As Filed with the Securities and Exchange Commission on November 14, 2002
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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 September 30, 2002
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 Securities
Exchange Act of 1934 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 / /
The number of shares outstanding of each of the issuer's classes of
common stock as of the close of business on November 12, 2002:
Class Number of Shares
Common Stock; $.001 Par Value 283,933,128
APPLIED DIGITAL SOLUTIONS, INC.
TABLE OF CONTENTS
Item Description Page
PART I - FINANCIAL INFORMATION
1. Financial Statements (unaudited)
Condensed Consolidated Balance Sheets
September 30, 2002, and December 31, 2001 3
Condensed Consolidated Statements of Operations -
Three and Nine Months ended September 30, 2002 and 2001 4
Condensed Consolidated Statement of Stockholders' Equity -
Nine Months ended September 30, 2002 5
Condensed Consolidated Statements of Cash Flows -
Nine Months ended September 30, 2002 and 2001 6
Notes to Consolidated Financial Statements 7
2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 30
3. Quantitative and Qualitative Disclosures About Market Risk 60
4. Controls and Procedures 60
PART II - OTHER INFORMATION
1. Legal Proceedings 60
2. Changes In Securities 62
3. Defaults Upon Senior Securities 63
4. Submission of Matters to a Vote of Security Holders 63
5. Other Information 63
6. Exhibits and Reports on Form 8-K 63
SIGNATURE 64
CERTIFICATIONS 65
EXHIBITS 67
2
PART I FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
ASSETS
SEPTEMBER 30, December 31,
2002 2001
---------------------------------
(UNAUDITED)
CURRENT ASSETS
Cash and cash equivalents $ 7,164 $ 3,696
Due from buyers of divested subsidiaries - 2,625
Accounts receivable and unbilled receivables (net of allowance
for doubtful accounts of $1,768 in 2002 and $2,581 in 2001) 18,379 21,871
Inventories 6,920 6,174
Notes receivable 2,985 2,256
Other current assets 3,389 4,786
- ----------------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 38,837 41,408
PROPERTY AND EQUIPMENT, NET 16,925 20,185
NOTES RECEIVABLE, NET 3,011 4,004
GOODWILL, NET 130,641 90,831
INVESTMENT IN AFFILIATE - 6,779
OTHER ASSETS, NET 5,598 4,282
- ----------------------------------------------------------------------------------------------------------------
$ 195,012 $ 167,489
================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Notes payable and current maturities of long-term debt $ 81,562 $ 83,995
Accounts payable 12,960 15,282
Accrued expenses 23,473 18,207
Earnout and put accruals 200 200
Net liabilities of Discontinued Operations 10,696 9,460
- ----------------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 128,891 127,144
LONG-TERM DEBT, NOTES PAYABLE AND OTHER LIABILITIES 3,919 2,586
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TOTAL LIABILITIES 132,810 129,730
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COMMITMENTS AND CONTINGENCIES - -
- ----------------------------------------------------------------------------------------------------------------
MINORITY INTEREST 35,938 4,460
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- ----------------------------------------------------------------------------------------------------------------
REDEEMABLE PREFERRED STOCK OPTIONS - SERIES C - 5,180
- ----------------------------------------------------------------------------------------------------------------
PREFERRED STOCK, COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY
Preferred shares: Authorized 5,000 shares in 2002 and 2001 of $10 par value;
special voting, no shares issued or outstanding in 2002 and 2001, Class B
voting, no shares issued or outstanding in 2002 and 2001 - -
Common shares: Authorized 345,000 shares in 2002 and 2001, of $.001
par value; 284,826 shares issued and 283,891 shares outstanding in 2002
and 252,449 shares issued and 251,514 shares outstanding in 2001 285 252
Common and preferred additional paid-in capital 377,330 342,189
Accumulated deficit (354,392) (304,581)
Common stock warrants 5,651 3,293
Treasury stock (carried at cost, 935 shares in 2002 and 2001) (1,777) (1,777)
Accumulated other comprehensive income (loss) (37) (747)
Notes received from shares issued (796) (10,510)
- ----------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------
Total Preferred Stock, Common Stock, and Other Stockholders' Equity 26,264 28,119
- ----------------------------------------------------------------------------------------------------------------
$ 195,012 $ 167,489
================================================================================================================
See the accompanying notes to condensed consolidated financial statements.
SEE NOTES 1, 4 AND 7 REGARDING THE RESTRICTION ON APPLIED DIGITAL SOLUTIONS,
INC.'S ABILITY TO EXERCISE CONTROL OVER THE AFFAIRS, MANAGE THE RESOURCES AND
TRANSFER FUNDS FROM A SIGNIFICANT OPERATING SUBSIDIARY.
3
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-----------------------------------------------------------
2002 2001 2002 2001
-----------------------------------------------------------
Product revenue $ 19,889 $ 30,834 $ 64,189 $ 92,265
Service revenue 4,014 10,532 13,769 36,381
- ---------------------------------------------------------------------------------------------------------------------------------
Total revenue 23,903 41,366 77,958 128,646
Cost of products sold 13,339 28,377 44,756 71,536
Cost of services sold 1,829 6,467 6,361 18,930
- ---------------------------------------------------------------------------------------------------------------------------------
Gross profit 8,735 6,522 26,841 38,180
Selling, general and administrative expenses 7,343 27,963 54,605 62,539
Research and development 743 1,653 2,405 4,741
Asset impairment - 68,764 784 68,764
Loss (gain) on disposition of assets - 3,967 (194) 4,052
Depreciation and amortization 1,209 7,626 3,597 21,483
Interest and other income (735) (481) (1,388) (1,568)
Interest expense 5,782 2,720 12,574 6,926
- ---------------------------------------------------------------------------------------------------------------------------------
Loss from continuing operations before taxes,
minority interest and equity in net loss of affiliate (5,608) (105,690) (45,543) (128,757)
Provision (benefit) for income taxes 105 3,666 200 21,718
- ---------------------------------------------------------------------------------------------------------------------------------
Loss from continuing operations before minority interest,
net loss on subsidiary merger transaction, and equity in
net loss of affiliate (5,713) (109,356) (45,743) (150,475)
Minority interest (324) (58) (762) (504)
Net loss on subsidiary merger transaction, stock issuances
and loss on sale of subsidiary stock 362 - 4,644 -
Equity in net loss of affiliate - 51 291 118
- ---------------------------------------------------------------------------------------------------------------------------------
Loss from continuing operations (5,751) (109,349) (49,916) (150,089)
Income from discontinued operations, net of income
taxes of $0 in 2001 - - - 213
Change in estimate on loss on disposal and operating
losses during the phase out period (119) (748) 105 (22,537)
- ---------------------------------------------------------------------------------------------------------------------------------
Loss before extraordinary gain (5,870) (110,097) (49,811) (172,413)
Extraordinary gain - - - 9,465
- ---------------------------------------------------------------------------------------------------------------------------------
Net loss (5,870) (110,097) (49,811) (162,948)
Preferred stock dividends and other - 82 - 1,143
Accretion of beneficial conversion feature of
redeemable preferred stock - series C - - - 9,392
- ---------------------------------------------------------------------------------------------------------------------------------
Net loss available to common stockholders $ (5,870) $(110,179) $(49,811) $(173,483)
=================================================================================================================================
Income (loss) per common share - basic and diluted
Income (loss) from continuing operations $ (0.02) $ (0.56) $ (0.19) $ (1.09)
Income from discontinued operations - - - (0.15)
Extraordinary gain - - - 0.06
- ---------------------------------------------------------------------------------------------------------------------------------
Net loss per common share - basic and diluted $ (0.02) $ (0.56) $ (0.19) $ (1.18)
=================================================================================================================================
Weighted average number of common shares outstanding - basic
and diluted 274,934 197,520 265,001 146,890
See the accompanying notes to condensed consolidated financial statements.
SEE NOTES 1, 4 AND 7 REGARDING THE RESTRICTION ON APPLIED DIGITAL SOLUTIONS,
INC.'S ABILITY TO EXERCISE CONTROL OVER THE AFFAIRS, MANAGE THE RESOURCES AND
TRANSFER FUNDS FROM A SIGNIFICANT OPERATING SUBSIDIARY.
4
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF PREFERRED STOCK,
COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002
(In Thousands)
(Unaudited)
ADDITIONAL
PREFERRED STOCK COMMON STOCK PAID-IN ACCUMULATED
NUMBER AMOUNT NUMBER AMOUNT CAPITAL DEFICIT
-----------------------------------------------------------------------------
BALANCE - DECEMBER 31, 2001 - $ - 252,449 $252 $342,189 $(304,581)
Net loss - - - - - (49,811)
Comprehensive income -
Foreign currency translation - - - - - -
---------
Total comprehensive loss - - - - - (49,811)
---------
Expiration of redeemable preferred
stock options - Series C - - - - 5,180 -
Adjustment to notes received
for shares issued - - - - (4,424) -
Allowance for uncollectible portion
of note receivable - - - - - -
Collection of notes receivable received
for shares issued - - - - - -
Repurchase of common stock - - - - 1,878 -
Retirement of treasury stock - - (984) (1) (1,877) -
Shares issuable for settlement of liability - - - 63 -
Obligation for shares issuable in settlement
of liability - - - - (63) -
Stock option repricing - - - - 33 -
Stock options - Digital Angel Corporation - - - - 18,788 -
Stock options - VeriChip Corporation 200
Issuance of warrants - - - - - -
Issuance of warrants - Verichip Corporation - - - - 44 -
Remeasurement of warrants -
Digital Angel Corporation - - - - 1,066 -
Issuance of common shares - - 7,415 8 1,361 -
Issuance of common shares and options for
services, compensation and other - - 25,946 26 12,892 -
- -------------------------------------------------------------------------------------------------------------------------------
BALANCE - SEPTEMBER 30, 2002 - $ - 284,826 $285 $377,330 $(354,392)
===============================================================================================================================
ACCUMULATED
COMMON OTHER NOTES TOTAL
STOCK TREASURY COMPREHENSIVE RECEIVED FOR STOCKHOLDERS'
WARRANTS STOCK INCOME (LOSS) SHARES ISSUED EQUITY
----------------------------------------------------------------------------------
BALANCE - DECEMBER 31, 2001 $3,293 $(1,777) $(747) $(10,510) $ 28,119
Net loss - - - - (49,811)
Comprehensive income -
Foreign currency translation - - 710 - 710
----- --------
Total comprehensive loss - - 710 - (49,101)
----- --------
Expiration of redeemable preferred
stock options - Series C - - - - 5,180
Adjustment to notes received
for shares issued - - - 4,424 -
Allowance for uncollectible portion
of note receivable - - - 4,134 4,134
Collection of notes receivable received
for shares issued - - - 1,156 1,156
Repurchase of common stock - (1,878) - - -
Retirement of treasury stock - 1,878 - - -
Shares issuable for settlement of liability - - - - 63
Obligation for shares issuable in settlement
of liability - - - - (63)
Stock option repricing - - - - 33
Stock options - Digital Angel Corporation - - - - 18,788
Stock options - VeriChip Corporation 200
Issuance of warrants 2,358 - - - 2,358
Issuance of warrants - Verichip Corporation - - - - 44
Remeasurement of warrants -
Digital Angel Corporation - - - - 1,066
Issuance of common shares - - - - 1,369
Issuance of common shares and options for
services, compensation and other - - - - 12,918
- ------------------------------------------------------------------------------------------------------------------------------------
BALANCE - SEPTEMBER 30, 2002 $5,651 $(1,777) $ (37) $ (796) $ 26,264
====================================================================================================================================
See the accompanying notes to condensed consolidated financial statements.
SEE NOTES 1, 4 AND 7 REGARDING THE RESTRICTION ON APPLIED DIGITAL SOLUTIONS,
INC.'S ABILITY TO EXERCISE CONTROL OVER THE AFFAIRS, MANAGE THE RESOURCES AND
TRANSFER FUNDS FROM A SIGNIFICANT OPERATING SUBSIDIARY.
5
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
-------------------------
2002 2001
-------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $(49,811) $(162,948)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
(Income) loss from discontinued operations (105) 22,324
Goodwill and asset impairment 784 68,764
Extraordinary gain - (9,465)
Non-cash compensation and administrative expenses 19,660 1,231
Issuance of stock for services 2,871 -
Depreciation and amortization 3,597 21,483
Deferred income taxes - 22,082
Impairment of notes receivable 4,134 10,795
Interest income on notes received for shares issued (475) -
Net loss on subsidiary merger transaction 4,644 -
Minority interest (762) (504)
Equity in net loss of affiliate 291 118
(Gain) loss on sale of subsidiaries and business assets (194) 2,965
Loss on sale of equipment 89 1,002
Change in assets and liabilities:
Decrease in accounts receivable 3,805 5,897
Increase (decrease) in inventories (679) 4,727
Decrease in other current assets 1,996 2,406
Decrease in other assets 4,335 883
Increase (decrease) in accounts payable and
accrued expenses 6,334 (3,666)
Net cash provided by (used in) discontinued operations 211 (1,098)
- -----------------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES 725 (13,004)
- -----------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Decrease in notes receivable 1,020 687
Received from buyers of divested subsidiaries 2,625 -
Increase in other assets (308) (471)
Proceeds from sale of property and equipment 2,510 200
Proceeds from sale of subsidiaries and business assets 1,106 -
Payments for property and equipment (1,367) (2,629)
Payments for costs of business acquisitions (73) -
Net cash used in discontinued operations (493) (1,002)
- -----------------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 5,020 (3,215)
- -----------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net amounts borrowed (repaid) on notes payable (5,066) 14,644
Proceeds from long term debt 1,258 -
Payments on long-term debt (1,349) (1,985)
Other financing costs (276) (375)
Issuance of common shares 1,681 316
Collection of notes receivable received for shares issued 1,156 -
Stock issuance costs (312) (756)
Proceeds from subsidiary issuance of common stock 631 126
Net cash provided by (used in) discontinued operations - (657)
- -----------------------------------------------------------------------------------------------
NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES (2,277) 11,313
- -----------------------------------------------------------------------------------------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 3,468 (4,906)
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD 3,696 8,039
- -----------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS - END OF PERIOD $ 7,164 $ 3,133
===============================================================================================
See the accompanying notes to condensed consolidated financial statements.
SEE NOTES 1, 4 AND 7 REGARDING THE RESTRICTION ON APPLIED DIGITAL SOLUTIONS,
INC.'S ABILITY TO EXERCISE CONTROL OVER THE AFFAIRS, MANAGE THE RESOURCES AND
TRANSFER FUNDS FROM A SIGNIFICANT OPERATING SUBSIDIARY.
6
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying financial statements have been prepared on a going
concern basis and do not reflect any adjustments that might result from the
outcome of any uncertainty described in Note 4.
The accompanying unaudited condensed consolidated financial
statements of Applied Digital Solutions, Inc. (the "Company") as of
September 30, 2002, and December 31, 2001 (the December 31, 2001 financial
information included herein has been extracted from the Company's audited
financial statements included in the Company's 2001 Annual Report on Form
10-K) and for the three and nine months ended September 30, 2002, and 2001,
have been prepared in accordance with accounting principles generally
accepted in the United States of America for interim financial information
and with the instructions to Form 10-Q and Article 10 of Regulation S-X
under the Securities Exchange Act of 1934. Accordingly, they do not include
all of the information and footnotes required by accounting principles
generally accepted in the United States of America for complete financial
statements. In the opinion of the Company's management, all adjustments
(including normal recurring adjustments) considered necessary to present
fairly the condensed consolidated financial statements have been made.
The condensed consolidated statements of operations for the three
and nine-months ended September 30, 2002, are not necessarily indicative of
the results that may be expected for the entire year. These statements
should be read in conjunction with the consolidated financial statements and
related notes thereto included in the Company's Annual Report on Form 10-K
for the year ended December 31, 2001.
Certain items in the condensed consolidated financial statements
for the 2001 periods have been reclassified for comparative purposes.
Accounting Policy
- -----------------
Gains and losses on issuance of unissued shares of stock by a
consolidated subsidiary are reflected in the consolidated statement of
operations.
Accounting Changes and Restatement
- ----------------------------------
METHOD OF ACCOUNTING FOR DIGITAL ANGEL CORPORATION
Effective March 27, 2002, the Company's 93% owned subsidiary,
Digital Angel Corporation, which we refer to as pre-merger Digital Angel,
merged with and into a wholly-owned subsidiary of a publicly traded company,
Medical Advisory Systems, Inc. (MAS), and MAS changed its name to Digital
Angel Corporation. Under the terms of the merger agreement, each issued and
outstanding share of common stock of pre-merger Digital Angel (including
each share issued upon exercise of options prior to the effective time of
the merger) was cancelled and converted into the right to receive 0.9375
shares of MAS's common stock. The Company obtained 18.75 million shares of
MAS common stock in the merger (representing approximately 61% of the shares
then outstanding). Prior to the transaction, the Company owned 850,000
shares of MAS, or approximately 16.7%. On September 30, 2002, the Company
7
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
owned 19.6 million shares, or approximately 74.08% of the shares outstanding.
Also, pursuant to the merger agreement, the Company contributed to MAS all
of its stock in Timely Technology Corp., a wholly-owned subsidiary, and
Signature Industries, Limited, an 85% owned subsidiary. Pre-merger Digital
Angel, Timely Technology Corp. and Signature Industries, Limited were
collectively referred to as the Advanced Wireless Group (AWG). The merger
has been treated as a reverse acquisition for accounting purposes, with the
AWG treated as the accounting acquirer.
The total purchase price of the transaction was $31.4 million,
which was comprised of the $25.0 million fair market value of MAS stock
outstanding not held by the Company immediately preceding the merger, the
$3.4 million estimated fair market value of MAS options and warrants
outstanding as well as the direct costs of the acquisition of $3.0 million.
The transaction resulted in Digital Angel Corporation tentatively allocating
approximately $29.0 million of the purchase price to goodwill.
The consolidated financial statements included in this Form 10-Q
include the accounts of Digital Angel Corporation and reflect the
outstanding voting stock not owned by the Trust (as defined in Note 4) as a
minority ownership interest in Digital Angel Corporation on the balance
sheet as of September 30, 2002. Significant intercompany balances and
transactions have been eliminated in consolidation. Digital Angel
Corporation is publicly traded on the AMEX:(DOC), with a closing market
price per share at September 30, 2002, and November 4, 2002, of $2.64 and
$2.45, respectively.
During the nine months ended September 30, 2002, the Company
recorded a net loss of $0.4 million occasioned by the merger transaction,
comprised of a loss of approximately $5.1 million resulting from the
exercise of 1.5 million pre-merger Digital Angel options (representing the
difference between the carrying amount of the Company's pro-rata share of
the investment in pre-merger Digital Angel and the exercise price of the
options) and a gain of approximately $4.7 million from the deemed sale of
22.85% of the AWG, as a result of the merger with MAS. In addition, during
the three and nine-months ended September 30, 2002, the Company recorded a
loss of $0.4 million and $4.2 million, respectively, on the issuances of 60
thousand and 1.0 million shares, respectively, of Digital Angel Corporation
common stock resulting primarily from the exercise of 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 and other changes in the minority
interest ownership.
The merger of pre-merger Digital Angel and MAS, "the reverse
acquisition transaction," occurred on the second to the last business day of
the quarter ended March 31, 2002. By operation of the trust agreement, as
more fully discussed in Note 4, the Company's share of Digital Angel
Corporation's net assets is effectively restricted. Although Digital Angel
Corporation may pay dividends, the Company's access to this subsidiary's
funds is restricted. The following condensed consolidating balance sheet
data at September 30, 2002, shows, among other things, the Company's
investment in Digital Angel Corporation. The following consolidating
financial data reflect the results of operations for the three and
nine-months ended September 30, 2002, and cash flows for the nine-months
ended September 30, 2002.
