UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2007

o		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: 1-15177

DIGITAL ANGEL CORPORATION

Delaware (State or other jurisdiction of incorporation or organization)		52-1233960 (I.R.S. Employer Identification Number)

490 Villaume Avenue, South St. Paul, MN (Address of principal executive offices)		55075 (Zip Code)

(651) 455-1621
Registrant’s telephone number, including area code

(Former Name, Former Address and Formal Fiscal Year, if Changed Since Last Report)

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 þ                    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 Rule 12b-2 of the Exchange Act (check one).

Large accelerated filer o          Accelerated filer o          Non-accelerated filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

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

Class		Outstanding at August 8, 2007
Common Stock, $.005 par value per share		44,641,388 shares

 

 

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES

TABLE OF CONTENTS

				Page
PART I — Financial Information
Item 1.		Financial Statements (unaudited):
		Condensed Consolidated Balance Sheets – As of June 30, 2007 and December 31, 2006			3
		Condensed Consolidated Statements of Operations – Three months and six months ended June 30, 2007 and 2006			4
		Condensed Consolidated Statement of Changes in Stockholders' Equity – Six months ended June 30, 2007			5
		Condensed Consolidated Statements of Cash Flows – Six months ended June 30, 2007 and 2006			6
		Notes to Condensed Consolidated Financial Statements			7
Item 2.		Management's Discussion and Analysis of Financial Condition and Results of Operations			20
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			32
Item 4T.		Controls and Procedures			33
PART II — Other Information
Item 1.		Legal Proceedings			34
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			34
Item 5.		Other Information			34
Item 6.		Exhibits			35
		Signatures			36
Exhibit 10.29
Exhibit 10.30
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

PART I — FINANCIAL INFORMATION

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(in thousands, except par values)

		June 30,				December 31,
		2007				2006
		(unaudited)
Assets
Current assets
Cash		$	1,004			$	1,521
Restricted cash			127				81
Accounts receivable, net of allowance for doubtful accounts of $183 and $203 at June 30, 2007 and December 31, 2006, respectively			10,816				9,609
Accounts receivable from VeriChip Corporation			35				425
Inventories			13,294				9,897
Other current assets			2,076				2,016
Current assets from discontinued operations			3,069				2,335
Total current assets			30,421				25,884
Property and equipment, net			11,040				9,985
Goodwill			53,276				51,244
Other intangible assets, net			1,589				1,633
Other assets, net			615				619
Other assets from discontinued operations			1,040				531
Total Assets		$	97,981			$	89,896
Liabilities and Stockholders’ Equity
Current liabilities
Line of credit and current maturities of long-term debt		$	9,294			$	4,127
Accounts payable			11,666				6,024
Due to Applied Digital Solutions, Inc.			67				11
Accrued expenses and other current liabilities			3,609				2,793
Current liabilities from discontinued operations			2,266				2,448
Total current liabilities			26,902				15,403
Long-term debt			3,790				4,036
Other long term liabilities
Derivative warrant liability			958				—
Other long term liabilities			373				386
Other liabilities from discontinued operations			2,585				1,060
Total other long term liabilities			3,916				1,446
Total Liabilities			34,608				20,885
Minority interest			409				465
Stockholders’ equity
Preferred stock ($1.75 par value; shares authorized, 1,000; shares issued, nil)			—				—
Common stock ($0.005 par value: shares authorized, 95,000: shares issued, 45,019 and 44,894: shares outstanding, 44,641 and 44,516)			226				226
Additional paid-in capital			215,027				214,509
Accumulated deficit			(150,962	)			(144,753	)
Treasury stock (carried at cost, 378 shares)			(1,580	)			(1,580	)
Accumulated other comprehensive income			253				144
Total Stockholders’ Equity			62,964				68,546
Total Liabilities and Stockholders’ Equity		$	97,981			$	89,896

See Notes to Condensed Consolidated Financial Statements.

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Operations (Unaudited)
(in thousands, except per share data)

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2007				2006				2007				2006
Total net revenue		$	19,533			$	12,428			$	34,831			$	27,747
Cost of sales			11,855				7,562				21,509				16,275
Gross profit			7,678				4,866				13,322				11,472
Selling, general and administrative expenses			7,763				5,685				15,277				11,631
Research and development expenses			1,585				727				2,804				1,522
Operating loss			(1,670	)			(1,546	)			(4,759	)			(1,681	)
Interest income			8				81				46				174
Interest expense			(674	)			(110	)			(998	)			(206	)
Change in derivative warranty liability			(105	)			—				296				—
Other income			30				27				62				45
Loss from continuing operations before income taxes and minority interest			(2,411	)			(1,548	)			(5,353	)			(1,668	)
Income tax (provision) benefit			(13	)			(11	)			(38	)			72
Minority interest share of loss (income)			10				(19	)			15				(58	)
Net loss from continuing operations			(2,414	)			(1,578	)			(5,376	)			(1,654	)
Loss from discontinued operations			(313	)			(546	)			(833	)			(1,056	)
Net loss		$	(2,727	)		$	(2,124	)		$	(6,209	)		$	(2,710	)
Earnings per common share — basic and diluted
Loss from continuing operations		$	(0.05	)		$	(0.04	)		$	(0.12	)		$	(0.04	)
Loss from discontinued operations			(0.01	)			(0.01	)			(0.02	)			(0.02	)
Net loss		$	(0.06	)		$	(0.05	)		$	(0.14	)		$	(0.06	)
Weighted average common shares outstanding — basic and diluted			44,562				44,286				44,539				44,097

See Notes to Condensed Consolidated Financial Statements.

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statement of Changes in Stockholders’ Equity (Unaudited)
For the Six Months Ended June 30, 2007
(in thousands)

																														Accumulated
																		Additional												Other				Total
		Preferred Stock								Common Stock								Paid-In				Accumulated				Treasury				Comprehensive				Stockholders'
		Number				Amount				Number				Amount				Capital				Deficit				Stock				Income				Equity
Balance, December 31, 2006			—			$	—				44,894			$	226			$	214,509			$	(144,753	)		$	(1,580	)		$	144			$	68,546
Net loss			—				—				—				—				—				(6,209	)			—				—				(6,209	)
Comprehensive loss:
Foreign currency translation adjustment			—				—				—				—				—				—				—				109				109
Total comprehensive loss																																			(6,100	)
Compensation expense			—				—				125				—				518				—				—				—				518
Balance, June 30, 2007			—			$	—				45,019			$	226			$	215,027			$	(150,962	)		$	(1,580	)		$	253			$	62,964

See Notes to Condensed Consolidated Financial Statements.

