As filed with the Securities and Exchange Commission on November 12, 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 September 30, 2002

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

For the transition period from to

Commission File Number: 1-15177

DIGITAL ANGEL CORPORATION

(Exact name of registrant as specified in its charter)

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

490 Villaume Avenue, South Saint Paul, Minnesota
(Address of registrant’s principal executive offices)

(651) 455-1621
(Registrant’s telephone number, including area code)

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

As of the close of business on November 7, 2002, there were 26,470,076 shares outstanding of the issuer’s $0.005 per share par value common stock.

DIGITAL ANGEL CORPORATION

TABLE OF CONTENTS

Item	Description

	PART I – FINANCIAL INFORMATION

1.	Financial Statements
	Condensed Balance Sheets as of September 30, 2002 (unaudited) and December 31, 2001
	Condensed Statements of Operations (unaudited) - for the three and nine months ended September, 2002 and 2001
	Condensed Statement of Stockholders’ Equity (unaudited) - for the nine months ended September 30, 2002
	Condensed Statements of Cash Flows (unaudited) - for the nine months ended September 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
4.	Controls and Procedures


	PART II – OTHER INFORMATION

1.	Legal Proceedings
2.	Changes in Securities and Use of Proceeds


6.	Exhibits and Reports on Form 8-K

SIGNATURE
CERTIFICATIONS
EXHIBITS

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) September 30, 2002			Advanced Wireless Group (Combined) December 31, 2001
	(Unaudited)
Assets
Current Assets
Cash and cash equivalents	$	480		$	596
Accounts receivable and unbilled receivables (net of allowance for doubtful accounts of $294 in 2002 and $296 in 2001)	6,369			5,402
Inventories	5,065			5,819
Other current assets	1,883			733
Total Current Assets	13,797			12,550

Property And Equipment, net	14,464			14,476

Goodwill and Other Intangible Assets, net	106,246			72,876

Investment In Affiliates	256			6,779

Other Assets, net	612			698

	$	135,375		$	107,379

Liabilities and Stockholders’ Equity

Current Liabilities
Line of credit and current maturities of long-term debt	$	214		$	82,802
Accounts payable	4,568			3,598
Accrued expenses and other current liabilities	3,949			2,044
Due to Applied Digital Solutions, Inc.	672			—
Total Current Liabilities	9,403			88,444

Long-Term Debt And Notes Payable	3,355			2,425

Other Long-Term Liabilities	500			—

Total Liabilities	13,258			90,869

Commitments And Contingencies

Minority Interest	320			394

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 in 2002, of $.005 par value; 26,508 shares issued and 26,458 shares outstanding in 2002 and 18,750 shares issued and outstanding in 2001	132			94
Additional paid-in capital	167,015			37,929
Accumulated deficit	(46,654		)	(21,700		)
Common stock warrants	1,638			300
Treasury stock (carried at cost, 50 shares in 2002)	(43		)	—
Accumulated other comprehensive loss	(291		)	(507		)
Total Stockholders’ Equity	121,797			16,116

	$	135,375		$	107,379

See the accompanying notes to condensed financial statements.

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 September 30,						For the Nine Months Ended September 30,
	2002			2001			2002			2001

Product revenue	$	9,004		$	8,416		$	25,117		$	25,168
Service revenue	335			881			1,215			2,803
Total net revenue	9,339			9,297			26,332			27,971

Cost of products sold	4,680			5,255			13,815			15,216
Cost of services sold	264			599			762			1,627
	4,944			5,854			14,577			16,843
Gross profit	4,395			3,443			11,755			11,128

Selling, general and administrative expenses	4,688			5,672			32,140			15,823
Management fees - Applied Digital Solutions, Inc.	—			185			193			556
Research and development expenses	614			1,332			2,159			3,742
Interest income	(2		)	(3		)	(2		)	(14		)
Interest expense - Applied Digital Solutions, Inc.	—			—			1,806			—
Interest expense - others	71			206			196			357

Loss before taxes, minority interest share of losses and equity in net loss (income) of affiliate	(976		)	(3,949		)	(24,737		)	(9,336		)

Provision (benefit) for income taxes	—			(52		)	—			55

Loss before minority interest share of losses and equity in net loss (income) of affiliate	(976		)	(3,897		)	(24,737		)	(9,391		)

Minority interest share of losses	(31		)	(27		)	(74		)	(54		)

Equity in net loss (income) of affiliate	—			51			291			118

Net loss	$	(945	)	$	(3,921	)	$	(24,954	)	$	(9,455	)

Net loss per common share - basic and diluted	$	(0.04	)	$	(0.21	)	$	(1.04	)	$	(0.50	)

Weighted average number of common shares outstanding - basic and diluted	26,439			18,750			23,910			18,750

See the accompanying notes to condensed financial statements.

