**As filed with the Securities and Exchange Commission on November 2,2004**

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C.  20549**

 

----

 

**FORM10-Q**

**(Mark One)**

 

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

 

**For the quarterly period ended September 30,2004**

 

**or**

 

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

 

**For the transition periodfrom         to         **

 

**Commission File Number:  1-15177**

 

**DIGITALANGEL CORPORATION**

(Exact name of registrant as specified in its charter)

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

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.

Yes     ý    No     o

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule12b-2 ofthe Exchange Act).

Yes  o    No  ý

 

As of the close ofbusiness on October 29, 2004, there were 33,267,053 shares outstanding ofthe 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 and Reports on Form 8-K                                                            |       |
|                                |       |
| SIGNATURE                           |       |
| CERTIFICATIONS                      |       |
| EXHIBITS                            |       |

 

2

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**PARTI    FINANCIAL INFORMATION**

 

Item 1.             FinancialStatements.

 

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

(Inthousands, except par value)

 
| ** **                                                                                                                                                                       | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                                       |       |                         |       |                        |       |
| **Current Assets**                                                                                                                                                               |       |                         |       |                        |       |
| Cash                                                                                                                                                                             | ** ** | **$**                        | **307**    |                        | $          | 894 |   |
| Restricted cash                                                                                                                                                                  | ** ** | **650**                      |       | 765                         |       |
| Applied Digital common stock                                                                                                                                                     | ** ** | **2,343**                    |       | —                      |       |
| Accounts receivable (net of allowance for  doubtful accounts of $239 in 2004 and $212 in 2003)                                                                                   | ** ** | **5,456**                    |       | 3,400                       |       |
| Inventories                                                                                                                                                                      | ** ** | **6,805**                    |       | 6,543                       |       |
| Other current assets                                                                                                                                                             | ** ** | **1,229**                    |       | 785                         |       |
| Net assets from discontinued operations                                                                                                                                          | ** ** | **101**                      |       | 1,251                       |       |
| **Total Current Assets**                                                                                                                                                         | ** ** | **16,891**                   |       | 13,638                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Property And Equipment, net**                                                                                                                                                  | ** ** | **5,985**                    |       | 6,528                       |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Goodwill and Other Intangible Assets, net**                                                                                                                                    | ** ** | **53,170**                   |       | 45,119                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Other Assets, net**                                                                                                                                                            | ** ** | **1,157**                    |       | 942                         |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| ** **                                                                                                                                                                       |       | **$**                        | **77,203** |                        | $          | 66,227 |   |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                    |       |                         |       |                        |       |
| **Current Liabilities**                                                                                                                                                          |       |                         |       |                        |       |
| Line of credit and current maturities of  long-term debt and notes payable                                                                                                       | ** ** | **$**                        | **3,942**  |                        | $          | 5,008 |   |
| Accounts payable                                                                                                                                                                 | ** ** | **4,851**                    |       | 5,226                       |       |
| Accrued expenses and other current  liabilities                                                                                                                                  | ** ** | **3,502**                    |       | 3,201                       |       |
| Deferred revenue                                                                                                                                                                 | ** ** | **1,446**                    |       | 1,144                       |       |
| Due to Applied Digital                                                                                                                                                           | ** ** | **63**                       |       | 347                         |       |
| **Total Current Liabilities**                                                                                                                                                    | ** ** | **13,804**                   |       | 14,926                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Long-Term Debt And Notes Payable**                                                                                                                                             | ** ** | **2,300**                    |       | 2,818                       |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Deferred Revenue**                                                                                                                                                             | ** ** | **700**                      |       | —                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Total Liabilities**                                                                                                                                                            | ** ** | **16,804**                   |       | 17,744                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Commitments And Contingencies (See Note 11)**                                                                                                                                  |       |                         |       |                        |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Minority Interest**                                                                                                                                                            | ** ** | **136**                      |       | —                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| **Stockholders’ Equity (See Note 1)**                                                                                                                                       |       |                         |       |                        |       |
| Preferred stock: Authorized 1,000 in 2002,  of $1.75 par value, 100 shares issued and outstanding in 2004 and 0 issued  and outstanding in 2003                                  | ** ** | **175**                      |       | —                      |       |
| Common stock: Authorized 95,000 shares, of  $.005 par value; 33,047 shares issued and 32,997 shares outstanding in 2004  and 28,891 shares issued and 28,841 outstanding in 2003 | ** ** | **165**                      |       | 144                         |       |
| Additional paid-in capital                                                                                                                                                       | ** ** | **189,753**                  |       | 171,909                     |       |
| Accumulated deficit                                                                                                                                                              | ** ** | **(129,777**                 | **)**      | (123,517                    | )          |
| Treasury stock (carried at cost, 50 shares)                                                                                                                                      | ** ** | **(43**                      | **)**      | (43                         | )          |
| Accumulated other comprehensive loss                                                                                                                                             | ** ** | **(10**                      | **)**      | (10                         | )          |
| Total Stockholders’ Equity                                                                                                                                                  | ** ** | **60,263**                   |       | 48,483                      |       |
|                                                                                                                                                                             |       |                         |       |                        |       |
| ** **                                                                                                                                                                       |       | **$**                        | **77,203** |                        | $          | 66,227 |   |

 

See the accompanying notes tocondensed consolidated financial 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,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                                           | ** ** | **2003**                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Product revenue                                                                    | ** ** | **$**                                              | **10,668** | ** **                                        | $          | 7,361 | ** ** | **$** | **30,582** | ** ** | $ | 25,090 |   |
| Service revenue                                                                    | ** ** | **512**                                            | ** ** | 650                                               | ** ** | **1,439** | ** ** | 1,476 |   |
| Total net revenue                                                                  | ** ** | **11,180**                                         | ** ** | 8,011                                             | ** ** | **32,021** | ** ** | 26,566 |   |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Cost of products sold                                                              | ** ** | **5,871**                                          | ** ** | 4,524                                             | ** ** | **17,479** | ** ** | 14,970 |   |
| Cost of services sold                                                              | ** ** | **293**                                            | ** ** | —                                            | ** ** | **841** | ** ** | 55 |   |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Gross profit                                                                       | ** ** | **5,016**                                          | ** ** | 3,487                                             | ** ** | **13,701** | ** ** | 11,541 |   |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Selling, general and administrative  expenses                                      | ** ** | **4,435**                                          | ** ** | 4,193                                             | ** ** | **13,162** | ** ** | 11,992 |   |
| Research and development expenses                                                  | ** ** | **731**                                            | ** ** | 1,551                                             | ** ** | **2,250** | ** ** | 3,634 |   |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Operating loss                                                                     | ** ** | **(150**                                           | **)**      | (2,257                                            | )          | **(1,711** | **)** | (4,085 | ) |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Interest income                                                                    | ** ** | **9**                                              | ** ** | 8                                                 | ** ** | **25** | ** ** | 8 |   |
| Interest expense                                                                   | ** ** | **(254**                                           | **)**      | (218                                              | )          | **(757** | **)** | (472 | ) |
| Realized and  unrealized losses on Applied Digital common stock                    | ** ** | **(279**                                           | **)**      | —                                            | ** ** | **(2,891** | **)** | — |   |
| Other income                                                                       | ** ** | **25**                                             | ** ** | 42                                                | ** ** | **83** | ** ** | 120 |   |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Loss before minority interest share of  (income)losses and discontinued operations | ** ** | **(649**                                           | **)**      | (2,425                                            | )          | **(5,251** | **)** | (4,429 | ) |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Minority interest share of (income) losses                                         | ** ** | **(133**                                           | **)**      | 91                                                |       | **(136** | **)** | 201 |   |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Net loss from  continuing operations                                               | ** ** | **(782**                                           | **)**      | (2,334                                            | )          | **(5,387** | **)** | (4,228 | ) |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Income (loss)  from discontinued operations                                        | ** ** | **255**                                            | ** ** | (306                                              | )          | **(873** | **)** | (679 | ) |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Net loss                                                                           | ** ** | **$**                                              | **(527**   | **)**                                             | $          | (2,640 | ) | **$** | **(6,260** | **)** | $ | (4,907 | ) |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Loss per common  share-basic and diluted:                                          |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Loss from  continuing operations                                                   | ** ** | **(0.02**                                          | **)**      | (0.09                                             | )          | **(0.17** | **)** | (0.16 | ) |
| Income (loss) from discontinued operations                                         | ** ** | **0.01**                                           | ** ** | (0.01                                             | )          | **(0.03** | **)** | (0.02 | ) |
| Net loss per common share –basic and  diluted                                 | ** ** | **$**                                              | **(0.01**  | **)**                                             | $          | (0.10 | ) | **$** | **(0.20** | **)** | $ | (0.18 | ) |
|                                                                               |       |                                               | ** ** |                                              |       |   | ** ** |   |   |
| Weighted average number of common shares outstanding  - basic and diluted          | ** ** | **32,892**                                         | ** ** | 26,993                                            | ** ** | **32,036** | ** ** | 26,839 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

4

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITY**

**For The Nine Months Ended September 30,2004**

(In Thousands)

(Unaudited)

 
| ** **                                             | ** ** | ** **          | ** ** | ** **       | ** ** | ** ** | ** ** | **Additional**** ****Paid-In**** ****Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Treasury  Stock** | ** ** | **Accumulated  Other  Comprehensive  Loss** | ** ** | **Total  Stockholders’****    E****quity** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|------------------|------------|------------|------------|----------------------------------------------------------|------------|--------------------------|------------|---------------------|------------|---------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                             | ** ** | ** **          | ** ** | ** **       | ** ** | ** ** | ** ** | ** **                                               | ** ** | ** **               | ** ** | ** **          |
| ** **                                             | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | ** ** | ** ** | ** **                                               | ** ** | ** **               |
| ** **                                             | ** ** | **Number**          | ** ** | **Amount**       | ** ** | **Number** | ** ** | **Amount**                                               | ** ** | ** **               | ** ** | ** **          | ** ** | ** **                                  |
| ** **                                             | ** ** | ** **          | ** ** | ** **       | ** ** | ** ** | ** ** | ** **                                               | ** ** | ** **               | ** ** | ** **          | ** ** | ** **                                  | ** ** | ** **                                           | ** ** | ** ** | ** ** |
| **Balance  — December 31, 2003**             |       | —              |       | $                | —     |       | 28,891     |                                                     | $          | 144                      |       | $                   | 171,909    |                                        | $          | (123,517                                             | )          | $ | (43 | ) | $ | (10 | ) | $ | 48,483 |   |
| Net loss                                               |       | —              |       | —           |       | —     |       | —                                                   |       | —                   |       | (6,260              | )          | —                                      |       | —                                               |       | (6,260 | ) |
| Comprehensive  loss —Foreign currency translation |       |                |       |             |       | —     |       | —                                                   |       | —                   |       | —              |       | —                                      |       | —                                               |       | — |   |
| Total  comprehensive income (loss)                     |       | —              |       | —           |       | —     |       | —                                                   |       | —                   |       | (6,260              | )          | —                                      |       | —                                               |       | (6,260 | ) |
| Merger  consideration-OuterLink Corporation            |       | 100                 |       | 175              |       | —     |       | —                                                   |       | 8,125                    |       | —              |       | —                                      |       | —                                               |       | 8,300 |   |
| Issuance of  common stock to Applied Digital           |       | —              |       | —           |       | 3,000      |       | 15                                                       |       | 7,905                    |       | —              |       | —                                      |       | —                                               |       | 7,920 |   |
| Conversion of  debt into stock                         |       | —              |       |             |       | 300        |       | 2                                                        |       | 697                      |       | —              |       | —                                      |       | —                                               |       | 699 |   |
| Shares cancelled  on settlement with vendor            |       | —              |       | —           |       | (23        | )          | —                                                   |       | —                   |       | —              |       | —                                      |       | —                                               |       | — |   |
| Issuance of stock  for services                        |       | —              |       | —           |       | 10         |       | —                                                   |       | 31                       |       | —              |       | —                                      |       | —                                               |       | 31 |   |
| Exercise of stock  options                             |       | —              |       | —           |       | 869        |       | 4                                                        |       | 1,086                    |       | —              |       | —                                      |       | —                                               |       | 1,090 |   |
|                                                   |       |                |       |             |       |       |       |                                                     |       |                     |       |                |       |                                        |       |                                                 |       |   |   |
| **Balance  — September 30, 2004**            |       | 100                 |       | $                | 175        |       | 33,047     |                                                     | $          | 165                      |       | $                   | 189,753    |                                        | $          | (129,777                                             | )          | $ | (43 | ) | $ | (10 | ) | $ | 60,263 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

5

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

(In thousands)

