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| ADSX > SEC Filings for ADSX > Form 10-K/A on 17-Feb-2004 | All Recent SEC Filings |
17-Feb-2004
Annual Report
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying financial statements and related notes included in this Annual Report. Certain statements contained herein may contain forward-looking statements - see "Cautionary Statement Regarding Forward-Looking Information and Risk Factors."
OVERVIEW
Our business has evolved during the past few years. We grew significantly through acquisitions and since 1996 have completed 51 acquisitions. During the last half of 2001 and during 2002, we sold or closed many of the businesses we had acquired that we believed did not enhance our strategy of becoming an advanced digital technology development company. These companies were primarily telephone system providers, software developers, software consultants, networking integrators, computer hardware suppliers or were engaged in other businesses or had a customer basis that we believed did not promote or complement our current business strategy. As of December 31, 2002, our business operations consisted of the operations of six wholly owned-subsidiaries, which we collectively refer to as the Advanced Technology segment, and two majority-owned subsidiaries, Digital Angel Corporation (AMEX:DOC), and InfoTech USA, Inc. (OTC:IFTH) (formerly SysComm International Corporation). As of December 31, 2002, we owned approximately 73.91% of Digital Angel Corporation and 52.5% of InfoTech USA, Inc.
Historically, we have suffered losses and we have not generated positive cash flows from operations. This raises doubt about our ability to continue as a going concern. The audit reports of Eisner LLP for the year ended December 31, 2002, and of PricewaterhouseCoopers LLP, for each of the two-years ended December 31, 2001 and 2000, contain an explanatory paragraph expressing doubt about our ability to continue as a going concern, as a result of payment and covenant defaults under our credit agreement with IBM Credit LLC ("IBM Credit"), which are more fully discussed in this Form 10-K under Part I - Item 1 - Business "Other Events" beginning on page 15, and in Note 2 to the Consolidated Financial Statements, as well as our historical losses and the negative cash flows from our operations. We incurred net losses from continuing operations of $113.9 million, $198.1 million and $29.2 million for the years ended December 31, 2002, 2001 and 2000, respectively and as of December 31, 2002, we had an accumulated deficit of $417.1 million. Our operating activities used cash of $3.9 million, $18.0 million and $43.4 million during 2002, 2001 and 2000.
Digital Angel Corporation has suffered losses and has not generated positive cash flows from operations. In addition, the audit reports of Eisner LLP for the year ended December 31, 2002, and of PricewaterhouseCoopers LLP, for each of the two-years ended December 31, 2001 and 2000, contain an explanatory paragraph expressing doubt about Digital Angel Corporation's ability to continue as a going concern. Digital Angel Corporation incurred losses during 2002, 2001 and 2000, which are presented below. In addition, its operating activities used cash of $2.7 million, $3.2 million and $1.4 million during 2002, 2001 and 2000, respectively.
Our profitability and liquidity depend on many factors, including our complying with the provisions of a forbearance agreement term sheet with IBM Credit, as more fully discussed in this Form 10-K under Part II - Item 7- Management's Discussion and Analysis of Financial Condition and Results of Operations - "Liquidity and Capital Resources from Continuing Operations" beginning on page 64 and in Note 2 to the Consolidated Financial Statements, the success of our marketing programs, the maintenance and reduction of expenses and our ability to successfully develop and bring to market our new products and technologies. We will need additional financing to comply with the provisions of the forbearance agreement term sheet and to fund operations. Without such additional financing, we will not have sufficient funds to continue
operations beyond the end of the current fiscal year.
We have established a management plan to mitigate the effect of our going concern uncertainty conditions over the next twelve months. The major components of our plan are as follows:
o To raise funds to repay a portion of our obligations to IBM Credit through the offering of up to 50 million shares of our common stock in a best efforts offering. These shares are currently being registered under a registration statement filed with the SEC on December 23, 2002 (File No. 333-102165);
o To utilize the shares of Digital Angel Corporation's common stock currently in the Digital Angel Trust and/or our receivables and inventory to secure additional funds to repay IBM Credit (noting that these assets will be released from liens by IBM Credit upon repayment in full of our obligations under the forbearance agreement);
o To borrow against Digital Angel Corporation's receivables and inventory, if necessary;
o To attempt to establish a sustainable positive cash flow business model;
o To attempt to produce additional cash flow and revenue from our advanced technology products - Digital Angel(TM), Thermo Life(TM), VeriChip(TM) and Bio-Thermo(TM); and
o To generate additional liquidity through divestiture of business units and assets that are not critical to our long-term strategy.
It is the opinion of our management that the likelihood of the above plan being effectively implemented is good. Our sources of revenue consist of sales of products and services from our three operating segments.
Our significant sources of revenue for 2002 were as follows:
Percentage of Sources of Revenue: Total Revenue ------------------- -------------Sales of voice, data and video telecommunications networks to government agencies 31.5%
Electronic visual identification tags and implantable microchips for the companion animal, livestock, laboratory animal, fish and wildlife markets 20.5% Sales of IT hardware and services from our InfoTech USA, Inc. segment 22.8%
GPS enabled search and rescue equipment, intelligent communications products and services for telemetry, mobile data and radio communications 10.1%
Other products and services (individually, none of these products and services exceeded 10% of our total revenues for 2002) 15.1%
------------
Total 100.0%
============
We hope to continue to grow our revenues. We see a possible increase in revenue from sales of voice, data and video telecommunications networks to government agencies will increase due to being awarded additional government contracts, such as the CONNECTIONS contract that we were awarded in January 2003. We expect sales of visual identification tags and implantable microchips to the companion animal, livestock, laboratory animal, fish and wildlife markets to increase. We plan to expand of our visual identification tags and implantable microchip product lines with complementary products, such as our Bio-Thermo product. Also, we believe that concerns over the safety and source of animal and other food sources will increase the markets for these products. We expect revenue from our InfoTech USA, Inc. segment to decrease as we continue to shift our focus from sales of lower-margin computer hardware products to sales of higher-margin products and technology services. Overall, in the short-term our cost of products and services sold (exclusive of depreciation and amortization) as a percentage of revenue will most likely increase as a result of competitive pressures. However, we are hoping that the cost of products and services sold (exclusive of depreciation and amortization) as a percentage of revenue will decrease once we begin selling significant quantities of our advanced technology products. To date, we have not recorded any significant revenues from our advanced technology products.