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

CONDENSED STATEMENT OF STOCKHOLDERS’ EQUITY

For The Nine Months Ended September 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	—	—		—			(24,954		)	—		—			—			(24,954		)
Comprehensive loss - Foreign currency translation	—	—		—			—			—		—			216			216
Total comprehensive loss	—	—		—			(24,954		)	—		—			216			(24,738		)
Transfer of MAS common shares to ADS	—	—		(6,488		)	—			—		—			—			(6,488		)
Contribution by ADS	—	—		6,433			—			—		—			—			6,433
Exercise of stock options	2,452	12		619			—			—		—			—			631
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
Stock option extension	—	—		70			—			—		—			—			70
Warrants remeasured in connection with merger	—	—		—			—			1,066		—			—			1,066

Balance - September 30, 2002	26,508	$	132	$	167,015		$	(46,654	)	$	1,638	$	(43	)	$	(291	)	$	121,797

See the accompanying notes to condensed financial statements.

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 Nine Months Ended September 30,
	2002			2001
Cash Flows From Operating Activities
Net loss	$	(24,954	)	$	(9,455	)

Adjustments to reconcile net loss to net cash used in operating activities:
Non-cash compensation and administrative expense	18,952			—
Interest allocated by ADS and contributed to capital	1,806			—
Depreciation and amortization	2,750			8,752
Minority interest	(74		)	(54		)
Equity in net loss of affiliate	291			118
Loss on sale of equipment	7			—
Change in assets and liabilities:
Increase in accounts receivable	(695		)	(930		)
Decrease (increase) in inventories	821			(978		)
(Increase) decrease in other current assets	(1,271		)	152
Increase in due to ADS	672			—
Increase in accounts payable and accrued expenses	580			444
Net Cash Used In Operating Activities	(1,115		)	(1,951		)

Cash Flows From Investing Activities
Decrease in other assets	79			145
Payments for property and equipment	(984		)	(1,509		)
Proceeds from sale of property and equipment	23			—
Acquisition costs, net of cash acquired through acquisition	(73		)	—
Net Cash Used In Investing Activities	(955		)	(1,364		)

Cash Flows From Financing Activities
Amounts paid on notes payable and line of credit	(40		)	(71		)
Amounts borrowed on long-term debt, net of repayments	757			—
Exercise of stock options	631			—
Payments for other financing costs	(78		)	—
Net transactions with Applied Digital Solutions, Inc.	684			3,185
Net Cash Provided By Financing Activities	1,954			3,114

Net Decrease In Cash And Cash Equivalents	(116		)	(201		)

Cash And Cash Equivalents - Beginning Of Period	596			206

Cash And Cash Equivalents - End Of Period	$	480		$	5

See the accompanying notes to condensed financial statements.

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, which was then a 93% owned subsidiary of Applied Digital Solutions, Inc. (“ADS”). In the merger, the corporate existence of Acquisition ceased, Digital Angel Corporation became a wholly-owned subsidiary of MAS and was renamed Digital Angel Technology Corporation (“DATC”), 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 DATC, 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 DATC, ADS owned 850,000 shares of MAS stock representing approximately 16.6% of the outstanding stock of MAS. (Unless the context otherwise requires, the term “Company” means Digital Angel Corporation and its subsidiaries.) In the merger, the shares of DATC 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 the Digital Angel Share Trust (the “Trust”) all shares of the Company’s common stock owned by ADS. The Trust is the owner of and, through its Advisory Board, votes all shares of the Company owned by ADS, including all shares issued to ADS in the 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 Company, and the acquisition of MAS was accounted for under the purchase method of accounting. 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 DATC 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

Corporation and subsidiaries as of and for three and nine month periods ended September 30, 2002 and the combined financial statements of AWG as of December 31, 2001 and for the three and nine month periods ended September 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 nine months ended September 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 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.