8
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
CONDENSED CONSOLIDATING BALANCE SHEET DATA
SEPTEMBER 30, 2002
(UNAUDITED)
APPLIED DIGITAL DIGITAL ANGEL CONSOLIDATION
SOLUTIONS, INC. CORPORATION ELIMINATIONS CONSOLIDATED
--------------------------------------------------------------------
(in thousands)
Current Assets
Cash and cash equivalents $ 6,684 $ 480 $ -- $ 7,164
Accounts receivable, net 12,010 6,369 -- 18,379
Inventories 1,855 5,065 -- 6,920
Notes receivable 2,985 -- -- 2,985
Other current assets 1,506 1,883 -- 3,389
--------------------------------------------------------------------
Total Current Assets 25,040 13,797 -- 38,837
Property And Equipment, net 2,461 14,464 -- 16,925
Notes Receivable, net 3,011 -- -- 3,011
Goodwill, net 20,366 105,496 4,779 130,641
Investment in Digital Angel Corporation 95,203 -- (95,203) --
Other Assets, net 3,980 1,618 -- 5,598
--------------------------------------------------------------------
Total Assets $150,061 $135,375 $ (90,424) $195,012
====================================================================
Current Liabilities
Notes payable and current maturities of long-term
debt $ 81,348 $ 214 $ -- $ 81,562
Accounts payable and accrued expenses 27,916 8,517 -- 36,433
Earnout and put accrual 200 -- -- 200
Intercompany (receivable) payable (672) 672 -- --
Net liabilities of Discontinued Operations 10,696 -- -- 10,696
--------------------------------------------------------------------
Total Current Liabilities 119,488 9,403 -- $128,891
Long-Term Debt, Notes Payable and Other Liabilities 64 3,855 -- 3,919
--------------------------------------------------------------------
Total Liabilities 119,552 13,258 -- 132,810
Minority Interest 3,954 320 31,664 35,938
--------------------------------------------------------------------
Accumulated other comprehensive income (loss) 254 (291) -- (37)
Other stockholders' equity 26,301 122,088 (122,088) 26,301
--------------------------------------------------------------------
Total Stockholders' Equity 26,555 121,797 (122,088) 26,264
--------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $150,061 $135,375 $ (90,424) $195,012
====================================================================
9
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS DATA
THREE-MONTHS ENDED SEPTEMBER 30, 2002
(UNAUDITED)
APPLIED
DIGITAL DIGITAL ANGEL CONSOLIDATION
SOLUTIONS, INC. CORPORATION ELIMINATIONS CONSOLIDATED
-------------------------------------------------------------------
(in thousands)
Product revenue $ 10,869 $9,004 $ 16 $19,889
Service revenue 3,679 335 -- 4,014
-------- ------ ----- -------
Total revenue 14,548 9,339 16 23,903
Cost of products sold 8,777 4,484 78 13,339
Cost of services sold 1,565 264 -- 1,829
-------- ------ ----- -------
Gross profit 4,206 4,591 (62) 8,735
Selling, general and administrative expenses 3,442 3,964 (62) 7,344
Research and development 129 614 -- 743
Depreciation and amortization 289 920 -- 1,209
Interest and other income (733) (2) -- (735)
Interest expense 5,711 71 -- 5,782
-------- ------ ----- -------
Loss from continuing operations before taxes, minority
interest, loss on subsidiary stock issuances and sale
of subsidiary stock, and equity in net loss of affiliate (4,632) (976) -- (5,608)
Provision for income taxes 105 -- -- 105
-------- ------ ----- -------
Loss from continuing operations before minority interest,
loss on subsidiary stock issuances and sale of subsidiary
stock and equity in net loss of affiliate (4,737) (976) -- (5,713)
Minority interest (293) (31) -- (324)
Loss on subsidiary stock issuances and sale of
subsidiary stock 362 -- -- 362
Equity in net loss of affiliate 945 -- (945) --
-------- ------ ----- -------
Loss from continuing operations $ (5,751) $ (945) $ 945 $(5,751)
======== ====== ===== =======
10
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS DATA
NINE-MONTHS ENDED SEPTEMBER 30, 2002
(UNAUDITED)
APPLIED
DIGITAL DIGITAL ANGEL CONSOLIDATION
SOLUTIONS, INC. CORPORATION ELIMINATIONS CONSOLIDATED
-------------------------------------------------------------------
(in thousands)
Product revenue $ 39,134 $ 25,117 $ (62) $ 64,189
Service revenue 12,554 1,215 -- 13,769
-------------------------------------------------------------------
Total revenue 51,688 26,332 (62) 77,958
Cost of products sold 31,138 13,618 -- 44,756
Cost of services sold 5,599 762 -- 6,361
-------------------------------------------------------------------
Gross profit 14,951 11,952 (62) 26,841
Selling, general and administrative expenses 25,081 29,587 (62) 54,606
Management fees (193) 193 -- --
Research and development 246 2,159 -- 2,405
Asset impairment 784 -- -- 784
Gain on disposition of assets (194) -- -- (194)
Depreciation and amortization 847 2,750 -- 3,597
Interest and other income (1,386) (2) -- (1,388)
Interest expense 12,378 2,002 (1,806) 12,574
-------------------------------------------------------------------
Loss from continuing operations before taxes,
minority interest, net loss on subsidiary/merger
transaction, and stock issuances and sale of subsidiary
stock, and equity in net loss of affiliate (22,612) (24,737) 1,806 (45,543)
Provision for income taxes 200 -- -- 200
-------------------------------------------------------------------
Loss from continuing operations before minority interest,
net loss on subsidiary/merger transaction and stock
issuances and sale of subsidiary stock, and equity in
net loss of affiliate (22,812) (24,737) 1,806 (45,743)
Minority interest (688) (74) -- (762)
Net loss on subsidiary/merger transaction, subsidiary
stock issuances and sale of subsidiary stock 4,644 -- -- 4,644
Equity in net loss of affiliate 23,148 291 (23,148) 291
-------------------------------------------------------------------
Loss from continuing operations $(49,916) $(24,954) $ 24,954 $(49,916)
====================================================================
11
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS DATA
NINE-MONTHS ENDED SEPTEMBER 30, 2002
(UNAUDITED)
APPLIED
DIGITAL DIGITAL ANGEL CONSOLIDATION
SOLUTIONS, INC. CORPORATION ELIMINATIONS CONSOLIDATED
--------------------------------------------------------------
(in thousands)
Cash Flows From Operating Activities
Net loss $(26,663) $(24,954) $ 1,806 $(49,811)
Adjustment to reconcile net loss to net cash provided by
(used in) operating activities:
Non-cash adjustments 12,608 23,732 (1,806) 34,534
Change in assets and liabilities:
(Increase) decrease in accounts receivable 4,500 (695) -- 3,805
(Increase) decrease in inventories (1,500) 821 -- (679)
(Increase) decrease in other current assets 3,267 (1,271) -- 1,996
Decrease in other assets 4,335 -- -- 4,335
Intercompany receivable (672) 672 -- --
Decrease in accounts payable and other
accrued expenses 5,754 580 -- 6,334
Net cash provided by (used in)
discontinued operations 211 -- -- 211
--------------------------------------------------------------
Net Cash Provided By (Used In) Operating Activities 1,840 (1,115) -- 725
--------------------------------------------------------------
Cash Flows From Investing Activities
Decrease in notes receivable 3,645 -- -- 3,645
(Increase) decrease in other assets (387) 79 -- (308)
Proceeds from the sale of property and equipment 2,487 23 -- 2,510
Proceeds from the sale of subsidiaries and business assets 1,106 -- -- 1,106
Payment for property and equipment (383) (984) -- (1,367)
Investment in subsidiaries (684) -- 684 --
Payment for costs of business acquisitions -- (73) -- (73)
Net cash used in discontinued operations (493) -- -- (493)
--------------------------------------------------------------
Net Cash Provided By (Used In) Investing Activities 5,291 (955) 684 5,020
--------------------------------------------------------------
Cash Flows From Financing Activities
Net amounts repaid on notes payable (5,026) (40) -- (5,066)
Proceeds from long-term debt 348 910 -- 1,258
Payments on long-term debt (1,196) (153) -- (1,349)
Other financing costs (198) (78) -- (276)
Issuance of common shares 1,681 631 (631) 1,681
Collection of notes receivable for shares issued 1,156 -- -- 1,156
Stock issuance costs (312) -- -- (312)
Proceeds from subsidiary issuance of common shares -- -- 631 631
Intercompany transactions -- 684 (684) --
--------------------------------------------------------------
Net Cash Provided By (Used In) Financing Activities (3,547) 1,954 (684) (2,277)
--------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents 3,584 (116) -- 3,468
Cash and Cash Equivalents - Beginning of Period 3,100 596 -- 3,696
--------------------------------------------------------------
Cash and Cash Equivalents - End of Period $ 6,684 $ 480 $ -- $ 7,164
--------------------------------------------------------------
12
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
There are no restrictions on Digital Angel Corporation's ability to
declare or pay dividends under the IBM Credit Agreement (defined in Note 4).
All of the consolidated assets of the Company, exclusive of the assets of
Digital Angel Corporation, are collateral under the IBM Credit Agreement. In
addition, the shares of Digital Angel Corporation common stock held in the
Trust (as defined in Note 4) also collateralize the amounts outstanding
under the IBM Credit Agreement.
CHANGE IN METHOD OF ACCOUNTING FOR GOODWILL
Effective January 1, 2002, the Company adopted Statement of
Financial Accounting Standard No. 142 Goodwill and Other Intangible Assets
(FAS 142). FAS 142 requires that goodwill and certain intangibles no longer
be amortized, but instead tested for impairment at least annually. There was
no impairment of goodwill upon adoption of FAS 142. However, there can be no
assurance that future goodwill impairment tests will not result in
impairment charges.
The following table presents the impact of FAS 142 on net loss
before extraordinary gain and net loss before extraordinary loss per share
had the standard been in effect beginning January 1, 2001:
Three- Nine-
Months Ended Months Ended
September 30, 2001 September 30, 2001
----------------------------------------------
Net loss before extraordinary gain:
Net loss before extraordinary gain as reported $(110,097) $(172,413)
Goodwill amortization 5,969 17,130
Equity method investment amortization 348 800
----------------------------------------------
Adjusted net loss $(103,780) $(154,483)
==============================================
Basic and diluted loss per share:
Net loss before extraordinary gains per share,
basic and diluted, as reported $ (0.56) $ (1.17)
Goodwill amortization 0.03 0.12
Equity method investment amortization -- --
----------------------------------------------
Adjusted net loss before extraordinary gain
per share, basic and diluted $ (0.53) $ (1.05)
==============================================
13
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
The following table presents the impact of FAS 142 on net loss and
net loss per share had the standard been in effect beginning January 1,
2001:
Three- Nine-
Months Ended Months Ended
September 30, 2001 September 30, 2001
----------------------------------------------
Net loss available to common stockholders:
Net loss available to common stockholders as reported $(110,179) $(173,483)
Goodwill amortization 5,969 17,130
Equity method investment amortization 348 800
----------------------------------------------
Adjusted net loss $(103,862) $(155,553)
==============================================
Basic and diluted loss per share:
Net loss per share, basic and diluted, as reported $ (0.56) $ (1.18)
Goodwill amortization 0.03 0.12
Equity method investment amortization -- --
----------------------------------------------
Adjusted net loss per share, basic and diluted $ (0.53) $ (1.06)
==============================================
2. PRINCIPLES OF CONSOLIDATION
The financial statements include the accounts of the Company and
its wholly-owned and majority-owned subsidiaries, including Digital Angel
Corporation. The minority interest represents outstanding voting stock of
the subsidiaries not owned by the Company or the Trust. All significant
intercompany accounts and transactions have been eliminated in
consolidation.
3. INVENTORY
September 30, December 31,
2002 2001
------------- ------------
Raw materials $ 1,577 $ 1,474
Work in process 1,783 176
Finished goods 4,768 6,226
------------- ------------
8,128 7,876
Allowance for excess and obsolescence (1,208) (1,702)
------------- ------------
Net inventory for continuing operations $ 6,920 $ 6,174
============= ============
4. FINANCING AGREEMENTS
On January 31, 2002, and again on February 27, 2002, the Company
entered into amendments to its prior credit agreement with IBM Credit
Corporation (IBM Credit). These amendments extended the principal and
interest payments to April 2, 2002, including principal payments that were
initially due on July 1, 2001.
On March 1, 2002, the Company, Digital Angel Share Trust, a newly
created Delaware business
14
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
trust (Trust) and IBM Credit entered into a Third Amended and Restated Term
Credit Agreement (IBM Credit Agreement). The IBM Credit Agreement became
effective on March 27, 2002, the effective date of the merger between
pre-merger Digital Angel and MAS. Amounts outstanding under the IBM Credit
Agreement bear interest at an annual rate of 17% and initially mature on
February 28, 2003. No principal or interest payments are due until the
maturity date. However, the maturity date will be automatically extended to
February 28, 2004, if the Company repays at least 40% of the original
principal amount outstanding, plus accrued interest and expenses, prior to
February 28, 2003. If the maturity date is extended to February 28, 2004,
the maturity date will be automatically extended again to February 28, 2005,
if the Company pays an additional 40% of the original principal amount
outstanding plus accrued interest and expenses prior to February 28, 2004.
Any amounts outstanding at February 28, 2005, must be repaid by August 31,
2005. If all amounts are not repaid by February 28, 2003, the unpaid amount
will accrue interest at an annual rate of 25%. If all amounts are not repaid
by February 28, 2004, the interest rate increases to 35%.
On September 30, 2002, the principal amount outstanding under the
IBM Credit Agreement was $80.9 million. As part of the amendments to the IBM
Credit Agreement, the Company incurred bank fees of $0.3 million in March
2002, and agreed to re-price warrants that were previously issued to IBM
Credit in April 2001. The re-priced warrants were valued at $1.0 million. In
addition, as a result of the merger between pre-merger Digital Angel and
MAS, warrants convertible into common stock of Digital Angel Corporation
that were previously issued to IBM Credit were revalued using the Black
Scholes method, resulting in additional deferred financing costs of $1.1
million. The bank fees and fair value of the warrants have been recorded as
deferred financing fees and are being amortized over the life of the debt as
interest expense.
On September 30, 2002, and on November 1, 2002, we entered into
amendments to the IBM Credit Agreement, which revised certain financial
covenants. The Company's covenants under the IBM Credit Agreement, as
amended, are as follows: (the Company's Current Asset to Current Liabilities
covenant is measured monthly and the Minimum Cumulative EBITDA, as defined,
is measured quarterly), (Minimum Cumulative Modified EBITDA, as defined in
the IBM Credit Agreement, excludes non-cash compensation expense, one-time
charges, impairment losses and any liability or claim that will be satisfied
by issuance of the Company's common stock):
COVENANT COVENANT REQUIREMENT
----------------------------------------------------------------------------------------------------------
As of the following date not less than:
Current Assets to Current
Liabilities September 30, 2002 .11:1
December 31, 2002 .11:1
----------------------------------------------------------------------------------------------------------
Minimum Cumulative
Modified EBITDA September 30, 2002 $(4,768,300)
December 31, 2002 (7,648,300)
----------------------------------------------------------------------------------------------------------
15
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
In addition, the IBM Credit Agreement contains covenants for
Digital Angel Corporation, as amended on September 30, 2002 and November 1,
2002, as follows: (Digital Angel Corporation's Current Asset to Current
Liabilities covenant and its Minimum Cumulative Modified EBITA, as defined
are measured quarterly):
COVENANT COVENANT REQUIREMENT
----------------------------------------------------------------------------------------------------------
As of the following date not less than:
Current Assets to Current
Liabilities September 30, 2002 1.05:1
December 31, 2002 1.09:1
----------------------------------------------------------------------------------------------------------
Minimum Cumulative
Modified EBITDA September 30, 2002 $(338,000)
December 31, 2002 732,000
----------------------------------------------------------------------------------------------------------
If these Digital Angel Corporation covenants are not met, the
Company will be in default under the IBM Credit Agreement.
The IBM Credit Agreement also contains restrictions on the
declaration and payment of dividends by the Company and its subsidiaries,
excluding Digital Angel Corporation.
At September 30, 2002, the Company and Digital Angel Corporation
were in compliance with the revised covenants under the IBM Credit
Agreement. At June 30, 2002, the Company was not in compliance with its
Minimum Cumulative Modified EBITDA debt covenant and with other provisions
of the IBM Credit Agreement and Digital Angel Corporation was not in
compliance with the Minimum Cumulative Modified EBITDA and Current Assets to
Current Liabilities debt covenants. On August 21, 2002, IBM Credit provided
the Company with a waiver of such noncompliance. As consideration for the
waiver, the Company issued to IBM Credit a five year-warrant to acquire 2.9
million shares of the Company's common stock at $0.15 per share, valued at
approximately $1.3 million, and a five year-warrant to purchase
approximately 1.8 million shares of the Company's wholly-owned subsidiary,
VeriChip Corporation's common stock at $0.05 per share, valued at
approximately $44 thousand. The fair value of the warrants has been recorded
as interest expense in three and nine-months ended September 30, 2002. Based
upon the Company's and Digital Angel Corporation's current level of operations,
the Company believes that it will be able to maintain compliance with the
revised covenants at December 31, 2002. However, if business conditions
are other than as anticipated or other unforeseen events or circumstances
occur, these may impact the Company's ability to remain in compliance with
the covenants. In the absence of a waiver or amendment to the financial
covenants, such noncompliance would constitute an event of default under
the IBM Credit Agreement, and IBM Credit would be entitled to accelerate the
maturity of all amounts the Company owes them. If such noncompliance appears
likely, or occurs, the Company will seek to renegotiate the covenants and/or
obtain waivers from IBM Credit, as required. There can be no assurance,
however, that the Company would be successful in negotiating such amendments
or obtaining such waivers.
Amounts outstanding under the IBM Credit Agreement are
collateralized by a security interest in substantially all of the Company's
assets, excluding the assets of Digital Angel Corporation. The shares of the
Company's subsidiaries, including the Digital Angel Corporation common stock
held in the Trust, also collateralize the amounts outstanding under the IBM
Credit Agreement.
16
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
The IBM Credit Agreement prohibits the Company from borrowing funds
from other lenders without the approval of IBM Credit, and does not provide
for any further advances by IBM Credit. The IBM Credit Agreement also limits
the amount the Company may pay its Chief Executive Officer, Richard Sullivan,
in cash, and prevents it from making certain cash incentive and perquisite
payments, including cash payment arising upon a change in control, to various
other executive officers. Accordingly, there can be no assurance that the
Company will have access to funds necessary to provide for its ongoing
operating expenses to the extent not provided from its ongoing operating
revenue.
The Company is continually seeking operational efficiencies and
synergies within each of its operating segments as well as evaluating
acquisitions of businesses and customer bases which complement its
operations. These strategic initiatives may include acquisitions, raising
additional funds through equity offerings, or the divestiture of non-core
business units that are not critical to the Company's long-term strategy or
other restructurings or rationalization of existing operations. The Company
will continue to review all alternatives to ensure maximum appreciation of
its stockholder's investments. There can be no assurance, however, that any
initiative will be found, or if found, that they will be on terms favorable
to the Company.
17
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
5. LOSS PER SHARE
The following is a reconciliation of the numerator and denominator
of basic and diluted loss per share:
---------------------------------------------------
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------------------------------
2002 2001 2002 2001
---- ---- ---- ----
NUMERATOR:
Loss from continuing operations $ (5,751) $(109,349) $(49,916) $(150,089)
Preferred stock dividends -- (82) -- (1,143)
Accretion of beneficial conversion feature of redeemable preferred
stock -- -- -- (9,392)
---------------------------------------------------
NUMERATOR FOR BASIC LOSS PER SHARE -
Net loss from continuing operations available to commons stockholders $ (5,751) $(109,431) $(49,916) $(160,624)
Net income (loss) from discontinued operations available to common
stockholders (119) (748) 105 (22,324)
Extraordinary gain -- -- -- 9,465
---------------------------------------------------
Net loss available to common stockholders $ (5,870) $(110,179) $(49,811) $(173,483)
===================================================
DENOMINATOR:
DENOMINATOR FOR BASIC LOSS PER SHARE -
Weighted-average shares 274,934 197,520 265,001 146,890
---------------------------------------------------
Denominator for diluted earnings (loss) per share(1) 274,934 197,520 265,001 146,890
---------------------------------------------------
BASIC AND DILUTED EARNINGS (LOSS) PER SHARE:
CONTINUING OPERATIONS $ (0.02) $ (0.56) $ ( 0.19) $ (1.09)
DISCONTINUED OPERATIONS -- -- -- ( .15)
EXTRAORDINARY GAIN -- -- -- .06
---------------------------------------------------
TOTAL - BASIC AND DILUTED $ (0.02) $ (0.56) $ (0.19) $ (1.18)
===================================================
<FN>
(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 NINE-MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-----------------------------------------------------
2002 2001 2002 2001
---- ---- ---- ----
Redeemable preferred stock -- 45,809 -- 140,714
Employee stock options 9,161 489 10,010 2,615
Warrants 2,917 -- 2,542 --
-----------------------------------------------------
12,078 46,298 12,552 143,329
=====================================================
18
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
6. SEGMENT INFORMATION
As a result of the merger of pre-merger Digital Angel and MAS, the
significant restructuring of the Company's business during the past year,
and the Company's emergence as an advanced technology development company,
the Company has re-evaluated and realigned its reporting segments. The
Company currently operates in three business segments - Advanced Technology,
Digital Angel Corporation and SysComm International.
