As filed with the Securities and Exchange Commission on August 14, 2002

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C.  20549

 

---

 

FORM 10-Q

(Mark One)

 

ý  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934.

 

For the quarterly period ended June 30, 2002

 

or

 

o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934.

 

For the transition period from        to       

 

Commission File Number: 1-15177

 

DIGITAL ANGEL CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for 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

 

The number of shares outstanding of each of the issuer’s classes of common stock as of the close of business on July 29, 2002:

 

 

 

DIGITAL ANGEL CORPORATION

 

TABLE OF CONTENTS

 

Item	Description
	PART I – FINANCIAL INFORMATION
1.	Financial Statements
	Condensed Balance Sheets as of June 30, 2002 (unaudited) and December 31, 2001
	Condensed Statements of Operations (unaudited) - for the three and six months ended June 30, 2002 and 2001
	Condensed Statement of Stockholders’ Equity (unaudited) - for the six months ended June 30, 2002
	Condensed Statements of Cash Flows (unaudited) - for the six months ended June 30, 2002 and 2001
	Notes to Condensed Financial Statements
2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
3.	Quantitative and Qualitative Disclosures About Market Risk
	PART II – OTHER INFORMATION
1.	Legal Proceedings
2.	Changes In Securities and Use of Proceeds
3.	Defaults Upon Senior Securities
4.	Submission of Matters to a Vote of Security Holders
5.	Other Information
6.	Exhibits and Reports on Form 8-K
SIGNATURE
EXHIBITS

 

2

 

PART I    FINANCIAL INFORMATION

Item 1.   Financial Statements.

 

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

 

CONDENSED BALANCE SHEETS

(In thousands, except par value)

 

		Digital Angel Corporation and Subsidiaries (Consolidated) June 30, 2002			Advanced Wireless Group (Combined) December 31, 2001
		(Unaudited)
Assets
Current Assets
Cash and cash equivalents		$	584		$	596
Accounts receivable and unbilled receivables (net of allowance for doubtful accounts of $318 in 2002 and $296 in 2001)		4,494			5,402
Inventories		5,574			5,819
Other current assets		1,157			733
Total Current Assets		11,809			12,550
Property And Equipment, net		14,951			14,476
Goodwill and Other Intangible Assets, net		106,258			72,876
Investment In Affiliates		256			6,779
Other Assets, net		547			698
		$	133,821		$	107,379
Liabilities and Stockholders’ Equity
Current Liabilities
Notes payable and current maturities of long-term debt		$	387		$	82,643
Accounts payable		3,416			3,757
Accrued expenses and other current liabilities		4,341			2,044
Due to Applied Digital Solutions, Inc.		153			—
Total Current Liabilities		8,297			88,444
Long-Term Debt And Notes Payable		2,410			2,425
Total Liabilities		10,707			90,869
Commitments And Contingencies
Minority Interest		351			394
Stockholders’ Equity (See Note 1)
Preferred shares: Authorized 1,000 in 2002, of $1.75 par value, no shares issued or outstanding
Common shares: Authorized 95,000 shares in 2002, of $.005 par value; 26,448 shares issued and 26,398 shares outstanding in 2002 and 18,750 shares issued and outstanding in 2001		132			94
Additional paid-in capital		167,075			37,929
Accumulated deficit		(45,709		)	(21,700		)
Common stock warrants		1,638			300
Treasury stock (carried at cost, 50 shares in 2002)		(43		)	—
Accumulated other comprehensive loss		(330		)	(507		)
Total Stockholders’ Equity		122,763			16,116
		$	133,821		$	107,379

 

See the accompanying notes to condensed financial statements.

 

3

 

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

 

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

		Digital Angel Corporation and Subsidiaries (Consolidated)			Advanced Wireless Group (Combined)			Digital Angel Corporation and Subsidiaries (Consolidated)			Advanced Wireless Group (Combined)
		For the Three Months Ended June 30,						For the Six Months Ended June 30,
		2002			2001			2002			2001
Product revenue		$	8,662		$	7,618		$	16,113		$	16,752
Service revenue		577			852			880			1,922
Total net revenue		9,239			8,470			16,993			18,674
Cost of products sold		4,835			4,600			9,135			9,961
Cost of services sold		247			479			498			1,028
Gross profit		4,157			3,391			7,360			7,685
Selling, general and administrative expenses		3,713			2,267			25,622			4,768
Management fees - Applied Digital Solutions, Inc.		—			178			193			371
Research and development expenses		782			1,326			1,545			2,410
Depreciation and amortization		1,095			3,024			1,830			5,383
Interest income		—			(8		)	—			(11		)
Interest expense - Applied Digital Solutions, Inc.		—			—			1,806			—
Interest expense - others		67			92			125			151
Loss before taxes, minority interest and equity in net loss of affiliate		(1,500		)	(3,488		)	(23,761		)	(5,387		)
Provision (benefit) for income taxes		—			(8		)	—			107
Loss before minority interest, and equity in net loss of affiliate		(1,500		)	(3,480		)	(23,761		)	(5,494		)
Minority interest		(2		)	(5		)	(43		)	(27		)
Equity in net loss of affiliate		—			49			291			67
Net loss		$	(1,498	)	$	(3,524	)	$	(24,009	)	$	(5,534	)
Net loss per common share - basic and diluted		$	(0.06	)	$	(0.19	)	$	(1.06	)	$	(0.30	)
Weighted average number of common shares outstanding - basic and diluted		26,169			18,750			22,616			18,750

 

See the accompanying notes to condensed financial statements.