DIGITAL ANGEL CORPORATION AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows (Unaudited)
(in thousands)

		For the Six Months
		Ended June 30,
		2007				2006
Cash Flows From Operating Activities
Net loss		$	(6,209	)		$	(2,710	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Equity-based compensation			518				288
Depreciation and amortization			1,150				925
Amortization of debt discount and financing costs			339				—
Reduction in derivative warrant liability			(296	)			—
Minority interest			(15	)			58
Loss on disposal of equipment			8				4
Loss from discontinued operations			833				1,056
Change in assets and liabilities:
(Increase) decrease in restricted cash			(46	)			195
(Increase) decrease in accounts receivable			(1,073	)			3,383
Decrease (increase) in accounts receivable from VeriChip Corporation			391				(45	)
Increase in inventories			(1,074	)			(1,662	)
Increase in other current assets			(78	)			(390	)
Decrease in deferred tax liability			(12	)			(132	)
Increase (decrease) in accounts payable and accrued expenses			6,265				(2,905	)
Net cash (used in) provided by discontinued operations			(295	)			160
Net Cash Provided by (Used in) Operating Activities			406				(1,775	)
Cash Flows From Investing Activities
Decrease in other assets			66				214
Payments for property and equipment			(886	)			(672	)
Net cash paid for acquisition			(4,215	)			(1,000	)
Net cash used in discontinued operations			(438	)			(175	)
Net Cash Used in Investing Activities			(5,473	)			(1,633	)
Cash Flows From Financing Activities
Borrowings on line of credit			2,458				2,427
Payments on line of credit			(2,413	)			(2,004	)
Borrowings on debt			6,000				—
Payments on notes payable and long-term debt			(764	)			(355	)
Exercise of stock options and warrants			—				563
Payments of dividends to minority shareholder in subsidiary			(53	)			(140	)
Payments for financing costs			(686	)			—
Net Cash Provided by Financing Activities			4,542				491
Effect of Exchange Rate Changes on Cash			8				27
Net Decrease In Cash			(517	)			(2,890	)
Cash — Beginning of Period			1,521				9,949
Cash — End of Period		$	1,004			$	7,059

See Notes to Condensed Consolidated Financial Statements.

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited)

1. Basis of Presentation

The accompanying condensed consolidated financial statements of Digital Angel Corporation and its subsidiaries (the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and with the instructions to Form 10-Q and Article 10 of Regulation S-X under the Securities Exchange Act of 1934, as amended. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. The interim financial information in this report has not been audited. In the opinion of the Company’s management, all adjustments (consisting of normal recurring adjustments) considered necessary for fair financial statement presentation have been made. Results of operations reported for interim periods may not be indicative of the results for the entire year. These condensed consolidated financial statements and notes should be read in conjunction with the consolidated financial statements and notes included in the 2006 Annual Report on Form 10-K, as amended, filed with the Securities and Exchange Commission.

The preparation of financial statements in conformity with GAAP 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 that we may undertake in the future, they may ultimately differ from actual results. Included in these estimates are assumptions about allowances for inventory obsolescence, bad debt reserves, lives of long-lived assets and intangible assets, assumptions used in Black-Scholes valuation models, estimates of the fair value of acquired assets and the determination of whether any impairment is to be recognized on long-lived and intangible assets, among others.

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned and majority-owned subsidiaries from the date of acquisition. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company is engaged in the business of developing and bringing to market proprietary technology used to identify, locate and monitor people, animals, and objects. The Company operates in two business segments: (1) Animal Applications and (2) GPS and Radio Communications, which are discussed further in Note 9.

The condensed consolidated financial statements have been prepared on a going concern basis. See Note 5 for a discussion of the Company’s debt obligations and the impact on its liquidity.

As of June 30, 2007, Applied Digital Solutions, Inc. (“Applied Digital”) owned 24,573,788 shares or approximately 55% of the Company’s common stock.

On April 5, 2007, the Company acquired certain assets and customer contracts of McMurdo Limited (“McMurdo”), a United Kingdom based subsidiary of Chemring Group Plc (“Chemring”), and manufacturer of emergency location beacons. Pursuant to the agreement, Signature Industries Limited (“Signature”), the Company’s London based subsidiary operating in the GPS and Radio Communication business segment, acquired certain assets of McMurdo’s marine electronics business, including fixed assets, inventory, customer lists, customer and supplier contracts and relations, trade and business names, and associated assets. For further discussion of the acquisition see Note 3.

On July 2, 2007, the Company completed the sale of its wholly-owned subsidiary, OuterLink Corporation (“OuterLink”) to Newcomb Communications, Inc. (“Newcomb”). OuterLink provides satellite-based mobile asset tracking and data messaging systems used to manage the deployment of aircraft and land vehicles. Pursuant to the agreement, the Company sold all of the issued and outstanding shares of stock of OuterLink. As a result, its operations are included as part of the Company’s discontinued operations for all periods presented. For further discussion of the sale see Note 4.

2. Recent and Not Yet Adopted Accounting Pronouncements

In September 2006, FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. Earlier application is encouraged provided that the reporting entity has not yet issued financial statements for that fiscal year including financial statements for an interim period within that fiscal year. The Company is currently assessing SFAS 157 and has not yet determined the impact that the adoption of SFAS 157 will have on the Company’s results of operations or financial position.

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

2. Recent and Not Yet Adopted Accounting Pronouncements (continued)

In September 2006, FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R),” (“SFAS 158”), which requires employers to: (a) recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status; (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year; and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Those changes will be reported in comprehensive income of a business entity. The requirement to recognize the funded status of a benefit plan and the disclosure requirements are effective as of the end of the fiscal year ending after December 15, 2006, for entities with publicly traded equity securities. The initial adoption did not have an impact on the Company’s consolidated financial position, results of operations, cash flows or financial statement disclosures. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after December 15, 2008. The Company has not yet determined the impact that this requirement will have on the Company’s consolidated financial position, results of operations, cash flows or financial statement disclosures.

In February 2007, FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities- including an amendment of FASB Statement 115,” (“SFAS 159”). This statement provides companies with an option to report selected financial assets and liabilities at fair value. This statement is effective for fiscal years beginning after November 15, 2007 with early adoption permitted. The Company is currently assessing SFAS 159 and has not yet determined the impact that the adoption of SFAS 159 will have on the Company’s results of operations or financial position.

3. Acquisition

In April 2007, the Company, through its wholly-owned subsidiary Signature, acquired certain assets and customer contracts of McMurdo, a United Kingdom based subsidiary of Chemring and manufacturer of emergency location beacons. McMurdo develops and manufactures safety equipment technology. Its products, including the original EPIRB (Emergency Position Indicating Radio Beacon) and the first GMDSS (Global Maritime Distress and Safety System) and the approved Search and Rescue Transponder, have become standard lifesaving equipment on many recreational, commercial and military marine vehicles. This acquisition was made to broaden the Company’s emergency location beacon product offering to serve the military and commercial maritime sectors and provide stability to the Company’s revenue base.

