AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON MARCH 15, 2004 AND AS
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AMENDED ON MARCH 16,2004, MAY 21, 2004 AND SEPTEMBER 24, 2004
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-K/A NO. 3
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 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: 000-26020
APPLIED DIGITAL SOLUTIONS, INC.
(Exact name of registrant as specified in its charter)
MISSOURI 43-1641533
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
1690 SOUTH CONGRESS AVENUE, SUITE 200
DELRAY BEACH, FLORIDA 33445
(Address of principal executive offices) (Zip code)
(561) 805-8000
(Registrant's telephone number,
including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $0.01 PAR VALUE
(Title of Class)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
At June 30, 2003, the last business day of our most recently completed second
fiscal quarter, the aggregate market value of the voting and non-voting common
stock held by non-affiliates, based upon the closing price of our stock on that
date of $6.00 per share was approximately $210,156,950.
At March 10, 2004, 50,289,399 shares of our common stock were outstanding. The
market value of our common stock held by non-affiliates on March 10, 2004, was
$170,555,604.
Documents Incorporated by Reference: None.
EXPLANATORY NOTE
The Registrant hereby amends its Annual Report on Form 10-K, as amended, for the
year ended December 31, 2003, filed by the Registrant on May 21, 2004, to
retroactively reflect its Medical Systems operations as part of its Discontinued
Operations.
2
Table of Contents
Item Description Page
Part I
1. Business 4
2. Properties 39
3. Legal Proceedings 40
4. Submission of Matters to a Vote of Security Holders 41
Part II
5. Market Price of the Registrant's Common Equity and Related
Stockholder Matters 42
6. Selected Financial Data 44
7. Management's Discussion and Analysis of Financial Condition
and Results of Operations 47
7a. Quantitative and Qualitative Disclosures About Market Risk 83
8. Financial Statements and Supplementary Data 84
9. Changes in and Disagreements With Accountants on
Accounting and Financial Disclosures 84
9a. Controls and Procedures 87
Part III
10. Directors and Executive Officers of the Registrant 88
11. Executive Compensation 92
12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters 99
13. Certain Relationships and Related Transactions 105
14. Principal Accountants Services and Fees 107
Part IV
15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 109
Signatures 110
Certifications
3
PART I
ITEM 1. BUSINESS
See "Risk Factors" beginning on page 28.
GENERAL
We are a Missouri corporation and were incorporated on May 11, 1993. Our
business has evolved during the past few years. We grew significantly through
acquisitions and since 1996 have completed 51 acquisitions. During the last half
of 2001 and during 2002, we sold or closed many of the businesses we had
acquired that we believed did not enhance our strategy of becoming an advanced
technology development company. These companies were primarily telephone system
providers, software developers, software consultants, networking integrators,
computer hardware suppliers or were engaged in other businesses or had customer
bases that we believed did not promote or complement our current business
strategy. As of December 31, 2003, our business operations consisted of the
operations of five 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 December 31, 2003, we owned
approximately 66.9% 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. Excluding the effects of a gain on the extinguishment of
debt of $70.1 million, we incurred a consolidated loss from continuing
operations of $64.1 million for the year ended December 31, 2003. We incurred
consolidated losses from continuing operations of $89.5 million and $188.6
million, respectively, for the years ended December 31, 2002 and 2001, and as of
December 31, 2003, we had an accumulated deficit of $413.9 million. Our
consolidated operating activities used cash of $11.4 million, $3.9 million and
$18.0 million during 2003, 2002 and 2001, respectively. Digital Angel
Corporation has suffered losses and has not generated positive cash flows from
operations. Digital Angel Corporation incurred losses during 2003, 2002 and
2001, which are presented below. In addition, its operating activities used cash
of $4.7 million, $2.7 million and $3.2 million during 2003, 2002 and 2001,
respectively.
The reduced settlement payment of our debt obligations to IBM Credit LLC
("IBM Credit"), the conversion to equity of our obligations under our 8.5%
Convertible Exchangeable Debentures (the "Debentures"), and the sale of 3.0
million shares of our common stock under our 3.0 million share offering have
been major factors mitigating concerns that existed about our ability to
continue as a going concern. Our profitability and liquidity depend on many
factors including the success of our marketing programs, the maintenance and
reduction of expenses, and our ability to successfully develop and bring to
market our new products and technologies. We have established a management plan
intending to guide us in achieving profitability and positive cash flows over
the twelve months ending December 31, 2003, however, no assurance can be given
that such plan will be realized. The major components of our plan are discussed
below under "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Liquidity and Capital Resources from Continuing
Operations."
4
BUSINESS SEGMENTS
As a result of (a) the merger of our 97% owned subsidiary, Digital Angel
Corporation, which we referred to herein as pre-merger Digital Angel, and
Medical Advisory Systems, Inc., referred to herein as MAS, on March 27, 2002,
(b) the significant restructuring of our business during 2002 and 2001, 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 SysComm International Corporation.
Business units that were part of our continuing operations and that were closed
or sold during 2002 and 2001 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.
The percentage of our revenues derived from each of our segments during
2003, 2002 and 2001 was as follows:
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
----- ----- -----
REVENUE BY SEGMENT:
Advanced Technology 48.0% 42.6% 28.5%
Digital Angel Corporation 36.5 32.9 22.9
InfoTech USA, Inc. 15.5 23.1 21.9
All Other -- 1.4 26.4
"Corporate/Eliminations" -- -- 0.3
----- ----- -----
Total 100.0% 100.0% 100.0%
===== ===== =====
Our sources of revenue consist of sales of products and services from our
three operating segments. Our significant sources of revenue for the year ended
December 31, 2003 were as follows:
SOURCES OF REVENUE: PERCENTAGE OF
TOTAL REVENUE
-------------
Sales of voice, data and video telecommunications networks to government agencies from
our Advanced Technology segment 39.9%
Visual identification tags and implantable microchips for the companion animal,
livestock, laboratory animal, fish and wildlife markets from our Digital Angel
Corporation segment 25.8%
Sales of IT hardware and services from our InfoTech USA, Inc. segment 15.5%
GPS enabled search and rescue equipment, intelligent communications products and
services for telemetry, mobile data and radio communications from our Digital Angel
Corporation segment 11.1%
Other products and services 7.7%
------------------
Total 100.0%
==================
5
Income (loss) 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 2003, 2002 and 2001 was as follows
(we evaluate performance based on stand-alone segment operating income as
presented below):
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---- ---- ----
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE
TAXES, MINORITY INTEREST, LOSSES ATTRIBUTABLE TO
CAPITAL TRANSACTIONS OF SUBSIDIARY AND EQUITY IN
LOSS OF AFFILIATE BY SEGMENT: (in thousands)
--------------
Advanced Technology $(108) $(786) $(41,493)
Digital Angel Corporation (1) (2) (6,271) (45,139) (16,262)
InfoTech USA, Inc. (3) (3,052) (422) (1,322)
All Other 298 (320) (71,636)
"Corporate/Eliminations" (2) (4) 19,441 (49,310) (37,428)
------------ ------------ -----------
Total $10,308 $(95,977) $(168,141)
============ ============ ===========
(1) For Digital Angel Corporation, the loss for 2002 includes a goodwill
impairment charge of $31.5 million and an impairment charge related to
certain software of $6.4 million
(2) For Digital Angel Corporation, the amount for 2002 excludes $1.8 million
of interest expense associated with our previous 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-K dated December 31, 2003. These charges are reflected in
"Corporate/Eliminations" for 2002.
(3) For InfoTech USA, Inc., the loss for 2003 includes a goodwill impairment
charge of $2.2 million.
(4) For "Corporate/Eliminations", the amount for 2003 includes extinguishment
of debt of $70.1 million, as a result of the repayment in full of all of
our obligations to IBM Credit on June 30, 2003, and $17.9 million of
non-cash compensation expense resulting from severance agreements with
certain former officers and directors.
Advanced Technology Products
Our current objective is to become an advanced technology development
company that focuses on a range of life enhancing, personal safeguard
technologies, early warning alert systems, miniaturized power sources and
security monitoring systems combined with the comprehensive data management
services required to support them. We have five life enhancing technology
products in various stages of development. They are Digital AngelTM, Thermo
LifeTM, VeriChipTM, Bio-ThermoTM and Personal Locating Device ("PLD"). As of
December 31, 2003, we have reported no revenues from the sales of our Thermo
Life and PLD products and we have had minimal sales of our Digital Angel,
Bio-Thermo And VeriChip products. These products are in various stages of
development as follows:
o Digital AngelTM 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). The development of the Digital Angel TM
technology began in April 1998. The first Digital Angel TM
technology product, a biosensor chip linked to GPS in a watch/pager
device, was marketed from November 2001 to the fourth quarter of
2002. Since then the Digital Angel TM technology been in the
development stage and we are uncertain when this technology will be
incorporated into our products;
o Thermo LifeTM is a thermoelectric generator. During the fourth
quarter of 2003, we began sending samples of Thermo Life to
potential customers. If and when, an order is received, the
manufacturing will be original equipment manufacturing;
o VeriChipTM is a human implantable radio frequency verification
microchip. VeriChip is currently being sold and shipped worldwide;
6
o Bio-ThermoTM is a temperature-sensing implantable microchip for use
in pets, livestock and other animals. Bio-Thermo was developed by
Digital Angel Corporation and is currently being sold and shipped by
them worldwide; and
o PLD is an implantable GPS location device. The first PLD prototype
was completed in December 2002. Since the first quarter of 2003, our
research group has worked on minimization of this product through
alternative location technology such as wireless triangulation. This
product currently remains in the development stage.
Each of these technologies is more fully discussed below beginning on page
16.
Advanced Technology Segment
The business units comprising our Advanced Technology segment represent
those business units that we believe will provide the necessary synergies,
support and infrastructure to allow us to develop, promote and fully-integrate
our technology products and services. This segment specializes in voice, data
and video telecommunications networks, software, and in 2002 and 2001, other
networking products and services. In addition, the VeriChipTM product has
multiple applications in security, personal identification, safety, healthcare
information (subject to FDA approval) and more. This segment's customer base
includes governmental agencies, commercial operations, distributors and
consumers.
As of December 31, 2003, 2002 and 2001, revenues from this segment were
$44.6 million, $41.9 million and $44.6 million, respectively, and accounted for
48.0%, 42.6% and 28.5%, respectively, of our total revenues. 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 (in 2002 and 2001);
o Website design and Internet access;
o Miniaturized implantable verification chip (VeriChipTM);
o Miniaturized power generator (Thermo LifeTM); and
o PLD.
Customers
Our Advanced Technology segment delivers products and services across a
multitude of industries, including government, insurance, utilities,
communications and high tech. Some of this segment's largest customers include
several agencies of the United States federal government, including the
Departments of Defense, Agriculture, Justice, the Social Security
Administration, the Veterans Administration and the United States Postal Service
and the Public Service Electric & Gas of New Jersey. Other than customary
payment terms, we do not offer any financing to our customers.
Approximately $37.1 million, or 83.2%, $31.3 million, or 74.7%, and $27.4
million, or 61.5%, of our Advanced Technology segment's revenues for 2003, 2002
and 2001, respectively, were generated by our wholly-owned subsidiary, Computer
Equity Corporation. No other products or services provided more than 10.0% of
the revenues for this segment during 2003 and 2002. Networking products and
services provided approximately 11.0%, and customer relationship management
software provided approximately 11.3% of the revenues from this segment during
2001. No other products or services provided more than 10% of revenues during
2001.
7
Computer Equity Corporation is a telecommunications network integrator and
a supplier to the federal government of telephone systems, data networks, video,
cable and wire infrastructure and wireless telecommunications products and
services.
Approximately 99.3%, 99.1% and 77.7% of Computer Equity Corporation's
revenues during 2003, 2002 and 2001, respectively, were generated through sales
to various agencies of the United States federal government. 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 ("GSA"). 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. Upon the expiration of WACS, no
new WACS tasks can be started; however, tasks started prior to the expiration
date can be completed. Due to the nature of the government's budget cycle,
projects funded in 2003 with fiscal year 2002 and 2003 funds will be continued
with an expected completion date by the end of 2004.
In January 2003, the WACS contract was replaced with the CONNECTIONS
contract. Computer Equity Corporation's wholly owned subsidiary, Government
Telecommunications Inc. ("GTI"), was one of seventeen companies awarded the
federal government's CONNECTIONS 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 government may terminate
the CONNECTIONS contract with or without cause. The CONNECTIONS contract is
similar to the WACS contract in that it allows 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.
As of December 31, 2003, 2002, and 2001, we have reported revenue of $0.5
million, $0.0 million and $0.0 million, respectively, from the sales of our
VeriChip product and no revenue from the sales of our Thermo Life and PLD
products.
VeriChip Corporation's contracts are generally five-year exclusive
distribution agreements. Upon signing an agreement with VeriChip Corporation, a
distributor is appointed as VeriChip Corporation's exclusive distributor of
products in a given territory. This provides the distributor with exclusive
rights to market, promote, sell and provide services for VeriChip. A distributor
must achieve certain sales quotas in order to maintain its exclusive
distribution rights. A distributor, with or without cause, may terminate a
contract without penalty upon thirty-days written notice to VeriChip
Corporation.
Operating Strategy
The principal components of our Advanced Technology segment's operating
strategy are to (a) increase the volume of government contract business and
leverage government contacts to enhance sales of our advanced technology
products, (b) develop new lines of business in technologies related to our
Computer Equity Corporation business including access control and video
surveillance systems and security networks, (c) develop the markets for our
VeriChip, Thermo Life and PLD products throughout the world, and (d) develop or
find one or two new advanced technology products each year. Our Advanced
Technology segment's strategy for retaining existing customers is to continue to
provide expertise in (a) project management, (b) negotiation of deliverables and
(c) development of proposals. The segment also plans to develop and upgrade our
proprietary software in order to meets our customers' needs. The segment plans
to continue to focus on excellence in customer service and to leverage our
current business relationships in order to retain our existing customers and to
generate new business.
8
Competitors
Our Advanced Technology segment's competitors include Booz Allen, EDS,
Mantech, Verizon, SBC, Engineering and Professional Services, Inc., CC-ops of
California, American Systems Corporation, Nortel, Genesys, Avaya, Aestea,
Metrix, People Soft, Cap Gemini, Datalan Corp. and Plural, Inc. Computer Equity
Corporation holds less than one percent of the federal telecommunications
contract market share.
VeriChip Corporation enjoys a first-to-market advantage over its
competitors, as well as licensing rights to patented technology. VeriChip
Corporation was the first to define the various applications of the implantable
radio frequency identification device ("RFID") technology in humans. VeriChip
Corporation's competitors include Texas Instruments, HID and GAITS. Texas
Instruments, HID and GAITS have greater capital resources, reputation and market
presence than VeriChip Corporation; however, we believe that the intellectual
property rights to the implantable human microchips we license from Digital
Angel Corporation may give us an advantage over our competitors.
We believe our business to be highly competitive, and we expect that the
competitive pressures we face will not diminish. Many of our competitors have
greater financial, technological, marketing and other resources than we do.
Patents
A German research company, Dunnschictht-Thermogenerator-Systemen GmbH
("DTS"), developed our Thermo Life product. We acquired certain assets of DTS,
including its intellectual property in June 2003. In May 2003, we filed a patent
application in the United States in connection with our Thermo Life product. Our
goal is to secure the proprietary rights to the Thermo Life technology. Digital
Angel Corporation currently owns our VeriChip technology. U.S. Patent No.
5,211,129 is jointly owned by Digital Angel Corporation and Hughes Aircraft and
was issued on May 18, 1993. U.S. Patent No. 6,400,338 was issued on June 4,
2002, to Destron Fearing Corporation and is now owned by Digital Angel
Corporation. Provided all maintenance fees are paid, Patent No. 5,211,129 will
expire on May 17, 2010, and Patent No. 6,400,338 will expire on January 11,
2020. VeriChip Corporation has acquired the rights to use this technology under
an exclusive product and technology license from Digital Angel Corporation that
will last through March 2013. Thermo Life and VeriChip are both trademarks, and
we have applied to the United States Patent & Trademark Office ("USPTO") for
their registration. In addition, certain of the software products that we sell
are proprietary software, which we have developed in-house and for which we have
copyright protection. We believe that our intellectual property assets including
patents, trademarks, copyrights and trade secrets provide something of a
competitive advantage to us. The intellectual property rights support our
commercial products and recognize our innovation. In large part, the success of
the Advanced Technology segment is dependent on our proprietary information and
technology. There is no guarantee that the steps taken by us will be adequate to
deter misappropriation of our proprietary rights or that third parties will not
develop substantially similar products or technologies. However, we intend to
seek patent protection when appropriate to maintain a competitive edge, and
otherwise rely on (a) regulatory-related exclusivity to protect certain of our
products and technologies; and (b) product superiority in order to maintain
market share.
Digital Angel Corporation Segment
Our Digital Angel Corporation segment develops and deploys sensor and
communications technologies that enable rapid and accurate identification,
location tracking, and condition monitoring of animals and high-value mobile
assets. Applications for Digital Angel Corporation's products include the
identification and monitoring of pets, fish and livestock through its patented
visual identification tags and implantable microchips, location tracking and
message monitoring of vehicles and aircraft in remote locations through systems
that integrate GPS and geosynchronous satellite communications, and monitoring
of asset conditions such as temperature and movement, through advanced miniature
sensors.
9
Before March 27, 2002, the business of Digital Angel Corporation was
operated in four segments: 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
segments: 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). With the acquisition on January 22, 2004 of OuterLink Corporation,
referred to as OuterLink, Digital Angel Corporation further realigned its
segments and effective January 1, 2004, it began operating in three segments:
Animal Applications, GPS and Radio Communications and Medical Systems. The new
GPS and Radio Communications segment consists of the GPS and Radio
Communications, Wireless and Monitoring and OuterLink divisions. The acquisition
of OuterLink is more fully described on page 21. We refer to Digital Angel
Corporation's operations in terms of its divisions: Animal Application, GPS and
Radio Communications, Wireless and Monitoring, OuterLink and Medical Systems.
The business assets associated with the Medical Systems operations, which
represented the business activity of MAS, were sold during the second quarter of
2004, and accordingly, the financial condition, results of operations and cash
flows of Medical Systems have been restated and are now presented as part of
Discontinued Operations.
As of December 31, 2003, 2002 and 2001, revenues from this segment were
$33.9 million, $32.4 million and $35.9 million, respectively, and accounted for
36.5%, 32.9% and 22.9%, respectively, of our total revenues. The principal
products and services in this segment by division are as follows:
Our Animal Applications division develops, manufactures, and markets a
broad line of electronic and visual identification devices for the companion
animal, livestock, laboratory animal, fish and wildlife markets worldwide. The
tracking of cattle and hogs are crucial both for asset management and for
disease control and food safety. The principal technologies employed by the
Animal Applications division are electronic ear tags and implantable microchips
that use radio frequency transmission. The Animal Applications division has
marketed visual identification products for livestock since the 1940s. Livestock
producers are currently evaluating electronic identification products for
livestock. Currently, sales of visual products represent virtually all of the
sales to livestock producers. The Animal Applications division's pet
identification system involves the insertion of a microchip with identifying
information in the animal. Readers at animal shelters, veterinary clinics and
other locations can determine the animal's owner and other information. This pet
identification system is marketed in the United States by Schering-Plough Animal
Health Corporation under the brand name "Home Again(TM)," in Europe by Merial
Pharmaceutical, and in Japan by Dainippon Pharmaceutical. Digital Angel
Corporation has distribution agreements with a variety of other companies
outside the United States to market its products. It has an established
infrastructure with readers placed in approximately seventy thousand global
animal shelters and veterinary clinics. Over 2.0 million companion animals in
the United States have been enrolled in the database, and more than five
thousand pet recoveries occur in the United States each month. Digital Angel
Corporation's Bio-Thermo TM product is included in this division.
Our 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 technology, which is referred to as 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 other systems). The Digital AngelTM technology continues to be in the
development stage and we are uncertain when this technology will be incorporated
into our products. The first Digital AngelTM technology product, a biosensor
chip linked to GPS in a watch/pager device, was marketed from November 2001 to
the fourth quarter of 2002. This technology has not generated any significant
revenue through December 31, 2003.
10
Our 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.
Customers
Sales of the Animal Applications division's products were $23.9 million,
$21.0 million and $22.2 million, respectively, and represented 70.6%, 64.7% and
60.3% of the total revenue from this segment during 2003, 2002 and 2001,
respectively. Sales of the GPS and Radio Communications division's products were
$10.4 million, $10.0 million and $11.1 million, respectively, and represented
30.5%, 30.9% and 30.2% of this segment's revenue during 2003, 2002 and 2001,
respectively. During 2003, the top six customers, Schering-Plough, United States
Army Corps of Engineers, Biomark, Inc., United States Department of Energy,
Pacific States Marine and Merial accounted for 44.0% of Digital Angel
Corporation's revenues, one of which accounted for 12.8% of the segment's
revenues. During 2002, the top seven customers, Schering-Plough, US Army Corps
of Engineers, Biomark, Inc., Pacific States Marine, Merial, Animal Care Limited
and San Bernardino County accounted for 39.2% of Digital Angel Corporation's
revenues; however, no single customer accounted for more than 10% of its
revenues. During 2001, the top four customers, Schering Plough, Merial, Pacific
States Marine and the US Army Corps of Engineers accounted for 30.4% of this
segment's revenues, one of which accounted for 10.3% of the segment's revenues.
Digital Angel Corporation has multi-year supply and distribution
agreements with its customers, which have varying expiration dates. The
remaining terms on the agreements are between one and three years. The supply
and distribution agreements describe products, delivery and payment terms and
distribution territories. The agreements generally do not have minimum purchase
requirements and can be terminated without penalty.
As of December 31, 2003, we have reported minimal sales of our Digital
AngelTM and Bio-ThermoTM products.
Operating Strategy
The principal components of our Digital Angel Corporation segment's
operating strategy are to focus on (a) animal identification products in the
growing livestock, fish and wildlife industries; (b) food source traceability
and safety tracking systems; (c) growing our high-value asset management
business; and (d) developing the Digital AngelTM technology. Our strategy for
retaining existing customers is to continue to develop new products based on
customers' needs. This segment will continue to provide product offerings to
identified market needs including, but not limited to, Country of Origin
Labeling (COOL) and food traceability safety. This segment plans to rely on its
historical arrangements with customers and past performance, as well as
continuous commitment to provide the services and products our customers require
to retain existing customers and to generate additional customers.
11
Competitors
The animal identification market is highly competitive. The principal
competitors in the visual identification market are All Flex USA, Inc. and Y-Tex
Corporation and the principal competitors in the electronic identification
market are AllFlex, USA, Inc., Datamars SA and Avid Plc. Digital Angel
Corporation believes that its intellectual property rights and reputation for
high quality products are competitive advantages in this market.
The principal competitor for the Digital AngelTM product is Wherify
Wireless, Inc. Other competitors in this market include National Scientific,
Child Locate, Pomals, Inc., ACR Electronics, Inc., Airbiquity and TCS. Our
Digital Angel product is not currently available for sale. If and when the
Digital Angel product is available for sale, Digital Angel Corporation
anticipates its product advantages will include: (a) the device's ability to
report the condition of the person being monitored (subject to any and all
required regulatory approvals); (b) its capability to work on all three global
satellite messaging frequencies being used throughout the world today; and (c)
its ability to use interactive voice response to monitor the wearer's condition
and location.
The principal competitors for the GPS and Radio Communications division
are Boeing North American Inc., General Dynamics Decision Systems, Tadiran
Spectralink Ltd., Becker Avionic Systems, and ACR Electronics, Inc. This
division's competitive advantages are: (a) that it was one of the first
companies to market GPS in search and rescue beacons; (b) its search and rescue
beacons are currently being used in over forty countries; and (c) the barriers
to entry in this market place are high due to the technical demands of its
customers.
Patents
The Digital Angel product is covered under U.S. Patent No. 5,629,678,
which was acquired by pre-merger Digital Angel in 1999 and is under an exclusive
license to Digital Angel Corporation. Provided all maintenance fees are paid,
this patent will extend until January 10, 2015. Additionally, Digital Angel
Corporation has filed for International Patent protection, and Patent
Application EP1330802 is currently pending in the European Patent Office for all
European Union member countries. U.S. Patent No. 6,400,338 and U.S. Patent No.
5,211,129 cover Digital Angel Corporation's implantable microchip technology,
including Bio-Thermo. This technology also has patent protection in Canada,
Brazil, China, Europe, Australia and various other countries. Furthermore,
Digital Angel Corporation's visual identification tags are covered under U. S.
Patent No. 4,741,117, which is owned by Digital Angel Corporation and will
expire on October 23, 2006. In addition, there are related patents issued in
Canada, Brazil, Europe, Australia and various other countries. Patents for the
implantable microchip and ear tag were filed on various dates over the past
fourteen years. The U.S. patents have a term of twenty years from the filing
date or seventeen years from the issue date depending upon when they were filed.
Digital Angel is a registered trademark and an application for trademark
registration on Bio-Thermo is pending. We believe that these patents and
trademarks in the aggregate constitute a valuable asset to Digital Angel
Corporation, and that they offer something of a competitive advantage and/or
barriers to entry in the Animal Applications and Wireless and Monitoring
divisions' markets. The intellectual property rights support Digital Angel
Corporation's commercial products and recognize its innovation. In large part,
the success of the Digital Angel Corporation segment is dependent on its
proprietary information and technology. There is no guarantee that the steps
taken by Digital Angel Corporation will be adequate to deter misappropriation of
its proprietary rights or that third parties will not develop substantially
similar products or technologies.
12
Ownership of Digital Angel Corporation
As of December 31, 2003 and March 10, 2004, we owned approximately 66.9%
and 68.5%, respectively, of the outstanding common stock of Digital Angel
Corporation. Digital Angel Corporation has outstanding options and warrants and
it has issued debt and preferred stock, which are convertible into shares of its
common stock. If all of the outstanding options and warrants and all of the
convertible debt and preferred stock were converted into shares of Digital Angel
Corporation's common stock, our ownership would be less than 50%. We desire to
maintain a controlling interest in Digital Angel Corporation, and therefore, in
the future, we may enter into share exchange agreements with Digital Angel
Corporation, or we may elect to buy back a portion of the outstanding shares of
Digital Angel Corporation's common stock that we do not currently own.
InfoTech USA, Inc. Segment (formerly SysComm International)
Our InfoTech USA, Inc. segment is a full service provider of Information
Technology, or IT, services and products. It specializes in tailoring its
approach to the individual customer's needs. During 2003 and 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 service firms and manufacturers of high-end IT
products.
As of December 31, 2003, 2002 and 2001, revenues from this segment were
$14.5 million, $22.7 million and $34.2 million and accounted for 15.5%, 23.1%
and 21.9%, respectively, of our total revenues. The principal products and
services in this segment were computer hardware and computer services. The
majority of InfoTech USA, Inc.'s revenue during 2003, 2002 and 2001 was derived
from sales of computer hardware, which provided approximately 80.3%, 88.3% and
89.2% of InfoTech USA, Inc.'s revenue in 2003, 2002 and 2001, respectively.
InfoTech's USA, Inc.'s services consist of IT consulting, installation, project
management, design and deployment, computer maintenance and other professional
services. No single service accounted for more than 10% of InfoTech's total
revenue during 2003, 2002 and 2001.
Customers
A significant percentage of InfoTech USA, Inc.'s revenue is derived from
sales to customers in educational institutions, the legal and financial
community, medical facilities, museums and New York City agencies. Its customer
base also includes retailers, manufacturers and distributors. During 2003, three
customers, GAF Material Corporation, Hackensack University Medical Center and
Centenary College, accounted for 15%, 12% and 11% of its consolidated revenues,
respectively. During 2002, five customers, Deutsche Bank, Hackensack University
Medical Center, Liberty Mutual, Morgan Stanley and Polytechnic University
accounted for 23%, 22%, 11%, 11% and 11% of InfoTech USA, Inc.'s revenues,
respectively. During 2001, two customers, Liberty Mutual and Mass Mutual Life
Insurance accounted for 40% and 31% of InfoTech USA, Inc.'s revenues,
respectively.
The majority of InfoTech USA, Inc.'s revenue is from purchase orders
received from customers for products and/or services that are fulfilled within a
few weeks time. Of InfoTech USA, Inc.'s total revenue for 2003, approximately
$1.6 million, or 11.3%, was related to contracts sales. All of InfoTech USA,
Inc.'s contracts are hardware maintenance contracts that generally last for a
period of one year and are cancelable by either party without penalty upon 90
days written notice.
13
InfoTech USA, Inc. competes in one of the world's largest IT markets, the
New York City metropolitan area. Its total market share is less than 1% and it
focuses primarily on small to medium sized businesses in a few vertical markets.
We believe that its small size and its focus on few vertical markets gives
InfoTech, USA, Inc. a competitive advantage in three ways: 1) because it is a
relatively small company, it is more easily able to adapt to the needs of each
of its customers and is able to tailor its product and service delivery in a way
that serves them best; 2) being relatively small also enables InfoTech USA, Inc.
to more easily foster close long-term relationships with its customers across
all levels and across all departments; and 3) focusing on a few vertical markets
gives InfoTech USA, Inc. an advantage over its competition because it has worked
in certain industries, such as education, banking and finance and insurance, for
years and it believes that it understands the needs of those particular
industries better than its competition. InfoTech USA, Inc. has developed an
excellent reputation in its vertical markets and this provides it with referral
business and strong, relevant reference accounts when pursuing new clients in
those industries.
Operating Strategy
The InfoTech USA, Inc. segment primarily targets small to medium-sized
businesses. Its operating strategy is to continue to focus on building
relationships with its larger customers and searching for new opportunities in
the Fortune 1000 market space. This segment believes the area of the greatest
potential growth will continue to be the small to medium-sized customers seeking
expertise they do not have within their organization. InfoTech USA, Inc.
continues to identify those companies that will fit well with its culture and
targets the vertical markets where it has previously been successful, including
educational institutions, legal and financial services, medical facilities,
museums and New York City agencies. Geographically, InfoTech USA, Inc. plans to
continue to focus on the New York City metropolitan area.
Competitors
InfoTech USA, Inc. competes in a highly competitive market with IT
products and service 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.
Certain of InfoTech USA, Inc.'s current and potential competitors have
greater financial, technical, marketing and other resources than InfoTech USA,
Inc. As a result, they may be able to respond more quickly to new or emerging
technologies and changes in customer requirements or to devote greater resources
to the development, promotion and sales of their services than InfoTech USA,
Inc. InfoTech USA, Inc.'s ability to compete successfully depends on a number of
factors such as breadth of product and service offerings, sales and marketing
efforts, pricing, quality and reliability of services, technical personnel and
other support capabilities. InfoTech USA, Inc. believes that it currently
competes favorably due to its focus and expertise in network integration and
technical services.
Patents
We do not hold patents or licenses to any of the products in our InfoTech,
USA Inc. segment, nor are intellectual property rights an important part of the
operations of this segment.
14
Research Group
Dr. Peter Zhou, Vice President and Chief Scientist, heads our Research
Group, which is located in Riverside California. Dr. Zhou, age 63, joined us in
January 2000. From 1988 to 1999, Dr. Zhou served as Vice President, Technology
for Sentry Technology Corp., and from 1985 to 1988, he served as Research
Investigator for the University of Pennsylvania's Department of Science &
Engineering. Prior to that, he was a research scientist for Max-Planck
Institute, Metallforschung in Stuttgart, Germany and a post-doctoral research
fellow at the University of Pennsylvania. Dr. Zhou has a PhD in materials
science/solid state physics from the University of Pennsylvania and a Master of
Sciences degree in physics from the Beijing University of Sciences and
Technology.
In addition to Dr. Zhou, the Research Group includes six researchers each
holding advanced degrees, one support engineer with a bachelors degree, an and
office manager. Dr. Zhou has thirty-eight years of scientific experience, and
collectively, the Research Group has over eighty-one years of research
experience.
Research and development expense was $6.3 million, $4.1 million and $8.8
million for the years 2003, 2002 and 2001, respectively. Research and
development expense relates primarily to the development of our Digital Angel,
Thermo Life, VeriChip and PLD products, and in 2001, to software development.
Included in research and development expense was software development cost of
$0.5 million, $0.9 million and $3.3 million in 2003, 2002 and 2001,
respectively.
Prior Segments
Prior to January 1, 2002, our business was organized into three segments:
Applications, Services and Advanced Wireless. Prior period information has been
restated to present our reportable segments on a comparative basis.
On February 22, 2001, our senior management approved a plan to sell
Intellesale, Inc. and all of our other non-core businesses. Our Board of
Directors approved the plan on March 1, 2001. 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 and prior periods have been restated.
GROWTH STRATEGY
We are an advanced technology development company that focuses on a range
of life enhancing, personal safeguard technologies, early warning systems,
miniature power sources and security monitoring systems combined with
comprehensive data management services required to support them. Our business
strategy is to position ourselves as a leading advanced technology development
company through the development and commercialization of proprietary technology
such as our Digital AngelTM, Thermo LifeTM, VeriChipTM, Bio-ThermoTM and PLD
products, all examples of what we refer to as our life enhancing technologies as
more fully discussed below.
Our Research Group is charged with the responsibility of finding or
developing one to two personal safeguard proprietary technologies on an annual
basis and bringing it to prototype form within 18 to 24 months. At that point,
each technology is paired with a complementary operating company that brings
revenue and management. Each technology hopes to be the "first of its kind," and
there are currently no businesses that compete directly with the technologies.
15
The first of these technologies was Digital Angel TM; the first
combination of GPS and "how you are" (sensor) information sent live over a
wireless network to a 24/7 call center where information is monitored and, if
necessary, acted upon. Digital Angel was paired with Destron Fearing
Corporation, a leading animal tracking and applications company that
complemented Digital Angel and brought revenue and management from its animal
tracking business. Digital Angel Corporation, the post-merger corporation, now
trades on the American Stock Exchange under the Symbol "DOC." Digital Angel
Corporation symbolizes our business model. Digital Angel Corporation also plans
to develop new advanced technologies and to date has developed Bio-ThermoTM.
VeriChip, which we believe to be the world's first implantable microchip
for humans, was the next technology developed by our Research Group. Its
distribution rights are licensed from Digital Angel Corporation to VeriChip
Corporation, our wholly owned subsidiary. VeriChip has multiple applications,
including but not limited to, applications in security, personal identification,
safety, healthcare information (subject to FDA approval) and more. Our strategy
is for VeriChip Corporation to follow a business model comparable to Digital
Angel Corporation. VeriChip Corporation is planned as our next "spawned"
technology company.
With Thermo Life launched in the fourth quarter of 2003 as the third
product developed by our Research Group (Digital Angel and VeriChip being the
first and second products), our business strategy will evolve over time and we
hope to become a group of technology companies underpinned by advanced
proprietary personal safeguard technologies, each complemented by an operating
company that brings revenue and management. By maintaining a majority ownership
position in each company, we will consolidate operating results and maximize our
investment.
Advanced Technology Products
Our five advanced technology products, which are in various stages of
development, are as follows:
DIGITAL ANGELTM is the integration and miniaturization into marketable
products of three technologies: wireless communications (such as cellular),
sensors (including bio-sensors) and position location technology (including GPS
and other systems). The product communicates through proprietary software to a
secure 24/7 operations center to provide "where-you-are" and "how-you-are"
information about loved ones (particularly elderly relatives and children),
their location and their vital signs via the subscriber's computer, personal
digital assistant or wireless telephone.
The development of the Digital Angel TM technology began in April 1998.
The first Digital AngelTM technology product, a watch/pager device with a
biosensor chip linked to GPS, was marketed from November 2001 to the fourth
quarter of 2002. Since then the Digital AngelTM technology has been in the
development stage to include assisted GPS capabilities to enhance "line of
sight" issues. We are uncertain when this technology will be incorporated into
our products.
THERMO LIFETM - Our wholly-owned subsidiary, Thermo Life Energy Corp.,
formerly Advanced Power Solutions, Inc., was formed to market our product,
Thermo Life, a small thermoelectric generator powered by body heat. Thermo Life
is intended to provide a miniaturized power source for a wide range of consumer
electronic devices including attachable or implantable medical devices, smoke
detectors and other heat-related sensors and wristwatches. The Thermo Life chip
is being designed for power supplies for embedded devices or devices that attach
to the human skin. The temperature difference between the human skin and the
environmental temperature is 3-5 degrees Fahrenheit. The size of the Thermo Life
chip is 9mm x 5.2mm x 1.8mm. This cross section is designed to match the size of
a human fingertip. Originally, the Thermo Life chip in this cross section and
with this temperature difference generated 1.5 volts of electrical power.
However, common electrical devices and electronic chips are mostly designed for
3 volts, therefore, the output of the original Thermo Life chip had greater
limitations as a working power supply for common electronic devices. On July 9,
2002, we announced that we had been able to increase the voltage of electrical
power generated by Thermo Life in laboratory tests from 1.5 volts to 3.0 volts
within the same cross section and using the same temperature difference. As a
result, these chips can now be used with most of the common electrical devices.
16
We began submitting samples of Thermo Life to potential customers during
the fourth quarter of 2003. If and when an order is received the manufacturing
of Thermo Life will be original equipment manufacturing.
VERICHIPTM - We have developed a miniaturized, implantable verification
chip called VeriChip that can be used in a variety of security, financial,
personal identification/safety and other applications. On February 7, 2002, we
announced that we had created a new wholly owned subsidiary, VeriChip
Corporation, to market and license VeriChip. About the size of a grain of rice,
each VeriChip product contains a unique verification number. Utilizing our
proprietary external RFID scanner, radio frequency energy passes through the
skin energizing the dormant VeriChip, which then emits a radio frequency signal
transmitting the verification number contained in the VeriChip. VeriChip
technology is produced under patent registrations #6,400,338 and #5,211,129.
This technology is owned by Digital Angel Corporation and licensed to VeriChip
Corporation under an exclusive product and technology license with a remaining
term until March 2013.
On October 22, 2002, we announced that the FDA had determined that
VeriChip is not a regulated medical device for security, financial and personal
identification/safety applications. The FDA specified in its ruling that
VeriChip is a regulated medical device for health information applications when
marketed to provide information to assist in the diagnosis or treatment of
injury or illness. We currently intend to market and distribute the VeriChip
product for security, financial and personal identification/safety applications,
and we plan to expand our marketing and distribution efforts to health
information applications of the product, subject to any and all necessary FDA
and other approvals more particularly discussed below.
VeriChip is fully developed and we began marketing VeriChip for security,
financial and personal identification/safety applications within the United
States on October 24, 2002. Examples of personal identification and safety
applications are control of authorized access to government installations and
private-sector buildings, nuclear power plants, national research laboratories,
correctional facilities and sensitive transportation resources. VeriChip is able
to function as a stand-alone, tamper-proof personal verification technology or
it can operate in conjunction with other security technologies such as standard
identification badges and advanced biometric devices (for example, retina
scanners, thumbprint readers or face recognition devices). The use of VeriChip
as a means for secure access can also be extended to include a range of consumer
products such as personal computers, laptop computers, cars, cell phones and
even access into homes and apartments.
Financial applications include VeriChip being used as a personal
verification technology that could help prevent fraudulent access to banking,
especially via automated teller machines, and credit card accounts. VeriChip's
tamper-proof, personal verification technology can provide banking and credit
card customers with the added protection of knowing their account could not be
accessed unless they themselves initiated and were physically present during the
transaction. VeriChip can also be used in identity theft protection.
17
One of our major strategic initiatives is to obtain FDA approval to market
our VeriChip product for healthcare information applications in the United
States. If we are successful in obtaining FDA approval pursuant to our 510-K
application, filed with the FDA in October 2003, we believe that the healthcare
information applications would expand the market for VeriChip and consequently
increase our VeriChip revenues. Examples of the healthcare information
applications for VeriChip include, among others:
o implanted medical device identification;
o emergency access to patient-supplied health information;
o portable medical records access including insurance
information;
o in-hospital patient identification;
o medical facility connectivity via patient; and
o disease/treatment management of at-risk populations (such as
vaccination history).
These potential medical applications are a very important piece of our
VeriChip business model, and therefore, the 510K application process and the
obtainment of FDA approval are key elements in enabling us to achieve our
business plans for VeriChip. Section 510(K) of the Food, Drug and Cosmetic Act
requires those device manufacturers who must register to notify the FDA, at
least 90 days in advance, of their intent to market a medical device. This is
known as Pre-market notification - also called PMN or 510(K). It allows the FDA
to determine whether the device is equivalent to a device already placed into
one of three classifications categories. Thus "new" devices that have not been
classified can be properly identified.
BIO-THERMOTM - On February 1l, 2003, we announced that we received written
clearances from the FDA and the United States Department of Agriculture to
market our new fully developed product, Bio-Thermo, for use in pets, livestock
and other animals. Bio-Thermo is our first fully integrated implantable
bio-sensing microchip that can transmit a signal containing accurate temperature
readings to our proprietary RFID scanners. With this new technology, accurate
temperature readings can be obtained by simply passing the RFID handheld scanner
over the animal or by having the animal walk through a portal scanner. We
believe that Bio-Thermo and other biosensors developed in the future will
provide vital internal diagnostics about the health of animals more efficiently
and accurately than the invasive techniques used in the industry today. Digital
Angel Corporation developed Bio-Thermo and sales of Bio-Thermo commenced in the
third quarter of 2003.
PLD - On May 13, 2003, we announced that we have developed and
successfully field-tested a working prototype of, what is to our knowledge, the
first sub-dermal personal location device called PLD. The dimensions of this
initial PLD prototype are 2.5 inches in diameter by 0.5 inches in depth, roughly
the size of a pacemaker. It is proposed that PLD be surgically implanted in the
clavicle area of a human. Our original PLD prototype is based on a combination
of GPS and cell wireless technologies. We believe that by removing the GPS and
using an alternative location technology such as wireless triangulation, we will
be able to shrink the size of the PLD. As the process of miniaturization
proceeds in the coming months, we hope to be able to shrink the size of the
device to at least one-half and perhaps to as little as one-tenth of the current
size. The PLD is charged by an induction-based power-recharging method which is
similar to that used to recharge implantable pacemakers. This recharging
technique functions without requiring any physical connection between the power
source and the implant. The exact timing of the commercial availability of PLD
is unclear pending further technological refinements and the procurement of any
and all required regulatory clearances.
18
Market Synergies
We believe that we have excellent relationships with our existing
customers and we are continually striving to improve our products and services
in order to maintain and grow our revenues from our existing customer base. In
addition, we intend to use our relationships with our existing customers to aid
in the generation of sales of our advanced technology products. For example, the
companion animal, livestock, laboratory animal, and wildlife customers for
Digital Angel Corporation's visual identification tags and implantable microchip
products provide a ready-made market for its Bio-Thermo product. We intend to
market VeriChip's security and identification applications to governmental
agencies including the agencies that are part of Computer Equity Corporation's
customer base. Computer Equity Corporation's key customers include the
Departments of Defense, Justice and Agriculture, the United States Postal
Service and the Social Security Administration.
RECENT EVENTS
Sale of Medical Systems' Assets
During the three-months ended June 30, 2004, Digital Angel Corporation's
Board of Directors approved a plan to sell its Medical Systems operations, which
were acquired on March 27, 2002, and the business assets of Medical Systems'
were sold off effective April 19, 2004. Medical Systems represented the business
operations of MAS. The business assets of Medical Systems were sold to MedAire,
Inc. in connection with an Asset Purchase Agreement, referred to as APA, dated
April 8, 2004, by and between Digital Angel Corporation and MedAire, Inc. Under
the terms of the APA, the purchase price was $0.4 million, plus any prepaid
deposits, the cost of certain pharmaceutical inventory and supplies, and the
assumption of certain liabilities, reduced by any pre-billing to or pro-rata
prepayments by certain customers. The assets sold included all of the tangible
and intangible intellectual property developed for the medical services business
including pharmaceutical supplies and other inventory items, customer and
supplier contracts, computer software licenses, internet website and domain name
and mailing lists, but did not include the land and building used by this
operation. The Medical Systems' land and building were sold in a separate
unrelated transaction to a third party on July 31, 2004 for approximately $1.5
million. Medical Systems was one of our reporting units in accordance with FAS
142. Accordingly, the financial condition, results of operations and cash flows
of Medical Systems have been reported as Discontinued Operations in our
financial statements, and prior periods have been restated.
Reverse Stock Split
On September 10, 2003, our shareholders approved the granting of
discretionary authority to our Board of Directors for a period of twelve months
to effect a reverse stock split not to exceed a ratio of 1-for 25, or to
determine not to proceed with a reverse stock split. On March 12, 2004, our
Board of Directors authorized a 1-for-10 reverse stock split, which was
effectuated on April 5, 2004. As a result of the reverse stock split, the par
value of our common stock increased from $0.001 to $0.01 per share. In
conjunction with the reverse stock split, our Board of Directors authorized a
reduction in the number of authorized shares of our common stock from 560.0
million to 125.0 million. All share information provided in this Annual Report
on Form 10-K/A has been retroactively adjusted to reflect the reverse stock
split. Our Board of Directors approved the reverse stock split to facilitate the
continuing listing of our common stock on the SmallCap, and also to reduce the
number of issued and outstanding shares of our common stock, resulting, in part,
from our past acquisitions, the payment of debt obligations to IBM Credit and
preferred stock and Debenture conversions.
Share Exchange Agreement with Digital Angel Corporation
On March 1, 2004, we exchanged shares of our common stock in consideration
for shares of the common stock of Digital Angel Corporation under the terms of a
Share Exchange Agreement dated August 14, 2003. The Share Exchange Agreement
represented a strategic investment by us, whereby we increased our ownership
interest in Digital Angel Corporation. As of August 14, 2003, we believed that
Digital Angel Corporation's common stock was undervalued, and we desire to
maintain a controlling interest in Digital Angel Corporation. Therefore, we
consider the additional investment in Digital Angel Corporation to be a
strategically advantageous undertaking. Under the terms of the Share Exchange
Agreement, we purchased 3.0 million new shares of Digital Angel Corporation's
common stock for $2.64 per share and we received a warrant to purchase up to 1.0
million shares of Digital Angel Corporation's common stock for a period of five
years from February 1, 2004, at an exercise price of $3.74 per share. The
aggregate purchase price for the 3.0 million shares was $7.9 million. The
purchase price was payable in 1.98 million shares of our common stock.
19
The aggregate purchase price of $7.9 million for the 3.0 million shares of
Digital Angel Corporation's common stock was based on the closing price of
Digital Angel Corporation's common stock on June 30, 2003, of $2.64 per share.
This price was used because we and Digital Angel Corporation felt that this was
a fair price and because it reflected the market price of Digital Angel
Corporation's common stock before any impact that may have resulted from the
Debentures as a result of the Debentures holders potentially hedging their
position in Digital Angel Corporation's common stock, and thereby affecting the
market price of Digital Angel Corporation's common stock. The Debentures are
more fully described below. Pursuant to the terms of the Share Exchange
Agreement, we were required to file a registration statement covering the sale
of the 1.98 million shares of our common stock. The registration statement
registering the shares was declared effective on February 17, 2004. Digital
Angel Corporation expects to generate cash by selling the 1.98 million shares of
our common stock. Digital Angel Corporation expects that the cash generated,
along with other funds available, will be sufficient to meet its projected
working capital requirements for the next 12 months.
InfoTech USA, Inc. Segment Financing Transaction
The InfoTech USA, Inc. segment finances its accounts receivable and
inventory. Its current financing arrangement with IBM Credit provides financing
on inventory purchases up to $1.8 million. Borrowing for purchases is based upon
75% of all eligible receivables due within 90 days and up to 100% of all
eligible inventories. Interest for balances not paid within the interest free
period provided in the arrangement accrues at prime plus 4.4%. Borrowings under
the financing arrangement were $0.8 million at December 31, 2003, and are
reflected in the balance sheet in either accounts payable or other accrued
expenses. On September 5, 2003, InfoTech USA, Inc. received a letter from IBM
Credit constituting their formal notice of termination of their agreement. The
effective date of such termination, which was originally set for March 10, 2004,
has been extended until April 9, 2004. InfoTech USA, Inc. is currently in the
process of securing other financing and expects to replace its financing
arrangement prior to the termination date set by IBM Credit. However, there is
no assurance that InfoTech USA, Inc. will be able to obtain a replacement for
its IBM Credit arrangement. See Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital Resources
from Continuing Operations."
Appointments and Changes in Management
On February 18, 2004, Scott R. Silverman was appointed Chairman of the
Board of Directors of Digital Angel Corporation. Effective March 3, 2004,
Richard J. Sullivan resigned from the Board of Directors of Digital Angel
Corporation.
On November 3, 2003, OuterLink's then Chief Executive Officer, Mr. Van
Chu, was appointed Chief Executive Officer of Digital Angel Corporation. Mr.
Chu's employment was terminated for cause, effective January 12, 2004, as a
result of Mr. Chu's failure to fulfill the obligations of his employment. The
terms of Mr. Chu's termination are subject to a confidentiality agreement, dated
January 22, 2004, among Digital Angel Corporation, OuterLink and Mr. Chu. On
January 15, 2004, the Digital Angel Corporation's Board of Directors appointed
Kevin N. McGrath as President and Chief Executive Officer of Digital Angel
Corporation. Prior to joining Digital Angel Corporation, Mr. McGrath spent 16
years at El Segundo, CA-based Hughes Electronics Corp., during which time he
served as, among other things, Chairman of DirecTV Latin America, a Hughes
subsidiary.
20
OuterLink Corporation Acquisition
On January 22, 2004, Digital Angel Corporation completed the acquisition
of OuterLink, based in Concord, Massachusetts. OuterLink manufactures and
markets a suite of satellite tracking systems, operates a mobile satellite data
communications service, and supplies tracking software systems for mapping and
messaging. The OuterLink "CP-2 system" provides real-time automated tracking,
wireless data transfer, and two-way messaging with large fleets of
vehicles--including utility trucks, helicopters and fixed-wing aircraft, long
haul trucks, service vehicles, short haul trucks, and ships. OuterLink's current
customer base includes various branches of the Department of Homeland Security
including the U.S. Border Patrol and U.S. Customs Service. As consideration for
the acquisition, Digital Angel Corporation issued 0.1 million shares of its
Series A Preferred Stock in exchange for all of the issued and outstanding
shares of OuterLink's capital stock. Approximately 20% of the shares are being
held in escrow as security for indemnified claims. The Series A Preferred Stock
is convertible into four million shares of Digital Angel Corporation's common
stock when the volume-weighted average price of Digital Angel Corporation's
common stock equals or exceeds $4.00 per share for ten consecutive trading days.
The preferred stockholders have the right to designate one director to Digital
Angel Corporation's Board of Directors prior to July 22, 2004.
OTHER DEVELOPMENTS
Securities Purchase Agreements Dated September 30, 2003 and December 2,
2003
During 2003, we offered 3.0 million shares of our common stock in a public
offering registered under the Securities Act of 1933. J.P. Carey Securities,
Inc. acted as our placement agent for the offering. We sold an aggregate of 2.2
million of these shares under the terms of three separate Securities Purchase
Agreements entered into on September 19, 2003, with each of First Investors
Holding Co., Inc., Magellan International LTD and Cranshire Capital, LP.
resulting in gross proceeds to us of approximately $8.0 million before deduction
of the 2.0% placement agency fee. In addition, we sold an aggregate of up to 0.8
million of the shares under eight separate Securities Purchase Agreements
entered into on December 2, 2003, as amended, with each of First Investors
Holding Co., Inc., Magellan International LTD, Elliott Associates, L.P.,
Islandia, L.P., Midsummer Investment, Ltd., Omicron Master Trust, Portside
Growth and Opportunity Fund and Elliott International L.P., resulting in
aggregate gross proceeds to us of approximately $2.9 million before deduction of
the 2.0% placement agency fee. As of March 10, 2004, we have used approximately
$4.3 million of the total net proceeds of approximately $10.7 from the 3.0
million share offering. We intend to use the remaining net proceeds from the 3.0
million share offering for general corporate purposes (including working capital
requirements, sales and marketing and capital expenditures). Our liquidity and
capital requirements are more fully discussed below under "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources from Continuing Operations."
Sale of WebNet Services, Inc.
Effective December 15, 2003, under the terms of a Stock Purchase Agreement
between us and Internet Technologies Group, LLC ("ITG"), we sold 100% of the
shares of our wholly-owned subsidiary, WebNet Services, Inc. The purchase price
for the shares was $0.4 million, and our loss on the sale was approximately $0.3
million. The purchase price is payable in twelve equal monthly installments
commencing on January 2, 2004, under the terms of a non-interest bearing
promissory note, which is collateralized by shares of WebNet Services, Inc.'s
common stock. WebNet Services, Inc. was included in our Advanced Technology
segment. The former owners of WebNet Services, Inc. are the principals of ITG.
21
Payment in Full of Obligations to IBM Credit
Our Third Amended and Restated Term Credit Agreement (the "IBM Credit
Agreement") with IBM Credit 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 then 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 7, 2003, we received a
notice from IBM Credit declaring the loan in default. Effective April 1, 2003,
we entered into a Forbearance Agreement with IBM Credit. In turn, we agreed to
dismiss with prejudice a lawsuit we filed against IBM Credit and IBM Corporation
in Palm Beach County, Florida on March 6, 2003. Under the terms of the
Forbearance Agreement, we had the right to purchase all of our outstanding debt
obligations to IBM Credit, totaling approximately $100.1 million (including
accrued interest), if we paid IBM Credit $30.0 million in cash by June 30, 2003.
As of June 30, 2003, we made cash payments to IBM Credit totaling $30.0 million
and, thus, we have satisfied in full our debt obligations to IBM Credit. As a
result, during the year ended December 31, 2003, we recorded a gain on the
extinguishment of debt of approximately $70.1 million, exclusive of the bonuses
discussed below.
On June 30, 2003, our Board of Directors (through the Compensation
Committee) approved the payment of approximately $4.3 million in discretionary
bonus awards. The bonuses were awarded to directors, executive officers and
other employees in recognition of their efforts in achieving the successful
repayment of all of our obligations to IBM Credit on June 30, 2003. This
repayment resulted in our recording a gain on the extinguishment of debt of
approximately $70.1 million during 2003. The approval of the bonuses directly
reflected the efforts of certain employees/directors in satisfying all of our
obligations to IBM Credit, and accordingly, the approval was not subject to
further conditions, except for continuation of employment until the bonuses were
paid. Our Board of Directors, based on various factors including the
contribution of the respective employee/director and our cash needs and
availability, determined the allocation of the bonuses among the group of
employees/directors and the timing of the payments. Our Board of Directors
determined to satisfy the payment of the bonuses in cash. The bonuses were paid
to the directors in November 2003, and to executive officers and other employees
on various dates in November 2003, December 2003 and January 2004.
Funding for $30.0 Million Payment to IBM Credit
Funding for the $30.0 million payment to IBM Credit consisted of $17.8
million in net proceeds from the sales of an aggregate of 5.0 million shares of
our common stock, $10.0 million in net proceeds from the issuance of our
Debentures, and $2.2 million from cash on hand.
The 5.0 million shares of our common stock were 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 agreed to pay J.P. Carey
Securities, Inc. a 3% placement agency fee. In connection with this offering, on
May 8, 2003, May 22, 2003 and June 4, 2003, we entered into Securities Purchase
Agreements with Cranshire Capital, L.P. and Magellan International Ltd. The
Securities Purchase Agreements provided for Cranshire Capital L.P. and Magellan
International Ltd. to purchase an aggregate of 2.0 million shares and 3.0
million shares of our common stock, respectively, resulting in net proceeds to
us of $17.8 million, after deduction of the 3% placement agency fee.
22
Issuance of 8.5% Convertible Exchangeable Debentures
On June 30, 2003, we entered into the Debenture Agreement ("the
Agreement") with certain Purchasers, collectively referred to herein as the
Purchasers or the Debenture holders. In connection with the Agreement, we issued
to the Purchasers the Debentures due November 1, 2005. Subject to the terms
under the various agreements, the Debentures were convertible into shares of our
common stock or exchangeable for shares of the Digital Angel Corporation common
stock owned by us, or a combination thereof, at the Purchasers' option prior to
the maturity date of November 1, 2005. On November 12, 2003, we announced that
we had entered into a letter agreement with the Debentures holders. Under the
letter agreement, the Debenture holders were required to convert a minimum of
50% of the outstanding principal amount of the Debentures, plus all accrued and
unpaid interest, into shares of our common stock on November 12, 2003, the First
Conversion Date, at a conversion price of $3.50 per share. In addition, the
Purchasers were required to convert any remaining outstanding principal amount
of the Debentures plus accrued interest on or before November 19, 2003, the
Second Conversion Date. The conversion price for the Second Conversion Date was
84% of the volume weighted average trading price of our common stock for the
five trading days prior to November 17, 2003, which average was $4.406. As of
November 19, 2003, the total principal amount of the Debentures has been
converted, and accordingly, our obligations under the Debentures have been
satisfied in full. We have issued an aggregate of 2.8 million shares of our
common stock in connection with the conversions taking place on the First and
Second Conversion Dates. In addition, in connection with the exchange of a
portion of the Debentures, we have issued an aggregate of 0.3 million shares of
the Digital Angel Corporation common stock that we owned.
In connection with the Debentures, we have granted to the Purchasers
warrants (the "Warrants") to acquire approximately 0.5 million shares of our
common stock, or 0.95 million shares of Digital Angel Corporation's common stock
currently outstanding and owned by us, or a combination of shares from both
companies, at the Purchasers' option. The exercise prices are $5.64 and $3.178
for our common stock and Digital Angel Corporation's common stock, respectively.
The Warrants are subject to anti-dilution provisions, vest immediately and are
exercisable through June 30, 2007.
The proceeds upon issuance of the Debentures were allocated as follows:
(in thousands)
Face value of Debentures $10,500
Beneficial conversion feature (3,120)
Relative fair value of Warrants (1,387)
-------------
Relative fair value of Debentures $ 5,993
=============
The beneficial conversion feature was calculated as the difference between
the beneficial conversion price and the fair value of our common stock,
multiplied by the number of shares into which the Debentures were convertible in
accordance with the Emerging Issues Task Force ("EITF") - 00-27. The beneficial
conversion feature was recorded as a reduction in the value assigned to the
Debentures (original issue discount) and an increase in additional
paid-in-capital. The fair value of the Warrants was estimated using the
Black-Scholes valuation model. The value assigned to the Warrants was recorded
as a reduction in the value assigned to the Debentures (original issue discount)
and an increase in long-term liabilities. The liability for the Warrants, to the
extent potentially settleable in shares of the Digital Angel Corporation common
stock owned by us, is being revalued at each reporting period with any resulting
increase/decrease being recorded as an increase/decrease in interest expense.
During 2003, we recorded interest expense of $2.0 million as a result of such
revaluation. We will be required to record an impairment loss if the carrying
value of the Digital Angel Corporation common stock underlying the Warrants
exceeds the exercise price. Should the Purchasers elect to exercise the Warrants
into shares of the Digital Angel Corporation common stock owned by us, such
exercise may result in our recording a gain on the transaction.
As a result of the repayment of all of the Debentures, the unamortized
balance of the original issue discount and debt issue costs of approximately
$4.2 million was recorded as interest expense during the fourth quarter of 2003.
In addition, as a result of the difference between the original conversion price
under the Agreement of $5.15 per share, and the revised conversion prices per
the terms of the letter agreement, which averaged $3.51 per share, we recorded
additional beneficial conversion feature of approximately $4.5 million during
the fourth quarter of 2003. This additional beneficial conversion feature was
recorded as interest expense and an increase in additional-paid in capital.
Thus, during the fourth quarter of 2003, we incurred $8.7 million in total
non-cash stock-based interest expense as a result of the conversions of the
Debentures under the terms of the letter agreement.
23
In connection with the Debentures, we incurred a placement agency fee of
$0.4 million and we reimbursed one of the Purchasers $0.1 million for legal,
administrative, due diligence and other expenses incurred to prepare and
negotiate the transaction documents. We realized net proceeds of $10.0 million
from the issuance of the Debentures, after deduction of the placement agency fee
and the transaction costs. To date, we have not realized any proceeds from the
issuance of the Warrants, as the Warrants have not been exercised.
In addition, Digital Angel Corporation has granted a five-year warrant to
the Debenture holders to acquire up to 0.5 million shares of its common stock at
an exercise price of $2.64 per share. The warrant was issued in consideration
for a waiver from the Debenture holders, which allowed us to register the shares
that we issued in connection with the Share Exchange Agreement between us and
Digital Angel Corporation. The fair value of the warrant of approximately $0.8
million was determined using the Black-Scholes valuation model and was recorded
as interest expense during 2003. The total interest expense recorded in 2003 in
connection with the Debentures was approximately $12.7 million.
As a result of the complete satisfaction of all of our obligations to IBM
Credit, we entered into an Amended and Restated Trust Agreement dated June 30,
2003, with the Digital Angel Share Trust ("Trust"). Under the terms of the
revised trust agreement, the Trust retained all of its rights, title and
interest in 15.0 million shares of the Digital Angel Corporation common stock
owned by us in consideration of the Debentures and in order to secure and
facilitate the payment of our obligations under the Debentures. As a result of
the repayment in full of the Debentures on November 19, 2003, we expect to
dissolve the Trust in the near future. Currently, Scott R. Silverman, our Chief
Executive Officer, serves as the sole advisory board member to the Trust.
SEC Informal Inquiry
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.
24
Severance Agreements
On March 21, 2003, Richard J. Sullivan, our then Chairman of the Board of
Directors and Chief Executive Officer, retired from such positions. Our Board of
Directors negotiated a severance agreement with Richard Sullivan under which he
received a one-time payment of 5.6 million shares of our common stock. We issued
the shares to Richard Sullivan on March 1, 2004. In addition, stock options held
by him exercisable for approximately 1.1 million shares of our common stock were
re-priced. The options surrendered had exercise prices ranging from $1.50 to
$3.20 per share and were replaced with options exercisable at $0.10 per share.
All of the re-priced options have been exercised. Richard Sullivan's severance
agreement provides that the payment of shares and re-pricing of options provided
for under that agreement is in lieu of all future compensation and other
benefits that would have been owed to him under his employment agreement.
Richard Sullivan's employment agreement 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);
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 us or his ceasing to serve as our
Chairman of the Board or Chief Executive Officer for any reason
other than due to his material default, with us having the option to
pay this amount in cash or in shares of our common stock or any
combination of the two. In the event we opted to make any portion of
the payment in shares of our common stock, the agreement stipulated
that the common stock was to be valued at the average closing price
of the stock on the Nasdaq National Market (our stock was, at the
time the agreement was entered into, listed on the Nasdaq National
Market but has since been transferred to the SmallCap) over the last
five business days prior to the date of the Triggering Event.
In total, the employment agreement obligated us to pay Richard Sullivan
approximately $17.3 million under, or in connection with, the termination of his
employment agreement. In view of our cash constraints and our need at the time
to dedicate our cash resources to satisfying our obligations to IBM Credit, we
commenced negotiations with Richard Sullivan that led to the proposed terms of
his severance agreement. The severance agreement required us to make
approximately $3.9 million less in payments to Richard Sullivan than would have
been owed to him under his employment agreement.
Effective March 3, 2004, Richard J. Sullivan resigned from Digital Angel
Corporation's Board of Directors, and thus, he no longer has any affiliation
with us.
