Veriteq (DIGA) 10-Q 2004 Q1 Quarterly report

As filed with the Securities and Exchange Commission on May 4, 2004

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549

FORM 10-Q
(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934.
For the quarterly period ended March 31, 2004
or
[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from         to         

Commission File Number: 0-26020

APPLIED DIGITAL SOLUTIONS, INC.
(Exact name of registrant as specified in its charter)

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

400 Royal Palm Way, Suite 410
Palm Beach, Florida 33480
(561) 805-8000
(Address, including zip code, and telephone number,
including area code, of registrant’s principal executive offices)

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

Yes  x  No  o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  x  No  o

     The number of shares outstanding of each of the issuer’s classes of common stock as of the close of business on April 30, 2004:

Class	Number of Shares
Common Stock; $.01 Par Value	52,483,008

APPLIED DIGITAL SOLUTIONS, INC.

TABLE OF CONTENTS

Item	Description	Page
	PART I - FINANCIAL INFORMATION
1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets     March 31, 2004 and December 31, 2003	3
	Condensed Consolidated Statements of Operations -     Three Months ended March 31, 2004 and 2003	4
	Condensed Consolidated Statement of Stockholders’ Equity -     Three Months ended March 31, 2004	5
	Condensed Consolidated Statements of Cash Flows -     Three Months ended March 31, 2004 and 2003	6
	Notes to Consolidated Financial Statements	7
2.	Management’s Discussion and Analysis of Financial Condition                         and Results of Operations	26
3.	Quantitative and Qualitative Disclosures About Market Risk	50
4.	Controls and Procedures	50
	PART II - OTHER INFORMATION
1.	Legal Proceedings	51
2.	Changes In Securities	51
3.	Defaults Upon Senior Securities	52
4.	Submission of Matters to a Vote of Security Holders	52
5.	Other Information	52
6.	Exhibits and Reports on Form 8-K	52
SIGNATURE		53
EXHIBITS		54
CERTIFICATIONS

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)

Assets
		March 31,		December 31,
		2004		2003
Current Assets		(unaudited	)
Cash and cash equivalents	$	9,515		$	10,161
Restricted cash		785			765
Accounts receivable and unbilled receivables (net of allowance for doubtful accounts of $810 in 2004 and $1,035 in 2003)		15,764			14,531
Inventories		10,208			9,490
Notes receivable		1,245			1,658
Other current assets		2,836			2,803
Total Current Assets		40,353			39,408
Property And Equipment, net		9,169			9,365
Notes Receivable, net		318			504
Goodwill, net		66,692			63,331
Other Assets, net		6,698			1,654
	$	123,230		$	114,262
Liabilities and Stockholders’ Equity
Current Liabilities
Notes payable and current maturities of long-term debt	$	7,324		$	6,136
Accounts payable		14,407			13,710
Other accrued expenses		21,262			22,616
Put accrual		200			200
Net liabilities of Discontinued Operations		5,701			9,545
Total Current Liabilities		48,894			52,207
Long-Term Debt and Notes Payable		2,549			2,860
Other Long-Term Liabilities		3,166			3,430
Total Liabilities		54,609			58,497
Commitments And Contingencies		-			-
Minority Interest		31,761			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 2003, of $.01 par value; 50,571 shares      issued and 49,028 shares outstanding in 2004 and 41,220 shares issued and 41,126 shares      outstanding in 2003		506			412
Common and preferred additional paid-in capital		449,217			443,099
Accumulated deficit		(412,447	)		(413,923	)
Common stock warrants		5,650			5,650
Treasury stock (carried at cost, 1,543 shares in 2004 and 94 in 2003)		(5,690	)		(1,777	)
Accumulated other comprehensive income		227			206
Notes received from shares issued		(603	)		(931	)
Total Stockholders’ Equity		36,860			32,736
	$	123,230		$	114,262
See the accompanying notes to condensed consolidated financial statements.

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)

		For The Three Months    Ended March 31,
		2004			2003
Product revenue	$	23,203		$	21,023
Service revenue		3,655			4,083
Total revenue		26,858			25,106
Cost of products sold		16,806			14,328
Cost of services sold		1,860			1,965
Gross profit		8,192			8,813
Selling, general and administrative expense		8,604			29,468
Research and development		925			1,201
Depreciation and amortization		539			470
Interest and other income		(466	)		(220	)
Interest expense		(310	)		4,631
Loss from continuing operations before taxes, minority interest and (gain) loss attributable to capital transactions of subsidiary		(1,100	)		(26,737	)
Provision (benefit) for income taxes		92			(192	)
Loss from continuing operations before minority interest and (gain) loss attributable to capital transactions of subsidiary		(1,192	)		(26,545	)
Minority interest		(379	)		(139	)
Net loss on capital transactions of subsidiary		1,963			171
(Gain) loss attributable to changes in minority interest as a result of capital transactions of subsidiary		(2,150	)		206
Loss from continuing operations		(626	)		(26,783	)
Change in estimate on loss on disposal of discontinued operations and operating losses during the phase out period		2,102			(157	)
Net income (loss)	$	1,476		$	(26,940	)
Income (loss) per common share - basic
Income (loss) from continuing operations	$	(0.01	)	$	(0.95	)
Income (loss) from discontinued operations		0.04			-
Net income (loss) per common share - basic	$	0.03		$	(0.95	)
Income (loss) per common share - diluted
Income (loss) from continuing operations	$	(0.01	)	$	(0.95	)
Income (loss) from discontinued operations		0.04			-
Net income (loss) per common share - diluted	$	0.03		$	(0.95	)
Weighted average number of common shares outstanding - basic		48,580			28,233
Weighted average number of common shares outstanding - diluted		48,580			28,233
See the accompanying notes to condensed consolidated financial statements.

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
For The Three Months Ended March 31, 2004
(In Thousands)
(Unaudited)

	Preferred Stock				Common Stock
	Number		Amount		Number		Amount		Additional Paid-in Capital			Accumulated Deficit			Common Stock Warrants		Treasury Stock			Accumulated Other Comprehensive Income		Notes Received for Shares Issued			Total Stockholders’ Equity
Balance - December 31, 2003		-	$	-		41,220	$	412	$	443,099		$	(413,923	)	$	5,650	$	(1,777	)	$	206	$	(931	)	$	32,736
Net income		-		-		-		-		-			1,476			-		-			-		-			1,476
Comprehensive income
Foreign currency translation		-		-		-		-		-			-			-		-			21		-			21
Total comprehensive income		-		-		-		-		-			1,476			-		-			21		-			1,497
Adjustment to allowance for
uncollectible portion of         notes receivable		-		-		-		-		-			-			-		-			-		328			328
Stock option repricing		-		-		-		-		(384	)		-			-		-			-		-			(384	)
Issuance of common shares for         options		-		-		134		1		122			-			-		-			-		-			123
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		5,313			-			-		(3,913	)		-		-			1,421
Balance - March 31, 2004		-	$	-		50,571	$	506	$	449,217		$	(412,447	)	$	5,650	$	(5,690	)	$	227	$	(603	)	$	36,860

See the accompanying notes to condensed consolidated financial statements.