Pursuant to the Asset Sale and Purchase Agreement (the “Agreement”), entered into in December 2006, Signature acquired certain assets and customer contracts of McMurdo’s marine electronics business including fixed assets, inventory, customer lists, customer and supplier contracts and relations, trade and business names, and associated assets. The assets excluded certain accrued liabilities and obligations and real property, including the plant facility which Signature has a license to occupy for a period of nine months from the Completion Date (as defined in the Agreement). Under the terms of the Agreement, Signature retained McMurdo’s employees related to the marine electronics business. In addition, pursuant to the terms of the Agreement, the Company guaranteed to McMurdo, Signature’s obligations and liabilities to McMurdo under the Guaranteed Agreements (as defined in the Agreement) and Chemring guaranteed to Signature, McMurdo’s obligations and liabilities under the Guaranteed Agreements. The Company paid consideration of approximately $4.7 million in cash, which included a payment of $0.5 million in the fourth quarter of 2006 and net of a purchase price adjustment of $0.9 million paid by Chemring in July 2007, and will make one additional deferred payment of up to $3 million. The deferred payment will be determined on a threshold basis with a minimum threshold, calculated on the basis of the invoiced value of specific products sold between November 1, 2006 and October 31, 2007 and payable when the parties finalize a statement of the sales.

The estimated fair values of assets acquired at the date of acquisition are as follows:

		April 5, 2007
		(in thousands)
Inventory		$	592
Fixed assets			2,178
Goodwill and other intangibles			1,972
Total assets acquired		$	4,742

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

3. Acquisition (continued)

The required purchase accounting adjustments, including the allocation of the purchase price based on the fair values of the assets acquired have been made based upon preliminary valuations, which are still in review and are subject to change. Based upon the Company’s final valuation and review it may determine that additional tangible assets or their estimated useful lives require revision. The Company anticipates that it will finalize the purchase price allocation within the next several months. Any adjustments to the purchase price allocation will be recorded as an increase or decrease in goodwill.

The acquisition was accounted for under the purchase method of accounting and, accordingly, the condensed consolidated financial statements reflect the results of operations of McMurdo from the date of acquisition. Unaudited pro forma results of operations for the three and six months ended June 30, 2007 and the three and six months ended June 30, 2006 are included below. Such pro forma information assumes that the above acquisition had occurred as of January 1, 2007 and 2006, respectively, and revenue is presented in accordance with the Company’s accounting policies. These unaudited pro forma statements have been prepared for comparative purposes only and are not intended to be indicative of what the Company’s results would have been had the acquisition occurred at the beginning of the periods presented or the results which may occur in the future.

		Pro Forma for the				Pro Forma for the				Pro Forma for the
		Three Months				Six Months Ended				Six Months Ended
		Ended June 30,				June 30,				June 30,
		2006				2007				2006
		(unaudited, in thousands)
Net operating revenue		$	15,265			$	39,009			$	33,186
Net loss from continuing operations			(1,957	)			(5,032	)			(2,587	)
Net loss from continuing operations per common share — basic and diluted			(0.04	)			(0.11	)			(0.06	)

4. Discontinued Operations

In May 2007, the Company entered into a Stock Purchase Agreement with Newcomb to sell 100% of the issued and outstanding shares of stock of OuterLink. OuterLink, which operated in the Company’s GPS and Radio Communications business segment, provides satellite-based mobile asset tracking and data messaging systems used to manage the deployment of aircraft and land vehicles. On July 2, 2007, the Company completed the sale of OuterLink. Consideration, which is subject to certain adjustments based on OuterLink’s closing balance sheet, initially consisted of a cash payment of $800,000 and a promissory note of $200,000 which matures on December 31, 2007. In connection with the closing, the Company also executed a one-year non-competition agreement with OuterLink. Mr. Paul F. Newcomb, President of Newcomb, was the founder and President of the predecessor company to OuterLink, which the Company acquired in January 2004.

In June 2007, in connection with the Company’s planned sale of OuterLink, the Company entered into an amendment of the Securities Purchase Agreement and the Registration Rights Agreement between the Company and Imperium Master Fund, Ltd. (“Imperium”) and Gemini Master Fund, Ltd. (“Gemini,” and together with Imperium, the “Investors”) and received a waiver letter from the Investors waiving certain of their rights under the Subsidiary Guaranty executed by OuterLink in favor of the Investors and the Security Agreement executed by the Company and OuterLink in favor of the Investors (collectively, the amendments and the waiver letter, the “OuterLink Amendments”). Pursuant to the terms of the OuterLink Amendments, the Investors consented to the sale of OuterLink, waived all existing defaults, if any, under Section 4.10(b) of the Securities Purchase Agreement, released the outstanding shares of OuterLink owned by the Company from the pledge and security interest granted to the Investors, and released OuterLink from its obligations arising under the Subsidiary Guaranty. As consideration, the Company exchanged the 699,600 existing warrants for 841,000 newly issued seven-year warrants with an exercise price of $1.701.

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

4. Discontinued Operations (continued)

As a result of the sale of OuterLink, its operations are included as part of the Company’s discontinued operations for all periods presented. The following discloses the operating losses from discontinued operations for the three and six months ended June 30, 2007 and 2006, attributable to OuterLink:

		Three Months Ended								Six Months Ended
		June 30,								June 30,
(in thousands)		2007				2006				2007				2006
		(unaudited)								(unaudited)
Total net revenue		$	716			$	528			$	1,417			$	1,031
Cost of sales			401				332				853				665
Gross profit			315				196				564				366
Selling, general and administrative expenses			354				318				730				604
Research and development expenses			274				425				667				819
Interest income			—				(1	)			—				(1	)
Loss from discontinued operations		$	(313	)		$	(546	)		$	(833	)		$	(1,056	)
Earnings per common share — basic and diluted:
Loss from discontinued operations		$	(0.01	)		$	(0.01	)		$	(0.02	)		$	(0.02	)

The results above do not include any allocated or common overhead expenses and do not reflect the gain on the sale of OuterLink, which is expected to be approximately $1.7 million, after taking into account potential future purchase price adjustments. Given the Company’s current tax status, the gain is not expected to result in a provision from income taxes due to federal and state net operating losses and carryforwards. This gain is expected to be recorded in the Company’s actual results of operations in the three months ended September 30, 2007.

