**As filed with theSecurities and Exchange Commission on November 14, 2003**

 

 

**UNITED STATESSECURI**TIES AND EXCHANGE COMMISSION

**WASHINGTON,D. C.  20549**

 

# ****

 

**FORM 10-Q**

 

**(Mark One)**

 

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

 

**For the quarterly period endedSeptember 30, 2003**

 

**or**

 

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

** **

**For the transition periodfrom         to         **

 

**CommissionFile Number:  1-15177**

 

**DIGITAL ANGELCORPORATION**

(Exact name of registrant as specified in itscharter)

 

| **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 bySection 13 or 15(d) of the Exchange Act during the preceding 12 months (orfor such shorter 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 November 11, 2003, there were 27,096,709 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         |
| INDEX TO EXHIBITS |

 

2

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**PART I    FINANCIAL INFORMATION**

 

Item 1.    FinancialStatements.

 

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

(In thousands, except par value)

 
|                                                                                                                                                                                    |   | **September 30,  2003** |       | **December 31,  2002** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                    |   | **(Unaudited)**              |       |                        | ** ** |
| **Assets**                                                                                                                                                                              |   |                         |       |                        |       |
| **Current Assets**                                                                                                                                                                      |   |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                               |   | **$**                        | **10**     |                        | $          | 214 |   |
| Restricted cash                                                                                                                                                                         |   | **717**                      | ** ** | **—**                  | ** ** |
| Accounts receivable and unbilled  receivables (net of allowance for doubtful accounts of $202 in 2003 and $296  in 2002)                                                                |   | **5,740**                    |       | 4,126                       |       |
| Inventories                                                                                                                                                                             |   | **6,305**                    |       | 4,945                       |       |
| Other current assets                                                                                                                                                                    |   | **719**                      |       | 1,478                       |       |
| **Total Current  Assets**                                                                                                                                                               |   | **13,491**                   |       | 10,763                      |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Property And  Equipment, net**                                                                                                                                                        |   | **7,621**                    |       | 7,769                       |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Goodwill and Other  Intangible Assets, net**                                                                                                                                          |   | **48,658**                   |       | 48,893                      |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Other Assets, net**                                                                                                                                                                   |   | **1,150**                    |       | 373                         |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
|                                                                                                                                                                                    |   | **$**                        | **70,920** |                        | $          | 67,798 |   |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                           |   |                         | ** ** |                        | ** ** |
| **Current Liabilities**                                                                                                                                                                 |   |                         |       |                        |       |
| Line of credit and current maturities of  long-term debt                                                                                                                                |   | **$**                        | **4,314**  |                        | $          | 816 |   |
| Accounts payable                                                                                                                                                                        |   | **6,221**                    |       | 4,142                       |       |
| Accrued expenses and other current  liabilities                                                                                                                                         |   | **3,335**                    |       | 3,637                       |       |
| Deferred revenue                                                                                                                                                                        |   | **1,374**                    |       | 67                          |       |
| Due to Applied Digital Solutions, Inc.                                                                                                                                                  |   | **516**                      |       | 462                         |       |
| **Total Current  Liabilities**                                                                                                                                                          |   | **15,760**                   |       | 9,124                       |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Long-Term Debt And  Notes Payable**                                                                                                                                                   |   | **4,145**                    |       | 3,314                       |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Deferred Revenue**                                                                                                                                                                    |   | **140**                      |       | 50                          |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Total Liabilities**                                                                                                                                                                   |   | **20,045**                   |       | 12,488                      |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Commitments And  Contingencies**                                                                                                                                                      |   |                         |       |                        |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Minority Interest**                                                                                                                                                                   |   | **97**                       |       | 298                         |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
| **Stockholders’ Equity  (See Note 1)**                                                                                                                                             |   |                         |       |                        |       |
| Preferred stock: Authorized 1,000 in 2002,  of $1.75 par value, no shares issued or outstanding                                                                                         |   | **—**                   | ** ** | **—**                  | ** ** |
| Common stock: Authorized 95,000 shares, of  $.005 par value; 27,052 shares issued and 27,002 shares outstanding in 2003  and  26,568 shares issued and 26,518  outstanding in 2002 |   | **135**                      |       | 133                         |       |
| Additional paid-in capital                                                                                                                                                              |   | **169,711**                  | ** ** | 169,166                     |       |
| Accumulated deficit                                                                                                                                                                     |   | **(118,966**                 | **)**      | (114,059                    | )          |
| Treasury stock (carried at cost, 50 shares)                                                                                                                                             |   | **(43**                      | **)**      | (43                         | )          |
| Accumulated other comprehensive loss                                                                                                                                                    |   | **(59**                      | **)**      | (185                        | )          |
| Total Stockholders’ Equity                                                                                                                                                         |   | **50,778**                   |       | 55,012                      |       |
|                                                                                                                                                                                    |   |                         |       |                        |       |
|                                                                                                                                                                                    |   | **$**                        | **70,920** |                        | $          | 67,798 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

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,** |       |
|-----------------------------------------------------------------------------------------------|--------|----------------------------------------------------|------------|----------------------------------------------------|------------|
|                                                                                          |   | **2003**                                           |       | **2002**                                           |       | **2003** |   | **2002** |   |
|                                                                                          |   |                                               |       |                                               |       |   |   |   |   |
| Product revenue                                                                               |   | **$**                                              | **7,500**  |                                               | $          | 8,780 | ** ** | **$** | **25,816** |   | $ | 24,739 |   |
| Service revenue                                                                               |   | **845**                                            |       | 826                                                | ** ** | **2,287** |   | 2,035 |   |
| Total net revenue                                                                             |   | **8,345**                                          |       | 9,606                                              | ** ** | **28,103** |   | 26,774 |   |
|                                                                                          |   |                                               |       |                                               |       |   |   |   |   |
| Cost of products sold                                                                         |   | **4,588**                                          |       | 4,622                                              | ** ** | **15,291** |   | 13,790 |   |
| Cost of services sold                                                                         |   | **238**                                            |       | 370                                                | ** ** | **887** |   | 937 |   |
|                                                                                          |   | **4,826**                                          |       | 4,992                                              | ** ** | **16,178** |   | 14,727 |   |
|                                                                                          |   |                                               |       |                                               |       |   |   |   |   |
| Gross profit                                                                                  |   | **3,519**                                          |       | 4,614                                              | ** ** | **11,925** |   | 12,047 |   |
|                                                                                          |   |                                               |       |                                               |       |   |   |   |   |
| Selling, general and administrative  expenses                                                 |   | **4,496**                                          |       | 4,774                                              | ** ** | **12,951** |   | 32,363 |   |
| Management fees - Applied Digital  Solutions, Inc.                                            |   | —                                             |       | —                                             |       | — |   | 193 |   |
| Research and development expenses                                                             |   | **1,551**                                          |       | 747                                                | ** ** | **3,634** |   | 2,228 |   |
| Interest income                                                                               |   | **(8**                                             | **)**      | (2                                                 | )          | **(8** | **)** | (2 | ) |
| Interest expense - Applied Digital  Solutions, Inc.                                           |   | **—**                                         | ** ** | —                                             |       | — | ** ** | 1,806 |   |
| Interest expense - others                                                                     |   | **257**                                            | ** ** | 71                                                 |       | **586** | ** ** | 196 |   |
| Other income                                                                                  |   | **(46**                                            | **)**      | —                                             |       | **(130** | **)** | — |   |
|                                                                                          |   |                                               | ** ** |                                               |       |   | ** ** |   |   |
| Loss before minority interest shares of  losses and equity in net loss of MAS prior to merger |   | **(2,731**                                         | **)**      | (976                                               | )          | **(5,108** | **)** | (24,737 | ) |
|                                                                                          |   |                                               | ** ** |                                               |       |   | ** ** |   |   |
| Minority interest share of losses                                                             |   | **(91**                                            | **)**      | (31                                                | )          | **(201** | **)** | (74 | ) |
|                                                                                          |   |                                               | ** ** |                                               |       |   | ** ** |   |   |
| Equity in net loss of MAS prior to merger                                                     |   | —                                             | ** ** | —                                             |       | — | ** ** | 291 |   |
|                                                                                          |   |                                               | ** ** |                                               |       |   | ** ** |   |   |
| Net loss                                                                                      |   | **$**                                              | **(2,640** | **)**                                              | $          | (945 | ) | **$** | **(4,907** | **)** | $ | (24,954 | ) |
|                                                                                          |   |                                               | ** ** |                                               |       |   | ** ** |   |   |
| Net loss per common share - basic and  diluted                                                |   | **$**                                              | **(0.10**  | **)**                                              | $          | (0.04 | ) | **$** | **(0.18** | **)** | $ | (1.04 | ) |
|                                                                                          |   |                                               | ** ** |                                               |       |   | ** ** |   |   |
| Weighted average number of common shares  outstanding - basic and diluted                     |   | **26,993**                                         | ** ** | 26,439                                             |       | **26,839** | ** ** | 23,910 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

4

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**DIGITAL ANGEL CORPORATION AND SUBSIDIARIES**

 

**CONDENSED CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITY**

**For The Nine Months Ended September 30,2003**

(In Thousands)

(Unaudited)

 
|                                                                      |   |              |   |       |       | **Additional  Paid-In  Capital** |       | **Accumulated  Deficit** |       | **Treasury  Stock** |       | **Accumulated  Other  Comprehensive  Loss** |       | **Total  Stockholders’  Equity** |       |
|---------------------------------------------------------------------------|--------|-------------------|--------|------------|------------|----------------------------------|------------|--------------------------|------------|---------------------|------------|---------------------------------------------|------------|---------------------------------------|------------|
|                                                                      |   |              |   |
|                                                                      |   | **Common  Stock** |   |
|                                                                      |   | **Number**        |   | **Amount** |       |
|                                                                      |   |              |   |       | ** ** |                             | ** ** |                     | ** ** |                | ** ** |                                        | ** ** |                                  | ** ** |
| **Balance — December 31, 2002**                                 |   | 26,568            |   | $          | 133        |                             | $          | 169,166                  |       | $                   | (114,059   | )                                           | $          | (43                                   | )          | $ | (185 | ) | $ | 55,012 |   |
| Net loss                                                                  |   | —            |   | —     |       | —                           |       | (4,907                   | )          | —              |       | —                                      |       | (4,907                                | )          |
| Comprehensive loss — Foreign currency  translation                   |   | —            |   | —     |       | —                           |       | —                   |       | —              |       | 126                                         |       | 126                                   |       |
| Total comprehensive income (loss)                                         |   | —            |   | —     |       | —                           |       | (4,907                   | )          | —              |       | 126                                         |       | (4,781                                | )          |
| Exercise of stock options                                                 |   | 484               |   | 2          |       | 244                              |       | —                   |       | —              |       | —                                      |       | 246                                   |       |
| Fair value of warrants granted in  connection with financing arrangements |   | —            |   | —     |       | 276                              |       | —                   |       | —              |       | —                                      |       | 276                                   |       |
| Stock option repricing                                                    |   | —            |   | —     |       | 25                               |       | —                   |       | —              |       | —                                      |       | 25                                    |       |
|                                                                      |   |              |   |       |       |                             |       |                     |       |                |       |                                        |       |                                  |       |
| **Balance — September 30, 2003**                                |   | 27,052            |   | $          | 135        |                             | $          | 169,711                  |       | $                   | (118,966   | )                                           | $          | (43                                   | )          | $ | (59 | ) | $ | 50,778 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

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,** |       |
|------------------------------------------------------------------------------|--------|---------------------------------------------------|------------|
|                                                                         |   | **2003**                                          |       | **2002** |   |
| **Cash Flows From  Operating Activities**                                    |   |                                              | ** ** |   |   |
| Net loss                                                                     |   | **$**                                             | **(4,907** | **)** | $ | (24,954 | ) |
|                                                                         |   |                                              | ** ** |   |   |
| Adjustments to reconcile net loss to net  cash used in operating activities: |   |                                              | ** ** |   |   |
| Equity-based compensation                                                    |   | **25**                                            | ** ** | 18,952 |   |
| Interest allocated by ADS and contributed  to capital                        |   | —                                            | ** ** | 1,806 |   |
| Depreciation and amortization                                                |   | **1,310**                                         | ** ** | 2,750 |   |
| Amortization of debt discount and financing  costs                           |   | **41**                                            | ** ** | — |   |
| Minority interest                                                            |   | **(201**                                          | **)**      | (74 | ) |
| Equity in net loss of affiliate                                              |   | —                                            | ** ** | 291 |   |
| Loss on disposal of equipment                                                |   | **21**                                            | ** ** | 7 |   |
| Change in assets and liabilities:                                            |   |                                              | ** ** |   |   |
| Increase in restricted cash                                                  |   | **(717**                                          | **)**      | — |   |
| Increase in accounts receivable                                              |   | **(1,671**                                        | **)**      | (695 | ) |
| (Increase) decrease in inventories                                           |   | **(1,361**                                        | **)**      | 821 |   |
| Decrease (increase) in other current assets                                  |   | **776**                                           | ** ** | (1,271 | ) |
| (Increase) decrease in other assets                                          |   | **(363**                                          | **)**      | 79 |   |
| Increase in due to ADS                                                       |   | **54**                                            | ** ** | 672 |   |
| Increase in accounts payable, accrued  expenses and deferred revenue         |   | **3,523**                                         | ** ** | 364 |   |
| **Net Cash Used In  Operating Activities**                                   |   | **(3,470**                                        | **)**      | (1,252 | ) |
|                                                                         |   |                                              | ** ** |   |   |
| **Cash Flows From  Investing Activities**                                    |   |                                              | ** ** |   |   |
| Payments for property and equipment                                          |   | **(769**                                          | **)**      | (984 | ) |
| Proceeds from sale of equipment                                              |   | —                                            | ** ** | 23 |   |
| Cash acquired through acquisition, net of  acquisition costs                 |   | —                                            | ** ** | (73 | ) |
| **Net Cash Used In  Investing Activities**                                   |   | **(769**                                          | **)**      | (1,034 | ) |
|                                                                         |   |                                              | ** ** |   |   |
| **Cash Flows From  Financing Activities**                                    |   |                                              | ** ** |   |   |
| Amounts borrowed on line of credit                                           |   | **24,886**                                        | ** ** | — |   |
| Repayment of line of credit                                                  |   | **(22,897**                                       | **)**      | (40 | ) |
| Amounts borrowed on debt                                                     |   | **2,584**                                         | ** ** | 757 |   |
| Payments of debt                                                             |   | **(88**                                           | **)**      | — |   |
| Payments for other financing costs                                           |   | **(461**                                          | **)**      | (78 | ) |
| Exercise of stock options                                                    |   | **246**                                           | ** ** | 631 |   |
| Capital contribution by Applied Digital  Solutions, Inc.                     |   | —                                            | ** ** | 684 |   |
| **Net Cash Provided  By Financing Activities**                               |   | **4,270**                                         | ** ** | 1,954 |   |
|                                                                         |   |                                              | ** ** |   |   |
| **Effect of Exchange Rate Changes on Cash**                                  |   | **(235**                                          | **)**      | 216 |   |
|                                                                         |   |                                              | ** ** |   |   |
| **Net Decrease In  Cash and Cash Equivalents**                               |   | **(204**                                          | **)**      | (116 | ) |
|                                                                         |   |                                              | ** ** |   |   |
| **Cash And Cash  Equivalents - Beginning Of Period**                         |   | **214**                                           | ** ** | 596 |   |
|                                                                         |   |                                              | ** ** |   |   |
| **Cash And Cash  Equivalents - End Of Period**                               |   | **$**                                             | **10**     | ** ** | $ | 480 |   |

 

See the accompanying notes to condensed consolidated financialstatements.