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

	For The Three Months Ended March 31,
	2004			2003
Cash Flows From Operating Activities
Net income (loss)	$	1,476		$	(26,940	)
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
(Income) loss from discontinued operations		(2,102	)		157
Non-cash compensation and administrative expenses		(385	)		(798	)
Issuance of stock for services		-			68
Depreciation and amortization		705			626
Non-cash interest expense		(515	)		520
Deferred income taxes		-			(173	)
Impairment (recovery) of notes receivable		328			(271	)
Net loss on capital transactions of subsidiary		1,963			171
(Gain) loss attributable to changes in minority interest as a result
of capital transactions of subsidiary		(2,150	)		206
Minority interest		(379	)		(139	)
Loss on sale of equipment		45			9
Change in assets and liabilities:
Increase in restricted cash		(20	)		(2,015	)
Increase in accounts receivable		(720	)		(2,581	)
Increase in inventories		(278	)		(1,379	)
Decrease in other current assets		119			331
(Decrease) increase in accounts payable, accrued expenses
and other long-term liabilities		(1,641	)		28,590
Net cash used in discontinued operations		(596	)		(99	)
Net Cash Used In Operating Activities		(4,150	)		(3,717	)
Cash Flows From Investing Activities
Decrease in notes receivable		599			992
(Increase) decrease in other assets		(118	)		(90	)
Proceeds from sale of property and equipment		8			-
Payments for property and equipment		(214	)		(267	)
Cash acquired (net of payments for costs of business acquisitions)		84			-
Net cash used in discontinued operations		-			(32	)
Net Cash Provided By Investing Activities		359			603
Cash Flows From Financing Activities
Net amounts borrowed on notes payable		814			101
Payments on long-term debt		(487	)		(32	)
Proceeds from long-term debt		367			-
Other financing costs		(25	)		-
Issuance of common shares		1,644			143
Stock issuance costs		(99	)		(34	)
Proceeds from subsidiary issuance of common stock		989			175
Net Cash Provided By Financing Activities		3,203			353
Net Decrease In Cash And Cash Equivalents		(588	)		(2,761	)
Effect Of Exchange Rate Changes On Cash And Cash Equivalents		(58	)		(39	)
Cash And Cash Equivalents - Beginning Of Period		10,161			5,818
Cash And Cash Equivalents - End Of Period	$	9,515		$	3,018

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

1.     Basis of Presentation

     The accompanying unaudited Condensed Consolidated Financial Statements of Applied Digital Solutions, Inc. (the “Company”) as of March 31, 2004, and December 31, 2003, (the December 31, 2003, financial information included in this report has been extracted from the Company’s audited financial statements included in the Company’s 2003 Annual Report on Form 10-K, as amended) and for the three-months ended March 31, 2004 and 2003, have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X under the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of the Company&# 146;s management, all adjustments (including normal recurring adjustments) considered necessary to present fairly the Condensed Consolidated Financial Statements have been made. Certain items in the 2003 period have been reclassified for comparative purposes.

     The Condensed Consolidated Statements of Operations for the three-months ended March 31, 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 the Company’s Annual Report on Form 10-K, as amended, for the year ended December 31, 2003.

     The Company’s objective is to become an advanced technology development company that focuses on a range of life enhancing, personal safeguard technologies, early warning alert systems, miniaturized power sources and security monitoring systems combined with the comprehensive data management services required to support them. To date, the Company has five life enhancing technology products, which are available commercially currently or which the Company expects to be available commercially in the future. They are Digital Angel™, Thermo Life™, VeriChip™, Bio-Thermo™ and Personal Locating Device, referred to as PLD. As of March 31, 2004, the Company’s business operations consisted of the operations of five wholly-owned subsidiaries, which are collectively referred to as the Advanced Technology segment, and two majority-owned subsidiaries, Digital Angel Corporation (AMEX:DOC), and InfoTech USA, Inc. (OTC:IFTH). Currently, the Company owns approximately 68.5% of Digital Angel Corporation and 52.5% of InfoTech USA, Inc.

     The Company’s operating results have improved significantly during the three-months ended March 31, 2004, as compared to the three-months ended March 31, 2003. During the three-months ended March 31, 2004, the Company earned net income of $1.5 million, as compared to a net loss of $26.9 million for the three-months ended March 31, 2003. The Company incurred a loss from continuing operations for the three-months ended March 31, 2004, of $0.6 million, a significant improvement over the loss from continuing operations of $26.8 million for the three-months ended March 31, 2003. The loss for the three-months ended March 31, 2004, included a reversal of approximately $0.6 million of interest expense 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 the Company. The Company’s operating activities used cash of $4.2 million a nd $3.7 million during the three-months ended March 31, 2004 and 2003, respectively. Historically, the Company has suffered losses and has not generated positive cash flows from operations. As of March 31, 2004, the Company had an accumulated deficit of $412.4 million. The Company’s majority-owned subsidiary, Digital Angel Corporation, has suffered losses and has not generated positive cash flows from operations. Digital Angel Corporation

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

incurred losses during the three months ended March 31, 2004, which are presented in Note 6. In addition, its operating activities used cash of $2.3 million and $3.1 million during the three-months ended March 31, 2004 and 2003, respectively.

     On September 10, 2003, the Company’s shareholders approved the granting of discretionary authority to the 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, the 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 the Company’s common stock increased from $0.001 to $0.01 per share. In conjunction with the reverse stock split, the Company’s Board of Directors authorized a reduction in the number of authorized shares of the Company’s common stock from 560.0 million to 125.0 million. The Board of Directors approved a reverse stock split to facilitate the continuing listing of the Company’s common stock on the Nasdaq SmallCap Market, referred to as the SmallCap , and also to reduce the number of issued and outstanding shares of the Company’s common stock, resulting, in part, from the Company’s past acquisitions, the payment of debt obligations to IBM Credit and preferred stock and debenture conversions. On April 23, 2004, the Nasdaq Stock Market notified the Company that it had regained compliance with the SmallCap’s minimum bid price requirement of $1.00 per share. The Board of Directors believes that the reverse stock split may also enhance the marketability of the Company’s common stock to the financial community and the investing public. All share information provided in this Form 10-Q has been adjusted to reflect the reverse stock split.

Stock-Based Compensation

     As permitted under Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-based Compensation (“FAS 123”), the Company has 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 its stock-based employee compensation arrangements. Accordingly, no compensation cost is recognized for any of the Company’s 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 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. The Company accounts for equity instruments issued to non-employees in accordance with the provisions of FAS 123.

     As of March 31, 2004, the Company had five stock-based employee compensation plans and the Company’s subsidiaries collectively had six stock-based employee compensation plans. As permitted under FAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure (“FAS 148”), which amended FAS 123, the Company has elected to continue to follow the intrinsic value method in accounting for its stock-based compensation arrangements as defined by APB 25 and FIN 44.

