SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)

Commission file number:  1-15177

DIGITAL ANGEL CORPORATION
(Exact Name of Registrant as Specified in Its Charter)

(651) 455-1621

(Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:

None

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. ý Yes  o No

Indicate by check mark if the disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K  ý

Indicate by check mark whether the registrant is an accelerated filer (as defined Rule 12b-2 of the Act).  o Yes  ý No

The aggregate market value of the registrant’s common stock held by non-affiliates computed by reference to the price at which the common stock was last sold on June 30, 2004, the last business day of the registrant’s most recently completed second fiscal quarter, was $34,376,117.  The registrant has no non-voting common equity.

As of the close of business on March 1, 2005, there were 44,044,914 shares outstanding of the issuer’s $0.005 per share par value common stock.

Documents Incorporated by Reference

Items 10, 11, 12, 13 and 14 of Part III of this Annual Report on Form 10-K incorporate certain information by reference from the registrant’s definitive Proxy Statement to be filed with the Securities and Exchange Commission not later than 120 days after the conclusion of the registrant’s last fiscal year, which ended December 31, 2004.

DIGITAL ANGEL CORPORATION

TABLE OF CONTENTS

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PART I

Item 1.                                                           Business

References in this Form 10-K to “we,” “us,” “our,” “our company,” and “Digital Angel Corporation” mean Digital Angel Corporation and our subsidiaries, unless the context otherwise requires.

Overview

We were incorporated in Delaware on December 1, 1981 as Medical Advisory Systems, Inc. to provide medical assistance and technical products and services. On March 27, 2002, we completed a merger pursuant to which the former Digital Angel Corporation became a wholly-owned subsidiary of Medical Advisory Systems and was renamed “Digital Angel Technology Corporation,” and Medical Advisory Systems was renamed  “Digital Angel Corporation.” In connection with the merger, Applied Digital Solutions, Inc. contributed to Medical Advisory Systems all of its stock in Timely Technology, a wholly-owned subsidiary, and Signature Industries, then an 85.0%-owned subsidiary. These two subsidiaries, along with Digital Angel Corporation, comprised Applied Digital’s Advanced Wireless Group (AWG). As a result of this contribution, Timely Technology became a wholly-owned subsidiary of Digital Angel Corporation and Signature Industries became an 85.0%-owned subsidiary. In 2004, Applied Digital, pursuant to the contractual agreement with the sellers of Signature Industries, Ltd., received an additional 6.9% interest in Signature Industries, Ltd. for no additional consideration.  Applied Digital contributed this interest to the Company. Further, on January 22, 2004, we acquired our wholly-owned subsidiary, OuterLink Corporation. As of March 1, 2005, Applied Digital owns 24,291,673 shares (or 55.2%) of our outstanding shares of common stock and we own 91.9% of Signature Industries.

Our corporate headquarters are located at 490 Villaume Avenue, South St. Paul, MN 55075. Our telephone number is 651-455-1621.

We presently operate two business segments:  Animal Applications and GPS and Radio Communications.

Animal Applications

Our Animal Applications segment develops, manufactures and markets radio electronic and visual identification devices for the companion animal, 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. We hold patents on our 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 for the animal in which it is implanted. The injectable 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.

The Animal Applications segment’s pet identification system involves the insertion of a microchip with identifying information in the animal. Scanners at animal shelters, veterinary clinics and other locations can determine the animal’s owner and other information. This pet identification system is marketed in the United States by Schering-Plough Animal Health Corporation under the brand name “Home Again™,” in Europe by Merial Pharmaceutical, and in Japan by Dainippon Pharmaceutical. We have distribution agreements with a variety of other companies outside the United States to market our products. We have an established infrastructure with scanners placed in approximately 70,000 global animal shelters and veterinary clinics. Over 2.5 million companion animals in the United States have been enrolled in the database, and approximately 7,000 pet recoveries occur in the United States each month.

The Animal Applications segment’s miniature electronic microchips are 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 can be identified without capturing or sacrificing the fish.

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 typically include numbered ear tags.  We have marketed visual identification products for livestock since the 1940s.  Electronic identification products are currently being utilized by livestock producers.  Currently, sales of visual products represent a substantial percentage of our sales to livestock producers.

In addition, the Company’s implantable radio frequency microchip was cleared by the FDA for medical applications in the United States in October 2004.  The Company has an exclusive distribution and licensing agreement with Verichip Corporation, a wholly-owned subsidiary of Applied Digital, covering the manufacturing, purchasing and distribution of the implantable microchip.  Through December 31, 2004 sales to Verichip Corporation have been minimal.

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In the year ended December 31, 2004, the Animal Applications segment represented 55.9% of our consolidated revenue.

GPS and Radio Communications

The GPS and Radio Communications segment includes what was previously reported as our Wireless and Monitoring operations, the business of OuterLink Corporation (which we acquired in January 2004) and Signature Industries, located in the United Kingdom. This segment primarily consists of the design, manufacture and support of GPS enabled equipment.  Applications for the segment’s products include location tracking and message monitoring of vehicles, aircraft and people in remote locations through systems that integrate GPS and 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).  Signature Industries businesses also include high grade equipment leasing and complementary data systems that customers can use to locate and monitor their assets and alarm sounder manufacturing.  In the year ended December 31, 2004, this GPS and Radio Communications segment represented 44.1% of our consolidated revenue.

Medical Systems

We sold substantially all of the assets comprising our Medical Systems segment on April 19, 2004 and July 30, 2004.  We no longer operate or own any of this business segment’s assets. This segment consisted of a staff of logistics specialists and physicians operating from our medical telecommunications response center that provided medical assistance services and interactive medical information services to people traveling anywhere in the world, 24 hours per day, 7 days per week. Assistance was provided by telephone, satellite, high frequency radio, fax, internet and telex. The primary market for our services was the maritime industry and the international travel insurance and assistance industry. Services included coordination of medical care, provision of general medical information, physician consultation, translation assistance, claims handling and cost containment on behalf of assistance companies, insurance companies or managed care organizations.  We also offered medical training services to the maritime industry.

This segment sold a variety of kits containing pharmaceutical and medical supplies. Included in the kits were both prescription and nonprescription medications, controlled substances, medical equipment and expendable medical supplies. The kits included our proprietary pharmaceutical manual, which provided information on proper storage, use and inventory control. All medications were specially labeled for use in our system. We directly supplied pharmaceuticals to our maritime and airline customers through our pharmaceutical warehouse facility, which was located in Owings, Maryland.

Recent Developments

Share Exchange

On February 25, 2005, Digital Angel Corporation entered into a Stock Purchase Agreement with Applied Digital Solutions, Inc. Pursuant to the agreement Digital Angel Corporation issued 644,140 shares of Digital Angel Corporation common stock to Applied Digital Solutions, Inc.  Digital Angel Corporation received 684,543 shares of Applied Digital Solutions, Inc. common stock as consideration.  The value of the stock exchanged was $3.5 million. The Applied Digital Solutions, Inc. common stock received by the Company was used as partial consideration for the acquisition of DSD Holdings A/S and its wholly-owned subsidiaries, Daploma International A/S and Digitag A/S, as described more fully below.

Acquisition

On February 28, 2005, Digital Angel Corporation completed the acquisition of DSD Holdings A/S and its wholly-owned subsidiaries Daploma International A/S and Digitag A/S.