The business units comprising the Advanced Technology segment
represent those businesses that management believes will provide the
necessary synergies, support and infrastructure to allow the Company to
develop, promote and fully-integrate its life-enhancing technology products
and services. The Company's VeriChip and Thermo Life products are included
in the Advanced Technology segment.
The Digital Angel Corporation segment consists of the business
operations of Digital Angel Corporation, the Company's 74.08% owned
subsidiary and is engaged in the business of developing and bringing to
market proprietary technologies used to identify, locate and monitor people,
animals and objects. Before March 27, 2002, the business of Digital Angel
Corporation was operated in four divisions: Animal Tracking, Digital Angel
Technology, Digital Angel Delivery System, and Radio Communications and
Other. With the acquisition of MAS on March 27, 2002, Digital Angel
Corporation re-organized into four new divisions: Animal Applications
(formerly Animal Tracking), Digital Angel Systems, GPS and Radio
Communications, and Physician Call Center and Other. Physician Call Center
and Other reflect the newly acquired MAS business.
The SysComm International segment consists of the business
operations of SysComm International Corporation (OTC:SYCM), the Company's
52.5% owned subsidiary. This segment provides professional services in the
areas of systems integration, information technology (IT) procurement and
logistics, and technology strategy. Doing business as "InfoTech," this
segment provides integrated eBusiness strategy and technology implementation
services on a regional basis to enterprise and small to medium businesses
who want to fully leverage eBusiness technologies as part of their overall
business strategy. Its service offerings includes technology strategy and
due diligence consulting, systems architecture and design, application and
technology infrastructure deployment, enterprise security, IT product
procurement and logistics, and provisioning.
Business units that were closed or sold during the 2001 and 2002
are reported as "All Other."
Prior to January 1, 2002, the Company's business units were
organized into three segments: Applications, Services and Advanced Wireless.
Prior period information has been restated to present the Company's
reportable segments on a comparative basis.
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 expense and other
expenses associated with corporate activities and functions. Included in
"Corporate/Eliminations" for the nine-months ended September 30, 2002, is a
non-cash compensation charge of $18.7 million associated with pre-merger
Digital Angel options, which were converted into options to acquire shares
of MAS in connection with the merger of pre-merger Digital Angel and MAS.
19
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
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 filed for the year-ended December 31, 2001,
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 September 30, 2002:
SEGMENTS
--------
Digital
Advanced Angel SysComm All Corporate/
Technology Corporation International Other Eliminations Consolidated
----------------------------------------------------------------------------------
Net revenue from external customers:
Product $ 7,019 $ 9,004 $3,850 $ -- $ 16 $ 19,889
Service 2,970 335 691 -- 18 4,014
Inter-segment revenue-product -- 16 -- -- (16) --
----------------------------------------------------------------------------------
Total revenue $ 9,989 $ 9,355 $4,541 $ -- $ 18 $ 23,903
==================================================================================
Income (loss) from continuing operations
before income taxes, minority interest,
net loss on subsidiary merger transaction
and equity in net loss of affiliate $ (90) $ (976) $ (33) $ (27) $(4,482) $ (5,608)
==================================================================================
Total assets (2) $41,540 $140,154 $9,757 $2,778 $ 783 $195,012
==================================================================================
Following is the selected segment data as of and for the
nine-months ended September 30, 2002:
SEGMENTS
--------
Digital
Advanced Angel SysComm All Corporate/
Technology Corporation International Other Eliminations Consolidated
----------------------------------------------------------------------------------
Net revenue from external customers:
Product $20,451 $ 25,117 $17,670 $1,014 $ (63) $ 64,189
Service 9,954 1,215 2,171 375 54 13,769
Inter-segment revenue-product -- (63) -- -- 63 --
----------------------------------------------------------------------------------
Total revenue $30,405 $ 26,269 $19,841 $1,389 $ 54 $ 77,958
==================================================================================
Income (loss) from continuing operations
before income taxes, minority interest,
net loss on subsidiary merger transaction
and equity in net loss of affiliate (1) $ (113) $ (4,250) $ (62) $ 117 $(41,235) $(45,543)
==================================================================================
Total assets (2) $41,540 $140,154 $ 9,757 $2,778 $ 783 $195,012
==================================================================================
<FN>
(1) For Digital Angel Corporation, amount excludes $1.8 million of
interest expense associated with the Company's obligation to IBM
Credit and $18.7 million of non-cash compensation expense
associated with pre-merger Digital Angel options which were
converted into options to acquire MAS stock, both of which have
been reflected as additional expense in the separate financial
statements of Digital Angel Corporation included in its Form 10-Q
dated September 30, 2002.
(2) For Digital Angel Corporation, amount includes $4.8 million of goodwill
associated with the Company's initial 16.6% investment in MAS.
20
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Following is the selected segment data as of and for the
three-months ended September 30, 2001:
SEGMENTS
--------
Digital
Advanced Angel SysComm All Corporate/
Technology Corporation International Other Eliminations Consolidated
-----------------------------------------------------------------------------------
Net revenue from external customers:
Product $ 5,416 $ 8,416 $10,880 $ 6,122 $ -- $ 30,834
Service 3,976 881 1,391 4,389 (105) 10,532
Inter-segment revenue - product -- -- -- -- -- --
Inter-segment revenue - service -- (119) -- -- 119 --
-----------------------------------------------------------------------------------
Total revenue $ 9,392 $ 9,178 $12,271 $ 10,511 $ 14 $ 41,366
===================================================================================
Loss from continuing operations before
income taxes, minority interest and equity
in net loss of affiliate $(32,377) $ (3,949) $ 154 $(45,224) $(24,294) $(105,690)
===================================================================================
Total assets $ 45,011 $111,800 $18,826 $ 25,072 $ (4,821) $ 195,888
===================================================================================
Following is the selected segment data as of and for the
nine-months ended September 30, 2001:
SEGMENTS
--------
Digital
Advanced Angel SysComm All Corporate/
Technology Corporation International Other Eliminations Consolidated
-----------------------------------------------------------------------------------
Net revenue from external customers:
Product $ 22,436 $ 25,168 $26,028 $ 18,722 $ (89) $ 92,265
Service 12,706 2,803 3,099 18,571 (798) 36,381
Inter-segment revenue - product -- -- -- (89) 89 --
Inter-segment revenue - service -- (119) -- (782) 901 --
-----------------------------------------------------------------------------------
Total revenue $ 35,142 $ 27,852 $29,127 $ 36,422 $ 103 $ 128,646
===================================================================================
Loss from continuing operations before
income taxes, minority interest and equity
in net loss of affiliate $(34,211) $ (9,336) $ (480) $(51,498) $(33,232) $(128,757)
===================================================================================
Total assets $ 45,011 $111,800 $18,826 $ 25,072 $ (4,821) $ 195,888
===================================================================================
21
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
7. ACQUISITIONS AND DISPOSITIONS
On February 27, 2001, the Company acquired 16.6% of the capital
stock of MAS, a provider of medical assistance and technical products and
services, in a transaction valued at approximately $8.3 million in
consideration for 3.3 million shares of its common stock. The Company became
the single largest stockholder and controlled two of the seven board seats.
The Company accounted for this investment under the equity method of
accounting. The excess of the purchase price over the net book value
acquired was approximately $6.8 million and was being amortized on a
straight-line basis over five years. Under FAS 142, which the Company
adopted on January 1, 2002, the goodwill embedded in the Company's equity
investment in MAS is no longer amortized. As a result of no longer
amortizing this goodwill, the Company's net income increased by $0.3 million
and $0.8 million for the three and nine-months ended September 30, 2002,
respectively.
Effective March 27, 2002, the Company's 93% owned subsidiary,
pre-merger Digital Angel, merged with MAS. As a result of the merger, the
Company now owns approximately 74.08% of Digital Angel Corporation, as more
fully discussed in Note 1.
In satisfaction of a condition to the consent to the merger by IBM
Credit, the Company transferred to the Trust all of the shares of MAS common
stock owned by it and, as a result, the Trust has legal title to
approximately 74.08% of the Digital Angel Corporation common stock. The
Trust has voting rights with respect to the Digital Angel Corporation common
stock until the Company's obligations to IBM Credit are repaid in full. The
Trust may be obligated to liquidate the shares of Digital Angel Corporation
common stock owned by it for the benefit of IBM Credit in the event the
Company fails to make payments, or otherwise defaults, under its IBM Credit
Agreement with IBM Credit, which became effective on the date of the merger.
The Company has retained beneficial ownership of the shares. See Note 4.
Unaudited pro forma results of operations for the nine-months ended
September 30, 2002, are included below. Such pro forma information assumes
that the merger of pre-merger Digital Angel and MAS had occurred as of
January 1, 2002.
-----------------
NINE-MONTHS ENDED
SEPTEMBER 30,
-----------------
2002
----
Net operating revenue from continuing operations $ 78,844
Loss from continuing operations $(50,605)
Loss available to common stockholders from continuing operations $(50,605)
Loss per common share from continuing operations - basic $ (0.19)
Loss per common share from continuing operations - diluted $ (0.19)
22
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Earnout Agreement
-----------------
Certain acquisition agreements the Company entered into during 2000
include additional consideration contingent on profits of the acquired
subsidiary. Upon earning this additional consideration, the value is
recorded as additional goodwill. The financial statements include the value
of shares earned upon attainment of certain profits by subsidiaries through
September 30, 2002. At September 30, 2002, based upon the expected
performance of these acquired subsidiaries, the Company is contingently
liable for additional consideration of approximately $60,000.
Dispositions
------------
The gain (loss) on the disposal of assets was $0.2 million in the
nine-months ended September 30, 2002, and ($4.0) million and ($4.1) million
in the three and nine-months ended September 30, 2001, respectively. The
gain in the nine-months ended September 30, 2002, was due primarily to the
sale of the business assets of our wholly-owned subsidiary Applied Digital
Oracle Practice, Inc., during the first quarter of 2002. The losses in the
2001 periods were primarily due to sales of the business assets of our
wholly-owned subsidiaries Signal Processors, Limited and ACT Wireless Corp.
during the third quarter of 2001. The total proceeds of $0.9 million in
cash and notes receivable resulted in a pre-tax loss of approximately $3.0
million.
8. ASSET IMPAIRMENT
As a result of the current economic slowdown, which was worsened
by the terrorist attacks on September 11, 2001, the Company experienced
deteriorating sales for certain of its businesses. This resulted in the
shut down of several of the Company's businesses during the three-months
ended September 30, 2001. Also, letters of intent that the Company received
during the third quarter of 2001 related to the sales of certain of its
businesses had indicated a decline in their fair values. The sales of these
businesses were due to the current financial condition of the Company and
did not comprise an entire business segment. Based upon these developments,
the Company reassessed its future expected operating cash flows and
business valuations. This reassessment resulted in the following asset
impairments for the nine-months ended September 30, 2002, and the three and
nine-months ended September 30, 2001:
Nine-Months Ended September 30, 2002
----------------------------------------
(In thousands)
Property and Software and
Equipment Other Total
Advanced Technology $ -- $ -- $ --
Digital Angel Corporation -- -- --
SysComm International -- -- --
All Other -- --
Corporate/Eliminations 448 336 784
----------------------------------------
Total $448 $336 $784
========================================
23
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Three and Nine-Months Ended September 30, 2001
---------------------------------------------------
(In thousands)
Property Software
Goodwill and Equipment and Other Total
Advanced Technology $29,840 $ -- $ -- $29,840
Digital Angel Corporation -- -- -- --
SysComm International -- -- -- --
All Other 30,365 2,541 1,044 33,950
Corporate/Eliminations -- 4,974 4,974
---------------------------------------------------
Total $60,205 $2,541 $6,018 $68,764
===================================================
In addition to the impairments above, the Company recorded an
inventory reserve of $4.3 million in the three and nine-months ended
September 30, 2001, which is included in the financial statements in cost of
products sold.
9. REDEEMABLE PREFERRED STOCK
For the nine-months ended September 30, 2001, the beneficial
conversion feature (BCF) associated with the Company's preferred stock
charged to earnings per share was $9.4 million. The Company had cumulatively
recorded a charge to earnings per share of $13.2 million, since the issuance
of the preferred stock. As of June 30, 2001, the BCF was fully accreted.
10. 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, 2002, the Company had sold or closed
substantially all of the businesses comprising Discontinued Operations and
there were two insignificant companies remaining. One of the remaining
businesses was sold effective May 23, 2002, and the Company anticipates
selling the remaining company within the next several months. Revenue and
net loss for the remaining business was $0.6 million and $0.2 million,
respectively, for the nine-months ended September 30, 2002. Proceeds from
the sales of Discontinued Operations companies were used to repay amounts
outstanding under the IBM Credit Agreement. Any additional proceeds on the
sale of the remaining business will also be used to repay the IBM debt.
24
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
The following discloses the results of Intellesale and all other
non-core businesses comprising Discontinued Operations for the period from
January 1, 2001, through March 1, 2001:
January 1, through
March 1,
----------------------
2001
----
Product revenue $13,039
Service revenue 846
----------------------
Total revenue 13,885
Cost of products sold 10,499
Cost of services sold 259
----------------------
Total cost of products and services sold 10,758
----------------------
Gross profit 3,127
Selling, general and administrative expenses 2,534
Depreciation and amortization 264
Interest, net 29
Provision for income taxes 34
Minority interest 53
----------------------
Income from discontinued operations $ 213
======================
The above results do not include any allocated or common overhead
expenses. Included in "Interest, net" above, are interest charges based on
the debt of one of these businesses. A purchaser assumed this debt when the
business was sold on January 31, 2002.
Assets and liabilities of Discontinued Operations are as follows at
September 30, 2002, and December 31, 2001.
September 30, 2002 December 31, 2001
----------------------------------------------
(In thousands)
Current Assets
Cash and cash equivalents $ 167 $ --
Accounts receivable and unbilled receivables, net 343 5,745
Inventories 38 4,430
Prepaid expenses and other current assets -- 291
----------------------------------------------
Total Current Assets 548 10,466
Property and equipment, net 105 3,553
Other assets -- 242
----------------------------------------------
$ 653 $14,261
==============================================
Current Liabilities
Notes payable and current maturities of
long-term debt $ 26 $ 5,040
Accounts payable 4,360 8,670
Accrued expenses 6,801 9,610
----------------------------------------------
Total Current Liabilities 11,187 23,320
Long-term debt -- --
Minority interest 162 401
----------------------------------------------
11,349 23,721
==============================================
Net Liabilities of Discontinued Operations $10,696 $ 9,460
==============================================
25
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
The Company recorded a provision for operating losses, estimated
loss on sale and carrying costs during the phase-out period including
operating and other disposal costs to be incurred in selling the businesses.
Carrying costs primarily include the cancellation of facility leases,
employment contract buyouts and litigation reserves. During the nine-months
ended September 30, 2002, the Company increased its estimated loss on sale
of its 85% ownership in its Canadian subsidiary, Ground Effects, Ltd., which
was sold on January 31, 2002, by $0.2 million, and it increased its
estimated loss on the sale of certain business assets of U.S. Electrical
Products Corp, which were sold on May 23, 2002, by $0.2 million. Proceeds on
the sale of Ground Effects, Ltd. approximated $1.6 million plus the
assumption of the Canadian portion of the IBM debt. Proceeds on the sale of
certain U.S. Electrical Products Corp.'s assets were $0.1 million.
Offsetting the increase in the estimated loss on sale was a reduction in
carrying costs of $0.7 million for the first nine months of 2002. This was
due to a change in estimated carrying costs as certain of these obligations
were settled for amounts less than previously anticipated.
The following table sets forth the roll forward of the liabilities
for estimated loss on sale and operating losses and carrying costs from
December 31, 2001 through September 30, 2002.
Balance Balance
Type of Cost December 31, 2001 Additions Deductions September 30, 2002
- ----------------------------------------------------------------------------------------------------------------------
Estimated loss on sale, net of change in
Estimated operating losses $1,173 $ 597 $1,770 $ --
Carrying costs 7,218 (702) 137 6,379
----------------------------------------------------------------
Total $8,391 $(105) $1,907 $6,379
================================================================
11. NON-CASH COMPENSATION EXPENSE ASSOCIATED WITH OPTIONS AND NOTES
RECEIVABLE FOR STOCK ISSUANCES
Pursuant to the terms of the pre-merger Digital Angel and MAS
merger agreement, effective March 27, 2002, options to acquire shares of
pre-merger Digital Angel common stock were converted into options to acquire
shares of MAS common stock. The transaction resulted in a new measurement
date for the options and, as a result, the Company recorded a non-cash
compensation expense of approximately $18.7 million on March 27, 2002. As
all of the option holders were employees or directors of the Company, these
options were considered fixed awards under APB Opinion No. 25 and expense
was recorded for the intrinsic value of the options converted. This charge
is included in the condensed consolidated statement of operations in
selling, general and administrative expenses.
26
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
In addition, during the three-months ended September 30, 2002,
Company reversed approximately $2.9 million of non-cash compensation
expense, and during the nine-months ended September 30, 2002, the Company
incurred approximately $0.5 million of non-cash compensation expense, due
primarily to re-pricing 19.3 million stock options during 2001. The
re-priced options had original exercise prices ranging from $0.69 to $6.34
per share and were modified to change the exercise price to $0.15 per share.
Due to the modification, these options are being accounted for as variable
options under APB Opinion No. 25 and, accordingly, fluctuations in the
Company's common stock price result in increases and decreases of non-cash
compensation expense until the options are exercised, forfeited or expired.
This non-cash charge (credit) is reflected in the condensed consolidated
statement of operations in selling, general and administrative expenses.
The Company incurred approximately $0.5 million and $3.9 million
for changes to increase valuation reserves associated with notes receivable
for stock issuances to directors and officers for the three and nine months
ended September 30, 2002.
12. COMPREHENSIVE LOSS
Comprehensive loss represents all non-owner changes in
stockholders' equity and consists of the following:
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
(In thousands) (In thousands)
----------------------------- ----------------------------
2002 2001 2002 2001
---- ---- ---- ----
----------------------------- ----------------------------
Net loss $(5,870) $(110,097) $(49,811) $(162,948)
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustments 49 (34) 710 (1,059)
----------------------------- ----------------------------
Total comprehensive loss $(5,821) $(110,131) $(49,101) $(164,007)
============================= ============================
13. RECENT DEVELOPMENTS
On June 8, 2002, the Company's stockholders approved an increase in
the number of common shares authorized from 345.0 million to 435.0 million.
On July 22, 2002, the Company announced that SysComm International
Corporation had conditionally offered to merge with VeriChip Corporation in
a stock transaction. The merger was contingent upon all necessary approvals,
including but not limited to, approval by SysComm International
Corporation's stockholders and IBM Credit. On October 28, 2002, the Company
issued a press release stating that its board of directors had decided,
based upon a number of factors, not to approve the proposed merger of
VeriChip Corporation with SysComm International Corporation.
From July 12, 2002, to July 30, 2002, the Company's common stock
was traded on the Pink Sheets under the symbol "ADSX.PK." Prior to that
time, the Company's shares were traded on the Nasdaq National Market
(NasdaqNM). Effective July 31, 2002, the Company's shares were relisted on
the NasdaqNM under the symbol "ADSX." As a condition of the relisting,
NasdaqNM advised the Company that it had until October 25, 2002, to regain
compliance with the minimum closing bid price requirement of at least $1.00
per share, and, immediately following, a closing bid price of at least $1.00
27
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
per share for a minimum of ten (10) consecutive trading days. The Company
was unable to satisfy the minimum closing bid price requirement by October
25, 2002, and, as a result, effective November 12, 2002, the Company's
common stock began trading on the Nasdaq SmallCap Market (SmallCap), under
its existing stock symbol ADSX. The Company expects to have until July 2003,
in which to regain the minimum bid requirement of at least $1.00 per share
for a minimum of ten (10) consecutive trading days to maintain its SmallCap
listing, providing the Company continues to comply with the SmallCap's other
listing requirements. Also, while the Company's common stock is listed on
the SmallCap, providing the Company continues to comply with all of the
other NasdaqNM listing requirements, the NasdaqNM rules will allow the
Company to regain its NasdaqNM listing if its common stock's minimum closing
bid price is at least $1.00 per share for a minimum of thirty (30)
consecutive trading days.