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

     The following table illustrates the effect on net income (loss) and income (loss) per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation for options granted under its arrangements as well as to the arrangement of its subsidiaries:

	Three-Months Ended March 31,
		2004			2003
	(in thousands, except per share amounts)
Net income (loss) available to common    shareholders, as reported	$	1,476		$	(26,940	)
Add back (deduct): Total stock-based          employee compensation expense          determined under APB 25 for all          awards, net of related tax effects (1)		(384	)		(1,004	)
Deduct: Total stock-based employee          compensation expense determined          under fair value-based method for all          awards, net of related tax effects (2)		(1,492	)		(1,449	)
Pro forma net loss	$	(400	)	$	(29,393	)
Income (loss) per share:
Basic—as reported		$0.03			$(0.95	)
Basic—pro forma		$(0.01	)		$(1.04	)
Diluted—as reported		$0.03			$(0.95	)
Diluted—pro forma		$(0.01	)		$(1.04	)

(1)	For the three-months ended March 31, 2004 and 2003, amounts include $0.0 million and $0.1 million of compensation expense, respectively, associated with subsidiary options.
(2)	For the three-months ended March 31, 2004 and 2003, amounts include $1.0 million and $0.5 million of compensation expense, respectively, associated with subsidiary options.

     The Company did not grant fixed stock options to acquire shares of its common stock to its employees during the three-months ended March 31, 2003. The weighted average per share fair value of options granted during the three-months ended March 31, 2004, was $2.71. 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 March 31, 2004
Estimated option life	8 years
Risk free interest rate	3.61	%
Expected volatility	69.00	%
Expected dividend yield	0.00	%

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

2.     Principles of Consolidation

     The financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries. The minority interest represents outstanding voting stock of the subsidiaries not owned by the Company. All significant intercompany accounts and transactions have been eliminated in consolidation.

     The Company’s 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 Company’s consolidated financial statements on a calendar year basis.

3.     Financing Agreements

     The InfoTech USA, Inc. segment finances its accounts receivable and inventory. Its current financing arrangement with IBM Credit provides financing on inventory purchases up to $1.8 million. Borrowing for purchases is based upon 75% of all eligible receivables due within 90 days and up to 100% of all eligible inventory. Interest for balances not paid within the interest free period provided in the arrangement accrues at prime plus 4.4%. Borrowings under the financing arrangement amounted to $1.7 million at March 31, 2004, and are reflected in the balance sheet in either accounts payable or other accrued expenses. On September 5, 2003, InfoTech USA, Inc. received a letter from IBM Credit constituting their formal notice of termination of the agreement. The effective date of such termination, which was originally set for March 10, 2004, has been extended until June 18, 2004. InfoTech USA, Inc. is currently in the process of securing other financing and expects to replace its financing arrangement prior to the termination date set by IBM Credit. InfoTech USA, Inc. believes that its present financing arrangement with IBM Credit, its current cash position, the expected replacement of the IBM Credit agreement, and the repayment by the Company of a $1.0 million loan from InfoTech USA, Inc., which is due on June 30, 2004, will provide InfoTech USA, Inc. with sufficient working capital for the next twelve months. However, there is no assurance that InfoTech USA, Inc. will be able to obtain a replacement for its IBM Credit arrangement. The $1.0 million loan from InfoTech USA, Inc. is more fully described in Note 9.

4.     Inventory

	March 31, 2004	December 31, 2003
	(in thousands)
Raw materials	$2,320	$  1,982
Work in process	4,062	2,723
Finished goods	6,234	6,644
	12,616	11,349
Less: Allowance for excess and obsolescence	2,408	1,859
	$10,208	$  9,490

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

5.     Income (Loss) Per Share

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

	Three-Months Ended March 31,
	2004		2003
	(in thousands, except per share amounts)
Numerator:
Loss from continuing operations	$(626	)	$(26,783	)
Net income (loss) from discontinued operations	2,102		(157	)
Net income (loss)	$1,476		$(26,940	)
Denominator:
Denominator for basic and diluted income (loss) per share (1)-
Weighted-average shares	48,580		28,233
Basic and diluted income (loss) per share:
Continuing operations	$(0.01	)	$(0.95	)
Discontinued operations	0.04		--
Total - Basic and Diluted	$0.03		$(0.95	)

⁽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 March 31,
	2004	2003
	(in thousands)
Stock options	357	1,080
Warrants	349	330
	706	1,410

6.     Segment Information

     The Company operates in three business segments: Advanced Technology, Digital Angel Corporation and InfoTech USA, Inc.

Advanced Technology

     The Advanced Technology segment represents those businesses that the Company believes will provide the necessary synergies, support and infrastructure to allow it to develop, promote and fully integrate its technology products and services. This segment specializes in voice, data and video telecommunications networks, proprietary software, implantable microchips, and in 2003, Internet access and website design. The majority of this segment’s revenue is from the Company’s wholly-owned subsidiary, Computer Equity Corporation. Computer Equity Corporation provides voice, data, and video

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statementstelecommunication networks to governmental agencies. The Company’s VeriChip™ product has multiple applications in security, personal identification, safety, healthcare (subject to FDA approval) and more. Expenses associated with the Company’s Thermo Life™ and PLD products are also included this segment. The Advanced Technology segment delivers products and services across a multitude of industries, including government, utilities, security and high tech. For the three-months ended March 31, 2004, the Company recorded revenue of $0.1 million from sales of its VeriChip product. The Company did not record any revenue associated with its VeriChip product during the three-months ended March 31, 2003. To date, the Company has not recorded any revenue fr om its Thermo Life or PLD products.

Digital Angel Corporation

     The Digital Angel Corporation division consists of the business operations of Digital Angel Corporation, the Company’s approximately 68.5% owned subsidiary and is engaged in the development and deployment of sensor and communications technologies that enable rapid and accurate identification, location tracking, and condition monitoring of animals and high-value mobile assets. Previously, Digital Angel Corporation operated in four divisions: Animal Applications, Wireless and Monitoring, GPS and Radio Communications and Medical Systems. Effective January 1, 2004, the GPS and Radio Communications division, the Wireless and Monitoring division and the OuterLink Corporation business, referred to as OuterLink, which was acquired on January 22, 2004, were combined to form the new GPS and Radio Communications division, which is now managed as a single business unit. The OuterLink acquisition is described in Note 7. During April 2004, Digital Angel Corporation sold certain business assets of its Medical Systems division as discussed in Note 7. The Medical Systems division was one of the Company’s reporting units as defined in FAS No. 142, Goodwill and Other Intangible Assets, and therefore, as a result of the disposition, the financial condition, results of operations and cash flows associated with this division will be presented as part of discontinued operations beginning in the second quarter of 2004 in accordance with FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“FAS 144”).

     The principal products and services in this segment by division are as follows:

     The Company’s Animal Applications division develops, manufactures, and markets a broad line of electronic and visual identification devices for the companion animal, livestock, laboratory animal, fish and wildlife markets worldwide. The tracking of cattle and hogs are crucial both for asset management and for disease control and food safety. The principal technologies employed by the Animal Applications division are electronic ear tags and implantable microchips that use radio frequency transmission. The Animal Applications division has marketed visual identification products for livestock since the 1940s. Livestock producers are currently evaluating electronic identification products for livestock. Currently, sales of visual products represent virtually all of the sales to livestock producers. The Animal Applications division’s pet identification system involves the insertion of a microchip with identifying informa tion in the animal. Readers at animal shelters, veterinary clinics and other locations can determine the animal’s owner and other information. This pet identification system is marketed in the United States by Schering-Plough Animal Health Corporation under the brand name “Home Again™,” in Europe by Merial Pharmaceutical, and in Japan by Dainippon Pharmaceutical. Digital Angel Corporation’s Bio-Thermo™ product is included in this division.