 

6

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

 

**1.**             Basis of Presentation

** **

On March 27, 2002, Digital Angel Acquisition Co. (“Acquisition”),then a wholly-owned subsidiary of Medical Advisory Systems, Inc. (“MAS”),merged with and into Digital Angel Corporation, which was then a 93% ownedsubsidiary of Applied Digital Solutions, Inc. (“ADS”). In the merger, thecorporate existence of Acquisition ceased, Digital Angel Corporation became awholly-owned subsidiary of MAS and was renamed Digital Angel TechnologyCorporation (“DATC”), and MAS was renamed “Digital Angel Corporation.” In connectionwith the merger transaction, ADS contributed to MAS all of its stock in TimelyTechnology Corp., a wholly-owned subsidiary, and Signature Industries, Limited,an 85% owned subsidiary. These two subsidiaries, along with DATC, comprised theAdvanced Wireless Group (“AWG”). As a result of this contribution by ADS,Timely Technology Corp. became a wholly-owned subsidiary of the Company andSignature Industries, Limited became an 85% subsidiary. Prior to the mergerwith DATC, ADS owned 850,000 shares of MAS stock, representing approximately16.3% of the outstanding stock of MAS. (Unless the context otherwise requires,the term “Company” means Digital Angel Corporation and its subsidiaries). Inthe merger, the shares of DATC owned by ADS were converted into a total of18,750,000 shares of MAS common stock. As a result of the merger, ADS owned19,600,000 shares or 77.15% of the Company’s common stock. The merger wastreated as a reverse acquisition for accounting purposes, with AWG treated asthe accounting acquirer.

 

At the time of the merger, ADS transferred to the Digital Angel ShareTrust (“Digital Angel Share Trust” or “Trust”), a newly created Delawarebusiness trust, all shares of the Company’s common stock beneficially owned byADS. Following the merger, the Trust was the owner of and, through its AdvisoryBoard, voted all these 19,600,000 shares of the Company and had the ability toelect the Board of Directors of the Company. The Trust arose as a condition ofthe merger. In the event of a default of certain obligations of Applied DigitalSolutions to IBM Credit Corporation (IBM Credit), the shares owned by theDigital Angel Share Trust could be sold or otherwise disposed of to satisfysuch obligations.  On March 7, 2003IBM Credit notified ADS that an event of default had occurred and IBM Creditwould immediately exercise any and/or all of its right and remedies it hadunder the IBM credit agreement and applicable law.

 

Effective April 1, 2003, ADS entered into a Forbearance Agreementwith IBM Credit. Under the terms of the Forbearance Agreement, ADS acquired theright to purchase all of its outstanding debt obligations to IBM Credit,totaling approximately $99.0 million (including accrued interest), if ADS paidIBM Credit $30.0 million in cash by June 30, 2003.  As of June 30, 2003, ADS had made cashpayments to IBM Credit totaling $30.0 million and had satisfied in full itsdebt obligations to IBM Credit.

 

The accompanying unaudited condensed consolidated financial statementsof Digital Angel Corporation and subsidiaries as of September 30, 2003 andfor the three and nine month periods ended September 30, 2003 and 2002have been prepared in accordance with accounting principles generally acceptedin the United 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 footnotesrequired by accounting principles generally accepted in the United States ofAmerica for complete financial statements. In the opinion of the Company’s management, all adjustments (includingnormal recurring adjustments) considered necessary to present fairly thefinancial statements have been made.

 

The consolidated statements of operations for the three and nine monthsended September 30, 2003 and 2002 are not necessarily indicative of theresults that may be expected for the entire year.  These statements should be read in conjunction with the DigitalAngel Corporation’s audited consolidated financial statements and related notesthereto for the year ended December 31, 2002 which are included in theCompany’s Annual Report on Form 10-K.

 

Certain items in the condensed consolidated financial statements forthe 2002 periods have been reclassified for comparative purposes.

 

The financial information in these financial statements includes anallocation of expenses incurred by ADS on behalf of the Company as discussed inNote 12.  However, these financialstatements may not necessarily be indicative of the results that may haveoccurred had the Company been a separate, independent entity during the periodspresented or of future results of the Company.

 

The Company is engaged in the business of developing and bringing tomarket proprietary technology used to identify, locate and monitor people,animals and objects. Prior to March 27, 2002, the Company operated in foursegments: Animal Tracking, Digital Angel Technology, Digital Angel DeliverySystem and Radio Communications and Other. With the acquisition of MAS inMarch 2002, the Company reorganized into four segments: AnimalApplications, Wireless and Monitoring, GPS and Radio Communications and MedicalSystems. Animal Applications is the name of the segment previously identifiedas Animal Tracking.  The Digital AngelTechnology segment and the Digital Angel Delivery System segment were combinedto form the Wireless and

 

7

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Monitoring segment, which is now managed as a single business unit. GPSand Radio Communications is the name of the segment previously identified asRadio Communications and Other and represents the activity of SignatureIndustries, which is located in the United Kingdom. Medical Systems reflectsthe MAS business, which was acquired on March 27, 2002.

 

*Animal Applications*—develops,manufactures, and markets a broad line of electronic and visual identificationdevices for the companion animal, livestock, laboratory animal, fish andwildlife markets worldwide. The tracking of cattle and hogs are crucial bothfor asset management and for disease control and food safety. The principaltechnologies employed by Animal Applications are electronic ear tags andimplantable microchips that use radio frequency transmission.

 

*Wireless and Monitoring*—developsand markets advanced technology to gather location and local sensory data andto communicate that data to an operations center. This segment is continuouslydeveloping its technology, which it refers to as its “Digital AngelTMtechnology.” The Digital AngelTM technology is the integration andminiaturization into marketable products of three technologies: wirelesscommunications (such as cellular), sensors (including bio-sensors) and positionlocation technology (including global positioning systems (GPS) and othersystems).

 

*GPS and Radio Communications*—consistsof the design, manufacture and support of secure GPS enabled search and rescueequipment and intelligent communications products and services for telemetry, mobiledata and radio communications applications serving commercial and militarymarkets. In addition, it designs, manufactures and distributes intrinsicallysafe sounders (horn alarms) for industrial use and other electronic components.

 

*Medical Systems*—isthe MAS business which was acquired on March 27, 2002. A staff oflogistics specialists and physicians provide medical assistance services andinteractive medical information services to people traveling anywhere in theworld. It also sells a variety of kits containing pharmaceutical and medicalsupplies.

 

**2.**             FinancingArrangements

** **

*ConvertibleNote*-On July 31,2003, the Company entered into a Securities Purchase Agreement (“PurchaseAgreement”) to sell to Laurus Master Fund, Ltd. (“Laurus”) a two-year SecuredConvertible Note (the “Convertible Note”) in the original principal amount of$2,000,000 and a five-year warrant to purchase up to 125,000 shares of theCompany’s common stock.  The per shareexercise price of the warrant is $2.68 for 75,000 shares, $2.91 for 35,000shares and $3.38 for 15, 000 shares. The Convertible Note is convertible, atLaurus’s option, into shares of the Company’s common stock at a per share priceof $2.33.  Laurus is not entitled to convertthe amount evidenced by the Convertible Note into a number of shares of commonstock which would exceed the difference between the number of shares of commonstock beneficially owned by Laurus and 4.99% of the outstanding shares ofcommon stock of the Company.  However,Laurus may acquire more than 4.99% of the Company’s outstanding common stockupon 75 days’ notice to the Company. The Convertible Note accrues interest atan annual rate equal to the higher of the prime rate plus 1.75% or 6% perannum.  The fair value of the warrantdetermined under the Black-Scholes method is $142,650.  The warrant is accounted for as a discountto the Convertible Note and is being amortized to interest expense over thelife of the Convertible Note.

 

Inconnection with the Convertible Note, the Company and Laurus entered into aSecurity Agreement granting to Laurus a lien and security interest in theCompany’s assets.

 

Under the RegistrationRights Agreement dated July 31, 2003 between the Company and Laurus, theCompany is obligated to file a Registration Statement on Form S-3 within30 days following the closing date and to cause such Registration Statement tobecome effective within 90 days following the closing date.  The Registration Statement covers the resaleof the shares of common stock underlying the Convertible Note and theWarrant.  We have filed a RegistrationStatement on Form S-3 with the Securities and Exchange Commission.  The Registration Statement on Form S-3remains subject to review by the Securities and Exchange Commission.

 

*Credit Facility-* Effective August 28,2003, the Company terminated its Credit and Security Agreement with Wells FargoBusiness Credit.  Under the terms of theCredit and Security Agreement, the Company paid a termination fee of $150,000to Wells Fargo.

 

*Revolving Note and Minimum Borrowing Note*- OnAugust 28, 2003, the Company entered into a Security Agreement with Laurusunder which the Company may borrow from Laurus the lesser of $5,000,000 or anamount that is determined based on percentages of the Company’s eligible accountsreceivable and inventory as prescribed by the terms of the SecurityAgreement.  Under the Security Agreement, the Company issued to Laurus athree-year Secured Revolving Convertible Note (“Revolving Note”) in theoriginal principal amount of $3,500,000 and a three-year Secured MinimumBorrowing Convertible Note (“Minimum Borrowing Note”) in the original principalamount of $1,500,000. The Company used proceeds from the Revolving Note andMinimum Borrowing Note to satisfy in full the Company’s credit facility fromWells Fargo Business Credit.  The Revolving Note and Minimum Borrowing Noteaccrue interest at an annual rate equal to the prime rate plus 2.5%.  As of September 30, 2003 theamount outstanding under the Minimum Borrowing Note and Revolving Note was $2.7million.  The availability under theRevolving Note was $850,000 at September 30, 2003.

 

8

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Beginning May 28, 2004, the Minimum BorrowingNote and the Revolving Note are convertible, at Laurus’s option, into shares ofthe Company’s common stock at a per price share of $2.64 (the “Fixed ConversionPrice”).  The Fixed Conversion Price is adjusted upward following eachconversion of $2,000,000, as defined.  Laurus is not entitled to convertthe amount evidenced by the Minimum Borrowing Note and the Revolving Note intoa number of shares of common stock which would exceed the differencebetween the number of shares of the Company’s common stock beneficiallyowned by Laurus or issuable upon the exercise of warrants held by Laurus and4.99% of the outstanding shares of the Company’s common stock.  However,Laurus may acquire more than 4.99% of the Company’s outstanding common stockupon 75 days’ notice to the Company.

 

The Company also issued to Laurus a five-yearwarrant to purchase up to 115,000 shares of the Company’s stock. The per shareexercise price of the warrant is $2.55 for 70,000 shares, $2.75 for 35,000shares, and $2.95 for 10,000 shares. The fair value of the warrant determinedunder the Black-Scholes method is $134,124. The warrant is accounted for as a discount to the Revolving Note andMinimum Borrowing Note and is being amortized to interest expense over thethree year life of the Revolving Note and Minimum Borrowing Note.

 

Under the Registration Rights Agreement between theCompany and Laurus, the Company is obligated to file a Registration Statementon Form S-3 no later than (1) December 28, 2003 or (2) thereafter, thirtydays following the date of issuance of each $1,000,000 tranche of loansevidenced by a Minimum Borrowing Note.  The registration statement mustregister the resale of the shares issuable upon conversion of the RevolvingNote and the Minimum Borrowing Note and upon exercise of the warrant.

 

*Working Capital Loan-*On March 7, 2003,Signature Industries Ltd., our subsidiary in the United Kingdom, entered into aLoan Agreement with The Royal Bank of Scotland for £500,000 to finance the workingcapital requirements of their Indian Air Force contract.  The Loan bears interest at 2.25% above thebase rate, as defined in the agreement. The base rate may vary from time to time.  Repayment of the loan is required on March 31, 2004.

 

*Invoice Discounting Agreement-*On April 9,2003, Signature Industries Ltd. entered into a two-year Invoice DiscountingAgreement with The Royal Bank of Scotland Commercial Services Limited(“RBS”).  The Invoice DiscountingAgreement provides for Signature to sell with full title guarantee most of itsreceivables, as defined in the Invoice Discounting Agreement.  RBS prepays 70% of the receivables sold, notto exceed an outstanding balance of £750,000 at any given time.  RBS pays Signature the remainder of thereceivable upon collection of the receivable. Receivables which remain outstanding 90 days from the end of the invoicemonth become ineligible and RBS may require Signature to repurchase thereceivable back.  The discounting chargeaccrues daily at 2.25% above the base rate, as defined in the InvoiceDiscounting Agreement.  Signature pays acommission charge to RBS of 0.2% of each receivable balance sold.  The Invoice Discounting Agreement requires aminimum commission charge of £833 per month.

 

*Stock Purchase Agreement with Applied Digital Solutions*-  On August 14, 2003, the Company enteredinto a Stock Purchase Agreement (“Stock Purchase Agreement”) with ADS as astrategic investment to increase ADS’s ownership of the Company.  The Stock Purchase Agreement provides thatthe Company is to sell to ADS 3,000,000 shares of the Company’s common stock at$2.64 per share and a warrant (the “ADS Warrant”) to purchase up to 1,000,000shares of the Company’s stock. The aggregate purchase price for the sale of theCompany’s 3,000,000 shares is payable in ADS common stock (“ADS ExchangeShares”) with a value equal to the purchase price divided by the average ofADS’s volume weighted average price for the ten trading days immediatelypreceding the closing date (“ADS Per Share Exchange Price”).  If the ADS Per Share Exchange Price is lessthan $0.40, then ADS shall have the option to postpone the closing date for aperiod not to exceed thirty calendar days or terminate the Stock PurchaseAgreement.  The Stock Purchase Agreementprovides for the ADS to register the ADS Exchange Shares for resale on Form S-1prior to the closing of the purchase and sale of the Company’s shares. ADS’sRegistration Statement on Form S-1 remains subject to review by the Securitiesand Exchange Commission.