Under the terms of the acquisition, Digital Angel Corporation 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 less 30% of the total compensation paid to Lasse Nordfjeld, CEO of DSD Holdings, A/S.  An initial payment of $3.5 million payment was made at closing through the delivery of Applied Digital Solutions, Inc. common stock valued at $3.5 million which Digital Angel Corporation acquired from Applied Digital Solutions, Inc. in exchange for $3.5 million of Digital Angel Corporation common stock, as described more fully above.

In addition, Digital Angel loaned DSD Holdings A/S the principal amount of $1.0 million and entered into employment agreements with the CEO of DSD Holdings A/S and its subsidiaries, Lasse Nordfjeld and his son, the President of Daploma, Torsten Nordfjeld.

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Denmark-based DSD Holdings A/S through its subsidiaries manufactures and markets visual and electronic radio frequency identification tags for livestock.  DSD Holdings A/S has a highly automated and efficient manufacturing facility for producing visual and RFID tags, as well as tamper-proof seals for packing and shipping applications. The company has been in business for more than 30 years and has successfully developed markets in the Middle East, Japan, Australia and throughout Europe, particularly in Eastern Europe where new European Union entrants have to meet strict livestock tagging and tracking standards.

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

Financial Information About Segments

Revenues from our various segments over the prior three years can be broken down as follows, amounts exclude revenue from our discontinued segment:

Refer to the segment information in Note 19 and discontinued operations information in Note 11 to our Financial Statements.

Competition

Principal methods of competition in all of our segments include geographic coverage, service and product performance.

Animal Applications

The animal identification market is highly competitive. The principal competitors in the visual identification market are AllFlex USA, Inc. and Y-Tex Corporation and the principal competitors in the electronic identification market are AllFlex, USA, Inc., Datamars SA and Avid Identification Systems, Inc.  We believe that our strong intellectual property position and our reputation for high quality products are our competitive advantages.

GPS and Radio Communications

The principal competitors for our subsidiary, Signature Industries, are Boeing North American Inc., General Dynamics Decision Systems, Tadiran Spectralink Ltd., Becker Avionic Systems, and ACR Electronics, Inc.  We believe that being first to market with GPS in our search and rescue beacons and the use of our search and rescue beacons in over forty countries are competitive advantages.  In addition, the barriers to entry in this market are high due to the technical demands of the market.

The principal competitors for our subsidiary, OuterLink, are Blue Sky Networks, Sky Connect and Comtech Mobile Data Com.  We believe our competitive advantages are lower cost communications, more frequent reporting on a near real time basis and the ability to provide additional messaging capabilities in addition to vehicle tracking.

Raw Materials

We did not experience any significant or unusual problems in the purchase of raw materials or commodities during 2003 or 2004.  We depend on a single production arrangement with a vendor for the manufacture of our patented syringe-injectable microchips that are used in our implantable electronic identification products.  Moreover, if Raytheon terminates our production arrangement, we would relocate our production equipment from Raytheon’s facility.  If we were required to relocate the production equipment we cannot ensure that the assembly of our microchips from another source would be on comparable or acceptable terms.  The failure to make such an alternative production arrangement could have an adverse effect on our business. While we are dependent, in certain situations, on a limited number of vendors to provide certain raw materials and components, during the recent past, we have not experienced significant problems or issues procuring any essential materials, parts or components.

Patents and Trademarks

We own various patents and trademarks which we consider in the aggregate to constitute a valuable asset.  We consider several of our patents offer a significant competitive advantage and/or barriers to entry in the Animal Applications segments.

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Backlog

We generally produce goods to fill orders received and anticipated orders based on distributors’ forecasts, and we also maintain inventories of finished goods to fill customer orders with short lead times.  As a result, we generally do not have a significant backlog of orders, and any such backlog is not indicative of future sales.

Research and Development

During 2004, we spent $2.8 million ($2.2 million in the Animal Applications segment and $0.6 million in the GPS and Radio Communications segment) on research and development activities relating to the development of new products or improvements of existing products. We spent $4.9 million ($3.0 million in the Animal Applications segment and $1.9 million in the GPS and Radio Communications segment) in 2003 and $3.0 million in 2002 ($1.7 million in the Animal Applications segment and $1.3 million in the GPS and Radio Communications segment) on research and development activities.

Environmental Matters

We do not anticipate any material effect on our capital expenditures, earnings or competitive position due to compliance with government regulations involving environmental matters.

Seasonality

Our Animal Applications segment’s revenues and operating income can be affected by the timing of animal reproduction cycles.  Our other business segments are not considered to be seasonal.

Employees

As of February 28, 2005 we have 246 full time employees, including 8 in management, 22 in sales positions, 43 in administrative positions, 50 in technical positions and 123 in production positions.  Our Animal Applications production workforce is party to a collective bargaining agreement which expires May 31, 2005.  Negotiations between the parties have not begun, however, we believe our relations with our employees are good and do not expect the impact of negotiations to materially impact our business.

Government Regulation

We are subject to federal, state and local regulation in the United States, including the FDA and Federal Communications Commission (FCC). We are also subject to regulation by government entities in other countries.

United States Regulation

Animal products for food producing animals have been reviewed by the FDA’s Center for Veterinary Medicine and the FDA has determined that our product, as presently configured, is unregulated. Our products coated with insecticide require approval by the United States Environmental Protection Agency, which has been obtained.  In October 2004, the FDA issued a letter stating that our product, Verichip ^TM, a radio frequency microchip for human use, had been cleared for medical applications in the United States.

The Company is subject to periodic inspections by the FDA, whose primary purpose is to audit the Company’s compliance with quality system regulations established by the FDA.  Regulatory action may be initiated in response to audit deficiencies or to protect performance problems.  The Company believes that its manufacturing and quality control procedures are in compliance with the requirements of the FDA regulations.

We are licensed by the FCC to transmit at specified frequencies on satellites.  Our aviation equipment must meet the approval of the Federal Aviation Authority and Transport Canada for manufacturing, installation and repair.

Regulation Abroad

Our products are subject to compliance with applicable regulatory requirements in those foreign countries where our products are sold. The contracts we maintain with our distributors in these foreign countries generally require the distributor to obtain all necessary regulatory approvals from the governments of the countries in which these distributors sell our products.

Financial Information About Geographic Areas

Revenues are attributed to geographic areas based on the location of the assets producing the revenues. Information concerning principal geographic areas as of and for the years ended December 31, 2004, 2003 and 2002 is as follows:

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Forward-Looking Statements and Associated Risks

We make written and oral statements from time to time regarding our business and prospects, such as projections of future performance, statements of management’s plans and objectives, forecasts of market trends, and other matters that are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21F of the Securities Exchange Act of 1934.  Statements containing the words or phrases “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimates,” “projects,” “believes,” “expects,” “anticipates,” “intends,” “target,” “goal,” “plans,” “objective,” “should” or similar expressions identify forward-looking statements, which may appear in documents, reports, filings with the Securities and Exchange Commission, news releases, written or oral presentations made by officers or other representatives made by us to analysts, stockholders, investors, news organizations and others, and discussions with management and other representatives of us.  For such statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Our future results, including results related to forward-looking statements, involve a number of risks and uncertainties.  No assurance can be given that the results reflected in any forward-looking statements will be achieved.  Any forward-looking statement made by or on behalf of us speaks only as of the date on which such statement is made.  Our forward-looking statements are based on assumptions that are sometimes based upon estimates, data, communications and other information from suppliers, government agencies and other sources that may be subject to revision.  Except as required by law, we do not undertake any obligation to update or keep current either (i) any forward-looking statement to reflect events or circumstances arising after the date of such statement, or (ii) the important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or which are reflected from time to time in any forward-looking statement which may be made by or on behalf of us.