The Company will assess the fair value of its goodwill annually or between annual tests if events occur or circumstances change that would more likely than not reduce the fair value of its goodwill below its carrying value. If the Company determines that significant impairment has occurred, the Company would be required to write-off the impaired portion of goodwill. It is possible that an impairment charge, if any, could have a material adverse effect on our financial condition and results of operations.

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 nine months ended September 30, 2001:

	Three Months Ended September 30, 2001			Nine Months Ended September 30, 2001

Net loss:
Net loss as reported	$	(3,921	)	$	(9,455	)
Goodwill amortization	2,300			6,259
Equity method investment amortization	363			812
Adjusted net loss	$	(1,258	)	$	(2,384	)

Basic and diluted loss per share:
Net loss per share, basic and diluted, as reported	$	(0.21	)	$	(0.50	)
Goodwill amortization	0.12			0.33
Equity method investment amortization	0.02			0.04
Adjusted net loss per share, basic and diluted	$	(0.07	)	$	(0.13	)

Amortization expense of other intangible assets totaled $335 and $141 for the nine months ended September 30, 2002 and 2001, respectively.

2. Principles of Consolidation and Combination

The September 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 nine months ended September 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

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 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 exclude 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

	September 30, 2002			December 31, 2001
Raw materials	$	1,577		$	1,474
Work in process	216			176
Finished goods	4,400			5,611
	6,193			7,261
Allowance for excess and obsolescence	(1,128		)	(1,442		)
Net inventory	$	5,065		$	5,819

5. Loss Per Share

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2002			2001			2002			2001
Numerator:
Net loss	$	(945	)	$	(3,921	)	$	(24,954	)	$	(9,455	)
Denominator:
Denominator for basic loss per share -
Weighted-average shares	26,439			18,750			23,910			18,750
Denominator for diluted loss per share(1)	26,439			18,750			23,910			18,750
Basic and diluted loss per share:	$	(0.04	)	$	(0.21	)	$	(1.04	)	$	(0.50	)

(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 September 30, 2002	Nine Months Ended September 30, 2002
Employee stock options	7,817	7,817
Warrants	1,289	1,289
	9,106	9,106

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 Systems 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 September 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	$	5,887	$	—		$	2,506		$	611		$	—	$	9,004
Service	—		335			—			—			—		335
Total revenue	$	5,887	$	335		$	2,506		$	611		$	—	$	9,339

Income (loss) before provision (benefit) for income taxes, minority interest share of losses and equity in net loss (income) of affiliate	$	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 customers accounted for 36.6% and 19.0% of our Animal Applications revenue two customers accounted for 68.8% and 22.4% of our Digital Angel Systems revenue, and two customers accounted for 29.5% and 26.0% of our Physician Call Center and Other revenue.

Following is the selected segment data as of and for the nine months ended September 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	$	16,314	$	—		$	7,622		$	1,181		$	—		$	25,117
Service	—		1,215			—			—			—			1,215
Total revenue	$	16,314	$	1,215		$	7,622		$	1,181		$	—		$	26,332

Income (loss) before provision (benefit) for income taxes, minority interest share of losses and equity in net loss (income) of affiliate	$	1,251	$	(4,597	)	$	(491	)	$	(413	)	$	(20,487)	(1)	$	(24,737	)

Total assets	$	81,669	$	16,304		$	5,423		$	31,979		$	—		$	135,375

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

In the nine month period ended September 30, 2002, two customers accounted for 16.7% and 14.8% of our Animal Applications revenue, three customers accounted for 61.9%, 12.3% and 10.6% of our Digital Angel Systems revenue and two customers accounted for 26.8% and 25.5% of our Physician Call Center and Other revenue.

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

	Animal Applications			Digital Angel Systems			GPS and Radio Communications			Physician Call Center and Other		Combined
Net revenue from external customers:

Product	$	5,501		$	—		$	2,915		$	—	$	8,416
Service	—			881			—			—		881
Total revenue	$	5,501		$	881		$	2,915		$	—	$	9,297

Loss before provision (benefit) for income taxes, minority interest share of losses and equity in net loss (income) of affiliate	$	(968	)	$	(2,663	)	$	(318	)	$	—	$	(3,949	)

Total assets	$	89,959		$	15,334		$	6,866		$	—	$	112,159

In the three month period ended September 30, 2001, two customers provided 20.5% and 18.8% of our Animal Applications revenue and two customers provided for 43.4% and 14.6% of our Digital Angel Systems revenue.

