As filed with the Securities and Exchange Commission on May 14, 2003,
and as Amended on December 11, 2003 and February 23, 2004
- -------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
-------------------------------------
FORM 10-Q/A
AMENDMENT NO. 2
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934.
For the quarterly period ended March 31, 2003
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from to
---- ----
COMMISSION FILE NUMBER: 0-26020
APPLIED DIGITAL SOLUTIONS, INC.
(Exact name of registrant as specified in its charter)
MISSOURI 43-1641533
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
400 ROYAL PALM WAY, SUITE 410
PALM BEACH, FLORIDA 33480
(561) 805-8000
(Address, including zip code, and telephone number,
including area code, of registrant's principal executive offices)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Exchange Act during the
preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes /X/ No / /
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act ).
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 May 9, 2003:
Class Number of Shares
Common Stock; $.001 Par Value 289,824,403
APPLIED DIGITAL SOLUTIONS, INC.
TABLE OF CONTENTS
Item Description Page
PART I - FINANCIAL INFORMATION
1. Financial Statements (unaudited)
Condensed Consolidated Balance Sheets
March 31, 2003 and December 31, 2002 3
Condensed Consolidated Statements of Operations -
Three-months ended March 31, 2003 and 2002 4
Condensed Consolidated Statement of Stockholders' Deficit -
Three-months ended March 31, 2003 5
Condensed Consolidated Statements of Cash Flows -
Three-months ended March 31, 2003 and 2002 6
Notes to Consolidated Financial Statements 7
2. Management's Discussion and Analysis of Financial Condition 30
and Results of Operations
3. Quantitative and Qualitative Disclosures About Market Risk 65
4. Controls and Procedures 66
PART II - OTHER INFORMATION
1. Legal Proceedings 66
2. Changes In Securities 68
3. Defaults Upon Senior Securities 68
4. Submission of Matters to a Vote of Security Holders 69
5. Other Information 69
6. Exhibits and Reports on Form 8-K 70
SIGNATURE 71
EXHIBITS 72
2
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
MARCH 31, December 31,
2003 2002
----------------------------------
(UNAUDITED)
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 3,018 $ 5,818
Cash held by note holder 2,015 -
Accounts receivable and unbilled receivables (net of allowance
for doubtful accounts of $486 in 2003 and $1,263 in 2002) 19,129 16,548
Inventories 7,788 6,409
Notes receivable 1,999 2,801
Other current assets 2,576 2,920
- ------------------------------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 36,525 34,496
PROPERTY AND EQUIPMENT, NET 9,553 9,822
NOTES RECEIVABLE, NET 553 758
GOODWILL, NET 67,818 67,818
OTHER ASSETS, NET 3,955 4,339
- ------------------------------------------------------------------------------------------------------------------------------
$ 118,404 $ 117,233
==============================================================================================================================
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Notes payable and current maturities of long-term debt $ 81,958 $ 81,879
Accounts payable 12,344 9,761
Accrued interest 14,069 10,149
Accrued severance 21,841 -
Other accrued expenses 19,300 19,145
Put accrual 200 200
Net liabilities of Discontinued Operations 9,397 9,368
- ------------------------------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 159,109 130,502
LONG-TERM DEBT AND NOTES PAYABLE 3,336 3,346
OTHER LONG-TERM LIABILITIES 1,103 1,055
- ------------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 163,548 134,903
- ------------------------------------------------------------------------------------------------------------------------------
COMMITMENTS AND CONTINGENCIES - -
- ------------------------------------------------------------------------------------------------------------------------------
MINORITY INTEREST 18,833 18,422
- ------------------------------------------------------------------------------------------------------------------------------
STOCKHOLDERS' DEFICIT
Preferred shares: Authorized 5,000 shares in 2003 and 2002 of $10 par
value; special voting, no shares issued or outstanding in 2003 and
2002, Class B voting, no shares issued or outstanding in 2003 and 2002 - -
Common shares: Authorized 435,000 shares in 2003 and 2002, of $.001 par
value; 285,549 shares issued and 284,614 shares outstanding in 2003
and 285,069 shares issued and 284,134 shares outstanding in 2002 286 285
Common and preferred additional paid-in capital 376,999 377,621
Accumulated deficit (444,006) (417,066)
Common stock warrants 5,650 5,650
Treasury stock (carried at cost, 935 shares in 2003 and 2002) (1,777) (1,777)
Accumulated other comprehensive (loss) income (7) 31
Notes received from shares issued (1,122) (836)
- ------------------------------------------------------------------------------------------------------------------------------
Total Stockholders' Deficit (63,977) (36,092)
- ------------------------------------------------------------------------------------------------------------------------------
$ 118,404 $ 117,233
==============================================================================================================================
See the accompanying notes to condensed consolidated financial statements.
SEE NOTES 1 AND 4 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
ENDED MARCH 31,
-----------------------------------
2003 2002
-----------------------------------
Product revenue $ 21,023 $ 23,063
Service revenue 4,083 5,156
- ------------------------------------------------------------------------------------------------------------------------------
Total revenue 25,106 28,219
Cost of products sold (exclusive of depreciation and amortization shown separately below) 14,172 16,516
Cost of services sold 1,965 2,325
- ------------------------------------------------------------------------------------------------------------------------------
Total cost of products and services sold (exclusive of depreciation and amortization shown
separately below) 16,137 18,841
Selling, general and administrative expense 29,468 28,900
Research and development 1,201 1,448
Depreciation and amortization 626 1,004
Interest and other income (220) (98)
Interest expense 4,631 2,059
- ------------------------------------------------------------------------------------------------------------------------------
Loss from continuing operations before taxes,
minority interest, losses attributable to capital transactions
of subsidiary, and equity in net loss of affiliate (26,737) (23,935)
(Benefit) provision for income taxes (192) 108
- ------------------------------------------------------------------------------------------------------------------------------
Loss from continuing operations before minority interest,
losses attributable to capital transactions of subsidiary,
and equity in net loss of affiliate (26,545) (24,043)
Minority interest (139) (36)
Net loss on capital transactions of subsidiary 171 394
Loss attributable to changes in minority interest as a result of capital
transactions of subsidiary 206 -
Equity in net loss of affiliate - 291
- ------------------------------------------------------------------------------------------------------------------------------
Loss from continuing operations (26,783) (24,692)
Change in estimate on loss on disposal of discontinued operations
and operating losses during the phase out period (157) 687
- ------------------------------------------------------------------------------------------------------------------------------
Net loss $ (26,940) $ (24,005)
==============================================================================================================================
(Loss) income per common share - basic and diluted
Loss from continuing operations $ (0.10) $ (0.10)
(Loss) income from discontinued operations - 0.01
- ------------------------------------------------------------------------------------------------------------------------------
Net loss per common share - basic and diluted $ (0.10) $ (0.09)
==============================================================================================================================
Weighted average number of common shares outstanding - basic and diluted 282,329 253,938
See the accompanying notes to condensed consolidated financial statements.
SEE NOTES 1 AND 4 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 STOCKHOLDERS' DEFICIT
FOR THE THREE MONTHS ENDED MARCH 31, 2003
(In Thousands)
(Unaudited)
PREFERRED STOCK COMMON STOCK ADDITIONAL
------------------------------------------------- PAID-IN ACCUMULATED
NUMBER AMOUNT NUMBER AMOUNT CAPITAL DEFICIT
--------------------------------------------------------------------------------
BALANCE - DECEMBER 31, 2002 - $ - 285,069 $ 285 $ 377,621 $ (417,066)
Net loss - - - - - (26,940)
Comprehensive loss -
Foreign currency translation - - - - - -
-----------
Total comprehensive loss - - - - - (26,940)
-----------
Adjustment to allowance for uncollectible
portion of notes receivable - - - - - -
Stock option repricing - - - - (979) -
Stock options - VeriChip Corporation 160
Issuance of common shares - - 310 1 108 -
Issuance of common shares and options for
services, compensation and other - - 170 - 89 -
- ----------------------------------------------------------------------------------------------------------------------------------
BALANCE - MARCH 31, 2003 - $ - 285,549 $ 286 $ 376,999 $ (444,006)
==================================================================================================================================
ACCUMULATED
COMMON OTHER NOTES TOTAL
STOCK TREASURY COMPREHENSIVE RECEIVED FOR STOCKHOLDERS'
WARRANTS STOCK INCOME (LOSS) SHARES ISSUED DEFICIT
-----------------------------------------------------------------------------------
BALANCE - DECEMBER 31, 2002 $ 5,650 $ (1,777) $ 31 $ (836) $ (36,092)
Net loss - - - - (26,940)
Comprehensive loss -
Foreign currency translation - - (38) - (38)
------------- --------------
Total comprehensive loss - - (38) - (26,978)
------------- --------------
Adjustment to allowance for uncollectible
portion of notes receivable - - - (286) (286)
Stock option repricing - - - - (979)
Stock options - VeriChip Corporation 160
Issuance of common shares - - - - 109
Issuance of common shares and options for
services, compensation and other - - - - 89
- ----------------------------------------------------------------------------------------------------------------------------------
BALANCE - MARCH 31, 2003 $ 5,650 $ (1,777) $ (7) $ (1,122) $ (63,977)
==================================================================================================================================
See the accompanying notes to condensed consolidated financial statements.
SEE NOTES 1 AND 4 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 THREE MONTHS
ENDED MARCH 31,
-----------------------------
2003 2002
-----------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $ (26,940) $ (24,005)
Adjustments to reconcile net loss to net cash (used in)
provided by operating activities:
Loss (income) from discontinued operations 157 (687)
Non-cash compensation and administrative expenses (798) 19,036
Issuance of stock for services 68 2,453
Depreciation and amortization 626 1,004
Non-cash interest expense 520 407
Deferred income taxes (173) 26
(Recovery) impairment of notes receivable (271) 576
Net loss on capital transactions of subsidiary 171 394
Loss attributable to changes in minority interest as a
result of capital transactions of subsidiary 206 -
Minority interest (139) (36)
Equity in net loss of affiliate - 291
(Gain) loss on sale of subsidiaries and business assets - (194)
Loss on sale of equipment 9 87
Change in assets and liabilities:
Increase in cash held by note holder (2,015) -
(Increase) decrease in accounts receivable (2,581) 4,791
Increase in inventories (1,379) (1,299)
Decrease (increase) in other current assets 331 (629)
Increase (decrease) in accounts payable, accrued expenses
and other long-term liabilities 28,590 (141)
Net cash provided by (used in) discontinued operations (99) 415
- -------------------------------------------------------------------------------------------------------------------------
NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES (3,717) 2,489
- -------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Decrease in notes receivable 992 92
Received from buyers of divested subsidiaries - 2,625
(Increase) decrease in other assets (90) 144
Proceeds from sale of property and equipment - 2,469
Proceeds from sale of subsidiaries and business assets - 1,106
Payments for property and equipment (267) (210)
Cash acquired (net of payments for costs of business acquisitions) - 218
Net cash used in discontinued operations (32) (658)
- -------------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY INVESTING ACTIVITIES 603 5,786
- -------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Net amounts borrowed (repaid) on notes payable 101 (3,583)
Payments on long-term debt (32) (1,137)
Other financing costs - (39)
Issuance of common shares 143 866
Stock issuance costs (34) (177)
Proceeds from subsidiary issuance of common stock 175 -
Net cash provided by discontinued operations - 13
- -------------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 353 (4,057)
- -------------------------------------------------------------------------------------------------------------------------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (2,761) 4,218
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS (39) (6)
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD 5,818 3,696
- -------------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS - END OF PERIOD $ 3,018 $ 7,908
=========================================================================================================================
See the accompanying notes to condensed consolidated financial statements.
SEE NOTES 1 AND 4 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. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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 the uncertainties described in Note 4.
The accompanying unaudited condensed consolidated financial
statements of Applied Digital Solutions, Inc. (the "Company") as of March
31, 2003, and December 31, 2002, (the December 31, 2002, financial
information included herein has been extracted from the Company's audited
financial statements included in the Company's 2002 Annual Report on Form
10-K) and for the three-months ended March 31, 2003 and 2002, 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-months ended March 31, 2003, are not necessarily indicative of the
results that may be expected for the entire year. These statements should be
read in conjunction with the consolidated financial statements and related
notes thereto included in the Company's Annual Report on Form 10-K for the
year ended December 31, 2002.
The Company's business has evolved during the past few years. The
Company grew significantly through acquisitions and since 1996 has completed
51 acquisitions. During the last half of 2001 and during 2002, the Company
sold or closed many of the businesses it had acquired that it believed did
not enhance its strategy of becoming an advanced digital technology
development company. These companies were primarily telephone system
providers, software developers, software consultants, networking
integrators, computer hardware suppliers or were engaged in other businesses
or had customer bases that the Company believed did not promote or
complement its current business strategy. As of March 31, 2003, the
Company's business operations consisted of the operations of six wholly-
owned subsidiaries, which are collectively referred to as the Advanced
Technology segment, and two majority-owned subsidiaries, Digital Angel
Corporation (AMEX:DOC), and InfoTech USA, Inc. (OTC:IFTH) (formerly SysComm
International Corporation). As of March 31, 2003, the Company owned
approximately 73.12% of Digital Angel Corporation and 52.5% of InfoTech USA,
Inc.
Historically the Company has suffered losses and has not generated
positive cash flows from operations. This raises doubt about its ability to
continue as a going concern. The audit reports of Eisner LLP for the year
ended December 31, 2002, and of PricewaterhouseCoopers LLP, for each of the
two-years ended December 31, 2001 and 2000, contain an explanatory paragraph
expressing doubt about the Company's ability to continue as a going concern,
as a result of payment and covenant defaults under its credit agreement with
IBM Credit LLC ("IBM Credit"), which are more fully discussed in Note 4, as
well its historical losses and the negative cash flows from its operations.
Additionally, the Company incurred consolidated net losses from continuing
operations of $26.8 million and $24.7 million for the three-months ended
March 31, 2003 and 2002, respectively, and as of March 31, 2003, the Company
had an accumulative deficit of $444.0 million. The Company's consolidated
operating activities used cash of $3.7 million and provided cash of $2.5
million during the three-months ended March 31, 2003 and 2002, respectively.
Digital Angel Corporation has suffered losses and has not
generated positive cash flows from operations. In addition, the audit
reports of Eisner LLP for the year ended December 31, 2002, and of
PricewaterhouseCoopers LLP, for each of the two-years ended December 31,
2001 and 2000, contain an explanatory paragraph expressing doubt about
7
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Digital Angel Corporation's ability to continue as a going concern. While
Digital Angel Corporation's operating income before taxes, minority interest
and net loss of affiliate was $0.1 million during the three-months ended
March 31, 2003, Digital Angel Corporation incurred operating loss before
taxes, minority interest and equity in net loss of affiliate during the
three-months ended March 31, 2002 of $1.9 million. Excluded from Digital
Angel Corporation's operating loss for the three-months ended March 31,
2002, was $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 Medical Advisory Systems ("MAS") stock, all of such
expense having been reflected as additional expense in the separate
financial statements of Digital Angel Corporation included in its Form 10-Q
dated March 31, 2002. In addition, the Company's operating activities used
cash of $3.1 million and $0.5 million during the three-months ended March
31, 2003 and 2002, respectively.
Because of its situation with IBM Credit, the Company is unable to
predict when and if it will be profitable. The Company's profitability and
liquidity depend on many factors, including its complying with the
provisions of a forbearance agreement term sheet with IBM Credit as more
fully discussed in Note 4, the success of its marketing programs, the
maintenance and reduction of expenses and its ability to successfully
develop and bring to market its new products and technologies. The Company
will need additional financing to comply with the provisions of the
forbearance agreement term sheet and to fund operations. Without such
additional financing, it will not have sufficient funds to continue
operations beyond the current fiscal year.
The Company has established a management plan to mitigate the
effect of its going concern uncertainty conditions over the next twelve
months. The major components of the Company's plan are discussed below in
Note 4 and under Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations - Liquidity and Capital Resources from
Continuing Operations.
STOCK-BASED COMPENSATION
As permitted under SFAS No. 123, Accounting for Stock-based
Compensation (SFAS No. 123), the Company has elected to continue to follow
the guidance of APB Opinion No. 25, Accounting for Stock Issued to Employees
(APB No. 25), and Financial Accounting Standards Board Interpretation No.
44, Accounting for Certain Transactions Involving Stock Compensation--an
Interpretation of APB Opinion No. 25 (FIN No. 44), in accounting for its
stock-based employee compensation arrangements. Accordingly, no compensation
cost is recognized for any of the Company's fixed stock options granted to
employees when the exercise price of each option equals or exceeds the fair
value of the underlying common stock as of the grant date for each stock
option. Changes in the terms of stock option grants, such as extensions of
the vesting period or changes in the exercise price, result in variable
accounting in accordance with APB Opinion No. 25. Accordingly, compensation
expense is measured in accordance with APB No. 25 and recognized over the
vesting period. If the modified grant is fully vested, any additional
compensation costs are recognized immediately. The Company accounts for
equity instruments issued to non-employees in accordance with the provisions
of SFAS No. 123.
At March 31, 2003, the Company had four stock-based employee
compensation plans, and the Company's subsidiaries had six stock-based
employee compensation plans. As permitted under SFAS No. 148, Accounting for
Stock-Based Compensation--Transition and Disclosure, which amended SFAS No.
123, the Company has elected to continue to follow the intrinsic value
method in accounting for its stock-based employee compensation arrangements
as defined by APB No. 25 and related interpretations including FIN No. 44.
The following table illustrates the effect on net loss and loss per share if
the Company had applied the fair value recognition provisions of SFAS No.
123 to stock-based employee compensation for options granted under its plans
as well as to the plans of its subsidiaries:
8
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
THREE-MONTHS ENDED THREE-MONTHS ENDED
MARCH 31, MARCH 31,
------------------------------------------
2003 2002
------------------------------------------
Net loss, as reported $(26,940) $(24,005)
Deduct: Total stock-based employee
compensation expense determined under fair
value-based method for all awards, net of
related tax effects (1) (753) (739)
-------- --------
Pro forma net loss $(27,693) $(24,744)
======== ========
Loss per share:
Basic and diluted--as reported $(0.10) $(0.09)
====== ======
Basic and diluted--pro forma $(0.10) $(0.10)
====== ======
<FN>
(1) Amount includes $0.5 million and $0.4 million of compensation expense
associated with subsidiary options for the three-months ended March 31, 2003
and 2002, respectively.
The Company did not grant fixed stock options to acquire shares of its
common stock to its employees during the three-months ended March 31, 2003.
The weighted average per share fair value of grants made during the
three-months ended March 31, 2002, for the Company's incentive plans was
$0.20. The fair value of the options granted was estimated on the grant date
using the Black-Scholes option-pricing model based on the following weighted
average assumptions:
THREE-
MONTHS
ENDED
MARCH 31,
2002
---------
Estimated option life 5.5 years
Risk free interest rate 2.89%
Expected volatility 76.00%
Expected dividend yield 0.00%
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 18.7 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 March 31, 2003, the Company owned
19.6 million, or approximately 73.12% 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
9
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 $32.0 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 approximately
$3.6 million. The transaction resulted in Digital Angel Corporation
allocating approximately $28.3 million of the purchase price to goodwill,
$25.9 million of which was deemed to be impaired during the fourth quarter
of 2002 in connection with the Company's annual goodwill impairment review.
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 Digital Angel Share Trust, which
we refer to as Digital Angel Trust, as a minority ownership interest in
Digital Angel Corporation on the balance sheets as of March 31, 2003, and
December 31, 2002. The Digital Angel Trust is more fully discussed in Note
4. Significant intercompany balances and transactions have been eliminated
in consolidation. Digital Angel Corporation is publicly traded on the
American Stock Exchange under the symbol DOC, with a closing market price
per share at March 31, 2003, and May 7, 2003, of $1.51 and $2.90,
respectively.
Gains where realized and losses on issuances of shares of stock by
the Company's consolidated subsidiary, Digital Angel Corporation, are
reflected in the consolidated statement of operations. The Company
determined that such recognition of gains and losses on issuances of shares
of stock by Digital Angel Corporation was appropriate since the shares
issued to date were not sales of unissued shares in a public offering, the
Company does not plan to reacquire the shares issued and the value of the
proceeds could be objectively determined. During the three-months ended
March 31, 2003, the Company recorded a loss of $0.2 million on the issuances
of 0.3 million shares of Digital Angel Corporation common stock resulting
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. In addition, during the three-months ended March 31,
2003, the Company recorded a loss of $0.2 million attributable to changes in
its minority interest ownership of Digital Angel Corporation as a result of
the stock issuances. See Note 11. During the three-months ended March 31,
2002, the Company recorded a net loss of $0.4 million, 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. The business operations of Digital Angel
Corporation are described in Note 6.
By operation of the Digital Angel Trust agreement, 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 March 31, 2003, shows, among other
things, the Company's investment in Digital Angel Corporation. The following
consolidating financial data provides supplementary information about the
results of operations and cash flows for the three-months ended March 31,
2003. The merger of pre-merger Digital Angel and MAS occurred on the second
to the last business day of the quarter ended March 31, 2002, and,
therefore, supplementary information about results of operations and cash
flows are not presented for the three-months ended March 31, 2002.