     The Company’s GPS and Radio Communications division consists of the design, manufacture

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statementsand support of global positioning system, referred to as GPS, enabled equipment. Applications for this division’s products include location tracking and message monitoring of vehicles and aircraft in remote locations through systems that integrate GPS and geosynchronous satellite communications, and GPS enabled equipment and intelligent communications products and services for telemetry, mobile data and radio communications applications serving commercial and military markets. This segment is also developing the Digital Angel™ product, which is the integration and miniaturization into marketable products of three technologies: wireless communications (such as cellular), sensors (including bio-sensors) and position location technology (including GPS and other systems).

     The Company’s Medical Systems division represents the business operations of Medical Advisory Systems Inc., referred to as MAS, which was acquired on March 27, 2002. A staff of logistics specialists and physicians provides medical assistance services and interactive medical information services to people traveling anywhere in the world. It also sells a variety of kits containing pharmaceutical and medical supplies. During April 2004, Digital Angel Corporation sold certain assets of the Medical Systems division as more fully discussed above and in Note 7.

     The majority of sales in this segment are from the Animal Applications division. Minimal sales of the Digital Angel and Bio-Thermo products have been recorded as of March 31, 2004.

InfoTech USA, Inc.

     The InfoTech USA, Inc. segment consists of the business operations of the Company’s 52.5% owned subsidiary, InfoTech USA, Inc. This segment is a full service provider of Information Technology, or IT, products and services. During 2003, this segment continued its strategy of moving away from a product-driven systems integration business model to a customer-oriented IT strategy-based business model. It has further developed its 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. The principal products and services in this segment are computer hardware and computer services. The majority of InfoTech USA, Inc.’s revenue is derived from sales of computer hardware. InfoTech USA, Inc.’s services consist of IT consulting, installation, project managem ent, design and deployment, computer maintenance and other professional services.

All Other

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

     The “Corporate/Eliminations” category includes all amounts recognized upon consolidation of the Company’s subsidiaries such as the elimination of intersegment revenues, expenses, assets and liabilities. “Corporation/Eliminations” also includes certain interest income, interest expense, and other income and expenses associated with corporate activities and functions. Included in “Corporate/Eliminations” for the three-months ended March 31, 2003, is a severance charge of approximately $22.0 million associated with the termination of certain former officers and directors as more fully discussed in Note 10.

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Notes to Condensed Consolidated Financial Statements

     Additionally, the Company’s previously reported Intellesale and all other non-core business segments are reported as discontinued operations.

     The accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Company’s Annual Report on Form 10-K, as amended, filed for the year-ended December 31, 2003, 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 utilizes the financial information to assist in making internal operating decisions. The Company evaluates performance based on segment operating income.

     Following is the selected segment data as of and for the three-months ended March 31, 2004:

	Segments
	Advanced Technology		Digital Angel Corporation			InfoTech USA, Inc.		All Other	Corporate/ Eliminations		Consolidated
	(in thousands)
Net revenue from external customers:
Product		$  8,963		$10,626			$  3,614	$ --	$ --		$23,203
Service		2,297		450			908	--	--		3,655
		11,260		11,076			4,522	--	--		26,858
Inter-segment revenue - product		--		50			--	--	(50	)	0
Total revenue		$11,260		$11,126			$  4,522	$ --	$(50	)	$26,858
Income (loss) from continuing operations before    income taxes, minority interest and gain/loss    attributable to capital transactions of subsidiary(1)		$     735		$(1,153	)		$         9	$ --	$(691	)	$(1,100	)
Total assets		$39,662		$78,468			$    6,131	$2,662	$(3,693	)	$123,230

(1) Amount for Digital Angel Corporation excludes $0.7 million in realized and $1.9 million in unrealized losses on shares of the Company’s common stock issued to Digital Angel Corporation under a Share Exchange Agreement, as more fully discussed in Note 7. These losses have been reflected in the separate financial statements of Digital Angel Corporation included in its Form 10-Q for the quarter ended March 31, 2004.

     Following is the selected segment data as of and for the three-months ended March 31, 2003:

	Segments
	Advanced Technology	Digital Angel Corporation		InfoTech USA, Inc.			All Other		Corporate/ Eliminations		Consolidated
	(in thousands)
Net revenue from external customers:
Product	$8,332		$10,757		$1,934		$ --		$ --		$21,023
Service	2,950		533		600		--		--		4,083
	11,282		11,290		2,534		--		--		25,106
Inter-segment revenue - product	--		108		--		--		(108	)	--
Total revenue	$11,282		$11,398		$2,534		$--		$(108	)	$25,106
Income (loss) from continuing operations before    income taxes, minority interest, and loss    attributable to capital transactions of subsidiary	$621		$77		$(460	)	$(5	)	$(26,970	)	$(26,737	)
Total assets	$43,364		$71,525		$8,799		$2,737		$(8,021	)	$118,404

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Notes to Condensed Consolidated Financial Statements

     The following is a breakdown of the Company’s revenue by segment and type of product and service:

	Three-Months Ended March 31, (In thousands)
	2004						2003
		Product		Service		Total		Product		Service		Total
Advanced Technology
Voice, data and video telecommunications networks	$	8,688	$	1,368	$	10,056	$	8,130	$	1,207	$	9,337
Call center and customer relationship management software		157		929		1,086		114		1,370		1,484
Implantable VeriChip		118		—		118		—		—		—
Website design and Internet access		—		—		—		88		373		461
Total	$	8,963	$	2,297	$	11,260	$	8,332	$	2,950	$	11,282
	Three-Months Ended March 31, (In thousands)
	2004						2003
		Product		Service		Total		Product		Service		Total
Digital Angel Corporation
Animal Applications	$	7,009	$	63	$	7,072	$	7,801	$	—	$	7,801
GPS and Radio Communications		3,502		197		3,699		2,699		154		2,853
Medical Systems		165		190		355		365		379		744
Total	$	10,676	$	450	$	11,126	$	10,865	$	533	$	11,398
	Three-Months Ended March 31, (In thousands)
	2004						2003
		Product		Service		Total		Product		Service		Total
InfoTech USA, Inc.
Computer hardware	$	3,614	$	—	$	3,614	$	1,934	$	—	$	1,934
Computer services		—		908		908		—		600		600
Total	$	3,614	$	908	$	4,522	$	1,934	$	600	$	2,534

7.     Acquisitions and Dispositions

     Share Exchange Agreement

     On August 14, 2003, the Company entered into a Share Exchange Agreement with Digital Angel Corporation. The Share Exchange Agreement represented a strategic investment by the Company, whereby the Company increased its ownership interest in Digital Angel Corporation. The Share Exchange Agreement provided for the Company to purchase 3.0 million shares of Digital Angel Corporation’s common stock at a price of $2.64 per share, and for Digital Angel Corporation to issue a warrant to the Company, 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 the Company’s

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Notes to Condensed Consolidated Financial Statements

common stock. The purchase price for the 3.0 million shares was payable in shares of the Company’s common stock having an aggregate market value of $7.9 million. The aggregate purchase price of $7.9 million for the 3.0 million shares of Digital Angel Corporation’s common stock was based on the closing price of Digital Angel Corporation’s common stock on June 30, 2003, of $2.64 per share. On March 1, 2004, the Company issued approximately 2.0 million shares of its common stock to Digital Angel Corporation as payment for the 3.0 million shares.