 

4

 

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

 

CONDENSED STATEMENT OF STOCKHOLDERS' EQUITY

For The Six Months Ended June 30, 2002

(In Thousands)

(Unaudited)

 

							Additional Paid-In Capital			Accumulated Deficit			Common Stock Warrants			Treasury Stock			Accumulated Other Comprehensive Loss			Total Stockholders’ Equity
		Common Stock
		Number		Amount
Balance - December 31, 2001		18,750		$	94		$	37,929		$	(21,700	)	$	300		$	—		$	(507	)	$	16,116
Net loss		—		—			—			(24,009		)	—			—			—			(24,009		)
Comprehensive loss - Foreign currency translation		—		—			—			—			—			—			177			177
Total comprehensive loss		—		—			—			(24,009		)	—			—			177			(23,832		)
Transfer of MAS common shares to ADS		—		—			(6,488		)	—			—			—			—			(6,488		)
Contribution by ADS		—		—			6,593			—			—			—			—			6,593
Exercise of stock options		2,392		12			589			—			—			—			—			601
Shares to be issued in settlement of liability		38		—			225			—			—			—			—			225
Merger consideration - Medical Advisory Systems, Inc.		5,268		26			28,163			—			272			(43		)	—			28,418
Assumption of debt by ADS		—		—			81,383			—			—			—			—			81,383
Stock options remeasured in connection with merger		—		—			18,681			—			—			—			—			18,681
Warrants remeasured in connection with merger		—		—			—			—			1,066			—			—			1,066
Balance - June 30, 2002		26,448		$	132		$	167,075		$	(45,709	)	$	1,638		$	(43	)	$	(330	)	$	122,763

 

See the accompanying notes to condensed financial statements.

 

5

 

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

 

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

		Digital Angel Corporation and Subsidiaries (Consolidated)			Advanced Wireless Group (Combined)
		For the Six Months Ended June 30,
		2002			2001
Cash Flows From Operating Activities
Net loss		$	(24,009	)	$	(5,534	)
Adjustments to reconcile net loss to net cash used in operating activities:
Non-cash compensation expense		18,877			—
Interest allocated by ADS and contributed to capital		1,806			—
Deferred income taxes		—			34
Depreciation and amortization		1,830			5,383
Minority interest		(43		)	(27		)
Equity in net loss of affiliate		291			67
Loss on sale of equipment		7			7
Change in assets and liabilities:
Decrease in accounts receivable		1,181			228
Decrease (increase) in inventories		312			(930		)
Increase in other current assets		(545		)	(514		)
Increase in due to ADS		153			—
(Decrease) increase in accounts payable and accrued expenses		(714		)	530
Net Cash Used In Operating Activities		(854		)	(756		)
Cash Flows From Investing Activities
Decrease in other assets		63			262
Payments for property and equipment		(673		)	(1,091		)
Proceeds from sale of property and equipment		23			—
Cash acquired through acquisition, net of acquisition costs		40			—
Net Cash Used In Investing Activities		(547		)	(829		)
Cash Flows From Financing Activities
Net amounts borrowed on notes payable		136			(2		)
Payments on long-term debt		(32		)	(35		)
Exercise of stock options		601			—
Net transactions with Applied Digital Solutions, Inc.		684			1,416
Net Cash Provided By Financing Activities		1,389			1,379
Net Decrease In Cash And Cash Equivalents		(12		)	(206		)
Cash And Cash Equivalents - Beginning Of Period		596			206
Cash And Cash Equivalents - End Of Period		$	584		$	—

 

See the accompanying notes to condensed financial statements.

 

6

 

DIGITAL ANGEL CORPORATION

NOTES TO CONDENSED 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 (“Digital Angel”), which was then a 93% owned subsidiary of Applied Digital Solutions, Inc. (“ADS”).  In the merger, the corporate existence of Acquisition ceased, Digital Angel became a wholly-owned subsidiary of MAS, and MAS was renamed “Digital Angel Corporation”.  In connection with the merger transaction, ADS contributed to MAS all of its stock in Timely Technology Corp., a wholly-owned subsidiary, and Signature Industries, Limited, an 85% owned subsidiary.  These two subsidiaries along with Digital Angel comprised the Advanced Wireless Group (“AWG”).   As a result of this contribution by ADS, Timely Technology Corp. became a wholly-owned subsidiary of the Company and Signature Industries, Limited became an 85% subsidiary.  Prior to the merger with Digital Angel, ADS owned 850,000 shares of MAS stock representing approximately 16.6% of the outstanding stock of MAS.  (The term “Company” means Digital Angel Corporation and its subsidiaries.)  In the merger, the shares of Digital Angel owned by ADS were converted into a total of 18,750,000 shares of MAS common stock.  As a result of the merger, ADS owned 19,600,000 shares or 77.15% of the Company’s common stock.  In connection with the merger, ADS transferred to Digital Angel Share Trust all shares of the Digital Angel Corporation common stock owned by ADS.  The trust is the owner of and, through its Advisory Board, votes all shares of Digital Angel Corporation owned by ADS, including all shares issued to ADS in consideration of the Digital Angel Corporation merger, and has the ability to elect the Board of Directors of the Company.  The Trust arose as a condition of the merger.  In connection with certain obligations of ADS the shares owned by the Trust may be sold or otherwise disposed of to satisfy such obligations.  Additionally, the Company has certain covenant obligations in connection with the ADS obligations (see Note 9).

 

The merger has been treated as a reverse acquisition for accounting purposes, with AWG treated as the accounting acquirer.  The historical combined financial statements of AWG became those of the Registrant, and the assets and liabilities of MAS were accounted for as required under the purchase method of accounting.  Although the equity accounts of AWG survive the merger, the capital structure of MAS survives the merger.  Accordingly, the equity accounts of AWG have been restated based on the common shares received by the former shareholders of AWG in the merger.