BUSINESS SEGMENTS
As a result of the merger of pre-merger Digital Angel and MAS, which occurred on March 27, 2002, the significant restructuring of our business during the past year and our emergence as an advanced technology development company, we have re-evaluated and realigned our reporting segments. Effective January 1, 2002, we currently operate in three business segments: Advanced Technology, Digital Angel Corporation and InfoTech USA, Inc., formerly SysComm International. Business units that were part of our continuing operations and that were closed or sold during 2002 and 2001 are reported as All Other. The "Corporate/Eliminations" category includes all amounts recognized upon consolidation of our subsidiaries, such as the elimination of intersegment revenues, expenses, assets and liabilities. "Corporation/Eliminations" also includes certain interest expense and other expenses associated with corporate activities and functions.
(Loss) income from continuing operations before taxes, minority interest, net loss on subsidiary merger transaction and equity in loss of affiliate from each of our segments during 2002, 2001 and 2000 was as follows (we evaluate performance based on stand-alone segment operating income as presented below):
YEAR ENDED DECEMBER 31,
-----------------------
2002 2001 2000
---- ---- ----
(IN THOUSANDS)
(LOSS) INCOME FROM CONTINUING OPERATIONS BEFORE TAXES,
MINORITY INTEREST, LOSSES ATTRIBUTABLE TO CAPITAL
TRANSACTIONS OF SUBSIDIARY AND EQUITY IN LOSS OF
AFFILIATE BY SEGMENT:
DIGITAL ANGEL CORPORATION(1)(2) (76,439) (16,262) (3,816)
INFOTECH USA, INC. (422) (1,322) 923
ALL OTHER (320) (71,636) (5,714)
"CORPORATE/ELIMINATIONS"(2) (49,310) (46,893) (23,834)
-------------------------------------
TOTAL $(127,277) $(177,606) $(33,985)
=====================================
(1) For Digital Angel Corporation, the loss for 2002 includes
goodwill impairment of $62.2 million and impairment of the value of
certain software of $6.4 million.
(2) For Digital Angel Corporation, the loss for 2002 excludes $1.8 million of interest expense associated with our obligation to IBM Credit and $18.7 million of non-cash compensation expense associated with pre-merger Digital Angel options which were converted into options to acquire MAS stock, all of such expenses having been reflected as additional expense in the separate financial statement of Digital Angel Corporation included in its Form 10-K dated December 31, 2002. The $1.8 million of interest expense and the $18.7 million of non-cash compensation expense are reflected in "Corporate/Eliminations" for 2002.
Today, we are an advanced technology company that focuses on the development of life-enhancing technology products and services. To date, we have four such products in various stages of development, they are:
o Digital Angel(TM), for monitoring and tracking people and
objects;o Thermo Life(TM), a thermoelectric generator;
o VeriChip(TM), an implantable radio frequency verification
device that can be used for security, financial, personal
identification/safety and other applications; and
o Bio-Thermo(TM), a temperature-sensing implantable microchip
for use in pets, livestock and other animals.These advanced technology products are more fully described in this Form 10-K under Part I - Item 1 - Business. We have not recorded any significant revenues from our advanced technology products.
Prior to January 1, 2002, our business was organized into three segments: Applications, Services and Advanced Wireless. Prior period information has been restated to present our reportable segments on a comparative basis.
On February 22, 2001, our senior management approved a plan to sell Intellesale, Inc. and all of our other non-core businesses. Our Board of Directors approved the plan on March 1, 2001. The results of operations, financial condition and cash flows of Intellesale and all of our other non-core businesses have been reported as Discontinued Operations in our financial statements and prior periods have been restated.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. As such, some accounting policies have a significant impact on the amount reported in these financial statements. The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates. We believe our most critical accounting policies include revenue recognition, software revenue recognition, VeriChip revenue recognition, goodwill and other intangible assets, stock-based compensation, proprietary software in development, inventory obsolescence, and legal contingencies as explained below.
REVENUE RECOGNITION
Advanced Technology Revenue Recognition
Computer Equity Corporation Revenue Recognition -
The largest company in the Advanced Technology segment is Computer Equity Corporation. This company supplies voice, data and video telecommunications networks and related products to government agencies. These products include voice mail, Internet cabling, phones and telephone wiring. Services are a minor part of the business and usually consist of small jobs such as phone moves. Computer Equity Corporation also receives monthly revenues from product related
maintenance contracts, which revenues represent the smallest portion of their business. For product sales, we recognize revenue after the products are shipped and title has transferred, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed and determinable and collectibility is deemed probable. If uncertainties regarding customer acceptance exists, revenue is recognized when such uncertainties are resolved. Hardware sales for products that are shipped to a customer's site and require modification or installation are recognized when the work is complete and accepted by the customer. We do not experience significant product returns, and therefore, management is of the opinion that no allowance for sales returns is necessary. We have no obligation for warranties on new hardware sales, because the manufacturer provides the warranty. Services and phone installation jobs are billed and the revenue recognized following the completion of the work and the receipt of a written acceptance from the customer. Revenue from maintenance contracts is recognized ratably over the term of the contract.
