          | 7,289 |   |
| GPS and Radio Communications |       | 8,504                                           |       | 6,412                                           |       |
| Total                        |       | $                                               | 18,571     |                                            | $          | 13,701 |   |

 

Gross profit margin from operationsfor each operating segment was:

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2005** | ** ** | **Nine Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                           | ** ** | **%**                                           | ** ** |
| Animal Applications          |       | 39.6                                            |       | 39.0                                            |       |
| GPS and Radio Communications |       | 51.2                                            |       | 48.1                                            |       |

 

The Animal Applications segment’sgross profit increased approximately $2.8 million, or 38.1%, in the nine monthperiod ended September 30, 2005 compared to the nine months endedSeptember 30, 2004.  We attributeapproximately $1.6 million of the increase to the previously mentioned salesincrease and $1.2 million of the increase to the inclusion of gross profit fromDSD Holdings A/S.  DSD Holdings A/S wasacquired on February 28, 2005.  Thegross margin percentage was 39.6% for the nine month period ended September 30,2005 and 39.0% for the nine month period ended September 30, 2004.

 

The GPS and Radio Communicationssegment’s gross profit increased approximately $2.1 million, or 32.6%, in thenine month period ended September 30, 2005 as compared to the nine monthperiod ended September 30, 2004. The gross margin percentage increased to 51.2% in the nine month periodended September 30, 2005 as compared to 48.1% in the nine month period endedSeptember 30, 2004.  The increase ingross profit margin results primarily from higher margins at our SignatureIndustries, Ltd subsidiary related to shipments of Sarbe accessories to theMinistry of Defence.

 

 

**Selling, Generaland Administrative Expenses**

 

Selling, general and administrativeexpenses increased approximately $4.0 million, or 30.7%, in the nine monthperiod ended September 30, 2005 as compared to the nine month period endedSeptember 30, 2004. As a percentage of revenue, selling, general andadministrative expenses were 40.9% and 41.1% for the nine months endedSeptember 30, 2005 and 2004, respectively.

 

19

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Selling, general and administrativeexpenses for each of the operating segments were as follows (dollars inthousands):

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2005** | ** ** | **Nine Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal Applications          |       | $                                               | 9,714      |                                            | $          | 6,010 |   |
| GPS and Radio Communications |       | 7,488                                           |       | 7,152                                           |       |
| Total                        |       | $                                               | 17,202     |                                            | $          | 13,162 |   |

 

Selling, general and administrativeexpenses as a percentage of revenue for each of the operating segments were:

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2005** | ** ** | **Nine Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                           | ** ** | **%**                                           | ** ** |
| Animal Applications          |       | 38.2                                            |       | 32.1                                            |       |
| GPS and Radio Communications |       | 45.1                                            |       | 53.7                                            |       |

 

The Animal Applications segment’sselling, general and administrative expenses increased approximately $3.7million in the nine month period ended September 30, 2005 as compared tothe nine month period ended September 30, 2004 and as a percentage ofrevenue increased to 38.2% from 32.1% in the same respective period.  The increase in selling, general andadministrative expenses relates primarily to increased legal, compensation andinsurance expense, and approximately $1.0 million of expense related to DSDHolding A/S.  DSD Holding A/S wasacquired on February 28, 2005.

 

The GPS and Radio Communicationssegment’s selling, general and administrative expenses increased approximately$0.3 million to approximately $7.5 million in the nine month period endedSeptember 30, 2005 from approximately $7.2 million in the nine monthperiod ended September 30, 2004. The increase results principally from increased sales and marketingexpenses at our subsidiary, Signature Industries.  As a percentage of revenue, selling, generaland administrative expenses decreased to 45.1% in the nine month period endedSeptember 30, 2005 from 53.7% in the nine month period endedSeptember 30, 2004 primarily due to the increase in sales in the currentperiod.