 

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

 

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

 

The accompanying unaudited condensed consolidated financial statements of Digital Angel

 

7

 

Corporation and subsidiaries as of and for three and six month periods ended June 30, 2002 and the combined financial statements of AWG as of December 31, 2001 and for the three and six month periods ended June 30, 2001 (unaudited) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X under the Securities Exchange Act of 1934.

 

Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of the Company’s management, all adjustments (including normal recurring adjustments) considered necessary to present fairly the financial statements have been made.

 

The consolidated statements of operations for the three and six months ended June 30, 2002 are not necessarily indicative of the results that may be expected for the entire year.  These statements should be read in conjunction with the AWG’s combined financial statements and related notes thereto for the year ended December 31, 2001 included as an exhibit to our form 8-K/A filed with the Securities and Exchange Commission on July 19, 2002.

 

Certain items in the combined financial statements for the 2001 period have been reclassified for comparative purposes.

 

The accompanying condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern.  The Company has suffered significant losses from operations and has not generated positive cash flows from operations.  Additionally, the Company does not have an available line of credit.  These factors raise substantial doubt about the Company’s ability to continue as a going concern.  The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.  The Company has conducted discussions with several banks regarding a credit facility.  Our capital requirements depend on a variety of factors, including, but not limited to, the rate of increase or decrease in our existing business base; the success, timing, and amount of investment required to bring new products on-line; revenue growth or decline; and potential acquisitions. Providing we are successful in obtaining the credit facility, of which there can be no assurance, management believes that we will have the financial resources to meet its future business requirements for at least the next twelve months.

 

The financial information in these financial statements includes an allocation of expenses incurred by ADS on behalf of the Company as discussed in Note 9.  However, these financial statements may not necessarily be indicative of the results that may have occurred had AWG been a separate, independent entity during the periods presented or of future results of the Company.

 

Accounting Changes

 

Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets (FAS 142).  FAS 142 requires that goodwill and certain intangibles no longer be amortized but instead tested for impairment at least annually.  There was no impairment of goodwill upon adoption of FAS 142.  However, there can be no assurance that future goodwill impairment tests will not result in impairment charges.

 

8

 

The following table presents the impact of FAS 142 on net loss and net loss per share had the standard been in effect for the three months and six months ended June 30, 2001:

 

		Three Months Ended June 30, 2001				Six Months Ended June 30, 2001
Net loss:
Net loss as reported		$	(3,524		)	$	(5,534	)
Goodwill amortization		2,024				3,959
Equity method investment amortization		336				449
Adjusted net loss		$		(1,164	)	$	(1,126	)
Basis and diluted loss per share:
Net loss per share, basis and diluted, as reported		$		(0.19	)	$	(0.30	)
Goodwill amortization		0.11				0.21
Equity method investment amortization		0.02				0.03
Adjusted net loss per share, basic and diluted		$		(0.06	)	$	(0.06	)

 

Amortization expense of other intangible assets totaled $224 and $20 for the six months ended June 30, 2002 and 2001, respectively.

 

2.             Principles of Consolidation and Combination

 

The June 30, 2002 condensed consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries from the date of acquisition.  The combined financial statements at December 31, 2001 and for the three and six months ended June 30, 2001 include the accounts of AWG entities under common control.  All significant intercompany accounts and transactions have been eliminated in consolidation and combination.  AWG used the equity method of accounting for its investments which are less than majority owned, but over which it had significant influence.

 

3.             Revenue Recognition

 

For software consulting and development services, the Company recognizes revenue based on the percent complete for fixed fee contracts, with the percent complete being calculated as either the number of direct labor hours in the project to date divided by the estimated total direct labor hours or based upon the completion of specific task orders.  It is the Company’s policy to record contract losses in their entirety in the period in which such losses are foreseeable.  For non fixed fee jobs, revenue is recognized based on the actual direct labor hours in the job times the standard billing rate and adjusted to realizable value, if necessary.  For product sales, the Company recognizes revenue at the time products

 

9

 

are shipped and title has transferred, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed and determinable and collectability is deemed probable.  If uncertainties regarding customer acceptance exists, revenue is recognized when such uncertainties are resolved.  There are no significant post-contract support obligations at the time of revenue recognition.  The Company’s accounting policy regarding vendor and post-contract support obligations is based on the terms of the customers’ contract, billable upon the occurrence of the post-sale support.  Costs of goods sold are recorded as the related revenue is recognized.  The Company provides warranties on certain of its products.  Estimated warranty costs are accrued in the same period in which the related revenue is recognized, based on anticipated parts and labor costs and utilizing historical experience.  The Company does not offer a warranty policy for services to customers. Revenues from contracts that provide unlimited services are recognized ratably over the term of the contract.  Fixed fee revenues from contracts for services are recorded when earned and excludes reimbursable costs.  Reimbursable costs incurred in performing such services are presented on a net basis and include transportation, medical and communication costs.  Other revenues are recognized at the time services or goods are provided.

 

4.             Inventory

 

		June 30, 2002			December 31, 2001
Raw materials		$	1,641		$	1,474
Work in process		216			176
Finished goods		4,979			5,611
		6,836			7,261
Allowance for excess and obsolescence		(1,262		)	(1,442		)
Net inventory		$	5,574		$	5,819

 

 

10

 

5.             Loss Per Share

 

The following is a reconciliation of the numerator and denominator of basic and diluted loss per share:

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2002			2001			2002			2001
Numerator:
Net loss		$	(1,498	)	$	(3,524	)	$	(24,009	)	$	(5,534	)
Denominator:
Denominator for basic loss per share -
Weighted-average shares		26,169			18,750			22,616			18,750
Denominator for diluted loss per share(1)		26,169			18,750			22,616			18,750
Basic and diluted loss per share:		$	(0.06	)	$	(0.19	)	$	(1.06	)	$	(0.30	)

 

(1) Potentially dilutive securities excluded from the computation of diluted loss per share because to do so would have been anti-dilutive.