 

The ADS Warrant provides ADS the right, for a period of five years fromFebruary 1, 2004, to purchase a total of 1,000,000 shares of the Company’scommon stock.  The exercise price of theADS Warrant will be equal to the daily volume weighted average price of ourcommon stock for the first 10 consecutive days of 2004 starting onJanuary 2, 2004.

 

As part of this transaction , the Company issued five-year warrants topurchase up to 500,000 shares of the Company’s stock at an exercise price of$2.64 per share anytime on or after February 1, 2004 to the holders of theADS 8.5% Convertible Exchangeable Debentures.

 

**3.**             Principles ofConsolidation and Combination

** **

The September 30, 2003 and 2002 condensed consolidated financialstatements include the accounts of the Company and its wholly-owned andmajority-owned subsidiaries from the date of acquisition.  All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

9

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**4.**             Revenue Recognition

** **

Forproduct sales, the Company recognizes revenue at the time products are shippedand title has transferred, provided that a purchase order has been received ora contract has been executed, there are no uncertainties regarding customeracceptance, the sales price is fixed and determinable and collectability isdeemed probable. If uncertainties regarding customer acceptance exists, revenueis recognized when such uncertainties are resolved. There are no significantpost-contract support obligations at the time of revenue recognition. TheCompany’s accounting policy regarding vendor and post-contract supportobligations is based on the terms of the customers’ contracts, billable uponthe occurrence of the post-sale support. Costs of goods sold are recorded asthe related revenue is recognized. The Company does not offer a warranty policyfor services to customers. It is the Company’s policy to record contract lossesin their entirety in the period in which such losses are foreseeable. Fornon-fixed fee jobs, revenue is recognized based on the actual direct laborhours in the job multiplied by the standard billing rate and adjusted torealizable value, if necessary. Revenues from contracts that provide servicesare recognized ratably over the term of the contract. Fixed fee revenues fromcontracts for services are recorded when earned and exclude reimbursable costs.Reimbursable costs incurred in performing such services are presented on a netbasis and include transportation, medical and communication costs. Otherrevenues are recognized at the time services or goods are provided.

 

**5.**             Stock-BasedCompensation

 

TheCompany applies APB Opinion No. 25 and related Interpretations in accountingfor all its stock option plans. Accordingly, no compensation cost has been recognized under these stockoption plans.  The Company has adoptedthe disclosure-only provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation” and SFAS No. 148, “Accounting for Stock-BasedCompensation-Transition and Disclosure,” which was released inDecember 2002 as an amendment to SFAS No. 123.  The following table illustrates the effect on net loss and lossper share if the fair value based method had been applied to all awards (inthousands, except per share data):

 
|                                                                                                                     |   | **Three Months Ended September 30,** |       | **Nine Months Ended September 30,** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|------------------------------------------|--------|
|                                                                                                                     |   | **2003**                                  |       | **2002**                                 |   | **2003** |   | **2002** |   |
| Reported net loss                                                                                                        |   | **$**                                     | **(2,640** | **)**                                    | $      | (945 | ) | **$** | **(4,907** | **)** | $ | (24,954 | ) |
| Stock-based employee compensation expense  in reported net loss, net of related tax effects                              |   | —                                    | ** ** | 75                                       |   | **25** | ** ** | 13,485 |   |
| **Stock-based employee compensation  expense determined under the fair value based method, net of related tax  effects** |   | **(1,548**                                | **)**      | **(1,704**                               | **)**  | **(4,906** | **)** | **(15,340** | **)** |
| Pro forma  net loss                                                                                                      |   | **$**                                     | **(4,188** | **)**                                    | $      | (2,574 | ) | **$** | **(9,788** | **)** | $ | (26,809 | ) |
|                                                                                                                     |   |                                      | ** ** |                                     |   |   | ** ** |   |   |
| Loss per  share -basic and diluted                                                                                       |   |                                      | ** ** |                                     |   |   | ** ** |   |   |
| As  reported                                                                                                             |   | **$**                                     | **(0.10**  | **)**                                    | $      | (0.04 | ) | **$** | **(0.18** | **)** | $ | (1.04 | ) |
| Pro forma                                                                                                                |   | **$**                                     | **(0.16**  | **)**                                    | $      | (0.10 | ) | **$** | **(0.36** | **)** | $ | (1.12 | ) |

 

**6.**             Inventory (inthousands)

 
|                                  |   | **September 30,  2003** |   | **December 31,  2002** |   |
|---------------------------------------|--------|------------------------------|--------|-----------------------------|--------|
| Raw materials                         |   | $                            | 1,720  |                        | $      | 1,725 |   |
| Work in process                       |   | 114                          |   | 128                         |   |
| Finished goods                        |   | 5,985                        |   | 4,474                       |   |
|                                  |   | 7,819                        |   | 6,327                       |   |
| Allowance for excess and obsolescence |   | (1,514                       | )      | (1,382                      | )      |
| Net inventory                         |   | $                            | 6,305  |                        | $      | 4,945 |   |

 

 

**7.**             Loss Per Share

 

The following is a reconciliation of the numerator and denominator ofbasic and diluted loss per share (in thousands, except per share data):

 
|                                                            |   | **Three Months  Ended September 30,** |       | **Nine Months  Ended September 30,** |       |
|-----------------------------------------------------------------|--------|--------------------------------------------|------------|-------------------------------------------|------------|
|                                                            |   | **2003**                                   |       | **2002**                                  |       | **2003** |   | **2002** |   |
| **Numerator:**                                                  |   |                                       |       |                                      |       |   |   |   |   |
| Net loss                                                        |   | **$**                                      | **(2,640** | **)**                                     | $          | (945 | ) | **$** | **(4,907** | **)** | $ | (24,954 | ) |
| **Denominator:**                                                |   |                                       | ** ** |                                      | ** ** |   | ** ** |   | ** ** |
| Denominator  for basic loss per share - Weighted-average shares |   | **26,993**                                 |       | 26,439                                    | ** ** | **26,839** |   | 23,910 |   |
| Denominator for diluted loss per share (1)-                     |   | **26,993**                                 |       | 26,439                                    | ** ** | **26,839** |   | 23,910 |   |
| **Basic and  diluted loss per share**                           |   | **$**                                      | **(0.10**  | **)**                                     | **$**      | **(0.04** | **)** | **$** | **(0.18** | **)** | **$** | **(1.04** | **)** |

 

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

 

10

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**8.**             Segment Information

 

The Company is engaged in the business of developing and bringing tomarket proprietary technologies used to identify, locate and monitor people,animals and objects. With the acquisition of MAS in March 2002, theCompany re-organized into four segments: Animal Applications, Wireless and Monitoring, GPS and RadioCommunications, and Medical Systems. Prior period segment information has beenrestated to reflect the Company’s current segment structure.

 

It is on this basis that management utilizes the financial informationto assist in making internal operating decisions.  The Company evaluates performance based on stand-alone segmentoperating income.

 

Following is the selected segment data as of and for the three monthsended September 30, 2003 (in thousands):

 
|                                                                     |   | **Animal  Applications** |       | **Wireless and  Monitoring** |       | **GPS and Radio  Communications** |       | **Medical Systems** |       | **Corporate /  Unallocated** |       | **Consolidated** |       |
|--------------------------------------------------------------------------|--------|--------------------------|------------|------------------------------|------------|-----------------------------------|------------|---------------------|------------|------------------------------|------------|------------------|------------|
|                                                                     |   |                     | ** ** |                         | ** ** |                              | ** ** |                | ** ** |                         | ** ** |             | ** ** |
| Net revenue from external customers:                                     |   |                     |       |                         |       |                              |       |                |       |                         |       |             |       |
|                                                                     |   |                     |       |                         |       |                              |       |                |       |                         |       |             |       |
| Product                                                                  |   | $                        | 4,835      |                         | $          | —                            |       | $                   | 2,526      |                         | $          | 139              |       | $ | — |   | $ | 7,500 |   |
| Service                                                                  |   | 525                      |       | 125                          |       | —                            |       | 195                 |       | —                       |       | 845              |       |
| Total revenue                                                            |   | $                        | 5,360      |                         | $          | 125                               |       | $                   | 2,526      |                         | $          | 334              |       | $ | — |   | $ | 8,345 |   |
|                                                                     |   |                     |       |                         |       |                              |       |                |       |                         |       |             |       |
| Income (loss) before minority interest share of  losses and income taxes |   | $                        | (1,258     | )                            | $          | (565                              | )          | $                   | (602       | )                            | $          | (306             | )          | $ | — |   | $ | (2,731 | ) |
|                                                                     |   |                     |       |                         |       |                              |       |                |       |                         |       |             |       |
| Total assets                                                             |   | $                        | 60,138     |                         | $          | 735                               |       | $                   | 6,003      |                         | $          | 4,044            |       | $ | — |   | $ | 70,920 |   |

 

In the three month period ended September 30, 2003, four customersaccounted for approximately 22.3%, 16.6%, 13.7% and 12.8% of our AnimalApplications revenue.

 

Following is the selected segment data as of and for the nine monthsended September 30, 2003 (in thousands):

 
|                                                                     |   | **Animal  Applications** |   | **Wireless  and  Monitoring** |   | **GPS and  Radio  Communications** |   | **Medical  Systems** |   | **Corporate  /  Unallocated** |   | **Consolidated** |   |
|--------------------------------------------------------------------------|--------|--------------------------|--------|-------------------------------|--------|------------------------------------|--------|----------------------|--------|-------------------------------|--------|------------------|--------|
|                                                                     |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Net revenue from external customers:                                     |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
|                                                                     |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Product                                                                  |   | $                        | 17,157 |                          | $      | —                             |   | $                    | 7,933  |                          | $      | 726              |   | $ | — |   | $ | 25,816 |   |
| Service                                                                  |   | 1,192                    |   | 284                           |   | —                             |   | 811                  |   | —                        |   | 2,287            |   |
| Total revenue                                                            |   | $                        | 18,349 |                          | $      | 284                                |   | $                    | 7,933  |                          | $      | 1,537            |   | $ | — |   | $ | 28,103 |   |
|                                                                     |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Income (loss) before minority interest  share of losses and income taxes |   | $                        | (737   | )                             | $      | (2,355                             | )      | $                    | (1,337 | )                             | $      | (679             | )      | $ | — |   | $ | (5,108 | ) |
|                                                                     |   |                     |   |                          |   |                               |   |                 |   |                          |   |             |   |
| Total assets                                                             |   | $                        | 60,138 |                          | $      | 735                                |   | $                    | 6,003  |                          | $      | 4,044            |   | $ | — |   | $ | 70,920 |   |

 

In the nine month period ended September 30, 2003, two customersaccounted for approximately 18.2% and 11.5% of our Animal Applicationsrevenue.  We buy most of our syringeinjectible microchips that are used in our electronic identification productsfrom one supplier.

 

11

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Following is the selected segment data as of and for the three monthsended September 30, 2002 (in thousands):

 
|                                                    |   | **Animal  Applications** |       | **Wireless  and  Monitoring** |       | **GPS and  Radio  Communications** |       | **Medical  Systems** |       | **Corporate  /  Unallocated** |       | **Consolidated** |       |
|---------------------------------------------------------|--------|--------------------------|------------|-------------------------------|------------|------------------------------------|------------|----------------------|------------|-------------------------------|------------|------------------|------------|
|                                                    |   |                     | ** ** |                          | ** ** |                               | ** ** |                 | ** ** |                          | ** ** |             | ** ** |
| Net revenue from external customers:                    |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
|                                                    |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
| Product                                                 |   | $                        | 5,887      |                          | $          | —                             |       | $                    | 2,506      |                          | $          | 387              |       | $ | — |   | $ | 8,780 |   |
| Service                                                 |   | 267                      |       | 335                           |       | —                             |       | 224                  |       | —                        |       | 826              |       |
| Total revenue                                           |   | $                        | 6,154      |                          | $          | 335                                |       | $                    | 2,506      |                          | $          | 611              |       | $ | — |   | $ | 9,606 |   |
|                                                    |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
| Income (loss) before minority interest share of  losses |   | $                        | 850        |                          | $          | (1,450                             | )          | $                    | (203       | )                             | $          | (173             | )          | $ | — |   | $ | (976 | ) |
|                                                    |   |                     |       |                          |       |                               |       |                 |       |                          |       |             |       |
| Total assets                                            |   | $                        | 81,669     |                          | $          | 16,304                             |       | $                    | 5,423      |                          | $          | 31,979           |       | $ | — |   | $ | 135,375 |   |

 

In the three month period ended September 30, 2002, two customersaccounted for 36.6% and 19.0% of our Animal Applications segment’s revenue, twocustomers accounted for 68.8% and 22.4% of our Wireless and Monitoringsegment’s revenue, and two customers accounted for 29.5% and 26.0% of ourMedical Systems segment’s revenue.

 

Following is the selected segment data as of and for the nine monthsended September 30, 2002 (in thousands):

 
|                                                                                                  |   | **Animal  Applications** |       | **Wireless  and  Monitoring** |       | **GPS and  Radio  Communications** |       | **Medical  Systems** |   | **Corporate  /  Unallocated** |       | **Consolidated** |       |
|-------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|-------------------------------|------------|------------------------------------|------------|----------------------|--------|-------------------------------|------------|------------------|------------|
|                                                                                                  |   |                     | ** ** |                          | ** ** |                               | ** ** |                 |   |                          | ** ** |             | ** ** |
| Net revenue from external customers:                                                                  |   |                     |       |                          |       |                               |       |                 |   |                          |       |             |       |
|                                                                                                  |   |                     |       |                          |       |                               |       |                 |   |                          |       |             |       |
| Product                                                                                               |   | $                        | 16,314     |                          | $          | —                             |       | $                    | 7,622  |                          | $          | 803              |       | $ | — |   | $ | 24,739 |   |
| Service                                                                                               |   | 442                      |       | 1,215                         |       | —                             |       | 378                  |   | —                        |       | 2,035            |       |
| Total revenue                                                                                         |   | $                        | 16,756     |                          | $          | 1,215                              |       | $                    | 7,622  |                          | $          | 1,181            |       | $ | — |   | $ | 26,774 |   |
|                                                                                                  |   |                     |       |                          |       |                               |       |                 |   |                          |       |             |       |
| Income (loss) before minority interest share of  losses and equity in net loss of MAS prior to merger |   | $                        | 1,251      |                          | $          | (4,597                             | )          | $                    | (491   | )                             | $          | (413             | )          | $ | (20,487 | )(1) | $ | (24,737 | ) |
|                                                                                                  |   |                     |       |                          |       |                               |       |                 |   |                          |       |             |       |
| Total assets                                                                                          |   | $                        | 81,669     |                          | $          | 16,304                             |       | $                    | 5,423  |                          | $          | 31,979           |       | $ | — |   | $ | 135,375 |   |

 

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(1)  Consists of $18,681,000 non-cash compensation expenseassociated with Digital Angel options converted into options to acquire DigitalAngel Corporation stock and $1,806,000 interest expense associated with ADSobligations to IBM Credit Corporation.

