UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

For the transition period from       to       

Commission File Number: 1-15177

DIGITAL ANGEL CORPORATION

(Exact name of registrant as specified in its charter)

490 Villaume Avenue, South Saint Paul, Minnesota, 55075

(Address of registrant’s principal executive offices)

(651) 455-1621

(Registrant’s telephone number, including area code)

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     ý    No     o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule12b-2 of the Exchange Act.

Large accelerated filer     o    Accelerated filer   o       Non-accelerated filer     ý

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12 b-2 of the Exchange Act).

Yes     o    No     ý

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

DIGITAL ANGEL CORPORATION

TABLE OF CONTENTS

PART I FINANCIAL INFORMATION

Item 1.             Financial Statements.

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

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

See the accompanying notes to condensed consolidated financial statements.

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DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

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

(Unaudited)

See the accompanying notes to condensed consolidated financial statements.

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DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
For The Three Months Ended March 31, 2006
(In Thousands)
(Unaudited)

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DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

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

See the accompanying notes to condensed consolidated financial statements.

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DIGITAL ANGEL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands)
(Unaudited)

1.                                      The Company and Basis of Presentation

Digital Angel Corporation and its subsidiaries (“the Company”) develops and deploys sensor and communications technologies that enable rapid and accurate identification, location tracking, and condition monitoring of high-value assets. The Company operates in two segments: (1) Animal Applications and (2) GPS and Radio Communications.

Animal Applications— 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 Animal Applications segment consists of our operations located in Minnesota and DSD Holdings A/S and its wholly-owned subsidiaries, located in Denmark. The positive identification and tracking of cattle and hogs are crucial for asset management and for disease control and food safety. In addition to the visual ear tags which have been sold by the Company since the late 1940’s, Animal Applications utilizes radio frequency transmission (“RFID”) technologies in its electronic ear tags and implantable microchips.

GPS and Radio Communications— consists of the design, manufacture and support of global positioning system (“GPS”) enabled equipment. The GPS and Radio Communications segment consists of the Company’s subsidiaries Signature Industries Limited (90.9% owned), located in the United Kingdom and OuterLink Corporation, located in Massachusetts. Applications for the segment’s products include location tracking and message monitoring of vehicles, aircraft and people in remote locations through systems that integrate geosynchronous satellite communications and GPS enabled equipment and intelligent communications products and services for telemetry, mobile data and radio communications applications serving commercial and military markets. Technology development in this segment includes the integration and miniaturization into marketable products of two technologies: wireless communications and position location technology (including GPS and other systems).

On February 28, 2005, the Company acquired Denmark-based DSD Holdings A/S and its wholly-owned subsidiaries Daploma International A/S and Digitag A/S, including Daploma International A/S’s 70%-owned subsidiary, Daploma Polska. DSD Holdings A/S became a wholly-owned subsidiary of Digital Angel Corporation. DSD Holdings A/S produces visual and RFID tags. DSD Holdings A/S’s operations are included from the date of acquisition.

As of March 31, 2006, Applied Digital Solutions, Inc. (“Applied Digital” or “ADS”) owned 24,291,673 shares or approximately 55.0% of the Company’s common stock.

The accompanying unaudited condensed consolidated financial statements of the Company as of March 31, 2006 and for the three month periods ended March 31, 2006 and 2005 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X under the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of the Company’s management, all adjustments (including normal recurring adjustments) considered necessary to present fairly the financial statements have been made.

The consolidated statements of operations for the three months ended March 31, 2006 and 2005 are not necessarily indicative of the results that may be expected for the entire year. These statements should be read in conjunction with the Digital Angel Corporation’s audited consolidated financial statements and related notes thereto for the year ended December 31, 2005 which are included in the Company’s Annual Report on Form 10-K.

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Certain items in the condensed consolidated financial statements for the 2005 periods have been reclassified for comparative purposes.