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

	Animal Applications			Digital Angel Systems			GPS and Radio Communications			Physician Call Center and Other		Combined
Net revenue from external customers:

Product	$	16,761		$	—		$	8,407		$	—	$	25,168
Service	—			2,803			—			—		2,803
Total revenue	$	16,761		$	2,803		$	8,407		$	—	$	27,971

Loss before provision (benefit) for income taxes, minority interest share of losses and equity in net loss (income) of affiliate	$	(4,102	)	$	(4,691	)	$	(543	)	$	—	$	(9,336	)

Total assets	$	89,959		$	15,334		$	6,866		$	—	$	112,159

In the nine month period ended September 30, 2001, two customers provided 18.1% and 15.0% of our Animal Applications revenue and three customers provided 32.4%, 18.7% and 18.4% of our Digital Angel Systems revenue.

7. Acquisitions

The following describes the acquisitions by the Company during the nine month period ended September 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	$	31,798	$	3,380	$	28,418	5,218	$	29,976	Provider of medical assistance and technical products and services

On February 27, 2001, ADS acquired 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 $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 through December 31, 2001 was being amortized on a straight-line basis over five years.

On March 27, 2002, DATC (formerly a part of ADS’s AWG) merged with a wholly-owned subsidiary of MAS. For accounting purposes, AWG is treated as the acquirer, and the acquisition of MAS was recorded at fair value under the purchase method of accounting. The excess of purchase price over the fair value of the assets and liabilities of MAS have been recorded as goodwill. Identifiable intangible assets have been recorded based upon preliminary estimates as of the date of the acquisition. Any changes to the preliminary estimates during the allocation period will be reflected as an adjustment to goodwill.

The cost of the March 27, 2002 acquisition consisted of 5.268 million shares of common stock, including 50,000 shares of treasury stock, valued at $25.0 million, options to purchase 1.2 million shares and warrants to purchase 75,000 shares valued at $3.4 million, and acquisition costs of $3.4 million. The valuation of the stock is based on the value of the shares of MAS held by stockholders other than ADS prior to the acquisition. The cost of the acquisition includes all payments according to the acquisition agreement plus costs for investment banking services, legal and accounting services that were direct costs of acquiring these assets. 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.

The results of MAS have been included in the consolidated financial statements since the date of acquisition. Unaudited pro forma results of operations for the three and nine months ended September 30, 2002 and 2001 are included below. Such pro forma information assumes that the above acquisition had occurred

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 September 30,						Nine Months Ended September 30,
	2002			2001			2002			2001
Net operating revenue	$	9,339		$	10,076		$	26,882		$	30,741
Net loss	$	(945	)	$	(4,457	)	$	(26,408	)	$	(10,666	)
Net loss per common share - basic and diluted	$	(0.04	)	$	(0.19	)	$	(0.95	)	$	(0.45	)

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, and 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.

9. Related Party Activity

Prior to the merger, ADS provided certain general and administrative services to the Company including finance, legal, benefits and other services. The costs of these services are included in the Company’s Statements of Operations as management fees and are based on utilization, which management believes to be reasonable. Costs of these services were $0.2 million for the three months ended September 30, 2001, and $0.2 million and $0.6 million for the nine months ended September 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. We continue to be charged by ADS approximately $42,000 a month to support ADS’ research group. Additionally, we are charged by ADS for product liability insurance through September 2002 and directors and officers insurance through June 2003. These transactions resulted in a due to ADS of $0.7 million at September 30, 2002.

ADS acquired Timely Technology Corp., a part of 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.

The Company has executed an exclusive eleven year Distribution and Licensing 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 the maintenance of the Verichip Registry by the Company. The agreement includes a license for the use of the Company’s technology in Verichip’s identified markets. The Company will be the sole manufacturer and supplier to Verichip. Revenue recognized under the Distribution and Licensing Agreement was $62,000 for the nine months ended September 30, 2002.