 

In the nine month period ended September 30, 2002, two customersaccounted for approximately 16.7% and 14.8% of our Animal Applicationssegment’s revenue, three customers accounted for 61.9%, 12.3% and 10.6% of ourWireless and Monitoring segment’s revenue and two customers accounted for 26.8%and 25.5% of our Medical Services segment’s revenue.

 

**9.**             Acquisitions

 

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

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

 

12

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On March 27, 2002, DATC (formerly a part of ADS’s AWG) merged witha wholly-owned subsidiary of MAS.  Foraccounting purposes, AWG is treated as the acquirer, and the acquisition of MASwas recorded at fair value under the purchase method of accounting.  The excess of purchase price over the fairvalue of the assets and liabilities of MAS have been recorded as goodwill.

 

The cost of the March 27, 2002 acquisition consisted of 5.268million shares of common stock valued at $25.0 million, including 50,000 sharesof treasury stock, options to purchase 1.2 million shares and warrants topurchase 75,000 shares together valued at $3.4 million, and acquisition costsof $3.6 million.  The valuation of thestock is based on the value of the shares of MAS held by stockholders otherthan ADS prior to the acquisition.  Thecost of the acquisition includes all payments according to the acquisitionagreement plus costs for investment banking services and legal and accountingservices that were direct costs of acquiring these assets.  Included in the acquisition costs arecertain severance liabilities of $2.5 million related to employment agreementsof two officers of MAS.  The value ofthe options and warrants is based on the fair value of the options and warrantsof MAS at the date of acquisition.  Thefair value was determined using the Black-Scholes option pricing model.

 

In considering the benefits of a merger of AWG and MAS, the managementof AWG recognized the strategic advantage of combining the advanced wirelesstechnologies being developed by AWG with the physician-staffed call centerinfrastructure of MAS.  One of theprincipal benefits of such a combination is the ability of the Company to offera complete “end-to-end solution” to the various vertical markets for DigitalAngelTM products.

 

The results of MAShave been included in the consolidated financial statements since the date ofacquisition.  Unaudited pro formaresults of operations for the nine months ended September 30, 2002 areincluded below.  Such pro formainformation assumes that the above acquisition had occurred as ofJanuary 1, 2002, and revenue is presented in accordance with the Company’saccounting policies.  This summary isnot necessarily indicative of what the result of operations of the Companywould have been had it been a combined entity during such periods, nor does itpurport to represent results of operations for any future periods.

 
| **(In thousands)**                             |   | **2002** |    |
|------------------------------------------------|--------|----------|---------|
| Net operating revenue                          |   | $        | 26,882  |   |
| Net loss                                       |   | $        | (26,408 | ) |
| Net loss per common share - basic and  diluted |   | $        | (0.95   | ) |

 

**10.**          Contingencies

 

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

 

On May 29, 2001, Janet Silva, individually and as Guardian *ad litem* for Jonathan Silva, a minor, andthe Estate of Clarence William Silva, Jr. filed suit against CustomizedServices Administrators, Incorporated (CSA), Pricesmart, Inc., CommercialUnion Insurance Company, CGU Insurance Group, and us in the Superior Court ofthe State of California in and for the County of Santa Clara. The allegationsof the complaint arise from a vacation guarantee insurance policy allegedlypurchased by the plaintiffs from the defendants on March 6, 2000. Thecomplaint alleges, among other things, that the defendants breached the termsof the insurance policy, defrauded plaintiffs, acted in bad faith and engagedin deceptive and unlawful business practices, resulting in the wrongful deathof Clarence William Silva, Jr. and the intentional infliction of emotionaldistress on plaintiffs. The complaint seeks the cost of funeral and burialexpenses of Mr. Silva and amounts constituting the loss of financialsupport of Mr. Silva, general damages, attorneys’ fees and costs, andexemplary damages.

 

CSA outsourced its travel assistance services to Medical AdvisorySystems. CSA filed a cross-claim against us alleging that we should be heldliable for any liability that CSA may have to the plaintiffs in this case. Wehave denied the allegations of the complaint and the CSA cross-claim.

 

Effective September 9, 2003, this lawsuit was settled and theplaintiffs executed a Full Release and Covenant Not to Sue in which theplaintiffs agree to forgo any action against Digital Angel Corporation inconsideration for a payment within Digital Angel Corporation’s insurancelimits.

 

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

 
|                                                         |   | **Nine Months  Ended September 30,** |       |
|--------------------------------------------------------------|--------|-------------------------------------------|------------|
|                                                         |   | **2003**                                  |       | **2002** |   |
| Interest paid                                                |   | **$**                                     | **570**    | ** ** | **$** | 244 | ** ** |
| **Taxes paid**                                               |   | **3**                                     |       | **24** |   |
| **Non-cash financing activities:**                           |   |                                      | ** ** |   | ** ** |
| **Shares to be issued in settlement  of liability**          |   | **—**                                | ** ** | **225** | ** ** |
| **Warrants issued in connection  with financing agreements** |   | **277**                                   | ** ** | **—** | ** ** |
|                                                              |        |                                           |            |  |  |  |  |

 

13

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**12.**          Related Party Activity

 

Prior to the merger, ADS provided certain general and administrativeservices to the Company, including finance, legal, benefits and otherservices.  The costs of these servicesare included in the Company’s Statements of Operations as management fees andare based on utilization, which management believes to be reasonable.  Costs of these services were $0.2 millionfor the nine month period ended September 30, 2002.  ADS also charged the Company $1.8 million ofinterest expense in 2002, for which the liability was converted to a capitalcontribution.  In addition, accruedexpenses of $0.3 million were relieved and contributed to capital by ADS.  Through June 2003, ADS charged usapproximately $30,000 a month to support ADS’s research group.  Additionally, we were charged by ADS forproduct liability insurance through September 2002 and directors’ andofficers’ insurance through June 2003. These transactions resulted in a due to ADS of $0.5 million atSeptember 30, 2003.

 

ADS acquired Timely Technology Corp., a part of AWG, in 2000, and themerger agreement included an earnout provision based on performance throughJune 30, 2002.  During the quarterended June 30, 2002, ADS paid the selling shareholder of Timely TechnologyCorp. $3.6 million, payable in shares of ADS stock, as the final payment underthe earnout provision.  This payout hasbeen reflected in the accompanying financial statements as a capitalcontribution by ADS and an increase to goodwill and other intangibles.

 

The Company has executed an exclusive eleven year Distribution andLicensing Agreement dated March 4, 2002 with Verichip Corporation(Verichip), a wholly-owned subsidiary of ADS, covering the manufacturing,purchasing and distribution of Verichip’s implantable microchip and themaintenance of the Verichip Registry by the Company.  The agreement includes a license for the use of the Company’stechnology in Verichip’s identified markets. The Company will be the sole manufacturer and supplier to Verichip.  Revenue recognized under the Distributionand Licensing Agreement was $0.1 million and $0.06 million for the nine monthsended September 30, 2003 and 2002, respectively.

 

**13.**          Subsequent Event

 

On November 2, 2003 the Company signedan agreement and plan of merger pursuant to which the Company will acquireOuterLink Corporation of Concord, Massachusetts, subject to certainconditions.   OuterLink manufactures andmarkets a suite of satellite tracking systems, operates a mobile satellite datacommunications service, and supplies tracking software systems for mapping andmessaging.  The OuterLink “CP-2 system”provides real-time automated tracking, wireless data transfer, and two-waymessaging with large fleets of vehicles — including utility trucks, helicoptersand fixed-wing aircraft, long haul trucks, service vehicles, short haul trucks,and ships. OuterLink’s current customer base includes various branches of theDepartment of Homeland Security (for example, U.S. Border Patrol and U.S.Customs Service).

 

The transaction consideration is the issuanceof a zero coupon preferred stock instrument that is convertible into fourmillion shares of the Company’s common shares when the Company’s common sharesclose at or above $4.00 per share for ten consecutive trading days.

 

On November 3, 2003, OuterLink’s CEO, Mr. Van Chu, was appointedCEO of Digital Angel Corporation.

 

14

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**Item2.****          Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

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

 

We consist of Digital AngelCorporation and its three subsidiaries — Digital Angel Technology Corporation(“DATC”), Timely Technology Corp. and Signature Industries, Limited. These three subsidiaries were previously known as the Advanced Wireless Group(“AWG”) of Applied Digital Solutions, Inc. (“ADS”).  Upon the acquisitionof Medical Advisory Systems, Inc. (“MAS”) in March 2002, the Companyre-organized into four segments:  Animal Applications, Wireless andMonitoring, GPS and Radio Communications, and Medical Systems.  Priorperiod segment information has been restated to reflect our current segmentstructure.

 

**RESULTSOF OPERATIONS**

 

The following table summarizes our results ofoperations as a percentage of net operating revenue for the three and ninemonths ended September 30, 2003 and 2002 and is derived from theaccompanying consolidated statements of operations included in this report.

 
|                                                                                         |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|----------------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                         |   | **2003**                                   |   | **2002**                                  |   | **2003** |   | **2002** |   |
|                                                                                         |   | **%**                                      |   | **%**                                     |   | **%** |   | **%** | ** ** |
| Product revenue                                                                              |   | 89.9                                       |   | 91.4                                      |   | 91.9 |   | 92.4 |   |
| Service revenue                                                                              |   | 10.1                                       |   | 8.6                                       |   | 8.1 |   | 7.6 |   |
| Total net revenue                                                                            |   | 100.0                                      |   | 100.0                                     |   | 100.0 |   | 100.0 |   |
| Cost of products sold                                                                        |   | 55.0                                       |   | 48.1                                      |   | 54.4 |   | 51.5 |   |
| Cost of services sold                                                                        |   | 2.9                                        |   | 3.9                                       |   | 3.2 |   | 3.5 |   |
| Total cost of products and services sold                                                     |   | 57.9                                       |   | 52.0                                      |   | 57.6 |   | 55.0 |   |
| Gross profit                                                                                 |   | 42.1                                       |   | 48.0                                      |   | 42.4 |   | 45.0 |   |
| Selling, general and administrative expenses                                                 |   | 53.8                                       |   | 49.7                                      |   | 46.1 |   | 120.9 |   |
| Management fees - Applied Digital Solutions, Inc.                                            |   | 0.0                                        |   | 0.0                                       |   | 0.0 |   | 0.7 |   |
| Research and development expenses                                                            |   | 18.6                                       |   | 7.8                                       |   | 12.9 |   | 8.3 |   |
| Interest income                                                                              |   | (0.1                                       | )      | 0.0                                       |   | 0.0 |   | 0.0 |   |
| Interest expense                                                                             |   | 3.1                                        |   | 0.7                                       |   | 2.1 |   | 7.5 |   |
| Other income                                                                                 |   | (0.6                                       | )      | 0.0                                       |   | (0.5 | ) | 0.0 |   |
| Loss before minority interest share of losses and  equity in net loss of MAS prior to merger |   | (32.7                                      | )      | (10.2                                     | )      | (18.2 | ) | (92.4 | ) |
| Minority interest share of losses                                                            |   | (1.1                                       | )      | (0.3                                      | )      | (0.7 | ) | (0.3 | ) |
| Equity in net loss of MAS prior to merger                                                    |   | 0.0                                        |   | 0.0                                       |   | 0.0 |   | 1.1 |   |
| Net loss                                                                                     |   | (31.6                                      | )      | (9.9                                      | )      | (17.5 | ) | (93.2 | ) |

 

15

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**ThreeMonths Ended September 30, 2003 Compared to the Three Months EndedSeptember 30, 2002**

 

**Revenue**

 

Revenue for the three months ended September 30,2003 decreased $1.3 million, or 13.1%, to $8.3 million when compared to $9.6million in revenue for the three months ended September 30, 2002.

 

Revenue for each of the operating segments was asfollows (in thousands):

 
|                          |   | **Three Months  Ended September 30,  2003** |   | **Three  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|--------------------------------------------------|--------|---------------------------------------------------|--------|
| Animal  Applications          |   | $                                                | 5,360  |                                              | $      | 6,154 |   |
| Wireless  and Monitoring      |   | 125                                              |   | 335                                               |   |
| GPS  and Radio Communications |   | 2,526                                            |   | 2,506                                             |   |
| Medical  Services             |   | 334                                              |   | 611                                               |   |
| Total                         |   | $                                                | 8,345  |                                              | $      | 9,606 |   |

 

The Animal Applications segment’s revenue decreased**$0.8 million, or 12.9%, in the threemonths ended September 30, 2003 compared to the three month period endedSeptember 30, 2002.  The decreaseis due to fewer sales to fish and wildlife industry customers in the threemonths ended September 30, 2003 when compared to the three months endedSeptember 30, 2002.

 

The Wireless and Monitoring segment’s revenuedecreased $0.2 million, or 62.7%, in the three months ended September 30,2003 as compared to the three month period ended September 30, 2002 due tothe cancellation of a significant software contract in February 2003.

 

TheMedical Services segment’s revenue decreased $0.3 million, or 45.3%, in thethree month period ended September 30, 2003 compared to the three monthperiod ended September 30, 2002. The decrease was primarily due to the cancellation of a significantservice contract in January 2003.

 

**GrossProfit and Gross Profit Margin**

 

Gross profit for the three month period endedSeptember 30, 2003 was $3.5 million, a decrease**of $1.1 million, or 23.7%, compared to $4.6 million in thethree month period ended September 30, 2002. As a percentage of revenue,the gross profit margin was 42.1% and 48.0% for the three months endedSeptember 30, 2003 and 2002, respectively.

 

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

 
|                          |   | **Three  Months  Ended September 30,  2003** |   | **Three  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|
| Animal  Applications          |   | $                                                 | 2,076  |                                              | $      | 3,047 |   |
| Wireless  and Monitoring      |   | 126                                               |   | 71                                                |   |
| GPS  and Radio Communications |   | 1,285                                             |   | 1,251                                             |   |
| Medical  Services             |   | 32                                                |   | 245                                               |   |
| Total                         |   | $                                                 | 3,519  |                                              | $      | 4,614 |   |

 

Gross profit margin from operations for each operatingsegment was:

 
|                          |   | **Three  Months  Ended September 30,  2003** |   | **Three  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|
|                          |   | **%**                                             |   | **%**                                             |   |
| Animal  Applications          |   | 38.7                                              |   | 49.5                                              |   |
| Wireless  and Monitoring      |   | 100.8                                             |   | 21.2                                              |   |
| GPS  and Radio Communications |   | 50.9                                              |   | 49.9                                              |   |
| Medical  Services             |   | 9.6                                               |   | 40.1                                              |   |

 

The Animal Applications segment’s gross profit decreased $1.0 million,or 31.9%, in the three month period ended September 30, 2003 compared tothe three months ended September 30, 2002.  The decrease is due tothe decrease in sales and sales with lower margins when compared to the threemonths ended September 30, 2002. The gross margin percentagedecreased to 38.7% in the three month period ended September 30, 2003 ascompared to 49.5% in the three month period ended September 30, 2002 dueto lower margin sales, increasedoverhead expenses and increased scrap expense.