2.                                      Principles of Consolidation

The March 31, 2006 and 2005 condensed consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries (DSD Holdings A/S operations are included from the date of acquisition, February 28, 2005). All significant intercompany accounts and transactions have been eliminated in consolidation.

3.                                      Revenue Recognition

The Company, except for its subsidiary OuterLink Corporation, recognizes product 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 collectibility 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, billable upon occurrence of the post-sale support. Costs of products sold and services provided are recorded as the related revenue is recognized. Digital Angel Corporation offers a warranty on its products. For non-fixed and fixed fee jobs, service revenue is recognized based on the actual direct labor hours in the job multiplied by the standard billing rate and adjusted to net realizable value, if necessary. Other revenue is recognized at the time service or goods are provided. It is the Company’s policy to record contract losses in their entirety in the period in which such losses are foreseeable.

The Company’s subsidiary, OuterLink Corporation, earns revenue from messaging services and from the sale of related products to customers (communication terminals and software). OuterLink Corporation’s messaging service is only available through use of its products and such products have no alternative use. Accordingly, service revenue is recognized as the services are performed. OuterLink Corporation’s product revenue, for which title and risk of loss transfers to the customer on shipment, is deferred upon shipment and is recognized ratably over the estimated customer service period of 42 months in the three month period ended March 31, 2006 and 30 months in the three month period ended March 31, 2005.

The Company records a liability for product warranties at the time it is probable that a warranty liability has been incurred and the amount of loss can be reasonably estimated. The Company’s warranty liability was $34,000 as of March 31, 2006. Following is a reconciliation of the Company’s product warranties (in thousands):

4.                                      Stock-Based Compensation

On January 1, 2006 we adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R). SFAS 123R replaced SFAS No. 123 and supercedes APB Opinion No. 25. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS 123 are no longer an alternative to financial statement recognition. We adopted SFAS 123R using the modified prospective method

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which requires the application of the accounting standard as of January 1, 2006. Our consolidated financial statements as of and for the quarter ended March 31, 2006 reflect the impact of adopting SFAS 123R. In accordance with the modified prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R. See Note 8, Stock Options and Restricted Stock for further details.

5.                                      Inventory (in thousands)

6.                                      Stock Exchange with Applied Digital Solutions, Inc.

On February 25, 2005, the Company entered into a Stock Purchase Agreement with Applied Digital. The purpose of the stock exchange was to use the shares as partial consideration for the acquisition of DSD Holdings A/S and its wholly-owned subsidiaries, Daploma International A/S and Digitag A/S, including Daploma International A/S’s 70%-owned subsidiary, Daploma Polska, as described more fully in Note 10. The Company and Applied Digital entered into the share exchange because of the selling shareholders’ desire, at the time the transaction was negotiated, to receive their consideration in Applied Digital common stock as opposed to the Company’s common stock. In addition, the stock purchase represented a strategic investment by Applied Digital whereby Applied Digital could increase its ownership interest in the Company. Pursuant to the agreement, the Company issued 644,140 shares of its common stock to Applied Digital. The Company received 684,543 shares of Applied Digital common stock as consideration. The exchange ratio of shares was based upon the average of the volume-weighted-average price of the Company’s common stock and Applied Digital’s common stock for the ten trading days immediately preceding, and not including, the transaction closing date which was $5.434 for the Company’s common stock and $5.113 for Applied Digital’s common stock. The value of the stock exchanged was $3.5 million.

7.                                      Discontinued Operations

In April 2004, our Board of Directors approved a plan to sell our Medical Systems segment. The Medical Systems segment represented the business operations of Medical Advisory Systems, Inc, which we acquired on March 27, 2002. The Medical Systems segment was one of our reporting units in accordance with SFAS 131, “Disclosures about Segments of an Enterprise and Related Information”. Accordingly, the financial condition, results of operations and cash flows of our Medical Systems segment have been reported as discontinued operations for all periods presented. For the three months ended March 31, 2006 and 2005, there were no losses attributable to the Medical Systems segment. The Company does not anticipate the Medical Systems division incurring additional losses in the future. However, in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, any additional operating losses or changes in the values of assets or liabilities will be reflected in the financial condition and results of operations as incurred.