Other Advanced Technology Companies Revenue Recognition (Excluding VeriChip Corporation) -
The other companies in the Advanced Technology segment that provide programming, consulting and software licensing services recognize revenue based on the expended actual direct labor hours in the job times the standard billing rate and adjusted to realizable value, if necessary. It is our policy to record contract losses in their entirety in the period in which such losses are foreseeable. We do not offer a warranty policy for services to our customers. Revenue from license royalties is recognized when licensed products are shipped. There are no significant post-contract support obligations at the time of revenue recognition. Our accounting policy regarding vendor and post-contract support obligations is based on the terms of the customers' contract, billable upon the occurrence of the post-sale support. Costs of goods sold are recorded as the related revenue is recognized.
For product sales, we recognize revenue after the products are shipped and title has transferred, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sale price is fixed and determinable and collectibility is deemed probable. If uncertainties regarding customer acceptance exists, revenue is recognized when such uncertainties are resolved. Hardware sales for products that are shipped to a customer's site and require modification or installation are recognized when the work is complete and accepted by the customer. We do not experience significant product returns, and therefore, management is of the opinion that no allowance for sales returns is necessary. We have no obligation for warranties on new hardware sales, because the manufacturer provides the warranty.
VeriChip Corporation Revenue Recognition
The VeriChip microchip is a miniaturized, implantable radio frequency identification device (RFID) for use in a variety of identification and information applications. About the size of a grain of rice, each VeriChip contains a unique identification number that can be used to access a subscriber-supplied database providing personal related information.
To complement the VeriChip microchip, the proprietary scanner is a scanning device that activates and reads the RFID within the microchip. The scanner emits a small amount of radio frequency energy that energizes the dormant VeriChip, which then emits a radio frequency signal containing the VeriChip identification number. The VeriChip subscriber number then provides instant access to the Global VeriChip Subscriber Registry - through secure password-protected web access to subscriber-supplied information.
VeriChip revenue is comprised of the sale of VeriChip microchips, scanners, and a distributorship fee. Generally, the distributorship rights include the rights to market, promote and sell the product(s) in a specific territory under the VeriChip name and trademarks for a specific period of time. For these rights, the distributor pays a one-time, upfront non-refundable fee. As long as minimum annual purchase requirements are satisfied, the customer's exclusive distribution rights are retained. The distributor strives to meet annual marketing goals, or quotas, as agreed-upon by the distributor and the Company, by ordering and taking delivery from the company of predetermined quantities of product each year through the term of the contract. The purchase requirements typically increase substantially, during the contract period, as we and the distributors hope to realize increased sales volumes for the VeriChip microchips and scanners over time.
Failure to meet the quota constitutes a material breach of the contract and the loss of distributorship exclusivity privileges within the territory. To renew a preexisting agreement, the distributor must request the renewal in-writing thirty days prior to the expiration date of the contract. The Company, at its own discretion, may then negotiate with the distributor for a renewal of the agreement.
As of December 31, 2002, we have not yet recognized revenue associated with our VeriChip product. We plan to recognize revenue associated with the distributor rights, product sales and monitoring services in the future based upon the following policy:
Distributor Rights Fees
The nonrefundable portion of the upfront fee paid for exclusive distributor rights, if any, will be recognized over the initial term of the distributor agreement. The initial term will start with the first product sale under the agreement, not the contract period itself. The formula used to calculate this amount should be an amount equal to the percentage that each product order represents in relation to the minimum product order quantities required by the agreement. Until the amount of product returns can be reasonably estimated, no revenues will be recognized until the expiration of the period of time the distributor has to accept or reject the products as provided in their agreements.
If the distributor materially breaches their agreement and this breach results in the loss of their exclusive distributor rights but not their non-exclusive distributor rights, the balance of the non-amortized upfront fees will continue to be recognized ratably over the remaining life of their agreement. The formula previously described will be used to recognize these remaining fees unless no orders are placed. If this is the case, then the recognition of revenue from the remaining portion of non-amortized fees will be delayed until the expiration of the contract term.
If a contract breach results in the loss of all distributor rights and the only way to remain a distributor is to pay an additional substantial monetary penalty, then the remaining portion of the initial distributor fee will be recognized as revenue in the month in which the contract requirement is breached.
Approximately $0.2 million of distributor fees were recorded as deferred revenue on our balance sheet at December 31, 2002, and included in accrued expenses.
Product Sales
Revenue from the sale of products such as microchips and scanners will be recorded at gross with a separate display of cost of sales. Until the amount of returns can be reasonably estimated, we will not recognize revenues until after the products are shipped and title has transferred, provided that a purchase order has been received or a contract has been executed, there are no uncertainties
regarding customer acceptance, the sales price is fixed and determinable, the period of time the distributor has to return the products as provided in their distributor agreement has expired and collectibility is reasonably assured. Once the amount of returns can be reasonably estimated, revenues (net of expected returns) will be recognized at the time of shipment and the passage of title, assuming there are no uncertainties regarding customer acceptance. If uncertainties regarding customer acceptance exist, revenue will not be recognized until such uncertainties are resolved. The period of time to accept or reject products is contract specific. This right of return privilege ranges from fifteen to ninety days. Statement of Financial Accounting Standards No. 48, Revenue Recognition When Right of Return Exists, precludes the recognition of revenue at the time of sale or passage of title unless the amount of returns can be reasonably estimated. The Company is currently unable to reasonably estimate the amount of returns because of the absence of historical experience. The Company anticipates that it will take at least one full year to accumulate enough historical data to reasonably estimate product returns. As a result, currently the Company will only recognize revenue from a product sale when the product return period has expired. Until that condition is met, revenue will not be recognized, and it will be recorded as deferred revenue. We had no deferred revenue associated with VeriChip product sales at December 31, 2002.