 

16

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The Wireless and Monitoring segment’s gross profit increased $0.05million, or 77.5%, in the three month period ended September 30, 2003 ascompared to the three month period ended September 30, 2002.  The increase is due to the completion of theAlpha phase of a project for which all related costs are included in researchand development expense.

 

The Medical Services segment’s gross profit decreased$0.2 million, or 86.9%, for the three month period ended September 30,2003. The decrease is due to the previously mentioned decrease in sales.   The gross margin percentage decreased to9.6% in the three month period ended September 30, 2003 as compared to40.1% in the three month period ended September 30, 2002.  The decrease in gross margin percentagerelates to the fixed nature of overhead expenses.

 

**Selling,General and Administrative Expenses**

 

Selling, general and administrative expenses decreased$0.3 million, or 5.8%, in the three month period ended September 30, 2003as compared to the three month period ended September 30, 2002. As apercentage of revenue, selling, general and administrative expenses were 53.8%and 49.7% for the three months ended September 2003 and 2002,respectively.

 

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

 
|                          |   | **Three  Months  Ended September 30,  2003** |   | **Three  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|
| Animal  Applications          |   | $                                                 | 2,127  |                                              | $      | 1,746 |   |
| Wireless  and Monitoring      |   | 447                                               |   | 1,219                                             |   |
| GPS  and Radio Communications |   | 1,619                                             |   | 1,395                                             |   |
| Medical  Services             |   | 303                                               |   | 414                                               |   |
| Total                         |   | $                                                 | 4,496  |                                              | $      | 4,774 |   |

 

Selling, general and administrative expenses as apercentage of revenue for each of the operating segments were:

 
|                          |   | **Three  Months  Ended September 30,  2003** |   | **Three  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|
|                          |   | **%**                                             |   | **%**                                             |   |
| Animal  Applications          |   | 39.7                                              |   | 28.4                                              |   |
| Wireless  and Monitoring      |   | 357.6                                             |   | 363.9                                             |   |
| GPS  and Radio Communications |   | 64.1                                              |   | 55.7                                              |   |
| Medical  Services             |   | 90.7                                              |   | 67.8                                              |   |

 

The Animal Applications segment’s selling, general andadministrative expenses increased $0.4 million in the three monthperiod ended September 30, 2003 as compared to the three month periodended September 30, 2002 and as a percentage of revenue increased to 39.7%from 28.4% in the same respective periods. The increase is primarily due to additional consulting expensesassociated with the Verichip Distribution and Licensing Agreement and the$150,000 line of credit termination fee paid to Wells Fargo.

 

The Wireless and Monitoring segment’s selling, generaland administrative expenses of $0.4 million decreased**$0.8 million in the three month periodended September 30, 2003 as compared to $1.2 million in the three monthperiod ended September 30, 2002. The decrease is primarily due to theexclusion of amortization expense for a license to a digital encryption anddistribution software system that the Company wrote off in the fourth quarterof 2002 and lower personnel costs. Included in the Wireless and Monitoring segment’s selling, general andadministrative expense for the three months ended September 30, 2002 is$0.5 million of amortization expense for the software.  Selling, general and administrative expensesdecreased as a percentage of revenue to 357.6% in the nine month period endedSeptember 30, 2003 compared to 363.9% in the three month period endedSeptember 30, 2002 due to the elimination of amortization expense offsetby the significant decrease in revenue in 2003.

 

The GPS and Radio Communications segment’s selling,general and administrative expenses increased$0.2 million in the three month period ended September 30, 2003 ascompared to the three month period ended September 30, 2002 primarily dueto an increase in sales and marketing expenses. As a percentage of revenue,selling, general and administrative expenses increased to 64.1% in the threemonth period ended September 30, 2003 from 55.7% in the three month periodended September 30, 2002.

 

The Medical Services segment’s selling, general andadministrative expenses decreased $0.1 million, or 26.8% in the three monthperiod ended September 30, 2003. The decrease results from the eliminationof certain administrative expenses.  Asa percentage of revenue, selling, general and administrative expenses were90.7% in the three month period ended September 30, 2003 from 67.8% in thethree month period ended September 30, 2002. The increase as a percentageof revenue relates to the fixed nature of

 

17

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most selling, general and administrative expenses andthe significant decrease in revenue.

 

**Researchand Development Expense**

 

Research and development expense was $1.5 million inthe three month period ended September 30, 2003, an increase of $0.8million, or 107.6%, from $0.7 million for the three month period endedSeptember 30, 2002.  As apercentage of revenue, research and development expense was 18.6% and 7.8% forthe three months ended September 30, 2003 and 2002, respectively.

 

Research and development expense for each of theoperating segments was as follows (in thousands):

 
|                          |   | **Three  Months  Ended September 30,  2003** |   | **Three  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|
| Animal  Applications          |   | $                                                 | 1,035  |                                              | $      | 453 |   |
| Wireless  and Monitoring      |   | 243                                               |   | 294                                               |   |
| GPS  and Radio Communications |   | 273                                               |   | —                                            |   |
| Medical  Services             |   | —                                            |   | —                                            |   |
| Total                         |   | $                                                 | 1,551  |                                              | $      | 747 |   |

 

The increase is due primarily to additional salary andconsulting expenses incurred for the development of the Animal Applicationsegment’s temperature-sensing implantable microchip and development expense forthe GPS and Radio Communications segment’s Sarbe (locator beacon) project.

 

**InterestExpense**

 

Interest expense was $0.3 million and $0.07 million for the three monthperiods ended September 30, 2003 and 2002, respectively.

 

**IncomeTaxes**

 

The Company accounts for income taxes underthe asset and liability approach. Deferred tax assets and liabilities are recognized for the expectedfuture tax consequences attributed to differences between the financialstatement carrying amounts of existing assets and liabilities and their respectivetax basis.  Deferred tax assets andliabilities are measured using the enacted tax rates expected to apply totaxable income in the years in which those temporary differences are expectedto reverse.  A valuation allowance isprovided against net deferred tax assets when it is more likely than not that atax benefit will not be realized.

 

**NineMonths Ended September 30, 2003 Compared to the Nine Months EndedSeptember 30, 2002**

 

**Revenue**

 

Revenue for the nine months ended September 30, 2003 increased$1.3 million, or 5.0%, to $28.1 million when compared to $26.8 million inrevenue for the nine months ended September 30, 2002.

 

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

 
|                          |   | **Nine  Months  Ended September 30,  2003** |   | **Nine  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|--------|
| Animal  Applications          |   | $                                                | 18,349 |                                             | $      | 16,756 |   |
| Wireless  and Monitoring      |   | 284                                              |   | 1,215                                            |   |
| GPS  and Radio Communications |   | 7,933                                            |   | 7,622                                            |   |
| Medical  Services             |   | 1,537                                            |   | 1,181                                            |   |
| Total                         |   | $                                                | 28,103 |                                             | $      | 26,774 |   |

 

The Animal Applications segment’s revenue increased**$1.6 million, or 9.5%, in the nine monthsended September 30, 2003 compared to the nine month period endedSeptember 30, 2002. The increase is due to increased product sales to thefish and wildlife industry and companion animal microchip customers andincreased engineering service revenue.

 

The Wireless and Monitoring segment’s revenuedecreased $0.9 million, or 76.6%, in the nine months ended September 30,2003 compared to the nine month period ended September 30, 2002.  The decrease results from the cancellationof a significant software contract in February 2003.

 

18

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The GPS and Radio Communications segment’s revenueincreased $0.3 million, or 4.1%, in the nine months ended September 30,2003 compared to the nine month period ended September 30, 2002.  The increase results from increases in theexchange rate.  Sales in the localcurrency for the nine months ended September 30, 2003 when compared tosales in local currency for the nine months ended September 30, 2002 havedecreased slightly due to decreased locator beacon sales.

 

MedicalServices segment’s revenue increased $0.4 million, or 30.1% in the nine monthperiod ended September 30, 2003 compared to the nine month period ended September 30,2002.  The increase is due to theinclusion of nine months of sales in 2003 compared to six months of sales in2002.  This segment became part of theCompany on March 27, 2002.

 

**GrossProfit and Gross Profit Margin**

 

Gross profit for the nine month periods endedSeptember 30, 2003 and 2002 remained constant at $12.0 million. As apercentage of revenue, the gross profit margin was 42.4% and 45.0% for the ninemonths ended September 30, 2003 and 2002, respectively.

 

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

 
|                          |   | **Nine  Months  Ended September 30,  2003** |   | **Nine  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|--------|
| Animal  Applications          |   | $                                                | 7,440  |                                             | $      | 7,265 |   |
| Wireless  and Monitoring      |   | 230                                              |   | 453                                              |   |
| GPS  and Radio Communications |   | 3,871                                            |   | 3,871                                            |   |
| Medical  Services             |   | 384                                              |   | 458                                              |   |
| Total                         |   | $                                                | 11,925 |                                             | $      | 12,047 |   |

 

Gross profit margin from operations for each operatingsegment was:

 
|                          |   | **Nine  Months  Ended September 30,  2003** |   | **Nine  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|--------|
|                          |   | **%**                                            |   | **%**                                            |   |
| Animal  Applications          |   | 40.5                                             |   | 43.4                                             |   |
| Wireless  and Monitoring      |   | 81.0                                             |   | 37.3                                             |   |
| GPS  and Radio Communications |   | 48.8                                             |   | 50.8                                             |   |
| Medical  Services             |   | 25.0                                             |   | 38.8                                             |   |

 

The Animal Applications segment’s gross profit increased $0.2 million,or 2.4%, in the nine month period ended September 30, 2003 compared to thenine months ended September 30, 2002 due to the previously mentioned sales increase.  The gross margin percentage decreasedto 40.5% in the nine month period ended September 30, 2003 as compared to43.4% in the nine month period ended September 30, 2002 due primarily to increased air freight,brokerage and customs expense.

 

The Wireless and Monitoring segment’s gross profit decreased $0.2million, or 49.2%, in the nine month period ended September 30, 2003 ascompared to the nine month period ended September 30, 2002.  Margins increased to 81.0% in the nine monthperiod ended September 30, 2003 from 37.3% in the nine month period endedSeptember 30, 2002.  The grossmargin percentage increase was primarily due to the completion of the Alphaphase of a project for which all related costs are included in research anddevelopment expense.

 

The Medical Services segment’s gross profit decreased$0.07 million, or 16.2%, for the nine month period ended September 30,2003 as compared to the nine month period ended September 30, 2002.  The gross margin percentage decreased to25.0% in the nine month period ended September 30, 2003 as compared to38.8% in the nine month period ended September 30, 2002.  The decrease in gross profit is dueprimarily to the loss of a significant customer in January 2003 partiallyoffset by the effect of the inclusion of nine months of operating resultsincluded in 2003 compared to six months of operating results included in2002.  This segment became part of theCompany on March 27, 2002.  Thedecrease in the gross margin percentage relates to the shift in product mixarising from the termination of a significant service contract and increasedpharmaceutical sales.  The shift inproduct mix resulted in increased material costs partially offset by lowerlabor expenses.

 

**Selling,General and Administrative Expenses**

 

Selling, general and administrative expenses decreased$19.4 million, or 60.0%, in the nine month period ended September 30, 2003as compared to the nine month period ended September 30, 2002. Thedecrease was caused primarily by an $18.7 million charge included in selling,general and administrative expenses in the nine month period endedSeptember 30, 2002 arising from the remeasurement of options in connectionwith the merger.  Pursuant to the termsof the merger agreement, options to acquire shares of

 

19

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DATC common stock were converted into options toacquire shares of MAS common stock effective March 27, 2002.  The conversion resulted in a new measurementdate for the options and, as a result, the Company recorded a charge ofapproximately $18.7 million in non-cash compensation expenses during the ninemonth period ended September 30, 2002. For current employees of the Company, these options are considered fixedawards under APB Opinion No. 25, and expense was recorded for the fair value ofthe option converted using the Black-Scholes option-pricing model.  As a percentage of revenue, selling, generaland administrative expenses were 46.1% and 120.9% for the nine months endedSeptember 30, 2003 and 2002, respectively.

 

Selling, general and administrative expenses,excluding the $18.7 million charge in the nine months ended September 30,2002, for each of the operating segments were as follows (dollars inthousands):

 
|                          |   | **Nine  Months  Ended September 30,  2003** |   | **Nine  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|--------|
| Animal  Applications          |   | $                                                | 5,561  |                                             | $      | 4,595 |   |
| Wireless  and Monitoring      |   | 1,860                                            |   | 4,046                                            |   |
| GPS  and Radio Communications |   | 4,571                                            |   | 4,176                                            |   |
| Medical  Services             |   | 959                                              |   | 865                                              |   |
| Total                         |   | $                                                | 12,951 |                                             | $      | 13,682 |   |

 

Selling, general and administrative expenses as apercentage of revenue for each of the operating segments were:

 
|                          |   | **Nine  Months  Ended September 30,  2003** |   | **Nine  Months  Ended September 30,  2002** |       |
|-------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|------------|
|                          |   | **%**                                            |   | **%**                                            | ** ** |
| Animal  Applications          |   | 30.3                                             |   | 27.4                                             |       |
| Wireless  and Monitoring      |   | 654.9                                            |   | 333.0                                            |       |
| GPS  and Radio Communications |   | 57.6                                             |   | 54.8                                             |       |
| Medical  Services             |   | 62.4                                             |   | 73.2                                             |       |

 

The Animal Applications segment’s selling, general andadministrative expenses increased $1.0 million in the nine monthperiod ended September 30, 2003 as compared to the nine month period endedSeptember 30, 2002 and as a percentage of revenue increased to 30.3% from27.4% in the same respective period. The increase relates primarily to additional consulting expensesassociated with the Verichip Distribution and Licensing Agreement, additionalboard of director related expenses and the line of credit termination fee.