In addition to other matters identified or described by us from time to time in filings with the SEC, there are several important factors that could cause our future results to differ materially from historical results or trends, results anticipated or planned by us, or results that are reflected from time to time in any forward-looking statement that may be made by or on behalf of us.  Some of these important factors, but not necessarily all important factors, include the following:

As of March 1, 2005, Applied Digital Solutions, Inc. owns 55.2% of our common stock.

As of March 1, 2005, Applied Digital Solutions, Inc. is the beneficial owner of 55.2% of our common stock, and it controls us with respect to all matters upon which our stockholders may vote, including the selection of the Board of Directors, mergers, acquisitions and other significant corporate transactions.  There can be no assurance as to how Applied Digital Solutions may support actions that are contrary to or conflict with the interests of the other stockholders.

New accounting pronouncements may impact our future results of operations

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123R “Share-Based Payment.” This statement, which will be effective in our third quarter of 2005, will change how we account for share-based compensation, and may have a significant impact on our future results of operations.

We currently account for share-based payments to employees and directors using the intrinsic value method. Under this method, we generally do not recognize any compensation related to stock option grants we issue under our stock option plans.

SFAS 123R will require us to recognize share-based compensation as compensation expense in the statement of operations based on the fair values of such equity on the date of the grant, with the compensation expense recognized over the period in which the recipient is required to provide service in exchange for the equity award. This statement will also require us to adopt a fair value-based method for measuring the compensation expense related to share-based compensation. We have begun, but have not completed, evaluating the impact of the adoption of SFAS 123R on our results of operations. In connection with evaluating the impact of SFAS 123R, we are considering the potential implementation of different valuation methods to determine the fair value of share-based compensation. We believe the adoption of SFAS 123R will have a material impact on our results of operations, regardless of the valuation method used.

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We may continue to incur losses.

We incurred a net loss of $5.0 million for the year ended December 31, 2004. We also incurred a net loss of $9.5 million and $92.4 million for the years ended December 31, 2003 and 2002, respectively. Included in the $92.4 million loss for the year ended December 31, 2002 is a goodwill impairment charge of $31.5 million, an asset impairment charge of $6.4 million, losses from discontinued operations of $26.5 and an $18.7 million charge arising from the remeasurement of options in connection with the 2002 merger. Although we achieved profitability in the fourth quarter of 2004, no assurance can be given as to whether we will be profitable in future periods. Profitability depends on many factors, including the success of marketing programs, the maintenance and reduction of expenses, and the ability to coordinate successfully the operations of our business units. If we fail to achieve and maintain sufficient profitability within the time frame expected by investors, the market price of our common stock may be adversely affected.

Infringement by third parties on our intellectual property or development of substantially equivalent proprietary technology by our competitors could negatively affect our business.

Our success depends significantly on our ability to maintain patent and trade secret protection, to obtain future patents and licenses, and to operate without infringing on the proprietary rights of third parties. There can be no assurance that the measures we have taken to protect our intellectual property will prevent its misappropriation or circumvention of our intellectual property.  In addition, there can be no assurance that any patent application, when filed, will result in an issued patent, or that our existing patents, or any patents that may be issued in the future, will provide us with significant protection against competitors. Moreover, there can be no assurance that any patents issued to or licensed by us will not be infringed upon or circumvented by others.  Litigation to establish the validity of patents, to assert infringement claims against others, and to defend against patent infringement claims can be expensive and time-consuming, even if the outcome is in our favor.  We also rely to a lesser extent on unpatented proprietary technology, and no assurance can be given that others will not independently develop substantially equivalent proprietary information, techniques or processes or that we can meaningfully protect our rights to such unpatented proprietary technology.  Infringement on our intellectual property or the development of substantially equivalent technology by our competitors could have a material adverse effect on our business.

Domestic and foreign government regulation and other factors could impair our ability to develop and sell our products in certain markets.

The electronic animal identification market can be negatively affected by such factors as food safety concerns, price, consumer perceptions regarding cost and efficacy, international technology standards, national infrastructures, and slaughterhouse removal of microchips.

We are also subject to federal, state and local regulation in the United States, including regulation by the FDA, FCC and the USDA, and similar regulatory bodies in other countries.  We cannot predict the extent to which we may be affected by further legislative and regulatory developments concerning our products and markets.  We are required to obtain regulatory approval before marketing most of our products.  The regulatory process can be very time-consuming and costly, and there is no assurance that we will receive the regulatory approvals necessary to sell our products under development.  Regulatory authorities also have the authority to revoke approval of previously approved products for cause, to request recalls of products and to close manufacturing plants in response to violations.  Any such regulatory action, including the failure to obtain such approval, could prevent us from selling, or materially impair our ability to sell, our products in certain markets and could negatively affect our business.

We rely on sales to government contractors of our animal identification products, and any decline in the demand by these customers for our products could negatively affect our business.

Certain customers for electronic identification devices for fish are government contractors that rely on funding from the United States government.  Since these contractors rely heavily on government funds, any decline in the availability of such funds could result in a decreased demand by these contractors for our products.  Any decrease in demand by such customers could have a material adverse effect on our financial condition and results of operations and result in a decline in the market value of our common stock.

We depend on a single production arrangement with Raytheon Microelectronics Espana, SA for our patented syringe-injectable microchips, and the loss of or any significant reduction in the production could have an adverse effect on our business.

We rely solely on a production arrangement with Raytheon Microelectronics Espana, SA (“Raytheon”) for the manufacture of our patented syringe-injectable microchips that are used in all of our implantable electronic identification products. In addition, we have no formal written agreement with Raytheon for the production of our microchips. Raytheon utilizes our proprietary technology and our equipment in the production of our syringe-injectable microchips. The termination, or any significant reduction, by Raytheon of the assembly of our microchips or a material increase in the price charged by Raytheon for the assembly of our microchips could have an adverse effect on our financial condition and results of operations.  In addition, Raytheon may not be able to produce sufficient quantities of the microchips to meet any significant increased demand for our products or to meet any such demand on a timely basis.  Any inability or unwillingness of Raytheon to meet our demand for microchips would require us to utilize an alternative production arrangement and remove our automated assembly production machinery from the Raytheon facility, which would be costly and could delay production.  Moreover, if Raytheon terminates our production arrangement, we would relocate our production equipment from Raytheon’s facility.  If we were required to

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relocate the production equipment we cannot ensure that the assembly of our microchips from another source would be on comparable or acceptable terms.  The failure to make such an alternative production arrangement could have an adverse effect on our business.

We depend on principal customers.

For the year ended December 31, 2004, we had two customers which accounted for 12.5% and 10.2% of our consolidated revenues. The GPS and Radio Communications segment is heavily dependent on contracts with domestic government agencies and foreign governments, including the United Kingdom, primarily relating to military applications. The loss of, or a significant reduction in, orders from these or our other major customers could have a material adverse effect on our financial condition and results of operations.