(Unaudited)

 
| ** **                                                                      | ** ** | **For the Nine Months  Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2004**                                          | ** ** | **2003** | ** ** |
| **Cash Flows From Operating Activities**                                        |       |                                              | ** ** |   |   |
| Net loss from continuing operations                                             | ** ** | **$**                                             | **(5,387** | **)** | $ | (4,228 | ) |
|                                                                            |       |                                              | ** ** |   |   |
| Adjustments to reconcile net loss to net  cash used in operating activities:    |       |                                              | ** ** |   |   |
| Loss from discontinued operations                                               | ** ** | **(873**                                          | **)**      | (679 | ) |
| Equity-based compensation                                                       | ** ** | **31**                                            | ** ** | 25 |   |
| Amortization of debt discount and deferred  financing costs                     | ** ** | **276**                                           | ** ** | 41 |   |
| Depreciation and amortization                                                   | ** ** | **1,501**                                         | ** ** | 1,310 |   |
| Minority interest                                                               | ** ** | **136**                                           | ** ** | (201 | ) |
| Loss on Applied Digital common stock                                            | ** ** | **2,891**                                         | ** ** | — |   |
| Loss on disposal of equipment                                                   | ** ** | **1**                                             | ** ** | 21 |   |
| Change in assets and liabilities:                                               |       |                                              | ** ** |   |   |
| Decrease (increase) in restricted cash                                          | ** ** | **53**                                            | ** ** | (717 | ) |
| Increase in accounts receivable                                                 | ** ** | **(1,539**                                        | **)**      | (1,835 | ) |
| Decrease (increase) in inventories                                              | ** ** | **5**                                             | ** ** | (1,370 | ) |
| (Increase) decrease in other current assets                                     | ** ** | **(364**                                          | **)**      | 773 |   |
| Increase in other assets                                                        | ** ** | **(270**                                          | **)**      | (358 | ) |
| (Decrease) increase in due to Applied  Digital                                  | ** ** | **(284**                                          | **)**      | 54 |   |
| (Decrease) increase in accounts payable,  accrued expenses and deferred revenue | ** ** | **(2**                                            | **)**      | 3,394 |   |
| Net cash provided by discontinued  operations                                   | ** ** | **154**                                           | ** ** | 300 |   |
| **Net Cash Used In Operating Activities**                                       | ** ** | **(3,671**                                        | **)**      | (3,470 | ) |
|                                                                            |       |                                              | ** ** |   |   |
| **Cash Flows From Investing Activities**                                        |       |                                              | ** ** |   |   |
| Proceeds from sale of Applied Digital  common stock                             | ** ** | **2,687**                                         | ** ** | — |   |
| Proceeds from the sale of assets                                                | ** ** | **18**                                            | ** ** | — |   |
| Payments for property and equipment                                             | ** ** | **(369**                                          | **)**      | (761 | ) |
| Acquisition costs, net of cash acquired                                         | ** ** | **(27**                                           | **)**      | — |   |
| Net cash provided by (used in) discontinued  operations                         | ** ** | **1,730**                                         | ** ** | (8 | ) |
| **Net Cash Provided By (Used In) Investing  Activities**                        | ** ** | **4,039**                                         | ** ** | (769 | ) |
|                                                                            |       |                                              | ** ** |   |   |
| **Cash Flows From Financing Activities**                                        |       |                                              | ** ** |   |   |
| Amounts borrowed on line of credit                                              | ** ** | **28,295**                                        | ** ** | 24,886 |   |
| Amounts paid on line of credit                                                  | ** ** | **(28,927**                                       | **)**      | (22,897 | ) |
| Payments on notes payable and long-term  debt                                   | ** ** | **(398**                                          | **)**      | (61 | ) |
| Proceeds from notes payable and long-term  debt                                 |       | —                                            | ** ** | 2,584 |   |
| Exercise of stock options                                                       | ** ** | **1,090**                                         | ** ** | 246 |   |
| Payments for financing costs                                                    | ** ** | **(101**                                          | **)**      | (461 | ) |
| Net cash used in discontinued operations                                        | ** ** | **(910**                                          | **)**      | (27 | ) |
| **Net Cash (Used In) Provided By Financing  Activities**                        | ** ** | **(951**                                          | **)**      | 4,270 |   |
|                                                                            |       |                                              | ** ** |   |   |
| **Effect of Exchange Rate Changes on Cash**                                     | ** ** | **(4**                                            | **)**      | (235 | ) |
|                                                                            |       |                                              | ** ** |   |   |
| **Net Decrease In Cash**                                                        | ** ** | **(587**                                          | **)**      | (204 | ) |
|                                                                            |       |                                              | ** ** |   |   |
| **Cash - Beginning Of Period**                                                  | ** ** | **894**                                           | ** ** | 206 |   |
|                                                                            |       |                                              | ** ** |   |   |
| **Cash - End Of Period**                                                        | ** ** | **$**                                             | **307**    | ** ** | $ | 2 |   |

 

See the accompanying notes tocondensed consolidated financial statements.

 

6

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**DIGITAL ANGEL CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(Dollars in thousands)**

**(Unaudited)**

 

**1.**                                      Basisof Presentation

** **

On March 27, 2002,Digital Angel Acquisition Co. (“Acquisition”), then a wholly-owned subsidiaryof Medical Advisory Systems, Inc. (“MAS”), merged with and into Digital AngelCorporation, which was then a 93% owned subsidiary of Applied Digital. In themerger, the corporate existence of Acquisition ceased, Digital AngelCorporation became a wholly-owned subsidiary of MAS and was renamed DigitalAngel Technology Corporation (“DATC”), and MAS was renamed “Digital AngelCorporation.” In connection with the merger transaction, Applied Digitalcontributed to MAS all of its stock in Timely Technology Corp., a wholly-ownedsubsidiary, and Signature Industries, Limited, an 85% owned subsidiary at thetime of the contribution. These two subsidiaries, along with DATC, comprisedthe Advanced Wireless Group (“AWG”). As a result of this contribution byApplied Digital, Timely Technology Corp. became a wholly-owned subsidiary ofthe Company and Signature Industries, Limited became an 85% subsidiary.  As of September 30, 2004, SignatureIndustries, Limited is a 91% subsidiary of the Company.  Prior to the merger with DATC, AppliedDigital owned 850,000 shares of MAS stock, representing approximately 16.3% ofthe outstanding stock of MAS. (Unless the context otherwise requires, the term “Company”means Digital Angel Corporation and its subsidiaries). In the merger, theshares of DATC owned by Applied Digital were converted into a total of18,750,000 shares of MAS common stock. As a result of the merger, AppliedDigital owned 19,600,000 shares or 77.15% of the Company’s common stock. Themerger was treated as a reverse acquisition for accounting purposes, with AWGtreated as the accounting acquirer.

 

The accompanyingunaudited condensed consolidated financial statements of Digital AngelCorporation and subsidiaries as of September 30, 2004 and for the threeand nine month periods ended September 30, 2004 and 2003 have beenprepared in accordance with accounting principles generally accepted in theUnited States of America for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X under theSecurities Exchange Act of 1934. Accordingly, they do not include all of the information and footnotes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements.  In theopinion of the Company’s management, all adjustments (including normalrecurring adjustments) considered necessary to present fairly the financialstatements have been made.

 

The consolidatedstatements of operations for the three and nine months ended September 30,2004 and 2003 are not necessarily indicative of the results that may beexpected for the entire year.  Thesestatements should be read in conjunction with the Digital Angel Corporation’saudited consolidated financial statements and related notes thereto for theyear ended December 31, 2003 which are included in the Company’s AnnualReport on Form 10-K.

 

Certain items in thecondensed consolidated financial statements for the 2003 periods have beenreclassified for comparative purposes.

 

TheCompany develops and deploys sensor and communications technologies that enablerapid and accurate identification, location tracking, and condition monitoringof high-value assets.  Prior to January 22,2004, the Company operated in four segments: Animal Applications, Wireless andMonitoring, GPS and Radio Communications and Medical Systems. With theacquisition of OuterLink Corporation in January 2004, the Companyreorganized into three segments: Animal Applications, GPS and RadioCommunications and Medical Systems.  TheGPS and Radio Communications segment, the Wireless and Monitoring segment andthe OuterLink Corporation business, which was acquired on January 22,2004, were combined to form the new GPS and Radio Communications segment.  On April 19, 2004, Digital Angel Corporation sold certain assetsof its Medical Systems segment’s medical services business.  Assets sold include all of the tangible andintangible intellectual property developed for the operation of the MedicalSystems segment’s medical services business, pharmaceutical supplies and otherinventory items, customer and supplier contracts, computer software licenses,internet website and domain name and mailing lists and did not include the landand building used by this operation.  TheCompany sold the Medical Systems segment’s land and buildings in a separatetransaction on July 30, 2004 for $1.5 million.  Net cash received on the sale of the land andbuildings, after paying off the related building mortgage, was approximately$0.4 million.

 

*AnimalApplications—*develops, manufactures, and marketsa broad line of electronic and visual identification devices for the companionanimal, livestock, laboratory animal, fish and wildlife markets worldwide.  The positive identification and tracking ofcattle and hogs are crucial for asset management and for disease control andfood safety. In addition to the visual ear tags, which have been sold by theCompany since the late 1940’s, Animal Applications utilizes radio frequencytransmission technologies in its electronic ear tags and implantablemicrochips.

 

*GPS and RadioCommunications*-consists of the design,manufacture and support of GPS enabled equipment. Applications for the segment’sproducts include location tracking and message monitoring of vehicles, aircraftand people in remote locations through systems that integrate GPS andgeosynchronous satellite communications and GPS enabled equipment andintelligent

 

7

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communicationsproducts and services for telemetry, mobile data and radio communicationsapplications serving commercial and military markets. Technology development inthis segment includes the integration and miniaturization into marketableproducts of

three technologies: wireless communications (such as cellular), sensorsand position location technology (including global positioning systems (GPS)and other systems).

 

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

 

TheSeptember 30, 2004 and 2003 condensed consolidated financial statementsinclude the accounts of the Company and its wholly-owned and majority-ownedsubsidiaries (OuterLink Corporation from the date of acquisition on January 22,2004).  All significant intercompanyaccounts and transactions have been eliminated in consolidation.

 

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

 

TheCompany, except for its subsidiary OuterLink Corporation, recognizes productrevenue at the time product is shipped and title has transferred, provided thata purchase order has been received or a contract has been executed, there areno uncertainties regarding customer acceptance, the sales price is fixed anddeterminable and collectibility is deemed probable. If uncertainties regardingcustomer acceptance exists, revenue is recognized when such uncertainties areresolved. There are no significant post-contract support obligations at thetime of revenue recognition. Digital Angel Corporation’s accounting policyregarding vendor and post contract support obligations is based on the terms ofthe customers’ contracts, billable upon occurrence of the post-sale support.Costs of products sold and services provided are recorded as the relatedrevenue is recognized. Digital Angel Corporation offers a warranty on itsproducts.  For non-fixed fee jobs,revenue 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. Revenues from contracts that provide services are recognizedratably over the term of the contract. Fixed fee revenues from contracts forservices are recorded when earned and exclude reimbursable costs. Other revenueis recognized at the time service or goods are provided.  It is the Company’s policy to record contractlosses in their entirety in the period in which such losses are foreseeable.

 

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

 

**4.**                                      Stock-BasedCompensation

** **

The Company applies APBOpinion No. 25 and related Interpretations in accounting for all its stockoption plans.  Accordingly, nocompensation cost has been recognized under these stock option plans.  The Company has adopted the disclosure-onlyprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and SFASNo. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,”which was released in December 2002 as an amendment to SFAS No. 123.  The following table illustrates the effect onnet loss and loss per share if the fair value based method had been applied toall awards (in thousands, except per share data):

 
| ** **                                                                                                          | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2004**                                  |       | **2003**                                 |       | **2004** | ** ** | **2003** | ** ** |
| Reported net loss                                                                                                   | ** ** | **$**                                     | **(527**   | **)**                                    | $          | (2,640 | ) | **(6,260** | **)** | $ | (4,907 | ) |
| Stock-based employee compensation expense  in reported net loss, net of related tax effects                         |       | —                                    | ** ** | —                                   |       | **31** | ** ** | 25 |   |
| Stock-based employee compensation expense  determined under the fair value based method, net of related tax effects | ** ** | **(2,024**                                | **)**      | (1,548                                   | )          | **(5,647** | **)** | (4,906 | ) |
| Pro forma net loss                                                                                                  | ** ** | **$**                                     | **(2,551** | **)**                                    | $          | (4,188 | ) | **$** | **(11,876** | **)** | $ | (9,788 | ) |
|                                                                                                                |       |                                      | ** ** |                                     |       |   | ** ** |   |   |
| Loss per share -basic and diluted                                                                                   |       |                                      | ** ** |                                     |       |   | ** ** |   |   |
| As reported                                                                                                         | ** ** | **$**                                     | **(0.01**  | **)**                                    | $          | (0.10 | ) | **$** | **(0.20** | **)** | $ | (0.18 | ) |
| Pro forma                                                                                                           | ** ** | **$**                                     | **(0.08**  | **)**                                    | $          | (0.16 | ) | **$** | **(0.37** | **)** | $ | (0.36 | ) |

 

8

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**5.**                                      Inventory(in thousands)

 
| ** **                            | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw materials                         |       | $                            | 3,264      |                        | $          | 1,976 |   |
| Work in process                       |       | 127                          |       | 94                          |       |
| Finished goods                        |       | 5,402                        |       | 6,294                       |       |
|                                  |       | 8,793                        |       | 8,364                       |       |
| Allowance for excess and obsolescence |       | (1,988                       | )          | (1,821                      | )          |
| Net inventory                         |       | $                            | 6,805      |                        | $          | 6,543 |   |

 

**6.****                                     ****Stock Exchange with Applied Digital**

 

On March 1, 2004, the Company issued3,000,000 shares of its common stock to Applied Digital pursuant to the StockPurchase Agreement (“Stock Purchase Agreement”) with Applied Digital dated August 14,2003.  The Stock Purchase Agreementprovided for Applied Digital to purchase 3,000,000 shares of the Company’scommon stock at a price of $2.64 per share and a warrant (the “Applied DigitalWarrant”) to purchase up to 1,000,000 shares of the Company’s common stock,which is exercisable for five years beginning February 1, 2004, at a priceper share of $3.74 payable in cash or shares of common stock of AppliedDigital.  The consideration for the saleof the Company’s 3,000,000 shares and the warrant was 1,980,000 shares ofApplied Digital common stock.  As of September 30,2004, the Company had sold 910,000 shares of Applied Digital common stock.  The Company accounted for the Applied Digitalstock as a trading security under SFAS 115, “Accounting for Certain Investmentsin Debt and Equity Securities”.  In thenine months ended September 30, 2004 the Company recorded realized lossesof $1.0 million on the 910,000 shares of Applied Digital common stock sold andunrealized losses of $1.9 million on the remaining 1,070,000 shares held by theCompany.  Fair value of the AppliedDigital common stock was determined by quoted values reported on NASDAQ.  On October 14, 2004 the Company sold theremaining 1,070,000 shares for net cash proceeds of $4.0 million.  The Company recorded a gain of $1.7 millionon the sale of the remaining shares of Applied Digital common stock.  