In connection with certain obligations of ADS, the Company has financial covenants. On September 30, 2002, the debt covenants were amended for the remainder of 2002. The amendment reduced the Company’s current assets to current liabilities ratio and Minimum Cumulative Modified EBITDA requirements for the quarters ended September 30, 2002 and December 31, 2002. The Company was in compliance with the amended debt covenants on September 30, 2002. Minimum Cumulative Modified 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. The debt covenants, as amended on September 30, 2002, are as follows:

COVENANT	COVENANTS REQUIREMENT
Current Assets to Current Liabilities	September 30, 2002	1.05:1
	December 31, 2002	1.09:1

Minimum Cumulative Modified EBITDA	September 30, 2002	$	0
	December 31, 2002	$	1,001,000

10. Investment in Affiliates

The change in the Company’s investment in 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 September 30, 2002	$	256

11. Option Grant

The Company adopted the Amended and Restated Digital Angel Corporation Transition Stock Option Plan which, as amended, provides for 11,195,312 shares of common stock for which options and other awards may be granted.

On June 27, 2002, the Company's Board of Directors granted options to purchase 3,910,000 shares to officers, employees and directors of the Company. The options have an exercise price of $3.39, the market price of the Company’s common stock on the date of grant, and expire in ten years. Options to purchase 3,000,000 shares vest one year from the date of grant, and the remaining options

vest one-third annually, beginning 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 at least two-thirds of the Company's stockholders. Approval of the grant was obtained on August 29, 2002. In addition, the grant of the options must be approved by the Trust, which approval the Company obtained.

12. Subsequent Events

On October 30, 2002, we signed a credit and security agreement and related agreements with Wells Fargo Business Credit, Inc. that, among other things, permit us to borrow up to $5,000,000 from Wells Fargo Business Credit from time to time under the terms of the credit and security agreement. Amounts borrowed under the credit facility are general obligations of the Company secured by a first priority lien on substantially all of the Company’s assets, including our accounts receivable and our patents and other intellectual property relating to the Digital Angel™ product. The outstanding principal balance of the credit facility bears interest at an annual rate equal to the rate of interest publicly announced from time to time by Wells Fargo Bank National Association as its “prime rate” plus three percentage points. However, the credit and security agreement requires that the total amount of interest paid to Wells Fargo Business Credit per year must be at least $120,000. The credit facility will expire on October 30, 2005, at which time the entire outstanding balance of the credit facility will become due and payable.

The credit and security agreement requires us to meet certain financial covenants, including a monthly minimum book net worth and monthly minimum earnings before taxes, and it limits our capital expenditures during 2003. Any breach of the financial covenants by us will constitute an event of default under the credit and security agreement. The credit and security agreement also provides that any change of control of the Company will be an event of default under the credit and security agreement. As defined in the credit and security agreement, a change of control includes the future acquisition by any person or group of persons of more than 25% of the voting power of all classes of our common stock. If ADS defaults under the IBM credit agreement, the Trust will be obligated, upon the request of IBM Credit Corporation, to sell all or a portion of our common stock held by the Trust. If such sales by the Trust result in a person or group of persons owning, in the aggregate, 25% or more of our common stock, such sales will be deemed to constitute an event of default under the credit and security agreement.

On November 1, 2002 we filed a Registration Statement on Form S-1 with the Securities and Exchange Commission. The Registration Statement is for the sale of up to 3,000,000 shares of our common stock and the sale by certain of our existing stockholders of up to 22,348,720 shares of their common stock of the Company. The existing stockholders’ 22,348,720 shares are being registered to permit the stockholders to sell their shares of the Company’s common stock from time to time in the public market. The Company will not receive any proceeds from the sale of the common stock by the selling stockholders. The Registration Statement on Form S-1 is subject to review by the Securities and Exchange Commission.

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 Digital Angel Corporation and its three subsidiaries – Digital Angel Technology Corporation (“DATC”), Timely Technology Corp. and Signature Industries, Limited. These three subsidiaries were known as the Advanced Wireless Group (“AWG”). DATC is engaged in the business of developing and bringing to market proprietary technologies used to identify, locate and monitor people, animals and objects. DATC 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 DATC 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.