By letter dated October 17, 2002, the Food and Drug Administration
(FDA) issued a determination that the VeriChip product is not a medical
device under Section 513(g) of the Federal Food, Drug and Cosmetic Act with
respect to the intended security, financial and personal identification/
safety applications. The FDA further stated in its letter determination that
with respect to the use of the VeriChip product in health information
applications, VeriChip is a medical device subject to the FDA's
jurisdiction. On November 8, 2002 the Company received a letter from the
FDA, based upon correspondence from the Company to the FDA, warning the
Company not to market Verichip for medical applications. The Company
currently intends to market and distribute the VeriChip product for
security, financial and personal identification/safety applications and, in
the future, the Company plans to expand its marketing and distribution
efforts to health information applications of the product, subject to any
and all necessary FDA and other approvals.
14. LEGAL PROCEEDINGS
During the quarter ended March 31, 2002, 510 Ryerson Road Inc.
filed a lawsuit against the Company and one of its subsidiaries in connection
with a lease for a facility that the Company vacated prior to the expiration
of the lease and which is no longer in use. The trial has been set for
December 2002.
In May 2002, a purported securities fraud class action was filed
against us and one of our directors. In the following weeks, fourteen
virtually identical complaints were filed and they have now been
consolidated into a single action. In re Applied Digital Securities
Litigation in the United States District Court for the Southern District of
Florida. The primary allegations in the recently filed Amended Consolidated
Complaint include claims that:
o the Company recklessly engaged in a strategy of acquiring
subsidiaries without regard to any strategic worth;
o the Company lacked the necessary accounting controls over its
subsidiaries;
o the Company manipulated its stock price through the issuance
of press releases; and
o the Company's statements about its Intellesale, Inc. and
VeriChip Corporation subsidiaries were false and misleading.
The Company believes these claims, and the action in general, are
without merit and it intends to vigorously defend the action.
28
APPLIED DIGITAL SOLUTIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
In July 2002, SRZ Trading LLC filed a derivative complaint
in the Circuit Court of Cole County, Missouri against the Company, and
several of its officers and directors. The complaint alleges that the
Company misrepresented its financial condition and disseminated false and
misleading statements about VeriChip. The Company believes the action
is without merit and intends to vigorously defend against it. The
plaintiff demanded monetary relief in an unspecified amount.
On September 25, 2002, The Bank of Scotland filed a
complaint in the Court of Session in Edinburgh, Scotland against the Company
alleging that it owes them money under the terms of an agreement dated
December 18, 2000, governing the Senior Term Loan and Overdraft Facilities
("Loan Agreement"). Under the terms of the Loan Agreement, Caledonian
Venture Holding Limited was purchased by the Company through the issuance of
its common stock. The complaint alleges that the Company is liable for a
shortfall of approximately $565,000 created under the price protection
provision of the loan.
On July 15, 2002, the Company entered into a settlement and release
agreement by and between certain former shareholders of Computer Equity
Corporation, also referred to as Compec, on behalf of themselves and on
behalf of the former shareholders of Compec. The Company acquired Compec
under the terms of a merger agreement entered into effective June 1, 2000.
Certain former shareholders of Compec had filed claims against the Company
in connection with the earnout provisions of the merger agreement and
damages relating to the registration of shares previously issued to them as
result of the merger. Under the terms of the settlement agreement and in
satisfaction of all claims relating to the merger agreement, the Company
issued 8.0 million shares of its common stock to the former stockholders of
Compec. The shares were valued at $3.0 million and have been reflected as
additional goodwill. On August 23, 2002, the Company issued an additional
100,000 shares of its common stock to the former stockholders of Computer
Equity Corporation in settlement of other matters, which shares were valued
at approximately $56 thousand.
The Company is party to various other legal actions as either a
plaintiff or a defendant. In its opinion, as of the date of this Form 10-Q,
these proceedings will not have a material adverse effect on the Company's
financial position, its cash flows or its overall trends in results. The
estimate of the potential impact on the Company's financial position, its
overall results of operations or its cash flows for these proceedings could
change in the future.
15. EXTRAORDINARY GAIN
As a result of settling certain disputes between the Company and
the former owners of Bostek, Inc. (a company acquired in June 1999) and an
affiliate (Bostek), the parties agreed to forgive a $9.5 million payable,
provided the Company registered approximately 3.0 million common shares by
June 15, 2001. The Company was successful in meeting the June 15, 2001
registration deadline and, accordingly, the extinguishment of the $9.5
million payable was recorded in June 2001 as an extraordinary gain.
29
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 quarterly
report as well as our 2001 Annual Report on Form 10-K.
We are an advanced technology development company. We focus on
developing advanced life-enhancing technology products and services. To
date, we have developed three such products:
o Digital Angel, for monitoring and tracking people and objects;
o VeriChip, an implantable radio frequency verification device
that can be used for security, financial, personal
identification/safety and other applications; and
o Thermo Life, a thermoelectric generator.
Over two years ago, we developed a proprietary location and
monitoring system that combines advanced biosensor technology and location
technology (such as global positioning satellite (GPS)) in a watch/pager
device that communicates through proprietary software to a secure 24/7
operations center in California. We filed an International Patent
Application directed to the system, which has been published under
publication no. W/0 02/44865. The application, which is in the name of
Digital Angel Corporation, is currently pending in several countries. This
technology provides "where-you-are" and "how-you-are" information about
loved ones (particularly elderly relatives and children), their location and
their vital signs via the subscriber's computer, personal digital assistant
(PDA) or wireless telephone. We branded this technology Digital Angel and
merged the technology with a company formerly known as Destron Fearing
Corporation. Our goal was to create a new corporation underpinned by the
patented technology and complemented by the products and services and
revenues of our existing business segments. We united our existing GPS,
application service provider and animal tracking business units to form
Digital Angel Corporation, which we refer to as pre-merger Digital Angel.
Effective March 27, 2002, pre-merger Digital Angel became its own public
company through its merger into Medical Advisory Systems, Inc. (MAS)
(AMEX:DOC). Currently, we are the beneficial owner of approximately 74.08%
of this new company which has been renamed Digital Angel Corporation. We
launched Digital Angel, the product, on November 26, 2001.
In October 2001, we announced our new wholly-owned subsidiary,
Thermo Life Energy Corp, formerly Advanced Power Solutions, Inc., will
develop, market and license our new product, Thermo Life, a small
thermoelectric generator powered by body heat. Thermo Life is intended to
provide a miniaturized power source for a wide range of consumer electronic
devices including attachable or implantable medical devices and
wristwatches. On July 9, 2002, we announced that we had achieved an
important breakthrough: 3.0-volts of electrical power were successfully
generated by Thermo Life in laboratory tests. We expect to begin marketing
Thermo Life during the first quarter of 2003.
In December 2001, we announced the development of a miniaturized,
implantable verification chip, called VeriChip that can be used in a variety
of security, financial, personal identification/safety and other applications.
On February 7 2002, we announced that we had created a new wholly-owned
subsidiary, VeriChip Corporation, that will develop, market and license
VeriChip. About the size a grain of rice, each VeriChip product contains
a unique verification number. Utilizing an external scanner, radio
frequency energy passes through the skin energizing the dormant VeriChip,
which then emits a radio frequency signal transmitting the verification
number contained in the VeriChip. VeriChip technology is produced under
patents #6,400,338 and #5,211,129. This technology is owned by Digital Angel
Corporation and licensed to VeriChip under an exclusive product and
technology license with a remaining term of approximately ten and one-half
years.
30
On October 22, 2002, we announced that the Food and Drug
Administration (FDA) had determined that VeriChip is not a regulated medical
device for security, financial and personal identification/safety
applications. The FDA specified in its ruling that VeriChip is a regulated
medical device for health information applications when marketed to provide
information to assist in the diagnosis or treatment of injury or illness. On
November 8, 2002, we received a letter from the FDA, based upon
correspondence from us to the FDA, warning us not to market VeriChip for
medical applications. We currently intend to market and distribute the
VeriChip product for security, financial and personal identification/safety
applications and, in the future, we plan to expand our marketing and
distribution efforts to health information applications of the product,
subject to any and all necessary FDA and other approvals. We began marketing
VeriChip for security, financial and personal identification/safety
applications within the United States, on October 24, 2002.
As a result of the merger of pre-merger Digital Angel and MAS, which
occurred on March 27, 2002, the significant restructuring of our business
during the past year and our emergence as an advanced technology development
company, we have re-evaluated and realigned our reporting segments.
Effective January 1, 2002, we operate in three business segments: Advanced
Technology, Digital Angel Corporation and SysComm International.
The business units comprising our Advanced Technology segment
represent those business units that we believe will provide the necessary
synergies, support and infrastructure to allow us to develop, promote and
fully-integrate our life-enhancing technology products and services. Our
VeriChip and Thermo Life products are included in our Advanced Technology
segment.
Our Digital Angel Corporation segment consists of the business
operations of Digital Angel Corporation and is engaged in the business of
developing and bringing to market proprietary technologies used to identify,
locate and monitor people, animals and objects. Before March 27, 2002, the
business of Digital Angel Corporation was operated in four divisions: Animal
Tracking, Digital Angel Technology, Digital Angel Delivery System, and Radio
Communications and Other. With the acquisition of MAS on March 27, 2002,
Digital Angel Corporation re-organized into four new divisions: Animal
Applications (formerly Animal Tracking), Digital Angel Systems, GPS and
Radio Communications, and Physician Call Center and Other. Physician Call
Center and Other reflects the newly acquired MAS business.
Our SysComm International segment consists of the business
operations of our 52.5% owned subsidiary, SysComm International Corporation.
This segment provides professional services in the areas of systems
integration, information technology (IT) procurement and logistics, and
technology strategy. Doing business as "InfoTech," this segment provides
integrated eBusiness strategy and technology implementation services on a
regional basis to enterprise and small to medium businesses who want to
fully leverage eBusiness technologies as part of their overall business
strategy. Its service offerings includes technology strategy and due
diligence consulting, systems architecture and design, application and
technology infrastructure deployment, enterprise security, IT product
procurement and logistics, and provisioning.
Business units that were part of our continuing operations and that
were closed or sold during 2001 and 2002 are reported as All Other.
Prior to January 1, 2002, our business was organized into three
segments: Applications, Services and Advanced Wireless. Prior period
information has been restated to present our reportable segments on a
comparative basis. Additionally, our previously reported Intellesale and all
other non-core business segments are reported as Discontinued Operations.
31
RECENT DEVELOPMENTS
- -------------------
Digital Angel/MAS Merger
On March 27, 2002, Digital Angel, which we refer to as pre-merger
Digital Angel, merged with MAS and MAS changed its name to Digital Angel
Corporation. Also, pursuant to the merger agreement, we contributed all of
our stock in Timely Technology Corp., our wholly-owned subsidiary, and
Signature Industries, Limited, an 85% owned subsidiary. Pre-merger Digital
Angel, Timely Technology Corp. and Signature Industries, Limited were
collectively referred to as the Advanced Wireless Group (AWG). In
satisfaction of a condition to the consent to the merger by IBM Credit, we
transferred all shares of Digital Angel Corporation common stock owned by us
to a Delaware business trust controlled by an advisory board and, as a
result, the trust has legal title to approximately 74.08% of the Digital
Angel Corporation common stock. The trust has voting rights with respect to
the Digital Angel Corporation common shares until we repay our obligations
to IBM Credit in full. We have retained beneficial ownership of the shares.
The trust may be obligated to liquidate the shares of Digital Angel
Corporation common stock owned by it for the benefit of IBM Credit in the
event we fail to make payments, or otherwise default, under our IBM Credit
Agreement with IBM Credit, as discussed below. Such liquidation of the
shares of Digital Angel Corporation common stock will be in accordance with
the Securities and Exchange Commission's (SEC) rules and regulations
governing affiliates.
On March 27, 2002, we recorded a net loss of $0.4 million arising
from the merger transaction. The net loss was comprised of a loss of
approximately $5.1 million resulting from the exercise of 1.5 million
pre-merger Digital Angel options, partially offset by a gain of
approximately $4.7 million from the deemed sale of approximately 22.85% of
pre-merger Digital Angel and the other subsidiaries comprising the AWG as a
result of the merger with MAS. In addition, during the three and nine-months
ended September 30, 2002, we recorded a loss of $0.4 million and $4.2
million respectively, on the issuances of 60 thousand and 1.0 million
shares, respectively, of Digital Angel Corporation common stock resulting
from the exercise of stock options, and the issuances of Digital Angel
Corporation common stock for services. The loss represents the difference
between the carrying amount of our pro-rata share of our investment in
Digital Angel Corporation and the net proceeds from the issuances of the
stock, and other changes in minority interest ownership.
Our investment in Digital Angel Corporation is being accounted for
under the consolidation method of accounting.
Credit Agreement
On January 31, 2002, and again on February 27, 2002, we entered into
amendments to our prior credit agreement with IBM Credit. These amendments
extended the principal and interest payments, which were due to April 2,
2002, including principal payments that were initially due on July 1, 2001.
Effective March 27, 2002, we entered into a new credit agreement, the
IBM Credit Agreement, with IBM Credit. On September 30, 2002, the principal
amount outstanding under the IBM Credit Agreement was $80.9 million. The
principal amount outstanding bears interest at an annual rate of 17% and
matures on February 28, 2003. No principal or interest payments are due
until the maturity date. However, the maturity date will be automatically
extended to February 28, 2004, if we repay at least 40% of the original
principal amount outstanding, plus accrued interest and expenses, prior to
February 28, 2003. If the maturity date is extended to February 28, 2004,
the maturity date will be automatically extended again to February 28, 2005,
if we repay an additional 40% of the original principal amount outstanding,
plus accrued interest and expenses, prior to February 28, 2004. Any amounts
outstanding at February 28, 2005, must be repaid by August 31, 2005. If all
amounts are not repaid by February 28, 2003, the unpaid amount will accrue
interest at an annual rate of 25%. If all amounts are not repaid by February
28, 2004, the interest rate increases to 35%.
32
The IBM Credit Agreement contains covenants relating to our financial
position and performance, as well as the financial position and performance
of Digital Angel Corporation. On September 30, 2002, we entered into an
amendment to the IBM Credit Agreement, which revised certain financial
covenants relating to our financial performance and the financial position
and performance of Digital Angel Corporation for the quarter ended September
30, 2002 and the fiscal year ending December 31, 2002. On November 1, 2002,
we entered into another amendment to the IBM Credit Agreement, which further
revised certain covenants relating to the financial performance of Digital
Angel Corporation for the quarter ended September 30, 2002, and the fiscal
year ending December 31, 2002. At September 30, 2002, we and Digital Angel
Corporation, were in compliance with the revised covenants under the IBM
Credit Agreement. At June 30, 2002, we were not in compliance with our
Minimum Cumulative Modified EBITDA debt covenant and with other provisions
of the IBM Credit Agreement and Digital Angel Corporation was not in
compliance with its Minimum Cumulative Modified EBITDA and Current Assets to
Current Liabilities debt covenants. On August 21, 2002, IBM Credit provided
us with a waiver of such noncompliance. As consideration for the waiver, we
issued to IBM Credit a five year-warrant to acquire 2.9 million shares of
our common stock at $0.15 per share, valued at approximately $1.3 million,
and a five year-warrant to purchase approximately 1.8 million shares of
VeriChip Corporation's, our wholly-owned subsidiary, common stock at $0.05
per share, valued at approximately $44 thousand. The fair value of these
warrants was included in interest expense for the three and nine-months
ended September 30, 2002. Based upon our and Digital Angel Corporation's
current level of operations, we believe that we will be able to maintain
compliance with the revised covenants at December 31, 2002. However, if
business conditions are other than as anticipated or other unforeseen
events or circumstances occur, these may impact our ability to remain in
compliance with the covenants. In the absence of waiver or amendment to
the financial covenants, such noncompliance would constitute an event of
default under the IBM Credit Agreement, and IBM Credit would be entitled
to accelerate the maturity of all amounts we owe them. In the event such
noncompliance appears likely, or occurs, we will seek to renegotiate the
covenants and/or obtain waivers from IBM Credit, as required. There can
be no assurance, however, that we would be successful in negotiating such
amendments or obtaining such waivers.
The IBM Credit Agreement further prohibits us from borrowing funds
from other lenders and does not provide for any additional advances from IBM
Credit. The IBM Credit Agreement also limits the amount we may pay our Chief
Executive Officer, Richard Sullivan, in cash, and prevents us from making
certain cash incentive and perquisite payments, including cash payment
arising upon a change in control, to various other executive officers.
Other
On June 8, 2002, our stockholders approved an increase in the number
of common shares authorized from 345.0 million to 435.0 million.
From July 12, 2002, to July 30, 2002, our common stock was traded
on the Pink Sheets under the symbol "ADSX.PK." Prior to that time, our
shares were traded on the Nasdaq National Market (NasdaqNM). Effective July
31, 2002, our shares were relisted on the NasdaqNM under the symbol "ADSX."
As a condition of our relisting, NasdaqNM advised us that we had until
October 25, 2002, to regain compliance with the minimum closing bid price
requirement of at least $1.00 per share, and, immediately following, a
closing bid price of at least $1.00 per share for a minimum of ten (10)
consecutive trading days. We were unable to satisfy the minimum closing bid
price requirement by October 25, 2002, and, as a result, effective November
12, 2002, our common stock began trading on the Nasdaq SmallCap Market
(SmallCap), under our existing stock symbol ADSX. We expect to have until
July 2003, in which to regain the minimum bid requirement of at least $1.00
per share for a minimum of ten (10) consecutive trading days to maintain our
SmallCap listing, providing we continue to comply with the SmallCap's other
listing requirements. Also, while our common stock is listed on the
SmallCap, providing we continue to
33
comply with all of the other NasdaqNM listing requirements, the NasdaqNM
rules will allow us to regain our NasdaqNM listing if our common stock's
minimum closing bid price is at least $1.00 per share for a minimum of
thirty (30) consecutive trading days.
On July 22, 2002, we announced that SysComm International
Corporation had conditionally offered to merge with VeriChip Corporation in
a stock transaction. The merger was contingent upon all necessary approvals,
including but not limited to, approval by SysComm International
Corporation's stockholders and IBM Credit. On October 28, 2002, we issued a
press release stating that our board of directors had decided, based upon a
number of factors, not to approve the proposed merger of VeriChip
Corporation with SysComm International Corporation.
34
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, 2002 and 2001 and is derived from the unaudited
consolidated statements of operations in Part I, Item 1 of this report.
------------------------ -----------------------
RELATIONSHIP TO RELATIONSHIP TO
REVENUE REVENUE
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ -----------------------
2002 2001 2002 2001
---- ---- ---- ----
% %
- -
Product revenue 83.2 74.5 82.3 71.7
Service revenue 16.8 25.5 17.7 28.3
------------------------ -----------------------
Total revenue 100.0 100.0 100.0 100.0
Cost of products sold 67.1 92.0 69.7 77.5
Cost of services sold 45.6 61.4 46.2 52.0
------------------------ -----------------------
Total cost of products and services sold 63.5 84.2 65.6 70.3
------------------------ -----------------------
Gross profit 36.5 15.8 34.4 29.7
Selling, general and administrative expenses 30.7 67.6 70.0 48.6
Research and development 3.1 4.0 3.1 3.7
Depreciation and amortization 5.1 18.4 4.6 16.7
Loss (gain) on disposition of assets -- 9.6 (0.2) 3.1
Asset impairment -- 166.2 1.0 53.5
Interest and other income (3.1) (1.2) (1.8) (1.2)
Interest expense 24.2 6.7 16.1 5.4
------------------------ -----------------------
Loss from continuing operations before benefit for income
taxes, minority interest, net loss on subsidiary merger
transaction, stock issuances and loss on sale of
subsidiary stock, and equity in net loss of affiliate (23.5) (255.5) (58.4) (100.1)
Provision (benefit) for income taxes 0.4 8.9 0.3 16.9
------------------------ -----------------------
Loss from continuing operations before minority interest (23.9) (264.4) (58.7) (117.0)
Minority interest (1.4) (0.1) (1.0) (0.4)
Net loss on subsidiary merger transaction, stock issuances
and loss on sale of subsidiary stock 1.5 -- 6.0 --
Equity in net loss of affiliate -- (0.1) 0.3 (0.1)
------------------------ -----------------------
Loss from continuing operations (24.1) (264.4) (64.0) (116.7)
(Loss) income from discontinued operations, net of income
taxes (0.5) (1.8) 0.1 (17.3)
Extraordinary gain -- -- -- 7.4
------------------------ -----------------------
Net loss (24.6) (266.2) (63.9) (126.7)
Preferred stock dividends and other -- (0.2) -- (0.9)
Accretion of beneficial conversion feature of redeemable
preferred stock - series C -- -- -- (7.3)
------------------------ -----------------------
Net loss available to common stockholders (24.6) (266.4) (63.9) (134.9)
======================== =======================
35
REVENUE
Revenue from continuing operations for the three-months ended
September 30, 2002, decreased $17.5 million, or 42.2%, to $23.9 from
$41.4 million in the three-months ended September 30, 2001. Revenue from
continuing operations for the nine-months ended September 30, 2002,
decreased $50.7 million, or 39.4%, to $78.0 million from $128.6 million
in the nine-months ended September 30, 2001.