 

**7.**                                      Discontinued Operations

** **

In April 2004, ourBoard of Directors approved a plan to sell our Medical Systems segment. TheMedical Systems segment represented the business operations of Medical AdvisorySystems, Inc, which we acquired on March 27, 2002.  The Medical Systems segment was one of ourreporting units in accordance with SFAS 142, “Goodwill and Other IntangibleAssets”.  Accordingly, the financialcondition, results of operations and cash flows of our Medical Systems segmenthave been reported as discontinued operations for all periods presented. Thefollowing discloses the operating losses from discontinued operations for thethree and nine-months ended September 30, 2004 and 2003, consisting oflosses attributable to the Medical Systems segment:

 
| ** **                                    | ** ** | **Three-Months  Ended September 30,** | ** ** | **Nine-Months  Ended September 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Product revenue                               |       | $                                          | —     |                                      | $          | 139 |   | $ | 204 |   | $ | 726 |   |
| Service revenue                               |       | —                                     |       | 195                                       |       | 223 |   | 811 |   |
| Total revenue                                 |       | —                                     |       | 334                                       |       | 427 |   | 1,537 |   |
| Cost of products sold                         |       | —                                     |       | 63                                        |       | 87 |   | 321 |   |
| Cost of services sold                         |       | —                                     |       | 239                                       |       | 317 |   | 832 |   |
| Total cost of products and services sold      |       | —                                     |       | 302                                       |       | 404 |   | 1,153 |   |
| Gross profit                                  |       | —                                     |       | 32                                        |       | 23 |   | 384 |   |
| Selling, general and administrative  expenses |       | 35                                         |       | 303                                       |       | 1,081 |   | 959 |   |
| Other (income) expense                        |       | (290                                       | )          | 35                                        |       | (185 | ) | 104 |   |
| Income (loss) from discontinued operations    |       | $                                          | 255        |                                      | $          | (306 | ) | $ | (873 | ) | $ | (679 | ) |

 

The above results do notinclude any allocated or common overhead expenses.  We have not provided a benefit for incometaxes on the losses attributable to the Medical Systems division.  We do not anticipate the Medical Systemsdivision 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 inour financial condition and results of operations as incurred.

 

The net assetsof discontinued operations as September 30, 2004 and December 31,2003, were comprised of the following:

 

9

----

 
| ** **                                              | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|---------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                              | ** ** | **(in thousands)**          | ** ** |
| Assets                                                  |       |                        |       |                       |       |
| Accounts receivable, net                                |       | $                           | 19         |                       | $          | 453 |   |
| Inventory                                               |       | —                      |       | 46                         |       |
| Other current assets                                    |       | —                      |       | 43                         |       |
| Property and equipment, net                             |       | —                      |       | 1,137                      |       |
| Goodwill and other intangible assets, net               |       | —                      |       | 489                        |       |
| Other assets                                            |       | 135                         |       | 163                        |       |
| Total Assets                                            |       | $                           | 154        |                       | $          | 2,331 |   |
|                                                    |       |                        |       |                       |       |
| Current Liabilities:                                    |       |                        |       |                       |       |
| Notes payable and current maturities of  long-term debt |       | $                           | —     |                       | $          | 910 |   |
| Accounts payable                                        |       | —                      |       | 71                         |       |
| Accrued expenses and deferred revenue                   |       | 53                          |       | 99                         |       |
| Total Liabilities                                       |       | $                           | 53         |                       | $          | 1,080 |   |
|                                                    |       |                        |       |                       |       |
| Net Assets                                              |       | $                           | 101        |                       | $          | 1,251 |   |

 

**8.****                                      Loss Per Share**

 

The following is areconciliation of the numerator and denominator of basic and diluted loss pershare (in thousands, except per share data):

 
| ** **                                  | ** ** | **Three Months  Ended September 30,** |       | **Nine Months  Ended September 30,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | **2004**                                   | ** ** | **2003**                                  |       | **2004** |   | **2003** | ** ** |
| **Numerator:**                              |       |                                       | ** ** |                                      |       |   |   |   |   |
| Net loss                                    | ** ** | **$**                                      | **(527**   | **)**                                     | $          | (2,640 | ) | **$** | **(6,260** | ) | $ | (4,907 | ) |
| **Denominator:**                            | ** ** | ** **                                 | ** ** | ** **                                |       | ** ** |   | ** ** | ** ** |
| Denominator for basic loss per share -      |       |                                       | ** ** |                                      |       |   |   |   |   |
| Weighted-average shares                     | ** ** | **32,892**                                 | ** ** | 26,993                                    |       | **32,036** |   | 26,839 |   |
| Denominator for diluted loss per share (1)- | ** ** | **32,892**                                 | ** ** | 26,993                                    |       | **32,036** |   | 26,839 |   |
| **Basic and diluted loss per share**        | ** ** | **$**                                      | **(0.01**  | **)**                                     | $          | (0.10 | ) | **$** | **(0.20** | ) | $ | (0.18 | ) |

 

----

(1) Potentially dilutive securities are excluded from thecomputation of diluted loss per share because to do so would have beenanti-dilutive.

 

**9.**                                      SegmentInformation

** **

The Company is an advanced technology company in the field of rapid andaccurate identification, location tracking, and condition monitoring ofhigh-value assets.  Prior to January 22,2004, the Company operated in four segments: Animal Applications, Wireless andMonitoring, GPS and Radio Communications and Medical Systems.  With the acquisition of OuterLink Corporationin January 2004, the Company reorganized into three segments: AnimalApplications, GPS and Radio Communications and Medical Systems.  The GPS and Radio Communications segment, theWireless and Monitoring segment and the OuterLink Corporation business, whichwas acquired on January 22, 2004, were combined to form the new GPS andRadio Communications segment.  Priorperiod segment information has been restated to reflect the Company’s currentsegment structure. On April 19, 2004, Digital Angel Corporation soldcertain assets of its Medical Systems segment’s medical services business.  Assets sold include all of the tangible andintangible intellectual property developed for the operation of the MedicalSystems segment’s medical services business, pharmaceutical supplies and otherinventory items, customer and supplier contracts, computer software licenses,internet website and domain name and mailing lists and did not include the landand building used by this operation.  TheCompany sold the Medical Systems segment’s land and buildings in a separatetransaction on July 30, 2004 for $1.5 million.  Net cash received on the sale of the land andbuildings, after paying off the related building mortgage, was approximately$0.4 million.

 

10

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

 

Following is the selectedsegment data as of and for the three months ended September 30, 2004 (inthousands):

 
| ** **                                                                                   | ** ** | **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 |   |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Income (loss) before minority interest  share of losses (income) and discontinued operations |       | $                        | (777       | )                                 | $          | 128                           |       | $                | —     |   | $ | (649 | ) |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Total assets                                                                                 |       | $                        | 59,743     |                              | $          | 17,359                        |       | $                | 101        |   | $ | 77,203 |   |

 

In the three month period endedSeptember 30, 2004, one customer accounted for approximately 20.7% of ourAnimal Applications revenue and one customer accounted for approximately 32.5%of our GPS and Radio Communications revenue.

 

Following is the selectedsegment data as of and for the three months ended September 30, 2003 (inthousands):

 
| ** **                                                                                   | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /   Unallocated** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------------|------------|-------------------------------|------------|------------------|------------|
| ** **                                                                                   | ** ** | ** **               | ** ** | ** **                        | ** ** | ** **                    | ** ** | ** **       | ** ** |
| Net revenue from external customers:                                                         |       |                     |       |                              |       |                          |       |             |       |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Product                                                                                      |       | $                        | 4,835      |                              | $          | 2,526                         |       | $                | —     |   | $ | 7,361 |   |
| Service                                                                                      |       | 525                      |       | 125                               |       | —                        |       | 650              |       |
| Total revenue                                                                                |       | $                        | 5,360      |                              | $          | 2,651                         |       | $                | —     |   | $ | 8,011 |   |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Income (loss) before minority interest  share of losses (income) and discontinued operations |       | $                        | (1,258     | )                                 | $          | (1,167                        | )          | $                | —     |   | $ | (2,425 | ) |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Total assets                                                                                 |       | $                        | 61,709     |                              | $          | 6,738                         |       | $                | 2,473      |   | $ | 70,920 |   |

 

In the three month period endedSeptember 30, 2003, four customers accounted for approximately 22.3%,16.6%, 13.7%, and 12.8% of our Animal Applications revenue.

 

Following is the selectedsegment data as of and for the nine months ended September 30, 2004 (inthousands):

 
| ** **                                                                                   | ** ** | **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 |   |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Income (loss) before minority interest  share of losses (income) and discontinued operations |       | $                        | (3,859     | )                                 | $          | (1,392                        | )          | $                | —     |   | $ | (5,251 | ) |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Total assets                                                                                 |       | $                        | 59,743     |                              | $          | 17,359                        |       | $                | 101        |   | $ | 77,203 |   |

 

11

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In the nine month period ended September 30,2004, one customer accounted for approximately 18.9% of our Animal Applicationsrevenue and one customer accounted for 16.4% of our GPS and RadioCommunications revenue.

 

Following is the selectedsegment data as of and for the nine months ended September 30, 2003 (inthousands):

 
| ** **                                                                                   | ** ** | **Animal  Applications** | ** ** | **GPS and Radio  Communications** | ** ** | **Corporate /   Unallocated** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------------|------------|-------------------------------|------------|------------------|------------|
| ** **                                                                                   | ** ** | ** **               | ** ** | ** **                        | ** ** | ** **                    | ** ** | ** **       | ** ** |
| Net revenue from external customers:                                                         |       |                     |       |                              |       |                          |       |             |       |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Product                                                                                      |       | $                        | 17,157     |                              | $          | 7,933                         |       | $                | —     |   | $ | 25,090 |   |
| Service                                                                                      |       | 1,192                    |       | 284                               |       | —                        |       | 1,476            |       |
| Total revenue                                                                                |       | $                        | 18,349     |                              | $          | 8,217                         |       | $                | —     |   | $ | 26,566 |   |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Income (loss) before minority interest  share of losses (income) and discontinued operations |       | $                        | (737       | )                                 | $          | (3,692                        | )          | $                | —     |   | $ | (4,429 | ) |
|                                                                                         |       |                     |       |                              |       |                          |       |             |       |
| Total assets                                                                                 |       | $                        | 61,709     |                              | $          | 6,738                         |       | $                | 2,473      |   | $ | 70,920 |   |

 

In the nine month period ended September 30,2003, two customers accounted for approximately 18.2% and 11.5% of our AnimalApplications revenue.

 

**10.****                              ****Acquisition**

 

Thefollowing describes the acquisition by the Company (in thousands):

 
| **Company  Acquired**  | ** ** | **Date  Acquired** | ** ** | **Acquisition  Price** | ** ** | **Value of  Series A  Preferred  Stock** | ** ** | **Series A  Preferred  Shares  Issued** | ** ** | **Goodwill  and   Other  Intangibles  Acquired** | ** ** | **Other Net  Assets and  Liabilities** | ** ** | **Business  Description** | ** ** |
|------------------------|------------|--------------------|------------|------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|---------------------------|------------|
| OuterLink  Corporation |       | 1/22/04            |       | $                      | 8,501      |                                     | $          | 8,300                                   |       | 100                                              |       | $                                      | 8,522      |                      | $          | (21 | ) | Provider of real-time, satellite-based  automated tracking, wireless data transfer and two-way messaging with large  fleets of vehicles. |   |
|                        |            |                    |            |                        |            |                                          |            |                                         |            |                                                  |            |                                        |            |                           |            |  |  |  |  |

 

12

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OnJanuary 22, 2004, the Company acquired OuterLink Corporation.  OuterLink Corporation became a wholly-ownedsubsidiary of Digital Angel Corporation. The acquisition was accounted for under the purchase method ofaccounting.  The excess of purchase priceover the fair value of the assets and liabilities of OuterLink Corporation wasrecorded as goodwill of $3.8 million and intangible assets of $4.7 million. Theintangible assets are being amortized over periods ranging from 4 to 8years.  Amortization recorded in thethree and nine month periods ended September 30, 2004 were $0.1 millionand $0.5 million, respectively. 

 

Thecost of 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 is convertibleinto four million shares of the Company’s common stock when the volume weightedaverage price of the Company’s common stock equals or exceeds $4.00 per sharefor ten consecutive trading days.

 

The valuation of the stock is primarily basedon historical trading history and stock prices of the Company’s common stockand a marketability discount of 30%.  Theacquisition costs consist of legal and accounting related services that weredirect costs of acquiring these assets.

 

Inconsidering the benefits the OuterLink Corporation acquisition, the managementof Digital Angel Corporation recognized the strategic complement of OuterLinkCorporation’s technologies and customer base with Digital Angel Corporation’sexisting animal applications and military GPS business lines.  This complement provides for a strongplatform for further development of Digital Angel Corporation’s capabilities inthe area of high-value asset identification, tracking and condition monitoring.