RESULTS OF OPERATIONS

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2002		2001		2002		2001
	%		%		%		%
Product revenue	96.4		90.5		95.4		90.0
Service revenue	3.6		9.5		4.6		10.0
Total net revenue	100.0		100.0		100.0		100.0
Cost of products sold	50.1		56.5		52.5		54.4
Cost of services sold	2.8		6.5		2.9		5.8
Total cost of products and services sold	52.9		63.0		55.4		60.2
Gross profit	47.1		37.0		44.6		39.8
Selling, general and administrative expenses	50.2		61.0		122.1		56.6
Management fees - Applied Digital Solutions, Inc.	0.0		2.0		0.7		2.0
Research and development expenses	6.6		14.3		8.2		13.4
Interest income	0.0		0.0		0.0		(0.1	)
Interest expense	0.8		2.2		7.6		1.3
Loss before provision (benefit) for income taxes, minority interest share of losses and equity in net loss (income) of affiliate	(10.5	)	(42.5	)	(94.0	)	(33.4	)
Provision (benefit) for income taxes	0.0		(0.6	)	0.0		0.2
Loss before minority interest share of losses and equity in net loss (income) of affiliate	(10.5	)	(41.9	)	(94.0	)	(33.6	)
Minority interest share of losses	(0.4	)	(0.3	)	(0.3	)	(0.2	)
Equity in net loss (income) of affiliate	0.0		0.5		1.1		0.4
Net loss	(10.1	)	(42.1	)	(94.8	)	(33.8	)

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

Revenue

Revenue from operations for the three months ended September 30, 2002 remained constant at $9.3 million when compared to the three months ended September 30, 2001.

Revenue for each of the operating segments was:

	Three Months Ended September 30, 2002		Three Months Ended September 30, 2001
Animal Applications	$	5,887	$	5,501
Digital Angel Systems	335		881
GPS and Radio Communications	2,506		2,915
Physician Call Center and Other	611		—
Total	$	9,339	$	9,297

The Animal Applications segment’s revenue increased $0.4 million, or 7.0%, in the three months ended September 30, 2002 compared to the three month period ended September 30, 2001. The increase is due primarily to sales of transponders to the fisheries industry customers.

The Digital Angel Systems segment’s revenue decreased $0.5 million, or 62.0%, in the three month period ended September 30, 2002 compared to the three month period ended September 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 $0.4 million, or 14.0%, in the three month period ended September 30, 2002 compared to three month period ended September 30, 2001 primarily as a result of order fluctuations.

Physician Call Center and Other segment’s revenue was $0.6 million in the three month period ended September 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 September 30, 2002 was $4.4 million, an increase of $1.0 million, or 27.7%, compared to $3.4 million in the three month period ended September 30, 2001. As a percentage of revenue, the gross profit margin was 47.1% and 37.0% for the three months ended September 30, 2002 and 2001, respectively.

Gross profit from operations for each operating segment was:

	Three Months Ended September 30, 2002		Three Months Ended September 30, 2001
Animal Applications	$	2,828	$	1,976
Digital Angel Systems	71		282
GPS and Radio Communications	1,251		1,185
Physician Call Center and Other	245		—
Total	$	4,395	$	3,443

Gross profit margin from operations for each operating segment was:

	Three Months Ended September 30, 2002	Three Months Ended September 30, 2001
	%	%
Animal Applications	48.0	35.9
Digital Angel Systems	21.2	32.0
GPS and Radio Communications	49.9	40.7
Physician Call Center and Other	40.1	—
Total	47.1	37.0

The Animal Applications segment’s gross profit increased $0.9 million in the three month period ended September 30, 2002 compared to the three months ended September 30, 2001 due to the previously mentioned sales increase. The gross margin percentage increased to 48.0% in the three month period ended September 30, 2002 as compared to 35.9% in the three month period ended September 30, 2001 due to higher margin product mix.

The Digital Angel Systems segment’s gross profit decreased $0.2 million, or 74.8 %, in the three month period ended September 30, 2002 as compared to the three month period ended September 30, 2001. Margins decreased to 21.2% in the three month period ended September 30, 2002 from 32.0% in the three month period ended September 30, 2001. The gross profit decrease was primarily due to a shift to lower margin contracts.

The GPS and Radio Communications segment’s gross profit increased $0.07 million, or 5.6%, in the three month period ended September 30, 2002 as compared to the three month period ended September 30, 2001. The gross margin percentage increased to 49.9% in the three month period ended September 30, 2002 as compared to 40.7% in the three month period ended September 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 September 30, 2002. The gross margin was 40.1% in the three month period ended September 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 decreased $1.0 million, or 17.3%, in the three month period ended September 30, 2002 as compared to the three month period ended September 30, 2001. As a percentage of revenue, selling, general and administrative expenses were 50.2% and 61.0% for the three months ended September 30, 2002 and 2001, respectively.