 

**Research andDevelopment Expense**

 

Research and development expensewas approximately $3.4 million in the nine month period endedSeptember 30, 2005, an increase of approximately $1.1 million, or 49.8%,from approximately $2.3 million for the nine month period endedSeptember 30, 2004.  As a percentageof revenue, research and development expense was 8.1% and 7.0% for the ninemonths ended September 30, 2005 and 2004, respectively.

 

Research and development expensefor each of the operating segments was as follows (in thousands):

 

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2005** | ** ** | **Nine Months  Ended September 30,  2004** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal Applications          |       | $                                               | 2,087      |                                            | $          | 1,715 |   |
| GPS and Radio Communications |       | 1,283                                           |       | 535                                             |       |
| Total                        |       | $                                               | 3,370      |                                            | $          | 2,250 |   |

 

 

The Animal Applications segmentsresearch and development expense increased approximately $0.4 million in thenine months ended September 30, 2005 as compared to the nine months endedSeptember 30, 2004.  The increaserelates primarily to the development  newlarge scale radio frequency identification (RFID) antenna detection system fora fish and wildlife customer.

 

The GPS and Radio Communicationssegment’s research and development expense was approximately $1.3 million forthe nine month period ended September 30, 2005 an increase of approximately$0.7 million, or 139.8%, when compared to approximately $0.5 million in the ninemonths ended September 30, 2004.  Ofthe approximately $0.7 million increase, approximately $0.4 million related toresearch and development expenses at our OuterLink subsidiary for the continueddevelopment of its next generation of communication system hardware andapproximately $0.3 million related to continuing product development programs.

 

**Interest Expense**

 

Interest expense was approximately$0.3 million and approximately $0.8 million for the nine month periods endedSeptember 30, 2005 and 2004, respectively. Interest expense for the nine month period ended September 30, 2004includes discount amortization and deferred debt cost amortization.  There were no corresponding charges in the2005 period.

 

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**Loss on AppliedDigital Common Stock**

 

On March 1, 2004, DigitalAngel Corporation issued 3,000,000 shares of its common stock and a warrant topurchase up to 1,000,000 shares of the Company’s common stock to AppliedDigital in exchange for 1,980,000 shares of Applied Digital’s common stock,exclusive of warrant proceeds.  In thenine months ended September 30, 2004, the Company recorded realized lossesof approximately $1.0 million on the approximately 910,000 shares of AppliedDigital common stock sold and unrealized losses of approximately $1.9 millionon the 1,070,000 shares held by the Company. As of December 31, 2004, the Company had sold all of the 1,980,000shares of Applied Digital common stock for approximately $6.7 million.

 

**Income Taxes**

 

The Company recorded an income taxprovision of $0.1 million in the nine month period ended September 30,2005 and no tax provision for the nine month period ended September 30,2004.  Income taxes for the nine monthperiod ended September 30, 2005 relate to income earned by a subsidiary ofDaploma International A/S.  The Companyaccounts for income taxes under the asset and liability approach.  Deferred tax assets and liabilities are recognizedfor the expected future tax consequences attributed to differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax basis.  Deferred taxassets and liabilities are measured using the enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to reverse.  A valuationallowance is provided against net deferred tax assets when it is more likelythan not that a tax benefit will not be realized.

 

**DiscontinuedOperations**

 

During2004, the Company sold substantially all the assets of its Medical Systemssegment.