 

		Three Months Ended June 30,		Six Months Ended June 30,
		2002		2002
Employee stock options		3,967		3,967
Warrants		1,239		1,239
		5,206		5,206

 

11

 

6.             Segment Information

 

The Company is engaged in the business of developing and bringing to market proprietary technologies used to identify, locate and monitor people, animals and objects.  Prior to March 27, 2002, the Company operated in four segments — Animal Tracking, Digital Angel Technology, Digital Angel Delivery System, and Radio Communications and Other.  With the acquisition of Medical Advisory Systems, Inc. in March 2002, the Company re-organized into four segments:  Animal Applications, Digital Angel Systems, GPS and Radio Communications, and Physician Call Center and Other.  Animal Applications is the new name of our segment previously identified as Animal Tracking.  We combined our Digital Angel Technology segment with our Digital Angel Delivery System segment to form the new Digital Angel Systems segment, which is now managed as a single business unit.  GPS and Radio Communications is the new name of our segment previously identified as Radio Communications and Other and represents the activity of Signature Industries Limited, which is located in the United Kingdom.  Physician Call Center and Other reflects the newly acquired Medical Advisory Systems, Inc. business.  Prior period segment information has been restated to reflect our current segment structure.

 

The accounting policies of the operating segments are the same as those described in the summary of accounting policies in the Company’s audited financial statements for the year ended December 31, 2001.  It is on this basis that management utilizes the financial information to assist in making internal operating decisions.  The Company evaluates performance based on stand-alone segment operating income.

 

Following is the selected segment data as of and for the three months ended June 30, 2002:

 

		Animal Applications			Digital Angel Systems			GPS and Radio Communications			Physician Call Center and Other			Corporate / Unallocated			Consolidated
Net revenue from external customers:
Product		$	5,612		$	—		$	2,480		$	570		$	—		$	8,662
Service		—			577			—			—			—			577
Total revenue		$	5,612		$	577		$	2,480		$	570		$	—		$	9,239
Income (loss) before provision (benefit) for income taxes, minority interest and equity in net loss of affiliate		$	122		$	(1,357	)	$	(25	)	$	(240	)	$	—		$	(1,500	)
Total assets		$	79,037		$	16,978		$	5,513		$	32,293		$	—		$	133,821

 

In the three month period ended June 30, 2002, 2 customers accounted for approximately 15.8% and 15.1% of our Animal Applications revenue and one customer accounted for 49.2% of our Digital Angel Systems revenue.

 

12

Following is the selected segment data as of and for the six months ended June 30, 2002

 

		Animal Applications			Digital Angel Systems			GPS and Radio Communications			Physician Call Center and Other			Corporate / Unallocated			Consolidated
Net revenue from external customers:
Product		$	10,427		$	—		$	5,116		$	570		$	—		$	16,113
Service		—			880			—			—			—			880
Total revenue		$	10,427		$	880		$	5,116		$	570		$	—		$	16,993
Income (loss) before provision (benefit) for income taxes, minority interest and equity in net loss of affiliate		$	401		$	(3,147	)	$	(288	)	$	(240	)	$	(20,487)	(1)	$	(23,761	)
Total assets		$	79,037		$	16,978		$	5,513		$	32,293		$	—		$	133,821

 

In the six month period ended June 30, 2002, 3 customers accounted for approximately 15.0%, 12.4% and 10.8% of our Animal Applications revenue.  We buy most of our syringe-injectable microchips that are used in our electronic identification products from one supplier.  In the six month period ended June 30, 2002, one customer accounted for approximately 57.1% of our Digital Angel Systems revenue.

 

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

 

Following is the selected segment data as of and for the three months ended June 30, 2001:

 

		Animal Applications			Digital Angel Systems			GPS and Radio Communications			Physician Call Center and Other			Combined
Net revenue from external customers:
Product		$	4,877		$	—		$	2,741		$	—		$	7,618
Service		—			852			—			—			852
Total revenue		$	4,877		$	852		$	2,741		$	—		$	8,470
Income (loss) before provision (benefit) for income taxes, minority interest and equity in net loss of affiliate		$	(2,090	)	$	(1,461	)	$	63		$	—		$	(3,488	)
Total assets		$	91,799		$	14,459		$	6,750		$	—		$	113,008

 

In the three month period ended June 30, 2001, 2 customers provided for approximately 22.7% and 22.6% of our Animal Applications revenue.

13

 

Following is the selected segment data as of and for the six months ended June 30, 2001:

 

		Animal Applications			Digital Angel Systems			GPS and Radio Communications			Physician Call Center and Other			Combined
Net revenue from external customers:
Product		$	11,260		$	—		$	5,492		$	—		$	16,752
Service		—			1,922			—			—			1,922
Total revenue		$	11,260		$	1,922		$	5,492		$	—		$	18,674
Income (loss) before provision (benefit) for income taxes, minority interest and equity in net loss of affiliate		$	(3,134	)	$	(2,028	)	$	(225	)	$	—		$	(5,387	)
Total assets		$	91,799		$	14,459		$	6,750		$	—		$	113,008

 

In the six month period ended June 30, 2001, 2 customers provided for approximately 17.8% and 17.0% of our Animal Applications revenue.