The net liabilities of discontinued operations as of March 31, 2006 and December 31, 2005, were comprised of accrued expenses aggregating $78,000 and $84,000, respectively.

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8.                                      Stock Options and Restricted Stock

Stock Option Plans

As of March 31, 2006 the Company maintains the Amended And Restated Digital Angel Corporation Transition Stock Option Plan (“DAC Stock Option Plan”), which is described below, and has outstanding stock options which were issued pursuant to another plan which was terminated on February 23, 2006. On January 1, 2006 we adopted SFAS 123R, using the modified prospective transition method. Accordingly, during the three month period ended March 31, 2006 we recorded stock-based compensation expense for awards granted prior to, but not yet vested as of January 1, 2006, as if the fair value method required for pro forma disclosure under SFAS 123 were in effect for expense recognition purposes. Upon adoption of SFAS 123R we elected to continue using the Black-Scholes option pricing and we have recognized compensation expense using a straight-line amortization method. During the three months ended March 31, 2006 we recorded $151,000 (this amount reflects compensation for options granted to non-employees and for restricted stock grants) in stock-based employee compensation expense.

As of March 31, 2006, the DAC Stock Option Plan, which is stockholder-approved, has 18,195,312 shares of common stock reserved for issuance, of which 15,601,516 shares have been issued and 2,593,796 remain available for issuance.  As of March 31, 2006 awards consisting of options to purchase 7,645,196 shares were outstanding under the DAC Stock Option Plan and awards consisting of options to purchase 476,820 shares were outstanding under the Company’s terminated stock option plan. Additionally, restricted stock awards for 154,230 shares of common stock have been granted under the DAC Stock Option Plan. Option awards are generally granted with an exercise price equal to 110% the market price of the Company’s stock at the date of grant; those option awards generally vest over 3 years and have 10-year contractual terms. Certain option and share awards provide for accelerated vesting if there is a change in control (as defined in the DAC Stock Option Plan).

Stock Option Activity

The fair value of each option award is estimated on the date of grant using a Black-Scholes valuation model. The following assumptions were used for options granted in the three month period ended March 31, 2005. There were no options granted in the three month period ended March 31, 2006. 

Prior to 2006, our computation of expected volatility was determined based on historical volatility. Our computation of expected life in 2005 was determined based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior. The interest rate is based on the U.S. Treasury yield curve in effect at the time of grant.

A summary of option activity under the Company’s option plans (the DAC Stock Option Plan and the Company’s terminated plan) as of March 31, 2006, and changes during the quarter then ended is presented below (in thousands, except per share amounts):

* The intrinsic value of a stock option is the amount by which the market value of the underlying stock exceeds the exercise price of the option. The market value of our stock was $4.30 at March 31, 2006.

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The weighted-average grant-date fair value of options granted during the quarter ended March 31, 2005 was $3.41. The total intrinsic value of options exercised during the quarters ended March 31, 2006 and 2005 was $534,000 and $72,000,  respectively.

A summary of the status of the Company’s nonvested stock options as of March 31, 2006, and changes during the three month period ended March 31, 2006, is presented below (in thousands, except per share amounts):

As of March 31, 2006, there was $0.6 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the DAC Stock Option Plan.  That cost is expected to be recognized over a weighted-average period of 2.0 years.  The total fair value of shares vested during the quarter ended March 31, 2006, was $17,000.

Cash received from option exercise under all share-based payment arrangements for the three months ended March 31, 2006, was $0.5 million.

On January 13, 2004, the Company granted its Chief Executive Officer (CEO) a ten-year option to purchase 1,000,000 shares of the Company’s common stock at $3.92 per share. This option was granted outside the Company’s stock plans. The option became exercisable on December 30, 2005. As of March 31, 2006 the option remains outstanding.