On March 21, 2003, Jerome C. Artigliere, our then Senior Vice President
and Chief Operating Officer, resigned from such positions. Under the terms of
his severance agreement, Mr. Artigliere received approximately 0.5 million
shares of our common stock. We issued the shares to Mr. Artigliere on March 1,
2004. In addition, stock options held by him exercisable for approximately 0.2
million shares of our common stock were re-priced. The options surrendered had
exercise prices ranging from $1.50 to $3.20 per share and were replaced with
options exercisable at $0.10 per share. All of the re-priced options have been
exercised. Mr. Artigliere's severance agreement provides that the payment of
shares and re-pricing of options provided under that agreement is in lieu of all
future compensation and other benefits that would have been owed to him under
his employment agreement. That agreement required us to make payments of
approximately $1.5 million to Mr. Artigliere.
25
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 negotiated a settlement of our obligations
under Garrett Sullivan's severance agreement that required us to issue to
Garrett Sullivan approximately 0.8 million shares of our common stock. We issued
the shares, valued at $3.5 million, to Garrett Sullivan on February 17, 2004.
Our shareholders have approved the issuances of the common stock and have
ratified the re-pricing of the options under the terms of the severance
agreements with Richard J. Sullivan and Jerome C. Artigliere and they have
approved the issuance of the common stock under the agreement entered into with
Garrett Sullivan. The terms of each of the severance agreements were subject to
shareholder approval, in accordance with applicable Nasdaq rules, because the
agreements: (i) were deemed to be compensatory arrangements under which our
common stock was being acquired by officers or directors; and (ii) in Richard
Sullivan's case, such issuance may have resulted 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.
As a result of the terminations of Messrs. Sullivan and Artigliere, we
recorded severance expense of $18.1 million during the year ended December 31,
2003, of which $17.9 million is reflected in "Corporate/Eliminations," and $0.2
million is reflected in the Advanced Technology segment. The expense is included
in our Consolidated Statements of Operations in selling, general and
administrative expense.
GEOGRAPHIC AREAS
Currently, we operate in two geographic areas: the United States, which
comprises the majority of our operations, and the United Kingdom. Our United
Kingdom operations consist of one company in our Digital Angel Corporation
segment. The majority of our revenues and expenses in each geographic area, both
from Continuing and Discontinued Operations, were generated in the same
currencies, except as noted below.
Previously, we operated in Canada. Our Canadian operation was comprised of
an automotive manufacturing and engineering company, which was part of our
Discontinued Operations, and which we disposed of in January 2002. Approximately
41% of the manufacturing and engineering company's revenues were generated in
U.S. Dollars for the year ended December 31, 2001, while 94% of its expenses
were incurred in Canadian Dollars during the same period.
From the latter part of December 2000 to April 2002, we operated a United
Kingdom company that was part of All Other. Approximately 89% of this company's
revenues were generated in foreign currencies during 2002, while approximately
45% of its expenses were generated in foreign currencies.
We did not incur any significant foreign currency gains or losses during
the three years ended December 31, 2003.
26
Revenues are attributed to geographic areas based on the location of the
assets producing the revenue. Information concerning principal geographic areas
from continuing operations as of and for the years ended December 31, was as
follows (in thousands):
UNITED
UNITED STATES KINGDOM CONSOLIDATED
-----------------------------------------------------------------
2003
Net revenue $82,625 $10,362 $92,987
Long-lived tangible assets 7,113 1,115 8,228
Deferred tax asset -- -- --
- ----------------------------------------------------------------------------------------------
2002
Net revenue $87,075 $11,410 $98,485
Long-lived tangible assets 7,577 855 8,432
Deferred tax asset 1,236 -- 1,236
- ----------------------------------------------------------------------------------------------
2001
Net revenue $139,060 $17,427 $156,487
Long-lived tangible assets 19,193 992 20,185
Deferred tax asset 1,167 -- 1,167
- ----------------------------------------------------------------------------------------------
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.
27
RISK FACTORS
WE HAVE A HISTORY OF OPERATING LOSSES AND NEGATIVE CASH FLOWS AND WE MAY
NOT BECOME PROFITABLE IN THE FUTURE, WHICH COULD RESULT IN OUR INABILITY TO
CONTINUE OPERATIONS IN THE NORMAL COURSE OF BUSINESS.
Historically we have suffered losses and have not generated positive cash
flows from operations. This raised doubt in the past about our ability to
continue as a going concern. As of December 31, 2003, as a result of the reduced
settlement payment of the our debt obligations to IBM, the conversion to equity
of our obligations under the Debentures, and the sale of 3.0 million shares of
our common stock under our 3.0 million share offering, we have mitigated the
substantial doubt regarding our ability to continue as a going concern.
Excluding a gain on the extinguishment of debt of $70.1 million, we
incurred a net loss from continuing operations for the year ended December 31,
2003, of $64.1 million and we incurred net losses from continuing operations of
$89.5 million and $188.6 million for the years ended December 31, 2002 and 2001,
respectively. Our consolidated operating activities used cash of $11.4 million,
$3.9 million and $18.0 million during 2003, 2002 and 2001, 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.
As of December 31, 2003, we reported minimal revenues from the sales of
our Digital AngelTM, VeriChip(TM) and Bio ThermoTM products and we have had no
sales of our Thermo Life(TM) and PLD products. As of December 31, 2003, we had a
consolidated cash balance of $10.2 million, which we believe, along with other
sources of funds, will provide us with sufficient working capital for the twelve
months ending December 31, 2004. However, beyond that time frame, we believe
that absent significant improvement in the sales of these advanced technology
products, our business operations are unlikely to provide sufficient cash flow
to support our operational requirements. Our profitability and liquidity depend
on many factors including the success of our marketing programs, the maintenance
and reduction of expenses and our ability to successfully develop and bring to
market our new products and technologies. Our ability to achieve profitability
and/or generate positive cash flows from operations is predicated upon numerous
factors with varying levels of importance as follows:
o First, we will attempt to successfully implement our business plans,
manage expenditures according to our budget, and generate positive
cash flow from operations;
o Second, we will attempt to develop an effective marketing and sales
strategy in order to grow our business and compete successfully in
our markets;
o Third, we will attempt to obtain the necessary approvals to expand
the market for the VeriChip product in order to improve the
product's salability;
o Fourth, we will attempt to realize positive cash flow with respect
to our investment in Digital Angel Corporation in order to provide
us with an appropriate return on our investment; and
o Finally, we will attempt to complete the development of the Digital
Angel and PLD products.
If we are not successful in managing these factors and achieving these
goals, it could have a material adverse effect on our business, financial
condition and results of operations, which could result in our inability to
continue operations in the normal course of business.
28
OUR FAILURE TO GENERATE POSITIVE CASH FLOW FROM OPERATIONS WILL HAVE A
SUBSTANTIAL NEGATIVE IMPACT ON OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
Our operating activities did not provide positive cash flow during 2003,
2002 and 2001. Our sources of liquidity may include proceeds from the sale of
common stock and preferred shares, proceeds from the sale of businesses,
proceeds from the sale of the Digital Angel Corporation common stock owned by
us, proceeds from the sale of our common stock issued to Digital Angel
Corporation under the Share Exchange Agreement, proceeds from accounts
receivable and inventory financing arrangements, 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, which may not be available to us
on favorable terms. In the future, if we fail to generate positive cash flow
from operations, it will have a materially adverse effect on our business,
financial condition and results of operations.
WE WERE REQUIRED TO ISSUE ADDITIONAL SHARES OF COMMON STOCK IN CONNECTION
WITH SEVERANCE AGREEMENTS WITH OUR FORMER EXECUTIVE OFFICERS AND DIRECTORS AND,
AS A RESULT, YOUR INVESTMENT IN OUR COMMON STOCK HAS BEEN DILUTED, AND YOU MAY
BE UNABLE TO RESELL YOUR SHARES AT OR ABOVE THE PRICE AT WHICH YOU ACQUIRED
THEM.
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 provided for the issuance of 5.6
million and approximately 0.5 million shares of our common stock to Richard
Sullivan and Jerome Artigliere, respectively. We issued the shares to Richard
Sullivan and Jerome Artigliere on March 1, 2004. In addition, stock options held
by Richard Sullivan and Jerome Artigliere, which were exercisable for
approximately 1.1 and 0.2 million shares of our common stock, respectively, were
re-priced. The options surrendered had exercise prices ranging from $1.50 to
$3.20 per share and were replaced with options exercisable at $0.10 per share,
all of which have been exercised. 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 Garrett
Sullivan's ceasing to serve in such capacity in December 2001, has been
triggered. We negotiated a settlement of our obligations under Garrett
Sullivan's severance agreement that required us to issue to him 0.8 million
shares of our common stock. We issued the shares to Garrett Sullivan on February
17, 2004. The issuance of these shares to our former executive officers and
directors, which have been approved by our shareholders, have resulted in an
increase in the total number of our shares outstanding and, as a result, your
investment in our common stock has been further diluted, and you may be unable
to resell your shares at or above the price at which you acquired them.
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 $180.00 to a low of $0.30, ($18.00 and $0.03, respectively, on a
pre-reverse stock split basis). The price of our common stock has been, and may
continue to be, highly volatile and subject to wide fluctuations. 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 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.
29
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 MAY BE REQUIRED TO ISSUE ADDITIONAL SHARES OF OUR COMMON STOCK IN
CONNECTION WITH PRIOR AGREEMENTS, AND AS A RESULT, YOUR INVESTMENT IN OUR COMMON
STOCK MAY BE FURTHER DILUTED.
As of March 10, 2004, there were 50,289,399 shares of our common stock
outstanding. Since January 1, 2001, we have issued a net aggregate of 40,140,729
shares of common stock, of which
o 9,726,163 shares were issued in connection with acquisitions of
businesses and assets;
o 6,481,063 shares were issued upon conversion of our Series C
Preferred Stock;
o 2,769,960 shares were issued in connection with the Debentures;
o 7,996,558 shares were issued in connection with two best-efforts
offerings of our common stock through the efforts of a placement
agent J.P. Carey Securities, Inc.;
o 6,825,000 shares were issued in connection with three severance
agreements with our former officers and directors; and
o 1,980,000 shares were issued to Digital Angel Corporation under the
terms of the Share Exchange Agreement.
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. Such issuances of additional securities may be dilutive to the value
of our common stock and may have a material adverse impact on the market price
of our common stock.
WE HAVE 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 March 10, 2004, there were outstanding warrants and options to
acquire up to 3,680,455 additional shares of our common stock. In addition, as
of March 10, 2004, we had 757,450 additional shares of our common stock
available to be issued in the future under our stock option plans, and we had
588,629 additional shares of our common stock available to be issued in the
future under our 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 HAVE MADE SIGNIFICANT CHANGES TO OUR BUSINESS MODEL AND WE HAVE
EXPANDED INTO DIFFERENT PRODUCT LINES INCLUDING NEW UNPROVEN TECHNOLOGIES AND
OUR 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, VeriChip 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.
30
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 $37.1 million, or 83.2%, $31.3 million, or 74.7%, and $27.4
million, or 61.5%, of our Advanced Technology segment's revenue for the years
2003, 2002 and 2001, respectively, were generated by our wholly-owned
subsidiary, Computer Equity Corporation. Approximately 99.3%, 99.1% and 77.7% of
Computer Equity Corporation's revenue for the years 2003, 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 and holds less than one percent of the
federal telecommunications market share. Computer Equity's business is highly
competitive, and we expect that the competitive pressures it faces 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.
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 it does. 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 Digital Angel
Corporation's 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.
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.
31
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 CONDITION 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 ON OUR SMALL TEAM OF SENIOR MANAGEMENT AND KEY PERSONNEL, AND WE
MAY HAVE DIFFICULTY ATTRACTING AND RETAINING ADDITIONAL PERSONNEL, AND THE LOSS
OF THE SERVICES OF ANY ONE OF THEM COULD 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. 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 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 December 31, 2003, the book value of our inventory was $9.4 million as
compared to a book value of $6.4 million as of December 31, 2002. We attribute
the increase to an increase in work-in-process related to government contract
projects and the accumulation of inventory by Digital Angel Corporation in
anticipation of future sales. Our success depends in part 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.
DIGITAL ANGEL CORPORATION MAY NOT HAVE SUFFICIENT FUNDS TO REPAY ITS
OBLIGATIONS TO LAURUS WHEN THEY BECOME.
Digital Angel Corporation may not have sufficient funds to repay Laurus
when its debt obligations to Laurus become due. Accordingly, it may be required
to obtain the funds necessary to repay these obligations either through
refinancing, the issuance of additional equity or debt securities or the sale of
assets. Digital Angel Corporation may be unable to obtain the funds needed, if
any, to repay the obligations from any one or more of these other sources on
favorable economic terms or at all. If Digital Angel Corporation is unable to
obtain funds to repay this indebtedness, it may be forced to dispose of its
assets or take other actions on disadvantageous terms, which could result in
losses to Digital Angel Corporation and could have a material adverse effect on
our financial condition and results of operations.
32
THE TERMS OF DIGITAL ANGEL CORPORATION'S DEBT OBLIGATIONS TO LAURUS
SUBJECT US TO THE RISK OF FORECLOSURE ON SUBSTANTIALLY ALL OF DIGITAL ANGEL
CORPORATION'S ASSETS.
To secure the payment of all obligations owed to Laurus, Digital Angel
Corporation has granted to Laurus a security interest in and lien upon all of
its property and assets, whether real or personal, tangible or intangible,
whether now owned or hereafter acquired, or in which it now has, or at any time
in the future may acquire, any right, title or interest. The occurrence of an
event of default under any of its obligations would subject Digital Angel
Corporation to foreclosure by Laurus on substantially all of its assets to the
extent necessary to repay any amounts due. Any such defaults and resulting
foreclosure would have a material adverse effect on our financial condition.
INFOTECH USA, INC. MAY NOT BE SUCCESSFUL IN OBTAINING A REPLACEMENT FOR
ITS IBM CREDIT FACILITY, WHICH COULD HAVE A MATERIAL ADVERSE IMPACT ON OUR
FINANCIAL CONDITION, RESULTS OF OPERATIONS AND CASH FLOWS.
The InfoTech USA, Inc. segment finances its accounts receivable and
inventory. Its current financing arrangement with IBM Credit provides financing
on inventory purchases up to $1.8 million. Borrowing for purchases is based upon
75% of all eligible receivables due within 90 days and up to 100% of all
eligible inventories. Borrowings under the financing arrangement with IBM Credit
were $0.8 million at December 31, 2003. On September 5, 2003, InfoTech USA, Inc.
received a letter from IBM Credit constituting their formal notice of
termination of the agreement. The effective date of such termination, which was
originally set for March 10, 2004, has been extended until April 9, 2004.
InfoTech USA, Inc. is currently in the process of securing other financing and
expects to replace its financing arrangement prior to the termination date set
by IBM Credit. However, if InfoTech USA, Inc. is not successful in obtaining a
replacement for the IBM Credit financing arrangement, which is needed to fund
its operations in the coming year and beyond, InfoTech USA, Inc. may not be able
to continue in the ordinary course of business, which would have a material
adverse impact on our financial condition, results of operations and cash flows.
THE ISSUANCES OF COMMON STOCK TO THIRD PARTIES BY DIGITAL ANGEL
CORPORATION GIVE RISE TO A REDUCTION OF OUR OWNERSHIP INTEREST AND MAY RESULT IN
SIGNIFICANT LOSSES, WHICH COULD ADVERSELY AFFECT OUR FINANCIAL CONDITIONS AND
RESULTS OF OPERATIONS.
Gains where realizable and losses on issuance of shares of stock by our
consolidated subsidiary, Digital Angel Corporation, are reflected in our
Consolidated Statements of Operations. These gains and losses result from the
difference between the carrying amount of the pro-rata share of our investment
in Digital Angel Corporation and the net proceeds from the issuances of the
stock. In the past, the issuances of stock to third parties by Digital Angel
Corporation have also given rise to losses as a result of the reduction of our
interest ownership in Digital Angel Corporation. Future stock issuances to third
parties by Digital Angel Corporation, including upon the exercise of stock
options and warrants, the conversion of debt, or the conversion of Digital Angel
Corporation's Series A Preferred Stock issued in connection with the OuterLink
acquisition, will further dilute our ownership percentage, which may give rise
to significant losses. If we incur such losses, and/or become unable to
consolidate the operations of Digital Angel Corporation, it could have a
material adverse impact on our financial condition and results of operations.
DIGITAL ANGEL CORPORATION DEPENDS 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.
33
IF WE DO NOT PREVAIL IN ONGOING LITIGATION WE MAY BE REQUIRED TO PAY
SUBSTANTIAL DAMAGES.
In addition to the litigation described under Legal Proceedings beginning
on page 40, we are party to various legal actions as either plaintiff or
defendant in the ordinary course of 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 have a
material adverse effect on our business. 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 through March 2013. 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 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
its intended security, financial and personal identification/safety
applications. However, the FDA further stated in its determination letter that
with respect to the use of the VeriChip product in health information
applications, VeriChip is a medical device subject to the FDA's jurisdiction. On
November 8, 2002, we received a letter from the FDA, based upon correspondence
from us to the FDA, warning us not to market VeriChip for medical applications.
While we currently intend to market and distribute the VeriChip product for
security, financial and personal identification/safety applications, in the
future, we plan to expand our marketing and distribution efforts to healthcare
information applications of the product, subject to any and all necessary FDA
and other approvals. 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.
34
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 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 effect Digital Angel
Corporation's business.
CERTAIN FACTORS COULD IMPAIR DIGITAL ANGEL CORPORATION'S ABILITY TO
DEVELOP AND SELL ITS PRODUCTS IN CERTAIN MARKETS.
The electronic animal identification market can be negatively affected by
such factors as food safety concerns, consumer perceptions regarding cost and
efficacy, international technology standards, national infrastructures, and
slaughterhouse removal of microchips. The occurrence of any of these factors
could prevent Digital Angel Corporation from selling, or materially impair its
ability to sell, its products in certain markets and could negatively affect our
business.
WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS FROM THE USE OF OUR PRODUCTS
THAT COULD RESULT IN COSTS OR DAMAGES PAYABLE BY US ADVERSELY EFFECTING OUR
BUSINESS, FINANCIAL CONDITION, AND RESULTS OF OPERATIONS.
Manufacturing, marketing, selling, and testing our products under
development entail a risk of product liability. We could be subject to product
liability claims in the event our products or products under development fail to
perform as intended. Even unsuccessful claims could result in the expenditure of
funds in litigation and the diversion of management time and resources and could
damage our reputation and impair the marketability of our products. While we
maintain liability insurance, it is possible that a successful claim could be
made against us, that the amount of indemnification payments or insurance would
not be adequate to cover the costs of defending against or paying such a claim,
or that damages payable by us would have a material adverse effect on our
business, financial condition, and results of operations.
THE DIGITAL ANGEL AND PLD TECHNOLOGIES ARE NOT DEVELOPED FOR COMMERCIAL
DEPLOYMENT AND THERE IS NO CERTAINTY THAT THEY WILL BE SUCCESSFULLY MARKETED.
Our ability to develop and commercialize products based on the Digital
Angel and PLD proprietary technologies will depend on our ability to develop our
products internally on a timely basis. However, there is no certainty that these
technologies will be developed, and if developed, that they will be successfully
marketed.
35
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
This Annual Report contains "forward-looking statements" within the
meaning of Section 27A of the Securities Act of 1933, Section 21E of the
Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act
of 1995. We intend that such forward-looking statements be subject to the safe
harbors created thereby. These forward-looking statements involve known and
unknown risks, uncertainties and other factors which may cause our actual
results, performances or achievements to be materially different from any future
results, performance or achievements expressed or implied by the forward-looking
statements.
Forward-looking statements include, but are not limited to:
o our working capital requirements over the next twelve months;
o our growth strategies including, without limitation, our
ability to deploy our products and services including Digital
AngelTM, Thermo LifeTM, VeriChipTM, Bio-ThermoTM and PLD;
o anticipated trends in our business and demographics;
o the ability to obtain regulatory agencies' approvals including
but not limited to FDA approval regarding VeriChip;
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 "will likely result," "are expected to," "will continue," "is anticipated,"
"projects," "target," "goal," "plans," "objective," "may," "should," "could,"
"would," "anticipates," "expects," "intends," "plans," "believes," "seeks,"
"estimates," "hopes," and similar expressions intended to identify
forward-looking statements. These forward-looking statements are not guarantees
of future performance and are subject to risks and uncertainties that could
cause actual results to differ materially from estimates or forecasts contained
in the forward-looking statements. Some of these risks and uncertainties are
beyond our control. Also, these forward-looking statements represent our
estimates and assumptions only as of the date the statement was made. We do not
undertake any obligation to publicly update or correct any forward-looking
statements to reflect events or circumstances that subsequently occur or which
we hereafter become aware of.
36
RAW MATERIALS AND SUPPLIES
To date, we have not been materially adversely affected by the inability
to obtain raw materials or products. Our principal manufacturing subcontractors
and suppliers by segment are as follows:
Advanced Technology Segment
Principal Suppliers
Computer Equity Corporation's major suppliers are Anixter, NEC America,
Inc., Graybar Electric, Koss Comm Systems, Inc., and Accu-Tech, among others.
Computer Equity Corporation does not enter into contracts with its suppliers.
Computer Equity Corporation is generally obligated to make net payments to its
suppliers within 30 days of the suppliers' invoice date.
The VeriChip product is licensed from Digital Angel Corporation under an
exclusive product and technology license with a remaining term until March 2013.
Digital Angel Corporation Segment
Principal Suppliers
Our Digital Angel Corporation segment relies solely on a production
arrangement with Raytheon Corporation for the assembly of its patented
syringe-injectable microchips, which are used in all of our implantable
electronic identification products. The loss of, or any significant reduction
in, the production could have an adverse effect on our and Digital Angel
Corporation's businesses. In addition to Raytheon, Digital Angel Corporation's
principal suppliers are TSI Molding, Inc., Motorola Ltd., EM
Microelectronics-Marin SA, and Elder Industries. Digital Angel Corporation does
not have contracts or supply arrangements with these suppliers.
InfoTech USA, Inc. Segment
Principal Suppliers
Over 74.7% of InfoTech USA, Inc.'s purchases during 2003 were from its top
four suppliers as follows: Ingram, 38.3%, IBM, 17.7%, Tech Data, 9.5%, Compaq,
9.2%. InfoTech USA, Inc. does not enter into contracts with its suppliers and is
generally obligated to make net payments to its suppliers within 30 days of the
suppliers' invoice date.
SEASONALITY
No material portion of our business is considered to be seasonal.
EMPLOYEES
At March 10, 2004, we and our subsidiaries employed approximately 403
employees.
BACKLOG
At March 10, 2004, we and our subsidiaries had a backlog of approximately
$34.7 million. We expect the entire backlog at March 10, 2004, to be filled in
2004 and 2005.
37
COMPLIANCE WITH ENVIRONMENTAL REGULATIONS
Federal, state, and local laws or regulations which have been enacted or
adopted regulating the discharge of materials into the environment have not had,
and under present conditions we do not foresee that they will have, a material
adverse effect on our capital expenditures, earnings, cash flows or our
competitive position. We will continue to monitor our operations with respect to
potential environmental issues, including changes in legally mandated standards.
GOVERNMENT REGULATION
We are subject to federal, state and local regulation in the United
States, including the FDA and Federal Communications Commission. We are also
subject to regulation by government entities in other countries.
UNITED STATES REGULATION
Advanced Technology Segment
The FDA ruled in October 2002, that VeriChip is a regulated medical device
when marketed to provide information to assist in the diagnosis or treatment of
injury or illness. On October 29, 2003, we announced that we had submitted a
510(k) application to the FDA seeking the FDA's approval to market VeriChip's
healthcare information applications in the United States. If approval is
obtained, we plan to market VeriChip for healthcare information applications
under the name VeriMedTM.
Digital Angel Corporation Segment
Animal products for food producing animals have been reviewed by the FDA's
Center for Veterinary Medicine and the FDA has determined that Digital Angel
Corporation's product, as presently configured, is unregulated. As of December
31, 2003, Digital Angel Corporation's products do not incorporate FDA regulated
components. However, any applications directly related to medical information
will require FDA approval. The FCC has also approved certain Digital Angel
Corporation products. Digital Angel Corporations insecticide products require
approval by the United States Environmental Protection Agency, which has been
obtained.
REGULATION ABROAD
Our products are subject to compliance with applicable regulatory
requirements in those foreign countries where our products are sold. The
contracts we maintain with our distributors in these foreign countries generally
require the distributor to obtain all necessary regulatory approvals from the
governments of the countries in which these distributors sell our products.
38
ITEM 2. PROPERTIES
As of March 15, 2004, our corporate headquarters were located in Palm
Beach, Florida. Since June 2004, are corporate headquarters are located in
Delray Beach, Florida. At March 10, 2003, we were obligated under leases for
approximately 163,614 square feet of facilities, of which 109,150 square feet
was for office facilities and 54,464 square feet was for factory and warehouse
space. These leases expire at various dates through 2042. In addition, we owned
111,977 square feet of office and manufacturing facilities, of which 78,800
square feet were for manufacturing, factory and warehouse use and 33,177 square
feet was for office space.
The following table sets forth our owned and leased properties by business
divisions:
FACTORY/
OFFICE WAREHOUSE TOTAL
----------------------------------------
(amounts in square feet)
Advanced Technology 56,005 13,464 69,469
Digital Angel Corporation 41,621 114,000 155,621
InfoTech USA, Inc. 9,119 1,000 10,119
Corporate (1) 20,582 -- 20,582
----------- -------------- -------------
Total Continuing Operations 127,327 128,464 255,791
Discontinued Operations 15,000 4,800 19,800
----------- -------------- -------------
Total 142,327 133,264 275,591
=========== ============== =============
The following table sets forth the principal locations of our properties:
FACTORY /
OFFICE WAREHOUSE TOTAL
----------------------------------------
(amounts in square feet)
California 27,649 -- 27,649
Florida 3,894 -- 3,894
Maryland 15,000 4,800 19,800
Massachusetts 10,471 10,471
Minnesota 6,000 74,000 80,000
New Hampshire 15,856 5,464 21,320
New Jersey (1) 20,838 1,000 21,838
New York 1,969 -- 1,969
Virginia 18,500 8,000 26,500
United Kingdom 22,150 40,000 62,150
----------- ---------------- ------------
Total 142,327 133,264 275,591
=========== ================ ============
(1) Includes office space leased to others.
In June 2001, the FASB issued Statement of Financial Accounting Standard
No. 143, Accounting for Asset Retirement Obligations (FAS 143), which is
effective for fiscal years beginning after June 15, 2002. FAS 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, the 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 any impact on our financial position and results of operations, as we
do not currently have any legal obligations associated with the retirement of
long-lived assets or leased facilities.
39
ITEM 3. LEGAL PROCEEDINGS
We, and certain of our subsidiaries, are parties to various legal actions
as either plaintiff or defendant and accordingly, we have recorded certain
reserves in our financial statements as of December 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.
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. On May
15, 2003, we settled the dispute with Treeline, Inc., subject to certain
conditions subsequent. The settlement provided for the issuance of 0.1 million
shares of our common stock, subject to price protection provisions under the
settlement agreement. The Securities and Exchange Commission declared our
registration statement registering the 0.1 million shares issued in connection
with this settlement effective on September 10, 2003.
On March 31, 2002, 510 Ryerson Road, Inc. filed a lawsuit against us and
one of our subsidiaries in connection with a lease for a facility that we
vacated prior to the expiration of the lease and which is no longer in use. The
plaintiffs demanded relief in the amount of $2.0 million. We have entered into a
settlement agreement with the plaintiffs pursuant to which we issued to the
plaintiff shares having a value of approximately $1.1 million plus interest. The
shares were issued on February 17, 2004.
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 from insurance, and is subject
to approval by the District Court. In December 2003, the District Court issued a
preliminary approval of the class action settlement and directed that Class
Members be given notice of the Settlement. The final hearing, at which the Court
will consider whether to issue its final approval and enter final judgment, is
set for March 19, 2004.
On October 22, 2002, Anat Ebenstein, InfoTech USA, Inc.'s former Chief
Executive Officer, filed a complaint against us and InfoTech USA, Inc. and
certain officers and directors in connection with the termination of her
employment. The complaint filed in the Superior Court of New Jersey, Mercer
County, seeks compensatory and punitive damages of $1.0 million arising from an
alleged improper termination. The action is currently in the discovery stage. We
believe that a portion of any ultimate damages may be covered under insurance.
On October 22, 2003, Melvin Maudlin (the "Plaintiff"), a former employee
at our subsidiary, Pacific Decision Sciences Corporation ("PDSC"), filed suit in
the Superior Court of California against PDSC, Hark Vasa and us in connection
with a purported trust agreement involving PDSC which, according to the
Plaintiff provides that he is to receive monthly payments of $10,000 for
approximately 17 years. The Plaintiff has obtained a pre-judgment right to
attach order in the amount of his total claim of $2.1 million, and subsequently
obtained a purported writ of attachment of certain PDSC assets. The suit has not
materially affected PDSC's ability to operate its business but could affect such
operations in the future. Discovery has not yet begun, and no trial date has
been set. We intend to vigorously defend this suit.
40
In February 2003, an action was filed in Middlesex County Superior Court
in the Commonwealth of Massachusetts. Digital Angel Corporation's subsidiary,
OuterLink (OuterLink was acquired in January 2004), as well as a significant
stockholder of OuterLink and a principal of the significant stockholder are
named as defendants. Such principal was a director of OuterLink. The complaint
alleged breach of an August 25, 1999 employment contract. The plaintiff was
President and Chief Executive Officer of OuterLink from July 1999 through August
2002. The Complaint seeks damages based principally on a contractual severance
provision that allegedly provided for four months of compensation for every year
or fraction thereof served prior to termination. At the time of termination, the
complaint alleges that the plaintiff's salary was approximately $0.3 million per
year. The Defendants answered denying all liability and asserting a
counterclaim. Discovery will be completed in this matter shortly and the
Defendants intend to vigorously defend this matter and pursue their
counterclaim. The ultimate outcome of this proceeding cannot be predicted at
this time, and we are currently unable to determine the potential effect of this
litigation on our consolidated financial position, results of operation or cash
flows.
In June, 2002, eResearch Technology, Inc. f/k/a Premier Research
Worldwide, Ltd. ("ERT") commenced a proceeding in the United States District
Court for the District of New Jersey against U.S. Bank National Association ("US
Bank") and Digital Angel Corporation. This suit was commenced to pursue alleged
damages of approximately $0.4 million due to the Digital Angel Corporation and
US Bank's alleged failure to register transfers of restricted Digital Angel
Corporation's common stock sold by ERT in May 2002. Digital Angel Corporation
has agreed to indemnify US Bank for all damages and reasonable costs relating to
this litigation. Digital Angel Corporation has asserted a counterclaim against
ERT based on ERT's breach of a license agreement and services agreements between
the parties that resulted in the original issuance of approximately 0.6 million
restricted shares of Digital Angel Corporation's common stock to ERT. The
damages to Digital Angel Corporation exceed $4 million and this amount does not
include the share of profits, which Digital Angel Corporation seeks to recover
had ERT not breached the agreements. Further, the alleged damages sought by the
Plaintiff in this matter do not take into account plaintiff's duty to mitigate
damages which if discharged would have resulted in a profit to ERT. The ultimate
outcome of this proceeding cannot be predicted at this time and we are currently
unable to determine the potential effect of this litigation on our consolidated
financial position, results of operation or cash flows.
In February 2004, Electronic Identification Devices, Ltd. ("EID")
commenced a Declaratory Judgment Action against Digital Angel Corporation in the
United States District Court for the Western District of Texas. This action
seeks a declaration of patent non-infringement relating to Digital Angel
Corporation's syringe implantable identification transponders. Monetary damages
are not being sought. The lawsuit alleges that Plaintiff EID has developed a new
transponder that it believes does not infringe on Digital Angel Corporation's
patent. The lawsuit acknowledges that Digital Angel Corporation obtained a
Judgment of Infringement and two Contempt Orders against EID based on selling
certain systems that infringed on Digital Angel Corporation's patent in 1997,
1998 and 1999. Digital Angel Corporation has not yet answered the Complaint and
given the very early stage of this matter, the ultimate outcome of this
proceeding cannot be predicted at this time.
We are not subject to any environmental or formal governmental
proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We did not submit any matters to a vote of security holders during the
fourth quarter of 2003.
41
PART II
ITEM 5. MARKET PRICE OF THE REGISTRANT'S COMMON EQUITY AND RELATED
SHAREHOLDER MATTERS
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). From July 31, 2002, to October
11, 2002, our shares were relisted on the NasdaqNM under the symbol "ADSX."
Since November 12, 2002, our common stock has been included in the SmallCap
under the symbol "ADSX."
The following table shows (on a post-reverse stock split basis), for the
periods indicated, the high and low sales prices per share of our common stock
based on published financial sources.
HIGH LOW
---- ---
2002
First Quarter $ 5.50 $ 2.80
Second Quarter 24.00 2.90
Third Quarter 8.40 0.30
Fourth Quarter 7.00 3.60
2003
First Quarter $ 6.40 $ 1.80
Second Quarter 6.10 3.50
Third Quarter 5.50 3.70
Fourth Quarter 5.00 2.80
HOLDERS
According to the records of our transfer agent, as of March 10, 2004,
there were approximately 2,661 holders of record of our common stock.
DIVIDENDS
We have never paid cash dividends on our common stock. The decision
whether to apply legally available funds to the payment of dividends on our
common stock will be made by our Board of Directors from time to time in the
exercise of its business judgment.
42
RECENT SALES OF UNREGISTERED SECURITIES
The following table lists all unregistered securities sold by us during
the year ended December 31, 2003, which have not previously been reported. These
shares were issued in connection with the earnout provisions of an acquisition
agreement, employee stock options and payment of directors' fees. 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.
Aggregate Number of
Amount of Number of Common
Name/Entity/Nature Date of Sale Consideration Persons Note Issued For Shares
- -----------------------------------------------------------------------------------------------------------------
Steven Couture October 2003 $138,832 1 1 Earnout 32,611
Jeffrey Couture October 2003 134,750 1 1 Earnout 31,652
Raymond Maggi October 2003 134,750 1 1 Earnout 31,652
Applied Digital
Solutions, Inc.'s
Directors, Officers and Employee stock
Employees November 2003 -- Various 2 options 672,000
Dan Penni November 2003 42,000 1 3 Services 9,333
Art Noterman November 2003 39,356 1 3 Services 8,746
Connie Weaver November 2003 47,778 1 3 Services 10,617
Angela Sullivan November 2003 10,000 1 3 Services 2,222
Michael Zarriello November 2003 11,034 1 3 Services 2,452
--------------- -------------
Total $558,500 801,285
=============== =============
1. Represents shares issued to the shareholder in connection with the
"earnout" provision of the agreement of sale relating to a prior
private transaction directly negotiated by the shareholder in
connection with the sale of their business to us, which transaction
was exempt from registration pursuant to Section 4(2) of the
Securities Act of 1933. The earnout provision provided for
post-closing compensation to the shareholder based on the
post-closing performance of the acquired company's business.
2. Represents options granted under our 2003 Flexible Stock Plan. No
consideration has been received in connection with these options as
none have been exercised.
3. Represents shares issued in lieu of cash payments for all or a
portion of the director's fees for the second, third and fourth
quarters of 2001, for the year ended December 31, 2002, and for the
first, second and third quarters of 2003. The certificates
representing the shares were legended to indicate that they were
restricted.
43
ITEM 6. SELECTED FINANCIAL DATA
The following table of selected financial data should be read in
conjunction with our consolidated financial statements and related notes,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," and other financial information appearing elsewhere in this Annual
Report. The Summary of Operations data set forth below for each of the years in
the three-year period ended December 31, 2003, and the Summary of Balance Sheet
Data as of December 31, 2003 and 2002, were derived from, and qualified by
reference to, our financial statements appearing elsewhere in this Annual
Report. The Summary of Operations data for the years ended December 31, 2000 and
1999, and the Summary of Balance Sheet Data as of December 31, 2001, 2000 and
1999, are derived from audited financial statements not included herein.
FOR THE FISCAL YEAR ENDED DECEMBER 31,
---------------------------------------------------------------------
2003 2002 2001 2000 1999
--------- --------- --------- --------- ---------
STATEMENT OF OPERATIONS DATA:
(in thousands, except per share amounts)
Net revenue $ 92,987 $ 98,485 $ 156,487 $ 135,007 $ 129,064
Cost of products and services sold 64,892 67,469 110,677 82,968 75,442
--------- --------- --------- --------- ---------
Gross profit 28,095 31,016 45,810 52,039 53,622
Selling, general and administrative 55,880 65,681 102,316 61,996 58,960
expense
Research and development expense 6,255 4,130 8,783 2,745 --
Depreciation and amortization 1,262 3,520 28,061 10,580 5,417
Asset impairment restructuring and
unusual costs 2,456 38,657 71,719 6,383 2,550
(Gain) loss on extinguishment of debt (70,064) -- (9,465) -- 249
Loss (gain) on sales of subsidiaries and
assets 330 (132) 6,058 (486) (20,075)
Interest and other income (919) (2,340) (2,076) (1,095) (422)
Interest expense 22,587 17,477 8,555 5,901 3,478
--------- --------- --------- --------- ---------
Income (loss) from continuing
operations before provision (benefit)
for taxes, minority interest, losses
attributable to capital
transactions of subsidiary and
equity in net loss of affiliate 10,308 (95,977) (168,141) (33,985) 3,465
Provision (benefit) for income taxes 1,702 326 20,870 (5,040) 1,091
--------- --------- --------- --------- ---------
Income (loss) from continuing
operations before minority interest,
losses attributable to capital transactions
of subsidiary and equity in net loss of
affiliate 8,606 (96,303) (189,011) (28,945) 2,374
Minority interest (4,132) (11,579) (718) 229 (46)
Net loss on capital transactions of
subsidiary 244 2,437 -- -- --
Loss attributable to changes in minority
interest as a result of capital transactions
of subsidiary 6,535 2,048 -- -- --
Equity in net loss of affiliate -- 291 328 -- --
--------- --------- --------- --------- ---------
Income (loss) from continuing operations 5,959 (89,500) (188,621) (29,174) 2,420
Income (loss) from discontinued
operations, net of income taxes (2,434) (24,405) 213 (75,702) 3,012
(Loss) income on disposal of
discontinued operations, including
provision for operating losses during
phase-out period, net of income taxes (382) 1,420 (16,695) (7,266) --
--------- --------- --------- --------- ---------
Net income (loss) 3,143 (112,485) (205,103) (112,142) 5,432
Preferred stock dividends and other -- -- (1,147) (191) --
Accretion of beneficial conversion
feature of preferred stock -- -- (9,392) (3,857) --
--------- --------- --------- --------- ---------
Net income (loss) available to common
shareholders $ 3,143 $(112,485) $(215,642) $(116,190) $ 5,432
========= ========= ========= ========= =========
44
EARNINGS (LOSS) PER SHARE ADJUSTED FOR THE REVERSE STOCK SPLIT
On March 12, 2004, our Board of Directors authorized a 1-for-10 reverse
stock split which was effectuated on April 5, 2004. The reverse stock split had
the effect of reducing the number of issued and outstanding shares of our common
stock, and accordingly, earnings (loss) per share increased as a result of the
decrease in the weighted average shares outstanding. The following presents our
basic and diluted earnings (loss) per share giving retroactive effect to the
reverse stock split:
FOR THE FISCAL YEAR ENDED DECEMBER 31,
--------------------------------------------------------------------------
2003 2002 2001 2000 1999
---------- ---------- ---------- ---------- ----------
Net income (loss) per common share - basic:
Continuing operations $ 0.17 $ (3.33) $ (11.71) $ (5.20) $ 0.52
Discontinued operations (0.08) (0.85) (0.97) (13.00) 0.64
---------- ---------- ---------- ---------- ----------
Net income (loss) per common
share-basic $ 0.09 $ (4.18) $ (12.68) $ (18.20) $ 1.16
========== ========== ========== ========== ==========
Net income (loss) per common
share - diluted:
Continuing operations $ 0.16 $ (3.33) $ (11.71) $ (5.20) $ 0.48
Discontinued operations (0.08) (0.85) (0.97) (13.00) 0.60
---------- ---------- ---------- ---------- ----------
Net income (loss) per common
share-diluted $ 0.08 $ (4.18) $ (12.68) $ (18.20) $ 1.08
========== ========== ========== ========== ==========
Average common shares outstanding:
Basic 36,178 26,923 17,001 6,382 4,681
---------- ---------- ---------- ---------- ----------
Diluted 37,299 26,923 17,001 6,382 5,009
---------- ---------- ---------- ---------- ----------
AS OF DECEMBER 31,
--------------------------------------------------------------------
2003 2002 2001 2000 1999
--------- --------- --------- --------- ---------
(AMOUNTS IN THOUSANDS)
BALANCE SHEET DATA:
Cash and cash equivalents $ 10,161 $ 5,809 $ 3,696 $ 8,039 $ 2,181
Restricted cash 765 -- -- -- --
Due from buyers of divested subsidiary -- -- 2,625 -- 31,302
Property and equipment 8,228 8,432 20,185 21,368 6,649
Goodwill 63,331 65,451 90,831 166,024 24,285
Net (liabilities) assets of discontinued
operations (8,294) (6,531) (9,460) 8,076 75,284
Total assets 111,931 111,156 167,489 319,451 186,605
Long-term debt 2,860 2,436 2,586 69,146 33,260
Total debt 8,086 84,265 86,422 74,374 62,915
Minority interest 23,029 18,422 4,460 4,879 1,292
Redeemable preferred stock and option -- -- 5,180 18,620 --
Stockholders' equity (deficit) 32,736 (36,092) 28,119 160,562 92,936
45
Effective January 1, 2002, we adopted Statement of Financial Accounting
Standard No. 142 Goodwill and Other Intangible Assets (FAS 142). FAS 142
requires that goodwill and certain intangibles no longer be amortized, but
instead tested for impairment at least annually.
The following table presents the impact of FAS 142 on our selected
financial data as indicated:
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2001 2000 1999
----------- ----------- -----------
Net (loss) income available to common stockholders:
Net (loss) income available to common stockholders
as reported $ (215,642) $ (116,190) $ 5,432
Add back: Goodwill amortization 21,312 9,415 2,602
Add back: Equity method investment amortization 1,161 -- --
----------- ----------- -----------
Adjusted net (loss) income $ (193,169) $ (106,775) $ 8,034
=========== =========== ===========
Earnings (loss) per common share - basic:
Net (loss) income per share - basic, as reported $ (12.68) $ (18.21) $ 1.16
Goodwill amortization 1.25 1.48 0.56
Equity method investment amortization 0.07 -- --
----------- ----------- -----------
Adjusted net (loss) income - basic $ (11.36) $ (16.73) $ 1.72
=========== =========== ===========
Earnings (loss) per common share - diluted:
Net (loss) income per share - diluted, as reported $ (12.68) $ (18.21) $ 1.08
Goodwill amortization 1.25 1.48 0.52
Equity method investment amortization 0.07 -- --
----------- ----------- -----------
Adjusted net (loss) income per share - diluted $ (11.36) $ (16.73) $ 1.60
=========== =========== ===========
We have adopted Statement of Financial Accounting Standard No. 145,
Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No.
13, and Technical Corrections (FAS 145), effective January 1, 2003. Under FAS
145, gains and losses on the extinguishment of debt are included as part of
continuing operations. FAS 145 requires all periods presented to be consistent,
and, as such, gains and losses on extinguishment of debt previously recorded as
extraordinary must be reclassified from extraordinary treatment and presented as
a component of continuing operations.
46
ITEM 7. 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 this Annual Report. Certain
statements contained herein may contain forward-looking statements - see
"Cautionary Statement Regarding Forward-Looking Information and Risk Factors."
OVERVIEW
Our business has evolved during the past few years. We grew significantly
through acquisitions and since 1996 have completed 51 acquisitions. During the
last half of 2001 and during 2002, we sold or closed many of the businesses we
had acquired that we believed did not enhance our strategy of becoming an
advanced technology development company. These companies were primarily
telephone system providers, software developers, software consultants,
networking integrators, computer hardware suppliers or were engaged in other
businesses or had customer bases that we believed did not promote or complement
our current business strategy. As of December 31, 2003, our business operations
consisted of the operations of five 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).
Excluding the effects of a gain on the extinguishment of debt of $70.1
million, we incurred a consolidated loss from continuing operations of $64.1
million for the year ended December 31, 2003. We incurred consolidated losses
from continuing operations of $89.5 million and $188.6 million, respectively,
for the years ended December 31, 2002 and 2001, and as of December 31, 2003, we
had an accumulative deficit of $413.9 million. Our consolidated operating
activities used cash of $11.4 million, $3.9 million and $18.0 million during
2003, 2002 and 2001, respectively. Digital Angel Corporation incurred losses
during 2003, 2002 and 2001, which are presented below. In addition, its
operating activities used cash of $4.7 million, $2.7 million and $3.2 million
during 2003, 2002 and 2001, respectively.
The reduced settlement payment of our debt obligations to IBM Credit LLC,
referred to as IBM Credit, the conversion to equity of our obligations under our
8.5% Convertible Exchangeable Debentures, and the sale of 3.0 million shares of
our common stock under our 3.0 million share offering, have been major factors
mitigating concerns that existed about our ability to continue as a going
concern. Our profitability and liquidity depend on many factors including the
success of our marketing programs, the maintenance and reduction of expenses and
our ability to successfully develop and bring to market our new products and
technologies. We have established a management plan intending to guide us in
achieving profitability and positive cash flows over the twelve-months ending
December 31, 2004. The major components of our plan are as follows:
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 AngelTM, Thermo LifeTM,
VeriChipTM, Bio-ThermoTM and PLD;
o to generate additional liquidity through divestiture of business
units and assets that are not critical to us;
o to position Digital Angel Corporation for growth under the
leadership of it new management team and through strategic
acquisitions such as the recent OuterLink acquisition;
47
o to generate additional liquidity for Digital Angel Corporation
through the Share Exchange Agreement between us and Digital Angel
Corporation;
o to attempt to pair VeriChip Corporation with a complementary company
that will bring experienced management, revenue and a synergistic
customer base.
Our management estimates that the above plan can be effectively
implemented.
BUSINESS SEGMENTS
As a result of the merger of pre-merger Digital Angel and MAS on March 27,
2002, the significant restructuring of our business during 2002 and 2001, and
our emergence as an advanced technology development company, we have
re-evaluated and realigned our reporting segments. Effective January 1, 2002, we
currently operate in three business segments: Advanced Technology, Digital Angel
Corporation and InfoTech USA, Inc., formerly SysComm International Corporation.
Business units that were part of our continuing operations and that were closed
or sold during 2002 and 2001 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.
Income (loss) 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 2003, 2002 and 2001 was as follows
(we evaluate performance based on stand-alone segment operating income as
presented below):
YEAR ENDED DECEMBER 31,
-----------------------
2003 2002 2001
---- ---- ----
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE
TAXES, MINORITY INTEREST, LOSSES ATTRIBUTABLE TO
CAPITAL TRANSACTIONS OF SUBSIDIARY AND EQUITY IN LOSS (IN THOUSANDS)
OF AFFILIATE BY SEGMENT:
ADVANCED TECHNOLOGY $ (108) $ (786) $ (41,493)
DIGITAL ANGEL CORPORATION (1) (2) (6,271) (45,139) (16,262)
INFOTECH USA, INC. (3) (3,052) (422) (1,322)
ALL OTHER 298 (320) (71,636)
"CORPORATE/ELIMINATIONS" (2) (4) 19,441 (49,310) (37,428)
--------- --------- ---------
TOTAL $ 10,308 $ (95,977) $(168,141)
========= ========= =========
(1) For Digital Angel Corporation, the loss for 2002 includes goodwill
impairment of $31.5 million and impairment of certain software of $6.4
million.
(2) For Digital Angel Corporation, amount for 2002 excludes $1.8 million of
interest expense associated with our previous 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-K dated December 31, 2003. These expenses are reflected in
"Corporate/Eliminations" for 2002.
(3) For InfoTech USA, Inc. the amount for 2003 includes a goodwill impairment
charge of $2.2 million.
(4) For "Corporate/Eliminations", the amount for 2003 includes extinguishment
of debt of $70.1 million, as a result of the repayment in full of all of
our obligations to IBM Credit on June 30, 2003, and $17.9 million of
non-cash compensation expense resulting from severance agreements with
certain former officers and directors.
Prior to January 1, 2002, our business was organized into three segments:
Applications, Services and Advanced Wireless. Prior period information has been
restated to present our reportable segments on a comparative basis.
48
On February 22, 2001, our senior management approved a plan to sell
Intellesale, Inc. and all of our other non-core businesses. Our Board of
Directors approved the plan on March 1, 2001. 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 and prior periods have been restated.
Our Medical Systems operations represented the business operations of MAS,
which we acquired on March 27, 2002. We sold the business assets of Medical
Systems during the second quarter of 2004, and accordingly, the financial
condition, results of operations and cash flows of Medical Systems are now
included as part of our Discontinued Operations in our financial statements, and
prior periods have been restated.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America.
As such, some accounting policies have a significant impact on the amount
reported in these financial statements. The preparation of our financial
statements requires us to make estimates and assumptions that affect the
reported amount of assets and liabilities, disclosure of contingent assets and
liabilities at the date of our financial statements, and the reported amounts of
revenue and expenses during the reporting period. There can be no assurance that
actual results will not differ from those estimates. We believe our most
critical accounting policies include revenue recognition, goodwill and other
intangible assets, gains/losses attributable to capital transactions of
subsidiary, stock-based compensation, warrants settleable in shares of Digital
Angel Corporation's common stock owned by us, proprietary software in
development, inventory obsolescence, and legal contingencies as explained below.
REVENUE RECOGNITION
Advanced Technology Segment Revenue Recognition
Computer Equity Corporation Revenue Recognition
The largest company in the Advanced Technology segment is Computer Equity
Corporation. This company supplies voice, data and video telecommunications
networks and related products to government agencies. These products include
voice mail, Internet cabling, phones and telephone wiring. Services are a minor
part of the business and usually consist of small jobs such as phone moves.
Computer Equity Corporation also receives monthly revenues from product related
maintenance contracts, which revenues represent the smallest portion of its
business. For product sales, we recognize revenue after the products are shipped
and title has transferred, provided that a purchase order has been received or a
contract has been executed, there are no uncertainties regarding customer
acceptance, the sales price is fixed and determinable and collectability is
deemed probable. If uncertainties regarding customer acceptance exist, revenue
is recognized when such uncertainties are resolved. Hardware sales for products
that are shipped to a customer's site and require modification or installation
are recognized when the work is complete and accepted by the customer. We do not
experience significant product returns, and therefore, management is of the
opinion that no allowance for sales returns is necessary. We have no obligation
for warranties on new hardware sales, because the manufacturer provides the
warranty. Services and phone installation jobs are billed and the revenue
recognized following the completion of the work and the receipt of a written
acceptance from the customer. Revenue from maintenance contracts is recognized
ratably over the term of the contract.
49
Other Advanced Technology Segment Companies Revenue Recognition (Excluding
VeriChip Corporation)
The other companies in the Advanced Technology segment that provide
programming, consulting and software licensing services recognize revenue based
on the expended actual direct labor hours in the job times the standard billing
rate and adjusted to realizable value, if necessary. It is our policy to record
contract losses in their entirety in the period in which such losses are
foreseeable. We do not offer a warranty policy for services to our customers.
Revenue from license royalties is recognized when licensed products are shipped.
There are no significant post-contract support obligations at the time of
revenue recognition. Our accounting policy regarding vendor and post-contract
support obligations is based on the terms of the customers' contract, billable
upon the occurrence of the post-sale support. Costs of goods sold are recorded
as the related revenue is recognized.
For product sales, we recognize revenue after the products are shipped and
title has transferred, provided that a purchase order has been received or a
contract has been executed, there are no uncertainties regarding customer
acceptance, the sale price is fixed and determinable and collectability is
deemed probable. If uncertainties regarding customer acceptance exist, revenue
is recognized when such uncertainties are resolved. Hardware sales for products
that are shipped to a customer's site and require modification or installation
are recognized when the work is complete and accepted by the customer. We do not
experience significant product returns, and therefore, management is of the
opinion that no allowance for sales returns is necessary. We have no obligation
for warranties on new hardware sales because the manufacturer provides the
warranty.
VeriChip Corporation Revenue Recognition
VeriChip is a miniaturized, implantable microchip for use in a variety of
identification, security and information applications. About the size of a grain
of rice, each VeriChip contains a unique verification number that can be used to
access a subscriber-supplied database providing personal related information.
To complement the VeriChip microchip, the VeriChip proprietary scanner is
a scanning device that activates and reads the RFID within the microchip. The
scanner emits a small amount of radio frequency energy that energizes the
dormant VeriChip, which then emits a radio frequency signal containing the
VeriChip verification number.
VeriChip revenue is comprised of the sale of VeriChip microchips, VeriChip
scanners, and a nominal distributorship fee. Generally, the distributorship
rights include the rights to market, promote and sell the product(s) in a
specific territory under the VeriChip name and trademarks for a specific period
of time. We are currently amending our distributor agreements such that the
distributor strives to meet annual marketing goals, or quotas, as agreed upon by
the distributor and us, by ordering and taking delivery from us of predetermined
quantities of product each year through the term of the contract. Failure to
meet the quota shall constitute a material breach of the contract and the loss
of distributorship exclusivity privileges within the territory. To renew a
preexisting agreement, the distributor must request so in-writing 30 days prior
to the expiration of the contract. We, at our own discretion, may then negotiate
in good faith with the distributor for a renewal of the agreement.
50
Originally, we entered into distributorship agreements whereby the
customer would pay an up-front fee in exchange for the exclusive right to
market, promote and sell VeriChip products within the agreed upon territory.
Under this arrangement, the distributorship fee was not credited against or
applied towards amounts due for any products subsequently ordered by the
distributor. However, it soon became clear that there was more realizable value
via a relationship where distributors could apply up-front monies in exchange
for product. We found that distributors expressed reluctance to pay fees without
receiving a tangible product in return. After time, it became clear that the
standard for entrants into comparable non-established marketplaces was to not
charge up-front fees. In an effort to retain our customer base, management
redefined its business strategy and amended its existing contracts to stipulate
that $1.00 of up-front money would be allocated to the distributorship fee, and
the remaining amounts were customer deposits, which were applied against future
purchases of VeriChip microchips and scanners. The advantage to this was that
the distributor was able to receive a tangible product to directly supply the
resellers, as opposed to fronting additional money to purchase additional
product.
Product Sales
Revenue from the sale of VeriChip microchips and scanners is recorded at
gross with a separate display of cost of products sold. Until the amount of
returns can be reasonably estimated, we do not recognize revenues until after
the products are shipped and title has transferred, provided that a purchase
order has been received or a contract has been executed, there are no
uncertainties regarding customer acceptance, the sales price is fixed and
determinable, the period of time the distributor has to return the products as
provided in their distributor agreement has expired and collectability is
reasonably assured. Once the amount of returns can be reasonably estimated,
revenues (net of expected returns) will be recognized at the time of shipment
and the passage of title, assuming there are no uncertainties regarding customer
acceptance. If uncertainties regarding customer acceptance exist, revenue will
not be recognized until such uncertainties are resolved. As of December 31,
2003, VeriChip deferred product revenue was $0.2 million.
Monitoring Services
When offered, monitoring services will be sold as a stand-alone contract
and treated as a separate earnings process from product sales. Revenues from
this service will be recognized on a straight-line basis over the term of the
service agreement. Since the final use of the product is unknown at the time it
is shipped to the distributor (end users will have the option of choosing from a
number of non-proprietary monitoring services or to choose none at all), and the
monitoring services are not essential to the functionality of all chips, we will
not attempt to bundle the revenue from the sale of chips with potential future
revenues from a monitoring service.
Digital Angel Corporation Segment Revenue Recognition
For product sales, Digital Angel Corporation recognizes revenue at the
time product is shipped and title has transferred, provided that a purchase
order has been received or a contract has been executed, there are no
uncertainties regarding customer acceptance, the sales price is fixed and
determinable and collectability is deemed probable. If uncertainties regarding
customer acceptance exists, revenue is recognized when such uncertainties are
resolved. There are no significant post-contract support obligations at the time
of revenue recognition. Digital Angel Corporation's accounting policy regarding
vendor and post contract support obligations is based on the terms of the
customers' contracts, billable upon occurrence of the post-sale support. Costs
of goods sold are recorded as the related revenue is recognized. Digital Angel
Corporation does not offer a warranty policy for services to customers. It is
Digital Angel Corporation's policy to record contract losses in their entirety
in the period in which such losses are foreseeable. For non-fixed fee jobs,
revenue is recognized based on the actual direct labor hours in the job
multiplied by the standard billing rate and adjusted to realizable value, if
necessary. Revenues from contracts that provide services are recognized ratably
over the term of the contract. Fixed fee revenues from contracts for services
are recorded when earned and exclude reimbursable costs. Reimbursable costs
incurred in performing such services are presented on a net basis and include
transportation and communication costs. Other revenues are recognized at the
time services or goods are provided.
51
InfoTech USA, Inc. Segment Revenue Recognition
For product sales, InfoTech USA, Inc. recognizes revenue in accordance
with the applicable products' shipping terms. InfoTech USA, Inc. has no
obligation for warranties on new product sales. The manufacturer provides the
warranty. For consulting and professional services, InfoTech USA, Inc.
recognizes revenue based on the direct labor hours incurred times the standard
billing rate, adjusted to realizable value, if necessary. Revenues from sales
contracts involving both products and consulting and other services are
allocated to each element based on vendor-specific objective evidence of fair
value, regardless of any separate prices that may be stated in the contract.
Vendor-specific objective evidence of fair value is the price charged when the
elements are sold separately. If an element is not yet being sold separately,
the fair value is the price established by management having the relevant
authority to do so. It is considered probable that the price established by
management will not change before the separate introduction of the element.
All Other
For arrangements where the contract to deliver software required
significant production, modification or customization of the software, revenue
was recognized using the percentage of completion accounting in accordance with
Statement of Position ("SOP") 97-2 and SOP 81-1. The service element of these
contracts was essential to the functionality of other elements in the contract
and could not be accounted for separately as allowed in SOP 97-2. The cost to
complete and extent of progress towards completion of these contracts was
reasonably ascertained based on the detailed tracking regarding labor hours
expended in accordance with SOP 97-2 and SOP 81-1. Progress payments on the
contracts were required and progress was measured using the efforts expended
input measure as allowed in SOP 81-1. As of December 31, 2001, we had sold the
business that recognized revenue using the percentage of completion accounting
as outlined above. The amount of revenue recognized using the percentage of
completion method for 2001 was $6.7 million.
GOODWILL AND OTHER INTANGIBLE ASSETS
Up through December 31, 2001, we reviewed goodwill and other intangible
assets quarterly for impairment whenever events or changes in business
circumstances indicated that the remaining useful life may have warranted
revision or that the carrying amount of the long-lived asset may not have been
fully recoverable. Included in factors considered were significant customer
losses, changes in profitability due to sudden economic or competitive factors,
changes in management's strategy for the business unit, letters of intent
received for the sale of the business unit, or other factors arising in the
quarterly period. We annually performed undiscounted cash flows analyses by
business unit to determine if impairment existed. For purposes of these
analyses, earnings before interest, taxes, depreciation and amortization were
used as the measure of cash flow. When impairment was determined to exist, any
related impairment loss was calculated based on fair value. Fair value was
determined based on discounted cash flows and where available, market related
information. The discount rate utilized by us was the rate of return expected
from the market or the rate of return for a similar investment with similar
risks. We recorded goodwill impairment charges of $63.6 million during 2001.
52
On January 1, 2002, we adopted Statement of Financial Accounting Standards
No. 142, Goodwill and Intangible Assets ("FAS 142"). FAS 142 eliminates the
amortization of goodwill and instead requires that goodwill be tested for
impairment at least annually. Intangible assets with finite lives are amortized
over the useful life. Other than goodwill, we currently do not have any
intangible assets with indefinite lives. As part of the implementation of FAS
142, we were required to complete a transitional impairment test of goodwill and
other intangible assets. There was no impairment of goodwill upon the adoption
of FAS 142. Annually, we test our goodwill and intangible assets for impairment
as a part of our annual business planning cycle during the fourth quarter of
each fiscal year. Based upon this annual test, we incurred a goodwill impairment
charge of $2.2 million in the fourth quarter of 2003 for goodwill associated
with our InfoTech USA, Inc. segment, and we recorded a goodwill impairment
charge $31.5 million in the fourth quarter of 2002 for goodwill associated with
our Digital Angel Corporation segment. (During the fourth quarters of 2003 and
2002, we also recorded goodwill impairment charges of $2.4 million and $30.7
million, respectively, and during the fourth quarter of 2003, we incurred an
impairment charge of $0.6 million for other intangible assets, all of which were
related to our Medical Systems operations, and all of which are now included in
our loss from Discontinued Operations). Future events, such as market conditions
or operational performance of our acquired businesses, could cause us to
conclude that additional impairment exists. Any resulting impairment loss could
also have a material adverse impact on our financial condition and results of
operations.
GAINS/LOSSES ATTRIBUTABLE TO CAPITAL TRANSACTIONS OF SUBSIDIARY
Gains where realizable and losses on issuances of shares of common stock
by our consolidated subsidiary, Digital Angel Corporation, are reflected in our
Consolidated Statements 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. These gains and
losses result from the differences between the carrying amount of the pro-rata
share of our investment in Digital Angel Corporation and the net proceeds from
the issuances of the stock. The issuances of stock by Digital Angel Corporation
have also given rise to losses as a result of the changes in the minority
interest ownership of Digital Angel Corporation. Future stock issuances to third
parties by Digital Angel Corporation will further dilute our ownership
percentage and may give rise to additional losses, which could have a material
adverse impact on our financial condition and results of operations.
STOCK-BASED COMPENSATION
We account for our employee stock-based compensation plans in accordance
with Accounting Principles Board 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, and the disclosure provisions of Statement
of Financial Accounting Standard No. 123 ("FAS 123"), Accounting for Stock-Based
Compensation. Accordingly, no compensation cost is recognized for any of our
fixed stock options granted to employees and directors 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. When options are granted to
employees and directors at a price less than fair market value on the date of
the grant, compensation expense is calculated based on the intrinsic value or
the difference between the exercise price and the fair value on the date of the
grant, and the compensation is recognized over the vesting period of the
options. If the options are fully vested, the expense is recognized immediately.
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 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. Under variable accounting, changes in the underlying price of our
stock may have a significant impact to our earnings. A rise in our stock price
results in additional compensation expense and a decrease in our common stock
price results in a reduction of reported compensation expense. During 2001, we
re-priced 1.9 million stock options. As a result, we have (recovered) recorded
non-cash compensation expense of $(1.3) million, $0.7 million and $5.3 million
in 2003, 2002 and 2001, respectively. In addition, on September 24, 2001, we
issued 0.4 million options to employees and directors with exercise prices of
$1.50 per share, or $0.20 per share less than the fair market value of the
underlying common stock on the date of grant. We have recognized compensation
expense of $0.1 million associated with these options. The compensation expense
was amortized over the vesting period of the options
53
We account for equity instruments issued to non-employees in accordance
with the provisions of FAS 123.
WARRANTS SETTLEABLE IN SHARES OF DIGITAL ANGEL CORPORATION'S COMMON STOCK OWNED
BY US
In connection with the Debentures, we granted to the Debenture holders,
also referred to as the Purchasers, warrants to acquire approximately 0.5
million shares of our common stock, or 0.95 million shares of Digital Angel
Corporation's common stock currently outstanding and owned by us, or a
combination of shares from both companies, at the Purchasers' option. The
exercise prices are $5.64 and $3.178 for our common stock and the Digital Angel
Corporation common stock owned by us, respectively. The Warrants vested
immediately, are subject to anti-dilution provisions and are exercisable through
June 30, 2007.
The value assigned to the Warrants was recorded as a reduction in the
value assigned to the Debentures (original issue discount) and an increase in
long-term liabilities. The liability for the Warrants, to the extent potentially
settleable in shares of the Digital Angel Corporation common stock owned by us,
is being revalued at each reporting period with any resulting increase/decrease
being recorded as an increase/decrease in interest expense. During the fourth
quarter of 2003, we recorded interest expense of $2.0 million as a result of
such revaluation. Going forward, changes in the market price of Digital Angel
Corporation's common stock will result in additional charges or credits to
operations, which charges could have a material adverse effect on our result of
operations. We will be required to record an impairment loss if the carrying
value of the Digital Angel Corporation common stock underlying the Warrants
exceeds the exercise price. Should the Purchasers elect to exercise the Warrants
into shares of the Digital Angel Corporation common stock owned by us, such
exercise may result in our recording a gain on the sale transaction equal to the
amount of the Warrant liability on the date of exercise.
PROPRIETARY SOFTWARE IN DEVELOPMENT
In accordance with Statement of Financial Accounting Standards 86,
Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise
Marketed ("FAS 86"), we have capitalized certain computer software development
costs upon the establishment of technological feasibility. Technological
feasibility is considered to have occurred upon completion of a detailed program
design that has been confirmed by documenting and tracing the detail program
design to product specifications and has been reviewed for high-risk development
issues, or to the extent a detailed program design is not pursued, upon
completion of a working model that has been confirmed by testing to be
consistent with the product design. Amortization is provided based on the
greater of the ratios that current gross revenues for a product bear to the
total of current and anticipated future gross revenues for that product, or the
straight-line method over the estimated useful life of the product. The
estimated useful life for the straight-line method is determined to be 2 to 5
years. Future events such as market conditions, customer demand, or
technological obsolescence could cause us to conclude that the software is
impaired. The determination of the possible impairment expense requires
management to make estimates that effect our consolidated financial statements.
54
INVENTORY OBSOLESCENCE
Estimates are used in determining the likelihood that inventory on hand
can be sold. Historical inventory usage and current revenue trends are
considered in estimating both obsolescence and slow-moving inventory. Inventory
is stated at lower of cost or market, determined by the first-in, first-out
method, net of any reserve for obsolete or slow-moving inventory.
LEGAL CONTINGENCIES
We are currently involved in several legal proceedings. We have accrued
our estimate of the probable costs for the resolution of these claims. This
estimate has been developed in consultation with outside counsel handling our
defense in these matters and is based upon an analysis of potential results,
assuming a combination of litigation and settlement strategies. We do not
believe these proceedings will have a material adverse effect on our
consolidated financial position. It is possible, however, that future results of
operations for any particular quarterly or annual period could be materially
affected by changes in our estimates.
55
RESULTS OF CONTINUING OPERATIONS
The following table sets forth data expressed as a percentage of total
revenue for the years indicated.
PERCENTAGE OF TOTAL REVENUE
---------------------------------
2003 2002 2001
% % %
------- ------- -------
Product revenue 83.6 81.6 72.3
Service revenue 16.4 18.4 27.7
------- ------- -------
Total revenue 100.0 100.0 100.0
------- ------- -------
Cost of products sold 64.0 59.9 55.9
Cost of services sold 5.8 8.6 14.8
------- ------- -------
Total cost of products and services sold 69.8 68.5 70.7
Gross profit 30.2 31.5 29.3
Selling, general and administrative expense 60.1 66.7 65.4
Research and development expense 6.7 4.2 5.6
Gain on extinguishment of debt (75.3) -- (6.0)
Asset impairment 2.6 39.3 45.8
Depreciation and amortization 1.4 3.6 17.9
Loss (gain) on sales of subsidiaries and
business assets 0.3 (0.1) 3.9
Interest and other income (1.0) (2.4) (1.3)
Interest expense 24.3 17.7 5.5
------- ------- -------
Income (loss) from continuing operations before
provision for income taxes, minority interest,
losses attributable to capital transactions of
subsidiary and equity in net loss of affiliate 11.1 (97.5) (107.5)
Provision for income taxes 1.8 0.3 13.3
------- ------- -------
Income (loss) from continuing operations before
minority interest, losses attributable to
capital transactions of subsidiary and equity
in net loss of affiliate 9.3 (97.8) (120.8)
Minority interest (4.4) (11.8) (0.5)
Net loss on capital transactions of subsidiary 0.3 2.5 --
Loss attributable to changes in minority
interest as a result of capital transactions of
subsidiary 7.0 2.1 --
Equity in net loss of affiliate -- 0.3 0.2
------- ------- -------
Income (loss) from continuing operations 6.4 (90.9) (120.5)
Income (loss) from discontinued operations, net
of income taxes (2.6) (24.7) 0.1
------- ------- -------
Change in estimate on loss on disposal and
operating losses during the phase out period (0.4) 1.4 (10.7)
------- ------- -------
Net income (loss) 3.4 (114.2) (131.1)
Preferred stock dividends and other -- -- (0.7)
Accretion of beneficial conversion feature of
preferred stock -- -- (6.0)
------- ------- -------
Net income (loss) available to common
shareholders 3.4 (114.2) (137.8)
======= ======= =======
56
Our significant sources of revenue for 2003 were as follows:
Sources of Revenue: PERCENTAGE OF
TOTAL REVENUE
-------------
Sales of voice, data and video telecommunications networks to government agencies
from our Advanced Technology segment 39.9%
Visual identification tags and implantable microchips for the companion animal,
livestock, laboratory animal, fish and wildlife markets from our Digital
Angel Corporation segment 25.8%
Sales of IT hardware and services from our InfoTech USA, Inc. segment 15.5%
GPS enabled search and rescue equipment, intelligent communications products and
services for telemetry, mobile data and radio communications from our Digital
Angel Corporation segment 11.1%
Other products and services 7.7%
------------------
Total 100.0%
==================
Our significant sources of gross profit and gross profit margin by product
type for 2003 were as follows:
Gross Profit and Gross Profit Margin by Product Type: GROSS PROFIT GROSS MARGIN
(IN THOUSANDS) PERCENTAGE
-------------- ----------
Sales of voice, data and video telecommunications networks to
government agencies from our Advanced Technology segment $7,015 18.9%
Visual identification tags and implantable microchips for the
companion animal, livestock, laboratory animal, fish and wildlife
markets from our Digital Angel Corporation segment 9,740 40.7%
Sales of IT hardware and services from our InfoTech USA, Inc. segment 2,510 17.4%
GPS enabled search and rescue equipment, intelligent communications
products and services for telemetry, mobile data and radio
communications from our Digital Angel Corporation segment 4,913 47.4%
Other products and services 3,917 55.1%
----------------- -----------------
Total $28,095 30.2%
================= =================
We hope to continue to grow our revenues and gross profits. We see a
possible increase in revenue from sales of voice, data and video
telecommunications networks to government agencies 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 traceability of animals and other food sources will increase the
markets for these products. With the IT market conditions improving and its
continued focus on higher-end Intel-based products, we are hoping that sales
volumes for our InfoTech USA, Inc. segment will increase during 2004. Overall,
in the short-term our gross profit margins will most likely decrease as a result
of competitive pressures. However, we are hoping that our gross profit margins
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.
57
REVENUE
Revenue from continuing operations for 2003 was $93.0 million, a decrease
of $5.5 million, or 5.6%, from $98.5 million in 2002. Revenue for 2002
represents a decrease of $58.0 million, or 37.1%, from $156.5 million in 2001.
The decrease in 2003 was primarily related to our InfoTech USA, Inc.'s decision,
in April 2002, to shift its focus to higher-margined products and related
technical services. The decrease in 2002 was primarily attributable to the sale
or closure of all businesses that were not cash flow positive or that did not
fit into our strategy of becoming an advanced technology development company.
Revenue for each of the continuing operating segments was:
2003 2002 2001
----------------------------- ----------------------------- --------------------------------
PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
----------------------------- ------------------------------ -------------------------------
(AMOUNTS IN THOUSANDS)
Digital Angel Corporation 32,364 1,558 33,922 30,330 2,116 32,446 33,220 2,691 35,911
InfoTech USA, Inc. 11,606 2,850 14,456 20,056 2,665 22,721 30,075 4,100 34,175
All Other -- -- -- 1,013 375 1,388 21,318 19,974 41,292
"Corporate/Eliminations" -- -- -- -- -- -- 411 128 539
- -------------------------------------------------------------------------------------------------------------------------------
$ 77,774 $15,213 $ 92,987 $ 80,390 $ 18,095 $ 98,485 $113,147 $ 43,340 $156,487
===============================================================================================================================
Changes during the years were:
Our Advanced Technology segment's revenue increased $2.7 million from 2002
to 2003. Product revenue increased by $4.8 million, or 16.6%, while service
revenue decreased by $2.1 million, or 16.5%. We attribute the increase in
product revenue in 2003 to increased government contract revenues from Computer
Equity Corporation. These revenues were associated with the CONNECTIONS, WACS
and various other United States government agency contracts that Computer Equity
has been awarded over the past two years. Computer Equity Corporation's revenue
accounted for 83.2% of this segment's revenue in 2003. We attribute $0.9 million
of the decrease in service revenue to the sale of our computer networking
business, which was sold during the fourth quarter of 2002, $0.9 million to
reduced website design and Internet access revenue associated with our WebNet
Services, Inc. business which was sold during the fourth quarter of 2003, and
reduced sales of call center and relationship software services of approximately
$0.3 million. We expect to grow our revenue from this segment as we realize
revenue associated with Computer Equity Corporation's CONNECTIONS and other
government contracts, and as we increase the sales of our VeriChip product. Our
Advanced Technology segment's revenue decreased $2.6 million from 2001 to 2002.
Product revenue increased by $0.9 million, or 3.1%, while service revenue
decreased by $3.5 million, or 21.3%. We attribute the decrease in revenue in
2002 to a soft market for sales of networking hardware, call center and
relationship management software products and reduced technology services for
all of the businesses in this segment, with the exception of Computer Equity
Corporation. The most significant decrease in revenue was from our computer
networking business, which experienced a decrease in revenue of approximately
$3.6 million. This business was sold during the fourth quarter of 2002. Computer
Equity Corporation's product revenue increased $3.9 million in 2002, primarily
as a result of additional sales under its WACS contract. Computer Equity
Corporation's service revenue remained relatively constant at approximately $4.8
million in each of the years 2002 and 2001. Computer Equity Corporation's
revenue accounted for 74.7% of this segment's revenue for 2002.
58
Our Digital Angel Corporation segment's revenue increased $1.5 million, or
4.5%, from 2002 to 2003. Product revenue increased by approximately $2.0
million, or 6.7%, while service revenue decreased by approximately $0.6 million,
or 26.4%. We attribute the increase in product revenue for 2003 primarily to an
increase in microchip sales to companion animal, fish and wildlife customers of
approximately $1.7 million and increased sales of visual identification
products. Despite an increase in engineering service revenue of approximately
$1.0 million in 2003 as compared to 2002, our service revenue decreased in 2003,
primarily as a result of the lower revenue of approximately $1.4 million in our
Wireless and Monitoring division due to the cancellation of a significant
software contract in February 2003. Engineering service revenue results from
research and development performed for certain of our fish and wildlife
customers. Our fish and wildlife industry customers consist of the Army Corps of
Engineers, Biomark, Inc., the Department of Energy and Pacific Marine Fisheries.
We expect that our revenues from this segment will increase in the future as a
result of the acquisition of OuterLink Corporation in January 2004, and
worldwide concerns over food safety and traceability. Several bills proposing
the establishment of a national electronic identification program for livestock
have recently been introduced in Congress. We cannot estimate the impact a
national identification program would have on the Animal Application division's
revenue. However, if implemented, we would expect the impact to be favorable.
Digital Angel Corporation segment's revenue decreased $3.5 million, or 9.6%,
from 2001 to 2002. Product revenue decreased by $2.9 million, or 8.7%, while
service revenue decreased by $0.6 million, or 21.4%. We attribute the decrease
in product sales for 2002 primarily to a decrease in the Animal Applications
division's shipments of visual identification tags, which contributed
approximately $1.4 million of the decrease, and electronic identification
products, which contributed approximately $0.3 million of the decrease. Also
contributing to the reduction was a decrease in the GPS and Radio Communication
division's control product sales, which contributed approximately $1.1 million
of the decrease. We attribute the decrease in service revenue to a decrease in
revenue from the Wireless and Monitoring division of approximately $1.0 million,
which was partly offset by an increase of approximately $0.4 million of
engineering service revenue related to our Animal Applications division.
Our InfoTech USA, Inc. segment's revenue decreased $8.3 million, or 36.4%,
from 2002 to 2003. Product revenue decreased by $ 8.5 million, or 42.1%, while
service revenue increased by $0.2 million, or 6.9%. We attribute the decrease in
product revenue to our decision in April 2002 to cease selling certain
lower-margin computer hardware products and to focus on sales of higher-margin
products and related technical services. The lower-margin computer hardware
products were mid-range Unix based computers, which offered little opportunity
for adjunct sales of related higher-margined technical services. InfoTech USA,
Inc.'s current offering of higher-margin products and related technical services
include Intel based computers and servers, which provide InfoTech USA, Inc. with
an opportunity to provide add-on higher-margin technical services. We attribute
the increase in service revenue in 2003 to InfoTech USA, Inc.'s focus on
providing its customers higher-margin technical services. With the IT market
conditions improving and InfoTech USA, Inc.'s continued focus on higher-end,
Intel-based products, InfoTech USA, Inc. is anticipating that sales volumes will
increase during 2004. Revenue decreased $11.5 million, or 33.5%, from 2001 to
2002. Product revenue decreased $10.0 million and service revenue decreased $1.5
million. The decreases in both product and service revenue were primarily a
result of an industry wide softening in demand that existed throughout 2002.
Additionally, product sales declined during 2002, as a result of our change in
focus to higher-margin products and related technical services as discussed
above.
Our All Other's revenue decreased $1.4 million, or 100.0%, from 2002 to
2003. Revenue decreased $39.9 million, or 96.6%, from 2001 to 2002. The
decreases in revenue in 2003 as compared to 2002, and in 2002 as compared to
2001, were due to the sale or closure of all of the business units comprising
this group during the last half of 2001 and the first half of 2002.
59
GROSS PROFIT AND GROSS PROFIT MARGIN
Gross profit from continuing operations for 2003 was $28.1 million, a
decrease of $2.9 million, or 9.4%, from $31.0 million in 2002. Gross profit for
2002 represents a decrease of $14.8 million, or 32.3%, from $45.8 million in
2001. As a percentage of revenue, gross profit margin was 30.2%, 31.5% and 29.3%
for the years ended December 31, 2003, 2002 and 2001, respectively.
Gross profit from continuing operations for each operating segment was:
2003 2002 2001
----------------------------- ----------------------------- --------------------------------
PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
----------------------------- ------------------------------ -------------------------------
(AMOUNTS IN THOUSANDS)
Advanced Technology $4,031 $7,344 $ 11,375 $5,392 $ 7,288 $ 12,680 $6,611 $8,593 $ 15,204
Digital Angel Corporation 12,652 1,558 14,210 12,307 723 13,030 12,620 644 13,264
InfoTech USA, Inc. 1,553 957 2,510 2,905 1,245 4,150 3,013 2,341 5,354
All Other -- -- -- 817 339 1,156 2,984 8,465 11,449
"Corporate/Eliminations" -- -- -- -- -- -- 411 128 539
- -------------------------------------------------------------------------------------------------------------------------------
$ 18,236 $ 9,859 $ 28,095 $ 21,421 $ 9,595 $ 31,016 $ 25,639 $ 20,171 $ 45,810
===============================================================================================================================
Gross profit margin from continuing operations for each operating segment
was:
2003 2002 2001
----------------------------- ----------------------------- --------------------------------
PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
----------------------------- ------------------------------ -------------------------------
% % % % % % % % %
----------------------------- ------------------------------ -------------------------------
Advanced Technology 11.9 68.0 25.5 18.6 56.3 30.2 23.5 52.2 34.1
Digital Angel Corporation 39.1 100.0 41.9 40.6 34.2 40.2 38.0 23.9 36.9
InfoTech USA, Inc. 13.4 33.6 17.4 14.5 46.7 18.3 10.0 57.1 15.7
All Other -- -- -- 80.7 90.4 83.3 14.0 42.4 27.7
"Corporate/Eliminations" -- -- -- -- -- -- 100.0 100.0 100.0
- -------------------------------------------------------------------------------------------------------------------------------
23.4 64.8 30.2 26.6 53.0 31.5 22.7 46.5 29.3
================================================================================================================================
Changes during the years were:
Our Advanced Technology segment's gross profit decreased $1.3 million from
2002 to 2003, and margins decreased to 25.5% in 2003, compared to 30.2% in 2002.
We attribute the decrease in gross profit and margins in 2003 primarily to a
reduction in gross profit from Computer Equity Corporation of approximately $1.0
million, as a result of competitive pressures. These competitive pressures have
resulted in lower margins from the CONNECTIONS and other current government
contracts as compared to margins realized under the WACS contract. Computer
Equity Corporation contributed 62.8% of the gross profit generated by this
segment during 2003. We anticipate that Computer Equity Corporation's gross
profits will increase in 2004, and that its margins will remain at its 2003
levels of approximately 19.0% during 2004. Also contributing to the reduction in
gross profit was a reduction in gross profit of approximately $0.4 million from
WebNet Services, Inc., which was sold during the fourth quarter of 2003.
Partially offsetting these decreases was gross margin from the initial sales of
our VeriChip product of $0.3 million in 2003. We hope to realize increased
margins from sales of VeriChip during 2004. Gross profit decreased $2.5 million
from 2001 to 2002 and margins decreased to 30.2% in 2002, compared to 34.1% in
2001. We attribute the decrease in gross profit and margin primarily to the
reduction in sales of services and of higher-margin networking products during
2002. Approximately $2.1 million of the decrease in gross profit was related to
the decrease in sales from our computer networking business, which was sold in
the fourth quarter of 2002. Computer Equity Corporation's gross profit increased
$1.1 million while its margins remained relatively constant at approximately
25.5%. Computer Equity Corporation contributed 61.8% of the gross profit
generated by this segment during 2002.
60
Our Digital Angel Corporation segment's gross profit increased $1.2
million, or 9.1%, from 2002 to 2003, and margins increased to 41.9% in 2003,
compared to 40.2% in 2002. We attribute the increase in gross profit and margins
during 2003 primarily to the increase in sales in the Animal Applications
division. We expect Digital Angel Corporation's gross margins to remain the same
in the future. Gross profit decreased by $0.2 million, or 1.8%, from 2001 to
2002, and margins increased to 40.2% from 36.9%. We attribute the decrease in
gross profit for 2002 to a decrease in gross profit from the Wireless and
Monitoring division as a result of the decrease in sales in this division.
Margins increased primarily as a result of higher margins realized on service
revenue.
Our InfoTech USA, Inc. segment's gross profit decreased $1.6 million, or
39.5%, from 2002 to 2003, and margins decreased to 17.4% in 2003 from 18.3% in
2002. The decreases in gross profit and margins were primarily due to a
combination of competitive pressures forcing product margins down and the
underutilization of technicians and engineers forcing service margins down. We
expect the service margins to improve during 2004 due to the improving IT market
conditions and our focus on higher-margin products and related services. We
anticipate these factors will result in a higher utilization rate of our
technicians and engineers. Gross profit decreased $1.2 million, or 22.5%, from
2001 to 2002. Gross margin percentage increased to 18.3% in 2002 compared to
15.7% in 2001. The decrease in gross profit was primarily due to the overall
decrease in revenue resulting from the soft market in the IT industry, while the
increase in gross margin was primarily attributable to the shift in our focus to
sales of higher-margin Intel based products and related technical services
during 2002.
Our All Other segment's gross profit decreased by $1.2 million, or 100.0%,
from 2002 to 2003. Gross margin percentage decreased to 0.0% in 2003 compared to
83.3% in 2002. Gross profit decreased $10.3 million, or 89.9%, from 2001 to
2002. Gross margin percentage was 83.3% in 2002 compared to 27.7% in 2001. The
decrease in gross profit in 2003 and 2002 is due to the sale or closure of all
of the business units comprising this segment during the last half of 2001 and
the first half of 2002. We attribute the higher gross profit margin in 2002 to
inventory reserves of $4.3 million, which were recorded during 2001, and to the
sale and closure of business units within this group. The majority of the
business units that were sold or closed in 2001 earned lower gross margins on
average than the remaining business unit comprising this group during the first
half of 2002.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expense from continuing operations was
$55.9 million in 2003, a decrease of $9.8 million, or 14.9%, over the $65.7
million reported in 2002. Selling, general and administrative expense from
continuing operations decreased $36.6 million in 2002, or 35.8%, from the $102.3
million reported in 2001. As a percentage of revenue, selling, general and
administrative expense from continuing operations has decreased to 60.1% in
2003, from 66.7% in 2002 and 65.4% in 2001.
Selling, general and administrative expense for each of the operating
segments was:
2003 2002 2001
---- ---- ----
(AMOUNTS IN THOUSANDS)
Advanced Technology $10,166 $12,100 $ 12,273
Digital Angel Corporation 14,875 14,846 9,595
InfoTech USA, Inc. 3,272 4,171 5,451
All Other (298) 1,504 28,876
"Corporate/Eliminations" 27,865 33,060 46,121
- --------------------------------------------------------------------------------
$55,880 $65,681 $102,316
================================================================================
61
Selling, general and administrative expense as a percentage of revenue for
each of the operating segments was:
2003 2002 2001
---- ---- ----
% % %
Advanced Technology 22.8 28.9 27.5
Digital Angel Corporation 43.9 45.8 26.7
InfoTech USA, Inc. 22.6 18.4 16.0
All Other -- 108.4 69.9
"Corporate/Eliminations" (1) 30.0 33.6 29.5
- ---------------------------------------------------------------------------
60.1 66.7 65.4
===========================================================================
(1) "Corporate/Eliminations" percentage has been calculated as a percentage of
total revenue.
Changes during the years were:
Our Advanced Technology segment's selling, general and administrative
expense decreased $1.9 million, or 16.0%, to $10.2 million in 2003 from $12.1
million in 2002. As a percentage of revenue, selling, general and administrative
expense decreased to 22.8% in 2003, as compared to 28.9% in 2002. We attribute
the decreases primarily to the sale of one of the businesses in this segment
during the fourth quarter of 2002, which contributed $0.9 million of the
decrease, and to overhead reductions associated with the decrease in service
revenue during 2003. We anticipate that selling, general and administrative
expenses from this segment will decrease in 2004 because we sold our WebNet
Services, Inc. business during the fourth quarter of 2003, and because we
incurred approximately $1.2 million in litigation reserves in both 2003 and
2002, that we do not anticipate incurring during 2004. Selling, general and
administrative expense decreased $0.2 million, or 1.4%, to $12.1 million in 2002
from $12.3 million in 2001. We attribute the decrease primarily to the reduction
in revenues and the corresponding overhead for the majority of the businesses
within this segment.
Our Digital Angel Corporation segment's selling, general and
administrative expense was $14.9 million in 2003, compared to $14.8 million in
2002. As a percentage of revenue, selling, general and administrative expense
decreased to 43.9% as compared to 45.8% in 2002. Digital Angel Corporation's
selling, general and administrative expense remained relatively constant in 2003
as compared to 2002. One-time costs associated with the merger of pre-merger
Digital Angel and MAS in 2002, and introductory costs associated with the
Digital Angel product launch that were incurred during 2002, were offset by
various additional expenses that were incurred during 2003 including: (a)
consulting expenses associated with the VeriChip product of approximately $0.7
million; (b) approximately $0.8 million of expenses related to the Digital Angel
product; (c) the payment of a $0.2 million credit termination fee to Wells
Fargo, Digital Angel Corporation's prior lender; and (d) additional expenses of
$0.2 million for the GPS and Radio and Communications division. We expect that
Digital Angel Corporation's selling, general and administrative expense will
increase in 2004 as a result of the acquisition of OuterLink. Selling, general
and administrative expense increased by $5.2 million, to $14.8 million in 2002
from $9.6 million in 2001. The increase in 2002 relates to expenses associated
with the merger of pre-merger Digital Angel and MAS during the first quarter of
2002, of approximately $2.1 million, approximately $2.5 million in expenses
associated with the Digital Angel product, which was introduced to the market in
November 2001, and approximately $0.6 million of additional commission and
marketing expense in the GPS and Radio Communications division.
62
Our InfoTech USA, Inc. segment's selling, general and administrative
expense decreased $0.9 million, or 21.6%, to $3.3 million in 2003 from $4.2
million in 2002. We attribute the decreases primarily to layoffs during 2002,
which contributed approximately $0.5 million of the decrease, and to $0.3
million in costs in 2002, which were related to a proposed merger with VeriChip
Corporation that was aborted during 2002. During the current fiscal year, as
market conditions improve, we believe that InfoTech USA, Inc.'s management and
administrative staff will be sufficient, however InfoTech USA, Inc. may need to
add additional personnel in the sales and technical areas of the business as
sales volume dictates. Selling, general and administrative expense decreased to
$4.2 million in 2002, from $5.5 million in 2001. The decrease in expense was due
to several cost savings measures taken in 2002 including the centralization of
the service and administrative operations, and the closure of two other small
offices, which contributed $0.2 million of the decrease. Also, we reduced our
work force and payments of sales commissions, both of which were related to the
decline in revenue, which contributed $0.8 million of the decrease.
Our All Other's selling, general and administrative expense decreased $1.8
million, or 119.8%, to $(0.3) million in 2003 from $1.5 million in 2002.
Selling, general and administrative expense decreased $27.4 million, or 94.8%,
to $1.5 million in 2002 from $28.9 million in 2001. The decreases resulted from
the sale or closure of all of the business units comprising this group during
the last half of 2001 and the first half of 2002.
"Corporate/Eliminations" selling, general and administrative expense
decreased $5.2 million, or 15.7%, to $27.9 million in 2003 from $33.1 million in
2002. We attribute the majority of the decrease to the following factors:
o we incurred a charge of approximately $4.3 million during 2002 for
valuation reserves associated with notes receivable for stock
issuances from certain current and former officers and directors.
The officers and directors received no cash proceeds from these
loans. In September 2000, when the notes were originated, we
notified these officers and directors that we intended to pay their
annual interest as part of their compensation expense/directors
remuneration and to provide a gross-up for the associated income
taxes. Annual interest payments were due on September 27, 2001 and
September 27, 2002. We chose not to pay the interest and related tax
gross-up. In addition, the principal amount of the notes and a final
annual interest payment became due on September 27, 2003. We,
therefore, consider such notes to be in default and have begun steps
to foreclose on the underlying collateral (all of the stock) in
satisfaction of the notes. Our decision to take this action relates
in part to the passage of the corporate reform legislation under the
Sarbanes-Oxley Act of 2002, which, among other things, prohibits
further extension of credit to officers and directors;
o we reduced approximately $1.3 million and incurred approximately
$0.7 million in non-cash compensation expense during 2003 and 2002,
respectively, due to re-pricing 1.9 million stock options during
2001. The re-priced options had original exercise prices ranging
from $6.90 to $63.40 per share and were modified to change the
exercise price to $1.50 per share. Due to the modification, these
options are being accounted for as variable options under APB No. 25
and, accordingly, fluctuations in our common stock price result in
increases and decreases of non-cash compensation expense until the
options are exercised, forfeited or expired; and
o we recorded non-cash compensation expense associated with pre-merger
Digital Angel options of approximately $18.7 million during 2002.
Under the terms of the merger, 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. 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.
63
Partially offsetting these decreases were the following:
o we incurred approximately $17.9 million in severance expense during
2003, which resulted from the termination of executive officers and
director during 2003, including $2.5 million resulting from
re-pricing stock options. (An additional $0.2 million of severance
expense associated with these terminations is included in the
Advanced Technology segment's selling, general and administrative
expense in 2003); and
o we incurred $4.3 million in bonus expense during 2003. The bonuses
were awarded to directors, executive officers and other employees in
recognition of their efforts in achieving the successful repayment
of all of our obligations to IBM Credit during 2003. As a result of
this repayment we recorded a gain on the extinguishment of debt of
approximately $70.1 million in 2003.
"Corporate/Eliminations" selling, general and administrative expenses
decreased $13.1 million, or 28.3% to $33.1 million in 2002 from $46.1 million in
2001. We attribute the decrease in 2002 primarily to the costs incurred during
2001 for bad debt reserves on notes and other receivables of $21.9 million (as
more fully discussed below), non-cash compensation expense of approximately $0.7
million in 2002 versus $5.3 million in 2001 resulting from the repricing of 1.9
million stock options in September 2001, and litigation reserves in 2001 of
approximately $3.6 million. Also contributing to the decrease in 2002 as
compared to 2001 was a reduction in legal fees of approximately $1.7 million.
Partially offsetting the decrease in 2002 were increases related to the options
to acquire shares of pre-merger Digital Angel common stock that were converted
into shares of MAS common stock as discussed above, the charge of approximately
$4.3 million during 2002 for valuation reserves associated with notes receivable
for stock issuances from certain current and former officers and directors, and
an increase in professional fees associated with accounting and auditing
services during 2002 of approximately $1.2 million.
The bad debt reserves on notes and other receivables of $21.9 million,
which were recorded in 2001, were considered necessary based upon several
factors that occurred during the third and fourth quarters of 2001. These
included:
o A debtor declared bankruptcy, which resulted in a reserve of $2.5
million;
o A $6.2 million note receivable, plus accrued interest, associated
with a business sold in December 2000 was deemed uncollectible as
the debtor has experienced significant business interruptions to a
business located in New York directly related to September 11, 2001;
o Three debtors were delinquent under required payment obligations
resulting in a reserve of $3.4 million; and
o A $9.0 million note received for issuance of shares of our common
stock was deemed uncollectible based upon the financial condition of
the debtor.
We anticipate that "Corporate/Eliminations" selling, general and
administrative expenses will decrease significantly in the future, as we no
longer have any employment contracts with our executive officers which could
potentially result in large severance payouts such as the amounts that were
incurred in 2003, and we do not anticipate incurring other one-time charges as
noted above.
64
RESEARCH AND DEVELOPMENT EXPENSE
Research and development expense from continuing operations for 2003 was
$6.3 million, an increase of approximately $2.1 million, or 51.5%, over the $4.1
million reported in 2002. Research and development expense from continuing
operations decreased $4.7 million in 2002, or 53.0% from the $8.8 million
reported in 2001. As a percentage of revenue, research and development expense
was 6.7%, 4.2% and 5.6% in 2003, 2002 and 2001, respectively.
Research and development expense for each of the operating segments was:
2003 2002 2001
---- ---- ----
(AMOUNTS IN THOUSANDS)
Advanced Technology $ 502 $ 861 $ 3,321
Digital Angel Corporation 4,898 3,034 5,244
InfoTech USA, Inc. -- -- --
All Other -- -- 218
"Corporate/Eliminations" 855 235 --
- ------------------------------------------------------------------------------
$6,255 $4,130 $8,783
==============================================================================
Research and development expense relates primarily to the development of
our products, Digital Angel, Thermo Life, VeriChip, Bio-Thermo and PLD, and in
2001, to software development costs. The research and development expense
associated with software development was $0.5 million, $0.9 million and $3.3
million in 2003, 2002 and 2001, respectively. We anticipate that we will incur
approximately $4.0 million in research and development expense in 2004.
ASSET IMPAIRMENT
2003 2002 2001
------- ------- -------
(AMOUNTS IN THOUSANDS)
Goodwill:
Advanced Technology $ -- $ -- $30,453
Digital Angel Corporation -- 31,460 726
InfoTech USA, Inc. 2,154 -- --
All Other -- -- 32,427
------- ------- -------
Total goodwill 2,154 31,460 62,606
Property and equipment -- 6,860 2,372
Software and other 302 337 5,741
------- ------- -------
$ 2,456 $38,657 $71,719
======= ======= =======
As of December 31, 2003, the net carrying value of our goodwill was $63.3
million. There was no impairment of goodwill upon the adoption of FAS 142 on
January 1, 2002. However, based upon our annual review for impairment, we
recorded impairment charges of $2.2 million and $31.5 million in the fourth
quarters of 2003 and 2002, respectively. The impairment charge recorded in 2003
relates to the goodwill associated with our InfoTech USA, Inc. segment. The
impairment charge for 2002 relates to the goodwill associated with Digital Angel
Corporation's Wireless and Monitoring division.
Methodology for Assigning Goodwill to Reporting Units:
In accordance with FAS 142, upon adoption, we were required to allocate
goodwill to our various reporting units. At January 1, 2002, our reporting units
consisted of the following (our reporting units listed below are those
businesses, which have goodwill and for which discrete financial information is
available and upon which segment management makes operating decisions):
65
o Advanced Technology segment's Computer Equity Corporation;
o Advanced Technology segment's P-Tech., Inc.;
o Advanced Technology segment's Pacific Decision Sciences;
o Pre-merger Digital Angel Corporation's Animal Applications division;
o Pre-merger Digital Angel Corporation's Wireless and Monitoring
division;
o Pre-merger Digital Angel Corporation's GPS and Radio Communications
division; and
o InfoTech USA, Inc.
The goodwill assigned to our reporting units was based on the goodwill
resulting from our acquisition of the reporting unit, with the goodwill
attributable to the merger of Destron Fearing Corporation, which was a publicly
held company trading on the Nasdaq (Destron), and Digital Angel.net Inc.
(DA.net) allocated between the Animal Applications and the Wireless and
Monitoring reporting units. The merger of Destron and DA.net occurred in
September 2000. The goodwill resulting from the Destron and DA.net merger was
approximately $74.7 million, of which $50.7 million was allocated to Animal
Applications and $24.0 million was allocated to Wireless and Monitoring. (The
Wireless and Monitoring reporting unit also included the goodwill associated
with the acquisition of Timely Technology Corp., of approximately $7.5 million).
We believe that a portion of the goodwill resulting from the Destron and
DA.net merger was due to the synergies of the combined companies. There were
several potential benefits/synergies of the merger that we believed would
contribute to the success of the combination. These potential benefits/synergies
included:
o the acceleration of the opportunities of the Digital Angel
technology through the combination with Destron and the current
products it offers, which establishes a company with stronger
capabilities;
o the combination of DA.net and Destron, with its injectable microchip
technology and its current products in the animal identification
markets, provide broader product offerings for the combined company;
o improvement in the purchasing power of the combined company as
compared to either company standing alone, resulting in reduced
costs;
o the management team of the combined company having greater depth of
knowledge of the injectable microchip and animal identification
industries and more business experience than that of either company
standing alone;
o the potential to expand the market presence of DA.net and Destron's
products globally through a larger combined sales force and
geographically more extensive sales and distribution channels;
o the complementary nature of each company's product offerings as an
extension of the offerings of the other company;
o increased product diversification and penetration of each company's
customer base;
o similarities in corporate culture; and
o the opportunity for expanded research and development of the
combined product offerings, including potential new product
offerings.
66
Since none of the assets and liabilities resulting from the merger had
been assigned to the Wireless and Monitoring reporting unit, we determined the
allocation of the goodwill between the Animal Applications and Wireless and
Monitoring reporting units based upon guidance provided in FAS 142. FAS 142
states that, "the methodology used to determine the amount of goodwill to assign
to a reporting unit shall be reasonable and supportable and shall be applied in
a consistent manner." Since Destron was a publicly held company at the time of
the merger, and as a result, its fair market value was readily determinable, we
allocated to the Animal Applications reporting unit the amount of goodwill equal
to Destron's fair market value prior to our public announcement of the potential
merger, which was approximately $50.7 million. This resulted in our allocation
of approximately $24.0 million to the Wireless and Monitoring reporting unit,
which we believed represented the fair market value of the unit at that point in
time, based on our belief in the market potential for the Digital Angel product,
coupled with the synergies of the combined companies, as discussed above.
As of December 31, 2002, our reporting units consisted of the following:
o Advanced Technology segment's Computer Equity Corporation:
o Advanced Technology segment's P. Tech, Inc.;
o Advanced Technology segment's Pacific Decision Sciences;
o Digital Angel Corporation's Animal Applications division;
o Digital Angel Corporation's Wireless and Monitoring division;
o Digital Angel Corporation's GPS and Radio Communications division;
o Digital Angel Corporation's Medical Systems division (consisting of
the business operations of MAS, which was acquired on March 27,
2002, and which is now included as part of Discontinued Operations
in our financial statements); and
o InfoTech USA, Inc.
Our reporting units at December 31, 2003, were the same as our reporting
units at December 31, 2002, except for the exclusion of Digital Angel
Corporation's Wireless and Monitoring division, as its goodwill was fully
impaired at December 31, 2002, as discussed below.
Our methodology for estimating the fair value of each reporting unit
during the fourth quarters of 2003 and 2002 was a combination of impairment
testing performed both internally and externally. The tests for the P-Tech.,
Inc., and Pacific Decision Sciences reporting units were performed internally
based primarily on discounted future cash flows. The tests for the Computer
Equity Corporation reporting unit, the reporting units associated with Digital
Angel Corporation and the InfoTech USA, Inc. reporting unit were performed
externally through the engagement of independent valuation professionals who
performed valuations using a combination of comparable company and discounted
cash flow analyses. The InfoTech USA, Inc. reporting unit has a fiscal year
ending on September 30, and therefore, these tests were performed during their
fiscal 2003 and 2002 fourth quarters. If the fair value of a reporting unit
exceeded its carrying value, then no further testing was required. However, if
the carrying value of a reporting unit exceeded its fair value, then an
impairment charge was recorded.
67
We engaged an independent valuation firm to review and evaluate the
goodwill of Digital Angel Corporation, as reflected on our books as of December
31, 2003 and 2002. Independently, the valuation firm reviewed the goodwill of
the various reporting units (Animal Applications, Wireless and Monitoring, GPS
and Radio Communications and Medical Systems) at the request of Digital Angel
Corporation. Digital Angel Corporation's management compiled the cash flow
forecasts, growth rates, gross margin, fixed and variable cost structure,
depreciation and amortization expenses, corporate overhead, tax rates, and
capital expenditures, among other data and assumptions related to the financial
projections upon which the valuation reports were based. The valuation firm's
methodology including residual or terminal enterprise values were based on the
following factors: risk free rate of 10 years; current leverage (E/V); leveraged
beta - Bloomberg; unleveraged beta; risk premium; cost of equity; after-tax cost
of debt; and weighted average cost of capital. These variables generated a
discount rate calculation. The assumptions used in the determination of fair
value using discounted cash flows were as follows:
o Cash flows were generated for 5 years, which was the expected
recovery period for the goodwill;
o Earnings before interest, taxes, depreciation and amortization were
used as the measure of cash flow; and
o Discount rates ranging from 15% to 20% were used. The rates were
determined based on the risk free rate of the 10-year U.S. Treasury
Bond plus a market risk premium of 7.5%. (The discount rate utilized
by us was the rate of return expected from the market or the rate of
return for a similar investment with similar risks).
Residual or Terminal Enterprise Value Calculation:
The independent valuation firm was engaged by Digital Angel Corporation to
perform a company comparable analysis utilizing financial and market information
on publicly traded companies that are considered to be generally comparable to
the Animal Applications, Wireless and Monitoring, GPS and Radio Communications
and Medical Systems reporting units. Each analysis provided a benchmark for
determining the terminal values for each business unit to be utilized in its
discounted cash flow analysis. The analysis generated a multiple for each
reporting unit, which was incorporated into the appropriate business unit's
discounted cash flow model.
The analyses for 2002 indicated that all of the goodwill associated with
Digital Angel Corporation's Wireless and Monitoring division of approximately
$31.5 million was impaired, as discussed below. (During the fourth quarters of
2003 and 2002, we also impaired $2.4 million and $30.7 million of goodwill,
respectively, associated with Digital Angel Corporation's Medical Systems
operations as more fully discussed below under the Results of Discontinued
Operations section).
On November 26, 2001, we launched the Digital Angel product and during
2002, we marketed the product extensively. Despite our aggressive marketing
campaign, the Digital Angel product did not achieve our forecasted revenues
during 2002. Sales of the Digital Angel product were affected, in part, by the
lack of GPS tracking capabilities within buildings. We are currently working on
the development of the Digital Angel technology to include assisted GPS
capabilities to enhance these "line of sight" issues. Neither we nor Digital
Angel Corporation had a historical track record of achieving forecasts for new
or existing technology products. The Digital Angel watch/pager was expected to
be the primary revenue driver for the Digital Angel Corporation's Wireless and
Monitoring division. In addition to the "line of sight issues," the poor sales
are partly explained by an overestimation of consumer demand as a result of a
challenging economic environment (i.e. consumers considered the Digital Angel
watch/pager to be a discretionary luxury item), and an uncertain marketplace (we
overestimated consumer demand for an innovative and new technology to be
introduced into the consumer marketplace). As of December 31, 2002, Digital
Angel Corporation's Wireless and Monitoring segment had not recorded any
significant revenues from its Digital Angel product, and it had not achieved the
revenue projections used as the basis for our impairment tests upon the adoption
of FAS 142 on January 1, 2002. At December 31, 2002, the market value of our
investment in Digital Angel Corporation was approximately $50.0 million. In
consideration of these factors, the newness of the Digital Angel Technology, the
operating history of Digital Angel Corporation, the challenging economic
environment and uncertainties in the marketplace along with the independent fair
value measurement valuations performed by the independent professionals, and
other valuations performed, we concluded that future cash flows from certain
operations would not be sufficient to recover all of the $31.5 million of
goodwill associated with Digital Angel Corporation's Wireless and Monitoring
division. Accordingly, this amount was recorded as an impairment charge during
the fourth quarter of 2002.
68
Our InfoTech USA, Inc. segment operates on a September 30 fiscal year end.
As part of InfoTech USA, Inc.'s fiscal year end planning cycle, its management
engaged an independent valuation firm to review and evaluate their goodwill of
approximately $2.2 million. The goodwill resulted from prior acquisitions by
InfoTech USA, Inc. The methodology used by the independent valuation firm to
evaluate InfoTech USA, Inc.'s goodwill was the same as discussed above for the
evaluations associated with Digital Angel Corporation. Based on the evaluation,
InfoTech USA, Inc.'s goodwill was not impaired as of September 30, 2003.
However, InfoTech USA, Inc. has not achieved its projected operating results,
and it has not returned to profitability (InfoTech USA, Inc. has incurred losses
for the past several years). Also, the market value of InfoTech USA, Inc.'s
common stock, even after adjustment for its limited public float, was
significantly less at December 31, 2003 than its book value. In addition,
certain third parties had expressed interest in purchasing InfoTech USA, Inc.
for amounts less than our carrying value. As a result of these factors, we
believe that the full value of InfoTech USA, Inc.'s goodwill of approximately
$2.2 million was impaired as of December 31, 2003.
Future goodwill impairment reviews may result in additional write downs.
Such determination involves the use of estimates and assumptions, which may be
difficult to accurately measure or value.
In addition, in the fourth quarter of 2002, Digital Angel Corporation
impaired $6.4 million of software associated with its Wireless and Monitoring
segment. The write off related to an exclusive license to a digital encryption
and distribution software system. The charge is included in the Consolidated
Statements of Operations under the caption Asset Impairment.
As a result of the economic slowdown during 2001, we experienced
deteriorating sales for certain of our businesses. In addition, management
concluded that a full transition to an advanced technology development company
required the sale or closure of all units that did not fit into our new business
model or were not cash flow positive. This resulted in the shutdown of several
of our businesses during the third and fourth quarters of 2001 and the first
quarter of 2002. Also, letters of intent that we had received during the last
half of 2001 and the first quarter of 2002 related to the sale of certain of our
businesses indicated a decline in their fair values. The sale of these
businesses did not comprise the sale of an entire business segment. Based upon
these developments, we reassessed our future expected operating cash flows and
business valuations and at December 31, 2001, we performed undiscounted cash
flow analyses by business unit to determine if an impairment existed. For
purposes of these analyses, earnings before interest, taxes, depreciation and
amortization were used as the measure of cash flow. When an impairment was
determined to exist, any related impairment loss was calculated based on fair
value. Fair value was determined based on discounted cash flows. The discount
rate utilized by us was the rate of return expected from the market or the rate
of return for a similar investment with similar risks. This reassessment
resulted in the asset impairments listed above during 2001. The assumptions used
in our determination of fair value using discounted cash flows were as follows:
o Cash flows were generated for periods ranging from 5 to 10 years
based on the expected life of the business' goodwill;
69
o Earnings before interest, taxes, depreciation and amortization were
used as the measure of cash flow; and
o A discount rate of 12.0% was used. The rate was determined based on
the risk free rate of the 10 year U.S. Treasury Bond plus a market
risk premium of 7%.
As a result of the restructuring and revision to our business model, the
plan to implement an enterprise wide software system purchased in 2000 was
discontinued during the third quarter of 2001, at which time the associated
software costs were fully written off and the computer hardware was written down
to its estimated net realizable value. During 2002, the remaining value of the
equipment, which was no longer deemed saleable, of approximately $0.5 million
was written off.
Depreciation and Amortization
Depreciation and amortization expense from continuing operations for 2003
was $1.3 million, a decrease of $2.3 million, or 64.1%, over the $3.5 million
reported in 2002. The 2002 expense represents a decrease of $24.5 million, or
87.5%, over the $28.1 million reported in 2001. As a percentage of revenue,
depreciation and amortization expense was 1.4%, 3.6% and 17.9% in 2003, 2002 and
2001, respectively. Depreciation and amortization expense related to cost of
products sold is included in gross profit above.
Under FAS 142, which we adopted on January 1, 2002, goodwill and certain
other intangible assets are no longer amortized. We incurred $22.5 million in
goodwill and equity method investment amortization during 2001.
Depreciation and amortization expense from continuing operations by
segments was as follows:
2003 2002 2001
---- ---- ----
(AMOUNTS IN THOUSANDS)
Advanced Technology $ 231 $ 322 $8,832
Digital Angel Corporation 618 2,641 11,950
InfoTech USA, Inc. 213 261 503
All Other -- -- 4,534
"Corporate/Eliminations" 200 296 2,242
- ------------------------------------------------------------------------------
$1,262 $3,520 $28,061
==============================================================================
Advanced Technology segment's depreciation and amortization expense
decreased $0.1 million, or 28.5%, to $0.2 million in 2003, from $0.3 million in
2002. We attribute the decrease to fully depreciating certain assets during 2002
and 2003, our decision in 2002 to limit our expenditures for property and
equipment, and the sale of one of the business units within this segment during
the fourth quarter of 2002. In 2004, we expect depreciation and amortization
expense to decrease slightly due to the sale of WebNet Services, Inc. in the
fourth quarter of 2003. Depreciation and amortization expense decreased $8.5
million, or 96.3% in 2002 as compared to 2001. We attribute the decrease in 2002
primarily to a reduction in goodwill amortization as a result of the adoption of
FAS 142.
70
Digital Angel Corporation segment's depreciation and amortization expense
decreased $2.0 million, or 76.6%, to $0.6 million in 2003, from $2.6 million in
2002. We attribute the decrease primarily to the exclusion of depreciation
expense for a digital encryption and distribution software system license for
which Digital Angel Corporation recorded an impairment charge during the fourth
quarter of 2002. In connection with this system, Digital Angel Corporation
incurred approximately $2.0 million of depreciation expense in 2002. We expect
that Digital Angel Corporation's depreciation and amortization expense will
remain at its current level during 2004. Depreciation and amortization expense
decreased $9.3 million, or 77.9% in 2002 as compared to 2001. We attribute the
decrease in 2002 primarily to a reduction in goodwill amortization as a result
of the adoption of FAS 142.
InfoTech USA, Inc. segment's depreciation and amortization expense
decreased slightly in 2003, as compared to 2002. We attribute the decrease
primarily to the sale of the Shirley, New York facility during the first quarter
of 2002, and to fully depreciating certain assets during 2002 and 2003. We
expect that InfoTech USA, Inc.'s depreciation and amortization expense will
decrease in 2004 as a result of fully depreciating certain assets during 2003.
Depreciation and amortization expense decreased $0.2 million, or 48.1% in 2002,
as compared to 2001. We attribute the decrease in 2002 primarily to a reduction
in goodwill amortization as a result of the adoption of FAS 142.
All Other's depreciation and amortization expense decreased in 2002, as
compared to 2001, primarily as a result of the adoption of FAS 142. Also
contributing to the decrease was the sale or closure of all of the business
units comprising this group during the last half of 2001 and the first half of
2002.
"Corporate/Eliminations" depreciation and amortization expense decreased
$0.1 million, or 32.4%, to $0.2 million in 2003, from $0.3 million in 2002. We
attribute the decrease primarily to our decision to limit our expenditures for
property and equipment and to fully depreciating certain assets during 2002 and
2003. We expect depreciation and amortization expense to remain at its current
level during 2004. Depreciation and amortization expense decreased $1.9 million,
or 86.8%, in 2002 as compared to 2001. The decrease is primarily the result of
the impairment and sale of software and other corporate assets during the last
half of 2001.
LOSS/GAIN ON SALES OF SUBSIDIARIES AND BUSINESS ASSETS
The loss (gain) on sales of subsidiaries and business assets was $0.3
million, $(0.1) million and $6.1 million for the years ended December 31, 2003,
2002 and 2001, respectively. The loss on the sales of subsidiaries and business
assets of $0.3 million for 2003 resulted from the sale of our wholly-owned
subsidiary, WebNet Services Inc. The loss of $6.1 million for 2001 was due to
the sale of our 85% ownership interest in Atlantic Systems, Inc., and the sales
of the business assets of our wholly-owned subsidiaries as follows: ADS Retail
Inc., Signal Processors, Limited, ACT Wireless Corp. and our ATI Communications
companies. Proceeds from the 2001 sales were $3.5 million and were used
primarily to repay debt.
INTEREST AND OTHER INCOME
Interest and Other Income was $0.9 million, $2.3 million and $2.1 million
for 2003, 2002 and 2001, respectively. Interest income is earned primarily from
short-term investments and notes receivable.
INTEREST EXPENSE
Interest expense was $22.6 million, $17.5 million and $8.6 million for
2003, 2002 and 2001, respectively. Interest expense is a function of the level
of outstanding debt. The interest expense associated with the Debentures and the
IBM Credit Agreement was $12.7 million and $8.8 million, respectively, in 2003.
Interest expense associated with the IBM Credit Agreement was $16.9 million and
$8.4 million in 2002 and 2001, respectively.
71
Due to the repayments of all of our obligations to IBM Credit and the
conversion of all of the Debentures during 2003, we anticipate that our interest
expense will be significantly lower during 2004. However, our interest expense
will vary as a result of increases and/or decreases in the market price of
Digital Angel Corporation's common stock. This is a result of the Warrants that
we issued to the Debenture holders. The liability for the Warrants, to the
extent potentially settleable in shares of the Digital Angel Corporation common
stock owned by us, is required to be revalued at each reporting period with any
resulting increase/(decrease) being charged/(credited) to operations as an
increase/(decrease) in interest expense. During the fourth quarter of 2003, we
recorded interest expense of $2.0 million as a result of such revaluation. As a
result of such revaluation, the exercise of the Warrants by the Debenture
holders into shares of the Digital Angel Corporation common stock owned by us
may result in our recording a gain on the transaction.
INCOME TAXES
We had effective income tax rates of 16.5%, 0.3% and 11.8% in 2003, 2002
and 2001, respectively. Differences in the effective income tax rates from the
statutory federal income tax rate arise from goodwill amortization associated
with acquisitions, state taxes net of federal benefits and the increase or
reduction of valuation allowances related to net operating loss carry forwards
and other deferred tax assets. Our tax provision for 2003 was primarily the
result of an increase in the valuation allowance associated with InfoTech USA,
Inc.'s deferred tax assets of approximately $1.6 million. As of December 31,
2003, we have provided a valuation allowance to fully reserve our net operating
loss carry forwards and our other existing net deferred tax assets. Our tax
provision for 2001 was primarily the result of an increase in the valuation
allowance due to the losses incurred during the year ended December 31, 2001, as
well as our projections of future taxable income.
NET LOSS ON CAPITAL TRANSACTIONS OF SUBSIDIARY AND LOSS ATTRIBUTABLE TO
CHANGES IN MINORITY INTEREST AS A RESULT OF CAPITAL TRANSACTIONS OF SUBSIDIARY
Gains where realizable and losses on the issuance of shares of stock by
our consolidated subsidiary, Digital Angel Corporation, are reflected in the
Consolidated Statements 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, since we do not plan to reacquire the shares
issued, and the value of the proceeds could be objectively determined. During
2003, we recorded a loss of $0.2 million on the issuances of 2.3 million shares
of Digital Angel Corporation's common stock resulting from the exercise of stock
options. During 2002, we recorded a net loss of $2.4 million, comprised of a
loss of approximately $5.1 million resulting from the exercise of 1.5 million
pre-merger Digital Angel options, 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, and a loss
of $2.0 million on the issuances of 1.1 million shares of Digital Angel
Corporation's common stock resulting primarily from the exercise of stock
options. The losses on the issuances of common stock by Digital Angel
Corporation represent the difference between the carrying amount of the pro-rata
share of our investment in Digital Angel Corporation, and the net proceeds from
the issuances of the stock. In addition, during 2003 and 2002, we recorded a
loss of $6.5 million and $2.0 million, respectively, attributable to changes in
our minority interest ownership of Digital Angel Corporation as a result of the
stock issuances. We anticipate that in the future we will continue to realize
gains and losses on the issuances of stock by Digital Angel Corporation.
72
RESULTS OF DISCONTINUED OPERATIONS
During the three-months ended June 30, 2004, Digital Angel Corporation's
Board of Directors approved a plan to sell its Medical Systems operations, which
were acquired on March 27, 2002, and the business assets of Medical Systems were
sold effective April 19, 2004. Medical Systems represented the business
operations of MAS. On March 31, 2002, our 93% owned subsidiary, Digital Angel
Corporation, which were refer to as pre-merger Digital Angel, merged with MAS
and MAS changed its name to Digital Angel Corporation. The Medical Systems
business activities consisted of a staff of logistics specialists and physicians
who provided medical assistance services and interactive medical information
services to people traveling anywhere in the world. Services included
coordination of medical care, provision of general medical information,
physician consultation, translation assistance, claims handling and cost
containment on behalf of assistance companies, insurance companies and managed
care organizations. It also offered medical training services to the maritime
industry, and sold a variety of kits containing pharmaceutical and medical
supplies to its maritime and airline customers through its pharmaceutical
warehouse facility located in Owings, Maryland. The land and building associated
with Medical Systems' operations were sold in a separate transaction on July 31,
2004.
Medical Systems was one of our reporting units in accordance with FAS 142.
Accordingly, the financial condition, results of operations and cash flows of
Medical Systems have been reported as Discontinued Operations in our financial
statements, and prior periods have been restated. The following discloses the
operating losses from Discontinued Operations for the years ended December 31,
2003 and 2002, which consist of the losses attributable to Medical Systems:
YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31,
-------- --------
(AMOUNTS IN THOUSANDS)
2003 2002
-------- --------
Product revenue $ 875 $ 546
Service revenue 1,405 1,181
-------- --------
Total revenue 2,280 1,727
Cost of products sold 383 270
Cost of services sold 1,172 823
-------- --------
Total cost of products and services sold 1,555 1,093
-------- --------
Gross profit 725 634
Selling, general and administrative expense 776 769
Asset impairment 2,986 30,725
Depreciation and amortization 492 409
Interest and other income (196) (16)
Interest expense 149 47
Minority interest (1,048) (6,895)
-------- --------
Loss from Discontinued Operations $ (2,434) $(24,405)
======== ========
The above results do not include any allocated or common overhead
expenses. We have not provided a benefit for income taxes on the losses
attributable to Medical Systems. We do not anticipate Medical Systems incurring
additional losses in the future. However, in accordance with FAS 144, any
additional operating losses or changes in the values of assets or liabilities
will be reflected in our financial statements as incurred.
73
The asset impairments for Medical Systems consisted of the impairment of
goodwill of approximately $2.4 million and $30.7 million as a result of our
annual impairment tests performed during the fourth quarters of 2003 and 2002,
respectively. In addition, during the fourth quarter of 2003, we incurred an
impairment charge of approximately $0.6 million related to Medical Systems'
intangible assets.
On February 22, 2001, our senior management approved a plan to sell
Intellesale, Inc. and all of our other non-core businesses. Our Board of
Directors approved the plan on March 1, 2001. 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, and prior periods have been restated.
The following discloses the income from Discontinued Operations for the
period January 1 through March 1, 2001, the measurement date. The income for the
period January 1 through March 1, 2001 consists of the income attributable to
our Intellesale and all other non-core businesses:
January 1, through
March 1, 2001
(amounts in thousands)
Product revenue $13,039
Service revenue 846
-----------
Total revenue 13,885
Cost of products sold (exclusive
of depreciation and amortization
shown separately below) 10,499
Cost of services sold 259
-----------
Total cost of products and
services sold (exclusive of
depreciation and amortization shown separately below) 10,758
-----------
Selling, general and administrative expense 2,534
Depreciation and amortization 264
Interest, net 29
Provision for income taxes 34
Minority interest 53
-----------
Income from Discontinued Operations $ 213
===========
The above results do not include any allocated or common overhead
expenses. Included in Interest, net, above are interest charges based on the
debt of one of these businesses that was repaid when the business was sold in
January 2002.
We have sold or closed all of the businesses comprising Discontinued
Operations. Proceeds from the sales of our Discontinued Operations companies
were used primarily to repay outstanding debt.
We accounted for the Intellesale segment and our other non-core businesses
as Discontinued Operations in accordance with Accounting Principles Board 30,
Reporting the Results of Operations-Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions ("APB 30"). APB 30, of which portions related to the
accounting for discontinued operations have been superceded by the provisions of
FAS 144, required that we accrue estimates for future operating losses,
gains/losses on sale, costs to dispose and carrying costs of these businesses at
the time the businesses were discontinued. Accordingly, at December 31, 2000, we
recorded a provision for operating losses and carrying costs during the
phase-out period for our Intellesale and other non-core businesses including
estimated disposal costs to be incurred in selling the businesses. Carrying
costs consisted primarily of cancellation of facility and equipment leases,
legal settlements, employment contract buyouts and sales tax liabilities.
74
During 2003, 2002 and 2001, Discontinued Operations incurred an increase
(decrease) in estimated loss on disposal and operating losses accrued on the
measurement date of $0.4 million, $(1.4) million and $16.7 million,
respectively. The primary reasons for the increase in estimated losses for 2003
were an increase in estimated facility cancellation costs of $0.2 million and
the operations of the one remaining business unit in this segment, which was
sold in July 2003. The primary reason for the decrease in estimated losses for
2002 was the settlement of litigation for an amount less than anticipated. The
primary reasons for the increase in estimated losses for 2001 were inventory
write-downs of $4.5 million, a decrease in estimated sales proceeds as certain
of the businesses were closed in the second and third quarters of 2001, an
increase in legal expenses related to ongoing litigation, additional sales tax
liabilities and additional facility lease costs. The business closures in 2001
were the result of a combination of the deteriorating market conditions for the
technology sector as well as our strategic decision to reallocate funding to our
core businesses. We also increased our estimated loss on the sale of Innovative
Vacuum Solutions, Inc., which was sold during the second quarter of 2001, by
$0.2 million, and on Ground Effects Ltd., which was sold in the first quarter of
2002, by $1.2 million.
We do not anticipate any future losses related to Discontinued Operations
as a result of changes in carrying costs. However, actual losses could differ
from our estimates and any adjustments will be reflected in our future financial
statements. During the years ended December 31, 2003, 2002 and 2001, the
estimated amounts recorded were as follows:
- -------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31,
2003 2002 2001
---- ---- ----
(amounts in thousands)
Operating losses and estimated loss on the sale of business units $205 $684 $13,010
Carrying Costs 177 (2,104) 3,685
Less: (Provision) benefit for income taxes -- -- --
-----------------------------------------
$382 $(1,420) $16,695
=========================================
The following table sets forth the rollforward of the liabilities for
operating losses and carrying costs from December 31, 2001, through December 31,
2003 (amounts in thousands):
Balance,
December 31, Balance
Type of Cost 2001 Additions Deductions December 31, 2002
- ---------------------------------- ----------------- ------------------- --------------- --------------------
Operating losses and estimated
loss on sale $ 1,173 $684 $1,857 $ --
Carrying costs 7,218 (2,104) 206 4,908
----------------- ------------------- --------------- --------------------
Total $ 8,391 $(1,420) $2,063 $ 4,908
================= =================== =============== ====================
Balance,
December 31, Balance
Type of Cost 2002 Additions Deductions December 31, 2003
- ---------------------------------- ----------------- ------------------- --------------- --------------------
Operating losses and estimated
loss on sale $ -- $205 $205 $ --
Carrying costs (1) 4,908 177 172 4,913
----------------- ------------------- --------------- --------------------
Total $ 4,908 $382 $377 $4,913
================= =================== =============== ====================
(1) Carrying costs at December 31, 2003, include all estimated costs to
dispose of the discontinued businesses including $2.2 million for lease
commitments, $1.7 million for severance and employment contract
settlements and $1.0 million for sales tax liabilities.
75
LIQUIDITY AND CAPITAL RESOURCES FROM CONTINUING OPERATIONS
As of December 31, 2003, cash and cash equivalents totaled $10.2 million,
an increase of $4.4 million, or 75.9%, from $5.8 million at December 31, 2002.
Cash used in operating activities totaled $11.4 million, $3.9 million and $18.0
million in 2003, 2002 and 2001, respectively. In each year, cash was used
primarily to fund operating losses. In addition, Digital Angel Corporation had
$0.8 million of restricted cash at December 31, 2003. Although Digital Angel
Corporation and InfoTech USA, Inc. may pay dividends, since we do not own 100%
of these subsidiaries, access to their funds is limited.
Accounts and unbilled receivables, net of allowance for doubtful accounts,
decreased $2.0 million, or 12.4%, to $14.1 million at December 31, 2003, from
$16.1 million at December 31, 2002. The decrease was due primarily to increased
collections during the fourth quarter of 2003. As a percentage of 2003 and 2002
revenue, accounts and unbilled receivable were 15.1% and 16.3%, respectively.
Inventories increased to $9.4 million at December 31, 2003, compared to
$6.4 million at December 31, 2002. We attribute the increase primarily to an
increase in work-in-process related to government contract projects and the
accumulation of inventory by Digital Angel Corporation in anticipation of future
sales.
Accounts payable increased $4.1 million, or 43.2%, to $13.6 million at
December 31, 2003, from $9.5 million at December 31, 2002. The increase was
primarily a result of the timing of vendor payments.
Accrued interest and other accrued expenses decreased $4.8 million, or
17.6%, to $22.5 million at December 31, 2003, from $27.3 million at December 31,
2002. The decrease is primarily attributable to a reduction in accrued interest,
as we fully satisfied all of our debt obligations to IBM Credit during 2003. The
decrease was partially offset by an accrual for bonuses at December 31, 2003.
Investing activities provided cash of $0.6 million, $8.1 million and $2.7
million in 2003, 2002 and 2001, respectively. In 2003, cash of $1.8 million was
provided by collection of notes receivables, and cash of $1.4 million was used
to purchase property and equipment. In 2002, cash of $3.2 million was provided
by collection of notes receivables, $4.9 million of proceeds was received from
the sale of subsidiaries, business assets and property and equipment, and $2.6
million was received from buyers of divested subsidiaries. Cash was used
primarily to purchase property and equipment and to fund Discontinued
Operations. In 2001, $2.8 million was used to acquire property and equipment,
offset by cash proceeds from the sale of subsidiaries and business assets of
$1.7 million, proceeds from the sale of property and equipment of $1.3 million,
collections of notes receivable of $1.3 million and a reduction in other assets
of $0.9 million.
Financing activities provided (used) cash of $15.0 million, $(2.8) million
and $10.9 million in 2003, 2002 and 2001, respectively. In 2003, cash of $29.9
million was provided by the issuance of common stock, and $12.0 million was
provided by long-term debt. Cash of $27.7 million was used to repay debt. In
2002, cash was used to pay $6.1 million in notes payable and long-term debt,
offset by $1.7 million provided from issuance of common shares, $1.2 million
from collections of notes receivable for shares issued, $0.4 million provided by
increases in notes payable, and $0.7 million provided by Discontinued
Operations. In 2001, cash of $14.0 million was obtained through notes payable,
$0.6 million was provided by long-term debt and $0.7 million was provided from
the issuance of common shares. Cash was used primarily for stock issuance costs
of $0.8 million, and payments of long-term debt of $2.5 million.
76
DEBT, COVENANT COMPLIANCE AND LIQUIDITY
On March 1, 2002, we and the Digital Angel Share 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. At
December 31, 2002, we failed to maintain compliance with the financial
performance covenant under the IBM Credit Agreement.
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 constituted 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.
Effective April 1, 2003, we entered into a Forbearance Agreement with IBM
Credit. Under the terms of the Forbearance Agreement, we had the right to
purchase all of our outstanding debt obligations to IBM Credit, totaling
approximately $100.1 million (including accrued interest), if we paid IBM Credit
$30.0 million in cash by June 30, 2003. As of June 30, 2003, we made cash
payments to IBM Credit totaling $30.0 million and, thus, we have satisfied in
full our debt obligations to IBM Credit. As a result, we recorded a gain on the
extinguishment of debt of approximately $70.1 million in 2003.
Funding for the $30.0 million payment to IBM Credit consisted of $17.8
million in net proceeds from the sales of an aggregate of 5.0 million shares of
our common stock, $10.0 million in net proceeds from the issuance of the
Debentures, and $2.2 million from cash on hand.
The 5.0 million shares of our common stock were purchased under Securities
Purchase Agreements entered into on May 8, 2003, May 22, 2003 and June 4, 2003,
with Cranshire Capital, L.P. and Magellan International Ltd. The Securities
Purchase Agreements provided for Cranshire Capital L.P. and Magellan
International Ltd. to purchase an aggregate of 2.0 million shares and 3.0
million shares of our common stock, respectively. The purchases resulted in net
proceeds to us of $17.8 million, after deduction of the 3% fee to our placement
agent, J.P. Carey Securities, Inc
On June 30, 2003, we issued our $10.5 million principal amount of 8.5%
Convertible Exchangeable Debentures (the "Debentures"). Subject to the terms
under the various related agreements, the Debentures were convertible into
shares of our common stock or exchangeable for shares of the Digital Angel
Corporation common stock owned by us, or a combination thereof at any time at
the option of the Debenture holders, through the maturity date of November 1,
2005. On November 12, 2003, we announced that we had entered in a letter
agreement with the Debenture holders. Under the terms of the letter agreement,
the Debenture holders were required to convert a minimum of 50% of the
outstanding principal amount of the Debentures plus all accrued and unpaid
interest into shares of our common stock on November 12, 2003. In addition, per
the terms of the letter agreement, the Debenture holders were required to
convert any remaining outstanding principal amount of the Debentures plus
accrued interest on or before November 19, 2003. As of November 19, 2003, the
total principal amount of the Debentures was converted, and accordingly, our
obligations under the Debentures have been satisfied in full. Net proceeds from
the issuance of the Debentures were $10.0 million.
77
We have recently offered up to 3.0 million shares of our common stock in a
public offering registered under the Securities Act of 1933. J.P. Carey
Securities, Inc. acted as our placement agent for the offering. An aggregate of
2.2 million of these shares were sold under the terms of three separate
securities purchase agreements entered into on September 19, 2003, with each of
First Investors Holding Co., Inc., Magellan International LTD and Cranshire
Capital, LP., resulting in gross proceeds to us of approximately $8.0 million
before deduction of the 2.0% placement agency fee. In addition, an aggregate of
0.8 million of the shares were sold under eight separate securities purchase
agreements entered into on December 2, 2003, as amended, with each of First
Investors Holding Co., Inc., Magellan International LTD, Elliott Associates,
L.P., Islandia, L.P., Midsummer Investment, Ltd., Omicron Master Trust, Portside
Growth and Opportunity Fund and Elliott International L.P., which resulted in
aggregate gross proceeds to us of approximately $2.9 million before deduction of
the 2.0% placement agency fee. To date, we have used approximately $4.3 million
of the net proceeds from the 3.0 million share offering. We intend to use the
remaining net proceeds for general corporate purposes (including working capital
requirements, sales and marketing and capital expenditures).
On August 28, 2003, Digital Angel Corporation entered into a Security
Agreement with Laurus under which it may borrow from Laurus the lesser of $5.0
million or an amount that is determined based on percentages of Digital Angel
Corporation's eligible accounts receivable and inventory as prescribed by the
terms of the Security Agreement. The terms of the Security Agreement, as well as
the terms of a $2.0 million two-year secured convertible note between Digital
Angel Corporation and Laurus, are fully described in Note 11 to our Consolidated
Financial Statements. Digital Angel Corporation had availability under the
Security Agreement of $0.2 million at December 31, 2003.
The InfoTech USA, Inc. segment finances its accounts receivable and
inventory. Its current financing arrangement with IBM Credit provides financing
on inventory purchases up to $1.8 million. Borrowing for purchases is based upon
75% of all eligible receivables due within 90 days and up to 100% of all
eligible inventories. Interest for balances not paid within the interest free
period provided for in the agreement accrues at prime plus 4.4%. Borrowings
under the financing arrangement with IBM Credit were $0.8 million at December
31, 2003. On September 5, 2003, InfoTech USA, Inc. received a letter from IBM
Credit constituting their formal notice of termination of the agreement. The
effective date of such termination, which was originally set for March 10, 2004,
has been extended to April 9, 2004. InfoTech USA, Inc. is currently in the
process of securing other financing and expects to replace the IBM Credit
financing arrangement prior to the termination date set by IBM Credit. InfoTech
USA, Inc. believes that its present financing arrangement with IBM Credit, its
current cash position, the expected replacement of the IBM Credit agreement, and
the repayment by us of our $1.0 million loan from InfoTech, USA, Inc., which is
due in June 2004, will provide InfoTech USA, Inc. with sufficient capital for
the next twelve months. However, if InfoTech USA, Inc. is not successful in
obtaining a replacement for the IBM Credit financing arrangement, which is
needed to fund its operations in the coming year and beyond, it could have a
material adverse impact on our financial condition, results of operations and
cash flows.
The reduced settlement payment of our debt obligations to IBM Credit, the
conversion to equity of our obligations under the Debentures, and the sale of
3.0 million shares of our common stock under our 3.0 million share offering,
have been major factors mitigating concerns that existed about our ability to
continue as a going concern. The repayment of all of our debt obligations to IBM
Credit, the repayment of all of our obligations under the Debentures, and the
sale of 3.0 million shares of our common stock under our share offering, as
discussed above, contributed to our ability to continue as a going concern. Our
future profitability and liquidity depend on many factors including the success
of our marketing programs, the maintenance and reduction of expenses and our
ability to successfully develop and bring to market our new products and
technologies. Our ability to achieve profitability and/or generate positive cash
flows from operations in the future is predicated upon numerous factors with
varying levels of importance as follows:
78
o First, we must attempt to successfully implement our business plans,
manage expenditures according to our budget, and generate positive
cash flow from operations;
o Second, we must attempt to develop an effective marketing and sales
strategy in order to grow our business and compete successfully in
our markets;
o Third, we must attempt to obtain the necessary approvals to expand
the market for the VeriChip product in order to improve the
product's salability;
o Fourth, we must attempt to realize positive cash flow with respect
to our investment in Digital Angel Corporation in order to provide
us with an appropriate return on our investment; and
o Finally, we must attempt to complete the development of the Digital
Angel and PLD products.
We have established a management plan to assist us in achieving
profitability and positive cash flows over the twelve-months ending December 31,
2004. The major components of our plan are as follows:
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 AngelTM, Thermo LifeTM,
VeriChipTM, Bio-ThermoTM and PLD;
o To generate additional liquidity through divestiture of business
units and assets that are not critical to us;
o To position Digital Angel Corporation for growth under the
leadership of it new management team and through strategic
acquisitions such as the recent OuterLink acquisition;
o To generate additional liquidity for Digital Angel Corporation
through the Share Exchange Agreement between us and Digital Angel
Corporation: and
o To attempt to pair VeriChip Corporation with a complementary company
that will bring experienced management, revenue and a synergistic
customer base.
Our management estimates that the above plan can be effectively
implemented. As of December 31, 2003, we had a working capital deficiency.
However a significant portion of the past due liabilities associated with the
Discontinued Operations and All Other business units have not been guaranteed by
us and/or we do not intend to repay such liabilities in cash during the next
twelve months. Therefore, notwithstanding our working capital deficiency, we
believe that with our current cash position, our expectation about the
achievement of our management plan, and the reliance on our various other
sources of liquidity as discussed below, that we should have sufficient working
capital to satisfy our needs over the next twelve months.
79
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 2003, the Advanced Technology
segment reported gross revenue of $44.6 million. Of this amount, Computer Equity
Corporation represented $37.1 million, or 83.2% of the total revenue. The future
revenue outlook for Computer Equity Corporation is expected 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 full procurement process for a new
contract. During 2004 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 the next twelve months and beyond as these products gain
customer acceptance and awareness throughout the world.
As of December 31, 2003, the Advanced Technology segment and
"Corporate/Eliminations" had a combined cash balance of $8.6 million, InfoTech
USA, Inc. had a cash balance of $0.7 million, and Digital Angel Corporation had
a cash balance of $1.7 million, including restricted cash of $0.8 million. 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 - $4.0 million;
o To fund capital expenditures - $1.5 million; and
o To fund principal debt payments - $6.3 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 2004 will be
approximately $0.5 million, that Digital Angel Corporation's capital
expenditures for 2004 will be approximately $1.0 million and that InfoTech USA,
Inc.'s capital expenditures for the next twelve months will be de minimus. For
2004, we anticipate the cash outlay for our research and development efforts
relating to our advanced technology products to be approximate $1.0 million and
that Digital Angel Corporation's cash outlay for such efforts will be
approximately $3.0 million. InfoTech USA, Inc. does not currently incur research
and development expense.
80
Contractual Obligations
The following table shows the aggregate of our contractual cash
obligations as of December 31, 2003:
Contractual Cash Obligations Total Less Than 1-3 Years 4-5 Years After 5
1 Year Years
- --------------------------------------------------------------------------------------------------------
(amounts in thousands)
- --------------------------------------------------------------------------------------------------------
NOTES PAYABLE, LONG-TERM DEBT AND OTHER
LONG-TERM LIABILITIES $9,228 $6,255 $ 745 $ 123 $2,105
OPERATING LEASES 13,158 1,345 1,516 1,163 9,134
EMPLOYMENT RELATED CONTRACTS 2,675 1,660 1,015 -- --
------- ------- ------- ------- -------
TOTAL CONTRACTUAL CASH OBLIGATIONS $25,061 $ 9,260 $ 3,276 $ 1,286 $11,239
======= ======= ======= ======= =======
Sources of Liquidity
Our sources of liquidity may include proceeds from the sale of common
stock and preferred shares, proceeds from the sale of businesses, proceeds from
the sale of the Digital Angel Corporation common stock owned by us, proceeds
from the sale of our common stock issued to Digital Angel Corporation under the
Share Exchange Agreement, proceeds from the exercise of stock options and
warrants, proceeds from accounts receivable and inventory financing
arrangements, and the raising of other forms of debt or equity through private
placement or public offerings. However, these options may not be available, or
if available, they may not be on favorable terms. Our capital requirements
depend on a variety of factors, including but not limited to, the rate of
increase or decrease in our existing business base, the success, timing, and
amount of investment required to bring new products on-line, revenue growth or
decline, and potential acquisitions. Failure to generate positive cash flow from
operations will have a 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 segments as well as evaluating acquisitions of businesses and customer
bases which complement our operations. These strategic initiatives may include
acquisitions, raising additional funds through debt or equity offerings, or the
divestiture of business units that are not critical to our long-term strategy or
other restructuring or rationalization of existing operations. We will continue
to review all alternatives to ensure maximum appreciation of our shareholders'
investments. However, initiatives may not be found, or if found, they may not be
on terms favorable to us.
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IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset
Retirement Obligations (FAS No. 143), which was effective for fiscal years
beginning after June 15, 2002. FAS No. 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 No. 143
on January 1, 2003. Application of the new rules did not have any impact on our
financial position and results of operations, as we do not currently have any
legal obligations associated with the retirement of long-lived assets or leased
facilities.
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.
Also, the exception to applying Opinion 30 is eliminated. 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 had the effect of reducing our loss from continuing
operations and eliminating an extraordinary gain as previously reported for the
year ended December 31, 2001.
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 was 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 any
impact on our operations or financial position. We have recorded the costs
associated with our Medical Systems operations, which were disposed of during
the three-months ended June 30, 2004, in accordance with the provisions of FAS
No. 146.
Effective January 1, 2003, we adopted the recognition and measurement
provisions of FASB Interpretation No. 45, Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others ("Interpretation 45"). This interpretation elaborates on the disclosures
to be made by a guarantor in interim and annual financial statements about the
obligations under certain guarantees. Interpretation 45 also clarifies that a
guarantor is required to recognize, at the inception of a guarantee, a liability
for the fair value of the obligation undertaken in issuing the guarantee. The
initial recognition and initial measurement provisions of this interpretation
are applicable on a prospective basis to guarantees issued or modified after
December 31, 2002. We do not currently provide significant guarantees on a
routine basis. As a result, this interpretation has not had a material impact on
our financial statements.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities--an Interpretation of ARB No. 51 ("FIN 46"), which
addresses consolidation of variable interest entities. FIN 46 expands the
criteria for consideration in determining whether a variable interest entity
should be consolidated by a business entity, and requires existing
unconsolidated variable interest entities (which include, but are not limited
to, Special Purpose Entities, or SPEs) to be consolidated by their primary
beneficiaries if the entities do not effectively disperse risks among parties
involved. On October 9, 2003, the FASB issued Staff Position No. 46-6 which
deferred the effective date for applying the provisions of FIN 46 for interests
held by public entities in variable interest entities or potential variable
interest entities created before February 1, 2003. On December 24, 2003, the
FASB issued a revision to FIN 46. Under the revised interpretation, the
effective date was delayed to periods ending after March 15, 2004 for all
variable interest entities, other than SPEs. The adoption of FIN 46 is not
expected to have an impact on our financial condition, results of operations or
cash flows.
82
In May 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities (FAS No. 149). FAS No. 149 amends
and clarifies accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities
under FAS No. 133. FAS No. 149 is effective for contracts entered into or
modified after June 30, 2003, and for hedging relationships designated after
June 30, 2003. The adoption of FAS No. 149 did not have any impact on our
current financial position or our results of operations.
In May 2003, the FASB issued SFAS 150, Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity (FAS No. 150).
FAS No. 150 establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. It requires that an issuer classify a financial instrument that is
within its scope as a liability (or an asset in some circumstances). Many of
those instruments were previously classified as equity. FAS No. 150 is effective
for financial instruments entered into or modified after May 31, 2003, and
otherwise is effective at the beginning of the first interim period beginning
after June 15, 2003. It is to be implemented by reporting the cumulative effect
of a change in accounting principle for financial instruments created before the
issuance date of the statement and still existing at the beginning of the
interim period of adoption. Restatement is not permitted. We adopted the
provisions of FAS No. 150 effective July 1, 2003. The adoption of FAS No. 150
did not have any impact on our financial position or results of operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
With our United Kingdom subsidiary we have operations and sales in various
regions of the world. Additionally, we export and import to and from other
countries. Our operations may therefore be subject to volatility because of
currency fluctuations, inflation and changes in political and economic
conditions in these countries. Sales and expenses are denominated in local
currencies and may be affected as currency fluctuations affect our product
prices and operating costs or those of our competitors.
We presently do not use any derivative financial instruments to hedge our
exposure to adverse fluctuations in interest rates, foreign exchange rates,
fluctuations in commodity prices or other market risks, nor do we invest in
speculative financial instruments. As of December 31, 2003, our debt consisted
of Digital Angel Corporation's borrowing under its loan agreements with Laurus,
mortgages and capitalized leases with fixed implicit interest rates. Digital
Angel Corporation's borrowings under its loan agreements with Laurus bear
interest at prime plus 1.75% to prime plus 2.75%. Our interest income is
sensitive to changes in the general level of U.S. interest rates, particularly
since the majority of our investments are short-term.
Due to the nature of our short-term investments, we have concluded that
there is no material market risk exposure and, therefore, no quantitative
tabular disclosure is required.
83
The table below presents the principal amount and weighted-average
interest rate for our debt portfolio:
Carrying Value at
Dollars in Millions December 31, 2003
- -------------------------------------------------------------------------------
Total notes payable and long-term debt $9.0 (1)
Notes payable bearing interest at fixed interest rates $3.4 (1)
Weighted-average interest rate during 2003 50% (2)
(1) Amount includes $0.9 million of debt associated with our Medical Systems
operations, which is included as part of our Discontinued Operations.
(2) The weighted-average interest rate during 2003 was significantly impacted
by non-cash interest expense associated with the Debentures, which were
fully repaid as of November 19, 2003. The total interest expense related
to the Debentures during 2003 was $12.7 million.
The table below presents a sensitivity analysis of fluctuations in foreign
currency exchange rates:
For the Year Ended
December 31, 2003
----------------------------------------------------------------------------
Exchange Rate Sensitivity:
Net foreign currency gains recorded
in our Consolidated Statements of Operations De minimus
Foreign currency translation adjustments included
in Other Comprehensive Income $0.2 million
A 10% change in the applicable foreign exchange rates would result in an
increase or decrease in our foreign currency gains and losses and translation
adjustments of a de minimus amount.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements and supplementary data included in
this Annual Report are listed in Item 15 and begin immediately after Item 15.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
On April 11, 2002, we notified our independent accountants,
PricewaterhouseCoopers LLP, that our Board of Directors had approved our
decision to transition our audit work to another firm and dismissed
PricewaterhouseCoopers, LLP. We had selected Grant Thornton LLP as our new
independent accountants.
84
The reports of PricewaterhouseCoopers LLP on the financial statements for
the past two fiscal years contained no adverse opinion or disclaimer of opinion
and were not qualified or modified as to uncertainty, audit scope or accounting
principle, except that the reports for each of the years ended December 31,
2000, and December 31, 2001 contained an explanatory paragraph expressing doubt
about our ability to continue as a going concern. In connection with its audits
for the three most recent fiscal years and through April 11, 2002, there had
been no disagreements with PricewaterhouseCoopers LLP on any matter of
accounting principles or practices, financial statement disclosure, or auditing
scope or procedure, which disagreements if not resolved to the satisfaction of
PricewaterhouseCoopers LLP would have caused them to make reference thereto in
their report on the financial statements for such years. The following were the
only reportable events as defined under Regulation S-K Item 304(a)(1)(v). During
the two most recent fiscal years and through April 11, 2002,
PricewaterhouseCoopers LLP discussed with the Audit Committee of the Board of
Directors the following findings, all of which we agreed with and all of which
have been remedied. During the year ended December 31, 2001, one of our
subsidiaries lacked evidence of customer acceptance prior to the recognition of
certain revenue and did not have proper restrictions to vendor access within its
accounts payable system. During the year ended December 31, 2000, a second
subsidiary lacked monitoring controls over its accounts receivable and was
unable to provide certain detailed inventory listings for certain general ledger
balances. That subsidiary was part of our Discontinued Operations and has been
closed since 2001. On April 17, 2002, we engaged Grant Thornton LLP as our new
independent accountants to audit the financial statements for the year ending
December 31, 2002. During 2000 and 2001, and in the subsequent interim period,
we had not consulted with Grant Thornton LLP on items which concerned the
application of accounting principles generally, or to a specific transaction or
group of either completed or proposed transactions, or the type of audit opinion
that might be rendered on our financial statements.
On April 22, 2002, we filed a Current Report on Form 8-K with the SEC to
report the engagement of Grant Thornton LLP. Attached to that report as an
exhibit was a letter from PricewaterhouseCoopers LLP addressed to the SEC
stating the following: "We have read the statements made by Applied Digital
Solutions, Inc. (copy attached), which was filed with the Commission, pursuant
to Item 4 of Form 8-K, as part of the Company's Form 8-K report dated April 11,
2002. On March 27, 2002, we issued a report to the Audit Committee listing two
material weaknesses from prior years. Management has represented they have
implemented remedial action plans. Since we have performed no audit procedures
subsequent to the date of our report, we cannot confirm the effectiveness of
these remedial actions. Otherwise, we agree with the statements concerning our
Firm in such Form 8-K."
On May 21, 2002, we filed a Current Report on Form 8-K with the SEC to
report that, by letter dated May 14, 2002, Grant Thornton LLP resigned as our
outside auditing firm. We, and Grant Thornton, had a disagreement on the proper
accounting treatment with respect to a non-cash item in connection with the
merger of pre-merger Digital Angel and MAS. As a result of the nature of the
disagreement as outlined below, Grant Thornton communicated its resignation as
our auditors. Grant Thornton advised us that our proposed treatment of the
non-cash item was inconsistent with the position taken in MAS's definitive proxy
statement dated February 14, 2002, related to the merger. Grant Thornton advised
that we had not brought to Grant Thornton's attention the change in accounting
position and that it did not believe it could rely upon future representations
made by our management. Grant Thornton also advised us that it had not completed
its review of our quarterly report on Form 10-Q for the first quarter of 2002.
The accounting item in question (about which we, and Grant Thornton LLP,
had the disagreement) related to options that MAS was to assume or convert into
MAS options under the terms of an Agreement and Plan of Merger, dated November
1, 2001, by and among MAS, an MAS wholly-owned subsidiary, and pre-merger
Digital Angel. On March 27, 2002, the MAS wholly-owned subsidiary was merged
with and into pre-merger Digital Angel under the terms of the merger agreement.
We also contributed certain other subsidiaries in the merger. Pre-merger Digital
Angel, as the surviving corporation, became a wholly-owned subsidiary of MAS,
which has since been renamed Digital Angel Corporation. Grant Thornton has also
communicated by letter dated May 14, 2002, the termination of its auditor
relationship with Digital Angel Corporation.
85
With respect to the dispute as to the proper accounting treatment for
these options, Grant Thornton's position was that we should recognize in the
first quarter of 2002 a one-time, non-cash, compensation expense, in the amount
of approximately $14.5 million, under the guidance provided by Accounting
Principles Board Opinion No. 25 (APB 25), as amended by FASB Interpretation No.
44 and Emerging Issues Task Force Issue 00-23. We were of the view that the cost
of the assumed or to-be-converted options represents part of the merger
consideration and should be capitalized and reflected on our balance sheet,
consistent with accounting for the transaction as a business combination using
the purchase method of accounting, in accordance with Accounting Principles
Board Opinion No. 16 (APB 16). We stated that we were intending to contact the
staff of the SEC with respect to this issue and that the Audit Committee of the
Board of Directors was advised of management's handling of the proposed
accounting treatment for the stock options. We also stated that we had
authorized Grant Thornton to respond fully to inquiries of the successor
accountant concerning the subject matter of the foregoing disagreement and that
we were in negotiations with a new independent accounting firm with respect to
the auditing of our financial statements.
On May 22, 2002, we filed a Current Report on Form 8-K/A with the SEC to
include as an exhibit a letter from Grant Thornton LLP addressed to the SEC in
which Grant Thornton LLP stated the following: "We have read Item 4 of Form
8-K/A of Applied Digital Solutions, Inc. dated May 21, 2002, and agree with the
statements concerning our Firm contained therein. As to the discussion of having
contacted the SEC and of the new accountants, we have no basis for agreeing or
disagreeing with such statements."
On May 28, 2002, we filed a Current Report on Form 8-K to announce that on
May 23, 2002, we engaged Eisner LLP as our new independent accountants to audit
our financial statements for the fiscal year ending December 31, 2002. During
2000 and 2001 and in the subsequent interim period, we had not consulted with
Eisner LLP on items which concerned the application of accounting principles
generally, or to a specific transaction or group of either completed or proposed
transactions, or the type of audit opinion that might be rendered on our
financial statements, or any other matters or reportable events as set forth in
Items 304(a)(2)(i) and (ii) of Regulation S-K.
We also reported that due to the timing of the resignation of Grant
Thornton LLP, the interim financial statements contained in our Quarterly Report
on Form 10-Q for the quarter ended March 31, 2002, which were filed with the SEC
on May 20, 2002, were not reviewed by an independent accountant as required
pursuant to Rule 10-01 (d) of Regulation S-X, and that our new independent
accountants, Eisner LLP, would complete the SAS 71 review of the Registrant's
first quarter financial statements and we would file an amended Form 10-Q/A.
On May 24, 2002, we filed a Current Report on Form 8-K to disclose that we
had issued a press release on May 22, 2002, stating that the timing of Grant
Thornton's resignation as our outside auditors prevented us from filing its Form
10-Q with an auditor's review. As a result, we received a letter from the Nasdaq
staff indicating that the Form 10-Q did not comply with Marketplace Rule
4310(c)(14), and, accordingly, that an "E" would be added to our trading symbol.
The letter indicated that our common stock was subject to delisting unless we
requested a hearing before a Nasdaq listing qualifications panel. We informed
Nasdaq that we intended to make such a request. In accordance with applicable
Marketplace Rules, the hearing request had the effect of staying any action
pending the decision of the hearing panel. In the interim, the letter "E" was
appended to our trading symbol and from July 12, 2002, to July 30, 2002, our
common stock was delisted by the Nasdaq NM and was traded on the Pink Sheets
under the symbol "ADSX.PK." On July 18, 2002, we filed an amended quarterly
report on Form 10-Q, which presented condensed financial statements that had
been reviewed by our independent public accountants, Eisner LLP. As a result,
the Nasdaq hearing panel temporarily relisted our common stock effective July
31, 2002. However, we were unable to satisfy the required 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 symbol
ADSX.
86
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
(a) The Company's Chief Executive Officer and Chief Financial Officer have
reviewed and evaluated the effectiveness of the Company's disclosure controls
and procedures (as defined in Exchange Act Rules 240.13a - 15(e) and 15d -
15(e)) as of the end of the period ended December 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.
(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 fourth fiscal quarter that have materially
affected, or are reasonable likely to materially affect the Company's internal
control over financial reporting. There were no significant deficiencies or
material weaknesses, and therefore no corrective actions were taken.
87
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Our directors and executive officers are:
NAME AGE POSITION POSITION HELD SINCE
- ----------------------------- --------- ---------------------------------------------------- ---------------------------------------
Scott R. Silverman 40 Chairman of the Board and Chief Executive Officer (March 2003 - Chairman and CEO)
Kevin H. McLaughlin 61 President and Chief Operating Officer (March 2003 - Chief Operating Officer)
(May 2003 - President)
Michael E. Krawitz 34 Executive Vice President, General Counsel and (April 1999 - General Counsel) (March
Secretary 2003 - Secretary) (April 2003 -
Executive Vice President)
Evan C. McKeown 45 Senior Vice President and Chief Financial Officer (March 2002 - Chief Financial Officer)
(March 2003 - Senior Vice President)
Peter Y. Zhou 64 Vice President and Chief Scientist (January 2000 - Vice President and
Chief Scientist)
J. Michael Norris 57 Director January 2004
Daniel E. Penni 56 Director March 1995
Dennis G. Rawan 60 Director December 2002
Constance K. Weaver 51 Director July 1998
Michael S. Zarriello 54 Director May 2003
Scott R. Silverman: Mr. Silverman, age 40, previously served since August
2001 as a special advisor to the Board of Directors. In March 2002, he was
appointed to the Board of Directors and named President. In March 2003, he was
appointed Chairman of the Board and Chief Executive Officer. From September 1999
to March 2002, Mr. Silverman operated his own private investment-banking firm
and prior to that time, from October 1996 to September 1999, he served in
various capacities for us including positions related to business development,
corporate development and legal affairs. From July 1995 to September 1996, he
served as President of ATI Communications, Inc., one of our subsidiaries. He
began his career as an attorney specializing in commercial litigation and
communications law at the law firm of Cooper Perskie in Atlantic City, New
Jersey, and Philadelphia, Pennsylvania. Mr. Silverman is a graduate of the
University of Pennsylvania and Villanova University School of Law.
88
Kevin H. McLaughlin: Mr. McLaughlin, age 61, was appointed our Chief
Operating Officer in March 2003 and President in May 2003. From April 2002 until
the present, Mr. McLaughlin has served as a director, and from April 2002 to
March 2003, Mr. McLaughlin served as Chief Executive Officer of InfoTech USA,
Inc., our 52.5% owned subsidiary. Prior to that time, he served as Chief
Executive Officer of Computer Equity Corporation, our wholly-owned subsidiary.
Mr. McLaughlin joined us as Vice President of Sales and Marketing in June 2000.
From June 1995 to May 2000, he served as Senior Vice President of Sales for SCB
Computer Technology, Inc.
Michael E. Krawitz: Mr. Krawitz, age 34, joined us as Assistant Vice
President and General Counsel in April 1999, and was appointed Vice President
and Assistant Secretary in December 1999, Senior Vice President in December
2000, Secretary in March 2003 and Executive Vice President in April 2003. From
1994 to April 1999, Mr. Krawitz was an attorney with Fried, Frank, Harris,
Shriver & Jacobson in New York. Mr. Krawitz earned a Bachelor of Arts degree
from Cornell University in 1991 and a juris doctorate from Harvard Law School in
1994.
Evan C. McKeown: Mr. McKeown, age 45, joined us as Vice President, Chief
Accounting Officer and Corporate Controller in March 2001. He was appointed Vice
President, Chief Financial Officer in March 2002 and Senior Vice President in
March 2003. Prior to joining us, Mr. McKeown served as Corporate Controller at
Orius Corporation in West Palm Beach, Florida. From 1992 to 1999, he served as
Controller and then Chief Financial Officer of Zajac, Inc., in Portland, Maine.
Mr. McKeown has more that 20 years experience in accounting and financial
reporting, including serving as a Tax Manager for Ernst & Young and public
accountant with Coopers & Lybrand. He is a graduate of the University of Maine
and is a certified public accountant.
Peter Zhou: Dr. Zhou, age 64, joined us as Vice President and Chief
Scientist in January 2000. From 1988 to 1999, Dr. Zhou served as Vice President,
Technology for Sentry Technology Corp., and from 1985 to 1988, he served as
Research Investigator for the University of Pennsylvania's Department of Science
& Engineering. Prior to that, he was a research scientist for Max-Planck
Institute, Metallforschung in Stuttgart, Germany and a post-doctoral research
fellow at the University of Pennsylvania. Dr. Zhou has a PhD in materials
science/solid state physics from the University of Pennsylvania and a Master of
Sciences degree in physics from the Beijing University of Sciences and
Technology.
J. Michael Norris: Mr. Norris, age 57, was appointed a director on January
12, 2004, and serves as an independent member of the Audit Committee of the
Board of Directors. Mr. Norris served as the Chairman and Chief Executive
Officer of Next Level Communications before it was acquired by Motorola in the
spring of 2003. Prior to joining Next Level Communications, Mr. Norris was a
Senior Vice President and General Manager of the Network Management Group where
he was responsible for Motorola's global Cellular Operating Joint Ventures,
International Satellite Gateway Operations and Wireless Resale Operations for
approximately10 years. Mr. Norris holds a bachelor's degree with a
specialization in economics and a master's degree with a specialization in
finance, from Rollins College, Winter Park, Florida.
Daniel E. Penni: Mr. Penni, age 56, has served as a director since March
1995, and is Chairman of the Compensation Committee and serves on the Audit
Committee of the Board of Directors. Currently, he is an Area Senior Vice
President for Arthur J. Gallagher & Co. (NYSE:AJG), and previously, since March
1998, he has held several positions including Area Executive Vice President for
Arthur J. Gallagher & Co.. He has worked in many sales and administrative roles
in the insurance business since 1969. He is the managing member of the Norsman
Group Northeast, LLC, a private sales and marketing company focused on
Internet-based education and marketing and serves as Treasurer and Chairman of
the Finance Committee of the Board of Trustees of the Massachusetts College of
Pharmacy and Health Sciences. Mr. Penni graduated with a Bachelor of Science
degree in 1969 from the School of Management at Boston College.
89
Dennis G. Rawan: Mr. Rawan, age 60, was appointed a director effective
December 10, 2002, and serves as Chairman of the Audit Committee of the Board of
Directors. Mr. Rawan was Chief Financial Officer of Expo International, Inc.
(Expo) from 1996 until his retirement in 2000. Expo provides information
technology products and services to the event industry. For over 20 years prior
to joining Expo, Mr. Rawan was a certified public accountant (CPA) providing
audit, review, tax and financial statement preparation services for a variety of
clients. From 1970 to 1988, while working as a CPA, Mr. Rawan taught graduate
level accounting courses at Babson College. Mr. Rawan earned a Bachelor of Arts
degree and a Master of Business Administration degree from Northeastern
University.
Constance K. Weaver: Ms. Weaver, age 51, was elected a director in July
1998, and serves on the Compensation Committee of the Board of Directors. Ms.
Weaver is Executive Vice President, Public Relations, Marketing Communications
and Brand Management for AT&T Corporation (AT&T) (NYSE:T). From 1996 to October
2002, Ms. Weaver was Vice President, Investor Relations and Financial
Communications for AT&T. From 1995 through 1996, she was Senior Director,
Investor Relations and Financial Communications for Microsoft Corporation. From
1993 to 1995, she was Vice President, Investor Relations, and, from 1991 to
1993, she was Director of Investor Relations for MCI Communications, Inc. She
earned a Bachelor of Science degree from the University of Maryland in 1975 and
has completed post-graduate financial management, marketing and strategic
planning courses at The Wharton School of the University of Pennsylvania,
Stanford University, Columbia University and Imede (Switzerland).
Michael S. Zarriello: Mr. Zarriello, age 54, was appointed a director
effective May 9, 2003, and serves on the Audit Committee of the Board of
Directors. Mr. Zarriello has served as a member of the board of directors of
Digital Angel Corporation since September 2003, and he currently serves as a
member of the Compensation Committee of Digital Angel Corporation's board of
directors. He has served as Senior Vice President and Chief Financial Officer
for Rural/Metro Corporation in Scottsdale, Arizona since July 2003. Mr.
Zarriello was a Senior Managing Director of Jesup & Lamont Securities
Corporation and President of Jesup & Lamont Merchant Partners LLC from 1998 to
2003. From 1989 to 1997, Mr. Zarriello was a Managing Director- Principal of
Bear Stearns & Co., Inc. and from 1989 to 1991 he served as Chief Financial
Officer of the Principal Activities Group that invested the Bear Stearns'
capital in middle market companies. Prior to that time, he has held positions as
Chief Financial Officer of United States Leather Holdings, Inc., Chief Financial
Officer of Avon Products, Inc. Healthcare Division and Assistant Corporate
Controller for Avon. He graduated with a Bachelors of Science degree from the
State University of New York at Albany; he holds a Masters in Business
Administration from Fairleigh Dickinson University and an Advanced Professional
Certificate from New York University. Mr. Zarriello holds several licenses from
the National Association of Securities Dealers.
DIRECTORSHIPS
Mr. McLaughlin serves on the Boards of Directors of InfoTech USA, Inc. and
Digital Angel Corporation. Messrs. Silverman and Zarriello serve on the Board of
Directors of Digital Angel Corporation. No other directors or executive officers
hold directorships in any other company that has a class of securities
registered pursuant to Section 12 of the Securities Exchange Act of 1934, or
subject to the requirements of Section 15(d) of the Exchange Act or any company
registered as an investment company under the Investment Company Act of 1940.
90
BOARD OF DIRECTORS AND COMMITTEES OF THE BOARD
The Board of Directors held 11 meetings and acted by written consent 38
times during 2003.
We have standing Audit and Compensation Committees of the Board of
Directors. The members of the committees are identified in the above-referenced
descriptions.
The Audit Committee recommends for approval by the Board of Directors a
firm of certified public accountants whose duty it is to audit our consolidated
financial statements for the fiscal year in which they are appointed, and
monitors the effectiveness of the audit effort, our internal and financial
accounting organization and controls and financial reporting. The Audit
Committee held four meetings and acted by written consent four times during
2003. The Audit Committee approves all auditor services and otherwise complies
with the provisions of the Sarbanes-Oxley Act of 2002. The Audit Committee
members are independent as defined in Rule 4200(a)(15) of the National
Association of Securities Dealers listing standards, as applicable and as may be
modified or supplemented and as defined by the Sarbanes-Oxley Act of 2002.
The Compensation Committee administers our 1996 Non-Qualified Stock Option
Plan, the 1999 Flexible Stock Plan, the 1999 Employees Stock Purchase Plan and
the 2003 Flexible Stock Plan including the review and grant of stock options to
officers and other employees under such plans, and recommends the adoption of
new plans. The Compensation Committee also reviews and approves various other
compensation policies and matters and reviews and approves salaries and other
matters relating to our executive officers. The Compensation Committee reviews
all senior corporate employees after the end of each fiscal year to determine
compensation for the subsequent year. Particular attention is paid to each
employee's contributions to our current and future success along with their
salary level as compared to the market value of personnel with similar skills
and responsibilities. The Compensation Committee also looks at accomplishments,
which are above and beyond management's normal expectations for their positions.
The Compensation Committee met two times and acted by written consent six times
during 2003.
COMPENSATION OF DIRECTORS
Our non-employee directors receive a fixed quarterly fee in the amount of
$7,000 per quarter, effective July 1, 2003. In addition, the Chairman of the
Audit Committee receives a quarterly fee of $2,500 and the Chairman of the
Compensation Committee receives a quarterly fee $1,500. Other non-employee
directors receive a quarterly fee in the amount of $1,000 for each committee on
which they serve as a member. Reasonable travel expenses are reimbursed when
incurred. During 2003, Messrs. Penni and Rawan and Ms. Weaver each received a
bonus of $150,000, and Mr. Zarriello received a bonus of $30,000, as a result of
the successful repayment of all of our obligations to IBM Credit on June 30,
2003, under the terms of a forbearance agreement. As a result of the repayment,
we recognized a gain on the extinguishment of debt of approximately $70.1
million during 2003. Individuals who become directors are automatically granted
an initial option to purchase 2,500 shares of common stock on the date they
become directors. Each of such options is granted pursuant to our 1996
Non-Qualified Stock Option Plan, the 1999 Flexible Stock Plan, or the 2003
Flexible Stock Plan on terms and conditions determined by our Board of
Directors. During 2003, Messrs. Penni, Rawan and Zarriello and Ms. Weaver were
granted 25,000, 25,000, 12,500 and 25,000 options, respectively, to purchase
shares of our common stock. Messrs. Penni and Rawan and Ms Weaver's options were
annual option awards. Twenty-five hundred of Mr. Zarriello's options were issued
in connection with his appointment to our Board of Directors in May 2003, and
10,000 were issued as part of our annual option award. The amount of the annual
option awards was discretionary and was determined by the Compensation Committee
of the Board of Directors. Directors who are not also executive officers are not
eligible to participate in any of our other benefit plans. Mr. Norris joined our
Board of Directors on January 12, 2004, and therefore, he did not receive any
compensation during 2003.
91
CODE OF ETHICS
We have adopted a code of ethics that applies to, among others, our
principal executive officer and principal financial officer, and other persons
performing similar functions. We will provide to any person without charge, upon
request, a copy of such code. Requests for the code should be directed to:
Corporate Secretary, Applied Digital Solutions, Inc., 1690 South Congress
Avenue, Suite 200, Delray Beach, Florida 33445.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth certain summary information concerning the
total remuneration received or accrued for services rendered in 2003 and the two
prior fiscal years to our Chief Executive Officer, our former Chief Executive
Officer who retired in March 2003, and our four other most highly compensated
executive officers (collectively, the "Named Executive Officers").
SUMMARY COMPENSATION TABLE
Annual Compensation
- -------------------------------------------------------------------------------
Other Annual
Compensation
Name and Principal Position (1) Year Salary ($) Bonus ($)(2) ($)(3)
- -------------------------------------------------------------------------------
Scott R. Silverman(5) 2003 $ 278,077 $1,350,000 $ 44,442
Chairman and CEO 2002 165,577 22,030 2,563
2001 -- -- --
Richard J. Sullivan(6) 2003 $ 103,406 -- $ 15,106
Former Chairman, CEO and 2002 450,000 $ 140,000 326,841
Secretary 2001 450,000 448,801 57,424
Kevin H. McLaughlin(7) 2003 $ 157,692 $ 650,000 $ 8,250
President and Chief
Operating 2002 152,885 20,000 9,517
Officer 2001 150,000 7,087 10,615
Michael E. Krawitz(8) 2003 $ 181,538 $ 650,000 --
Executive Vice President, 2002 170,769 22,030 --
General Counsel 2001 160,000 14,174 --
Secretary
Evan C. McKeown(9) 2003 $ 167,692 $ 650,000 --
Senior Vice President, 2002 155,673 7,868 --
Chief Financial Officer, 2001 93,750 7,087 --
Peter Zhou 2003 $ 228,981 $ 7,500 --
Vice President, 2002 216,058 7,500 --
Chief Scientist 2001 212,839 -- --
Long-Term Compensation
---------------------------------------------------------------------------
Awards Payouts
- ------------------------------------------------------------------------------------------------------------
Restricted
Stock Options/ LTIP All Other
Name and Principal Position (1) Awards ($) SAR's(#)(4) Payouts(#) Compensation ($)
- ------------------------------------------------------------------------------------------------------------
Scott R. Silverman(5) -- 1,450,000(10) -- --
Chairman and CEO -- 1,460,000(11) -- --
-- 276,250(12) -- --
Richard J. Sullivan(6) -- 1,088,500(13)(30) $13,069,204 (31)
Former Chairman, CEO and -- 3,230,000(14)(29)(30) -- --
Secretary -- 1,551,000(15)(28)(29) -- --
Kevin H. McLaughlin(7) -- 575,000(16) -- --
President and Chief
Operating -- 375,500(17) -- --
Officer -- 288,275(18)(28) -- --
Michael E. Krawitz(8) -- 950,000(19) -- --
Executive Vice President, -- 1,390,000(20) -- --
General Counsel -- 207,275 -- --
Secretary
Evan C. McKeown(9) -- 325,000(22) -- --
Senior Vice President, -- 115,000(23) -- --
Chief Financial Officer, -- 45,469(24) -- --
Peter Zhou -- 415,000(25) -- --
Vice President, -- 20,000(26) -- --
Chief Scientist -- 136,650(27)(28) -- --
- --------------------------
(1) See "Related Party Transactions."
(2) The amounts in the Bonus column were discretionary awards granted by the
Compensation Committee in consideration of the contributions of the
respective Named Executive Officers.
(3) Other annual compensation includes: (a) in 2003, for Mr. Silverman, a
general expense allowance of $38,462 and an auto allowance of $5,980, and
for Richard J. Sullivan, health insurance reimbursements of $10,190 and an
auto allowance of $4,916, for Mr. McLaughlin, a car allowance of $8,250;
(b) in 2002, for Mr. Silverman, an auto allowance of $2,563, for Richard
J. Sullivan, $296,190 related to the difference between the price used to
determine the number of shares of common stock issued to Mr. Sullivan in
lieu of cash compensation and the market price of stock at the time of
issuance, a general expense allowance of $17,362, an auto allowance of
$10,242 and a payment of $3,047 for a tax gross up, and for Mr.
McLaughlin, an auto allowance of $9,517; and (c) in 2001, for Richard J.
Sullivan, a general expense allowance of $39,673 and an auto allowance of
$17,751, and for Mr. McLaughlin, an auto allowance of $10,615.
92
(4) Indicates number of securities underlying options. Includes options
granted by our subsidiaries.
(5) Mr. Silverman joined us as a Director and President in March 2002. He
assumed the positions of Chairman of the Board of Directors and Chief
Executive Officer in March 2003.
(6) Mr. Sullivan retired in March 2003.
(7) Mr. McLaughlin joined us as Vice President of Sales and Marketing in June
2000. He assumed the positions of Chief Operating Officer and President in
March 2003, and May 2003, respectively.
(8) Mr. Krawitz assumed the position of Secretary in March 2003.
(9) Mr. McKeown joined us as Vice President, Chief Accounting Officer and
Corporate Controller in March 2001. He was appointed Vice President, Chief
Financial Officer in March 2002 and Senior Vice President in March 2003.
(10) Includes 200,000 options granted by us, 500,000 options granted by Digital
Angel Corporation and 750,000 options granted by Thermo Life Energy Corp.
(11) Includes 160,000 options granted by us, 350,000 options granted by
InfoTech USA, Inc., 950,000 options granted by VeriChip Corporation.
(12) Includes 32,500 options granted by us, 143,750 options granted by Digital
Angel Corporation, 100,000 options granted by InfoTech USA, Inc.
(13) Includes 1,088,500 options which were granted by us in prior years and
that were re-priced in March 2003, under the terms of Mr. Sullivan's
severance agreement.
(14) Includes 330,000 options granted by us, 1,000,000 options granted by
Digital Angel Corporation, 350,000 options granted by InfoTech USA, Inc.,
1,450,000 options granted by VeriChip Corporation, and 100,000 shares of
VeriChip Corporation belonging to Mr. Sullivan's wife.
(15) Includes 1,341,000 options granted by us, 200,000 options granted by
InfoTech USA, Inc, and 10,000 shares of Applied Digital Solutions
belonging to Mr. Sullivan's wife.
(16) Includes 25,000 options granted by us, 250,000 options granted by Digital
Angel Corporation, 100,000 options granted by VeriChip Corporation, and
200,000 options granted by Thermo Life Energy Corp.
(17) Includes 7,500 options granted by us, and 350,000 options granted by
InfoTech USA, Inc.
(18) Includes 53,900 options granted by us, and 234,375 options granted by
Digital Angel Corporation.
(19) Includes 100,000 options granted by us, 100,000 options granted by Digital
Angel Corporation, and 750,000 options granted by Thermo Life Energy Corp.
(20) Includes 100,000 options granted by us, 350,000 options granted by
InfoTech USA, Inc, and 940,000 options granted by VeriChip Corporation.
(21) Includes 60,400 options granted by us, 46,875 options granted by Digital
Angel Corporation, and 100,000 options granted by InfoTech USA, Inc.
(22) Includes 25,000 options granted by us, 100,000 options granted by VeriChip
Corporation, and 200,000 options granted by Thermo Life Energy Corp.
(23) Includes 15,000 options granted by us, and 100,000 options granted by
VeriChip Corporation.
(24) Includes 15,000 options granted by us, and 30,469 options granted by
Digital Angel Corporation.
(25) Includes 15,000 options granted by us, and 100,000 options granted by
VeriChip Corporation, and 300,000 options granted by Thermo Life Energy
Corp.
(26) Includes 20,000 options granted by us.
(27) Includes 42,900 options granted by us, and 93,750 options granted by
Digital Angel Corporation.
(28) Includes options granted by us in prior years that were re-priced during
2001 as follows; (a) for Richard J. Sullivan, 767,500; (b) for Kevin
McLaughlin, 18,900; (c) for Michael E. Krawitz, 15,400; and (d) Peter
Zhou, 12,900.
(29) Info Tech USA, Inc. options forfeited on resignation.
(30) VeriChip Corporation options forfeited on resignation.
(31) Includes the value of 5,600,000 shares of our common stock of $10,976,000,
which were issued to Mr. Sullivan on March 1, 2004, and the value of
1,088,500 common stock options of $2,093,204, which were re-priced in
March 2003, under the terms of Mr. Sullivan's severance agreement. The
issuance of the shares and the re-pricing of the stock options were
approved by our shareholders on July 25, 2003.
93
The following table contains information concerning the grant under all of
our stock option plans and under all of our subsidiary stock option plans, to
the Named Executive Officers during the year ended December 31, 2003:
OPTION GRANTS IN 2003
Individual Grants
- ------------------------------------------------------------------------------------------------------------------------------------
Potential Realizable Value At
Assumed Rates of Stock
Appreciation for Option Term
- ------------------------------------------------------------------------------------------------------------------------------------
% of Total
Options
Number of Securities Granted to
Underlying Options Employees in Exercise
Name Granted (#) 2003 Price ($/Sh) Expiration Date 5% ($) 10% ($)
- ----------------------------------------------------------------------------------------------------------------------------------
Scott R. Silverman 200,000 (1) 9.9% $3.90 November-11 $955,701 $2,289,417
250,000 (2) 13.9 1.91 September-14 177,756 463,838
250,000 (2) 13.9 3.89 December-14 413,768 1,434,072
750,000 (4) 19.2 0.05 April-11 358,388 858,531
Richard J. Sullivan 200,000 (5) 9.9 0.10 (5) July-08 595,572 1,327,890
120,000 (5) 6.0 0.10 (5) February-08 321,946 709,038
18,500 (5) 0.9 0.10 (5) April-04 9,614 19,245
350,000 (5) 17.4 0.10 (5) September-06 654,798 1,392,898
100,000 (5) 5.0 0.10 (5) September-07 246,439 537,768
200,000 (5) 9.9 0.10 (5) January-07 405,154 867,665
100,000 (5) 5.0 0.10 (5) May-05 110,784 227,824
Kevin H. McLaughlin 25,000 (1) 1.2 3.90 November-11 119,463 286,177
250,000 (2) 13.9 1.91 September-11 177,699 463,652
100,000 (3) 12.7 0.25 April-11 47,785 114,471
200,000 (4) 5.1 0.05 April-11 95,570 228,942
Michael E. Krawitz 100,000 (1) 5.0 3.90 November-11 477,850 1,144,709
100,000 (2) 5.6 3.89 December-14 165,507 573,629
750,000 (4) 19.2 0.05 April-11 358,388 858,531
Evan C. McKeown 25,000 (1) 1.2 3.90 November-14 119,463 286,177
100,000 (3) 12.7 0.25 April-11 47,785 114,471
200,000 (4) 5.1 0.05 April-11 95,570 228,942
Peter Zhou 15,000 (1) 0.7 3.90 November-14 94,432 239,366
100,000 (3) 12.7 0.25 April-11 47,785 114,471
300,000 (4) 7.7 0.05 April-11 143,355 343,413
- -------------------
(1) These options were granted under the 2003 Flexible Stock Plan at an
exercise price equal to the fair market value of our common stock on the
date of grant. These options vest one year from the date of grant.
(2) Digital Angel Corporation granted these options at an exercise price equal
to the fair market value of our common stock on the date of grant. These
options vest one year from the date of grant.
(3) VeriChip Corporation granted these options at an exercise price equal to
the fair market value of our common stock on the date of grant. These
options vest one year from the date of grant.
(4) Thermo Life Energy Corp. granted these options at an exercise price equal
to the fair market value of our common stock on the date of grant. These
options vest one year from the date of grant.
(5) These options were granted by us under the 1996 Non-Qualified Stock Option
Plan and/or the 1999 Flexible Stock Plan in prior years and were re-priced
on March 24, 2003, as part of Mr. Sullivan's severance agreement. The
re-priced options are exercisable at $0.10 per share. All other terms
remained unchanged.
The terms of the 1996 Non-Qualified Stock Option Plan, the 1999 Flexible
Stock Plan and the 2003 Flexible Stock Plan include change of control
provisions. Upon a change of control, as defined in the plans, all stock options
become fully vested, exercisable or payable.
94
The following table sets forth information with respect to stock options
exercised by the Named Executive Officers concerning the exercise of options
during the fiscal year ended December 31, 2003 and stock options held as of
December 31, 2003 by each Named Executive Officer:
2003 AGGREGATE OPTION EXERCISES IN LAST FISCAL YEAR AND
FISCAL YEAR-END OPTION VALUES
Number of Securities
Underlying Value of Unexercised
Exercised in 2003 Unexercised Options at In-The-Money Options at
December 31, 2003 (#) December 31, 2003 ($)(2)
--------------------------------- ---------------------------- -------------------------------
Shares Acquired Value
Name Upon Exercise (#) Realized ($)(1) Exercisable Unexercisable Exercisable Unexercisable
- ------------------------------------------------------------------------------------------------------------------------------------
Scott R. Silverman
Applied Digital Solutions, Inc. - - 192,500 200,000 $368,000 $160,000
Digital Angel Corporation - - 250,000 250,000 707,500 212,500
InfoTech USA, Inc. - - 100,000 350,000 - -
VeriChip Corporation - - 500,000 450,000 100,000 90,000
Thermo Life Energy Corp. - - - 750,000 - -
Richard J. Sullivan
Applied Digital Solutions, Inc. 1,148,500 (3) $4,662,159 (3) 10,000 (4) - 15,000 -
Digital Angel Corporation - - 1,093,750 (5) - 4,601,078 -
InfoTech USA, Inc. - - - (4) - - -
VeriChip Corporation - - 100,000 - 20,000 -
Thermo Life Energy Corp. - - - -
Kevin H. McLaughlin
Applied Digital Solutions, Inc. - - 39,166 25,000 112,583 20,000
Digital Angel Corporation - - - 250,000 - 707,500
InfoTech USA, Inc. - - - 350,000 - -
VeriChip Corporation - - - 100,000 - -
Thermo Life Energy Corp. - 200,000 - -
Michael E. Krawitz
Applied Digital Solutions, Inc. - - 150,400 100,000 327,280 80,000
Digital Angel Corporation - - 114,188 100,000 506,161 85,000
InfoTech USA, Inc. - - 100,000 350,000 - -
VeriChip Corporation - - 500,000 440,000 100,000 88,000
Thermo Life Energy Corp. - 750,000 - -
Evan C. McKeown
Applied Digital Solutions, Inc. - - 23,333 26,667 51,166 25,333
Digital Angel Corporation - - - - - -
InfoTech USA, Inc. - - - - - -
VeriChip Corporation - - 100,000 100,000 20,000 -
Thermo Life Energy Corp. - 200,000 - -
Peter Zhou
Applied Digital Solutions, Inc. - - 32,900 15,000 73,280 12,000
Digital Angel Corporation - - 271,875 - 1,086,986 -
InfoTech USA, Inc. - - - - - -
VeriChip Corporation - - - 100,000 - -
Thermo Life Energy Corp. - 300,000 - -
- ---------------------------
(1) The values realized represent the aggregate market value of the shares
covered by the option on the date of exercise less the aggregate exercise
price paid by the executive officer, but do not include deduction for
taxes or other expenses associated with the exercise of the option or the
sale of the underlying shares.
(2) The value of the unexercised in-the-money options at December 31, 2003, is
based upon the following fair market values: $4.70 for options exercisable
into shares of our common stock (based on the closing price of our common
stock as reported on the Nasdaq SmallCap Market on December 31, 2003,
adjusted for the reverse stock split); $4.74 for options exercisable into
shares of Digital Angel Corporation's common stock (based upon the closing
price of Digital Angel Corporations common stock as reported on the
American Stock Exchange on December 31, 2003); $0.23 for options
exercisable into shares of InfoTech USA, Inc.'s common stock (based on the
closing price of InfoTech USA, Inc.'s common stock on the OTC Bulletin
Board on December 31, 2003); $0.25 for options exercisable into shares of
VeriChip Corporation's common stock based upon the estimated fair value on
December 31, 2003; and $0.05 for options exercisable into shares of Thermo
Life Energy Corp.'s common stock based upon the estimated fair value on
December 31, 2003. The values shown are net of the option exercise price,
but do not include deduction for taxes or other expenses associated with
the exercise of the option or the sale of the underlying shares.
(3) Includes 60,000 options exercised by Mr. Sullivan's wife. The value
received for these shares was $198,000.
(4) These options are owned by Mr. Sullivan's wife.
(5) Includes 93,570 exercisable options, which are owned by Mr. Sullivan's
wife. The options have a value of $394,378.
95
The following table sets forth information with respect to the named
executive officers concerning the repricing of options during 2003 and 2001 and
for the last ten completed fiscal years:
10-Year Option/SAR Re-pricing
Number of Securities Length of Original
Underlying Market Price of Exercise Price at Option Term
Options/SARs Stock at Time of Time of Repricing or Remaining at Date
Re-priced or Amended Repricing or Amendment ($) New Exercis of Repricing or
Name Date (#) Amendment ($) Price ($) Amendment
- ----------------------------------------------------------------------------------------------------------------------------------
Richard J. Sullivan March 24, 2003 200,000 $2.00 $2.80 $ 0.10 55 months
March 24, 2003 120,000 2.00 3.20 0.10 50 months
March 24, 2003 18,500 2.00 1.50 0.10 4 months
March 24, 2003 350,000 2.00 1.50 0.10 33 months
March 24, 2003 100,000 2.00 1.50 0.10 45 months
March 24, 2003 200,000 2.00 1.50 0.10 36 months
March 24, 2003 100,000 2.00 1.50 0.10 17 months
September 21, 2001 50,000 1.50 39.30 1.50 22 months
September 21, 2001 50,000 1.50 55.80 1.50 25 months
September 21, 2001 63,000 1.50 44.60 1.50 12 months
September 21, 2001 4,500 1.50 42.50 1.50 10 months
September 21, 2001 50,000 1.50 35.10 1.50 30 months
September 21, 2001 50,000 1.50 30.30 1.50 31.5 months
September 21, 2001 50,000 1.50 21.90 1.50 38 months
September 21, 2001 100,000 1.50 20.30 1.50 104.5 months
September 21, 2001 350,000 1.50 27.50 1.50 60 months
September 21, 2001 200,000 1.50 6.90 1.50 63 months
Scott R. Silverman September 21, 2001 10,000 1.50 2.70 1.50 58.5 months
Kevin McLaughlin September 21, 2001 3,333 1.50 36.60 1.50 57.5 months
September 21, 2001 3,333 1.50 36.60 1.50 69.5 months
September 21, 2001 3,333 1.50 36.60 1.50 81.5 months
September 21, 2001 3,900 1.50 27.50 1.50 60 months
September 21, 2001 7,500 1.50 6.90 1.50 63 months
Michael E. Krawitz September 21, 2001 2,500 1.50 20.30 1.50 104.5 months
September 21, 2001 5,000 1.50 20.00 1.50 49.5 months
September 21, 2001 7,900 1.50 27.50 1.50 60 months
September 21, 2001 10,000 1.50 6.90 1.50 63 months
Evan C. McKeown September 21, 2001 1,667 1.50 12.20 1.50 66 months
September 21, 2001 1,667 1.50 12.20 1.50 78 months
September 21, 2001 1,666 1.50 12.20 1.50 90 months
Peter Zhou September 21, 2001 1,667 1.50 63.40 1.50 51.5 months
September 21, 2001 1,667 1.50 63.40 1.50 63.5 months
September 21, 2001 1,666 1.50 63.40 1.50 75.5 months
September 21, 2001 7,900 1.50 27.50 1.50 60 months
September 21, 2001 10,000 1.50 6.90 1.50 63 months
Incentive Plans
Cash and Stock Incentive Compensation Programs. To reward performance, we
provide our executive officers and our subsidiary officers with additional
compensation in the form of a cash bonus and/or stock awards. As of December 31,
2003, no fixed formula or weighting has been applied by the Compensation
Committee to corporate performance versus individual performance in determining
these awards. The Compensation Committee acting in its discretion has determined
the amounts of such awards. Such determination, except in the case of the award
for the Chairman, was made after considering the recommendations of the Chairman
and President and such other matters as the Compensation Committee deems
relevant. The Compensation Committee, acting in its discretion, may determine to
pay a lesser award than the maximum amount specified. The amount of the total
incentive is divided between cash and stock at the discretion of the
Compensation Committee.
96
Stock Options and Other Awards Granted under the 1996 Non-Qualified Stock
Option Plan, the 1999 Flexible Stock Plan and the 2003 Flexible Stock Plan. The
1996 Non-Qualified Stock Option Plan, the 1999 Flexible Stock Plan and the 2003
Flexible Stock Plan are long-term plans designed to link rewards with
shareholder value over time. Stock options are granted to aid in the retention
of employees and to align the interests of employees with shareholders. The
value of the stock options to an employee increases as the price of our stock
increases above the fair market value on the grant date, and the employee must
remain in our employ for the period required for the stock option to be
exercisable, thus providing an incentive to remain in our employ.
These Plans allow grants of stock options to all of our employees,
including executive officers. Grants to our executive officers and to officers
of our subsidiaries are made at the discretion of the Compensation Committee.
The Compensation Committee may also make available a pool of options to each
subsidiary to be granted at the discretion of such subsidiary's president.
The 2003 Flexible Stock Plan is also designed to encourage ownership of
our common stock by employees, directors and other individuals, and to promote
and further the best interests of us by granting cash and other stock awards. We
also intend to grant awards of our common stock in lieu of payments of cash
compensation pursuant to the mutual agreement with the participant.
Stock Options Granted under the 1999 Employee Stock Purchase Plan. The
1999 Employee Stock Purchase Plan, which is intended to qualify as an "employee
stock purchase plan" under Section 423 of the Internal Revenue Code, provides
eligible employees with an opportunity to accumulate, through payroll
deductions, funds to be used toward the purchase of our stock pursuant to
options granted under the plan. Options granted in connection with an offering
under the plan, permit the option holder to purchase our stock at a price per
share equal to 85% of the fair market value of the stock on (i) the date on
which the option is granted (i.e., the first business day of the offering) and
(ii) the date on which the option is exercised (i.e., the last business day of
the offering), whichever is less. Section 423 of the Internal Revenue Code also
provides certain favorable tax consequences to the option holder, provided that
the stock acquired under the plan is held for a specified minimum period of
time.
Other than as otherwise disclosed herein, there were no plans pursuant to
which cash or non-cash compensation was paid or distributed during the last
fiscal year.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN
COMPENSATION DECISIONS
None
EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
ARRANGEMENTS
We have not entered into employment contracts with any of our executive
officers. Previously, we had entered into an employment contract with Michael E.
Krawitz, Executive Vice President, General Counsel and Secretary, which Mr.
Krawitz agreed to terminate for no consideration in November 2003. We have
established a severance policy for our executive officers under which, if we
terminate an employee without cause, as defined, or the employee resigns with
good reason the employee will receive severance payments. Under the policy,
senior vice presidents and above will receive one year of base salary and vice
presidents will receive six months of base salary, based on the salary in effect
at time of the termination. The severance amount is reduced by half if the
employee has been in our employ for less than one year. Payments cease if, in
any material respect, the employee engages in an activity that competes with us
or if the employee breaches a duty of confidentiality.
97
On March 21, 2003, Richard J. Sullivan retired. Under the terms of Mr.
Sullivan's, severance agreement, Mr. Sullivan received a one-time payment of 5.6
million shares of our common stock, which were issued to Mr. Sullivan on March
1, 2004, and 1.1 million re-priced options. The options surrendered had exercise
prices ranging from $1.50 to $3.20 per share and were replaced with options
exercisable at $0.10 per share. All of the options have been exercised.
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);
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 us or his ceasing to serve as our
Chairman of the Board or Chief Executive Officer for any reason
other than due to his material default, with us having the option to
pay this amount in cash or in our common stock or any combination of
the two. In the event we 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 (our 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 us to pay Richard Sullivan
approximately $17.3 million under or in connection with the termination of his
employment agreement. In view of our cash constraints and our need at the time
to dedicate essentially all of our cash resources to satisfying our obligations
to IBM Credit, we commenced negotiations with Richard Sullivan that led to the
proposed terms of his severance agreement.
Effective March 3, 2004, Richard J. Sullivan resigned from Digital Angel
Corporation's Board of Directors, and thus, he no longer has any affiliation
with us.
SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Exchange Act requires our officers and directors and
persons who own more than 10% of our Common Stock to file reports of ownership
and changes in ownership with the Securities and Exchange Commission and to
furnish copies of all such reports to us. We believe, based on our stock
transfer records and other information available to us, that all reports
required under Section 16(a) were timely filed during 2003 except for a joint
Form 4 for Applied Digital Solutions, Inc. and the Digital Angel Share Trust
related to the disposition of 4,546 shares of the Digital Angel Corporation
common stock owned by us in connection with the exchange of a portion of our
8.5% Convertible Exchangeable Debentures that was filed approximately two months
late.
98
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
OWNERSHIP OF EQUITY SECURITIES
The following table sets forth information regarding beneficial ownership
of our common stock by each director and by each executive officer named in the
summary compensation table and by all the directors and executive officers as a
group as of March 10, 2004:
---------------------------------
Number of
Shares of Percent of
Common Stock Common Stock
Beneficially Beneficially
Name of Beneficial Owner Owned (1) Owned
- --------------------------------------------------------------------- ---------------- --------------
Scott R. Silverman 194,500 *
J. Michael Norris -- --
Daniel E. Penni 191,264 *
Dennis G. Rawan 1,333 *
Constance K. Weaver 132,917 *
Michael S. Zarriello 2,452 *
Richard J. Sullivan (2) (3) 12,222 *
Kevin H. McLaughlin 40,233 *
Michael E. Krawitz 156,236 *
Evan C. McKeown 25,155 *
Peter Zhou 35,253 *
All directors and executive officers as a group (12 persons) 834,817 1.6%
- ---------------------------
* Represents less than 1% of the issued and outstanding shares of our common
stock.
(1) This table includes presently exercisable stock options and options that
are exercisable within sixty days of March 10, 2004, in accordance with
Rule 13d-3(d) under the Securities Exchange Act of 1934. The following
directors and executive officers hold the number of exercisable options
set forth following their respective names: Scott R. Silverman - 192,500;
Daniel E. Penni - 116,400; Dennis G. Rawan - 833; Constance K. Weaver -
98,900; Richard J. Sullivan - 10,000; Kevin H. McLaughlin -39,133; Michael
E. Krawitz - 150,400; Evan C. McKeown - 25,000; Peter Zhou - 32,900; and
all directors and officers as a group - 703,467.
(2) Includes 10,000 presently exercisable options and 2,222 shares of common
stock owned by Mr. Sullivan's spouse.
(3) Mr. Sullivan did not respond to our request for information about his
holdings.
99
The following table sets forth information regarding beneficial ownership
of our 68.5% subsidiary, Digital Angel Corporation, by each of our directors and
by each executive officer named in the summary compensation table and by all the
directors and executive officers as a group as of March 10, 2004:
NUMBER OF
SHARES OF PERCENT OF
COMMON COMMON
STOCK STOCK
BENEFICIALLY BENEFICIALLY
NAME OF BENEFICIAL OWNER OWNED (1) OWNED
- ---------------------------------------------------------------------------------------
Scott R. Silverman
400 Royal Palm Way, Palm Beach, FL 33480 78,450 *
J. Michael Norris
400 Royal Palm Way, Palm Beach, FL 33480 -- --
Daniel E. Penni
260 Eliot Street, Ashland, MA 01721 93,750 *
Dennis G. Rawan -- --
400 Royal Palm Way, Palm Beach, FL 33480
Constance K. Weaver 82,950 *
295 North Maple Ave, Basking Ridge, NJ 07920
Michael S. Zarriello -- --
400 Royal Palm Way, Palm Beach, FL 33480
Richard J. Sullivan
400 Royal Palm Way, Palm Beach, FL 33480 1,143,750 (2) 3.3%
(3)
Kevin H. McLaughlin
400 Royal Palm Way, Palm Beach, FL 33480 -- --
Michael E. Krawitz
400 Royal Palm Way, Palm Beach, FL 33480 114,118 *
Evan C. McKeown
400 Royal Palm Way, Palm Beach, FL 33480 -- --
Peter Zhou
5750 Division Street, Riverside, CA 92506 271,875 *
All directors and executive officers as a group (12 1,802,706 5.3%
persons)
- ----------------
* Represents less than 1% of the issued and outstanding shares of Digital Angel
Corporation's common stock.
(1) This table includes presently exercisable stock options and options that
are exercisable within sixty days of March 10, 2004, in accordance with
Rule 13d-3(d) under the Securities Exchange Act of 1934. The following
directors and executive officers hold the number of exercisable options
set forth following their respective names: Scott R. Silverman - 50,000;
Constance K. Weaver - 82,950; Richard J. Sullivan - 1,143,750; Michael E.
Krawitz - 114,118; Peter Zhou - 271,875; and all directors and officers as
a group - 1,680,506.
(2) Includes 93,750 presently exercisable options owned by Mr. Sullivan's
spouse.
(3) Mr. Sullivan did not respond to our request for information about his
holdings.
100
The following table sets forth information regarding beneficial ownership
of our 52.5% subsidiary, InfoTech USA, Inc., by each of our directors and by
each executive officer named in the summary compensation table and by all the
directors and executive officers as a group as of March 10, 2004:
NUMBER OF
SHARES OF PERCENT OF
COMMON COMMON
STOCK STOCK
BENEFICIALLY BENEFICIALLY
NAME OF BENEFICIAL OWNER OWNED (1) OWNED
- -------------------------------------------------------------------------------------
Scott R. Silverman
400 Royal Palm Way, Palm Beach, FL 33480 450,000 7.3%
J. Michael Norris
400 Royal Palm Way, Palm Beach, FL 33480 -- --
Daniel E. Penni
260 Eliot Street, Ashland, MA 01721 -- --
Dennis G. Rawan
400 Royal Palm Way, Palm Beach, FL 33480 -- --
Constance K. Weaver
295 North Maple Ave, Basking Ridge, NJ 07920 -- --
Michael S. Zarriello
400 Royal Palm Way, Palm Beach, FL 33480 -- --
Richard J. Sullivan
400 Royal Palm Way, Palm Beach, FL 33480 -- --
Kevin H. McLaughlin
400 Royal Palm Way, Palm Beach, FL 33480 350,000 5.7%
Michael E. Krawitz
400 Royal Palm Way, Palm Beach, FL 33480 450,000 7.3%
Evan C. McKeown
400 Royal Palm Way, Palm Beach, FL 33480 -- --
Peter Zhou
5750 Division Street, Riverside, CA 92506 -- --
All directors and executive officers as a group (12 1,250,000 20.3%
persons)
(1) This table includes presently exercisable stock options and options that
are exercisable within sixty days of March 10, 2004, in accordance with
Rule 13d-3(d) under the Securities Exchange Act of 1934. The following
directors and executive officers hold the number of exercisable options
set forth following their respective names: Scott R. Silverman - 450,000;
Kevin H. McLaughlin - 350,000; Michael E. Krawitz - 450;000; and all
directors and officers as a group - 1,250,000.
101
The following table sets forth information regarding beneficial ownership
of our wholly owned subsidiary, VeriChip Corporation, by each of our directors
and by each executive officer named in the summary compensation table and by all
the directors and executive officers as a group as of March 10, 2004:
NUMBER OF
SHARES OF PERCENT OF
COMMON COMMON
STOCK STOCK
BENEFICIALLY BENEFICIALLY
NAME OF BENEFICIAL OWNER OWNED (1) OWNED
- --------------------------------------------------------------------------------------
Scott R. Silverman 950,000 4.2%
400 Royal Palm Way, Palm Beach, FL 33480
J. Michael Norris -- --
400 Royal Palm Way, Palm Beach, FL 33480
Daniel E. Penni 100,000 *
260 Eliot Street, Ashland, MA 01721
Dennis G. Rawan -- --
400 Royal Palm Way, Palm Beach, FL 33480
Constance K. Weaver 100,000 *
295 North Maple Ave, Basking Ridge, NJ 07920
Michael S. Zarriello -- --
400 Royal Palm Way, Palm Beach, FL 33480
Richard J. Sullivan 100,000 (2) *
400 Royal Palm Way, Palm Beach, FL 33480
Kevin H. McLaughlin 100,000 *
400 Royal Palm Way, Palm Beach, FL 33480
Michael E. Krawitz 940,000 4.1%
400 Royal Palm Way, Palm Beach, FL 33480
Evan C. McKeown 200,000 *
400 Royal Palm Way, Palm Beach, FL 33480
Peter Zhou 100,000 *
5750 Division Street, Riverside, CA 92506
All directors and executive officers as a group (12 2,655,000 11.8%
persons)
- --------------
* Represents less than 1% of the issued and outstanding shares of VeriChip
Corporation's common stock.
(1) This table includes presently exercisable stock options and options that
are exercisable within sixty days of March 10, 2004, in accordance with
Rule 13d-3(d) under the Securities Exchange Act of 1934. The following
directors and executive officers hold the number of exercisable options
set forth following their respective names; Scott R. Silverman - 950,000;
Daniel E. Penni - 100,000; Constance K. Weaver - 100,000; Richard Sullivan
- 100,000; Kevin H. McLaughlin - 100,000; Michael E. Krawitz - 940,000;
Evan C. McKeown - 200,000; Peter Zhou - 100,000; and all directors and
officers as a group - 4,765,000.
(2) Includes 100,000 presently exercisable options owned by Mr. Sullivan's
spouse.
102
The following table sets forth information regarding beneficial ownership
of our wholly owned subsidiary, Thermo Life Energy Corp., by each of our
directors and by each executive officer named in the summary compensation table
and by all the directors and executive officers as a group as of March 10, 2004:
NUMBER OF
SHARES OF PERCENT OF
COMMON COMMON
STOCK STOCK
BENEFICIALLY BENEFICIALLY
NAME OF BENEFICIAL OWNER OWNED (1) OWNED
- --------------------------------------------------------------------------------------
Scott R. Silverman 750,000 3.3%
400 Royal Palm Way, Palm Beach, FL 33480
J. Michael Norris -- --
400 Royal Palm Way, Palm Beach, FL 33480
Daniel E. Penni 200,000 *
260 Eliot Street, Ashland, MA 01721
Dennis G. Rawan 200,000 --
400 Royal Palm Way, Palm Beach, FL 33480
Constance K. Weaver 200,000 *
295 North Maple Ave, Basking Ridge, NJ 07920
Michael S. Zarriello -- --
400 Royal Palm Way, Palm Beach, FL 33480
Richard J. Sullivan -- --
400 Royal Palm Way, Palm Beach, FL 33480
Kevin H. McLaughlin 200,000 *
400 Royal Palm Way, Palm Beach, FL 33480
Michael E. Krawitz 750,000 3.3%
400 Royal Palm Way, Palm Beach, FL 33480
Evan C. McKeown 200,000 *
400 Royal Palm Way, Palm Beach, FL 33480
Peter Zhou -- --
5750 Division Street, Riverside, CA 92506
All directors and executive officers as a group (12 2,585,000 11.4%
persons)
- --------------
* Represents less than 1% of the issued and outstanding shares of Thermo Life
Energy Corp.'s common stock.
(1) This table includes presently exercisable stock options and options that
are exercisable within sixty days of March 10, 2004, in accordance with
Rule 13d-3(d) under the Securities Exchange Act of 1934. The following
directors and executive officers hold the number of exercisable options
set forth following their respective names; Scott R. Silverman - 750,000;
Daniel E. Penni - 200,000; Dennis G. Rawan - 200,000; 3.3Constance K.
Weaver - 200,000; Kevin H. McLaughlin - 200,000; Michael E. Krawitz -
750,000; Evan C. McKeown - 200,000; and all directors and officers as a
group - 2,585,000.
103
CHANGES IN CONTROL
There are no arrangements known to us, including any pledge of our
securities by any person, the operation of which may at a subsequent date result
in a change in control us.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
During 2003, we granted 2,016,800 options under our 2003 Flexible Stock
Plan, 1999 Flexible Stock Plan and 1996 Non-Qualified Stock Option Plan,
including 1,321,400 options that were re-priced in March 2003, under the terms
of two severance agreements with our former officers and director. As of
December 31, 2003, the following shares of our common stock were authorized for
issuance under our equity compensation plans:
EQUITY COMPENSATION PLAN INFORMATION
(a) (b) (c)
Plan Category (1) Number of securities to Weighted-average Number of securities
be issued upon exercise exercise price remaining available for
of outstanding options, per share of future issuance under
warrants and rights outstanding equity compensation
options, warrants plans (excluding
and rights securities reflected in
column (a))
Equity compensation plans
approved by security holders 2,491,530 $9.30 1,352,376 (2)
Equity compensation plans not
approved by security holders -- -- --
----------------------------------------------------------------------------
Total 2,491,530 $9.30 1,352,376
============================================================================
(1) A narrative description of the material terms of our equity compensation
plans is set forth in Note 15 to our Consolidated Financial Statements.
(2) Includes 594,926 shares available for future issuance under our 1999
Employees Stock Purchase Plan.
104
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
INDEBTEDNESS OF MANAGEMENT AND OTHERS
Daniel E. Penni, a member of our Board of Directors, has executed a
revolving line of credit promissory note in favor of Applied Digital Solutions
Financial Corp., our subsidiary, in the amount of $450,000. The promissory note,
which was executed on March 23, 1999, is payable on demand, with interest
payable monthly on the unpaid principal balance at the rate equal to one
percentage point above the base rate announced by State Street Bank and Trust
Company (which interest rate shall fluctuate contemporaneously with changes in
such base rate). On March 10, 2004, the interest rate equaled 5.0%. The largest
amount outstanding of principal under the promissory note during 2002 was
$420,000, and as of March 10, 2004, $390,000 was outstanding under the note.
There was no interest due under the note as of March 10, 2004.
Mr. Richard Sullivan, our former Chairman of the Board, Chief Executive
Officer and Secretary, had executed a promissory note in our favor in the amount
of $59,711. The promissory note was payable on demand and interest accrued at a
rate of 7.0% per annum. The largest amount of principal outstanding under the
promissory note during 2003 was $59,711, plus accrued interest, and on March 21,
2003, this note was paid in full.
On September 27, 2000, the following Named Executive Officers and
directors exercised options granted to them under our 1999 Flexible Stock Plan
to purchase shares of our common stock. Under the terms of the grant, the Named
Executive Officers each executed and delivered a non-recourse, interest bearing
promissory note and stock pledge agreement to us in consideration for the
purchase of the shares (the officers and directors received no cash proceeds
from these loans) as follows:
Named Executive Officer Amount Interest Rate Due Date
- ----------------------- ------ ------------- --------
Richard J. Sullivan $1,375,000 6.0% September 27, 2003
Kevin H. McLaughlin 30,250 6.0 September 27, 2003
Michael E. Krawitz 57,750 6.0 September 27, 2003
Peter Zhou 57,750 6.0 September 27, 2003
Directors Amount Interest Rate Due Date
- --------- ------ ------------- --------
Daniel E. Penni $236,500 6.0% September 27, 2003
Constance K. Weaver 236,500 6.0 September 27, 2003
In September 2000, when the loans were originated, we notified these
officers and directors that we intended to pay their annual interest as part of
their compensation expense/directors remuneration and to provide a gross-up for
the associated income taxes. Annual interest payments were due on September 27,
2001 and September 27, 2002. We have chosen not to pay the interest and related
tax gross-up. In addition, the principal balance and a final interest payment
became due on September 27, 2003. We, therefore, consider such notes to be in
default and are in the process of foreclosing on the underlying collateral (all
of our stock) in satisfaction of the notes.
105
Marc Sherman, the former Chief Executive Officer of Intellesale, Inc. and
brother-in-law of Constance Weaver, a member of our Board of Directors, was
indebted to us for approximately $990,000, which amount was satisfied in
connection with a settlement agreement described below. This amount represents
the amount due to us under seven promissory notes with principal balances
aggregating $795,000, plus accrued interest of approximately $195,000. The
largest principal amount outstanding under the seven promissory notes during
2003 was $795,000, plus accrued interest. Six of the promissory notes with an
aggregate principal balance of $595,000 were executed during a six-month period
beginning March 26, 1998 through September 10, 1998. These six promissory notes
were due on demand and bore interest at the rate of 6% per annum. Following the
institution of litigation, a settlement was negotiated which became effective in
March of 2004. Pursuant to the settlement, these principal amounts were paid by
offsetting (on a dollar-for-dollar basis) a pension obligation we had to Mr.
Sherman's family. The seventh promissory note is a non-interest bearing
promissory note in the amount of $200,000, which was executed on January 1,
1999. The proceeds of the $200,000 note were used by Mr. Sherman to acquire
10,000 shares of our common stock, which 10,000 shares were the security for
such note. As part of the settlement, Mr. Sherman is to deliver those shares
back to us, along with 5,000 additional shares.
SARBANES-OXLEY ACT OF 2002
The Sarbanes-Oxley Act of 2002, referred to herein as the Act, makes it
unlawful for a public company to make material modifications to any existing
loans made to its executive officers and directors. The Act does not provide
guidance as to whether a company's election not to make demand on a demand
promissory note will be deemed a material modification.
TRANSACTIONS WITH SUBSIDIARIES
Digital Angel Corporation
As of December 31, 2003, we are the beneficial owner of approximately
66.9% of Digital Angel Corporation's outstanding common stock. During 2003,
Digital Angel Corporation reimbursed us $0.1 million for research services and
billed us $0.5 million for VeriChip product. During 2002, the Digital Angel
Corporation paid us approximately $0.3 million for research services. Other
transactions, primarily for research services and insurance premiums, resulted
in a $0.3 million payment due to us from Digital Angel Corporation as of
December 31, 2003.
Before March 27, 2002, we provided certain general and administrative
services to pre-merger Digital Angel, including finance, legal, benefits and
other miscellaneous items. The costs of these services were about $0.2 million
for the year ended December 31, 2002. In addition, during 2002, accrued expenses
of $0.3 million were relieved and contributed to pre-merger Digital Angel's
capital by us.
All of the transactions noted above between us and Digital Angel
Corporation have been eliminated in consolidation.
InfoTech USA, Inc.
On June 22, 2003, we borrowed $1.0 million from InfoTech USA, Inc. under
the terms of a commercial loan agreement and a term note. The loan accrues
interest at an annual rate of 16% and interest is payable monthly beginning on
July 31, 2003, with principal and accrued interest due on June 30, 2004. As of
March 10, 2004, $1.0 million of principal was outstanding under the note and
accrued interest was approximately five thousand dollars. Under the terms of a
Stock Pledge Agreement, we pledged 0.8 million shares of the Digital Angel
Corporation common stock that we own as collateral for the loan. The proceeds of
the loan were used to fund operations.
106
Beginning in April 2002, and for the period of time during which Kevin
McLaughlin served as InfoTech USA, Inc.'s President, Chief Executive Officer and
Chief Operating Officer, we had a financial arrangement with InfoTech USA, Inc.
whereby the salary, bonus and benefits for Mr. McLaughlin were paid by us.
InfoTech USA, Inc. reimbursed us for all payroll and benefit-related expenses
incurred as a result of such financial arrangement on a monthly basis. Mr.
McLaughlin resigned as InfoTech USA, Inc.'s President, Chief Executive Officer
and Chief Operating Officer on March 10, 2003. In addition, InfoTech USA, Inc.
reimburses us on a monthly basis for various business insurance coverages and
other miscellaneous business expenses. During 2003 and 2002, InfoTech USA, Inc.
reimbursed us approximately $0.2 million and $0.4 million, respectively, for
such expenses.
All of the transactions noted above between us and InfoTech USA, Inc. have
been eliminated in consolidation.
ITEM 14. PRINCIPAL ACCOUNTANTS SERVICES AND FEES
AUDIT AND NON-AUDIT FEES
For the fiscal years ended December 31, 2003 and 2002, fees for services
provided by Eisner LLP were as follows:
2003 2002
--------------- ---------------
A. Audit Fees $467,546 $1,137,859
B. Audit Related Fees (review of registration
statements and other SEC filings) 266,525 473,958
C. Tax fees (tax-related services, including
income tax advice regarding
income taxes within the United States) 25,166 --
--------------- ---------------
Total Fees $759,237 $1,611,817
=============== ===============
The Audit Committee of the Board of Directors has authorized the fees
incurred above for all services provided.
Compatibility of Fees
The Audit Committee of the Board of Directors has considered whether the
provision of the services covered in All Other Fees is compatible with
maintaining the principal accountant's independence and has concluded that the
services did not interfere with the principal accountant's independence.
107
Pre-Approval Policies and Procedures
The Audit Committee has a policy for the pre-approval of audit services
requiring its prior approval for all audit and non-audit services provided by
our independent auditors. Our independent auditors may not provide certain
prohibited services. The Audit Committee's prior approval must be obtained
before the scope or cost of pre-approved services is increased.
108
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A)(1)THE FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE LISTED BELOW
ARE INCLUDED IN THIS REPORT
Report of Management
Reports of Independent Accountants
Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Preferred Stock, Common Stock and Other
Stockholders' (Deficit) Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Financial Statement Schedule
Schedule of Valuation and Qualifying Accounts
(A)(2) FINANCIAL STATEMENT SCHEDULES HAVE BEEN INCLUDED IN ITEM 15(A)(1) ABOVE.
(A)(3) EXHIBITS
See Index to Exhibits filed as part of this Annual Report on Form 10-K.
(B) REPORTS ON FORM 8-K
(i) Form 8-K filed November 3, 2003, furnished under Item 5. "Other
Events" containing our press release dated October 31, 2003,
announcing that we had received notification from the Nasdaq that
our common stock did not meet the $1.00 minimum bid closing price
requirement of Nasdaq Marketplace Rule 4310 (c)(4).
(ii) Form 8-K filed dated November 14, 2003, furnished under Item 5.
"Other Events" announcing the terms of an agreement to satisfy our
aggregate principal amount of $10.5 million 8.5% Convertible
Exchangeable Debentures, which were originally issued on June 30,
2003.
(iii) Form 8-K filed dated November 14, 2003, furnished under Item
9. "Regulation FD" containing our earnings release dated November
14, 2003.
(iv) Form 8-K filed November 20, 2003, furnished under Item 5.
"Other Events" announcing that we had satisfied in full our
obligations under our $10.5 million 8.5% Convertible Exchangeable
Debentures.
(v) Form 8-K filed December 3, 2003, furnished under Item 5. "Other
Events" announcing that we had entered into eight securities
purchase agreements on December 2, 2003 for the sale of up to 8.0
million shares of our common stock.
(C) EXHIBITS - INCLUDED IN ITEM 15(A)(3) ABOVE.
109
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this amendment to be signed on its behalf by the
undersigned thereunto duly authorized.
DATE: SEPTEMBER 22, 2004 APPLIED DIGITAL SOLUTIONS, INC. (REGISTRANT)
By: /s/ Evan C. McKeown
----------------------------------
Evan C. McKeown,
Senior Vice President and
Chief Financial Officer
110
List Of Exhibits
(Item 15 (c))
EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
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 July 1, 2000, by and among
Applied Digital Solutions, Inc., Web Serve Acquisition Corp., WebNet
Services, Inc., Steven P. Couture, Jeffery M. Couture and Raymond D.
Maggi (incorporated by reference to Exhibit 2.8 to the registrant's
Annual Report on Form 10-K/A for the year ended December 31, 2003,
filed with the Commission on December 11, 2003)
2.9 Agreement and Plan of Merger, dated November 2, 2003, by and among
Digital Angel Corporation, DA Acquisition, Inc. and OuterLink
Corporation (incorporated herein by reference to Exhibit 2.9 to the
registrant's Registration Statement on Form s-1 (File No. 109512)
filed with the Commission on February 17, 2004)
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)
111
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)
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 by reference to Exhibit 4.4 to the registrant's
Pre-Effective Amendment No. 1 to Registration Statement on Form S-1
(File No. 333-102165) filed with the Commission on February 6, 2003)
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)
4.7 Amended and Restated Bylaws of the Registrant dated March 31, 1998
(incorporated by reference to Exhibit 4.7 to the registrant's
Post-Effective Amendment No. 1 to Registration Statement on Form S-1
(File No. 333-102165) filed with the Commission on April 11, 2003)
4.8 Fourth Restated Articles of Incorporation of the Registrant filed
with the Secretary of State of Missouri on August 26, 2003
(incorporated by reference to Exhibit 4.5 to the registrant's
Registration Statement on Form S-1 (File No. 333-108338) filed with
the Commission on August 28, 2003)
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)
112
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)*
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 between 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)
113
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
registrant'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
registrant'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)
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 dated March 24, 2003 (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, 2003)*
10.30 Letter Agreement between Applied Digital Solutions, Inc. and J.C.
Artigliere dated March 24, 2003 (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)
114
10.32 Securities Purchase Agreement among Applied Digital Solutions, Inc.
and the Purchasers, dated June 30, 2003 (incorporated herein by
reference to Exhibit 10.1 to the registrant's Current Report on Form
8-K filed with the Commission on July 9, 2003)
10.33 Form of 8.5% Convertible Exchangeable Debentures Due November 1,
2005, between Applied Digital Solutions, Inc. and each of the
Purchasers (incorporated herein by reference to Exhibit 10.2 to the
registrant's Current Report on Form 8-K filed with the Commission on
July 9, 2003)
10.34 Stock Purchase Warrant (incorporated herein by reference to Exhibit
10.3 to the registrant's Current Report on Form 8-K filed with the
Commission on July 9, 2003)
10.35 Amend and Restated Trust Agreement dated June 30, 2003, between
Wilmington Trust Company and Applied Digital Solutions, Inc.
(incorporated herein by reference to Exhibit 10.4 to the
registrant's Current Report on Form 8-K filed with the Commission on
July 9, 2003)
10.36 Security Agreement among Applied Digital Solutions, Inc., Computer
Equity Corporation and the Secured Parties (incorporated herein by
reference to Exhibit 10.5 to the registrant's Current Report on Form
8-K filed with the Commission on July 9, 2003)
10.37 Pledge Agreement made by Applied Digital Solution, Inc. in favor of
the investors (incorporated herein by reference to Exhibit 10.6 to
the registrant's Current Report on Form 8-K filed with the
Commission on July 9, 2003)
10.38 Registration Rights Agreement among Applied Digital Solutions, Inc.
and the Purchasers (incorporated herein by reference to Exhibit 10.7
to the registrant's Current Report on Form 8-K filed with the
Commission on July 9, 2003)
10.39 Share Exchange Agreement between Applied Digital Solutions, Inc. and
Digital Angel Corporation dated August 14, 2003 (incorporated herein
by reference to Exhibit 10.30 to the registrant's Registration
Statement on Form S-1 (File No. 333-109512) filed with the
Commission on October 6, 2003)
10.40 Securities Purchase Agreement between Applied Digital Solutions,
Inc. and First Investors Holding Co., Inc. dated September 19, 2003,
(incorporated herein by reference to Exhibit 10.1 to the
registrant's Current Report on Form 8-K filed with the Commission on
September 22, 2003)
10.41 Securities Purchase Agreement between Applied Digital Solutions,
Inc. and Magellan International LTD dated September 19, 2003,
(incorporated herein by reference to Exhibit 10.2 to the
registrant's Current Report on Form 8-K filed with the Commission on
September 22, 2003)
10.42 Securities Purchase Agreement between Applied Digital Solutions,
Inc. and Cranshire Capital, LP dated September 19, 2003,
(incorporated herein by reference to Exhibit 10.3 to the
registrant's Current Report on Form 8-K filed with the Commission on
September 22, 2003)
10.43 Form of letter agreement between Applied Digital Solutions, Inc. and
each of the Purchasers (incorporated herein by reference to Exhibit
99.1 to the registrant's Current Report on Form 8-K filed with the
Commission on November 14, 2003)
10.44 Letter Agreement between Applied Digital Solutions, Inc. and G.A.
Sullivan. (incorporated herein by reference to Exhibit 10.30 to the
registrant's Annual Report on Form 10-K/A for the year ended
December 31, 2003, filed with the Commission on December 11, 2003)*
10.45 Amendment to Letter Agreement between Applied Digital Solutions,
Inc. and G.A. Sullivan (incorporated herein by reference to Exhibit
10.45 to the registrant's Registration Statement on Form s-1 (File
No. 109512) filed with the Commission on February 17, 2004)*
10.46 International Distribution Agreement, dated March 8, 2003, by and
between VeriChip Corporation and the Company La Font, Ltda.
(incorporated herein by reference to Exhibit 10.46 to the
registrant's Annual Report on Form 10-K/A for the year ended
December 31, 2003, filed with the Commission on December 11, 2003)
115
10.47 International Distribution Agreement, dated March 8, 2003, by and
between VeriChip Corporation and RussGPS, Ltd. (incorporated herein
by reference to Exhibit 10.47 to the registrant's Quarterly Report
on Form 10-Q/A for the period ended March 31, 2003, filed with the
Commission on December 11, 2003)
10.48 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 to the
registrant's Registration Statement on Form S-1 (File No. 109512)
filed with the Commission on February 17, 2004)
10.49 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 to the
registrant's Registration Statement on Form s-1 (File No. 109512)
filed with the Commission on February 17, 2004)
10.50 Securities Purchase Agreement, dated May 22, 2003, by and between
Applied Digital Solution, Inc. and Cranshire Capital, L.P.
(incorporated herein by reference to Exhibit 10.50 to the
registrant's Registration Statement on Form S-1 (File No. 109512)
filed with the Commission on February 17, 2004)
10.51 Securities Purchase Agreement, dated May 22, 2003, by and between
Applied Digital Solution, Inc. and Magellan International Ltd.
(incorporated herein by reference to Exhibit 10.51 to the
registrant's Registration Statement on Form S-1 (File No. 109512)
filed with the Commission on February 17, 2004)
10.52 Securities Purchase Agreement, dated June 4, 2003, by and between
Applied Digital Solution, Inc. and Cranshire Capital, L.P.
(incorporated herein by reference to Exhibit 10.52 to the
registrant's Registration Statement on Form S-1 (File No. 109512)
filed with the Commission on February 17, 2004)
10.53 Securities Purchase Agreement, dated June 4, 2003, by and between
Applied Digital Solution, Inc. and Magellan International Ltd.
(incorporated herein by reference to Exhibit 10.53 to the
registrant's Registration Statement on Form S-1 (File No. 109512)
filed with the Commission on February 17, 2004)
10.54 United States Postal Service Contract, effective June 16, 2003, by
and between United States Postal Service and Government
Telecommunications, Inc. (incorporated herein by reference to
Exhibit 10.54 the registrant's Registration Statement on Form S-1
(File No. 109512) filed with the Commission on February 17, 2004)
10.55 Blanket Purchase Agreement by and between United States Department
of Agriculture and Government Telecommunications, Inc. (incorporated
herein by reference to Exhibit 10.55 the registrant's Registration
Statement on Form S-1 (File No. 109512) filed with the Commission on
February 17, 2004)
10.56 International Distribution Agreement, dated September 10, 2003, by
and between VeriChip Corporation and Metro Risk Management LLC, for
the territory of Brazil (incorporated herein by reference to Exhibit
10.56 to the registrant's Quarterly Report on Form 10-Q/A for the
period ended September 30, 2003, filed with the Commission on
December 11, 2003)
10.57 Master Product Purchase Agreement, dated September 5, 2003, by and
between VeriChip Corporation and Metro Risk Management, for the
territory of the State of New York (incorporated herein by reference
to Exhibit 10.57 to the registrant's Quarterly Report on Form 10-Q/A
for the period ended September 30, 2003, filed with the Commission
on December 11, 2003)
10.58 2003 Flexible Stock Plan (incorporated herein by reference to
Appendix E of the registrant's Proxy Statement filed with the
Commission on June 10, 2003)
116
10.59 International Distribution Agreement, dated September 25, 2002, by
and between VeriChip Corporation and Sistemas 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 10K/A filed with the
Commission on December 11, 2003)
10.60 International Distribution Agreement, dated September 3, 2003, by
and between VeriChip Corporation and Metro Risk Management LLC, for
the territories including Argentina, Chile, Paraguay, Uruguay, and
Spain (incorporated herein by reference to Exhibit 10.60 to the
registrant's Quarterly Report on Form 10-Q/A for the period ended
September 30, 2003, filed with the Commission on December 11, 2003)
10.61 International Distribution Agreement, dated August 20, 2003, by and
between VeriChip Corporation and Metro Risk Management LLC, for the
territory of Ecuador (incorporated herein by reference to Exhibit
10.61 to the registrant's Quarterly Report on Form 10-Q/A for the
period ended September 30, 2003, filed with the Commission on
December 11, 2003)
10.62 International Distribution Agreement, dated March 8, 2003, by and
between VeriChip Corporation and the Company La Font, Ltda., for the
territory of Columbia (incorporated herein by reference to Exhibit
10.61 to the registrant's Registration Statement on Form S-1 (File
No. 109512) filed with the Commission on February 17, 2004)
10.63 International Distribution Agreement, dated September 25, 2003, by
and between VeriChip Corporation and Digital Applied Technology
Associates (incorporated herein by reference to Exhibit 10.63 to the
registrant's Registration Statement on Form S-1 (File No. 109512)
filed with the Commission on February 17, 2004)
21.1 List of Subsidiaries of Applied Digital Solutions, Inc.**
23.1 Consent of Eisner LLP**
23.2 Consent of PricewaterhouseCoopers LLP**
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**
- -------
* - Management contract or compensatory plan.
** - Filed herewith
117
APPLIED DIGITAL SOLUTIONS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND FINANCIAL STATEMENT SCHEDULE
CONTENTS
- --------------------------------------------------------------------------------
PAGE
REPORT OF MANAGEMENT ...................................................................................F-2
REPORT OF REGISTERED PUBLIC ACCOUNTING FIRMS............................................................F-3
CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2003 AND 2002............................................F-5
CONSOLIDATED STATEMENTS OF OPERATIONS FOR EACH OF THE YEARS IN THE THREE-YEAR PERIOD ENDED
DECEMBER 31, 2003.............................................................................F-6
CONSOLIDATED STATEMENTS OF PREFERRED STOCK, COMMON STOCK AND OTHER
STOCKHOLDERS' EQUITY (DEFICIT) FOR EACH OF THE YEARS IN THE THREE YEAR PERIOD
ENDED DECEMBER 31, 2003.......................................................................F-7
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR EACH OF THE YEARS IN THE THREE-YEAR PERIOD ENDED
DECEMBER 31, 2003............................................................................F-10
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.............................................................F-11
SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS.......................................................F-78
Page F-1
REPORT OF MANAGEMENT
Senior management is responsible for the preparation, integrity and objectivity
of the accompanying financial statements and related information. These
statements have been prepared in conformity with accounting principles generally
accepted in the United States of America, and include amounts that are based on
our best judgments with due consideration given to materiality.
Management maintains a system of internal accounting controls. The system is
designed to provide reasonable assurance, at reasonable cost, that assets are
safeguarded and that transactions and events are recorded properly. The internal
accounting control system is augmented by appropriate reviews by management,
written policies and guidelines, careful selection and training of qualified
personnel and a written Code of Business Conduct adopted by the Company's Board
of Directors, applicable to all employees of the Company and its subsidiaries.
In our opinion, the Company's internal accounting controls provide reasonable
assurance that assets are safeguarded against material loss from unauthorized
use or disposition and that the financial records are reliable for preparing
financial statements and other data and for maintaining accountability of
assets.
Eisner LLP, the Company's independent auditors, were recommended by the Audit
Committee of the Board of Directors and selected by the Board of Directors.
Eisner LLP communicates the quality, not just the acceptability, and clarity of
the Company's accounting procedures and their disclosures. Eisner LLP obtains an
understanding of internal controls and conducts such tests and other auditing
procedures considered necessary in the circumstances to express their opinion in
the report that follows.
The Audit Committee of the Company's Board of Directors has reviewed the audited
financials statements with management and the outside auditors and has discussed
with them their judgments of the financial statements. The Audit Committee has
met periodically with the independent auditors and the vice president of
internal audit without management present to ensure that the independent
auditors and the vice president of internal audit have free access to the
Committee. The Audit Committee has also discussed the judgments among
themselves, without others present. As a result of these discussions, the Audit
Committee, in reliance on review with management and discussions with the
outside auditors, believes the financial statements are fairly presented in
accordance with generally accepted accounting principles.
SCOTT R. SILVERMAN EVAN C. MCKEOWN
Chairman of the Board of Directors and Senior Vice President and
Chief Executive Officer Chief Financial Officer
March 15, 2004
Page F-2
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Applied Digital Solutions, Inc.
We have audited the accompanying consolidated balance sheets of Applied Digital
Solutions, Inc. and subsidiaries (the "Company") as of December 31, 2003 and
2002, and the related consolidated statements of operations, preferred stock,
common stock and other stockholders' equity and cash flows for the years then
ended. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with the Standards of the Public
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements enumerated above present fairly,
in all material respects, the consolidated financial position of Applied Digital
Solutions, Inc. and subsidiaries as of December 31, 2003 and 2002, and the
consolidated results of their operations and their consolidated cash flows for
the years then ended in conformity with the Standards of the Public Accounting
Oversight Board (United States).
As discussed in Note 1 to the consolidated financial statements, in 2002,
the Company adopted the new standard addressing financial accounting and
reporting for goodwill subsequent to an acquisition.
As discussed in Note 31 to the consolidated financial statements, the
Company retroactively restated the financial statements to reflect a 1-for-10
reverse stock split effectuated on April 5, 2004.
As discussed in Note 30 to the consolidated financial statements, the
Company retroactively restated the financial statements to reflect as
discontinued operations a reporting unit previously included in continuing
operations and disposed on April 19, 2004.
In connection with our audits of the financial statements referred to
above, we audited the financial schedules of Valuation and Qualifying Accounts
for 2003 and 2002. In our opinion, these financial schedules, when considered in
relation to the financial statements taken as a whole, present fairly, in all
material respects, the information stated therein.
Eisner LLP
New York, New York
February 20, 2004
With respect to Note 17
March 1, 2004
With respect to the reverse stock split
April 5, 2004
With respect to the disposition of a reporting unit
April 19, 2004
Page F-3
REPORT OF INDEPENDENT REGISTERED CERTIFIED PUBLIC ACCOUNTING FIRM
To the Board of Directors and
Stockholders of Applied Digital Solutions, Inc.
In our opinion, the consolidated statements of operations, preferred stock,
common stock and other stockholders' equity (deficit) and cash flows for the
year ended December 31, 2001 listed in the index under Item 15(a)(1), present
fairly, in all material respects, the results of operations and cash flows of
Applied Digital Solutions, Inc. and its subsidiaries for the year ended December
31, 2001 in conformity with accounting principles generally accepted in the
United States of America. In addition, in our opinion, the financial statement
schedule for the year ended December 31, 2001 listed in the index under Item
15(a)(1), presents fairly, in all material respects, the information set forth
therein when read in conjunction with the related consolidated financial
statements. These financial statements and financial statement schedule are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements and financial statement schedule based on
our audit. We conducted our audit of these statements in accordance with the
standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Notes 1 and 2 to the
financial statements, the Company has suffered significant losses from
continuing operations and discontinued operations and was in violation of
certain covenants and payment obligations of its debt agreement at December 31,
2001. The Company amended its credit agreement on March 27, 2002. This debt
agreement requires the Company to maintain compliance with certain covenants. In
order to maintain compliance with these covenants, the Company will be required
to substantially improve its operating results in 2002. If the Company violates
these covenants in 2002, it could result in the lender's declaration that
amounts are due and immediately payable. These factors raise substantial doubt
about the Company's ability to continue as a going concern. Management's plans
in regard to these matters are also discussed in Note 2. The financial
statements do not include any adjustments that might result from the outcome of
this uncertainty.
PricewaterhouseCoopers LLP
St. Louis, Missouri
March 27, 2002, except for the 2001 segment information
included in Note 27, which is as of August 23, 2002,
Note 21, which is as of May 30, 2003, and as to the
reverse stock split which is as of April 5, 2004.
Page F-4
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PAR VALUE)
ASSETS DECEMBER 31,
------------------------
2003 2002
--------- ---------
CURRENT ASSETS
Cash and cash equivalents $ 10,161 $ 5,809
Restricted cash 765 --
Accounts receivable and unbilled receivables (net of allowance
for doubtful accounts of $1,028 in 2003 and $1,158 in 2002) 14,078 16,058
Inventories 9,444 6,352
Notes receivable 1,658 2,801
Other current assets 2,760 2,866
- ----------------------------------------------------------------------------------------- --------- ---------
TOTAL CURRENT ASSETS 38,866 33,886
PROPERTY AND EQUIPMENT, NET 8,228 8,432
NOTES RECEIVABLE, NET 504 758
GOODWILL, NET 63,331 65,451
OTHER ASSETS, NET 1,002 2,629
- ----------------------------------------------------------------------------------------- --------- ---------
$ 111,931 $ 111,156
========================================================================================= ========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Notes payable and current maturities of long-term debt $ 5,226 $ 81,829
Accounts payable 13,639 9,520
Accrued interest -- 10,149
Other accrued expenses 22,517 17,106
Put accrual 200 200
Net liabilities of Discontinued Operations 8,294 6,531
- ----------------------------------------------------------------------------------------- --------- ---------
TOTAL CURRENT LIABILITIES 49,876 125,335
LONG-TERM DEBT AND NOTES PAYABLE 2,860 2,436
OTHER LONG-TERM LIABILITIES 3,430 1,055
- ----------------------------------------------------------------------------------------- --------- ---------
TOTAL LIABILITIES 56,166 128,826
- ----------------------------------------------------------------------------------------- --------- ---------
COMMITMENTS AND CONTINGENCIES
- ----------------------------------------------------------------------------------------- --------- ---------
MINORITY INTEREST 23,029 18,422
- ----------------------------------------------------------------------------------------- --------- ---------
PREFERRED STOCK, COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY (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 560,000 shares in 2003 and 435,000 shares in 2002 of
$.01 par value; 41,220 shares issued and 41,126 shares outstanding in 2003 and 412 285
28,507 shares issued and 28,413 shares outstanding in 2002
Additional paid-in-capital 443,099 377,621
Accumulated deficit (413,923) (417,066)
Common stock warrants 5,650 5,650
Treasury stock (carried at cost, 94 shares in 2003 and 2002) (1,777) (1,777)
Accumulated other comprehensive income 206 31
Notes received for shares issued (931) (836)
- ----------------------------------------------------------------------------------------- --------- ---------
TOTAL PREFERRED STOCK, COMMON STOCK, AND OTHER STOCKHOLDERS' EQUITY (DEFICIT) 32,736 (36,092)
- ----------------------------------------------------------------------------------------- --------- ---------
$ 111,931 $ 111,156
========================================================================================= ========= =========
See the accompanying notes to consolidated financial statements.
Page F-5
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------------
2003 2002 2001
--------- --------- ---------
PRODUCT REVENUE $ 77,774 $ 80,390 $ 113,147
SERVICE REVENUE 15,213 18,095 43,340
- ------------------------------------------------------------------------- --------- --------- ---------
TOTAL REVENUE 92,987 98,485 156,487
COST OF PRODUCTS SOLD 59,538 58,969 87,508
COST OF SERVICES SOLD 5,354 8,500 23,169
- ------------------------------------------------------------------------- --------- --------- ---------
GROSS PROFIT 28,095 31,016 45,810
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE 55,880 65,681 102,316
RESEARCH AND DEVELOPMENT EXPENSE 6,255 4,130 8,783
GAIN ON EXTINGUISHMENT OF DEBT (70,064) -- (9,465)
ASSET IMPAIRMENT 2,456 38,657 71,719
DEPRECIATION AND AMORTIZATION 1,262 3,520 28,061
(GAIN) LOSS ON SALES OF SUBSIDIARIES AND BUSINESS ASSETS 330 (132) 6,058
INTEREST AND OTHER INCOME (919) (2,340) (2,076)
NTEREST EXPENSE 22,587 17,477 8,555
- ------------------------------------------------------------------------- --------- --------- ---------
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE PROVISION FOR
INCOME TAXES, MINORITY INTEREST, LOSSES ATTRIBUTABLE TO CAPITAL
TRANSACTIONS OF SUBSIDIARY AND EQUITY IN NET LOSS OF AFFILIATE 10,308 (95,977) (168,141)
PROVISION FOR INCOME TAXES 1,702 326 20,870
- ------------------------------------------------------------------------- --------- --------- ---------
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE MINORITY
INTEREST, LOSSES ATTRIBUTABLE TO CAPITAL TRANSACTIONS
OF SUBSIDIARY AND AND EQUITY IN NET LOSS OF AFFILIATE 8,606 (96,303) (189,011)
MINORITY INTEREST (4,132) (11,579) (718)
NET LOSS ON CAPITAL TRANSACTIONS OF SUBSIDIARY 244 2,437 --
LOSS ATTRIBUTABLE TO CHANGES IN MINORITY INTEREST AS A
RESULT OF CAPITAL TRANSACTIONS OF SUBSIDIARY 6,535 2,048 --
EQUITY IN NET LOSS OF AFFILIATE -- 291 328
- ------------------------------------------------------------------------- --------- --------- ---------
INCOME (LOSS) FROM CONTINUING OPERATIONS 5,959 (89,500) (188,621)
INCOME FROM DISCONTINUED OPERATIONS,
NET OF INCOME TAXES OF $0 IN 2001 (2,434) (24,405) 213
CHANGE IN ESTIMATE ON LOSS ON DISPOSAL AND OPERATING
LOSSES DURING THE PHASE OUT PERIOD (382) 1,420 (16,695)
- ------------------------------------------------------------------------- --------- --------- ---------
NET INCOME (LOSS) 3,143 (112,485) (205,103)
PREFERRED STOCK DIVIDENDS AND OTHER -- -- 1,147
ACCRETION OF BENEFICIAL CONVERSION FEATURE OF
REDEEMABLE PREFERRED STOCK - SERIES C -- -- 9,392
- ------------------------------------------------------------------------- --------- --------- ---------
NET INCOME (LOSS) AVAILABLE TO COMMON SHAREHOLDERS $ 3,143 $(112,485) $(215,642)
========================================================================= ========= ========= =========
EARNINGS (LOSS) PER COMMON SHARE - BASIC
INCOME (LOSS) FROM CONTINUING OPERATIONS $ 0.17 $ (3.33) $ (11.71)
(LOSS) INCOME FROM DISCONTINUED OPERATIONS (0.08) (0.85) (0.97)
- ------------------------------------------------------------------------- --------- --------- ---------
NET INCOME (LOSS) PER COMMON SHARE - BASIC $ 0.09 $ (4.18) $ (12.68)
========================================================================= ========= ========= =========
EARNINGS (LOSS) PER COMMON SHARE - DILUTED
INCOME (LOSS) FROM CONTINUING OPERATIONS $ 0.16 $ (3.33) $ (11.71)
(LOSS) INCOME FROM DISCONTINUED OPERATIONS (0.08) (0.85) (0.97)
- ------------------------------------------------------------------------- --------- --------- ---------
NET INCOME (LOSS) PER COMMON SHARE - DILUTED $ 0.08 $ (4.18) $ (12.68)
========================================================================= ========= ========= =========
WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING - BASIC 36,178 26,923 17,001
WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING - DILUTED 37,299 26,923 17,001
========================================================================= ========= ========= =========
See the accompanying notes to consolidated financial statements.
Page F-6
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF PREFERRED STOCK
COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY (DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
(IN THOUSANDS)
PREFERRED STOCK COMMON STOCK ADDITIONAL
------------------------- ------------------------- PAID-IN- ACCUMULATED
NUMBER AMOUNT NUMBER AMOUNT CAPITAL DEFICIT
---------- ---------- ---------- ---------- ---------- ----------
BALANCE - DECEMBER 31, 2000 -- $ -- 10,306 $ 103 $ 266,573 $ (99,478)
Net loss -- -- -- -- -- (205,103)
Comprehensive loss -
Foreign currency translation -- -- -- -- -- --
----------
Total comprehensive loss -- -- -- -- -- (205,103)
Conversion of redeemable preferred
shares to common shares -- -- 6,481 65 14,485 --
Accretion of beneficial conversion
feature of redeemable preferred
shares -- -- -- -- (9,392) --
Dividends accrued on redeemable
preferred stock -- -- -- -- (535) --
Beneficial conversion feature of
redeemable preferred stock -- -- -- -- 9,392 --
Penalty paid by issuance of
redeemable preferred stock -- -- -- -- (612) --
Stock option re-pricing -- -- -- -- 5,274 --
Stock option discounts -- -- -- -- 246 --
Issuance of warrants -- -- -- -- 115 --
Issuance of common shares -- -- 763 8 1,980 --
Issuance of common shares for
software license purchase -- -- 628 6 10,195 --
Issuance of common shares for
investment -- -- 332 3 8,070 --
Issuance of common shares under
earnout, put and price
protection provisions of
acquisition agreements -- -- 6,181 61 27,030 --
Common shares repurchased -- -- -- -- -- --
Notes received for shares issued -- -- 554 6 9,368 --
Note received for shares issued
charged to bad debt expense -- -- -- -- -- --
---------- ---------- ---------- ---------- ---------- ----------
BALANCE - DECEMBER 31, 2001 -- $ -- 25,245 $ 252 $ 342,189 $ (304,581)
========== ========== ========== ========== ========== ==========
ACCUMULATED
COMMON OTHER NOTES TOTAL
STOCK TREASURY COMPREHENSIVE RECEIVED FOR STOCKHOLDERS'
WARRANTS STOCK (LOSS) INCOME SHARES ISSUED EQUITY (DEFICIT)
---------- ---------- ---------- ---------- ----------
BALANCE - DECEMBER 31, 2000 $ 1,406 $ (2,803) $ (729) $ (4,510) $ 160,562
Net loss -- -- -- -- (205,103)
Comprehensive loss -
Foreign currency translation -- -- (18) -- (18)
---------- ----------
Total comprehensive loss -- -- (18) -- (205,121)
Conversion of redeemable preferred
shares to common shares -- -- -- -- 14,550
Accretion of beneficial conversion
feature of redeemable preferred
shares -- -- -- -- (9,392)
Dividends accrued on redeemable
preferred stock -- -- -- -- (535)
Beneficial conversion feature of
redeemable preferred stock -- -- -- -- 9,392
Penalty paid by issuance of
redeemable preferred stock -- -- -- -- (612)
Stock option re-pricing -- -- -- -- 5,274
Stock option discounts -- -- -- -- 246
Issuance of warrants 1,887 -- -- -- 2,002
Issuance of common shares -- -- -- -- 1,988
Issuance of common shares for
software license purchase -- -- -- -- 10,201
Issuance of common shares for
investment -- -- -- -- 8,073
Issuance of common shares under
earnout, put and price
protection provisions of
acquisition agreements -- -- -- -- 27,091
Common shares repurchased -- (4,600) -- -- (4,600)
Notes received for shares issued -- 5,626 -- (15,000) --
Note received for shares issued
charged to bad debt expense -- -- -- 9,000 9,000
---------- ---------- ---------- ---------- ----------
BALANCE - DECEMBER 31, 2001 $ 3,293 $ (1,777) $ (747) $ (10,510) $ 28,119
========== ========== ========== ========== ==========
Page F-7
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF PREFERRED STOCK
COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY (DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
(IN THOUSANDS)
PREFERRED STOCK COMMON STOCK ADDITIONAL
------------------------- ------------------------- PAID-IN- ACCUMULATED
NUMBER AMOUNT NUMBER AMOUNT CAPITAL DEFICIT
---------- ---------- ---------- ---------- ---------- ----------
BALANCE - DECEMBER 31, 2001
(BROUGHT FORWARD) -- $ -- 25,245 $ 252 $ 342,189 $(304,581)
Net loss -- -- -- -- -- (112,485)
Comprehensive loss -
Foreign currency translation -- -- -- -- -- --
----------
Total comprehensive loss -- -- -- -- -- (112,485)
Expiration of redeemable preferred
stock option - Series C -- -- -- -- 5,180 --
Adjustment for notes received for
shares issued (4,424)
Allowance for uncollectible portion
of notes received for shares issued -- -- -- -- -- --
Collection of notes received
for shares issued -- -- -- -- -- --
Treasury stock transaction -- -- -- -- 1,878 --
Retirement of treasury stock -- -- (98) (1) (1,878) --
Shares issuable for settlement of -- -- -- -- 63 --
liability
Obligation for shares issuable in
settlement of liability -- -- -- -- (63) --
Stock option re-pricing -- -- -- -- 254 --
Stock options - Digital Angel -- -- -- -- 18,800 --
Corporation
Stock options - VeriChip Corporation 200 --
Issuance of warrants -- -- -- -- -- --
Issuance of warrants - Digital
Angel Corporation -- -- -- -- 163 --
Issuance of warrants - VeriChip -- -- -- --
Corporation -- -- -- -- 44 --
Remeasurement of warrants-
Digital Angel Corporation -- -- -- -- 1,066 --
Issuance of common shares for exercise
of stock options -- -- 746 8 1,169 --
Issuance of common shares and options
for services, compensation and other -- -- 2,614 26 12,979 --
--------- --------- --------- --------- --------- ---------
BALANCE - DECEMBER 31, 2002 -- $ -- 28,507 $ 285 $ 377,621 $(417,066)
========= ========= ========= ========= ========= =========
ACCUMULATED
COMMON OTHER NOTES TOTAL
STOCK TREASURY COMPREHENSIVE RECEIVED FOR STOCKHOLDERS'
WARRANTS STOCK (LOSS) INCOME SHARES ISSUED EQUITY (DEFICIT)
---------- ---------- ------------- ------------- ---------------
BALANCE - DECEMBER 31, 2001
(BROUGHT FORWARD) $ 3,293 $ (1,777) $ (747) $ (10,510) $ 28,119
Net loss -- -- -- -- (112,485)
Comprehensive loss -
Foreign currency translation -- -- 778 -- 778
--------- ---------
Total comprehensive loss -- -- 778 -- (111,707)
Expiration of redeemable preferred
stock option - Series C -- -- -- -- 5,180
Adjustment for notes received for
shares issued 4,424 --
Allowance for uncollectible portion
of notes received for shares issued -- -- -- 4,094 4,094
Collection of notes received
for shares issued -- -- -- 1,156 1,156
Treasury stock transaction -- (1,878) -- -- --
Retirement of treasury stock -- 1,878 -- -- --
Shares issuable for settlement of -- -- -- -- 63
liability
Obligation for shares issuable in
settlement of liability -- -- -- -- (63)
Stock option re-pricing -- -- -- -- 254
Stock options - Digital Angel -- -- -- -- 18,800
Corporation
Stock options - VeriChip Corporation -- -- -- -- 200
Issuance of warrants 2,357 -- -- -- 2,357
Issuance of warrants - Digital
Angel Corporation -- -- -- -- 163
Issuance of warrants - VeriChip
Corporation -- -- -- -- 44
Remeasurement of warrants-
Digital Angel Corporation -- -- -- -- 1,066
Issuance of common shares for exercise
of stock options -- -- -- -- 1,177
Issuance of common shares and options
for services, compensation and other -- -- -- -- 13,005
--------- --------- --------- --------- ---------
BALANCE - DECEMBER 31, 2002 $ 5,650 $ (1,777) $ 31 $ (836) $ (36,092)
========= ========= ========= ========= =========
Page F-8
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF PREFERRED STOCK
COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY (DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
(IN THOUSANDS)
PREFERRED STOCK COMMON STOCK ADDITIONAL
----------------------- ------------------------- PAID-IN- ACCUMULATED'
NUMBER AMOUNT NUMBER AMOUNT CAPITAL DEFICIT
---------- ---------- ---------- ---------- ---------- ------------
BALANCE - DECEMBER 31, 2002
(BROUGHT FORWARD) -- $ -- 28,507 $ 285 $ 377,621 $ (417,066)
Net income -- -- -- -- -- 3,143
Comprehensive income
Foreign currency translation -- -- -- -- --
----------
Total comprehensive income -- -- -- -- -- 3,143
Adjustment to allowance for uncollectible
portion of notes received for shares -- -- -- -- -- --
issued
Stock option re-pricing -- -- -- -- (1,340) --
Stock options - VeriChip Corporation 188 --
Issuance of warrants - Digital
Angel Corporation -- -- -- -- 1,055 --
Issuance of common shares -- -- 9,645 96 28,803 --
Liability to be settled in common -- -- -- -- 17,966 --
stock
Issuance of common shares under earnout
provision of acquisition agreement -- -- 96 1 407 --
Issuance of common shares to settle
convertible debt -- -- 2,770 28 9,711 --
Beneficial conversion feature of
convertible, exchangeable debentures -- -- -- -- 7,652 --
Issuance of common shares and options
for services, compensation and other -- -- 202 2 1,036 --
-------- ---------- ---------- ---------- ---------- ----------
BALANCE - DECEMBER 31, 2003 -- $ -- 41,220 $ 412 $ 443,099 $ (413,923)
======== ========== ========== ========== ========== ==========
ACCUMULATED
COMMON OTHER NOTES TOTAL
STOCK TREASURY COMPREHENSIVE RECEIVED FOR STOCKHOLDERS'
WARRANTS STOCK (LOSS) INCOME SHARES ISSUED EQUITY (DEFICIT)
---------- ---------- ------------- ------------- ---------------
BALANCE - DECEMBER 31, 2002
(BROUGHT FORWARD) $ 5,650 $ (1,777) $ 31 $ (836) $ (36,092)
Net income -- -- -- -- 3,143
Comprehensive income
Foreign currency translation -- -- 175 -- 175
---------- ----------
Total comprehensive income -- -- 175 -- 3,318
Adjustment to allowance for uncollectible
portion of notes received for shares -- -- -- (95) (95)
issued
Stock option re-pricing -- -- -- -- (1,340)
Stock options - VeriChip Corporation -- -- -- -- 188
Issuance of warrants - Digital
Angel Corporation -- -- -- -- 1,055
Issuance of common shares -- -- -- -- 28,899
Liability to be settled in common -- -- -- -- 17,966
stock
Issuance of common shares under earnout
provision of acquisition agreement -- -- -- -- 408
Issuance of common shares to settle
convertible debt -- -- -- -- 9,739
Beneficial conversion feature of
convertible, exchangeable debentures -- -- -- -- 7,652
Issuance of common shares and options
for services, compensation and other -- -- -- -- 1,038
---------- ---------- ---------- ---------- ----------
BALANCE - DECEMBER 31, 2003 $ 5,650 $ (1,777) $ 206 $ (931) $ 32,736
========== ========== ========== ========== ==========
See the accompanying notes to consolidated financial statements.
Page F-9
APPLIED DIGITAL SOLUTIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
FOR THE YEARS ENDED DECEMBER 31,
---------------------------------------
2003 2002 2001
--------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss) $ 3,143 $(112,485) $(205,103)
Adjustments to reconcile net income (loss)
to net cash used in operating activities:
Asset impairment 2,456 38,657 71,719
Loss (income) from discontinued operations 2,816 22,985 16,482
Depreciation and amortization 1,891 4,364 28,899
Stock-based interest expense 13,178 5,760 --
Deferred income taxes 1,236 (69) 21,435
(Recovery) impairment of notes receivable (5) 4,472 21,873
Interest income on notes received for shares issued -- (475) --
Net loss on capital transactions of subsidiary 244 2,437 --
Loss attributable to changes in minority interest as a result
of capital transactions of subsidiary 6,535 2,048 --
Non-cash gain from extinguishment of debt (70,064) -- (9,465)
Minority interest (4,132) (11,579) (718)
Loss (gain) on sale of subsidiaries and business assets 330 (132) 6,058
Loss (gain) on sale of equipment and assets 15 (406) --
Stock-based compensation and administrative expenses 16,835 20,143 5,274
Equity in net loss of affiliate -- 291 328
Issuance of stock for services 262 2,958 --
Increase in restricted cash (765) -- --
Net change in operating assets and liabilities 14,848 17,225 28,365
Net cash (used in) provided by discontinued operations (224) (108) (3,127)
- ------------------------------------------------------------------------ --------- --------- ---------
NET CASH USED IN OPERATING ACTIVITIES (11,401) (3,914) (17,980)
- ------------------------------------------------------------------------ --------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Decrease in notes receivable 1,795 3,155 1,299
Received from buyers of divested subsidiaries -- 2,625 --
Proceeds from sale of property and equipment 15 3,535 1,347
Proceeds from sale of subsidiaries and business assets -- 1,382 1,673
Payments for property and equipment (1,409) (1,858) (2,757)
Payment for asset and business acquisition (net of cash balances
acquired) -- (261) --
Decrease in other assets 46 210 944
Net cash (used in) provided by discontinued operations 200 (714) 208
- ------------------------------------------------------------------------ --------- --------- ---------
NET CASH PROVIDED BY INVESTING ACTIVITIES 647 8,074 2,714
- ------------------------------------------------------------------------ --------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Net amounts (paid) borrowed on notes payable (26,987) (4,648) 13,981
Proceeds on long-term debt 12,035 377 553
Payments for long-term debt (736) (1,422) (2,485)
Other financing costs (587) (798) (375)
Issuance of common shares and warrants 29,858 1,695 678
Collection of notes receivable for shares issued -- 1,156 --
Proceeds from subsidiary issuance of common stock 2,404 630 126
Stock issuance costs (959) (518) (798)
Net cash used in discontinued operations (50) 703 (757)
- ------------------------------------------------------------------------ --------- --------- ---------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 14,978 (2,825) 10,923
- ------------------------------------------------------------------------ --------- --------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 4,224 1,335 (4,343)
EFFECT OF EXCHANGE RATES CHANGES ON CASH
AND CASH EQUIVALENTS 128 778 --
- ------------------------------------------------------------------------ --------- --------- ---------
CASH AND CASH EQUIVALENTS - BEGINNING OF YEAR 5,809 3,696 8,039
- ------------------------------------------------------------------------ --------- --------- ---------
CASH AND CASH EQUIVALENTS - END OF YEAR $ 10,161 $ 5,809 $ 3,696
======================================================================== ========= ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Income taxes paid (refunds received) $ 1,027 $ (971) $ (2,227)
Interest paid 2,346 3,778 4,071
- ------------------------------------------------------------------------ --------- --------- ---------
See the accompanying notes to consolidated financial statements.
Page F-10
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION
Applied Digital Solutions, Inc., a Missouri corporation, and subsidiaries (the
"Company") is an advanced technology development company. As of December 31,
2003, the Company's business operations consisted of the operations of five
wholly-owned subsidiaries, which are collectively referred to as the Advanced
Technology segment, and two majority-owned subsidiaries, Digital Angel
Corporation (AMEX:DOC), and InfoTech USA, Inc. (OTC:IFTH) (formerly SysComm
International Corporation). As of December 31, 2003, the Company owned
approximately 66.9% of Digital Angel Corporation and 52.5% of InfoTech USA, Inc.
Sale of Medical Systems' Assets
Medical Systems represented the business operations of Medical Advisory Systems,
Inc., referred to as MAS, which was acquired on March 27, 2002. The acquisition
of MAS is more fully described in Note 3. Digital Angel Corporation sold the
business assets of Medical Systems during the second quarter of 2004, and
accordingly, its financial condition, results of operations and cash flows are
now included as part of the Company's Discontinued Operations, and prior periods
have been restated. See Notes 20 and 30.
Reverse Stock Split
On September 10, 2003, the Company's shareholders approved the granting of
discretionary authority to the Board of Directors for a period of twelve months
to effect a reverse stock split not to exceed a ratio of 1-for-25, or to
determine not to proceed with a reverse stock split. On March 12, 2004, the
Board of Directors authorized a 1-for-10 reverse stock split, which was
effectuated on April 5, 2004. As a result of the reverse stock split, the par
value of the Company's common stock increased from $0.001 to $0.01 per share. In
conjunction with the reverse stock split, the Company's Board of Directors
authorized a reduction in the number of authorized shares of the Company's
common stock from 560.0 million to 125.0 million. All share information provided
in the Consolidated Financial Statements and the accompanying Notes has been
adjusted to reflect the reverse stock split.
The reduced settlement payment of the Company's debt obligations to IBM Credit
LLC ("IBM Credit"), the conversion to equity of its obligations under the
Debentures, and the sale of 3.0million shares of the Company's common stock
under its 3.0 million share offering, have been major factors mitigating
concerns that existed about the Company's ability to continue as a going
concern. The Company's profitability and liquidity depend on many factors
including 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 has established a management plan
intending to guide it in achieving profitability and positive cash flows over
the next twelve months; however, no assurance can be given that such plan will
be realized. The major components of the plan are discussed in Note 2.
During the last half of 2001 and during 2002, the Company sold or closed many of
the businesses the Company had acquired that it believed did not enhance its
strategy of becoming an advanced technology development company. The Company has
emerged from being a supplier of computer hardware, software and
telecommunications products and services to becoming an advanced technology
company that focuses on a range of life enhancing, personal safeguard
technologies, early warning alert systems, miniaturized power sources and
security monitoring systems combined with the comprehensive data management
services required to support them. The Company has five such products in various
stages of development. They are:
Page F-11
o Digital AngelTM, a device used for monitoring and tracking people
and objects;
o Thermo LifeTM, a thermoelectric generator;
o VeriChipTM, a human implantable radio frequency verification
microchip that can be used for security, financial, personal
identification/safety and other applications;
o Bio-ThermoTM, a temperature-sensing implantable microchip for use in
pets, livestock and other animals; and
o Personal Locating Device ("PLD"), an implantable global positioning
system ("GPS") location device.
BUSINESS SEGMENTS
As a result of the merger of pre-merger Digital Angel and MAS on March 27, 2002,
(which is more fully described in Note 3), the significant restructuring of the
Company's business during 2002 and 2001, and the Company's emergence as an
advanced technology development company, the Company re-evaluated and realigned
its reporting segments. Effective as of January 1, 2002, the Company operates in
three business segments: Advanced Technology, Digital Angel Corporation and
InfoTech USA, Inc. Prior to January 1, 2002, the Company was organized into
three segments: Applications, Services and Advanced Wireless. Prior period
information has been restated to present the Company's reportable segments on a
comparative basis.
ADVANCED TECHNOLOGY SEGMENT
The business units comprising the Company's Advanced Technology segment
represent those business units that the Company believes will provide the
necessary synergies, support and infrastructure to allow it to develop, promote
and fully integrate its advanced technology products and services. Its customer
base includes governmental agencies, commercial operations, and consumers. As of
December 31, 2003, 2002 and 2001, revenues from this segment were $44.6 million,
$41.9 million and $44.6 million, respectively, and accounted for 48.0%, 42.6%
and 28.5%, respectively, of the Company's total revenues. 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 (in 2002 and 2001);
o Website design and Internet access;
o Miniaturized implantable verification chip (VeriChipTM);
o Miniaturized power generator (Thermo Life TM); and
o Implantable GPS device (PLD).
Approximately $37.1 million, or 83.2%, $31.3 million, or 74.7%, and $27.4
million, or 61.5%, of the Company's Advanced Technology segment's revenues for
2003, 2002 and 2001, respectively, were generated by its wholly-owned
subsidiary, Computer Equity Corporation. Computer Equity Corporation is a
telecommunications network integrator and a supplier to the federal government
of telephone systems, data networks, video, cable and wire infrastructure and
wireless telecommunications products and services. No other products or services
provided more than 10.0% of the revenues for this segment during 2003 and 2002.
Networking products and services provided approximately 11.0%, and customer
relationship management software provided approximately 11.3% of the revenues
for this segment during 2001. No other products or services provided more than
10% of revenues during 2001. As of December 31, 2003, 2002, and 2001, the
Company has reported revenue of $0.5 million, $0.0 million and $0.0 million,
respectively, from the sale of its VeriChip product and no revenue from the sale
of its Thermo Life and PLD products. During the fourth quarter of 2003, the
Company began sending samples of Thermo Life to potential customers. If, and
when, an order is received, the manufacturing will be original equipment
manufacturing. PLD is currently in the development stage.
Page F-12
DIGITAL ANGEL CORPORATION SEGMENT
The Company's Digital Angel Corporation segment consists of the business
operations of Digital Angel Corporation (AMEX:DOC). Digital Angel Corporation
develops and deploys sensor and communications technologies that enable rapid
and accurate identification, location tracking, and condition monitoring of
animals and high-value mobile assets. Applications for Digital Angel
Corporation's products include the identification and monitoring of pets, fish
and livestock through its patented visual identification tags and implantable
microchips, location tracking and message monitoring of vehicles and aircraft in
remote locations through systems that integrate GPS and geosynchronous satellite
communications, and monitoring of asset conditions such as temperature and
movement, through advanced miniature sensors.
Before March 27, 2002, the business of Digital Angel Corporation was operated in
four segments: 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 the following four
segments: 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). With the acquisition on January 22, 2004 of OuterLink Corporation,
referred to as OuterLink, Digital Angel Corporation further realigned its
segments and effective January 1, 2004, it began operating in three segments:
Animal Applications, GPS and Radio Communications and Medical Systems. The new
GPS and Radio Communications segment consists of the GPS and Radio
Communications, Wireless and Monitoring and OuterLink divisions. The acquisition
of OuterLink is more fully described in Note 30. The Company refers to Digital
Angel Corporation's operations in terms of its divisions: Animal Application,
GPS and Radio Communications, Wireless and Monitoring, OuterLink and Medical
Systems. The business assets associated with the Medical Systems operations,
which represented the business activity of MAS, were sold during the second
quarter of 2004, and accordingly, the financial condition, results of operations
and cash flows of Medical Systems have been restated and are now presented as
part of Discontinued Operations. See Note 20.
The 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 principal
technologies employed by the Animal Applications division are electronic ear
tags and implantable microchips that use radio frequency transmission. The
Animal Applications division's pet identification system involves the insertion
of a microchip with identifying information in the animal. Readers at animal
shelters, veterinary clinics and other locations can determine the animal's
owner and other information. This pet identification system is marketed in the
United States by Schering-Plough Pharmaceutical under the brand name "Home
Again(TM)," in Europe by Merial Pharmaceutical, and in Japan by Dainippon
Pharmaceutical. Digital Angel Corporation has distribution agreements with a
variety of other companies outside the United States to market its products. It
has an established infrastructure with readers placed in approximately seventy
thousand global animal shelters and veterinary clinics. Over 2.0 million
companion animals in the United States have been enrolled in the database, and
more than five thousand pet recoveries occur in the United States each month.
Digital Angel Corporation's Bio-Thermo TM product is included in this division.
The 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 technology, which is referred to as 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 other
systems). The Digital AngelTM technology continues to be in the development
stage, and the Company is uncertain when this technology will be incorporated
into its products. The first Digital AngelTM technology product, a bio-sensor
chip linked to GPS in a watch/pager device, was marketed from November 2001 to
the fourth quarter of 2002. This technology has not generated any significant
revenue through December 31, 2003.
Page F-13
The 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, this division designs, manufactures and distributes intrinsically safe
sounders (horn alarms) for industrial use and other electronic components.
Sales of the Animal Applications division's products were $23.9 million, $21.0
million and $22.2 million, respectively, and represented 70.6%, 64.7% and 60.3%
of the total revenue from this segment during 2003, 2002 and 2001, respectively.
Sales of the GPS and Radio Communications division's products were $10.4
million, $10.0 million and $11.1 million, respectively, and represented 30.5%,
30.9% and 30.2% of this segment's revenue during 2003, 2002 and 2001,
respectively.
INFOTECH USA, INC., SEGMENT (FORMERLY THE SEGMENT TITLED SYSCOMM INTERNATIONAL)
The InfoTech USA, Inc. segment consists of the business operations of our
majority-owned subsidiary, InfoTech USA, Inc. This segment is a full service
provider of Information Technology, or IT, products and services. In 2003, this
segment continued its strategy of moving away from a product-driven systems
integration business model to a customer-oriented IT strategy-based business
model. It has further developed its deliverable IT products and services by
adding new consulting and service offerings, and increasing the number of
strategic alliances with outside technical service firms and manufacturers of
high-end IT products.
As of December 31, 2003, 2002 and 2001, revenues from this segment accounted for
15.5%, 23.1% and 21.9%, respectively, of the Company's total revenues. The
principal products and services in this segment were computer hardware and
computer services. The majority of InfoTech USA, Inc.'s revenue during 2003,
2002 and 2001 was derived from sales of computer hardware, which provided
approximately 80.3%, 88.3% and 89.2% of InfoTech USA, Inc.'s revenue in 2003,
2002 and 2001, respectively. InfoTech's USA, Inc.'s services consist of IT
consulting, installation, project management, design and deployment, computer
maintenance and other professional services. No single service accounted for
more than 10% of InfoTech's total revenue during 2003, 2002 and 2001.
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.
"Corporate/Eliminations" also includes certain interest expense and other
expenses associated with corporate activities and functions. Included in
"Corporate/Eliminations" for the year ended December 31, 2003, is a gain on the
extinguishment of debt obligations to IBM Credit of approximately $70.1 million,
$4.3 million of bonuses awarded to directors, officers and employees for the
successful repayment of all obligations to IBM Credit, and a severance charge of
approximately $17.9 million associated with the termination of certain former
officers and directors. Included in "Corporate/Eliminations" for the year ended
December 31, 2002, is a non-cash, stock-based 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 on March 27, 2002.
On March 1, 2001, the Company's Board of Directors approved a plan to sell or
close Intellesale, Inc. and all of the Company's other non-core businesses. The
results of operations, financial condition and cash flows now reflect these
operations as "Discontinued Operations." As of December 31, 2003, all of these
businesses have been sold or closed.
Page F-14
Certain items in the Consolidated Financial Statements for the 2002 and 2001
periods have been reclassified for comparative purposes.
SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The financial statements include the accounts of the Company and its
wholly-owned and majority-owned subsidiaries. The minority interest represents
outstanding voting stock of the subsidiaries not owned by the Company. All
significant intercompany accounts and transactions have been eliminated in
consolidation.
The Company's majority-owned subsidiary, InfoTech USA, Inc. operates on a fiscal
year ending September 30. InfoTech USA, Inc.'s results of operations have been
reflected in the Company's consolidated financial statements on a calendar year
basis.
USE OF ESTIMATES
The preparation of the financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make certain estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Although these
estimates are based on the knowledge of current events and actions the Company
may undertake in the future, they may ultimately differ from actual results. The
Company uses estimates, among others, to determine whether any impairment is to
be recognized.
FOREIGN CURRENCIES
As of December 31, 2003, the Company had one foreign subsidiary located in the
United Kingdom. This subsidiary uses its local currency as its functional
currency. Results of operations and cash flow are translated at average exchange
rates during the period, and assets and liabilities are translated at end of
period exchange rates. Translation adjustments resulting from this process are
included in accumulated other comprehensive income (loss) in the statement of
preferred stock, common stock and other stockholders' equity (deficit).
Transaction gains and losses that arise from exchange rate fluctuations on
transactions denominated in a currency other than the functional currency are
included in the results of operations as incurred. These amounts are not
material to the financial statements.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments purchased with an original
maturity of three months or less to be cash equivalents.
UNBILLED RECEIVABLES
Unbilled receivables consist of certain direct costs and profits recorded in
excess of amounts currently billable pursuant to contract provisions in
connection with information system installation projects. Unbilled receivables
included in accounts receivable was $0.2 million and $0.1 million in 2003 and
2002, respectively.
INVENTORIES
Inventories consist of raw materials, work in process and finished goods. The
majority of the components are plastic ear tags, electronic microchips,
electronic readers and components as well as products and components related to
GPS search and rescue equipment and work-in-process related to government
contract projects. Inventory is valued at the lower of cost or market,
determined by the first-in, first-out method. The Company monitors and analyzes
inventory for potential obsolescence and slow-moving items based upon the aging
of the inventory and the inventory turns by product. Inventory items designated
as obsolete or slow moving are reduced to net realizable value.
Page F-15
PROPERTY AND EQUIPMENT
Property and equipment are carried at cost, less accumulated depreciation and
amortization computed using straight-line and accelerated methods. Building and
leasehold improvements are depreciated and amortized over periods ranging from
10 to 40 years and equipment is depreciated over periods ranging from 3 to 10
years. Repairs and maintenance, which do not extend the useful life of the
asset, are charged to expense as incurred. Gains and losses on sales and
retirements are reflected in the Consolidated Statements of Operations.
GOODWILL AND OTHER INTANGIBLE ASSETS
Up through December 31, 2001, the Company reviewed goodwill and other intangible
assets quarterly for impairment whenever events or changes in business
circumstances indicated that the remaining useful life may have warranted
revision or that the carrying amount of the long-lived asset may not have been
fully recoverable. Included in factors considered were significant customer
losses, changes in profitability due to sudden economic or competitive factors,
change in managements' strategy for the business unit, letters of intent
received for the sale of the business unit, or other factors arising in the
quarterly period. The Company annually performed undiscounted cash flows
analyses by business unit to determine if impairment existed. For purposes of
these analyses, earnings before interest, taxes, depreciation and amortization
were used as the measure of cash flow. When impairment was determined to exist,
any related impairment loss was calculated based on fair value. Fair value was
determined based on discounted cash flows and where available, market related
information. The discount rate utilized by the Company was the rate of return
expected from the market or the rate of return for a similar investment with
similar risks. The Company recorded goodwill impairment charges of $63.6 million
during 2001.
On January 1, 2002, the Company adopted Statement of Financial Accounting
Standards ("FAS") No. 142, Goodwill and Intangible Assets ("FAS 142"). FAS 142
eliminates the amortization of goodwill. Intangible assets deemed to have an
indefinite life under FAS 142, such as goodwill, are no longer amortized, but
instead reviewed at least annually for impairment. Intangible assets with finite
lives are amortized over the useful life. Other than goodwill, the Company does
not have any intangible assets with indefinite lives. As part of the
implementation of FAS 142, the Company was required to complete a transitional
impairment test of goodwill and other intangible assets. There was no impairment
of goodwill upon the adoption of FAS 142. Annually, the Company tests its
goodwill and intangible assets for impairment as a part of its annual business
planning cycle. Based upon this annual test, the Company recorded a goodwill
impairment charge of approximately $2.2 million in the fourth quarter of 2003
for goodwill associated with the Company's InfoTech USA, Inc. segment, and it
recorded a goodwill impairment charge of $31.5 million in the fourth quarter of
2002 for goodwill associated with its Digital Angel Corporation segment. (During
the fourth quarters of 2003 and 2002, the Company also recorded goodwill
impairment charges of $2.4 million and $30.7 million, respectively, and during
the fourth quarter of 2003, it incurred an impairment charge of $0.6 million for
other intangible assets, all of which were related to Medical Systems, and all
of which are now included in the loss from Discontinued Operations). Future
events, such as market conditions or operational performance of the Company's
acquired businesses, could cause the Company to conclude that additional
impairment exists. Any resulting impairment loss could also have a material
adverse impact on the Company's financial condition and results of operations.
See Notes 8 and 18.
Page F-16
PROPRIETARY SOFTWARE IN DEVELOPMENT
In accordance with FAS No. 86, Accounting for the Costs of Computer Software to
be Sold, Leased, or Otherwise Marketed ("FAS 86"), the Company has capitalized
certain computer software development costs upon the establishment of
technological feasibility. Technological feasibility is considered to have
occurred upon completion of a detailed program design which has been confirmed
by documenting and tracing the detail program design to product specifications
and has been reviewed for high-risk development issues, or to the extent a
detailed program design is not pursued, upon completion of a working model that
has been confirmed by testing to be consistent with the product design.
Amortization is provided based on the greater of the ratios that current gross
revenues for a product bear to the total of current and anticipated future gross
revenues for that product, or the straight-line method over the estimated useful
life of the product. The estimated useful life for the straight-line method is
determined to be 2 to 5 years.
These unamortized computer software and computer software development costs were
$0.1 million and $0.3 million at December 31, 2003 and 2002, respectively. The
total amount charged to expense for the amortization of these capitalized
computer software costs and for amounts written down to net realizable were $0.3
million, $2.4 million and $0.7 million in 2003, 2002 and 2001, respectively.
Research and developments costs incurred for the development of computer
software were $0.5 million, $0.9 million and $3.3 million in 2003, 2002 and
2001, respectively.
ADVERTISING COSTS
The Company expenses production costs of print advertisements on the first date
the advertisements take place. Advertising expense, included in selling, general
and administrative expense, was $0.8 million, $0.3 million and $0.3 million in
2003, 2002 and 2001, respectively.
REVENUE RECOGNITION
ADVANCED TECHNOLOGY SEGMENT REVENUE RECOGNITION
Computer Equity Corporation Revenue Recognition
The largest company in the Advanced Technology segment is Computer Equity
Corporation. This company supplies voice, data and video telecommunications
networks and related products to government agencies. These products include
voice mail, Internet cabling, phones and telephone wiring. Services are a minor
part of the business and usually consist of small jobs such as phone moves.
Computer Equity Corporation also receives monthly revenues from product-related
maintenance contracts, which revenues represent the smallest portion of its
business. For product sales, the Company recognizes revenue after the products
are shipped and title has transferred, provided that a purchase order has been
received or a contract has been executed, there are no uncertainties regarding
customer acceptance, the sales price is fixed and determinable and
collectability is deemed probable. If uncertainties regarding customer
acceptance exists, revenue is recognized when such uncertainties are resolved.
Hardware sales for products that are shipped to a customer's site and require
modification or installation are recognized when the work is complete and
accepted by the customer. The Company does not experience significant product
returns, and therefore, management is of the opinion that no allowance for sales
returns is necessary. The Company has no obligation for warranties on new
hardware sales, because the manufacturer provides the warranty. Services and
phone installation jobs are billed and the revenue is recognized following the
completion of the work and the receipt of a written acceptance from the
customer. Revenue from maintenance contracts is recognized ratably over the term
of the contract.
Page F-17
Other Advanced Technology Companies Revenue Recognition (Excluding VeriChip
Corporation)
The other companies in the Advanced Technology segment that provide programming,
consulting and software licensing services recognize revenue based on the
expended actual direct labor hours in the job times the standard billing rate
and adjusted to realizable value, if necessary. It is the Company's policy to
record contract losses in their entirety in the period in which such losses are
foreseeable. The Company does not offer a warranty policy for services to its
customers. Revenue from license royalties is recognized when licensed products
are shipped. There are no significant post-contract support obligations at the
time of revenue recognition. The Company's accounting policy regarding vendor
and post-contract support obligations is based on the terms of the customers'
contract, billable upon the occurrence of the post-sale support. Costs of goods
sold are recorded as the related revenue is recognized.
For product sales, the Company recognizes revenue after the products are shipped
and title has transferred, provided that a purchase order has been received or a
contract has been executed, there are no uncertainties regarding customer
acceptance, the sale price is fixed and determinable and collectability is
deemed probable. If uncertainties regarding customer acceptance exist, revenue
is recognized when such uncertainties are resolved. Hardware sales for products
that are shipped to a customer's site and require modification or installation
are recognized when the work is complete and accepted by the customer. The
Company does not experience significant product returns, and therefore,
management is of the opinion that no allowance for sales returns is necessary.
The Company has no obligation for warranties on new hardware sales because the
manufacturer provides the warranty.
VeriChip Corporation Revenue Recognition
VeriChip is a miniaturized, implantable radio frequency identification device
("RFID") for use in a variety of identification and information applications.
About the size of a grain of rice, each VeriChip contains a unique
identification number that can be used to access a subscriber-supplied database
providing personal related information.
To complement the VeriChip microchip, the VeriChip Proprietary Scanner is a
scanning device that activates and reads the RFID within the microchip. The
scanner emits a small amount of radio frequency energy that energizes the
dormant VeriChip, which then emits a radio frequency signal containing the
VeriChip identification number.
VeriChip revenue is comprised of the sale of VeriChip microchips, VeriChip
scanners, and a nominal distributorship fee. Generally, the distributorship
rights include the rights to market, promote and sell the product(s) in a
specific territory under the VeriChip name and trademarks for a specific period
of time. The Company is currently amending the distributor agreements such that
the distributor strives to meet annual marketing goals, or quotas, as agreed
upon by the distributor and the Company, by ordering and taking delivery from
the Company of predetermined quantities of product each year through the term of
the contract. Failure to meet the quota will constitute a material breach of the
contract and the loss of distributorship exclusivity privileges within the
territory. To renew a pre-existing agreement, the distributor must request so,
in writing, 30 days prior to the expiration of the contract. The Company, at its
own discretion, may then negotiate in good faith with the distributor for a
renewal of the agreement.
Originally, the Company entered into distributorship agreements whereby the
distributor would pay an up-front fee in exchange for the exclusive right to
market, promote and sell VeriChip products within the agreed upon territory.
Under this arrangement, the distribution fee was not credited against or applied
towards amounts due for any products subsequently ordered by the distributor.
However, it soon became clear that there was more realizable value via a
relationship where distributors could apply up-front monies in exchange for
product. The Company found that distributors expressed reluctance to pay fees
without receiving a tangible product in return. After time, it became clear that
the standard for entrants into comparable non-established marketplaces was not
to charge up-front fees. In an effort to retain the Company's customer base,
management redefined its business strategy and amended its existing contracts in
2003 to stipulate that $1.00 of up-front money would be allocated to the
distribution fee, and the remaining amounts were customer deposits, which were
applied against future purchases of VeriChip microchips and scanners. The
advantage to this was that the distributor was able to receive a tangible
product to directly supply to the resellers, as opposed to fronting additional
money to purchase additional product.
Page F-18
Product Sales
Revenue from the sale of VeriChip microchips and VeriChip scanners is recorded
at gross with a separate display of cost of sales. Until the amount of returns
can be reasonably estimated, the Company does not recognize revenues until after
the products are shipped and title has transferred, provided that a purchase
order has been received or a contract has been executed, there are no
uncertainties regarding customer acceptance, the sales price is fixed and
determinable, the period of time the distributor has to return the products as
provided in their distributor agreement has expired and collectability is
reasonably assured. Once the amount of returns can be reasonably estimated,
revenues (net of expected returns) will be recognized at the time of shipment
and the passage of title, assuming there are no uncertainties regarding customer
acceptance. If uncertainties regarding customer acceptance exist, revenue will
not be recognized until such uncertainties are resolved.
Monitoring Services
When offered, monitoring services will be sold as a stand-alone contract and
treated as a separate earnings process from product sales. Revenue from this
service will be recognized on a straight-line basis over the term of the service
agreement. Since the final use of the product is unknown at the time it is
shipped to the distributor, end users will have the option of choosing from a
number of non-proprietary monitoring services or to choose none at all.
Therefore, the monitoring services are not essential to the functionality of all
chips, and the Company will not attempt to bundle the revenue from the sale of
chips with potential future revenues from a monitoring service.
DIGITAL ANGEL CORPORATION SEGMENT REVENUE RECOGNITION
For product sales, Digital Angel Corporation recognizes revenue at the time
product is shipped and title has transferred, provided that a purchase order has
been received or a contract has been executed, there are no uncertainties
regarding customer acceptance, the sales price is fixed and determinable and
collectability is deemed probable. If uncertainties regarding customer
acceptance exist, revenue is recognized when such uncertainties are resolved.
There are no significant post-contract support obligations at the time of
revenue recognition. Digital Angel Corporation's accounting policy regarding
vendor and post contract support obligations is based on the terms of the
customers' contracts, and billable upon occurrence of the post-sale support.
Costs of goods sold are recorded as the related revenue is recognized. Digital
Angel Corporation does not offer a warranty policy for services to customers. It
is Digital Angel Corporation's policy to record contract losses in their
entirety in the period in which such losses are foreseeable. For non-fixed fee
jobs, revenue is recognized based on the actual direct labor hours in the job
multiplied by the standard billing rate and adjusted to realizable value, if
necessary. Revenues from contracts that provide services are recognized ratably
over the term of the contract. Fixed fee revenues from contracts for services
are recorded when earned and exclude reimbursable costs. Reimbursable costs
incurred in performing such services are presented on a net basis and include
transportation and communication costs. Other revenues are recognized at the
time the service or goods are provided.
INFOTECH USA, INC. SEGMENT REVENUE RECOGNITION
For product sales, InfoTech USA, Inc. recognizes revenue in accordance with the
applicable product's shipping terms. InfoTech USA, Inc. has no obligation for
warranties on new product sales. The manufacturer provides the warranty. For
consulting and professional services, InfoTech USA, Inc. recognizes revenue
based on the direct labor hours incurred times the standard billing rate,
adjusted to realizable value, if necessary. Revenues from sales contracts
involving both products and consulting and other services are allocated to each
element based on vendor-specific objective evidence of fair value, regardless of
any separate prices that may be stated in the contract. Vendor-specific
objective evidence of fair value is the price charged when the elements are sold
separately. If an element is not yet being sold separately, the fair value is
the price established by management having the relevant authority to do so. It
is considered probable that the price established by management will not change
before the separate introduction of the element.
Page F-19
STOCK-BASED COMPENSATION
As permitted under FAS No. 123, Accounting for Stock-based Compensation ("FAS
123"), the Company has elected to continue to follow the guidance of Accounting
Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to
Employees (APB No. 25), and Financial Accounting Standards Board Interpretation
("FIN") No. 44, Accounting for Certain Transactions Involving Stock
Compensation--an Interpretation of APB Opinion No. 25 ("FIN 44"), in accounting
for its stock-based compensation arrangements. Accordingly, no compensation cost
is recognized for any of the Company's fixed stock options granted to directors
and 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.
When options are granted to officers and directors at a price less than the fair
market value on the date of grant, compensation expense is calculated based on
the difference between the exercise price and the fair market value on the date
of grant, and the compensation expense is recognized over the vesting period of
the options. If the options are fully vested, the expense is recognized
immediately. 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 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 cost is
recognized immediately. The Company accounts for equity instruments issued to
non-employees and non-directors in accordance with the provisions of FAS 123.
At December 31, 2003, the Company had five stock-based employee compensation
plans and the Company's subsidiaries had six stock-based employee compensation
plans, which are described more fully in Note 15. As permitted under FAS No.
148, Accounting for Stock-Based Compensation--Transition and Disclosure ("FAS
148"), which amended FAS 123, the Company has elected to continue to follow the
intrinsic value method in accounting for its stock-based compensation
arrangements as defined by APB No. 25 and FIN 44.
Page F-20
The following table illustrates the effect on net income (loss) and income
(loss) per share if the Company had applied the fair value recognition
provisions of FAS 123 to stock-based employee compensation for options granted
under its plans as well as to the plans of its subsidiaries:
YEAR ENDED DECEMBER 31
--------------------------------------------------
2003 2002 2001
--------------------------------------------------
Net income (loss) available to common $ 3,143 $ (112,485) $ (215,642)
shareholders, as reported
Add back (deduct): Total stock-based employee
compensation expense determined under APB 25
for all awards, net of related tax effects (1) (1,304) 19,318 5,256
Deduct: Total stock-based employee
compensation expense determined under fair
value-based method for all awards, net of
related tax effects (2) (5,194) (23,558) (4,450)
--------------------------------------------------
Pro forma net loss $ (3,355) $ (116,725) $ (214,836)
==================================================
Income (loss) per share:
Basic--as reported $ 0.09 $ (4.18) $ (12.68)
Basic--pro forma $ (0.09) $ (4.34) $ (12.64)
Diluted--as reported $ 0.08 $ (4.18) $ (12.68)
Diluted--pro forma $ (0.09) $ (4.34) $ (12.64)
(1) For 2003, 2002 and 2001, amounts include $0.0 million, $18.9 million and
$0.0 million of compensation expense, respectively, associated with
subsidiary options.
(2) For 2003, 2002 and 2001, amounts include $4.4 million, $20.5 million and
$0.3 million of compensation expense, respectively, associated with
subsidiary options.
The weighted average per share fair values of grants made in 2003, 2002 and 2001
for the Company's incentive plans were $2.70, $1.90 and $3.60, respectively. The
fair values of the options granted were estimated on the grant date using the
Black-Scholes valuation model based on the following weighted-average
assumptions:
2003 2002 2001
------------------------------------------
Estimated option life 7.9 years 5.5 years 5 years
Risk free interest rate 3.69% 2.89% 4.49%
Expected volatility 69.24% 76.00% 68.75%
Expected dividend yield 0.00% 0.00% 0.00%
RESEARCH AND DEVELOPMENT
Research and development expense consists of personnel costs, supplies, other
direct costs and indirect costs, primarily rent and other overhead, of
developing new products and technologies and is charged to expense as incurred.
Page F-21
WARRANTS SETTLEABLE IN SHARES OF THE DIGITAL ANGEL CORPORATION COMMON STOCK
OWNED BY THE COMPANY
In connection with the Company's 8.5% Convertible Exchangeable Debentures (the
"Debentures"), which were issued on June 30, 2003, the Company granted to the
Debenture holders warrants (the "Warrants") to acquire approximately 0.5 million
shares of its common stock, or 0.95 million shares of the Digital Angel
Corporation common stock owned by the Company, or a combination of shares from
both companies, at the Debenture holders' option. The exercise prices are $5.64
and $3.178 for the Company's common stock and the Digital Angel Corporation
common stock owned by the Company, respectively. The Warrants vested
immediately, are subject to anti-dilution provisions, and are exercisable
through June 30, 2007.
The value assigned to the Warrants was recorded as a reduction in the value
assigned to the Debentures (original issue discount) and an increase in
long-term liabilities. The liability for the Warrants, to the extent potentially
settleable in shares of the Digital Angel Corporation common stock owned by the
Company, is being revalued at each reporting period with any resulting
increase/decrease being recorded as interest expense/income. During the fourth
quarter of 2003, the Company recorded interest expense of $2.0 million as a
result of such revaluation. Going forward, changes in the market price of
Digital Angel Corporation's common stock will result in additional charges or
credits to operations, and any such charges could have a material adverse effect
on the Company's result of operations. The Company will be required to record an
impairment loss if its carrying value of the Digital Angel Corporation common
stock underlying the Warrants exceeds the exercise price. Should the Purchasers
elect to exercise the Warrants into shares of the Digital Angel Corporation
common stock owned by the Company, such exercise may result in the Company
recording a gain on the sale transaction.
INCOME TAXES
The Company accounts for income taxes under the asset and liability approach for
the financial accounting and reporting for income taxes. Deferred taxes are
recorded based upon the tax impact of items affecting financial reporting and
tax filings in different periods. A valuation allowance is provided against net
deferred tax assets where the Company determines realization is not currently
judged to be more likely than not. Income taxes include U.S. and international
taxes. The Company and its 80% or more owned U.S. subsidiaries file a
consolidated federal income tax return.
GAINS/LOSSES ATTRIBUTABLE TO CAPITAL TRANSACTIONS OF SUBSIDIARY
Gains where realizable and losses on issuances of shares of common stock by the
Company's consolidated subsidiary, Digital Angel Corporation, are reflected in
the Consolidated Statements 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, since the Company does not plan to
reacquire the shares issued, and the value of the proceeds could be objectively
determined. These gains and losses result from the differences between the
carrying amount of the pro-rata share of the Company's investment in Digital
Angel Corporation and the net proceeds from the issuances of the stock. The
issuances of stock by Digital Angel Corporation have also given rise to losses
as a result of the changes in the minority interest ownership of Digital Angel
Corporation. Future stock issuances to third parties by Digital Angel
Corporation will further dilute the Company's ownership percentage and may give
rise to additional losses, which could have a material adverse impact on the
Company's financial condition and results of operations. A detail of the amount
of gains and losses for the three years ended December 31, 2003, is presented in
Note 3.
Page F-22
EARNINGS (LOSS) PER COMMON SHARE AND COMMON SHARE EQUIVALENT
Income (loss) available to common stockholders has been adjusted to reflect
preferred stock dividends and the accretion to the redemption value and
beneficial conversion charge associated with the Series C redeemable preferred
stock for the purpose of calculating earnings per share ("EPS"). Basic EPS is
computed by dividing income (loss) available to common stockholders by the
weighted average number of common shares outstanding for the period. Diluted EPS
is computed giving effect to all dilutive potential common shares that were
outstanding during the period. Dilutive potential common shares consist of
incremental shares issuable upon exercise of stock options and warrants,
contingent stock, and conversion of debentures and preferred stock outstanding.
COMPREHENSIVE INCOME (LOSS)
The Company's comprehensive accumulated other income (loss) consists of foreign
currency translation adjustments, and is reported in the consolidated statements
of preferred stock, common stock and other stockholders' equity (deficit).
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In June 2001, the Financial Accounting Standards Board ("FASB") issued FAS No.
143, Accounting for Asset Retirement Obligations ("FAS 143"), which was
effective for fiscal years beginning after June 15, 2002. FAS 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. The Company adopted FAS 143 on January 1, 2003. Application of the new
rules did not have any impact on the Company's financial position and results of
operations, as it does not currently have any legal obligations associated with
the retirement of long-lived assets or leased facilities.
In May 2002, the FASB issued FAS No. 145, Rescission of FASB Statements No. 4,
44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections ("FAS
145"). FAS 145 eliminates FAS 4 (and FAS 64, as it amends FAS 4), which requires
gains and losses from extinguishments of debt to be aggregated and, if material,
classified as an extraordinary item. Also, the exception to applying APB No. 30
is eliminated. This statement is effective for years beginning after May 2002
for the provisions related to the rescission of FAS 4 and 64, and for all
transactions entered into beginning May 2002 for the provision related to the
amendment of FAS 13. The adoption of FAS 145 had the effect of reducing the
Company's loss from continuing operations and eliminating an extraordinary gain
as previously reported for the year ended December 31, 2001.
In June 2002, the FASB issued FAS No. 146, Accounting for Costs Associated with
Exit or Disposal Activities ("FAS 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
was required with the beginning of fiscal year 2003. The Company adopted this
statement on January 1, 2003. The adoption of FAS 146 did not have any impact on
the Company's financial position or results of operations. The Company has
recorded the costs associated with its Medical Systems operations, which were
disposed of during the three-months ended June 30, 2004, in accordance with the
provisions of FAS 146.
Effective January 1, 2003, the Company adopted the recognition and measurement
provisions of FASB Interpretation No. 45), Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others ("Interpretation 45"). This interpretation elaborates on the disclosures
to be made by a guarantor in interim and annual financial statements about the
obligations under certain guarantees. Interpretation 45 also clarifies that a
guarantor is required to recognize, at the inception of a guarantee, a liability
for the fair value of the obligation undertaken in issuing the guarantee. The
initial recognition and initial measurement provisions of this interpretation
are applicable on a prospective basis to guarantees issued or modified after
December 31, 2002. The Company does not currently provide significant guarantees
on a routine basis. As a result, this interpretation has not had a material
impact on the Company's financial statements.
Page F-23
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities--an Interpretation of ARB No. 51 ("FIN 46"), which
addresses consolidation of variable interest entities. FIN 46 expands the
criteria for consideration in determining whether a variable interest entity
should be consolidated by a business entity, and requires existing
unconsolidated variable interest entities (which include, but are not limited
to, Special Purpose Entities, or SPEs) to be consolidated by their primary
beneficiaries if the entities do not effectively disperse risks among parties
involved. On October 9, 2003, the FASB issued Staff Position No. 46-6 which
deferred the effective date for applying the provisions of FIN 46 for interests
held by public entities in variable interest entities or potential variable
interest entities created before February 1, 2003. On December 24, 2003, the
FASB issued a revision to FIN 46. Under the revised interpretation, the
effective date was delayed to periods ending after March 15, 2004 for all
variable interest entities, other than SPEs. The adoption of FIN 46 is not
expected to have an impact on the Company's financial condition, results of
operations or cash flows.
In May 2003, the FASB issued FAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities ("FAS 149"). FAS 149 amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under FAS
No. 133. FAS 149 is effective for contracts entered into or modified after June
30, 2003, and for hedging relationships designated after June 30, 2003. The
adoption of FAS 149 did not have any impact on the Company's financial position
or results of operations.
In May 2003, the FASB issued FAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity ("FAS 150"). FAS
150 establishes standards for how an issuer classifies and measures certain
financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope
as a liability (or an asset in some circumstances). Many of those instruments
were previously classified as equity. FAS 150 is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. It is to be implemented by reporting the cumulative effect of a change in
accounting principle for financial instruments created before the issuance date
of the statement and still existing at the beginning of the interim period of
adoption. Restatement is not permitted. The Company adopted the provisions of
FAS 150 effective July 1, 2003. The adoption of FAS 150 did not have any impact
on the Company's financial position or results of operations.
2. FINANCING AGREEMENTS AND LIQUIDITY
Payment in Full of Obligations to IBM Credit LLC
The Company's Third Amended and Restated Term Credit Agreement (the "IBM Credit
Agreement") with IBM Credit LLC ("IBM Credit") and the Digital Angel Share Trust
contained covenants relating to the Company's financial position and
performance, as well as the financial position and performance of Digital Angel
Corporation. At December 31, 2002, the Company 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, the Company was 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.
The Company did not make such payment by February 28, 2003, and on March 7,
2003, it received a notice from IBM Credit declaring the loan in default.
Effective April 1, 2003, the Company entered into a Forbearance Agreement with
IBM Credit. 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. Under the terms of the Forbearance Agreement, the Company had the
right to purchase all of its outstanding debt obligations to IBM Credit,
totaling approximately $100.1 million (including accrued interest), if it paid
IBM Credit $30.0 million in cash by June 30, 2003. As of June 30, 2003, the
Company made cash payments to IBM Credit totaling $30.0 million and, thus, it
has satisfied in full its debt obligations to IBM Credit. As a result, during
2003 the Company recorded a gain on the extinguishment of debt of $70.1 million,
exclusive of the bonuses discussed below.
Page F-24
On June 30, 2003, the Company's Board of Directors (through the Compensation
Committee) approved the payment of approximately $4.3 million in discretionary
bonus awards. The approval of the bonuses directly reflected the efforts of
certain employees/directors in satisfying all of the Company's obligations to
IBM Credit, which resulted in the Company recording a gain on the extinguishment
of debt of $70.1 million during 2003, and accordingly, the approval was not
subject to further conditions, except for continuation of employment until the
bonuses were paid. The Company's Board of Directors, based on various factors
including the contribution of the respective employee/director and the Company's
cash needs and availability, determined the allocation of the bonuses among the
group of employees/directors and the timing of the payments. The Company's Board
of Directors determined to satisfy the payment of the bonuses in cash. The
bonuses were paid to the directors in November 2003, and to executive officers
and other employees on various dates in November 2003, December 2003 and January
2004.
Funding for $30.0 Million Payment to IBM Credit
Funding for the $30.0 million payment to IBM Credit consisted of $17.8 million
in net proceeds from the sales of an aggregate of 5.0 million shares of the
Company's common stock, $10.0 million in net proceeds from the issuance of the
Company's 8.5% Convertible Exchangeable Debentures, and $2.2 million from cash
on hand.
The 5.0 million shares of the Company's common stock were 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 agreed to pay
J.P. Carey Securities, Inc. a 3% placement agency fee. In connection with this
offering, on May 8, 2003, May 22, 2003 and June 4, 2003, the Company entered
into Securities Purchase Agreements with Cranshire Capital, L.P. and Magellan
International Ltd. The Securities Purchase Agreements provided for Cranshire
Capital L.P. and Magellan International Ltd. to purchase an aggregate of 2.0
million shares and 3.0 million shares of the Company's common stock,
respectively, resulting in net proceeds to the Company of $17.8 million, after
deduction of the 3% placement agency fee.
Issuance of 8.5% Convertible Exchangeable Debentures
On June 30, 2003, the Company entered into the Securities Purchase Agreement
(the "Agreement") with certain investors, collectively referred to herein as the
Debenture holders or "the Purchasers." In connection with the Agreement, the
Company issued to the Purchasers its $10,500,000 aggregate principal amount of
8.5% Convertible Exchangeable Debentures due November 1, 2005 (the
"Debentures"). Subject to the terms under the various agreements, the Debentures
were convertible into shares of the Company's common stock or exchangeable for
shares of the Digital Angel Corporation common stock owned by the Company, or a
combination thereof, at any time at the Purchasers' option prior to the maturity
date of November 1, 2005. On November 12, 2003, the Company announced that it
had entered into a letter agreement with the Purchasers. Under the letter
agreement, the Purchasers were required to convert a minimum of 50% of the
outstanding principal amount of the Debentures plus all accrued and unpaid
interest into shares of the Company's common stock on November 12, 2003, and any
remaining outstanding principal amount of the Debentures plus accrued interest
on or before November 19, 2003. As of November 19, 2003, the total principal
amount of the Debentures has been converted, and accordingly, the Company's
obligations under the Debentures have been satisfied in full. The Company
realized net proceeds from the issuance of the Debentures of $10.0 million,
which were used to repay a portion of its obligation to IBM Credit.
In connection with the Debentures, the Company granted to the Debenture holders
the Warrants to acquire approximately 0.5 million shares of the Company's common
stock, or 0.95 million shares of the Digital Angel Corporation common stock
owned by the Company, or a combination of shares from both companies, at the
Purchasers' option. The Debentures and the Warrants are more fully described in
Note 11.
Page F-25
Digital Angel Corporation Financing Transactions
On July 31, 2003, Digital Angel Corporation entered into a securities purchase
agreement to sell securities to Laurus Master Fund, Ltd. ("Laurus"). Under the
terms of the securities purchase agreement, Digital Angel Corporation issued and
sold to Laurus a two-year secured convertible note in the original principal
amount of $2.0 million. In addition, on August 28, 2003, Digital Angel
Corporation entered into a second security agreement with Laurus under which it
may borrow from Laurus the lesser of $5.0 million or an amount that is
determined based on percentages of Digital Angel Corporation's eligible accounts
receivable and inventory as prescribed by the terms of the Security Agreement.
Digital Angel Corporation's financing transactions with Laurus are more fully
described in Note 11.
InfoTech USA, Inc. Financing Transaction
The InfoTech USA, Inc. segment finances its accounts receivable and inventory.
Its current financing arrangement with IBM Credit provides financing on
inventory purchases up to $1.8 million. Borrowing for purchases is based upon
75% of all eligible receivables due within 90 days and up to 100% of all
eligible inventory. Interest for balances not paid within the interest free
period provided for in the arrangement accrues at prime plus 4.4%. Borrowings
under the financing arrangement amounted to $0.8 million at December 31, 2003,
and are reflected in the balance sheet in either accounts payable or other
accrued expenses. On September 5, 2003, InfoTech USA, Inc. received a letter
from IBM Credit constituting their formal notice of termination of the
agreement. The effective date of such termination, which was originally set for
March 10, 2004, has been extended until April 9, 2004. InfoTech USA, Inc. is
currently in the process of securing other financing and expects to replace its
financing arrangement prior to the termination date set by IBM Credit. InfoTech
USA, Inc. believes that its present financing arrangement with IBM Credit, its
current cash position, the expected replacement of the IBM Credit agreement, and
the repayment by the Company of its $1.0 million loan from InfoTech, which is
due in June 2004, will provide InfoTech USA, Inc. with sufficient working
capital for the next twelve months. The $1.0 million loan from InfoTech USA,
Inc. is more fully described in Note 28. However, there is no assurance that
InfoTech USA, Inc. will be able to obtain a replacement for its IBM Credit
arrangement.
Securities Purchase Agreements Dated September 30, 2003 and December 2, 2003
During 2003, the Company offered up to 3.0 million shares of its common stock in
a public offering registered under the Securities Act of 1933. J.P. Carey
Securities, Inc. acted as the Company's placement agent for the offering. The
Company sold an aggregate of 2.2 million of these shares under the terms of
three separate Securities Purchase Agreements entered into on September 19,
2003, with each of First Investors Holding Co., Inc., Magellan International LTD
and Cranshire Capital, LP., resulting in gross proceeds to the Company of
approximately $8.0 million before deduction of the 2.0% placement agency fee. In
addition, the Company sold an aggregate of 0.8 million of the shares under eight
separate Securities Purchase Agreements entered into on December 2, 2003, as
amended, with each of First Investors Holding Co., Inc., Magellan International
LTD, Elliott Associates, L.P., Islandia, L.P., Midsummer Investment, Ltd.,
Omicron Master Trust, Portside Growth and Opportunity Fund and Elliott
International L.P., resulting in aggregate gross proceeds to the Company of
approximately $2.9 million before deduction of the 2.0% placement agency fee.
The Company has used approximately $4.3 million of the net proceeds of
approximately $10.7 million from the 3.0 million-share offering to pay the
bonuses accrued at June 30, 2003.
The repayment of all of the Company's debt obligations to IBM Credit, the
repayment of all of its obligations under the Debentures, and the sale of 3.0
million shares of the Company's common stock under its 3.0 million-share
offering, contributed to its ability to continue as a going concern. The
Company's profitability and liquidity depend on many factors including 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's ability to achieve profitability and/or generate
positive cash flows from operations in the future is predicated upon numerous
factors with varying levels of importance as follows:
Page F-26
o First, the Company will attempt to successfully implement its
business plans, manage expenditures according to its budget, and
generate positive cash flow from operations;
o Second, the Company will attempt to develop an effective marketing
and sales strategy in order to grow its business and compete
successfully in its markets;
o Third, the Company will attempt to obtain the necessary approvals to
expand the market for the VeriChip product in order to improve the
product's salability;
o Fourth, the Company will attempt to realize positive cash flow with
respect to its investment in Digital Angel Corporation in order to
provide it with an appropriate return on its investment; and
o Finally, the Company will attempt to complete the development of the
Digital Angel and PLD products.
The Company has established a management plan to assist it in achieving
profitability and positive cash flows over the next twelve months. The major
components of its plan are as follows:
o To attempt to establish a sustainable positive cash flow business
model;
o To attempt to produce additional cash flow and revenue from its
advanced technology products - Digital AngelTM, Thermo LifeTM,
VeriChipTM, Bio-ThermoTM and PLD;
o To generate additional liquidity through divestiture of business
units and assets that are not critical to the Company;
o To position Digital Angel Corporation for growth under the
leadership of its new management team and through strategic
acquisitions such as the recent OuterLink acquisition;
o To generate additional liquidity for Digital Angel Corporation
through the Share Exchange Agreement between the Company and Digital
Angel Corporation. The Share Exchange Agreement is described in Note
3; and
o To attempt to pair VeriChip Corporation with a complementary company
that will bring experienced management, revenue and a synergistic
customer base.
The Company's management estimates that the above plan can be effectively
implemented. As of December 31, 2003, the Company had a working capital
deficiency. However, a significant portion of the past due liabilities
associated with the Discontinued Operations and All Other business units have
not been guaranteed by the Company and/or the Company does not intend to repay
such liabilities in cash during the next twelve months. Therefore,
notwithstanding the Company's working capital deficiency, the Company believes
that with its current cash position, its expectation about the achievement of
its management plan, and the reliance on its various other sources of liquidity
as discussed below, that it should have sufficient working capital to satisfy
its needs over the next twelve months.
Sources of Liquidity
The Company's sources of liquidity may include proceeds from the sale of common
stock and preferred shares, proceeds from the sale of businesses, proceeds from
the sale of the Digital Angel Corporation common stock owned by the Company,
proceeds from the sale of the Company's stock issued to Digital Angel
Corporation under the Share Exchange Agreement, proceeds from the exercise of
stock options and warrants, proceeds from accounts receivable and inventory
financing arrangements, and the raising of other forms of debt or equity through
private placement or public offerings. However, these options may not be
available, or if available, they may not be on favorable terms. The Company's
capital requirements depend on a variety of factors, including but not limited
to, the rate of increase or decrease in its existing business base, the success,
timing, and amount of investment required to bring new products on-line, revenue
growth or decline, and potential acquisitions. Failure to generate positive cash
flow from operations will have a materially adverse effect on the Company's
business, financial condition and results of operations.
Page F-27
3. ACQUISITIONS AND DISPOSITIONS
On February 27, 2001, the Company acquired 16.6% of the capital stock of MAS, a
provider of medical assistance and technical products and services, in a
transaction valued at approximately $8.3 million in consideration for 0.3
million shares of its common stock. The Company became the single largest
stockholder and controlled two of the seven board seats. The Company accounted
for this investment under the equity method of accounting.
Effective March 27, 2002, the Company's 93% owned subsidiary, Digital Angel
Corporation, which the Company refers to herein as pre-merger Digital Angel,
merged with and into a wholly-owned subsidiary of a publicly traded company,
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
0.85 million shares of MAS, or approximately 16.6%. As of December 31, 2003, the
Company owned 19.3 million shares, or approximately 66.9% of the shares
outstanding. Also, pursuant to the merger agreement, the Company contributed to
MAS all of its stock in Timely Technology Corp., a wholly-owned subsidiary, and
Signature Industries, Limited, an 85% owned subsidiary. Pre-merger Digital
Angel, Timely Technology Corp. and Signature Industries, Limited were
collectively referred to as the Advanced Wireless Group (AWG). The merger has
been treated as a reverse acquisition for accounting purposes, with the AWG
treated as the accounting acquirer.
The total purchase price of the transaction was $32.0 million, which was
comprised of the $25.0 million fair market value of MAS's common stock
outstanding and 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.
During the three-months ended June 30, 2004, Digital Angel Corporation's Board
of Directors approved a plan to sell the Medical Systems operations, which were
acquired on March 27, 2002, and the business assets of Medical Systems were sold
effective April 19, 2004. The land and building associated with Medical Systems
were sold in a separate transaction on July 31, 2004. Medical Systems was one of
the Company's reporting units in accordance with FAS 142. Accordingly, the
financial condition, results of operations and cash flows of Medical Systems
have been reported as Discontinued Operations in the financial statements, and
the prior periods have been restated. As a result, unaudited pro forma results
of operations for 2002 have not been provided.
Page F-28
NET LOSS ON CAPITAL TRANSACTIONS OF SUBSIDIARY AND LOSS ATTRIBUTABLE TO CHANGES
IN MINORITY INTEREST AS A RESULT OF CAPITAL TRANSACTIONS OF SUBSIDIARY
During 2003, the Company recorded a loss of $0.2 million on the issuances of 2.3
million shares of Digital Angel Corporation's common stock resulting from the
exercise of stock options. During 2002, the Company recorded a net loss of $2.4
million, comprised of a loss of approximately $5.1 million resulting from the
exercise of 1.5 million pre-merger Digital Angel options, 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, and a loss of $2.0 million on the issuances of
1.1 million shares of Digital Angel Corporation common stock resulting primarily
from the exercise of stock options. The losses on the issuances of stock
represent the difference between the carrying amount of the Company's pro-rata
share of its investment in Digital Angel Corporation and the proceeds from the
issuances of the stock. In addition, during 2003 and 2002, the Company recorded
a loss of $6.5 million and $2.0 million, respectively, attributable to changes
in its minority interest ownership of Digital Angel Corporation as a result of
the stock issuances. The details and the impact of Digital Angel Corporation's
stock issuances during 2003 and 2002 were as follows:
====================================================================================================
For the Year Ended
December 31,
---------------------------------
2003 2002 2001
(in thousands, except per share amounts)
Issuances of common stock for stock option exercises 2,323 2,452 --
Issuances of common stock for services -- 98 --
---------------------------------
Total issuances of common stock 2,323 2,550 --
=================================
Proceeds from stock issuances $ 2,404 $ 1,192 --
=================================
Average price per share $ 1.03 $ 0.47 --
=================================
Beginning ownership percentage of Digital Angel Corporation 73.91% 100.0% --
Ending ownership percentage of Digital Angel Corporation (1) 66.9% 73.91% --
---------------------------------
Change in ownership percentage (1) 7.01% 26.09% --
=================================
Loss on the issuances of stock by Digital Angel Corporation $ 244 $ 7,192 --
Gain on the sale of AWG (1) -- (4,755) --
---------------------------------
Net loss on capital transactions of subsidiary (2) $ 244 $ 2,437
=================================
Loss attributable to changes in minority interest as a result
of capital transactions of subsidiary (2) $ 6,535 $ 2,048 --
====================================================================================================
(1) The reduction in the Company's ownership percentage for 2002 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 loss attributable to changes in minority
interest as a result of capital transactions of subsidiary.
Share Exchange Agreement
On August 14, 2003, the Company entered into a Share Exchange Agreement with
Digital Angel Corporation. The Share Exchange Agreement represents a strategic
investment by the Company, whereby the Company is increasing its ownership
interest in Digital Angel Corporation. On August 14, 2003, the Company believed
that Digital Angel Corporation's common stock was undervalued, and the Company
desires to maintain a controlling interest in Digital Angel Corporation.
Therefore, the Company considers the additional investment in Digital Angel
Corporation to be a strategically advantageous undertaking. The Share Exchange
Agreement provided for the Company to purchase 3.0 million shares of Digital
Angel Corporation's common stock at a price of $2.64 per share, and for Digital
Angel Corporation to issue a warrant to the Company (the "DAC Warrant") for the
purchase of up to 1.0 million shares of Digital Angel Corporation's common
stock. The DAC Warrant is exercisable for five years beginning on February 1,
2004, at a price per share of $3.74 payable in cash or in shares of the
Company's common stock. The purchase price for the 3.0 million shares was
payable in the Company's common stock having an aggregate value of $7.9 million.
The aggregate purchase price of $7.9 million for the 3.0 million shares of
Digital Angel Corporation's common stock was based on the closing price of
Digital Angel Corporation's common stock on June 30, 2003, of $2.64 per share.
This price was used because the Company and Digital Angel Corporation felt that
this was a fair price and because it reflected the market price of Digital Angel
Corporation's common stock before any impact of the Debentures as a result of
the Purchasers potentially hedging their position in Digital Angel Corporation's
common stock and thereby affecting the market price of the stock. On March 1,
2004, the Company issued 1.98 million shares of its common stock to Digital
Angel Corporation as payment for the 3.0 million shares. Digital Angel
Corporation expects to generate cash by selling the 1.98 million shares of the
Company's common stock. Digital Angel Corporation expects that the cash
generated, along with other funds available, will be sufficient to meet its
projected working capital requirements for the next 12 months.
Page F-29
Digital Angel Corporation has granted a five-year warrant to the Debenture
holders to acquire up to 0.5 million shares of its common stock at an exercise
price of $2.64 per share. The warrant was issued in consideration for a waiver
from the Debenture holders allowing the Company to register the shares issued to
Digital Angel Corporation in connection with the Share Exchange Agreement. The
value of the warrant of $0.8 million, which was determined using the
Black-Scholes valuation model, was recorded as interest expense during 2003.
As of December 31, 2003, the Company owned approximately 66.9% of the
outstanding common stock of Digital Angel Corporation. Digital Angel Corporation
has outstanding options and warrants and it has issued debt and preferred stock,
which are convertible into shares of its common stock. If all of the outstanding
options and warrants and all of the convertible debt and preferred stock were
converted into shares of Digital Angel Corporation's common stock, the Company's
ownership would be less than 50%. The Company desires to maintain a controlling
interest in Digital Angel Corporation, and therefore, the Company may enter into
additional share exchange agreements with Digital Angel Corporation, or it may
elect in the future to buy back a portion of the outstanding shares of Digital
Angel Corporation's common stock that is does not currently own.
DISPOSITIONS
Gain (Loss) on Sale of Subsidiaries and Business Assets
The gain (loss) on sale of subsidiaries and business assets was $(0.3) million,
$0.1 million and $(6.1) million for the years ended December 31, 2003, 2002 and
2001, respectively. The loss on the sale of subsidiaries and business assets of
$0.3 million for 2003 resulted from the sale of the Company's wholly-owned
subsidiary, WebNet Services Inc. The loss on the sale of subsidiaries and
business assets of $6.1 million for 2001 was due to the sale of the Company's
85% ownership interest in Atlantic Systems, Inc., and the sales of the business
assets of its wholly-owned subsidiaries as follows: ADS Retail Inc., Signal
Processors, Limited, ACT Wireless Corp. and ATI Communications companies.
Proceeds from the sales were approximately $3.5 million and were used primarily
to repay debt.
See Note 20 for a discussion of dispositions related to Discontinued Operations
companies.
EARNOUT AND PUT AGREEMENTS
Certain acquisition agreements included additional consideration, generally
payable in shares of the Company's common stock, contingent on profits of the
acquired subsidiary. Upon earning this additional consideration, the value was
recorded as additional goodwill. As of December 31, 2003, there were no earnout
arrangements outstanding. In January 2001, the Company entered into an agreement
with the minority shareholders of Intellesale to terminate all put rights and
employment agreements that each shareholder had with or in respect of
Intellesale. In exchange, the Company issued an aggregate of 0.7 million shares
of the Company's common stock valued at $10.3 million. In addition, during the
years ended December 31, 2003, 2002 and 2001, 0.1 million common shares valued
at $0.4 million, 1.4 million common shares valued at $6.6 million and 2.8
million common shares valued at $16.9 million, respectively, were issued to
satisfy earnouts and to purchase minority interests.
Page F-30
4. INVENTORIES
Inventories consist of the following:
DECEMBER 31,
------------
2003 2002
---- ----
(in thousands)
Raw materials $ 1,982 $ 1,725
Work in process 2,723 1,447
Finished goods 6,598 4,602
- ---------------------------------------------------------- ------- -------
11,303 7,774
Less: Allowance for excess and obsolescence 1,859 1,422
- ---------------------------------------------------------- ------- -------
$ 9,444 $ 6,352
========================================================== ======= =======
5. NOTES RECEIVABLE
Notes receivable consist of the following:
DECEMBER 31,
------------
2003 2002
-----------------------------------------
(in thousands)
Due from purchaser of subsidiary, collateralized by pledge of rights to
distributions from a joint venture of the purchaser and an unrelated entity,
bears interest at the London Interbank Offered Rate plus 1.65%, payable in
quarterly installments of principal and interest totaling
$332. Allowance of $25 reflected in allowance for bad debts in 2003. $ 436 $ 1,023
Due from purchaser of four subsidiaries, bears interest at 5%,
interest payable quarterly, principal due October 2004. Allowance of
$2,700 reflected in allowance for bad debts in 2002. -- 2,700
Due from purchaser of subsidiary, collateralized by pledge of investment
securities, bears interest at prime, interest payable semi-annually, principal
due November 2004. Allowance of $2,328
reflected in allowance for bad debts in 2003 and 2002. 2,328 2,328
Due from purchaser of subsidiary, collateralized by pledge of investment
securities, principal payable in monthly installments of
$33. Balance due December 2004. 397 --
Due from officers, directors and employees of the Company, unsecured,
bears interest at varying interest rates, due on demand. Allowance of
$90 reflected in allowance for bad debts in 2003. 653 677
Due from individuals and corporations, bearing interest at varying rates above
prime, secured by business assets, personal guarantees, and
securities, due various dates through July 2004. 31 858
Due from purchaser of divested subsidiary, collateralized by business
assets, bears interest at 8%, payable in monthly installments of
principal and interest of $10, balance due in February 2006. Allowance
of $1,266 reflected in allowance for bad debts in 2003 and 2002. 1,266 1,266
Page F-31
DECEMBER 31,
------------
2003 2002
-----------------------------------------
(in thousands)
Due from purchaser of divested subsidiary, collateralized by personal guarantee
and securities of the purchaser, bears interest at prime plus 1%, payable in
monthly installments of interest only through March 2003, and then payable in
monthly installments of principal and interest of $11 through December 2007. 412 497
Due from purchaser of divested subsidiary, collateralized, bears interest at 5%,
payable in monthly payments of interest, and annual
payments of principal through March 2005. 318 478
Due from purchaser of business assets, secured by maker's assets, bears
interest at 8.7% and provides for monthly payments of principal and interest
equal to 10% of the maker's net cash revenue for each preceding month, balance
due October 2001. Allowance of $373 reflected in allowance for bad debts in 2002. -- 373
Other 30 26
- ------------------------------------------------------------------------------------------------------------------------
5,871 10,226
Less: Allowance for bad debts 3,709 6,667
Less: Current portion 1,658 2,801
- ------------------------------------------------------------------------------------------------------------------------
$ 504 $ 758
========================================================================================================================
6. OTHER CURRENT ASSETS
Other Current Assets consist of the following:
DECEMBER 31,
------------
2003 2002
--------------------------------
(in thousands)
Deferred tax asset $ -- $ 13
Prepaid expenses 1,774 2,733
Prepaid taxes 800 --
Other 186 120
- --------------------------------------------------------------- ----------------
$2,760 $ 2,866
=============================================================== ================
7. PROPERTY AND EQUIPMENT
Property and Equipment consist of the following:
DECEMBER 31,
------------
2003 2002
--------------------------------
(in thousands)
Land $ 546 $546
Building and leasehold improvements 5,900 6,435
Equipment 9,530 14,385
Software 15 94
- --------------------------------------------------------------------------------
15,991 21,460
Less: Accumulated depreciation 7,763 13,028
- --------------------------------------------------------------------------------
$ 8,228 $ 8,432
================================================================================
Included above are vehicles and equipment acquired under capital lease
obligations in the amount of $0.3 million and $1.0 million at December 31, 2003
and 2002, respectively. Related accumulated depreciation amounted to $0.2 and
$0.7 million as of December 31, 2003 and 2002, respectively.
Page F-32
Depreciation expense charged against income amounted to $1.7 million, $3.9
million and $4.6 million for the years ended December 31, 2003, 2002 and 2001,
respectively. Accumulated depreciation related to disposals of property and
equipment amounted to $0.3 million and $4.0 million in 2003 and 2002,
respectively.
During 2002, the Company recorded an impairment charge of $6.4 million to
write-down certain software related to its Digital Angel Corporation segment.
The write off related to an exclusive license to a digital encryption and
distribution software system, which was on longer usable. The charge is included
in the Consolidated Statements of Operations under the caption Asset Impairment.
8. GOODWILL
Goodwill consists of the excess of cost over fair value of net tangible and
identifiable intangible assets of companies purchased. The Company applies the
principles of FAS No. 141, Business Combinations ("FAS 141"), and uses the
purchase method of accounting for acquisitions of wholly-owned and
majority-owned subsidiaries.
DECEMBER 31,
------------
2003 2002
--------- ---------
Beginning balance $ 96,672 $ 123,060
Acquisitions, earnout payments and other changes 450 6,080
Sale of business (408) --
Less goodwill impairment (2,154) (31,460)
Accumulated amortization (31,229) (32,229)
- ---------------------------------------------------------- --------- ---------
Carrying value $ 63,331 $ 65,451
========================================================== ========= =========
Goodwill amortization expense amounted to $21.3 million for the year ended
December 31, 2001.
CHANGE IN METHOD OF ACCOUNTING FOR GOODWILL
Upon the adoption of FAS 142, on January 1, 2002, the Company discontinued the
amortization of goodwill. (Other than goodwill, the Company does not have any
intangible assets deemed to have indefinite lives). Instead, the Company is
required to test goodwill for impairment annually as part of its annual business
planning cycle during the fourth quarter of each year or earlier depending on
specific changes in conditions surrounding its business units.
As part of the implementation of FAS 142 on January 1, 2002, the Company was
required to complete a transitional impairment test for goodwill. The
transitional impairment test required the Company to compare the fair value of
each of its reporting units to its carrying value. At January 1, 2002, the
Company's reporting units consisted of the following (the Company's reporting
units listed below are those businesses, which have goodwill and for which
discrete financial information is available and upon which segment management
makes operating decisions). Goodwill was assigned to each applicable reporting
unit as of the date of acquisition.
o Advanced Technology segment's Computer Equity Corporation;
o Advanced Technology segment's P-Tech., Inc.;
o Advanced Technology segment's Pacific Decision Sciences;
o Pre-merger Digital Angel Corporation's Animal Applications division;
o Pre-merger Digital Angel Corporation's Wireless and Monitoring
division;
o Pre-merger Digital Angel Corporation's GPS and Radio Communications
division; and
o InfoTech USA, Inc.
Page F-33
Methodology for Assigning Goodwill to Reporting Units:
The goodwill assigned to the Company's reporting units was based on the goodwill
resulting from the Company's acquisition of the reporting unit, with the
goodwill attributable to the merger of Destron Fearing Corporation, which was a
publicly held company trading on the Nasdaq ("Destron"), and Digital Angel.net
Inc. ("DA.net") allocated between the Animal Applications and the Wireless and
Monitoring reporting units. The merger of Destron and DA.net occurred in
September 2000. The goodwill resulting from the Destron and DA.net merger was
approximately $74.7 million, of which $50.7 million was allocated to Animal
Applications and $24.0 was allocated to Wireless and Monitoring. (The Wireless
and Monitoring reporting unit also included the goodwill associated with the
acquisition of Timely Technology Corp., of approximately $7.5 million).
The Company believed that a portion of the goodwill resulting from the Destron
and DA.net merger was due to the synergies of the combined companies. There were
several potential benefits/synergies of the merger that it believed would
contribute to the success of the combination. These potential benefits/synergies
included:
o the acceleration of the opportunities of the Digital Angel
technology through the combination with Destron and the current
products it offers, which establishes a company with stronger
capabilities;
o the combination of DA.net and Destron, with its injectable microchip
technology and its current products in the animal identification
markets, provide broader product offerings for the combined company;
o improvement in the purchasing power of the combined company as
compared to either company standing alone, resulting in reduced
costs;
o the management team of the combined company having greater depth of
knowledge of the injectable microchip and animal identification
industries and more business experience than that of either company
standing alone;
o the potential to expand the market presence of DA.net and Destron's
products globally through a larger combined sales force and
geographically more extensive sales and distribution channels;
o the complementary nature of each company's product offerings as an
extension of the offerings of the other company;
o increased product diversification and penetration of each company's
customer base;
o similarities in corporate culture; and
o the opportunity for expanded research and development of the
combined product offerings, including potential new product
offerings.
Since none of the assets and liabilities resulting from the merger had been
assigned to the Wireless and Monitoring reporting unit, the Company determined
the allocation of the goodwill between the Animal Applications and Wireless and
Monitoring reporting units based upon guidance provided in FAS 142. FAS 142
states that, "the methodology used to determine the amount of goodwill to assign
to a reporting unit shall be reasonable and supportable and shall be applied in
a consistent manner." Since Destron was a publicly held company at the time of
the merger, and as a result, its fair market value was readily determinable, the
Company allocated to the Animal Applications reporting unit the amount of
goodwill equal to Destron's fair market value prior to the public announcement
of the potential merger, which was approximately $50.7 million. This resulted in
the allocation of approximately $24.0 million to the Wireless and Monitoring
reporting unit, which the Company believed represented the fair market value of
the unit at that point in time, based on its belief in the market potential for
the Digital Angel product, coupled with the synergies of the combined companies,
as discussed above.
Page F-34
The Company's methodology for estimating the fair value of each reporting unit
at January 1, 2002, was a combination of impairment testing both internally (for
the Computer Equity Corporation, P-Tech, Inc., Pacific Decision Sciences and
InfoTech USA, Inc. reporting units based primarily on discounted future cash
flows), and externally (by engagement of independent valuation professionals to
analyze the reporting units associated with pre-merger Digital Angel
Corporation, using a combination of comparable company and discounted cash flow
analyses). If the fair value of a reporting unit exceeded its carrying value,
then no further testing was required. However, if the carrying value of a
reporting unit exceeded its fair value, then an impairment charge was required.
Based upon the conclusion of the Company's internal and external impairment
testing methodology, the adoption of FAS 142 did not result in an impairment
charge.
In the fourth quarters of 2003 and 2002, the Company tested goodwill at each
reporting unit level. At December 31, 2002, the Company's reporting units
consisted of the following:
o Advanced Technology segment's Computer Equity Corporation:
o Advanced Technology segment's P. Tech, Inc.;
o Advanced Technology segment's Pacific Decision Sciences;
o Digital Angel Corporation's Animal Applications division;
o Digital Angel Corporation's Wireless and Monitoring division;
o Digital Angel Corporation's GPS and Radio Communications division;
o Digital Angel Corporation's Medical Systems division (consisting of
the business operations of MAS, which was acquired on March 27,
2002, and which is now included as part of Discontinued Operations
in the financial statements); and
o InfoTech USA, Inc.
The Company's reporting units at December 31, 2003, were the same as its
reporting units at December 31, 2002, except for the exclusion of Digital Angel
Corporation's Wireless and Monitoring division, as its goodwill was fully
impaired at December 31, 2002, as discussed below.
The Company's methodology for estimating the fair value of each reporting unit
during the fourth quarters of 2003 and 2002 was a combination of impairment
testing performed both internally and externally. The tests for the P-Tech.,
Inc., and Pacific Decision Sciences reporting units were performed internally
based primarily on discounted future cash flows. The tests for the Computer
Equity Corporation reporting unit, the reporting units associated with Digital
Angel Corporation and the InfoTech USA, Inc. reporting unit were performed
externally through the engagement of independent valuation professionals who
performed valuations using a combination of comparable company and discounted
cash flow analyses. The InfoTech USA, Inc. reporting unit has a fiscal year
ending on September 30, and therefore, these tests were performed during their
fiscal 2003 and 2002 fourth quarters. If the fair value of a reporting unit
exceeded its carrying value, then no further testing was required. However, if
the carrying value of a reporting unit exceeded its fair value, then an
impairment charge was recorded. The assumptions used in the comparable company
and discounted cash flow analyses are described in Note 18.
As of December 31, 2002, Digital Angel Corporation's Wireless and Monitoring
segment had not recorded any significant revenues from its Digital Angel product
and it had not achieved the revenue projections used as the basis for the
Company's impairment tests upon the adoption of FAS 142 on January 1, 2002. At
December 31, 2002, the market value of the Company's investment in Digital Angel
Corporation was approximately $50.0 million. In consideration of these factors,
the newness of the Digital Angel Technology, the operating history of Digital
Angel Corporation, the challenging economic environment and uncertainties in the
marketplace along with the independent fair value measurement valuations
performed by the independent professionals, the Company concluded that future
cash flows from certain operations would not be sufficient to recover all of the
$31.5 million of goodwill associated with Digital Angel Corporation's Wireless
and Monitoring division. Accordingly, this amount was recorded as an impairment
charge during the fourth quarter of 2002. This impairment charge is more fully
discussed in Note 18. (During the fourth quarters of 2003 and 2002, the Company
also impaired $2.4 million and $30.7 million of goodwill, respectively,
associated with Digital Angel Corporation's Medical Systems division, which is
included as part of Discontinued Operations in the financial statements, as more
fully discussed in Note 20).
Page F-35
The Company's InfoTech USA, Inc. reporting unit operates on a September 30
fiscal year end. As part of InfoTech USA, Inc.'s fiscal year end 2003 planning
cycle, it engaged an independent valuation firm to review and evaluate its
goodwill of approximately $2.2 million. The goodwill resulted from prior
acquisitions by InfoTech USA, Inc. The methodology used by the independent
valuation firm to evaluate InfoTech USA, Inc.'s goodwill was the same as
discussed above (and in Note 18) for the evaluations associated with Digital
Angel Corporation. Based on the evaluation, InfoTech USA, Inc.'s goodwill was
not impaired as of September 30, 2003. However, InfoTech USA, Inc. has not
achieved its projected operating results, and it has not returned to
profitability (InfoTech USA, Inc. has incurred losses during the past several
years). Also, the market value of InfoTech USA, Inc.'s common stock, even after
adjustment for its limited public float, was significantly less at December than
its current book value. In addition, certain third parties had expressed
interest in purchasing InfoTech USA, Inc. for amounts less than the Company's
carrying value. As a result of these factors, the full value of InfoTech USA,
Inc.'s goodwill of approximately $2.2 million was impaired as of December 31,
2003.
In conjunction with the Company's review for impairment of goodwill and other
intangible assets in the fourth quarter of 2000, the Company reviewed the useful
lives assigned to goodwill and, effective October 1, 2000, changed the lives to
periods ranging from 5 to 10 years, down from periods ranging from 10 to 20
years. The impact in 2001 of this change was an increase in goodwill
amortization of $7.2 million and a decrease in earnings per share of $0.40.
Goodwill and other intangible assets are stated on the cost basis and have been
amortized, principally on a straight-line basis, over the estimated future
periods to be benefited (ranging from 5 to 10 years) through December 31, 2001.
Prior to the adoption of FAS 142 on January 1, 2002, the Company reviewed
goodwill and other intangible assets quarterly for impairment whenever events or
changes in business circumstances indicated that the remaining useful life may
have warranted revision or that the carrying amount of the long-lived asset may
not have been fully recoverable. The Company followed the provisions of FAS No.
121 "Accounting for the Impairment Of Long-Lived Assets and Of Long-Lived Assets
to be Disposed Of," to assess and measure the asset impairments. Factors
considered included significant customer losses, changes in profitability due to
sudden economic or competitive factors, change in management's strategy for the
business unit, letters of intent received for the sale of the business unit, or
other factors arising in the quarterly period. The Company annually performed
undiscounted cash flow analyses by business unit to determine if an impairment
existed and, where available, market related information. For purposes of these
analyses, earnings before interest, taxes, depreciation and amortization were
used as the measure of cash flow. When an impairment was determined to exist,
any related impairment loss was calculated based on fair value. Fair value was
determined based on discounted cash flows. The discount rate utilized by the
Company was the rate of return expected from the market or the rate of return
for a similar investment with similar risks. Based on these analyses, the
Company recorded goodwill impairment charges of $63.6 million during 2001. See
Note 18. The business operations of the Company's reporting units are described
above beginning on page F-12.
Page F-36
The changes in the carrying amount of goodwill for the two years ended December
31, 2003, by reporting unit are as follows (in thousands):
COMPUTER PACIFIC WEBNET ANIMAL
EQUITY P-TECH, DECISIONS SERVICES APPLICATIONS
CORPORATION(1) INC.(1) SCIENCES (1) INC.(1) (2)
- --------------------------------------------------------------------------------------
Balance January 1, $ 13,178 $ 530 $ 1,504 $-- $ 43,971
2002
Acquisitions,
adjustments and
earnout payments 3,000 -- -- -- --
Less goodwill
impairment -- -- -- -- --
- --------------------------------------------------------------------------------------
Balance December $ 16,178 $ 530 $ 1,504 $-- $ 43,971
31, 2002
Earnout payments
and other
adjustments -- -- -- 408 --
Less sale of
business -- -- -- (408) --
Less goodwill
impairment -- -- -- -- --
- --------------------------------------------------------------------------------------
Balance December $ 16,178 $ 530 $ 1,504 $-- $ 43,971
31, 2003
======================================================================================
GPS AND
RADIO
WIRELESS AND COMMUNI- INFOTECH,
MONITORING(2) CATIONS(2)(3) UAS, INC. CORPORATE TOTAL
- ----------------------------------------------------------------------------------------
Balance January 1, $ 27,854 $ 1,051 $ 2,154 589 $ 90,831
2002
Acquisitions,
adjustments and
earnout payments 3,606 63 -- (589) 6,080
Less goodwill
impairment (31,460) -- -- -- (31,460)
- ----------------------------------------------------------------------------------------
Balance December $-- $ 1,114 $ 2,154 -- $ 65,451
31, 2002
Earnout payments
and other
adjustments -- 34 -- -- 442
Less sale of
business -- -- -- -- (408)
Less goodwill
impairment -- -- (2,154) -- (2,154)
- ----------------------------------------------------------------------------------------
Balance December $-- $ 1,148 $-- $-- $ 63,331
31, 2003
========================================================================================
(1) Reporting unit is a component of the Advanced Technology segment.
(2) Reporting unit is a component of the Digital Angel Corporation segment.
(3) The InfoTech USA, Inc. segment is a reporting unit.
Page F-37
The following table presents the impact of FAS 142 on net loss and
net loss per share had the standard been in effect beginning January
1, 2001:
YEAR ENDED
DECEMBER 31,
2001
(in thousands)
Net loss available to common stockholders:
Net loss available to common stockholders as reported $ (215,642)
Add back: Goodwill amortization 21,312
Add back: Equity method investment amortization 1,161
-----------
Adjusted net loss $ (193,169)
-----------
Loss per common share - basic
Net loss per share - basic, as reported $ (12.68)
Goodwill amortization 1.25
Equity method investment amortization 0.07
-----------
Adjusted net loss - basic $ (11.36)
-----------
Loss per share - diluted
Net loss per share - diluted, as reported $ (12.68)
Goodwill amortization 1.25
Equity method investment amortization 0.07
-----------
Adjusted net loss per share - diluted $ (11.36)
-----------
The Company had entered into various earnout arrangements with the selling
shareholders of certain acquired subsidiaries. These arrangements provided for
additional consideration to be paid in future years if certain earnings levels
were met. As of December 31, 2003, there were no remaining earnout arrangements.
Payments made under earnout arrangements were added to goodwill as earned.
9. OTHER ASSETS
Other Assets consist of the following:
DECEMBER 31,
------------
2003 2002
- ---------------------------------------------------- ------- -------
Proprietary software $ 1,725 $ 940
Loan acquisition costs 487 10,502
Other assets 577 2,206
- ---------------------------------------------------- ------- -------
2,789 13,648
Less: Accumulated amortization 2,139 12,681
- ---------------------------------------------------- ------- -------
650 967
Other investments 248 --
Deferred tax asset -- 1,223
Other 104 439
- ---------------------------------------------------- ------- -------
$ 1,002 $ 2,629
==================================================== ======= =======
Amortization of other assets charged against income amounted to $0.2 million,
$0.5 million and $1.8 million for the years ended December 31, 2003, 2002 and
2001, respectively.
Page F-38
10. OTHER ACCRUED EXPENSES
Other Accrued Expenses consist of the following:
DECEMBER 31,
------------
2003 2002
-------------------------------
(in thousands)
Accrued wages and payroll expenses $1,728 $ 1,824
Accrued severance 1,443 --
Accrued bonuses 2,270 --
Accrued purchases 4,857 4,837
Accrued legal reserves 3,746 2,379
Accrued professional fees 839 1,553
Other accrued expenses 5,146 4,655
Deferred revenue 2,488 1,858
- ------------------------------------------------------------ -----------------
$22,517 $17,106
============================================================ =================
11. NOTES PAYABLE AND LONG-TERM DEBT
NOTES PAYABLE AND LONG-TERM DEBT
Notes Payable and Long-Term Debt consist of the following:
DECEMBER 31,
------------------------------------
2003 2002
-------------------------------------
(in thousands)
Term Loan - IBM Credit, collateralized by all domestic assets of the Company and
a pledge of the stock of the Company's subsidiaries, bearing
interest from 17% to 25% through February 28, 2003, due February 28, 2003. $ -- $80,655
Digital Angel Corporation
Mortgage notes payable, collateralized by land and buildings, payable in monthly
installments of principal and interest totaling $30 thousand,
bearing interest at 8.18%, due through November 2010. 2,376 2,369
Convertible note payable, collateralized by all Digital Angel Corporation
assets, net of unamortized discount of $113, due July 31, 2005, bearing
interest at the higher of prime plus 1.75% or 6% at December 31, 2003. 1,601
Page F-39
DECEMBER 31,
------------------------------------
2003 2002
-------------------------------------
(in thousands)
Revolving note payable, collateralized by all Digital Angel Corporation assets,
net of unamortized discount of $119, interest payable monthly at
prime plus 2.5%, due in August 2006. 2,868 --
Line of credit, interest payable monthly at prime plus 2.25%, due in
September 2004. 889 --
Line of credit, collateralized by all Digital Angel Corporation assets,
interest payable monthly at prime plus 3%, due in October 2005. -- 709
Notes payable - other 92 299
Capital lease obligations 260 233
- -----------------------------------------------------------------------------------------------------------------------
8,086 84,265
Less: Current maturities 5,226 81,829
- -----------------------------------------------------------------------------------------------------------------------
$ 2,860 $ 2,436
=======================================================================================================================
Payment in Full of Obligations to IBM Credit LLC
As more fully discussed in Note 2, effective April 1, 2003, the Company entered
into a Forbearance Agreement with IBM Credit. Under the terms of the Forbearance
Agreement, the Company had the right to purchase all of its outstanding debt
obligations to IBM Credit, totaling approximately $100.1 million (including
accrued interest), if it paid IBM Credit $30.0 million in cash by June 30, 2003.
As of June 30, 2003, the Company made cash payments to IBM Credit totaling $30.0
million and, thus, it has satisfied in full its debt obligations to IBM Credit.
As a result, during 2003, the Company recorded a gain on the extinguishment of
debt of $70.1 million.
Amendment, Restatement and Waiver Fees Associated With the IBM Credit Agreements
During 2002 and 2001, IBM Credit amended and restated its credit agreements with
the Company on several occasions. As part of the amendments and restatements to
the credit agreements, the Company paid bank fees of $0.4 million and $0.3
million in 2002 and 2001, respectively, and during 2001, the Company issued a
five-year warrant to acquire 0.3 million shares of the Company's common stock to
IBM Credit valued at $1.9 million. In 2002, the Company agreed to re-price these
warrants. The re-priced warrants were valued at $1.0 million. In addition, as a
result of the merger between pre-merger Digital Angel and MAS, warrants
convertible into common stock of Digital Angel Corporation that were previously
issued to IBM Credit were revalued using the Black Scholes valuation method,
resulting in additional deferred financing costs of $1.1 million. The bank fees
and fair value of the warrants have been recorded as interest expense.
During 2002, IBM Credit provided the Company with a waiver of noncompliance of
certain debt covenants under the IBM Credit Agreement. As consideration for the
waiver, the Company issued to IBM Credit a five year warrant to acquire 0.3
million shares of the Company's common stock at $1.50 per share, valued at
approximately $1.3 million, and a five year-warrant to purchase approximately
1.8 million shares of the Company's wholly-owned subsidiary, VeriChip
Corporation's common stock at $0.05 per share, valued at approximately $44
thousand. The fair value of the warrants was determined using the Black-Scholes
valuation model, and was recorded as interest expense in 2002.
Page F-40
Issuance of 8.5% Convertible Exchangeable Debentures
On June 30, 2003, the Company entered into the Securities Purchase Agreement
(the "Agreement") with certain investors, collectively referred to herein as the
Debenture holders or "the Purchasers." In connection with the Agreement, the
Company issued to the Purchasers its $10.5 million aggregate principal amount of
8.5% Convertible Exchangeable Debentures due November 1, 2005 ("the
Debentures"). Subject to the terms under the various agreements, the Debentures
were convertible into shares of the Company's common stock or exchangeable for
shares of Digital Angel Corporation common stock owned by the Company, or a
combination thereof, at any time prior to the maturity date of November 1, 2005,
at the Purchasers' option.
On November 12, 2003, the Company announced that it had entered into a letter
agreement with the Purchasers. Under the letter agreement, the Purchasers were
required to convert a minimum of 50% of the outstanding principal amount of the
Debentures plus all accrued and unpaid interest into shares of the Company's
common stock on November 12, 2003, the First Conversion Date. The conversion
price was $3.50 per share. In addition, per the terms of the letter agreement
the Purchasers were required to convert any remaining outstanding principal
amount of the Debentures plus accrued interest on or before November 19, 2003,
the Second Conversion Date. The conversion price for the Second Conversion Date
was 84% of the volume weighted average trading price of the Company's common
stock for the five trading days prior to November 17, 2003, which average was
$4.406. As of November 19, 2003, the total principal amount of the Debentures
has been converted, and accordingly, the Company's obligations under the
Debentures have been satisfied in full. The Company has issued an aggregate of
2.8 million shares of its common stock in connection with the conversions taking
place on the First and Second Conversion Dates. In addition, in connection with
the Debentures, the Company has issued an aggregate of 0.3 million shares of the
Digital Angel Corporation common stock that it owned at an exchange price of
$2.20 per share per the terms of the Debentures. Following these exchanges, the
Company owned 19.3 million shares of Digital Angel Corporation's common stock.
As a result of the repayment of all of the Debentures, the unamortized balance
of the original issue discount and debt issue costs of approximately $4.2
million was recorded as additional interest expense during the fourth quarter of
2003. In addition, as a result of the difference between the original conversion
price under the Agreement of $5.15 per share, and the revised conversion prices
per the terms of the letter agreement, which averaged $3.51 per share, the
Company recorded additional beneficial conversion feature of approximately $4.5
million during the fourth quarter of 2003. This additional beneficial conversion
feature was recorded as interest expense and an increase in additional-paid in
capital. Thus, during the fourth quarter of 2003, the Company incurred $8.7
million in total non-cash stock-based interest expense as a result of the
conversions of the Debentures under the terms of the letter agreement.
Common Stock Warrants Issued to the Debenture Holders
In connection with the Debentures, the Company granted to the Debenture holders
Warrants to acquire approximately 0.5 million shares of the Company's common
stock, or 0.95 million shares of the Digital Angel Corporation common stock
owned by the Company, or a combination of shares from both companies, at the
Purchasers' option. The exercise prices are $5.64 and $3.178 for the Company's
common stock and the Digital Angel Corporation common stock, respectively. The
Warrants are subject to anti-dilution provisions, vested immediately and are
exercisable through June 30, 2007. The Company had registered its common shares
issuable upon conversion of the Debentures and Warrants in accordance with the
terms of a Registration Rights Agreement entered into among the Company and the
Purchasers.
Page F-41
The proceeds upon issuance of the Debentures were allocated as follows:
Face value of Debentures $ 10,500
Beneficial conversion feature (3,120)
Relative fair value of Warrants (1,387)
--------
Relative fair value of Debentures $ 5,993
========
The beneficial conversion feature was calculated as the difference between the
beneficial conversion price and the fair value of the Company's common stock,
multiplied by the number of shares into which the Debentures were convertible in
accordance with the Emerging Issues Task Force ("EITF") - 00-27. The beneficial
conversion feature was recorded as a reduction in the value assigned to the
Debentures (original issue discount) and an increase in additional
paid-in-capital. The value assigned to the Warrants was recorded as a reduction
in the value assigned to the Debentures (original issue discount) and an
increase in long-term liabilities. The liability for the Warrants, to the extent
potentially settleable in shares of the Digital Angel Corporation common stock
owned by the Company, is being revalued at each reporting period and any
resulting increase/decrease will result in an increase/decrease in interest
expense. During 2003, the Company recorded interest expense of $2.0 million as a
result of such revaluation. The Company will be required to record an impairment
loss if the carrying value of the Digital Angel Corporation common stock
underlying the Warrants exceeds the exercise price. Should the Purchasers elect
to exercise the Warrants into shares of the Digital Angel Corporation common
stock owned by the Company, such exercise may result in the Company recording a
gain on the transaction.
The original issue discount of $4.5 million was being accreted over the life of
the Debentures as additional interest expense. During 2003, the Company incurred
approximately $0.7 million of interest expense as a result of the accretion of
the original issue discount. As a result of conversion of all of the Debentures
in November 2003, the remaining balance of the original issue discount and debt
issue costs, such debt issue costs are discussed below, of approximately $3.8
million was recorded as interest expense during the fourth quarter of 2003.
In addition, Digital Angel Corporation has granted a five-year warrant to the
Debenture holders to acquire up to 0.5 million shares of its common stock at an
exercise price of $2.64 per share. The warrant was issued in consideration for a
waiver from the Debenture holders, which allowed the Company to register the
shares that were issued in connection with a Share Exchange Agreement between
the Company and Digital Angel Corporation. The fair value of the warrant of
approximately $0.8 million was determined using the Black-Scholes valuation
model and was recorded as interest expense during 2003. The Share Exchange
Agreement is described in Note 3. The total interest expense recorded in 2003 in
connection with the Debentures was approximately $12.7 million.
In connection with the Debentures, the Company incurred a placement agency fee
of $0.4 million, and it reimbursed one of the Purchasers $0.1 million for legal,
administrative, due diligence and other expenses incurred to prepare and
negotiate the transaction documents. The Company realized net proceeds of $10.0
million from the issuance of the Debentures, after deduction of the placement
agency fee and transaction costs. The Company used the net proceeds to repay a
portion of the $30.0 million payment that it made to IBM Credit on June 30,
2003. To date, the Company has not realized any proceeds from the issuance of
the Warrants, as the Warrants have not been exercised.
As a result of the complete satisfaction of all of the Company's obligations to
IBM Credit, the Company entered into an Amended and Restated Trust Agreement
dated June 30, 2003, with the Digital Angel Share Trust ("Trust"). Under the
terms of the revised trust agreement, the Trust retained all of its rights,
title and interest in 15.0 million shares of the Digital Angel Corporation
common stock owned by the Company in consideration of the Debentures and in
order to secure and facilitate the payment of the Company's obligations under
the Debentures. As a result of the repayment in full of the Debentures on
November 19, 2003, the Company expects to dissolve the Trust in the near future.
Currently, Scott R. Silverman, the Company's Chief Executive Officer, serves as
the sole advisory board member to the Trust.
Page F-42
Digital Angel Corporation Financing Transactions
On July 31, 2003, Digital Angel Corporation entered into a securities purchase
agreement to sell securities to Laurus Master Fund, Ltd. ("Laurus"). Under the
terms of the securities purchase agreement, Digital Angel Corporation issued and
sold to Laurus a two-year secured convertible note in the original principal
amount of $2.0 million and a common stock warrant to purchase up to 0.1 million
shares of Digital Angel Corporation's common stock. The note is convertible, at
Laurus' option, into shares of Digital Angel Corporation's common stock at a per
share price of $2.33, subject to limitations. The note accrues interest at an
annual rate equal to the greater of prime plus 1.75% or 6%. The exercise prices
of the warrant range from $2.68 to $3.38 per share and the warrant is
exercisable for five years. In connection with the note, Digital Angel
Corporation and Laurus entered into a security agreement granting to Laurus a
lien and security interest in Digital Angel Corporation's assets, having a net
book value of $48.5 million as of December 31, 2003. On August 28, 2003, Digital
Angel Corporation entered into a second security agreement with Laurus under
which it may borrow from Laurus the lesser of $5.0 million or an amount that is
determined based on percentages of Digital Angel Corporation's eligible accounts
receivable and inventory as prescribed by the terms of the Security Agreement.
Under the Security Agreement, Digital Angel Corporation issued to Laurus a
Secured Revolving Convertible Note (the "Revolving Note") in the original
principal amount of $3.5 million and a Secured Minimum Borrowing Convertible
Note (the "Minimum Borrowing Note") in the original principal amount of $1.5
million. The notes accrue interest at an annual rate equal to prime plus 2.50%.
Digital Angel Corporation used proceeds from the loans from Laurus to satisfy in
full its credit facility with Wells Fargo Business Credit, Inc., which was
cancelled effective August 28, 2003. As of December 31, 2003, the aggregate
amount outstanding under the Minimum Borrowing Note and Revolving Note was $3.0
million and the availability under the Revolving Note was $0.2 million.
Beginning May 28, 2004, the Minimum Borrowing Note and the Revolving Note are
convertible, at Laurus' option, into shares of Digital Angel Corporation's
common stock at a price per share of $2.64, subject to adjustments upward
following each conversion of $2.0 million. Additionally, the securities purchase
agreement with Laurus includes default provisions should an Event of Default (as
defined in the agreement) occur; furthermore, under a related registration
rights agreement, Digital Angel Corporation has agreed to register the common
stock underlying the Convertible Note.
The scheduled payments due based on maturities of long-term debt and amounts
subject to acceleration at December 31, 2003 are presented in the following
table. These amounts are based on the stated principal maturities, and are
presented gross of unamortized debt discount.
Year Amount
---- ------
2004 $5,345
2005 672
2006 73
2007 60
2008 63
Thereafter 2,105
------------------------
$8,318
========================
Interest expense on the long and short-term notes payable amounted to $22.6
million, $17.5 million and $8.6 million for the years ended December 31, 2003,
2002 and 2001, respectively.
The weighted average interest rate was 50% and 21% for the years ended
December 31, 2003 and 2002, respectively.
The Medical Systems operations, which are included in Discontinued Operations,
also had a mortgage note obligation of approximately $0.9 million and $1.0
million as of December 31, 2003 and 2002, respectively. The mortgage note was
paid in full on July 31, 2004. Certain of the Company's subsidiaries included in
Discontinued Operations also have capital lease obligations of $26 thousand at
December 31, 2003 and 2002.
Page F-43
12. OTHER LONG-TERM LIABILITIES
Other Long-Term Liabilities consist of the following:
DECEMBER 31,
------------
2003 2002
---- ----
(in thousands)
Warrants payable $3,430 $ --
Deferred compensation payable -- 1,005
Other -- --
------ ------
$3,430 $1,005
====== ======
13. FAIR VALUE OF FINANCIAL INSTRUMENTS
CASH AND CASH EQUIVALENTS
The carrying amount approximates fair value because of the short maturity
of those instruments.
NOTES RECEIVABLE
The carrying value of the notes, net of the allowance for doubtful accounts,
approximate fair value because either the interest rates of the notes
approximate the current rate that the Company could receive on a similar note,
or because of the short-term nature of the notes.
NOTES PAYABLE
The carrying amount approximates fair value because of the current rates
approximate market rates.
LONG-TERM DEBT
The carrying amount approximates fair value because the current rates
approximate market rates.
ACCOUNTS PAYABLE AND ACCRUED EXPENSES
The carrying amount approximates fair value.
WARRANTS PAYABLE
The carrying amount of warrants payable is revalued each reporting period
and approximates current fair value.
14. REDEEMABLE PREFERRED SHARES - SERIES C
On October 26, 2000, the Company issued 26 thousand shares of its Series C
convertible preferred stock to a select group of institutional investors in a
private placement. The stated value of the preferred stock was $1,000 per share,
or an aggregate of $26.0 million, and the purchase price of the preferred stock
and the related warrants and options was an aggregate of $20.0 million. The
preferred stock was convertible into shares of the Company's common stock at
various conversion rates.
The proceeds upon issuance were allocated to the preferred stock, the detachable
warrants and the option based upon their relative fair values. The value
assigned to the warrants and option increased the discount on preferred stock,
as follows (in thousands):
Page F-44
Face value of preferred stock $ 26,000
Discount on preferred stock (6,000)
Preferred stock issuance costs (944)
============================================================= ========
Net proceeds $ 19,056
============================================================= ========
Relative fair value of warrants $ 627
Relative fair value of option 5,180
Relative fair value of preferred shares 13,249
- ------------------------------------------------------------- --------
Total $ 19,056
============================================================= ========
The beneficial conversion feature was calculated as the difference between the
most beneficial conversion price and the fair value of the Company's common
stock, multiplied by the number of shares into which the preferred stock was
convertible in accordance with EITF 98-5 and 00-27. For the year ended December
31, 2001, the beneficial conversion feature (BCF) associated with the Company's
preferred stock charged to earnings per share was $9.4 million. The Company has
cumulatively recorded a charge to earnings per share of $13.2 million since the
issuance of the preferred stock. As of June 30, 2001, the BCF was fully
accreted. As of December 31, 2001, all of the preferred shares have been
converted into shares of the Company's common stock.
The BCF was recorded as a reduction in the value assigned to the preferred stock
and an increase in additional paid-in capital. The Company recorded the
accretion of the BCF over the period from the date of issuance to the earliest
beneficial conversion date available through equity, reducing the income
available to common stockholders and earnings per share.
The holders of the preferred stock also received 0.1 million warrants to
purchase up to 0.1 million shares of the Company's common stock. The warrants
expire in October 2005. At December 31, 2002, the exercise price was $46.60 per
share, subject to adjustment for various events, including the issuance of
shares of common stock, or options or other rights to acquire common stock, at
an issuance price lower than the exercise price under the warrants. The exercise
price may be paid in cash, in shares of common stock or by surrendering
warrants. The warrants were valued using the Black Scholes valuation model. See
Note 15 for the valuation and related assumptions.
OPTION TO ACQUIRE ADDITIONAL PREFERRED STOCK
The investors had the option to purchase up to an additional $26.0 million in
stated value of Series C convertible preferred stock and warrants with an
initial conversion price of $50.00 per share, for an aggregate purchase price of
$20.0 million, at any time up to ten months following the effective date of the
Company's registration statement relating to the common stock issuable on
conversion of the initial series of the preferred stock. The additional
preferred stock would have had the same preferences, qualifications and rights
as the initial preferred stock. The fair value of the option was estimated using
the Black-Scholes option-pricing model with the following assumptions: dividend
yield of 0%, expected volatility of 40% and a risk free interest rate of 5.5%.
The investors elected not to exercise the option and it expired on February 24,
2002. Upon expiration, the value of the option was reclassified to Additional
Paid-in-Capital.
15. PREFERRED STOCK, COMMON STOCK AND OTHER STOCKHOLDERS' EQUITY (DEFICIT)
PREFERRED SHARES
The Company has authorized 5.0 million shares of preferred stock, $10.00 par
value, to be issued from time to time on such terms as are specified by the
Company's Board of Directors. At December 31, 2003, no preferred shares were
issued or outstanding.
WARRANTS
The Company has issued warrants convertible into shares of common stock for
consideration, as follows (in thousands, except exercise price):
Page F-45
BALANCE
CLASS OF DECEMBER 31, EXERCISE EXERCISABLE
WARRANTS AUTHORIZED ISSUED EXERCISED EXPIRED 2003 PRICE DATE OF ISSUE PERIOD
- -------- ---------- ------ --------- ------- ---- ----- ------------- ------
Class S 60 60 22 38 -- 20.00 April 1998 5 years
Class U 25 25 -- 25 -- 83.80 November 1998 5 yearS
Class W 84 84 -- -- 84 44.80 October 2000 5 yearS
Class X 290 290 -- -- 290 1.50 April 2001 5 yearS
Class Y 290 290 -- -- 290 1.50 August 2002 5 yearS
Class Z 535 535 -- -- 535 5.64 June 2003 4 yearS
----- ----- ------ ------- -------
1,284 1,284 22 63 1,199
----- ----- ------ ------- -------
The warrants in classes S and U were issued at the then-current market value of
the common stock in consideration for investment banking services provided to
the Company.
The class W warrants were issued in connection with the Series C preferred stock
issuance. These warrants were valued at $0.6 million, and were recorded as a
discount on the preferred stock at issuance.
The class X warrants were issued to IBM Credit Corporation in connection with an
"Acknowledgement, Waiver and Amendment No. 1 to the Second Amended and Restated
Term and Revolving Credit Agreement" with IBM Credit. The warrants were valued
at $1.9 million. Under the terms of the IBM Credit Agreement, which became
effective on March 27, 2002, these warrants were re-priced from an exercise
price of $12.50 per share to an exercise price of $1.50 per share. The re-priced
warrants were valued at $1.0 million. The fair values of the warrants and the
re-priced warrants were reflected as deferred financing fees and were amortized
as interest expense.
The class Y warrants were issued to IBM Credit Corporation in connection with
the IBM Credit Agreement. The warrants were valued at $1.3 million. The fair
value of the warrants was reflected as deferred financing fees and was amortized
as interest expense.
The class Z warrants were issued in connection with the Debentures. The Warrants
were originally valued at $1.4 million. The original fair value assigned to the
Warrants was recorded as a reduction in the value assigned to the Debentures
(original issue discount) and an increase in long-term liabilities. The original
issue discount was amortized as interest expense. The unamortized portion of the
original issue discount was fully expensed during the fourth quarter of 2003,
when the Debentures were satisfied in full. The Warrants are settleable in
either the Company's common stock or shares of the Digital Angel Corporation
common stock owned by the Company, or a combination of both, at the Purchasers'
option. The liability for the Warrants, to the extent potentially settleable in
shares of the Digital Angel Corporation common stock owned by the Company, is
being revalued at each reporting period and any resulting increase/decrease will
result in an increase/decrease in interest expense. During 2003, the Company
recorded interest expense of $2.0 million as a result of such revaluation. The
Company will be required to record an impairment loss if the carrying value of
the Digital Angel Corporation common stock underlying the Warrants exceeds the
exercise price. Should the Purchasers elect to exercise the Warrants into shares
of the Digital Angel Corporation common stock owned by the Company, such
exercise may result in the Company recording a gain on the transaction.
Page F-46
The valuation of warrants utilized the following assumptions in the
Black-Scholes valuation model:
WARRANT SERIES DIVIDEND YIELD VOLATILITY EXPECTED LIVES (YRS.) RISK-FREE RATES
-------------- -------------- ---------- --------------------- ---------------
S & U 0% 43.69% 1.69 8.5%
W 0% 43.41% 1.69 6.4%
X (initial grant) 0% 53.32% 5.0 4.6%
X (re-pricing) 0% 68.75% 4.0 4.4%
Y 0% 68.75% 5.0 3.3%
Z (initial grant) 0% 76.00% 4.0 1.5%
Z (revaluation) 0% 126.76% 3.4 2.8%
STOCK OPTION PLANS
During 1996, the Company adopted a nonqualified stock option plan (the "Option
Plan"). During 2000, the Company adopted the 1999 Flexible Stock Plan (the "1999
Flexible Plan"). With the 2000 acquisition of Destron Fearing, the Company
acquired two additional stock option plans, an Employee Stock Option Plan and
Non-employee Director Stock Option Plan. The names of the plans were changed to
Digital Angel.net Inc. Stock Option Plan (the "Employee Plan") and the Digital
Angel.net Inc. Non-employee Director Stock Option Plan (the "Director Plan").
During 2003, the Company adopted the 2003 Flexible Stock Plan (the "2003
Flexible Plan").
Under the Option Plan, options for 1.0 million common shares were authorized for
issuance to certain officers, directors and employees of the Company. As of
December 31, 2003, 1.0 million options have been issued and 0.3 million are
outstanding under the Option Plan. The options may not be exercised until one to
three years after the options have been granted, and are exercisable for a
period of five years.
Under the 1999 Flexible Plan, the number of shares which may be issued or sold,
or for which options, Stock Appreciation Rights (SARs) or Performance Shares may
be granted to officers, directors and employees of the Company is 3.6 million.
As of December 31, 2003, 3.6 million options have been granted and 1.4 million
are outstanding. The options may not be exercised until one to three years after
the grant date, and are exercisable over a period of five years.
Under the Employee Plan, the Plan authorized the grant of options to the
employees to purchase shares of common stock. As of December 31, 2003, 0.1
million options have been granted and 0.1 million are outstanding. The Plan
provides for the grant of incentive stock options, as defined in the Internal
Revenue Code, and non-incentive options. The Plan has been discontinued with
respect to any future grant of options.
Under the Director Plan, the Plan authorized the grant of options to the
non-employee directors to purchase shares of common stock. As of December 31,
2003, 30 thousand options have been granted and 10 thousand are outstanding. The
Plan has been discontinued with respect to any future grant of options.
Under the 2003 Flexible Plan, the number of shares which may be issued or sold,
or for which options, Stock Appreciation Rights (SARs) or Performance Shares may
be granted to officers, directors and employees of the Company is 1.4 million.
As of December 31, 2003, 0.7 million options have been granted and 0.7 million
are outstanding. The options may not be exercised until one to four years after
the grant date, and are exercisable over a period of seven years. In addition,
as of December 31, 2003, 30 thousand shares of restricted common stock have been
granted under the 2003 Flexible Plan to non-employee directors in payment of
certain directors' fees.
Page F-47
A summary of stock option activity for 2003, 2002 and 2001 is as follows (in
thousands, except weighted-average exercise price):
2003 2002 2001
------------------- ----------------------- -----------------------
WEIGHTED- WEIGHTED- WEIGHTED-
NUMBER AVERAGE AVERAGE AVERAGE
OF EXERCISE NUMBER OF EXERCISE NUMBER OF EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
------- ------ -------- ------ -------- --------
Outstanding on January 1 3,404 $ 7.10 3,023 $ 7.60 2,246 $28.70
Granted (1) 2,017 1.40 1,013 3.20 1,229 3.30
Exercised (2) 1,544 0.30 (629) 2.30 (237) 1.50
Forfeited (1) (2) 1,385 2.80 (3) 10.09 (215) 8.80
----- ----- -----
Outstanding on December 31 2,492 9.30 3,404 7.10 3,023 7.60
----- ----- -----
Exercisable on December 31 1,780 11.30 2,372 8.70 2,000 9.90
----- ----- -----
Shares available on December 31
for options that may be granted 758 28 204
----- ----- -----
(1) For 2001, amount excludes options to acquire approximately 1.9 million
shares of the Company's common stock, which were re-priced during 2001.
See Note 16.
(2) Includes approximately 1.3 million options, which were re-priced in 2003.
See Note 17.
The Company recovered approximately $1.3 million and incurred approximately $0.7
million and $5.3 million of non-cash stock based compensation expense during
2003, 2002 and 2001, respectively, due primarily to re-pricing 1.9 million stock
options during 2001. The re-priced options are more fully described in Note 16.
In addition, on September 24, 2001, the company issued 0.4 million options to
employees and directors with exercise prices of $1.50 per share, or $0.20 per
share less than the fair market value of the underlying common stock on the date
of grant. In accordance with APB No. 25, the Company recognized compensation
expense of $0.1 million associated with these options. The compensation expense
was amortized over the vesting period of the options. These non-cash,
stock-based charges are reflected in the Consolidated Statements of Operations
in selling, general and administrative expense.
The following table summarizes information about stock options at December
31, 2003, (in thousands, except weighted-average amounts):
OUTSTANDING STOCK OPTIONS EXERCISABLE STOCK OPTIONS
------------------------- -------------------------
WEIGHTED-
AVERAGE WEIGHTED- WEIGHTED-
REMAINING AVERAGE AVERAGE
RANGE OF CONTRACTUAL EXERCISE EXERCISE
EXERCISE PRICES SHARES LIFE PRICE SHARES PRICE
--------------- ------ ---- ----- ------ -----
$0.01 to $10.00 1,851 5.2 $ 3.30 1,146 $ 2.90
$10.01 to $20.00 143 3.5 14.80 137 14.90
$20.01 to $30.00 375 2.1 25.00 375 25.00
$30.01 to $40.00 79 1.7 35.40 78 35.40
$40.01 to $50.00 25 1.7 45.00 25 45.00
$50.01 to $60.00 19 1.5 55.90 19 55.90
-------- ----- ------------- ------- -------
2,492 4.5 $ 9.30 1,780 $ 11.30
===== ===== =======
In addition to the above options, certain subsidiaries of the Company have
issued options to various employees, officers and directors. Information
pertaining to option plans of the Company's subsidiaries is as follows:
Digital Angel Corporation
During 1999, Digital Angel Corporation adopted a non-qualified stock option plan
(the "Stock Option Plan"). In connection with the merger with MAS, Digital Angel
Corporation assumed the options granted under the Stock Option Plan under its
Amended and Restated Digital Angel Corporation Transition Stock Option Plan
("DAC Stock Option Plan"). As amended, 11.2 million shares of Digital Angel
Corporation's common stock may be granted under the DAC Stock Option Plan. As of
December 31, 2003, options to purchase 6.4 million shares were outstanding and
0.9 million shares were available for the grant. The options vest as determined
by Digital Angel Corporation's Board of Directors and are exercisable for a
period of no more than 10 years.
Page F-48
Under MAS's nonqualified stock option plan (the "MAS Stock Option Plan"),
options may be granted at or below the fair market value of the stock and have 5
and 10 year lives. Options granted to certain individuals vest ratably over
three years. The MAS Stock Option Plan provides for 1.6 million shares of common
stock for which options may be granted. As of December 31, 2003, options to
purchase 1.0 million shares were outstanding and 0.3 million shares were
available for the grant.
A summary of stock option activity for Digital Angel Corporation's stock option
plans for 2003, 2002 and 2001 is as follows (in thousands, except
weighted-average exercise price data):
2003 2002 2001
-------------------------- -------------------------- --------------------------
SHARES WEIGHTED SHARES WEIGHTED SHARES WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
PRICE PRICE PRICE
------------ ------------ ------------ ------------ ------------ ------------
Outstanding on January 1 7,816 $ 2.56 5,148 $ 0.44 4,340 $ 0.38
Granted 1,825 2.63 3,910 3.39 1,050 0.67
Assumed in MAS Acquisition -- -- 1,211 4.23 -- --
Exercised (1,672) 0.67 (2,452) 0.25 -- --
Forfeited (612) 3.44 (1) 10.00 (242) (0.49)
------------ ------------ ------------
Outstanding on December 31 7,357 2.98 7,816 2.56 5,148 0.44
============ ============ ============
Exercisable on December 31 5,333 3.07 3,893 1.70 4,270 0.39
============ ============ ============
Shares available for grant on
December 31 1,157 2,370 8
============ ============ ============
The following table summarizes information about Digital Angel Corporation's
stock options at December 31, 2003 (in thousands, except weighted-average
exercise price data):
OUTSTANDING STOCK OPTIONS EXERCISABLE STOCK
-----------------------------------------------------------------
WEIGHTED
AVERAGE WEIGHTED
REMAINING AVERAGE
CONTRACTUAL EXERCISE WEIGHTED AVERAGE
RANGE OF EXERCISE PRICES SHARES LIFE PRICE SHARES EXERCISE PRICE
- ------------------------------ --------- -------------- ------------------- -------------------
$ 0.01 to $2.00 1,945 8.04 $ 1.10 1,096 $ 0.49
$ 2.01 to $4.00 4,720 8.76 2.70 3,546 3.42
$ 4.01 to $6.00 550 7.17 4.15 550 4.15
$ 6.01 to $8.00 -- -- -- -- --
$ 8.01 to $10.00 142 6.38 10.00 141 10.00
--------- -------- ----------
7,357 $ 2.98 5,333 $ 3.07
========= ========
InfoTech USA, Inc.
In February 1998, InfoTech USA, Inc.'s shareholders approved a stock option plan
(the "InfoTech 1998 Plan"), as amended. Under the InfoTech 1998 Plan, 1.0
million shares of InfoTech USA, Inc.'s common stock are reserved for issuance
upon the exercise of options designated as either incentive stock options or
non-qualified stock options. The InfoTech 1998 Plan will terminate in February
2008. During 1998, 1999 and 2000, options were granted to directors and
employees of InfoTech USA, Inc. with immediate vesting. All other options
granted under the plan vest over a four-year period following the date of grant.
Options granted under the InfoTech 1998 Plan expire from five to 11 years from
the date of grant. As of December 31, 2003, 0.8 million options have been issued
under the InfoTech 1998 Plan and 0.2 million options remain outstanding.
Page F-49
In March 2001, the shareholders of InfoTech USA, Inc. approved the InfoTech USA,
Inc. 2001 Flexible Stock Plan (the "InfoTech 2001 Plan"). Under the InfoTech
2001 Plan, the number of shares which were issued, or for which options, SARs or
performance shares may be granted to certain directors, officers and employees
of InfoTech USA, Inc. was 2.5 million with a provision for an annual increase,
effective as of the first day of each calendar year, commencing with 2002, equal
to 25% of the number of InfoTech USA, Inc.'s outstanding shares as of the first
day of such calendar year, but in no event more than 10.0 million shares in the
aggregate. As of December 31, 2003, 3.5 million stock options have been issued
under the InfoTech 2001 Plan, and 3.2 million were outstanding as of December
31, 2003. No SARs have been granted as of December 31, 2003. The options may not
be exercised until six-months to one year after the options have been granted,
and are exercisable over a period of ranging from seven to ten years.
VeriChip Corporation
In February 2002, the Board of Directors of VeriChip Corporation approved the
VeriChip Corporation 2002 Flexible Stock Plan (the "VeriChip 2002 Plan"). Under
the VeriChip 2002 Plan, the number of shares for which options, SARs or
performance shares may be granted to certain directors, officers and employees
is 8.0 million. As of December 31, 2003, 6.2 million options, net of
forfeitures, have been granted to directors, officers and employees under the
plan, and all of the options granted were outstanding as of December 31, 2003.
The options vest from one to two years from the date of grant and expire ten
years from the vesting date. As of December 31, 2003, no SARs have been granted
under the VeriChip 2002 Plan.
Thermo Life Energy Corp.
In April 2003, the Board of Directors of Thermo Life Energy Corp. approved the
Thermo Life Energy Corp. 2003 Flexible Stock Plan (the "Thermo Life 2003 Plan").
Under the Thermo Life 2003 Plan, the number of shares for which options, SARs or
performance shares may be granted to certain directors, officers and employees
is 7.0 million. As of December 31, 2003, 3.9 million options have been granted
to directors, officers and employees under the plan, and all of the options
granted were outstanding as of December 31, 2003. The options vest from six
months to three years from the date of grant and expire seven years from the
vesting date. As of December 31, 2003, no SARs have been granted under the
Thermo Life 2003 Plan.
All options granted under the stock option plans of the Company's subsidiaries
have been issued at the fair market value on the date of grant.
QUALIFIED EMPLOYEE STOCK PURCHASE PLAN
During 1999, the Company adopted a non-compensatory, qualified Employee Stock
Purchase Plan (the Stock Purchase Plan). Under the Stock Purchase Plan, options
are granted at an exercise price of the lesser of 85% of the fair market value
on the date of grant or 85% of the fair market value on the exercise date. Under
the Stock Purchase Plan, options for 0.9 million common shares were authorized
for issuance to substantially all full-time employees of the Company, of which
0.3 million shares have been issued and exercised through December 31, 2003.
Each participant's options to purchase shares will be automatically exercised
for the participant on the exercise dates determined by the Company's Board of
Directors.
16. STOCK-BASED COMPENSATION EXPENSE ASSOCIATED WITH OPTIONS AND NOTES
RECEIVABLE FOR STOCK ISSUANCES
The Company recovered approximately $1.3 million and incurred approximately $0.7
million and $5.3 million of non-cash, stock-based compensation expense during
2003, 2002 and 2001, respectively, due primarily to re-pricing 1.9 million stock
options during 2001. The re-priced options had original exercise prices ranging
from $6.90 to $63.40 per share and were modified to change the exercise price to
$1.50 per share. Due to the modification, these options are being accounted for
as variable options under APB No. 25 and, accordingly, fluctuations in the
Company's common stock price result in increases and decreases of non-cash,
stock-based compensation expense until the options are exercised, forfeited or
expired.
Page F-50
During 2003 and 2002, the Company incurred approximately $0.1 million and $4.1
million, respectively, for charges to increase valuation reserves associated
with the uncollectibility of notes received for stock issuances of which $0.1
million and $3.8 million, respectively, related to notes received for stock
issuances to directors and officers being held in escrow by the Company.
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, stock-based compensation expense of
approximately $18.7 million during 2002.
The non-cash, stock-based compensation charges associated with options and notes
receivable for stock issuances are included in the Consolidated Statements of
Operations in selling, general and administrative expense.
17. 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. The
Company's Board of Directors negotiated a severance agreement with Richard
Sullivan under which he received a one-time payment of 5.6. million shares of
the Company's common stock. The Company issued the shares to Richard Sullivan on
March 1, 2004. In addition, stock options held by him exercisable for
approximately 1.1 million shares of the Company's common stock were re-priced.
The options surrendered had exercise prices ranging from $1.50 to $3.20 per
share and were replaced with options exercisable at $0.10 per share. All of the
re-priced options have been exercised. Richard Sullivan's severance agreement
provides that the payment of shares and re-pricing of options provided for under
that agreement is in lieu of all future compensation and other benefits that
would have been owed to him under his employment agreement. Richard Sullivan's
employment agreement 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);
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 the Company's Chairman of the Board or Chief Executive Officer
for any reason other than due to his material default, with the
Company having the option to pay this amount in cash or in shares of
its common stock or any combination of the two. In the event the
Company opted to make any portion of the payment in shares of its
common stock, the agreement stipulated that the common stock was to
be valued at the average closing price of the stock on the Nasdaq
National Market (the Company's stock was, at the time the agreement
was entered into, listed on the Nasdaq National Market but has since
been transferred to the SmallCap) over the last five business days
prior to the date of the Triggering Event.
In total, the employment agreement obligated the Company to pay Richard Sullivan
approximately $17.3 million under, or in connection with, the termination of his
employment agreement. In view of the Company's cash constraints and its need at
the time to dedicate its cash resources to satisfying its obligations to IBM
Credit, the Company commenced negotiations with Richard Sullivan that led to the
proposed terms of his severance agreement. The severance agreement required the
Company to make approximately $3.9 million less in payments to Richard Sullivan
than would have been owed to him under his employment agreement.
Page F-51
On March 21, 2003, Jerome C. Artigliere, the Company's then Senior Vice
President and Chief Operating Officer, resigned from such positions. Under the
terms of his severance agreement, Mr. Artigliere received 0.5 million shares of
the Company's common stock. The Company issued the shares to Mr. Artigliere on
March 1, 2004. In addition, stock options held by him exercisable for
approximately 0.2 million shares of the Company's common stock were re-priced.
The options surrendered had exercise prices ranging from $1.50 to $3.20 per
share and were replaced with options exercisable at $0.10 per share. All of the
re-priced options have been exercised. Mr. Artigliere's severance agreement
provides that the payment of shares and re-pricing of options provided under
that agreement is in lieu of all future compensation and other benefits that
would have been owed to him under his employment agreement. That 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
negotiated a settlement of its obligations under Garrett Sullivan's severance
agreement that required the Company to issue to Garrett Sullivan 0.8 million
shares of the Company's common stock. The Company issued the shares, valued at
approximately $3.5 million, to Garrett Sullivan on February 17, 2004.
The Company's shareholders have approved the issuances of the common stock and
have ratified the re-pricing of the options under the terms of the severance
agreements with Richard J. Sullivan and Jerome C. Artigliere and they have
approved the issuance of the common stock under the agreement entered into with
Garrett Sullivan. The terms of each of the severance agreements were subject to
shareholder approval, in accordance with applicable Nasdaq rules, because the
agreements: (i) were deemed to be compensatory arrangements under which the
Company's common stock was being acquired by officers or directors; and (ii) in
Richard Sullivan's case, such issuance may have resulted in his potentially
holding more than 20% of the outstanding shares of the Company's common stock
following the issuance of the shares and exercise of options covered by his
severance agreement.
During the year ended December 31, 2003, as a result of the terminations of
Messrs. Sullivan and Artigliere, the Company recorded severance expense of
approximately $18.1 million, including $2.7 million of expense relating to the
re-priced options. The severance expense is included in the Consolidated
Statements of Operations in selling, general and administrative expense. The
remaining obligation under the severance agreements as of December 31, 2003, is
included in the Consolidated Balance Sheets as a component of additional paid-in
capital under the caption "Liability to be settled in common stock." The shares
were issued to Garrett Sullivan on February 17, 2004, and to Messrs. Sullivan
and Artigliere on March 1, 2004.
18. ASSET IMPAIRMENT
Asset impairment during the years ended December 31, 2003, 2002 and 2001
was:
2003 2002 2001
---- ---- ----
Goodwill:
Advanced Technology $ -- $ -- $30,453
Digital Angel Corporation -- 31,460 726
All Other 2,154 -- 32,427
- ---------------------------------- ------- ------- -------
Total goodwill 2,154 31,460 63,606
Property and equipment -- 6,860 2,372
Software and other 302 337 5,741
- ---------------------------------- ------- ------- -------
$ 2,456 $38,657 $71,719
================================== ======= ======= =======
Page F-52
As of December 31, 2003, the net carrying value of the Company's goodwill was
$63.3 million. There was no impairment of goodwill upon the adoption of FAS 142
on January 1, 2002. However, based upon the Company's annual review for
impairment, the Company recorded goodwill impairment charges of $2.2 million and
$31.5 million in the fourth quarters of 2003 and 2002, respectively. The
impairment charge recorded in 2003 relates to the goodwill associated with the
Company's InfoTech USA, Inc. segment. The impairment charge for 2002 relates to
the goodwill associated with Digital Angel Corporation's Wireless and Monitoring
division. (During the fourth quarters of 2003 and 2002, the Company also
impaired $2.4 million and $30.7 million of goodwill, respectively, and $0.6
million of intangible assets associated with Digital Angel Corporation's Medical
Systems operations, all of which are included in Discontinued Operations, as
more fully discussed in Note 20).
In accordance with FAS 142, upon adoption, the Company was required to allocate
goodwill to its reporting units. The Company's reporting units are those
businesses, which have goodwill and for which discrete financial information is
available and upon which segment management make operating decisions. The
Company's methodology for assigning goodwill to its reporting units is described
in Note 8.
As of December 31, 2002, the Company's reporting units consisted of the
following:
o Advanced Technology segment's Computer Equity Corporation:
o Advanced Technology segment's P. Tech, Inc.;
o Advanced Technology segment's Pacific Decision Sciences;
o Digital Angel Corporation's Animal Applications division;
o Digital Angel Corporation's Wireless and Monitoring division;
o Digital Angel Corporation's GPS and Radio Communications division;
o Digital Angel Corporation's Medical Systems division (consisting of
the business operations of MAS, which was acquired on March 27,
2002, and which is now included as part of Discontinued Operations
in the financial statements); and
o InfoTech USA, Inc.
The Company's reporting units at December 31, 2003, were the same as its
reporting units at December 31, 2002, except for the exclusion of Digital Angel
Corporation's Wireless and Monitoring division, as its goodwill was fully
impaired at December 31, 2002, as discussed below.
The Company's methodology for estimating the fair value of each reporting unit
during the fourth quarters of 2003 and 2002 was a combination of impairment
testing performed both internally and externally. The tests for the P-Tech.,
Inc., and Pacific Decision Sciences reporting units were performed internally
based primarily on discounted future cash flows. The tests for the Computer
Equity Corporation reporting unit, the reporting units associated with Digital
Angel Corporation and the InfoTech USA, Inc. reporting unit were performed
externally through the engagement of independent valuation professionals who
performed valuations using a combination of comparable company and discounted
cash flow analyses). The InfoTech USA, Inc. reporting unit has a fiscal year
ending on September 30, and therefore, these tests were performed during their
fiscal 2003 and 2002 fourth quarters. If the fair value of a reporting unit
exceeded its carrying value, then no further testing was required. However, if
the carrying value of a reporting unit exceeded its fair value, then an
impairment charge was recorded.
Digital Angel Corporation engaged an independent valuation firm to review and
evaluate the goodwill of Digital Angel Corporation, as reflected on the
Company's books as of December 31, 2003 and 2002. Independently, the valuation
firm reviewed the goodwill of the various reporting units (Animal Applications,
Wireless and Monitoring, GPS and Radio Communications and Medical Systems) at
the request of Digital Angel Corporation. Digital Angel Corporation's management
compiled the cash flow forecasts, growth rates, gross margin, fixed and variable
cost structure, depreciation and amortization expenses, corporate overhead, tax
rates, and capital expenditures, among other data and assumptions related to the
financial projections upon which the valuation reports were based.
Page F-53
The valuation firm's methodology including residual or terminal enterprise
values were based on the following factors: risk free rate of 10 years; current
leverage (E/V); leveraged beta - Bloomberg; unleveraged beta; risk premium; cost
of equity; after-tax cost of debt; and weighted average cost of capital. These
variables generated a discount rate calculation. The assumptions used in the
determination of fair value using discounted cash flows were as follows:
o Cash flows were generated for 5 years, which was the expected
recovery period for the goodwill;
o Earnings before interest, taxes, depreciation and amortization were
used as the measure of cash flow; and
o Discount rates ranging from 15% to 20% were used. The rates were
determined based on the risk free rate of the 10-year U.S. Treasury
Bond plus a market risk premium of 7.5%. (The discount rate utilized
by the Company was the rate of return expected from the market or
the rate of return for a similar investment with similar risks).
Residual or Terminal Enterprise Value Calculation:
The independent valuation firm was engaged by Digital Angel Corporation to
perform a company comparable analysis utilizing financial and market information
on publicly traded companies that are considered to be generally comparable to
the Animal Applications, Wireless and Monitoring, GPS and Radio Communications
and Medical Systems reporting units. Each analysis provided a benchmark for
determining the terminal values for each business unit to be utilized in its
discounted cash flow analysis. The analysis generated a multiple for each
reporting unit, which was incorporated into the appropriate business unit's
discounted cash flow model.
The analyses for 2002 indicated that all of the goodwill associated with Digital
Angel Corporation's Wireless and Monitoring division of approximately $31.5
million was impaired, as discussed below.
On November 26, 2001, the Company launched the Digital Angel product and during
2002, it marketed the product extensively. Despite the Company's aggressive
marketing campaign, the Digital Angel product did not achieve the Company's
forecasted revenues during 2002. Sales of the Digital Angel product were
affected, in part, by the lack of GPS tracking capabilities within buildings.
The Company is currently working on the development of the Digital Angel
technology to include assisted GPS capabilities to enhance these "line of sight"
issues. Neither the Company nor Digital Angel Corporation had a historical track
record of achieving forecasts for new or existing technology products. The
Digital Angel watch/pager is the primary revenue driver for the Digital Angel
Corporation's Wireless and Monitoring division. In addition to the "line of
sight issues," the poor sales are partly explained by an overestimation of
consumer demand as a result of a challenging economic environment (i.e.
consumers considered the Digital Angel watch/pager to be a discretionary luxury
item), and an uncertain marketplace (the Company overestimated consumer demand
for an innovative and new technology to be introduced into the consumer
marketplace). As of December 31, 2002, Digital Angel Corporation's Wireless and
Monitoring segment had not recorded any significant revenues from its Digital
Angel product and it had not achieved the revenue projections used as the basis
for the Company's impairment tests upon the adoption of FAS 142 on January 1,
2002. At December 31, 2002, the market value of the Company's investment in
Digital Angel Corporation (AMEX:DOC) was approximately $50.0 million. In
consideration of these factors, the newness of the Digital Angel Technology, the
operating history of Digital Angel Corporation, the challenging economic
environment and uncertainties in the marketplace along with the independent fair
value measurement valuations performed by the independent professionals, and
other valuations performed, the Company concluded that future cash flows from
certain operations would not be sufficient to recover all of the $31.5 million
of goodwill associated with Digital Angel Corporation's Wireless and Monitoring
division. Accordingly, this amount was recorded as an impairment charge during
the fourth quarter of 2002.
Page F-54
The Company's InfoTech USA, Inc. segment operates on a September 30 fiscal year
end. As part of InfoTech USA, Inc.'s fiscal year end planning cycle, they
engaged an independent valuation firm to review and evaluate their goodwill of
approximately $2.2 million. The goodwill resulted from prior acquisitions by
InfoTech USA, Inc. The methodology used by the independent valuation firm to
evaluate InfoTech USA, Inc.'s goodwill was the same as discussed above for the
evaluations associated with Digital Angel Corporation. Based on the evaluation,
InfoTech USA, Inc.'s goodwill was not impaired as of September 30, 2003.
However, InfoTech USA, Inc. has not achieved its projected operating results,
and it has not returned to profitability (InfoTech USA, Inc. has incurred losses
during the past several years.). Also, the market value of InfoTech USA, Inc.'s
common stock, even after adjustment for its limited public float, was
significantly less at December 31, 2003, than its book value. In addition, third
parties had expressed interest in purchasing InfoTech USA, Inc. for amounts less
than the Company's carrying value. As a result of these factors, the Company
believes that the full value of InfoTech USA, Inc.'s goodwill of approximately
$2.2 million was impaired as of December 31, 2003.
Future goodwill impairment reviews may result in additional write-downs. Such
determination involves the use of estimates and assumptions, which may be
difficult to accurately measure or value.
In the fourth quarter of 2002, Digital Angel Corporation impaired $6.4 million
of software associated with its Wireless and Monitoring segment. The write off
related to an exclusive license to a digital encryption and distribution
software system. The charge is included in the Consolidated Statements of
Operations under the caption Asset Impairment.
As a result of the economic slowdown during 2001, the Company experienced
deteriorating sales for certain of its businesses. In addition, management
concluded that a full transition to an advanced technology company required the
sale or closure of all units that did not fit into the Company's new business
model or were not cash-flow positive. This resulted in the shutdown of several
of the Company's businesses during the third and fourth quarters of 2001 and the
first quarter of 2002. Also, letters of intent that the Company had received
during the last half of 2001 and the first quarter of 2002 related to the sale
of certain of its businesses indicated a decline in their fair values. The sale
of these businesses did not comprise the sale of an entire business segment.
Based upon these developments, the Company reassessed its future expected
operating cash flows and business valuations and at December 31, 2001, it
performed undiscounted cash flow analyses by business unit to determine if an
impairment existed. For purposes of these analyses, earnings before interest,
taxes, depreciation and amortization were used as the measure of cash flow. When
an impairment was determined to exist, any related impairment loss was
calculated based on fair value. Fair value was determined based on discounted
cash flows. The discount rate utilized by the Company was the rate of return
expected from the market or the rate of return for a similar investment with
similar risks. This reassessment resulted in the asset impairments listed above
during 2001. The assumptions used in the Company's determination of fair value
using discounted cash flows were as follows:
o Cash flows were generated for periods ranging from 5 to 10 years
based on the expected life of the business' goodwill;
o Earnings before interest, taxes, depreciation and amortization were
used as the measure of cash flow; and
o A discount rate of 12.0% was used. The rate was determined based on
the risk free rate of the 10 year U.S. Treasury Bond plus a market
risk premium of 7%.
As a result of the restructuring and revision to the Company's business model,
the plan to implement an enterprise wide software system purchased in 2000 was
discontinued during the third quarter of 2001, at which time the associated
software costs were fully written off and the computer hardware was written down
to its estimated net realizable value. During 2002, the remaining value of the
equipment, which was no longer deemed saleable of approximately $0.5 million,
was written off.
Page F-55
19. INCOME TAXES
The provision for income taxes consists of:
2003 2002 2001
-------- -------- --------
Current:
United States at statutory rates $ 101 $ 392 $ --
-------- -------- --------
International -- 3 --
Current taxes covered by net operating
loss -- -- (565)
-------- -------- --------
Current income tax provision (credit) 101 395 (565)
-------- -------- --------
Deferred:
United States 1,601 (69) 21,484
International -- -- (49)
-------- -------- --------
Deferred income taxes provision (credit) 1,601 (69) 21,435
-------- -------- --------
$ 1,702 $ 326 $ 20,870
======== ======== ========
The tax effects of temporary differences and carryforwards that give rise to
significant portions of deferred tax assets and liabilities consist of the
following:
2003 2002
-----------------------------
Deferred Tax Assets:
Liabilities and reserves $ 6,104 $ 6,000
Stock-based compensation 11,847 7,799
Property and equipment 2,142 2,115
Net operating loss carryforwards 68,504 80,222
- -------------------------------------------------------------------------------
Gross deferred tax assets 88,597 96,136
Valuation allowance (87,274) (93,214)
- -------------------------------------------------------------------------------
1,323 2,922
- -------------------------------------------------------------------------------
Deferred Tax Liabilities:
Accounts receivable -- 366
Installment sales 1,151 1,151
Property and equipment -- --
Intangible assets 172 169
- -------------------------------------------------------------------------------
1,323 1,686
- -------------------------------------------------------------------------------
Net Deferred Tax Asset $ -- $ 1,236
===============================================================================
The current and long-term components of the deferred tax asset are as follows:
2003 2002
-------------------------
Current deferred tax asset $ -- $ 13
Long-term deferred tax asset -- 1,223
- --------------------------------------------------------------------------------
$ -- $1,236
================================================================================
The valuation allowance for deferred tax asset decreased by $5.9 million and
increased by $26.3 million in 2003 and 2002, respectively, due mainly to the
generation and use of net operating losses. The valuation allowance was provided
for net deferred tax assets that exceeded the Company's available carryback and
the level of existing deferred tax liabilities and projected pre-tax income. The
deferred tax asset of $1.2 million at December 31, 2002, relates entirely to the
Company's 52.5% interest its InfoTech USA, Inc. subsidiary, which files a
separate federal income tax return.
Page F-56
Approximate domestic and international loss from continuing operations before
provision for income taxes consists of:
2003 2002 2001
------------------------------------------------
Domestic $ 12,312 $(95,464) $(158,552)
International (2,004) (513) (9,589)
- --------------------------------------------------------------------------------
$ 10,308 $(95,977) $(168,141)
================================================================================
At December 31, 2003, the Company had aggregate net operating loss carryforwards
of approximately $171.3 million for income tax purposes that expire in various
amounts through 2022. In 2003, the Company's gain on extinguishment of the IBM
debt is excluded from taxable income under ss. 108(a)(1)(B) of the Internal
Revenue Code. As a result, the net operating loss carryforwards at December 31,
2003, have been reduced by the amount of the gain of $70.1 million.
Approximately $14.2 million of the net operating loss carryforwards were
acquired in connection with various acquisitions and are limited as to use in
any particular year based on Internal Revenue Code sections related to separate
return year and change of ownership restrictions. Digital Angel Corporation and
InfoTech USA, Inc. file separate federal income tax returns. Of the aggregate
net operating loss carryforwards, $33.9 million and $4.7 million relate to
Digital Angel Corporation and InfoTech USA, Inc., respectively. These net
operating loss carryforwards are available to only offset future taxable income
of those companies.
The reconciliation of the effective tax rate with the statutory federal income
tax benefit rate is as follows:
2003 2002 2001
--------------------------------
% % %
--------------------------------
Statutory benefit rate 34 34 34
Nondeductible goodwill amortization/impairment 27 (17) (17)
State income taxes, net of federal benefits 2 -- --
International tax rates different from the
the statutory US federal rate -- -- (2)
Increase in value of warrants exercisable
in Digital Angel common stock 10 -- --
Nondeductible interest 53 -- --
Change in deferred tax asset valuation
Allowance (104)(1) (20) (30)
Other 3 3 3
- --------------------------------------------------------------------------------
25 -- (12)
================================================================================
(1) INCLUDES THE TAX EFFECT ON STOCK OPTIONS EXERCISED IN 2003 OF 18%.
Page F-57
20. DISCONTINUED OPERATIONS
During the three-months ended June 30, 2004, Digital Angel Corporation's Board
of Directors approved a plan to sell its Medical Systems operations, which were
acquired on March 27, 2002, and the business assets of Medical Systems were sold
effective April 19, 2004. Medical Systems represented the business operations of
MAS. On March 31, 2002, the Company's 93% owned subsidiary, Digital Angel
Corporation, referred to as pre-merger Digital Angel, merged with MAS and MAS
changed its name to Digital Angel Corporation. Medical Systems business
activities consisted of a staff of logistics specialists and physicians who
provided medical assistance services and interactive medical information
services to people traveling anywhere in the world. Services included
coordination of medical care, provision of general medical information,
physician consultation, translation assistance, claims handling and cost
containment on behalf of assistance companies, insurance companies and managed
care organizations. It also offered medical training services to the maritime
industry, and sold a variety of kits containing pharmaceutical and medical
supplies to its maritime and airline customers through its pharmaceutical
warehouse facility located in Owings, Maryland.
The business assets of Medical Systems were sold to MedAire, Inc. in connection
with an Asset Purchase Agreement, referred to as APA, dated April 8, 2004, by
and between Digital Angel Corporation and MedAire, Inc. Under the terms of the
APA, the purchase price was $0.4 million, plus any prepaid deposits, the cost of
certain pharmaceutical inventory and supplies, and the assumption of certain
liabilities, reduced by any pre-billing to or pro-rata prepayments by certain
customers. The assets sold included all of the tangible and intangible
intellectual property developed for the medical services business including
pharmaceutical supplies and other inventory items, customer and supplier
contracts, computer software licenses, internet website and domain name and
mailing lists, but did not include the land and building used by this operation.
Medical Systems' land and building were sold in a separate unrelated transaction
to a third party on July 31, 2004 for approximately $1.5 million.
Medical Systems was one of the Company's reporting units in accordance with FAS
142. Accordingly, the financial condition, results of operations and cash flows
of Medical Systems have been reported as Discontinued Operations in the
Company's financial statements, and prior periods have been restated. The
following discloses the operating losses from Discontinued Operations for the
years ended December 31, 2003 and 2002, which consist of the losses attributable
to Medical Systems:
YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31,
--------------------------------
(AMOUNTS IN THOUSANDS)
2003 2002
---- ----
Product revenue $ 875 $ 546
Service revenue 1,405 1,181
--------------------------------
Total revenue 2,280 1,727
Cost of products sold 383 270
Cost of services sold 1,172 823
--------------------------------
Total cost of products and services sold 1,555 1,093
--------------------------------
Gross profit 725 634
Selling, general and administrative expense 776 769
Asset impairment 2,986 30,725
Depreciation and amortization 492 409
Interest and other income (196) (16)
Interest expense 149 47
Minority interest (1,048) (6,895)
--------------------------------
Loss from Discontinued Operations $ (2,434) $(24,405)
================================
Page F-58
The above results do not include any allocated or common overhead expenses. The
Company has not provided a benefit for income taxes on the losses attributable
to Medical Systems. The Company does not anticipate Medical Systems incurring
additional losses in the future. However, in accordance with FAS 144, any
additional operating losses or changes in the values of assets or liabilities
will be reflected in the Company's financial statements as incurred.
The asset impairments for Medical Systems consisted of the impairment of
goodwill of approximately $2.4 million and $30.7 million as a result of the
Company's annual impairment tests performed during the fourth quarters of 2003
and 2002, respectively. In addition, during the fourth quarter of 2003, the
Company incurred an impairment charge of approximately $0.6 million related to
Medical Systems' intangible assets.
On March 1, 2001, the Company's Board of Directors approved a plan to offer for
sale its IntelleSale business segment and several 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
non-core 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 the Company's core businesses. Accordingly, these
operating results have been reclassified and reported as discontinued operations
for all periods presented. The plan of disposal anticipated that these entities
would be sold or closed within 12 months from March 1, 2001, the defined
"measurement date".
As of December 31, 2003, the Company has sold or closed all of the businesses
comprising Discontinued Operations. Proceeds from the sales of Discontinued
Operations companies were used primarily to repay amounts outstanding under the
IBM Credit Agreement.
The following discloses the results of the discontinued operations for the
period January 1, 2001 to March 1, 2001. The income for the period January 1
through March 1, 2001 consists of the income attributable to the Company's
Intellesale and all other non-core businesses:
JANUARY 1, 2001
TO
MARCH 1, 2001
(in thousands)
Product revenue $13,039
Service revenue 846
- ----------------------------------------------------------------- -------
Total revenue 13,885
Cost of products sold (exclusive of depreciation and 10,499
amortization shown separately below)
Cost of services sold 259
- ----------------------------------------------------------------- -------
Total cost of products and services sold (exclusive of 10,758
depreciation and amortization shown separately below)
Selling, general and administrative expense 2,534
Depreciation and amortization 264
Interest, net 29
Provision for income taxes 34
Minority interest 53
- ----------------------------------------------------------------- -------
Income from Discontinued Operations $ 213
================================================================= =======
The above results do not include any allocated or common overhead expenses.
Included in Interest, net, above are interest charges based on the debt of one
of these businesses. This debt was repaid when the business was sold on January
31, 2002.
Page F-59
Assets and liabilities of Discontinued Operations are as follows at
December 31:
MEDICAL SYSTEMS DIVISION: 2003 2002
-------- --------
Assets
Cash and cash equivalents $ -- $ 9
Accounts and unbilled receivables, net 453 490
Inventories 46 57
Other current assets 43 54
Property and equipment, net 1,137 1,390
Goodwill, net -- 2,367
Intangible and other Assets, net 652 1,710
- ----------------------------------------------------------------------------------------
Total Assets $ 2,331 $ 6,077
========================================================================================
Current Liabilities
Notes payable and current
maturities of long-term debt $ 910 $ 960
Accounts payable 71 241
Accrued expenses 99 2,039
- ----------------------------------------------------------------------------------------
Total Current Liabilities 1,080 3,240
Minority interest -- --
- ----------------------------------------------------------------------------------------
Total Liabilities 1,080 3,240
- ----------------------------------------------------------------------------------------
Net Assets Of Medical Systems Division $ 1,251 $ 2,837
========================================================================================
INTELLESALE AND OTHER NON-CORE BUSINESSES: 2003 2002
Assets -------- --------
Cash and cash equivalents $-- $ 66
Accounts and unbilled receivables, net -- 167
Inventories -- 38
Property and equipment, net -- 56
- ----------------------------------------------------------------------------------------
Total Assets $ -- $ 327
========================================================================================
Current Liabilities
Notes payable and current
maturities of long-term debt $ 26 $ 26
Accounts payable 4,178 4,189
Accrued expenses 5,341 5,334
- ----------------------------------------------------------------------------------------
Total Current Liabilities 9,545 9,549
Minority interest -- 146
- ----------------------------------------------------------------------------------------
Total Liabilities 9,545 9,695
- ----------------------------------------------------------------------------------------
Net Liabilities Of Intellesale and
Other Non-Core Businesses $ (9,545) $ (9,368)
========================================================================================
TOTAL DISCONTINUED OPERATIONS: 2003 2002
Assets -------- --------
Cash and cash equivalents $ -- $ 75
Accounts and unbilled receivables, net 453 657
Inventories 46 95
Other current assets 43 54
Property and equipment, net 1,137 1,446
Goodwill, net -- 2,367
Intangible and other Assets, net 652 1,710
- ----------------------------------------------------------------------------------------
Total Assets $ 2,331 $ 6,404
========================================================================================
Current Liabilities
Notes payable and current
maturities of long-term debt $ 936 $ 986
Accounts payable 4,249 4,430
Accrued expenses 5,440 7,373
- ----------------------------------------------------------------------------------------
Total Current Liabilities 10,625 12,789
Minority interest -- 146
- ----------------------------------------------------------------------------------------
Total Liabilities 10,625 12,935
- ----------------------------------------------------------------------------------------
Total Net Liabilities Of Discontinued Operations $ (8,294) $ (6,531)
========================================================================================
The Company has sold or closed all of the businesses comprising Discontinued
Operations. Proceeds from the sales of the Discontinued Operations companies
were used primarily to repay outstanding debt.
Page F-60
The Company accounted for the Intellesale segment and its other non-core
businesses as Discontinued Operations in accordance with Accounting Principles
Board 30, Reporting the Results of Operations-Reporting the Effects of Disposal
of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions ("APB 30"). APB 30, of which portions related
to the accounting for discontinued operations have been superceded by the
provisions of FAS 144, required that the Company accrue estimates for future
operating losses, gains/losses on sale, costs to dispose and carrying costs of
these businesses at the time the businesses were discontinued. Accordingly, at
December 31, 2000, the Company recorded a provision for operating losses and
carrying costs during the phase-out period for its Intellesale and other
non-core businesses including estimated disposal costs to be incurred in selling
the businesses. Carrying costs consisted primarily of cancellation of facility
and equipment leases, legal settlements, employment contract buyouts and sales
tax liabilities.
During 2003, 2002 and 2001, Discontinued Operations incurred an increase
(decrease) in estimated loss on disposal and operating losses accrued on the
measurement date of $0.4 million, $(1.4) million and $16.7 million,
respectively. The primary reasons for the increase in estimated losses for 2003
were an increase in estimated facility cancellation costs of $0.2 million and
the operations of the one remaining business unit in Discontinued Operations,
which was sold in July 2003. The primary reason for the decrease in estimated
losses for 2002 was the settlement of litigation for an amount less than
anticipated. The primary reasons for the increase in estimated losses for 2001
were inventory write-downs of $4.5 million, a decrease in estimated sales
proceeds as certain of the businesses were closed in the second and third
quarters of 2001, an increase in legal expenses related to ongoing litigation,
additional sales tax liabilities and additional facility lease costs. The
business closures in 2001 were the result of a combination of the deteriorating
market conditions for the technology sector as well as the Company's strategic
decision to reallocate funding to its core businesses. The Company also
increased its estimated loss on the sale of Innovative Vacuum Solutions, Inc.,
which was sold during the second quarter of 2001, by $0.2 million, and on the
Company's 85% owned subsidiary, Ground Effects Ltd., which was sold in the first
quarter of 2002, by $1.2 million.
The Company does not anticipate any future losses related to Discontinued
Operations as a result of changes in carrying costs. However, actual losses
could differ from its estimates and any adjustments will be reflected in the
Company's future financial statements. During the years ended December 31, 2003,
2002 and 2001, the estimated amounts recorded were as follows:
----------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31,
2003 2002 2001
---- ---- ----
(amounts in thousands)
Operating losses and estimated loss
on the sale of business units $205 $684 $13,010
Carrying costs 177 (2,104) 3,685
----------------------------------------------
$382 $(1,420) $16,695
==============================================
A provision (benefit) for income taxes was not provided on the change in
estimated loss on disposal and operating losses during the phase out period due
to the Company's net operating losses.
Page F-61
The following table sets forth the roll forward of the liabilities for operating
losses and carrying costs from December 31, 2001, through December 31, 2003:
Balance, Balance
Type of Cost December 31, 2001 Additions Deductions December 31, 2002
- --------------------------------------- --------------------- ---------------------- ------------------ -----------------------
Operating losses and estimated loss
on sale $ 1,173 $684 $1,857 $ --
Carrying costs 7,218 (2,104) 206 4,908
--------------------- ---------------------- ------------------ -----------------------
Total $ 8,391 $(1,420) $2,063 $ 4,908
===================== ====================== ================== =======================
Balance, Balance
Type of Cost December 31, 2002 Additions Deductions December 31, 2003
- --------------------------------------- --------------------- ---------------------- ------------------ -----------------------
Operating losses and estimated loss
on sale $ -- $205 $205 $ --
Carrying costs (1) 4,908 177 172 4,913
- --------------------------------------- --------------------- ---------------------- ------------------ -----------------------
Total $ 4,908 $382 $377 $4,913
======================================= ===================== ====================== ================== =======================
(1) Carrying costs at December 31, 2003, include all estimated costs to
dispose of the discontinued businesses including $2.2 million for
lease commitments, $1.7 million for severance and employment
contract settlements and $1.0 million for sales tax liabilities.
21. EXTRAORDINARY GAIN AND IMPACT OF FAS 145
The Company recorded an extraordinary gain as a result of settling certain
disputes between the Company and the former owners of Bostek, Inc. and an
affiliate (Bostek). As part of the settlement agreement, the parties agreed to
forgive a $9.5 million payable provided the Company registered approximately 0.3
million shares of the Company's common stock by June 15, 2001. The Company was
successful in meeting the June 15, 2001 registration deadline, and accordingly,
the extinguishment of the $9.5 million payable was recorded in 2001 as an
extraordinary gain.
CHANGE IN METHOD OF ACCOUNTING FOR EXTINGUISHMENT OF DEBT - IMPACT OF FAS 145
As required, the Company has adopted FAS 145 effective January 1, 2003. Under
FAS 145, gains and losses on the extinguishment of debt are included as part of
continuing operations. FAS 145 requires all periods presented to be consistent,
and as such, gains and losses on the extinguishment of debt previously recorded
as extraordinary must be reclassified from extraordinary treatment and presented
as a component of continuing operations.
Page F-62
The following table presents the impact of FAS 145 on the Company's Consolidated
Statements of Operations as indicated (in thousands, except per share amounts):
YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31,
2002 2001
------------ ------------
Loss from continuing operations before provision (benefit)
for income taxes and minority interest: Loss from continuing
operations before provision (benefit) for income taxes and
minority interest, as previously reported $ (95,977) $ (177,606)
Gain from extinguishment of debt, previously reported as
extraordinary -- 9,465
------------ ------------
Adjusted loss from continuing operations before provision
(benefit) for income taxes and minority interest $ (95,977) $ (168,141)
============ ============
Loss from continuing operations before minority interest:
Loss from continuing operations before minority interest, as
previously reported $ (96,303) $ (198,476)
Gain from extinguishment of debt, previously reported as
extraordinary -- 9,465
Deduct taxes on gain from extinguishment of debt (1) -- --
------------ ------------
Adjusted loss from continuing operations before
minority interest $ (96,303) $ (189,011)
============ ============
Loss from continuing operations:
Loss from continuing operations, as previously reported $ (89,500) $ (198,086)
Gain from extinguishment of debt, previously reported as
extraordinary -- 9,465
Deduct taxes on gain from extinguishment of debt (1) -- --
------------ ------------
Adjusted loss from continuing operations $ (89,500) $ (188,621)
============ ============
Loss before extraordinary gain:
Loss before extraordinary gain, as previously reported $ (112,485) $ (214,568)
Gain from extinguishment of debt, previously reported as
extraordinary -- 9,465
Deduct taxes on gain from extinguishment of debt (1) -- --
------------ ------------
Adjusted loss before extraordinary gain $ (112,485) $ (205,103)
============ ============
Earnings (loss) per common share - basic and diluted:
Loss from continuing operations, as previously reported $ (3.33) $ (12.27)
Gain from extinguishment of debt, previously reported as
Extraordinary -- 0.56
------------ ------------
Adjusted loss from continuing operations $ (3.33) $ (11.71)
============ ============
Earnings (loss) per common share - basic and diluted:
Extraordinary gain, previously as reported $ -- $ (0.56)
Reclassify gain from extinguishment of debt -- (0.56)
------------ ------------
Adjusted extraordinary gain $ -- $ --
============ ============
(1) No taxes were provided on the gain from the extinguishment of debt
due to the Company's net operating losses.
Page F-63
22. EARNINGS (LOSS) PER SHARE
A reconciliation of the numerator and denominator of basic and diluted
earnings (loss) per share is provided as follows:
2003 2002 2001
---- ---- ----
NUMERATOR:
Income (loss) from continuing operations $ 5,959 $ (89,500) $ (188,621)
Preferred stock dividends -- -- (1,147)
Accretion of beneficial conversion feature
of redeemable preferred stock -- -- (9,392)
- ------------------------------------------------------------------------------- ----------- ----------- -----------
Numerator for basic earnings per share -
Income (loss) from continuing operations available to common
stockholders 5,959 (89,500) (199,160)
(Loss) income from discontinued operations available to
common stockholders (2,816) (22,985) (16,482)
- ------------------------------------------------------------------------------- ----------- ----------- -----------
Net income (loss) available to common stockholders $ 3,143 $ (112,485) $ (215,642)
=============================================================================== =========== =========== ===========
DENOMINATOR:
Denominator for basic earnings per
share - weighted-average shares outstanding (1) 36,178 26,923 17,001
Weighted-average shares:
Stock options 759 -- --
Warrants 362 -- --
- ------------------------------------------------------------------------------- ----------- ----------- -----------
Denominator for diluted earnings per
share - weighted-average shares outstanding (1) 37,299 26,923 17,001
- ------------------------------------------------------------------------------- ----------- ----------- -----------
EARNINGS (LOSS) PER SHARE - BASIC
Continuing operations $ 0.17 $ (3.33) $ (11.71)
Discontinued operations (0.08) (0.85) (0.97)
- ------------------------------------------------------------------------------- ----------- ----------- -----------
TOTAL - BASIC $ 0.09 $ (4.18) $ (12.68)
=============================================================================== =========== =========== ===========
EARNINGS (LOSS) PER SHARE - DILUTED
Continuing operations $ 0.16 $ (3.33) $ (11.71)
Discontinued operations (0.08) (0.85) (0.97)
- ------------------------------------------------------------------------------- ----------- ----------- -----------
TOTAL - DILUTED $ 0.08 $ (4.18) $ (12.68)
=============================================================================== =========== =========== ===========
- ------------------
(1) The weighted-average shares listed below were not included in the
computation of diluted loss per share for the years ended December 31,
2003, 2002 and 2001, because to do so would have been anti-dilutive.
2003 2002 2001
------ ------ ------
Debenture conversion 749 -- --
Redeemable preferred stock conversion -- -- 14,077
Warrants -- 295 --
Stock options -- 1,540 417
- --------------------------------------------------------------------------------
749 1,835 14,494
================================================================================
Page F-64
23. COMMITMENTS AND CONTINGENCIES
Rentals of space, vehicles, and office equipment under operating leases amounted
to approximately $1.7 million, $2.0 million and $3.5 million for the years ended
December 31, 2003, 2002 and 2001, respectively.
The approximate minimum payments required under operating leases and employment
contracts that have initial or remaining terms in excess of one year at December
31, 2003, are as follows (in thousands):
MINIMUM EMPLOYMENT
YEAR RENTAL PAYMENTS CONTRACTS
- --------------------------------------------------------------------------------
2004 $1,345 $1,660
2005 939 648
2006 577 367
2007 590 --
2008 573 --
Thereafter 9,134 --
- --------------------------------------------------------------------------------
$13,158 $2,675
================================================================================
The Company currently does not have employment contracts with any of the
executive officers of Applied Digital Solutions, Inc. The Company has
established a severance policy for its executive officers under which, if it
terminates an executive officer without cause, as defined, or the employee
resigns with good reason the employee will receive severance payments. Under the
policy, senior vice presidents and above will receive one year of base salary
and vice presidents will receive six-months of base salary, based on the salary
in effect at time of the termination. The severance amount is reduced by half if
the employee has been in the Company's employ for less than one year. Payments
cease if, in any material respect, the employee engages in an activity that
competes with the Company or if the employee breaches a duty of confidentiality.
On June 30, 2003, the Company's Board of Directors (through the Compensation
Committee) approved the payment of approximately $4.3 million in discretionary
bonus awards. The approval of the bonuses directly reflected the efforts of
certain employees/directors in satisfying all of the Company's obligations to
IBM Credit, which resulted in the Company recording a gain on the extinguishment
of debt of $70.1 million during 2003. These bonuses are more fully described in
Note 2.
The Company has entered into employment contracts with key officers and
employees of the Company's subsidiaries. The agreements are for periods ranging
from one to three years through February 2007. Some of the employment contracts
also call for bonus arrangements based on earnings of a particular subsidiary.
The Company recorded $0.0 million and $0.5 million associated with these bonus
arrangements during 2003 and 2002, respectively.
On March 24, 2003, the Company terminated its employment agreements with two of
its executive officers. The terms of the IBM Credit Agreement limited the amount
of salary the Company could pay these executive officers in cash and prevented
the Company from making certain cash incentive and perquisite payments to these
executive officers. These terminations are more fully discussed in Note 17.
Effective December 31, 2001, one of the Company's directors, who had previously
been an executive officer of the Company, retired and resigned from the Board of
Directors. As part of his termination agreement, the Company agreed to grant him
0.2 million shares of the Company's common stock the value of which was recorded
as compensation expense in the year ended December 31, 2001.
Page F-65
One of Computer Equity Corporation's major suppliers has filed a UCC lien
against the ongoing accounts receivable related to Computer Equity Corporation's
telecommunications infrastructure contract with the United States Postal
Service. Currently Computer Equity Corporation is current on all payment
obligations under the contract.
24. PROFIT SHARING PLAN
The Company has a savings plan under section 401(k) of the Internal Revenue Code
for the benefit of eligible United States employees. The Company has made no
contributions to the 401(k) Plan.
In 1994, MAS adopted a Retirement Savings Plan (the "MAS Plan") in accordance
with Section 401(k) of the Internal Revenue Code. The MAS Plan is available to
all eligible employees of the Medical Systems division. Digital Angel
Corporation provides for discretionary matching contributions to the MAS Plan
equal to a percentage of the participant's contributions. Digital Angel
Corporation made no contributions to the MAS Plan during 2003 or 2002.
The Company's international subsidiary operates certain defined contribution
pension plans. The Company's expense relating to the plans approximated $0.1
million, $0.1 million and $0.2 million for the years ended December 31, 2003,
2002 and 2001, respectively.
25. LEGAL PROCEEDINGS
The Company is party to various legal proceedings and other legal matters
encompassing all threatened, pending claims, judgments and or settlements, etc.,
and accordingly, has recorded a provision of $3.7 million in the financial
statements at December 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.
On January 31, 2002, Treeline, Inc. filed a complaint in the Common Pleas Court
of Cuyahoga County, Ohio against the Company, and one of the Company's
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 the Company. On May 15, 2003, the Company settled the dispute with Treeline,
Inc., subject to certain conditions subsequent. The settlement provided for the
issuance of 0.1 million shares of the Company's common stock, subject to price
protection provisions under the settlement agreement. The Securities and
Exchange Commission declared the Company's Registration Statement registering
the 0.1 million shares issued in connection with this settlement agreement
effective on September 10, 2003.
On March 31, 2002, 510 Ryerson Road, Inc. filed a lawsuit against the Company
and one of its subsidiaries in connection with a lease for a facility that the
Company vacated prior to the expiration of the lease and which is no longer in
use. The plaintiffs demanded relief in the amount of $2.0 million. The Company
has entered into a settlement agreement with the plaintiffs pursuant to which it
issued to the plaintiff shares having a value of approximately $1.1 million plus
interest. The shares were issued on February 17, 2004.
On May 20, 2002, a purported securities fraud class action was filed against the
Company and one of its former directors. In the following weeks, fourteen
virtually identical complaints were consolidated into a single action, In re
Applied Digital Solutions Litigation, which was filed in the United States
District Court for the Southern District of Florida. In March 2003, the Company
entered into a memorandum of understanding to settle the pending lawsuit. The
settlement of $5.6 million will be entirely covered by proceeds from insurance,
and is subject to approval by the District Court. In December 2003, the District
Court issued a preliminary approval of the class action settlement and directed
that Class Members be given notice of the Settlement. The final hearing, at
which the Court will consider whether to issue its final approval and enter
final judgment, is set for March 19, 2004.
Page F-66
On October 22, 2002, Anat Ebenstein, InfoTech USA, Inc.'s former Chief Executive
Officer, filed a complaint against the Company and InfoTech USA, Inc. and
certain officers and directors in connection with the termination of her
employment. The complaint filed in the Superior Court of New Jersey, Mercer
County, seeks compensatory and punitive damages of $1.0 million arising from an
alleged improper termination. The action is currently in the discovery stage.
The Company believes that a portion of any ultimate damages may be covered under
insurance.
On October 22, 2003, Melvin Maudlin (the "Plaintiff"), a former employee at the
Company's subsidiary, Pacific Decision Sciences Corporation ("PDSC"), filed suit
in the Superior Court of California against PDSC, Hark Vasa and the Company in
connection with a purported trust agreement involving PDSC which, according to
the Plaintiff provides that he is to receive monthly payments of $10,000 for
approximately 17 years. The Plaintiff has obtained a pre-judgment right to
attach order in the amount of his total claim of $2.1 million and subsequently
obtained a purported writ of attachment of certain PDSC assets. The suit has not
materially affected PDSC's ability to operate its business but could affect such
operations in the future. Discovery has not yet begun, and no trial date has
been set. The Company intends to vigorously defend this suit.
In February 2003, an action was filed in Middlesex County Superior Court in the
Commonwealth of Massachusetts. Digital Angel Corporation's subsidiary, OuterLink
(OuterLink was acquired in January 2004, see Note 30), as well as a significant
stockholder of OuterLink and a principal of the significant stockholder are
named as defendants. Such principal was a director of OuterLink. The complaint
alleged breach of an August 25, 1999 employment contract. The plaintiff was
President and Chief Executive Officer of OuterLink from July 1999 through August
2002. The Complaint seeks damages based principally on a contractual severance
provision that allegedly provided for four months of compensation for every year
or fraction thereof served prior to termination. At the time of termination, the
complaint alleges that the plaintiff's salary was approximately $0.3 million per
year. The Defendants answered denying all liability and asserting a
counterclaim. Discovery will be completed in this matter shortly and the
Defendants intend to vigorously defend this matter and pursue their
counterclaim. The ultimate outcome of this proceeding cannot be predicted at
this time and the Company is currently unable to determine the potential effect
of this litigation on its consolidated financial position, results of operation
or cash flows.
In June 2002, eResearch Technology, Inc. f/k/a Premier Research Worldwide, Ltd.
("ERT") commenced a proceeding in the United States District Court for the
District of New Jersey against U.S. Bank National Association ("US Bank") and
Digital Angel Corporation. This suit was commenced to pursue alleged damages of
approximately $0.4 million due to the Digital Angel Corporation and US Bank's
alleged failure to register transfers of restricted Digital Angel Corporation
stock sold by ERT in May 2002. Digital Angel Corporation has agreed to indemnify
US Bank for all damages and reasonable costs relating to this litigation.
Digital Angel Corporation has asserted a counterclaim against ERT based on ERT's
breach of a license agreement and services agreements between the parties that
resulted in the original issuance of approximately 0.6 million restricted shares
of Digital Angel Corporation's common stock to ERT. The damages to Digital Angel
Corporation exceed $4 million and this amount does not include the share of
profits, which Digital Angel Corporation seeks to recover had ERT not breached
the agreements. Further, the alleged damages sought by the Plaintiff in this
matter do not take into account plaintiff's duty to mitigate damages, which if
discharged, would have resulted in a profit to ERT. The ultimate outcome of this
proceeding cannot be predicted at this time, and the Company is currently unable
to determine the potential effect of this litigation on its consolidated
financial position, results of operation or cash flows.
In February 2004, Electronic Identification Devices, Ltd. ("EID") commenced a
Declaratory Judgment Action against Digital Angel Corporation in the United
States District Court for the Western District of Texas. This action seeks a
declaration of patent non-infringement relating to Digital Angel Corporation's
syringe implantable identification transponders. Monetary damages are not being
sought. The lawsuit alleges that Plaintiff EID has developed a new transponder
that it believes does not infringe on Digital Angel Corporation's patent. The
lawsuit acknowledges that Digital Angel Corporation obtained a Judgment of
infringement and two Contempt Orders against EID based on selling certain
systems that infringed on Digital Angel Corporation's patent in 1997, 1998 and
1999. Digital Angel Corporation has not yet answered the Complaint and given the
very early stage of this matter, the ultimate outcome of this proceeding cannot
be predicted at this time.
Page F-67
26. SUPPLEMENTAL CASH FLOW INFORMATION
The changes in operating assets and liabilities are as follows:
For the Years Ended December 31,
------------------------------------------
2003 2002 2001
------------------------------------------
Decrease in accounts receivable
and unbilled receivables $ 1,726 $ 5,567 $ 16,020
(Increase) decrease in inventories (3,148) (258) 4,090
Decrease in other current assets 79 2,465 2,969
Increase in other assets -- 361 1,626
Increase in accounts payable,
accrued expenses and other liabilities 16,191 9,089 3,660
- ---------------------------------------------------------------------------------------------------
$ 14,848 $ 17,224 $ 28,365
===================================================================================================
In the years ended December 31, 2003, 2002, and 2001, the Company had the
following non-cash investing and financing activities (in thousands):
2003 2002 2001
----------------------------------
Assets acquired for common stock $ -- $ -- $10,201
Due from buyer of divested subsidiary -- -- 2,625
Common shares issued to settle convertible debt 9,739 -- --
Assets acquired for long-term debt and capital leases 184 -- --
Common stock issued upon conversion of preferred stock -- -- 14,550
27. SEGMENT INFORMATION
As a result of (a) the merger of pre-merger Digital Angel and MAS on March 27,
2002, (b) the significant restructuring of the Company's business during the
first quarter of 2002 and (c) the Company's emergence as an advanced technology
development company, the Company has re-evaluated and realigned its reporting
segments. On January 1, 2002, the Company began operating in the three business
segments: Advanced Technology, Digital Angel Corporation and InfoTech USA, Inc.
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.
"Corporate/Eliminations" also includes certain interest expense and other
expenses associated with corporate activities and functions. Included in
"Corporate/Elimination" for the year ended December 31, 2003, is a gain on the
extinguishment of debt obligations to IBM Credit of approximately $70.1 million,
$4.3 million of bonuses awarded to directors, officers and employees for the
successful repayment of all obligations to IBM Credit, and a severance charge of
approximately $17.9 million associated with the termination of certain former
officers and directors. Included in "Corporate/Eliminations" for the year ended
December 31, 2002, is a non cash stock based 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 on March 27, 2002.
Page F-68
Prior to January 1, 2002, the Company's business units were organized into the
three segments: Applications, Services and Advanced Wireless. Prior period
information has been restated to present the Company's reportable segments on a
comparative basis.
The Advanced Technology, Digital Angel Corporation and InfoTech USA, Inc.
segment's products and services are as follows:
OPERATING SEGMENT PRINCIPAL PRODUCTS AND SERVICES
- ----------------- -------------------------------
Advanced Technology
o Voice, data and video communications
networks
o Call center and customer relationship
management
o Networking products and services
o Website design and Internet access
o Miniaturized implantable verification
chip
o Miniaturized power generator
o Position location device
Digital Angel Corporation
o Animal Applications
o Wireless and Monitoring
o GPS and Radio Communications
InfoTech USA, Inc.
o Computer hardware
o Computer services
The accounting policies of the operating segments are the same as those
described in the summary of significant accounting policies, except that
intersegment sales and transfers are generally accounted for as if the sales or
transfers were to third parties at current market prices and segment data for
the Advanced Technology segment includes an allocated charge for corporate
overhead costs. 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. Certain
amounts in 2002 and 2001 have been reclassified for comparative purposes.
Corporate amounts have been adjusted from amounts previously reported to reflect
the reclassification of the 2001 gain on extinguishment of debt from
extraordinary to Continuing Operations (see Note 21).
Page F-69
2003 (IN THOUSANDS)
----------------------------------------------------------------------------------
ADVANCED DIGITAL ANGEL INFOTECH CORPORATE/
TECHNOLOGY CORPORATION USA, INC. ALL OTHER ELIMINATIONS CONSOLIDATED
---------- ----------- --------- --------- ------------ ------------
Net product revenue from external customers $ 33,804 $ 32,364 $ 11,606 $ -- $ -- $ 77,774
Net service revenue from external customers 10,805 1,558 2,850 -- -- 15,213
Intersegment net revenue -- 510 -- -- (510) --
-------- -------- -------- -------- -------- --------
Total revenue $ 44,609 $ 34,432 $ 14,456 $ -- $ (510) $ 92,987
-------- -------- -------- -------- -------- --------
Depreciation and amortization (1) $ 245 $ 1,233 $ 213 $ -- $ 200 $ 1,891
Asset impairment 302 -- 2,154 -- -- 2,456
Interest income 88 172 95 -- 564 919
Interest expense 162 772 18 -- 21,635 22,587
(Loss) income from continuing operations
before provision for income taxes, minority
interest, losses attributable to capital
transactions of subsidiary, and equity in
net loss of affiliate (2) (108) (6,271) (3,052) 298 19,441 10,308
Goodwill, net 18,212 45,119 -- -- -- 63,331
Segment assets 38,282 64,976 5,789 2,662 222 111,931
Expenditures for property and equipment 192 1,165 42 -- 18 1,417
2002 (IN THOUSANDS)
----------------------------------------------------------------------------------
ADVANCED DIGITAL ANGEL INFOTECH CORPORATE/
TECHNOLOGY CORPORATION USA, INC. ALL OTHER ELIMINATIONS CONSOLIDATED
---------- ----------- --------- --------- ------------ ------------
Net product revenue from external customers $ 28,991 $ 30,330 $ 20,056 $ 1,013 $ -- $ 80,390
Net service revenue from external customers 12,939 2,116 2,665 375 -- 18,095
Intersegment net revenue -- 70 -- -- (70) --
--------- --------- --------- --------- --------- ---------
Total revenue $ 41,930 $ 32,516 $ 22,721 $ 1,388 $ (70) $ 98,485
--------- --------- --------- --------- --------- ---------
Depreciation and amortization (1) $ 569 $ 3,229 $ 262 $ 9 $ 295 $ 4,364
Asset impairment -- 37,872 -- -- 785 38,657
Interest income 239 585 45 -- 1,471 2,340
Interest expense 422 256 184 148 16,467 17,477
Loss from continuing operations
before provision for income taxes, minority
interest, losses attributable to capital
transactions of subsidiary, and equity in
net loss of affiliate (2) (786) (45,139) (422) (320) (49,310) (95,977)
Goodwill, net 18,212 45,085 2,154 -- -- 65,451
Segment assets 41,404 61,721 9,340 2,753 (4,062) 111,156
Expenditures for property and equipment 340 1,437 41 -- 38 1,856
Page F-70
2001 (IN THOUSANDS)
----------------------------------------------------------------------------------
ADVANCED DIGITAL ANGEL INFOTECH CORPORATE/
TECHNOLOGY CORPORATION USA, INC. ALL OTHER ELIMINATIONS CONSOLIDATED
---------- ----------- --------- --------- ------------ ------------
Net product revenue from external customers $ 28,123 $ 33,220 $ 30,075 $ 21,318 $ 411 $ 113,147
Net service revenue from external customers 16,447 2,691 4,100 19,974 128 43,340
Intersegment net revenue 232 964 -- 870 (2,066) --
--------- --------- --------- --------- --------- ---------
Total revenue $ 44,802 $ 36,875 $ 34,175 $ 42,162 $ (1,527) $ 156,487
--------- --------- --------- --------- --------- ---------
Depreciation and amortization (1) $ 9,088 $ 12,298 $ 503 $ 4,768 $ 2,242 $ 28,899
Asset impairment 30,453 726 -- 32,427 8,113 71,719
Interest and other income 20 17 68 34 1,937 2,076
Interest expense 216 529 325 1,465 6,020 8,555
Income (loss) from continuing operations
before provision for income taxes,
minority interest and equity in net loss
of affiliate (41,493) (16,262) (1,322) (71,636) (37,428) (168,141)
Goodwill, net 15,379 73,095 2,357 -- -- 90,831
Segment assets 38,247 105,042 15,004 4,968 4,228 167,489
Expenditures for property and equipment 151 1,591 490 1,703 10,226 14,161
(1) Depreciation and amortization includes $0.6 million, $0.8 million and $0.8
million included in cost of products sold in 2003, 2002 and 2001,
respectively.
(2) For Digital Angel Corporation, for 2002, amount excludes $1.8 million of
interest expense associated with the Company's obligation to IBM Credit
and $18.7 million of non-cash stock based 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-K dated December 31, 2003.
The following is a breakdown of the Company's revenue by segment and type of
product and service:
2003 2002 2001
-----------------------------------------------------------------------------------------------
ADVANCED TECHNOLOGY PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
------- ------- ------- ------- ------- ------- ------- ------- -------
Voice, data and video
telecommunications networks $32,253 $ 4,862 $37,115 $26,535 $ 4,792 $31,327 $22,656 $ 4,757 $27,413
Call center and customer
relationship management software 608 4,819 5,427 976 5,165 6,141 1,197 7,314 8,511
Networking products and services -- -- -- 357 940 1,297 2,505 2,466 4,971
Website design and Internet access 398 1,124 1,522 1,123 2,042 3,165 1,765 1,910 3,675
Implantable verification chip 545 -- 545 -- -- -- -- -- --
Intersegment revenue -- -- -- -- -- -- -- 232 232
-----------------------------------------------------------------------------------------------
Total $33,804 $10,805 $44,609 $28,991 $12,939 $41,930 $28,123 $16,679 $44,802
===============================================================================================
Page F-71
2003 2002 2001
-----------------------------------------------------------------------------------------------
DIGITAL ANGEL CORPORATION PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
------- ------- ------- ------- ------- ------- ------- ------- -------
Animal Applications $21,880 $ 1,558 $23,438 $20,308 $ 613 $20,921 $22,074 $ 173 22,247
GPS and Radio Communications 10,362 -- 10,362 10,022 -- 10,022 11,144 11,144
Wireless and Monitoring 122 -- 122 -- 1,503 1,503 2 2,518 2,520
Intersegment revenue 510 -- 510 70 -- 70 -- 964 964
-----------------------------------------------------------------------------------------------
Total $32,874 $ 1,558 $34,432 $30,400 $ 2,116 $32,515 $33,220 $ 3,655 $36,875
===============================================================================================
2003 2002 2001
-----------------------------------------------------------------------------------------------
INFOTECH USA, INC. PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
------- ------- ------- ------- ------- ------- ------- ------- -------
Computer hardware $11,606 $ -- $11,606 $20,056 $ -- $20,056 $30,075 $ -- $30,075
Computer services -- 2,850 2,850 -- 2,665 2,665 -- 4,100 4,100
-----------------------------------------------------------------------------------------------
Total $11,606 $ 2,850 $14,456 $20,056 $ 2,665 $22,721 $30,075 $ 4,100 $34,175
===============================================================================================
2003 2002 2001
-----------------------------------------------------------------------------------------------
ALL OTHER PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
------- ------- ------- ------- ------- ------- ------- ------- -------
Telephony systems $ -- $ -- $ -- $ -- $ -- $ -- $ 8,720 $ 7,210 $15,930
Software development
and applications -- -- -- 1,013 375 1,388 11,451 11,325 22,776
Networking products
and services -- -- -- -- -- -- 1,147 1,439 2,586
Intersegment revenue -- -- -- -- -- -- 88 782 870
-----------------------------------------------------------------------------------------------
Total $ -- $ -- $ -- $ 1,013 $ 375 $ 1,388 $21,406 $20,756 $42,162
===============================================================================================
Page F-72
Approximately $37.1 million, or 83.2%, $31.3 million, or 74.7%, and $27.4
million, or 61.5%, of the Company's Advanced Technology segment's revenues for
2003, 2002 and 2001, respectively, were generated by the Company's wholly-owned
subsidiary, Computer Equity Corporation. Approximately 99.3%, 99.1% and 77.7% of
Computer Equity Corporation's revenues during 2003, 2002 and 2001, respectively,
were generated through sales to various agencies of the United States Federal
Government. No other sales to an individual customer amounted to 10% of more of
this segment's revenues in 2003, 2002 and 2001.
During 2003, the top six customers, Schering-Plough, United States Army Corps of
Engineers, Biomark, Inc., United States Department of Energy, Pacific States
Marine and Merial and accounted for 44.0% of the Digital Angel Corporation
segment's revenues, one of which accounted for 12.8% of the segment's revenues.
During 2002, the top seven customers, Schering-Plough, US Army Corps of
Engineers, Biomark, Inc., Pacific States Marine and San Bernardino County,
Merial, Animal Care Limited and San Bernardino County accounted for 39.2% of the
Digital Angel Corporation segment's revenues; however, no single customer
accounted for more than 10% of revenues. During 2001, the top four customers,
Schering Plough, Merial, Pacific States Marine and the US Army Corps of
Engineers accounted for 30.4% of the Digital Angel Corporation segment's
revenues, one of which accounted for 10.3% of the segment's revenues.
During 2003, three customers, GAF Material Corporation, Hackensack University
Medical Center and Centenary College, accounted for 15%, 12% and 11% of the
InfoTech USA, Inc segment's consolidated revenues, respectively. During 2002,
five customers, Deutsche Bank, Hackensack University Medical Center, Liberty
Mutual, Morgan Stanley and Polytechnic University accounted for 23%, 22%, 11%,
11% and 11% of the InfoTech USA, Inc. segment's revenues, respectively. During
2001, two customers, Liberty Mutual and Mass Mutual Life Insurance accounted for
40% and 31% of the InfoTech USA, Inc. segment's revenues, respectively.
Goodwill by segment for the year ended December 31, 2003, was as follows (in
thousands):
YEAR ENDED DECEMBER 31, 2003
- --------------------------------------------------------------------------------------------------------------------
ADVANCED DIGITAL ANGEL INFOTECH
TECHNOLOGY CORPORATION USA, INC. ALL OTHER CORPORATE CONSOLIDATED
---------- ----------- --------- --------- --------- ------------
Balance As of January 1, 2003 $ 18,212 $ 45,085 $ 2,154 $ -- $ -- $ 65,451
Goodwill acquired during the year 408 -- -- -- -- 408
Sale of subsidiary (408) (408)
Translation adjustment and other -- 34 -- -- -- 34
Impairment losses -- (2,154) -- -- (2,154)
-------- -------- -------- -------- -------- --------
Balance as of December 31, 2003 $ 18,212 $ 45,119 $ -- $ -- $ -- $ 63,331
======== ======== ======== ======== ======== ========
Page F-73
Revenues are attributed to geographic areas based on the location of the assets
producing the revenue. Information concerning principal geographic areas as of
and for the years ended December 31, was as follows (in thousands):
UNITED UNITED
STATES KINGDOM CONSOLIDATED
------------------------------------------
2003
Net revenue $ 82,625 $ 10,362 $ 92,987
Long-lived tangible assets 7,113 1,115 8,228
Deferred tax asset -- -- --
- --------------------------------------------------------------------------------
2002
Net revenue $ 87,075 $ 11,410 $ 98,485
Long-lived tangible assets 7,577 855 8,432
Deferred tax asset 1,236 -- 1,236
- --------------------------------------------------------------------------------
2001
Net revenue $139,060 $ 17,427 $156,487
Long-lived tangible assets 19,193 992 20,185
Deferred tax asset 1,167 -- 1,167
- --------------------------------------------------------------------------------
28. RELATED PARTY TRANSACTION
On June 27, 2003, the Company borrowed $1.0 million from InfoTech USA, Inc.
under the terms of a commercial loan agreement and term note. The loan accrues
interest at an annual rate of 16% and interest is payable monthly beginning on
July 31, 2003, with principal and accrued interest due June 30, 2004. Under the
terms of a Stock Pledge Agreement, the Company has pledged 0.8 million shares of
the Digital Angel Corporation common stock that it owns as collateral for the
loan. The proceeds of the loan were used to fund operations. This loan has been
eliminated in consolidation.
29. OTHER EVENTS
The staff of the Securities and Exchange Commission's Southeast Regional Office
is conducting an informal inquiry concerning the Company. The Company is fully
and voluntarily cooperating with this informal inquiry. At this point, the
Company is unable to determine whether this informal inquiry may lead to
potentially adverse action.
Nasdaq SmallCap Listing
Since November 12, 2002, the Company's common stock has traded on the National
SmallCap Market (SmallCap) under the symbol "ADSX." Since being traded on the
SmallCap, the minimum bid price of the Company's common stock has been less than
the SmallCap's minimum bid price requirement. On January 6, 2004, the Nasdaq
Listing Qualifications Panel notified the Company that it has been granted an
extension until July 25, 2004, to meet the requirements for continued inclusion
on the SmallCap pursuant to an exception to the bid price requirement as set
forth in Nasdaq Marketplace Rule 4310 (c) (4). Currently, the Company complies
with all of the SmallCap's listing requirements with the exception of the
minimum bid price requirement. If the Company is unable to regain compliance
with the minimum bid price requirement by July 25, 2004, and its stock is
delisted from the SmallCap, it may trade on the OTC Bulletin Board or another
market or quotation system. While the Company does not anticipate that a
delisting of its common stock from the SmallCap would have any material
implications on its results of operations, it may impact the Company's ability
to raise funds in the equity markets, and it may reduce the liquidity of the
Company's common stock. The delisting of the Company's common stock would not
currently constitute an event of default under any of its significant
contractual agreements. The Company's Board of Directors has approved a reverse
stock split as more fully described in Note 31.
Page F-74
30. SUBSEQUENT EVENTS
OuterLink Corporation Acquisition
On January 22, 2004, Digital Angel Corporation completed the acquisition of
OuterLink pursuant to an Agreement and Plan of Merger dated November 2, 2003, by
and among Digital Angel Corporation, DA Acquisition and OuterLink. Pursuant to
the terms of the agreement, OuterLink became a wholly-owned subsidiary of
Digital Angel Corporation.
Under the terms of the agreement, Digital Angel Corporation issued to OuterLink
0.1 million shares of its Series A Preferred Stock. Approximately 20% of the
shares are being held in escrow as security for indemnified claims. The Series A
Preferred Stock is convertible into 4.0 million shares of Digital Angel
Corporation's common stock when the volume weighted average price of Digital
Angel Corporation's common stock equals or exceeds $4.00 per share for ten
consecutive trading days. The preferred stockholders have the right to designate
one Director to Digital Angel Corporation's Board of Directors prior to July 22,
2004.
OuterLink provides real-time, satellite-based automated tracking, wireless data
transfer and two-way messaging with large fleets of vehicles, such as utility
trucks, helicopters, fixed-wing aircraft, long and short-haul trucks, service
vehicles and ships. OuterLink's current customer base includes various branches
of the U.S. Department of Homeland Security, including the U.S. Border Patrol
and the U.S. Customs Service.
Sale of Medical Systems' Assets
During the three-months ended June 30, 2004, Digital Angel Corporation's Board
of Directors approved a plan to sell its Medical Systems operations, which were
acquired on March 27, 2002, and the business assets of Medical Systems were sold
effective April 19, 2004. Medical Systems represented the business operations of
MAS. The business assets of Medical Systems were sold to MedAire, Inc. in
connection with an Asset Purchase Agreement, referred to as APA, dated April 8,
2004, by and between Digital Angel Corporation and MedAire, Inc. Under the terms
of the APA, the purchase price was $0.4 million, plus any prepaid deposits, the
cost of certain pharmaceutical inventory and supplies, and the assumption of
certain liabilities of Medical Systems reduced by any pre-billing to or pro-rata
prepayments by certain customers. The assets sold included all of the tangible
and intangible intellectual property developed for the medical services business
including pharmaceutical supplies and other inventory items, customer and
supplier contracts, computer software licenses, internet website and domain name
and mailing lists, but did not include the land and building used by this
operation. Medical Systems' land and building were sold in a separate unrelated
transaction to a third party on July 31, 2004 for approximately $1.5 million.
Medical Systems was one of the Company's reporting units in accordance with FAS
142. Accordingly, the financial condition, results of operations and cash flows
of Medical Systems have been reported as Discontinued Operations in the
Company's financial statements, and prior periods have been restated. See Note
20.
31. REVERSE STOCK SPLIT
On September 10, 2003, the Company's shareholders approved the granting of
discretionary authority to the Company's Board of Directors for a period of
twelve months to effect a reverse stock split not to exceed a ratio of 1-for 25,
or to determine not to proceed with a reverse stock split. On March 12, 2004,
the Company's Board of Directors authorized a 1-for-10 reverse stock split,
which was effectuated on April 5, 2004. In conjunction with the reverse stock
split, the Company's Board of Directors has authorized a reduction in the number
of authorized shares of the Company's common stock from 560.0 million pre-split
to 125.0 million post-split. The Board of Directors approved a reverse stock
split to facilitate the continuing listing of the Company's common stock on the
SmallCap, and also to reduce the number of issued and outstanding shares of the
Company's common stock, resulting, in part, from the Company's past
acquisitions, the payment of debt obligations to IBM Credit and preferred stock
and Debenture conversions. All share information provided in the Consolidated
Financial Statements and accompanying Notes has been adjusted to reflect the
reverse stock split.
Page F-75
32. SUMMARIZED QUARTERLY DATA (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE
AMOUNTS)
FIRST SECOND THIRD FOURTH FULL
QUARTER QUARTER QUARTER QUARTER YEAR
------- ------- ------- ------- ----
2003
Total revenue $ 24,362 $ 20,430 $ 23,468 $ 24,727 $ 92,987
Gross Profit 8,729 6,101 7,240 6,025 28,095
Net income (loss) from Continuing Operations (1) (26,696) 56,975 (1,045) (23,275) 5,959
Net (loss) income from Discontinued Operations (245) (609) (115) (1,847) (2,816)
Basic net income (loss) per share from
Continuing Operations (3) (0.95) 1.84 (0.03) (0.59) 0.17
Basic net income (loss) per share from
Discontinued Operations (3) (0.01) (0.02) -- (0.05) (0.08)
Diluted net income (loss) per share
from Continuing Operations (3) (0.95) 1.76 (0.03) (0.59) 0.16
Diluted net income (loss) per share
from Discontinued Operations (3) (0.01) (0.02) -- (0.05) (0.08)
FIRST SECOND THIRD FOURTH FULL
QUARTER QUARTER QUARTER QUARTER YEAR
------- ------- ------- ------- ----
2002
Total revenue $ 28,391 $ 25,269 $ 23,559 $ 21,266 $ 98,485
Gross Profit 9,346 8,308 8,543 4,819 31,016
Net loss from Continuing Operations (2) (24,692) (19,295) (5,623) (39,890) (89,500)
Net income (loss) from Discontinued Operations 687 (641) (247) (22,784) (22,985)
Basic and diluted net loss per share from
Continuing Operations (3) (0.96) (0.73) (0.20) (1.42) (3.33)
Basic and diluted net income (loss) per share
from Discontinued Operations (3) 0.02 (0.02) (0.01) (0.81) (0.85)
A. CHANGE IN METHOD OF ACCOUNTING FOR GOODWILL
Effective January 1, 2002, the Company adopted FAS 142, which requires that
goodwill and certain intangibles no longer be amortized, but instead tested for
impairment at least annually. There was no impairment of goodwill upon the
adoption of FAS 142. The Company performed its annual review for impairment
during the fourth quarters of 2003, and 2002, which resulted in impairment
charges of $2.2 million and $31.5 million in 2003 and 2002, respectively. There
can be no assurance that future goodwill impairment tests will not result in
additional impairment charges.
(1) The loss from continuing operations for the first quarter of 2003
includes a non-cash stock based severance charge of approximately
$22.0 million pursuant to certain severance agreements. The income
from continuing operations for the second quarter of 2003 includes a
gain on extinguishment of debt of approximately $70.1 million and
bonus compensation expense of $4.3 million. The loss from continuing
operations for the third quarter of 2003 includes the reversal of
approximately $3.9 million of the severance expense recorded during
the first quarter of 2003. The loss from continuing operations for
the fourth quarter of 2003 includes approximately $11.1 million of
non-cash interest expense associated with the Company's Debentures,
an impairment charge of approximately $2.5 million and losses
attributable to capital transactions of a subsidiary of
approximately $5.9 million.
Page F-76
(2) The first quarter of 2002 loss from continuing operations includes a
non-cash stock based compensation charge of approximately $18.7
million associated with pre-merger Digital Angel options. Pursuant
to the terms of the merger of pre-merger Digital Angel and MAS,
options to acquire pre-merger Digital Angel common stock were
converted into options to acquire shares of MAS common stock, which
resulted in a new measurement date for the options. In addition, the
Company incurred a loss on issuances of subsidiary stock of
approximately $3.9 million. Second quarter of 2002 loss from
continuing operations includes non-cash, stock-based compensation
expense of $6.1 million associated with options that were re-priced
in 2001, and valuation reserves on notes receivable from officers
and directors. The third quarter of 2002 loss from continuing
operations includes a reversal of approximately $2.9 million of
non-cash, stock-based compensation expense associated with the
options re-priced in 2001, and a reversal of approximately $0.9
million of bad debt reserves. The fourth quarter of 2002 loss from
continuing operations includes asset impairments of $38.7 million.
(3) Earnings per share are computed independently for each of the
quarters presented. Therefore, the sum of the quarterly net earnings
per share will not necessarily equal the total for the year.
Page F-77
FINANCIAL STATEMENT SCHEDULE
VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
ADDITIONS
--------------
BALANCE AT CHARGED BALANCE
BEGINNING TO COST AT END OF
DESCRIPTION OF PERIOD AND EXPENSES DEDUCTIONS PERIOD
- ----------------------------------------------------------------------------------------------------------
VALUATION RESERVE DEDUCTEDIN THE BALANCE
SHEET FROM THE ASSET TO WHICH IT APPLIES:
ACCOUNTS RECEIVABLE:
2003 ALLOWANCE FOR DOUBTFUL ACCOUNTS $ 1,158 $ 148 $ 278 $ 1,028
2002 ALLOWANCE FOR DOUBTFUL ACCOUNTS 2,476 4,236 5,554 1,158
2001 ALLOWANCE FOR DOUBTFUL ACCOUNTS 1,681 1,914 1,014 2,581
INVENTORY:
2003 ALLOWANCE FOR EXCESS AND OBSOLESCENCE $ 1,422 $ 439 $ 2 $ 1,859
2002 ALLOWANCE FOR EXCESS AND OBSOLESCENCE 1,702 104 384 1,422
2001 ALLOWANCE FOR EXCESS AND OBSOLESCENCE 1,500 570 368 1,702
NOTES RECEIVABLE:
2003 ALLOWANCE FOR DOUBTFUL ACCOUNTS $ 6,667 $ 115 $ 3,073 $ 3,709
2002 ALLOWANCE FOR DOUBTFUL ACCOUNTS 12,671 1,266 7,270 6,667
2001 ALLOWANCE FOR DOUBTFUL ACCOUNTS -- 12,671 -- 12,671
DEFERRED TAXES:
2003 VALUATION RESERVE $93,214 $ 1,601 $ 7,541 $87,274
2002 VALUATION RESERVE 66,932 26,282 -- 93,214
2001 VALUATION RESERVE 15,850 51,082 -- 66,932
Page F-78