Revenue from continuing operations during the three and nine-months
ended September 30, 2002, and 2001 by segment was as follows:
THREE-MONTHS ENDED SEPTEMBER 30,
(IN THOUSANDS)
---------------------------------------------------------------------
2002 2001
---- ----
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
Advanced Technology $ 7,019 $2,970 $ 9,989 $ 5,416 $ 3,976 $ 9,392
Digital Angel Corporation 9,020 335 9,355 8,416 762 9,178
SysComm International 3,850 691 4,541 10,880 1,391 12,271
All Other -- -- -- 6,122 4,389 10,511
Corporate / Eliminations -- 18 18 -- 14 14
---------------------------------------------------------------------
Total $19,889 $4,014 $23,903 $30,834 $10,532 $41,366
=====================================================================
NINE-MONTHS ENDED SEPTEMBER 30,
(IN THOUSANDS)
---------------------------------------------------------------------
2002 2001
---- ----
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
Advanced Technology $20,451 $ 9,954 $30,405 $22,436 $12,706 $ 35,142
Digital Angel Corporation 25,054 1,215 26,269 25,168 2,684 27,852
SysComm International 17,670 2,171 19,841 26,028 3,099 29,127
All Other 1,014 375 1,389 18,633 17,789 36,422
Corporate / Eliminations -- 54 54 -- 103 103
---------------------------------------------------------------------
Total $64,189 $13,769 $77,958 $92,265 $36,381 $128,646
=====================================================================
Advanced Technology's revenue increased $0.6 million and decreased $4.7
million in the three and nine-month periods ended September 30, 2002,
respectively, when compared to the three and nine-month periods ended
September 30, 2001. When compared to the amounts for the three-months ended
September 30, 2002, product revenue increased by $1.6 million, or 29.6%, and
service revenue decreased by $1.0 million, or 25.3%. When compared to the
amounts for the nine-months ended September 30, 2002, product revenue
decreased by $2.0 million, or 8.8%, and service revenue decreased by $2.8
million, or 21.7%. We attribute the increase in product revenue in the
three-months ended September 30, 2002, to increased government contract
projects. We attribute the decreases to reduced sales of hardware and
software products in the nine-months ended September 30, 2002, and reduced
technology services in the three and nine-months ended September 30, 2002.
Digital Angel Corporation's revenue increased $0.2 million and decreased
$1.6 million in the three and nine-month periods ended September 30,
2002, respectively, when compared to the three and nine-month periods
ended September 30, 2001. When compared to the amounts for the three-
months ended September 30, 2001, product revenue increased by $0.6
million, or 7.2%, and service revenue decreased by $0.4 million, or
56.0%. When compared to the amounts for the nine-months ended September
30, 2001, product revenue decreased by $0.1 million, or 0.5%, and
service revenue decreased by $1.5 million, or 54.7%. We attribute the
increase in product revenue for the three-months ended September 30,
2002, primarily to sales of transponders to the fisheries industry
customers and revenues associated with MAS, which merged with pre-merger
Digital Angel on March 27, 2002. We attribute the decrease in
36
product sales for the nine-months ended September 30, 2002, primarily to
higher sales in the first quarter of 2001 to a large customer to prepare
for the launch of pet identification products in France. We attribute
the decreases in service revenue to completed client assignments that
were not replaced.
SysComm International's revenue decreased $7.7 million and $9.3 million
in the three and nine-months ended September 30, 2002, respectively,
when compared the three and nine-month periods ended September 30, 2001.
When compared to the amounts for the three-months ended September 30,
2001, product revenue decreased by $7.0 million, or 64.6%, and service
revenue decreased by $0.7 million, or 50.3%. When compared to the
amounts for the nine-months ended September 30, 2001, product revenue
decreased by $8.4 million, or 32.1%, and service revenue decreased by
$0.9 million, or 29.9%. We attribute the decreases to a soft market in
both product and services sales. Additionally, we made a decision in
April 2002, to exit the lower margin mid-range platform computer
equipment business and to focus our efforts on the higher margin Intel
based products and related technical services.
All Other's revenue decreased $10.5 million, or 100.0%, and $35.0
million, or 96.2%, in the three and nine-month periods ended September
30, 2002, respectively, when compared to the three and nine-months ended
September 30, 2001. The decreases were due to the sale or closure of all
of the business units comprising this group during the last half of 2001
and the first half of 2002.
GROSS PROFIT AND GROSS PROFIT MARGIN
Gross profit from continuing operations for the three-months ended
September 30, 2002, increased $2.2 million, or 33.9%, to $8.7 million
from $6.5 million for the three-months ended September 30, 2001. Gross
profit from continuing operations for the nine-months ended September
30, 2002 decreased $11.3 million, or 29.7%, to $26.8 million from $38.2
million in nine-months ended September 30, 2001. Our gross profit margin
was 36.5% and 34.4% of revenue, respectively, for the three and nine-
months ended September 30, 2002, and 15.8% and 29.7% of revenue,
respectively, for the three and nine-months ended September 30, 2001.
Gross profit from continuing operations during the three and nine-months
ended September 30, 2002, and 2001 by segment was as follows:
THREE-MONTHS ENDED SEPTEMBER 30,
(IN THOUSANDS)
---------------------------------------------------------------------
2002 2001
---- ----
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
Advanced Technology $1,169 $1,765 $2,934 $ 1,175 $1,931 $ 3,106
Digital Angel Corporation 4,536 71 4,607 3,161 282 3,443
SysComm International 845 331 1,176 894 976 1,870
All Other -- -- -- (2,773) 863 (1,910)
Corporate / Eliminations -- 18 18 -- 13 13
---------------------------------------------------------------------
Total $6,550 $2,185 $8,735 $ 2,457 $4,065 $ 6,522
=====================================================================
NINE-MONTHS ENDED SEPTEMBER 30,
(IN THOUSANDS)
---------------------------------------------------------------------
2002 2001
---- ----
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
Advanced Technology $ 4,677 $5,551 $10,228 $ 6,049 $ 6,226 $12,275
Digital Angel Corporation 11,435 453 11,888 9,952 1,176 11,128
SysComm International 2,496 1,010 3,506 2,704 1,827 4,531
All Other 826 339 1,165 2,025 8,118 10,143
Corporate / Eliminations -- 54 54 -- 103 103
---------------------------------------------------------------------
Total $19,434 $7,407 $26,841 $20,730 $17,450 $38,180
=====================================================================
37
Gross profit margin from continuing operations during the three and
nine-months ended September 30, 2002, and 2001 by segment was as
follows:
THREE-MONTHS ENDED SEPTEMBER 30
---------------------------------------------------------------------
2002 2001
---- ----
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
% % % % % %
- - - - - -
Advanced Technology 16.7 59.4 29.4 21.7 48.6 33.1
Digital Angel Corporation 50.3 21.2 49.2 37.6 37.0 37.5
SysComm International 21.9 47.9 25.9 8.2 70.2 15.2
All Other -- -- -- (45.3) 19.7 (18.2)
Corporate / Eliminations -- 100.0 100.0 -- 92.9 92.9
---------------------------------------------------------------------
Total 32.9 54.4 36.5 8.0 38.6 15.8
=====================================================================
NINE-MONTHS ENDED SEPTEMBER 30
---------------------------------------------------------------------
2002 2001
---- ----
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
% % % % % %
- - - - - -
Advanced Technology 22.9 55.8 33.6 27.0 49.0 34.9
Digital Angel Corporation 45.6 37.3 45.3 39.5 43.8 40.0
SysComm International 14.1 46.5 17.7 10.4 59.0 15.6
All Other 81.5 90.4 83.9 10.9 45.6 27.8
Corporate / Eliminations -- 100.0 100.0 -- 100.0 100.0
---------------------------------------------------------------------
Total 30.3 53.8 34.4 22.5 48.0 29.7
=====================================================================
Advanced Technology's gross profit decreased $0.2 million in the three-
months ended September 30, 2002, and margin decreased to 29.4% from
33.1% when compared to the three-months ended September 30 2001. Gross
profit decreased $2.0 million in the nine-months ended September 30,
2002, and margin decreased slightly to 33.6% from 34.9% when compared to
the nine-months ended September 30, 2001. We attribute the decrease in
gross profit primarily to the reduction in sales during the first three
and nine-months of 2002, and the decrease in margin primarily to the
reduction in sales of software and other higher-margin products and
services.
Digital Angel Corporation's gross profit increased $1.2 million in the
three-months ended September 30, 2002, while margins increased to 49.2%
in the three-months ended September 30, 2002, from 37.5% in the three-
months ended September 30, 2001. Gross profit increased $0.8 million in
the nine-months ended September 30, 2002, and margins increased to 45.3%
in the nine-months ended September 30, 2002, from 40.0% in the nine-
months ended September 30, 2001. We attribute the increase in gross
profit for the three and nine-months ended September 30, 2002, primarily
to higher sales for transponders. We attribute the increases in gross
margin in the three and nine-months ended September 30, 2002, to a
favorable shift in the product mix.
SysComm International's gross profit decreased $0.7 million in the
three-months ended September 30, 2002, while margin increased to 25.9%
in the three-months ended September 30, 2002, from 15.2% in the three-
months ended September 30, 2001. Gross profit decreased $1.0 million in
the nine-months ended September 30, 2002, while margin increased to
17.7% in the nine-months ended September 30, 2002, from 15.6% in the
nine-months ended September 30, 2001. We attribute the decrease in gross
profit for the three and nine-months ended September 30, 2002, to a
reduced number of lower margin sales and dollars received from
manufacturers. We attribute the increase in gross margin in the three and
38
nine-months ended September 30, 2002, to our decision, in April 2002, to
exit the lower margin mid-range platform computer equipment business and
focus our efforts on the higher margin Intel based products and related
technical services.
All Other's gross profit and margins were zero during the three-months
ended September 30, 2002 as all of the businesses comprising this group
were sold or closed during the last half of 2001 and the first half of
2002. During the three-months ended September 30, 2001, gross profit was
a negative $(1.9) million due to inventory reserves of approximately
$4.3 million. The inventory reserves were attributable to letters of
intent that we had received during the third and fourth quarter of 2001
that indicated a decline in the fair values of certain inventories
associated with these businesses. Gross profit decreased $9.0 million in
the nine-months ended September 30, 2002, and margin increased to 83.9%
in the nine-months ended September 30, 2002 from 27.8% in the nine-
months ended September 30, 2001. The decrease in gross profit resulted
from the sale or closure of all of the business units comprising this
group during the last half of 2001 and the first half of 2002. We
attribute the increase in gross margin during the nine-months ended
September 30, 2002 to the inventory reserves recorded during the three-
months ended September 30, 2001, and to the sale and closure of business
units within this group. The majority of the business units that were
sold or closed earned lower gross margins on average than the remaining
business unit comprising the group during the first half of 2002.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expenses from continuing operations
was $7.3 million in the three-months ended September 30, 2002, a
decrease of $20.6 million, or 73.7%, from $28.0 million in the three-
months ended September 30, 2001. Selling, general and administrative
expenses from continuing operations was $54.6 million in the nine-months
ended September 30, 2002, a decrease of $7.9 million, or 12.7%, from
$62.5 in the nine-months ended September 30, 2001. As a percentage of
total revenue, selling, general and administrative expenses from
continuing operations decreased to 30.7% in the three-months ended
September 30, 2002, from 67.6% in the three-months ended September 30,
2001 and increased to 70.0% in the nine-months ended September 30, 2002,
from 48.6% in the nine-months ended September 30, 2001.
Selling, general and administrative expense from continuing operations
during the three and nine-months ended September 30, 2002, and 2001 by
segments was as follows:
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
(In thousands) (In thousands)
----------------------- -------------------------
2002 2001 2002 2001
---- ---- ---- ----
Advanced Technology $3,106 $ 2,437 $ 9,508 $ 7,846
Digital Angel Corporation 3,965 2,299 11,099 7,049
SysComm International 1,125 1,526 3,224 4,400
All Other 11 6,976 1,067 20,861
Corporate / Eliminations (863) 14,725 29,708 22,383
----------------------- -------------------------
Total $7,344 $27,963 $54,606 $62,539
======================= =========================
39
Selling, general and administrative expense as a percentage of
revenue for each of the operating segments was:
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------- -------------------------
2002 2001 2002 2001
---- ---- ---- ----
% % % %
- - - -
Advanced Technology 31.1 25.9 31.3 22.3
Digital Angel Corporation 42.4 25.0 42.3 25.3
SysComm International 24.8 12.4 16.2 15.1
All Other -- 66.4 -- 57.3
Corporate / Eliminations (1) (3.6) 35.6 38.1 17.4
----------------------- -------------------------
Total 30.7 67.6 70.0 48.6
======================= =========================
<FN>
(1) Corporate's percentage has been calculated as a percentage of
total revenue.
Advanced Technology's selling general and administrative expense
increased $0.7 million, or 27.5%, to $3.1 million in the three-months
ended September 30, 2002 from $2.4 million in the three-months ended
September 30, 2001. Selling general and administrative expense increased
$1.7 million, or 21.2%, to $9.5 million in the nine-months ended
September 30, 2002 from $7.8 million in the nine-months ended September
30, 2001. We attribute the increases primarily to legal and other costs
associated with a lawsuit that was settled on July 15, 2002 and to
marketing and administrative expenses associated with the preparation of
our VeriChip product launch. As a percentage of revenue, selling,
general and administrative expense increased in the three and nine-month
periods ended September 30, 2002 due to the increased cost associated
with the lawsuit, the launch of VeriChip, and a reduction in sales
during the nine-month period ended September 30, 2002.
Digital Angel Corporation's selling general and administrative expense
increased $1.7 million, or 72.5%, to $4.0 million in the three-months
ended September 30, 2002, from $2.3 million in the three-months ended
September 30, 2001. Selling general and administrative expense increased
$4.1 million, or 57.5%, to $11.1 million in the nine-months ended
September 30, 2002, from $7.0 million in the nine-months ended September
30, 2001. We attribute the increases in the three-months ended September
30, 2002, primarily to the scale up of marketing personnel, advertising
and media programs and the infrastructure to support the introduction of
Digital Angel products. We attribute the increase in the nine-months
ended September 30, 2002, primarily to expenses associated with the
merger of pre-merger Digital Angel and MAS during the first quarter of
2002, as well as to the costs associated with the Digital Angel products
introduction. As a percentage of revenue, selling, general and
administrative expense increased in the three and nine-month periods
ended September 30, 2002, due primarily to the increase in expenses
associated with the merger and the Digital Angel products, and a
reduction in sales during the nine-months ended September 30, 2002.
SysComm International's selling general and administrative expense
decreased $0.4 million, or 26.3%, to $1.1 million in the three-months
ended September 30, 2002, from $1.5 million in the three-months ended
September 30, 2001. Selling general and administrative expense decreased
$1.2 million, or 26.7%, to $3.2 million in the nine-months ended
September 30, 2002, from $4.4 million in the nine-months ended September
30, 2001. We attribute the decreases primarily to layoffs, the
elimination of expenses related to the Shirley, New York facility, which
was sold in January 2002, and other cost control programs. As a
percentage of revenue, selling general and administrative expense
increased in both the three and nine-months period ended September 30,
2002.
All Other's selling, general and administrative expenses decreased $7.0
million, or 99.8%, in the three-months ended September 30, 2002, from
$7.0 million in the three-months ended September 30, 2001. Selling
general and administrative expense decreased $19.8 million, or 94.9%, to
$1.1 million in the nine-months ended September 30, 2002, from $20.9
million in the nine-months ended September 30,
40
2001. The decreases resulted from the sale or closure of all of the business
units comprising this group during the last half of 2001 and the first half
of 2002.
"Corporate / Eliminations" selling, general and administrative expenses
decreased $15.6 million, or 105.9%, to $0.9 million in the three-months
ended September 30, 2002, from $14.7 million in the three-months ended
September 30, 2001. Selling, general and administrative expenses
increased $7.3 million, or 32.7%, to $29.7 million in the nine-months
ended September 30, 2002, from $22.4 million in the nine-months ended
September 30, 2001.
We attribute the decrease in the three-months ended September 30, 2002,
primarily to following two factors: 1) During the three-months ended
September 30, 2001, we recorded bad debt reserves associated with notes
receivable of approximately $12.0 million. During the three-months ended
September 30, 2002, we restructured one of the notes receivable and,
accordingly, we reversed $0.9 million of bad debt reserves associated
with the note. 2) We incurred approximately $1.2 million in non-cash
compensation expense in the three-months ended September 30, 2001, due
primarily to re-pricing 19.3 million stock options in September 2001.
The options had original exercise prices ranging from $0.69 to $6.34 per
share and were modified to change the exercise price to $0.15 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 compensation
expense until the options are exercised, forfeited or expired. During
the three-months ended September 30, 2002, as a result of a decline in
our common stock price, we reversed approximately $2.9 million of non-
cash compensation expense associated with these options.
Partially offsetting the decreases noted above were increases in
expenses during the three-months ended September 30, 2002, primarily
associated with legal and accounting fees and valuation reserves
associated with notes receivable for stock issuances to directors and
officers, as more fully discussed below.
We attribute the increase in the nine-months ended September 30, 2002,
primarily to the following three factors: 1) Pursuant to the terms of
the pre-merger Digital Angel and MAS merger agreement, which became
effective March 27, 2002, options to acquire shares of pre-merger
Digital Angel common stock were converted into options to acquire shares
of MAS common stock. The transaction resulted in a new measurement date
for the options and, as a result, we recorded non-cash compensation
expense of approximately $18.7 million during the nine-months ended
September 30, 2002. As all of the option holders were our employees or
directors, these options were considered fixed awards under APB Opinion
No. 25 and expense was recorded for the intrinsic value of the options
converted. 2) We incurred approximately $0.5 million in non-cash
compensation expense in the nine-months ended September 30, 2002, due
primarily to re-pricing 19.3 million stock options during September
2001. 3) We incurred approximately $3.9 million in the nine-months ended
September 30, 2002, for charges to valuation reserves associated with
notes receivable for stock issuances to directors and officers. The
officers and directors received no cash proceeds from these loans. In
September 2000, when the notes were originated, we notified these
officers and directors that we intended to pay their annual interest as
part of their compensation expense/directors remuneration and to provide
a gross-up for the associated income taxes. Annual interest payments
were due on September 27, 2001 and September 27, 2002. We have chosen
not to pay the interest and related tax gross-up. We, therefore,
consider such notes to be in default and have begun steps to foreclose
on the underlying collateral (all of the stock) in satisfaction of the
notes. Our decision to take this action relates in part to the passage
of the recent corporate reform legislation under the Sarbanes-Oxley Act
of 2002, which, among other things, prohibits further extension of
credit to officers and directors.
41
RESEARCH AND DEVELOPMENT
Research and development expense from continuing operations was $0.7
million and $1.7 million for the three-months ended September 30, 2002,
and 2001, respectively. Research and development expense from continuing
operations was $2.4 million and $4.7 million for the nine-months ended
September 30, 2002 and 2001, respectively. Research and development
expense decreased to 3.1% of revenue in the three-months ended September
30, 2002, from 4.0% of revenue in the three-months ended September 30,
2001 and decreased to 3.1% of revenue in the nine months ended September
30, 2002, from 3.7% of revenue in the nine months ended September 30,
2001. Research and development expense relates primarily to the
development of our products, Digital Angel, Thermo Life and VeriChip.
Research and development expense from continuing operations during the
three and nine-months ended September 30, 2002, and 2001 by segments was as
follows:
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
(In thousands) (In thousands)
----------------------- -------------------------
2002 2001 2002 2001
---- ---- ---- ----
Advanced Technology $ 32 $ 252 $ 148 $ 800
Digital Angel Corporation 614 1,328 2,159 3,742
SysComm International -- -- -- --
All Other -- 73 -- 199
Corporate / Eliminations 97 -- 98 --
----------------------- -------------------------
Total $743 $1,653 $2,405 $4,741
======================= =========================
DEPRECIATION AND AMORTIZATION
Depreciation and amortization expense from continuing operations was
$1.2 million and $7.6 million for the three-months ended September 30,
2002, and 2001, respectively. Depreciation and amortization expense from
continuing operations was $3.6 million and $21.5 million for the nine-
months ended September 30, 2002, and 2001, respectively. Depreciation
and amortization expense decreased to 5.1% of revenue in the three-
months ended September 30, 2002, from 18.4% of revenue in the three-
months ended September 30, 2001, and decreased to 4.6% of revenue in the
nine-months ended September 30, 2002, from 16.7% of revenue in the nine-
months ended September 30, 2001.