     Digital Angel Corporation plans to generate cash by selling the approximately 2.0 million shares of the Company’s common stock, and as of March 31, 2004, Digital Angel Corporation generated net proceeds of approximately $1.4 million on the sale of approximately 0.5 million of the shares. Digital Angel Corporation realized a loss on the sale of the Company’s shares of $0.7 million, which is reflected in its separate financial statements included in its Form 10-Q for the quarter ended March 31, 2004. In addition, during the three-months ended March 31, 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 the Company’s common stock on the date of the share exchange, which value was $4.00 per share, and the value as of March 31, 2004, of $2.70 per share. Future changes in the market price of the Company’s common stock will result in additional realized and unrealized gains and losses on the shares of the Company’s common stock owned by Digital Angel Corporation. Because such realized and unrealized gains and losses result from transactions in the Company’s common stock, they are eliminated upon consolidation of Digital Angel Corporation and the Company’s operating results, and accordingly, they are not reflected in the Condensed Consolidated Financial Statements. The fair value of the Company’s common stock held by Digital Angel Corporation as of March 31, 2004, of approximately $3.9 million, is reflected in the Condensed Consolidated Balance Sheets as treasury stock. Digital Angel Corporation expects that the cash generated from the sale of the approximately 2.0 million shares, along with other funds available, will be sufficient to meet its projected working capital requirements during the next twelve months.

     As of April 30, 2004, the Company owned approximately 68.5% 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, the Company’s ownership would be less than 50%. The Company desires to maintain a controlling interest in Digital Angel Corporation, and therefore, the Company may enter into additional stock purchase agreements with Digital Angel Corporation, or it may elect in the future to buy back a portion of the outstanding shares of Digital Angel Corporation’s common stock that is does not currently own.

Net Loss on Capital Transactions of Subsidiary and Gain/Loss Attributable to Changes in Minority Interest As a Result of Capital Transactions of Subsidiary

     Gains where realized and losses on issuances of shares of stock by the Company’s consolidated subsidiary, Digital Angel Corporation, are reflected in the Condensed Consolidated Statement of Operations. The Company determined that such recognition of gains and losses on issuances of shares of stock by Digital Angel Corporation was appropriate since the shares issued to date were not sales of unissued shares in a public offering, the Company does not plan to reacquire the shares issued and the value of the proceeds could be objectively determined. During the three-months ended March 31, 2004 and 2003, the Company recorded losses of $2.0 million and $0.2 million, respectively, on the issuances

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Notes to Condensed Consolidated Financial Statements

of 3.7 million and 0.3 million shares of Digital Angel Corporation’s common stock, respectively. Three million of the shares issued during the three-months ending March 31, 2004, resulted from the Share Exchange Agreement between the Company and Digital Angel Corporation more fully discussed above. The remaining 0.7 million shares issued during the three-months ended March 31, 2004, and all of the shares issued during the three-months ended March 31, 2003, resulted from the exercise of Digital Angel Corporation’s stock options. The loss represents the difference between the carrying amount of the Company’s pro-rata share of its investment in Digital Angel Corporation and the net proceeds from the issuances of the stock. In addition, the Company recorded a (gain) loss of ($2.2) million and $0.2 million during the three-months ended March 31, 2004 and 2003, respectively, attributable to changes in the minority interest ownership as a result of the capital transactions of Digital Angel Corporation. The following is a summary of the capital transactions of Digital Angel Corporation:

	Three-Months Ended March 31,
	2004			2003
	(in thousands, except per share amounts)
Issuances of common stock for stock option exercises		735			288
Issuances of common stock under Share Exchange Agreement		3,000			—
Total issuances of common stock		3,735			288
Proceeds from stock issuances	$	8,910		$	174
Average price per share	$	2.39		$	0.60
Beginning ownership percentage of Digital Angel Corporation		66.93	%		73.91	%
Ending ownership percentage of Digital Angel Corporation		68.47	%		73.12	%
Change in ownership percentage		1.54	%		0.79	%
Net loss on capital transactions of subsidiary(1)	$	1,963		$	171
(Gain) loss attributable to changes in minority interest as a result of capital transactions of subsidiary(1)	$	(2,150	)	$	206

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

     OuterLink Acquisition

     On January 22, 2004, Digital Angel Corporation completed the acquisition of OuterLink Corporation pursuant to an Agreement and Plan of Merger dated November 2, 2003, by and among Digital Angel Corporation, DA Acquisition and OuterLink. Pursuant to the terms of the agreement, OuterLink became a wholly-owned subsidiary of Digital Angel Corporation. OuterLink manufactures and markets a suite of satellite tracking systems, operates a mobile satellite data communications service, and supplies tracking software systems for mapping and messaging. The OuterLink “CP-2 system” provides real-time automated tracking, wireless data transfer, and two-way messaging with large fleets of vehicles including utility trucks, helicopters and fixed-wing aircraft, long haul trucks, service vehicles, short haul trucks,

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Notes to Condensed Consolidated Financial Statements

and ships. OuterLink’s current customer base includes various branches of the Department of Homeland Security including the U.S. Border Patrol and U.S. Customs Service.

     The following describes the 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		Business Description
OuterLink Corporation	1/22/04	$	8,400	$	8,300		100	$	8,393	$	7	Provider of real-time, satellite-based automated tracking, wireless data transfer and two-way messaging with large fleets of vehicles.

     Under the terms of the agreement, Digital Angel Corporation issued to OuterLink 0.1 million shares of its Series A Preferred Stock. Approximately 20% of the preferred shares are being held in escrow as security for indemnified claims. The Series A Preferred Stock is convertible into four million shares of Digital Angel Corporation’s common stock when the volume weighted average price of Digital Angel Corporation’s common stock equals or exceeds $4.00 per share for ten consecutive trading days. The aggregate purchase price of $8.4 million, which represents the fair market value of the preferred stock of $8.3 million and $0.1 million of acquisition costs, was allocated to the identifiable assets and liabilities with the excess of $3.3 million recorded as goodwill. Identifiable intangible assets of approximately $5.1 million have been recorded based upon preliminary estimates as of the date of the acquisition. Any chan ges to the preliminary estimates during the allocation period will be reflected as an adjustment to goodwill. The valuation of the preferred 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 acquisition costs consist of legal and accounting related services that were direct costs of acquiring OuterLink. The preferred stockholders have the right to designate one director to Digital Angel Corporation’s Board of Directors prior to July 22, 2004.

     In considering the benefits of the OuterLink acquisition, the Company’s management recognized the strategic complement of OuterLink’s technologies and customer base with Digital Angel Corporation’s existing animal applications and military GPS business lines. Company management believes the acquisition provides for a strong platform for further development of Digital Angel Corporation’s capabilities in the area of high-value asset identification, tracking and condition monitoring.

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Notes to Condensed Consolidated Financial Statements

     The financial results of the OuterLink acquisition 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 March 31, 2004 and 2003 are included below. Such pro forma information assumes that the above acquisition had occurred as of January 1, 2003, and revenue is presented in accordance with the Company’s accounting policies. This summary is not necessarily indicative of what the result of operations of the Company would have been had it been a combined entity during such periods, nor does it purport to represent results of operations for any future periods.