The net assets of discontinued operations as of June 30, 2007 and December 31, 2006 were comprised of the following:

		June 30,				December 31,
(in thousands)		2007				2006
		(unaudited)
Current assets
Cash		$	152			$	2
Accounts receivable			1,645				956
Inventory			608				503
Other current assets			664				874
Total current assets			3,069				2,335
Property and equipment, net			345				274
Other assets, net			695				257
Total long-term assets			1,040				531
Total assets		$	4,109			$	2,866
Current liabilities
Accounts payable			274				408
Accrued expenses and other current liabilities			439				270
Deferred revenue			1,553				1,770
Total current liabilities			2,266				2,448
Other long-term liabilities			2,585				1,060
Total liabilities		$	4,851			$	3,508
Net liabilities from discontinued operations		$	742			$	642

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

5. Financing Arrangements and Liquidity

On February 6, 2007, the Company entered into a Securities Purchase Agreement pursuant to which the Company sold a 10.25% senior secured debenture (“debenture”) in the original principal amount of $6,000,000 and issued five-year warrants to purchase 699,600 shares of the Company’s common stock at a per share exercise price of $2.973. Concurrently with the Securities Purchase Agreement, the Company executed a Registration Rights Agreement (the “Registration Agreement”), pursuant to which the Company is obligated to register for resale shares of the Company’s common stock sufficient to cover the shares necessary to pay the principal and interest payments due on the debenture and the shares underlying the warrants. If the Company does not comply with the registration deadlines set forth in the registration agreement, the Company will be obligated to pay each Investor, pro rata, a default payment equal to 1% of the aggregate purchase price of the debenture for each month the registration default is not cured, capped at 9% and the exercise price is subject to certain reset provisions.

In connection with the debenture, the Company and its direct subsidiaries entered into the Security Agreement, whereby the Investors were granted a security interest in certain assets and properties of Digital Angel and its direct subsidiaries. In addition, Digital Angel’s direct subsidiaries entered into a subsidiary guarantee, under which the subsidiaries guaranteed Digital Angel’s obligations.

On June 28, 2007, the Company entered into amendments of each of the Securities Purchase Agreement and the Registration Rights Agreement in connection with the planned sale of OuterLink and the Investors delivered a waiver letter to the Company waiving certain of their rights under the Subsidiary Guaranty executed by OuterLink in favor of the Investors and the Security Agreement executed by the Company and OuterLink in favor of the Investors (collectively, the amendments and the waiver letter are referred to as the “OuterLink Amendments”). Pursuant to the terms of the OuterLink Amendments, the Investors (1) consented to the sale of OuterLink, (2) waived all existing defaults, if any, under Section 4.10(b) of the Securities Purchase Agreement, (3) released the outstanding shares of OuterLink owned by the Company from the pledge and security interest granted to the Investors and (4) released OuterLink from its obligations arising under the Subsidiary Guaranty. In addition, the parties agreed to extend the registration deadline provided in the Registration Rights Agreement to October 1, 2007. As consideration, the Company exchanged the 699,600 existing warrants for 841,000 newly issued seven-year warrants with an exercise price to $1.701.

The warrants contain certain anti-dilution provisions and, accordingly, the Company has accounted for the fair value of the warrants as a derivative liability subject to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” At issuance, the fair value of the 699,600 five-year warrants, as calculated using the Black-Scholes valuation model, was $1,253,000 using the following assumptions: volatility of 83.13%, risk free interest rate of 4.6%, dividend rate of 0.0% and expected life of 5 years. The fair value of the warrants was recorded as a discount to the debenture and is being amortized to interest expense over the life of the debenture. The warrant fair value is revalued at each balance sheet date using the Black-Scholes valuation model with changes in value recorded in the condensed consolidated statement of operations as income or expense. At June 30, 2007, the warrant derivative fair value for the 841,000 seven-year warrants then outstanding was $958,000 using the following assumptions: volatility of 73.91%, risk free interest rate of 4.6%, dividend rate of 0.0% and expected life of 7 years. Approximately $105,000 of expense and approximately $296,000 of income is included in the condensed consolidated statement of operations for the three and six months ended June 30, 2007, respectively, as a result of the changes in the fair value of the warrant.

The debenture was originally scheduled to mature on February 6, 2010, but the Company, at its option, had the right to prepay the debenture in cash at any time by paying a premium of 2% of the outstanding principal amount of the debenture. The Company was obligated to make monthly payments of principal plus accrued, but unpaid interest (including default interest, if any) beginning on September 4, 2007. On June 28, 2007, the Company delivered its sixty-day prepayment notice to the Investors pursuant to Section 4 of the debenture(s). Pursuant to the terms of the debenture, the Company is required to pay 102% of the outstanding principal amount of the debenture on the date of its repayment plus all accrued and unpaid interest. Based on the Company’s election to prepay the debenture, the Company will be required to write off $1.5 million of deferred financing costs and debt discount in the third quarter of 2007.

As long as the debenture is outstanding, the Company and its subsidiary, Signature, are required to comply with certain financial covenants including minimum net tangible asset ratios and limits on the total amount of liabilities that exist at each entity and on a combined basis. As of June 30, 2007, the Company and its subsidiary, Signature, were in compliance with each of the financial covenants. A breach of any of these covenants, after notice from the Investors and if not remedied within the specified period, could result in an event of default. Upon the occurrence of any default, the Investors can elect to declare all amounts of principal outstanding under such debenture, together with all accrued interest, to be immediately due and payable. Furthermore, if such an event of default or a change of control occurs, the Investors have the right to require the Company to redeem the debenture for a cash amount equal to 110% of the outstanding principal plus interest.

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

5. Financing Arrangements and Liquidity (continued)

In addition to the financings discussed above, the Company has additional loans and credit facilities, which are discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Liquidity and Capital Resources from Continuing Operations” which is presented below.

The Company will be required to generate funds to repay the debentures through a combination of operating cash flow, borrowings under the existing invoice discounting agreement and other financing arrangements and/or third party financings. The Company’s historical sources of liquidity have included proceeds from the sale of common stock, proceeds from the issuance of debt, proceeds from the sale of one of its businesses, proceeds from the sale of shares of Applied Digital’s common stock under share exchange agreements, and proceeds from the exercise of stock options and warrants. In addition to these sources, other sources of liquidity may include the raising of capital through additional private placements or public offerings of debt or equity securities and proceeds from the sale of additional businesses. However, going forward some of these sources may not be available, or if available, they may not be on favorable terms. Accordingly, these conditions indicate that the Company may be unable to continue as a going concern. The accompanying financial statements have been prepared on a going concern basis and do not reflect any adjustments that might result from the outcome of this uncertainty.