 

The followingdiscloses the operating losses from discontinued operations for the nine monthsended September 30, 2005 and 2004, consisting of losses attributable tothe Medical Systems segment:

 
| ** **                                    | ** ** | **Nine-Months  Ended September 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| Product revenue                               |       | $                                         | —     |   | $ | 204 |   |
| Service revenue                               |       | —                                    |       | 223 |   |
| Total revenue                                 |       | —                                    |       | 427 |   |
| Cost of products sold                         |       | —                                    |       | 87 |   |
| Cost of services sold                         |       | —                                    |       | 317 |   |
| Total cost of products and  services sold     |       | —                                    |       | 404 |   |
| Gross profit                                  |       | —                                    |       | 23 |   |
| Selling, general and  administrative expenses |       | —                                    |       | 1,081 |   |
| Other income                                  |       | (85                                       | )          | (185 | ) |
| Income (loss) from discontinued operations    |       | $                                         | 85         |   | $ | (873 | ) |

 

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**LIQUIDITY ANDCAPITAL RESOURCES**

 

As of September 30, 2005, theCompany had cash of $12.1 million.  Cashused in operating activities totaled $1.6 million and $0.7 million in the firstnine months of 2005 and 2004, respectively.

 

In the first nine months of 2005,the use of cash was due primarily to the loss from continuing operations of$2.5 million, an increase in inventory of $1.1 million and a decrease inaccounts payable, accrued expenses and deferred revenue of $1.5 million.  The increase inventory primarily relates to abuild up of inventory in our Animal Applications division in planning for fourthquarter sales.  The decrease in accruedexpenses relates primarily to the payment of employee bonuses in the firstquarter of 2005.  Offsetting these usesof cash was depreciation and amortization of $1.8 million.

 

Accounts payable increased by $1.2million to $5.1 million at September 30, 2005 from $3.9 million atDecember 31, 2004.  The increaseprimarily relates to $1.1 million of accounts payable acquired in the acquisitionof DSD Holdings A/S.

 

Investing activities used cash of$2.6 million in the first nine months of 2005 and provided cash of $1.1 millionin the first nine months of 2004. In the first nine months of 2005, cash usedwas primarily for the acquisition of DSD Holdings A/S of $1.3 and expendituresfor plant property and equipment of $1.3 million.

 

Financing activities used cash of$1.0 million in the first nine months of 2005 and 2004.  In the first nine months of 2005, cash usedwas primarily for the purchase of 328,100 shares of treasury stock for $1.5million.  In the first nine months of2005, proceeds to the Company related to stock option and warrant exerciseswere $0.4 million.

 

The Company expects that currentavailable funds will adequately fund the Company’s operations for the nexttwelve months.

 

*Debt, Covenant Compliance and Liquidity*

 

*Invoice Discounting Agreement* OnApril 9, 2003, Signature Industries Ltd. entered into a two-year InvoiceDiscounting Agreement with The Royal Bank of Scotland Commercial ServicesLimited (“RBS”).  The Invoice DiscountingAgreement, as amended October 28, 2003 and June 21, 2005, 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 inthe United Kingdom and 75% of the receivables sold in the rest of the world,not to exceed an outstanding balance of £750,000 ($1.3 million atSeptember 30, 2005) at any given time. RBS pays Signature the remainder of the receivable upon collection ofthe receivable.  Receivables which remainoutstanding 90 days from the end of the invoice month become ineligible and RBSmay require Signature to repurchase the receivable back.  The discounting charge accrues daily at anannual rate of 1.85% above the base rate, as defined in the amended InvoiceDiscounting Agreement (6.35% at September 30, 2005).  Signature pays a commission charge to RBS of0.16% of each receivable balance sold. The Invoice Discounting Agreement, as amended, requires a minimumcommission charge of £833 per month. Discounting charges of $30,000 and $52,000 are included in interestexpense for the nine months ended September 30, 2005 and 2004,respectively.  As of September 30, 2005Signature did not have any receivables financed under the Invoice DiscountingAgreement.

 

*Credit Facility*As ofSeptember 30, 2005, DSD Holdings is party to a credit agreement withDanske Bank.  The credit facilityprovides for borrowings up to DKK 12 million ($1,932,000 at September 30,2005).  At September 30, 2005, theannual interest rate on the facility was 4.2%. Borrowing availability under the facility as of September 30, 2005was approximately $205,000.  As ofSeptember 30, 2005, $1.6 million was outstanding under the credit agreementwith Danske Bank.