Since the final use of the product is unknown at the time it is shipped to the distributor, and end users may choose from a number of non-proprietary monitoring services or choose none at all, and the monitoring services are not essential to the functionality of all chips, we do not currently anticipate bundling the revenue from the sale of chips with potential future revenues from a monitoring service.
Monitoring Services
Monitoring services (when offered) will be treated as a separate earnings process from product sales. Revenues from this service will be recognized on a straight-line basis over the term of the service agreement.
Digital Angel Corporation Revenue Recognition
For product sales, Digital Angel Corporation recognizes revenue at the time product is shipped and title has transferred, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed and determinable and collectibility is deemed probable. If uncertainties regarding customer acceptance exists, revenue is recognized when such uncertainties are resolved. There are no significant post-contract support obligations at the time of revenue recognition. Digital Angel Corporation's accounting policy regarding vendor and post contract support obligations is based on the terms of the customers' contracts, billable upon occurrence of the post-sale support. Costs of goods sold are recorded as the related revenue is recognized. Digital Angel Corporation does not offer a warranty policy for services to customers. It is Digital Angel Corporation's policy to record contract losses in their entirety in the period in which such losses are foreseeable. For non-fixed fee jobs, revenue is recognized based on the actual direct labor hours in the job multiplied by the standard billing rate and adjusted to realizable value, if necessary. Revenues from contracts that provide services are recognized ratably over the term of the contract. Fixed fee revenues from contracts for services are recorded when earned and exclude reimbursable costs. Reimbursable costs incurred in performing such services are presented on a net basis and include transportation, medical and communication costs. Other revenues are recognized at the time service or goods are provided.
InfoTech USA, Inc. Revenue Recognition
For product sales, InfoTech USA, Inc. recognizes revenue in accordance with the applicable products' shipping terms. InfoTech USA, Inc. has no obligation for warranties on new product sales. The manufacturer provides the warranty. For consulting and professional services, InfoTech USA, Inc. recognizes revenue based on the direct labor hours incurred times the standard billing rate, adjusted to realizable value, if necessary. Revenues from sales contracts involving both products and consulting and other services are allocated to each element based on vendor specific objective evidence of fair value, regardless of any separate prices that may be stated in the contract. Vendor specific objective evidence of fair value is the price charged when the elements are sold separately. If an element is not yet being sold separately, the fair value is the price established by management having the relevant authority to do so. It is considered probable that the price established by management will not change before the separate introduction of the element.
All Other
For arrangements where the contract to deliver software require significant production, modification or customization of the software, revenue is recognized using the percentage of completion accounting in accordance with Statement of Position ("SOP") 97-2 and SOP 81-1. The service element of these contracts was essential to the functionality of other elements in the contract and could not be accounted for separately as allowed in SOP 97-2. The cost to complete and extent of progress towards completion of these contracts was reasonably ascertained based on the detailed tracking regarding labor hours expended in accordance with SOP 97-2 and SOP 81-1. Progress payments on the contracts were required and progress was measured using the efforts expended input measure as allowed in SOP 81-1. As of December 31, 2001, we had sold or closed the business that recognized revenue using the percentage of completion accounting as outlined above. The amount of revenue recognized using the percentage of completion method for 2001 and 2000 was $6.7 million and $8.8 million, respectively.
GOODWILL AND OTHER INTANGIBLE ASSETS
Up through 2001, we reviewed goodwill and other intangible assets quarterly for impairment whenever events or changes in business circumstances indicated that the remaining useful life may have warranted revision or that the carrying amount of the long-lived asset may not have been fully recoverable. Included in factors considered were significant customer losses, changes in profitability due to sudden economic or competitive factors, change in managements' strategy for the business unit, letters of intent received for the sale of the business unit, or other factors arising in the quarterly period. We annually performed undiscounted cash flows analyses by business unit to determine if impairment existed. For purposes of these analyses, earnings before interest, taxes, depreciation and amortization were used as the measure of cash flow. When impairment was determined to exist, any related impairment loss was calculated based on fair value. Fair value was determined based on discounted cash flows. The discount rate utilized by us was the rate of return expected from the market or the rate of return for a similar investment with similar risks. We recorded goodwill impairment charges of $63.6 million and $0.8 million during 2001 and 2000, respectively.
On January 1, 2002, we adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Intangible Assets" (FAS 142). FAS 142 eliminates the amortization of goodwill and instead requires that goodwill be tested for impairment at least annually. Intangible assets deemed to have indefinite life under FAS 142, such as goodwill, are no longer amortized, but instead reviewed at least annually for impairment. Goodwill amortization amounted to $21.3 million during 2001. Intangible assets with finite lives are amortized over the useful life. As part of the implementation of
FAS 142, we were required to complete a transitional impairment test for goodwill and other intangible assets. There was no impairment of goodwill upon the adoption of FAS 142. Annually, we test our goodwill and intangible assets for impairment as a part of our annual business planning cycle during the fourth quarter of each fiscal year. Based upon this annual test in the fourth quarter of 2002, we recorded a goodwill impairment of approximately $62.2 million at December 31, 2002, for goodwill associated with our Digital Angel Corporation segment. In addition, future events such as market conditions or operational performance of our acquired businesses could cause us to conclude that additional impairment exists. Any resulting impairment loss could also have a material adverse impact on our financial condition and results of operations.
