APPLIED DIGITAL SOLUTIONS INC - 10-Q Quarterly Report

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	For The Nine Months
	Ended September 30,
		2004			2003
Cash Flows From Operating Activities
Net income (loss)	$	(3,975	)	$	28,266

Adjustments to reconcile net income (loss) to net cash
used in operating activities:
(Income) loss from discontinued operations		(1,596	)		988
Non-cash compensation and administrative expenses		(391	)		16,679
Issuance of stock for services		—			112
Depreciation and amortization		1,961			1,438
Non-cash interest expense (reduction)		(971	)		1,878
Deferred income taxes		—			(309	)
Impairment of notes receivable		371			61
Gain on forgiveness of debt		—			(69,968	)
Net loss on capital transactions of subsidiary		1,805			324
(Gain) loss attributable to changes in minority interest as a result
of capital transactions of subsidiary		(1,593	)		577
Minority interest		(808	)		(1,498	)
Loss on sale of equipment		79			15
Change in assets and liabilities:
Decrease in restricted cash		115			—
(Increase) decrease in accounts receivable		(1,114	)		1,282
Increase in inventories		(2,953	)		(3,380	)
Decrease in other current assets		855			1,020
(Decrease) increase in accounts payable, accrued expenses
and other long-term liabilities		(175	)		17,716
Net cash used in discontinued operations		(1,253	)		(168	)
Net Cash Used In Operating Activities		(9,643	)		(4,967	)

Cash Flows From Investing Activities
Decrease in notes receivable		683			1,543
Increase in other assets		(731	)		(243	)
Proceeds from sale of property and equipment		34			11
Payments for property and equipment		(1,120	)		(960	)
Payments for costs of business acquisition, net of cash acquired		(46	)		—
Purchase of shares of Digital Angel Corporation		(455	)		—
Net cash provided by (used in) discontinued operations		1,730			(20	)
Net Cash Provided By Investing Activities		95			331

Cash Flows From Financing Activities
Net amounts borrowed (repaid) on notes payable		180			(27,641	)
Proceeds from long-term debt		—			2,027
Payments on long-term debt		(843	)		(150	)
Proceeds from issuance of debentures		—			10,035
Other financing costs		(101	)		(554	)
Issuance of common shares		5,702			20,752
Stock issuance costs		(318	)		(600	)
Proceeds from subsidiary issuance of common stock		3,789			247
Net cash used in discontinued operations		(910	)		(27	)
Net Cash Provided By Financing Activities		7,499			4,089

Net Decrease In Cash And Cash Equivalents		(2,049	)		(547	)

Effect Of Exchange Rate Changes On Cash And Cash Equivalents		(4	)		—

Cash And Cash Equivalents - Beginning Of Period		10,161			5,809

Cash And Cash Equivalents - End Of Period	$	8,108		$	5,262

See the accompanying notes to condensed consolidated financial statements.


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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

We develop innovative security products for consumer, commercial and government sectors worldwide. Our unique and often proprietary products provide security for people, animals, food chains, government/military assets, and commercial assets. Included in this diverse product line are applications for radio frequency identification systems, commonly known as RFID, end-to-end food safety systems, global positioning systems, referred to as GPS, satellite communications, and secure telecomm infrastructure. Our adage is Security Through Innovation^TM. We have developed a product, for which we recently received Food and Drug Administration (“FDA”) approval, to provide a secure tamper proof means of managing medical information. Two of our mature brands are: Home Again~~TM and SARBE^TM, and our newer brands include VeriChip^TM, Bio Thermo^TM and Digital Angel^TM. We plan to grow our suite of products through acquisitions and in-house development.~~

The accompanying unaudited Condensed Consolidated Financial Statements of Applied Digital Solutions, Inc. (doing business as Applied Digital) (the “Company”) as of September 30, 2004, and December 31, 2003, (the December 31, 2003 financial information included herein comes from the audited financial statements included in our 2003 Annual Report on Form 10-K, as amended) and for the three and nine-months ended September 30, 2004 and 2003, have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S.) 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 ge nerally accepted in the U.S. for complete financial statements. In the opinion of management, all adjustments (including normal recurring adjustments) considered necessary to present fairly the Condensed Consolidated Financial Statements have been made.

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of sales and expenses during the reporting period. Actual results could differ from those estimates.

During the second quarter of 2004, we made a decision to sell the business assets of Medical Systems, as more fully discussed in Notes 7 and 8. As a result, its operations are now included as part of our Discontinued Operations for all periods presented. In addition, certain items in the 2003 periods have been reclassified to conform to the presentation in the current periods.

The Condensed Consolidated Statements of Operations for the three and nine-months ended September 30, 2004 and 2003, are not necessarily indicative of the results that may be expected for the entire year. These statements should be read in conjunction with the consolidated financial statements and related notes thereto included in our Annual Report on Form 10-K, as amended, for the year ended December 31, 2003.

We incurred a net loss of approximately $2.5 million for the three-months ended September 30, 2004, as compared to a net loss of approximately $1.2 million for the three-months ended September 30, 2003. Included in the net loss for the three-months ended September 30, 2003, was a one time reversal of approximately $3.9 million of severance expense associated with the termination of certain officers and director during 2003. Excluding the effects of a one-time gain on the forgiveness of debt of approximately $70.0 million recorded

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

during the nine-months ended September 30 2003, as a result of the payment in full of certain debt obligations, our operating results also improved significantly during the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003. We incurred a net loss of approximately $4.0 million for the nine-months ended September 30, 2004, as compared to a net loss of approximately $41.7 million, for the nine-months ended September 30, 2003, after adjusting for the gain on foregiveness of debt. Also included in the results for the nine-months ended September 30, 2003, was approximately $18.1 million of severance expense associated with the termination of certain officers and director during 2003. In addition, the loss for the three and nine-months ended September 30, 2004, included a reversal o f approximately $0.3 million and $1.3 million of interest expense, respectively, as a result of the revaluation of certain common stock warrants, which are settleable in shares of the Digital Angel Corporation common stock owned by us. Digital Angel Corporation is one of our majority-owned subsidiaries, as more fully discussed in Note 2. Our operating activities used cash of $9.6 million and $5.0 million during the nine-months ended September 30, 2004 and 2003, respectively. In the past, we have suffered losses and have not generated positive cash flows from operations. As of September 30, 2004, we had an accumulated deficit of approximately $417.9 million. Digital Angel Corporation has suffered losses and has not generated positive cash flows from operations. As presented in Note 6, Digital Angel Corporation incurred losses during the three and nine-months ended September 30, 2004 and 2003. In addition, its operating activities used cash of approximately $3.7 million and approximately $3.5 million during th e nine-months ended September 30, 2004 and 2003, respectively.

Reverse Stock Split

On September 10, 2003, our shareholders approved the granting of discretionary authority to our Board of Directors for a period of twelve months to effect a reverse stock split not to exceed a ratio of 1-for-25, or to determine not to proceed with a reverse stock split. On March 12, 2004, our Board of Directors authorized a 1-for-10 reverse stock split, which was effectuated on April 5, 2004. As a result of the reverse stock split, the par value of our common stock increased from $0.001 to $0.01 per share. In conjunction with the reverse stock split, our Board of Directors authorized a reduction in the number of authorized shares of our common stock from 560.0 million to 125.0 million. All share information provided in this Form 10-Q has been adjusted to reflect the reverse stock split.

Revenue Recognition for Acquired Subsidiary

On January 22, 2004, we acquired OuterLink Corporation, referred to as OuterLink. OuterLink earns revenue from location and communication services, providing for service on a month-to month basis and from the sale of related products to customers (communication terminals and software). The location and communication services are only available through use of such products, which have no alternative use. Accordingly, service revenue is recognized as the services are performed. Product revenue, for which title and risk of loss transfers to the customer on shipment, is deferred upon shipment and is recognized ratably over the estimated customer service period, which is currently 30 months.

Stock-Based Compensation

As permitted under Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation (“FAS 123”), we have elected to continue to follow the guidance of APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB Opinion No. 25 (“FIN 44”), in accounting for our stock-based employee compensation arrangements. Accordingly, no compensation cost is recognized for any of our fixed stock options granted to employees when the exercise price of each option equals or exceeds the fair value of the underlying common stock as of the grant date for each stock option. Changes in the terms of

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

stock option grants, such as extensions of the vesting period or changes in the exercise price, result in variable accounting in accordance with APB 25. Accordingly, compensation expense is measured in accordance with APB 25 and recognized over the vesting period. If the modified grant is fully vested, any additional compensation costs are recognized immediately. We account for equity instruments issued to non-employees in accordance with the provisions of FAS 123.

As of September 30, 2004, we had five stock-based employee compensation plans and our subsidiaries collectively had six stock-based employee compensation plans. As permitted under SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure (“FAS 148”), which amended FAS 123, we have elected to continue to follow the intrinsic value method in accounting for our and our subsidiaries’ stock-based employee compensation plans as defined by APB 25 and FIN 44.

The following table illustrates the effect on net (loss) income and (loss) income per share if we had applied the fair value recognition provisions of FAS 123 to employee stock options granted under our stock-based employee compensation plans and the plans of our subsidiaries:

Three-Months Ended

September 30,

Three-Months Ended

September 30,

Nine-Months Ended

September 30,

Nine-Months Ended

September 30,

2004

2003

2004

2003

(in thousands, except per share amounts)

Net (loss) income, as reported

$

(2,480

)

$

(1,160

)

$

(3,975

)

$

28,266

Add back (deduct): Total stock-based employee compensation expense

determined under APB 25 for all awards, net of related tax effects⁽¹⁾

(24

)

(460

)

(382

)

(1,459

)

Deduct: Total stock-based employee compensation expense determined

under fair value based method for all awards, net of related tax effects ⁽²⁾

(2,017

)

(1,210

)

(5,483

)

(4,089

)

Pro forma net (loss) income

$

(4,521

)

$

(2,830

)

$

(9,840

)

$

22,718

(Loss) income per share:

Basic—as reported

$

(0.05

)

$

(0.03

)

$

(0.08

)

$

0.90

Diluted—as reported

$

(0.05

)

$

(0.03

)

$

(0.08

)

$

0.89

Basic—pro forma

$

(0.09

)

$

(0.08

)

$

(0.20

)

$

0.72

Diluted—pro forma

$

(0.09

)

$

(0.08

)

$

(0.20

)

$

0.72

(1) For the three-months ended September 30, 2004 and 2003, amounts do not include any compensation expense associated with subsidiary options. For the nine-months ended September 30, 2004 and 2003, amounts include $21 thousand and $19 thousand of compensation expense, respectively, associated with subsidiary options.

(2) For the three-months ended September 30, 2004 and 2003, amounts include $1.4 million and $1.1 million of compensation expense, respectively, associated with subsidiary options. For the nine-months ended September 30, 2004 and 2003, amounts include $4.0 million and $3.7 million of compensation expense, respectively, associated with subsidiary options.

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The weighted-average per share fair value of options granted during the three-months ended September 30, 2004, under our plans was $1.73. (We did not grant options during the three-months ended September 30, 2003). The weighted-average per share fair value of options granted during the nine-months ended September 30, 2004 and 2003, under our plans was $1.78 and $2.60, respectively. The fair value of the options granted was estimated on the grant date using the Black-Scholes option-pricing model based on the following weighted-average assumptions:

Three-Months Ended September 30, 2004

Three-Months Ended September 30, 2003

Nine-Months Ended September 30, 2004

Nine-Months Ended September 30, 2003

Estimated option life

8 years

—

8 years

5.5 years

Risk free interest rate

4.07

%

—

4.03

%

1.51

%

Expected volatility

69.00

%

—

69.00

%

76.00

%

Expected dividend yield

0.00

%

—

0.00

%

0.00

%

2. Principles of Consolidation

The financial statements include our accounts and the accounts of our wholly-owned and majority-owned subsidiaries, including our 68.05% owned subsidiary, Digital Angel Corporation (AMEX:DOC), and our 52.5% owned subsidiary, InfoTech USA, Inc. (OTC:IFTH). The minority interest represents outstanding voting stock of the subsidiaries not owned by us. All significant intercompany accounts and transactions have been eliminated in consolidation.

Our majority-owned subsidiary InfoTech USA, Inc. operates on a fiscal year ending September 30. InfoTech USA, Inc.’s results of operations have been reflected in the Condensed Consolidated Financial Statements on a calendar year basis.

3. Inventory

The components of inventories, stated at the lower of cost or market with cost determined on the first-in first-out (FIFO) method, are as follows:

September 30,

2004

December 31,

2003

(in thousands)

Raw materials

$

3,264

$

1,982

Work in process

5,885

2,723

Finished goods

5,658

6,598

14,807

11,303

Allowance for excess and obsolescence

(2,015

)

(1,859

)

$

12,792

$

9,444

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

4. Financing Agreements

Securities Purchase Agreement with Institutional Investor

On April 16, 2004, we sold 2.0 million shares, referred to as the Shares, of our common stock, par value $0.01 per share, in a private placement to an institutional investor, Satellite Strategic Finance Associates, LLC, referred to as SSFA, under the terms of a Securities Purchase Agreement, referred to as the SPA. The SPA provided SSFA with a Series A Warrant, which was exercisable into an additional 1.0 million shares, referred to as the Series A Warrant Shares, of our common stock, and a Series B Warrant, which is exercisable into 0.7 million shares, referred to as the Series B Warrant Shares, of our common stock. The purchase price for the Shares was $2.749 per share and was based on the average daily volume weighted-average price of our common stock for the period of ten trading days ending on and including April 13, 2004. The exercise price of the Series A Warrant Shares was $2.749 and the exercise price of the Series B Warrant Shares is $3.299. The Series A Warrant, initially expiring on July 11, 2004, was extended until October 11, 2004, as discussed below. The Series B Warrant may be exercised at any time beginning on the one-year anniversary of the issue date and expiring on the sixth anniversary of such issue date. The proceeds from the sale were allocated on a relative fair value basis as follows:

(in thousands)

Shares of common stock
$

4,240

Series A Warrant
378

Series B Warrant
880

      Subtotal
5,498

Less costs and expenses
(180

)

      Net proceeds
$

5,318

As a result of the extension of the Series A Warrant on July 11, 2004, during the three-months ended September 30, 2004, we recorded $0.2 million of deferred costs, which represented the additional fair value of the Series A Warrant as a result of the extension. The Series A Warrant was exercised on October 11, 2004, and accordingly, the additional fair value will be charged to additional paid-in-capital during the fourth quarter of 2004. Proceeds from the exercise of the Series A Warrant totaled $2.7 million.

The offer and sale of our securities to SSFA was exempt from the registration requirements of the Securities Act of 1933 pursuant to Regulation D or Section 4(2) of the Securities Act of 1933. Pursuant to a Registration Rights Agreement, we registered the shares on a registration statement, which became effective on May 12, 2004.

In addition, on October 21, 2004, we sold 2.5 million shares of our common stock to SSFA under a second Securities Purchase Agreement, referred to as the SSPA. The purchase price for these shares was based on the average daily volume weighted-average market price of our common stock for the period of five trading days beginning on Wednesday, October 13, 2004, and ending on and including Tuesday, October 19, 2004, which average was $3.61 per share. The SSPA provides SSFA with a Series C Warrant, which is exercisable into an additional 1.5 million shares (the “Series C Warrant Shares”) of our common stock at an exercise price equal to 120% of the purchase price of the 2.5 million shares. The Series C Warrant may be exercised at any time, at SSFA’s option, until the 150th day following the effective date of the registration statement registering the Series C Warrant Shares. The SSPA also provides for a Series D Warrant, which is exercisable into 666,667 shares (the “Series D Warrant Shares”) of our common stock at

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

an exercise price equal to 140% of the purchase price of the 2.5 million shares. The Series D Warrant may be exercised at any time beginning on the one-year anniversary of the issue date and expiring on the sixth anniversary of such issue date. The exercise price of the Series C Warrant Shares and the Series D Warrant Shares is $4.33 and $5.05 per share, respectively. The proceeds from the sale of the 2.5 million shares were approximately $9.0 million. Pursuant to a Registration Rights Agreement, we are obligated to register the common stock and the shares of common stock underlying the warrants.

Wells Fargo Credit Facility and IBM Credit Wholesale Agreement

On June 30, 2004, InfoTech USA, Inc. entered into a credit agreement and credit facility, referred to as the Credit Facility, with Wells Fargo Business Credit, Inc., referred to as Wells Fargo, providing for up to $4.0 million in borrowings. Amounts borrowed under the Credit Facility bear interest at Wells Fargo’s prime rate plus 3%. The Credit Facility matures on June 29, 2007, and automatically renews for successive one-year periods thereafter unless terminated by either party. In connection with the execution of the Credit Facility, InfoTech USA, Inc. and IBM Credit LLC, referred to as IBM Credit, replaced a prior agreement for wholesale financing dated as of April 20, 1994, with a new wholesale financing agreement, referred to as the Wholesale Agreement. Under the terms of the Credit Facility, Wells Fargo may, at its election, make advances as requested from time to time in amounts up to an amount equal to the difference between the borrowing base (described below) and the sum of (i) the amount outstanding under the Credit Facility, and (ii) the $0.6 million letter of credit agreement outstanding under the Credit Facility which secures InfoTech USA, Inc.’s obligations to IBM Credit under the Wholesale Agreement. The borrowing base is equal to the lesser of $4.0 million or the amount equal to 85% of (i) eligible accounts receivable, plus (ii) the amount of available funds on deposit at Wells Fargo, and minus (iii) certain specified reserves. As of September 30, 2004, the borrowing base was approximately $1.8 million, the letter of credit was approximately $0.6 million, approximately $0.8 million was outstanding under the Credit Facility, and approximately $0.4 million was available under the Credit Facility.

In connection with the execution of the Credit Agreement, Wells Fargo was paid an origination fee of $40 thousand. Each year Wells Fargo will be paid a facility fee of $15 thousand and an unused line fee at the annual rate of 0.5% of the daily-unused amount under the Credit Facility. Minimum monthly interest is due based on minimum borrowings of $1.5 million. Additional fees are due if the Credit Facility is terminated by Wells Fargo upon default or if InfoTech USA, Inc. terminates the Credit Facility prior to its termination date. Such fees are approximately $0.1 million during the first year, $60 thousand during the second year and $20 thousand each year thereafter.

The Credit Facility requires InfoTech USA, Inc. to maintain certain financial covenants, limits its capital expenditures, and contains other standard covenants including prohibitions on its incurrence of additional debt, its sales of assets and other corporate transactions of InfoTech USA, Inc. without Wells Fargo’s consent.