We compete with other companies in the visual and electronic identification and pilot locator beacon markets, and the products sold by our competitors could become more popular than our products or render our products obsolete.

The market for visual and electronic identification and pilot locator beacon products is highly competitive. We believe that our principal competitors in the visual identification market for livestock are AllFlex USA and Y-Tex Corporation, that our principal competitors in the electronic identification market are AllFlex USA, Datamars SA and Avid Identification Systems, Inc. and that our principal competitors in the pilot locator beacon market are Boeing North American Inc., General Dynamics Decision Systems and Tadiran Spectralink Ltd.

In addition, other companies could enter this line of business in the future.  Certain of our competitors may have substantially greater financial and other resources than us. We may not be able to compete successfully with these competitors, and those competitors may develop or market technologies and products that are more widely accepted than ours or that would render our products obsolete or noncompetitive.

Our earnings will decline if we write-off goodwill and other intangible assets.

As of December 31, 2004, we had recorded goodwill of $49.0 million. On January 1, 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets.”  SFAS No. 142 requires that goodwill and certain intangibles no longer be amortized but instead tested for impairment at least annually by applying a fair value based test. In the fourth quarter of 2004, the Company performed its annual impairment test for goodwill using a fair value based approach, primarily discounted cash flows.  Based on the Company’s evaluation goodwill was not impaired in 2004.  During the fourth quarter of 2003, the Company performed the annual impairment test for goodwill and an evaluation of the Medical Systems reporting unit indicated that $2.4 million of goodwill was impaired. Additionally, management estimated that certain intangible assets at our Medical Systems reporting unit were impaired by $0.6 million.  Accordingly, the Company recorded an impairment charge of $3.0 million in the fourth quarter of 2003, which is included in asset impairment in the 2003 statement of operations.  During the fourth quarter of 2002, we recorded an impairment charge of $31.5 million for goodwill at our GPS and Radio Communications reporting unit.

We will assess the fair value of our goodwill annually or earlier if events occur or circumstances change that would more likely than not reduce the fair value of our goodwill below its carrying value. These events or circumstances would include a significant change in business climate, including a significant, sustained decline in an entity’s market value, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business, or other factors. If we determine that significant impairment has occurred, we would be required to write off the impaired portion of goodwill. Impairment charges could have a material adverse effect on our reported net income.

The exercise of options and warrants outstanding and available for issuance may adversely affect the market price of our common stock.

As of February 20, 2005, we had 6,383,000 options and 720,000 warrants outstanding to purchase from us a total of 7,103,000 shares of common stock at exercise prices ranging from $0.05 to $10.50 per share. In addition, as of February 20, 2005, we had 4,546,000 additional shares of common stock which may be issued in the future under our stock option plans. The exercise of outstanding options and warrants and the sale in the public market of the shares purchased upon such exercise may adversely affect the market price of our common stock.

Currency exchange rate fluctuations could have an adverse effect on our sales and financial results.

We generate a portion of our sales and incur a portion of our expenses in currencies other than U.S. dollars.  To the extent that we are unable to match revenues received in foreign currencies with costs paid in the same currency, exchange rate fluctuations in any such currency could have an adverse effect on our financial results.

We depend on a small team of senior management, and we may have difficulty attracting and retaining additional personnel.

Our future success will depend in large part upon the continued services and performance of senior management and other key personnel.  If we lose the services of certain members of our senior management team, our overall operations could be materially and adversely affected.  In addition, our future success will depend on our ability to identify, attract, hire, train, retain and motivate other highly skilled technical, managerial, marketing, purchasing and customer service personnel when they are needed.  Competition

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for these individuals is intense.  We cannot ensure that we will be able to successfully attract, integrate or retain sufficiently qualified personnel when the need arises.  Any failure to attract and retain the necessary technical, managerial, marketing, purchasing and customer service personnel could have a material adverse effect on our financial condition and results of operations.

Item 2.                                                           Properties

We own a 79,692 square foot (gross building area) masonry and steel industrial two-building complex located in South St. Paul, Minnesota that is currently occupied by the Animal Application division’s administrative, sales, engineering and manufacturing operations. The buildings have 6,000 square feet of office area, nine loading docks, one drive-in door and 13 to 16 foot clear ceilings. The South St. Paul property is encumbered by a mortgage in the aggregate principal amount of $2.3 million.

Our subsidiary, Signature Industries Ltd.  leases, under a long-term lease expiring September, 2042, a 60,000 square foot building located in Thamesmead, London that is currently occupied by administrative, sales, engineering and manufacturing personnel.  In addition, this division leases three single-story buildings totaling 5,400 square feet within a small industrial estate in Springburn, Glasgow for repair and servicing operations.  Rent payments for Signature Industries Ltd.’s facilities are $36,000 a month.

We currently lease a 2,500 square foot facility in a modern technology park in Riverside, California.  The facility contains office and engineering space.  The facility is rented on a month-to-month lease.  Rent payments are $2,600 per month.  The month-to-month lease can be terminated on 30 days notice.

Our subsidiary, OuterLink Corporation, leases 5,400 square feet in an office building located in Lowell, Massachusetts. The lease expires on July 31, 2009 with no renewal options. Rent is $5,600 per month.

We consider our properties to be suitable and adequate for their present purposes, well maintained and in good operating condition.

Item 3.                                                           Legal Proceedings

John Fernandez vs. United States of America vs. Medical Advisory Systems, Inc.

On December 29, 2003, John Fernandez filed a lawsuit in the Orlando Division of the United States District Court for the Middle District of Florida.  The plaintiff filed the lawsuit against the Unites States of America as the operator of the ship on which the plaintiff served.  He alleged that the United States had contracted with Medical Advisory Systems to provide medical advice and that the physician at Medical Advisory Systems had rendered an incorrect long-distance diagnosis, resulting to injury to the plaintiff. Mr. Fernandez asserted against the United States claims of negligence under the Jones Act, unseaworthiness and maintenance and cure. He alleged damages in excess of $75,000, plus prejudgment and post-judgment interest at the legal rate and costs and disbursements of the action.  On April 14, 2004, the United States served Medical Advisory Systems with a third party complaint in Admirality Court in which it alleged that Medical Advisory Systems was liable to it for all or part of the plaintiff’s claim in that Medical Advisory Systems and/or its employee/physician rendering the medical advice was negligent.  In response, on May 12, 2004, Medical Advisory Systems filed a motion to dismiss the third party complaint.  The parties agreed to settle this matter in December 2004.    The settlement amount will be paid by Digital Angel’s insurance carrier and other parties to the action.  Digital Angel was required to pay a $20,000 deductible to Digital Angel’s insurance carrier.

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 (Court File No. 04-4545MJD/JGL)  claims that Allflex is marketing and selling a syringe implantable identification transponder that infringes 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 claims that PetHealth is using, selling and/or distributing the same transponder in violation of the Company’s patent.  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.  Allflex has 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.

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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 Management International, Inc. (“Banfield”).  This suit (Court File No. 04-4544ADM/AJB) 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 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.

Crystal v. Digital Angel, et al.