10
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
CONDENSED CONSOLIDATING BALANCE SHEET DATA
MARCH 31, 2003
(UNAUDITED)
APPLIED DIGITAL DIGITAL ANGEL CONSOLIDATION
SOLUTIONS, INC. CORPORATION ELIMINATIONS CONSOLIDATED
-------------------------------------------------------------------------
(in thousands)
Current Assets
Cash and cash equivalents $ 3,018 $ -- $ -- $ 3,018
Cash held by note holder 2,015 -- -- 2,015
Accounts receivable, net 11,453 7,676 -- 19,129
Inventories 1,869 5,919 -- 7,788
Notes receivable 1,999 -- -- 1,999
Other current assets 1,467 1,109 -- 2,576
-------------------------------------------------------------------------
Total Current Assets 21,821 14,704 -- 36,525
Property and Equipment, net 1,897 7,656 -- 9,553
Notes Receivable, net 553 -- -- 553
Goodwill, net 20,365 47,453 -- 67,818
Investment in Digital Angel Corporation 40,669 -- (40,669) --
Other Assets, net 2,243 1,712 -- 3,955
-------------------------------------------------------------------------
Total Assets $ 87,548 $71,525 $(40,669) $118,404
=========================================================================
Current Liabilities
Notes payable, current maturities of long-
term debt $ 79,171 $ 3,809 $ -- $ 82,980
Accounts payable and accrued expenses 58,156 8,376 -- 66,532
Put accrual 200 -- -- 200
Intercompany (receivable) payable (323) 323 -- --
Net liabilities of Discontinued Operations 9,397 -- -- 9,397
-------------------------------------------------------------------------
Total Current Liabilities 146,601 12,508 -- $159,109
Long-Term Debt, Notes Payable, Other
Liabilities and Deferred Revenue 1,032 3,407 -- 4,439
-------------------------------------------------------------------------
Total Liabilities 147,633 15,915 -- 163,548
Minority Interest 3,669 265 14,899 18,833
-------------------------------------------------------------------------
Accumulated other comprehensive income (loss) 216 (223) -- (7)
Other stockholders' (deficit) equity (63,970) 55,568 (55,568) (63,970)
-------------------------------------------------------------------------
Total Stockholders' (Deficit) Equity (63,754) 55,345 (55,568) (63,977)
-------------------------------------------------------------------------
Total Liabilities and Stockholders'
(Deficit) Equity $ 87,548 $71,525 $(40,669) $118,404
=========================================================================
11
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS DATA
THREE-MONTHS ENDED MARCH 31, 2003
(UNAUDITED)
APPLIED
DIGITAL DIGITAL ANGEL CONSOLIDATION
SOLUTIONS, INC. CORPORATION ELIMINATIONS CONSOLIDATED
--------------------------------------------------------------------
(in thousands)
Product revenue $ 10,266 $10,865 $(108) $ 21,023
Service revenue 3,550 533 -- 4,083
--------------------------------------------------------------------
Total revenue 13,816 11,398 (108) 25,106
Cost of products sold (exclusive of depreciation
and amortization shown separately below) 8,703 5,483 (14) 14,172
Cost of services sold 1,570 395 -- 1,965
--------------------------------------------------------------------
Total cost of products and services sold (exclusive
of depreciation and amortization shown separately
below) 10,273 5,878 (14) 16,137
Selling, general and administrative expense 25,466 4,002 -- 29,468
Research and development 290 911 -- 1,201
Depreciation and amortization 192 434 -- 626
Interest and other income (178) (42) -- (220)
Interest expense 4,493 138 -- 4,631
--------------------------------------------------------------------
(Loss) income from continuing operations before taxes,
minority interest, losses attributable to capital
transactions of subsidiary and equity in net income
of affiliate (26,720) 77 (94) (26,737)
Benefit for income taxes (192) -- -- (192)
--------------------------------------------------------------------
(Loss) income from continuing operations before
minority interest, losses attributable to capital
transactions of subsidiary and equity in net income
of affiliate (26,528) 77 (94) (26,545)
Minority interest (106) (33) -- (139)
Net loss on capital transactions of subsidiary 171 -- -- 171
Loss attributable to changes in minority interest as
a result of capital transactions of subsidiary 206 -- -- 206
Equity in net income of affiliate 110 -- (110) --
--------------------------------------------------------------------
(Loss) income from continuing operations $(26,689) $ 110 $(204) $(26,783)
====================================================================
12
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS DATA
THREE-MONTHS ENDED MARCH 31, 2003
(UNAUDITED)
APPLIED
DIGITAL DIGITAL ANGEL CONSOLIDATION
SOLUTIONS, INC. CORPORATION ELIMINATIONS CONSOLIDATED
--------------------------------------------------------------------
(in thousands)
Cash Flows From Operating Activities
Net (loss) income $(27,050) $ 110 $-- $(26,940)
Adjustment to reconcile net (loss) income to net cash
used in operating activities:
Non-cash adjustments (119) 495 -- 376
Net change in operating assets and liabilities 26,501 (3,555) -- 22,946
Decrease in intercompany receivable/payable 139 (139) -- --
Net cash used in Discontinued Operations (99) -- -- (99)
----------------------------------------------------------------------
Net Cash Provided By (Used In) Operating Activities (628) (3,089) -- (3,717)
----------------------------------------------------------------------
Cash Flows From Investing Activities
Decrease in notes receivable 992 -- -- 992
Increase in other assets (99) 9 -- (90)
Payments for property and equipment (17) (250) -- (267)
Net cash used in Discontinued Operations (32) -- -- (32)
----------------------------------------------------------------------
Net Cash Provided By (Used In) Investing Activities 844 (241) -- 603
----------------------------------------------------------------------
Cash Flows From Financing Activities
Net amounts borrowed (repaid) on notes payable (2,899) 3,000 -- 101
Payments on long-term debt (12) (20) -- (32)
Issuance of common shares 143 -- -- 143
Stock issuance costs (34) -- -- (34)
Proceeds from subsidiary stock issuances -- 175 -- 175
----------------------------------------------------------------------
Net Cash (Used In) Provided By Financing Activities (2,802) 3,155 -- 353
----------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents (2,586) (175) -- (2,761)
Effect of exchange rates changes on cash and cash
equivalents -- (39) -- (39)
Cash and Cash Equivalents - Beginning of Period 5,604 214 -- 5,818
----------------------------------------------------------------------
Cash and Cash Equivalents - End of Period $ 3,018 $ -- $-- $ 3,018
----------------------------------------------------------------------
13
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 and InfoTech USA, Inc. (formerly SysComm International
Corporation) (OTC:IFTH). The minority interest represents outstanding voting
stock of the subsidiaries not owned by the Company or the Digital Angel
Trust. All significant intercompany accounts and transactions have been
eliminated in consolidation.
The Company's majority-owned subsidiary, InfoTech USA, Inc.,
operates on a fiscal year ending September 30. Their results of operations
have been reflected in the Company's consolidated financial statements on a
calendar year basis.
3. INVENTORY
MARCH 31, DECEMBER 31,
2003 2002
---- ----
Raw materials $1,821 $1,725
Work in process 1,830 1,447
Finished goods 5,487 4,659
------ ------
9,138 7,831
Less: Allowance for excess and obsolescence 1,350 1,422
------ ------
$7,788 $6,409
====== ======
4. DEBT COVENANT COMPLIANCE, LIQUIDITY AND GOING CONCERN CONSIDERATIONS
On March 1, 2002, the Company and Digital Angel Trust, a newly
created Delaware business trust, entered into the Third Amended and Restated
Term Credit Agreement (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. Upon completion of the merger, and in
satisfaction of a condition to the consent to the merger by IBM Credit, the
Company transferred to the Digital Angel Trust, which is controlled by an
advisory board, all shares of Digital Angel Corporation common stock owned
by it and, as a result, the Digital Angel Trust has legal title to
approximately 73.12% of the Digital Angel Corporation common stock at March
31, 2003. The Company retained beneficial ownership of the shares. The
Digital Angel Trust may be obligated to liquidate the shares of Digital
Angel Corporation common stock owned by it for the benefit of IBM Credit as
discussed below.
The IBM Credit Agreement contained covenants relating to the
Company's financial position and performance, as well as the financial
position and performance of Digital Angel Corporation as of December 31,
2002. The Company was not in compliance with certain of these covenants at
December 31, 2002. Also, under the terms of the IBM Credit Agreement, the
Company was required to repay IBM Credit $29.8 million of the $77.2 million
outstanding principal balance owed to them, plus $16.4 million of accrued
interest and expenses (totaling approximately $46.2 million), on or before
February 28, 2003. The Company did not make such payment by February 28,
2003. On March 3, 2003, IBM Credit notified the Company that it had until
March 6, 2003, to make the payment. The Company did not make the payment on
March 6, 2003, as required. The Company's failure to comply with the payment
terms imposed by the IBM Credit Agreement and to maintain compliance with
the financial covenants constitute events of default under the IBM Credit
Agreement. IBM Credit did not provide a waiver of
14
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
such defaults. On March 7, 2003, the Company received a letter from IBM
Credit declaring the loan in default and indicating that IBM Credit would
exercise any and/or all of its remedies.
In addition, as of March 31, 2003, and December 31, 2002, Digital
Angel Corporation did not maintain compliance with certain financial
covenants under its credit agreement with its lender, Wells Fargo Business
Credit, Inc. (Wells Fargo). Well Fargo provided Digital Angel Corporation
with waivers of such non-compliance.
Forbearance Agreement
On March 27, 2003, the Company announced that it had executed a
forbearance agreement term sheet with IBM Credit. The forbearance agreement
was executed on April 2, 2003 (the "Forbearance Agreement"). In turn, the
Company agreed to dismiss with prejudice a lawsuit it filed against IBM
Credit and IBM Corporation in Palm Beach County, Florida on March 6, 2003.
The payment provisions and purchase rights under the terms of the
Forbearance Agreement are as follows:
o the Tranche A Loan, consisting of $68.0 million plus accrued
interest, must be repaid in full no later than September 30,
2003, provided that all but $3 million of the Tranche A Loan
(the "Tranche A Deficiency Amount") will be deemed to be paid
in full on such date if less than the full amount of the
Tranche A Loan is repaid but all of the net cash proceeds of
the Digital Angel Corporation shares held in the Digital
Angel Trust are applied to the repayment of the Tranche A
Loan. The Tranche A Deficiency Amount (if any) must be repaid
no later than March 31, 2004. The Tranche A Loan bore
interest at seventeen percent (17%) per annum through
February 28, 2003. Effective March 1, 2003, the interest rate
increased to twenty-five percent (25%) per annum; and
o the Tranche B Loan, consisting of $9.2 million plus accrued
interest, must be repaid in full no later than March 31,
2004. The Tranche B Loan bore interest at seventeen percent
(17%) per annum through February 28, 2003, and from March 1,
2003, to March 24, 2003, the Tranche B Loan bore interest at
twenty-five percent (25%) per annum. Effective March 25,
2003, the interest rate decreased to seven percent (7%) per
annum.
The Tranche A and B Loans may be purchased under the terms of the
Forbearance Agreement by or on behalf of the Company as follows:
o the loans and all the other obligations may be purchased on or
before June 30, 2003, for $30.0 million in cash;
o the loans and all the other obligations may be purchased on
or before September 30, 2003, for $50.0 million in cash; and
o the Tranche A Loan may be purchased on or before September
30, 2003, for $40.0 million in cash with an additional $10.0
million cash payment due on or before December 31, 2003.
15
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Payment of the specified amounts by the dates set forth herein will
constitute complete satisfaction of any and all of the Company's obligations
to IBM Credit under the IBM Credit Agreement, provided that there has not
earlier occurred a "Termination Event," as defined in the Forbearance
Agreement.
In addition, the Company has agreed under the terms of the
Forbearance Agreement that the Digital Angel Trust will immediately engage
an investment bank to pursue the sale of the 19,600,000 shares of Digital
Angel Corporation common stock that are currently held in the Digital Angel
Trust. In May 2003, an investment bank was engaged. All proceeds from the
sale of the Digital Angel Corporation common stock will be applied to the
loans and other obligations to satisfy the Tranche A payment provisions as
discussed above, in the event that the Company has not satisfied its
purchase rights by September 30, 2003.
The Forbearance Agreement also modifies other provisions of the IBM
Credit Agreement, including but not limited to, the imposition of additional
limitations on permitted expenditures.
Provided there has not earlier occurred a "Termination Event," as
defined, at the end of the forbearance period, the provisions of the
Forbearance Agreement shall become of no force and effect. At that time, if
the repayment terms of the Forbearance Agreement are not met, IBM Credit
will be free to exercise and enforce, or to take steps to exercise and
enforce, all rights, powers, privileges and remedies available to them under
the IBM Credit Agreement, as a result of the payment and covenant defaults
existing on March 24, 2003. If the Company is not successful in satisfying
the repayment obligations under the Forbearance Agreement or it does not
comply with the terms of the Forbearance Agreement or the IBM Credit
Agreement, and IBM Credit were to enforce its rights against the collateral
securing the obligations to IBM Credit, there would be substantial doubt
that the Company would be able to continue operations in the normal course
of business.
As a result of the payment and financial covenant defaults
discussed above, IBM Credit has exercised its rights to control the
Company's cash, excluding the cash of Digital Angel Corporation and InfoTech
USA, Inc. At March 31, 2003, IBM held in its possession $2.0 million of the
Company's cash, which it subsequently remitted back to the Company. IBM
Credit continues to maintain control over the Company's deposits and
disbursements. Under the terms of the forbearance agreement, the Company is
required to be cash flow positive beginning May 2, 2003. The Company
requests weekly from IBM Credit a release of funds for the prior weeks cash
collections and provides to IBM Credit a schedule detailing cash
disbursements complying with the cash flow positive requirement.
The ability of the Company to continue as a going concern and to
continue operations in the normal course of business is predicated upon
numerous issues including its ability to:
o Raise the funds necessary to satisfy its obligations to IBM
Credit by September 30, 2003;
o Obtain shareholder approval of the terms of the severance
agreements with the Company's former officers and directors as
more fully discussed in Note 10;
o Successfully implement its business plans, manage expenditures
according to its budget, and generate positive cash flow from
operations;
o Develop an effective marketing and sales strategy;
16
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
o Obtain the necessary approvals to expand the market for its
VeriChip product;
o Realize positive cash flow with respect to its investment in
Digital Angel Corporation; and
o Complete the development of its second generation Digital Angel
product.
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 debt or 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 shareholder's investments. However, the Company cannot
be certain that any initiatives will be found, or if found, that they will
be on terms favorable to the Company.
17
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. LOSS PER SHARE
The following is a reconciliation of the numerator and denominator
of basic and diluted loss per share:
----------------------------------
THREE-MONTHS ENDED MARCH 31,
----------------------------------
2003 2002
---- ----
NUMERATOR:
Loss from continuing operations $(26,783) $(24,692)
Net (loss) income from Discontinued Operations available to common
shareholders (157) 687
----------------------------------
Net loss available to common shareholders $(26,940) $(24,005)
==================================
DENOMINATOR:
DENOMINATOR FOR BASIC AND DILUTED LOSS PER SHARE (1)-
Weighted-average shares 282,329 253,938
----------------------------------
BASIC AND DILUTED LOSS PER SHARE:
CONTINUING OPERATIONS $(0.10) $(0.10)
DISCONTINUED OPERATIONS -- .01
----------------------------------
TOTAL - BASIC AND DILUTED $(0.10) $(0.09)
==================================
<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 ENDED MARCH 31,
2003 2002
---- ----
Employee stock options 10,802 16,020
Warrants 3,301 2,103
----------------------------------
14,103 18,123
==================================
6. SEGMENT INFORMATION
The Company operates in three business segments: Advanced
Technology, Digital Angel Corporation and InfoTech USA, Inc. (formerly the
segment known as SysComm International).
Advanced Technology
The Advanced Technology segment represents those businesses that
the Company believes will provide the necessary synergies, support and
infrastructure to allow it to develop, promote and fully-integrate its
life-enhancing technology products and services. This segment specializes in
voice, data and video telecommunications networks, propriety software and
Internet access and website design. The majority of the revenue in this
segment is from the Company's wholly-owned subsidiary, Computer Equity
Corporation. In January 2003, Computer Equity Corporation's wholly-owned
subsidiary, GTI, was one of seventeen companies awarded the federal
government's CONNECTIONS contract, which replaced the previous Wire and
Cable Service ("WACS") contract. The CONNECTIONS contract has a
18
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
three-year base term and five successive one-year renewal options. The
renewal options are at the discretion of the government. The CONNECTIONS
contract is similar to the WACS contract in that it will allow Computer
Equity Corporation to provide government agencies with equipment and
services for campus and building communications networks and related
infrastructure without the need to follow the full procurement process for a
new contract.
Expenses associated with VeriChip and Thermo Life products are
also included in the Advanced Technology segment. The Company's VeriChip(TM)
product has multiple applications in security, personal identification,
safety, healthcare (subject to FDA approval) and more.
The Advanced Technology segment's customer base includes
governmental agencies, commercial operations, and consumers. The principal
products and services in this segment are as follows:
o Voice, data and video telecommunications networks;
o Call center and customer relationship management software;
o Networking products and services;
o Website design and Internet access;
o Miniaturized implantable verification chip (VeriChip(TM));
and
o Miniaturized power generator (Thermo Life(TM)).
The Advanced Technology segment delivers products and services
across a multitude of industries, including government, insurance,
utilities, communications and high tech. As of March 31, 2003, the Company
had not recorded any revenue from its VeriChip or Thermo Life products.
Digital Angel Corporation
The Digital Angel Corporation segment consists of the business
operations of Digital Angel Corporation, the Company's approximately 73.12%
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), Wireless and Monitoring (a combination of the
former Digital Angel Technology and the Digital Angel Delivery System
segments), GPS and Radio Communications (formerly Radio Communications and
Other), and Medical Systems (formerly Physician Call Center and Other).
Medical Systems represents the business activity of the newly acquired MAS.
The principal products and services in this segment by division are as
follows:
Animal Applications division--develops, manufactures, and markets a
broad line of electronic and visual identification devices for the companion
animal, livestock, laboratory animal, fish and wildlife markets worldwide.
The tracking of cattle and hogs are crucial both for asset management and
for disease control and food safety. The principal technologies employed by
Animal Applications are electronic ear tags and implantable microchips that
use radio frequency transmission. This segment includes our Bio-Thermo(TM)
product;
Wireless and Monitoring division--develops and markets advanced
technology to gather
19
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
location and local sensory data and to communicate that data to an
operations center. This segment is continuously developing its technology,
which it refers to as its "Digital Angel(TM) technology." The Digital
Angel(TM) technology is the integration and miniaturization into marketable
products of three technologies: wireless communications (such as cellular),
sensors (including bio-sensors) and position location technology (including
global positioning systems (GPS) and other systems);
GPS and Radio Communications division--consists of the design,
manufacture and support of secure GPS enabled search and rescue equipment
and intelligent communications products and services for telemetry, mobile
data and radio communications applications serving commercial and military
markets. In addition, it designs, manufactures and distributes intrinsically
safe sounders (horn alarms) for industrial use and other electronic
components; and
Medical Systems division--is the MAS business that was acquired on
March 27, 2002. A staff of logistics specialists and physicians provide
medical assistance services and interactive medical information services to
people traveling anywhere in the world. It also sells a variety of kits
containing pharmaceutical and medical supplies.
InfoTech USA, Inc.
The InfoTech USA, Inc. segment consists of the business operations
of the Company's 52.5% owned subsidiary, InfoTech USA, Inc. This segment is
a full service provider of Information Technology (IT) products and
services. During 2002, this segment continued its strategy of moving away
from a product-driven systems integration business model to a
customer-oriented IT strategy-based business model. It has further developed
its deliverable IT products and services by adding new consulting and
service offerings, and increasing the number of strategic alliances with
outside technical services firms and manufacturers of high-end IT products.
The principal products and services in this segment are computer hardware
and computer services. The majority of InfoTech USA, Inc.'s revenue is
derived from sales of computer hardware. InfoTech's services consist of IT
consulting, installation, project management, design and deployment,
computer maintenance and other professional services.
All Other
Business units that were part of the Company's continuing
operations and that were closed or sold during 2001 and 2002 are reported as
"All Other."
The "Corporate/Eliminations" category includes all amounts
recognized upon consolidation of the Company's subsidiaries such as the
elimination of intersegment revenues, expenses, assets and liabilities.
"Corporation/Eliminations" also includes certain interest expense and other
expenses associated with corporate activities and functions. As discussed in
Note 10, included in "Corporate/Eliminations" for the three-months ended
March 31, 2003, is a severance charge of $22.0 million associated with the
termination of certain former officers and director. As discussed in Note 9,
included in "Corporate/Eliminations" for the three-months ended March 31,
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 common stock in connection with the merger of
pre-merger Digital Angel and MAS.
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, 2002,
except that intersegment sales and transfers are generally accounted for as
if the
20
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 stand-alone segment operating income.
Following is the selected segment data as of and for the
three-months ended March 31, 2003:
SEGMENTS
--------
Advanced Digital Angel All Corporate/
Technology Corporation InfoTech USA, Inc. Other Eliminations Consolidated
---------------------------------------------------------------------------------------
Net revenue from external customers:
Product $ 8,332 $10,757 $1,934 $ -- $ -- $ 21,023
Service 2,950 533 600 -- -- 4,083
---------------------------------------------------------------------------------------
11,282 11,290 2,534 -- -- 25,106
Inter-segment revenue -- 108 -- -- (108) --
---------------------------------------------------------------------------------------
Total revenue $11,282 $11,398 $2,534 $ -- $ (108) $ 25,106
=======================================================================================
Income (loss) from continuing operations
before income taxes, minority interest
and losses attributable to capital
transactions of subsidiary $ 621 $ 77 $ (460) $ (5) $(26,970) $(26,737)
=======================================================================================
Total assets $43,364 $71,525 $8,799 $2,737 $ (8,021) $118,404
=======================================================================================
Following is the selected segment data as of and for the three-months
ended March 31, 2002:
SEGMENTS
--------
Advanced Digital Angel All Corporate/
Technology Corporation InfoTech USA, Inc. Other Eliminations Consolidated
---------------------------------------------------------------------------------------
Net revenue from external customers:
Product $ 4,904 $ 7,452 $ 9,694 $1,013 $ -- $ 23,063
Service 3,616 303 811 375 51 5,156
Inter-segment revenue -- -- -- -- -- --
---------------------------------------------------------------------------------------
Total revenue $ 8,520 $ 7,755 $10,505 $1,388 $ 51 $ 28,219
=======================================================================================
Income (loss) from continuing operations
before income taxes, minority
interest, losses attributable to
capital transactions of subsidiary
and equity in net loss of affiliate (1) $ 910 $ (1,819) $ 25 $ 134 $(23,185) $(23,935)
=======================================================================================
Total assets (2) $37,943 $136,073 $14,099 $2,909 $ 6,072 $197,096
=======================================================================================
<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.
(2) For Digital Angel Corporation, amount includes $4.8 million of
goodwill associated with the Company's initial 16.6% investment in
MAS. This goodwill was fully impaired during the fourth quarter of
2002.
21
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following is a breakdown of the Company's revenue by segment
and type of product and service:
THREE-MONTHS ENDED MARCH 31,
(IN THOUSANDS)
------------------------------------------------------------------------------------
2003 2002
---- ----
------------------------------------------------------------------------------------
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
ADVANCED TECHNOLOGY
Voice, data and video
telecommunications networks $8,130 $1,207 $9,337 $4,193 $1,226 $5,419
Call center and customer
relationship management
software 114 1,370 1,484 225 1,460 1,685
Networking products and
services - - - 180 389 569
Website design and Internet
access 88 373 461 306 541 847
------------------------------------------------------------------------------------
Total $8,332 $2,950 $11,282 $4,904 $3,616 $8,520
====================================================================================
------------------------------------------------------------------------------------
THREE-MONTHS ENDED MARCH 31,
(IN THOUSANDS)
------------------------------------------------------------------------------------
2003 2002
---- ----
------------------------------------------------------------------------------------
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
DIGITAL ANGEL CORPORATION
Animal Applications $7,801 $ $7,801 $4,816 $- $4,816
GPS and Radio Communications 2,699 - 2,699 2,636 - 2,636
Wireless and Monitoring - 154 154 - 303 303
Medical Systems 365 379 744 - - -
------------------------------------------------------------------------------------
Total $10,865 $533 $11,398 $7,452 $303 $7,755
====================================================================================
THREE-MONTHS ENDED MARCH 31,
(IN THOUSANDS)
------------------------------------------------------------------------------------
2003 2002
---- ----
------------------------------------------------------------------------------------
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
INFOTECH USA, INC.