Depreciation and amortization expense from continuing operations during
the three and nine-months ended September 30, 2002, and 2001 by segments
was as follows:
THREE-MONTHS ENDED NINE-MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
(In thousands) (In thousands)
----------------------- -------------------------
2002 2001 2002 2001
---- ---- ---- ----
Advanced Technology $ 158 $2,416 $ 407 $ 6,721
Digital Angel Corporation 920 3,363 2,750 8,732
SysComm International 62 134 205 440
All Other -- 1,553 9 4,728
Corporate / Eliminations 69 160 226 862
----------------------- -------------------------
Total $1,209 $7,626 $3,597 $21,483
======================= =========================
Under FAS 142, which we adopted on January 1, 2002, goodwill and certain
other intangible assets are no longer amortized. This resulted in a
reduction in depreciation and amortization expense of
42
approximately $6.3 million and $17.9 million during the three and
nine-months ended September 30, 2002, respectively.
Advanced Technology's depreciation and amortization expense decreased by
$2.3 million, or 93.5%, to $0.2 million in the three-months ended
September 30, 2002 from $2.4 million in the three-months ended September
30, 2001. Depreciation and amortization expense decreased by $6.3
million, or 93.9%, to $0.4 million in the nine-months ended September
30, 2002 from $6.7 million in the nine-months ended September 30, 2001.
We attribute the decreases to a reduction in goodwill amortization as a
result of the adoption of FAS 142.
Digital Angel Corporation's depreciation and amortization expense
decreased by $2.4 million, or 72.6%, to $0.9 million in the three-months
ended September 30, 2002 from $3.4 million in the three-months ended
September 30, 2001. Depreciation and amortization expense decreased by
$6.0 million, or 68.5%, to $2.8 million in the nine-months ended
September 30, 2002 from $8.7 million in the nine-months ended September
30, 2001. We attribute the decrease to a reduction in goodwill
amortization as a result of the adoption of FAS 142.
SysComm International's depreciation and amortization expense decreased
by $0.1 million, or 53.7%, to $0.1 million in the three-months ended
September 30, 2002 from $0.1 million in the three-months ended September 30,
2001. Depreciation and amortization expense decreased by $0.2 million, or
53.4%, to $0.2 million in the nine-months ended September 30, 2002 from $0.4
million in the nine-months ended September 30, 2001. We attribute the
decrease primarily to a reduction of goodwill amortization as a result of
the adoption of FAS 142 and management's decision to sell the Shirley, New
York facility thus ceasing depreciation of the building and equipment.
All Other's depreciation and amortization expense decreased primarily
due to the sale or closure of all of the business units comprising this
group during the last half of 2001 and the first half of 2002.
"Corporate / Eliminations" depreciation and amortization expense
decreased $0.1 million, or 56.9%, to $0.1 million in the three-months ended
September 30, 2002 from $0.2 million in the three-months ended September 30,
2001. Depreciation and amortization expense decreased $0.6 million, or
73.8%, to $0.2 million in the nine-months ended September 30, 2002 from $0.9
million in the nine-months ended September 30, 2001. We attribute the
decreases primarily to the impairment and sale of software and other
corporate assets during the last half of 2001.
GAIN (LOSS) ON DISPOSAL OF ASSETS
The gain (loss) on the disposal of assets was $0.2 million for the
nine-months ended September 30, 2002, and ($4.0) million and ($4.1)
million for the three and nine-months ended September 30, 2001,
respectively. The gain in the nine-months ended September 30, 2002, was
due primarily to the sale of the business assets of our wholly-owned
subsidiary Applied Digital Oracle Practice, Inc. during the first
quarter of 2002. The losses in the 2001 periods were primarily due to
sales of the business assets of our wholly-owned subsidiaries Signal
Processors, Limited and ACT Wireless Corp. during the third quarter of 2001.
ASSET IMPAIRMENT
As a result of the current economic slowdown, which was worsened by the
terrorist attacks on September 11, 2001, we experienced deteriorating
sales for certain of its businesses. This resulted in the shut down of
several of our businesses during the three-months ended September 30,
2001. Also, letters of intent that we received during the third quarter
of 2001 related to the sales of certain of our businesses had indicated
a decline in their fair market values. The sales of these businesses
were due to our
43
financial condition and did not comprise an entire business segment. Based
upon these developments, we reassessed our future expected operating cash
flows and business valuations. This reassessment resulted in the following
asset impairments for the nine-months ended September 30, 2002 and the
three and nine months ended September 30, 2001:
Nine-Months Ended September 30, 2002
(In thousands)
Property and Software and
Equipment Other Total
Advanced Technology $ -- $ -- $ --
Digital Angel Corporation -- -- --
SysComm International -- -- --
All Other -- -- --
Corporate/Eliminations 448 336 784
-------------------------------------------
Total $448 $336 $784
===========================================
Three and Nine-Months Ended September 30, 2001
(In thousands)
Software
Property and and
Goodwill Equipment Other Total
Advanced Technology $29,840 $ -- $ -- $29,840
Digital Angel Corporation -- -- -- --
SysComm International -- -- -- --
All Other 30,365 2,541 1,044 33,950
Corporate/Eliminations -- -- 4,974 4,974
----------------------------------------------------
Total $60,205 $2,541 $6,018 $68,764
====================================================
In addition to the impairments above, we recorded an inventory reserve
of $4.3 million in the three and nine-months ended September 30, 2001,
which is included in our financial statements in cost of products sold.
INTEREST AND OTHER INCOME
Interest and other income was $.07 million and $0.5 million, for the
three-months ended September 30, 2002 and 2001, respectively, and $1.4
million and $1.6 million for the nine-months ended September 30, 2002
and 2001, respectively. Interest income is earned primarily from short-
term investments and notes receivable.
INTEREST EXPENSE
Interest expense was $5.8 million and $2.7 million, for the three-months
ended September 30, 2002 and 2001, respectively, and $12.6 million and
$6.9 million for the nine-months ended September 30, 2002 and 2001,
respectively. Interest expense is primarily a function of the level of
outstanding debt and is principally associated with notes payable and
term loans. On August 21, 2002, we issued to IBM Credit a five year-warrant
to acquire 2.9 million shares of our common stock at $0.15 per share,
valued at approximately $1.3 million, and a five year-warrant to purchase
approximately 1.8 million shares of VeriChip Corporation's, our wholly-owned
subsidiary, common stock at $0.05 per share, valued at approximately
$44 thousand. The fair value of these warrants was included in interest
expense for the three and nine-months ended September 30, 2002.
44
INCOME TAXES
Our effective income tax rates were 1.9% and 3.5% in the three-months
ended September 30, 2002 and 2001, respectively, and 0% and 16.9% in the
nine-months ended September 30, 2002 and 2001, respectively. Differences
in the effective income tax rate from the statutory federal income tax
rate arise primarily from the recognition of net operating loss
carryforwards, non-deductible goodwill amortization associated with
acquisitions and state taxes net of federal benefits. In addition, the
rates for the three and nine-month periods ended September 30, 2001 were
impacted by an increase in our deferred tax valuation allowance to fully
reserve both our third quarter 2001 tax benefit and our existing net
deferred tax assets, as it became more likely than not that our deferred
tax assets would not be realized. This was the result of the losses
incurred during the three and nine-month periods ended September 30, 2001
and our projections of future taxable income.
EXTRAORDINARY GAIN
As a result of settling certain disputes between us, the former owners
of Bostek, Inc and an affiliate of Bostek, Inc. (we acquired Bostek,
Inc. & Affiliate in June 1999) the parties agreed to forgive a $9.5
million payable provided we registered approximately 3.0 million common
shares by June 15, 2001. We were successful in meeting the June 15, 2001
deadline and, accordingly, the extinguishment of the $9.5 million
payable was recorded in June 2001 as an extraordinary gain.
RESULTS OF DISCONTINUED OPERATIONS
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." Accordingly, the operating results of these entities have
been reclassified and reported as Discontinued Operations for all
periods presented. As of March 1, 2002, we had sold or closed
substantially all of the businesses comprising Discontinued Operations,
and there were two insignificant companies remaining. One of the
remaining businesses was sold effective May 23, 2002 and we anticipate
selling the remaining company within the next several months. Revenue
and net loss for the remaining business was $0.6 million and
$0.2 million, respectively, for the nine months ended September 30, 2002. We
used the proceeds from the sales of companies classified as Discontinued
Operations to repay amounts outstanding under the IBM Credit Agreement.
45
The following discloses the results of Intellesale and all other non-
core businesses comprising Discontinued Operations for the period from
January 1, 2001 through March 1, 2001, the measurement date:
January 1, through
March 1,
----------------------
2001
----
(amounts in thousands)
Product revenue $13,039
Service revenue 846
----------------------
Total revenue 13,885
Cost of products sold 10,499
Cost of services sold 259
----------------------
Total cost of products and services sold 10,758
----------------------
Gross profit 3,127
Selling, general and administrative expenses 2,534
Depreciation and amortization 264
Interest, net 29
Provision for income taxes 34
Minority interest 53
----------------------
Income from Discontinued Operations $ 213
======================
The above results do not include any allocated or common overhead
expenses. Included in "Interest, net" above, are interest charges based
on the debt of one of these businesses. A purchaser assumed this debt
when the business was sold on January 31, 2002.
We recorded a provision for operating losses, estimated loss on sale and
carrying costs during the phase-out period including operating and other
disposal costs to be incurred in selling the businesses. Carrying costs
primarily include the cancellation of facility leases, employment
contract buyouts and litigation reserves. During the nine-months ended
September 30, 2002, we increased the estimated loss on sale of our 85%
ownership in our Canadian subsidiary, Ground Effects, Ltd, which we sold
on January 31, 2002 by $0.2 million, and we increased our estimated loss
on the sale of certain business assets of U.S. Electrical Products Corp,
which were sold on May 23, 2002, by $0.2 million. Proceeds on the sale
of Ground Effects, Ltd. approximated $1.6 million plus the assumption of
the Canadian portion of the IBM debt. Proceeds on the sale of U.S.
Electrical Products Corp.'s assets were $0.1 million. Offsetting the
increase in the estimated loss on sale was a reduction in carrying costs
of $0.7 million for the first nine-months of 2002. This was due to a
change in estimated carrying costs as certain of these obligations were
settled during the first nine-months of 2002 for amounts less than
previously anticipated.
The following table sets forth the roll forward of the liabilities for
estimated loss on sale and operating losses and carrying costs from
December 31, 2001 through September 30, 2002.
Balance Balance
Type of Cost December 31, 2001 Additions Deductions September 30, 2002
- ---------------------------------------------------------------------------------------------------
Estimated loss on sale, net of change in
Estimated operating losses $1,173 $ 597 $1,770 $ --
Carrying costs 7,218 (702) 137 6,379
----------------------------------------------------
Total $8,391 $(105) $1,907 $6,379
====================================================
46
LIQUIDITY AND CAPITAL RESOURCES FROM CONTINUING OPERATIONS
As of September 30, 2002, cash and cash equivalents totaled $7.2
million, an increase of $3.5 million, or 94.6%, from $3.7 million at
December 31, 2001.
Operations provided cash of $0.7 million during the first nine-months of
2002, and used cash of $13.0 million during the first nine-months of
2001. During the nine-months ended September 30, 2002, cash was provided
primarily by an increase in accounts payable and accrued expenses and
collections on accounts receivable, and cash was used primarily to
purchase inventory. In the nine-months ended September 30, 2001, cash
was used primarily to decrease accounts payable and accrued expenses and
to fund Discontinued Operations. Partially offsetting the uses of cash
were increases in cash from the collection of accounts receivable and
decreases in inventory and current and other assets.
Due from buyers of divested subsidiaries represented the deferred
purchase price due on the sale of several businesses during the fourth
quarter of 2001. We collected these proceeds during the first nine-
months of 2002.
Accounts and unbilled receivables, net of allowance for doubtful
accounts, decreased by $3.5 million, or 16.0%, to $18.4 million at
September 30, 2002 from $21.9 million at December 31, 2001. We attribute
the decrease primarily to increased collection efforts during 2002 and a
reduction in revenues for the three-months ended September 30, 2002, as
compared to the three-months ended December 31, 2001.
Inventory levels increased to $6.9 million, or 13.1%, at September 30,
2002 from $6.1 million at December 31, 2001.
Accounts payable decreased by $2.3 million, or 15.0%, to $13.0 million
at September 30, 2002 from $15.3 million at December 31, 2001. Cash
generated during the first nine months of 2002 was used to bring certain
payables current. Also, accounts payable decreased for various business
units classified as All Other, since all of these business units had
ceased operations as of September 30, 2002.
Accrued expenses increased to $23.5 million at September 30, 2002,
compared to $18.2 million at December 31, 2001, primarily due to accrued
interest.
Investing activities provided cash of $5.0 million in the first nine
months of 2002, and used cash of $3.2 million in the first nine months
of 2001. In the first nine months of 2002, cash was provided primarily
by collections of amounts due from buyers of divested subsidiaries of
$2.6 million, proceeds from the sale of property and equipment of $2.5
million, collections of notes receivable of $1.0 million and proceeds
from the sale of subsidiaries and business assets of $1.1 million.
Partially offsetting the amounts provided were cash used by discontinued
operations of $0.5 million and cash used to purchase property and
equipment of $1.4 million. In the first nine months of 2001, $2.6
million was used to acquire property and equipment, $1.0 million was
used by discontinued operations and $0.5 million was used to increase
other assets.
Financing activities in the first nine months of 2002 used cash of
$2.3 million and financing activities in the first nine months of 2001
provided cash of $11.3 million. In the first nine months of 2002, cash
was used primarily to repay $6.4 million against long-term debt and
notes payable. Partially offsetting the use of cash during the first
nine months of 2002 was cash of $2.3 million provided from the issuance
of common shares and subsidiary issuance of common stock and
$1.2 million from collection of notes
47
receivable for stock issued. The primary source of cash in the first nine
months of 2001 was borrowings of $14.7 million against notes payable.
Debt, Covenant Compliance and Liquidity
On March 1, 2002, we and Digital Angel Share Trust, a newly created
Delaware business trust (Trust), entered into the IBM Credit Agreement
with IBM Credit, which became effective on March 27, 2002, the effective
date of the merger between pre-merger Digital Angel and MAS. On
September 30, 2002, the principal amount outstanding under the IBM
Credit Agreement was $80.9 million. The principal amount outstanding
bears interest at an annual rate of 17% and matures on February 28,
2003. No principal or interest payments are due until the maturity date.
However, the maturity date will be automatically extended to February
28, 2004, if we repay at least $32.8 million, or 40%, of the original
principal amount outstanding, plus accrued interest and expenses, prior
to February 28, 2003. If the maturity date is extended to February 28,
2004, the maturity date will be automatically extended again to February
28, 2005, if we repay an additional 40% of the original principal amount
outstanding, plus accrued interest and expenses, prior to February 28,
2004. Any amounts outstanding at February 28, 2005, must be repaid by
August 31, 2005. If all amounts are not repaid by February 28, 2003, the
unpaid amount will accrue interest at an annual rate of 25%. If all
amounts are not repaid by February 28, 2004, the interest rate increases
to 35%.
The IBM Credit Agreement contains debt covenants relating to our
financial position and performance, as well as the financial condition
and performance of the Digital Angel Corporation. Our covenants under
the IBM Credit Agreement, as amended on September 30, 2002, are as
follows: (the Current Asset to Current Liabilities covenant is measured
monthly and the Minimum Cumulative Modified EBITDA, as defined, is
measured quarterly), (Minimum Cumulative Modified EBITDA, as defined in
the IBM Credit Agreement, excludes non-cash compensation expense, one-
time charges, impairment losses and any liability or claim that will be
satisfied by issuances of our common stock):
COVENANT COVENANT REQUIREMENT
----------------------------------------------------------------------------
As of the following date not less than:
Current Assets to Current
Liabilities September 30, 2002 .11:1
December 31, 2002 .11:1
----------------------------------------------------------------------------
Minimum Cumulative
Modified EBITDA September 30, 2002 $(4,768,300)
December 31, 2002 (7,648,300)
----------------------------------------------------------------------------
48
Digital Angel Corporation's covenants under the IBM Credit Agreement,
as amended on September 30, 2002, and November 1, 2002, are as follows:
(Digital Angel Corporation's Current Asset to Current Liabilities
covenant and its Minimum Cumulative Modified EBITA, as defined, are
measured quarterly):
COVENANT COVENANT REQUIREMENT
----------------------------------------------------------------------------
As of the following date not less than:
Current Assets to Current
Liabilities September 30, 2002 1.05:1
December 31, 2002 1.09:1
----------------------------------------------------------------------------
Minimum Cumulative
Modified EBITDA September 30, 2002 $(338,000)
December 31, 2002 732,000
----------------------------------------------------------------------------
If these Digital Angel Corporation covenants are not met, we will
be in default under the IBM Credit Agreement.
In satisfaction of a condition to the consent of the merger by IBM
Credit, we transferred to the Trust all shares of Digital Angel
Corporation common stock owned by us and, as a result, the Trust has
legal title to approximately 74.08% of the Digital Angel Corporation
common stock. The Trust has voting rights with respect to the Digital
Angel Corporation common stock until we repay our obligations to IBM
Credit in full. We retained beneficial ownership of the shares. The
Trust may be obligated to liquidate the shares of Digital Angel
Corporation common stock owned by it for the benefit of IBM Credit in
the event we fail to make payments, or otherwise default, under the IBM
Credit Agreement. Such liquidation of the shares of Digital Angel
Corporation common stock will be in accordance with the SEC rules and
regulations governing affiliates.
On September 30, 2002, we entered into an amendment to the IBM Credit
Agreement, which revised certain financial covenants relating to our
financial performance and the financial position and performance of
Digital Angel Corporation for the quarter ended September 30, 2002 and
the fiscal year ending December 31, 2002. On November 1, 2002, we
entered into another amendment to the IBM Credit Agreement, which
further revised certain covenants relating to the financial performance
of Digital Angel Corporation for the quarter ended September 30, 2002,
and the fiscal year ending December 31, 2002. At September 30, 2002, we,
and Digital Angel Corporation, were in compliance with the revised
covenants under IBM Credit Agreement. At June 30, 2002, we were not in
compliance with our Minimum Cumulative Modified EBITDA debt covenant and
with other provisions of the IBM Credit Agreement and Digital Angel
Corporation was not in compliance with its Minimum Cumulative Modified
EBITDA and Current Assets to Current Liabilities debt covenants. On
August 21, 2002, IBM Credit provided us with a waiver of such
noncompliance. As consideration for the waiver, we issued to IBM Credit
a five year-warrant to acquire 2.9 million shares of our common stock at
$0.15 per share, valued at approximately $1.3 million, and a five year-
warrant to purchase approximately 1.8 million shares of our wholly-owned
subsidiary, VeriChip Corporation's common stock at $0.05 per share,
valued at approximately $44 thousand. The fair value of these warrants
was included in interest expense for the three and nine-months ended
September 30, 2002. Based upon our and Digital Angel Corporation's
current level of operations, we believe that we will be able to maintain
compliance with the revised covenants at December 31, 2002. However, if
business conditions are other than as anticipated or other unforeseen
events or circumstances occur, these may impact our ability to remain in
compliance
49
with the covenants. In the absence of waiver or amendment to the financial
covenants, such noncompliance would constitute an event of default under
the IBM Credit Agreement, and IBM Credit would be entitled to accelerate
the maturity of all amounts we owe them. If such noncompliance appears
likely, or occurs, we will seek to renegotiate the covenants and/or obtain
waivers from IBM Credit, as required. There can be no assurance, however,
that we would be successful in negotiating such amendments or obtaining
such waivers.
The IBM Credit Agreement prohibits us from borrowing funds from other
lenders without the approval of IBM Credit, and does not provide for any
further advances by IBM Credit. The IBM Credit Agreement also limits the
amount we may pay our Chief Executive Officer, Richard Sullivan, in
cash, and prevents us from making certain cash incentive and perquisite
payments, including cash payment arising upon a change in control, to
various other executive officers.
Amounts outstanding under the IBM Credit Agreement are secured by a
security interest in substantially all of our assets, excluding the
assets of Digital Angel Corporation. The shares of our subsidiaries,
including the Digital Angel Corporation common stock held in the Trust,
also secure the amounts outstanding under the IBM Credit Agreement.