 

*Mortgage Notes Payable*  The Company is party to a mortgage notespayable collateralized by land and building. Principal and interest payments totaling approximately $30,000 arepayable monthly.  Payments are due throughNovember of 2010.  The interest rate onthe note is fixed at 8.18%.  As ofSeptember 30, 2005, the amount outstanding under the mortgage note payable was$2.2 million.

 

*Equipment Loans*  Daploma is party to equipment loans which arecollateralized by production equipment. Principal and interest payments totaling approximately DKK 0.2 million($29,000 at September 30, 2005) are payable monthly.  Payments are due through January of2010.  The interest rate on the loans arevariable and range from 4.5% to 7.8% as of September 30, 2005.  As of September 30, 2005, the amountoutstanding under the equipment loans was $1.2 million.

 

*StockIssuances to Applied Digital* OnFebruary 25, 2005, the Company entered into a Stock Purchase Agreement with AppliedDigital.  Pursuant to the agreement theCompany issued 644,140 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.

 

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

 

The following table summarizes theCompany’s fixed cash obligations as of September 30, 2005 over variousfuture years (in thousands):

 
| ** **                       | ** ** | ** ** | ** ** | **Payments Due  by Period** | ** ** |
|----------------------------------|------------|------------|------------|-----------------------------|------------|
| **Contractual cash obligations** | ** ** | **Total**  | ** ** | **Less than  1 Year**       | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **After  5 Years** | ** ** |
| Notes Payable and Long-Term Debt |       | $          | 5,932      |                        | $          | 2,236 |   | $ | 950 |   | $ | 769 |   | $ | 1,977 |   |
| Operating Leases                 |       | 18,544     |       | 681                         |       | 1,211 |   | 1,049 |   | 15,603 |   |
| Employment Contracts             |       | 1,149      |       | 1,113                       |       | 36 |   | — |   | — |   |
|                             |       | $          | 25,625     |                        | $          | 4,030 |   | $ | 2,197 |   | $ | 1,818 |   | $ | 17,580 |   |
|                                  |            |            |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**IMPACT OF RECENTLY ISSUED ACCOUNTINGSTANDARDS**

 

In December 2004, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards(SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R), whichreplaces SFAS No. 123, “Accounting for Stock-Based Compensation,” (SFAS123) and supercedes APB Opinion No. 25, “Accounting for Stock Issued toEmployees.” SFAS 123R requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the financial statementsbased on their fair values beginning with fiscal years after June 15,2005, with early adoption encouraged. The pro forma disclosures previouslypermitted under SFAS 123 no longer will be an alternative to financial statementrecognition. The Company is required to adopt SFAS 123R beginningJanuary 1, 2006. Under SFAS 123R, the Company must determine theappropriate fair value model to be used for valuing share-based payments, theamortization method for compensation cost and the transition method to be usedat date of adoption. The transition methods include prospective and retroactiveadoption options. The Company has begun, but has not completed, evaluating theimpact of the adoption of SFAS 123R on its results of operations. Inconnection with evaluating the impact of SFAS 123R, the Company isconsidering the potential implementation of different valuation methods todetermine the fair value of share-based compensation.  The Company believes the adoption ofSFAS 123R will have a material impact on its results of operations,regardless of the valuation method used.

 

In November 2004, the FASB issued SFASNo. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.”SFAS No. 151 amends Accounting Research Bulletin (“ARB”) No. 43,Chapter 4, to clarify that abnormal amounts of idle facility expense, freight,handling costs and wasted materials (spoilage) should be recognized ascurrent-period charges. In addition, SFAS No. 151 requires that allocationof fixed production overhead to inventory be based on the normal capacity ofthe production facilities. The Company is required to adopt SFAS 151 beginningJanuary 1, 2006. The Company believes the adoption of SFAS 151 will nothave a material impact on the results of its operations, financial position orcash flows.