6. Factored Accounts Receivable

		June 30,				December 31,
		2007				2006
		(in thousands)
Receivables assigned to factor		$	4,490			$	1,094
Advances from factor			(3,592	)			(875	)
Amounts due from factor			898				219
Unfactored accounts receivable			10,101				9,593
Allowance for doubtful accounts			(183	)			(203	)
		$	10,816			$	9,609

On March 23, 2007, the Company entered into a revolving invoice funding facility (“Greater Bay facility”) with Greater Bay Business Funding, a division of Greater Bay Bank N.A (“Greater Bay”). The Greater Bay facility provides that the Company sell and assign to Greater Bay, all rights, title, and interest in the accounts receivable of Digital Angel Technology Corporation. Under the Greater Bay facility, Greater Bay advances 80% of the eligible receivables, as defined, not to exceed a maximum of $5,000,000 at any given time. Greater Bay pays the remainder of the receivable upon collection. Interest is payable on the daily outstanding balance of funds drawn and is equal to the Greater Bay Bank N.A. prime rate (8.25% at June 30, 2007) plus 3.00%. The Greater Bay facility has an initial term of 12 months and is guaranteed by security interests covering all accounts, contract rights, and general intangibles relating to the Company’s accounts receivable. As of June 30, 2007, $2.1 million of receivables were financed under the Greater Bay facility. The Company had $0.4 million of advances available under the Greater Bay facility at June 30, 2007.

Signature has entered into an Invoice Discounting Agreement, (as amended, the “RBS Invoice Discounting Agreement”) with The Royal Bank of Scotland Commercial Services Limited (“RBS”). The RBS Invoice Discounting Agreement provides for Signature to sell with full title guarantee most of its receivables, as defined in the RBS Invoice Discounting Agreement. Under the agreement, RBS prepays 80% of the receivables sold in the United Kingdom and 80% of the receivables sold in the rest of the world, not to exceed an outstanding balance of £2,000,000 (approximately $4.0 million at June 30, 2007) at any given time. RBS pays Signature the remainder of the receivable upon collection of the receivable. Receivables which remain outstanding 90 days from the end of the invoice month become ineligible and RBS may require Signature to repurchase the receivable. The discounting charge accrues at an annual rate of 1.5% above the base rate as defined in the RBS Invoice Discounting Agreement (5.75% at June 30, 2007). Signature pays a commission charge to RBS of 0.16% of each receivable balance sold. The RBS Invoice Discounting Agreement requires a minimum commission charge of £833 (approximately $1,700) per month. Discounting charges of $33,000 and $57,000 are included in interest expense for the three and six months ended June 30, 2007, respectively. As of June 30, 2007, $1.5 million of receivables were financed under the RBS Invoice Discounting Agreement.

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

7. Inventory

Inventory consists of the following:

		June 30,				December 31,
		2007				2006
		(in thousands)
Raw materials		$	5,470			$	3,291
Work in process			1,024				402
Finished goods			7,953				7,215
			14,447				10,908
Allowance for excess and obsolescence			(1,153	)			(1,011	)
Net inventory		$	13,294			$	9,897

Inventory located in Europe and Asia amounted to $8.3 million and $5.7 million as of June 30, 2007 and December 31, 2006, respectively.

8. Stock Options and Restricted Stock

Stock Option Plans

As of June 30, 2007, the Company maintained 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 that was terminated on February 23, 2006. On January 1, 2006, the Company adopted SFAS 123R, “Share-Based Payment” (“SFAS 123R”), using the modified prospective transition method. Accordingly, during the six month period ended June 30, 2006, the Company recorded stock-based compensation expense for awards granted in 2006 and 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, the Company elected to continue using the Black-Scholes valuation model and has recognized compensation expense using a straight-line amortization method. During the three and six month periods ended June 30, 2007, the Company recorded $227,000 and $518,000, respectively, in stock-based employee compensation expense (including compensation for options granted to non-employees and for restricted stock grants). During the three and six month periods ending June 30 2006, the Company recorded $137,000 and $288,000, respectively, of stock-based compensation expense.

Prior to the adoption of SFAS123R, the Company presented all tax benefits related to stock-based compensation as an operating cash inflow. SFAS 123R requires the cash flows resulting from tax deductions in excess of compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The Company did not record any excess income tax benefits relating to SFAS 123R during the six months ended June 30, 2007 and June 30, 2006.

As of June 30, 2007, the DAC Stock Option Plan, which is stockholder-approved, has 18,195,312 shares of common stock reserved for issuance, of which 16,641,333 shares have been issued and 1,553,979 remain available for issuance. As of June 30, 2007, awards consisting of options to purchase 8,766,531 shares were outstanding under the DAC Stock Option Plan and awards consisting of options to purchase 472,820 shares were outstanding under the Company’s terminated stock option plan. Additionally, restricted stock awards for 213,526 shares of common stock have been granted under the DAC Stock Option Plan. Option awards are generally granted with exercise prices between market price and 110% of the market price of the Company’s stock at the date of grant; option awards generally vest over 3 to 9 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).

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

8. Stock Options and Restricted Stock (continued)

Stock Option Activity

The fair value of each option award is estimated on the date of grant using the Black-Scholes valuation model. The following assumptions were used for options granted during the six month period ended June 30:

		2007				2006
Risk-free interest rate			5.18-4.62	%			4.89	%
Expected life (in years)			5				4 - 10
Dividend yield			0.00	%			0.00	%
Expected volatility			81.00-83.78	%			87.19	%
Weighted-average volatility			83.57	%			87.19	%

The Company’s computation of expected volatility is determined based on historical volatility. The computation of expected life is 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 risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant.

A summary of the Company’s stock option activity as of June 30, 2007, and changes during the six months then ended is presented below (in thousands, except per share amounts):

										Weighted
						Weighted				Average				Aggregate
		Stock				Average				Contractual				Intrinsic
		Options				Exercise Price				Term				Value
Outstanding at January 1, 2007			11,705			$	3.84
Granted			280				2.68
Exercised			—				—
Forfeited or expired			(1,246	)			3.85
Outstanding at June 30, 2007			10,739			$	3.81				7.04			$	596	*
Vested or expected to vest at June 30, 2007			10,235			$	3.83				6.94			$	591	*
Exercisable at June 30, 2007			8,858			$	3.94				6.63			$	596	*

^* 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 the Company’s common stock was $1.60 per share at June 30, 2007.

The weighted average grant-date fair value of options granted during the six month periods ended June 30, 2007 and 2006 was $1.81 and $2.73, respectively. The total intrinsic value of options exercised during the six month periods ended June 30, 2007 and 2006 was nil and $644,000, respectively.

A summary of the status of the Company’s nonvested stock options as of June 30, 2007 and changes during the six month period ended June 30, 2007, is presented below (in thousands, except per share amounts):

						Weighted Average
						Grant-Date
		Stock Options				Fair Value
Nonvested at January 1, 2007			2,458			$	2.64
Granted			280				1.81
Vested			(283	)			2.22
Forfeited or expired			(574	)			2.09
Nonvested at June 30, 2007			1,881			$	2.59

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

8. Stock Options and Restricted Stock (continued)

As of June 30, 2007, there was $3.7 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 6.2 years.