STOCK-BASED COMPENSATION
We account for our employee stock-based compensation plans in accordance with APB Opinion No. 25 (APB No. 25), Accounting for Stock Issued to Employees and Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensationan Interpretation of APB Opinion No. 25, and the disclosure provisions of SFAS No. 123 (SFAS No. 123), Accounting for Stock-Based Compensation. Accordingly, no compensation cost is recognized for any of our fixed stock options granted to employees when the exercise price of each option equals or exceeds the fair value of the underlying common stock as of the grant date for each stock option. When options are granted to employees and directors at a price less than fair market value on the date of grant, compensation expense is calculated based on the intrinsic value or the difference between the exercise price and the fair value on the date of grant, and the compensation is recognized over the vesting period of the options. If the options are fully vested, the expense is recognized immediately. Changes in the terms of stock option grants, such as extensions of the vesting period or changes in the exercise price, result in variable accounting in accordance with APB Opinion No. 25. Accordingly, compensation expense is measured in accordance with APB No. 25 and recognized over the vesting period. If the modified grant is fully vested, any additional compensation costs are recognized immediately. Under variable accounting, changes in the underlying price of our stock may have a significant impact to earnings. A rise in our stock price results in additional compensation expense and a decrease in our stock price results in a reduction of reported compensation expense. During 2001, we re-priced 19.3 million stock options. As a result, we have recorded non-cash compensation expense of $0.7 million and $5.3 million in 2002 and 2001, respectively. In addition, on September 24, 2001, we issued 3.9 million options to employees and directors with exercise prices of $0.15 per share, or $0.02 per share less than the fair market value of the underlying common stock on the date of grant. We have recognized compensation expense of $0.1 million associated with these options. The compensation expense was amortized over the vesting period of the options.
We account for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123.
PROPRIETARY SOFTWARE IN DEVELOPMENT
In accordance with Statement of Financial Accounting Standards (FAS) 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed, we have capitalized certain computer software development costs upon the establishment of technological feasibility. Technological feasibility is considered to have occurred upon completion of a detailed program design that has been confirmed by documenting and tracing the detail program design to product specifications and has been reviewed for high-risk development issues, or to the extent a detailed program design is not pursued, upon completion of a working model that has been confirmed by testing to be consistent with the product design. Amortization is provided based on the greater of the ratios that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product, or the straight-line method over the estimated useful life of the product. The
estimated useful life for the straight-line method is determined to be 2 to 5 years. Future events such as market conditions, customer demand, or technological obsolescence could cause us to conclude that the software is impaired. The determination of the possible impairment expense requires management to make estimates that effect our consolidated financial statements.
INVENTORY OBSOLESCENCE
Estimates are used in determining the likelihood that inventory on hand can be sold. Historical inventory usage and current revenue trends are considered in estimating both obsolescence and slow-moving inventory. Inventory is stated at lower of cost or market, determined by the first-in, first-out method, net of any reserve for obsolete or slow-moving inventory.
LEGAL CONTINGENCIES
We are currently involved in several legal proceedings. We have accrued our estimate of the probable costs for the resolution of these claims. This estimate has been developed in consultation with outside counsel handling our defense in these matters and is based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. We do not believe these proceedings will have a material adverse effect on our consolidated financial position. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in our estimates.
RESULTS OF CONTINUING OPERATIONSThe following table sets forth data expressed as a percentage of total revenue for the years indicated.
PERCENTAGE OF TOTAL REVENUE
--------------------------------------------
2002 2001 2000
% % %
--------------------------------------------
Product revenue 81.3 72.4 77.7
Service revenue 18.7 27.6 22.3
--------------------------------------------
Total revenue 100.0 100.0 100.0
--------------------------------------------
Cost of products sold (exclusive of
depreciation and amortization shown
separately below) 58.6 55.4 51.1
Cost of services sold 9.4 14.8 10.1
--------------------------------------------
Total cost of products and services sold
(exclusive of depreciation and amortization
shown separately below) 68.0 70.3 61.2
Cost of products and services sold
Selling, general and administrative expense 66.7 65.5 46.0
Research and development expense 3.5 5.5 1.9
Interest and non-cash charges:
Asset impairment 69.7 45.9 4.7
Depreciation and amortization 4.8 18.5 8.2
Loss (gain) on sales of subsidiaries and
business assets (0.1) 3.9 0.4
Interest and other income (2.4) (1.3) (0.8)
Interest expense 17.6 5.5 4.4
--------------------------------------------
Loss before provision (benefit) for income
taxes, minority interest and equity in net loss
of affiliate (127.8) (113.6) (25.2)
Provision (benefit) for income taxes 0.3 13.4 (3.7)
--------------------------------------------
Loss from continuing operations before minority
interest and equity in net loss of affiliate (128.1) (127.0) (21.5)
Minority interest (18.5) (0.5) 0.2
Net loss on capital transactions of subsidiary 2.4 -- --
Loss attributable to changes in minority interest