On February 18, 2004, the Company granted its Chairman of the Board of Directors a ten-year option to purchase 500,000 shares of the Company’s common stock at $3.43 per share. This option was granted outside the Company’s stock plans. The option became exercisable on February 18, 2005. As of March 31, 2006 the option remains outstanding.

Restricted Stock

In March 2005, the Company granted its Chairman of the Board 100,000 shares of the Company’s restricted stock. The restricted stock vests 50% on March 7, 2006 and 50% on March 7, 2007. The Company determined the value of the stock to be $506,000 based on the closing price of the Company’s stock on the date of grant. The value of the restricted stock has been recorded as deferred compensation and is being amortized to compensation expense over the two year vesting period. In the three month period March 31, 2006, $63,000 was recognized as compensation expense in the Company’s results of operations.

In February 2005, the Company granted an employee 54,230 shares of the Company’s restricted stock. The restricted stock vests 30% on February 25, 2006, 30% on February 25, 2006 and 40% on February 25, 2007. The Company determined the value of the stock to be $250,000 based on the closing price of the Company’s stock on the date of grant. The value of the restricted stock has been recorded as deferred compensation and is being amortized to compensation expense over the vesting period. In the three month period March 31, 2006 $17,000 was recognized as compensation expense in the Company’s results of operations.

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Pro Forma Information for Periods Prior to the Adoption of SFAS 123R

Prior to the adoption of SFAS 123R, we provided the disclosures required under SFAS 123 as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosures.”  Employee stock-based compensation expenses recognized under SFAS 123R was not reflected in our results of operations for the three month period ended March 31, 2005 for employee stock option awards as all stock options were granted with an exercise price greater than or equal to the market value of the underlying common stock on the date of grant. Previously reported results have not been restated.

The pro forma information for the three months ended March 31, 2005 was as follows (in thousands, except per share amounts):

9.                                      Segment Information

The Company is an advanced technology company in the field of rapid and accurate identification, location tracking, and condition monitoring of high-value assets. The Company’s operating segments are: (1) Animal Applications and (2) GPS and Radio Communications.

It is on the basis of segment reporting that management utilizes the financial information to assist in making internal operating decisions. The Company evaluates performance based on stand-alone segment operating income.

Following is the selected segment data for the three months ended March 31, 2006 (in thousands):

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Following is the selected segment data as of and for the three months ended March 31, 2005 (in thousands):

10.                               Acquisitions

The following describes the acquisitions by the Company (in thousands) in the three months ended March 31, 2006 and the year ended December 31, 2005:

On February 28, 2005, the Company acquired DSD Holdings A/S and its wholly-owned subsidiaries Daploma International A/S and Digitag A/S, including Daploma International A/S’s 70%-owned subsidiary. DSD Holdings A/S became a wholly-owned subsidiary of Digital Angel Corporation. Denmark-based DSD Holdings A/S through its subsidiaries manufactures and markets visual and electronic RFID tags for livestock. The acquisition was accounted for under the purchase method of accounting. The excess of purchase price over the fair value of the assets and liabilities of DSD Holdings A/S has been recorded as goodwill of $4.0 million and intangible assets of $2.0 million. The intangible assets are customer relationships, tradename, patents and a non-compete agreement. The customer relationships, patents and a non-compete agreement are being amortized over periods ranging from 3 to 15 years. Amortization recorded in the three months ended March 31, 2006 was $45,000. The tradename has an indefinite life.