 

Theresults of OuterLink Corporation have been included in the consolidatedfinancial statements since the date of acquisition of January 22,2004.  Unaudited pro forma results ofoperations for the three months ended September 30, 2003 and the ninemonths ended September 30, 2004 and 2003 are included below.  Such pro forma information assumes that theabove acquisition had occurred as of January 1, 2004 and 2003, and revenueis presented in accordance with the Company’s accounting policies.  This summary is not necessarily indicative ofwhat the result of operations of the Company would have been had it been acombined entity during such periods, nor does it purport to represent resultsof operations for any future periods.

 
| **(In thousands)**                             | ** ** | **For the  three-months  ended September 30,  2003** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Net revenue                                    |       | $                                                         | 8,438      |   |
| Net loss                                       |       | $                                                         | (3,388     | ) |
| Net loss per  common share - basic and diluted |       | $                                                         | (0.13      | ) |

 
| ** **                                     | ** ** | **For the  nine-months ended September 30,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------|------------|
| **(In thousands)**                             | ** ** | **2004**                                          | ** ** | **2003** | ** ** |
| Net revenue                                    |       | $                                                 | 32,108     |   | $ | 27,588 |   |
| Net loss                                       |       | $                                                 | (6,963     | ) | $ | (7,843 | ) |
| Net loss per  common share - basic and diluted |       | $                                                 | (0.22      | ) | $ | (0.29 | ) |

 

**11.**                               Contingencies

** **

*Electronic Identification Devices Litigation*

 

InFebruary 2004, Electronic Identification Devices, Ltd. (“EID”) commenced aDeclaratory Judgment Action against the Company in the United States DistrictCourt for the Western District of Texas. This action sought a declaration of patent non-infringement relating tothe Company’s patented syringe implantable identification transponder.  The lawsuit alleged that EID has developed anew transponder that it believed did not infringe on the Company’s patent.  The lawsuit acknowledged that the Companyobtained a Judgment of infringement and two contempt orders against EID basedon selling certain systems that infringed the Company’s patent in 1997, 1998and 1999.  On September 17, 2004 theUnited States District Court for the Western District of Texas dismissed EID’scause of action. 

 

*John Fernandez vs. United States of America vs. Medical AdvisorySystems, Inc.*

 

OnDecember 29, 2003, John Fernandez filed a lawsuit in the Orlando Divisionof the United States District Court for the Middle District of Florida.  The plaintiff filed the lawsuit against theUnites States of America as the operator of the ship on which the plaintiffserved.  He alleged that the UnitedStates had contracted with Medical Advisory Systems to provide medical adviceand that the physician at Medical Advisory Systems had rendered an incorrectlong-distance diagnosis, resulting to injury to the plaintiff.  Mr. Fernandez asserted against the UnitedStates claims of negligence under the Jones Act, unseaworthiness andmaintenance and cure. He alleged damages in excess of $75,000, plus prejudgmentand post-judgment interest at the legal rate and costs and disbursements of 

 

13

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theaction.  On April 14, 2004, theUnited States served Medical Advisory Systems with a third party complaint inAdmirality in which it alleged that Medical Advisory Systems is liable to itfor all or part of the plaintiff’s claim in that Medical Advisory Systemsand/or its employee/physician rendering the medical advice was negligent.  In response, on May 12, 2004, MedicalAdvisory Systems filed a motion to dismiss the third party complaint.  The matter is presently scheduled for trialin April 2005.  The ultimate outcomeof this proceeding cannot be predicted at this time.  The Company is currently unable to determinethe potential effect of this litigation on our consolidated financial position,results of operations or cash flows. 

 

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

 

On October 20,2004, the Company commenced an action in the United Stated District Court forthe District of Minnesota against AllFlex USA, Inc. and Pet Health Services(USA), Inc.  This suit (Court File No.04-4545MJD/JGL) claims that Allflex is marketing and selling a syringeimplantable identification transponder that infringes a 1993 patent granted tothe Company for syringe implantable identification transponders previouslyfound by the United States District Court for the District of Colorado to beenforceable.  The suit also claims thatPetHealth is using, selling and/or distributing the same transponder inviolation of the Company’s patent.  Thesuit seeks, among other things, an adjudication of infringement and that theinfringing parties be enjoined from further improper action.  The suit also seeks actual damages, punitivedamages and interest, costs and attorneys’ fees.  The Company believes that the suit iswell-grounded in law and fact.

 

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

 

On October 20,2004, the Company commenced an action in the United States District Court forthe District of Minnesota against Datamars, Inc., Datamars, S.A., The CrystalImport Corporation, and Medical Management International, Inc. (“Banfield”).  This suit (Court File No. 04-4544ADM/AJB)claims that the defendants are marketing and selling syringe implantableidentification transponders manufactured by Datamars that infringe the Company’s1993 patent for syringe implantable identification transponders previouslyfound by the United States District Court for the District of Colorado to beenforceable.  Certain of the locations inwhich the infringing 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 other things, an adjudication of infringement andthat the infringing parties be enjoined from further improper action.  The suit also seeks actual damages, punitivedamages and interest, costs and attorneys’ fees.  The Company believes that the suit iswell-grounded in law and fact.

 

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

 
| ** **                                                 | ** ** | **Nine Months  Ended September 30,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                                       | ** ** | **2003** | ** ** |
| Interest paid                                              | ** ** | **$**                                          | **378**    |   | $ | 570 |   |
| Taxes paid                                                 |       | —                                         |       | 3 |   |
| Non-cash  activity:                                        |       |                                           |       |   |   |
| Issuance of  preferred stock for business acquisition      | ** ** | **$**                                          | **8,300**  |   | — |   |
| Issuance of  common stock for Applied Digital common stock | ** ** | **7,920**                                      |       | — |   |
| Conversion of  debt into common stock                      | ** ** | **699**                                        |       | — |   |
| Warrants issued  in connection with financing arrangements |       | —                                         |       | 277 |   |
|                                                            |            |                                                |            |  |  |  |  |

 

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

 

In 2003,Applied Digital charged the Company for research expenses and directors andofficers insurance.  Amounts due toApplied Digital were offset by receivables due from Applied Digital resultingfrom the Distribution and Licensing Agreement with Verichip Corporation, awholly-owned subsidiary of Applied Digital. At September 30, 2004, these transactions resulted in a net amountdue to Applied Digital of $0.1 million. 

 

The Companyhas executed an exclusive eleven year Distribution and Licensing Agreementdated March 4, 2002 with Verichip Corporation (Verichip), a wholly-ownedsubsidiary of Applied Digital, covering the manufacturing, purchasing anddistribution of Verichip’s implantable microchip and the maintenance of theVerichip Registry by the Company.  Theagreement includes a license for the use of the Company’s technology inVerichip’s identified markets.  TheCompany will be the sole manufacturer and supplier to Verichip.  Revenue recognized under the Distribution andLicensing Agreement was $0.1 million for each of the nine months ended September 30,2004 and 2003.

 

14

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**14.****                               SubsequentEvent**

 

On October 12,2004, the FDA issued a letter stating that VeriChipTM has beencleared for medical applications in the United States.  The FDA’s clearance follows the completion ofa de novo application review of the product. Digital Angel Corporation is the manufacturer of VeriChipTM,and has licensed the technology to VeriChip Corporation, a wholly-ownedsubsidiary of Applied Digital, for human applications.

 

**Item 2.****                              Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

The followingdiscussion and analysis of our financial condition and results of operationsshould be read in conjunction with the accompanying financial statements andrelated notes thereto.

 

Weconsist of Digital Angel Corporation and its four subsidiaries — Digital AngelTechnology Corporation (“DATC”), Timely Technology Corp., Signature Industries,Limited, and OuterLink Corporation

 

**RESULTSOF OPERATIONS**

 

The followingtable summarizes our results of operations as a percentage of net operatingrevenue for the three and nine months ended September 30, 2004 and 2003and is derived from the accompanying consolidated statements of operationsincluded in this report.

 
| ** **                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                 | ** ** | **%**                                      | ** ** | **%**                                     | ** ** | **%** | ** ** | **%** | ** ** |
| Product revenue                                                            |       | 95.4                                       |       | 91.9                                      |       | 95.5 |   | 94.4 |   |
| Service revenue                                                            |       | 4.6                                        |       | 8.1                                       |       | 4.5 |   | 5.6 |   |
| Total net revenue                                                          |       | 100.0                                      |       | 100.0                                     |       | 100.0 |   | 100.0 |   |
| Cost of products sold                                                      |       | 52.5                                       |       | 56.5                                      |       | 54.6 |   | 56.4 |   |
| Cost of services sold                                                      |       | 2.6                                        |       | 0.0                                       |       | 2.6 |   | 0.2 |   |
| Total cost of products and services sold                                   |       | 55.1                                       |       | 56.5                                      |       | 57.2 |   | 56.6 |   |
| Gross profit                                                               |       | 44.9                                       |       | 43.5                                      |       | 42.8 |   | 43.4 |   |
| Selling, general and administrative  expenses                              |       | 39.7                                       |       | 52.3                                      |       | 41.1 |   | 45.1 |   |
| Research and development expenses                                          |       | 6.5                                        |       | 19.4                                      |       | 7.0 |   | 13.7 |   |
| Operating loss                                                             |       | (1.3                                       | )          | (28.2                                     | )          | (5.3 | ) | (15.4 | ) |
| Interest income                                                            |       | 0.1                                        |       | 0.1                                       |       | 0.1 |   | 0.0 |   |
| Interest expense                                                           |       | (2.3                                       | )          | (2.7                                      | )          | (2.4 | ) | (1.8 | ) |
| Loss on Applied Digital common stock                                       |       | (2.5                                       | )          | 0.0                                       |       | (9.0 | ) | 0.0 |   |
| Other income                                                               |       | 0.2                                        |       | 0.5                                       |       | 0.2 |   | 0.5 |   |
| Loss before minority interest share of  losses and discontinued operations |       | (5.8                                       | )          | (30.3                                     | )          | (16.4 | ) | (16.7 | ) |
| Minority interest share of (income) losses                                 |       | (1.2                                       | )          | 1.1                                       |       | (0.4 | ) | 0.8 |   |
| Net loss from continuing operations                                        |       | (7.0                                       | )          | (29.2                                     | )          | (16.8 | ) | (15.9 | ) |
| Income (loss) from discontinued operations                                 |       | 2.3                                        |       | (3.8                                      | )          | (2.7 | ) | (2.6 | ) |
| Net loss                                                                   |       | (4.7                                       | )          | (33.0                                     | )          | (19.5 | ) | (18.5 | ) |

 

15

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**ThreeMonths Ended September 30, 2004 Compared to the Three Months Ended September 30,2003**

 

**Revenue**

 

Revenue for thethree months ended September 30, 2004 increased $3.2 million, or 39.6%, to$11.2 million when compared to $8.0 million in revenue for the three monthsended September 30, 2003.

 

Revenue for eachof the operating segments was as follows (in thousands):

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2004** | ** ** | **Three Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Animal Applications          |       | $                                                | 5,515      |                                             | $          | 5,360 |   |
| GPS and Radio Communications |       | 5,665                                            |       | 2,651                                            |       |
| Total                        |       | $                                                | 11,180     |                                             | $          | 8,011 |   |

 

The AnimalApplications segment’s revenue increased**$0.2million, or 2.9%, in the three months ended September 30, 2004 compared to$5.4 million in the three month period ended September 30, 2003. Theincrease is the result of increased sales to companion animal customers in2004, offset by decreased sales to our fish and wildlife customers. 

 

The GPS and RadioCommunications segment’s revenue increased $3.0 million, or 113.7%, in thethree months ended September 30, 2004 compared to the three month periodended September 30, 2003. The increase primarily relates to increasedrevenue at our subsidiary, Signature Industries, related to the shipments ofthe G2R pilot locator beacon to fulfill a contract with the government ofIndia.  OuterLink Corporation revenue was$0.5 million for the three months ended September 30, 2004.  OuterLink Corporation was acquired on January 22,2004 and is not included in our results for the three months ended September 30,2003.  

 

**GrossProfit and Gross Profit Margin**

 

Gross profit for thethree month period ended September 30, 2004 was $5.0 million, an increase**of $1.5 million, or 43.8%, compared to$3.5 million in the three month period ended September 30, 2003. As apercentage of revenue, the gross profit margin was 44.9% and 43.5% for thethree months ended September 30, 2004 and 2003, respectively.

 

Gross profit fromoperations for each operating segment was as follows (in thousands):

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2004** | ** ** | **Three Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Animal Applications          |       | $                                                | 2,155      |                                             | $          | 2,076 |   |
| GPS and Radio Communications |       | 2,861                                            |       | 1,411                                            |       |
| Total                        |       | $                                                | 5,016      |                                             | $          | 3,487 |   |

 

Gross profitmargin from operations for each operating segment was:

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2004** | ** ** | **Three Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                            | ** ** | **%**                                            | ** ** |
| Animal Applications          |       | 39.1                                             |       | 38.7                                             |       |
| GPS and Radio Communications |       | 50.5                                             |       | 53.2                                             |       |

 

The Animal Applicationssegment’s gross profit increased $0.1 million, or 3.8%, in the three monthperiod ended September 30, 2004 compared to $2.1 million in the three monthsended September 30, 2003.  The grossmargin percentage increased to 39.1% in the three month period ended September 30,2004 as compared to 38.7% in the three month period ended September 30,2003.  The gross margin percentageincrease is the primarily the result of lower overhead expenses in 2004. 

 

The GPS and RadioCommunications segment’s gross profit increased $1.5 million, or 102.8%, in thethree month period ended September 30, 2004 as compared to the three monthperiod ended September 30, 2003. The GPS and Radio Communications segment’s gross profit is attributableto increased gross profit at our subsidiary Signature Industries of $1.4million as a result of the previously mentioned sales increase. The grossmargin percentage decreased to 50.5% in the three month period ended September 30,2004 as compared to 53.2% in the three month period ended September 30,2003.  The gross margin decrease relatesto low margins on OuterLink Corporation sales. OuterLink Corporation gross profit was $0.1 million in the three monthsended September 30, 2004. OuterLink Corporation was acquired in January 2004.

 

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**Selling,General and Administrative Expenses**

 

Selling, generaland administrative expenses increased $0.2 million, or 5.8%, in the three monthperiod ended September 30, 2004 as compared to the three month periodended September 30, 2003. As a percentage of revenue, selling, general andadministrative expenses were 39.7% and 52.3% for the three months ended September 30,2004 and 2003, respectively.