 

14

 

7.             Acquisitions

 

The following describes the acquisition by the Company during the six month period ended June 30, 2002:

 

Company Acquired		Date Acquired		Acquisition Price			Acquisition Costs			Value of Shares, Warrants & Options Issued or Issuable			Common Shares Issued		Goodwill and Other Intangibles Acquired			Business Description
Medical Advisory Systems, Inc.		03/27/02		$	31,723		$	3,305		$	28,418		5,218		$	29,901		Provider of medical assistance and technical products and services

 

On February 27, 2001, ADS acquired approximately 16.6% of the capital stock of MAS (AMEX:DOC), a provider of medical assistance and technical products and services, in a transaction valued at approximately $8.3 million in consideration for 3.3 million shares of ADS’s common stock.  ADS controlled two of the seven seats on the Company’s Board of Directors and became the largest single shareholder.  This investment was accounted for under the equity method from February 27, 2001 through March 27, 2002.  The excess of the purchase price over the estimated fair value of the shares acquired was approximately $6.8 million (goodwill) and was being amortized on a straight-line basis over five years, through December 31, 2001.

 

On March 27, 2002, Digital Angel Corporation merged with a wholly-owned subsidiary of MAS.  For accounting purposes, AWG is treated as the acquirer, and the assets and liabilities of MAS were recorded at fair value under the purchase method of accounting.  The consolidated financial statements reflect the results of operations of MAS from the date of acquisition.  The costs of acquisitions include all payments according to the acquisition agreements plus costs for investment banking services, legal and accounting services that were direct costs of acquiring these assets.

 

The cost of the March 27, 2002 acquisition consisted of 5.218 million shares of common stock valued at $25.0 million, 1.2 million options and 75,000 warrants valued at $3.4 million, and acquisition costs of $3.3 million.  The valuation of the stock is based on the value of the shares of MAS held by stockholders other than Applied Digital Solutions prior to the acquisition.  Included in the acquisition costs are certain severance liabilities of $2.5 million, related to employment agreements of two officers of MAS.  The value of the options and warrants is based on the fair value of the options and warrants of MAS at the date of acquisition.  The fair value was determined using the Black-Scholes option pricing model.

 

In considering the benefits of a merger of AWG and MAS, the management of AWG recognized the strategic advantage of combining the advanced wireless technologies being developed by AWG with the physician-staffed call center infrastructure of MAS.  One of the principal benefits of such a combination is the ability of the Company to offer a complete “end-to-end solution” to the various vertical markets for Digital Angel^TM products.

 

Unaudited pro forma results of operations for the three and six months ended June 30, 2002 and 2001 are included below.  Such pro forma information assumes that the above acquisition had occurred

 

15

 

as of January 1, 2002 and 2001, respectively, and revenue is presented in accordance with the Company's accounting policies.  This summary is not necessarily indicative of what the result of operations of the Company would have been had it been a combined entity during such periods, nor does it purport to represent results of operations for any future periods.

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2002			2001			2002			2001
Net operating revenue		$	9,239		$	9,387		$	17,543		$	20,665
Net loss		$	(1,498	)	$	(3,863	)	$	(25,463	)	$	(6,209	)
Net loss per common share - basic and diluted		$	(0.06	)	$	(0.16	)	$	(0.88	)	$	(0.26	)

 

8.             Contingencies

 

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

 

On May 29, 2001, Janet Silva, individually and as Guardian ad Litem for Jonathan Silva, a minor, and the Estate of Clarence William Silva, Jr. (collectively, “Plaintiffs”) filed suit against Customized Services Administrators, Incorporated (“CSA”), Pricesmart, Inc. (“Pricesmart”), Commercial Union Insurance Company (“Commercial Union”), CGU Insurance Group, and the Company (collectively the “Defendants”) in the Superior Court of the State of California in and for the County of Santa Clara.  The allegations of the complaint arise from a vacation guarantee insurance policy (the “Insurance Contract”) allegedly purchased by Plaintiffs from Defendants on March 6, 2000.  The complaint alleges, among other things, that Defendants breached the Insurance Contract, defrauded Plaintiffs, acted in bad faith, engaged in deceptive and unlawful business practices, resulting in the wrongful death of Clarence William Silva, Jr. (the “Deceased”) and the intentional infliction of emotional distress on Plaintiffs.  The complaint seeks the cost of funeral and burial expenses of the Deceased and amounts constituting the loss of financial support of the Deceased, general damages, attorney’s fees and costs, and exemplary damages.

 

CSA has filed a cross-claim against the Company alleging that the Company should be held liable for any liability that CSA may have to Plaintiffs.  The Company has denied the allegations of the complaint and the CSA cross-claim and is vigorously contesting all aspects of this action.

 

The Company is party to various other legal proceedings.  In the opinion of management, these proceedings are not likely to have a material adverse effect on the financial position, cash flows or overall trends in results of the Company.  The estimate of potential impact on the Company’s financial position, overall results of operations or cash flows for the above legal proceedings could change in the future.

 

16

 

9.             Related Party Activity

 

ADS provided certain general and administrative services to the Company including finance, legal, benefits and other miscellaneous items.  The costs of these services are included in the Company’s Statements of Operations based on utilization, which management believes to be reasonable.  Costs of these services were $0.2 million for the three months ended June 30, 2001, and $0.2 million and $0.4 million for the six months ended June 30, 2002 and 2001, respectively.  ADS also charged the Company $1.8 million of interest expense in 2002, for which the liability was converted to a capital contribution.  In addition, accrued expenses of $0.3 million were relieved and contributed to capital by ADS.  Other transactions resulted in a due to ADS of $0.2 million at June 30, 2002.