Under the terms of the DSD Holdings A/S acquisition, the Company purchased all of the outstanding capital stock of DSD Holdings A/S in consideration for a purchase price of seven times DSD Holdings A/S’s average annual EBITDA over the next three years less outstanding indebtedness at the end of the time period. An initial payment of $3.5 million was made at closing through the delivery of Applied Digital common stock valued at $3.5 million which the Company acquired from Applied Digital in exchange for $3.5 million of Digital Angel Corporation common stock. To account for pre-closing pricing fluctuations the Company paid additional consideration of $195,000 to the shareholders of DSD Holdings A/S on June 7, 2005. Pursuant to the terms of the stock purchase agreement, at any time between the closing date of the acquisition and December 31, 2006 the Company had the right to buyout the remaining purchase price. On April 13, 2006 the Company exercised its right to buyout the remaining purchase price by electing to pay the set amount, as defined in the agreement, of $2 million. The $2 million buyout price will be satisfied by a cash payment of $1 million and shares of the Company’s unregistered common stock valued at $1 million. The $1 million cash payment was made on April 13, 2006.

In addition, Digital Angel entered into employment agreements with the Chief Executive Officer of DSD Holdings A/S and its subsidiaries, Lasse Nordfjeld and his son, the President of Daploma, Torsten Nordfjeld.

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Digital Angel Corporation operates DSD Holdings A/S and its operating subsidiaries from their current headquarters near Copenhagen, Denmark.

The results of DSD Holdings A/S have been included in the consolidated financial statements since its date of acquisition. Unaudited pro forma results of operations for the three months ended March 31, 2005 are included below. Such pro forma information assumes that the above acquisition had occurred as of January 1, 2005, and revenue is presented in accordance with the Company’s accounting policies. This summary is not necessarily indicative of what the results of operations of the Company would have been had it been a combined entity during such periods, nor does it purport to represent results of operations for any future periods.

11.                               Litigation

Digital Angel Corporation vs. Allflex USA, Inc and Pet Health Services (USA), Inc.

On October 20, 2004, the Company commenced an action in the United Stated District Court for the District of Minnesota against AllFlex USA, Inc. and Pet Health Services (USA), Inc. This suit claimed that Allflex was marketing and selling a syringe implantable identification transponder that infringed a 1993 patent granted to the Company for syringe implantable identification transponders previously found by the United States District Court for the District of Colorado to be enforceable. The suit also claimed that PetHealth was using, selling and/or distributing the same transponder in violation of the Company’s patent. The suit sought, among other things, an adjudication of infringement and that the infringing parties be enjoined from further improper action. The suit sought actual damages, punitive damages and interest, costs and attorneys’ fees. Allflex asserted a counterclaim for breach of contract of an existing license agreement between the Company and Allflex and asserted a counterclaim seeking a declaration of the parties’ rights and obligations under the license agreement. Allflex also moved for a judgment on the pleadings, asserting that the license agreement should act as a bar to a case for infringement. The Company contested the motion on the ground that Allflex’s actions exceed the scope of the license and constituted an impermissible infringement of the patent and asked the Court for leave to amend the complaint to assert a claim for infringement of a separate patent licensed exclusively to the Company by Bio Medic Data Systems. On June 23, 2005, the Court issued a ruling granting the Defendant’s motion for judgment on the pleadings and denying the Company’s motion for leave to amend.

On July 21, 2005, Allflex filed an action in the United Stated District Court for the Northern District of Texas seeking a declaratory judgment that it did not infringe the Bio Medic patent. The Company has not been served with this complaint and Allflex agreed to withdraw the complaint without prejudice.

On September 28, 2005, Allflex sought an award of attorneys fees and costs based on a fee-shifting clause in the license agreement and under 35 U.S.C. §285, which provides for an award of attorneys fees and costs in exceptional cases. The Company contested this motion, and on October 6, 2005, the Court denied the motion in its entirety. Final judgment in the action was entered on February 21, 2006. On March 20, 2006, the Company filed a notice of appeal with the Federal Circuit Court of Appeals in Washington, D.C. The appeal is presently pending.

Digital Angel Corporation vs. Datamars, Inc., Datamars, S.A., The Crystal Import Corporation and Medical Management International, Inc.