 

Selling, generaland administrative expenses for each of the operating segments were as follows(in thousands):

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2004** | ** ** | **Three Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Animal Applications          |       | $                                                | 1,944      |                                             | $          | 2,127 |   |
| GPS and Radio Communications |       | 2,491                                            |       | 2,066                                            |       |
| Total                        |       | $                                                | 4,435      |                                             | $          | 4,193 |   |

 

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

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2004** | ** ** | **Three Months  Ended September 30  2003** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                            | ** ** | **%**                                           | ** ** |
| Animal Applications          |       | 35.2                                             |       | 39.7                                            |       |
| GPS and Radio Communications |       | 44.0                                             |       | 77.9                                            |       |

 

The AnimalApplications segment’s selling, general and administrative expenses decreased $0.2 million in the threemonth period ended September 30, 2004 as compared to $2.1 million in thethree month period ended September 30, 2003 and as a percentage of revenuedecreased to 35.2% from 39.7% in the same respective period.  The decrease in selling, general andadministrative expense is primarily due to bank charges incurred in the threemonth period ended September 30, 2003 that were not incurred in the threemonth period ended September 30, 2004. 

 

The GPS and RadioCommunications segment’s selling, general and administrative expenses increased $0.4 million in the threemonth period ended September 30, 2004 as compared to $2.1 million in thethree month period ended September 30, 2003.  The increase of $0.4 million results fromincreased expenses of $0.2 million at Signature Industries, $0.5 million ofexpense at OuterLink, which was acquired in January 2004, offset by adecrease of $0.3 million related to the scaleback of the Digital Angel TMtechnology development. As a percentage of revenue, selling, general andadministrative expenses decreased to 44.0% in the three month period ended September 30,2004 from 77.9% in the three month period ended September 30, 2003primarily due to the increase in sales in the three months ended September 30,2004. 

 

**Researchand Development Expense**

 

Research anddevelopment expense was $0.7 million in the three month period ended September 30,2004, a decrease of $0.8 million, or 52.9%, from $1.6 million for the threemonth period ended September 30, 2003. As a percentage of revenue, research and development expense was 6.5%and 19.4% for the three months ended September 30, 2004 and 2003,respectively.  

 

Research anddevelopment expense for each of the operating segments was as follows (inthousands):

 
| ** **                   | ** ** | **Three Months  Ended September 30,  2004** | ** ** | **Three Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| Animal Applications          |       | $                                                | 539        |                                             | $          | 1,035 |   |
| GPS and Radio Communications |       | 192                                              |       | 516                                              |       |
| Total                        |       | $                                                | 731        |                                             | $          | 1,551 |   |

 

The decrease inthe Animal Applications segment’s research and development expenses was dueprimarily to the completion of development of the BiothermoTMmicrochip and development of new reader technology in 2003. The decrease in theGPS and Radio Communications segment’s research and development expenses wasdue primarily to the continued scaleback of research and development on theDigital AngelTM technology and completion of development onSignature Industries’ pilot locator beacon. 

 

17

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**InterestExpense**

 

Interest expense was $0.3million and $0.2 million for the three month periods ended September 30,2004 and 2003, respectively.  

 

**Loss on Applied Digital Common Stock**

 

On March 1,2004, Digital Angel Corporation issued 3,000,000 shares of its common stock anda warrant to purchase up to 1,000,000 shares of the Company’s common stock toApplied Digital in exchange for 1,980,000 shares of Applied Digital’s commonstock, exclusive of the proceeds which may be received when the warrant isexercised. The Company accounted for the Applied Digital stock as a tradingsecurity under SFAS 115, “Accounting for Certain Investments in Debt and EquitySecurities”.  In the quarter ended September 30,2004, the Company did not sell any shares of Applied Digital common stock.  The Company recorded unrealized losses of$0.3 million in the quarter ended September 30, 2004.  Fair value of the Applied Digital commonstock was determined by quoted values reported on the NASDAQ.  On October 14, 2004 the Company sold the remaining1,070,000 shares for net cash proceeds of $4.0 million.  The Company recorded a gain of $1.7 millionon the sale of the remaining shares of Applied Digital common stock.  

 

**IncomeTaxes**

 

TheCompany accounts 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 likely thannot that a tax benefit will not be realized. Income taxes included U.S. and foreign taxes.

 

**Discontinued Operations**

 

On April 19, 2004, the Companysold certain assets of its Medical Systems segment’s medical services businesspursuant to an Asset Purchase Agreement dated April 8, 2004 by and betweenDigital Angel Corporation and MedAire, Inc. Assets sold include all of the tangible and intangible intellectualproperty developed for the operation of the Medical Systems segment’s medicalservices business, pharmaceutical supplies and other inventory items, customerand supplier contracts, computer software licenses, internet website and domainname and mailing lists.

 

Under the terms of the agreement,the purchase price, in addition to MedAire, Inc.’s assumption of certainliabilities was $420,000 plus any prepaid deposits and the cost of thepharmaceutical inventory and supplies reduced by any pre-billing to or pro-rataprepayment by the Company’s customers.

 

In connection with exiting thisactivity, the Company recorded income of approximately $0.3 million in thethree months ended September 30, 2004. The Company sold the Medical Systems segment’s land and buildingsin a separate transaction on July 30, 2004 for $1.5 million.  Net cash received on the land and buildingsale, after paying off the related building mortgage, was approximately $0.4million.

 

The following disclosesthe income (loss) from discontinued operations for the three-months ended September 30,2004 and 2003, consisting of losses attributable to the Medical Systems segment:

 
| ** **                                    | ** ** | **Three-Months  Ended September 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| Product revenue                               |       | $                                          | —     |   | $ | 139 |   |
| Service revenue                               |       | —                                     |       | 195 |   |
| Total revenue                                 |       | —                                     |       | 334 |   |
| Cost of products sold                         |       | —                                     |       | 63 |   |
| Cost of services sold                         |       | —                                     |       | 239 |   |
| Total cost of products and services sold      |       | —                                     |       | 302 |   |
| Gross profit                                  |       | —                                     |       | 32 |   |
| Selling, general and administrative  expenses |       | 35                                         |       | 303 |   |
| Other (income) expense                        |       | (290                                       | )          | 35 |   |
| Income (loss) from discontinued operations    |       | $                                          | 255        |   | $ | (306 | ) |

 

18

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**NineMonths Ended September 30, 2004 Compared to the Nine Months Ended September 30,2003**

 

**Revenue**

 

Revenue for the ninemonths ended September 30, 2004 increased $5.5 million, or 20.5%, to $32.0million when compared to $26.6 million in revenue for the nine months ended September 30,2003.

 

Revenue for each of theoperating segments was as follows (in thousands):

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2004** | ** ** | **Nine Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal Applications          |       | $                                               | 18,700     |                                            | $          | 18,349 |   |
| GPS and Radio Communications |       | 13,321                                          |       | 8,217                                           |       |
| Total                        |       | $                                               | 32,021     |                                            | $          | 26,566 |   |

 

The AnimalApplications segment’s revenue increased**$0.3million, or 1.9%, in the nine months ended September 30, 2004 compared to$18.3 million in the nine month period ended September 30, 2003. Theincrease is due to increased sales in the nine months ended September 30,2004 to companion animal customers of $0.9 million and livestock customers of$1.0 million, offset by decreased sales to our fish and wildlife customers of$1.6 million.

 

The GPS and RadioCommunications segment’s revenue increased $5.1 million, or 62.1%, in the ninemonths ended September 30, 2004 compared to the nine month period ended September 30,2003.  The increase primarily relates toincreased revenue at our subsidiary, Signature Industries, related to theshipments of the G2R pilot locator beacon and increased sales in Signature’sClifford and Snell division. OuterLink Corporation revenue was $1.2 million forthe nine months ended September 30, 2004. OuterLink Corporation was acquired on January 22, 2004 and is notincluded in our results for the nine months ended September 30, 2003.  

 

**GrossProfit and Gross Profit Margin**

 

Gross profit forthe nine month period ended September 30, 2004 was $13.7 million, anincrease**of $2.2 million, or 18.7%,compared to $11.5 million in the nine month period ended September 30,2003. As a percentage of revenue, the gross profit margin was 42.8% and 43.4%for the nine months ended September 30, 2004 and 2003, respectively.

 

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

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2004** | ** ** | **Nine Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal Applications          |       | $                                               | 7,289      |                                            | $          | 7,440 |   |
| GPS and Radio Communications |       | 6,412                                           |       | 4,101                                           |       |
| Total                        |       | $                                               | 13,701     |                                            | $          | 11,541 |   |

 

Gross profitmargin for each operating segment was:

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2004** | ** ** | **Nine Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                           | ** ** | **%**                                           | ** ** |
| Animal Applications          |       | 39.0                                            |       | 40.5                                            |       |
| GPS and Radio Communications |       | 48.1                                            |       | 49.9                                            |       |

 

The Animal Applicationssegment’s gross profit decreased $0.2 million, or 2.0%, in the nine monthperiod ended September 30, 2004 compared to the nine months ended September 30,2003 due to increased material costslightly offset by lower freight costs in 2004. The gross margin percentage decreased to 39.0% in the nine monthperiod ended September 30, 2004 as compared to 40.5% in the nine monthperiod ended September 30, 2003 dueprimarily due to increased material costs.

 

The GPS and RadioCommunications segment’s gross profit increased $2.3 million, or 56.4%, in thenine month period ended September 30, 2004 compared to the nine monthsended September 30, 2003 due toincreased gross profit of $2.3 million at Signature Industries and $0.3 millionat OuterLink.  OuterLink was acquired in January 2004.  The increases in gross profit were offset bya decrease of $0.3 million related to the scaleback of Digital Angel TMtechnology development.  The grossmargin percentage decreased to 48.1% in the nine month period ended September 30,2004 as compared to 49.9% in the nine month period ended September 30,

 

19

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2003 due primarily to the addition of lowermargin OuterLink Corporation sales in 2004. 

 

**Selling,General and Administrative Expenses**

 

Selling, generaland administrative expenses increased $1.2 million, or 9.8%, in the nine monthperiod ended September 30, 2004 as compared to the nine month period endedSeptember 30, 2003.  As a percentageof revenue, selling, general and administrative expenses were 41.1% and 45.1%for the nine months ended September 30, 2004 and 2003, respectively.

 

Selling, generaland administrative expenses were as follows (in thousands):

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2004** | ** ** | **Nine Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal Applications          |       | $                                               | 6,010      |                                            | $          | 5,561 |   |
| GPS and Radio Communications |       | 7,152                                           |       | 6,431                                           |       |
| Total                        |       | $                                               | 13,162     |                                            | $          | 11,992 |   |

 

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

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2004** | ** ** | **Nine Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                   | ** ** | **%**                                           | ** ** | **%**                                           | ** ** |
| Animal Applications          |       | 32.1                                            |       | 30.3                                            |       |
| GPS and Radio Communications |       | 53.7                                            |       | 78.3                                            |       |

 

The AnimalApplications segment’s selling, general and administrative expenses increased $0.4 million in the ninemonth period ended September 30, 2004 as compared to the nine month periodended September 30, 2003 and as a percentage of revenue increased to 32.1%from 30.3% in the same respective period. The increase relates primarily to additional legal, accounting andinvestor relation expenses in the nine months ended September 30, 2004.

 

The GPS and RadioCommunications segment’s selling, general and administrative expenses increased $0.7 million in the ninemonth period ended September 30, 2004 as compared to the nine month periodended September 30, 2003.  Thisincrease is primarily due to $1.4 million of OuterLink expense, $0.6 million ofincreased expense at our subsidiary, Signature Industries, offset by a decreaseof $1.3 million related to the scaleback of Digital Angel TMtechnology development. OuterLink was acquired in January 2004. As apercentage of revenue, selling, general and administrative expenses decreasedto 53.7% in the nine month period ended September 30, 2004 from 78.3% inthe nine month period ended September 30, 2003.

 

**Researchand Development Expense**

 

Research anddevelopment expense was $2.2 million in the nine month period ended September 30,2004, a decrease of $1.4 million, or 38.1%, from $3.6 million for the ninemonth period ended September 30, 2003. As a percentage of revenue, research and development expense was 7.0%and 13.7% for the nine months ended September 30, 2004 and 2003,respectively.  

 

Research anddevelopment expense for each of the operating segments was as follows (inthousands):

 
| ** **                   | ** ** | **Nine Months  Ended September 30,  2004** | ** ** | **Nine Months  Ended September 30,  2003** | ** ** |
|------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Animal Applications          |       | $                                               | 1,715      |                                            | $          | 2,276 |   |
| GPS and Radio Communications |       | 535                                             |       | 1,358                                           |       |
| Total                        |       | $                                               | 2,250      |                                            | $          | 3,634 |   |

 

The decrease inthe Animal Applications segment’s research and development expenses was dueprimarily to the completion of development of the BiothermoTMmicrochip and development of new reader technology. The decrease in the GPS andRadio Communications segment’s research and development expenses was dueprimarily to the continued scaleback of research and development on the DigitalAngelTM technology and completion of development on SignatureIndustries’ pilot locator beacon. 

 

**InterestExpense**

 

Interest expense was $0.8million and $0.5 million for the nine months period ended September 30,2004 and 2003, respectively. The increase relates to the amortization ofdeferred financing costs related to the financings in July and August of2003. 

 

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**IncomeTaxes**

 

The Company accounts forincome taxes under the asset and liability approach.  Deferred tax assets and liabilities arerecognized for the expected future tax consequences attributed to differencesbetween the financial statement carrying amounts of existing assets andliabilities and their respective tax basis. Deferred tax assets and liabilities are measured using the enacted taxrates expected to apply to taxable income in the years in which those temporarydifferences are expected to reverse.  Avaluation allowance is provided against net deferred tax assets when it is morelikely than not that a tax benefit will not be realized.  Income taxes included U.S. and foreign taxes.