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

	Three Months Ended September 30, 2002		Three Months Ended September 30, 2001
Animal Applications	$	1,746	$	3,181
Digital Angel Systems	1,219		1,011
GPS and Radio Communications	1,309		1,480
Physician Call Center and Other	414		—
Total	$	4,688	$	5,672

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

	Three Months Ended September 30, 2002	Three Months Ended September 30, 2001
	%	%
Animal Applications	29.7	57.8
Digital Angel Systems	363.9	114.8
GPS and Radio Communications	52.2	50.8
Physician Call Center and Other	67.8	—
Total	50.2	61.0

The Animal Applications segment’s selling, general and administrative expenses decreased $1.4 million in the three month period ended September 30, 2002 as compared to the three month period ended September 30, 2001 and as a percentage of revenue decreased to 29.7% from 57.8% in the same respective periods.

The decrease is 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 September 30, 2002.

The Digital Angel Systems segment’s selling, general and administrative expenses of $1.2 million increased $0.2 million in the three month period ended September 30, 2002 as compared $1.0 million in the three month period ended September 30, 2001. Selling, general and administrative expenses increased as a percentage of revenue to 363.9% in the three month period ended September 30, 2002 compared to 114.8% in the three month period ended September 30, 2001 primarily as a result of software amortization expenses.

The GPS and Radio Communications segment’s selling, general and administrative expenses decreased $0.2 million in the three month period ended September 30, 2002 as compared to the three month period ended September 30, 2001 primarily due to administrative cost reductions. As a percentage of revenue, selling, general and administrative expenses increased to 52.2% in the three month period ended September 30, 2002 from 50.8% in the three month period ended September 30, 2001.

The Physician Call Center segment’s selling, general and administrative expenses were $0.4 million in the three month period ended September 30, 2002. As a percentage of revenue, selling, general and administrative expenses were 67.8% in the three month period ended September 30, 2002. This segment became part of the Company on March 27, 2002.

Management Fees – Applied Digital Solutions, Inc.

Management fees charged by ADS amounted to $0.2 million for the three months ended September 30, 2001. These fees were for general and administrative services performed for us. After March 27, 2002, we no longer pay a management fee to ADS.

Research and Development Expense

Research and development expense from operations was $0.6 million in the three month period ended September 30, 2002, a decrease of $0.7 million, or 53.9%, from $1.3 million for the three month period ended September 30, 2001. As a percentage of revenue, research and development expense was 6.6% and 14.3% for the three months ended September 30, 2002 and 2001, respectively. Included in research and development expense are charges by ADS of approximately $42,000 a month to support ADS’ research group.

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

	Three Months Ended September 30, 2002		Three Months Ended September 30, 2001
Animal Applications	$	186	$	218
Digital Angel Systems	294		1,114
GPS and Radio Communications	134		—
Physician Call Center and Other	—		—
Total	$	614	$	1,332

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

Interest Expense

Interest expense was $0.07 million and $0.2 million for the three months period ended September 30, 2002 and 2001, respectively.

Income Taxes

The Company and AWG had effective income tax rates of 0.0% and a (1.3)% for the three month period ended September 30, 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. The differences 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.

Nine Months Ended September 30, 2002 Compared to the Nine Months Ended September 30, 2001

Revenue

Revenue from operations for the nine months ended September 30, 2002 was $26.3 million, a decrease of $1.6 million, or 5.9%, from $28.0 million in the nine months ended September 30, 2001.

Revenue for each of the operating segments was:

	Nine Months Ended September 30, 2002		Nine Months Ended September 30, 2001
Animal Applications	$	16,314	$	16,761
Digital Angel Systems	1,215		2,803
GPS and Radio Communications	7,622		8,407
Physician Call Center and Other	1,181		—
Total	$	26,332	$	27,971

The Animal Applications segment’s revenue decreased $0.4 million, or 2.7%, in the nine month period ended September 30, 2002 as compared to the nine month period ended September 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 $1.6 million, or 56.7%, in the nine month period ended September 30, 2002 as compared to the nine month period ended September 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 $0.8 million, or 9.3%, in the nine month period ended September 30, 2002 as compared to the nine month period ended September 30, 2001 primarily as a result of order fluctuations.

The Physician Call Center and Other revenue was $1.2 million for the nine months ended September 30, 2002. This segment became part of the Company on March 27, 2002.

Gross Profit and Gross Profit Margin

Gross profit for the nine months ended September 30, 2002 was $11.8 million, a decrease of $0.6 million, or 5.6%, from $11.1 million in the nine months ended September 30, 2001. As a percentage of revenue, the gross profit margin was 44.6 % and 39.8% for the nine months ended September 30, 2002 and 2001, respectively.