 

ADS acquired Timely Technology Corp., a part AWG, in 2000 and the merger agreement included an earnout provision based on performance through June 30, 2002.  ADS has agreed to pay the selling shareholder of Timely Technology Corp., $3.6 million, payable in shares of ADS stock, as the final payment under the earnout provision.  This obligation has been reflected in the accompanying financial statements as a capital contribution by ADS and an increase to goodwill and other intangibles.

 

In connection with certain obligations of ADS, the Company has the following covenants.  Minimum Cumulative EBITDA, as defined, in the credit agreement, excludes non-cash compensation expense, one-time charges, impairment losses or any liability or claim that will be satisfied by issuance of the Company’s common stock.

 

COVENANT		COVENANTS REQUIREMENT
Current Assets to Current Liabilities		June 30, 2002	1.8:1
		September 30, 2002	1.8:1
		December 31, 2002	2.0:1
Minimum Cumulative Modified EBITDA		June 30, 2002	$	577,000
		September 30, 2002	$	1,547,000
		December 31, 2002	$	3,329,000

 

At June 30, 2002, the Company and ADS are out of compliance with certain of the covenants.  ADS has received a communication from its lender indicating that pending the expected execution of formal agreements the lender has agreed to waive such noncompliance of the Company and ADS.

 

10.          Investment in Affiliates

 

The change in the Company’s affiliates is as follows:

 

Balance December 31, 2001		$	6,779
Equity in net loss of affiliate		(291		)
MAS common shares transferred to ADS		(6,488		)
MAS affiliates obtained through merger (at cost)		256
Balance June 30, 2002		$	256

 

11.          Option Grant

 

The Company adopted the Digital Angel Corporation Transition Stock Option Plan, which as amended, provides for 11.2 million shares of common stock for which options and other grants may be granted.

 

On June 27, 2002, the Company's Board of Directors granted 3,910,000 options to employees and directors of the Company.  The options have an exercise price of $3.39, the fair value of the Company's common stock on the date of grant, and expire in 10 years.  3,000,000 of the options vest one year from the date of grant and the remaining vest one-third annually on the first anniversary of the grant date.  Pursuant to an amendment to the Company's Certificate of Incorporation, required by the terms of the Digital Angel Share Trust Agreement, the option grant requires the approval of two thirds of the Company's stockholders.  Approval of the grant has not been obtained.

 

 

17

 

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

 

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

 

We consist of MAS and its three subsidiaries, which formerly were subsidiaries of Applied Digital Solutions, Inc. (“ADS”) – Digital Angel Corporation (“DAC”), Timely Technology Corp. and Signature Industries, Limited.  These three subsidiaries were known as the Advanced Wireless Group (“AWG”).  DAC is engaged in the business of developing and bringing to market proprietary technologies used to identify, locate and monitor people, animals and objects.  DAC is the result of the merger in September 2000 of Destron Fearing Corporation and Digital Angel.net Inc., which was then a wholly-owned subsidiary of ADS. Before March 27, 2002, the business of DAC was operated in four segments:  Animal Tracking, Digital Angel Technology, Digital Angel Delivery System, and Radio Communications and Other.  With the acquisition of MAS in March 2002, the Company re-organized into four segments:  Animal Applications, Digital Angel Systems, GPS and Radio Communications, and Physician Call Center and Other.  Animal Applications is the new name of our segment previously identified as Animal Tracking.  We combined our Digital Angel Technology Segment with our Digital Angel Delivery System segment to form the new Digital Angel Systems segment, which is now managed as a single business unit.  GPS and Radio Communications is the new name of our segment previously identified as Radio Communications and Other.  Physician Call Center and Other reflects the newly acquired MAS business.  Prior period segment information has been restated to reflect our current segment structure.

 

18

 

RESULTS OF OPERATIONS

 

The following table summarizes our results of operations as a percentage of net operating revenue for the three and six months ended June 30, 2002 and 2001 and is derived from the accompanying consolidated and combined statements of operations included in this report.

 

		Three Months Ended June 30,				Six Months Ended June 30,
		2002		2001		2002		2001
		%		%		%		%
Product revenue		93.8		89.9		94.8		89.7
Service revenue		6.2		10.1		5.2		10.3
Total net revenue		100.0		100.0		100.0		100.0
Cost of products sold		52.3		54.3		53.8		53.3
Cost of services sold		2.7		5.7		2.9		5.5
Total cost of products and services sold		55.0		60.0		56.7		58.8
Gross profit		45.0		40.0		43.3		41.2
Selling, general and administrative expenses		40.2		26.8		150.7		25.5
Management fees - Applied Digital Solutions, Inc.		0.0		2.1		1.1		2.0
Research and development expenses		8.4		15.6		9.1		12.9
Depreciation and amortization expenses		11.9		35.7		10.8		28.9
Interest income		0.0		(0.1	)	0.0		(0.1	)
Interest expense		0.7		1.1		11.4		0.8
Loss before provision (benefit) for income taxes, minority interest and equity in net loss of affiliate		(16.2	)	(41.2	)	(139.8	)	(28.8	)
Provision (benefit) for income taxes		0.0		(0.1	)	0.0		0.6
Loss before minority interest and equity in net loss of affiliate minority interest		(16.2	)	(41.1	)	(139.8	)	(29.4	)
Minority interest		(0.0	)	(0.1	)	(0.2	)	(0.1	)
Equity in net loss of affiliate		0.0		0.6		1.7		0.3
Net loss		(16.2	)	(41.6	)	(141.3	)	(29.6	)

 

Three Months Ended June 30, 2002 Compared to the Three Months Ended June 30, 2001

 

Revenue

Revenue from operations for the three months ended June 30, 2002 was $ 9.2 million, an increase of $0.7 million, or 8.2%, from $8.5 million in the three months ended June 30, 2001.