 

**Loss on Applied Digital Common Stock**

 

On March 1,2004, Digital Angel Corporation issued 3,000,000 shares of its common stock anda warrant to purchase up to 1,000,000 shares of the Company’s common stock toApplied Digital in exchange for 1,980,000 shares of Applied Digital’s commonstock, exclusive of the proceeds which may be received when the warrant isexercised.  As of September 30,2004, the Company had sold approximately 910,000 shares of Applied Digitalcommon stock.  The Company accounted forthe Applied 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 approximately910,000 shares of Applied Digital common stock sold and unrealized losses of$1.9 million on the 1,070,000 shares held by the Company.  Fair value of the Applied Digital commonstock was determined by quoted values reported on the NASDAQ.  On October 14, 2004 the Company sold the remaining1,070,000 shares for net cash proceeds of $4.0 million.  The Company recorded a gain of $1.7 millionon the sale of the remaining shares of Applied Digital common stock.  

 

**Discontinued Operations**

 

On April 19, 2004, the Companysold certain assets of its Medical Systems segment’s medical services businesspursuant to an Asset Purchase Agreement dated April 8, 2004 by and betweenDigital Angel Corporation and MedAire, Inc. Assets sold include all of the tangible and intangible intellectualproperty developed for the operation of the Medical Systems segment’s medicalservices business, pharmaceutical supplies and other inventory items, customerand supplier contracts, computer software licenses, internet website and domainname and mailing lists.

 

Under the terms of the agreement,the purchase price, in addition to MedAire, Inc.’s assumption of certainliabilities was $420,000 plus any prepaid deposits and the cost of thepharmaceutical inventory and supplies reduced by any pre-billing to or pro-rataprepayment by the Company’s customers.

 

In connection with the sale toMedAire, Inc., the Company recognized obligations and recorded a loss ofapproximately $0.6 million in the nine months ended September 30,2004.  In addition, on July 30,2004, the Company sold the Medical Systems segment’s land and building for $1.5million. The Company recorded a gain of approximately $0.3 million on the saleof the land and buildings.  Netcash received on the sale of the land and building, after paying off therelated building mortgage, was approximately $0.4 million.  The net loss recorded by the Company in thenine months ended September 30, 2004 in connection with exiting thisactivity was $0.3 million. 

 

The following disclosesthe losses from discontinued operations for the nine-months ended September 30,2004 and 2003, consisting of losses attributable to the Medical Systemssegment:

 
| ** **                                    | ** ** | **Nine-Months  Ended September 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| Product revenue                               |       | $                                         | 204        |   | $ | 726 |   |
| Service revenue                               |       | 223                                       |       | 811 |   |
| Total revenue                                 |       | 427                                       |       | 1,537 |   |
| Cost of products sold                         |       | 87                                        |       | 321 |   |
| Cost of services sold                         |       | 317                                       |       | 832 |   |
| Total cost of products and services sold      |       | 404                                       |       | 1,153 |   |
| Gross profit                                  |       | 23                                        |       | 384 |   |
| Selling, general and administrative  expenses |       | 1,081                                     |       | 959 |   |
| Other (income) expense                        |       | (185                                      | )          | 104 |   |
| Loss from discontinued operations             |       | $                                         | (873       | ) | $ | (679 | ) |

 

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**LIQUIDITYAND CAPITAL RESOURCES**

 

As of September 30,2004, the Company had cash of $0.3 million compared to $0.9 million at December 31,2003.  In addition, at September 30,2004 we held Applied Digital common stock of $2.3 million compared to $0.0million at December 31, 2003.  Cashused in operating activities totaled $3.7 million and $3.5 million in the firstnine months of 2004 and 2003, respectively.

 

In the firstnine months of 2004, the use of cash was due primarily to the loss generatedfrom operations and an increase in accounts receivable.  Accounts receivable, net of allowance fordoubtful accounts, increased by $2.1 million, or 60.5%, to $5.5 million at September 30,2004 from $3.4 million at December 31, 2003.  Approximately $0.5 million of the increasewas accounts receivable acquired in the acquisition of OuterLink Corporation inJanuary 2004.  Offsetting these usesof cash were depreciation and amortization of $1.5 million and realized andunrealized losses on Applied Digital common stock of $2.9 million. 

 

Inventory levelsincreased by $0.3 million to $6.8 million at September 30, 2004 from $6.5million at December 31, 2003 due to an increase in inventory at SignatureIndustries, Ltd. offset by decreased inventory at our Animal Applicationssegment. 

 

Accounts payabledecreased by $0.4 million to $4.8 million at September 30, 2004 from $5.2million at December 31, 2003.

 

Accrued expenses andother current liabilities increased by $0.3 million, or 9.4%, to $3.5 millionat September 30, 2004 from $3.2 million at December 31, 2003.  Accrued expenses acquired in the OuterLinkacquisition totaled $0.6 million.

 

Investingactivities provided cash of $4.0 million in the first nine months of 2004 andused cash of $0.8 million in the first nine months of 2003.  In the first nine months of 2004, cashprovided was primarily from the sale of Applied Digital common stock and thesale of the Medical Systems segment’s assets. During the first nine months of2004 and 2003, $0.4 million and $0.8 million was spent to acquire property andequipment, respectively.

 

Financingactivities used cash of $1.0 million in the first nine months of 2004 andprovided cash of $4.3 million in the first nine months of 2003.  In the nine months ended September 30,2004, cash was used primarily for payments on our debt and line of credit,including net cash used in discontinued operations, of $1.9 million offset byproceeds from stock option exercises of $1.1 million.

 

*Debt andLiquidity*

 

The followingtable summarizes the Company’s fixed cash obligations as of September 30,2004 over various future periods (in thousands):

 
| ** **                       | ** ** | ** ** | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------|------------|------------|------------|----------------------------|------------|
| **Contractual cash obligations** | ** ** | **Total**  | ** ** | **Less than  1 Year**      | ** ** | **1-3  Years** | ** ** | **4-5  Years** | ** ** | **After  5 Years** | ** ** |
| Notes Payable and Long-Term Debt |       | $          | 6,387      |                       | $          | 4,087 |   | $ | 117 |   | $ | 130 |   | $ | 2,053 |   |
| Operating Leases                 |       | 19,062     |       | 746                        |       | 1,286 |   | 1,114 |   | 15,916 |   |
| Employment Contracts             |       | 1,604      |       | 865                        |       | 739 |   | — |   | — |   |
|                             |       | $          | 27,053     |                       | $          | 5,698 |   | $ | 2,142 |   | $ | 1,244 |   | $ | 17,969 |   |

* *

*Convertible Note**. *On July 31,2003, we entered into a Securities Purchase Agreement (“Purchase Agreement”) tosell to Laurus Master Fund, Ltd. (“Laurus”) a two-year Secured Convertible Note(the “Convertible Note”) in the original principal amount of $2,000,000 and afive-year warrant to purchase up to 125,000 shares of our common stock.  The per share exercise price of the warrantis $2.68 for 75,000 shares, $2.91 for 35,000 shares and $3.38 for 15,000shares. The Convertible Note is convertible, at Laurus’s option, into shares ofour common stock at a per share price of $2.33. Laurus is not entitled to convert the amount evidenced by theConvertible Note into a number of shares of common stock which would exceed thedifference between the number of shares of common stock beneficially owned byLaurus and 4.99% of the outstanding shares of our common stock.  However, Laurus may acquire more than 4.99%of our outstanding common stock upon 75 days notice to the Company. Through September 30,2004, Laurus has converted $699,000 into 300,000 shares of our commonstock.  Subsequent to September 30,2004, Laurus converted an additional $233,000 of principal into 100,000 sharesof our common stock. Through September 30, 2004 Laurus sold 150,000 of thecommon shares to Applied Digital. Subsequent to September 30, 2004 Laurus sold an additional 50,000shares of our common stock to Applied Digital. As of September 30, 2004the principal balance of the Convertible Note was $730,000.  The Convertible Note accrues interest at anannual rate equal to the higher of the prime rate plus 1.75% or 6% perannum.  We allocated $143,000 of theproceeds to the warrant issued.  Theamount allocated represents the fair value of the warrant calculated under theBlack-Scholes method.  The value of thewarrant is included in additional paid-in capital and is being amortized tointerest expense over the life of the Convertible Note.

 

In connection with theConvertible Note, we entered into a Security Agreement with Laurus granting toLaurus a lien and 

 

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security interest in our assets.  Additionally, the Securities PurchaseAgreement includes default provisions should an Event of Default (as defined inthe agreement) occur.  Furthermore, undera related registration rights agreement, the common stock underlying theConvertible Note is registered with the Securities and Exchange Commission.

 

*Revolving Note and MinimumBorrowing Note*.  On August 28, 2003, we entered into aSecurity Agreement with Laurus under which we may borrow from Laurus the lesserof $5,000,000 or an amount that is determined based on percentages of oureligible accounts receivable and inventory as prescribed by the terms of theSecurity Agreement.  Under the SecurityAgreement, we issued to Laurus a three-year Secured Revolving Convertible Note(“Revolving Note”) in the original principal amount of $3,500,000 and athree-year Secured Minimum Borrowing Convertible Note (“Minimum Borrowing Note”)in the original principal amount of $1,500,000. We used proceeds from theRevolving Note and Minimum Borrowing Note to satisfy in full our creditfacility from Wells Fargo Business Credit. The Revolving Note and Minimum Borrowing Note accrue interest at an annualrate equal to the prime rate plus 2.5%. As of September 30, 2004 theprincipal amount outstanding under the Revolving Note and Minimum BorrowingNote was $1.6 million.  The availabilityunder the Revolving Note at September 30, 2004 was $2.1 million.

 

BeginningMay 28, 2004, the Minimum Borrowing Note and the Revolving Note areconvertible, at Laurus’s option, into shares of our common stock at a per priceshare of $2.64 (the “Fixed Conversion Price”). The Fixed Conversion Price is adjusted upward following each conversionof $2,000,000, as defined.  Laurus is notentitled to convert the amount evidenced by the Minimum Borrowing Note and theRevolving Note into a number of shares of common stock which would exceed thedifference between the number of shares of our common stock beneficiallyowned by Laurus or issuable upon the exercise of warrants held by Laurus and4.99% of our outstanding shares of our common stock.  However, Laurus may acquire more than 4.99%of our outstanding common stock upon 75 days’ notice to us.  Additionally, the Securities PurchaseAgreement includes default provisions should an Event of Default (as defined inthe agreement) occur.  Furthermore, undera related registration rights agreement, the common stock underlying the RevolvingNote and Minimum Borrowing Note has been registered with the Securities andExchange Commission.

 

We also issued to Laurus afive-year warrant to purchase up to 115,000 shares of our common stock. The pershare exercise price of the warrant is $2.55 for 70,000 shares, $2.75 for35,000 shares, and $2.95 for 10,000 shares. We allocated $133,000 of theproceeds to the warrant issued.  Theamount allocated represents the fair value of the warrant calculated under theBlack-Scholes method.  The value of thewarrant is included in additional paid-in capital and is being amortized tointerest expense over the life of the Revolving Note and Minimum BorrowingNote.

 

On June 1, 2004, weexecuted a letter agreement with Laurus and Applied Digital that amendedcertain terms of various transaction documents executed by us and Laurus inconnection with the issuance by us of the Convertible Note, Revolving Note andMinimum Borrowing Note to Laurus.  Theletter agreement provides that:

 

•                  We agreed to not prepay any outstandingprincipal amounts evidenced by the Revolving Note and Minimum Borrowing Note.

 

•                  Laurus agreed to waive any and all feesallegedly due to Laurus from us as a result of our failure to timely cause theshares underlying the Revolving Note and Minimum Borrowing Note to beregistered. 

 

•                  Laurus shall convert the portion of theRevolving Note equal to 150,000 shares of our common stock a the fixedconversion price set forth in the Convertible Note and, as promptly aspracticable following such conversion, Applied Digital shall purchase such sharesat a purchase price equal to the volume weighted average price of our commonstock for the three trading days prior to Laurus’ conversion.

 

•                  Laurus shall not convert any of theoutstanding principal balance on the Revolving Note, the Minimum Borrowing Noteor any other obligation issued by us to Laurus in an amount that exceeds 25% ofthe aggregate dollar trading volume of our common stock for the thirty daytrading period immediately preceding the delivery of a notice of conversion byLaurus to us. 

 

•                  Upon conversion of any of the outstandingprincipal balance on the Revolving Note, the Minimum Borrowing Note or anyother obligations issued by us to Laurus, we and Applied Digital shall have theright to purchase all of the shares acquired by Laurus in such conversion at aprice per share equal to the volume weighted average price of our common stockfor the three trading days prior to Laurus’ conversion; and 

 

•                  Laurus shall not convert any portion of theMinimum Borrowing Note prior to repayment in full of all obligationsoutstanding under the Revolving Note.

 

*Working Capital Loan**. *On March 7,2003, Signature Industries Ltd., our subsidiary in the United Kingdom, enteredinto a Loan Agreement (“Working Capital Loan”) with The Royal Bank of Scotland for£500,000 to finance the working capital requirements of their Indian Air Forcecontract.  The loan bears interest at anannual rate equal to 2.25% above the base rate, as defined in the agreement (7%at September 30, 2004).  The baserate may vary from time to time.  On January 22,2004, the agreement was amended to increase the loan amount to £1,000,000($1,800,000 as of September 30, 2004). On June 10, 2004, the repayment terms of the Agreement wereamended.  Signature Industries, Ltd.,repaid the principal balance of the Working Capital Loan on October 29,2004.  

 

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*Invoice DiscountingAgreement**. *On April 9, 2003, Signature Industries Ltd. entered into atwo-year Invoice Discounting Agreement with The Royal Bank of ScotlandCommercial Services Limited (“RBS”).  TheInvoice Discounting Agreement, as amended October 28, 2003, provides forSignature to sell with full title guarantee most of its receivables, as definedin the Invoice Discounting Agreement. RBS prepays 80% of the receivables sold, not to exceed an outstandingbalance of £750,000 ($1,350,000 as of September 30, 2004) at any giventime.  RBS pays Signature the remainderof the receivables upon their collection. Receivables which remain outstanding 90 days from the end of the invoicemonth become ineligible, and RBS may require Signature to repurchase thesereceivables.  The discounting chargeaccrues daily at an annual rate equal to 2.25% above the base rate, as definedin the amended Invoice Discounting Agreement (7% at September 30,2004).  Signature pays a commissioncharge to RBS of 0.2% of each receivable balance sold.  The Invoice Discounting Agreement, asamended, requires a minimum commission charge of £833 per month.  Discounting charges of $52,000 are includedin interest expense in the statement of operations for the nine months ended September 30,2004. The amount of receivables financed at September 30, 2004 was$0.7 million.