 

The Wireless and Monitoring segment’s selling, generaland administrative expenses of $1.9 million decreased**$2.2 million in the nine month periodended September 30, 2003 as compared $4.1 million in the nine month periodended September 30, 2002. The decrease is primarily due to the exclusionof amortization expense for a license to a digital encryption and distributionsoftware system that the Company wrote off in the fourth quarter of 2002.  Included in the Wireless and Monitoringsegment’s selling, general and administrative expense for the nine months endedSeptember 30, 2002 is $1.5 million of amortization expense for thisasset.  Selling, general andadministrative expenses increased as a percentage of revenue to 654.9% in thenine month period ended September 30, 2003 compared to 333.0% in the ninemonth period ended September 30, 2002 due to the significant decline inrevenue in 2003.

 

The GPS and Radio Communications segment’s selling,general and administrative expenses increased$0.4 million in the nine month period ended September 30, 2003 as comparedto the nine month period ended September 30, 2002 primarily due to anincrease in marketing expenses. As a percentage of revenue, selling, generaland administrative expenses increased to 57.6% in the nine month period endedSeptember 30, 2003 from 54.8% in the nine month period endedSeptember 30, 2002.

 

The Medical Services segment’s selling, general andadministrative expenses increased $0.09 million, or 10.9%, in the nine monthperiod ended September 30, 2003 as compared to the nine month period endedSeptember 30, 2002.  As apercentage of revenue, selling, general and administrative expenses were 62.4%in the nine month period ended September 30, 2003 as compared to 73.2% inthe nine month period ended September 30, 2002.  The increase in selling, general and administrative expense isdue primarily to the inclusion of nine months of expense in 2003 compared tosix months of expense in 2002.  Thissegment became part of the Company on March 27, 2002. The decrease inselling, general and administrative expense as a percentage of revenue is theresult of a reduction in certain administrative expenses.

 

**Researchand Development Expense**

 

Research and development expense was $3.6 million inthe nine month period ended September 30, 2003, an increase of $1.4million, or 63.1%, from $2.2 million for the nine month period endedSeptember 30, 2002.  As apercentage of revenue, research and development expense was 12.9% and 8.3% forthe nine months ended September 30, 2003 and 2002, respectively.

 

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Research and development expense for each of theoperating segments was as follows (in thousands):

 
|                          |   | **Nine  Months  Ended September 30,  2003** |   | **Nine  Months  Ended September 30,  2002** |   |
|-------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|--------|
| Animal  Applications          |   | $                                                | 2,276  |                                             | $      | 1,233 |   |
| Wireless  and Monitoring      |   | 723                                              |   | 995                                              |   |
| GPS  and Radio Communications |   | 635                                              |   | —                                           |   |
| Medical  Services             |   | —                                           |   | —                                           |   |
| Total                         |   | $                                                | 3,634  |                                             | $      | 2,228 |   |

 

The increase is due primarily to additionaldevelopment expenses incurred for the Animal Application segment’stemperature-sensing implantable microchip and the GPS and Radio Communicationssegment’s Sarbe project.

 

**InterestExpense**

 

Interest expense was $0.6 million and $2.0 million for the nine monthsperiod ended September 30, 2003 and 2002, respectively.  Included in the $2.0 million of interestexpense for the nine months ended September 30, 2002 is $1.8 million ofinterest expense charged by ADS.

 

**IncomeTaxes**

 

The Company accounts for income taxes underthe asset and liability approach. Deferred tax assets and liabilities are recognized for the expectedfuture tax consequences attributed to differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax basis.  Deferred taxassets and liabilities are measured using the enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to reverse.  A valuationallowance is provided against net deferred tax assets when it is more likelythan not that a tax benefit will not be realized.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

As of September 30, 2003, the Company had cashand cash equivalents of $0.01 million compared to $0.2 million atDecember 31, 2002.  Cash used inoperating activities totaled $3.5 million and $1.3 million in the first ninemonths of 2003 and 2002, respectively.

 

In the first nine months of 2003, the use of cash was due primarily tothe loss generated from operations and a significant increase in accountsreceivable and inventory.  Accountsreceivable, net of allowance for doubtful accounts, increased by $1.6 million,or 39.1%, to $5.7 million at September 30, 2003 from $4.1 million atDecember 31, 2002.  This increaseis primarily due to the seasonality of our business.  Offsetting these uses of cash were increases in accounts payable,accrued expenses and deferred revenue.

 

Inventory levels increased by $1.4 million to $6.3million at September 30, 2003 from $4.9 million at December 31, 2002due to a significant number of shipments in December 2002, resulting in areduction of inventory at December 31, 2002.

 

Accounts payable increased by $2.1 million to $6.2million at September 30, 2003 from $4.1 million at December 31, 2002.

 

Accrued expenses and other current liabilities decreased by $0.3million, or 8.3%, to $3.3 million at September 30, 2003 from $3.6 millionat December 31, 2002.

 

Investing activities used cash of $0.8 million and $1.0 million in thefirst nine months of 2003 and 2002, respectively, to acquire property andequipment.

 

Financing activities provided cash of $4.3 million and$2.0 million in the first nine months of 2003 and 2002, respectively.  In 2003, cash was provided primarily byborrowing on our new line of credit and proceeds from our convertible note.

 

*Debt, Covenant Compliance andLiquidity*

 

The following table summarizes the Company’s fixed cash obligations asof September 30, 2003 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 |   | $         | 5,228  |                        | $      | 917 |   | $ | 2,070 |   | $ | 120 |   | $ | 2,121 |   |
| Operating Leases                 |   | 14,225    |   | 544                         |   | 889 |   | 731 |   | 12,061 |   |
| Employment Contracts             |   | 1,881     |   | 877                         |   | 968 |   | 36 |   | — |   |
|                             |   | $         | 21,334 |                        | $      | 2,338 |   | $ | 3,927 |   | $ | 887 |   | $ | 14,182 |   |

 

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*ConvertibleNote*-On July 31,2003, the Company entered into a Securities Purchase Agreement (“PurchaseAgreement”) to sell to Laurus Master Fund, Ltd. (“Laurus”) a two-year SecuredConvertible Note (the “Convertible Note”) in the original principal amount of$2,000,000 and a five-year warrant to purchase up to 125,000 shares of theCompany’s common stock.  The per shareexercise price of the warrant is $2.68 for 75,000 shares, $2.91 for 35,000shares and $3.38 for 15,000 shares. The Convertible Note is convertible, atLaurus’s option, into shares of the Company’s common stock at a per share priceof $2.33.  Laurus is not entitled toconvert the amount evidenced by the Convertible Note into a number of shares ofcommon stock which would exceed the difference between the number of shares ofcommon stock beneficially owned by Laurus and 4.99% of the outstanding sharesof common stock of the Company. However, Laurus may acquire more than 4.99% of the Company’s outstandingcommon stock upon 75 days’ notice to the Company. The Convertible Note accruesinterest at an annual rate equal to the higher of the prime rate plus 1.75% or6% per annum.  The fair value of thewarrant determined under the Black-Scholes method is $142,650.  The warrant is accounted for as a discountto the Convertible Note and is being amortized to interest expense over thelife of the Convertible Note.

 

Inconnection with the Convertible Note, the Company and Laurus entered into aSecurity Agreement granting to Laurus a lien and security interest in theCompany’s assets.

 

Under the RegistrationRights Agreement dated July 31, 2003 between the Company and Laurus, theCompany is obligated to file a Registration Statement on Form S-3 within30 days following the closing date and to cause such Registration Statement tobecome effective within 90 days following the closing date.  The Registration Statement covers the resaleof the shares of common stock underlying the Note and the Warrant.  We have filed a Registration Statement onForm S-3 with the Securities and Exchange Commission.  The Registration Statement on Form S-3 is still subject to reviewby the Securities and Exchange Commission.

 

*Credit Facility-* Effective August 28,2003, the Company terminated its Credit and Security Agreement with Wells FargoBusiness Credit.  Under the terms of theCredit and Security Agreement, the Company paid a termination fee of $150,000to Wells Fargo.

 

*Revolving Note and Minimum Borrowing Note*- OnAugust 28, 2003, the Company entered into a Security Agreement with Laurusunder which the Company may borrow from Laurus the lesser of $5,000,000 or anamount that is determined based on percentages of the Company’s eligibleaccounts receivable and inventory as prescribed by the terms of the SecurityAgreement.  Under the Security Agreement, the Company issued to Laurus athree-year Secured Revolving Convertible Note (“Revolving Note”) in theoriginal principal amount of $3,500,000 and a three-year Secured MinimumBorrowing Convertible Note (“Minimum Borrowing Note”) in the original principalamount of $1,500,000. The Company used proceeds from the Revolving Note andMinimum Borrowing Note to satisfy in full the Company’s credit facility fromWells Fargo Business Credit.  The Revolving Note and Minimum Borrowing Noteaccrue interest at an annual rate equal to the prime rate plus 2.5%.  As of September 30, 2003 theamount outstanding under the Minimum Borrowing Note and Revolving Note was $2.7million.  The availability under theRevolving Note was $850,000 at September 30, 2003.

 

Beginning May 28, 2004, the Minimum BorrowingNote and the Revolving Note are convertible, at Laurus’s option, into shares ofthe Company’s common stock at a per price share of $2.64 (the “Fixed ConversionPrice”).  The Fixed Conversion Price is adjusted upward following eachconversion of $2,000,000, as defined.  Laurus is not entitled to convertthe amount evidenced by the Minimum Borrowing Note and the Revolving Note intoa number of shares of common stock which would exceed the differencebetween the number of shares of the Company’s common stock beneficiallyowned by Laurus or issuable upon the exercise of warrants held by Laurus and4.99% of the outstanding shares of the Company’s common stock.  However, Laurusmay acquire more than 4.99% of the Company’s outstanding common stock upon 75days’ notice to the Company.

 

The Company also issued to Laurus a warrant topurchase up to 115,000 shares of the Company’s stock for a period of five yearsfrom the date of the warrant.  The per share exercise price of the CommonStock Purchase Warrant is $2.55 for 70,000 shares, $2.75 for 35,000 shares, and$2.95 for 10,000 shares. The fair value of the warrant determined under theBlack-Scholes Method is $134,124.  Thewarrant is accounted for as a discount to the Revolving Note and MinimumBorrowing Note and is being amortized to interest expense over the three yearlife of the Revolving Note and Minimum Borrowing Note.

 

Under the Registration Rights Agreement between theCompany and Laurus, the Company is obligated to file a Registration Statementon Form S-3 no later than (1) December 28, 2003 or (2) thereafter, thirtydays following the date of issuance of each $1,000,000 tranche of loansevidenced by a Minimum Borrowing Note.  The registration statement mustregister the resale of the shares issuable upon conversion of the RevolvingNote and the Minimum Borrowing Note and upon exercise of the warrant.

 

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*Working Capital Loan-*On March 7, 2003,Signature Industries Ltd., our subsidiary in the United Kingdom, entered into aLoan Agreement with The Royal Bank of Scotland for £500,000 to finance the workingcapital requirements of their Indian Air Force Contract.  The Loan bears interest at 2.25% above thebase rate, as defined in the agreement. The base rate may vary from time to time.  Repayment of the loan is required on March 31, 2004.

 

*Invoice Discounting Agreement-*On April 9,2003, Signature Industries Ltd. entered into a two-year Invoice DiscountingAgreement with The Royal Bank of Scotland Commercial Services Limited(“RBS”).  The Invoice DiscountingAgreement provides for Signature to sell with full title guarantee most of its receivables,as defined in the Invoice Discounting Agreement.  RBS prepays 70% of the receivables sold, not to exceed anoutstanding balance of £750,000 at any given time. RBS pays Signature the remainder of the receivable upon collection ofthe receivable.  Receivables whichremain outstanding 90 days from the end of the invoice month become ineligibleand RBS may require Signature to repurchase the receivable back.  The discounting charge accrues daily at2.25% above the base rate, as defined in the Invoice DiscountingAgreement.  Signature pays a commissioncharge to RBS of 0.2% of each receivable balance sold.  The Invoice Discounting Agreement requires aminimum commission charge of £833 per month.

 

*Stock Purchase Agreement with Applied Digital Solutions*-  On August 14, 2003, the Company enteredinto a Stock Purchase Agreement (“Stock Purchase Agreement”) with ADS as astrategic investment to increase ADS’s ownership of the Company.  The Stock Purchase Agreement provides thatthe Company is to issue and sell to ADS 3,000,000 shares of the Company’scommon stock at $2.64 per share and a warrant (the “ADS Warrant”) to purchaseup to 1,000,000 shares of the Company’s stock. The aggregate purchase price forthe sale of the Company’s 3,000,000 shares is payable in ADS common stock (“ADSExchange Shares”) with a value equal to the purchase price divided by theaverage of ADS’s daily volume weighted average price for the ten trading daysimmediately preceding the closing date (“ADS Per Share Exchange Price”).  If the ADS Per Share Exchange Price is lessthan $0.40, then ADS shall have the option to postpone the closing date for aperiod not to exceed thirty calendar days or terminate the Stock PurchaseAgreement.  The Stock Purchase Agreementprovides for ADS to register the ADS Exchange Shares for resale on Form S-1prior to the closing of the purchase and sale of the Company’s shares. ADS’sRegistration Statement on Form S-1 remains subject to review by the Securitiesand Exchange Commission.

 

The ADS Warrant provides ADS the right, for a period of five years fromFebruary 1, 2004, to purchase a total of 1,000,000 shares of the Company’scommon stock.  The exercise price of theADS Warrant will be equal to the daily volume weighted average price of ourcommon stock for the first 10 consecutive days of 2004 starting onJanuary 2, 2004.

 

As part of this transaction , the Company issued five-year warrants topurchase up to 500,000 shares of the Company’s stock at an exercise price of$2.64 per share anytime on or after February 1, 2004 to the holders of theADS 8.5% Convertible Exchangeable Debentures.

 

*IBM Credit Agreement and ADS 8.5% Debentures-*ADShad a term and revolving credit agreement (IBM Credit Agreement) with IBMCredit. Effective April 1, 2003, ADS entered into a Forbearance Agreementwith IBM Credit.  Under the terms of theForbearance Agreement, ADS acquired the right to purchase all of itsoutstanding debt obligations to IBM Credit, totaling $99.0 million (includingaccrued interest), if ADS paid IBM Credit $30.0 million by June 30,2003.  As of June 30, 2003, ADS hadmade cash payments to IBM Credit Corporation totaling $30.0 million and hadsatisfied in full its debt obligations to IBM Credit Corporation under theForbearance Agreement.

 

Funding for the $30.0 million payment to IBM Credit included $10.0million in net proceeds from the issuance by ADS of 8.5% ConvertibleExchangeable Debentures.  Thesedebentures are convertible into shares of ADS common stock or exchangeable forshares of our common stock owned by ADS, or a combination thereof, at any timeat the purchasers’ option.  ADS owned19.6 million shares, or approximately 72.9%, of our issued and outstandingcommon stock as of June 30, 2003. The exchange price for our common stock subject to purchase pursuant tothe debentures is $2.20 per share as to the first 50.0% of the originalprincipal amount of the debentures and $4.25 per share as to the remaining50.0% of the original principal amount, subject to anti-dilutionprovisions.  Of the 19,600,000 shares ofour common stock owned by ADS, it has pledged 15,000,000 shares to thedebenture holders as collateral.