On or about December 29, 2004, The Crystal Import Corporation filed an action against AVID Identification Systems, Inc. and Digital Angel in the United States District Court for the Northern District of Alabama (Court File No. CV-04-CO-3545-S).  Crystal’s complaint primarily asserts federal and state antitrust and related claims against AVID, though it also asserts similar claims against Digital Angel.  Given the uncertainties associated with all litigation and given that this case was not commenced against Digital Angel until February 2, 2005, we are unable to offer any assessment of the potential liability exposure, if any, to Digital Angel from this lawsuit.

Item 4.                                                           Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of our security holders during the fourth quarter of the fiscal year covered by this report.

PART II

Item 5.                                                           Market for Registrant’s Common Equity and Related Stockholder Matters

Our common stock is traded on the American Stock Exchange (AMEX) under the symbol “DOC.” The following table shows the high and low sales prices for our common stock as reported on AMEX for the periods indicated. On March 1, 2005, the last reported sale price of our common stock was $4.98. As of March 1, 2005, there were 44,094,914 shares of our common stock issued and 44,044,914 shares of our common stock outstanding, and we had approximately 184 stockholders of record.

We did not declare or pay dividends on our common stock in the years ended December 31, 2004 or 2003. We have never paid dividends on our common stock and do not anticipate paying dividends in the foreseeable future.

Item 6.                                                           Selected Financial Data

The following selected financial data should be read in conjunction with our financial statements and related notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and other financial information appearing elsewhere in this annual report on Form 10-K. We derived the following historical financial information from the consolidated financial statements of Digital Angel Corporation for the years ended December 31, 2004, 2003 and 2002 which have been audited by Eisner LLP and the combined financial statements of the Advanced Wireless Group (AWG) for the years ended December 31, 2001 and 2000, which have been audited by PricewaterhouseCoopers LLP. PricewaterhouseCoopers LLP’s report on the combined financial statements for the years ended December 31, 2001 and 2000 contained an explanatory paragraph expressing doubt about AWG’s ability to continue as a going concern. The equity accounts of AWG have been restated based on the common shares received by the former shareholders of AWG in the merger.

All periods presented have been restated to reflect the discontinued operations of the Medical Systems division.

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(1)                                  Includes the results of operations of OuterLink Corporation from January 22, 2004

(2)                                  Includes the results of operations of Medical Advisory Systems from March 27, 2002 as net loss from discontinued operations.

(3)                                  Includes the results of operations of (i) Timely Technology from April 1, 2000 and (ii) Destron Fearing Corporation from September 8, 2000.

(4)                                  Selling, general and administrative expense includes management fees paid to Applied Digital of $193, $771 and $262 for the years ended December 31, 2002, 2001 and 2000.

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(5)                                  Asset impairment expense for 2002 consists of a goodwill impairment charge of $31,460 and an asset impairment charge of $6,411 related to the write off of an exclusive perpetual license to a digital encryption and distribution software system.  Asset impairment expense for 2001 relates to a goodwill impairment.

(6)                                    Potentially dilutive securities of 7,263, 13,603 and 9,105 are excluded from the number of weighted average shares outstanding in 2004, 2003 and 2002, respectively.  Including the dilutive securities would have had an anti-dilutive effect on our net loss per common share. Weighted average shares outstanding for the years ended December 31, 2001 and 2000 have been restated to reflect the number of common shares received by the former shareholders of the Advanced Wireless Group in the March 27, 2002 merger.

(7)                                  Total number of shares outstanding were 43,425, 28,891, 26,518, 18,750 and 18,750, at December 31, 2004, 2003, 2002, 2001 and 2000, respectively.  Shares outstanding for the years ended December 31, 2001 and 2000 have been restated to reflect the number of common shares received by the former shareholders of the Advanced Wireless Group in the March 27, 2002 merger.

Effective January 1, 2002, we adopted Statement of Financial Accounting Standard No. 142, “Goodwill and Other Intangible Assets” (SFAS No. 142). SFAS No. 142 requires that goodwill and certain intangibles no longer be amortized but instead tested for impairment at least annually.

The following table presents the impact of SFAS No. 142 on our summary financial data as indicated:

Item 7.                                                           Management’s Discussion and Analysis of Financial Condition and Results of Operations

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

We consist of Digital Angel Corporation and its five subsidiaries — Digital Angel Technology Corporation (“DATC”), Timely Technology Corp.,  Signature Industries, Limited, OuterLink Corporation and DA International, Inc.

Overview

The Company is an advanced technology company in the field of rapid and accurate identification, location tracking, and condition monitoring of high-value assets.  With the acquisition of OuterLink Corporation in January 2004, the Company reorganized into three segments:  Animal Applications, GPS and Radio Communications and Medical Systems.  On April 19, 2004 and July 30, 2004 the Company sold substantially all of the assets of its Medical System’s segment’s medical services business.

The Company is currently comprised of two segments: Animal Applications and GPS and Radio Communications.

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

GPS and Radio Communications—designs, manufactures and supports GPS enabled equipment. The GPS and Radio Communications segment consists of the Company’s subsidiaries Signature Industries Ltd. and OuterLink Corporation.  Signature Industries businesses also include high grade equipment leasing and complementary data systems that customers can use to locate and monitor their assets and alarm sounder manufacturing.

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In 2004 the Company significantly improved its balance sheet and reported record net revenue of $46.3 million, an increase of $11.9 million or 34.5% from $34.4 million in the prior year.  Both of the Company’s operating segments contributed to the year over year revenue growth.  Revenue growth was strongest in the Company’s GPS and Radio Communications segment.   The GPS and Radio Communications segment’s revenue increased $9.9 million or 94.9% to $20.4 million in 2004 from $10.5 million in 2003.  The growth in this segment is primarily related to increased revenue at our subsidiary Signature Industries, Ltd. related to the shipments of its G2R pilot locator beacon to the Indian Air Force and the inclusion of OuterLink Corporation’s sales from January 22, 2004.

Gross profit increased $5.4 million, or 36.4%, to $20.1 million in 2004 from $14.7 million in 2003, both of the Company’s operating segments contributed to the year over year growth in gross profit.

In 2004 the Company reported net loss of $5.0 million compared to $9.5 million in 2003.  In 2004, net loss was negatively impacted by additional interest expense of $0.4 million related to the accelerated amortization of deferred debt costs and debt discounts associated with debt that was converted to equity in 2004.  Additionally, the Company recorded losses of $1.2 million on Applied Digital common stock held by the Company in 2004.

As of December 31, 2004, the Company’s cash was $17.5 million as compared to $0.9 million at December 31, 2003.  During 2004, $4.4 million of cash was used in operating activities, compared to $5.1 million in 2003 and $2.7 million in 2002.  Net cash provided by investing activities totaled $7.8 million in 2004 compared to net cash used by investing activities of $1.0 million in 2003 and $0.6 million in 2002.  The principal sources of cash from investing activities in 2004 were $6.7 million proceeds on the sale of Applied Digital common stock and net cash provided by discontinued operations of $1.7 million.  Net cash provided by financing activities totaled $13.0 million in 2004 compared to $6.6 million in 2003 and $2.6 million in 2002.  Cash used by financing activities during 2004 consisted primarily of proceeds from the exercise of stock options and warrants, offset by payments on our debt and lines of credit.  Total debt at December 31, 2004 amounted to $2.4 million compared to $7.8 million at December 31, 2003.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses.  On an on-going basis, we evaluate these estimates, including those related to inventory obsolescence, goodwill, intangibles and other long-lived assets and income taxes.  We base these estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.  We believe the following critical accounting policies reflect our more significant estimates and assumptions used in the preparation of the financial statements.