 

*StockIssuance to Applied Digital. *On March 1, 2004, we issued3,000,000 shares of our common stock to Applied Digital pursuant to the stockpurchase agreement with Applied Digital dated August 14, 2003.  The stock purchase agreement provided forApplied Digital to purchase 3,000,000 shares of our common stock at a price of$2.64 per share and a warrant to purchase up to 1,000,000 shares of our commonstock.  The warrant is exercisable forfive years beginning February 1, 2004 at an exercise price per share of$3.74 payable in cash or shares of common stock of Applied Digital.  The purchase price for the sale of our3,000,000 shares and the warrant was payable in shares of Applied Digitalcommon stock having an aggregate value of $7.92 million.  The number of shares of Applied Digitalcommon stock received by Digital Angel Corporation as payment of the purchaseprice was 1,980,000 shares (as adjusted for a subsequent one-for-10 reversestock split of Applied Digital’s common stock), exclusive of the proceeds onexercise of the warrant.  In the ninemonths ended September 30, 2004, we had sold 910,000 shares of AppliedDigital common stock, resulting in aggregate net proceeds of approximately $2.7million.  On October 14, 2004 we sold the remaining 1,070,000shares for net cash proceeds of $4.0 million. We recorded a gain of $1.7 million on the sale of the remaining sharesof Applied Digital common stock.

 

As part ofthis transaction, we issued five-year warrants to purchase up to 500,001 sharesof our common stock at an exercise price of $2.64 per share anytime on or afterFebruary 1, 2004 to the holders of the Applied Digital 8.5% ConvertibleExchangeable Debentures.

 

During thenine months ended September 30, 2004, we received aggregate proceeds of$1.1 million on the exercise of stock options.

 

**Forward****– Looking Statements and Associated Risk**

 

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

 

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

 

•                  anticipatedtrends in our business and demographics;

 

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

 

•                  ourfuture profitability and liquidity; and

 

•                  regulatory,competitive or other economic influences.

 

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

 

**RiskFactors**

 

You shouldcarefully consider the risk factors listed below.  These risk factors may cause our futureearnings to be less or our financial condition to be less favorable than weexpect.  You should read this section togetherwith the other information contained herein. 

 

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**Recentchanges in our senior management could have an adverse effect on our financialresults.**

 

We have recentlyexperienced numerous changes with respect to our senior management. On September 4,2003, Randolph K. Geissler resigned as Chief Executive Officer of Digital AngelCorporation after serving in such position since the March 2002 mergerbetween Digital Angel Corporation and Medical Advisory Systems. From September 2000until March 2002, Mr. Geissler served as Chief Executive Officer ofDigital Angel Corporation, one of the predecessor corporations to our Company. 

 

Following Mr. Geissler’sresignation, our Board appointed Kevin McLaughlin as the interim ChiefExecutive Officer of Digital Angel Corporation while we conducted a formalsearch for a permanent Chief Executive Officer. At the time of his appointmentas interim Chief Executive Officer, Mr. McLaughlin was serving asPresident and Chief Operating Officer of Applied Digital. On November 3,2003, we announced that we had agreed to appoint Van Chu as Chief ExecutiveOfficer. At the time of this announcement, Mr. Chu was Chief ExecutiveOfficer of OuterLink Corporation, a company that was acquired by Digital AngelCorporation in a merger on January 22, 2004. Mr. Chu assumed hisduties as our Chief Executive Officer on November 7, 2003. 

 

Mr. Chu wasterminated as Chief Executive Officer of the Company on January 12, 2004and the Company’s board of directors appointed Kevin N. McGrath as Presidentand Chief Executive Officer of the Company. 

 

Because wedepend heavily on the skills of those persons holding senior managementpositions, the loss of any senior executive could materially adversely affectour financial results. These senior executives, in many cases, have strongrelationships with our customers and suppliers. Therefore, the loss of theservices of such senior executives or any general instability in thecomposition of our senior management could have a negative impact on ourrelationship with these customers and suppliers. We cannot ensure that we willbe able to retain our senior executives and this uncertainty could have amaterial negative impact on our business. 

 

**Asof September 30, 2004, our majority stockholder, Applied Digital owned68.1% of our common stock. Thus, it is able to completely control the board ofdirectors and may support actions that conflict with the interests of the otherstockholders.**

 

As of September 30,2004, Applied Digital was the beneficial owner of 68.1% of our common stock. Itcontrols us with respect to all matters upon which our stockholders may vote,including the selection of the Board of Directors, mergers, acquisitions andother significant corporate transactions. Applied Digital has the ability toexercise control over us. Applied Digital may support actions that are contraryto or conflict with the interests of the other stockholders. 

 

**Ourstockholders will experience dilution if Laurus Master Fund exercises its rightto convert certain debt owed by us into shares of our common stock.**

 

On July 31, 2003, weissued to Laurus Master Fund a two-year secured convertible note in theoriginal principal amount of $2,000,000. The secured convertible note isconvertible, at Laurus Master Fund’s option, into shares of our common stock ata per share price of $2.33. In connection with the issuance of the securedconvertible note, we also issued to Laurus Master Fund a five-year warrant topurchase 125,000 shares of our common stock at exercise prices ranging from$2.68 to $3.38 per share. 

 

On August 28, 2003, weissued a three-year secured revolving convertible note in the principal amountof $3,500,000 and a three-year secured minimum borrowing convertible note inthe principal amount of $1,500,000 to Laurus Master Fund. When the two-yearsecured convertible note is repaid in full, either in cash or by conversioninto our common stock, each of these notes will be convertible, at LaurusMaster Fund’s option, into shares of our common stock at $2.64 per share. Inconnection with the issuance of these notes, Laurus Master Fund also acquired afive-year warrant to purchase 115,000 shares of our common stock at exerciseprices ranging from $2.55 to $2.95 per share. 

 

Through September 30,2004, Laurus Master Fund had converted $699,000 in principal amount of thetwo-year secured convertible note dated July 31, 2003 into 300,000 sharesof our common stock. Subsequent to September 30, 2004, Laurus Master Fundconverted an additional $233,000 of principal into 100,000 shares of our commonstock. Our issuance of shares to Laurus Master Fund upon any other conversionof these notes or any exercise of the warrants may result in substantialdilution to other Digital Angel Corporation stockholders. In addition, LaurusMaster Fund may offer and sell any and all of the shares of our common stockreceived in connection with conversion of the notes or exercise of the warrantsat prices and times to be determined in its sole discretion. There is noindependent or third-party underwriter involved in the offering of the sharesof our common stock acquired by Laurus Master Fund, and there can be noguarantee that any disposition of those shares will be completed in a mannerthat is not disruptive to the trading market for our common stock. 

 

**Ourstockholders will experience dilution upon conversion of the Series APreferred Stock issued by us in the OuterLink Corporation acquisition.**

 

On January 22, 2004, weacquired OuterLink Corporation of Concord, Massachusetts, in a merger. Asconsideration for the

 

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merger, we issued 100,000 shares of ourSeries A Preferred Stock in exchange for all of the issued and outstandingshares of OuterLink’s capital stock. The Series A Preferred Stock isconvertible into 4,000,000 shares of our common stock when the volume-weightedaverage price of our common stock equals or exceeds $4.00 per share for 10consecutive trading days. The issuance of our common stock upon any conversionof the Series A Preferred Stock issued to the OuterLink stockholders wouldresult in dilution to our current stockholders. 

 

**The termsof our debt obligations to Laurus Master Fund subject us to the risk offoreclosure on substantially all of our assets.**

 

We may not have sufficientfunds to repay Laurus Master Fund when the obligations on the convertible note,minimum borrowing note and revolving note mature. Accordingly, we may berequired to obtain the funds necessary to repay these obligations eitherthrough refinancing, the issuance of additional equity or debt securities orthe sale of assets. There can be no assurance that we can obtain the funds needed,if any, to repay the obligations from any one or more of these other sources onfavorable economic terms or at all. If we are unable to obtain funds to repaythis indebtedness, we may be forced to dispose of assets or take other actionson disadvantageous terms, which could result in losses to Digital AngelCorporation and could have a material adverse effect on our financialcondition. 

 

To secure thepayment of all debts, liabilities and obligations owed to Laurus Master Fund,we have granted to Laurus Master Fund a security interest in and lien upon allof our property and assets, whether real or personal, tangible or intangible,whether now owned or hereafter acquired, or in which we now have, or at anytime in the future may acquire, any right, title or interest. The occurrence ofan event of default under the convertible note, minimum borrowing note orrevolving note would subject us to foreclosure by Laurus Master Fund onsubstantially all of our assets to the extent necessary to repay any amounts due.Any such default and resulting foreclosure will have a material adverse effecton our financial condition.

 

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

 

As of September 30,2004, we had goodwill of $49.0 million. On January 1, 2002, we adoptedSFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142requires that goodwill and certain intangibles no longer be amortized butinstead tested for impairment at least annually by applying a fair value basedtest. During the fourth quarter of 2003, we performed the annual impairmenttest for goodwill using a fair value based approach, primarily discounted cashflows. An evaluation of the Medical Systems reporting unit indicated that$2.4 million of goodwill was impaired. Additionally, management estimatedthat certain intangible assets at our Medical Systems reporting unit wereimpaired by $0.6 million. Accordingly, we recorded an impairment charge of$3.0 million in the fourth quarter of 2003, which is included as an assetimpairment charge in the 2003 statement of operations. During the fourthquarter of 2002, we recorded an impairment charge of $57.4 million forgoodwill at our GPS and Radio Communications and Medical Systems reportingunits. 

 

We assess thefair value of our goodwill annually or earlier if events occur or circumstanceschange that would more likely than not reduce the fair value of our goodwillbelow its carrying value. These events or circumstances would include asignificant change in business climate, including a significant, sustaineddecline in an entity’s market value, legal factors, operating performanceindicators, competition, sale or disposition of a significant portion of thebusiness, or other factors. If we determine that significant impairment hasoccurred, we would be required to write off the impaired portion of goodwill.Impairment charges could have a material adverse effect on our financialcondition and results of operations. 

 

**Theexercise of outstanding options and warrants may adversely affect the marketprice of our common stock.**

 

As of September 30,2004, we had 9,993,000 options and 3,029,000 warrants outstanding to purchasefrom us a total of 13,022,000 shares of common stock at exercise prices rangingfrom $0.50 to $10.50 per share. In addition, as of September 30, 2004, wehad 4,504,000 additional shares of common stock which may be issued in thefuture under our stock option plans. The exercise of outstanding options andwarrants and the sale in the public market of the shares purchased upon suchexercise may adversely affect the market price of our common stock. 

 

**Wemay continue to incur losses.**

 

We incurred anet loss of $6.3 million for the nine months ended September 30,2004.  In addition, we incurred net lossesof $9.5 million, $92.4 million, $17.4 million in the years endedDecember 31, 2003, 2002 and 2001, respectively. Included in the$92.4 million loss for the year ended December 31, 2002 is a goodwillimpairment charge of $57.4 million, an asset impairment charge of$6.4 million, and an $18.7 million charge arising from theremeasurement of options in connection with the merger. No assurance can begiven as to when we will achieve profitability, if at all. Profitabilitydepends on many factors, including the success of our marketing programs, ourmaintenance and reduction of expenses, and the ability to coordinatesuccessfully the operations of our business units. If we fail to achieve andmaintain sufficient profitability within the time frame expected by investors,the market price of our common stock may be adversely affected. 

 

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

 

Our success dependssignificantly on our ability to maintain patent and trade secret protection, toobtain future patents and licenses, and to operate without infringing on theproprietary rights of third parties. There can be no assurance that themeasures we have taken to protect our intellectual property, including thoserelating to the Digital Angel technology, will prevent the misappropriation orcircumvention of our intellectual property. In addition, there can be noassurance that any patent application, when filed, will result in an issuedpatent, or that our existing patents, or any patents that may be issued in thefuture, will provide us with significant protection against competitors. Moreover,there can be no assurance that any patents issued to or licensed by us will notbe infringed upon or circumvented by others. Litigation to establish thevalidity of patents, to assert infringement claims against others, and todefend against patent infringement claims can be expensive and time-consuming,even if the outcome is in our favor. We also rely to a lesser extent onunpatented proprietary technology, and no assurance can be given that otherswill not independently develop substantially equivalent proprietaryinformation, techniques or processes or that we can meaningfully protect ourrights to such unpatented proprietary technology.  Infringement on our intellectualproperty or the development of substantially equivalent technology by our competitorscould have a material adverse effect on our business. 

 

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

 

The electronicanimal identification market can be negatively affected by such factors as foodsafety concerns, consumer perceptions regarding cost and efficacy,international technology standards, national infrastructures, andslaughterhouse removal of microchips. 

 

We are alsosubject to federal, state and local regulation in the United States, includingregulation by the U.S. Food and Drug Administration, the U.S. FederalCommunications Commission, the Federal Aviation Authority and the U.S.Department of Agriculture, and to regulation in other countries. We cannotpredict the extent to which we may be affected by further legislative andregulatory developments concerning our products and markets. We are required toobtain regulatory approval before marketing most of our products. Theregulatory process can be very time-consuming and costly, and there is noassurance that we will receive the regulatory approvals necessary to sell ourproducts. Regulatory authorities also have the authority to revoke approval ofpreviously approved products for cause, to request recalls of products and toclose manufacturing plants in response to violations. Any such regulatoryaction, including the failure to obtain such approval, could prevent us fromselling, or materially impair our ability to sell, our products in certainmarkets and could negatively affect our business. 