(In thousands)	Three-Months Ended March 31, 2004			Three-Months Ended March 31, 2003
		Unaudited
Net operating revenue	$	26,945		$	25,371
Net loss from continuing operations	$	(1,329	)	$	(27,761	)
Net loss per common share - basic and diluted	$	(0.03	)	$	(0.98	)

     Sale of Digital Angel Corporation’s Medical Systems Division

     On April 19, 2004, Digital Angel Corporation sold certain assets of its Medical Systems division pursuant to an Asset Purchase Agreement. Under the terms of the Asset Purchase Agreement, MedAire, Inc. purchased substantially all the operating assets, excluding land and buildings, of the Medical Systems division for approximately $0.4 million, plus certain prepaid deposits and the cost of the pharmaceutical inventory and supplies. The assets sold include all of the tangible and intangible intellectual property developed for the operation of the division’s medical services business, including the systems, procedures, manuals, training materials and customer deliverables, pharmaceutical supplies and other inventory items, customer and supplier contracts, computer software licenses, applications and databases, internet website and domain name, mailing lists, customer records and trademarks, trade names, service marks and copyrights. The Asset Purchase Agreement excluded all other Medical Systems division’s assets, property and equipment. The Company will incur a loss of approximately $0.3 million during the three-months ended June 30, 2004, in connection with this transaction.

     In a separate transaction, Digital Angel Corporation has entered into a letter of intent to sell Medical Systems division’s real property and certain related fixed assets and expects the proceeds from the sale to be above its carrying cost. The closing is expected to occur during the second quarter of 2004.

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Notes to Condensed Consolidated Financial Statements

     The operations of the Medical Systems division will be presented as part of the Company’s discontinued operations beginning in the second quarter of 2004, in accordance with FAS 144. The Medical Systems division’s operating results for the three-months ended March 31, 2004 and 2003, were as follows:

	Three-Months Ended March 31, 2004		Three-Months Ended March 31, 2003
	(in thousands)
Revenue		$355		$744
Loss before provision for income taxes		$378		$125

8.     Discontinued Operations

     On March 1, 2001, the Company’s Board of Directors approved a plan to offer for sale its Intellesale business segment and all of its other non-core businesses. Accordingly, the operating results of these entities have been reclassified and reported as Discontinued Operations for all periods presented. As of March 1, 2004, the Company had sold or closed all of the businesses comprising Discontinued Operations.

     Liabilities of Discontinued Operations at March 31, 2004 and December 31, 2003, are as follows:

		March 31, 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		1,497		5,341
Total Liabilities of Discontinued Operations	$	5,701	$	9,545

     During the three-months ended March 31, 2004, Discontinued Operations realized income associated with the change in estimated loss on disposal of Discontinued Operations of approximately $2.1 million as a result of a reduction in certain carrying costs, which were settled for less than previously anticipated. During the three-months ended March 31, 2003, Discontinued Operations incurred expense associated with a change in estimated operating losses accrued on the measurement date of approximately $0.2 million primarily as a result of the operations of the one remaining business unit within this group, which was sold in July 2003.

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Notes to Condensed Consolidated Financial Statements

     The following table sets forth the roll forward of the liability for carrying costs from December 31, 2003, through March 31, 2004.

Type of Cost (in thousands)	Balance December 31, 2003		Additions (Reductions)			Deductions		Balance March 31, 2004
Carrying costs		$4,913		$(2,102	)		$1,735		$1,076

9.     Related Party Transactions

     On June 22, 2003, the Company borrowed $1.0 million from InfoTech USA, Inc. under the terms of a commercial loan agreement and a term note. The loan accrues interest at an annual rate of 16% and interest is payable monthly beginning on July 31, 2003, with principal and accrued interest due June 30, 2004. Under the terms of a Stock Pledge Agreement the Company has pledged 750,000 shares of the Digital Angel Corporation common stock that it owns as collateral for the loan. The proceeds of the loan were used to fund the Company’s operations.

10.     Non-Cash Stock-Based Compensation Expense

     On March 21, 2003, Richard J. Sullivan, the Company’s former Chairman of the Board of Directors and Chief Executive Officer, retired from such positions. The Company’s Board of Directors negotiated a severance agreement with Richard Sullivan under which he received a one-time payment of 5.6 million shares of the Company’s common stock. The Company issued the shares to Richard Sullivan on March 1, 2004. In addition, stock options held by him exercisable for approximately 1.1 million shares of the Company’s common stock were re-priced. The options surrendered had exercise prices ranging from $1.50 to $3.20 per share and were replaced with options exercisable at $0.10 per share. All of the re-priced options have been exercised. Richard Sullivan’s severance agreement provides that the payment of shares and re-pricing of options provided for under that agreement is in lieu of all future compensation and other benefits that would have been owed to him under his employment agreement. Richard Sullivan’s employment agreement had provided for:

     •  an annual salary of $450,000 and an annual bonus of not less than $140,000 for the term of his employment agreement (which was due to expire March 1, 2008, roughly five years later);

     •  supplemental compensation of $2,250,000 (to be paid in 60 equal monthly payments of $37,500 each), in the event of a termination of his employment for any reason other than a termination due to his material default under the agreement; and

     •  a lump sum payment of $12,105,000, upon the occurrence of a “Triggering Event,” defined under the employment agreement to include a change of control of the Company or Richard Sullivan ceasing to serve as the Company’s Chairman of the Board or Chief Executive Officer for any reason other than due to his material default, with the Company having the option to pay this amount in cash or in shares of its common stock or any combination of the two. In the event the Company opted to make any portion of the payment in shares of its common stock, the agreement stipulated that the common stock was to be valued at the average closing price of the stock on the Nasdaq National Market (the Company’s stock was, at the time the agreement was entered into, listed on the Nasdaq National

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES

Notes to Condensed Consolidated Financial StatementsMarket but has since been transferred to the SmallCap) over the last five business days prior to the date of the Triggering Event.     In total, the employment agreement obligated the Company to pay Richard Sullivan approximately $17.3 million under, or in connection with, the termination of his employment with the Company. In view of the Company’s cash constraints and its need at the time to dedicate its cash resources to satisfying its obligations to IBM Credit, the Company commenced negotiations with Richard Sullivan that led to the proposed terms of his severance agreement. The severance agreement required the Company to make approximately $3.9 million less in payments to Richard Sullivan than would have been owed to him under his employment agreement.

     On March 21, 2003, Jerome C. Artigliere, the Company’s former Senior Vice President and Chief Operating Officer, resigned from such positions. Under the terms of his severance agreement, Mr. Artigliere received 0.5 million shares of the Company’s common stock. The Company issued the shares to Mr. Artigliere on March 1, 2004. In addition, stock options held by him exercisable for approximately 0.2 million shares of the Company’s common stock were re-priced. The options surrendered had exercise prices ranging from $1.50 to $3.20 per share and were replaced with options exercisable at $0.10 per share. All of the re-priced options have been exercised. Mr. Artigliere’s severance agreement provides that the payment of shares and re-pricing of options provided under that agreement is in lieu of all future compensation and other benefits that would have been owed to him under his employment agreement. That agreeme nt required the Company to make payments of approximately $1.5 million to Mr. Artigliere.