On October 20, 2004, the Company commenced an action in the United States District Court for the District of Minnesota against Datamars, Inc., Datamars, S.A., The Crystal Import Corporation, and Medical

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Management International, Inc. (“Banfield”). This suit claims that the defendants are marketing and selling syringe implantable identification transponders manufactured by Datamars that infringe the Company’s 1993 patent for syringe implantable identification transponders previously found by the United States District Court for the District of Colorado to be enforceable. Certain of the locations in which the infringing transponders are or have been sold, include, but are not limited to, “Banfield, The Pet Hospital” of which certain locations are associated with PetSmart stores. The suit seeks, among other things, an adjudication of infringement and that the infringing parties be enjoined from further improper action. The suit also seeks actual damages, punitive damages and interest, costs and attorneys’ fees. The Company believes that the suit is well-grounded in law and fact. Discovery in the action has been commenced and is continuing. On February 28, 2006, the Court conducted a hearing (the “Markman Hearing”) in which each of the parties presented the Court with their views regarding the scope of the claims set forth in the subject patent. Following the hearing, the Court took the matter under advisement, and indicated that a ruling on the scope of the claims would be issued in the ordinary course. As of the date of this filing, no ruling has been received by the Company.

Crystal Import Corporation v. Digital Angel, et al.

On or about December 29, 2004, The Crystal Import Corporation filed an action against AVID Identification Systems, Inc. and the Company in the United States District Court for the Northern District of Alabama. Crystal’s complaint primarily asserted federal and state antitrust and related claims against AVID, though it also asserted similar claims against the Company. The Company filed a motion to dismiss the action for failure to state a claim on which relief could be granted, or in the alternative, to have the action transferred to the United States District Court for the District of Minnesota. On October 12, 2005, the Alabama Court denied the Company’s motion to dismiss the complaint, but granted the Company’s motion to transfer the action to Minnesota. Following the docketing of the action in Minnesota, the Company and AVID filed a motion seeking to stay the case until the corresponding patent infringement actions have been resolved. This motion has been scheduled for hearing in May, 2006. Given the uncertainties associated with all litigation and given the early stage of this proceeding, the Company is unable to offer any assessment on the potential liability exposure, if any, to the Company from this lawsuit.

Digital Angel Corporation v. Corporativo SCM, S.A. de C.V.

On or about June 2, 2005, the Company filed a declaratory judgment action in the U.S. District Court for the District of Minnesota seeking to have the Court determine the rights and liabilities of the Company under a 2002 distribution agreement with Corporativo SCM, S.A. de C.V., a Mexican company which entered into a distribution agreement for a product that was then under development by the Company but the development of which was subsequently abandoned. Although the distribution agreement required that any actions arising out of or related to the agreement be filed within two years of the occurrence of the events giving rise to the claim, the Company received a letter in 2005 from the defendant threatening to assert a claim notwithstanding the two year limit set forth in the agreement. The defendant accordingly filed a motion to dismiss the declaratory judgment action, which the Court denied. On or about January 10, 2006, the defendant filed an answer and asserted a counterclaim against the Company for fraud seeking damages in an amount in excess of $75,000. The Company filed a response denying the allegations of the counterclaim, and has asked that the Court dismiss the claim both because the claim was not timely filed in accordance with the provisions of the agreement and because the counterclaim was not plead with the specificity required by the applicable rules of Civil Procedure. The defendant filed a responsive brief and, in addition, filed an amended complaint repleading its claims and adding a counterclaim for fraud in the inducement. Arguments on the Company’s motion to dismiss were heard on March 22, 2006. The Court took the matter under advisement, and as of the date of the filing of this quarterly report, the Court has not ruled on the merits of the motion. Given the uncertainties associated with all litigation and given the early stage of this proceeding, the Company is unable to offer any assessment on the potential liability exposure, if any, to the Company from this lawsuit.