Gross profit from operations for each operating segment was:

	Nine Months Ended September 30, 2002		Nine Months Ended September 30, 2001
Animal Applications	$	6,973	$	6,147
Digital Angel Systems	453		1,176
GPS and Radio Communications	3,871		3,805
Physician Call Center and Other	458		—
Total	$	11,755	$	11,128

Gross profit margin from operations for each operating segment was:

	Nine Months Ended September 30, 2002	Nine Months Ended September 30, 2001
	%	%
Animal Applications	42.7	36.7
Digital Angel Systems	37.3	42.0
GPS and Radio Communications	50.8	45.3
Physician Call Center and Other	38.8	—
Total	44.6	39.8

The Animal Applications segment’s gross profit of $7.0 million in the nine months ended September 30, 2002 increased $0.8 million compared to $6.2 million in the nine month period ended September 30, 2001. The gross profit margin increased to 42.7% in the nine month period ended September 30, 2002 as compared to 36.7% in the nine months ended September 30, 2001 due to a more favorable product mix.

The Digital Angel Systems segment’s gross profit decreased $0.7 million, or 61.5%, in the nine months ended September 30, 2002 as compared to the nine months ended September 30, 2001. Margins decreased to 37.3% in the nine months ended September 30, 2002 from 42.0% in the nine months ended September 30, 2001. The gross profit decrease was primarily due to the sales decline. The margin percentage declined due to the retention of personnel as resources were shifted to support the Digital Angel^TM products.

The GPS and Radio Communications segment’s gross profit increased $0.07 million or 1.7% in the nine months ended September 30, 2002 as compared to the nine months ended September 30, 2001. The gross margin percentage increased to 50.8% in the nine months ended September 30, 2002 compared to 45.3% in the nine months ended September 30, 2001 due to a favorable shift in the product mix.

The Physician Call Center and Other segment’s gross profit was $0.5 million for the nine months ended September 30, 2002. The gross margin was 38.8% in the nine months ended September 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 $16.3 million, or 103.1%, in the nine months ended September 30, 2002 as compared to the nine months ended September 30, 2001. This increase was caused primarily by an $18.7 million charge arising from the remeasurement of options in connection with the merger. Pursuant to the terms of the merger agreement, options to acquire shares of DATC 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.

Offsetting the non-cash compensation expense is the decrease in amortization expense 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 first nine months of 2002.

As a percentage of revenue, selling, general and administrative expenses were 122.1% and 56.6% for the nine months ended September 30, 2002 and 2001, respectively.

Selling, general and administrative expenses for each of the operating segments excluding the $18.7 million charge were:

	Nine Months Ended September 30, 2002		Nine Months Ended September 30, 2001
Animal Applications	$	4,595	$	9,413
Digital Angel Systems	4,046		2,085
GPS and Radio Communications	3,953		4,325
Physician Call Center and Other	865		—
Total	$	13,459	$	15,823

Selling, general and administrative expenses as a percentage of revenue for each of the operating segments excluding the $18.7 million charge were:

	Nine Months Ended September 30, 2002	Nine Months Ended September 30, 2001
	%	%
Animal Applications	28.2	56.2
Digital Angel Systems	333.0	74.4
GPS and Radio Communications	51.9	51.4
Physician Call Center and Other	73.2	—
Total	51.1	56.6

The Animal Applications segment’s selling, general and administrative expenses decreased $4.8 million in the nine months ended September 30, 2002 compared to the nine months September 30, 2001 and as a percentage of revenue decreased to 28.2% from 56.2% in the same respective periods. The decrease is due primarily to the adoption of FAS 142, which took effect on 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. The decrease was offset by increased legal, accounting, and investor relations expenses.

The Digital Angel Systems segment’s selling, general and administrative expenses increased $2.0 million in the nine months ended September 30, 2002 as compared to the nine months ended September 30, 2001. Selling, general and administrative expenses increased as a percentage of revenue to 333.0% in the nine months ended September 30, 2002 compared to 74.4% in the nine months ended September 30, 2001 as a result of the scale up of marketing personnel, advertising and media programs, and infrastructure to support the introduction of Digital Angel^TM products.

The GPS and Radio Communications segment’s selling, general and administrative expenses decreased $0.4 million in the nine mo