Computer hardware $1,934 $- $1,934 $9,694 $- $9,694
Computer services - 600 600 - 811 811
------------------------------------------------------------------------------------
Total $1,934 $600 $2,534 $9,694 $811 $10,505
====================================================================================
------------------------------------------------------------------------------------
THREE-MONTHS ENDED MARCH 31,
(IN THOUSANDS)
------------------------------------------------------------------------------------
2003 2002
---- ----
------------------------------------------------------------------------------------
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
ALL OTHER
Telephony systems $- $- $- $- $- $-
Software development and
applications - - - 1,013 375 1,388
Networking products and
services - - - - - -
------------------------------------------------------------------------------------
Total $- $- $- $1,013 $375 $1,388
====================================================================================
7. ACQUISITIONS AND DISPOSITIONS
Effective March 27, 2002, the Company's 93% owned subsidiary,
pre-merger Digital Angel,
22
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
merged with MAS. As a result of the merger, the Company now owns
approximately 73.12% of Digital Angel Corporation, as more fully discussed
in Note 1.
Unaudited pro forma results of operations for the three-months
ended March 31, 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.
------------------------
THREE-MONTHS ENDED
MARCH 31,
------------------------
2002
----
Net operating revenue from continuing operations $ 29,105
Loss from continuing operations (25,383)
Loss per common share from continuing operations - basic and diluted $ (0.10)
8. DISCONTINUED OPERATIONS
On March 1, 2001, the Company's Board of Directors approved a plan
to offer for sale its Intellesale business segment and all of its other
"non-core businesses." Prior to approving the plan, the assets and results
of operations of the noncore businesses had been segregated for external and
internal financial reporting purposes from the assets and results of
operations of the Company. All of these noncore businesses were part of
their own reporting unit for segment reporting purposes and all of these
businesses were being held for sale. These five individually managed
businesses, operated in manufacturing and fabricating industries apart from
our 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, 2003, the Company had sold or closed
substantially all of the businesses comprising Discontinued Operations.
There is one insignificant company remaining at March 31, 2003, which had
revenue and net loss for the three-months ended March 31, 2003, of $7,000
and $0.1 million, respectively. The Company anticipates selling or closing
the remaining company in 2003. 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.
23
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Assets and liabilities of Discontinued Operations at March 31,
2003, and December 31, 2002 are as follows:
March 31, 2003 December 31, 2002
---------------------------------------------
(In thousands)
Current Assets
Cash and cash equivalents $ 97 $ 66
Accounts receivable, net 91 167
Inventories 38 38
---------------------------------------------
Total Current Assets 226 271
Property and equipment, net 34 56
---------------------------------------------
$ 260 $ 327
=============================================
Current Liabilities
Notes payable and current maturities of long-term debt $ 26 $ 26
Accounts payable 4,178 4,189
Accrued expenses 5,318 5,334
---------------------------------------------
Total Current Liabilities 9,522 9,549
Minority interest 135 146
---------------------------------------------
9,657 9,695
=============================================
Net Liabilities of Discontinued Operations $(9,397) $(9,368)
=============================================
During the three-months ended March 31, 2003, Discontinued
Operations incurred a change in estimated operating losses accrued on the
measurement date of $0.2 million. The primary reason for the increase in the
estimated losses during the three-months ended March 31, 2003, was due to
the operations of the one remaining business within this group. During the
three-months ended March 31, 2002, the Company recorded a reduction of its
estimated operating loss on disposal and operating losses during the phase
out period of $0.7 million. This reduction was comprised primarily of an
increase in the estimated loss on the sale of the Company's 85% ownership in
its Canadian subsidiary, Ground Effects Ltd., which was sold in January
2002, of $1.2 million, offset by a decrease in carrying costs as certain of
these obligations were settled during the three-months ended March 31, 2002,
for amounts less than previously anticipated. Carrying costs include the
cancellation of facility leases, employment contract buyouts, sales tax
liabilities and litigation reserves.
The Company does not anticipate a further loss on sale of the
remaining business comprising Discontinued Operations. However, actual
losses could differ from the Company's estimates and any adjustments will be
reflected in the Company's future financial statements.
24
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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, 2002, through March 31, 2003.
Balance Balance
Type of Cost December 31, Additions Deductions March 31,
2002 2003
- --------------------------------------------------------------------------------------------------------------------
Estimated loss on sale, net of change in
estimated operating losses $ -- $157 $157 $ --
Carrying costs 4,908 -- 23 4,885
--------------------------------------------------------------
Total $4,908 $157 $180 $4,885
==============================================================
9. NON-CASH COMPENSATION EXPENSE
Included in selling, general and administrative expense for the
three-months ended March 31, 2003 and 2002, was non-cash compensation
expense as follows:
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 non-cash
compensation expense of approximately $18.7 million during the three-months
ended March 31, 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.
In addition, the Company reversed approximately $1.0 million and
incurred approximately $0.3 million in non-cash compensation expense for the
three-months ended March 31, 2003 and 2002, respectively, 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 fluctuations in the Company's common stock
price result in increases and decreases of non-cash compensation expense
until the options are exercised, forfeited, modified or expired.
10. SEVERANCE AGREEMENTS
On March 21, 2003, Richard J. Sullivan, the Company's then Chairman
of the Board of Directors and Chief Executive Officer, retired from such
positions. Replacing him in these positions is Scott R. Silverman, the
Company's then President and Director. The Company's Board of Directors
negotiated a severance agreement with Richard Sullivan under which he is to
receive a one-time payment of 56.0 million shares of the Company's common
stock. In addition, stock options held by him exercisable for approximately
10.9 million shares of the Company's common stock were re-priced. The
options surrendered had exercise prices ranging from $0.15 to $0.32 per
share and were replaced with options exercisable at $0.01 per share. Richard
Sullivan's severance agreement provides that the payment of shares and
re-pricing of options provided for under that agreement is in lieu of all
future compensation and other benefits that would have been owed to him
under his employment agreement. Richard Sullivan's employment agreement
provided for:
o an annual salary of $450,000 and an annual bonus of not less than
$140,000 for the term of his employment agreement (which was due to
expire March 1, 2008, roughly five years later);
25
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
o supplemental compensation of $2,250,000 (to be paid in 60 equal
monthly payments of $37,500 each), in the event of a termination of
his employment for any reason other than a termination due to his
material default under the agreement; and
o a lump sum payment of $12,105,000, upon the occurrence of a
"Triggering Event," defined under the employment agreement to
include a change of control of the Company or his ceasing to serve
as our Chairman of the Board and Chief Executive Officer for any
reason other than due to his material default, with the Company
having the option to pay this amount in cash or in the Company's
common stock or any combination of the two. In the event the
Company opted to make any portion of the payment in common stock,
the agreement stipulated that the common stock is to be valued at
the average closing price of the stock on the Nasdaq National
Market (the Company's stock was, at the time the agreement was
entered into, listed on the Nasdaq National Market but has since
been transferred to the Nasdaq SmallCap Market) over the last five
business days prior to the date of the Triggering Event.
In total, the employment agreement obligated the Company to pay
Richard Sullivan roughly $17.3 million under or in connection with the
termination of his employment agreement. In view of our cash constraints and
our need to dedicate essentially all of our cash resources to satisfying our
obligations to IBM Credit, we commenced negotiations with Richard Sullivan
that led to proposed terms of his severance agreement.
Richard J. Sullivan has retained his position of Chairman of the
Board of Digital Angel Corporation.
On March 21, 2003, Jerome C. Artigliere, the Company's then Senior
Vice President and Chief Operating Officer, resigned from such positions.
Replacing Mr. Artigliere is Kevin H. McLaughlin, the Company's President and
Chief Operating Officer. Mr. McLaughlin had served most recently as the
Chief Executive Officer of the Company's majority-owned subsidiary, InfoTech
USA, Inc. Under the terms of his severance agreement, Mr. Artigliere is to
receive 4.8 million shares of the Company's common stock. In addition, stock
options held by him exercisable for approximately 2.3 million shares of the
Company's common stock were re-priced. The options surrendered had exercise
prices ranging from $0.15 to $0.32 per share and were replaced with options
exercisable at $0.01 per share. Mr. Artigliere's severance agreement
provides that the payment of shares and re-pricing of options provided under
that agreement is in lieu of all future compensation and other benefits that
would have been owed to him under his employment agreement. His employment
agreement required the Company to make payments of approximately $1.5
million to Mr. Artigliere.
As a result of the termination of Richard Sullivan's employment
with the Company, a "triggering event" provision in the severance agreement
the Company entered into with Garrett Sullivan, the Company's former Vice
Chairman of the Board (who is not related to Richard Sullivan), at the time
of his ceasing to serve in such capacity in December 2001, has been
triggered. The Company recently negotiated a settlement of its obligations
under Garrett Sullivan's severance agreement that requires the Company to
issue to him 7.5 million shares of the Company's common stock on or before
August 31, 2003.
26
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The terms of each of the severance agreements are subject to
shareholder approval, in accordance with applicable Nasdaq rules, because
the agreements (i) are deemed to be compensatory arrangements under which
the Company's common stock may be acquired by officers or directors, and
(ii) in Richard Sullivan's case, it may result in his potentially holding
more than 20% of the outstanding shares of the Company's common stock
following the issuance of the shares and exercise of options covered by his
severance agreement. In connection with such shareholder approval, the
Company also intends to seek shareholder approval of an increase in the
number of authorized shares of its common stock.
The Company intends to include proposals in its proxy statement for
its 2003 annual meeting of shareholders to solicit shareholder approval of
the terms of such agreements and the increase in the number of authorized
shares of its common stock. Should shareholders not approve the terms of the
severance agreements or the Company lacks a sufficient number of authorized
shares to effect the share issuances provided for by the severance
agreements, its former executive officers and directors may take actions
against the Company to enforce the terms of their employment agreements.
Under such circumstances, there would be substantial doubt that the Company
would be able to continue operations in the normal course of business. In
such event, holders of the Company's securities may face the loss of their
entire investment.
By virtue of the need to obtain shareholder approval of the terms
of the severance agreements, the date by which the Company would otherwise
have been obligated to file a registration statement covering the resale of
the shares to be issued to its former executive officers and directors under
their severance agreements has been extended and the filing of such
registration statement will await the outcome of the shareholder vote.
As a result of the terminations of Messrs. Sullivan and Artigliere,
the Company has recorded severance expense of $22.0 million during the
three-months ended March 31, 2003. This expense is reflected in the
Company's condensed consolidated financial statements for the three-months
ended March 31, 2003, as selling, general and administrative expense and
represents, in all material respects, the total amount due to these former
officers and director and to Garrett Sullivan under their respective
employment agreements.
11. NET LOSS ON CAPITAL TRANSACTIONS OF SUBSIDIARY AND LOSS ATTRIBUTABLE
TO CHANGES IN MINORITY INTEREST AS A RESULT OF CAPITAL TRANSACTIONS
OF SUBSIDIARY
Effective March 27, 2002, the Company's 93% owned subsidiary,
Digital Angel Corporation, which the Company refers 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 March 31, 2003, the
Company owned 19.6 million shares, or approximately 73.12% 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
27
business operations of Digital Angel Corporation are described in Note 6.
During the three-months ended March 31, 2003 and 2002, Digital
Angel Corporation had the following stock issuances of its common stock:
- -----------------------------------------------------------------------------------------------------------------
Three-Months Ended March 31,
- -----------------------------------------------------------------------------------------------------------------
2003 2002
---- ----
(in thousands, except per share amounts)
Issuances of common stock for stock option exercises 288 1,437
Issuances of common stock for services -- --
-----------------------------------------------
Total issuances of common stock 288 1,437
===============================================
Proceeds from stock issuances $174 $95
===============================================
Average price per share $0.60 $0.07
===============================================
Beginning ownership percentage of Digital Angel Corporation 73.91% 100.00%
Ending ownership percentage of Digital Angel Corporation (1) 73.12% 77.0%
===============================================
Change in ownership percentage (1) 0.79% 23.0%
===============================================
Loss on the issuances of stock by Digital Angel Corporation $171 $5,149
Gain on the sale of AWG (1) -- (4,755)
-----------------------------------------------
Net loss on capital transactions of subsidiary (2) $171 $394
===============================================
Loss attributable to changes in minority interest as a result
of capital transactions of subsidiary (2) $206 $--
=================================================================================================================
<FN>
(1) The reduction in the Company's ownership percentage includes
the impact of the sale of the AWG, as well as the stock
issuances by Digital Angel Corporation.
(2) The Company has not provided a tax benefit for the net loss on
capital transactions of subsidiary and the loss attributable to
changes in minority interest as a result of capital
transactions of subsidiary.
12. OTHER EVENTS
The Staff of the Securities and Exchange Commission's Southeast
Regional Office is conducting an informal inquiry concerning the Company.
The Company is fully and voluntarily cooperating with the informal inquiry.
At this point, the Company is unable to determine whether the informal
investigation may lead to potentially adverse action.
The Company is currently offering up to 50,000,000 shares of its
common stock in a public offering registered under the Securities Act of
1933. The shares of the Company's common stock are being offered on a best
efforts basis through the efforts of a placement agent J.P. Carey
Securities, Inc. under the terms of a placement agency agreement. The
Company has agreed to pay J.P. Carey Securities, Inc. a 3% placement agency
fee. In connection with this offering, on May 8, 2003, the Company entered
into Securities Purchase Agreements with Cranshire Capital, L.P and Magellan
International Ltd. Each of the Securities Purchase Agreements provide for
the purchase of up to 12.5 million shares of the Company's common stock
(25.0 million shares in the aggregate) by each of the purchasers on up to
five settlement dates within a 16-trading day period following the Company's
issuance of a press release announcing that it had entered into these
agreements, which occurred on May 9, 2003. The agreements provide that if
the average of the volume weighted average trading price of the Company's
common stock
28
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
- ------------------------------------------------------------------------------
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
on the three trading days immediately preceding the applicable settlement
date is less than $0.40, the purchaser has the right (but not the
obligation) to purchase on such settlement date up to the maximum aggregate
amount of the shares under the applicable purchase agreement at $0.35 per
share. As of May 14, 2003, 7.5 million shares of the Company's common stock
were sold under the Securities Purchase Agreements at a price of $0.3833 per
share.
Effective May 9, 2003, Michael Zarriello joined the Company's Board
of Directors. Mr. Zarriello was most recently a Senior Managing Director of
Jesup & Lamont Securities Corporation and served as President of Jesup and
Lamont Merchant Partners LLC. Prior to that, he was Managing Director and
Principal of Bear Stearns & Co., Inc. He has extension financial experience
having served earlier in his career as Chief Financial Officer of the
Principal Activities Group that invested the Bear Stearns & Co., Inc.
capital in middle market companies, Chief Financial Officer of United States
Leather Holdings, Inc. and Chief Financial Officer of Avon Products, Inc.
Healthcare Division. He serves on the Audit Committee of the Board of
Directors.
Effective May 12, 2003, Kevin H. McLaughlin was appointed President
and Chief Operating Officer of the Company. Prior to his appointment as
President, Mr. McLaughlin served as the Company's Senior Vice President and
Chief Operating Officer.
13. NASDAQ LISTING REQUIREMENTS
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
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 October
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, which as of March 31, 2003, it was in
compliance with.
14. LEGAL PROCEEDINGS
The Company is party to various legal proceedings, and accordingly,
has recorded $1.5 million in reserves in its financial statements at March
31, 2003. In the opinion of management, these proceedings are not likely to
have a material adverse affect on the financial position or overall trends
in results of the Company. The estimate of potential impact on the Company's
financial position, overall results of operations or cash flows for the
above legal proceedings could change in the future.
In May 2002, a class action was filed against the Company and one
of its directors. Fourteen virtually identical complaints were consolidated
into a single action, In re Applied Digital Solutions Litigation, which was
filed in the United States District Court for the Southern District of
Florida. In March 2003, the Company entered into a memorandum of
understanding to settle the pending lawsuit. The settlement of $5.6 million,
which is subject to approval by the District Court and review by an
independent special litigation committee, is expected to be covered by
proceeds from insurance.
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 report as
well as our 2002 Annual Report on Form 10-K.
Our company, Applied Digital Solutions, Inc., together with our
subsidiaries, is an advanced technology development company. We grew
significantly through acquisitions and since 1996 have completed 51
acquisitions. During the last half of 2001 and the first half of 2002, we
sold or closed many of these business that we had acquired that we believed
did not enhance our strategy of becoming an advanced technology development
company. These companies were primarily telephone system providers, software
developers, software consultants, networking integrators, computer hardware
suppliers or were engaged in other businesses or had a customer basis that
we believed did not promote or complement our current business strategy. As
of March 31, 2003, our business operations consisted of the operations of
six wholly-owned subsidiaries, which we collectively refer to as the
Advanced Technology segment, and two majority-owned subsidiaries, Digital
Angel Corporation (AMEX:DOC), and InfoTech USA, Inc. (OTC:IFTH) (formerly
SysComm International Corporation). As of March 31, 2003, we owned
approximately 73.12% of Digital Angel Corporation and 52.5% of InfoTech USA,
Inc.
Historically we have suffered losses and have not generated
positive cash flows from operations. This raises doubt about our ability to
continue as a going concern. The audit reports of Eisner LLP for the year
ended December 31, 2002, and of PricewaterhouseCoopers LLP, for each of the
two-years ended December 31, 2001 and 2000, contain an explanatory paragraph
expressing doubt about our ability to continue as a going concern, as a
result of payment and covenant defaults under our credit agreement with IBM
Credit LLC ("IBM Credit"), which are more fully discussed in Note 4 to our
Condensed Consolidated Financial Statements, as well as our historical
losses and the negative cash flows from our operations, as more fully
discussed in Note 1 to our Condensed Consolidated Financial Statements.
Digital Angel Corporation has suffered losses and has not generated positive
cash flows from operations, as more fully discussed in Note 1 to our
Condensed Consolidated Financial Statements. In addition, the audit
reports of Eisner LLP for the year ended December 31, 2002, and of
PricewaterhouseCoopers LLP, for each of the two-years ended December 31,
2001 and 2000, contain an explanatory paragraph expressing doubt about
Digital Angel Corporation's ability to continue operations as a going concern.
Our profitability and liquidity depend on many factors, including
our complying with the provisions of a forbearance agreement term sheet with
IBM Credit as more fully discussed in Note 4 to our Condensed Consolidated
Financial Statements, the success of our marketing programs, the maintenance
and reduction of expenses and our ability to successfully develop and bring
to market our new products and technologies. We will need additional
financing to comply with the provisions of the forbearance agreement term
sheet and to fund operations. Without such additional financing, we will not
have sufficient funds to continue as a going concern.
We have established a management plan to mitigate the effect of our
going concern uncertainty conditions over the next twelve months. The major
components of our plan are discussed below under the section Liquidity and
Capital Resources from Continuing Operations.
RECENT/OTHER DEVELOPMENTS
Digital Angel/MAS Merger
On March 27, 2002, pre-merger Digital Angel merged with MAS, and
MAS changed its name to
30
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, our 85% owned subsidiary.
Prior to the merger, 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, which we refer to
herein as the Digital Angel Trust, controlled by an advisory board and, as a
result, the Digital Angel Trust has legal title to approximately 73.12% of
the Digital Angel Corporation common stock as of March 31, 2003. The Digital
Angel 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 Digital Angel 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 as more fully
discussed below.
IBM Credit Agreement
Our IBM Credit Agreement, contained covenants relating to our
financial position and performance, as well as the financial position and
performance of Digital Angel Corporation. At December 31, 2002, we did not
maintain compliance with the revised financial performance covenant under
the IBM Credit Agreement. In addition, under the terms of the IBM Credit
Agreement we were required to repay IBM Credit $29.8 million of the $77.2
million outstanding principal balance currently owed to them, plus $16.4
million of accrued interest and expenses (totaling approximately $46.2
million), on or before February 28, 2003. We did not make such payment by
February 28, 2003. On March 3, 2003, IBM Credit notified us that we had
until March 6, 2003, to make the payment. We did not make the payment on
March 6, 2003, as required. Our failure to comply with the payment terms
imposed by the IBM Credit Agreement and to maintain compliance with the
financial performance covenant constitute events of default under the IBM
Credit Agreement. On March 7, 2003, we received a letter from IBM Credit
declaring the loan in default and indicating that IBM Credit would exercise
any and/or all of its remedies.
In addition, as of December 31, 2002, and March 31, 2003, Digital
Angel Corporation did not maintain compliance with certain financial
covenants under its credit agreement with its lender, Wells Fargo Business
Credit, Inc. (Wells Fargo). Well Fargo provided Digital Angel Corporation
with waivers of such non-compliance.
Forbearance Agreement
On March 27, 2003, we announced that we had executed a forbearance
agreement term sheet with IBM Credit. The forbearance agreement was executed
on April 2, 2003 (the "Forbearance Agreement"). In turn, we also agreed to
dismiss with prejudice a lawsuit we filed against IBM Credit and IBM
Corporation in Palm Beach County, Florida on March 6, 2003.
The payment provisions of the Forbearance Agreement are as follows:
o the Tranche A Loan, consisting of $68.0 million plus accrued
interest, must be repaid in full no later than September 30, 2003,
provided that all but $3 million of the Tranche A Loan (the
"Tranche A Deficiency Amount") will be deemed to be paid in full on
such date if less than the full amount of the Tranche A Loan is
repaid but all of the net cash proceeds of the Digital Angel
Corporation shares held in the Digital Angel Trust are applied to
the repayment of the Tranche A Loan. The Tranche A Deficiency
Amount (if any) must be repaid no later than
31
March 31, 2004. The Tranche A Loan bore interest at seventeen
percent (17%) per annum through February 28, 2003. Effective March
1, 2003, the interest rate increased to twenty-five percent (25%)
per annum; and
o the Tranche B Loan, consisting of $9.2 million plus accrued
interest, must be repaid in full no later than March 31, 2004. The
Tranche B Loan bore interest at seventeen percent (17%) per annum
through February 28, 2003, and from March 1, 2003, to March 24,
2003, the Tranche B Loan bore interest at twenty-five percent (25%)
per annum. Effective March 25, 2003, the interest rate decreased to
seven percent (7%) per annum.
o the Tranche A and B Loans may be purchased under the terms of
the Forbearance Agreement by or on our behalf as follows:
o the loans and all the other obligations may be purchased on or
before June 30, 2003, for $30.0 million in cash;
o the loans and all the other obligations may be purchased on
or before September 30, 2003, for $50.0 million in cash; or
o the Tranche A Loan may be purchased on or before September 30,
2003, for $40.0 million in cash with an additional $10.0 million
cash payment due on or before December 31, 2003.