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12.                               Supplemental Cash Flow Information (in thousands)

13.                               Related Party Activity

The Company has an exclusive eleven-year Distribution and Licensing Agreement dated March 4, 2002, amended December 28, 2005,  with VeriChip Corporation (VeriChip), a wholly-owned subsidiary of Applied Digital, covering the manufacturing, purchasing and distribution of the Company’s implantable microchip and the maintenance of the VeriChip Registry by the Company. The amended agreement contains, among other things, minimum purchase requirements in order to maintain exclusivity, whereby VeriChip is required to purchase $875,000, $1,750,000 and $2,500,000 for each of 2007, 2008 and 2009, respectively, and $3,750,000 for 2010 and each year thereafter. The agreement continues until March 2013, and, as long as VeriChip continues to meet the minimum purchase requirements, will automatically renew annually under its terms. The Distribution and Licensing agreement includes a license for the use of the Company’s technology in VeriChip’s identified markets. Under the Distribution and Licensing Agreement the Company is the sole manufacturer and supplier to VeriChip. The existing terms with the Company’s sole supplier of implantable microchips, Raytheon Microelectronics Espana, SA, expire on June 30, 2010. The Distribution and Licensing Agreement also includes indemnity and hold harmless provisions for VeriChip. Further, the agreement provides that the Company shall, at VeriChip’s option, furnish and operate a computer database to provide data collection, storage and related services for VeriChip’s customers for a fee.

Revenue recognized under the Distribution and Licensing Agreement was $0.2 million and $0.4 million for the three months ended March 31, 2006 and 2005, respectively.

See Note 6 for a description of the stock exchange transactions with Applied Digital.

Following is a summary of amounts due from and amounts due to related parties as of March 31, 2006 and December 31, 2005. (In thousands)

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying financial statements and related notes thereto.

We consist of Digital Angel Corporation and our subsidiaries - Digital Angel Technology Corporation (“DATC”), Fearing Manufacturing, Inc., Timely Technology Corp., Signature Industries Limited (90.9% owned subsidiary), OuterLink Corporation, DSD Holdings A/S and its subsidiaries Daploma International A/S (including its 70%-owned subsidiary, Daploma Polska) and Digitag A/S, Digital Angel Holdings, LLC and Digital Angel International, Inc. and its subsidiaries Digital Angel S.A. and Digital Angel do Brasil Produtos de Informatica LTDA.

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RESULTS OF OPERATIONS

The following table summarizes our results of operations as a percentage of net operating revenue for the three months ended March 31, 2006 and 2005 and is derived from the accompanying consolidated statements of operations included in this report.

Three Months Ended March 31, 2006 Compared to the Three Months Ended March 31, 2005

Revenue

Revenue for the three months ended March 31, 2006 increased $2.4 million, or 18.0%, to $15.8 million when compared to $13.4 million in revenue for the three months ended March 31, 2005.

Revenue for each of the operating segments was as follows (in thousands):

The Animal Applications segment’s revenue increased approximately $3.2 million, or 38.6%, in the three months ended March 31, 2006 compared to the three month period ended March 31, 2005. The increase in revenue was principally due to an increase in electronic and visual product sales to livestock customers of approximately $0.9 million, an increase in sales to companion animal customers of approximately $1.5 million, and an increase in revenue of approximately $0.8 million at our subsidiary DSD Holdings A/S. The increase in sales at DSD Holdings A/S results primarily from the inclusion of three months of results in the three month period ended March 31, 2006 compared to the inclusion of one month of results in the three month period ended March 31, 2005. DSD Holdings A/S was acquired on February 28, 2005.

The GPS and Radio Communications segment’s revenue decreased approximately $0.8 million, or 15.4% to approximately $4.3 million in the three months ended March 31, 2006 from approximately $5.1 million in the three months ended March 31, 2005. The decrease in revenue was principally due to a decrease in sales in Signature’s Sarbe Division of $1.0 million, a decrease in sales in Signature’s Clifford and Snell division of $0.1 million offset by increases of $0.2 million in each of Signature’s Control Products and Radio divisions. In the three months ended March 31, 2006 there were no shipments by Signature Industries Limited of the G2R Sarbe locator beacon under the contract with the government of India compared to approximately $0.9 million of shipments in the three months ended March 31, 2005. Signature completed shipments under the contract with the government of India occurred in May 2005.