     As a result of the termination of Richard Sullivan’s employment with the Company, a provision was triggered in the Company’s severance agreement with Garrett Sullivan, the Company’s former Vice Chairman of the Board (unrelated to Richard Sullivan), at the time of his ceasing to serve in such capacity in December 2001 requiring the Company’s payment of cash under the agreement. The Company negotiated a settlement of its obligations under Garrett Sullivan’s severance agreement that required the Company to issue to Garrett Sullivan 0.8 million shares of the Company’s common stock. The Company issued the shares, valued at approximately $3.5 million, to Garrett Sullivan on February 17, 2004.

     At the annual meeting of shareholders held on July 25, 2003, the Company’s shareholders approved the issuances of the common stock and ratified the re-pricing of the options under the terms of the severance agreements with Richard J. Sullivan and Jerome C. Artigliere and approved the issuance of the common stock under the agreement entered into with Garrett Sullivan. The terms of each of the severance agreements were subject to shareholder approval, in accordance with applicable Nasdaq Stock Market rules, because the agreements: (i) were deemed to be compensatory arrangements under which the Company’s common stock was being acquired by officers or directors, and (ii) in Richard Sullivan’s case, such common stock issuance may have resulted in his potentially holding more than 20% of the outstanding shares of the Company’s common stock following the issuance of the shares and exercise of options covered by h is severance agreement.

     During the three-months ended March 31, 2003, as a result of the terminations of Messrs. Sullivan and Artigliere, the Company recorded non-cash, stock-based severance expense of approximately $22.0 million, including $2.7 million of expense relating to the re-priced options. The amount of the severance expense recorded during the three-months ended March 31, 2003, was based upon the terms of the original employment agreements as discussed above. As a result of the shareholder approval of the

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Notes to Condensed Consolidated Financial Statements

terms of the severance agreements entered into in March 2003, the Company reversed approximately $3.9 million of the $22.0 million in severance expense during the three-months ended September 30, 2003, since Richard Sullivan’s severance agreement required the Company to make approximately $3.9 million less in payments to him than would have been owed under his employment agreement. The severance expense is included in the Consolidated Statements of Operations in selling, general and administrative expense.

     The Company reversed approximately $0.4 million and $1.0 million in non-cash stock-based compensation expense during the three-months ended March 31, 2004 and 2003, respectively, due to re-pricing 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 25 and fluctuations in the Company’s common stock price result in increases and decreases of non-cash, stock-based compensation expense until the options are exercised, forfeited, modified or expired.

11.     Other Events

     The staff of the Securities and Exchange Commission’s Southeast Regional Office is conducting an informal inquiry concerning the Company. The Company is fully and voluntarily cooperating with this informal inquiry. At this point, the Company is unable to determine whether this informal inquiry may lead to potentially adverse action.

12.     Legal Proceedings

     The Company is a party to various legal proceedings and accordingly has recorded $4.1 million in reserves in its financial statements as of March 31, 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 results of the Company. The estimate of potential impact on the Company’s financial position, overall results of operations or cash flows for the above legal proceedings could change in the future.

     On May 20, 2002, a purported securities fraud class action was filed against the Company and one of its former directors. In the following weeks, fourteen virtually identical complaints were consolidated into a single action, In re Applied Digital Solutions Litigation, which was filed in the United States District Court for the Southern District of Florida. In March 2003, the Company entered into a memorandum of understanding to settle the pending lawsuit, which was settled in March 2004 for $5.6 million and covered entirely by proceeds from insurance.

     In February 2003, an action was filed in Middlesex County Superior Court in the Commonwealth of Massachusetts. Digital Angel Corporation’s subsidiary, OuterLink Corporation (OuterLink was acquired in January 2004, see Note 7), as well as a significant stockholder of OuterLink and a principal of the significant stockholder are named as defendants. Such principal was a director of OuterLink. The complaint alleged breach of an August 25, 1999 employment contract. The plaintiff was President and Chief Executive Officer of OuterLink from July 1999 through August 2002. The Complaint seeks damages based principally on a contractual severance provision that allegedly provided for four months of compensation for every year or fraction thereof served prior to termination. At the time of

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Notes to Condensed Consolidated Financial Statements

termination, the complaint alleges that the plaintiff’s salary was approximately $0.3 million per year. The Defendants answered denying all liability and asserting a counterclaim. Discovery will be completed in this matter shortly, and the Defendants intend to vigorously defend this matter and pursue their counterclaim. The ultimate outcome of this proceeding cannot be predicted at this time, and the Company is currently unable to determine the potential effect of this litigation on its consolidated financial position, results of operations or cash flows.

     In June 2002, eResearch Technology, Inc. f/k/a Premier Research Worldwide, Ltd. (“ERT”) commenced a proceeding in the United States District Court for the District of New Jersey against U.S. Bank National Association (“US Bank”) and Digital Angel Corporation. This suit was commenced to pursue alleged damages of approximately $0.4 million due to the Digital Angel Corporation and US Bank’s alleged failure to register transfers of restricted shares of Digital Angel Corporation common stock sold by ERT in May 2002. Digital Angel Corporation has agreed to indemnify US Bank for all damages and reasonable costs relating to this litigation. Digital Angel Corporation has asserted a counterclaim against ERT based on ERT’s breach of a license agreement and service agreements between the parties that resulted in the original issuance of approximately 0.6 million restricted shares of Digital Angel Corporation ’s common stock to ERT. The damages to Digital Angel Corporation exceed $4.0 million and this amount does not include the share of profits, which Digital Angel Corporation seeks to recover had ERT not breached the agreements. Further, the alleged damages sought by the Plaintiff in this matter do not take into account plaintiff’s duty to mitigate damages which if discharged would have resulted in a profit to ERT. The ultimate outcome of this proceeding cannot be predicted at this time, and the Company is currently unable to determine the potential effect of this litigation on its consolidated financial position, results of operations or cash flows.

     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 syringe implantable identification transponders. Monetary damages are not being sought. The lawsuit alleges that Plaintiff 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 on Digital Angel Corporation’s patent in 1997, 1998 and 1999. Digital Angel Corporation has not yet answered the Complaint and the ultimate outcome of this proceeding cannot be predicted at this time.

13.     Subsequent Events

     Employment Agreement

     On April 8, 2004, the Company entered into an employment agreement with Scott R. Silverman, its Chairman of the Board and Chief Executive Officer, which became retroactively effective on January 1, 2004, and terminates five years from such effective date. The employment agreement provides for a base salary of approximately $0.3 million with minimum annual increases of 10% of the base salary, a discretionary bonus and other fringe benefits. In addition, it provides for the grant of options to acquire approximately 0.9 million shares of the Company’s common stock with exercise prices equal to the fair market value on the date of grant. To date, 0.8 million options have been granted with an exercise price of $2.57 per share. The options vest ratably over a three-year period commencing April 8, 2004 and

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APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

expiring on April 8, 2012. Upon termination of Mr. Silverman’s employment, certain payments become due, the amounts of which depend on the nature of the termination. In addition, the employment agreement contains a change of control provision that provides for the payment of five times the then current base salary and five times the average bonus paid to Mr. Silverman for the three full calendar years immediately prior to the change of control, or the number of years that were completed commencing on the effective date of the agreement and ending on the date of the change of control if less than three calendar years. In addition, any outstanding stock options held by Mr. Silverman as of the date of the change of control become vested and exercisable as of such date, and remain exercisable during the remaining life of the option. All severance and change of control payments made in connection with the employment agreement may be paid in sha res of the Company’s common stock, subject to necessary approvals, or in cash at Mr. Silverman’s option.