Payment of any of these amounts by the dates set forth herein will
constitute complete satisfaction of any and all of our obligations to IBM
Credit under the IBM Credit Agreement provided that there has not earlier
occurred a "Termination Event," as defined in the Forbearance Agreement.
In addition, we have agreed under the terms of the Forbearance
Agreement that the Digital Angel Trust will immediately engage an investment
bank to pursue the sale of the 19,600,000 shares of Digital Angel
Corporation common stock that are currently held in the Digital Angel Trust.
In May 2003, an investment bank was engaged. All proceeds from the sale of
the Digital Angel Corporation common stock will be applied to the loans and
other obligations to satisfy the Tranche A payment provisions as discussed
above, in the event that we have not satisfied our purchase rights by
September 30, 2003.
The Forbearance Agreement also modifies other provisions of the IBM
Credit Agreement, including but not limited to, the imposition of additional
limitations on permitted expenditures.
Provided there has not earlier occurred a "Termination Event," as
defined, at the end of the forbearance period, the provisions of the
Forbearance Agreement shall become of no force and effect. At that time, if
the repayment terms of the Forbearance Agreement are not met, IBM Credit
will be free to exercise and enforce, or to take steps to exercise and
enforce, all rights, powers, privileges and remedies available to them under
the IBM Credit Agreement, as a result of the payment and covenant defaults
existing on March 24, 2003. If we are not successful in satisfying the
repayment obligations under the Forbearance Agreement or we do not comply
with the terms of the Forbearance Agreement or the IBM Credit Agreement, and
IBM Credit were to enforce its rights against the collateral securing the
obligations to IBM Credit, there would be substantial doubt that we would be
able to continue operations in the normal course of business.
As a result of the payment and financial covenant defaults
discussed above, IBM Credit has exercised its rights to control our cash,
excluding the cash of Digital Angel Corporation and InfoTech USA, Inc. At
March 31, 2003, IBM held in its possession $2.0 million of our cash, which
it subsequently remitted back to us. IBM Credit continues to maintain
control over our deposits and disbursements.
32
Under the terms of the forbearance agreement, we are required to be cash
flow positive beginning May 2, 2003. We request weekly from IBM Credit a
release of funds for the prior weeks cash collections and provide to IBM
Credit a schedule detailing cash disbursements complying with the cash flow
positive requirement.
Other
The Staff of the Securities and Exchange Commission's Southeast
Regional Office is conducting an informal inquiry concerning us. We are
fully and voluntarily cooperating with this informal inquiry. At this point,
we are unable to determine whether this informal investigation may lead to
potentially adverse action.
We are currently offering up to 50,000,000 shares of our common
stock in a public offering registered under the Securities Act of 1933. The
shares of our common stock are being offered on a best efforts basis through
the efforts of a placement agent J.P. Carey Securities, Inc. under the terms
of a placement agency agreement. We have agreed to pay J.P. Carey
Securities, Inc. a 3% placement agency fee. In connection with this
offering, on May 8, 2003, we entered into Securities Purchase Agreements
with Cranshire Capital, L.P. and Magellan International Ltd. Each of the
Securities Purchase Agreements provide for the purchase of up to 12.5
million shares of our common stock (25.0 million shares in the aggregate) by
each of the purchasers on up to five settlement dates within a 16-trading
day period following our issuance of a press release announcing that we had
enter into these agreements, which occurred on May 9, 2003. The agreements
provide that if the average of the volume weighted average trading price of
our common stock on the three trading days immediately preceding the
applicable settlement date is less than $0.40, the purchaser has the right
(but not the obligation) to purchase on such settlement date up to the
maximum aggregate amount of the shares under the applicable purchase
agreement at $0.35 per share. As of May 14, 2003, 7.5 million shares of our
common stock were sold under the Securities Purchase Agreements at a price
of $0.3833 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, Nasdaq 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 SmallCap, under our existing
stock symbol ADSX. To maintain our SmallCap listing, we must continue to
comply with the SmallCap's listing requirements and, prior to October 2003,
regain the minimum bid requirement of at least $1.00 per share for a minimum
of ten (10) consecutive trading days.
On March 21, 2003, Richard J. Sullivan, our then Chairman of the
Board of Directors and Chief Executive Officer, retired from such positions.
Replacing him in these positions is Scott R. Silverman, our then President
and Director. Our Board of Directors negotiated a severance agreement with
Richard Sullivan under which he is to receive a one-time payment of 56.0
million shares of our common stock. In addition, stock options held by him
exercisable for approximately 10.9 million shares of our common stock were
re-priced. The options surrendered had exercise prices ranging from $0.15 to
$0.32 per share and were replaced with options exercisable at $0.01 per
share. Richard Sullivan's severance agreement provides that the payment of
shares and re-pricing of options provided for under that agreement is in
lieu of all future compensation and other benefits that would have been owed
to him under his employment agreement. His employment agreement required us
to make payments of approximately $17.0 million to
33
him, a portion of such payments of which could be made in either cash or
stock, at our option, as more fully discussed in Note 10 to our Condensed
Consolidated Financial Statements.
On March 21, 2003, Jerome C. Artigliere, our then Senior Vice
President and Chief Operating Officer, resigned from such positions.
Replacing Mr. Artigliere is Kevin H. McLaughlin, our President and Chief
Operating Officer. Mr. McLaughlin had served most recently as the Chief
Executive Officer of our majority-owned subsidiary, InfoTech USA, Inc. Under
the terms of his severance agreement, Mr. Artigliere is to receive 4.8
million shares of our common stock. In addition, stock options held by him
exercisable for approximately 2.3 million shares of our common stock were
re-priced. The options surrendered had exercise prices ranging from $0.15 to
$0.32 per share and were replaced with options exercisable at $0.01 per
share. Mr. Artigliere's severance agreement provides that the payment of
shares and re-pricing of options provided under that agreement is in lieu of
all future compensation and other benefits that would have been owed to him
under his employment agreement. His employment agreement required us to make
payments of approximately $1.5 million to Mr. Artigliere.
As a result of the termination of Richard Sullivan's employment
with us, a "triggering event" provision in the severance agreement we
entered into with Garrett Sullivan, our former Vice Chairman of the Board
(who is not related to Richard Sullivan) at the time of his ceasing to
serve in such capacity in December 2001, has been triggered. We recently
negotiated a settlement of our obligations under Garrett Sullivan's
severance agreement that requires us to issue to him 7.5 million shares of
our common stock on or before August 31, 2003.
The terms of each of the severance agreements are subject to
shareholder approval, in accordance with applicable Nasdaq rules, because
the agreements (i) are deemed to be compensatory arrangements under which
our common stock may be acquired by officers or directors, and (ii) in
Richard Sullivan's case, it may result in his potentially holding more than
20% of the outstanding shares of our common stock following the issuance of
the shares and exercise of options covered by his severance agreement. In
connection with such shareholder approval, we also intend to seek
shareholder approval of an increase in the number of authorized shares of
our common stock.
We intend to include proposals in our proxy statement for our 2003
annual meeting of shareholders to solicit shareholder approval of the terms
of such agreements and the increase in the number of authorized shares of
our common stock. Should shareholders not approve the terms of the severance
agreements or we lack a sufficient number of authorized shares to effect the
share issuances provided for by the severance agreements, our former
executive officers and directors may take actions against us to enforce the
terms of their employment agreements. Under such circumstances, there would
be substantial doubt that we would be able to continue operations in the
normal course of business. In such event, holders of our securities may face
the loss of their entire investment.
By virtue of the need to obtain shareholder approval of the terms
of the severance agreements, the date by which we would otherwise have been
obligated to file a registration statement covering the resale of the shares
to be issued to our former executive officers and directors under their
severance agreements has been extended and the filing of such registration
statement will await the outcome of the shareholder vote.
As a result of the terminations of Messrs. Sullivan and Artigliere,
we have recorded severance expense of $22.0 million during the three-months
ended March 31, 2003. This expense is reflected in our condensed
consolidated financial statements for the three-months ended March 31, 2003,
as selling, general and administrative expense and represents, in all
material respects, the total amount due to these former officers and
director and to Garrett Sullivan under their respective employment
agreements.
Effective May 9, 2003, Michael Zarriello joined our Board of
Directors. Mr. Zarriello was most
34
recently a Senior Managing Director of Jesup & Lamont Securities Corporation
and served as President of Jesup and Lamont Merchant Partners LLC. Prior to
that, he was Managing Director and Principal of Bear Stearns & Co., Inc. He
has extensive financial experience having served earlier in his career as
Chief Financial Officer of the Principal Activities Group that invested the
Bear Stearns & Co., Inc. capital in middle market companies, Chief Financial
Officer of United States Leather Holdings, Inc. and Chief Financial Officer
of Avon Products, Inc. Healthcare Division. He serves on the Audit Committee
of the Board of Directors.
Effective May 12, 2003, Kevin H. McLaughlin was appointed our
President and Chief Operating Officer. Prior to his appointment as
President, Mr. McLaughlin served as our Senior Vice President and Chief
Operating Officer.
BUSINESS SEGMENTS
As a result of (a) the merger of pre-merger Digital Angel and MAS,
which occurred on March 27, 2002, (b) the significant restructuring of our
business during the past year, and (c) our emergence as an advanced
technology development company, we have re-evaluated and realigned our
reporting segments. Since January 1, 2002, we operate in three business
segments: Advanced Technology, Digital Angel Corporation and InfoTech USA,
Inc., (formerly the segment known as SysComm International). Business units
that were part of our continuing operations and that were closed or sold
during 2001 and 2002 are reported as "All Other." The
"Corporate/Eliminations" category includes all amounts recognized upon
consolidation of our subsidiaries, such as the elimination of intersegment
revenues, expenses, assets and liabilities. "Corporate/Eliminations" also
includes certain interest expense and other expenses associated with
corporate activities and functions. Included in "Corporate/Eliminations" for
the three-months ended March 31, 2003, is a severance charge of $22.0
million associated with the termination of certain former officers and
director. Included in "Corporate/Eliminations" for the three-months ended
March 31, 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.
(Loss) income from continuing operations before taxes, minority
interest, losses attributable to capital transactions of subsidiary and
equity in loss of affiliate from each of our segments during the
three-months ended March 31, 2003 and 2002, was as follows (we evaluate
performance based on stand-alone segment operating income as presented
below):
THREE-MONTHS ENDED
------------------
MARCH 31,
---------
2003 2002
---- ----
(IN THOUSANDS)
--------------
(LOSS) INCOME FROM CONTINUING OPERATIONS BEFORE TAXES,
MINORITY INTEREST, LOSSES ATTRIBUTABLE TO CAPITAL
TRANSACTIONS OF SUBSIDIARY AND EQUITY IN LOSS OF
AFFILIATE BY SEGMENT:
ADVANCED TECHNOLOGY $ 621 $ 910
DIGITAL ANGEL CORPORATION(1) 77 (1,819)
INFOTECH USA, INC. (460) 25
ALL OTHER (5) 134
"CORPORATE/ELIMINATIONS"(1) (26,970) (23,185)
------------------------
TOTAL $(26,737) $(23,935)
========================
<FN>
(1) For Digital Angel Corporation, the loss for the three-months
ended March 31, 2002 excludes $1.8 million of interest expense
associated with our obligations 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, all of such expenses having been reflected as additional
expense in the separate financial statement of Digital Angel
Corporation included in its Form 10-Q dated March 31, 2002. The
$1.8 million of interest expense and the $18.7 million of non-cash
compensation expense are reflected in "Corporate/Eliminations" for
the three-months ended March 31, 2002.
35
Our sources of revenue consist of sales of products and services
from our three operating segments. Our significant sources of revenue for
the three-months ended March 31, 2003, were as follows:
Percentage of
Sources of Revenue: Total Revenue
- ------------------- -------------
Sales of voice, data and video telecommunications networks to government agencies 37.2%
Electronic visual identification tags and implantable microchips for the companion
animal, livestock, laboratory animal, fish and wildlife markets 31.1%
Sales of IT hardware and services from our InfoTech USA, Inc. segment 10.1%
GPS enabled search and rescue equipment, intelligent communications products and
services for telemetry, mobile data and radio communications 10.8%
Other products and services (individually, none of these products and services
exceeded 10% of our total revenues for the three-months ended March 31, 2003) 10.8%
-----------
Total 100.0%
===========
Our significant sources of cost of products and services sold
(exclusive of depreciation and amortization shown separately below) and cost
of products and services sold (exclusive of depreciation and amortization
shown separately below) as a percentage of revenue by product type for the
three-months ended March 31, 2003, were as follows:
COST OF
COST OF PRODUCTS AND
PRODUCTS AND SERVICES SOLD
SERVICES SOLD (EXCLUSIVE OF
(EXCLUSIVE OF DEPRECIATION AND
Cost of Products and Services Sold (Exclusive of Depreciation and DEPRECIATION AND AMORTIZATION SHOWN
Amortization Shown Separately Below) and Cost of Products and AMORTIZATION SHOWN SEPARATELY BELOW)
Services Sold (Exclusive of Depreciation and Amortization Shown SEPARATELY BELOW AS A PERCENTAGE
Separately Below) as a Percentage of Revenue by Product Type: (IN THOUSANDS) OF REVENUE
- ----------------------------------------------------------------- ------------------ ------------------
Sales of voice, data and video telecommunications networks to government
agencies $ 7,239 77.6%
Visual identification tags and implantable microchips for the companion
animal, livestock, laboratory animal, fish and wildlife markets 4,141 53.1%
Sales of IT hardware and services from our InfoTech USA, Inc. segment 2,046 80.7%
GPS enabled search and rescue equipment, intelligent communications
products and services for telemetry, mobile data and radio communications 1,334 49.4%
Other products and services 1,377 50.3%
---------------- -----------------
Total $16,137 64.3%
================ =================
A breakdown of our revenues and cost of products and services sold
(exclusive of depreciation and amortization shown separately below) and our
cost of products and services sold (exclusive of
36
depreciation and amortization shown separately below) as a percentage of
revenue from continuing operations by segment for the three-months ended
March 31, 2003 and 2002, is presented under the heading "Results of
Continuing Operations", which begins on page 40. We hope to continue to grow
our revenues. We see a possible increase in revenue from sales of voice,
data and video telecommunications networks to government agencies will
increase due to being awarded additional government contracts, such as the
CONNECTIONS contract that we were awarded in January 2003. We expect sales
of visual identification tags and implantable microchips to the companion
animal, livestock, laboratory animal, fish and wildlife markets to increase.
We plan to expand our visual identification tags and implantable microchip
product lines with complementary products, such as our Bio-Thermo product.
Also, we believe that concerns over the safety and source of animal and
other food sources will increase the markets for these products. We expect
revenue from our InfoTech USA, Inc. segment to decrease as we continue to
shift our focus from sales of higher cost computer hardware products to
sales of products and technology services with lower cost of products and
services sold (exclusive of depreciation and amortization) as a percentage
of revenue. Overall, in the short-term our cost of products and services
sold (exclusive of depreciation and amortization shown separately below) as
a percentage of revenue will most likely increase as a result of competitive
pressures. However, we are hoping that our cost of products and services
sold (exclusive of depreciation and amortization shown separately below) as
a percentage of revenue will improve once we begin selling significant
quantities of our advanced technology products. To date, we have not
recorded any significant revenues from our advanced technology products.
Advanced Technology
Our Advanced Technology segment represents those businesses 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. This segment specializes in voice, data
and video telecommunications networks, propriety software and Internet
access and website design.
The majority of the revenue in this segment is generated from the
Company's wholly-owned subsidiary, Computer Equity Corporation. In January
2003, Computer Equity Corporation's wholly-owned subsidiary, GTI, was one of
seventeen companies awarded the federal government's CONNECTIONS contract,
which replaced the previous Wire and Cable Service ("WACS") contract. The
CONNECTIONS contract has a three-year base term and five successive one-year
renewal options. The renewal options are at the discretion of the
government. The CONNECTIONS contract is similar to the WACS contract in that
it will allow Computer Equity Corporation to provide government agencies
with equipment and services for campus and building communications networks
and related infrastructure without the need to follow the full procurement
process for a new contract.
Expenses associated with VeriChip and Thermo Life products are also
included in the Advanced Technology segment. Our VeriChip(TM) product has
multiple applications in security, personal identification, safety,
healthcare (subject to FDA approval) and more. However, as of March 31,
2003, we have not recorded any revenue from our VeriChip or Thermo Life
products.
The Advanced Technology segment's customer base includes
governmental agencies, commercial operations, and consumers. The principal
products and services in this segment are as follows:
o Voice, data and video telecommunications networks;
o Call center and customer relationship management software;
o Networking products and services;
37
o Website design and Internet access;
o Miniaturized implantable verification chip (VeriChip(TM));
and
o Miniaturized power generator (Thermo Life(TM)).
The Advanced Technology segment delivers products and services
across a multitude of industries, including government, insurance,
utilities, communications and high tech.
Digital Angel Corporation
Our Digital Angel Corporation segment consists of the business
operations of Digital Angel Corporation, our approximately 73.12% 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), Wireless and Monitoring (a combination of the
former Digital Angel Technology and the Digital Angel Delivery System
segments), GPS and Radio Communications (formerly Radio Communications and
Other), and Medical Systems (formerly Physician Call Center and Other).
Medical Systems represents the business activity of the newly acquired MAS.
The principal products and services in this segment by division are
as follows:
Animal Applications division--develops, manufactures, and markets a
broad line of electronic and visual identification devices for the companion
animal, livestock, laboratory animal, fish and wildlife markets worldwide.
The tracking of cattle and hogs are crucial both for asset management and
for disease control and food safety. The principal technologies employed by
Animal Applications are electronic ear tags and implantable microchips that
use radio frequency transmission. This segment includes our Bio-Thermo(TM)
product;
Wireless and Monitoring division--develops and markets advanced
technology to gather location and local sensory data and to communicate that
data to an operations center. This segment is continuously developing its
technology, which it refers to as its "Digital Angel(TM) technology." The
Digital Angel(TM) technology is the integration and miniaturization into
marketable products of three technologies: wireless communications (such as
cellular), sensors (including bio-sensors) and position location technology;
GPS and Radio Communications division--consists of the design,
manufacture and support of secure GPS enabled search and rescue equipment
and intelligent communications products and services for telemetry, mobile
data and radio communications applications serving commercial and military
markets. In addition, it designs, manufactures and distributes intrinsically
safe sounders (horn alarms)for industrial use and other electronic
components; and
Medical Systems division--is the MAS business that was acquired on
March 27, 2002. A staff of logistics specialists and physicians provide
medical assistance services and interactive medical information services to
people traveling anywhere in the world. It also sells a variety of kits
containing pharmaceutical and medical supplies.
The majority of sales in this segment are from the Animal
Applications division. Minimal sales
38
of the Digital Angel product and no sales of the Bio-Thermo product have
been recorded as of March 31, 2003.
InfoTech USA, Inc.
Our InfoTech USA, Inc. segment consists of the business operations
of our 52.5% owned subsidiary, InfoTech USA, Inc. This segment is a full
service provider of Information Technology (IT) products and services.
During 2002, this segment continued its strategy of moving away from a
product-driven systems integration business model to a customer-oriented IT
strategy-based business model. It has further developed its deliverable IT
products and services by adding new consulting and service offerings, and
increasing the number of strategic alliances with outside technical services
firms and manufacturers of high-end IT products. The principal products and
services in this segment are computer hardware and computer services. The
majority of InfoTech USA, Inc.'s revenue is derived from sales of computer
hardware. InfoTech USA, Inc.'s services consist of IT consulting,
installation, project management, design and deployment, computer
maintenance and other professional services.
Discontinued Operations
On March 1, 2001, our Board of Directors approved a plan to sell
Intellesale, Inc. and all of our other non-core businesses. The results of
operations, financial condition and cash flows of Intellesale and all of our
other non-core businesses have been reported as Discontinued Operations in
our financial statements.
39
RESULTS OF CONTINUING OPERATIONS
The following table summarizes our results of operations as a
percentage of net operating revenue for the three-month periods ended March
31, 2003 and 2002, and is derived from the unaudited consolidated statements
of operations in Part I, Item 1 of this report.
RELATIONSHIP TO
REVENUE
----------------------------------------
THREE-MONTHS ENDED MARCH 31,
----------------------------------------
2003 2002
---- ----
% %
---- ----
Product revenue 83.7 81.7
Service revenue 16.3 18.3
----------------------------------------
Total revenue 100.0 100.0
Cost of products sold (exclusive of depreciation and
amortization shown separately below) 67.4 71.6
Cost of services sold 48.1 45.1
----------------------------------------
Total cost of products and services sold (exclusive of
depreciation and amortization shown separately below) 64.3 66.7
Gross profit 35.7 33.2
Selling, general and administrative expense 117.4 102.5
Research and development 4.8 5.1
Depreciation and amortization 2.5 3.6
Interest income (0.9) (0.5)
Interest expense 18.4 7.3
----------------------------------------
Loss from continuing operations before income taxes, minority interest,
losses attributable to capital transactions of subsidiary and equity
in net loss of affiliate (106.5) (84.8)
(Benefit) provision for income taxes (0.8) 0.4
----------------------------------------
Loss from continuing operations before minority interest, losses
attributable to capital transactions of subsidiary and equity
in net loss of affiliate (105.7) (85.2)
Minority interest (0.6) (0.1)
Net loss on capital transactions of subsidiary 0.8 1.4
Loss attributable to changes in minority interest as a result of
capital transactions of subsidiary 0.8 --
Equity in net loss of affiliate -- 1.0
----------------------------------------
Loss from continuing operations (106.7) (87.5)
(Loss) income from Discontinued Operations, net of income taxes (0.6) 2.4
----------------------------------------
Net loss (107.3) (85.1)
========================================
40
REVENUE
Revenue from continuing operations for the three-months ended March 31,
2003, decreased $3.1 million, or 11.0%, to $25.1 from $28.2 million for the
three-months ended March 31, 2002.