 

 

 

19

Revenue for each of the operating segments was:

 

		Three Months Ended June 30,			Three Months Ended June 30,
		2002			2001
Animal Applications		$	5,612		$	4,877
Digital Angel Systems		577			852
GPS and Radio Communications		2,480			2,741
Physician Call Center and Other		570			—
Total		$	9,239		$	8,470

 

The Animal Applications segment’s revenue increased $0.7 million, or 15.1%, in the three months ended June 30, 2002 compared to the three month period ended June 30, 2001.  The increase is due primarily to sales of transponders to the fisheries industry customers.

 

The Digital Angel Systems segment’s revenue decreased $0.3 million, or 32.3%, in the three month period ended June 30, 2002 compared to the three month period ended June 30, 2001 primarily due to a shift in emphasis to the Digital Angel™ products which are in the initial stages of development.

 

The GPS and Radio Communications segment’s revenue decreased $0.3 million, or 9.5%, in the three month period ended June 30, 2002 compared to three month period ended June 30, 2001 primarily as a result of order fluctuations.

 

Physician Call Center and Other revenue was $0.6 million in the three months period ended June 30, 2002.  The segment became part of the Company on March 27, 2002.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the three month period ended June 30, 2002 was $4.2 million, an increase of $0.8 million, or 22.6%, compared to $3.4 million in the three month period ended June 30, 2001. As a percentage of revenue, the gross profit margin was 45.0 % and 40.0% for the three months ended June 30, 2002 and 2001, respectively.

 

Gross profit from operations for each operating segment was:

 

		Three Months Ended June 30,			Three Months Ended June 30,
		2002			2001
Animal Applications		$	2,266		$	1,680
Digital Angel Systems		330			372
GPS and Radio Communications		1,348			1,339
Physician Call Center and Other		213			—
Total		$	4,157		$	3,391

 

Gross profit margin from operations for each operating segment was:

 

		Three Months Ended June 30,		Three Months Ended June 30,
		2002		2001
		%		%
Animal Applications		40.4		34.4
Digital Angel Systems		57.2		43.7
GPS and Radio Communications		54.4		48.9
Physician Call Center and Other		37.4		—
Total		45.0		40.0

 

20

 

The Animal Applications segment’s gross profit increased $0.6 million in the three month period ended June 30, 2002 compared to the three months ended June 30, 2001 due to the previously mentioned sales increase.  The gross margin percentage increased to 40.4% in the three month period ended June 30, 2002 as compared to 34.4% in the three month period ended June 30, 2001 due to higher margin product mix.

 

The Digital Angel Systems segment’s gross profit decreased $42,000, or 11.3%, in the three month period ended June 30, 2002 as compared to the three month period ended June 30, 2001.  Margins increased to 57.2 % in the three month period ended June 30, 2002 from 43.7% in the three month period ended June 30, 2001.  The gross profit increase was primarily due to a shift to higher margin contracts.

 

The GPS and Radio Communications segment’s gross profit remained constant at $1.3 million for the three month period ended June 30, 2002.  The gross margin percentage increased to 54.4 % in the three month period ended June 30, 2002 as compared to 48.9 % in the three month period ended June 30, 2001 due to a favorable shift in the product mix.

 

The Physician Call Center and Other segment’s gross profit was $0.2 million for the three month period ended June 30, 2002.  The gross margin was 37.4% in the three month period ended June 30, 2002.  This segment became part of the Company on March 27, 2002.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses from operations increased $1.4 million, or 63.8%, in the three month period ended June 30, 2002 as compared to the three month period ended June 30, 2001.  As a percentage of revenue, selling, general and administrative expenses were 40.2% and 26.8% for the three months ended June 30, 2002 and 2001, respectively.

 

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

 

		Three Months Ended June 30,			Three Months Ended June 30,
		2002			2001
Animal Applications		$	1,544		$	888
Digital Angel Systems		843			190
GPS and Radio Communications		1,051			1,189
Physician Call Center and Other		275			—
Total		$	3,713		$	2,267

 

 

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

 

		Three Months Ended June 30,		Three Months Ended June 30,
		2002		2001
		%		%
Animal Applications		27.5		18.2
Digital Angel Systems		146.1		22.3
GPS and Radio Communications		42.4		43.4
Physician Call Center and Other		48.2		—
Total		40.2		26.8

 

The Animal Applications segment’s selling, general and administrative expenses increased $0.7 million in the three month period ended June 30, 2002 as compared to the three month period ended June 30, 2001 and as a percentage of revenue increased to 27.5% from 18.2% in the same respective periods.

 

21

 

The increase is primarily due to increased expenses in legal, accounting, and investor relations categories.

 

The Digital Angel Systems segment’s selling, general and administrative expenses of $0.8 million increased $653,000 in the three month period ended June 30, 2002 as compared $0.2 million in the three month period ended June 30, 2001.  Selling, general and administrative expenses increased as a percentage of revenue to 146.1% in the three month period ended June 30, 2002 compared to 22.3% in the three month period ended June 30, 2001 primarily as a result of software amortization expenses.

 

The GPS and Radio Communications segment’s selling, general and administrative expenses decreased $0.1 million in the three month period ended June 30, 2002 as compared to the three month period ended June 30, 2001 primarily due to administrative cost reductions. As a percentage of revenue, selling, general and administrative expenses decreased to 42.4% in the three month period ended June 30, 2002 from 43.4% in the three month period ended June 30, 2001.

 

The Physician Call Center segment’s selling, general and administrative expenses were $0.3 million in the three month period ended June 30, 2002.  As a percentage of revenue, selling, general and administrative expenses were 48.2% in the three month period ended June 30, 2002.  This segment became part of the Company on March 27, 2002.