Cash received from option exercises under all share-based payment arrangements for the six month periods ended June 30, 2007 and 2006, was nil and $0.6 million, respectively.

On January 13, 2004, the Company granted its Chief Executive Officer 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 and approved by the Company’s shareholders on May 6, 2004. The option became exercisable on December 30, 2005. As of June 30, 2007, 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 and approved by the Company’s shareholders on May 6, 2004. The option became exercisable on February 18, 2005. As of June 30, 2007, 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 vested 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 was recorded as deferred compensation and was amortized to compensation expense over the two year vesting period. In the six month periods ended June 30, 2007 and 2006, $42,000 and $125,000, respectively, was recognized as compensation expense in the Company’s results of operations related to the restricted stock.

In February 2005, the Company granted an employee 54,230 shares of the Company’s restricted stock. The restricted stock vested 30% on February 25, 2006, 30% on February 25, 2007 and will vest 40% on February 25, 2008. 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 six month periods ended June 30, 2007 and 2006, $44,000 and $37,000, respectively, was recognized as compensation expense in the Company’s results of operations related to the restricted stock.

9. Segment Information

The Company develops and deploys sensor and communication technologies that enable rapid and accurate identification, location tracking, and condition monitoring of high-value assets. The Company’s two main operating segments are: (1) Animal Applications and (2) GPS and Radio Communications. Previously, the Company combined its Corporate functions with its Animal Applications segment. Beginning April 1, 2007, Corporate has been reclassified and presented separately. Prior period results have also been reclassified for consistency.

Animal Applications—develops, manufactures, and markets electronic radio frequency and visual identification devices for the companion animal, equine, fish and wildlife, and livestock markets worldwide.

The Animal Applications segment’s radio frequency identification products consist of miniature electronic microchips, scanners, and for some applications, injection systems. The Company holds patents on its syringe-injectable microchip, which is encased in a glass or glass-like material capsule and incorporates an antenna and a microchip with a unique permanent identification code. The microchip is typically injected under the skin using a hypodermic syringe, without requiring surgery. An associated scanner device uses radio frequency to interrogate the microchip and read the code.

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

9. Segment Information (continued)

The Animal Applications segment’s companion pet identification system involves the insertion of a microchip with identifying information into the animal. Scanners at animal shelters, veterinary clinics and other locations can read the microchip’s unique identification number. Through the use of a database, the unique identification number identifies the animal, 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™,” pursuant to a multi-year exclusive license, in Europe by Merial Pharmaceutical, and in Japan by Dainippon Pharmaceutical. The Company has distribution agreements with a variety of other companies outside the United States to market its products.

The Animal Applications segment’s miniature electronic microchips are also used for the tagging of fish, especially salmon, for identification in migratory studies and other purposes. The electronic microchips are accepted as a safe, reliable alternative to traditional identification methods because the fish, once implanted, can be identified without being captured or sacrificed.

In addition to pursuing the market for permanent identification of companion animals and tracking microchips for fish, the Animal Applications segment also produces visual and electronic identification products for livestock producers. Visual identification products for livestock are typically numbered ear tags, which the Company has marketed since the 1940s. Currently, sales of visual products represent a substantial percentage of the Company’s sales to livestock producers.

In addition, the Company’s implantable radio frequency microchip was cleared by the U.S. Food and Drug Administration for medical applications in humans in the United States in October 2004. The Company has a long-term exclusive distribution and licensing agreement with VeriChip Corporation (“VeriChip”), an affiliated, majority-owned subsidiary of Applied Digital, covering the manufacturing, purchasing and distribution of the human implantable microchip, which is more fully described in Note 12.

GPS and Radio Communications—designs, manufactures and supports GPS enabled equipment. The GPS and Radio Communications segment consists of the operations of the Company’s subsidiary, Signature (90.9% owned), which is located in the United Kingdom, and includes the operations of the McMurdo business acquired in April 2007. Applications for the segment’s products include location tracking and message monitoring of marine 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. Signature’s businesses also include communication equipment leasing and complementary data systems that customers can use to locate and monitor their assets and alarm sounder manufacturing. Technology development in this segment includes the integration and miniaturization into marketable products of two technologies: wireless communications and position location technology (including global positioning systems (“GPS”) and other systems).

The Corporate category includes general and administrative expenses, interest expense and income and other expenses associated with corporate activities and functions.

It is on this basis that the Company’s management utilizes the financial information to assist in making internal operating decisions. The Company evaluates performance based on stand-alone segment operating performance as presented below.

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

9. Segment Information (continued)

The following is the selected segment data as of and for the periods ended:

														Total From
		Animal				GPS and Radio								Continuing
As of and For the Three Months Ended June 30,		Applications				Communications				Corporate				Operations
		(in thousands)
2007
Total net revenue		$	11,029			$	8,504			$	—			$	19,533
Operating loss			(504	)			(510	)			(656	)			(1,670	)
Operating loss from continuing operations before income taxes and minority interest			(560	)			(562	)			(1,289	)			(2,411	)
Segment assets from continuing operations		$	77,103			$	18,301			$	(1,532	)		$	93,872
2006
Total net revenue		$	8,375			$	4,053			$	—			$	12,428
Operating loss			(718	)			(218	)			(610	)			(1,546	)
Operating loss from continuing operations before income taxes and minority interest			(743	)			(229	)			(576	)			(1,548	)
Segment assets from continuing operations		$	79,180			$	7,840			$	10			$	87,030

														Total From
		Animal				GPS and Radio								Continuing
As of and For the Six Months Ended June 30,		Applications				Communications				Corporate				Operations
		(in thousands)
2007
Total net revenue		$	21,289			$	13,542			$	—			$	34,831
Operating loss			(2,070	)			(1,083	)			(1,606	)			(4,759	)
Operating loss from continuing operations before income taxes and minority interest			(2,153	)			(1,160	)			(2,040	)			(5,353	)
Segment assets from continuing operations		$	77,103			$	18,301			$	(1,532	)		$	93,872
2006
Total net revenue		$	19,877			$	7,870			$	—			$	27,747
Operating income (loss)			163				(355	)			(1,488	)			(1,681	)
Operating income (loss) from continuing operations before income taxes and minority interest			119				(376	)			(1,411	)			(1,668	)
Segment assets from continuing operations		$	79,180			$	7,840			$	10			$	87,030

10. Supplemental Cash Flow Information

		Six Months Ended
		June 30,
		2007				2006
		(in thousands)
Interest paid		$	232			$	199
Taxes paid			55				59
Non-cash activity:
Issuance of common stock to former shareholders of DSD Holdings A/S			—				1,000
Reclass of other assets to acquisition cost			494				—
Financing of equipment through capital lease			546				352

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

11. Income Taxes

Effective January 1, 2007, the Company adopted FASB Interpretation No. 48, “Accounting for Uncertainties in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The impact of adoption was immaterial to the Company’s condensed consolidated results of operations and financial position and, therefore, no FIN 48 liability was recorded. In addition, the Company did not record any liability for income tax-related interest and penalties. Any future expense for income tax-related interest and penalties will be classified as a component of income taxes.