Revenue from continuing operations for the three-months ended March 31,
2003 and 2002, by segment was as follows:
THREE-MONTHS ENDED MARCH 31,
(IN THOUSANDS)
---------------------------------------------------------------------------------
2003 2002
---- ----
---------------------------------------------------------------------------------
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
Advanced Technology $ 8,332 $2,950 $11,282 $ 4,904 $3,616 $ 8,520
Digital Angel Corporation 10,865 533 11,398 7,452 303 7,755
InfoTech USA, Inc. 1,934 600 2,534 9,694 811 10,505
All Other -- -- -- 1,013 375 1,388
Corporate / Eliminations (108) -- (108) -- 51 51
---------------------------------------------------------------------------------
Total $21,023 $4,083 $25,106 $23,063 $5,156 $28,219
=================================================================================
Advanced Technology segment's revenue increased $2.8 million for
the three-months ended March 31, 2003, compared to the three-months ended
March 31, 2002. Product revenue increased by $3.4 million, or 69.9%, and
service revenue decreased by $0.7 million, or 18.4%. The increase in product
revenue was due to an increase of approximately $3.9 million in Computer
Equity Corporation's government contract sales. Most of Computer Equity
Corporation's business was being performed under a contract vehicle entitled
Wire and Cable Service (WACS) that was managed by the General Services
Administration. WACS allowed Computer Equity Corporation to provide
government agencies with equipment and services for campus and building
communications networks and related infrastructure without the need to
follow the full procurement process for a new contract. We attribute the
decrease in service revenue to a reduction in demand for our software and
technology related services and to the sale of one of the businesses in this
group during the fourth quarter of 2002. The business that was sold during
the fourth quarter of 2002 contributed $0.4 million in service revenue
during the three-months ended March 31, 2002.
Digital Angel Corporation segment's revenue increased $3.6 million
for the three-months ended March 31, 2003, compared to the three-months
ended March 31, 2002. Product revenue increased by $3.4 million, or 45.8%,
and service revenue increased by approximately $0.2 million, or 75.9%. We
attribute the increase in product sales primarily to an increase in sales of
approximately $2.0 million to the fisheries industry customers. Our primary
fish and wildlife customers are the Army Corp of Engineers, BioMark, Inc.,
the Department of Energy and Pacific States Marine Fisheries. Additionally,
approximately $0.9 million of the increase was due to increased shipments of
companion animal microchips when compared to the three-months ended March
31, 2002, and approximately $0.4 million was attributable to the inclusion
of product sales of the Medical Services division, which we acquired on
March 27, 2002. We attribute the increase in service revenue to the
inclusion of the Medical Services division's revenue of approximately $0.2
million for the three-months ended March 31, 2003.
InfoTech USA, Inc. segment's revenue decreased $8.0 million for the
three-months ended March 31, 2003, compared to the three-months ended March
31, 2002. Product revenue decreased by $7.8 million, or 80.0%, and service
revenue decreased by $0.2 million, or 26.0%. We attribute the majority of
the decrease in revenue to two large orders shipped during the three-months
ended March 31, 2002. These sales to two customers were primarily product
sales and were in excess of $5.3 million. The continued soft market for IT
products also contributed to the decrease in revenue.
41
All Other's revenue decreased $1.4 million, or 100.0%, for the three-
months ended March 31, 2003, compared to the three-months ended March 31, 2002.
The decrease was 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.
COST OF PRODUCTS AND SERVICES SOLD (EXCLUSIVE OF DEPRECIATION AND
AMORTIZATION SHOWN SEPARATELY BELOW) AND COST OF PRODUCTS AND SERVICES SOLD
(EXCLUSIVE OF DEPRECIATION AND AMORTIZATION SHOWN SEPARATELY BELOW) AS A
PERCENTAGE OF REVENUE
Cost of products and services sold (exclusive of depreciation and
amortization shown separately below) from continuing operations for the
three-months ended March 31, 2003, decreased $2.7 million, or 14.4%, to $16.1
million from $18.8 million for the three-months ended March 31, 2002. Cost
of products and services sold (exclusive of depreciation and amortization
shown separately below) as a percentage of revenue was 64.3% and 66.8% of
revenue for the three-months ended March 31, 2003 and 2002, respectively.
Cost of products and services sold (exclusive of depreciation and
amortization shown separately below) from continuing operations during the
three-months ended March 31, 2003 and 2002, by segment was as follows:
THREE-MONTHS ENDED MARCH 31,
(IN THOUSANDS)
-------------------------------------------------------------------------------
2003 2002
---- ----
-------------------------------------------------------------------------------
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
Advanced Technology $ 7,046 $1,181 $ 8,227 $ 3,293 $1,633 $ 4,926
Digital Angel Corporation 5,483 395 5,878 4,301 251 4,552
InfoTech USA, Inc. 1,657 389 2,046 8,734 406 9,140
All Other -- -- -- 188 35 223
Corporate / Eliminations (14) -- (14) -- -- --
-------------------------------------------------------------------------------
Total $14,172 $1,965 $16,137 $16,516 $2,325 $18,841
========================================== ===================================
Cost of products and services sold (exclusive of depreciation and
amortization shown separately below) as a percentage of revenue from
continuing operations during the three-months ended March 31, 2003 and 2002,
by segment was as follows:
THREE-MONTHS ENDED MARCH 31,
-------------------------------------------------------------------------------
2003 2002
---- ----
-------------------------------------------------------------------------------
Product Service Total Product Service Total
------- ------- ----- ------- ------- -----
% % % % % %
- - - - - -
Advanced Technology 84.6 40.0 72.9 67.1 45.2 57.8
Digital Angel Corporation 50.5 74.1 51.6 57.7 82.8 58.7
InfoTech USA, Inc. 85.7 64.8 80.7 90.1 50.1 87.0
All Other -- -- -- 18.6 9.3 16.1
Corporate / Eliminations 13.0 -- 13.0 -- -- --
---------------------------------------------------------------------------------
Total 67.4 48.1 64.3 71.6 45.1 66.8
============================================ ===================================
Our Advanced Technology segment's cost of products and services
sold (exclusive of depreciation and amortization shown separately below)
increased $3.3 million for the three-months ended March 31, 2003, as compared
to the three-months ended March 31, 2002, and cost of products and services
sold (exclusive of depreciation and amortization shown separately below) as
a percentage of revenue increased to 72.9% for the three-months ended March 31,
2003, from 57.8% for the three-months ended March 31, 2002. We attribute the
increase in cost of products and services sold (exclusive of depreciation
and amortization shown separately below) primarily to an increase in cost of
products and
42
services sold (exclusive of depreciation and amortization shown separately
below) related to government contract sales of approximately $4.1 million
during the three-months ended March 31, 2003, as a result of a change in the
product mix to, which included more sales of certain higher cost telephony
integration systems. Partially offsetting the increase in costs, were
decreases in software and technology related cost of products and services
sold (exclusive of depreciation and amortization shown separately below)
during the three-months ended March 31, 2003, as a result of a decrease in
revenue from these sources. We attribute the increase in cost of products
and services sold (exclusive of depreciation and amortization shown
separately below) as a percentage of revenue primarily to the higher cost of
products and services sold (exclusive of depreciation and amortization shown
separately below) as a percentage of revenue from our government contract
sales during the three-months ended March 31, 2003. Cost of products and
services sold as percentage of revenue for our government contract sales
were approximately 77.6% and 58.0% during the three-months ended March 31,
2003 and 2002, respectively.
Digital Angel Corporation's cost of products and services sold
(exclusive of depreciation and amortization shown separately below)
increased $1.3 million for the three-months ended March 31, 2003, as compared to
the three-months ended March 31, 2002, and cost of products and services
sold (exclusive of depreciation and amortization shown separately below) as
a percentage of revenue decreased to 51.6% for the three-months ended March 31,
2003, from 58.7% for the three-months ended March 31, 2002. We attribute $1.2
million of the increase in cost of products and services sold (exclusive of
depreciation and amortization shown separately below) primarily to the
previously mentioned sales increase in our Animal Applications division.
Additionally, we attribute $0.4 million of the increase to our Medical
Services division acquired on March 27, 2002. These increases were partially
offset by decreases in costs in the Wireless and Monitoring and GPS and
Radio Communications divisions. The decrease in cost of products and
services sold (exclusive of depreciation and amortization shown separately
below) as a percentage of revenue is primarily related to lower material
costs in our Animal Applications division.
InfoTech USA, Inc.'s cost of products and services sold (exclusive
of depreciation and amortization shown separately below) decreased $7.1 million
for the three-months ended March 31, 2003, as compared to the three-months
ended March 31, 2002, and cost of products and services sold (exclusive of
depreciation and amortization shown separately below) as a percentage of
revenue decreased to 80.7% for the three-months ended March 31, 2003, from
87.0% for the three-months ended March 31, 2002. We attribute the decrease in
cost of products and services sold (exclusive of depreciation and amortization
shown separately below) to the overall decrease in revenue. We attribute the
decrease in cost of products and services sold (exclusive of depreciation
and amortization shown separately below) as a percentage of revenue
primarily to our strategy to cease selling some of our higher-cost computer
hardware and to focus more of our efforts on selling products and technical
services with lower cost of products and services sold (exclusive of
depreciation and amortization) as a percentage of revenue. The higher-cost
computer hardware products were mid-range Unix based computers, which
offered little opportunity for adjunct sales of related technical services,
which have with lower cost of products and services sold (exclusive of
depreciation and amortization) as a percentage of revenue. InfoTech USA,
Inc.'s current offering of products and related technical services with
lower cost of products and services sold (exclusive of depreciation and
amortization) as a percentage of revenue include Intel based computers and
servers, which provide InfoTech USA, Inc. with an opportunity to provide
add-on technical services.
All Other's cost of products and services sold (exclusive of
depreciation and amortization shown separately below) decreased $.02
million, or 100%, for the three-months ended March 31, 2003, compared to the
three-months ended March 31, 2002. Cost of products and services sold
(exclusive of depreciation and amortization shown separately below) as a
percentage of revenue was 0% for the three-months ended March 31, 2003, from
16.1% for the three-months ended March 31, 2002. The decrease in
43
cost of products and services sold (exclusive of depreciation and
amortization shown separately below) and cost of products and services sold
(exclusive of depreciation and amortization shown separately below) as a
percentage of revenue 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 2002.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expense from continuing operations
was $29.5 million for the three-months ended March 31, 2003, an increase of
$0.6 million, or 2.0%, from $28.9 million for the three-months ended March 31,
2002. As a percentage of total revenue, selling, general and administrative
expense from continuing operations increased to 117.4% for the three-months
ended March 31, 2003, from 102.5% for the three-months ended March 31, 2002.
Selling, general and administrative expense from continuing operations
for the three-months ended March 31, 2003 and 2002, by segments was as
follows:
THREE-MONTHS ENDED MARCH 31,
(IN THOUSANDS)
-------------------------------
2003 2002
---- ----
Advanced Technology $ 2,273 $ 1,909
Digital Angel Corporation 4,001 2,660
InfoTech USA, Inc. 894 1,184
All Other -- 914
Corporate / Eliminations 22,300 22,233
-------------------------------
Total $29,468 $28,900
===============================
Selling, general and administrative expense from continuing
operations as a percentage of revenue for the three-months ended March 31,
2003 and 2002, by segments was as follows:
THREE-MONTHS ENDED MARCH 31,
-------------------------------
2003 2002
---- ----
% %
- -
Advanced Technology 20.1 22.4
Digital Angel Corporation 35.1 34.3
InfoTech USA, Inc. 35.3 11.3
All Other -- 65.9
Corporate / Eliminations (1) 88.8 78.8
-------------------------------
Total 117.4 102.5
===============================
<FN>
(1) Corporate / Eliminations percentage has been calculated as a percentage
of total revenue.
Advanced Technology's selling, general and administrative expense
increased $0.4 million, or 19.1%, to $2.3 million for the three-months ended
March 31, 2003, from $1.9 million for the three-months ended March 31, 2002.
We attribute the increase primarily to approximately $0.2 million of
severance expense as a result of extending the expiration date of stock
options to acquire VeriChip Corporation common stock in connection with the
termination of one of our former officers during the three-months ended
March 31, 2003, (additional severance expense associated with the
termination of officers and director during the three-months ended March 31,
2003, is included in the "Corporate/Eliminations" segment below), and to
approximately $0.3 million in expenses associated with the VeriChip product,
which we began marketing during the latter part of 2002. Selling, general
and administrative expense decreased as a percentage of revenue due to the
previously mentioned sales increase.
44
Digital Angel Corporation's selling, general and administrative
expense increased $1.3 million, or 50.4%, to $4.0 million for the
three-months ended March 31, 2003, from $2.7 million for the three-months
ended March 31, 2002. We attribute the increase primarily to increased
compensation expense and insurance expense in our Animal Applications
segment and $0.2 million associated with the acquisition of the Medical
Services division on March 27, 2002. Selling, general and administrative
expense as a percentage of revenue remained relatively constant at 35.1% for
the three-months ended March 31, 2003, as compared to 34.3% for the
three-months ended March 31, 2002.
InfoTech USA, Inc.'s selling, general and administrative expense
decreased $0.3 million, or 24.5%, to $0.9 million for the three-months ended
March 31, 2003, from $1.2 million for the three-months ended March 31, 2002.
As a percentage of revenue, selling general and administrative expense
increased to 35.3% of revenue for the three-months ended March 31, 2003,
from 11.3% of revenue for the three-months ended March 31, 2002. We
attribute approximately $0.6 million of the decrease primarily to headcount
reduction, the elimination of expenses related to the Shirley, New York
facility, which was sold in January 2002, and approximately $0.3 million to
reduced commissions on lower sales and other cost control programs. The
increase in selling, general and administrative expense as a percentage of
revenue resulted from the decrease in sales for the three-months ended
March 31, 2003.
All Other's selling, general and administrative expense decreased
$0.9 million, or 100.0%, to $0.0 million for the three-months ended March 31,
2003, from $0.9 million for the three-months ended March 31, 2002. The decrease
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
expense increased $0.1 million, or 0.3%, to $22.3 million for the
three-months ended March 31, 2003, from $22.2 million for the three-months
ended March 31, 2002. Included in selling, general and administrative
expense for the three-months ended March 31, 2003, was severance expense of
approximately $21.8 million, which resulted from the termination of
executive officers and director during the three-months ended March 31,
2003. (An additional $0.2 million of severance expense associated with these
terminations is included in the Advance Technology segment's selling,
general and administrative expense for the three-months ended March 31,
2003). Included in selling, general and administrative expense for the
three-months ended March 31, 2002, was non-cash compensation expense
resulting from the pre-merger Digital Angel and MAS merger, whereby 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
first quarter of 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.
In addition, we reversed approximately $1.0 million and incurred
approximately $0.3 million of non-cash compensation expense for the
three-months ended March 31, 2003 and 2002, respectively, 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 fluctuations in the Company's common stock
price result in increases and decreases of non-cash compensation expense
until the options are exercised, forfeited, modified or expired.
Excluding the effects of the severance and non-cash compensation
expense discussed above, "Corporate / Eliminations" decreased $1.7 million,
or 53.1%, to $1.5 million for the three-months ended
45
March 31, 2003, from the $3.2 million for the three-months ended March 31,
2002. The decrease resulted primarily from cost reduction programs initiated
during 2002.
RESEARCH AND DEVELOPMENT
Research and development expense from continuing operations was
$1.2 million and $1.4 million for the three-months ended March 31, 2003 and
2002, respectively. Research and development expense decreased to 4.8% of
revenue for the three-months ended March 31, 2003, from 5.1% of revenue for
the three-months ended March 31, 2002.
Research and development expense from continuing operations during the
three-months ended March 31, 2003 and 2002, by segments was as follows:
THREE-MONTHS ENDED MARCH 31,
(IN THOUSANDS)
--------------------------------
2003 2002
---- ----
Advanced Technology $ 55 $ 117
Digital Angel Corporation 911 1,331
InfoTech USA, Inc. -- --
All Other -- --
Corporate/Eliminations 235 --
--------------------------------
Total $1,201 $1,448
================================
Research and development expense relates primarily to the development
of our advanced technology products: Digital Angel, VeriChip, Thermo Life
and Bio-Thermo.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization expense from continuing operations
for the three-months ended March 31, 2003, decreased $0.4 million, or 37.6%,
to $0.6 million from $1.0 million for the three-months ended March 31, 2002.
As a percentage of revenue, depreciation and amortization expense decreased
to 2.5% for the three-months ended March 31, 2003, from 3.6% for the
three-months ended March 31, 2002.
Depreciation and amortization expense from continuing operations
during the three-months ended March 31, 2003 and 2002, by segments was as
follows:
THREE-MONTHS ENDED MARCH 31,
(IN THOUSANDS)
--------------------------------
2003 2002
---- ----
Advanced Technology $ 69 $ 105
Digital Angel Corporation 434 735
InfoTech USA, Inc. 55 74
All Other -- 9
Corporate/Eliminations 68 81
--------------------------------
Total $626 $1,004
================================
Advanced Technology's depreciation and amortization expense decreased
by $36,000, or 34.3%, to $69,000 for the three-months ended March 31, 2003,
from $0.1 million for the three-months ended March 31, 2002. We attribute the
decrease to fully depreciating certain assets during 2002 and our decision to
limit our expenditures for property and equipment.
Digital Angel Corporation's depreciation and amortization expense
decreased by $0.3 million, or 41.0%, to $0.4 million for the three-months
ended March 31, 2003, from $0.7 million for the three-months ended March 31,
2002. We attribute the decrease primarily to the exclusion of depreciation
46
expense for a license to a digital encryption and distribution software
system that Digital Angel Corporation impaired during the fourth quarter
of 2002.
InfoTech USA, Inc.'s depreciation and amortization expense decreased
by $19,000, or 25.7%, to $55,000 for the three-months ended March 31, 2003,
from $74,000 for the three-months ended March 31, 2002. We attribute the
decrease primarily to the sale of the Shirley, New York facility during the
three-months ended March 31, 2002.
All Other's depreciation and amortization expense decreased 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.
INTEREST AND OTHER INCOME AND EXPENSE
Interest and other income was $0.2 million and $0.1 million, for the
three-months ended March 31, 2003 and 2002, respectively. Interest income is
earned primarily from short-term investments and notes receivable.
Interest expense was $4.6 million and $2.1 million for the three-months
ended March 31, 2003 and 2002, respectively. The increase in interest
expense resulted primarily from an increase in the interest rate charged by
IBM Credit under the terms of the IBM Credit Agreement, which became
effective on March 27, 2002.
INCOME TAXES
We had an effective (benefit) income tax rate of (0.7)% and 0.4% for
the three-months ended March 31, 2003 and 2002, 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 and
state taxes net of federal benefits.
NET LOSS ON CAPITAL TRANSACTIONS OF SUBSIDIARY AND LOSSES
ATTRIBUTABLE TO CHANGES IN MINORITY INTEREST AS A RESULT OF CAPITAL
TRANSACTIONS OF SUBSIDIARY
Gains where realized and losses on issuances of shares of stock by
our consolidated subsidiary, Digital Angel Corporation, are reflected in the
Condensed Consolidated Statement of Operations. We determined that such
recognition of gains and losses on issuances of shares of stock by Digital
Angel Corporation was appropriate since the shares issued to date were not
sales of unissued shares in a public offering, we do not plan to reacquire
the shares issued and the value of the proceeds could be objectively
determined. During the three-months ended March 31, 2003, we recorded a loss
of $0.2 million on the issuances of 0.3 million shares of Digital Angel
Corporation common stock resulting from the exercise of stock options. 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. In addition, during the three-months ended
March 31, 2003, we recorded a loss of $0.2 million attributable to changes
in its minority interest ownership of Digital Angel Corporation as a result
of the stock issuances. See Note 11. During the three-months ended March 31,
2002, we recorded a net loss of $0.4 million, 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 our 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. The business operations of Digital Angel
Corporation are described in Note 6 to the Condensed Consolidated Financial
Statements. We anticipate that in the future we will continue to realize
gains and losses on the issuances of stock by Digital Angel Corporation.
47
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 "noncore
businesses". Prior to approving the plan, the assets and results of
operations of the noncore businesses had been segregated for external and
internal financial reporting purposes from the assets and results of
operations of the Company. All of these noncore businesses were part of
their own reporting unit for segment reporting purposes and all of these
businesses were being held for sale. These five individually managed
businesses operated in manufacturing and fabricating industries apart from
our 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 classified as Discontinued Operations. There is one
insignificant company remaining at March 31, 2003, which had combined
revenue and net loss for the quarter ended March 31, 2003, of $7,000 million
and $0.1 million, respectively. We anticipate selling or closing the
remaining business within the next several months. We used the proceeds from
the sales of companies classified as Discontinued Operations to repay
amounts outstanding under the IBM Credit Agreement.
During the three-months ended March 31, 2003, Discontinued
Operations incurred a change in estimated operating losses accrued on the
measurement date of $0.2 million. The primary reason for the increase in the
estimated losses during the three-months ended March 31, 2003, was due to
the operations of the one remaining business within this group. During the
three-months ended March 31, 2002, we recorded a reduction of our estimated
operating loss on disposal and operating losses during the phase out period
of $0.7 million. This reduction was comprised primarily of an increase in
the estimated loss on the sale of our 85% ownership in our Canadian
subsidiary, Ground Effects Ltd., which was sold in January 2002, of $1.2
million, offset by a decrease in carrying costs as certain of these
obligations were settled during the three-months ended March 31, 2002, for
amounts less than previously anticipated. Carrying costs include the
cancellation of facility leases, employment contract buyouts, sales tax
liabilities and litigation reserves.
We do not anticipate a further loss on sale of the remaining
business comprising Discontinued Operations. However, actual losses could
differ from our estimates and any adjustments will be reflected in our
future financial statements.
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, 2002, through March 31, 2003.
Balance Balance
Type of Cost December 31, Additions Deductions March 31,
2002 2003
- --------------------------------------------------------------------------------------------------------------------
Estimated loss on sale, net of change in
estimated operating losses $ -- $157 $157 $ --
Carrying costs 4,908 -- 23 4,885
--------------------------------------------------------------
Total $4,908 $157 $180 $4,885
==============================================================
48
LIQUIDITY AND CAPITAL RESOURCES FROM CONTINUING OPERATIONS
As of March 31, 2003, cash and cash equivalents totaled $3.0 million,
a decrease of $2.8 million, or 48.1%, from $5.8 million at December 31, 2002.
Operating activities used cash of $3.7 million and provided cash of
$2.5 million during the three-months ended March 31, 2003 and 2002,
respectively. During the three-months ended March 31, 2003, an increase in
cash held by note holder, an increase in accounts receivable, and purchases
of inventory resulted in the use of cash from operating activities. During
the three-months ended March 31, 2002, cash was provided primarily by
collections on accounts receivable and cash was used primarily to purchase
inventory and for other assets.
Accounts and unbilled receivables, net of allowance for doubtful
accounts, increased by $2.6 million, or 15.6%, to $19.1 million at March 31,
2003, from $16.5 million at December 31, 2002. We attribute the increase
primarily to a significant number of shipments made by Digital Angel
Corporation during the month of March 2003.
Inventory levels increased by $1.4 million, or 21.5%, to $7.8 million
at March 31, 2003, from $6.4 million at December 31, 2002. We attribute the
increase primarily to the accumulation of inventory by Digital Angel
Corporation in anticipation of current year sales.