 

**Forward-LookingStatements and Associated Risk**

 

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

 

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

•                  anticipatedtrends in our business and demographics;

•                  our abilityto successfully integrate the business operations of recently acquiredcompanies;

•                  our futureprofitability and liquidity; and

•                  regulatory,competitive or other economic influences.

 

Words such as “anticipates,” “expects,”“intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressionsalso identify forward-looking statements. These forward-looking statements are not guarantees of futureperformance and are subject to risks and uncertainties that could cause actualresults to differ materially from estimates or forecasts contained in theforward-looking statements.  Some ofthese risks and uncertainties are beyond our control.

 

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**Risk Factors**

 

You should carefully consider therisk factors listed below.  These riskfactors may cause our future earnings to be less or our financial condition tobe less favorable than we expect.  Thesefactors may also affect the trading price of our common stock.  You should read this section together withthe other information contained herein.

 

**As of September 30, 2005, ourmajority stockholder, Applied Digital, owns 55.4% of our common stock, is ableto completely control the board of directors and may support actions thatconflict with the interests of the other stockholders.**

 

As of September 30, 2005,Applied Digital Solutions is the beneficial owner of 55.4% of our common stock,and it controls us with respect to all matters upon which our stockholders mayvote, including the selection of the Board of Directors, mergers, acquisitions,sale of additional equity securities and other significant corporatetransactions.  There can be no assuranceas to how Applied Digital Solutions may support actions that are contrary to orconflict with the interests of the other stockholders.

 

**New accounting pronouncements expected to negatively impact our futureresults of operations.**

 

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 123R “Share-Based Payment.” This statement, which will be effective inour first quarter of 2006, will change how we account for share-basedcompensation, and will have a material impact on our future results of operations.

 

We currently account for share-based payments toemployees and directors using the intrinsic value method. Under this method, wegenerally do not recognize any compensation related to stock option grants weissue under our stock option plans.

 

SFAS 123R will require us to recognize share-basedcompensation as compensation expense in the statement of operations based onthe fair values of such equity on the date of the grant, with the compensationexpense recognized over the period in which the recipient is required toprovide service in exchange for the equity award. This statement will alsorequire us to adopt a fair value-based method for measuring the compensationexpense related to share-based compensation. We have begun, but have notcompleted, evaluating the impact of the adoption of SFAS 123R on ourresults of operations. In connection with evaluating the impact ofSFAS 123R, we are considering the potential implementation of differentvaluation methods to determine the fair value of share-based compensation. Webelieve the adoption of SFAS 123R will have a material impact on ourresults of operations, regardless of the valuation method used.

 

**We may continue to incur losses.**

 

We incurred a net loss of $2.4million for the nine months ended September 30, 2005. We also recorded anet loss of $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 DigitalSolutions.  No assurance can be given asto whether we will achieve profitability, if at all. Profitability depends onmany factors, 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 by third parties on ourintellectual property or development of substantially equivalent proprietarytechnology by our competitors could negatively affect our business.**

 

Our success depends significantly onour 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 the future,will provide us with significant protection against competitors. Moreover,there can be no assurance that any patents issued to or licensed by us will notbe infringed upon or circumvented by others. Litigation to establish the validity of patents, to assert infringementclaims against others, and to defend against patent infringement claims hasbeen and is expected to continue to be expensive and time-consuming, even ifthe outcome is in our favor.  We also relyto a lesser extent on unpatented proprietary technology, and no assurance canbe given that others will not independently develop substantially equivalentproprietary information, techniques or processes or that we can meaningfullyprotect our rights to such unpatented proprietary technology.  Infringement on our intellectual property orthe development of substantially equivalent technology by our competitors couldhave a material adverse effect on our business.

 

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**Domestic and foreign government regulationand other factors could impair our ability to develop and sell our products incertain 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 or programs, and slaughterhouseremoval of microchips.