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Gross Profit and Gross Profit Margin

Gross profit for the three month period ended March 31, 2006 was approximately $6.8 million, an increase of approximately $0.8 million, or 13.0%, compared to approximately $6.0 million in the three month period ended March 31, 2005. As a percentage of revenue, the gross profit margin decreased to 42.8% for the three months ended March 31, 2006 from 44.7% for the three months ended March 31, 2005.

Gross profit from operations for each operating segment was as follows (in thousands):

Gross profit margin from operations for each operating segment was:

The Animal Applications segment’s gross profit increased approximately $1.2 million, or 36.2%, in the three month period ended March 31, 2006 compared to the three months ended March 31, 2005. We attribute approximately $0.4 million of the increase to the previously mentioned sales increases and $0.4 million to the inclusion of DSD Holdings A/S for an additional two months of operations in three month period ended March 31, 2006. DSD Holdings A/S was acquired on February 28, 2005. The gross margin percentage was 40.4% for the three month period ended March 31, 2006 compared to 41.1% for the three month period ended March 31, 2005. The gross margin percentage decreased in the three month period ended March 31, 2006 due to increased freight, brokerage and customs expenses.

The GPS and Radio Communications segment’s gross profit decreased approximately $0.5 million, or 17.7%, in the three month period ended March 31, 2006 as compared to the three month period ended March 31, 2005. The decrease in gross profit relates to the decrease in sales and decreased gross margin percentage. The gross margin percentage decreased to 49.2% in the three month period ended March 31, 2006 as compared to 50.5% in the three month period ended March 31, 2005. The decrease in gross margin percentage relates primarily to higher margins on G2R Sarbe locator beacons shipped under the contract with the government of India in the first three months of 2005. Signature completed shipments under the contract with the government of India occurred in May 2005.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased approximately $0.9 million, or 17.0%, in the three month period ended March 31, 2006 as compared to the three month period ended March 31, 2005. As a percentage of revenue, selling, general and administrative expenses were 39.4% and 39.8% for the three months ended March 31, 2006 and 2005, respectively.

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Selling, general and administrative expenses for each of the operating segments were as follows (dollars in thousands):

Selling, general and administrative expenses as a percentage of revenue for each of the operating segments were:

The Animal Applications segment’s selling, general and administrative expenses increased approximately $1.2 million in the three month period ended March 31, 2006 as compared to the three month period ended March 31, 2005 and selling, general and administrative expense as a percentage of revenue increased to 34.4% from 33.5% in the same respective periods. The increase in selling, general and administrative expense relates primarily to a charge of approximately $0.2 million in acquisition expenses, approximately $0.6 million of increased compensation expense, and approximately $0.3 million of expense related to DSD Holding A/S. DSD Holding A/S was acquired on February 28, 2005. The increase in compensation expense relates primarily to increased bonus expense of $0.3 million, increased salaries of $0.2 and increased stock based compensation expense of $0.1 related to options granted to non-employees and restricted stock granted to in 2005. All of the Company’s out-of-the-money, unvested stock options issued to current employees, officers and directors prior to November 15, 2005 were vested on December 30, 2005 and no stock options were granted in the first quarter of 2006, therefore equity based compensation expense related to unvested stock options was immaterial in the three month period ended March 31, 2006.

The GPS and Radio Communications segment’s selling, general and administrative expenses decreased approximately $0.3 million to approximately $2.3 million in the three month period ended March 31, 2006 from approximately $2.6 million in the three month period ended March 31, 2005. The decrease in selling, general and administrative expense relates primarily to reduced salary expense and intangible amortization expense at our subsidiary, OuterLink Corporation. As a percentage of revenue, selling, general and administrative expenses increased to 52.8% in the three month period ended March 31, 2006 from 49.8% in the three month period ended March 31, 2005. The increase in selling, general and administrative expense as a percentage of sales resulted primarily from the decrease in sales in the current period.