Accounts payable increased by $2.5 million, or 25.5%, to $12.3 million
at March 31, 2003, from $9.8 million at December 31, 2002, due primarily to
an increase in inventory and improved cash management.
Investing activities provided cash of $0.6 million and $5.8 million
during the three-months ended March 31, 2003 and 2002, respectively. During
the three-months ended March 31, 2003, $1.0 million was provided from the
collection of notes receivable and $0.3 million was used to purchase
property and equipment. During the three-months ended March 31, 2002, cash
was provided primarily from 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 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 $0.7 million and cash used to
purchase property and equipment of $0.2 million.
Financing activities provided cash of $0.4 million and used cash of
$4.1 million during the three-months ended March 31, 2003 and 2002,
respectively. The primary source of cash during the three-months ended March
31, 2003, was the proceeds of subsidiary stock issuance of $0.2 million and
proceeds of the issuance of common stock of $0.1 million. During the
three-months ended March 31, 2002, cash was used primarily to repay $3.6
million against notes payable and $1.1 million against long-term debt.
Partially offsetting the use of cash during the three-months ended March 31,
2002, was cash of $0.9 million provided from the issuance of common shares.
Debt, Covenant Compliance and Liquidity
On March 1, 2002, we and the Digital Angel 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. The principal amount outstanding had an annual rate of 17% and matured
on February 28, 2003. If certain amounts were not repaid on or before
February 28, 2003, the interest rate increased to an annual rate of 25%. 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
49
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 were in compliance with the
revised covenants under IBM Credit Agreement, however, at December 31, 2003,
we failed to maintain compliance with the revised financial performance
covenant. In addition, as of March 31, 2003, and December 31, 2002, Digital
Angel Corporation did not maintain compliance with certain financial
covenants under its credit agreement with its lender, Wells Fargo Business
Credit, Inc. (Wells Fargo). Well Fargo provided Digital Angel Corporation
with waivers of such non-compliance. IBM did not provide a waiver.
Under the terms of the IBM Credit Agreement we were required to
repay IBM Credit $29.8 million of the $77.2 million outstanding principal
balance owed to them plus $16.4 million of accrued interest and expenses
(totaling approximately $46.2 million), on or before February 28, 2003. We
did not make such payment by February 28, 2003 and on March 3, 2003, IBM
Credit notified us that we had until March 6, 2003, to make the payment. Our
failure to comply with the payment terms imposed by the IBM Credit Agreement
and our failure to maintain compliance with the financial performance
covenant constitute events of default under the IBM Credit Agreement. On
March 7, 2003, we received a letter from IBM Credit declaring the loan in
default and indicating that IBM Credit would exercise any and/or all of its
remedies.
On March 27, 2003, we announced that we had executed a forbearance
agreement term sheet with IBM Credit. The Forbearance Agreement became
effective on April 2, 2003 and grants us more favorable loan repayment terms
and more time in which to meet our current obligations to IBM Credit. It
contains various purchase rights for us to buy back our existing
indebtedness from IBM Credit, including a one-time payment on or before June
30, 2003 of $30.0 million. Payment of this amount will constitute complete
satisfaction of any and all of our obligations to IBM Credit. Provided there
has not earlier occurred a "Termination Event," as defined in the
Forbearance Agreement, at the end of the forbearance period, the provisions
of the Forbearance Agreement shall become of no force and effect. At that
time, if the repayment terms of the Forbearance Agreement are not met, IBM
Credit shall be free to exercise and enforce, or to take steps to exercise
and enforce, all rights, powers, privileges and remedies available to them
under the IBM Credit Agreement, as a result of the payment and covenant
defaults existing on March 24, 2003. If we are not successful in satisfying
the payment obligations under the Forbearance Agreement or we do not comply
with the terms of the Forbearance Agreement or the IBM Credit Agreement, and
IBM Credit were to enforce its rights against the collateral securing the
obligations to IBM Credit, there would be substantial doubt that we would be
able to continue operations in the normal course of business.
Our ability to continue as a going concern and to continue
operations in the normal course of business is also predicated upon numerous
factors including the following:
o First to the repayment of all our obligations to IBM
Credit, is to obtain shareholder approval of the terms of
the severance agreements with the Company's former
officers and directors as more fully discussed in Note 10
to the Condensed Consolidated Financial Statements;
o Second, we must successfully implement our business plans,
manage expenditures according to our budget, and generate
positive cash flow from operations;
o Third, we must develop an effective marketing and sales
strategy;
o Fourth, we must realize positive cash flow with respect to
our investment in Digital Angel Corporation;
50
o Fifth, we must obtain the necessary approvals to expand
the market for the VeriChip product; and
o Finally, we must complete the development of the second
generation Digital Angel product.
We have established a management plan to mitigate the effect of our
going concern uncertainty conditions over the next twelve months. The major
components of our plan are as follows:
o To raise funds to repay a portion of our obligations to IBM Credit
through the offering of up to 50 million shares of our common stock
in a best efforts offering. These shares are currently being
registered under a registration statement filed with the SEC on
December 23, 2002 (File No. 333-102165);
o To utilize the shares of Digital Angel Corporation's common stock
currently in the Digital Angel Trust and/or our receivables and
inventory to secure additional funds to repay IBM Credit (noting
that these assets will be released from liens by IBM Credit upon
repayment in full of our obligations under the forbearance
agreement);
o To borrow against Digital Angel Corporation's receivables and
inventory, if necessary;
o To attempt to establish a sustainable positive cash flow business
model;
o To attempt to produce additional cash flow and revenue from our
advanced technology products - Digital Angel(TM), Thermo Life(TM),
VeriChip(TM) and Bio-Thermo(TM); and
o To generate additional liquidity through divestiture of business
units and assets that are not critical to our long-term strategy.
It is the opinion of our management that the likelihood of the
above plan being effectively implemented is good. On a consolidated
reporting basis, cash of $3.9 million was used by operations for the year
ended December 31, 2002. Of this amount, Digital Angel Corporation used
approximately $2.7 million. For the three-months ended March 31, 2003, cash
of $3.7 million was used by operations, of which Digital Angel Corporation
used approximately $3.1 million, while our remaining operations used $0.6
million. Our goal is to establish a sustainable positive cash flow business
model.
We believe that we will be able to generate sufficient revenues and
related cash flow in the next twelve months from the Advanced Technology
segment to cover the operating expenses of this segment as well as our
corporate overhead (exclusive of the corporate overhead of Digital Angel
Corporation and InfoTech USA, Inc.). The primary source of revenue for the
Advanced Technology segment is Computer Equity Corporation. For the quarter
ended March 31, 2003, the Advanced Technology segment reported gross revenue
of $11.3 million. Of this amount, Computer Equity Corporation represented
$9.3 million or 82.3% of the total revenue. The future revenue outlook for
Computer Equity Corporation appears to be positive. In January 2003,
Computer Equity Corporation's wholly-owned subsidiary, GTI, was one of
seventeen companies awarded the federal government's CONNECTIONS contract,
which replaced the previous WACS contract. The CONNECTIONS contract has a
three-year base term and five successive one-year renewal options. The
CONNECTIONS contract is similar to the WACS contract in that it will allow
Computer Equity Corporation to provide government agencies with equipment
and services for campus and building communications networks and related
infrastructure without the need to follow the
51
full procurement process for a new contract. During the remainder of 2003
and beyond, our focus will be to generate significant revenue and cash flow
from our advanced technology products. We hope to realize positive cash flow
in 2003 and beyond as these products gain customer acceptance and awareness
throughout the world.
As of March 31, 2003, the Advanced Technology segment and
"Corporate/Eliminations" had a combined cash balance of $3.0 million and
InfoTech USA, Inc. had a cash balance of $2.0 million. Digital Angel
Corporation did not have cash on hand. The specific components and the
approximate amount of funds that we anticipate that we will need to continue
operating for the next twelve months are as follows:
o To fund operations (excluding research and development) -
none, as we expect to achieve cash flow from operations
exclusive of research and development expense
o To fund research and development - $6.2 million
o To fund capital expenditures - $1.4 million
o To fund debt service - $30.5 million
The nature of our business is such that it does not require a
material cash outlay for capital expenditures, and we have no plans to make
significant investments in capital expenditures for the next twelve months.
We estimate that our Advanced Technology segment's capital expenditures for
the next twelve months will be less than $0.4 million, that Digital Angel
Corporation's capital expenditures for 2003 will be approximately $1.0
million and that InfoTech USA, Inc.'s capital expenditures for the next
twelve months will be de minimus. For the next twelve months, we anticipate
the cash outlay for our research and development efforts relating to our
advanced technology products to approximate $0.8 million and that Digital
Angel Corporation's cash outlay for such efforts will be approximately $5.4
million. InfoTech USA, Inc. does not incur research and development expense.
Assuming that we are successful in satisfying our obligations to
IBM Credit under the terms of the forbearance agreement, that we have
positive cash flow from operations and that we rely on our various other
sources of liquidity as discussed below, we believe that we should have
sufficient working capital to satisfy our short-term needs over the next
twelve months.
Sources of Liquidity
Our operating activities did not provide positive cash flow during
the three-months ending March 31, 2003, or during 2002 and 2001. While we
anticipate that our operations will provide positive cash flow during 2003,
our operating activities did not provide positive cash flow during 2002 and
2001. In addition, during 2003, we are required to make substantial debt
payments under the terms of the Forbearance Agreement with IBM Credit.
Accordingly, we may not have access to funds necessary to provide for our
ongoing operations or to make the required debt payments. Our sources of
liquidity may include proceeds from the sale of common stock and preferred
shares, proceeds for the sale of businesses, proceeds from the sale of the
Digital Angel Corporation common stock held in the Digital Angel Trust,
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.
These options may not be available, or if available, may not be on favorable
terms. Our capital requirements depend on a variety of factors, including
but not limited to, repayment obligations under the IBM Credit Agreement,
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.
52
Failure to obtain additional funding, to generate positive cash
flow from operations and to comply with the payment and other provisions of
the Forbearance Agreement with IBM Credit will have a materially adverse
effect on our business, financial condition and results of operations.
Outlook
We are constantly looking for ways to maximize shareholder value.
As such, we are continually seeking operational efficiencies and synergies
within our operating 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 shareholders'
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 SFAS No. 141, Business Combinations
(FAS No. 141) and FAS No. 142, Goodwill and Other Intangible Assets (FAS
No. 142). FAS No. 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 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 No. 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 No. 142. We recorded an impairment charge of $62.2
million based upon our annual review of our goodwill during the fourth
quarter of 2002. Future impairment reviews may result in additional
write-downs.
In June 2001, the FASB issued SFAS 143, Accounting for Asset
Retirement Obligations, which is effective for fiscal years beginning after
June 15, 2002. SFAS 143 requires legal obligations associated with the
retirement of long-lived assets to be recognized at their fair value at the
time the obligations are incurred. Upon initial recognition of a liability,
that cost should be capitalized as part of the related long-lived asset and
allocated to expense over the useful life of the asset. We adopted FAS 143
on January 1, 2003. Application of the new rules did not have a significant
impact on our financial position and results of operations.
In August 2001, the FASB issued SFAS 144, Accounting for the
Impairment or Disposal of Long-Lived Assets (FAS No. 144). This standard
supersedes SFAS 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 (APB 30), 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
53
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 No. 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 (FAS No. 145). FAS No. 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. The adoption of FAS No.
145 did not have a material effect on our operations or financial position.
In June 2002, the FASB issued SFAS 146, Accounting for Costs
Associated with Exit or Disposal Activities (FAS No. 146). This statement
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. Adoption of this Statement is required with the beginning of
fiscal year 2003. We adopted this statement on January 1, 2003. The adoption
of FAS No. 146 did not have a material impact on our operations or financial
position.
In December 2002, the FASB issued SFAS 148, Accounting for
Stock-Based Compensation -- Transition and Disclosure an amendment of FASB
Statement No. 123 (FAS No. 148). This Statement amends SFAS 123, Accounting
for Stock-Based Compensation (FAS No. 123), to provide alternative methods
of transition for an entity that voluntarily changes to the fair value based
method of accounting for stock-based employee compensation. It also amends
the disclosure provisions of that Statement to require prominent disclosure
about the effects on reported net income of an entity's accounting policy
decisions with respect to stock-based employee compensation. Finally, this
Statement amends APB Opinion No. 28, Interim Financial Reporting, to require
disclosure about those effects in interim financial information. We intend
to continue to account for stock-based compensation based on the provisions
of APB Opinion No. 25. FAS No. 148's amendment of the transition and annual
disclosure provisions of FAS No. 123 are effective for fiscal years ending
after December 15, 2002, and the disclosure requirements for interim
financial statements are effective for interim periods beginning after
December 15, 2002. We have adopted the disclosure provisions of FAS No. 148
effective December 31, 2002.
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.
All forward looking statements in this Form 10-Q are made only as of the
date of this report, and we do not undertake any obligation to update these
forward-looking statements even though circumstances may change in the
future.
Forward-looking statements include, but are not limited to:
o our ability to raise the required funds to repay our
obligations to IBM Credit Corporation (IBM Credit)
by September 30, 2003;
o our growth strategies including, without limitation, our
ability to deploy our products and services including
Digital Angel(TM), Thermo Life(TM), VeriChip(TM) and
Bio-Thermo(TM);
54
o anticipated trends in our business and demographics;
o the ability to hire and retain skilled personnel;
o relationships with and dependence on technological partners;
o uncertainties relating to customer plans and commitments;
o our ability to successfully integrate the business
operations of acquired companies;
o our future profitability and liquidity;
o governmental export and import policies, global trade
policies, worldwide political stability and economic growth;
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.
Associated Risk Factors
-----------------------
IF WE ARE NOT SUCCESSFUL IN SATISFYING THE PAYMENT OBLIGATIONS
UNDER THE FORBEARANCE AGREEMENT OR WE DO NOT COMPLY WITH THE TERMS OF THE
FORBEARANCE AGREEMENT OR THE IBM CREDIT AGREEMENT, THERE IS SUBSTANTIAL
DOUBT THAT WE WILL BE ABLE TO CONTINUE AS A GOING CONCERN AND YOU ARE AT
RISK OF LOSING YOUR ENTIRE INVESTMENT.
Under the terms of the IBM Credit Agreement we were required to
repay IBM Credit $29.8 million of the $77.2 million outstanding principal
balance currently owed to them, plus $16.4 million of accrued interest and
expenses (totaling approximately $46.2 million), on or before February 28,
2003. We did not make such payment by February 28, 2003. On March 3, 2003,
IBM Credit notified us that we had until March 6, 2003, to make the payment.
We did not make the payment on March 6, 2003, as required. Our failure to
comply with the payment terms imposed by the IBM Credit Agreement and to
maintain compliance with the financial performance covenant constitute
events of default under the IBM Credit Agreement. On March 7, 2003, we
received a letter from IBM Credit declaring the loan in default and
indicating that IBM Credit would exercise any and/or all of its remedies.
On March 27, 2003, we announced that we had executed a forbearance
agreement term sheet with IBM Credit. The Forbearance Agreement was executed
on April 2, 2003, and grants us more favorable loan repayment terms and more
time in which to meet our current obligations to IBM Credit. It contains
various purchase rights for us to buy back our existing indebtedness from
IBM Credit, including a one-time payment on or before June 30, 2003 of $30
million. Payment of this amount will constitute complete satisfaction of any
and all of our obligations to IBM Credit. Provided that there has not
earlier occurred a "Termination Event," as defined in the Forbearance
Agreement, at the end of the forbearance period, the provisions of the
Forbearance Agreement shall become of no force and effect. At that time, if
the repayment terms of the Forbearance Agreement are not met, IBM Credit
shall be free to exercise and enforce, or to take steps to exercise and
enforce, all rights, powers, privileges and remedies available to them under
the IBM Credit Agreement, as a result of the payment and covenant defaults
existing on March 24, 2003. If we are not successful in satisfying the
payment obligations under the Forbearance Agreement or we do not comply with
the terms of the Forbearance Agreement or the IBM Credit Agreement, IBM
Credit will enforce its rights against the collateral securing the
obligations to IBM
55
Credit and, as a result there would be substantial doubt that we would be
able to continue as a going concern and you are at risk of losing your
entire investment.
IF WE ARE UNABLE TO CONTINUE AS A GOING CONCERN, YOU COULD LOSE
THE ENTIRE VALUE OF YOUR INVESTMENT.
Our financial statements have been prepared on a going concern
basis. Our ability to continue as a going concern is predicated upon
numerous factors with varying levels of importance as follows:
o First, we must successfully repay all of our debt
obligations to IBM Credit;
o Second, we must obtain shareholder approval of the terms
of the severance agreements with our former officers and
directors as more fully discussed in Note 10 to the
Condensed Consolidated Financial Statements;
o Third, we must successfully implement our business plans,
manage expenditures according to our budget, and generate
positive cash flow from operations so that we can become
profitable and generate sufficient cash flow to meet our
operating needs;
o Fourth, we must develop an effective marketing and sales
strategy in order to grow our business and compete
successfully in our markets;
o Fifth, we must obtain the necessary approvals to expand
the market for the VeriChip product;
o Sixth, we must realize positive cash flow with respect
to our investment in Digital Angel Corporation in order to
provide us with an appropriate return on our investment; and
o Finally, we must complete the development of the second
generation Digital Angel product in order to improve the
product's salability.
OUR FAILURE TO REMAIN CASH FLOW POSITIVE ON A CONSOLIDATED BASIS
SUBSEQUENT TO MAY 2, 2003, WILL RESULT IN A TERMINATION EVENT AS DEFINED
UNDER THE FORBEARANCE AGREEMENT ALLOWING IBM CREDIT TO IMMEDIATELY EXERCISE
ITS RIGHTS AND REMEDIES UNDER THE TERMS OF THE IBM CREDIT AGREEMENT.
Beginning on May 2, 2003, we have been able to provide for our
operating expenses with funds provided by our business operations as
required under the Forbearance Agreement. However, if we fail to maintain a
positive cash flow from operations at all times subsequent to May 2, 2003,
it would result in a "Termination Event," as defined in the Forbearance
Agreement, and IBM Credit shall be free to exercise and enforce, or to take
steps to exercise and enforce, all rights, powers, privileges and remedies
available to them under the IBM Credit Agreement.
OUR FAILURE TO OBTAIN ADDITIONAL FUNDING WILL HAVE A SUBSTANTIAL
NEGATIVE IMPACT ON OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
The IBM Credit Agreement prohibits us from borrowing funds from
other lenders without IBM Credit's approval and does not provide for
additional funding. It is possible that we will not have access to funds
necessary to provide for our ongoing operating expenses. Failure to obtain
additional funding will have a material adverse effect on our business,
financial condition and results of operations.
56
See the risk factor entitled, "If we are not successful in
satisfying the payment obligations under the Forbearance Agreement or we do
not comply with the terms of the Forbearance Agreement or the IBM Credit
Agreement, there is substantial doubt that we will be able to continue as a
going concern."
WE HAVE A HISTORY OF OPERATING LOSSES AND NEGATIVE CASH FLOW AND WE
MAY NOT BECOME PROFITABLE IN THE FUTURE.
We incurred net losses from continuing operations of $26.8 million,
$113.9 million, $188.6 million and $29.2 million during the three-months
ended March 31, 2003, and for the years ended December 31, 2002, 2001 and
2000, respectively. Our consolidated operating activities used cash of $3.7
million, $3.9 million, $18.0 million and $43.4 million during the
three-months ended March 31, 2003, and during 2002, 2001 and 2000,
respectively. We have funded our operating cash requirements, as well as our
capital needs, during these periods with the proceeds from our investing
and/or our financing activities. We may not be able to generate sufficient
operating cash flow in the future to meet our operating expenses.
As of March 31, 2003, we reported no revenues from the sale of our
VeriChip(TM), Bio Thermo(TM) and Thermo Life(TM) products and we have had
minimal sales of our Digital Angel product. We believe that absent
significant improvement the sales of our Digital Angel, Bio Thermo, VeriChip
and Thermo Life products, our future business operations are unlikely to
provide sufficient cash flow to support our operational requirements. Our
sources of liquidity in the future may include proceeds from the sale of
common stock and preferred stock, proceeds from the sale of businesses,
proceeds from the sale of the Digital Angel Corporation common stock owned
by us, proceeds from the exercise of stock options and warrants, and the
raising of other forms of debt or equity through private placement or public
offerings. However, we may not be able to obtain sufficient additional
financing to meet such requirements on terms acceptable to us, or at all.
Our failure to obtain additional funding could have a materially adverse
effect on our business, financial condition and results of operations, and
may result in our inability to continue operations in the normal course of
business.
IF WE ARE REQUIRED TO SELL THE SHARES HELD IN THE DIGITAL ANGEL
TRUST, IT WILL HAVE A SUBSTANTIAL NEGATIVE IMPACT ON OUR BUSINESS, FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
According to the terms of the trust agreement for the Digital Angel
Trust, if the amounts we owe IBM Credit are not paid when due, or if we
otherwise default under the Forbearance Agreement or the IBM Credit Agreement,
IBM Credit will have the right to require that the shares of the Digital Angel
Corporation common stock held in the Digital Angel Trust be sold to provide
funds to satisfy our obligations to IBM Credit. We have agreed under the
terms of the Forbearance Agreement that the Digital Angel Trust will
immediately engage an investment bank to pursue the sale of the 19,600,000
shares of Digital Angel Corporation common stock that are currently held in
the Digital Angel Trust. All proceeds from the sale of the Digital Angel
Corporation common stock will be applied to the loans and other obligations
to satisfy certain obligations to IBM Credit, in the event that the Company
has not satisfied its purchase rights by September 30, 2003.
If we are required to sell the shares held in the Digital Angel
Trust for an amount less than our current book value, we would incur a
significant non-cash charge and our financial position and operating results
would be materially adversely effected.
In addition, under the terms of the employment agreement dated
March 8, 2002, as amended, by and between Digital Angel Corporation and
Randolph K. Geissler (the President and Chief Executive Officer of Digital
Angel Corporation), a "change in control" occurs under that employment
agreement if
57
any person becomes the "beneficial owner" (as defined in Rule 13d-3 under
the Securities Exchange Act of 1934), directly or indirectly, of securities
of Digital Angel Corporation representing 20% or more of the combined voting
power of the then outstanding shares of common stock. Therefore, if the
Digital Angel Trust were required to sell more than approximately 5.3
million shares of Digital Angel Corporation's common stock, such sale would
constitute a change in control under the employment agreement with Mr.