Goodwill, Intangibles and Other Long-Lived Assets

On January 1, 2002, we adopted SFAS No. 142, “Goodwill and Other Intangible Assets.”  SFAS No. 142 requires that goodwill and certain intangibles no longer be amortized but instead be tested for impairment at least annually by applying a fair value based test. There was no impairment of goodwill upon the adoption of SFAS 142 on January 1, 2002.  In addition, there was no impairment of goodwill as a result of our 2004 annual impairment review.  However based upon an annual review for impairment in 2003 and 2002, we recorded impairment charges of $3.0 million and $57.4 million in the fourth quarters of 2003 and 2002, respectively (of which $3.0 million and $25.9 million in 2003 and 2002, respectively, related to our Medical Systems segment and is included in discontinued operations).  The impairment charge in 2002 related to the goodwill at the GPS and Radio Communications reporting unit.

In accordance with FAS 142, we are required to allocate goodwill to the various reporting units.  As of December 31, 2004 the reporting units consisted of the following (the reporting units listed below are those businesses, which have goodwill and for which discrete financial information is available and upon which management makes operating decisions):

•                              Animal Applications

•                              Signature Industries, Ltd.

•                              OuterLink Corporation

We engaged an independent valuation firm to review and evaluate the goodwill as reflected on our books as of December 31, 2004, 2003 and 2002. Independently, the valuation firm reviewed the goodwill of the various reporting units. The Company’s management compiled the cash flow forecasts, growth rates, gross margin, fixed and variable cost structure, depreciation and amortization expenses, corporate overhead, tax rates, and capital expenditures, among other data and assumptions related to the financial projections upon which the valuation reports were based.  The valuation firm’s methodology including residual or terminal

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enterprise values were based on the following factors: risk free rate of 10 years; current leverage (E/V); leveraged beta – Bloomberg; unleveraged beta; risk premium; cost of equity; after-tax cost of debt; and weighted average cost of capital.  These variables generated a discount rate calculation.

The assumptions used in the determination of fair value using discounted cash flows were as follows:

•                                                   Cash flows were generated for 5 years based on the expected recovery period for the goodwill;

•                                                   Adjusted earnings before interest, taxes, depreciation and amortization were used as the measure of cash flow; and

•                                                   Discount rates ranging from 15% to 22.5%. The rate was determined based on the risk free rate of the 10-year U.S. Treasury Bond plus a market risk premium of 7.5%.  (The discount rate utilized by the Company was the rate of return expected from the market or the rate of return for a similar investment with similar risks).

The independent valuation firm performed a company comparable analysis utilizing financial and market information on publicly traded companies that are considered to be generally comparable to the Company’s reporting units.  Each analysis provided a benchmark for determining the terminal values for each business unit to be utilized in its discounted cash flow analysis.  The analysis generated a multiple for each reporting unit, which was incorporated into the appropriate business unit’s discounted cash flow model.

Future goodwill impairment reviews may result in additional write-downs.  Such determination involves the use of estimates and assumptions, which may be difficult to accurately measure or value.

We will assess the fair value of our goodwill annually or earlier if events occur or circumstances change that would more likely than not reduce the fair value of our goodwill below its carrying value. These events or circumstances would include a significant change in business climate, including a significant, sustained decline in an entity’s market value, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of the business, or other factors. If we determine that significant impairment has occurred, we would be required to write off the impaired portion of goodwill. Impairment charges could have a material adverse effect on our financial condition and results of operations.

Property, plant and equipment and definite-lived intangible assets are depreciated or amortized over their useful lives.  Useful lives are based on management’s estimates of the period that the assets will generate revenue.  Long-lived assets are evaluated for impairment whenever events and circumstances indicate an asset may be impaired.  During the fourth quarter of 2002, we determined that an exclusive perpetual license to a digital encryption and distribution software system that was purchased by Applied Digital in April 2001 and contributed to AWG in 2001 was impaired. Accordingly, we wrote off the net book value of the asset, which resulted in an impairment charge of $6.4 million. There were no write downs of any long-lived assets in 2004 or 2003.

Inventories

Estimates are used in determining the likelihood that inventory on hand can be sold.  Historical inventory usage and current revenue trends are considered in estimating both obsolescence and slow-moving inventory.  Inventory is stated at lower of cost or market, determined by the first-in, first-out method, net of any reserve for obsolete or slow-moving inventory.

Deferred Taxes

We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized.  While we have considered future taxable income and tax planning strategies in assessing the need for the valuation allowance, in the event we were to subsequently determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made.  Similarly, should we determine that we would not be able to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax asset would reduce income in the period such determination was made.

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 fee 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

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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 location and messaging services, which generally provide for service on a month-to-month basis and from the sale of related products to customers (communication terminals and software).  OuterLink Corporation’s services are only available through use of its products, 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, which customarily is  30 months.

Results of Operations

The following table summarizes our results of operations as a percentage of net operating revenues and is derived from the accompanying consolidated and combined statements of operations included in this report.

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Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003

Revenue

Revenue from operations for the year ended December 31, 2004 was $46.3 million, an increase of $11.9 million, or 34.5%, from $34.4 million in the year ended December 31, 2003.  Revenue for the years ended December 31, 2004 and 2003 for each of the operating segments was as follows (in thousands):

The Animal Applications segment’s revenue increased $1.9 million, or 8.0%, in the year ended December 31, 2004 as compared to the year ended December 31, 2003.  The increase in revenue was principally due to an increase in microchip sales to companion animal customers of $1.4 million and an increase in microchip and visual product sales to livestock customers of $2.3 million.  The increase in sales is offset by a decrease in sales to fish and wildlife and other customers of $1.8 million.  Several proposals related to the  establishment of a national electronic identification program for livestock are being considered by the Administration and Congress.  We cannot estimate the impact a national identification program would have on the Animal Application segment’s revenue.  However, if implemented, we would expect the impact to be favorable.

The GPS and Radio Communications segment’s revenue increased $9.9 million, or 94.9%, in the year ended December 31, 2004 as compared to the year ended December 31, 2003.  The increase primarily relates to increased revenue at our subsidiary, Signature Industries, related to the shipments of the G2R pilot locator beacon in connection with the fulfillment of the G2R contract with the Indian Air Force and increased sales at its Clifford and Snell Division.  Included in 2004 are sales of $5.9 million of G2R sales compared to no sales in 2003.  Sales in Signature’s Clifford and Snell division increased $1.7 million in 2004.  OuterLink Corporation revenue was $1.8 million for the year ended December 31, 2004.  OuterLink Corporation was acquired on January 22, 2004.

Gross Margin

Gross profit for the year ended December 31, 2004 was $20.1 million, an increase of $5.4 million, or 36.4%, from $14.7 million in the year ended December 31, 2003.  As a percentage of revenue, the gross profit margin was 43.4% and 42.8% for the years ended December 31, 2004 and 2003, respectively.

Gross profit for the years ended December 31, 2004 and 2003 for each operating segment was as follows (in thousands):

Gross profit margin for the years ended December 31, 2004 and 2003 for each operating segment was as follows:

The Animal Applications segment’s gross profit of $10.1 million in the year ended December 31, 2004 increased $0.4 million compared to $9.7 million in the year ended December 31, 2003.  Gross profit margin decreased to 39.1% in 2004 from 40.7% in 2003 primarily due to increased material cost of 2.5% of sales in 2004 offset by decreased freight cost in 2004.