12. Related Party Activity

The Company has a Distribution and Licensing Agreement dated March 4, 2002, amended December 28, 2005 and May 9, 2007, with VeriChip, a majority-owned subsidiary of Applied Digital at March 31, 2007, covering the manufacturing, purchasing and distribution of the Company’s implantable microchip and the maintenance of the VeriChip Registry by us. The amended agreement contains, among other things, minimum purchase requirements in order to maintain exclusivity, whereby VeriChip is required to purchase $0, $875,000, $1,750,000 and $2,500,000 for each of 2007, 2008, 2009 and 2010, respectively, and $3,750,000 for 2011 and each year thereafter. The agreement continues until March 2014 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 España, SA, expire on June 30, 2010.

Revenue recognized under the Distribution and Licensing Agreement was $35,000 and $14,000 for the three months ended June 30, 2007 and 2006, respectively, and $39,000 and $173,000 for the six months ended June 30, 2007 and 2006, respectively. Amounts due from VeriChip as of June 30, 2007 and December 31, 2006 were $35,000 and $425,000, respectively.

13. Legal Proceedings

Digital Angel Corporation v. 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, (“Crystal”), and Medical Management International, Inc. 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. The suit seeks, among other things, an adjudication of infringement, injunctive relief, and actual and punitive damages. 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. On May 22, 2006, the Court issued its order on the Markman Hearing, largely adopting the Company’s views on the scope of the claims in the subject patent.

The Crystal Import Corporation v. Digital Angel, et al.

On or about December 29, 2004, Crystal 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. On October 12, 2005, the Alabama Court transferred 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.

DIGITAL ANGEL CORPORATION
Notes to Condensed Consolidated Financial Statements (Unaudited) (continued)

13. Legal Proceedings (continued)

Settlement Negotiations

On July 27, 2007, pursuant to the Court’s settlement conference procedures, the parties in the above described legal proceedings reached agreement on the terms of a global settlement, which settlement would, among other things, result in a dismissal of all claims with prejudice. Such final settlement is subject to execution of definitive settlement documentation and entry of appropriate orders with the Court.

14. Subsequent Events

On July 2, 2007, the Company completed the sale of its wholly-owned subsidiary, OuterLink, to Newcomb. The sale is more fully described in Note 4.

On August 8, 2007, the Company and Applied Digital entered into an Agreement and Plan of Reorganization by and among the Company, Applied Digital, and Digital Angel Acquisition Corp., a Delaware corporation and wholly-owned subsidiary of Applied Digital (the “Acquisition Subsidiary”), pursuant to which the Acquisition Subsidiary will be merged with and into us, with the Company surviving and becoming a wholly-owned subsidiary of Applied Digital (the “Merger”). Upon the consummation of the Merger, each outstanding share of our common stock not currently owned by Applied Digital will be converted into 1.4 shares of Applied Digital’s common stock. This amount represents a premium for our common stock of 21% over the closing price of our stock as of the twenty trading days ending on August 7, 2007. The acquisition will be accounted for under purchase accounting.

Effective August 6, 2007, Kevin McGrath resigned as the Company’s president, chief executive officer and director. The Company’s board of directors approved a severance payment for Mr. McGrath in the total amount of $750,000, which will result in a third quarter charge, of which $320,000 shall be payable in cash over the next twelve months in accordance with the Company’s ordinary payroll practices, less required deductions and withholdings, and $430,000 shall be payable through the issuance of 307,143 shares of restricted stock, which restrictions would lapse in one year from the date of issuance. The Company will pay all of Mr. McGrath’s accrued benefits through September 7, 2007, including unused vacation time, reimbursement of outstanding business expenses, accrued but unpaid salary or bonus amounts, and the like. In addition, the Company will reimburse Mr. McGrath the cost of COBRA contributions through September 7, 2008. In exchange for the severance payment, Mr. McGrath was required to enter into a severance agreement with the Company containing a general release and waiver and non-competition and non-solicitation provisions.

On August 6, 2007, the Company, with Board approval, appointed Barry Edelstein, as President and Chief Executive Officer. In connection with his appointment, Mr. Edelstein will receive a salary in the amount of $40,000 per month, plus incentive bonus of up to $120,000. Mr. Edelstein will also receive a grant of 100,000 stock options, exercisable at a strike price equal to the closing market price of the Company’s common stock on the American Stock Exchange as of August 6, 2007. The stock options granted shall have an exercise term of 10 years, and shall vest and become exercisable as to 10% per year for eight years, beginning on August 6, 2008, and 20% on August 6, 2016. Mr. Edelstein will be entitled to participate in such other benefits programs as are made available to the Company’s officers from time to time.

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 condensed consolidated 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, (“Signature”) (90.9% owned subsidiary), DSD Holdings A/S and its subsidiaries Daploma International A/S (“DSD Holdings”), Daploma Polska (70% owned subsidiary), and Digitag A/S, Digital Angel Holdings, LLC and Digital Angel International, Inc. and its subsidiaries Digital Angel S.A. (99.58% owned subsidiary), Digital Angel do Brasil Produtos de Informatica LTDA, Digital Angel Chile S.A., Digital Angel Paraguay S.A. and Digital Angel Uruguay S.A.

Overview

We develop and deploy sensor and communication technologies that enable rapid and accurate identification, location tracking and condition monitoring of high value assets. We operate in two business segments: (1) Animal Applications and (2) GPS and Radio Communications. Previously, we combined our Corporate functions with our Animal Applications segment. Beginning April 1, 2007, Corporate has been reclassified and presented separately. Prior period results have also been reclassified for consistency.

Animal Applications — Develops, manufactures and markets visual and electronic identification tags and RFID microchips, primarily for identification, tracking and location of companion pets, horses, livestock, fish and wildlife worldwide, and, more recently, for animal bio-sensing applications, such as temperature reading for companion pet, horse and livestock applications. The Animal Applications segment consists of our operations located in Minnesota, DSD Holdings A/S and its wholly and majority-owned subsidiaries, located in Denmark and Poland, and Digital Angel International, Inc. and its subsidiaries located in Argentina, Brazil, Chile, Paraguay and Uruguay. The positive identification and tracking of livestock and fish are crucial for asset management and for disease control and food safety. In addition to the visual ear tags which have been sold by us since the late 1940’s, Animal Applications utilizes RFID technologies in its electronic ear tags and implantable microchips.