 

The debentures require that ADS pay interest to each debenture holderat the rate of 8.5% per annum, payable on a quarterly basis beginningSeptember 1, 2003 and, beginning on November 1, 2003, on a monthlybasis, as to the principal amount required to be redeemed each month. A finalinterest payment is due on the maturity date. Interest payments may be made ineither cash or in shares of our common stock, or a combination thereof at ADS’soption, subject to certain restrictions. The interest conversion rate for ourcommon stock is calculated based upon 90.0% of the average of the lowest 10 ofthe 20 volume-weighted average stock prices immediately prior to the applicableinterest payment date, subject to a late payment adjustment.  Principal redemption payments of $0.4million are due monthly beginning November 1, 2003.  The principal redemption payments may bemade in cash, in ADS common stock or our common stock at ADS’s option, subjectto certain limitations regarding the average market value and trading volume ofour common stock. The conversion prices are based upon the lesser of (a) 90.0%of the lowest 10 of the 20 volume-weighted average stock prices prior to theredemption date, and (b) the set prices as defined in the purchase agreement.The set prices are based upon the market prices of ADS common stock and ourcommon stock on the date of the transaction.

 

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ADS has also granted to the debenture holders, warrants to purchaseapproximately 5.35 million shares of ADS common stock or 0.95 million shares ofour common stock currently owned by ADS, or a combination of shares from bothcompanies, at each purchaser’s option. The exercise price with respect to our common stock issuable pursuant tothe warrants is $3.178 per share.  Thewarrants contain anti-dilution provisions, vest immediately and are exercisablethrough June 30, 2007.

 

**Forward****– LookingStatements and Associated Risks**

 

This Form 10-Q contains forward-looking statementswithin the “safe harbor” provisions of the Private Securities Litigation ReformAct of 1995 with respect to our financial condition, results of operations andbusiness, and it includes statements relating to:

 
| • |   | our growth strategies including, without limitation,  our ability to deploy**new products and services; |
|--------|--------|---------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                    |
| • |   | anticipated trends in our business and demographics;                                                    |
|   |   |                                                                                                    |
| • |   | our ability to successfully integrate the business  operations of recently acquired companies;          |
|   |   |                                                                                                    |
| • |   | our future profitability and liquidity; and                                                             |
|   |   |                                                                                                    |
| • |   | regulatory, competitive or other economic  influences.                                                  |

 

 

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

 

**RiskFactors**

 

You should carefully consider the risk factors listedbelow.  These risk factors may cause ourfuture earnings to be less or our financial condition to be less favorable thanwe expect.  You should read thissection together with the other information contained herein.

 

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

 

Historically, the Company has suffered losses and has not generatedpositive cash flows from operations. This raises substantial doubt about the Company’s ability to continue asa going concern.  The audit reports ofEisner LLP for the year ended December 31, 2002 for the Company’sfinancial statements and PricewaterhouseCoopers LLP for each of the two yearsended December 31, 2001 and 2000 for AWG’s financial statements, whichbecame our historical financial statements in the merger, contained anexplanatory paragraph expressing doubt about the Company’s and AWG’s ability to continue as a going concern.

 

**Our stockholders will experience dilution if Laurus MasterFund exercises its right to convert certain debt owned by us into shares of ourcommon stock.**

 

On July 31, 2003, the Company sold to Laurus atwo-year Secured Convertible Note (the Convertible Note) in the originalprincipal amount of $2,000,000.  TheConvertible Note is convertible, at Laurus’s option, into shares of theCompany’s common stock at a per share price of $2.33.  The Company has theoption to determine whether to satisfy interest and principal payments on theConvertible Note in cash or in shares of the Company’s common stock, or anycombination of both, subject to certain limitations as defined in theConvertible Note.  In connection withthe issuance of the Convertible Note, was also issued to Laurus onJuly 31, 2003 a five-year warrant to purchase 125,000 shares of our commonstock at exercise prices ranging from $2.68 to $3.38 per share.

 

On August 28, 2003, the Company entered into aSecurity Agreement with Laurus under which the Company issued to Laurus aSecured Revolving Convertible Note (the Revolving Note) in the originalprincipal amount of $3,500,000 and a Secured Minimum Borrowing Convertible Note(the Minimum Borrowing Note) in the original principal amount of $1,500,000.Beginning May 28, 2004, the Minimum Borrowing Note and the Revolving Noteare convertible, at Laurus’s option, into shares of the Company’s common stockat a per price share of $2.64 (the Fixed Conversion Price).  The FixedConversion Price is adjusted upward following each conversion of $2,000,000, asdefined.    In connection with theissuance of the Minimum Borrowing Note and the Revolving Note, was also issuedto Laurus on August 28, 2003 a five-year warrant to purchase 115,000shares of our common stock at exercise prices ranging from $2.55 to $2.95 pershare.

 

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Conversion of the Convertible Note, the Minimum BorrowingNote or the Revolving Note into shares of our common stock or exercise of theabove-described warrants, in whole or in part, will result in an increase inthe total number of our shares outstanding and may result in our stockholdersexperiencing dilution in the net tangible book value per share of our commonstock.

 

**Our stockholders will experience dilution when the StockPurchase Agreement with ADS closes.**

 

On August 14, 2003,the Company entered into a Stock Purchase Agreement (“Stock Purchase Agreement”)with ADS as a strategic investment to increase ADS’s ownership of theCompany.  The Stock Purchase Agreementprovides that the Company is to issue and sell to ADS 3,000,000 shares of theCompany’s common stock at $2.64 per share and a five-year warrant to purchaseup to 1,000,000 shares of the Company’s stock at an exercise price equal to theaverage of the Compay’s volume weighted average price for the first tenconsecutive trading days of 2004, commencing January 2, 2004. Theaggregate purchase price for the sale of the Company’s 3,000,000 shares ispayable in ADS common stock equal to the purchase price divided by the averageof ADS’s volume weighted average price for the ten trading days immediatelypreceding the closing date (“ADS Per Share Exchange Price”).  If the ADS Per Share Exchange Price is lessthan $0.40, then ADS has the option to postpone the closing date for a periodnot to exceed thirty calendar days or terminate the Stock Purchase Agreement.

 

The issuance of 3,000,000 shares of the Company’sstock will result in an increase in the total number of our shares outstandingand will result in our stockholders experiencing dilution in the net tangiblebook value per share of our common stock.

 

**The terms of our notes with Laurus subject us to the risk offoreclosure on substantially all of our assets.**

 

We may not have sufficient funds to repay Lauruswhen the obligations of the Convertible Note, Minimum Borrowing Note andRevolving Note mature.  Accordingly, wemay be required to obtain the funds necessary to repay the obligations eitherthrough refinancing, the issuance of additional equity or debt securities orthe sale of assets.  There can be noassurance that, if needed, we can obtain the funds needed to repay theobligations from any one or more of these other sources on favorable economicterms or at all.  If we are unable toobtain funds to repay this indebtedness, we may be forced to dispose of assetsor take other actions on disadvantageous terms, which could result in losses tothe Company and have a material adverse effect on our financial condition.  For these reasons, there can be no assurancethat we will be able to repay the obligations upon their maturity.

 

To secure the payment of all debts, liabilities andobligations owed to Laurus, we have granted to Laurus a security interest inand lien upon all of our property and assets, whether real or personal,tangible or intangible, and whether now owned or hereafter acquired, or inwhich it now has or at any time in the future may acquire any right, title orinterests.  The occurrence of any of theforegoing or any other events of default under the Convertible Note, MinimumBorrowing Note or Revolving Note would subject us to foreclosure by Laurus onsubstantially all of our assets to the extent necessary to repay any amountsdue.   Any such default and resultingforeclosure could have a material adverse effect on our financial condition.

 

**The Company’s majority stockholder, Applied Digital Solutions, Inc.,owns 72.6% of the Company’s common stock at September 30, 2003, is able tocompletely control the board of directors and may support actions that conflictwith the interests of the other stockholders.**

 

ADS is the beneficial owner of 72.6% of our common stock, and itcontrols us with respect to all matters upon which our stockholders may vote,including the selection of the Board of Directors, mergers, acquisitions andother significant corporate transactions. There can be no assurance as to how ADS will exercise control overus.  ADS may support actions that arecontrary to or conflict with the interests of the other stockholders.

 

**Any sales of ourcommon stock acquired in the exchange of the ADS debentures, the exercise ofthe ADS warrants, or any foreclosure of the pledge of our shares by ADS to thedebenture holders may cause a reduction in the market value of our commonstock.**

 

Of the 19,595,454 shares of our common stock owned by ADS, it haspledged 15,000,000 shares as collateral in connection with the issuance by ADSof the 8.5% Convertible Exchangeable Debentures.  The debentures are convertible into shares of ADS common stock orexchangeable for shares of our common stock owned by ADS, or a combinationthereof, at the purchasers’ option.  Inaddition, the debentures provide for the payment of interest by ADS to eachdebenture holder at the rate of 8.5% per annum.  Interest payments may be made in either cash, shares of ourcommon stock or a combination thereof, at ADS’s option, subject to certainrestrictions.  The principal redemptionpayments may be made in cash, ADS common stock or our common stock at ADS’soption, subject to certain limitations regarding the average market value andtrading volume of our common stock.

 

ADS has also granted to the debenture holders warrants to acquireapproximately 5.35 million shares of ADS common stock, or 0.95 million sharesof our common stock currently owned by ADS, or a combination of shares fromboth companies, at each

 

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purchaser’s option.  Thesewarrants are subject to anti-dilution provisions, vest immediately and areexercisable through June 30, 2007.

 

Exchange of the debentures, exercise of the warrants, foreclosure ofthe pledge, or any combination of these events, could result in the transfer ofa significant number of shares of our common stock to one or more persons.There can be no assurance that any shares transferred in any of thesetransactions will be held for any period of time by the debenture holders.  The debenture holders may elect to sell ourshares in private transactions or in the public market.  If our shares are sold by the debentureholders, we will have little or no control over such sales.  We can give no assurance as to how theseshares of our common stock will be sold, who will purchase such shares or thenumber of shares that will be sold at any given time.  The sale of a significant number of shares of our common stock ina single transaction or in a series of transactions over a short period of timecould result in a significant decline in the market value of our common stock.

 

**Our earnings will decline if we writeoff additional goodwill and other intangible assets.**

 

As of September 30, 2003, we had recorded goodwill of $47.5million. On January 1, 2002, we adopted SFAS No. 142, “Goodwill and OtherIntangible Assets.”  SFAS No. 142requires that goodwill and certain intangibles no longer be amortized butinstead tested for impairment at least annually by applying a fair value basedtest. During the first quarter of 2002, we completed the transitional goodwillimpairment test required by SFAS No. 142 and recorded no impairment of ourgoodwill.  During the fourth quarter of2002, we performed the annual impairment test for goodwill using a fair valuebased approach, primarily discounted cash flows.  An evaluation of the Wireless and Monitoring and Medical Systemsreporting units indicated that $31.5 million and $25.9 million of goodwill,respectively, was impaired. Accordingly, we recorded an impairment charge of $57.4million in the fourth quarter of 2002. Factors contributing to the impairmentcharge were a longer than anticipated timeframe in developing the new DigitalAngelTM technology for the Wireless and Monitoring reporting unit and a changein business focus for the Medical Systems reporting unit. We will 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 eventsor circumstances would include a significant change in business climate,including a significant, sustained decline in an entity’s market value, legalfactors, operating performance indicators, competition, sale or disposition ofa significant portion of the business, or other factors. If we determine thatsignificant impairment has occurred, we would be required to write off theimpaired portion of goodwill. Impairment charges could have a material adverseeffect on our financial condition and results of operations.

 

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

 

As of September 30, 2003, we had options and warrants outstandingto purchase a total of 10,687,000 shares of common stock at exercise pricesranging from $0.05 to $10.50 per share, with a weighted average exercise priceof $2.49.  In addition, as ofSeptember 30, 2003, we had 2,045,000 additional shares of common stockwhich may be issued in the future 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.

 

**We maycontinue to incur losses.**

 

We incurred net losses of $4.9 million in the nine months endedSeptember 30, 2003 and of $92.4 million, $17.4 million and $3.9 million inthe years ended December 31, 2002, 2001 and 2000.  No assurance can be given as to whether wewill achieve profitability, if at all. Profitability depends on many factors,including the success of marketing programs, the maintenance and reduction ofexpenses, and the ability to coordinate successfully the operations of businessunits. If we fail to achieve and maintain sufficient profitability within thetime frame expected by investors, the market price of our common stock may beadversely affected.

 

**The Wireless and Monitoring segment isexpected to incur future losses and may never achieve profitability*.***

 

We have invested approximately $14.6 million in the Digital Angeläproduct for the period from April 1998 through September 30,2003.  We expect the Wireless andMonitoring segment to incur additional development, sales and marketing, andother general expenses.  As a result,the Wireless and Monitoring segment is expected to incur losses for theforeseeable future and will need to generate significant revenues to achieveprofitability.  There can be noassurance that the segment will achieve profitability or, if profitability is achieved,that it will be sustained.  The Wirelessand Monitoring segment’s failure to achieve or sustain profitability would havea material adverse effect on the market value of our common stock.

 

The Wireless andMonitoring segment is the initial stage of operations and may encounterunforeseen difficulties that could negatively affect our business.  It has generated no substantial revenue. Asa result, it has minimal operating history upon which to base an evaluation ofits current business and future prospects. The first Digital Angel product wasintroduced in November 2001. Moreover, this segment does not currently have any contracts in placethat will provide any significant revenue. Because of this segment’s lack of an operating history, management haslimited insight into trends that may emerge and could materially adversely

 

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affect its business. This segment’s prospects must be considered in light of the risks,expenses and difficulties frequently encountered by companies in new andrapidly evolving markets.  This segmentcould encounter risks and difficulties in its new and rapidly evolving market,especially given its lack of operating history. These risks include theWireless and Monitoring segment’s ability to:

 

•      develop andmarket Digital Angel products by integrating and miniaturizing new technologiesinto marketable products and services;

 

•      build acustomer base;

 

•      generaterevenues;

 

•      competesuccessfully in a highly competitive market;

 

•      accesssufficient capital to support growth;

 

•      recruit andretain qualified employees;

 

•      introduce newproducts and services; and

 

•      buildtechnology and support systems.

 

Each of these risks could lead to unforeseen expenses or losses, whichcould have a material adverse effect on our financial condition and results ofoperations.