Sources of Liquidity
If we are unable to generate the funds that will be required for the
payments under the IBM Credit Agreement, as discussed above, shares of
Digital Angel Corporation common stock initially owned by us upon
completion of the merger between pre-merger Digital Angel and MAS and
transferred to the Trust may be liquidated, if so directed by IBM
Credit, to provide funds necessary to make these payments. The IBM
Credit Agreement prohibits us from borrowing funds from other lenders,
and does not provide for any further advances by IBM Credit. In
addition, our current and prior accountants have expressed doubt about
our ability to continue as a going concern. Accordingly, there can be no
assurance that we will have access to funds necessary to repay IBM
Credit or to provide for our ongoing operating expenses to the extent
not provided from our ongoing operating revenue. In addition, we may be
able to use proceeds from the sale of businesses, proceeds from the sale
of common and preferred shares, proceeds from the exercise of stock
options and warrants, and the raising of other forms of debt or equity
through private placement or public offerings to fund ongoing
operations. There can be no assurance, however, that these options will
be available, or if available, 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 investment required to bring new products
on-line; revenue growth or decline; and potential acquisitions.
Outlook
We are constantly looking for ways to maximize stockholder value. As
such, we are continually seeking operational efficiencies and synergies
within our operating segment 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 stockholders'
investments. There can be no assurance, however, that any initiatives
will be found, or if found, that they will be on terms favorable to us.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In July 2001, the FASB issued FAS No. 141 Business Combinations and FAS
No. 142 Goodwill and Other Intangible Assets. FAS 141 requires business
combinations initiated after June 30, 2001 to be accounted for using the
purchase method of accounting, and broadens the criteria for recording
intangible
50
assets separate from goodwill. Recorded goodwill and intangibles will be
evaluated against these new criteria and may result in certain intangibles
being included in goodwill, or alternatively, amounts initially recorded
as goodwill may be separately identified and recognized apart from goodwill.
FAS 142 requires the use of a non- amortization approach to account for
purchased goodwill and certain intangibles. Under a non-amortization
approach, goodwill and certain intangibles will not be amortized into
results of operations, but instead would be reviewed for impairment and
written down and charged to results of operations only in the periods in
which the recorded value of goodwill and certain intangibles is more than
its fair value. We adopted the provisions of each statement, which apply to
goodwill and certain intangibles acquired prior to June 30, 2001, on
January 1, 2002. The adoption of these standards had the impact of reducing
our amortization of goodwill commencing January 1, 2002. There was no
impairment of goodwill upon adoption of FAS 142. However, future impairment
reviews may result in periodic write-downs.
In August 2001, the FASB issued FAS 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. This standard supersedes FAS 121,
Accounting for the Impairment of Long-Lived Assets to Be Disposed Of,
and provides a single accounting model for long-lived assets to be
disposed of. This standard significantly changes the criteria that would
have to be met to classify an asset as held-for-sale. This distinction
is important because assets to be disposed of are stated at the lower of
their fair values or carrying amounts and depreciation is no longer
recognized. The new rules will also supercede the provisions of APB
Opinion 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, with regard to reporting
the effects of a disposal of a segment of a business and will require
expected future operating losses from Discontinued Operations to be
displayed in Discontinued Operations in the period in which the losses
are incurred, rather than as of the measurement date as presently
required by APB 30. This statement is effective for fiscal years
beginning after December 15, 2001. We adopted this statement on January
1, 2002. The adoption of FAS 144 did not have a material impact on our
operations or financial position.
In May 2002, the FASB issued SFAS 145, Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS 145 eliminates Statement 4 (and Statement 64, as it
amends Statement 4), which requires gains and losses from
extinguishments of debt to be aggregated and, if material, classified as
an extraordinary item, and thus, also the exception to applying Opinion
30 is eliminated as well. This statement is effective for years
beginning after May 2002 for the provisions related to the rescission of
Statements 4 and 64, and for all transactions entered into beginning May
2002 for the provision related to the amendment of Statement 13. We have
not yet determined what impact the adoption of FAS 145 will have on our
operations and financial position.
In June 2002, the FASB issued FAS 146, Accounting for Costs Associated
with Exit or Disposal Activities. FAS 146 requires recording costs
associated with exit or disposal activities at their fair values when a
liability has been incurred. Under previous guidance, certain exit costs
were accrued upon management's commitment to an exit plan. We are
required to adopt of FAS 146 on January 1, 2003. We have not yet
determined what impact the adoption of FAS 146 will have on our
operations and financial position.
51
RISK FACTORS
You should carefully consider the risk factors listed below. These risk
factors may cause our future earnings to be less or our financial
condition to be less favorable than we expect. You should read this
section together with the other information contained herein.
FORWARD-LOOKING STATEMENTS AND ASSOCIATED RISK.
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 include statements relating to:
o our growth strategies including, without limitation, our
ability to deploy our products and services including Digital Angel,
VeriChip and Thermo Life;
o anticipated trends in our business and demographics;
o our ability to successfully integrate the business operations of
acquired companies and divestitures of our remaining company within
our Discontinued Operations;
o our future profitability and liquidity; and
o regulatory, competitive or other economic influences.
In some cases, you can identify forward-looking statements by
terms such as "may," "should," "could," "would," "anticipates," "expects,"
"intends," "plans," "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.
WE CANNOT BE CERTAIN OF FUTURE FINANCIAL RESULTS.
We reported losses from continuing operations of $49.9 million and
$150.1 million for the nine-months ended September 30, 2002 and 2001,
respectively. We incurred losses of $198.1 million and $29.2 million
from continuing operations for the years ended December 31, 2001 and
2000, respectively. We reported income from continuing operations of
$2.6 million for the year ended December 31, 1999, which included a loss
from continuing operations of $17.4 million, offset by a gain of $20.0
million from the sale of our Canadian subsidiary, TigerTel, Inc. Our
business plan depends on our attaining and maintaining profitability;
however, we cannot predict whether we will be profitable in the future.
Our profitability depends 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 new products and
technologies. As of September 2002, we reported no revenues from the
sale of our VeriChip and ThermoLife products. We can give no
assurance that we will be able to achieve profitable operations. In
addition, if we fail to experience profits within the time frame
expected by investors, this could have a detrimental effect on the
market price of our common stock and there would be substantial doubt
that we would be able to continue operations in the normal course of
business.
52
OUR STOCK PRICE MAY CONTINUE TO BE VOLATILE, AND YOU MAY BE UNABLE TO
RESELL YOUR SHARES AT OR ABOVE THE PRICE AT WHICH YOU ACQUIRE THEM.
Since January 1, 2000, the price per share of our common stock has
ranged from a high of $18.00 to a low of $0.03. The price of our common
stock has been, and may continue to be, highly volatile and subject to
wide fluctuations in response to factors, including the following:
o Significant changes to our business resulting from
acquisitions and/or expansions into different product lines;
o quarterly fluctuations in our financial results or cash flows;
o changes in investor perception of us or the market for our
products and services;
o changes in economic and capital market conditions for other
companies in our market sector; and
o changes in general economic and market conditions.
In addition, the stock market in general, and stocks of technology
companies in particular, have often experienced extreme price and volume
fluctuations. This volatility is often unrelated or disproportionate to
the operating performance of these companies. Broad market and industry
factors may decrease the market price of our common stock, regardless of
our actual operating performance. Declines in the market price of our
common stock could also harm employee morale and retention, our access
to capital and other aspects of our business. If our share price is
volatile, we may be the target of additional securities litigation,
which is costly and time-consuming to defend. Because of recent periods
of volatility in the market price of our securities, we face a
heightened risk of securities class action litigation. In May 2002, a
purported securities fraud class action was filed against us and one of
our directors. In the following weeks, fourteen virtually identical
complaints were filed and they have now been consolidated into a single
action. Litigation of this type could result in substantial costs and a
diversion of management's attention and resources, which could
significantly harm our business operations and financial condition.
WE MAY ISSUE PREFERRED STOCK, WHICH WILL RANK SENIOR TO THE SHARES
OF OUR COMMON STOCK AND WHICH MAY DELAY OR PREVENT A CHANGE IN CONTROL
OF US.
Preferred stock may be created and issued from time to time by our
board of directors, with such rights and preferences as our board of
directors may determine. Because of our board of directors' broad
discretion with respect to the creation and issuance of any series of
preferred stock without stockholder approval, our board of directors
could adversely affect the voting power of our common stock. The
issuance of preferred stock may also have the effect of delaying,
deferring or preventing a change in control of us.
WE WERE RECENTLY DELISTED FROM THE NASDAQ NATIONAL MARKET AND
CANNOT PROVIDE ASSURANCES THAT AN ACTIVE TRADING MARKET WILL DEVELOP FOR
OUR SECURITIES ON THE NASDAQ SMALLCAP MARKET.
Our ability to remain listed on Nasdaq depends on our ability to satisfy
applicable Nasdaq criteria including our ability to maintain a minimum bid
price of $1.00 per share. From July 12, 2002, to July 30, 2002, our common
stock was traded on the Pink Sheets under the symbol "ADSX.PK." Prior to
that time, our shares were traded on the Nasdaq National Market (NasdaqNM).
Effective July 31, 2002, our shares were relisted on the NasdaqNM under the
symbol "ADSX." As a condition of our relisting, NasdaqNM advised us that we
had until October 25, 2002, to regain compliance with the minimum closing
bid price requirement of at least $1.00 per share, and, immediately
following, a closing bid price of at least $1.00 per share for a minimum of
ten (10) consecutive trading days. We were unable to satisfy the minimum
closing bid price requirement by October 25, 2002, and, as a result,
effective November 12, 2002, our common stock began trading on the Nasdaq
SmallCap Market (SmallCap), under our existing stock symbol ADSX. We expect
to have until July 2003, in which to regain the minimum bid requirement of
at least $1.00 per share for a minimum of ten (10) consecutive trading days
to maintain our SmallCap listing,
53
providing we continue to comply with the SmallCap's other listing
requirements. Also, while our common stock is listed on the SmallCap,
providing we continue to comply with all of the other NasdaqNM listing
requirements, the NasdaqNM rules will allow us to regain our NasdaqNM
listing if our common stock's minimum closing bid price is at least $1.00
per share for a minimum of thirty (30) consecutive trading days.
We cannot provide assurances that an active trading market for our
common stock will develop on the SmallCap. As a result of our recent
movement to the SmallCap, trading in our shares of common stock will
likely decline.
IF WE ARE REQUIRED TO ISSUE ADDITIONAL SHARES OF COMMON STOCK IN
CONNECTION WITH PRIOR ACQUISITIONS OUR STOCK MAY BE FURTHER DILUTED.
As of November 12, 2002, there were 283,933,128 shares of our
common stock outstanding. Since January 1, 2001, we have issued a net
aggregate of 182,446,427 shares of common stock, of which 97,261,634
shares were issued in connection with acquisitions of businesses and
assets and 64,810,635 shares were issued upon conversion of our Series C
preferred stock. We have effected, and will likely continue to effect,
acquisitions or contract for services through the issuance of common
stock or our other equity securities. In addition, we have agreed to
future earnout and "price protection" provisions in prior acquisition
and other agreements, which may result in additional shares of common
stock being issued. Such issuances of additional securities may be
dilutive to the value of our common stock and may have a material
adverse impact on the market price of our common stock.
COMPETITION COULD REDUCE OUR MARKET SHARE AND DECREASE OUR
REVENUE.
Each of our business units operates in a highly competitive
environment, and we expect that competitive pressures will continue in
the future. Many of our competitors have far greater financial,
technological, marketing, personnel and other resources than us. The
areas that we have identified for continued growth and expansion are
also target market segments for some of the largest and most strongly
capitalized companies in the United States and Europe. In response to
competitive pressures, we may be required to reduce prices or increase
spending in order to retain or attract customers or to pursue new market
opportunities. As a result, our revenue, gross profit and market share
may decrease, each of which could significantly harm our results of
operations. In addition, increased competition could prevent us from
increasing our market share, or cause us to lose our existing market
share, either of which would harm our revenues and profitability. We
cannot assure you that we will have the financial, technical, marketing
and other resources required to successfully compete against current and
future competitors or that competitive pressures faced by us will not
have a material adverse effect on our business, financial condition or
results of operations.
IF WE DEFAULT ON OUR OBLIGATIONS UNDER THE IBM CREDIT AGREEMENT,
OUR BUSINESS OPERATIONS MAY BE MATERIALLY ADVERSELY AFFECTED.
On several occasions during 2001 and 2002, we failed to comply
with the covenants contained in our previous credit agreement with IBM
Credit, and, as a result, at times we were in default under that
agreement. We entered into the Third Amended and Restated Term Credit
Agreement with IBM Credit, which we refer to as the IBM Credit
Agreement, which became effective on March 27, 2002, upon the completion
of the merger between pre-merger Digital Angel and MAS. The IBM Credit
Agreement contains various financial and other restrictive covenants
that, among other things, limit our ability to borrow additional funds
and declare and pay dividends, and requires us, and Digital Angel
Corporation to, among other things, maintain various financial ratios
and comply with various other financial covenants. At June 30, 2002, we,
and Digital Angel Corporation, were not in compliance with certain of
the financial ratios contained in the IBM Credit Agreement and we were
not in compliance with other provisions of the IBM Credit Agreement. On
August 21, 2002, IBM Credit provided us with a waiver of such
noncompliance. As consideration for the waiver, we issued to IBM a
five-year warrant to purchase
54
approximately 2.9 million shares of our common stock at $0.15 per share
and a warrant to purchase 1,849,000 shares of VeriChip Corporation's
common stock at $.05 per share. On September 30, 2002, we entered into
an amendment to the IBM Credit Agreement, which revised certain financial
covenants relating to our performance and the financial position and
performance of Digital Angel Corporation for the quarter ended September 30,
2002, and the fiscal year ending December 31, 2002. On November 1, 2002,
we entered into an amendment to the IBM Credit Agreement, which further
revised certain covenants relating to the financial performance of Digital
Angel Corporation for the quarter ended September 30, 2002, and the fiscal
year ending December 31, 2002. Based upon our and Digital Angel Corporation's
current level of operations, we believe that we and Digital Angel Corporation
will be able to maintain compliance with these revised financial covenants.
However, in the future, if business conditions are other than as anticipated
or other unforeseen events or circumstances occur, these may impact our
ability to remain in compliance with the covenants. Failure to obtain any
required waivers may have a material adverse effect on our business and
financial condition. In the absence of a waiver or amendment to the financial
covenants, such noncompliance would constitute an event of default under the
IBM Credit Agreement, and IBM Credit would be entitled to accelerate the
maturity of all amounts we owe them. We do not currently have available funds
to repay the amounts owed to IBM Credit if the maturity of the obligation is
accelerated. If IBM Credit were to accelerate these obligations and enforce
its rights against the collateral securing these obligations, without
additional financing resources, there would be substantial doubt that we
would be able to continue operations in the normal course of business.
IF WE NEED ADDITIONAL CAPITAL FOR OUR ONGOING OPERATIONS OR TO
REPAY IBM CREDIT, WE MAY NOT BE ABLE TO CONTINUE OPERATIONS IN THE
NORMAL COURSE OF BUSINESS.
We may require additional capital for our ongoing operations or to
repay IBM Credit the amounts owed it. Under the terms of the IBM Credit
Agreement, amounts outstanding bear interest at an annual rate of 17%
and mature on February 28, 2003. No principal or interest payments are
due until the maturity date. However, the maturity date will be
automatically extended to February 28, 2004, if we repay at least $32.8
million, or 40%, of the original principal amount outstanding, plus
accrued interest and expenses, prior to February 28, 2003. If the
maturity date is extended to February 28, 2004, the maturity date will
be automatically extended again to February 28, 2005, if we repay an
additional $32.8 million, or 40%, of the original principal amount
outstanding, plus accrued interest and expenses, prior to February 28,
2004. Any amounts outstanding at February 28, 2005, must be repaid by
August 31, 2005. If all amounts are not repaid by February 28, 2003, the
unpaid amount will accrue interest at an annual rate of 25%. If all
amounts are not repaid by February 28, 2004, the interest rate increases
to 35%. We do not currently have the funds that will be required for
such payments, and there is no likelihood that the funds will be
available when required for these payments. Shares of Digital Angel
Corporation common stock, which we transferred to a Delaware business
trust, may be liquidated, if so directed by IBM Credit, to provide funds
necessary to make these payments. Such liquidation of the shares of
Digital Angel common stock will be made in accordance with the SEC rules
and regulations governing affiliates.
The IBM Credit Agreement prohibits us from borrowing funds from
other lenders, and will not provide for any further advances by IBM
Credit. Accordingly, there can be no assurance that we will have access
to funds necessary to provide for our ongoing operating expenses to the
extent not provided from our ongoing operating revenue. Failure to
obtain additional funding may have a negative impact on our business,
financial condition and results of operations. In the absence of a
waiver or amendment to the financial covenants, such noncompliance would
constitute an event of default under the IBM Credit Agreement, and IBM
Credit would be entitled to accelerate the maturity of all amounts we
owe them. We do not currently have available funds to repay the amounts
owed to IBM Credit if the maturity of the obligation is accelerated. If
IBM Credit were to accelerate these obligations and enforce its rights
against the collateral securing these obligations, without additional
financing resources, there would be substantial doubt that we would be
able to continue operations in the normal course of business.
55
WE DEPEND ON OUR SMALL TEAM OF SENIOR MANAGEMENT, AND WE MAY HAVE
DIFFICULTY ATTRACTING AND RETAINING ADDITIONAL PERSONNEL.
The success of our business depends on the continued service of
our executive officers and key personnel. We have entered into
employment contracts ranging for periods of one to five years through
February 2006 with our key officers and employees. Some of these
employment contracts call for bonus arrangements based on earnings.
There can be no assurance that we will be successful in retaining our
key employees or that we can attract and retain additional skilled
personnel as required. The loss of the services of any of our central
management team could harm our business, financial condition and results
of operations. In addition, the operations of any of our individual
facilities could be adversely affected if the services of the local
managers should be unavailable.
WE FACE THE RISKS THAT THE VALUE OF OUR INVENTORY MAY DECLINE
BEFORE WE SELL IT OR THAT WE MAY NOT BE ABLE TO SELL THE INVENTORY AT
THE PRICES WE ANTICIPATE.
Our success will depend on our ability to purchase inventory at
attractive prices relative to its resale value and our ability to turn
our inventory rapidly through sales. If we pay too much or hold
inventory too long, we may be forced to sell our inventory at a discount
or at a loss or write down its value, and our business could be
materially adversely affected.
BECAUSE WE WILL NOT PAY DIVIDENDS ON OUR COMMON STOCK FOR THE
FORESEEABLE FUTURE, STOCKHOLDERS MUST RELY ON STOCK APPRECIATION FOR ANY
RETURN ON THEIR INVESTMENT IN THE COMMON STOCK.
We have never declared or paid dividends on our common stock, and
we cannot assure you that any dividends will be paid in the foreseeable
future. Our IBM Credit Agreement places restrictions on the declaration
and payment of dividends. We intend to use any earnings which we
generate to finance our operations and to repay the amounts outstanding
under the IBM Credit Agreement, and, we do not anticipate paying cash
dividends in the future. As a result, only appreciation of the price of
our common stock will provide a return to our stockholders.
PROVISIONS IN OUR EMPLOYMENT AGREEMENTS MAY MAKE IT DIFFICULT FOR A
THIRD PARTY TO ACQUIRE US, DESPITE THE POSSIBLE BENEFITS TO OUR
STOCKHOLDERS.
Our employment or other agreements with Richard Sullivan and
Jerome Artigliere include change of control provisions under which the
employees may terminate their employment within one year after a change
of control and are entitled to receive specified severance payments
and/or continued compensation payments for sixty months. The employment
agreement for Richard Sullivan also provides for supplemental
compensation payments for sixty months upon termination of employment,
even if there is no change in control, unless his employment is
terminated due to a material breach of the terms of the employment
agreement. Also, our agreements with Richard Sullivan and Garrett
Sullivan, our former president, provide for certain "triggering events,"
which include a change in control, the termination of Richard Sullivan's
employment other than for cause, or if Richard Sullivan ceases to hold
his current position with us for any reason other than a material breach
of the terms of his employment agreement. In that case, we would be
obligated to pay, in cash and/or in stock, $12.1 million and $3.5
million, respectively, to Richard Sullivan and to Garrett Sullivan, in
addition to certain other compensation. Finally, the employment
agreements provide for a gross up for excise taxes which are payable by
these executive officers if any payments upon a change of control are
subject to such taxes as excess parachute payments.