The GPS and Radio Communications segment’s gross profit of $10.0 million in the year ended December 31, 2004 increased $5.0 million compared to $5.0 million in the year ended December 31, 2003.  The increase relates primarily to increased sales.  Gross profit margin increased to 48.8% in 2004 from 47.5% in 2003.

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Selling, General and Administrative Expense

Selling, general and administrative expense increased $3.0 million, or 19.5%, in the year ended December 31, 2004 as compared to the year ended December 31, 2003.  As a percentage of revenue, selling, general and administrative expense was 40.0% and 45.0% for the years ended December 31, 2004 and 2003, respectively.

Selling, general and administrative expenses for the years ended December 31, 2004 and 2003 for each of the operating segments was as follows (in thousands):

Selling, general and administrative expense as a percentage of revenue for each of the operating segments for the years ended December 31, 2004 and 2003 for each of the operating segments was as follows:

The Animal Applications segment’s selling, general and administrative expenses increased $1.6 million in the year ended December 31, 2004 compared to the year ended December 31, 2003 and as a percentage of revenue increased to 33.6% from 29.6% in the same respective period. The increase relates primarily to additional legal, accounting, investor relations and compensation expense in the year ended December 31, 2004.

The GPS and Radio Communications segment’s selling, general and administrative expense increased $1.4 million in the year ended December 31, 2004 to $9.8 million as compared to $8.4 million in the year ended December 31, 2003 due primarily to the inclusion of $1.8 million of expense at our subsidiary, OuterLink Corporation, increased expense of $1.1 million at our subsidiary, Signature Industries Ltd, offset by a $1.5 decrease in expense related to the scaleback of the operations related to Digital Angel ^TM technology.  OuterLink Corporation was acquired on January 22, 2004 and is therefore not included in our 2003 results.  The increase in expense at Signature Industries Ltd. is related to increased salary expense and changes in the exchange rate. . As a percentage of revenue, selling, general and administrative expenses decreased to 48.1% in 2004 from 80.1% in 2003, primarily due to increased revenue, as discussed above.

Research and Development Expense

Research and development expense was $2.8 million in the year ended December 31, 2004, a decrease of $2.1 million, or 43.7%, from $4.9 million for the year ended December 31, 2003.  As a percentage of revenue, research and development expense was 6.0% and 14.3% for the years ended December 31, 2004 and 2003, respectively.

Research and development expense for the years ended December 31, 2004 and 2003 for each of the operating segments was as follows (in thousands):

The decrease in the Animal Applications segment’s research and development expense was due primarily to the completion of development of the Biothermo ^TM microchip product and development of new scanner technology.  The decrease in the GPS and Radio Communications segment’s research and development expenses was due primarily to the continued scaleback of research and development on the Digital Angel ^TM  technology and completion of development on Signature Industries’ pilot locator beacon.

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Interest Expense

Interest expense was $1.3 million and $0.8 million for each of the years ended December 31, 2004 and 2003, respectively.  Included in interest expense for the year ended December 31, 2004 is approximately $0.8 million of discount amortization and deferred debt cost amortization associated with the Laurus Master Fund financings.

Realized Loss on Applied Digital Common Stock

On March 1, 2004, the Company issued 3,000,000 shares of its common stock to Applied Digital pursuant to the Stock Purchase Agreement with Applied Digital dated August 14, 2003.  The Stock Purchase Agreement provided for Applied Digital to purchase 3,000,000 shares of the Company’s common stock at a price of $2.64 per share and a warrant to purchase up to 1,000,000 shares of the Company’s common stock, which was exercisable for five years beginning February 1, 2004, at a price per share of $3.74 payable in cash or shares of common stock of Applied Digital.  The consideration for the sale of the Company’s 3,000,000 shares and the warrant was 1,980,000 shares of Applied Digital common stock.  As of December 31, 2004, the Company had sold all of the 1,980,000 shares of Applied Digital common stock for $6.7 million.  The Company accounted for the Applied Digital stock as a trading security under SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities”.  In the year ended December 31, 2004, the Company recorded realized losses on the Applied Digital common stock of $1.2 million.  In December 2004, Applied Digital exercised its warrant for 1,000,000 shares of our common stock.  Net proceeds to the Company upon exercise of the warrant were $3.74 million.

Income Taxes

The Company had effective income tax rates of 0.0% in 2004 and 2003, respectively.  At December 31, 2004, the Company had aggregate net operating loss carryforwards of approximately $60.6 million for income tax purposes.  The net operating loss carryforwards expire in various amounts through 2024.  Approximately $31.8 million of the net operating loss carryforwards were acquired in connection with various acquisitions and are limited as to use in any particular year.  A full valuation allowance for the net deferred tax asset was recorded at December 31, 2004.

Discontinued Operations

On April 19, 2004, the Company sold certain assets of its Medical Systems segment’s medical services business pursuant to an Asset Purchase Agreement dated April 8, 2004 by and between Digital Angel Corporation and MedAire, Inc.  Assets sold include all of the tangible and intangible intellectual property developed for the operation of the Medical Systems segment’s medical services business, pharmaceutical supplies and other inventory items, customer and supplier contracts, computer software licenses, internet website and domain name and mailing lists. Under the terms of the agreement, the purchase price, in addition to MedAire, Inc.’s assumption of certain liabilities was $420,000 plus any prepaid deposits and the cost of the pharmaceutical inventory and supplies reduced by any pre-billing to or pro-rata prepayment by the Company’s customers.

In addition, on July 30, 2004, the Company sold the Medical Systems segment’s land and building for $1.5 million. The Company recorded a gain of approximately $0.3 million on the sale of the land and buildings.   Net cash received on the sale of the land and building, after paying off the related building mortgage, was approximately $0.4 million.  The net loss recorded by the Company in the year ended December 31, 2004 in connection with exiting this activity was $1.1 million.

The following discloses the losses from discontinued operations for the year ended December 31, 2004 and 2003, consisting of losses attributable to the Medical Systems segment:

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Year Ended December 31, 2003 Compared to the Year Ended December 31, 2002

Revenue

Revenue from operations for the year ended December 31, 2003 was $34.4 million, an increase of $1.9 million, or 5.9%, from $32.5 million in the year ended December 31, 2002.  Revenue for the years ended December 31, 2003 and 2002 for each of the operating segments was as follows (in thousands):

The Animal Applications segment’s revenue increased $3.0 million, or 14.1%, in the year ended December 31, 2003 as compared to the year ended December 31, 2002.  The increase in revenue results from increased engineering service revenue of approximately $1.0 million in 2003, an increase in microchip sales to companion animal and fish and wildlife customers of approximately $1.7 million and increased sales of visual identification products.   The engineering service revenue results from research and development performed for certain of our fish and wildlife customers.

The GPS and Radio Communications segment’s revenue decreased $1.0 million, or 9.0%, in the year ended December 31, 2003 as compared to the year ended December 31, 2002.  The decrease relates primarily to the cancellation of a significant software support contract in February 2003.  The decrease is offset by increased revenue of $0.3 million at our subsidiary Signature Industries, Ltd.