as a result of capital transactions of subsidiary 2.1 -- --
Equity in net loss of affiliate 0.3 0.2 --
--------------------------------------------
Loss from continuing operations (114.4) (126.7) (21.6)
Income (loss) from discontinued operations, net
of income taxes -- 0.1 (56.2)
--------------------------------------------
Loss on disposal and operating income (losses)
during the phase out period 1.4 (10.7) (5.4)
--------------------------------------------
Loss before extraordinary gain (113.0) (137.3) (83.2)
Extraordinary gain 6.0 --
--------------------------------------------
Net loss (113.0) (131.2) (83.2)
Preferred stock dividends and other -- (0.7) (0.1)
--------------------------------------------
Accretion of beneficial conversion feature of
preferred stock -- (6.0) (2.9)
--------------------------------------------
Net loss available to common stockholders (113.0) (138.0) (86.2)
============================================
Our significant sources of revenue for 2002 were as follows:
PERCENTAGE OF Sources of Revenue: TOTAL REVENUE ------------------- -------------Sales of voice, data and video telecommunications networks to government agencies 31.5%
Electronic visual identification tags and implantable microchips for the companion animal, livestock, laboratory animal, fish and wildlife markets 20.5%
Sales of IT hardware and services from our InfoTech USA, Inc. segment 22.8%
GPS enabled search and rescue equipment, intelligent communications products and services for telemetry, mobile data and radio communications 10.1%
Other products and services (individually, none of these products and services exceeded 10% of our total revenues for 2002) 15.1%
----------
Total 100.0%
==========
Our significant sources of cost of products and services sold (exclusive of depreciation and amortization shown separately below) and cost of products and services sold (exclusive of depreciation and amortization shown separately below) as a percentage of revenue by product type for 2002 were as follows:
COST OF COST OF
PRODUCTS AND PRODUCTS AND
SERVICES SOLD SERVICES SOLD
(EXCLUSIVE OF (EXCLUSIVE
DEPRECIATION OF DEPRECIATION
AND AND AMORTIZATION
Cost of Products and Services Sold (Exclusive of Depreciation and AMORTIZATION SHOWN SEPARATELY
Amortization Shown Separately Below) and Cost of Products and Services SHOWN SEPARATELY BELOW)
Sold (Exclusive of Depreciation and Amortization Shown Separately Below) BELOW) AS A PERCENTAGE
as a Percentage of Revenue by Product Type: (IN THOUSANDS) OF REVENUE
-------------------------------------------------------------------------- ---------------- ----------------
Sales of voice, data and video telecommunications networks to government agencies $23,335 74.5%Visual identification tags and implantable microchips for the companion
animal, livestock, laboratory animal, fish and wildlife markets 12,291 60.3%
Sales of IT hardware and services from our InfoTech USA, Inc. segment 18,571 81.7%GPS enabled search and rescue equipment, intelligent communications
products and services for telemetry, mobile data and radio communications 5,144 51.3%
Other products and services 8,377 55.3%
--------------------------------
Total $67,718 68.0%
================================
REVENUE
Revenue from continuing operations for 2002 was $99.6 million, a decrease of $56.7 million, or 36.3%, from $156.3 million in 2001. Revenue for 2001 represents an increase of $21.5 million, or 16.0% from $134.8 million in 2000. The decrease in 2002 was primarily attributable to the sale or closure of all businesses that were not cash positive or that did not fit into our strategy of becoming an advanced technology development company. The increase in 2001 was primarily attributable to the growth through acquisitions.
Revenue for each of the continuing operating segments was:
2002 2001 2000
--------------------------- ----------------------------- ------------------------------
PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
------- ------- ----- ------- ------- ----- ------- ------- -----
(AMOUNTS IN THOUSANDS)
Advanced Technology $28,991 $12,939 $41,930 $ 28,123 $16,447 $ 44,570 $ 24,384 $ 7,970 $ 32,354
Digital Angel Corporation 30,876 2,685 33,561 33,220 2,518 35,738 19,605 2,647 22,252
InfoTech USA, Inc. 20,056 2,665 22,721 30,075 4,100 34,175 24,774 2,514 27,288
All Other 1,013 375 1,388 21,318 19,974 41,292 35,805 16,876 52,681
Corporate -- -- -- 411 128 539 191 0 191
---------------------------------------------------------------------------------------------------------------------------
$80,936 $18,664 $99,600 $113,147 $43,167 $156,314 $104,759 $30,007 $134,766
===========================================================================================================================
Changes during the years were:
Our Advanced Technology segment's revenue decreased $2.6 million from 2001 to 2002. Product revenue increased by $0.9 million, or 3.1%, while service revenue decreased by $3.5 million, or 21.3%. We attribute the decrease in revenue in 2002 to a soft market for sales of networking hardware, call center and relationship management software products and reduced technology services for all of the businesses in this segment, with the exception of Computer Equity Corporation. The most significant decrease in revenue was from our computer networking business, which experienced a decrease of $3.6 million in revenue. This business was sold during the fourth quarter of 2002. Computer Equity Corporation's product revenue increased $3.9 million in 2002, primarily as a result of additional sales under its WACS contract. Computer Equity Corporation's service revenue remained relatively constant at $4.8 million in 2002 and 2001. Computer Equity Corporation's revenue accounted for 74.7% of this segment's revenue for 2002. During 2001, this segment experienced an increase in sales due primarily to the inclusion of twelve months of operating results for two significant acquisitions acquired in 2000. These two significant acquisitions include Computer Equity Corporation, acquired on June 1, 2000, which contributed $10.0 million of the increase, and Pacific Decision Sciences Corporation, acquired on October 1, 2000, which contributed $3.9 million of the increase.
Our Digital Angel Corporation segment's revenue decreased $2.2 million, or 6.1%, from 2001 to 2002. Product revenue decreased by $2.3 million, or 7.1%, while service revenue increased by $0.2 million, or 6.6%. We attribute the decrease in product sales for 2002 primarily to a decrease in shipments of visual identification tags, which contributed approximately $1.4 million of the decrease, a decrease in the shipment of the Animal Application division's electronic identification products, which contributed approximately $0.3 million of the decrease, a decrease in the GPS and Radio Communication division's control product sales, which contributed approximately $1.1 million of the decrease, partially offset by an increase of $0.6 million in the Medical Systems division's product revenue. We attribute the increase in service revenue to the acquisition of the Medical Systems in March 2002, which contributed approximately $1.2 million of the increase in service revenue during 2002. This was partly offset by a decrease in service revenue from the Wireless and Monitoring division of approximately$1.0 million. Revenue increased $13.5 million, or 60.8%, from 2000 to 2001. The increase in revenue in 2001 was primarily the result of the acquisitions of Timely Technology Corp. in April 2000, which contributed $0.9 million of the increase, and Destron Fearing
Corporation in September 2000, which contributed $15.5 million of the increase. These increases were partially offset by a reduction in revenue from our one existing business in this segment.
Our InfoTech USA, Inc. segment's revenue decreased $11.5 million, or 33.5%, from 2001 to 2002. Product revenue decreased by $10.0 million, or 33.3%, while service revenue decreased by $1.4 million, or 35.0%. The decrease in product and service sales was primarily a result of an industry wide softening in demand that existed throughout 2002. Additionally, product sales declined as a result of a decision in April 2002, to cease selling certain lower-margin computer hardware products and to focus on sales of higher-margin products and related technical services. The lower-margin computer hardware products were mid-range Unix based computers, which offered little opportunity for adjunct sales of related higher-margined technical services. InfoTech USA, Inc.'s current offering of higher-margin products and related technical services include Intel based computers and servers, which provide InfoTech USA, Inc. with an opportunity to provide add-on higher-margined technical services. Revenue increased $6.9 million, or 25.2%, from 2000 to 2001. Both product and service revenue increased as a result of internal growth and the acquisition of InfoTech USA, Inc.
Our All Other's revenue decreased $39.9 million, or 96.6%, from 2001 to 2002. Product revenue decreased by $20.3 million, or 95.2%, while service revenue decreased by $19.6 million, or 98.1%. Revenue decreased $11.4 million, or 21.6%, from 2000 to 2001. The decreases in revenue in 2002 as compared to 2001, and in 2001 as compared to 2000, were due to the sale or closure of all of the business units comprising this group during the last half of 2001 and the first half of 2002.
COST OF PRODUCTS AND SERVICES SOLD (EXCLUSIVE OF DEPRECIATION AND
AMORTIZATION SHOWN SEPARATELY BELOW)
Cost of products and services sold (exclusive of depreciation and amortization shown separately below) from continuing operations for 2002 was $67.7 million, a decrease of $42.1 million, or 38.3% from $109.8 million in 2001. Cost of products and services sold (exclusive of depreciation and amortization shown separately below) for 2001 represents an increase of $27.3 million, or 33.1% from $82.5 million in 2000. As a percentage of revenue, cost of products and services sold (exclusive of depreciation and amortization shown separately below) was 68.0%, 70.3%, and 61.2% for the years ended December 31, 2002, 2001 and 2000, respectively.
Cost of products and services sold (exclusive of depreciation and amortization shown separately below) from continuing operations for each operating segment was:
2002 2001 2000
------------------------ -------------------------- --------------------------
PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
------- ------- ----- ------- ------- ----- ------- ------- -----
(AMOUNTS IN THOUSANDS)
Advanced Technology $23,352 $5,651 $29,003 $21,256 $ 7,854 $ 29,110 $15,899 $ 2,855 $18,754
Digital Angel Corporation 17,705 2,216 19,921 20,252 2,047 22,299 11,519 1,434 12,953
InfoTech USA, Inc. 17,151 1,420 18,571 27,062 1,759 28,821 20,012 1,473 21,485
All Other 187 36 223 18,100 11,509 29,609 21,469 7,814 29,283
Corporate -- -- -- -- -- -- -- -- --
-----------------------------------------------------------------------------------------------------------
$58,395 $9,323 $67,718 $86,670 $23,169 $109,839 $68,899 $13,576 $82,475
===========================================================================================================
Cost of products and services sold (exclusive of depreciation and amortization shown separately below) for each operating segment was:
2002 2001 2000
------------------------ -------------------------- --------------------------
PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL PRODUCT SERVICE TOTAL
------- ------- ----- ------- ------- ----- ------- ------- -----
% % % % % % % % %
------- ------- ----- ------- ------- ----- ------- ------- -----
Advanced Technology 80.5 43.7 69.2 75.6 47.8 65.3 65.2 35.8 58.0
Digital Angel Corporation 57.3 82.5 59.4 61.0 81.3 62.4 58.8 54.2 58.2
InfoTech USA, Inc. 85.5 53.3 81.7 90.0 42.9 84.3 80.8 58.6 78.7
All Other 18.2 9.6 15.9 84.9 57.6 71.7 60.0 46.3 55.6
Corporate -- -- -- -- -- -- -- -- --
-----------------------------------------------------------------------------------------------------------
72.1 50.0 68.0 76.6 53.7 70.3 65.8 45.2 61.2
===========================================================================================================
Changes during the years were:
Our Advanced Technology segment's cost of products and services sold (exclusive of depreciation and amortization shown separately below) remained relatively constant in 2002, as compared to 2001, at $29.0 million and $29.1 million, respectively. Cost of products sold (exclusive of depreciation and amortization shown separately below) increased by $2.1 million in 2002, as compared to 2001, while cost of services sold deceased by $2.2 million in 2002, as compared to 2001. As a percentage of revenue cost of products and services sold (exclusive of depreciation and amortization shown separately below) increased to 69.2% in 2002, as compared to 65.3% in 2001. We attribute the increase in cost of products sold (exclusive of depreciation and amortization shown separately below) primarily to the increase in costs of approximately $4.8 million associated with the increase in revenue of Computer Equity Corporation. Partially offsetting this increase was a reduction in cost of products sold (exclusive of depreciation and amortization shown separately below) of approximately $2.2 million related to our computer networking business, which was sold in the fourth quarter of 2002. Cost of products and services sold (exclusive of depreciation and amortization shown separately below) increased approximately $10.4 million in 2001 as compared to 2000. As a percentage of revenue cost of products and services sold (exclusive of depreciation and amortization shown separately below) increased to 65.3% in 2001 as compared to 58.0% in 2000. During 2001, this segment experienced an increase in cost of products and services sold (exclusive of depreciation and amortization shown separately below) due primarily to the inclusion of twelve months of operating results for two significant businesses acquired in 2000. These two significant acquisitions were Computer Equity Corporation, acquired on June 1, 2000, and Pacific Decision Sciences Corporation, acquired on October 1, 2000. Companies acquired in 2000 contributed $12.8 million of the increase in cost of products and services sold (exclusive of depreciation and amortization shown separately below) in 2001, which was partially offset by a reduction in costs from our existing businesses.