The obligations under the Credit Facility have been guaranteed and the capital stock of certain of InfoTech USA, Inc.’s subsidiaries has been pledged as collateral under a stock pledge agreement. In addition, certain rights under the loan agreement between InfoTech USA, Inc. and us, which is more fully discussed in Note 12, have been assigned to Wells Fargo under the terms of a collateral agreement. The Credit Facility is further secured by a first priority security interest in substantially all of the assets of InfoTech USA, Inc.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Under the terms of the Wholesale Agreement, IBM Credit may, at its election, advance InfoTech USA, Inc. up to $0.6 million to be used for the purchase of certain computer hardware and software products approved in advance by IBM Credit. Amounts outstanding under the Wholesale Agreement are required to be secured by a $0.6 million irrevocable letter of credit and bear finance charges in an amount to be agreed upon with IBM Credit from time to time. The Wholesale Agreement will remain in effect until terminated by either party upon at least 90 days written notice. As of September 30, 2004, $0.3 million was outstanding under the Wholesale Agreement, which is reflected in our Condensed Consolidated Balance Sheets in accounts payable and accrued expenses.

As of September 30, 2004, InfoTech USA, Inc. may not be in compliance with certain of its financial covenants under its Credit Facility with Wells Fargo. In the event of any such noncompliance, InfoTech USA, Inc. will seek to obtain a waiver. No assurance can be given that such waiver will be granted. If such a waiver is not granted, it could have an adverse effect on InfoTech USA, Inc. and us.

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. (Loss) Earnings Per Share

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

Three-Months Ended

September 30,

Nine-Months Ended

September 30,

2004

2003

2004

2003

Numerator:

    Numerator for basic earnings (loss) per share -

    Net (loss) income from continuing operations

$

(2,752

)

$

(1,037

)

$

(5,571

)

$

29,254

    Net income (loss) from discontinued operations

272

(123

)

1,596

(988

)

    Net (loss) income

$

(2,480

)

$

(1,160

)

$

(3,975

)

$

28,266

    Numerator for diluted (loss) earnings per share -

    Net (loss) income from continuing operations

$

(2,752

)

$

(1,037

)

$

(5,571

)

$

29,254

Add back interest on convertible exchangeable debentures

—

—

—

1,558

Adjusted net (loss) income from continuing operations

(2,752

)

(1,037

)

(5,571

)

30,812

    Net income (loss) from discontinued operations

272

(123

)

1,596

(988

)

    Net (loss) income available to common shareholders

$

(2,480

)

$

(1,160

)

$

(3,975

)

$

29,824

Denominator:

Denominator for basic (loss) earnings per share -

    Weighted-average shares

51,195

35,356

50,003

31,538

    Convertible exchangeable debentures

—

—

—

687

    Stock options

—

—

—

874

    Warrants

—

—

—

363

Denominator for diluted (loss) earnings per share ⁽¹⁾-

    Weighted-average shares

51,195

35,356

50,003

33,462

Basic (loss) earnings per share:

        Continuing operations

$

(0.05

)

$

(0.03

)

$

(0.11

)

$

0.93

        Discontinued operations

—

—

0.03

(0.03

)

Total - Basic

$

(0.05

)

$

(0.03

)

$

(0.08

)

$

0.90

Diluted (loss) earnings per share:

        Continuing operations

$

(0.05

)

$

(0.03

)

$

(0.11

)

$

0.92

        Discontinued operations

—

—

0.03

(0.03

)

Total - Diluted

$

(0.05

)

$

(0.03

)

$

(0.08

)

$

0.89

(1) The weighted-average shares listed below were not included in the computation of diluted loss per share because to do so would have been anti-dilutive for the periods presented:

Three-Months Ended

September 30,

Three-Months Ended

September 30,

Nine-Months Ended

September 30,

2004

2003

2004

Convertible exchangeable debentures

—

2,039

—

Stock options

78

463

159

Warrants

199

377

278

277

2,879

437

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

6. Segment Information

We operate in three business segments: Advanced Technology, Digital Angel Corporation and InfoTech USA, Inc.

Advanced Technology

Our Advanced Technology segment specializes in developing innovative security products including:

·   secure voice, data and video telecommunications networks;

·   implantable microchips and RFID scanners;

·   proprietary software; and

·   a thermo-electric generator.

Our voice, data and video telecommunications networks are sold to various branches of the United States government. Our VeriChip^TM implantable microchip has multiple applications in securing medical information, personal identification, building access, financial transactions and more. The Advanced Technology segment’s customer base includes governmental agencies, commercial operations, and consumers. Through our Advanced Technology segment, we deliver products and services across a multitude of industries, including government, insurance, utilities, security, communications, healthcare and high tech. As of September 30, 2004, we ha ve recorded minimal revenues associated with our VeriChip^TM product, and we have not recorded any revenues from the sale of our Thermo Life^TM product.

Digital Angel Corporation

Our Digital Angel Corporation segment’s proprietary products provide security for companion pets, food chains, government/military assets and commercial assets. Through this segment, we provide electronic and visual identification devices for companion pets, livestock, laboratory animals, fish and wildlife markets worldwide. The tracking of cattle and hogs are crucial in order to provide security both for asset management and for disease control and food safety.

Our principal products/technologies are:

·   visual ear tags for livestock;

·   electronic implantable microchips and RFID scanners for the companion pet, fish, livestock and wildlife industries, including our Home Again^TM and Bio-Thermo^TM product brands;

·   GPS enabled search and rescue equipment and intelligent communications products and services for telemetry, mobile data and radio communications applications, including our SARBE^TM brand, which serve commercial and military markets;

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

·   GPS and geosynchronous satellite tracking systems, including tracking software systems for mapping and messaging associated with the security of high-value assets; and

·   intrinsically safe sounders (horn alarms) for industrial use and other electronic components.

InfoTech USA, Inc.

Our InfoTech USA, Inc. segment is a full service provider of Information Technology, or IT, products and services. Through this segment we provide IT consulting, networking, procurement, deployment, integration, migration and network security services. We also provide on-going system and networking maintenance services. During 2003 and 2004, we continued our strategy of moving away from a product-driven systems integration business model to a customer-oriented IT strategy-based business model. We have further developed our deliverable IT products and services by adding new consulting and service offerings, and increasing the number of strategic alliances with outside technical services firms and manufacturers of high-end IT products. Our principal products and services in this segment are sales of computer hardware and computer services, which consist of IT consulting, installation, project management, design and deployment, computer network security and maintenance, and other professional services.

All Other

Business units that were closed or sold during 2001 and 2002 are reported in “All Other.”

“Corporate/Eliminations”

Our “Corporate/Eliminations” category includes all amounts recognized upon consolidation of our subsidiaries such as the elimination of intersegment revenues, expenses, assets and liabilities. “Corporate/Eliminations” also includes certain interest income/expense and other expenses associated with corporate activities and functions. Included in “Corporate/Eliminations” for the nine-months ended September 30, 2003, is a gain on the forgiveness of debt obligations to IBM Credit of approximately $70.0 million, and a severance charge of approximately $17.9 million associated with the termination of certain former executive officers and directors. (An additional $0.2 million of severance expenses associated with the terminations is included in the Advanced Technology segment's results for the n ine-months ended September 30, 2003).

Discontinued Operations

Our previously reported Medical Systems operations, certain assets of which were sold during the three and nine-months ended September 30, 2004, and our Intellesale segment and other non-core businesses, are reported as Discontinued Operations, as more fully discussed in Notes 7 and 8.

Accounting Policies

The accounting policies of our segments are the same as those described in the summary of significant accounting policies in our Annual Report on Form 10-K filed for the year-ended December 31, 2003, as amended, except that intersegment sales and transfers are generally accounted for as if the sales or transfers were to third parties at current market prices. It is on this basis that management

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

utilizes the financial information to assist in making internal operating decisions. We evaluate performance based on segment operating income.

Selected Segment Data

Following is the selected segment data as of and for the three-months ended September 30, 2004:

Three-Months Ended September 30, 2004

(in thousands)

Advanced

Technology

Digital Angel

Corporation

InfoTech USA,

Inc.

All Other

“Corporate/

Eliminations”

Consolidated

Net revenue from external customers:

Product

$

10,282

$

10,668

$

2,876

$

—

$

(18

)

$

23,808

Service

2,723

512

683

—

—

3,918

Intersegment revenue - product

—

(18

)

—

—

18

—

Total revenue

$

13,005

$

11,162

$

3,559

$

—

$

—

$

27,726

Income (loss) from continuing operations before taxes, minority interest and loss (gain) attributable to capital transactions of subsidiary

$

(253

)

$

(328

)

$

(249

)

$

(200

)

$

(1,518

)

$

(2,548

)

Total assets

$

43,002

$

77,102

$

9,208

$

2,662

$

(10,088

)

$

121,886

Following is the selected segment data as of and for the three-months ended September 30, 2003:

Three-Months Ended September 30, 2003

(in thousands)

Advanced

Technology

Digital Angel

Corporation

InfoTech USA,

Inc.

All Other

“Corporate/

Eliminations”

Consolidated

Net revenue from external customers:

Product

$

8,514

$

6,693

$

3,419

$

—

$

(18

)

$

18,608

Service

2,737

1,317

806

—

—

4,860

Intersegment revenue - product

—

(18

)

—

—

18

—

Total revenue

$

11,251

$

7,992

$

4,225

$

—

$

—

$

23,468

Income (loss) from continuing operations before taxes, minority interest and loss (gain) attributable to capital transactions of subsidiary

$

481

$

(2,319

)

$

(108

)

$

44

$

(73

)

$

(1,975

)

Total assets

$

40,618

$

65,530

$

9,228

$

2,737

$

(6,900

)

$

111,213

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Following is the selected segment data as of and for the nine-months ended September 30, 2004:

Nine-Months Ended September 30, 2004

(in thousands)

Advanced

Technology

Digital Angel

Corporation

InfoTech USA,

Inc.

All Other

“Corporate/

Eliminations”

Consolidated

Net revenue from external customers:

Product

$

28,288

$

30,582

$

10,511

$

—

$

(76

)

$

69,305

Service

7,375

1,439

2,446

—

—

11,260

Intersegment revenue - product

—

(76

)

—

—

76

—

Total revenue

$

35,663

$

31,945

$

12,957

$

—

$

—

$

80,565

Income (loss) from continuing operations before taxes, minority interest and loss (gain) attributable to capital transactions of subsidiary

$

978

$

(2,235

)

$

(268

)

$

(200

)

$

(4,337

)

$

(6,062

)

Total assets

$

43,002

$

77,102

$

9,208

$

2,662

$

(10,088

)

$

121,886

Following is the selected segment data as of and for the nine-months ended September 30, 2003:

Nine-Months Ended September 30, 2003

(in thousands)

Advanced

Technology

Digital Angel

Corporation

InfoTech USA,

Inc.

All Other

“Corporate/

Eliminations”

Consolidated

Net revenue from external customers:

Product

$

22,768

$

25,090

$

8,686

$

—

$

(106

)

$

56,438

Service

8,303

1,476

2,043

—

—

11,822

Intersegment revenue - product

—

(106

)

—

—

106

—

Total revenue

$

31,071

$

26,460

$

10,729

$

—

$

—

$

68,260

Income (loss) from continuing operations before taxes, minority interest and loss (gain) attributable to capital transactions of subsidiary

$

974

$

(4,359

)

$

(731

)

$

373

$

33,158

$

29,415

Total assets

$

40,618

$

65,530

$

9,228

$

2,737

$

(6,900

)

$

111,213

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following is a breakdown of our revenue by segment and type of product and service:

Three-Months Ended September 30,

(in thousands)

2004

2003

Product

Service

Total

Product

Service

Total

Advanced Technology

Voice, data and video telecommunications networks

$

9,261

$

1,561

$

10,822

$

8,064

$

1,182

$

9,246

Call center and customer relationship management software

998

1,162

2,160

243

1,314

1,557

Implantable microchips and RFID scanners

23

—

157

148

—

148

Website design and Internet access

—

—

—

289

744

1,033

Total

$

10,282

$

2,723

$

13,005

$

8,514

$

2,737

$

11,251

Three-Months Ended September 30,

(in thousands)

2004

2003

Product

Service

Total

Product

Service

Total

Digital Angel Corporation

Visual ear tags and electronic implantable microchips and RFID scanners

$

5,303

$

212

$

5,515

$

4,167

$

1,192

$

5,359

GPS and radio communications products

5,365

300

5,665

2,526

125

2,651

Intersegment revenue

(18

)

—

(18

)

(18

)

—

(18

)

Total

$

10,650

$

512

$

11,162

$

6,675

$

1,317

$

7,992

Three-Months Ended September30,

(in thousands)

2004

2003

Product

Service

Total

Product

Service

Total

InfoTech USA, Inc.

Computer hardware

$

2,876

$

—

$

2,876

$

3,419

$

—

$

3,419

Computer services

—

683

683

—

806

806

Total

$

2,876

$

683

$

3,559

$

3,419

$

806

$

4,225

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The following is a breakdown of our revenue by segment and type of product and service (continued):

Nine-Months Ended September 30,

(in thousands)

2004

2003

Product

Service

Total

Product

Service

Total

Advanced Technology

Voice, data and video telecommunications networks

$

26,859

$

4,307

$

31,166

$

21,619

$

3,553

$

25,172

Call center and customer relationship management software

1,250

3,068

4,318

505

3,764

4,269

Implantable microchips and RFID scanners

179

—

179

271

—

271

Website design and Internet access

—

—

—

373

986

1,359

Total

$

28,288

$

7,37523

$

35,663

$

22,768

$

8,303

$

31,071

Nine-Months Ended September 30,

(in thousands)

2004

2003

Product

Service

Total

Product

Service

Total

Digital Angel Corporation

Visual ear tags and electronic implantable microchips and RFID scanners

$

18,091

$

609

$

18,700

$

17,157

$

1,192

$

18,349

GPS and radio communications products

12,491

300

13,321

7,933

284

8,217

Intersegment revenue

(76

)

—

(76

)

(106

)

—

(106

)

Total

$

30,506

$

1,439

$

31,945

$

24,984

$

1,476

$

26,460

Nine-Months Ended September30,

(in thousands)

2004

2003

Product

Service

Total

Product

Service

Total

InfoTech USA, Inc.

Computer hardware

$

10,511

$

—

$

10,511

$

8,686

$

—

$

8,686

Computer services

—

2,446

2,446

—

2,043

2,043

Total

$

10,511

$

2,446

$

12,957

$

8,686

$

2,043

$

10,.729

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

7. Acquisitions and Dispositions

The following describes our acquisition of OuterLink (in thousands):

Company

Acquired

Date

Acquired

Acquisition

Price

Value of

Digital Angel

Corporation

Series A Preferred Stock

Digital Angel Corporation Series A Preferred

Shares

Issued

Goodwill and

Other

Intangibles

Acquired

Other Net Assets and Liabilities

Acquired

OuterLink Corporation

1/22/04

$8,501

$8,300

100

$8,522

$(21)

On January 22, 2004, we acquired OuterLink. OuterLink provides satellite-based tracking, wireless data transfer and two-way messaging with large fleets of vehicles. The acquisition was accounted for under the purchase method of accounting. Identifiable intangible assets of $4.7 million have been recorded based upon preliminary estimates as of the date of the acquisition. The excess of purchase price over the fair value of the assets and liabilities of $3.8 million was recorded as goodwill. Any changes to the preliminary estimates during the allocation period will be reflected as an adjustment to goodwill. We recorded $0.1 million and $0.5 million of amortization expense associated with the identifiable intangible assets during the three and nine-months ended September 30, 2004, respectively.

The cost of the acquisition consisted of 0.1 million shares of Digital Angel Corporation’s Series A preferred stock valued at $8.3 million and acquisition costs of $0.2 million. The Series A preferred stock is convertible into 4.0 million shares of Digital Angel Corporation’s common stock when the volume weighted-average price of its common stock equals or exceeds $4.00 per share for ten consecutive trading days. The valuation of the stock was primarily based on historical trading history and stock prices of Digital Angel Corporation’s common stock and a marketability discount of 30%. The cost of the acquisition consists of legal and accounting related services that were direct costs of acquiring these assets.

In considering the benefits of the OuterLink acquisition, management recognized the strategic complement of OuterLink’s technologies and customer base with our existing implantable microchip and RFID scanner applications, and our military GPS business lines. This complement provides for a strong platform for further development of our capabilities in the area of high-value asset identification, tracking and condition monitoring.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Pro Forma Information Related to Acquisition of OuterLink

The results of OuterLink have been included in the Condensed Consolidated Financial Statements since the date of acquisition. Unaudited pro forma results of operations for the three-months ended September 30, 2003, and the nine-months ended September 30, 2004 and 2003, are included below. Such pro forma information assumes that the acquisition had occurred as of January 1, 2003, and revenue is presented in accordance with our accounting policies. This summary is not necessarily indicative of what our results of operations would have been had OuterLink been a combined entity during such periods, nor does it purport to represent results of operations for any future periods.

(In thousands)

Three-Months

Ended September 30, 2003

Nine-Months

Ended September 30, 2004

Nine-Months

Ended September 30, 2003

Net operating revenue

$

23,895

$

80,652

$

69,282

Net (loss) income from continuing operations

$

(1,581

)

$

(6,030

)

$

27,115

(Loss) income per share from continuing operations:

(Loss) income per common share - basic

$

(0.04

)

$

(0.12

)

$

0.86

(Loss) income per common share - diluted

$

(0.04

)

$

(0.12

)

$

0.86

Sale of Medical Systems Assets

On April 19, 2004, we sold certain assets of our Medical Systems operations pursuant to an Asset Purchase Agreement. Under the terms of the Asset Purchase Agreement, MedAire, Inc. purchased substantially all of the operating assets, excluding land and buildings, of Medical Systems for approximately $0.4 million, plus certain prepaid deposits and the cost of the pharmaceutical inventory and supplies. The assets sold included all of the tangible and intangible intellectual property developed for the operation of medical services business, including the systems, inventories, customer and supplier contracts, licenses, applications and databases, Internet website and domain name, mailing lists, customer records, trademarks, and copyrights. The Asset Purchase Agreement excluded all other assets, property and equipment of Med ical Systems. We incurred a loss of approximately $0.6 million during the nine-months ended September 30, 2004, in connection with this transaction. In addition, on July 30, 2004, we sold Medical Systems’ real property and certain related fixed assets for $1.5 million, which resulted in a gain on the sale of approximately $0.3 million and cash proceeds after paying off the related building mortgage of approximately $0.4 million.

Medical Systems represented a reporting unit in accordance with SFAS 142, Goodwill and Other Intangible Assets (“FAS 142”). As a result of our decision to sell Medical Systems assets during the second quarter of 2004, we have reflected the assets, liabilities and results of operations of Medical Systems as part of our Discontinued Operations for all periods presented in accordance with FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets ( 7;FAS 144”). See Note 8.

Share Exchange Agreement

On August 14, 2003, we entered into a Share Exchange Agreement with Digital Angel Corporation. The Share Exchange Agreement represented a strategic investment by us, whereby we

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

increased our ownership interest in Digital Angel Corporation. The Share Exchange Agreement provided for us to purchase 3.0 million shares of Digital Angel Corporation's common stock at a price of $2.64 per share, $7.9 million in the aggregate, and for Digital Angel Corporation to issue a warrant to us, referred to as the DAC Warrant, for the purchase of up to 1.0 million shares of Digital Angel Corporation’s common stock. The DAC Warrant is exercisable for five years commencing on February 1, 2004, at a price per share of $3.74, payable in cash or in shares of our common stock. The purchase price for the 3.0 million shares was payable in shares of our common stock having an aggregate market value of $7.9 million. On March 1, 2004, we issued approximately 2.0 million shares of our common stock to Digital Angel Corporation as pa yment for the 3.0 million shares.

Digital Angel Corporation has generated cash by selling approximately 2.0 million shares of our common stock, and as of September 30, 2004, Digital Angel Corporation generated gross proceeds of approximately $1.3 million on the sale of approximately 0.9 million of the shares. Digital Angel Corporation realized an aggregate loss on the sale of our shares of approximately $1.0 million, which is reflected in its separate financial statements included in its Form 10-Q for the quarter ended September 30, 2004. In addition, during the nine-months ended September 30, 2004, Digital Angel Corporation was required to record an unrealized loss of approximately $1.9 million representing the reduction in the fair market value of our common stock on the date of the share exchange, which value was $4.00 per share, and the value of the 1.1 million unsold shares as of September 30, 2004, of $2.19 per share. During October 2004, Digital Ang el Corporation sold the remaining 1.1 shares of our common stock, resulting in net proceeds to Digital Angel Corporation of approximately $4.0 million. Because such realized and unrealized gains and losses result from transactions in our common stock, they are eliminated upon the consolidation of Digital Angel Corporation’s and our operating results, and accordingly, they are not reflected in the Condensed Consolidated Financial Statements. The fair value of our common stock held by Digital Angel Corporation as of September 30, 2004, was approximately $2.3 million and is reflected in the Condensed Consolidated Balance Sheets as treasury stock.

As of September 30, 2004, we owned approximately 68.05% of the outstanding common stock of Digital Angel Corporation. Digital Angel Corporation has outstanding options and warrants and it has issued debt and preferred stock, which are convertible into shares of its common stock. If all of the outstanding options and warrants and all of the convertible debt and preferred stock were converted into shares of Digital Angel Corporation’s common stock, our ownership would be less than 50%. We desire to maintain a controlling interest in Digital Angel Corporation, and therefore, we and Digital Angel Corporation have entered into a Letter Agreement with Laurus Master Fund, Ltd., referred to as Laurus, which is described below. In addition, we may enter into additional share exchange agreements with Digital Angel Corporati on, or we may elect in the future to buy back a portion of the outstanding shares of Digital Angel Corporation’s common stock that we do not currently own.

Letter Agreement With Laurus

On June 1, 2004, we and Digital Angel Corporation entered into a Letter Agreement with Laurus. On July 31, 2003, Digital Angel Corporation issued to Laurus a Secured Convertible Note, referred to as the Convertible Note, in the amount of $2.0 million, and on August 28, 2003, Digital Angel Corporation issued to Laurus a Minimum Borrowing Convertible Note in the amount of $1.5 million. Under the terms of the Letter Agreement, Laurus agreed to convert (such conversion, the “Initial Conversion”) a portion of the Convertible Note that was equal to 0.15 million shares of Digital Angel Corporation’s common stock at the fixed conversion price applicable to the Convertible Note, which price is $2.33 per share, and we agreed to purchase such shares of Digital Angel Corporation’s common stock from Laurus< /FONT>

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

at a purchase price equal to the volume weighted-average price, referred to as the VWAP, of the common stock for the three trading days immediately preceding the Initial Conversion, which price was $3.04 per share. Digital Angel Corporation issued the 0.15 million shares to Laurus on June 8, 2004, and we purchased such shares from Laurus on June 30, 2004.

In addition, pursuant to the terms of the Letter Agreement, Laurus agreed that with respect to each conversion by Laurus of an outstanding amount of the Convertible Note or the Minimum Borrowing Convertible Note into Digital Angel Corporation’s common stock occurring after the Initial Conversion, we and Digital Angel Corporation shall have the right to purchase all of such common stock converted by Laurus at a price per share equal to the VWAP of Digital Angel Corporation’s common stock for the three trading days immediately preceding such conversion, for a specified time period. The conversion price to be paid by Laurus under the terms of the Minimum Borrowing Note is $2.64 per share, subject to adjustment upward. On September 30, 2004, Digital Angel Corporation issued an additional 50 thousand shares to Lau rus pursuant to such terms, and we acquired the shares from Laurus on October 26, 2004, at a purchase price of $2.96 per share. On October 25, 2004, Digital Angel Corporation issued an additional 0.1 million shares of its common stock to Laurus, which we also intend to purchase under the terms of the Letter Agreement.

Based upon the terms of the Letter Agreement, and assuming that Laurus were to convert 100% of the $0.7 million outstanding under the Convertible Note as of September 30, 2004, and the full $1.5 million capacity under the Minimum Borrowing Convertible Note, the aggregate number of shares of Digital Angel Corporation’s common stock that we may be entitled to purchase, assuming that we were to purchase 100% of such shares and including the 0.15 million shares purchased in June and the 50 thousand shares purchased in October 2004, as discussed above, is approximately 1.1 million shares, subject to increases if accrued interest is added to the outstanding principal balance under the Convertible Note. As of September 30, 2004, $0.7 million was outstanding under the Minimum Borrowing Convertible Note. We recorded goodwi ll of $0.1 million in connection with our purchase of the 0.15 million shares from Laurus on June 30, 2004, based upon preliminary estimates as of the date of the acquisition. We may record additional goodwill during the fourth quarter of 2004, as a result of our purchase of the 50 thousand shares from Laurus on October 26, 2004, as well as any additional purchases. Any changes to our preliminary estimates of goodwill during the allocation period will be reflected as an adjustment to goodwill.

Net Loss (Gain) on Capital Transactions of Subsidiary and Loss (Gain) Attributable to Changes in Minority Interest as a Result of Capital Transactions of Subsidiary

Gains, where realized, and losses on issuances of certain shares of stock by Digital Angel Corporation are reflected in the Condensed Consolidated Statements of Operations. We determined that such recognition of gains and losses on the issuances of certain shares of stock by Digital Angel Corporation was appropriate since such shares were not sales of unissued shares in a public offering, we do not plan to reacquire such shares, and the value of the proceeds could be objectively determined. During the three-months ended September 30, 2004 and 2003, we recorded a loss of $38 thousand and $0.1 million, respectively, on the issuances of 0.1 million and 0.1 million shares of Digital Angel Corporation’s common stock, respectively. During the nine-months ended September 30, 2004 and 2003, we recorded a loss of $1.8 mill ion and $0.3 million, respectively, on the issuances of 4.0 million and 0.5 million shares of Digital Angel Corporation’s common stock, respectively. Included in the issuances for the nine-months ended September 30, 2004, were the 3.0 million shares of common stock issued by Digital Angel Corporation to us in connection with the Share Exchange Agreement. The loss represents the difference between the carrying amount of the pro-rata share of our investment in Digital Angel Corporation and the net proceeds from the issuances of the stock, as well as the portion of the minority owners’ interest in the capital contributed to Digital Angel Corporation by us in connection with the

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Share Exchange Agreement. During the three and nine-months ended September 30, 2004, Digital Angel Corporation issued 50 thousand and 0.2 million shares, respectively, which we acquired under the terms of the Letter Agreement with Laurus. Gains/losses on issuances of shares under the Letter Agreement are not included in the gains/losses noted above, as the issuances relate to shares that we intend to acquire. In addition, we recorded a loss (gain) of $0.3 million and $(0.4) million during the three-months ended September 30, 2004 and 2003, respectively, and a (gain) loss of $(1.6) million and $0.6 million during the nine-months ended September 30, 2004 and 2003, respectively, attributable to changes in the minority interest ownership as a result of the capital transactions of Digital Angel Corporation. The business ope rations of Digital Angel Corporation are described in Note 6.

The following is a summary of the capital transactions of Digital Angel Corporation for the three and nine-months ended September 30, 2004 and 2003:

                        For The Three-

                       Months Ended

                         September 30,

                          For The Nine-

                          Months Ended

                             September 30,

2004

2003

2004

2003

(in thousands, except per share amounts)

Issuances of common stock for stock option exercises

127

106

957

484

Issuance of common stock under the Letter Agreement

50

—

200

—

Issuance of common stock under the Share Exchange Agreement

—

—

3,000

—

Total issuances of common stock

177

106

4,157

484

Proceeds from stock issuances

$

211

$

14

$

9,740

$

238

Average price per share

$

1.20

$

0.13

$

2.34

$

0.49

Beginning ownership percentage of Digital Angel Corporation

68.41

%

72.87

%

66.93

%

73.91

%

Ending ownership percentage of Digital Angel Corporation

68.05

%

72.57

%

68.05

%

72.57

%

Decrease (increase) in ownership percentage

0.36

%

0.30

%

(1.12

)%

1.34

%

Net loss on capital transactions of subsidiary ⁽¹⁾

$

38

$

103

$

1,805

$

324

Loss (gain) attributable to changes in minority interest as a

result of capital transactions of subsidiary ⁽¹⁾

$

298

$

(371

)

$

(1,593

)

$

577

(1) We have not provided a tax provision/benefit for the net loss on capital transactions of subsidiary and the loss (gain) attributable to changes in minority interest as a result of capital transactions of subsidiary.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

8. Discontinued Operations

During the second quarter of 2004, Digital Angel Corporation’s Board of Directors approved a plan to sell our Medical Systems operations, which we acquired on March 27, 2002. Medical Systems represented the business operations of Medical Advisory Systems, Inc., referred to as MAS. On March 31, 2002, our 93% owned subsidiary, Digital Angel Corporation, which we refer to as pre-merger Digital Angel, merged with MAS and MAS changed its name to Digital Angel Corporation. Medical Systems was one of our reporting units in accordance with FAS 142. Accordingly, the financial condition, results of operations and cash flows of Medical Systems have been reported as Discontinued Operations for all periods presented. The following discloses the income/operating losses from Discontinued Operations for the three and nine-months ended September 30, 2004 and 2003, consisting of income (loss) attributable to Medical Systems:

Three-Months Ended

September 30,

Three-Months Ended

September 30,

Nine-Months Ended

September 30,

Nine-Months Ended

September 30,

2004

2003

2004

2003

Product revenue

$

—

$

139

$

204

$

726

Service revenue

—

195

223

811

Total revenue

—

334

427

1,537

Cost of products sold

—

63

87

321

Cost of services sold

—

239

317

832

Total cost of products and services sold

—

302

404

1,153

Gross profit

—

32

23

384

Selling, general and administrative expense

35

134

974

573

Depreciation and amortization

—

169

107

386

Gain on sale of property and equipment

(290

)

—

(290

)

—

Other income and expense

—

35

105

104

Minority interest

53

(84

)

(285

)

(183

)

Income (loss) from Discontinued Operations

$

202

$

(222

)

$

(588

)

$

(496

)

The above results do not include any allocated or common overhead expenses. We have not provided a provision/benefit for income taxes on the income/losses attributable to Medical Systems. We do not anticipate Medical Systems incurring additional losses in the future. However, in accordance with FAS 144, any additional operating losses or changes in the values of assets or liabilities will be reflected in our financial condition and results of operations as incurred.

26

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

On March 1, 2001, our Board of Directors approved a plan to offer for sale our Intellesale business segment and all of our other non-core businesses, and accordingly, these entities, which have all been sold or closed, are presented in Discontinued Operations for all periods presented.

The net liabilities of Discontinued Operations as of September 30, 2004 and December 31, 2003, were comprised of the following:

Medical Systems

September 30, 2004

December 31, 2003

(in thousands)

Assets

Accounts receivable, net

$

19

$

453

Inventory

—

46

Other current assets

—

43

Property and equipment, net

—

1,137

Intangible assets, net

—

489

Other assets

135

163

Total Assets

$

154

$

2,331

Current Liabilities:

Notes payable and current maturities of long-term debt

$

—

$

(910

)

Accounts payable

—

(71

)

Accrued expenses

(53

)

(99

)

Total Liabilities

$

(53

)

$

(1,080

)

Net Assets

$

101

$

1,251

Intellesale and Other Non-Core Businesses

September 30, 2004

December 31, 2003

(in thousands)

Current Liabilities:

Notes payable and current maturities of long-term debt

$

(26

)

$

(26

)

Accounts payable

(4,178

)

(4,178

)

Accrued expenses

(1,298

)

(5,341

)

Total Liabilities

$

(5,502

)

$

(9,545

)

Net Liabilities

$

(5,502

)

$

(9,545

)

27

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Total Discontinued Operations

September 30, 2004
December 31, 2003

(in thousands)

Assets

Accounts receivable, net

$

19

$
453

Inventory

—

46

Other current assets

—

43

Property and equipment, net

—

1,137

Intangible assets, net

—

489

Other assets

135

163

Total Assets

$

154

$
2,331

Current Liabilities:

Notes payable and current maturities of long-term debt

$

(26

)

$
(936 )

Accounts payable

(4,178

)

(4,249
)

Accrued expenses

(1,351

)

(5,440
)

Total Liabilities

$

(5,555

)

$
(10,625 )

Net Liabilities of Discontinued Operations

$

(5,401

)

$
(8,294 )

We accounted for the Intellesale segment and our other non-core businesses as Discontinued Operations in accordance with Accounting Principles Board 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“APB 30”). APB 30, of which portions related to the accounting for discontinued operations have been superceded by the provisions of FAS 144, required that we accrue estimates for future operating losses, gains/losses on sale, costs to dispose and carrying costs of these businesses at the time the businesses wer e discontinued. Accordingly, at December 31, 2000, we recorded a provision for operating losses and carrying costs during the phase-out period for our Intellesale and other non-core businesses including estimated disposal costs to be incurred in selling the businesses. Carrying costs consisted primarily of cancellation of facility and equipment leases, legal settlements, employment contract buyouts and sales tax liabilities. The following table sets forth the roll forward of the liabilities for operating losses and carrying costs for the periods December 31, 2002 to September 30, 2003, and December 31, 2003 through September 30, 2004. The additions/reductions represent a change in the estimated carrying costs during the phase out period, as certain of these costs were settled for more/less than anticipated, as well as to operating costs associated with one remaining business within this group, which was sold in July 2003.

Type of Cost (in thousands)

Balance

December 31, 2002

Additions

Deductions

Balance

September 30, 2003

Change in estimated operating losses

$

—

$

176

$

176

$

—

Carrying costs

4,908

316

111

5,113

Total

$

4,908

$

492

$

287

$

5,113

28

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Type of Cost (in thousands)

Balance

December 31,

2003

Additions (Reductions)

Deductions

Balance

September 30,

2004

Carrying costs

$

4,913

$

(2,184

)

$

1,853

$

876

9. Reclassification of Minority Interest from Continuing Operations to Discontinued Operations

We have revised our calculation of the loss (income) from Continuing Operations and Discontinued Operations for the three and six-months ended June 30, 2004, as present in our June 30, 2004 Form 10-Q, to reclassify the minority interest associated with Medical Systems’ losses from Continuing Operations to Discontinued Operations. The effect of the change does not impact the reported net loss in the periods, as follows:

Previously Reported

Three-Months Ended

June 30, 2004

Revised

Three-Months Ended

June 30, 2004

Previously Reported

Six-Months Ended

June 30, 2004

Revised

Six-Months Ended

June 30, 2004

(in thousands, except per share amounts)

Net loss from Continuing Operations

$

(2,232

)

$

(2,457

)

$

(2,481

)

$

(2,819

)

Net (loss) income from Discontinued Operations

(737

)

(512

)

987

1,325

Total net loss

$

(2,969

)

$

(2,969

)

$

(1,494

)

$

(1,494

)

Total basic and diluted loss per share - Continuing Operations

$

(0.04

)

$

(0.05

)

$

(0.05

)

$

(0.06

)

Total basic and diluted (loss) earnings per share -

Discontinued Operations

(0.02

)

(0.01

)

0.02

0.03

Total net loss per share - basic and diluted

$

(0.06

)

$

(0.06

)

$

(0.03

)

$

(0.03

)

10. Non-Cash Stock-Based Compensation Expense

During the three-months ended September 30, 2004 and 2003, and the nine-months ended September 30, 2004 and 2003, we reduced by $0.0 million, $0.5 million, $0.4 million and $1.5 million, respectively, certain non-cash stock-based compensation expense. The reductions relate primarily to compensation expense recorded in prior periods in connection with the re-pricing of 1.9 million stock options during 2001. The re-priced options had original exercise prices ranging from $6.90 to $63.40 per share and were modified to change the exercise price to $1.50 per share. Due to the modification, these options are being accounted for as variable options under APB Opinion No. 25 and fluctuations in our common stock price result in increases and decreases of non-cash stock-based compensation expense until the options are exerci sed, forfeited, modified or expired. As of September 30, 2004, approximately 0.1 million of these options remain outstanding. This reduction of compensation expense has been reflected in the Condensed Consolidated Statements of Operations as selling, general and administrative expense.

29

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

11. Comprehensive (Loss) Income

Comprehensive (loss) income represents all non-owner changes in stockholders’ equity and consists of the following:

Three-Months Ended

September 30,

(In thousands)

Nine-Months Ended

September 30,

(In thousands)

2004

2003

2004

2003

Net (loss) income

$

(2,480

)

$

(1,160

)

$

(3,975

)

$

28,266

Other comprehensive (loss) income, net of tax:

Foreign currency translation adjustments

(12
)
78

—

126

Total comprehensive (loss) income $
(2,492
)
$

(1,082

)
$
(3,975

)

$

28,392

12. Related Party Transaction

On June 27, 2003, we borrowed $1.0 million from InfoTech USA, Inc. under the terms of a commercial loan agreement and term note. On June 28, 2004, we and InfoTech USA, Inc. agreed to extend the date on which the principal is due under the terms of the loan from June 30, 2004 to June 30, 2005. Under the terms of the loan, interest accrues at an annual rate of 16% and is payable on a monthly basis. Under the terms of a stock pledge agreement, we have pledged approximately 0.8 million shares of the Digital Angel Corporation common stock that we own as collateral for the loan. The proceeds of the loan were used to fund operations. The loan is not reflected in the Condensed Consolidated Balance Sheets as it has been eliminated in consolidation.

13. Legal Proceedings

We are party to various legal proceedings, and accordingly, we have recorded $1.9 million in reserves in our financial statements as of September 30, 2004. In the opinion of management, these proceedings are not likely to have a material adverse affect on the financial position or overall trends in our results. The estimate of potential impact on our financial position, overall results of operations or cash flows could change in the future.

Melvin Maudlin vs. Pacific Decision Sciences Corporation, Hark Vasa and Applied Digital Solutions, Inc.

On October 22, 2003, Melvin Maudlin (the “Plaintiff”), a former employee at our subsidiary, Pacific Decision Sciences Corporation (“PDSC”), filed suit in the Superior Court of California against PDSC, Hark Vasa and us in connection with a purported trust agreement involving PDSC which, according to the Plaintiff, provides that he is to receive monthly payments of $10 thousand for approximately 17 years. The Plaintiff has obtained a pre-judgment right to attach order in the amount of his total claim of $2.1 million, and subsequently obtained a purported writ of attachment of certain PDSC assets, which we appealed and were successful in defeating. On or about April 10, 2004, the Plaintiff filed a Second Amended Complaint against us for breach of contract, breach of fiduciary duties, negligence, & #147;creditor’s suit” under Section 491.310 of the California Code of Civil Procedure, fraudulent conveyance, improper corporate distribution and alter ego. We answered the Second Amended Complaint on or about

30

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

July 8, 2004. On or about July 6, 2004, Hark Vasa filed a Cross-Complaint against us and PDSC for equitable contribution and indemnity. The suit has not materially affected PDSC’s ability to operate its business but could affect such operations in the future. The parties have been conducting discovery. The trial date, which was originally set to commence on September 7, 2004, has been reset to November 8, 2004. We intend to vigorously defend this suit.

Electronic Identification Devices Ltd. vs. Digital Angel Corporation

In February 2004, Electronic Identification Devices, Ltd. (“EID”) commenced a Declaratory Judgment Action against Digital Angel Corporation in the United States District Court for the Western District of Texas. This action seeks a declaration of patent non-infringement relating to Digital Angel Corporation’s patented syringe implantable identification transponder. The lawsuit alleges that EID has developed a new transponder that it believes does not infringe on Digital Angel Corporation’s patent. The lawsuit acknowledges that Digital Angel Corporation obtained a Judgment of infringement and two contempt orders against EID based on selling certain systems that infringed the its patent in 1997, 1998 and 1999. On September 17, 2004, the United States District Court for the Western District of Texa s dismissed EID’s cause of action.

John Fernandez vs. United States of America vs. Medical Advisory Systems, Inc.

On December 29, 2003, John Fernandez filed a lawsuit in the Orlando Division of the United States District Court for the Middle District of Florida. The plaintiff filed the lawsuit against the United States of America as the operator of the ship on which the plaintiff served. He alleged that the United States had contracted with MAS to provide medical advice and that the physician at MAS had rendered an incorrect long-distance diagnosis, resulting in injury to the plaintiff. Mr. Fernandez asserted against the United States claims of negligence under the Jones Act, unseaworthiness and maintenance and cure. He alleged damages in excess of $75,000, plus prejudgment and post-judgment interest at the legal rate and costs and disbursements of the action. On April 14, 2004, the United States served Medical Advisory Systems wi th a third part complaint in Admirality in which it alleged that MAS is liable to it for all or part of the plaintiff’s claim in that MAS and/or its employee/physician rendering the medical advice was negligent. In response, on May 12, 2004, MAS filed a motion to dismiss the third party complaint. The matter is presently scheduled for trial in April 2005. The ultimate outcome of this trial cannot be predicted at this time. We are currently unable to determine the potential effect of this litigation on our consolidated financial position, results of operations or cash flows.

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

On October 20, 2004, Digital Angel Corporation commenced an action in the United Stated District Court for the District of Minnesota against AllFlex USA, Inc. and Pet Health Services (USA), Inc. This suit (Court File No. 04-4545MJD/JGL) claims that AllFlex is marketing and selling an implantable transponder that infringes a 1993 patent granted to Digital Angel Corporation for implantable transponders previously found by the United States District Court for the District of Colorado to be enforceable. The suit also claims that Pet Health is using, selling and/or distributing the same transponder in violation of Digital Angel Corporation’s patent. The suit seeks, among other things, an adjudication of infringement and that the infringing parties be enjoined from further improper action. The suit also seeks actual damages, punitive damages and interest, costs and attorneys’ fees. We believe that the suit is well grounded in law and fact.

31

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Digital Angel Corporation vs. Datamars, Inc., Datamars, S.A., The Crystal Import Corporation, and Medical Management International, Inc.

On October 20, 2004, Digital Angel Corporation commenced an action in the United States District Court for the District of Minnesota against Datamars, Inc., Datamars, S.A., The Crystal Import Corporation, and Medical Management International, Inc. (“Banfield”). This suit (Court File No. 04-4544ADM/AJB) claims that the defendants are marketing and selling implantable transponders manufactured by Datamars that infringe on Digital Angel Corporation’s 1993 patent for implantable transponders previously found by the United States District Court for the District of Colorado to be enforceable. Certain of the locations in which the infringing transponders are sold, include, but are not limited to, “Banfield, The Pet Hospital” of which certain locations are associated with PetSmart stores. The suit seeks, among other things, an adjudication of infringement and that the infringing parties be enjoined from further improper action. The suit also seeks actual damages, punitive damages and interest, costs and attorneys’ fees. We believe that the suit is well grounded in law and fact.

14. Subsequent Events

FDA Clears VeriChip^TM for Medical Applications

On October 12, 2004, the FDA issued a letter stating that VeriChip^TM has been cleared for medical applications in the United States. The FDA’s clearance follows the completion of a de novo application review of the product. Digital Angel Corporation is the manufacturer of VeriChip^TM, and has licensed the technology to VeriChip Corporation, our wholly-owned subsidiary, for human applications.

Securities Purchase Agreement

On October 21, 2004, we sold 2.5 million shares of our common stock and issued certain warrants to acquire shares of our common stock under a Securities Purchase Agreement with SSFA, as more fully discussed in Note 4.

eXI Wireless, Inc. Acquisition

Effective November 1, 2004, the Company has entered into a letter of intent to acquire, subject to certain conditions, eXI Wireless, Inc., referred to as eXI. eXI is a publicly held company located in Richmond, British Columbia, Canada. Its shares are listed on the TSX Venture Exchange. The Company has agreed to pay CAD$1.60 for each outstanding share of eXI (approximately 10.1 million shares are outstanding). This payment to the eXI shareholders will be made in shares of a newly formed Canadian subsidiary of the Company that will, in turn, be exchangeable for shares of the Company’s common stock. The exchange ratio will be calculated at closing. All existing eXI options and warrants outstanding (fewer than 1.7 million options and warrants are outstanding) would convert pro rata into options or warrants exercisabl e into shares of the Company’s common stock. If the options or warrants are exercised prior to closing, such additional shares shall be purchased for CAD$1.60. eXI has committed to deliver net assets of at least CAD$4.75 million at closing. The purchase price will be reduced on a dollar-for-dollar basis to the extent that the net assets delivered are less than the minimum prescribed amount.

eXI states that it has developed patient wandering, infant protection and asset tracking / location systems uniquely combining automated identification and real-time location technologies. Once completed, this acquisition will hopefully add a significant number of dealers and distributors to VeriChip Corporation, the Company’s wholly-owned subsidiary. These dealers and distributors already market eXI’s proprietary security products like HALO™, ROAM ALERT™, ASSETRAC™, and HOUNDWARE™ to hospitals, nursing homes and commercial customers, respectively. Closing of the transaction remains subject to, among other conditions, final documentation, eXI’s board of directors’ receiving a fairness opinion, and required approvals (including approval by eXI’s shareholders and the British C olumbia Supreme Court). The closing will occur once those conditions are satisfied and once the registration statement registering the shares of the Company’s common stock issuable in connection with the transaction is declared effective by the Securities and Exchange Commission. The Company anticipates that such closing will occur during the first quarter of 2005.

32

Table of Contents

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 included in Item 1 of this report as well as our 2003 Annual Report on Form 10-K, as amended.

We develop innovative security products for consumer, commercial and government sectors worldwide. Our unique and often proprietary products provide security for people, animals, food chains, government/military assets, and commercial assets. Included in this diverse product line are applications for radio frequency identification systems, commonly referred to as RFID, end-to-end food safety systems, global positioning systems, referred to as GPS, satellite communications, and secure telecomm infrastructure. Our adage is Security Though Innovation^TM. We have developed a product, for which we recently received FDA approval, to provide a secure tamper proof means of managing medical information. Two of our mature brands are: Home Again^TM and SARBE^TM, and our newer bra nds include VeriChip^TM, Bio Thermo^TM and Digital Angel^TM. We plan to grow our suite of products through acquisitions and in-house development.

We incurred a net loss of approximately $2.5 million for the three-months ended September 30, 2004, as compared to a net loss of approximately $1.2 million for the three-months ended September 30, 2003. Included in the net loss for the three-months ended September 30, 2003, was a one time reversal of approximately $3.9 million of severance expense associated with the termination of certain officers and director during 2003. Excluding the effects of a one-time gain on the forgiveness of debt of approximately $70.0 million recorded during the nine-months ended September 30 2003, as a result of the payment in full of certain debt obligations, our operating results also improved significantly during the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003. We incurred a net loss of approximately $4.0 million for the nine-months ended September 30, 2004, as compared to a net loss of approximately $41.7 million, for the nine-months ended September 30, 2003, after adjusting for the gain on foregiveness of debt. Also included in the results for the nine-months ended September 30, 2003, was approximately $18.1 million of severance expense associated with the termination of certain officers and director during 2003. In addition, the loss for the three and nine-months ended September 30, 2004, included a reversal of approximately $0.3 million and $1.3 million of interest expense, respectively, as a result of the revaluation of certain common stock warrants, which are settleable in shares of the Digital Angel Corporation common stock owned by us. Our operating activities used cash of approximately $9.6 million and approximately $5.0 million during the nine-months ended September 30, 2004 and 2003, respectively. In the past, we have suffered losses and have not generated positive cash flo ws from operations. As of September 30, 2004, we had an accumulated deficit of approximately $417.9 million. Our majority-owned subsidiary, Digital Angel Corporation, has suffered losses and has not generated positive cash flows from operations. Digital Angel Corporation incurred losses during the three and nine-months ended September 30, 2004 and 2003, which are presented below in the Business Segments section. In addition, its operating activities used cash of approximately $3.7 million and approximately $3.5 million during the nine-months ended September 30, 2004 and 2003, respectively.

Recent /Other Developments

FDA Clears VeriChip for Medical Applications

On October 12, 2004, the FDA issued a letter stating that VeriChip^TM has been cleared for medical applications in the United States. The FDA’s clearance follows the completion of a de novo application review of the product. Digital Angel Corporation is the manufacturer of VeriChip^TM, and has licensed the technology to VeriChip Corporation, our wholly-owned subsidiary, for human applications.

33

Table of Contents

Securities Purchase Agreement

On October 21, 2004, we sold 2.5 million shares of our common stock and issued certain warrants to acquire shares of our common stock under a Securities Purchase Agreement with SSFA, as more fully described in Note 4 to our Condensed Consolidated Financial Statements.

eXI Wireless, Inc. Acquisition

Effective November 1, 2004, the Company has entered into a letter of intent to acquire, subject to certain conditions, eXI Wireless, Inc., referred to as eXI. eXI is a publicly held company located in Richmond, British Columbia, Canada. Its shares are listed on the TSX Venture Exchange. The Company has agreed to pay CAD$1.60 for each outstanding share of eXI (approximately 10.1 million shares are outstanding). This payment to the eXI shareholders will be made in shares of a newly formed Canadian subsidiary of the Company that will, in turn, be exchangeable for shares of the Company’s common stock. The exchange ratio will be calculated at closing. All existing eXI options and warrants outstanding (fewer than 1.7 million options and warrants are outstanding) would convert pro rata into options or warrants exercisabl e into shares of the Company’s common stock. If the options or warrants are exercised prior to closing, such additional shares shall be purchased for CAD$1.60. eXI has committed to deliver net assets of at least CAD$4.75 million at closing. The purchase price will be reduced on a dollar-for-dollar basis to the extent that the net assets delivered are less than the minimum prescribed amount.

eXI states that it has developed patient wandering, infant protection and asset tracking / location systems uniquely combining automated identification and real-time location technologies. Once completed, this acquisition will hopefully add a significant number of dealers and distributors to VeriChip Corporation, the Company’s wholly-owned subsidiary. These dealers and distributors already market eXI’s proprietary security products like HALO™, ROAM ALERT™, ASSETRAC™, and HOUNDWARE™ to hospitals, nursing homes and commercial customers, respectively. Closing of the transaction remains subject to, among other conditions, final documentation, eXI’s board of directors’ receiving a fairness opinion, and required approvals (including approval by eXI’s shareholders and the British C olumbia Supreme Court). The closing will occur once those conditions are satisfied and once the registration statement registering the shares of the Company’s common stock issuable in connection with the transaction is declared effective by the Securities and Exchange Commission. The Company anticipates that such closing will occur during the first quarter of 2005.

Reverse Stock Split

On September 10, 2003, our shareholders approved the granting of discretionary authority to our Board of Directors for a period of twelve months to effect a reverse stock split not to exceed a ratio of 1-for-25, or to determine not to proceed with a reverse stock split. On March 12, 2004, our Board of Directors authorized a 1-for-10 reverse stock split, which was effectuated on April 5, 2004. All share information provided in this Form 10-Q has been adjusted to reflect the reverse stock split. The reverse stock split is more fully described in Note 1 to our Condensed Consolidated Financial Statements.

Termination of VeriChip Corporation Officer

On August 5, 2004, Kevin J. Wiley, VeriChip Corporation’s then Chief Executive Officer, resigned. Replacing Mr. Wiley as VeriChip Corporation’s interim Chief Executive Officer is Kevin H. McLaughlin, our current President and Chief Operating Officer.

Business Segments

We operate in three business segments: Advanced Technology, Digital Angel Corporation and InfoTech USA, Inc. Business units that were part of our continuing operations and that were closed or sold during 2001 and 2002 are reported as “All Other.” Our “Corporate/Eliminations” category includes all amounts recognized upon consolidation of our subsidiaries such as the elimination of intersegment revenues, expenses, assets and liabilities. “Corporate/Eliminations” also includes certain interest income/expense and other expenses associated with corporate activities and functions.

Our Medical Systems operations, certain assets of which were sold during the three and nine-months ended September 30, 2004, and our Intellesale segment and other non-core businesses, are reported as Discontinued Operations, as more fully discussed in Notes 7 and 8 to our Condensed Consolidated Financial Statements.

Each of our business segments is more fully described in Note 6 to our Condensed Consolidated Financial Statements.

34

Table of Contents

RESULTS OF CONTINUING OPERATIONS

The following table summarizes our results of operations as a percentage of net operating revenue for the three and nine-month periods ended September 30, 2004 and 2003, and is derived from the unaudited Condensed Consolidated Statements of Operations in Part I, Item 1 of this report.

Relationship to

Revenue

Three-Months Ended

September 30,

Relationship to

Revenue

Nine-Months Ended

September 30,

2004

2003

2004

2003

% % % %

Product revenue

85.9

79.3

86.0

82.7

Service revenue

14.1

20.7

14.0

17.3

Total revenue

100.0

100.0

100.0

100.0

Cost of products sold

64.7

64.2

64.5

62.1

Cost of services sold

7.8

5.6

7.0

6.3

Total cost of products and services sold

72.5

69.8

71.5

68.4

Gross profit

27.5

30.2

28.5

31.6

Selling, general and administrative expense

32.2

21.1

31.9

68.0

Research and development

3.6

7.8

3.8

6.5

Depreciation and amortization

1.6

1.1

1.8

1.4

Interest and other income

(0.9

)

(1.0

)

(1.0

)

(1.0

)

Gain on forgiveness of debt

—

1.8

—

(102.5

)

Interest expense (reduction)

0.2

7.8

(0.5

)

16.0

(Loss) income from continuing operations before taxes, minority interest and loss (gain) attributable to capital transactions of subsidiary

(9.2

)

(8.4

)

(7.5

)

43.2

(Benefit) provision for income taxes

(0.1

)

(0.1

)

0.1

1.1

(Loss) income from continuing operations before minority interest and loss (gain) attributable to capital transactions of subsidiary

(9.1

)

(8.3

)

(7.6

)

42.1

Minority interest

(0.4

)

(2.8

)

(1.0

)

(2.2

)

Net loss on capital transactions of subsidiary

0.1

0.4

2.2

0.5

Loss (gain) attributable to changes in minority interest as a result of capital transactions of subsidiary

1.1

(1.6

)

(2.0

)

0.8

(Loss) income from continuing operations

(9.9

)

(4.3

)

(6.8

)

43.0

Income (loss) from discontinued operations

0.7

(0.9

)

(0.7

)

(0.7

)

Change in estimated loss on disposal of discontinued operations and operating losses during the phase out period

0.2

0.4

2.7

(0.7

)

Net (loss) income

(9.0

)

(4.8

)

(4.8

)

41.6

35

Table of Contents

(Loss) income from continuing operations before taxes, minority interest, and loss (gain) attributable to capital transactions of subsidiary from each of our segments during the three and nine-months ended September 30, 2004 and 2003, was as follows (we evaluate performance based on stand-alone segment operating income as presented below):

Three-Months Ended

September 30,

(In thousands)

Nine-Months Ended

September 30,

(In thousands)

2004

2003

2004

2003

(Loss) income from continuing operations before taxes, minority interest and loss (gain) attributable to capital transactions of subsidiary by segment:

Advanced Technology

$

(253

)

$

481

$

978

$

974

Digital Angel Corporation

(328

)

(2,319

)

(2,235

)

(4,359

)

InfoTech USA, Inc.

(249

)

(108

)

(268

)

(731

)

All Other

(200

)

44

(200

)

373

“Corporate / Eliminations”⁽¹⁾

(1,518

)

(73

)

(4,337

)

33,158

Total

$

(2,548

)

$

(1,975

)

$

(6,062

)

$

29,415

⁽¹⁾For “Corporate/Eliminations,” the loss from the three-months ended September 30, 2003, includes the reversal of approximately $3.9 million of severance expense associated with the termination of certain former officers and director. The income for the nine-months ended September 30, 2003, includes approximately $70.0 million of gain on forgiveness of debt, and approximately $17.9 million of severance expense associated with the termination of certain former executive officers and director. (An additional $0.2 million of severance expense associated with these terminations is included in Advanced Technology's income for the nine-months ended September 30, 2003).

Sources of Revenue and Gross Profit and Gross Profit Margin

Our sources of revenue consist of sales of products and services from our three operating segments. Our significant sources of revenue for the nine-months ended September 30, 2004, were as follows:

Sources of Revenue:

Percentage of

Total Revenue

Voice, data and video telecommunications networks to government agencies from our Advanced Technology segment

38.7

%

Visual ear tags and implantable microchips and RFID scanners for the companion animal, livestock, laboratory animal, fish and wildlife markets from our Digital Angel Corporation segment

23.1

%

IT hardware and services from our InfoTech USA, Inc. segment

16.1

%

GPS enabled tracking and message monitoring, search and rescue equipment, intelligent communications products and services for telemetry, mobile data and radio communications from our Digital Angel Corporation segment

16.5

%

Other products and services

5.6

%

Total

100.0

%

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Table of Contents

Our significant sources of gross profit and gross profit margin by product type for the nine-months ended September 30, 2004, were as follows:

Gross Profit and Gross Profit Margin by Product Type:

Gross Profit

(in thousands)

Gross Margin Percentage

Voice, data and video telecommunications networks to government agencies from our Advanced Technology segment

$

4,847

15.6

%

Visual ear tags and implantable microchips and RFID scanners for the companion animal, livestock, laboratory animal, fish and wildlife markets from our Digital Angel Corporation segment

7,213

38.7

%

IT hardware and services from our InfoTech USA, Inc. segment

2,140

16.5

%

GPS enabled tracking and message monitoring, search and rescue equipment, intelligent communications products and services for telemetry, mobile data and radio communications from our Digital Angel Corporation segment

6,412

48.1

%

Other products and services

2,325

51.7

%

Total

$

22,937

28.5

%

Revenue

Revenue from continuing operations for the three-months ended September 30, 2004, increased $4.2 million, or 17.9%, to $27.7 from $23.5 million in the three-m onths ended September 30, 2003. Revenue from continuing operations for the nine-months ended September 30, 2004, increased $12.3 million, or 18.0%, to $80.6 from $68.3 million in the nine-months ended September 30, 2003.

Revenue from continuing operations during the three and nine-months ended September 30, 2004 and 2003, by segment was as follows:

Three-Months Ended September 30,

(in thousands)

2004

2003

Product
Service

Total

Product

Service

Total

Advanced Technology

$

10,282

$

2,723

$

13,005

$

8,514

$

2,737

$

11,251

Digital Angel Corporation

10,650

512

11,162

6,675

1,317

7,992

InfoTech USA, Inc.

2,876

683

3,559

3,419

806

4,225

“Corporate / Eliminations”

—

—

—

—

—

—

Total

$

23,808

$

3,918

$

27,726

$

18,608

$

4,860

$

23,468

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Table of Contents

Nine-Months Ended September 30,

(In thousands)

2004

2003

Product

Service

Total

Product

Service

Total

Advanced Technology

$

28,288

$

7,375

$

35,663

$

22,768

$

8,303

$

31,071

Digital Angel Corporation

30,506

1,439

31,945

24,984

1,476

26,460

InfoTech USA, Inc.

10,511

2,446

12,957

8,686

2,043

10,729

“Corporate / Eliminations”

—

—

—

—

—

—

Total

$

69,305

$

11,260

$

80,565

$

56,438

$

11,822

$

68,260

Advanced Technology’s revenue increased $1.8 million and $4.6 million in the three and nine-months ended September 30, 2004, respectively, as compared to the three and nine-months ended September 30, 2003. When comparing the three-months ended September 30, 2004, to the three-months ended September 30, 2003, product revenue increased by $1.8 million, or 20.8%, and service revenue remained constant at approximately $2.7 million for each period. When comparing the nine-months ended September 30, 2004, to the nine-months ended September 30, 2003, product revenue increased by $5.5 million, or 24.2%, and service revenue decreased by $0.9 million, or 11.2%. We attribute the increase in product revenue during the three and nine-months ended September 30, 2004 and 2003, primarily to an increase in sales of voice, data and video telecommunications networks. The increase in revenue in the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003, was partially offset by a decrease in website design and Internet access revenue of approximately $1.4 million due to the sale of this business during the fourth quarter of 2003. Product revenue from voice, data and video telecommunications networks was approximately $10.8 million and $9.2 million for the three-months ended September 30, 2004 and 20 03, respectively, and approximately $31.2 million and $25.2 million for the nine-months ended September 30, 2004 and 2003, respectively. We hope to continue to grow our revenue from this segment as we realize increased revenue for data, video and telecommunications networks, and we attempt to increase the sales of our VeriChip^TM implantable microchips and RFID scanners. Effective October 12, 2004, the FDA approved VeriChip^TM for use in medical applications.

Digital Angel Corporation’s revenue increased $3.2 million and $5.5 million in the three and nine-months ended September 30, 2004, respectively, as compared to the three and nine-months ended September 30, 2003. Product revenue increased by $4.0 million, or 59.6%, and service revenue decreased by $0.8 million, or 61.1%, in the three-months ended September 30, 2004, as compared to the three-months ended September 30, 2003. Product revenue increased by $5.5 million, or 22.1%, and service revenue remai ned constant in the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003. The increase for the three-months ended September 30, 2004, was the result of increased revenues of approximately $2.5 million from our GPS-enabled search and rescue equipment and communications products, particularly sales of our G2R pilot locator beacon to fulfill a contract with the government of India, approximately $0.5 million of revenue from the satellite and tracking systems business we acquired in January 2004, and increased sales to our companion animal and livestock customers. We attribute the increases for the nine-months ended September 30, 2004 primarily to increases of approximately $5.1 million related to our GPS and Radio Communications products, including approximately $0.9 million associated with the satellite and tracking systems business we acquired in January 2004, and approximately $1.9 million in increased sales to our companion animal and livestock customers, offset by a decrease in sales to our fish and wildlife customers of approximately $1.6 million. We are hopeful that revenue will increase in the future due to the recent introduction of our new pilot locator beacon, and worldwide concerns over food safety and traceability. Several bills proposing the establishment of a national electronic identification program for livestock have recently

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been introduced in Congress. We cannot estimate the impact a national identification program would have on our revenue, though we think it would be favorable.

InfoTech USA, Inc.’s revenue decreased $0.7 million and increased $2.2 million in the three and nine-months ended September 30, 2004, respectively, as compared to the three and nine-months ended September 30, 2003. Product revenue decreased by approximately $0.5 million, or 15.9%, and service revenue decreased by approximately $0.1 million, or 15.3%, in the three-months ended September 30, 2004, as compared to the three-months ended September 30, 2003. We attribute the decrease in product and service revenue to a generally soft market during the three-months ended September 30, 2004, compared to the same period last year, combined with large laptop rollout projects in the three-months ended September 30, 2003, that did not recur during the quarter ended September 30, 2004. Product revenue increased by approximately $1.8 million, or 21.0%, and service revenue increased by $0.4 million, or 19.7%, in the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003. The increase in revenue in the nine-months ended September 30, 2004, was primarily a result of improved market conditions and our focus on higher-end, Intel-based products, which pr ovided us with more opportunity to sell related technical services. The focus on higher-end Intel-based products, such as storage area networks, has generated additional sales from our current customer base. In addition, we have continued to grow our customer base.

Gross Profit and Gross Profit Margin

Gross profit from continuing operations for the three-months ended September 30, 2004, increased $0.5 million, or 7.8%, to $7.6 million from $7.1 million for the three-months ended September 30, 2003. Gross profit from continuing operations for the nine-months ended September 30, 2004, increased $1.3 million, or 6.2%, to $22.9 million from $21.6 million in nine-months ended September 30, 2003. Our gross profit margin was 27.5% and 28.5% of revenue, respectively, for the three and nine-months ended September 30, 2004, and 30.2% and 31.6% of revenue, respectively, for the three and nine-months ended September 30, 2003.

Gross profit from continuing operations during the three and nine-months ended September 30, 2004, and 2003 by segment was as follows:

Three-Months Ended September 30,

(in thousands)

2004

2003

Product

Service

Total

Product

Service

Total

Advanced Technology

$

696

$

1,355

$

2,051

$

794

$

1,931

$

2,725

Digital Angel Corporation

4,779

220

4,999

2,218

1,370

3,588

InfoTech USA, Inc.

406

175

581

531

236

767

“Corporate / Eliminations”

—

—

—

—

—

—

Total

$

5,881

$

1,750

$

7,631

$

3,543

$

3,537

$

7,080

Nine-Months Ended September 30,

(in thousands)

2004

2003

Product

Service

Total

Product

Service

Total

Advanced Technology

$

2,966

$

4,207

$

7,173

$

2,858

$

5,321

$

8,179

Digital Angel Corporation

13,027

598

13,625

10,097

1,511

11,608

InfoTech USA, Inc.

1,356

783

2,139

1,120

690

1,810

“Corporate / Eliminations”

—

—

—

—

—

—

Total

$

17,349

$

5,588

$

22,937

$

14,075

$

7,522

$

21,597

39

Table of Contents

Gross profit margin from continuing operations during the three and nine-months ended September 30, 2004 and 2003, by segment was as follows:

Three-Months Ended September 30,

2004

2003

Product

Service

Total

Product

Service

Total

% % % % % %

Advanced Technology

6.8

49.8

15.8

9.3

70.6

24.2

Digital Angel Corporation

44.9

43.0

44.8

33.2

104.0

44.9

InfoTech USA, Inc.

14.1

25.6

16.3

15.5

29.3

18.2

Corporate / Eliminations

—

—

—

—

—

—

Total

24.7

44.7

27.5

19.9

72.8

30.2

Nine-Months Ended September 30,

2004

2003

Product

Service

Total

Product

Service

Total

% % % % % %

Advanced Technology

10.5

57.0

20.1

12.6

64.1

26.3

Digital Angel Corporation

42.7

41.6

42.7

40.4

102.4

43.9

InfoTech USA, Inc.

12.9

32.0

16.5

12.9

33.8

16.9

Corporate / Eliminations

—

—

—

—

—

—

Total

25.0

49.6

28.5

24.9

63.6

31.6

Advanced Technology’s gross profit decreased $0.7 million in the three-months ended September 30, 2004, and gross profit margin decreased to 15.8% from 24.2%, when compared to the three-months ended September 30 2003. Gross profit decreased $1.0 million in the nine-months ended September 30, 2004, and gross profit margin decreased to 20.1% from 26.3%, when compared to the nine-months ended September 30, 2003. We attribute the overall decrease in gross profit and gross profit margin for the three and nine-months ended September 30, 2004, as compared to the three and nine-months ended September 30, 2003, primarily to lower margins on sales of voice, data and video communications networks, and to the sale of our website design and Internet access business in the fourth quarter of 2003. We expect our gross profits and margins from s ales of data, voice and video telecommunications networks to remain at their current levels during the remainder of 2004, due to lower margins earned on our Postal Service telecommunications contract. We hope to realize increased gross profit from sales of our VeriChip^TM implantable microchip and RFID scanners during the fourth quarter of 2004 and beyond.

Digital Angel Corporation’s gross profit increased $1.4 million in the three-months ended September 30, 2004, as compared to the three-months ended September 30, 2003, and gross profit margin remained constant at 44.8% and 44.9%, in the three-months ended September 30, 2004 and 2003, respectively. Gross profit increased $2.0 million in the nine-months ended September 30, 2004, while gross profit margin decreased slightly to 42.7% from 43.9%, when compared to the nine-months ended September 30, 2003. We attribute the increase in gross profit for the three-months ended September 30, 2004, as compared to the three-months ended September 30, 2003, primarily to the increase in revenue as discussed above. We attribute the increase in gross profit for the nine-months ended September 30, 2004, as compared to the nine-months ended Septem ber 30, 2003, due primarily to increased gross profit of approximately $2.3 million from the previously mentioned increase in sales of our GPS and radio communications products, partially offset by a decrease in gross profit from sales of visual ear tags and electronic implantable microchips and RFID scanners of approximately $0.2 million. The gross margin percentage decreased in the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003, due to lower margins earned on revenues from the satellite and tracking

40

Table of Contents

systems business that we acquired in January 2004. We anticipate that our gross profit margins will remain at their current levels in the future.

InfoTech USA, Inc.’s gross profit decreased $0.2 million in the three-months ended September 30, 2004, and gross profit margin decreased to 16.3% from 18.2%, when compared to the three-months ended September 30, 2003. Gross profit increased $0.3 million in the nine-months ended September 30, 2004, while gross profit margin decreased slightly to 16.5% from 16.9%, when compared to the nine-months ended September 30, 2003. We attribute the decrease in gross profit for the three-months ended September 30, 2004, as compared to the three-months ended September 30, 2003, primarily to the decrease in revenue. We attribute the increase in gross profit for the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003, primarily to the overall increase in revenue. We attribute the decrease in gross profi t margin for the three-months ended September 30, 2004, as compared to the three-months ended September 30, 2003, primarily to large laptop rollout projects in the three-months ended September 30, 2003, that did not recur during the three-months ended September 30, 2004. Despite a competitive climate, we cautiously look for steady margins for both products and services for the balance of the year due to our continued focus on higher-end products and services. We are hopeful that this approach will provide us with more service sales opportunities which yield higher margins.

Selling, General and Administrative Expense

Selling, general and administrative expense from continuing operations was $8.9 million in the three-months ended September 30, 2004, an increase of $4.0 million, or 80.7%, from $4.9 million in the three-months ended September 30, 2003. Selling, general and administrative expense from continuing operations was $25.7 million in the nine-months ended September 30, 2004, a decrease of $20.7 million, or 44.6%, from $46.4 million in the nine-months ended September 30, 2003. As a percentage of total revenue, s elling, general and administrative expense from continuing operations increased to 32.2% in the three-months ended September 30, 2004, from 21.1% in the three-months ended September 30, 2003, and decreased to 31.9% in the nine-months ended September 30, 2004, from 68.0% in the nine-months ended September 30, 2003.

Selling, general and administrative expense from continuing operations during the three and nine-months ended September 30, 2004 and 2003, by segment was as follows:

Three-Months Ended

September 30,

(In thousands)

Nine-Months Ended

September 30,

(In thousands)

2004

2003

2004

2003

Advanced Technology

$

2,594

$

2,151

$

6,960

$

6,824

Digital Angel Corporation

4,132

4,081

12,143

11,542

InfoTech USA, Inc.

772

849

2,324

2,411

All Other

200

(44

)

200

(373

)

“Corporate / Eliminations”

1,228

(2,096

)

4,103

26,028

Total

$

8,926

$

4,941

$

25,730

$

46,432

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Table of Contents

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

Three-Months Ended

September 30,

Nine-Months Ended

September 30,

2004

2003

2004

2003

%

%

%

%

Advanced Technology

19.9

19.1

19.5

22.0

Digital Angel Corporation

37.0

51.1

38.0

43.6

InfoTech USA, Inc.

21.7

20.1

17.9

22.5

All Other

—

—

—

—

“Corporate / Eliminations” ⁽¹⁾

4.4

(8.9)

5.1

38.1

Total

32.2

21.1

31.9

68.0

⁽¹⁾Corporate/Eliminations percentage has been calculated as a percentage of total revenue.

Advanced Technology’s selling, general and administrative expense increased $0.4 million, or 20.6%, to $2.6 million in the three-months ended September 30, 2004, from $2.2 million in the three-months ended September 30, 2003. Selling, general and administrative expense increased $0.1 million, or 2.0%, to $7.0 million in the nine-months ended September 30, 2004, from $6.8 million in the nine-months ended September 30, 2003. As a percentage of revenue, selling, general and administrative expense incre ased slightly in the three months ended September 30, 2004, as compared to the three-months ended September 30, 2003, and decreased in the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003. We attribute the increase in selling, general and administrative expense in the three-months ended September 30, 2004, primarily to expenses associated with marketing our VeriChip^TM product. We attribute the increase in selling, general and administrative expense in the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003, to the aforementioned increase in VeriChip^TM related expenses, partially offset by a decrease in selling, general and administrative expense due to the sale of our website design and Internet access business during the fourth quarter of 2003. We anticipate that selling, general and administrative expense will increase with the aforementioned anticipation of increased revenues during the remainder of 2004.

Digital Angel Corporation’s selling, general and administrative expense remained constant at $4.1 million in the three-months ended September 30, 2004, and $4.1 million in the three-months ended September 30, 2003. Selling, general and administrative expense increased $0.6 million, or 5.2%, to $12.1 million in the nine-months ended September 30, 2004, from $11.5 million in the nine-months ended September 30, 2003. As a percentage of revenue, selling, general and administrative expense decreased during the three and nine-months ended September 30, 2004, as compared to the three and nine-months ended September 30, 2003, primarily as a result of the increases in revenue. During the three-months ended September 30, 2004, selling, general and administrative expense increased approximately $0.5 million as a result of expenses associat ed with the satellite and tracking systems business that we acquired in January 2004. Offsetting this increase were decreases in expenses of approximately $0.3 million associated with the scale-back of the Digital Angel^TM technology, and $0.2 million associated with loan termination fees, which we had incurred in the three-months ended September 30, 2003. The increase in the nine-months ended September 30, 2004 relates primarily to approximately $1.4 million of expenses from the satellite and tracking systems business, approximately $0.6 million of expenses related to our GPS and radio communications operations, partially offset by a decrease in expenses of approximately $1.3 related to the scale-back of the Digital Angel™ technology. We expect selling, general and administrative expense to remain relatively constant duri ng the remainder of 2004.

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Table of Contents

InfoTech USA, Inc.’s selling, general and administrative expense remained relatively constant at approximately $0.8 million and approximately $0.8 million in the three-months ended September 30, 2004 and 2003, respectively. Selling, general and administrative expense remained relatively constant at $2.3 million in the nine-months ended September 30, 2004, as compared to $2.4 million and in the nine-months ended September 30, 2003. Increases and decreases in selling, general and admini strative expense as a percentage of revenue are the result of the decrease/increase in revenue during the comparable periods. We expect selling, general and administrative expense to remain relatively constant during the remainder of 2004.

“Corporate / Eliminations” selling, general and administrative expense increased $3.3 million, or 158.6%, to $1.2 million in the three-months ended September 30, 2004, from a credit of $2.1 million in the three-months ended September 30, 2003. We attribute the increase in the three-month ended September 30, 2004, primarily to the reversal of approximately $3.9 million of severance expense related to the termination of certain former executive officers and director during the first quarter of 2003. During the three-months ended September 30, 2003, our shareholders approved the terms of the severance agreements, which resulted in us owing one of the officers and director less than we originally owed him under the terms of his employment contract. Selling, general and administrative expense decreased $21.9 million, or 84.2%, to $4.1 million in the nine-months ended September 30, 2004, from $26.0 million in the nine-months ended September 30, 2003. We attribute the decrease primarily to severance expense of approximately $17.9 million recorded in the nine-months ended September 30, 2003, associated with the termination of the former executive officers and director during the first quarter of 2003, and to bonuses of $4.3 million, which were accrued as of June 30, 2003. The bonuses were awarded to directors, officers and other employees in recognition of their efforts in negotiating a Forbearance Agreement with IBM Credit and in achieving the successful repayment of all of our obligations to I BM Credit on June 30, 2003. Partially offsetting the decrease were bonuses of $0.7 million recorded in the nine-months ended September 30, 2004.

Research and Development

Research and development expense from continuing operations was $1.0 million and $1.8 million for the three-months ended September 30, 2004, and 2003, respectively. Research and development expense from continuing operations was $3.1 million and $4.5 million for the nine-months ended September 30, 2004 and 2003, respectively. Research and development expense decreased to 3.6% of revenue in the three-months ended September 30, 2004, from 7.8% of revenue in the three-months ended September 30, 2003, and decreased to 3.8% of revenue in the nine-months ended September 30, 2004, from 6.5% of revenue in the nine-months ended September 30, 2003.

Research and development expense from continuing operations during the three and nine-months ended September 30, 2004 and 2003, by segment was as follows:

Three-Months Ended

September 30,

(in thousands)

Nine-Months Ended

September 30,

(in thousands)

2004

2003

2004

2003

Advanced Technology

$

101

$

46

$

250

$

147

Digital Angel Corporation

732

1,551

2,251

3,634

InfoTech USA, Inc.

—

—

—

—

“Corporate / Eliminations”

162

242

559

683

Total

$

995

$

1,839

$

3,060

$

4,464

Research and development expense relates primarily to the development of our products, Digital Angel^TM and VeriChip^TM, Thermo Life^TMand a personal locating device product, referred to as PLD.

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Table of Contents

Depreciation and Amortization

Depreciation and amortization expense from continuing operations was $0.4 million and $0.3 million for the three-months ended September 30, 2004, and 2003, respectively. Depreciation and amortization expense from continuing operations was $1.4 million and $1.0 million for the nine-months ended September 30, 2004, and 2003, respectively. Depreciation and amortization expense increased to 1.6% of revenue in the three-months ended September 30, 2004, from 1.1% of revenue in the three-months ended September 30, 2003, and increased to 1.8% of revenue in the nine-months ended September 30, 2004, from 1.4% of revenue in the nine-months ended September 30, 2003.

Depreciation and amortization expense from continuing operations during the three and nine-months ended September 30, 2004 and 2003, by segment was as follows:

Three-Months Ended

September 30,

(in thousands)

Nine-Months Ended

September 30,

(in thousands)

2004 2003 2004 2003

Advanced Technology

$

51

$

57

$

164

$

191

Digital Angel Corporation

305

108

1,019

447

InfoTech USA, Inc.

46

56

138

167

“Corporate / Eliminations”

43

38

104

161

Total

$

445

$

259

$

1,425

$

966

Advanced Technology’s depreciation and amortization expense remained relatively constant in the three-months ended September 30, 2004, as compared to the three-months ended September 30, 2003. Its depreciation and amortization expense decreased in the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003, due primarily to the sale of our website design and Internet access business during the fourth quarter of 2003.

Digital Angel Corporation’s depreciation and amortization expense increased $0.2 million, or 182.4%, to $0.3 million in the three-months ended September 30, 2004, from $0.1 million in the three-months ended September 30, 2003, and increased $0.6 million, or 128.0%, to $1.0 million in the nine-months ended September 30, 2004, from $0.4 million in the nine-months ended September 30, 2003. We attribute the increase primarily to depreciation and amortization expense related to the satellite and tracking systems business that we acquired on January 22, 2004.

InfoTech USA, Inc.’s depreciation and amortization expense decreased in the three and nine-months ended September 30, 2004, as compared to the three and nine-months ended September 30, 2003, due to fully depreciating certain assets during 2003.

“Corporate/Eliminations” depreciation expense increased in the three-months ended September 30, 2004, as compared to the three-months ended September 30, 2003, primarily as a result of depreciation expense associated with furniture and leasehold improvements for our new corporate headquarters. We moved our corporate headquarters to Delray Beach, Florida in June 2004. The decrease in the nine-months ended September 30, 2004, as compared to the nine-months ended September 30, 2003, was due primarily to fully depreciating certain assets during 2003.

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Table of Contents

Interest and Other Income and Interest Expense (Reduction)

Interest and other income was $0.2 million and $0.2 million, for the three-months ended September 30, 2004 and 2003, respectively, and $0.8 million and $0.7 million for the nine-months ended September 30, 2004 and 2003, respectively. Interest income is earned primarily from short-term investments and notes receivable.

Interest expense (reduction) was $0.1 million and $1.8 million for the three-months ended September 30, 2004 and 2003, respectively, and $(0.4) million and $11.0 million for the nine-months ended September 30, 2004 and 2003, respectively. Included in interest expense for the three and nine-months ended September 30, 2004, was a credit of approximately $0.3 million and $1.3 million, respectively, related to the value of certain of our warrants, which are settleable in shares of the Digital Angel Corporation common stock that we own. Increases and decreases in the fair market value of Digital Angel Corporation’s common stock result in increases and reductions of our interest expense until the warrants are exercised, forfeited or expired. The interest expense incurred during the nine-months ended September 30, 2003, related primarily to our obligations to IBM credit, which were repaid-in-full on June 30, 2003.

Income Taxes

We had an effective (benefit) income tax rate of (0.5%) and (0.9%) for the three-months ended September 30, 2004 and 2003, respectively, and 1.7% and 2.6% for the nine-months ended September 30, 2004 and 2003, respectively. Differences in the effective (benefit) income tax rate from the statutory federal income tax rate arise primarily from the net operating loss carry-forwards generated in 2004, for which no benefit has been recognized and state taxes net of federal benefits. In addition, during the nine-months ended September 30, 2003, we recorded approximately $0.9 million of alternative minimum tax.

Net (Gain) Loss on Capital Transactions of Subsidiary and (Gain) Loss Attributable to Changes in Minority Interest as a Result of Capital Transactions of Subsidiary

During the three-months ended September 30, 2004 and 2003, we recorded a loss of $38 thousand and $0.1 million, respectively, on the issuances of 0.1 million and 0.1 million shares of Digital Angel Corporation’s common stock, respectively. During the nine-months ended September 30, 2004 and 2003, we recorded a loss of $1.8 million and $0.3 million, respectively, on the issuances of 4.0 million and 0.5 million shares of Digital Angel Corporation’s common stock, respectively. Included in the issuances for the nine-months ended September 30, 2004, were 3.0 million shares of common stock issued by Digital Angel Corporation to us in connection with the Share Exchange Agreement, which is more fully discussed in Note 7 to our Condensed Consolidated Financial Statements. The loss represents the difference between the carrying amount of the pro-rata share of our investment in Digital Angel Corporation and the net proceeds from the issuances of the stock, as well as the portion of the minority owners’ interest in the capital contributed to Digital Angel Corporation by us in connection with the Share Exchange Agreement. In addition, we recorded a loss (gain) of $0.3 million and $(0.4) million during the three-months ended September 30, 2004 and 2003, respectively, and a (gain) loss of $(1.6) million and $0.6 million during the nine-months ended September 30, 2004 and 2003, respectively, attributable to changes in the minority interest ownership as a result of the capital transactions of Digital Angel Corporation. The business operations of Digital Angel Corporation and its capital transactions are described in Notes 6 and 7, respectively, to our Condensed Consolidated Financial Statements.

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RESULTS OF DISCONTINUED OPERATIONS

During the second quarter of 2004, Digital Angel Corporation’s Board of Directors approved a plan to sell our Medical Systems operations, which we acquired on March 27, 2002. Medical Systems represented the business operations of MAS. On March 27, 2002, our 93% owned subsidiary pre-merger Digital Angel, merged with MAS and MAS changed its named to Digital Angel Corporation. Medical Systems was one of our reporting units in accordance with FAS 142. Accordingly, the financial condition, results of operations and cash flows of Medical Systems have been reported as Discontinued Operations for all periods presented. The following discloses the operating losses from Discontinued Operations for the three and nine-months ended September 30, 2004 and 2003, consisting of income (loss) attributable to Medical Systems:

Three-Months Ended

September 30,

Three-Months Ended

September 30,

Nine-Months Ended

September 30,

Nine-Months Ended

September 30,

2004

2003

2004

2003

Product revenue

$

—

$

139

$

204

$

726

Service revenue

—

195

223

811

Total revenue

—

334

427

1,537

Cost of products sold

—

63

87

321

Cost of services sold

—

239

317

832

Total cost of products and services sold

—

302

404

1,153

Gross profit

—

32

23

384

Selling, general and administrative expense

35

134

974

573

Depreciation and amortization

—

169

107

386

Gain on sale of property and equipment

(290

)

—

(290

)

—

Other income and expense

—

35

105

104

Minority interest

53

(84

)

(285

)

(183

)

Income (loss) from Discontinued Operations

$

202

$

(222

)

$

(588

)

$

(496

)

The above results do not include any allocated or common overhead expenses. We have not provided a benefit for income taxes on the losses attributable to Medical Systems. We do not anticipate that Medical Systems will incur additional losses in the future. However, in accordance with FAS 144, any additional operating losses or changes in the values of assets and liabilities will be reflected in our financial condition and results of operations as incurred.

On March 1, 2001, our Board of Directors approved a plan to offer for sale our Intellesale segment and all of our other non-core businesses, and accordingly, these entities are presented in Discontinued Operations for all periods presented. We accounted for the Intellesale segment and our other non-core businesses as Discontinued Operations in accordance with Accounting Principles Board 30, Reporting the Results of Operations- Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions (“APB 30”). APB 30, of which portions related to the accounting for discontinued opera tions have been superceded by the provisions of FAS 144, required that we accrue estimates for future operating loses, gains/losses on sale, costs to dispose and carry costs of these businesses at the time the businesses were discontinued. Accordingly, at December 31, 2000, we recorded a provision for operating losses and carrying costs during the phase-out period for our Intellesale and other non-core businesses including estimated disposal costs to be incurred in selling the businesses. Carrying costs consisted primarily of cancellation of facility and equipment leases, legal settlements, employment contract buyouts and sales tax liabilities. The following table sets forth the roll forward of the liabilities for operating losses and carrying costs for

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the periods December 31, 2002 to September 30, 2003, and December 31, 2003 through September 30, 2004. The additions/reductions represent a change in the estimated carrying costs during the phase out period, as certain of these costs were settled for more/less than anticipated, as well as to operating costs associated with one remaining business within this group, which was sold in July 2003.

Type of Cost (in thousands)

Balance

December 31,

2002

Additions

Deductions

Balance

September 30,

2003

Change in estimated operating losses

$

—

$

176

$

176

$

—

Carrying costs

4,908

316

111

5,113

Total

$

4,908

$

492

$

287

$

5,113

Type of Cost (in thousands)

Balance

December 31, 2003

Additions (Reductions)

Deductions

Balance

September 30, 2004

Carrying costs

$

4,913

$

(2,184

)

$

1,853

$

876

LIQUIDITY AND CAPITAL RESOURCES FROM CONTINUING OPERATIONS

As of September 30, 2004, cash and cash equivalents totaled $8.1 million, a decrease of $2.1 million, or 20.6%, from $10.2 million at December 31, 2003.

Operating activities used cash of $9.6 million and $5.0 million during the nine-months ended September 30, 2004 and 2003, respectively. During the nine-months ended September 30, 2004, cash was used primarily to fund losses, for purchases of inventory, to fund discontinued operations, and also as a result of an increase in accounts receivable. During the nine-months ended September 30, 2003, cash was used primarily to purchase inventory.

Accounts and unbilled receivables, net of allowance for doubtful accounts increased by $1.5 million, or 10.6%, to $15.6 million at September 30, 2004, from $14.1 million at December 31, 2003. We attribute the increase primarily to accounts receivable associated with our Digital Angel segment as a result of increased sales during the three-months ended September 30, 2004, as compared to the three-months ended December 31, 2003.

Inventory levels increased by $3.4 million, or 36.2%, to $12.8 million at September 30, 2004, from $9.4 million at December 31, 2003. We attribute the increase primarily to an increase in work-in-process related to government contract projects.

Accounts payable increased by $1.9 million, or 14.0%, to $15.5 million at September 30, 2004, from $13.6 million at December 31, 2003, primarily as a result of vendor invoices associated with the increase in work-in-process related to government contract projects.

Accrued expenses decreased by $1.8 million, or 7.9%, to $20.9 million at September 30, 2004, from $22.7 million at December 31, 2003, due primarily to the payment of certain bonuses during January 2004, which were accrued in 2003.

Investing activities provided cash of $0.1 million and $0.3 million during the nine-months ended September 30, 2004 and 2003, respectively. During the nine-months ended September 30, 2004, cash of $0.7 million was provided primarily from the collection of notes receivable and cash of $1.7 million was provided from the sale of certain assets related to our Discontinued Operations, offset by cash of $1.1 million

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used to purchase property and equipment, and cash of $0.7 million used to purchase other assets. During the nine-months ended September 30, 2003, cash was provided primarily by collections on notes receivable of $1.5 million, and used primarily to purchase property and equipment of $1.0 million.

Financing activities provided cash of $7.5 million and $4.1 million during the nine-months ended September 30, 2004 and 2003, respectively. During the nine-months ended September 30, 2004, cash of $5.7 million was provided from the issuances of common shares, and $3.8 million of cash was provided by subsidiary issuances of common stock. During the nine-months ended September 30, 2003, cash of $20.8 million was provided primarily from the issuances of common stock, $10.0 million was provided from the issuance of debentures, and cash of $27.6 million was used primarily to repay notes payable.

Liquidity and Debt Covenants

As of September 30, 2004, our consolidated cash and cash equivalents totaled $8.8 million, including restricted cash of $0.7 million. During October 2004, we generated cash of approximately $11.8 million from the sale of 2.5 million shares of our common stock to SSFA, and the exercise of SSFA’s Series A Warrants. These transactions are more fully described in Note 4 to our Condensed Consolidated Financial Statements. In addition, on October 13, 2004, Digital Angel Corporation realized net proceeds of $4.0 million from the sale of 1.1 million shares of our common stock that we issued to them in March 2004 under the terms of the Share Exchange Agreement, which is more fully described in Note 7 to our Condensed Consolidated Financial Statements.

We believe that we have sufficient funds to operate our business over the next twelve months. However, our goal is to achieve profitability and to generate positive cash flows from operations. We have established a management plan to guide us in achieving profitability and positive cash flows from operations during the remainder of 2004 and 2005. The major components of the plan are discussed below. No assurance can be given that we will be successful in implementing the plan. Our profitability and cash flows from operations depend on many factors including the success of our marketing programs, the maintenance and reduction of expenses and our ability to successfully develop and bring to market our new products and technologies. On October 12, 2004, we obtained the FDA’s clearance to market VeriChip^TM for medical applications, which had previously been one of the major components of our plan.

Laurus Master Fund Ltd. Credit Agreements

On July 31, 2003, Digital Angel Corporation entered into a Securities Purchase Agreement, referred to as the Purchase Agreement, to sell to Laurus Master Fund Ltd., referred to as Laurus, the Secured Convertible Note, referred to as the Convertible Note, in the original principal amount of $2.0 million and a five-year warrant to purchase up to approximately $0.1 million new shares of Digital Angel Corporation’s common stock. The Convertible Note is convertible, at Laurus’s option, into shares of Digital Angel Corporation’s common stock at a per share price of $2.33. The Convertible Note accrues interest at an annual rate equal to the higher of the prime rate plus 1.75% or 6% per annum, and matures on July 31, 2005. On September 30, 2004, $0.7 million was outstanding under the Convertible Note. In connection with the Convertible Note, Digital Angel Corporation entered into a Security Agreement with Laurus granting to Laurus a lien and security interest in its assets. Additionally, the Purchase Agreement includes default provisions should an event of default (as defined in the agreement) occur. On August 28, 2003, Digital Angel Corporation entered into a second security agreement, referred to as the Second Security Agreement, with Laurus under which we may borrow from Laurus the lesser of $5.0 million or an amount that is determined based on percentages of certain eligible accounts receivable and inventory as prescribed by the terms of the Second Security Agreement. Borrowings under the Second Security Agreement accrue interest at an annual rate equal to the prime rate plus 2.5%. We had availability under the Second Security

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Agreement of $2.1 million as of September 30, 2004.

Wells Fargo Credit Facility and IBM Credit Wholesale Agreement

On June 30, 2004, InfoTech USA, Inc. entered into the Credit Facility with Wells Fargo providing for up to $4.0 million in borrowings. Amounts borrowed under the Credit Facility bear interest at Wells Fargo’s prime rate plus 3%. The Credit Facility matures on June 29, 2007, and automatically renews for successive one-year periods thereafter unless terminated by either party. In connection with the execution of the Credit Facility, InfoTech USA, Inc. and IBM Credit entered into a new Wholesale Agreement. Under the terms of the Credit Facility, Wells Fargo may, at its election, make advances as requested from time to time in amounts up to an amount equal to the difference between the borrowing base and the sum of (i) the amount outstanding under the Credit Facility, and (ii) the $0.6 million letter of credit agreeme nt outstanding under the Credit Facility which secures the obligations to IBM Credit under the Wholesale Agreement. The borrowing base is equal to the lesser of $4.0 million or the amount equal to 85% of (i) eligible accounts receivable, plus (ii) the amount of available funds on deposit at Wells Fargo, and minus (iii) certain specified reserves. As of September 30, 2004, the borrowing base was approximately $1.8 million and approximately $0.4 million was available under the Credit Facility. The Credit Facility requires InfoTech USA, Inc. to maintain certain financial covenants, limits its capital expenditures, and contains other standard covenants including prohibitions on its incurrence of additional debt, sales of its assets and other corporate transactions of InfoTech USA, Inc. without Wells Fargo’s consent.

Under the terms of the Wholesale Agreement, IBM Credit may, at its election, advance InfoTech USA, Inc. up to $0.6 million to be used for the purchase of certain computer hardware and software products approved in advance by IBM Credit. Amounts outstanding under the Wholesale Agreement are required to be secured by a $0.6 million irrevocable letter of credit and bear finance charges in an amount to be agreed upon with IBM Credit from time to time. The Wholesale Agreement will remain in effect until terminated by either party upon at least 90 days written notice. As of September 30, 2004, $0.3 million was outstanding under the Wholesale Agreement and $0.3 million was available for future advances.

As of September 30, 2004, InfoTech USA, Inc. may not be in compliance with certain of its financial covenants under its Credit Facility with Wells Fargo. In the event of any such noncompliance, InfoTech USA, Inc. will seek to obtain a waiver. No assurance can be given that such waiver will be granted. If such a waiver is not granted, it could have an adverse effect on InfoTech USA, Inc. and us.

Management Plan to Achieve Profitability and Positive Cash Flow from Operations

Our ability to achieve profitability and/or generate positive cash flows from operations in the future is predicated upon numerous factors with varying levels of importance as follows:

·   First, we will attempt to successfully implement our business plans, manage expenditures according to our budget, and generate positive cash flow from operations;

·   Second, we will attempt to develop an effective marketing and sales strategy in order to grow our business and compete successfully in our markets;

·   Third, we will attempt to expand the market for our VeriChip^TM product, particularly for its medical, security and financial applications;

·   Fourth, we will attempt to realize positive cash flow with respect to our investment in Digital Angel Corporation in order to provide us with an appropriate return on our investment; and

·   Finally, we will attempt to complete the development of the Digital Angel^TM technology.

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We have established a management plan to assist us in achieving profitability and positive cash flows over the twelve-months ending September 30, 2005. The major components of our plan are as follows:

·   To attempt to establish a sustainable positive cash flow business model;

·   To attempt to produce additional cash flow and revenue from our advanced technology products -VeriChip^TM, Bio-Thermo^TM, Digital Angel^TM and Thermo Life^TM;

·   To attempt to capitalize on the FDA’s recent approval of VeriChip^TM for medical applications through strategic partnerships and alliances with healthcare providers;

·   To generate additional liquidity through divestiture of business units and assets that are not critical to us;

·   To position Digital Angel Corporation for growth under the leadership of its management team and through strategic acquisitions such as the OuterLink acquisition made in January 2004;

·   To generate additional liquidity through transactions such as the Share Exchange Agreement described in Note 7 to our Condensed Consolidated Financial Statements; and

·   To attempt to pair VeriChip Corporation with a complementary company that will bring experienced management, revenue and a synergistic customer base.

Our management believes that the above plan can be effectively implemented. As of September 30, 2004, we had a working capital deficiency. However, a significant portion of the past due liabilities associated with the Discontinued Operations and All Other business units have not been guaranteed by us and/or we do not intend to repay such liabilities in cash during the next twelve months. Therefore, notwithstanding our working capital deficiency, we believe that with our current cash position, our expectations about the achievement of our management plan, and the reliance on our various other sources of liquidity as discussed below, we should have sufficient working capital to satisfy our needs over the next twelve months.

We believe that with the cash we have on hand and the revenue and related cash flows we expect to generate during the next twelve months from our Advanced Technology segment, we will have sufficient funds available to cover the operating expenses of this segment as well as our corporate overhead (exclusive of the corporate overhead of Digital Angel Corporation and InfoTech USA, Inc.). We believe that our Digital Angel Corporation segment will have sufficient funds to cover its operating expenses over the next twelve months as a result of cash flow from operations, the availability under the credit facilities with Laurus and the proceeds from the sale of our common stock issued under the Share Exchange Agreement. We believe that our InfoTech USA, Inc. segment will have sufficient funds to cover its operating expenses ov er the next twelve months as a result of cash flow from operations and availability under the Credit Facility with Wells Fargo and the Wholesale Agreement with IBM Credit.

The primary source of revenue for the Advanced Technology segment is the sale of voice, data and video telecommunications networks to various branches of the U.S. government. The future revenue outlook for such sales is expected to be positive. During the last quarter of 2004 and beyond, our focus will be to generate significant revenue and cash flow from our advanced technology products. We hope to realize

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positive cash flow in the next twelve months and beyond as these products gain customer acceptance and awareness throughout the world.

The specific components and the approximate amount of funds we anticipate we will need to continue operating for the next twelve months are as follows:

·   To fund operations (excluding research and development) - none, as we are hopeful that we will be able to achieve cash flow from operations, exclusive of research and development expense;

·   To fund research and development - approximately $4.0 million;

·   To fund capital expenditures - approximately $1.5 million; and

·   To fund current maturities of principal debt payments - approximately $4.9 million.

The nature of our business is such that it does not require a material cash outlay for capital expenditures, and we have no plans to make significant investments in capital expenditures for the next twelve months.

Sources of Liquidity

Our sources of liquidity include proceeds from the sale of common stock and preferred shares, availability under our credit agreements with Laurus and Wells Fargo, proceeds from the sale of businesses, proceeds from the sale of the Digital Angel Corporation common stock owned by us, proceeds from the exercise of stock options and warrants, proceeds from InfoTech USA, Inc.’s Wholesale Agreement with IBM Credit, and the raising of capital through the private placement or public offering of our debt or equity securities. However, some of these options may not be available, or if available, they may not be on favorable terms. 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 investmen t required to bring new products on-line, revenue growth or decline, and potential acquisitions. Failure to generate positive cash flow from operations will have a material adverse effect on our business, financial condition and results of operations.

Outlook

We are constantly looking for ways to maximize shareholder value. As such, we are continually seeking operational efficiencies and synergies within our operating segments as well as evaluating acquisitions of businesses and customer bases which complement our operations. These strategic initiatives may include acquisitions, raising additional funds through debt or equity offerings, or the divestiture of business units that are not critical to our long-term strategy or other restructuring or rationalization of existing operations. We will continue to review all alternatives to ensure maximum appreciation of our shareholders’ investments. However, initiatives may not be found, or if found, they may not be on terms favorable to us.

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IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities—an Interpretation of ARB No. 51 (“FIN 46”), which addresses consolidation of variable interest entities. FIN 46 expands the criteria for consideration in determining whether a variable interest entity should be consolidated by a business entity, and requires existing unconsolidated variable interest entities (which include, but are not limited to, Special Purpose Entities, or SPEs) to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. On October 9, 2003, the FASB issued Staff Position No. 46-6 which deferred the effective date for applying the provisions of FIN 46 for interests held by public entities in variable interest entities or potential variable interest entities created before February 1, 2003. On December 24, 2003, the FASB issued a revision to FIN 46. Under the revised interpretation, the effective date was delayed to periods ending after March 15, 2004, for all variable interest entities, other than SPEs. The adoption of FIN 46 did not have any impact on our financial condition, results of operations or cash flows.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“FAS No. 150”). FAS 150 establishes standards for how companies classify and measure certain financial instruments with characteristics of both liabilities and equity. It requires companies to classify a financial instrument that is within its scope as a liability, or an asset, in some circumstances. FAS No. 150 is effective beginning with the second quarter of fiscal 2004. We do not currently have financial instruments with characteristics of both liabilities and equity, and therefore, the adoption of FAS No. 150 did not presently have an impact on our financial condition, results of operations or cash flows.

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Forward-Looking Statements

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

·   our growth strategies including, without limitation, our ability to deploy our products and services including VeriChip^TM, Bio-Thermo^TM, Digital Angel^TM and Thermo Life^TM;

·   anticipated trends in our business and demographics;

·   the ability to hire and retain skilled personnel;

·   relationships with and dependence on technological partners;

·   uncertainties relating to customer plans and commitments;

·   our ability to successfully integrate the business operations of acquired companies;

·   our future profitability and liquidity;

·   governmental export and import policies, global trade policies, worldwide political stability and economic growth;

·   regulatory, competitive or other economic influences; and

·   all statements referring to the future or future events.

In some cases, you can identify forward-looking statements by terms such as “may,” “should,” “could,” “would,” “anticipates,” “expects,” “attempt,” “intends,” “plans,” “hopes,” “believes,” “seeks,” “estimates” and similar expressions intended to identify forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from estimates or forecasts contained in the forward-looking statements. Some of these risks and uncertainties are beyond our control. Also, these forward-looking statements represent our estimates and assumptions only as of the date the statement was made.

The information in this Form 10-Q is as of September 30, 2004, or, where clearly indicated, as of the date of this filing. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. We also may make additional disclosures in our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K that we may file from time to time with the Securities and Exchange Commission. Please also note that we provide a cautionary discussion of risks and uncertainties under the section entitled “Risk Factors” in our Annual Report on Form 10-K, as amended, for the year ended December 31, 2003. These are factors that we think could cause our actual results to differ materially from expected results. Other factors b esides those listed could also adversely affect us.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As with our United Kingdom subsidiary, we have operations and sales in various regions of the world. Additionally, we export and import to and from other countries. Our operations may therefore be subject to volatility because of currency fluctuations, inflation and changes in political and economic conditions in these countries. Sales and expenses are denominated in local currencies and may be affected as currency fluctuations affect our product prices and operating costs or those of our competitors.

We presently do not use any derivative financial instruments to hedge our exposure to adverse fluctuations in interest rates, foreign exchange rates, fluctuations in commodity prices or other market risks, nor do we invest in speculative financial instruments. As of September 30, 2004, our debt consisted of borrowings under our loan agreements with Laurus and Wells Fargo, mortgage notes with fixed interest rates and capitalized leases with fixed implicit interest rates. Our borrowings under our loan agreements with Laurus bear interest at prime plus 1.75% to prime plus 2.5%, and our borrowings under our Credit Facility with Wells Fargo bear interest at prime plus 3%. Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since the majority of our investments are short-term .

Due to the nature of our short-term investments, and the de minimus amounts of our foreign currency gains and losses, we have concluded that there is no material market risk exposure and, therefore, no quantitative tabular disclosure is required.

The table below presents the principal amount and weighted-average interest rate for our debt portfolio:

Carrying Value at

September 30, 2004

Dollars in Thousands

Total notes payable and long-term debt (including current portion)

$7,177

Notes payable bearing interest at fixed interest rates (including current portion)

$2,342

Weighted-average interest rate on notes payable and

long-term debt during the nine-months

ended September 30, 2004

14.4%

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ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

The Company’s Chief Executive Officer and Chief Financial Officer have reviewed and evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 240.13a - 15(e) and 240.15d - 15(e)) as of the end of the quarterly period ended September 30, 2004. Based on that evaluation, they have concluded that the Company’s disclosure controls and procedures as of the end of the period covered by this report are effective in timely providing them with material information relating to the Company required to be disclosed in the reports the Company files or submits under the Exchange Act. The Company’s disclosure controls and procedures are designed to provide reasonable assurances of achieving their objectives and the Company’s Chief Executive Officer and Ch ief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective in reaching that level of reasonable assurance.

(b) Changes in Internal Control Over Financial Reporting

There have not been any changes in the Company’s internal controls over financial reporting identified in connection with an evaluation thereof that occurred during the Company’s third fiscal quarter that have materially affected, or are reasonable likely to materially affect the Company’s internal control over financial reporting. There were no significant deficiencies or material weaknesses, and therefore no corrective actions were taken.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

We, and certain of our subsidiaries, are parties to various legal actions as either plaintiff or defendant and accordingly, have recorded certain reserves in our financial statements as of September 30, 2004. In our opinion, these proceedings are not likely to have a material adverse affect on our financial position, our cash flows or our overall trends in results. The estimate of the potential impact on our financial position, our overall results of operations or our cash flows for these proceedings could change in the future. See Note 13 to our Condensed Consolidated Financial Statements for a description of certain of these proceedings.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

An annual meeting of our shareholders was held on July 24, 2004. The results of the matters voted on by our shareholders at the meeting are presented in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.

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ITEM 5. OTHER INFORMATION

Website Access to Information and Disclosure of Web Access to Company Reports

Our website address is: http://www.adsx.com. We make available free of charge through our website our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, Forms 3, 4 and 5, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with the Securities and Exchange Commission.

ITEM 6. EXHIBITS
Exhibits

i. We have listed the exhibits by numbers corresponding to the Exhibit Table of Item 601 in Regulation S-K on the Exhibit list attached to this report

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SIGNATURE

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

Applied Digital Solutions, Inc.

(Registrant)

Date: November 3, 2004 By:   /s/ EVAN C. MCKEOWN

Evan C. McKeown

Senior Vice President, Chief

Financial Officer

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Exhibit
Number

Description

3.1

Amended and Restated Bylaws of the Registrant dated March 31, 1998 (incorporated by reference to Exhibit 4.7 to the registrant’s Post-Effective Amendment No. 1 to Registration Statement on Form S-1 (File No. 333-102165) filed with the Commission on April 14, 2003)

3.2

Fourth Restated Articles of Incorporation of the Registrant filed with the Secretary of State of Missouri on August 26, 2003 (incorporated by reference to Exhibit 4.8 to the registrant’s Registration Statement on Form S-1 (File No. 333-108338) filed with the Commission on August 28, 2003)

3.3

Amendment of Fourth Restated Articles of Incorporation of the Registrant filed with the Secretary of State of Missouri on March 19, 2004 (incorporated by reference to Exhibit 3.14 to the registrant’s Quarterly Report on Form 10-Q filed with the Commission on May 5, 2004)

10.1
International Distribution Agreement dated September 22, 2004, by and between VeriChip Corporation and Surge IT Solutions for the territory of England*

31.1

Certification by Scott R. Silverman, Chief Executive Officer, pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a)*

31.2

Certification by Evan C. McKeown, Chief Financial Officer, pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a)*

32.1

Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*

32.2

Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*

* Filed herewith

58

MISSOURI	43-1641533
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

Class	Number of Shares
Common Stock: $.01 Par Value	56,365,010

	September 30,			December 31,
	2004			2003
Current Assets	(unaudited)
Cash and cash equivalents	$	8,108		$	10,161
Restricted cash		650			765
Accounts receivable and unbilled receivables (net of allowance
for doubtful accounts of $1,033 in 2004 and $1,028 in 2003)		15,638			14,078
Inventories		12,792			9,444
Notes receivable		1,188			1,658
Other current assets		2,274			2,760
Total Current Assets		40,650			38,866

Property And Equipment, net		7,949			8,228

Notes Receivable, net		291			504

Goodwill, net		67,296			63,331

Other Assets, net		5,700			1,002

	$	121,886		$	111,931

Liabilities and Stockholders’ Equity

Current Liabilities
Notes payable and current maturities of long-term debt	$	4,873		$	5,226
Accounts payable		15,502			13,639
Other accrued expenses		20,875			22,717
Net liabilities of Discontinued Operations		5,401			8,294
Total Current Liabilities		46,651			49,876

Long-Term Debt and Notes Payable		2,304			2,860

Other Long-Term Liabilities		2,873			3,430

Total Liabilities		51,828			56,166

Commitments And Contingencies

Minority Interest		31,919			23,029

Stockholders’ Equity
Preferred shares: Authorized 5,000 shares in 2004 and 2003 of $10 par value; special voting,
no shares issued or outstanding in 2004 and 2003, Class B voting, no shares issued or
outstanding in 2004 and 2003		—			—
Common shares: Authorized 125,000 shares in 2004 and 560,000 shares in 2003, of $.01 par
value; 52,581 shares issued and 51,411 shares outstanding in 2004
and 41,220 shares issued and 41,126 shares outstanding in 2003		526			412
Common and preferred additional paid-in capital		452,887			443,099
Accumulated deficit		(417,898	)		(413,923	)
Common stock warrants		7,085			5,650
Treasury stock (carried at cost, 1,170 shares in 2004 and 94 in 2003)		(4,120	)		(1,777	)
Accumulated other comprehensive income		206			206
Notes received for shares issued		(547	)		(931	)
Total Stockholders’ Equity		38,139			32,736

	$	121,886		$	111,931

Item	Description	Page

	PART I - FINANCIAL INFORMATION

1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets — September 30, 2004 and December 31, 2003	3
	Condensed Consolidated Statements of Operations — Three and Nine-Months ended September 30, 2004 and 2003	4
	Condensed Consolidated Statement of Stockholders’ Equity — Nine-Months ended September 30, 2004	5
	Condensed Consolidated Statements of Cash Flows — Nine-Months ended September 30, 2004 and 2003	6
	Notes to Condensed Consolidated Financial Statements	7
2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	33
3.	Quantitative and Qualitative Disclosures About Market Risk	54
4.	Controls and Procedures	55

	PART II - OTHER INFORMATION

1.	Legal Proceedings	55
2.	Unregistered Sales of Equity Securities and Use of Proceeds	55
3.	Defaults Upon Senior Securities	55
4.	Submission of Matters to a Vote of Security Holders	55
5.	Other Information	56
6.	Exhibits	56

SIGNATURE		57
EXHIBITS		58
CERTIFICATIONS

	For The Three-Months						For The Nine-Months
	Ended September 30,						Ended September 30,
	2004			2003			2004			2003

Product revenue	$	23,808		$	18,608		$	69,305		$	56,438
Service revenue		3,918			4,860			11,260			11,822
Total revenue		27,726			23,468			80,565			68,260

Cost of products sold		17,927			15,065			51,956			42,363
Cost of services sold		2,168			1,323			5,672			4,300

Gross profit		7,631			7,080			22,937			21,597

Selling, general and administrative expense		8,926			4,941			25,730			46,432
Research and development		995			1,839			3,060			4,464
Depreciation and amortization		445			259			1,425			966
Interest and other income		(247	)		(232	)		(827	)		(664	)
Gain on forgiveness of debt		—			424			—			(69,968	)
Interest expense (reduction)		60			1,824			(389	)		10,952

(Loss) income from continuing operations before taxes,
minority interest and (gain) loss attributable to capital
transactions of subsidiary		(2,548	)		(1,975	)		(6,062	)		29,415

(Benefit) provision for income taxes		(14	)		(17	)		105			758

(Loss) income from continuing operations before minority interest and
loss (gain) attributable to capital transactions of subsidiary		(2,534	)		(1,958	)		(6,167	)		28,657

Minority interest		(118	)		(653	)		(808	)		(1,498	)

Net loss on capital transactions of subsidiary		38			103			1,805			324

Loss (gain) attributable to changes in minority interest as a result of capital transactions of subsidiary		298			(371	)		(1,593	)		577

(Loss) income from continuing operations		(2,752	)		(1,037	)		(5,571	)		29,254

Income (loss) from discontinued operations		202			(222	)		(588	)		(496	)

Change in estimate on loss on disposal of discontinued operations
and operating losses during the phase out period		70			99			2,184			(492	)

Net (loss) income	$	(2,480	)	$	(1,160	)	$	(3,975	)	$	28,266

(Loss) income per common share - basic
(Loss) income from continuing operations	$	(0.05	)	$	(0.03	)	$	(0.11	)	$	0.93
(Loss) income from discontinued operations		—			—			0.03			(0.03	)

Net (loss) income per common share - basic	$	(0.05	)	$	(0.03	)	$	(0.08	)	$	0.90

(Loss) income per common share - diluted
(Loss) income from continuing operations	$	(0.05	)	$	(0.03	)	$	(0.11	)	$	0.92
(Loss) income from discontinued operations		—			—			0.03			(0.03	)

Net (loss) income per common share - diluted	$	(0.05	)	$	(0.03	)	$	(0.08	)	$	0.89

Weighted average number of common shares outstanding - basic		51,195			35,356			50,003			31,538

Weighted average number of common shares outstanding - diluted		51,195			35,356			50,003			33,462

								Additional Paid-In Capital			Accumulated Deficit			Common Stock Warrants		Treasury Stock			Accumulated Other Comprehensive Income		Notes Received For Shares Issued			Total Stockholders' Equity

	Preferred Stock			Common Stock
	Number		Amount	Number		Amount

Balance - December 31, 2003	—	$	—	41,220	$	412	$	443,099		$	(413,923	)	$	5,650	$	(1,777	)	$	206	$	(931	)	$	32,736
Net loss	—		—	—		—		—			(3,975	)		—		—			—		—			(3,975	)
Comprehensive (loss) income -
Foreign currency translation	—		—	—		—		—			—			—		—			—		—			—

Total comprehensive (loss) income	—		—	—		—		—			(3,975	)		—		—			—		—			(3,975	)

Adjustment to allowance for uncollectible portion of notes receivable	—		—	—		—		—			—			—		—			—		384			384
Stock option repricing	—		—	—		—		(391	)		—			—		—			—		—			(391	)
Extension of warrants	—		—	—		—		—			—			176		—			—		—			176
Issuance of common shares and warrants	—		—	2,144		21		4,104			—			1,259		—			—		—			5,384
Issuance of common shares for compensation and legal settlement	—		—	7,238		72		1,067			—			—		—			—		—			1,139
Issuance of common shares to Digital Angel Corporation	—		—	1,979		21		5,008			—			—		(2,343	)		—		—			2,686

Balance - September 30, 2004	—	$	—	52,581	$	526	$	452,887		$	(417,898	)	$	7,085	$	(4,120	)	$	206	$	(547	)	$	38,139

		Three-Months Ended September 30,			Three-Months Ended September 30,			Nine-Months Ended September 30,			Nine-Months Ended September 30,
		2004			2003			2004			2003
	(in thousands, except per share amounts)

Net (loss) income, as reported	$	(2,480	)	$	(1,160	)	$	(3,975	)	$	28,266
Add back (deduct): Total stock-based employee compensation expense determined under APB 25 for all awards, net of related tax effects⁽¹⁾		(24	)		(460	)		(382	)		(1,459	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects ⁽²⁾		(2,017	)		(1,210	)		(5,483	)		(4,089	)

Pro forma net (loss) income	$	(4,521	)	$	(2,830	)	$	(9,840	)	$	22,718

(Loss) income per share:
Basic—as reported	$	(0.05	)	$	(0.03	)	$	(0.08	)	$	0.90
Diluted—as reported	$	(0.05	)	$	(0.03	)	$	(0.08	)	$	0.89
Basic—pro forma	$	(0.09	)	$	(0.08	)	$	(0.20	)	$	0.72
Diluted—pro forma	$	(0.09	)	$	(0.08	)	$	(0.20	)	$	0.72

	Three-Months Ended September 30, 2004			Three-Months Ended September 30, 2003		Nine-Months Ended September 30, 2004			Nine-Months Ended September 30, 2003
Estimated option life		8 years			—		8 years			5.5 years
Risk free interest rate		4.07	%		—		4.03	%		1.51	%
Expected volatility		69.00	%		—		69.00	%		76.00	%
Expected dividend yield		0.00	%		—		0.00	%		0.00	%

		September 30, 2004			December 31, 2003
	(in thousands)
Raw materials	$	3,264		$	1,982
Work in process		5,885			2,723
Finished goods		5,658			6,598
		14,807			11,303
Allowance for excess and obsolescence		(2,015	)		(1,859	)
	$	12,792		$	9,444

	(in thousands)
Shares of common stock	$	4,240
Series A Warrant		378
Series B Warrant		880
Subtotal		5,498
Less costs and expenses		(180	)
Net proceeds	$	5,318

	Three-Months Ended September 30, 2004
	(in thousands)
		Advanced Technology			Digital Angel Corporation			InfoTech USA, Inc.			All Other			“Corporate/ Eliminations”			Consolidated
Net revenue from external customers: Product	$	10,282		$	10,668		$	2,876		$	—		$	(18	)	$	23,808
Service		2,723			512			683			—			—			3,918
Intersegment revenue - product		—			(18	)		—			—			18			—
Total revenue	$	13,005		$	11,162		$	3,559		$	—		$	—		$	27,726

Income (loss) from continuing operations before taxes, minority interest and loss (gain) attributable to capital transactions of subsidiary	$	(253	)	$	(328	)	$	(249	)	$	(200	)	$	(1,518	)	$	(2,548	)

Total assets	$	43,002		$	77,102		$	9,208		$	2,662		$	(10,088	)	$	121,886

		Three-Months Ended September 30, (in thousands)
		2004						2003
		Product		Service		Total		Product		Service		Total

Advanced Technology
Voice, data and video telecommunications networks	$	9,261	$	1,561	$	10,822	$	8,064	$	1,182	$	9,246
Call center and customer relationship management software		998		1,162		2,160		243		1,314		1,557
Implantable microchips and RFID scanners		23		—		157		148		—		148
Website design and Internet access		—		—		—		289		744		1,033

Total	$	10,282	$	2,723	$	13,005	$	8,514	$	2,737	$	11,251

		Three-Months Ended September30, (in thousands)
		2004						2003
		Product		Service		Total		Product		Service		Total

InfoTech USA, Inc.
Computer hardware	$	2,876	$	—	$	2,876	$	3,419	$	—	$	3,419
Computer services		—		683		683		—		806		806

Total	$	2,876	$	683	$	3,559	$	3,419	$	806	$	4,225

		Nine-Months Ended September 30, (in thousands)
		2004						2003
		Product		Service		Total		Product		Service		Total

Advanced Technology
Voice, data and video telecommunications networks	$	26,859	$	4,307	$	31,166	$	21,619	$	3,553	$	25,172
Call center and customer relationship management software		1,250		3,068		4,318		505		3,764		4,269
Implantable microchips and RFID scanners		179		—		179		271		—		271
Website design and Internet access		—		—		—		373		986		1,359

Total	$	28,288	$	7,37523	$	35,663	$	22,768	$	8,303	$	31,071

		Nine-Months Ended September30, (in thousands)
		2004						2003
		Product		Service		Total		Product		Service		Total

InfoTech USA, Inc.
Computer hardware	$	10,511	$	—	$	10,511	$	8,686	$	—	$	8,686
Computer services		—		2,446		2,446		—		2,043		2,043

Total	$	10,511	$	2,446	$	12,957	$	8,686	$	2,043	$	10,.729

(In thousands)		Three-Months Ended September 30, 2003			Nine-Months Ended September 30, 2004			Nine-Months Ended September 30, 2003
Net operating revenue	$	23,895		$	80,652		$	69,282
Net (loss) income from continuing operations	$	(1,581	)	$	(6,030	)	$	27,115
(Loss) income per share from continuing operations:
(Loss) income per common share - basic	$	(0.04	)	$	(0.12	)	$	0.86
(Loss) income per common share - diluted	$	(0.04	)	$	(0.12	)	$	0.86

	For The Three- Months Ended September 30,						For The Nine- Months Ended September 30,
	2004			2003			2004			2003
	(in thousands, except per share amounts)
Issuances of common stock for stock option exercises		127			106			957			484
Issuance of common stock under the Letter Agreement		50			—			200			—
Issuance of common stock under the Share Exchange Agreement		—			—			3,000			—
Total issuances of common stock		177			106			4,157			484
Proceeds from stock issuances	$	211		$	14		$	9,740		$	238
Average price per share	$	1.20		$	0.13		$	2.34		$	0.49
Beginning ownership percentage of Digital Angel Corporation		68.41	%		72.87	%		66.93	%		73.91	%
Ending ownership percentage of Digital Angel Corporation		68.05	%		72.57	%		68.05	%		72.57	%
Decrease (increase) in ownership percentage		0.36	%		0.30	%		(1.12	)%		1.34	%
Net loss on capital transactions of subsidiary ⁽¹⁾	$	38		$	103		$	1,805		$	324
Loss (gain) attributable to changes in minority interest as a result of capital transactions of subsidiary ⁽¹⁾	$	298		$	(371	)	$	(1,593	)	$	577

Medical Systems	September 30, 2004			December 31, 2003
	(in thousands)
Assets
Accounts receivable, net	$	19		$	453
Inventory		—			46
Other current assets		—			43
Property and equipment, net		—			1,137
Intangible assets, net		—			489
Other assets		135			163
Total Assets	$	154		$	2,331

Current Liabilities:
Notes payable and current maturities of long-term debt	$	—		$	(910	)
Accounts payable		—			(71	)
Accrued expenses		(53	)		(99	)
Total Liabilities	$	(53	)	$	(1,080	)

Net Assets	$	101		$	1,251

Intellesale and Other Non-Core Businesses	September 30, 2004			December 31, 2003
	(in thousands)
Current Liabilities:
Notes payable and current maturities of long-term debt	$	(26	)	$	(26	)
Accounts payable		(4,178	)		(4,178	)
Accrued expenses		(1,298	)		(5,341	)
Total Liabilities	$	(5,502	)	$	(9,545	)

Net Liabilities	$	(5,502	)	$	(9,545	)

Total Discontinued Operations	September 30, 2004				December 31, 2003
	(in thousands)
Assets
Accounts receivable, net	$	19		$		453
Inventory		—				46
Other current assets		—				43
Property and equipment, net		—				1,137
Intangible assets, net		—				489
Other assets		135				163
Total Assets	$	154		$		2,331

Current Liabilities:
Notes payable and current maturities of long-term debt	$	(26	)	$		(936	)
Accounts payable		(4,178	)			(4,249	)
Accrued expenses		(1,351	)			(5,440	)
Total Liabilities	$	(5,555	)	$		(10,625	)

Net Liabilities of Discontinued Operations	$	(5,401	)	$		(8,294	)

Type of Cost (in thousands)		Balance December 31, 2002		Additions		Deductions		Balance September 30, 2003

Change in estimated operating losses	$	—	$	176	$	176	$	—
Carrying costs		4,908		316		111		5,113
Total	$	4,908	$	492	$	287	$	5,113

Type of Cost (in thousands)	Balance December 31, 2003		Additions (Reductions)			Deductions		Balance September 30, 2004

Carrying costs	$	4,913	$	(2,184	)	$	1,853	$	876

	Previously Reported Three-Months Ended June 30, 2004			Revised Three-Months Ended June 30, 2004			Previously Reported Six-Months Ended June 30, 2004			Revised Six-Months Ended June 30, 2004
	(in thousands, except per share amounts)
Net loss from Continuing Operations	$	(2,232	)	$	(2,457	)	$	(2,481	)	$	(2,819	)
Net (loss) income from Discontinued Operations		(737	)		(512	)		987			1,325
Total net loss	$	(2,969	)	$	(2,969	)	$	(1,494	)	$	(1,494	)
Total basic and diluted loss per share - Continuing Operations	$	(0.04	)	$	(0.05	)	$	(0.05	)	$	(0.06	)
Total basic and diluted (loss) earnings per share - Discontinued Operations		(0.02	)		(0.01	)		0.02			0.03
Total net loss per share - basic and diluted	$	(0.06	)	$	(0.06	)	$	(0.03	)	$	(0.03	)


	Relationship to Revenue Three-Months Ended September 30,						Relationship to Revenue Nine-Months Ended September 30,
	2004			2003			2004			2003
	%			%			%			%
Product revenue		85.9			79.3			86.0			82.7
Service revenue		14.1			20.7			14.0			17.3
Total revenue		100.0			100.0			100.0			100.0
Cost of products sold		64.7			64.2			64.5			62.1
Cost of services sold		7.8			5.6			7.0			6.3
Total cost of products and services sold		72.5			69.8			71.5			68.4
Gross profit		27.5			30.2			28.5			31.6
Selling, general and administrative expense		32.2			21.1			31.9			68.0
Research and development		3.6			7.8			3.8			6.5
Depreciation and amortization		1.6			1.1			1.8			1.4
Interest and other income		(0.9	)		(1.0	)		(1.0	)		(1.0	)
Gain on forgiveness of debt		—			1.8			—			(102.5	)
Interest expense (reduction)		0.2			7.8			(0.5	)		16.0
(Loss) income from continuing operations before taxes, minority interest and loss (gain) attributable to capital transactions of subsidiary		(9.2	)		(8.4	)		(7.5	)		43.2
(Benefit) provision for income taxes		(0.1	)		(0.1	)		0.1			1.1
(Loss) income from continuing operations before minority interest and loss (gain) attributable to capital transactions of subsidiary		(9.1	)		(8.3	)		(7.6	)		42.1
Minority interest		(0.4	)		(2.8	)		(1.0	)		(2.2	)
Net loss on capital transactions of subsidiary		0.1			0.4			2.2			0.5
Loss (gain) attributable to changes in minority interest as a result of capital transactions of subsidiary		1.1			(1.6	)		(2.0	)		0.8
(Loss) income from continuing operations		(9.9	)		(4.3	)		(6.8	)		43.0
Income (loss) from discontinued operations		0.7			(0.9	)		(0.7	)		(0.7	)
Change in estimated loss on disposal of discontinued operations and operating losses during the phase out period		0.2			0.4			2.7			(0.7	)
Net (loss) income		(9.0	)		(4.8	)		(4.8	)		41.6

Sources of Revenue:	Percentage of Total Revenue

Voice, data and video telecommunications networks to government agencies from our Advanced Technology segment		38.7	%

Visual ear tags and implantable microchips and RFID scanners for the companion animal, livestock, laboratory animal, fish and wildlife markets from our Digital Angel Corporation segment		23.1	%

IT hardware and services from our InfoTech USA, Inc. segment		16.1	%

GPS enabled tracking and message monitoring, search and rescue equipment, intelligent communications products and services for telemetry, mobile data and radio communications from our Digital Angel Corporation segment		16.5	%

Other products and services		5.6	%

Total		100.0	%

Gross Profit and Gross Profit Margin by Product Type:		Gross Profit (in thousands)	Gross Margin Percentage

Voice, data and video telecommunications networks to government agencies from our Advanced Technology segment	$	4,847	15.6	%

Visual ear tags and implantable microchips and RFID scanners for the companion animal, livestock, laboratory animal, fish and wildlife markets from our Digital Angel Corporation segment		7,213	38.7	%

IT hardware and services from our InfoTech USA, Inc. segment		2,140	16.5	%

GPS enabled tracking and message monitoring, search and rescue equipment, intelligent communications products and services for telemetry, mobile data and radio communications from our Digital Angel Corporation segment		6,412	48.1	%

Other products and services		2,325	51.7	%

Total	$	22,937	28.5	%

	Three-Months Ended September 30,
			2004						2003
	Product		Service		Total		Product		Service		Total
	%		%		%		%		%		%
Advanced Technology		6.8		49.8		15.8		9.3		70.6		24.2
Digital Angel Corporation		44.9		43.0		44.8		33.2		104.0		44.9
InfoTech USA, Inc.		14.1		25.6		16.3		15.5		29.3		18.2
Corporate / Eliminations		—		—		—		—		—		—
Total		24.7		44.7		27.5		19.9		72.8		30.2

	Nine-Months Ended September 30,
			2004						2003
	Product		Service		Total		Product		Service		Total
	%		%		%		%		%		%
Advanced Technology		10.5		57.0		20.1		12.6		64.1		26.3
Digital Angel Corporation		42.7		41.6		42.7		40.4		102.4		43.9
InfoTech USA, Inc.		12.9		32.0		16.5		12.9		33.8		16.9
Corporate / Eliminations		—		—		—		—		—		—
Total		25.0		49.6		28.5		24.9		63.6		31.6

Type of Cost (in thousands)	Balance December 31, 2002		Additions		Deductions		Balance September 30, 2003

Change in estimated operating losses	$	—	$	176	$	176	$	—
Carrying costs		4,908		316		111		5,113
Total	$	4,908	$	492	$	287	$	5,113

Type of Cost (in thousands)		Balance December 31, 2003		Additions (Reductions)			Deductions		Balance September 30, 2004

Carrying costs	$	4,913	$	(2,184	)	$	1,853	$	876

	Carrying Value at September 30, 2004
Dollars in Thousands
Total notes payable and long-term debt (including current portion)		$7,177
Notes payable bearing interest at fixed interest rates (including current portion)		$2,342
Weighted-average interest rate on notes payable and long-term debt during the nine-months ended September 30, 2004		14.4%


	Applied Digital Solutions, Inc. (Registrant)

Date: November 3, 2004	By:	/s/ EVAN C. MCKEOWN

		Evan C. McKeown
		Senior Vice President, Chief
		Financial Officer

Exhibit Number		Description

3.1		Amended and Restated Bylaws of the Registrant dated March 31, 1998 (incorporated by reference to Exhibit 4.7 to the registrant’s Post-Effective Amendment No. 1 to Registration Statement on Form S-1 (File No. 333-102165) filed with the Commission on April 14, 2003)

3.2		Fourth Restated Articles of Incorporation of the Registrant filed with the Secretary of State of Missouri on August 26, 2003 (incorporated by reference to Exhibit 4.8 to the registrant’s Registration Statement on Form S-1 (File No. 333-108338) filed with the Commission on August 28, 2003)

3.3		Amendment of Fourth Restated Articles of Incorporation of the Registrant filed with the Secretary of State of Missouri on March 19, 2004 (incorporated by reference to Exhibit 3.14 to the registrant’s Quarterly Report on Form 10-Q filed with the Commission on May 5, 2004)

10.1		International Distribution Agreement dated September 22, 2004, by and between VeriChip Corporation and Surge IT Solutions for the territory of England*

31.1		Certification by Scott R. Silverman, Chief Executive Officer, pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a)*

31.2		Certification by Evan C. McKeown, Chief Financial Officer, pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a)*

32.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*

32.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*