Gross Margin

Gross profit for the year ended December 31, 2003 was $14.7 million, an increase of $1.6 million, or 12.4%, from $13.1 million in the year ended December 31, 2002.  As a percentage of revenue, the gross profit margin was 42.8% and 40.3% for the years ended December 31, 2003 and 2002, respectively.

Gross profit for the years ended December 31, 2003 and 2002 for each operating segment was as follows (in thousands):

Gross profit margin for the years ended December 31, 2003 and 2002 for each operating segment was as follows:

The Animal Applications segment’s gross profit of $9.7 million in the year ended December 31, 2003 increased $1.6 million compared to $8.1 million in the year ended December 31, 2002.  We attribute $0.5 million of the increase to the increase in sales and $1.1 million of the increase to increased gross profit margin resulting from increased engineering service revenue. The gross profit margin increased to 40.7% in the year ended December 31, 2003 as compared to 38.6% in the year ended December 31, 2002 due to decreased material costs and an increase in higher margin service revenue in 2003.

The GPS and Radio Communication segment’s gross profit remains unchanged in 2003 when compared to 2002.  Gross profit margin increased to 47.5% in 2003 from 43.3% in 2002 due to a slight shift in product mix to lower margin products in 2003 compared to 2002.

Selling, General and Administrative Expense

Selling, general and administrative expense decreased $20.7 million, or 57.2%, in the year ended December 31, 2003 as

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compared to the year ended December 31, 2002.  This decrease in expense was the result of an $18.7 million charge in 2002 arising from the remeasurement of options in connection with the merger in 2002 which did not recur in 2003.  Pursuant to the terms of the merger agreement, options to acquire shares of DATC common stock were converted into options to acquire shares of Medical Advisory Systems common stock effective March 27, 2002.  The conversion resulted in a new measurement date for the options and, as a result, the Company recorded a charge of approximately $18.7 million in non-cash compensation expense during the three months ended March 31, 2002.

As a percentage of revenue, selling, general and administrative expenses, excluding the $18.7 million charge in 2002, was 45.0% and 53.8% for the years ended December 31, 2003 and 2002, respectively.

Selling, general and administrative expenses for the years ended December 31, 2003 and 2002 for each of the operating segments, excluding the $18.7 million charge in 2002, was as follows (in thousands):

Selling, general and administrative expense as a percentage of revenue for each of the operating segments for the years ended December 31, 2003 and 2002 for each of the operating segments excluding the $18.7 million charge in 2002 was as follows:

The Animal Applications segment’s selling, general and administrative expenses increased $0.7 million in the year ended December 31, 2003 compared to the year ended December 31, 2002 and as a percentage of revenue decreased to 29.6% from 30.5% in the same respective period.  We attribute the increase in expense to additional consulting expenses of $0.7 million associated with the Verichip Distribution and Licensing Agreement.

The GPS and Radio Communications segment’s selling, general and administrative expenses decreased $2.7 million in the year ended December 31, 2003 to $8.4 million as compared to $11.1 million in the year ended December 31, 2002.   The decrease is primarily due to the exclusion of amortization expense for a license to a digital encryption and distribution software system that the Company wrote off in the fourth quarter of 2002.  Included in the GPS and Radio Communications segment’s selling, general and administrative expenses for the year ended December 31, 2002 is $2.0 million of amortization expense for this asset. In addition, the decrease results from the significant scale back in development of the Digital Angel ^TM  technology, including a reduction in personnel, resulting in a decrease in selling, general and administrative expense.  As a percentage of revenue, selling, general and administrative expenses decreased to 80.1% in 2003 from 96.2% in 2002.

Management Fees — Applied Digital Solutions, Inc.

Management fees charged by Applied Digital amounted to $0.2 million for the year ended December 31, 2002.  These fees were for general and administrative services performed for us by Applied Digital.  The management fee arrangement with Applied Digital terminated on  March 27, 2002.

Research and Development Expense

Research and development expense was $4.9 million in the year ended December 31, 2003, an increase of $1.9 million, or 61.4%, from $3.0 million for the year ended December 31, 2002.  As a percentage of revenue, research and development expense was 14.3% and 9.3% for the years ended December 31, 2003 and 2002, respectively.

Research and development expense for the years ended December 31, 2003 and 2002 for each of the operating segments was as follows (in thousands):

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The increase in expense is due to research and development expenses at our GPS and Radio Communications segment for its recent search and rescue beacon project and research and development expenses incurred for the Animal Application segment’s temperature sensing implantable microchip and engineering expenses to support improved transponder performance.  The increase is offset by a decrease in research and development expense at our GPS and Radio Communications segment due to a scale back in the development of the Digital Angel ^TM technology.

Asset Impairment

Asset impairment expense was $0.0 and $37.9 million in the years ended December 31, 2003 and 2002, respectively.  Asset impairment expense for 2002 consists of a goodwill impairment charge of $31.5 million and an asset impairment charge of $6.4 million related to the write off of an exclusive perpetual license to a digital encryption and distribution software system in our GPS and Radio Communications segment.

Interest Expense

Interest expense was $0.8 million and $2.1 million for each of the years ended December 31, 2003 and 2002, respectively.  Interest expense in 2002 includes interest expense of $1.8 million on the debt owed to IBM Credit by Applied Digital.  This debt was recognized by the Advanced Wireless Group due to Applied Digital’s default on the loan agreement.  On March 27, 2002, Applied Digital restructured its loan agreement with IBM Credit.  The provisions of this restructuring included the Advanced Wireless Group being released from responsibility to repay this debt.  Accordingly, Applied Digital assumed this liability on March 27, 2002.

Income Taxes

The Company had effective income tax rates of 0.0% in 2003 and 2002, respectively.  The U.S. companies included in the Advanced Wireless Group were included in Applied Digital’s consolidated federal income tax return through March 27, 2002.  Medical Advisory Systems, Inc. and its subsidiaries filed a separate consolidated federal income tax return through March 27, 2002.  After March 27, 2002, Digital Angel Corporation’s U.S. subsidiaries file a consolidated federal tax return.

Discontinued Operations

On April 19, 2004, the Company sold certain assets of its Medical Systems segment’s medical services business pursuant to an Asset Purchase Agreement dated April 8, 2004 by and between Digital Angel Corporation and MedAire, Inc.  Assets sold include all of the tangible and intangible intellectual property developed for the operation of the Medical Systems segment’s medical services business, pharmaceutical supplies and other inventory items, customer and supplier contracts, computer software licenses, internet website and domain name and mailing lists. Under the terms of the agreement, the purchase price, in addition to MedAire, Inc.’s assumption of certain liabilities was $420,000 plus any prepaid deposits and the cost of the pharmaceutical inventory and supplies reduced by any pre-billing to or pro-rata prepayment by the Company’s customers. In connection with the sale to MedAire, Inc., the Company recognized obligations and recorded a loss of approximately $0.6 million in the nine months ended September 30, 2004.

In addition, on July 30, 2004, the Company sold the Medical Systems segment’s land and building for $1.5 million. The Company recorded a gain of approximately $0.3 million on the sale of the land and buildings.   Net cash received on the sale of the land and building, after paying off the related building mortgage, was approximately $0.4 million.

The following discloses the losses from discontinued operations for the year ended December 31, 2003 and 2002, consisting of losses attributable to the Medical Systems segment: