10-K/A 1 v06849_10ka.txt AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON MARCH 15, 2004 AND AS ----------------------------------------------------------------------------- AMENDED ON MARCH 16,2004, MAY 21, 2004 AND SEPTEMBER 24, 2004 ------------------------------------------------------------- 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. 81 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
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