     Securities Purchase Agreement with Institutional Investor

     On April 16, 2004, the Company sold 2.0 million shares, referred to as the Shares, of its common stock, par value $0.01 per share, in a private placement to an institutional investor, Satellite Strategic Finance Associates, LLC, referred to as the SSFA, under the terms of a Securities Purchase Agreement, referred to as the Agreement. The Agreement provides SSFA with a Series A Warrant, which is exercisable into an additional 1.0 million shares, referred to as the Series A Warrant Shares, of the Company’s common stock, and a Series B Warrant, which is exercisable into 0.7 million shares, referred to as the Series B Warrant Shares, of the Company’s common stock. The purchase price for the Shares was $2.749 per share and was based on the average of the daily volume weighted average price of the Company’s common stock for the period of ten trading days ending on and including April 13, 2004. The exercise pri ce of the Series A Warrant Shares and the Series B Warrant Shares is $2.749 and $3.299 per share, respectively. The Series A Warrant may be exercised at any time, at SSFA’s option, until the 60th day following the effective date of the registration statement registering the shares, at which time it will expire. 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 of the Shares were approximately $5.5 million.

     The offer and sale of the securities by the Company to SSFA was exempt from the registration requirements of the Securities Act of 1933. The Company has agreed to effect the registration of the Shares, the Series A Warrant Shares and the Series B Warrant Shares pursuant to a Registration Rights Agreement.

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      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.

     General

     Our business has evolved during the past few years. We grew significantly through acquisitions and since 1996 completed 51 acquisitions. During the last half of 2001 and during 2002, we sold or closed many of the businesses we had acquired that we believed did not enhance our strategy of becoming an advanced technology development company. These companies were primarily telephone system providers, software developers, software consultants, networking integrators, computer hardware suppliers or were engaged in other businesses or had customer bases that we believed did not promote or complement our current business strategy. Our objective is to become an advanced technology development company that focuses on a range of life enhancing, personal safeguard technologies, early warning alert systems, miniaturized power sources and security monitoring systems combined with the comprehensive data management services required to supp ort them. To date, we have five life enhancing technology products, which are available commercially currently or which we expect to be available commercially in the future. They are Digital Angel™, Thermo Life™, VeriChip™, Bio-Thermo™ and PLD. As of March 31, 2004, our business operations consisted of the operations of five wholly-owned subsidiaries, which are collectively referred to as the Advanced Technology segment, and two majority-owned subsidiaries, Digital Angel Corporation (AMEX:DOC) and InfoTech USA, Inc. (OTC:IFTH). Currently, we own approximately 68.5% of Digital Angel Corporation and 52.5% of InfoTech USA, Inc.

     Our operating results have improved significantly during the three-months ended March 31, 2004, as compared to the three-months ended March 31, 2003. During the three-months ended March 31, 2004, we earned net income of $1.5 million, as compared to a net loss of $26.9 million for the three-months ended March 31, 2003. We incurred a loss from continuing operations for the three-months ended March 31, 2004, of $0.6 million, a significant improvement over the loss from continuing operations of $26.8 million for the three-months ended March 31, 2003. The loss for the three-months ended March 31, 2004, included a reversal of approximately $0.6 million of interest expense 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 $4.2 million and $3.7 million during the three-months ended March 31, 2 004 and 2003, respectively. Historically, we have suffered losses and have not generated positive cash flows from operations. As of March 31, 2004, we had an accumulated deficit of $412.4 million. Our majority-owned subsidiary, Digital Angel Corporation, has suffered losses and has not generated positive cash flows from operations.

     Recent Events

     Share Exchange Agreement with Digital Angel Corporation

     On March 1, 2004, we exchanged shares of our common stock in consideration for shares of the common stock of Digital Angel Corporation under the terms of a Share Exchange Agreement dated August 14, 2003. The Share Exchange Agreement represented a strategic investment by us, whereby we increased our ownership interest in Digital Angel Corporation. The Share Exchange Agreement is more fully described in Note 7 to our Condensed Consolidated Financial Statements.

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     OuterLink Acquisition

     On January 22, 2004, Digital Angel Corporation completed the acquisition of OuterLink Corporation, based in Concord, Massachusetts. OuterLink manufactures and markets a suite of satellite tracking systems, operates a mobile satellite data communications service, and supplies tracking software systems for mapping and messaging. As consideration for the acquisition, Digital Angel Corporation issued 0.1 million shares of its Series A Preferred Stock in exchange for all of the issued and outstanding shares of OuterLink’s capital stock. The acquisition is more fully described in Note 7 to the Condensed Consolidated Financial Statements.

     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. Our Board of Directors decided to implement a reverse stock split to facilitate the continuing listing of our common stock on the SmallCap, and also to reduce the number of issued and outstanding shares, resulting, in part, from our past acquisitions, the payment of debt obligations to IBM Credit and preferred stock and debenture conversions. On April 23, 2004, the Nasdaq Stock Market notified us that we had regained compliance with the SmallCap’s minimum bid price requirement of $1.00 per share. The reverse stock split is mo re fully described in Note 1 to our Condensed Consolidated Financial Statements.

     Employment Agreement

     On April 8, 2004, we entered into an employment agreement with Scott R. Silverman, our Chairman of the Board and Chief Executive Officer. The agreement, which became retroactively effective on January 1, 2004, and terminates five years from the effective date, is more fully described in Note 13 to our Condensed Consolidated Financial Statements.

     Securities Purchase Agreement with Institutional Investor

     On April 16, 2004, we sold 2.0 million shares of our common stock, par value $0.01 per share, and issued 1.7 million common stock purchase warrants in a private placement to an institutional investor as more fully described in Note 13 to our Condensed Consolidated Financial Statements.

     Other

     The Staff of the Securities and Exchange Commission’s Southeast Regional Office is conducting an informal inquiry concerning us. We are fully and voluntarily cooperating with this informal inquiry. At this point, we are unable to determine whether this informal investigation may lead to potentially adverse action.

     Business Segments

     We operate in three business segments: Advanced Technology, Digital Angel Corporation and InfoTech USA, Inc. The “Corporate/Eliminations” category includes all amounts recognized upon consolidation of our subsidiaries such as the elimination of intersegment revenues, expenses, assets and liabilities. “Corporation/Eliminations” also includes certain interest income, interest expense and other income and expenses associated with corporate activities and functions. On March 1, 2001, our Board of

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Directors approved a plan to sell Intellesale, Inc. and all of our other non-core businesses. The results of operations, financial condition and cash flows of Intellesale and all of our other non-core businesses have been reported as Discontinued Operations in our financial statements.

     Each of our business segments are more fully described in our Annual Report on Form 10-K, as amended, for the year ended December 31, 2003, and in Note 6 to our Condensed Consolidated Financial Statements.

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