Geissler. Upon the occurrence of a change in control, Mr. Geissler, at his
sole option and discretion, may terminate his employment with Digital Angel
Corporation at any time within one year after such change in control upon 15
days' notice. In the event of such termination, the employment agreement
provides that Digital Angel Corporation must pay to Mr. Geissler a severance
payment equal to three times the base amount as defined in Section
280G(b)(3) of the Internal Revenue Code of 1986, as amended, minus $1.00 (or
a total of approximately $750,000), which would be payable no later than one
month after the effective date of Mr. Geissler's termination of employment.
In addition, upon the occurrence of a change of control under the employment
agreement, all outstanding stock options held by Mr. Geissler would become
fully exercisable.
The employment agreement also provides that upon:
o a change of control;
o the termination of Mr. Geissler's employment for any reason
other than due to his material default under the employment
agreement; or
o if he ceases to be Digital Angel Corporation's President and
Chief Executive Officer for any reason other than termination
due to his material default under the employment agreement,
within 10 days of the occurrence of any such events, Digital
Angel Corporation is to pay to Mr. Geissler $4,000,000.
Digital Angel Corporation may pay such amount in cash or in
its common stock or with a combination of cash and common
stock. The employment agreement also provides that if the
$4,000,000 is paid in cash and stock, the amount of cash paid
must be sufficient to cover the tax liability associated with
such payment, and such payment shall otherwise be structured
to maximize tax efficiencies to both Digital Angel
Corporation and Mr. Geissler.
Also, effective October 30, 2002, Digital Angel Corporation entered
into a Credit and Security Agreement with Wells Fargo. The Credit and
Security Agreement provides that a "change in control" under that agreement
results in a default. A change in control is defined as either Mr. Geissler
ceasing to actively manage Digital Angel Corporation's day-to-day business
activities or the transfer of at least 25% of the outstanding shares of
Digital Angel Corporation's common stock. Also, if Digital Angel Corporation
owes Mr. Geissler $4,000,000 under his employment agreement, the obligation
would most likely result in a breach of Digital Angel Corporation's
financial covenants under the Credit and Security Agreement. If these
defaults occurred and were not waived by Wells Fargo, and if Wells Fargo
were to enforce these defaults under the terms of the Credit and Security
Agreement and related agreements, Digital Angel Corporation's and the
Company's business and financial condition would be materially and adversely
affected, and it may force Digital Angel Corporation to cease operations.
WE ARE REQUIRED TO ISSUE ADDITIONAL SHARES OF COMMON STOCK IN
CONNECTION WITH SEVERANCE AGREEMENTS WITH OUR FORMER EXECUTIVE OFFICERS AND
DIRECTORS AND, AS A RESULT, OUR STOCK WILL BE FURTHER DILUTED.
On March 21, 2003, we entered into severance agreements with
Richard J. Sullivan, our then Chairman of the Board of Directors and Chief
Executive Officer, and Jerry C. Artigliere, our then Senior Vice President
and Chief Operating Officer. The severance agreements provide for the
payment of 56.0
58
million and 4.75 million shares of our common stock to Richard Sullivan and
Jerome Artigliere, respectively. In addition, stock options held by Richard
Sullivan and Jerome Artigliere, which were exercisable for approximately
10.9 and 2.3 million shares of our common stock, respectively, were
re-priced. The options surrendered had exercise prices ranging from $0.15 to
$0.32 per share and were replaced with options exercisable at $0.01 per
share. As a result of the termination of Richard Sullivan's employment with
the Company, a "triggering event" provision in the severance agreement we
entered into with Garrett Sullivan, our former Vice Chairman of the Board
(who is not related to Richard Sullivan), at the time of Garrett Sullivan's
ceasing to serve in such capacity in December 2001, has been triggered. We
recently negotiated a settlement of our obligations under Garrett Sullivan's
severance agreement that requires us to issue to him 7.5 million shares of
our common stock on our before August 31, 2003. The issuance of these shares
to our former executive officers and directors, which is subject to
shareholder approval, and the exercise of the re-priced options, will result
in an increase in the total number of our shares outstanding and may result
in investors experiencing a dilution in the net tangible book value per
share of our common stock.
IF SHAREHOLDERS DO NOT APPROVE THE TERMS OF THE SEVERANCE
AGREEMENTS WITH OUR FORMER EXECUTIVE OFFICERS AND DIRECTORS OR WE LACK A
SUFFICIENT NUMBER OF AUTHORIZED SHARES OF COMMON STOCK TO EFFECT THE SHARE
ISSUANCES PROVIDED FOR BY SUCH SEVERANCE AGREEMENTS, OUR FORMER EXECUTIVE
OFFICERS AND DIRECTORS MAY TAKE ACTION TO ENFORCE THEIR RIGHTS UNDER THEIR
EMPLOYMENT AGREEMENTS WITH US. THIS COULD RESULT IN OUR BEING UNABLE TO
CONTINUE OPERATIONS IN THE NORMAL COURSE OF BUSINESS.
The severance agreements entered into with our former executive
officers and directors provide for their receipt of shares of our common
stock and re-priced options in lieu of all future compensation and other
benefits that would have been owed to them under their employment
agreements. The employment agreements required us to make payments in the
aggregate amount of approximately $22.0 million. The terms of each of the
severance agreements are subject to shareholder approval, in accordance with
applicable Nasdaq rules, because the agreements (i) are deemed to be
compensatory arrangements under which our common stock may be acquired by
officers or directors, and (ii) in Richard Sullivan's case, it may result in
his potentially holding more than 20% of the outstanding shares of our
common stock following the issuance of the shares and exercise of options
covered by his severance agreement. We intend to include proposals in our
proxy statement for our 2003 annual meeting of shareholders to solicit
shareholder approval of the terms of such agreements, as well as an increase
in the number of authorized shares of our common stock, which may be
necessary to effect the share issuances under the severance agreements.
Should shareholders not approve the terms of the severance agreements or we
lack a sufficient number of authorized shares of common stock to effect the
share issuances provided under such agreements, our former officers and
directors may take actions against us to enforce the terms of their
employment agreements. Under such circumstances, there would be substantial
doubt that we would be able to continue operations in the normal course of
business. In such event, holders of our securities may face the loss of
their entire investment.
OUR STOCK PRICE HAS BEEN VOLATILE, AND HAS DECREASED SIGNIFICANTLY
OVER THE PAST FEW YEARS, AND YOU MAY BE UNABLE TO RESELL YOUR SHARES AT OR
ABOVE THE PRICE AT WHICH YOU ACQUIRED 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. Further, the market value of our common stock has declined
over the past few years in part due to our operating performance. In the
future, 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 affect our access to capital,
which may impact
59
our ability to continue as a going concern. In addition, declines in the
price of our common stock may harm employee morale and retention, curtail
investment opportunities presented to us, and negatively impact other
aspects of our business. As a result of these declines, you may be unable to
resell your shares at or above the price at which you acquired them.
IF WE ARE DELISTED FROM THE NASDAQ SMALLCAP MARKET IN THE FUTURE IT
MAY REDUCE THE LIQUIDITY OF OUR COMMON STOCK, WHICH WOULD IMPACT OUR ABILITY
TO RAISE FUNDS IN THE EQUITY MARKETS AND MAY REDUCE THE MARKET VALUE OF YOUR
INVESTMENT.
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. To
maintain our SmallCap listing, we must continue to comply with the
SmallCap's listing requirements and, prior to October 2003, regain the
minimum bid requirement of at least $1.00 per share for a minimum of
ten (10) consecutive trading days.
BECAUSE OF RECENT PERIODS OF VOLATILITY IN THE MARKET PRICE OF OUR
SECURITIES, WE FACE A HEIGHTENED RISK OF SECURITIES CLASS ACTION LITIGATION,
WHICH COULD SIGNIFICANTLY HARM OUR BUSINESS OPERATIONS AND FINANCIAL
CONDITION.
Because of recent periods of volatility in the market price of our
securities, we face a heightened risk of securities class action litigation.
In March 2003, we settled subject to court approval a purported securities
fraud class action, which was filed against us and one of our former
directors. While the class action was tentatively settled in March 2003,
additional 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 HAVE MADE SIGNIFICANT CHANGES TO OUR BUSINESS MODEL AND WE HAVE
EXPANDED INTO DIFFERENT PRODUCT LINES INCLUDING NEW UNPROVEN TECHNOLOGIES
AND THE NEW BUSINESS MODEL MAY NOT BE SUCCESSFUL.
During the past few years, we have made significant changes to our
business model as a result of a new business strategy and the expansion into
different product lines including new unproven technologies such as Digital
Angel and Thermo Life. If we are not successful in implementing our new
business model and developing and marketing our new technology products, our
advanced technology products may not gain sufficient market acceptance to be
profitable or otherwise be successful and the market price of our securities
will most likely decrease.
WE ARE REQUIRED TO ISSUE ADDITIONAL SHARES OF COMMON STOCK IN
CONNECTION WITH PRIOR ACQUISITIONS, AND AS A RESULT, YOUR INVESTMENT IN OUR
COMMON STOCK WILL BE FURTHER DILUTED.
As of May 9, 2003, there were 289,396,988 shares of our common
stock outstanding. Since January 1, 2001, we have issued a net aggregate of
187,910,287 shares of common stock, of which 97,261,634 shares were issued
in connection with acquisitions of businesses and assets and 64,810,635
60
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.
In addition, we have the authority to issue up to a total of
435,000,000 shares of common stock and up to 5,000,000 shares of preferred
stock without further stockholder approval, including shares, which could be
convertible into our common stock, subject to applicable SmallCap
requirements for issuing additional shares of stock. Were we to issue any
such shares, including the 50,000,000 shares being offered under our
Registration Statement on Form S-1 (File No. 333-102165) which became
effective on May 6, 2003, or enter into any other financing transactions,
the terms may have the effect of significantly diluting or adversely
affecting the holdings or the rights of the holders of our common stock.
THERE ARE ISSUED AND OUTSTANDING A SIGNIFICANT NUMBER OF DERIVATIVE
SECURITIES AND THE EXERCISE OF THESE OPTIONS AND WARRANTS MAY ADVERSELY
AFFECT THE MARKET PRICE OF OUR COMMON STOCK, AND COULD HAVE A NEGATIVE
IMPACT ON THE VALUE OF YOUR INVESTMENT IN OUR COMMON STOCK.
As of May 7, 2003, there were outstanding warrants and options to
acquire up to 37,124,926 additional shares of our common stock. In addition,
as of March 7, 2003, we had 80,710 additional shares of our common stock
available to be issued in the future under our stock option plans and
6,432,340 shares of our common stock available to be issued in the future
under our 1999 Employee Stock Purchase Plan. The exercise of outstanding
options and warrants and the sale in the public market of the shares
purchased upon exercise could have a negative impact on the value of your
investment in our common stock.
WE RELY HEAVILY ON OUR REVENUES DERIVED FROM OUR FEDERAL
TELECOMMUNICATIONS BUSINESS, AND THE LOSS OF, OR A SIGNIFICANT REDUCTION IN,
ORDERS FROM THE UNITED STATES GOVERNMENT COULD HAVE A MATERIAL ADVERSE
EFFECT ON OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Approximately $9.3 million, or 82.7%, $31.3 million, or 74.7%, and
$27.4 million, or 61.5%, of our Advanced Technology segment's revenues for
the three-months ended March 31, 2003, and for the years 2002 and 2001,
respectively, were generated by our wholly-owned subsidiary, Computer Equity
Corporation. Approximately 99.9%, 99.1% and 77.7% of Computer Equity
Corporation's revenues during the three-months ended March 31, 2003, and for
the years 2002 and 2001, respectively, were generated through sales to
various agencies of the United States Federal Government. Computer Equity
Corporation provides telecommunications products and services. Computer
Equity has less than one percent of the federal telecommunications market
share. Computer Equity's business is highly competitive, and we expect that
the competitive pressures we face will not diminish in the future. Many of
our competitors have greater financial, technological, marketing and other
resources than we do. The loss of, or a significant reduction in, federal
telecommunications orders could have a material adverse effect on our
financial condition and results of operations.
61
DIGITAL ANGEL CORPORATION COMPETES WITH OTHER COMPANIES IN THE
VISUAL AND ELECTRONIC IDENTIFICATION MARKET, AND THE PRODUCTS SOLD BY ITS
COMPETITORS COULD BECOME MORE POPULAR THAN ITS PRODUCTS OR RENDER ITS
PRODUCTS OBSOLETE, WHICH COULD HAVE A MATERIAL ADVERSE AFFECT ON OUR
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The market for visual and electronic identification for companion
animals and livestock is highly competitive. We believe that our principal
competitors in the visual identification market for livestock are AllFlex
USA and Y-Tex Corporation, and that our principal competitors in the
electronic identification market that have developed permanent electronic
identification devices for the companion animal market are AllFlex USA,
Datamars SA and Avid Plc. In addition, other companies could enter this line
of business in the future. Some of Digital Angel Corporation's competitors
have substantially greater financial and other resources than they do.
Digital Angel Corporation may not be able to compete successfully with those
competitors, and those competitors may develop or market technologies and
products that are more widely accepted than its products or that could
render its products obsolete or noncompetitive, which could have a material
adverse affect on our financial condition and results of operations. We are
not currently aware of any other competitors currently marketing products
that would compete directly with the Digital Angel product. However, we are
aware of several potential competitors that have expressed an interest in
similar technologies. There is no substantial revenue from product sales of
any participant in the market for the Digital Angel product.
OUR DIGITAL ANGEL CORPORATION'S ANIMAL APPLICATIONS DIVISION RELIES
HEAVILY ON SALES TO GOVERNMENT CONTRACTORS, AND ANY DECLINE IN THE DEMAND BY
THESE CUSTOMERS FOR ITS PRODUCTS COULD NEGATIVELY AFFECT OUR BUSINESS.
The principal customers for electronic identification devices for
fish are government contractors that rely on funding from the United States
government. Because the contractors rely heavily on government funds, any
decline in the availability of such funds could result in a decreased demand
by these contractors for Digital Angel Corporation's products. Any decrease
in demand by such customers could have a material adverse effect on our
financial condition and results of operations.
INFOTECH USA, INC. COMPETES IN A HIGHLY COMPETITIVE MARKET, AND IT
EXPECTS TO FACE FURTHER COMPETITION FROM NEW MARKET ENTRANTS AND POSSIBLE
ALLIANCES BETWEEN COMPETITORS IN THE FUTURE, WHICH COULD HAVE A MATERIAL
ADVERSE EFFECT ON OUR FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS.
InfoTech USA, Inc. competes in a highly competitive market with IT
products and services providers that vary greatly in their size and
technical expertise. Its primary competitors are Manchester Technologies,
Inc., AlphaNet Solution, Inc., En Pointe Technologies, Inc.,
Micros-to-Mainframes, Inc., and Pomeroy Computer Resources. Additionally, we
expect InfoTech USA, Inc. to face further competition from new market
entrants and possible alliances between competitors in the future, which
could have a material adverse effect on our financial condition and results
of operations.
WE DEPEND GREATLY ON OUR SMALL TEAM OF SENIOR MANAGEMENT AND KEY
PERSONNEL, AND WE MAY HAVE DIFFICULTY ATTRACTING AND RETAINING ADDITIONAL
PERSONNEL; THE LOSS OF THE SERVICES OF ANY OF SUCH PERSONNEL COULD
MATERIALLY HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The success of our business depends on the continued service of our
executive officers and key personnel. Some of these employment contracts
call for bonus arrangements based on earnings. Presently, we have not
experienced problems recruiting and retaining qualified personnel. However,
in the future, we may not be successful in retaining our key employees or
in attracting and retaining
62
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.
THE BOOK VALUE OF OUR INVENTORY HAS INCREASED AND 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 OUR INVENTORY AT THE PRICES WE ANTICIPATE.
On March 31, 2003, the book value of our inventory was $7.8 million as
compared to a book value of $6.4 million as of December 31, 2002. We
attribute the increase primarily to the accumulation of inventory by Digital
Angel Corporation in anticipation of current year sales. Our success depends
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.
WE DEPEND ON A SINGLE PRODUCTION ARRANGEMENT WITH RAYTHEON
CORPORATION FOR OUR PATENTED SYRINGE-INJECTABLE MICROCHIPS WITHOUT THE
BENEFIT OF A FORMAL WRITTEN AGREEMENT, AND THE LOSS OF OR ANY SIGNIFICANT
REDUCTION IN THE PRODUCTION COULD HAVE AN ADVERSE EFFECT ON OUR BUSINESS.
We rely solely on a production arrangement with Raytheon
Corporation for the manufacture of our patented syringe-injectable
microchips that are used in all of our implantable electronic identification
products, but we do not have a formal written agreement with Raytheon.
Raytheon utilizes our proprietary technology and our equipment in the
production of our syringe-injectable microchips. The termination, or any
significant reduction, by Raytheon of the assembly of our microchips or a
material increase in the price charged by Raytheon for the assembly of our
microchips could have an adverse effect on our financial condition and
results of operations. In addition, Raytheon may not be able to produce
sufficient quantities of the microchips to meet any significant increased
demand for our products or to meet any such demand on a timely basis. Any
inability or unwillingness of Raytheon to meet our demand for microchips
would require us to utilize an alternative production arrangement and remove
our automated assembly production machinery from the Raytheon facility,
which would be costly and could delay production. Moreover, if Raytheon
terminates our production arrangement, we cannot ensure that the assembly of
our microchips from another source would be on comparable or acceptable
terms. The failure to make such an alternative production arrangement could
have an adverse effect on our business.
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. The 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.
IF WE DO NOT PREVAIL IN ONGOING LITIGATION, WE MAY BE REQUIRED TO
PAY SUBSTANTIAL DAMAGES.
In addition to the litigation described in this Form 10-Q under the
section entitled Legal Proceedings, we are party to various legal actions as
either plaintiff or defendant in the ordinary course of
63
business. 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.
OUR INTELLECTUAL PROPERTY RIGHTS OR PATENT RIGHTS MIGHT NOT PROVIDE
PROTECTION AND MIGHT BE INVALID OR UNENFORCEABLE.
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. The patent applications licensed to or
owned by us may not result in issued patents, patent protection may not be
secured for any particular technology, any patents that have been or may be
issued to us may not be valid or enforceable and patents issued may not
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 years. VeriChip Corporation may be unable to retain
licensing rights to the use of these patents beyond the licensing period or
the license may be terminated early.
OUR FAILURE TO COMPLY WITH APPLICABLE REGULATORY REQUIREMENTS
REGARDING VERICHIP CAN, AMONG OTHER THINGS, RESULT IN FINES, SUSPENSIONS OF
REGULATORY APPROVALS, PRODUCT RECALLS, OPERATING RESTRICTIONS AND CRIMINAL
PROSECUTION.
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 (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. However, the FDA further
stated in its determination letter that with respect to the use of the
VeriChip product in healthcare 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 healthcare
information applications of the product, subject to any and all necessary
FDA and other approvals. It is possible that the required FDA regulatory
reviews will not be conducted in a timely manner or that regulatory
approvals will not 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 CORPORATION IS SUBJECT TO GOVERNMENT REGULATION AND
ANY ACTION ON THE PART OF REGULATORS COULD HAVE A MATERIAL ADVERSE EFFECT ON
DIGITAL ANGEL CORPORATION'S BUSINESS.
Digital Angel Corporation 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
Corporation develops, assembles and markets a broad line of electronic and
visual identification devices for the companion animal, livestock and
wildlife markets. Digital Angel Corporation'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 Corporation 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
64
Angel Corporation's primary business and do not represent a material part of
its operations or revenues. Digital Angel Corporation's products also are
subject to compliance with foreign government agency requirements. Digital
Angel Corporation'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
Corporation'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
Corporation's business.
THE THERMO LIFE TECHNOLOGY HAS NOT YET BEEN DEVELOPED FOR
COMMERCIAL DEPLOYMENT, AND THERE IS NO CERTAINTY THAT THIS TECHNOLOGY WILL
BE SUCCESSFULLY MARKETED.
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. However, there is no certainty that this
technology will be successfully marketed or generate material sales revenue.
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. In addition, based upon our annual
goodwill impairment review performed during the fourth quarter of 2002, we
impaired certain goodwill and software related to Digital Angel Corporation.
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.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Digital Angel Corporation has a foreign subsidiary operating in the
United Kingdom. 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 and borrowings under Digital Angel Corporation's mortgage notes
payable 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 (less than three month)
investments.
Due to the nature of our short-term investments, and we have concluded
that there is no material market risk exposure and, therefore, no
quantitative tabular disclosure is required. Due to the de
65
minimus amounts of foreign currency exchange gains and losses and
translation adjustments during the three-months ended March 31, 2003, a
sensitivity analysis of fluctuations in foreign currency exchange rates is
not required.
The table below presents the principal amount and weighted-average
interest rate for our debt portfolio:
Carrying Value at
Dollars in Millions March 31, 2003*
-------------------------------------------------------------------------------
Total notes payable and long-term debt $85.3
Notes payable bearing interest at fixed interest rates $81.5
Weighted-average interest rate for the three-months
ended March 31, 2003 21.4%
<FN>
*Due to the current default and resulting Forbearance Agreement
with respect to the IBM debt, it is not practicable to determine the fair
value of the Company's notes payable and long-term debt.
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 the end of the quarterly period ended March 31, 2003.
Based on that evaluation, they have concluded that the Company's disclosure
controls and procedures as of the end of the period covered by this report
are effective in timely providing them with material information relating to
the Company required to be disclosed in the reports the Company files or
submits under the Exchange Act. The Company's disclosure controls and
procedures are designed to provide reasonable assurances of achieving their
objectives and the Company's Chief Executive Officer and Chief Financial
Officer have concluded that the Company's disclosure controls and procedures
are effective in reaching that level of reasonable assurance.
(b) Internal Control Over Financial Reporting
There have not been any changes in the Company's internal controls
over financial reporting identified in connection with an evaluation thereof
that occurred during the Company's first fiscal quarter that have materially
affected, or are reasonably likely to materially affect the Company's
internal control over financial reporting. There were no significant
deficiencies or material weaknesses, and therefore no corrective actions
were taken.
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We, and certain of our subsidiaries, are parties to various legal
actions as either plaintiff or defendant and accordingly, have recorded
certain reserves in our financial statements as of March 31, 2003. 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.
66
On January 31, 2002, Treeline, Inc. filed a complaint in the Common
Pleas Court of Cuyahoga County, Ohio against us, and one of our
subsidiaries, STR, Inc., now known as ARJANG, Inc. ("STR") and another
defendant who was formerly an executive of STR, alleging that STR breached
its lease agreement with Treeline, Inc. in connection with a facility no
longer being used by us. The complaint alleges that we, and the former
executive of STR, are liable as Guarantors of the lease for damages
sustained by Treeline as a result of the alleged breach. The plaintiff
demanded monetary relief of an unspecified amount.
On March 31, 2002, 510 Ryerson Road Inc. filed a lawsuit in the
Superior Court of New Jersey, Essex County 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 plaintiffs
have demanded relief in the amount of $2.0 million. The trial date,
originally set for December 2002, has been postponed until July 2003.