 

**Infringement by third parties on ourintellectual property or the development of substantially equivalentproprietary technology by our competitors could negatively affect our business.**

 

Our success depends significantly on our ability to maintain patent andtrade secret protection, to obtain future patents and licenses, and to operatewithout infringing on the proprietary rights of third parties. There can be noassurance that the measures we have taken to protect our intellectual property,including those relating to the Digital Angel technology, will prevent themisappropriation or circumvention of our intellectual property.  In addition, there can be no assurance that anypatent application, when filed, will result in an issued patent, or that ourexisting patents, or any patents that may be issued in the future, will provideus with significant protection against competitors. Moreover, there can be noassurance that any patents issued to or licensed by us will not be infringedupon or circumvented by others. Litigation to establish the validity of patents, to assert infringementclaims against others, and to defend against patent infringement claims can beexpensive 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 intellectual property or the development ofsubstantially equivalent technology by our competitors could have a materialadverse effect on our business.

 

**Domestic and foreign governmentregulation and other factors could impair our ability to develop and sell ourproducts in certain markets.**

 

The electronic animal identification market can be negatively affectedby such factors as food safety concerns, consumer perceptions regarding costand efficacy, international technology standards, national infrastructures, andslaughterhouse removal of microchips.

 

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

 

**We relyheavily 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.**

 

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The principal customers for electronic identification devices for fishare government contractors that rely on funding from the United Statesgovernment.  Because these contractorsrely heavily on government funds, any decline in the availability of such fundscould result in a decreased demand by these contractors for our products.  Any decrease in demand by such customerscould have a material adverse effect on our financial condition and results ofoperations and result in a decline in the market value of our common stock.

 

**We depend on a single productionarrangement with Raytheon Corporation for our patented syringe-injectablemicrochips, and the loss of or any significant reduction in the productioncould have an adverse effect on our business.**

 

We rely solely on a production arrangement with Raytheon Corporation(“Raytheon”) for the manufacture of our patented syringe-injectable microchipsthat are used in all of our implantable electronic identificationproducts.  Raytheon utilizes ourproprietary technology and our equipment in the production of oursyringe-injectable microchips. The termination, or any significant reduction,by Raytheon of the assembly of our microchips or a material increase in theprice charged by Raytheon for the assembly of our microchips could have anadverse effect on our financial condition and results of operations.  In addition, Raytheon may not be able toproduce sufficient quantities of the microchips to meet any significantincreased demand for our products or to meet any such demand on a timelybasis.  Any inability or unwillingnessof Raytheon to meet our demand for microchips would require us to utilize analternative production arrangement and remove our automated assembly productionmachinery from the Raytheon facility, which would be costly and could delayproduction.  Moreover, if Raytheonterminates our production arrangement, we cannot ensure that the assembly ofour microchips from another source would be on comparable or acceptable terms.  The failure to make such an alternativeproduction arrangement could have an adverse effect on our business.

 

**We depend onprincipal customers.**

 

For the nine month period ended September 30, 2003, four customers— Schering Plough, Biomark, United States Department of Energy and PacificStates — together accounted for 30.5% of our consolidated revenues. For thethree month period ended September 30, 2003, the same customers togetheraccounted for 28.8% of our consolidated revenues.  In addition, the GPS and Radio Communications segment is heavilydependent on contracts with domestic government agencies and foreigngovernments, including the United Kingdom, primarily relating to militaryapplications. The loss of, or a significant reduction in, orders from these orour other major customers could have a material adverse effect on our financialcondition and results of operations.

 

**We compete with other companies inthe visual and electronic identification market, and the products sold by ourcompetitors could become more popular than our products or render our productsobsolete.**

 

The market for visual and electronic identification for companionanimals and livestock is highly competitive. We believe that our principalcompetitors in the visual identification market for livestock are AllFlex USAand Y-Tex Corporation, and that our principal competitors in the electronicidentification market that have developed permanent electronic identificationdevices for the companion animal market are AllFlex USA, Datamars SA and AvidPlc.  Neither Datamars nor Avid has beengranted a U.S. license to use implantable technology.

 

In addition, other companies could enter this line of business in thefuture.  Some of our competitors havesubstantially greater financial and other resources than us. We may not be ableto compete successfully with these competitors, and those competitors maydevelop or market technologies and products that are more widely accepted thanours or that would render our products obsolete or noncompetitive.  We are not aware of any other competitors currentlymarketing products that would compete with the Digital Angel product.  However, we are aware of several potentialcompetitors that have expressed an interest in similar technologies.  We are unaware of any actual sales of acompeting product.  If such competitorsenter the market and compete with the Digital Angel product, such competitioncould have a material adverse effect on our business.

 

**We are subject to risks as a resultof our foreign operations.**

 

We maintain operations outside of the United States, which subjects usto risks that are inherent in international operations, including the riskthat:

 

•      it is moredifficult to enforce agreements and collect receivables through many foreignlegal systems;

 

•      foreigncustomers may have longer payment cycles than customers in the United States;

 

•      tax rates insome foreign countries may exceed those in the United States, and foreignearnings may be subject to withholding requirements or the imposition oftariffs, exchange controls or other restrictions;

 

•      generaleconomic and political conditions in countries where we operate may have anadverse effect on our operations or other presence in those countries;

 

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•      thedifficulties associated with managing a large organization spread throughoutvarious countries may adversely affect our business in those countries; and

 

•      requiredcompliance with a variety of foreign laws and regulations may prove onerous andadversely affect our operations abroad.

 

As we continue to expand our business globally, our success willdepend, in part, on our ability to anticipate and effectively manage these andother risks.  These and other factorsmay have a material adverse effect on our international operations or our businessas a whole.

 

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

 

We generate a portion of our sales and incur a portion of our expensesin currencies other than U.S. dollars. To the extent that we are unable to match revenues received in foreigncurrencies with costs paid in the same currency, exchange rate fluctuations inany such currency could have an adverse effect on our financial results.

 

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

 

Our future success will depend in large part upon the continuedservices and performance of senior management and other key personnel.  If we lose the services of any member of oursenior management team, our overall operations could be materially andadversely affected.  In addition, ourfuture success will depend on our ability to identify, attract, hire, train,retain and motivate other highly skilled technical, managerial, marketing, purchasingand customer service personnel when they are needed.  Competition for these individuals is intense.  We cannot ensure that we will be able tosuccessfully attract, integrate or retain sufficiently qualified personnel whenthe need arises.  Any failure to attractand retain the necessary technical, managerial, marketing, purchasing andcustomer service personnel could have a material adverse effect on ourfinancial condition and results of operations. We have employment agreementswith certain key personnel.

 

**The Digital AngelTM technology is notproven, and we may not be able to develop products from this unproventechnology.**

 

The Wireless and Monitoring segment depends on the development,integration, miniaturization and successful marketing of several advancedtechnologies that have not previously been integrated or used as anticipated bythis segment. The Wireless and Monitoring segment depends upon advancedtechnology, including wireless communication, biosensors, motion determinationand global positioning system capabilities. Many of these technologies areunproven or relatively new.  Noassurances can be given as to when or if the Digital Angel product will besuccessfully marketed. Our ability to develop and commercialize products basedon our proprietary technology will depend on our ability to develop ourproducts internally on a timely basis or to enter into arrangements with thirdparties to provide these functions.  Ourfailure to develop and commercialize products successfully could have amaterial adverse effect on our financial condition and results of operations.

 

**IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS**

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for CertainFinancial Instruments with characteristics of both Liabilities and Equity.”  SFAS No. 150 establishes standards forclassifying and measuring certain financial instruments with characteristics ofboth liabilities and equity.  SFAS No.150 is effective for financial instruments entered into or modified afterMay 31, 2003.  The Company does notexpect this pronouncement to have a material impact on its results ofoperations or financial condition.

 

In April 2003, the FASB issued SFAS No. 149, “Amendment ofStatement No. 133 on Derivative Instruments and Hedging Activities.”  Among other things, this Statement requiresthat contracts with comparable characteristics be accounted for similarly andclarifies under what circumstances a contract with an initial net investmentmeets the characteristics of a derivative. SFAS No. 149 is effective July 1, 2003.  The Company does not expect this pronouncement to have a materialimpact on its results of operations or financial condition.

 

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

 

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

 

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

 

Due to the nature of our borrowings and our short-term investments, wehave concluded that there is no material market risk exposure and, therefore,no quantitative tabular disclosures are required.

 

**Item4.****    Controlsand Procedures**

 

At the end of the period covered by this report, the Company carriedout an evaluation, under the supervision and with the participation of theCompany’s management, including the Company’s Chief Executive Officer and ChiefFinancial Officer, of the effectiveness of the design and operation of theCompany’s disclosure controls and procedures. Based upon that evaluation, Company’s management, including its ChiefExecutive Officer and Chief Financial Officer, concluded that the Company’sdisclosure controls and procedures were effective as of September 30,2003.

 

There have been no changes in the Company’s internal controls overfinancial reporting that occurred during the most recent fiscal quarter thathave materially affected, or are reasonably likely to materially affect, theCompany’s internal controls over financial reporting.

 

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**PART II    OTHER INFORMATION**

 

**Item 1.**                    Legal Proceedings.

 

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

 

On May 29, 2001, Janet Silva, individually and as Guardian *ad litem* for Jonathan Silva, a minor, andthe Estate of Clarence William Silva, Jr. filed suit against CustomizedServices Administrators, Incorporated (CSA), Pricesmart, Inc., CommercialUnion Insurance Company, CGU Insurance Group, and us in the Superior Court ofthe State of California in and for the County of Santa Clara. The allegationsof the complaint arise from a vacation guarantee insurance policy allegedlypurchased by the plaintiffs from the defendants on March 6, 2000. Thecomplaint alleges, among other things, that the defendants breached the termsof the insurance policy, defrauded plaintiffs, acted in bad faith and engagedin deceptive and unlawful business practices, resulting in the wrongful deathof Clarence William Silva, Jr. and the intentional infliction of emotionaldistress on plaintiffs. The complaint seeks the cost of funeral and burialexpenses of Mr. Silva and amounts constituting the loss of financialsupport of Mr. Silva, general damages, attorneys’ fees and costs, andexemplary damages.

 

CSA outsourced its travel assistance services to Medical AdvisorySystems. CSA filed a cross-claim against us alleging that we should be heldliable for any liability that CSA may have to the plaintiffs in this case. Wehave denied the allegations of the complaint and the CSA cross-claim.

 

Effective September 9, 2003, this lawsuit was settled and theplaintiffs executed a Full Release and Covenant Not to Sue in which theplaintiffs agree to forgo any action against Digital Angel Corporation inconsideration for a payment within Digital Angel Corporation’s insurancelimits.

 

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| **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 of MAS (incorporated herein by reference to  MAS’s Registration Statement  on Form S-18 (No. 2-98314) filed by MAS with the Commission on June 7,  1985 and MAS’s Annual Report on Form 10-KSB filed by MAS with the Commission  on March 28, 1990).         |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |
| 3.2         |                                   | Bylaws of MAS (incorporated  herein by reference to MAS’s Registration Statement on Form S-18 (No.  2-98314) filed by MAS with the Commission on June 7, 1985).                                                                                                                                                           |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |
| 10.1        |                                   | Forbearance Agreement dated March 24, 2003 by and among Applied  Digital Solutions, Inc. IBM Credit LLC, Digital Angel Corporation and the  other parties named therein (incorporated by herein reference to Exhibit 10.1  to the Annual Report on Form 10-K filed by the Company for the year ended  December 31, 2002). |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |
|        |                                   | 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.                                                                                                                                                                       |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |
| 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** |   |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |   |   |
|        |                                   | (i)                                                                                                                                                                                                                                                                                                                                 | On August 8, 2003 the Company filed a Current Report on Form 8-K  dated July 31, 2003 in which the Company reported that it sold to Laurus  Master Fund, Ltd. a $2 million two-year Secured Convertible Note and a Common  Stock Purchase Warrant to purchase up to 125,000 shares of the Company’s  common stock. |   |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |   |   |
|        |                                   | (ii)                                                                                                                                                                                                                                                                                                                                | On August 18, 2003 the Company furnished a Current Report on  Form 8-K dated August 14, 2003 in which the Company reported its second  quarter financial results. |   |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |   |   |
|        |                                   | (iii)                                                                                                                                                                                                                                                                                                                               | On August 18, 2003 the Company filed a Current Report on Form  8-K dated August 15, 2003 in which the Company reported that Richard S.  Friedland resigned as a Director of the Company. |   |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |   |   |
|        |                                   | (iv)                                                                                                                                                                                                                                                                                                                                | On September 3, 2003 the Company filed a Current Report on Form  8-K dated August 28, 2003 in which the Company reported that it entered  into a Security Agreement with Laurus Master Fund, Ltd. under which the  Company may borrow an amount up to $5 million. |   |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |   |   |
|        |                                   | (v)                                                                                                                                                                                                                                                                                                                                 | On September 4, 2003, the Company filed a Current Report on Form  8-K dated September 4, 2003 announcing that Randolph K. Geissler will  become CEO of the Company’s Animal Applications and Information/Medical  divisions. |   |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |   |   |
|        |                                   | (vi)                                                                                                                                                                                                                                                                                                                                | On September 23, 2003, the Company filed a Current Report on  Form 8-K dated September 9, 2003 announcing that the Silva, et al. v. Customized Services  Administrators, Incorporated, dba CSA Travel Protection, Inc. et al.  litigation had been settled. |   |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |   |   |
|        |                                   | (vii)                                                                                                                                                                                                                                                                                                                               | On November 5, 2003, the Company filed a Current Report on Form  8-K dated November 2, 2003, announcing the Agreement and Plan of Merger  with Outerlink Corporation. |   |
|        |                                   |                                                                                                                                                                                                                                                                                                                                |   |   |
|        |                                   | (viii)                                                                                                                                                                                                                                                                                                                              | On November 7, 2003, the Company filed a Current Report on Form  8-K dated November 7, 2003 announcing that Mr. Van Chu assumed  responsibilities of Chief Executive Officer of Digital Angel Corporation. |   |

 

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**SIGNATURE**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                          | DIGITAL ANGEL CORPORATION                             |
|-------------------------------|-------------------------------------------------------|
|                          | (Registrant)                                          |
|                          |                                                  |
| Dated: November 14, 2003 | By:                                                   | /s/ JAMES P. SANTELLI |   |
|                          | James P. Santelli                                     |   |
|                          | Vice President - Finance and Chief  Financial Officer |   |

 

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**INDEX TO EXHIBITS**

 

The following exhibits are filed with this QuarterlyReport 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.           |
|   |   |                                                                                                                                                                     |
| 32.2   |   | Certification of Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.           |

 

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