 

We are also subject to federal,state and local regulation in the United States, including regulation by theFDA, FCC and the USDA, and local regulation in other countries.  We cannot predict the extent to which we maybe affected by further legislative and regulatory developments concerning ourproducts and markets.  We are required toobtain regulatory approval before marketing most of our products.  The regulatory process can be verytime-consuming and costly, and there is no assurance that we will receive theregulatory approvals necessary to sell our products under development.  Regulatory authorities also have the authorityto revoke approval of previously approved products for cause, to requestrecalls 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 andcould negatively affect our business.

 

**We rely heavily on sales to governmentcontractors of our animal identification products, and any decline in thedemand by these customers for our products could negatively affect ourbusiness.**

 

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 a single productionarrangement with Raytheon Microelectronics Espana, SA for our patentedsyringe-injectable microchips, and the loss of or any significant reduction inthe 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 our implantableelectronic identification products. In addition, we have no formal writtenagreement with Raytheon for the production of our microchips. Raytheon utilizesour 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 theprice charged by Raytheon for the assembly of our microchips could have anadverse effect on our financial condition and results of operations.  In addition, Raytheon may not be able toproduce sufficient quantities of the microchips to meet any significantincreased demand 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 delay production.  Moreover, if Raytheon terminates ourproduction arrangement, we cannot ensure that the assembly of our microchipsfrom another source would be on comparable or acceptable terms.  The failure to make such an alternativeproduction arrangement could have an adverse effect on our business.

 

**We depend on principal customers.**

 

Our five largest customers, inaggregate, accounted for 23.0% of our consolidated revenue in the nine monthsended September 30, 2005. Our subsidiary, Signature Industries, Ltd. isheavily dependent 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.

 

 

**We compete with other companies in thevisual and electronic identification and pilot locator beacon markets, and theproducts sold by our competitors could become more popular than our products orrender 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 thatour principal competitors in the pilot locator beacon market are Boeing NorthAmerican Inc., General Dynamics Decision Systems and Tadiran Spectralink Ltd.

 

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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 our productsobsolete or noncompetitive.

 

**Our earnings will decline if we write offgoodwill and other intangible assets.**

 

As of September 30, 2005, wehad recorded goodwill of $53.6 million. On January 1, 2002, we adoptedSFAS No. 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 certain intangibleassets 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.

 

We assess the fair value of ourgoodwill annually or earlier if events occur or circumstances change that wouldmore likely than not reduce the fair value of our goodwill below its carryingvalue. These events or circumstances would include a significant change inbusiness climate, including a significant, sustained decline in an entity’smarket value, legal factors, operating performance indicators, competition,sale or disposition of a significant portion of the business, or other factors.If we determine that significant impairment has occurred, we would be requiredto write off the impaired portion of goodwill. Impairment charges could have amaterial adverse effect on our financial condition and results of operations.

 

**The exercise of options and warrantsoutstanding and available for issuance may adversely affect the market price ofour common stock*.***

 

As of September 30, 2005, wehad 9,958,000 options and 530,000 warrants outstanding to purchase from us atotal of 10,488,000 shares of common stock at exercise prices ranging from$0.05 to $10.50 per share. As of September 30, 2005 the weighted averageexercise price of the options and warrants outstanding was $3.89.  The exercise of outstanding options andwarrants and the sale in the public market of the shares purchased upon such exercisemay adversely affect the market price of our common stock.

 

**Currency exchange rate fluctuations couldhave an adverse effect on our sales and financial results.**

 

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

 

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 and Qualitative Disclosures About Market Risk**

 

We have operations and sales invarious regions of the world. Additionally, we may export and import to andfrom other countries.  Our operations maytherefore be subject to volatility because of currency fluctuations, inflation,and changes in political and economic conditions in these countries. Sales andexpenses may be denominated in local currencies and may be affected as currencyfluctuations affect our product prices and operating costs or those of ourcompetitors.