On May 20, 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 consolidated into a single action, In re
Applied Digital Solutions Litigation, which was filed in the United States
District Court for the Southern District of Florida. In March 2003, we
entered into a memorandum of understanding to settle the pending lawsuit.
The settlement of $5.6 million will be entirely covered by proceeds form
insurance, and is subject to approval by the District Court and review by an
independent special litigation committee.
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 for unspecified damages. The complaint alleged that
the defendants made false and misleading statements about Applied Digital
Solutions, Inc.'s business and financial performance. The Missouri action
was voluntarily dismissed and re-filed in federal court in the Southern
District of Florida. The Florida action was voluntarily dismissed with
prejudice on March 7, 2003.
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
(also referred to as Transatlantic Software Corporation) was purchased by us
through the issuance of our common stock. The complaint alleged that we are
liable for a shortfall of approximately $565,000 created under the price
protection provision of the loan. During the second quarter of 2003, the
plaintiff voluntarily dismissed this action. The plaintiff agreed to pay our
attorney's fees in connection with the case.
On May 29, 2001, Janet Silva, individually and as Guardian ad Litem
for Jonathan Silva, a minor, and the Estate of Clarence William Silva, Jr.
(collectively, "Plaintiffs") filed suit against Customized Services
Administrators, Incorporated ("CSA"), Pricesmart, Inc. ("Pricesmart"),
Commercial Union Insurance Company ("Commercial Union"), CGU Insurance
Group, and Digital Angel Corporation (collectively the "Defendants") in the
Superior Court of the State of California in and for the County of Santa
Clara. The allegations of the complaint arise from a vacation guarantee
insurance policy (the "Insurance Contract") allegedly purchased by
Plaintiffs from Defendants on March 6, 2000. The complaint alleges, among
other things, that Defendants breached the Insurance Contract, defrauded
Plaintiffs, acted in bad faith, and engaged in deceptive and unlawful
business practices, resulting in the wrongful death of Clarence William
Silva, Jr. (the "Deceased") and the intentional infliction of
67
emotional distress on Plaintiffs. The complaint seeks the cost of funeral
and burial expenses of the Deceased and amounts constituting the loss of
financial support of the Deceased, general damages, attorney's fees and
costs, and exemplary damages of an unspecified amount. CSA has filed a
cross-claim against Digital Angel Corporation alleging that Digital Angel
Corporation should be held liable for any liability that CSA may have to
Plaintiffs. Digital Angel Corporation has denied the allegations of the
complaint and the CSA cross-claim and is vigorously contesting all aspects
of this action.
ITEM 2. CHANGES IN SECURITIES
Recent Sales of Unregistered Securities
The following table lists all unregistered securities sold by the
Company between January 1, 2003, and March 31, 2003. These shares were
issued in for settlement of debt for services performed. 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 AMOUNT NUMBER OF NOTE ISSUED FOR NUMBER OF
OF CONSIDERATION PERSONS COMMON
SHARES
- -----------------------------------------------------------------------------------------------------------------
Integral, Inc. February 2003 $68,000 1 1 Settlement 170,000
-----------
Total 170,000
===========
<FN>
1. Represents shares issued in connection with the settlement of a debt
for services performed, 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 acquiring 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. Norman W. Gorin, Chief Financial Officer, has sole voting
and dispositive power with respect to the shares held by Integral, Inc.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Under the terms of the IBM Credit Agreement we were required to
repay IBM Credit $29.8 million of the $77.2 million outstanding principal
balance currently owed to them, plus $16.4 million of accrued interest and
expenses (totaling approximately $46.2 million), on or before February 28,
2003. We did not make such payment by February 28, 2003. On March 3, 2003,
IBM Credit notified us that we had until March 6, 2003, to make the payment.
We did not make the payment on March 6, 2003, as required. Our failure to
comply with the payment terms imposed by the IBM Credit Agreement and to
maintain compliance with the financial performance covenant constitute
events of default under the IBM Credit Agreement. On March 7, 2003, we
received a letter from IBM Credit declaring the loan in default and
indicating that IBM Credit would exercise any and/or all of its remedies.
The total amount of principal and interest due to IBM Credit at March 31,
2003, was $92.1 million.
On March 27, 2003, we announced that we had executed a forbearance
agreement term sheet with IBM Credit. The Forbearance Agreement became
executed on April 2, 2003, and grants us more favorable loan repayment terms
and more time in which to meet our current obligations to IBM Credit. It
contains various purchase rights for us to buy back our existing
indebtedness from IBM Credit, including a one-time payment on or before June
30, 2003 of $30 million. Payment of this amount will constitute complete
satisfaction of any and all of our obligations to IBM Credit. Provided that
there has not earlier occurred a "Termination Event," as defined in the
Forbearance Agreement, at the end of the forbearance period, the provisions
of the Forbearance Agreement shall become of no force and effect. At that
time, if the repayment terms of the Forbearance Agreement are not met, IBM
Credit shall be free to exercise and enforce, or to take steps to exercise
and enforce, all rights, powers, privileges and remedies available to them
under the IBM Credit Agreement, as a result of the payment and covenant
defaults existing on March 24, 2003. If we are not successful in satisfying
the payment obligations under the Forbearance
68
Agreement or we do not comply with the terms of the Forbearance Agreement or
the IBM Credit Agreement, IBM Credit will enforce its rights against the
collateral securing the obligations to IBM Credit and, as a result there
would be substantial doubt that we would be able to continue as a going
concern.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
WEBSITE ACCESS TO INFORMATION AND DISCLOSURE OF WEB ACCESS TO COMPANY
REPORTS
Our website address is: http://www.adsx.com. We make available free
of charge through our website our Annual Report on Form 10-K, our Quarterly
Reports on Form 10-Q, our Current Reports on Form 8-K, and all amendments to
those reports as soon as reasonably practicable after such material is
electronically filed with the SEC.
69
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
(i) On March 4, 2003, we filed a Current Report on
Form 8-K, which reported the failure to make a
required payment on February 28, 2002, under the
Third Amended and Restated Term Credit Agreement
with IBM Credit LLC (formerly IBM Credit
Corporation).
(ii) On March 7, 2003, we filed a Current Report on
Form 8-K, which reported the failure to make a
required payment on March 6, 2003, under the Third
Amended and Restated Term Credit Agreement with IBM
Credit LLC and certain litigation filed against IBM
Credit LLC and IBM Corporation.
(iii) On March 7, 2003, we filed a Current Report
on Form 8-K, which reported that we had received a
notice of default under the Third Amended and
Restated Term Credit Agreement.
(iv) On March 10, 2003, we filed a Current Report
on Form 8-K, which reported that we had
conditionally settled the pending and consolidated
shareholder class action lawsuit.
(v) On March 27, 2003, we filed a Current Report on
Form 8-K announcing that we had agreed to the terms
of a Forbearance Agreement with IBM Credit, that
Richard J. Sullivan retired effective March 21,
2003, and that Scott R. Silverman had assumed the
titles of Chairman and Chief Executive Officer.
(vi) On April 3, 2003, we filed a Current Report on
Form 8-K, which contained our earning release dated
April 1, 2003.
70
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: February 23, 2004 By: /S/ EVAN C. MCKEOWN
------------------------------------
Evan C. McKeown
Senior Vice President, Chief
Financial Officer
71
EXHIBITS
2.1 Agreement of Purchase and Sale dated as of June 4, 1999 by and
among Intellesale.com, Inc., Applied Cellular Technology, Inc.,
David Romano and Eric Limont (incorporated by reference to Exhibit
99.1 to the registrant's Current Report on Form 8-K filed with the
Commission on June 11, 1999, as amended on August 12, 1999)
2.2 Amendment No. 1 to the Agreement of Purchase and Sale, dated as of
June 9, 1999 by and among Intellesale.com, Inc., Applied Cellular
Technology, Inc., David Romano and Eric Limont (incorporated by
reference to Exhibit 99.2 to the registrant's Current Report on
Form 8-K filed with the Commission on June 11, 1999, as amended on
August 12, 1999)
2.3 Agreement and Plan of Merger, dated April 24, 2000, by and among
the Applied Digital Solutions, Inc., Digital Angel Corporation and
Destron Fearing Corporation (incorporated by reference to Exhibit
2.1 to the registrant's Current Report on Form 8-K filed with the
Commission on May 1, 2000)
2.4 Agreement dated as of November 28, 1999 by and between AT&T Canada
Corp. and TigerTel, Inc. (incorporated by reference to Exhibit 99.1
to the registrant's Current Report on Form 8-K filed with the
Commission on December 13, 1999, as amended on December 22, 1999
and January 11, 2000)
2.5 Agreement and Plan of Merger dated as of June 30, 2000 by and among
the Applied Digital Solutions, Inc. and Compec Acquisition Corp. and
Computer Equity Corporation and John G. Ballenger, Christopher J.
Ballenger and Frederick M. Henschel (incorporated by reference to
Exhibit 2 to the registrant's Current Report on Form 8-K filed with the
Commission on July 14, 2000, as amended on September 11, 2000)
2.6 Agreement and Plan of Merger dated as of October 18, 2000, by and
among the Applied Digital Solutions, Inc. and PDS Acquisition
Corp., and Pacific Decision Sciences Corporation, and H&K Vasa
Family 1999 Limited Partnership, H&K Vasa Family 2000 Limited
Partnership, David Dorret, and David Englund (incorporated by
reference to Exhibit 2 to the registrant's Current Report on Form
8-K filed with the Commission on November 1, 2000, as amended on
December 29, 2000)
2.7 MCY Agreement dated as of October 19, 2000 by and between MCY.com,
Inc. and Applied Digital Solutions, Inc. (incorporated by reference to
Exhibit 2 to the registrant's Current Report on Form 8-K filed with the
Commission on December 5, 2000)
2.8 Agreement and Plan of Merger, dated as of July 1, 2000, by and
among Applied Digital Solutions, Inc., Web Serve Acquisition Corp.,
WebNet Services, Inc., Steven P. Couture, Jeffrey M. Couture and
Raymond D. Maggi (incorporated by reference to Exhibit 2.8 to the
registrant's Annual Report on Form 10-K/A filed with the
Commission on December 11, 2003)
3.1 Amended and Restated Bylaws of the Company dated March 31, 1998
(incorporated by reference to Exhibit 3.4 to the registrant's
Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2002
filed with the Commission on August 14, 2002)
3.2 Amendment to Bylaws of the Company dated April 4, 2002
(incorporated by reference to Exhibit 3.4 to the registrant's
Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2002
filed with the Commission on August 14, 2002)
3.3 Second Restated Articles of Incorporation of the Registrant
(incorporated herein by reference to Exhibit 4.1 to the
registrant's Post-Effective Amendment No. 1 on Form S-1 to
Registration Statement (Form S-3 File No. 333-64605) filed with the
Commission on June 24, 1999)
3.4 Amendment of Articles of Incorporation of the Registrant 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
Registrant'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)
3.5 Amendment of Second Restated Articles of Incorporation of the
Registrant filed with the Secretary of State of Missouri on July
18, 2001 (incorporated herein by reference to Exhibit 4.3 to the
Registrant's Quarterly Report on Form 10-Q filed with the
Commission on August 17, 2001)
4.1 Second Restated Articles of Incorporation, of the Registrant
(incorporated herein by reference to Exhibit 4.1 to the
registrant's Post-Effective Amendment No. 1 on Form S-1 to
Registration Statement (Form S-3 File No. 333-64605) filed with the
Commission on June 24, 1999)
72
4.2 Amendment of Articles of Incorporation of the Registrant 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
registrant'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)
4.3 Amendment of Second Restated Articles of Incorporation of the
Registrant filed with the Secretary of State of Missouri on July
18, 2001 (incorporated herein by reference to Exhibit 4.3 to the
registrant's Quarterly Report on Form 10-Q filed with the
Commission on August 17, 2001)
4.4 Third Restated Articles of Incorporation of the Registrant filed
with the Secretary of State of Missouri on December 20, 2002
(incorporated herein by reference to Exhibit 4.4 to the
registrant's Registration Statement on Form S-1 (File No.
333-102165) filed with Commission on December 23, 2002.
4.5 Certificate of Designation of Preferences of Series C Convertible
Preferred Stock (incorporated herein by reference to Exhibit 3.1 to
the registrant's Current Report on Form 8-K filed with the
Commission on October 26, 2000)
4.6 Amended and Restated Bylaws of the Registrant dated March 31, 1998
(incorporated by reference to Exhibit 3.4 to the registrant's
Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2002
filed with the Commission on August 14, 2002)
10.1 1996 Non-Qualified Stock Option Plan of Applied Cellular Technology,
Inc., as amended through June 13, 1998 (incorporated herein by
reference to Exhibit 4.1 to the registrant's Registration
Statement on Form S-8 (File No. 333-91999) filed with the
Commission on December 2, 1999)
10.2 Applied Digital Solutions, Inc. 1999 Employees Stock Purchase
Plan, as amended through September 23, 1999 (incorporated herein
by reference to Exhibit 10.1 to the registrant's Registration
Statement on Form S-8 (File No. 333-88421) filed with the
Commission on October 4, 1999)
10.3 Applied Digital Solutions, Inc. 1999 Flexible Stock Plan
(incorporated herein by reference to Exhibit 4.1 to the
registrant's Registration Statement on Form S-8 (File No.
333-92327) filed with the Commission on December 8, 1999)
10.4 Credit Agreement between Applied Digital Solutions, Inc. and State
Street Bank and Trust Company dated as of August 25, 1998
(incorporated herein by reference to Exhibit 10.2 to the
registrant's Quarterly Report on Form 10-Q filed with the
Commission on November 16, 1998)
10.5 First Amendment to Credit Agreement between Applied Digital
Solutions, Inc. and State Street Bank and Trust Company dated as of
February 4, 1999 (incorporated by reference to Exhibit 10.3 the
registrant's Annual Report on Form 10-K filed with the Commission
on March 31, 1999)
10.6 Richard J. Sullivan Employment Agreement (incorporated by
reference to Exhibit 10.8 to the registrant's Annual Report on
Form 10-K filed with the Commission on March 30, 2000)*
10.7 Garrett A. Sullivan Employment Agreement (incorporated by
reference to Exhibit 10.9 to the registrant's Annual Report on
Form 10-K filed with the Commission on March 30, 2000)*
10.8 Letter Agreement, dated December 30, 2001, between Applied Digital
Solutions, Inc. and Garrett A. Sullivan (incorporated by reference
to Exhibit 10.13 to the registrant's Amendment to the Registration
Statement on Form S-1 (File No. 333-75928) filed with the
Commission on February 8, 2002)*
10.9 Jerome C. Artigliere Employment Agreement (incorporated by
reference to Exhibit 10.11 to the registrant's Annual Report on
Form 10-K filed with the Commission on April 10, 2001)*
10.10 Mercedes Walton Employment Agreement (incorporated by reference to
Exhibit 10.12 to the registrant's Annual Report on Form 10-K filed
with the Commission on April 10, 2001)*
10.11 David I. Beckett Employment Agreement (incorporated by reference to
Exhibit 10.13 to the registrant's Annual Report on Form 10-K filed
with the Commission on April 10, 2001)*
73
10.12 Michael E. Krawitz Employment Agreement (incorporated by reference
to Exhibit 10.14 to the registrant's Annual Report on Form 10-K
filed with the Commission on April 10, 2001)*
10.13 Dr. Peter Zhou Employment Agreement (incorporated by reference to
Exhibit 10.19 to the registrant's Amendment to the Registration
Statement on Form S-1 (File No. 333-75928) filed with the
Commission on February 8, 2002)*
10.14 Securities Purchase Agreement, dated as of October 24, 2000,
relating to the Registrant's Series C Convertible Preferred Stock
(incorporated by reference to Exhibit 10.1 to the registrant's
Current Report on Form 8-K filed with the Commission on October 26,
2000)
10.15 Form of warrant to purchase common stock of the Registrant issued
to the holders of the Series C Convertible Preferred Stock
(incorporated by reference to Exhibit 4.1 to the registrant's
Current Report on Form 8-K filed with the Commission on October 26,
2000)
10.16 Registration Rights Agreement between the Registrant and the
holders of the Series C Convertible Preferred Stock (incorporated
by reference to Exhibit 10.2 to the registrant's Current Report on
Form 8-K filed with the Commission on October 26, 2000)
10.17 Lock-Up Agreement dated as of November 28, 1999 by and among AT&T
Canada Corp. and Applied Digital Solutions, Inc. (incorporated by
reference to the Exhibit 99.2 to the registrant's Current Report on
Form 8-K filed with the Commission on December 13, 1999, as amended
on December 22, 1999 and January 11, 2000)
10.18 Voting Agreement by and among Applied Digital Solutions, Inc. and
certain security holders of Destron Fearing Corporation
(incorporated by reference to Exhibit 10.1 to the registrant's
Current Report on Form 8-K filed with the Commission on May 1,
2000)
10.19 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 registrant's Current Report on Form 8-K filed
with the Commission on March 8, 2002)
10.20 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)
10.21 Amendment to The Third Amended and Restated Term Credit Agreement
dated as of September 30, 2002, amending certain financial
covenants under the Third Amended and Restated Term Credit
Agreement (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)
10.22 Amendment to The Third Amended and Restated Term Credit Agreement
dated as of November 1, 2002, amending certain financial covenants
under the Third Amended and Restated Term Credit Agreement
(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)
10.23 Warrant Agreement between Applied Digital Solutions, Inc. and IBM
Credit Corporation dated August 21, 2002 (incorporated herein by
reference to Exhibit 10.21 to the registrant's Registration
Statement on Form S-1 (File No. 333-98799) filed with the
Commission on August 27, 2002)
10.24 Warrant Agreement between VeriChip Corporation and IBM Credit
Corporation dated August 21, 2002 (incorporated herein by reference
to Exhibit 10.22 to the registrant's Registration Statement on Form
S-1 (File No. 333-98799) filed with the Commission on August 27,
2002)
10.25 Agreement of Settlement and Release by and between Applied Digital
Solutions, Inc. and John G. Ballenger, Christopher J. Ballenger and
Frederick M. Henschel, dated July 17, 2002 (incorporated herein by
reference to Exhibit 10.23 to the registrant's Registration
Statement on Form S-1 (File No. 333-98799) filed with the Commission
on August 27, 2002)
74
10.26 Amendment to Agreement of Settlement and Release by and between
Applied Digital Solutions, Inc. and John G. Ballenger, Christopher
J. Ballenger and Frederick M. Henschel, dated August 23, 2002
(incorporated herein by reference to Exhibit 10.24 to the
registrant's Registration Statement on Form S-1 (File No.
333-98799) filed with the Commission on August 27, 2002)
10.27 Summary of Terms and Conditions setting forth the terms and
conditions of the Forbearance Agreement among IBM Credit LLC,
Applied Digital Solutions, Inc., Digital Angel Share Trust, and
their applicable subsidiaries (if any) dated March 24, 2003
(incorporated herein by reference to Exhibit 10.2 to the
registrant's Current Report on Form 8-K filed with the Commission
on March 27, 2002)
10.28 Forbearance Agreement, Consent and Amendment, dated as of April 2,
2003, with respect to the Third Amended and Restated Credit
Agreement, dated as of March 1, 2002 and amended as of September
30, 2002 and November 1, 2002 (as amended, supplemented, restated
or otherwise modified through the date hereof, the "Credit
Agreement"), among IBM Credit LLC, a Delaware limited liability
company, formerly IBM Credit Corporation ("IBM Credit"), Applied
Digital Solutions, Inc., a Missouri corporation ("ADS" or the
"Tranche B Borrower"), Digital Angel Share Trust, a Delaware
statutory business trust (in such capacity, the "Trust"; in its
capacity as a Borrower, the "Tranche A Borrower"; and together with
the Tranche B Borrower, the "Borrowers") and the other Loan Parties
party thereto (incorporated herein by reference to Exhibit 10.27 to
the registrant's Post-Effective Amendment No. 1 to Registration
Statement on Form S-1 (File No. 333-102165) filed with the
Commission on April 11, 2003)
10.29 Letter Agreement between Applied Digital Solutions, Inc. and R. J.
Sullivan (incorporated herein by reference to Exhibit 10.3 to the
registrant's Current Report on Form 8-K filed with the Commission
on March 27, 2002)*
10.30 Letter Agreement between Applied Digital Solutions, Inc. and J. C.
Artigliere (incorporated herein by reference to Exhibit 10.29 to
the registrant's Annual Report on Form 10-K filed with the
Commission on March 31, 2003)*
10.31 Placement Agency Agreement by and between Applied Digital
Solutions, Inc. and J.P. Carey Securities Inc. (incorporated
herein by reference to Exhibit 10.31 to the registrant's
Post-Effective Amendment No. 2 to Registration Statement on Form
S-1 (File No. 333-102165) filed with the Commission on April 17,
2003)
10.32 Letter Agreement between Applied Digital Solutions, Inc. and G.A.
Sullivan (incorporated herein by reference to Exhibit 10.30 of the
registrant's Annual Report on Form 10-K/A filed with the Commission
on February 17, 2004)*
10.33 International Distribution Agreement, dated March 8, 2003, by and
between VeriChip Corporation and the Company La Font, LTDA
(incorporated herein by reference to Exhibit 10.31 of the
registrant's Annual Report on Form 10-K/A filed with the Commission
on December 22, 2003)
10.34 Securities Purchase Agreement dated May 8, 2003, by and between
Applied Digital Solutions, Inc. and Cranshire Capital, L.P.
(incorporated herein by reference to Exhibit 10.48 of the
registrant's Pre-Effective Amendment No. 2 to Registration
Statement on Form S-1 (File No. 333-109512) filed with the
Commission on February 17, 2004)
10.35 Securities Purchase Agreement dated May 8, 2003, by and between
Applied Digital Solutions, Inc. and Magellan International Ltd.
(incorporated herein by reference to Exhibit 10.49 of the
registrant's Pre-Effective Amendment No. 2 to Registration
Statement on Form S-1 (File No. 333-109512) filed with the
Commission on February 17, 2004)
10.36 International Distribution Agreement, dated September 25, 2002, by
and between VeriChip Corporation and Sistemus de Proteccion
Integral de Mexico, S.A. de C.V. (incorporated herein by reference
to Exhibit 10.32 of the registrant's Annual Report on Form 10-K/A
filed with the Commission on December 11, 2003)
31.1 Certification by Scott R. Silverman, Chief Executive Officer,
pursuant to Exchange Act Rules 13A-14(a) and 15d-14(a)**
31.2 Certification by Evan C. McKeown, Chief Financial Officer,
pursuant to Exchange Act Rules 13A-14(a) and 15d-14(a)**
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002**
<FN>
- -------
* -Management contract or compensatory plan.
** -Filed herewith
75