Under the terms of the IBM Credit Agreement, we are prevented from
making cash payments to various executive officers, including certain
portions of Richard J. Sullivan's salary and bonus in cash and,
including the payments described in the preceding paragraph in cash to
Richard Sullivan, Garrett Sullivan and Jerome Artigliere until our
obligations to IBM Credit are repaid in full. Our obligations to make
the payments described in the preceding paragraph could adversely affect
our financial condition or
56
could discourage other parties from entering into transactions with us,
which might be treated as a change in control or triggering event for
purposes of these agreements.
WE MAY NOT PREVAIL IN ONGOING LITIGATION AND MAY BE REQUIRED TO
PAY SUBSTANTIAL DAMAGES.
In addition to the litigation described in PART II. OTHER
INFORMATION, ITEM 1. LEGAL PROCEEDINGS, we are party to various legal
actions as either plaintiff or defendant in the ordinary course of
business. While we believe that the final outcome of these proceedings
will not have a material adverse effect on our financial position, cash
flows or results of operations, we cannot assure the ultimate outcome of
these actions and the estimates of the potential future impact on our
financial position, cash flows or results of operations for these
proceedings could change in the future. In addition, we will continue to
incur additional legal costs in connection with pursuing and defending
such actions.
WE CANNOT ENSURE THE VALIDITY OR PROTECTION OF OUR INTELLECTUAL
PROPERTY RIGHTS OR PATENT RIGHTS.
Our ability to commercialize any of our products under development
will depend, in part, on our ability to obtain patents, enforce those
patents, preserve trade secrets, and operate without infringing on the
proprietary rights of third parties. There can be no assurance that the
patent applications licensed to or owned by us will result in issued
patents, that patent protection will be secured for any particular
technology, that any patents that have been or may be issued to us will
be valid or enforceable or that any patents will provide meaningful
protection to us. Furthermore, we do not own the VeriChip technology
that is produced under patents #6,400,338 and #5,211,129. This
technology is owned by Digital Angel Corporation and licensed to
VeriChip under an exclusive product and technology license with a
remaining term of approximately ten and one-half years. We cannot
provide assurances that VeriChip Corporation will retain licensing
rights to the use of these patents beyond the licensing period.
There can be no assurance that the patents owned and licensed by
us, or any future patents, will prevent other companies from developing
similar or equivalent products. Furthermore, there can be no assurance
that any of our future products or methods will be patentable, that such
products or methods will not infringe upon the patents of third parties,
or that our patents or future patents will give us an exclusive position
in the subject matter claimed by those patents. We may be unable to
avoid infringement of third party patents and may have to obtain a
license, defend an infringement action, or challenge the validity of the
patents in court. There can be no assurance that a license will be
available to us, if at all, on terms and conditions acceptable to us, or
that we will prevail in any patent litigation. Patent litigation is
costly and time consuming, and there can be no assurance that we will
have or will devote sufficient resources to pursue such litigation. If
we do not obtain a license under such patents and if we are found liable
for infringement or if we are not able to have such patents declared
invalid, we may be liable for significant money damages, may encounter
significant delays in bringing products to market, or may be precluded
from participating in the manufacture, use, or sale of products
requiring such licenses.
We also rely on trade secrets and other unpatented proprietary
information in our product development activities. To the extent that we
rely on trade secrets and unpatented know-how to maintain our
competitive technological position, there can be no assurance that
others may not independently develop the same or similar technologies.
We seek to protect trade secrets and proprietary knowledge in part
through confidentiality agreements with our employees, consultants,
advisors and collaborators. Nevertheless, these agreements may not
effectively prevent disclosure of our confidential information and may
not provide us with an adequate remedy in the event of unauthorized
disclosure of such information.
OUR BUSINESS IS SUBJECT TO GOVERNMENT REGULATION.
Some of our current or future products may be subject to
government regulation and, in some cases, pre-approval. By letter dated
October 17, 2002, the Food and Drug Administration (the "FDA") issued a
determination that the VeriChip product is not a medical device under
Section 513(g) of the Federal
57
Food, Drug and Cosmetic Act with respect to the intended security,
financial and personal identification/safety applications. However, the FDA
further stated in its determination letter that with respect to the use of
the VeriChip product in health information applications, VeriChip is a
medical device subject to the FDA's jurisdiction. On November 8, 2002, we
received a letter from the FDA, based upon correspondence from us to the
FDA, warning us not to market VeriChip for medical applications. While we
currently intend to market and distribute the VeriChip product for security,
financial and personal identification/safety applications, in the future, we
plan to expand our marketing and distribution efforts to health information
applications of the product, subject to any and all necessary FDA and other
approvals. There can be no assurances that the required FDA regulatory
reviews will be conducted in a timely manner or that regulatory approvals
will be obtained. Our future failure to comply with the applicable
regulatory requirements can, among other things, result in fines,
suspensions of regulatory approvals, product recalls, operating restrictions
and criminal prosecution, any of which could have a material adverse effect
on us.
Digital Angel is subject to federal, state and local regulation in
the United States and other countries, and it cannot predict the extent
to which it may be affected by future legislative and other regulatory
developments concerning its products and markets. Digital Angel
develops, assembles and markets a broad line of electronic and visual
identification devices for the companion animal, livestock and wildlife
markets. Digital Angel's readers must and do comply with the FCC Part 15
Regulations for Electromagnetic Emissions, and the insecticide products
purchased and resold by Digital Angel have been approved by the U.S.
Environmental Protection Agency (EPA) and are produced under EPA
regulations. Sales of insecticide products are incidental to Digital
Angel's primary business and do not represent a material part of its
operations or revenues. Digital Angel's products also are subject to
compliance with foreign government agency requirements. Digital Angel's
contracts with its distributors generally require the distributor to
obtain all necessary regulatory approvals from the governments of the
countries into which they sell Digital Angel's products. However, any
such approval may be subject to significant delays. Some regulators also
have the authority to revoke approval of previously approved products
for cause, to request recalls of products and to close manufacturing
plants in response to violations. Any actions by these regulators could
materially adversely affect Digital Angel's business.
WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS FROM THE USE OF OUR
PRODUCTS.
Manufacturing, marketing, selling, and testing our products under
development entails a risk of product liability. We could be subject to
product liability claims in the event our products or products under
development fail to perform as intended. Even unsuccessful claims could
result in the expenditure of funds in litigation and the diversion of
management time and resources and could damage our reputation and impair
the marketability of our products. While we maintain liability
insurance, there can be no assurance that a successful claim could not
be made against us, that the amount of indemnification payments or
insurance would be adequate to cover the costs of defending against or
paying such a claim, or that damages payable by us would not have a
material adverse effect on our business, financial condition, and
results of operations and on the price of our common stock.
THE THERMO LIFE TECHNOLOGY HAS NOT YET BEEN DEVELOPED FOR
COMMERCIAL DEPLOYMENT.
The Thermo Life technology has been successfully tested in the
laboratory. Our ability to develop and commercialize products based on
this proprietary technology will depend on our ability to develop our
products internally on a timely basis. No assurances can be given as to
when or if the Thermo Life technology will be successfully marketed.
OUR SUCCESS DEPENDS ON OUR ABILITY TO SELL INCREASING QUANTITIES
OF OUR PRODUCTS.
Our success currently depends primarily upon our ability to
successfully market and sell increasing quantities of our products. Our
ability to successfully sell increasing quantities of our products will
depend significantly on the increasing acceptance of our products. Our
failure to sell our products would have a material adverse effect on us.
Unfavorable publicity concerning our products or technology also could
have an adverse effect on our ability to obtain regulatory approvals and
to achieve acceptance by intended users; any of which would have a
material adverse effect on us.
58
WE HAVE BEEN, AND MAY CONTINUE TO BE, ADVERSELY AFFECTED BY RECENT
EVENTS.
The events of September 11, 2001, in New York City and Washington
D.C. have, and are likely to continue to have, a negative effect on the
economic condition of the U.S. financial markets in general and on the
technology sector in particular. As a result of the current economic
slowdown, which was worsened by the events of September 11, 2001, we
have experienced deteriorating sales for certain of our businesses. This
resulted in the shut down of several of our businesses during the third
and fourth quarters of 2001, which resulted in a decrease in our
revenues during 2002. Also, letters of intent that we had received
during the last half of 2001 and the first quarter of 2002 related to
the sales of certain of our businesses indicated a decline in their fair
values. As a result, we recorded asset impairment charges and increased
inventory reserves during the third and fourth quarters of 2001. If the
economic condition of the U.S. financial markets in general and of the
technology sector in particular do not improve in the near term, and if
the current economic slowdown continues, we may be forced to shut down
additional businesses, causing us to incur additional charges, which
could have a material adverse effect on our business, operating results
and financial condition.
59
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Digital Angel Corporation has a foreign subsidiary operating in the
United Kingdom, which has very limited foreign currency related
transactions. Our United States companies may 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.
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. Borrowings under the IBM
Credit Agreement bear interest at a fixed rate. Our interest income is
sensitive to changes in the general level of U.S. interest rates,
particularly since the majority of our investments are in short-term
investments.
Due to the nature of our borrowings and our short-term investments, we
have concluded that there is no material market risk exposure and,
therefore, no quantitative tabular disclosures are required.
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 - 14(c)
and 15d - 14(c)) as of a date within ninety days before the filing
date of this quarterly report. Based on that evaluation, they have
concluded that the Company's current disclosure controls and procedures
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.
(b) Changes in Internal Controls
There have not been any significant changes in the Company's internal
controls or in other factors that could significantly affect these
controls subsequent to November 14, 2002, the date of evaluation. 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, 2002.
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.
On June 8, 2001, three individuals filed suit against us and
four of our officers in the United States District Court for Delaware
seeking equitable relief and damages. The plaintiffs had acquired our
stock when the company in which they were shareholders, Computer Equity
Corporation, was merged into one of our subsidiaries in 2000. The suit
alleged, inter alia, that, because of asserted violations of federal and
state securities laws and breach of a contract by us, the merger
transaction should be rescinded. The suit was not served until August 6,
2002, by which time, a First Amended Complaint had been filed. As
amended, the suit had eight plaintiffs, all of whom had formerly owned
stock in Computer Equity
60
Corporation. The various counts of the complaint asserted violations of
federal and state securities laws for our alleged failure to register timely
the shares issued in connection with the merger; breach of contract by us
for allegedly failing to comply with a registration rights agreement
regarding the shares; and breach of a covenant of good faith and fair
dealing arising from the same matters. In addition, in two counts the
plaintiffs sought a declaratory judgment that any future payments due to
them under the merger agreement, so called "earnout" payments, due on or
before September 30, 2001, and 2002, be made in cash instead of through
issuance of stock, as is permitted in the agreement, because of our alleged
failures with regard to registration of shares in the past. The damages
sought were those which allegedly arose because of the claimed delay in the
registration of the stock issued in connection with the merger in 2000 and
described in the First Amended Complaint as being "not less than $1
million." On October 18, 2001, the eight plaintiffs filed a motion for leave
to file a second amended complaint. The proposed second amended complaint
added Computer Equity Corporation as a defendant. It continued to assert
claims for violation of federal securities law, breach of contract for
failure to comply with a registration rights agreement, and breach of the
covenant of good faith and fair dealing. The proposed second amended
complaint added a breach of contract claim for failure to make the September
30, 2001 "earnout" payment. All other claims were eliminated. Plaintiffs
sought over $10 million in damages and rescission, as they asked the Court
to return the shares of Computer Equity Corporation. In January 2002, the
Delaware court dismissed the action without prejudice. Certain of the
plaintiffs filed a new lawsuit in Delaware Chancery Court, claiming amounts
in connection with the earnout and claiming damages relating to the
registration of the shares previously issued to them. On July 15, 2002, we
entered into a settlement and release agreement with the plaintiffs on
behalf of themselves and on behalf of the former shareholders of Computer
Equity Corporation. Under the terms of the settlement agreement and in
satisfaction of all claims relating to the merger agreement, we issued
8,000,000 shares of our common stock to the former stockholders of Computer
Equity Corporation. The shares were valued at $3.0 million and have been
reflected as additional goodwill at June 30, 2002. On August 23, 2002, we
issued an additional 100,000 shares of our common stock to the former
stockholders of Computer Equity Corporation in settlement of other matters,
which shares were valued at approximately $56,000.
During the quarter ended March 31, 2002, 510 Ryerson Road Inc. filed a
lawsuit against us and one of our subsidiaries in connection with a lease
for a facility that we vacated prior to the expiration of the lease and
which is no longer in use. The trial has been set for December 2002.
In May 2002, a purported securities fraud class action was filed
against us and one of our directors. In the following weeks, fourteen
virtually identical complaints were filed and they have now been
consolidated into a single action. In re Applied Digital Securities
Litigation in the United States District Court for the Southern District
of Florida. The primary allegations in the recently filed Amended
Consolidated Complaint include claims that:
o we recklessly engaged in a strategy of acquiring subsidiaries
without regard to any strategic worth;
o we lacked the necessary accounting controls over our subsidiaries;
o we manipulated our stock price through the issuance of press
releases; and
o our statements about our subsidiaries Intellesale, Inc. and
VeriChip Corporation were false and misleading.
We believe these claims, and the action in general, are without merit
and we intend to vigorously defend the action.
In July 2002, SRZ Trading LLC filed a derivative complaint in the
Circuit Court of Cole County, Missouri against us, and several of our
officers and directors. The complaint alleges that we misrepresented our
financial condition and disseminated false and misleading statements
about VeriChip. The plaintiff demanded monetary relief in an unspecified
amount. We believe the action is without merit
61
and intend to vigorously defend against it. On September 25, 2002, The Bank
of Scotland filed a complaint in the Court of Session in Edinburgh, Scotland
against us alleging that we owe them money under the terms of an agreement
dated December 18, 2000, governing the Senior Term Loan and Overdraft
Facilities ("Loan Agreement"). Under the terms of the Loan Agreement,
Caledonian Venture Holding Limited was purchased by us through the issuance
of our common stock. The complaint alleges that we are liable for a
shortfall of approximately $565,000 created under the price protection
provision of the loan.
ITEM 2. CHANGES IN SECURITIES
Recent Sales of Unregistered Securities
The following table lists all unregistered securities sold by the
Company between July 1, 2002 and Septemeber 30, 2002. These shares were
issued in (i) connection with the earnout provision of an acquisition
agreement (ii) for settlement of legal disputes, or (iii) for purchases
of equipment. These shares were issued without registration in reliance
upon the exemption provided by Section 4(2) of the Securities Act of
1933, as amended, or Rule 506 of Regulation D promulgated thereunder.
Name/Entity/Nature Date of Sale Aggregate Number of Note Issued For Number of
Amount of Persons Common Shares
Consideration
--------------------------------------------------------------------------------------------------------------------
Foley & Lardner July, 2002 $3,056,000 1 1 Settlement 8,100,000
Sudiar Limited August, 2002 278,000 1 2 Settlement 719,012
Avnet, Inc. August, 2002 27,000 1 3 Settlement 54,000
Timely Technology Corp. September, 2002 3,609,600 1 4 Acquisition 5,502,439
--------------
14,375,451
==============
<FN>
1. Represents shares issued in connection with the settlement of certain
litigation between us, and the former shareholders of Computer Equity
Corporation, which transaction was exempt from registration pursuant to
Section 4(2) of the Securities Act. The transaction document included
an acknowledgment that the sale was not registered, that the purchaser
was acquiring the shares for investment and not for resale, and that
the purchaser acknowledged that he must hold the shares until and
unless registered or transferred in another transaction exempt from
registration. In addition, certificates representing the shares were
legended to indicate that they were restricted.
2. Represents shares issued to a creditor of Caledonian Venture Holdings
Limited (CVH) in connection with the acquisition of CVH and exempt from
registration pursuant to Section 4(2) of the Securities Act of 1933.
The transaction document included an acknowledgment that the sale was
not registered, that the party was acquiring the shares for investment
and not for resale, and that the party acknowledged that it must hold
the shares until and unless registered or transferred in another
transaction exempt from registration. In addition, certificates
representing the shares were legended to indicate that they were
restricted.
3. Represents shares issued for amounts owed to Avnet, Inc. for purchases
of computer equipment, which transaction was exempt from registration
pursuant to Section 4(2) of the Securities Act. The transaction
document included an acknowledgment that the sale was not registered,
that shares were acquired for investment and not for resale, and that
the shares must be held until and unless registered or transferred in
another transaction exempt from registration. In addition, certificates
representing the shares were legended to indicate that they were
restricted. Nasim Kahn, an officer of Avenet, Inc., has sole voting and
dispositive power with respect to the shares held by Avnet, Inc.
4. Represents shares issued to the selling shareholder(s) in connection
with the "earnout" provision of the agreement of sale relating to a
prior private transaction directly negotiated by the shareholders in
connection with the sale of their business to us, which transaction was
exempt from registration pursuant to Rule 4(2) of the Securities Act of
1933.
62
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
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.
(b) REPORTS ON FORM 8-K
On November 13, 2002, we filed a Current Report on Form 8-K, which
announced that our common stock will begin to trade on the Nasdaq SmallCap
Market effective November 12, 2002.
63
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)
Dated: November 14, 2002 By: /S/ EVAN C. MCKEOWN
--------------------------
Evan C. McKeown
Vice President and Chief
Financial Officer
64
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Richard J. Sullivan, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Applied Digital
Solutions, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and
the audit committee of registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal
controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.
Date: November 14, 2002
/s/ Richard J. Sullivan
Richard J. Sullivan
Chairman, Chief Executive Officer and Secretary
65
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CERTIFICATION PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002
I, Evan C. McKeown, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Applied Digital
Solutions, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and
the audit committee of registrant's board of directors (or persons
performing the equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal
controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies
and material weaknesses.
Date: November 14, 2002
/s/ Evan C. McKeown
Evan C. McKeown
Vice President and Chief Financial Officer
66
EXHIBITS
Exhibit
Number Description
- ------- -----------
3.1 Second Restated Articles of Incorporation of the Company (incorporated
herein by reference to Exhibit 4.1 to the Company's Registration
Statement on Form S-1 (Form S-3 File No. 333-64605) filed with the
Commission on June 23, 1999).
3.2 Amendment of Second Restated Articles of Incorporation of the Company
filed with the Secretary of State of the State of Missouri on
September 5, 2000 (incorporated herein by reference to Exhibit 4.3
to the Company's Post-Effective Amendment No. 3 on Form S-3 to
Registration Statement on Form S-4 (File No. 333-38420-02) filed
with the Commission on September 29, 2000).
3.3 Amendment of Second Restated Articles of Incorporation of the Company
filed with the Secretary of State of the State of Missouri on July 18,
2001 (incorporated herein by reference to Exhibit 4.3 to the Company's
Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2001
filed with the Commission on August 18, 2001).
3.4 Amended and Restated Bylaws of the Company dated March 31, 1998
(incorporated herein by reference to Exhibit 3.4 to the Company's
Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2002
filed with the Commission on August 14, 2002).
3.5 Amendment to Bylaws of the Company dated April 4, 2002 (incorporated
herein by reference to Exhibit 3.4 to the Company's Quarterly Report
on Form 10-Q for the Quarter Ended June 30, 2002 filed with the
Commission on August 14, 2002).
10.1 Third Amended and Restated Term Credit Agreement dated March 1, 2002
among Applied Digital Solutions, Inc., Digital Angel Share Trust and
IBM Credit Corporation (incorporated by reference to Exhibit 10.2 to
the Company' Current Report on Form 8-K filed with the Commission on
March 8, 2002).
10.2 Letter dated August 13, 2002 from IBM Corporation discussing the
waiver of certain existing defaults under the Third Amended and
Restated Term Credit Agreement (incorporated herein by reference
to Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q for
the Quarter Ended June 30, 2002 filed with the Commission on
August 14, 2002).
10.3 Waiver Agreement from IBM Credit Corporation, waiving existing
defaults under the Third Amended and Restated Term Credit Agreement
as of June 30, 2002 (incorporated herein by reference to Exhibit
10.20 to the registrant's Registration Statement on Form S-1
(File No. 333-98799) filed with the Commission on August 27, 2002)
10.4 Amendment to the Third Amended And Restated Term Credit Agreement
dated as of September 30, 2002 (incorporated herein by reference
to Exhibit 10.21 to the Company's Post-Effective Amendment No. 1
to Registration Statement on Form S-1 (File No. 333-98799) filed
with the Commission on November 5, 2002).
10.5 Amendment to the Third Amended And Restated Term Credit Agreement
dated as of November 1, 2002 (incorporated herein by reference to
Exhibit 10.22 to the Company's Post-Effective Amendment No. 1 to
Registration Statement on Form S-1 (File No. 333-98799) filed with
the Commission on November 5, 2002).
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002*
99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002*
<FN>
* Filed herewith
67