 

We presently do not use anyderivative financial instruments to hedge our exposure to adverse fluctuationsin interest rates, foreign exchange rates, fluctuations in commodity prices orother market risks, nor do we invest in speculative financial instruments.

 

 

**Item 4. Controls and Procedures**

 

As of the end of the period coveredby this Form 10-Q, we carried out an evaluation, under the supervision andwith the participation of our management, including the Chief Executive Officerand the Chief Financial Officer, of the effectiveness of the design andoperation of our disclosure controls and procedures.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective.

 

During the period covered by the Form 10-Q, there wereno changes in our internal control over financial reporting that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

 

 

**PART II    OTHER INFORMATION**

 

**Item 1. Legal Proceedings.**

 

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

 

On October 20, 2004, the Company commenced anaction in the United Stated District Court for the District of Minnesotaagainst AllFlex USA, Inc. and Pet Health Services (USA), Inc.  This suit claimed that Allflex is marketingand selling a syringe implantable identification transponder that infringes a1993 patent granted to the Company for syringe implantable identificationtransponders previously found by the United States District Court for theDistrict of Colorado to be enforceable. The suit also claimed that PetHealth is using, selling and/ordistributing the same transponder in violation of the Company’s patent.  The suit sought, among other things, anadjudication of infringement and that the infringing parties be enjoined fromfurther improper action.  The suit soughtactual damages, punitive damages and interest, costs and attorneys’ fees.  Allflex asserted a counterclaim for breach ofcontract of an existing license agreement between the Company and Allflex andasserted a counterclaim seeking a declaration of the parties’ rights andobligations under the license agreement. Allflex also moved for a judgment on the pleadings, asserting that thelicense agreement should act as a bar to a case for infringement.  The Company contested the motion on theground that Allflex’s actions exceed the scope of the license and constituted animpermissible infringement of the patent and asked the Court for leave to amendthe complaint to assert a claim against a separate patent licensed exclusivelyto the Company by Bio Medic Data Systems.  On June 23, 2005, the Court issued a ruling granting the Defendant’smotion for judgment on the pleadings and denying the Company’s motion for leaveto amend.

 

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

 

On September 28, 2005, Allflex sought an award ofattorneys fees and costs based on a fee-shifting clause in the licenseagreement and under 35 U.S.C. §285, which provides for an award of attorneysfees and costs in exceptional cases.  TheCompany contested this motion, and on October 6, 2005, the Court denied themotion in its entirety.  Final judgmentin the action has not yet entered, and the Company is considering whether toappeal the Court’s ruling granting judgment on the pleadings.

 

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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 anaction in the United States District Court for the District of Minnesotaagainst Datamars, Inc., Datamars, S.A., The Crystal 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, etal.*

 

Onor about December 29, 2004 The Crystal Import Corporation filed an actionagainst AVID Identification Systems, Inc. and the Company in the UnitedStates District Court for the Northern District of Alabama.  Crystal’s complaint primarily assertedfederal and state antitrust and related claims against AVID, though it alsoasserted similar claims against the Company. The Company  filed a motion todismiss the action for failure to state a claim on which relief could begranted, or in the alternative, to have the action transferred to the UnitedStates District Court for the District of Minnesota for consolidation with theDatamars patent infringement action referred to above or to have the actionstayed until the completion of the Datamars action.   On October 12, 2005, the Alabama Courtdenied the Company’s motion to dismiss the complaint, but granted the Company’smotion to transfer the action to Minnesota, where the Company intends to seekto consolidate the action with the patent infringement action.  Given the uncertainties associated with alllitigation and given the early stage of this proceeding, the Company is unableto offer any assessment on the potential liability exposure, if any, to theCompany from this lawsuit

 

 

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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: October 31, 2005 |   | By:                       | /s/ JAMES P. SANTELLI |
|                    |   |                      | James P. Santelli |
|                    |   |                      | Vice President - Finance and Chief Financial Officer |

 

 

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