 

Management Fees – Applied Digital Solutions, Inc.

 

Management fees charged by Applied Digital Solutions, Inc. amounted to $0.2 million for the three months ended June 30, 2001.  These fees were for general and administrative services performed for us.  After March 31, 2002, we no longer pay a management fee to ADS.

 

Research and Development Expense

 

Research and development expense from operations was $0.8 million in the three month period ended June 30, 2002, a decrease of $0.5 million, or 41.0%, from $1.3 million for the three month period ended June 30, 2001.  As a percentage of revenue, research and development expense was 8.4% and 15.6% for the three months ended June 30, 2002 and 2001, respectively.

 

Research and development expense for each of the operating segments was:

 

		Three Months Ended June 30,			Three Months Ended June 30,
		2002			2001
Animal Applications		$	361		$	253
Digital Angel Systems		296			1,073
GPS and Radio Communications		125			—
Physician Call Center and Other		—			—
Total		$	782		$	1,326

 

The significant decrease is due primarily to a reduction in basic research and development expenses associated with the Digital Angel^TM product.  Since the fundamental technology has now been developed, research expenses have declined and expenses are now focused on development for specific vertical markets.

 

Depreciation and Amortization

 

Depreciation and amortization expense from operations was $1.1 million in the three month period ended June 30, 2002, a decrease of $1.9 million, or 63.8%, from $3.0 million in the three month period ended June 30, 2001.  As a percentage of revenue, the depreciation and amortization expense was 11.9% and 35.7% for the three months ended June 30, 2002 and 2001, respectively.

 

The decrease was primarily due to the adoption of FAS 142, which took effect January 1, 2002.  The adoption of FAS 142 requires the testing of goodwill for impairment at least annually, eliminating the need for monthly amortization of goodwill.  Accordingly, goodwill amortization was not recorded during the three months ended June 30, 2002.

 

22

 

Depreciation and amortization expense for each of the operating segments was:

 

		Three Months Ended June  30,			Three Months Ended June 30,
		2002			2001
Animal Applications		$	195		$	2,360
Digital Angel Systems		547			577
GPS and Radio Communications		177			87
Physician Call Center and Other		176			—
Total		$	1,095		$	3,024

 

Interest Expense

 

Interest expense was $0.1 million for the three month periods ended June 30, 2002 and 2001.

 

Income Taxes

 

The Company and AWG had effective income tax rates of 0% and a (0.2)% for the three month period ended June 30 of 2002 and 2001, respectively.  Differences in the effective income tax rates from the statutory federal income tax rate in 2002 arise primarily from valuation allowances recorded on deferred tax assets resulting from net operating losses and in 2001 arise primarily from valuation allowances recorded on deferred tax assets resulting from net operating losses, non-deductible goodwill amortization associated with acquisitions and state taxes net of federal benefits. The U.S. companies in AWG were included in ADS’s consolidated federal income tax return through March 27, 2002.  MAS and its subsidiaries file a separate consolidated federal income tax return.  After March 27, 2002, AWG’s U.S. subsidiaries will file a consolidated federal tax return with MAS.

 

Six Months Ended June 30, 2002 Compared to the Six Months Ended June 30, 2001

 

Revenue

 

Revenue from operations for the six months ended June 30, 2002 was $17.0 million, a decrease of $1.7 million, or 9.0%, from $18.7 million in the six months ended June 30, 2001.

 

Revenue for each of the operating segments was:

 

		Six Months Ended June 30,			Six Months Ended June 30,
		2002			2001
Animal Applications		$	10,427		$	11,260
Digital Angel Systems		880			1,922
GPS and Radio Communications		5,116			5,492
Physician Call Center and Other		570			—
Total		$	16,993		$	18,674

 

23

 

The Animal Applications segment’s revenue decreased $0.8 million, or 7.4%, in the six month period ended June 30, 2002 as compared to the six month period ended June 30, 2001.  The decline is due primarily to the higher sales in the first quarter of 2001 to a large customer to prepare for the launch of the pet identification product in France.

 

The Digital Angel Systems segment’s revenue decreased $1.0 million, or 54.2%, in the six month period ended June 30, 2002 as compared to the six month period ended June 30, 2001 due to completed client assignments that were not replaced and a shift in emphasis to the Digital Angel™ products which are in the initial stages of development.

 

The GPS and Radio Communications segment’s revenue decreased  $0.4 million, or 6.8%, in the six month period ended June 30, 2002 as compared to six month period ended June 30, 2001 primarily as a result of order fluctuations.

 

The Physician Call Center and Other revenue was $0.6 million for the six months ended June 30, 2002.  This segment became part of the Company on March 27, 2002.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the six months ended June 30, 2002 was $7.4 million, a decrease of $0.3 million, or 4.2%, from $7.7 million in the six months ended June 30, 2001.  As a percentage of revenue, the gross profit margin was 43.3% and 41.2% for the six months ended June 30, 2002 and 2001, respectively.

 

Gross profit from operations for each operating segment was:

 

		Six Months Ended June 30,			Six  Months Ended June 30,
		2002			2001
Animal Applications		$	4,145		$	4,171
Digital Angel Systems		382			894
GPS and Radio Communications		2,620			2,620
Physician Call Center and Other		213			—
Total		$	7,360		$	7,685

 

Gross profit margin from operations for each operating segment was:

 

		Six Months Ended June 30,		Six Months Ended June 30,
		2002		2001
		%		%
Animal Applications		39.8		37.0
Digital Angel Systems		43.4		46.5
GPS and Radio Communications		51.2		47.7