GPS and Radio Communications — Designs, manufactures, and markets GPS enabled equipment used for location tracking and message monitoring of marine vehicles, aircraft and people in remote locations. The GPS and Radio Communications segment consists of the operations of our subsidiary, Signature, located in the United Kingdom, and includes the operations of the McMurdo business acquired by Signature in April 2007. Our focus is in the areas of search and rescue and locator beacons, and tracking systems, which include mobile satellite data communications service and software for mapping and messaging for a variety of industries including the military, air and ground ambulance operators, law enforcement agencies and energy companies.

Significant Factors Affecting our Results of Operations and Financial Condition

On April 5, 2007, our subsidiary, Signature acquired certain assets of McMurdo’s marine electronics business, including fixed assets, inventory, customer lists, customer and supplier contracts and relations, trade and business names and associated assets.

On July 2, 2007, we completed the sale of our wholly-owned subsidiary, OuterLink to Newcomb. OuterLink provides satellite-based mobile asset tracking and data messaging systems used to manage the deployment of aircraft and land vehicles. Pursuant to the agreement, we sold all of the issued and outstanding shares of stock of OuterLink. As a result of the sale of OuterLink, its operations are included as part of our discontinued operations for all periods presented.

Recent Accounting Pronouncements

For information regarding recent and not yet adopted accounting pronouncements and their expected impact on our future consolidated results of operations or financial condition, see Note 2 to our Condensed Consolidated Financial Statements.

Revenue Recognition for the McMurdo business

Consistent with our existing policy, we recognize revenue for the McMurdo business 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. Our accounting policy regarding vendor and post contract support obligation is revenue is recognized upon occurrence of the post-sale support. Costs of products sold and services provided are recorded as the related revenue is recognized. We offer a warranty on our 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 our policy to record contract losses in their entirety in the period in which such losses are foreseeable.

Our Annual Report on Form 10-K for the year ended December 31, 2006 contains further information regarding other critical accounting policies.

Consolidated Results of Operations

The following table summarizes our results of operations as a percentage of net operating revenues and is derived from the accompanying unaudited condensed consolidated statements of operations in Part I, Item 1 of this quarterly report.

		For the Three Months								For the Six Months
		Ended June 30,								Ended June 30,
		2007				2006				2007				2006
Total net revenue			100.0	%			100.0	%			100.0	%			100.0	%
Cost of sales			60.7				60.8				61.8				58.7
Gross profit			39.3				39.2				38.2				41.3
Selling, general and administrative expenses			39.7				45.7				43.9				41.9
Research and development expenses			8.1				5.9				8.0				5.5
Operating loss			(8.5	)			(12.4	)			(13.7	)			(6.1	)
Interest income			—				0.6				0.1				0.6
Interest expense			(3.4	)			(0.9	)			(2.9	)			(0.7	)
Change in derivative warrant liability			(0.4	)			—				0.9				—
Other income			—				0.2				0.1				0.2
Loss from continuing operations before income taxes and minority interest			(12.3	)			(12.5	)			(15.3	)			(6.0	)
Income tax (provision) benefit			(0.1	)			(0.1	)			(0.1	)			0.2
Minority interest share of loss (income)			—				(0.1	)			—				(0.2	)
Loss from continuing operations			(12.4	)			(12.7	)			(15.4	)			(6.0	)
Net loss from discontinued operations			(1.6	)			(4.4	)			(2.4	)			(3.8	)
Net loss			(14.0	)%			(17.1	)%			(17.8	)%			(9.8	)%

Results of Operations by Segment

Three Months Ended June 30, 2007 Compared to Three Months Ended June 30, 2006

Animal Applications

		Three Months Ended June 30,
						% of								% of
		2007				Revenue				2006				Revenue				Change
		(in thousands, except percentages)
Total net revenue		$	11,029				100.0	%		$	8,375				100.0	%		$	2,654				31.7	%
Cost of sales			7,214				65.4				5,568				66.5				1,646				29.6
Gross profit			3,815				34.6				2,807				33.5				1,008				35.9
Selling, general and administrative expenses			3,642				33.0				2,798				33.4				844				30.2
Research and development expenses			677				6.1				727				8.7				(50	)			(6.9	)
Operating loss		$	(504	)			(4.5	)%		$	(718	)			(8.6	)%		$	214				(29.8	)

Revenues

Our Animal Applications segment’s revenue increased approximately $2.7 million for the three months ended June 30, 2007 compared to the three months ended June 30, 2006. The increase was principally due to an increase in microchip sales of approximately $2.9 million to Schering-Plough, our exclusive distributor in the U.S. of our companion pet implantable microchips. Schering-Plough, who markets the chips under the brand name Home Again, has been investing significant resources in marketing and advertising the chip. We expect orders for 2007 to exceed 4 million pet chips by year end, which is more than twice the units sold in 2006. This increase was partially offset by a decrease of electronic identification and visual product sales to livestock customers of $0.2 million. Sales to fish and wildlife customers are expected to increase in the third quarter of 2007.

Gross Profit and Gross Profit Margin

Our Animal Applications segment’s gross profit increased approximately $1.0 million in the three months ended June 30, 2007 compared to the three months ended June 30, 2006. The gross profit margin increased to 34.6% in the three months ended June 30, 2007 as compared to 33.5% in the three months ended June 30, 2006. We attribute the increase in gross profit and gross profit margin to increased sales in the current period.

Selling, General and Administrative Expenses

Our Animal Applications segment’s selling, general and administrative increased $0.8 million in the three months ended June 30, 2007 compared to the three months ended June 30, 2006. The increase in selling, general and administrative expenses relates primarily to legal expenses of $0.5 million related to the maintenance and protection of our intellectual property as well as an increase in compensation expense associated with an increase in our sales and marketing force in the United States. Selling, general and administrative expenses as a percentage of revenue remained relatively constant for the respective periods. We have reached a tentative settlement in the lawsuit that we initiated to protect our intellectual property and, as a result, we expect that our legal expenses will decrease going forward.

Research and Development Expenses

Our Animal Applications segment’s research and development remained relatively constant in the three months ended June 30, 2007 compared to the three months ended June 30, 2006. Research and development expenses relate to new product development associated with RFID microchips and related scanners.

GPS and Radio Communications

		Three Months Ended June 30,
						% of								% of
		2007				Revenue				2006				Revenue				Change
		(in thousands, except percentages)
Total net revenue		$	8,504				100.0	%		$	4,053				100.0	%		$	4,451				#	%
Cost of sales			4,641				54.6				1,994				49.2				2,647				#
Gross profit			3,863				45.4				2,059				50.1				1,804				87.6
Selling, general and administrative expenses			3,464				40.7				2,277				56.2				1,187				52.1
Research and development expenses			909				10.7				—				—				909				#
Operating loss		$	(510	)			(6.0	)%		$	(218	)			(5.4	)%		$	(292	)			#