 

**Werely heavily on sales to government contractors of our animal identificationproducts, and any decline in the demand by these customers for our productscould negatively affect our business.**

 

The principal customers forelectronic identification devices for fish are government contractors that relyon funding from the United States government. Because these contractors relyheavily on government funds, any decline in the availability of such funds couldresult in a decreased demand by these contractors 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. 

 

**Wedepend on a single production arrangement with Raytheon MicroelectronicsEspana, SA for our patented syringe-injectable microchips, and the loss of orany significant reduction in the production could have an adverse effect on ourbusiness.**

 

We rely solely on aproduction arrangement with Raytheon Microelectronics Espana, SA for themanufacture of our patented syringe-injectable microchips that are used in allof our implantable electronic identification products. Raytheon utilizes our proprietarytechnology and our equipment in the production of our syringe-injectablemicrochips. The termination, or any significant reduction, by Raytheon of theassembly of our microchips or a material increase in the price charged byRaytheon for the assembly of our microchips could have an adverse effect on ourfinancial condition and results of operations. In addition, Raytheon may not beable to produce 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 to meet our demand for microchipswould require us to utilize an alternative production arrangement and removeour automated assembly production machinery from the Raytheon facility, whichwould be costly and could delay production. Moreover, if Raytheon terminatesour production arrangement, we cannot assure that the assembly of ourmicrochips from another source would be on comparable or acceptable terms. Thefailure to make such an alternative production arrangement could have anadverse effect on our business. 

 

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**We dependon principal customers.**

 

For the nine months ended September 30,2004, we had one customer which accounted for 11.1% of our consolidatedrevenue, and our four largest customers, in the aggregate, accounted for 28.6%of our consolidated revenue. For the year ended December 31, 2003, we hadone customer that accounted for 11.8% of our consolidated revenues, and ourfour largest customers accounted for, in the aggregate, 30.9% of ourconsolidated revenues.  Our subsidiary,Signature Industries, Ltd., is heavily dependent on contracts with domesticgovernment agencies and foreign governments, including the United Kingdom,primarily relating to military applications. The loss of, or a significantreduction in, orders from these or our other major customers could have amaterial adverse effect on our financial condition and results of operations. 

 

**We compete withother companies in the visual and electronic identification market, and theproducts sold by our competitors could become more popular than our products orrender our products obsolete.**

 

The market for visual andelectronic identification for companion animals and livestock 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 are AllFlexUSA, Datamars SA and Avid Identification Systems, Inc. 

 

In addition,other companies could enter this line of business in the future. Certain of ourcompetitors have substantially greater financial and other resources than us.We may not be able to compete successfully with these competitors, and thesecompetitors may develop or market technologies and products that are morewidely accepted than ours or that would render our products obsolete ornoncompetitive. 

 

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

 

We generate aportion of our sales and incur a portion of our expenses in currencies otherthan U.S. dollars. To the extent that we are unable to match revenues receivedin foreign currencies with costs paid in the same currency, exchange ratefluctuations in any such currency could have an adverse effect on our financialresults. 

 

**Wedepend on a small team of senior management, and we may have difficultyattracting and retaining additional personnel.**

 

Our futuresuccess will depend in large part upon the continued services and performanceof senior management and other key personnel. If we lose the services of anymember of our senior management team, our overall operations could be materiallyand adversely affected. In addition, our future success will depend on ourability to identify, attract, hire, train, retain and motivate other highlyskilled technical, managerial, marketing, purchasing and customer servicepersonnel when they are needed. Competition for these individuals is intense.We cannot ensure that we will be able to successfully attract, integrate orretain sufficiently qualified personnel when the need arises. Any failure toattract and retain the necessary technical, managerial, marketing, purchasingand customer service personnel could have a material adverse effect on ourfinancial condition and results of operations. 

 

**IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS**

 

InJune 2002, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards (SFAS) No. 146, “Accounting for Costs Associatedwith Exit or Disposal Activities.” SFAS No. 146 requires recording costsassociated with exit or disposal activities at their fair values when aliability has been incurred. Under previous guidance, certain exit costs wereaccrued upon management’s commitment to an exit plan. The Company adopted SFASNo. 146 on January 1, 2003. The adoption of SFAS No. 146 did not have amaterial impact on the results of operations or financial position.

 

EffectiveJanuary 1, 2003, the Company adopted the recognition and measurementprovisions of FASB Interpretation No. 45 (“Interpretation 45”), “Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others.” This interpretation elaborates on thedisclosures to be made by a guarantor in interim and annual financialstatements about the obligations under certain guarantees. Interpretation 45also clarifies that a guarantor is required to recognize, at the inception of aguarantee, a liability for the fair value of the obligation undertaken inissuing the guarantee. The initial recognition and initial measurementprovisions of this interpretation are applicable on a prospective basis toguarantees issued or modified after December 31, 2002. The Company doesnot currently provide significant guarantees on a routine basis. As a result,this interpretation has not had a material impact on the Company’s financialstatements.

 

InDecember 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003)(“Interpretation 46”), “Consolidation of Variable Interest Entities.”Application of this interpretation is required in the Company’s financialstatements for interests in variable interest entities that are considered tobe special-purpose entities for the year ended December 31, 2003. TheCompany determined that it does not have any arrangements or relationships withspecial-purpose entities.

 

Interpretation46 addresses the consolidation of business enterprises to which the usualcondition (ownership of a majority voting interest) of consolidation does notapply. This interpretation focuses on controlling financial interests that maybe achieved through arrangements that do not involve voting interests. Itconcludes that in the absence of clear control through voting interests, acompany’s exposure (variable interest) to the economic risks and potentialrewards from the variable interest entity’s assets and 

 

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activitiesare the best evidence of control. If an enterprise holds a majority of thevariable interests of an entity, it would be considered the primarybeneficiary. The primary beneficiary is required to include assets, liabilitiesand the results of operations of the variable interest entity in its financialstatements. The adoption of FIN 46 did not have an impact on the financialposition or operations of the Company.

 

InMay 2003, the FASB issued SFAS 150, Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity (SFAS No. 150).SFAS No. 150 establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity. It requires that an issuer classify a financial instrument that iswithin its scope as a liability (or an asset in some circumstances). Many ofthose instruments were previously classified as equity. SFAS No. 150 iseffective for financial instruments entered into or modified after May 31,2003, and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003. It is to be implemented by reporting thecumulative effect of a change in accounting principle for financial instrumentscreated before the issuance date of the statement and still existing at thebeginning of the interim period of adoption. Restatement is not permitted. TheCompany adopted the provisions of SFAS No.150 effective July 1, 2003. Theadoption of SFAS No. 150 did not have an impact on the Company’s financialposition or results of operations.

 

**Item 3.****          ****Quantitative and Qualitative Disclosures About Market Risk**

 

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

 

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

 

Dueto the nature of our borrowings and our short-term investments, we haveconcluded that there is no material market risk exposure and, therefore, noquantitative tabular disclosures are required.

 

**Item 4.****          ****Controlsand Procedures**

 

Withinthe 90 days prior to the date of this report, the Company carried out anevaluation, under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Exchange Act Rule 13a-14 underthe Securities Exchange Act of 1934. Based upon that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that the Company’s disclosure controls andprocedures are effective in timely alerting them to material informationrelating to the Company (including its consolidated subsidiaries) required tobe included in the Company’s periodic SEC filings with the Securities andExchange Commission.  Since the date oftheir evaluation, there have been no significant changes in our internal controlsor in other factors that could significantly affect the Company’s internalcontrols.

 

**PART II    OTHERINFORMATION**

 

**Item 1.****          ****LegalProceedings.**

 

*Electronic Identification Devices Litigation*

 

InFebruary 2004, Electronic Identification Devices, Ltd. (“EID”) commenced aDeclaratory Judgment Action against the Company in the United States DistrictCourt for the Western District of Texas. This action sought a declaration of patent non-infringement relating tothe Company’s patented syringe implantable identification transponder.  The lawsuit alleged that EID has developed anew transponder that it believed did not infringe on the Company’s patent.  The lawsuit acknowledged that the Companyobtained a Judgment of infringement and two contempt orders against EID basedon selling certain systems that infringed the Company’s patent in 1997, 1998and 1999.  On September 17, 2004 theUnited States District Court for the Western District of Texas dismissed EID’scause of action. 

 

*John Fernandez vs. United States of America vs. Medical AdvisorySystems, Inc.*

 

OnDecember 29, 2003, John Fernandez filed a lawsuit in the Orlando Divisionof the United States District Court for the Middle District of Florida.  The plaintiff filed the lawsuit against theUnites States of America as the operator of the ship on which the

 

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plaintiffserved.  He alleged that the UnitedStates had contracted with Medical Advisory Systems to provide medical adviceand that the physician at Medical Advisory Systems had rendered an incorrectlong-distance diagnosis, resulting to injury to the plaintiff.  Mr. Fernandez asserted against the UnitedStates claims of negligence under the Jones Act, unseaworthiness andmaintenance and cure. He alleged damages in excess of $75,000, plus prejudgmentand post-judgment interest at the legal rate and costs and disbursements of theaction.  On April 14, 2004, theUnited States served Medical Advisory Systems with a third party complaint inAdmirality in which it alleged that Medical Advisory Systems is liable to itfor all or part of the plaintiff’s claim in that Medical Advisory Systemsand/or its employee/physician rendering the medical advice was negligent.  In response, on May 12, 2004, MedicalAdvisory Systems filed a motion to dismiss the third party complaint.  The matter is presently scheduled for trialin April 2005.  The ultimate outcomeof this proceeding cannot be predicted at this time.  We are currently unable to determine thepotential effect of this litigation on our consolidated financial position,results of operations or cash flows. 

 

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

 

On October 20,2004, the Company commenced an action in the United Stated District Court forthe District of Minnesota against AllFlex USA, Inc. and Pet Health Services(USA), Inc.  This suit (Court File No.04-4545MJD/JGL) claims that Allflex is marketing and selling a syringeimplantable identification transponder that infringes a 1993 patent granted tothe Company for syringe implantable identification transponders previouslyfound by the United States District Court for the District of Colorado to beenforceable.  The suit also claims thatPetHealth is using, selling and/or distributing the same transponder inviolation of the Company’s patent.  Thesuit seeks, among other things, an adjudication of infringement and that theinfringing parties be enjoined from further improper action.  The suit also seeks actual damages, punitivedamages and interest, costs and attorneys’ fees.  The Company believes that the suit iswell-grounded in law and fact.

 

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

 

On October 20,2004, the Company commenced an action in the United States District Court forthe District of Minnesota against Datamars, Inc., Datamars, S.A., The CrystalImport Corporation, and Medical Management International, Inc. (“Banfield”).  This suit (Court File No. 04-4544ADM/AJB)claims that the defendants are marketing and selling syringe implantableidentification transponders manufactured by Datamars that infringe the Company’s1993 patent for syringe implantable identification transponders previouslyfound by the United States District Court for the District of Colorado to beenforceable.  Certain of the locations inwhich the infringing 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.

 

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

 
| ** ** | **(a)**                                                                                                                                                                                                                             | **Exhibits** |   |
|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|--------|
|       |                                                                                                                                                                                                                                |         |
| ** ** | The following exhibits are hereby incorporated into this  Quarterly Report on Form 10-Q by reference to the reports and schedules  identified below filed with the Securities and Exchange Commission (“Commission”)**:** |         |
|       |                                                                                                                                                                                                                                |         |
| 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)                                                                    |         |
|       |                                                                                                                                                                                                                                |         |
|       | The following exhibits are filed with this Quarterly  Report on Form 10-Q:                                                                                                                                                          |         |
|       |                                                                                                                                                                                                                                |         |
| 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.                                                                       |         |

 

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| 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. |                                                                                                                                                                                                                                                                                                                                                                            |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                            |
| ** ** | **(b)**                                                                                                                                                       | **Reports on Form 8-K**                                                                                                                                                                                                                                                                                                                                                         |   |
|       |                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                            |
|       | During the three months ended September 30, 2004,  the Company filed the following Current Reports on Form 8-K:                                          |                                                                                                                                                                                                                                                                                                                                                                            |
|       |                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                            |
|       | •                                                                                                                                                        | On July 1, 2004 the Company filed an Amendment to  Current Report on Form 8-K dated April 19, 2004 to provide the pro forma  financial information for the sale of certain assets of the Company’s Medical  Systems segment                                                                                                                                      |   |
|       |                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                            |   |
|       | •                                                                                                                                                        | On August 3, 2004 the Company filed a Current Report  on Form 8-K dated August 3, 2004 to report the Company’s second quarter  financial results.                                                                                                                                                                                                                |   |
|       |                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                            |   |
|       | •                                                                                                                                                        | On August 19, 2004 the Company filed a Current  Report on Form 8-K dated August 19, 2004 to announce the Company’s  conference call to report recent developments in the Company’s Animal  Applications segment and announce the Company’s execution of a ten year  Supply and Distribution Agreement with Schering Plough Animal Health  Corporation. |   |
|       |                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                            |   |
|       | •                                                                                                                                                        | On August 20, 2004 the Company filed a Current  Report on Form 8-K dated July 27, 2004 to report the terms of the  Company’s ten year Supply and Distribution Agreement with Schering Plough  Animal Health Corporation.                                                                                                                                         |   |
|            |                                                                                                                                                               |                                                                                                                                                                                                                                                                                                                                                                                 |  |  |

 

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**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|                         |   | DIGITAL ANGEL CORPORATION |
|------------------------------|--------|---------------------------|
|                         |   | (Registrant)              |
|                         |   |                      |   |
| Dated: November 2, 2004 |   | By:                       | /S/ JAMES P. SANTELLI |
|                         |   |                      | James P. Santelli |
|                         |   |                      | Vice President - Finance and  Chief  Financial Officer |

 

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