Our Digital Angel Corporation segment's cost of products and services sold (exclusive of depreciation and amortization shown separately below) decreased $2.4 million, or 10.7%, in 2002, as compared to 2001. As a percentage of revenue, cost of products and services sold (exclusive of depreciation and amortization shown separately below) decreased to 59.4% in 2002 from 62.4% in 2001. We attribute the decrease in cost of products and services sold (exclusive of depreciation and amortization shown separately below) in 2002 to a decrease in revenue in our Animal Applications, Wireless and Monitoring, and GPS and Radio Communications divisions. This was partially offset by an increase in cost of products and services sold (exclusive of depreciation and amortization shown separately below) related to our Medical Systems division, which we acquired in March 2002. Cost of products and services sold (exclusive of depreciation and amortization shown separately below) increased by $9.3 million, or 72.2%, in 2001, as compared to 2000. As a percentage of revenue, cost of products and services sold (exclusive of depreciation and amortization shown separately below) increased to 62.4% in 2001 from 58.2% in 2000. Cost of products and services sold (exclusive of depreciation and amortization shown separately below) increased in 2001 primarily as a result of the acquisitions of Timely Technology Corp. in April 2000, which contributed $0.6 million of the
increase, and Destron Fearing Corporation in September 2000, which contributed $9.8 million of the increase. These increases were partially offset by a reduction in cost of products and services sold (exclusive of depreciation and amortization shown separately below) from our one existing business in this group. Cost of products and services sold (exclusive of depreciation and amortization shown separately below) increased as a percentage of revenue in 2001, primarily because the businesses acquired in 2000 experience higher costs of sales than our one existing business in this segment.
Our InfoTech USA, Inc. segment's cost of products sold (exclusive of depreciation and amortization shown separately below) decreased $9.9 million, or 36.6%, in 2002, as compared to 2001, while cost of services sold decreased by $0.3 million in 2002, as compared to 2001. As a percentage of revenue, cost of products and services sold (exclusive of depreciation and amortization shown separately below) remained relatively stable at 81.7% versus 84.3% in 2002 and 2001, respectively. The decrease in cost of products sold (exclusive of depreciation and amortization shown separately below) was primarily due to the overall decrease in revenue resulting from the soft market in the IT industry. Cost of products and services increased $7.3 million, or 34.1%, in 2001, as compared to 2000. As a percentage of revenue, cost of products and services increased to 84.3% in 2001, as compared to 78.7% in 2000. We attribute the increase in cost of products and services sold (exclusive of depreciation and amortization shown separately below) in 2001 to internal growth and the acquisition of InfoTech USA, Inc. We attribute the increase in cost of products and services sold (exclusive of depreciation and amortization shown separately below) as a percentage of revenue primarily to the poor performance of the economy and the technology sector in particular, which resulted in increased incentives to our customers during 2001 as compared to 2000.
Our All Other segment's cost of products and services sold (exclusive of depreciation and amortization shown separately below) decreased by $29.4 million, or 99.3%, from 2001 to 2002. As a percentage of revenue cost of products and services sold (exclusive of depreciation and amortization shown separately below) decreased to 15.9% in 2002, as compared to 71.7% in 2001. Cost of products and services sold (exclusive of depreciation and amortization shown separately below) remained relatively constant in 2001, as compared to 2000 at approximately $29.6 million and $29.3 million, respectively. As a percentage of revenue, cost of products and services sold (exclusive of depreciation and amortization shown separately below) increased to 71.7% in 2001, as compared to 55.6% in 2000. The decrease in cost of products and services sold (exclusive of depreciation and amortization shown separately below) in 2002 is primarily due to the sale or closure of the business units comprising this segment during the last half of 2001 and the first half of 2002. We attribute the increase in cost of products and services sold (exclusive of depreciation and amortization shown separately below) as a percentage of revenue in 2001 primarily to inventory reserves of $4.3 million.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSE
Selling, general and administrative expense from continuing operations was $66.5 million in 2002, a decrease of $35.9 million, or 35.1%, over the $102.3 million reported in 2001. Selling, general and administrative expense from continuing operations increased $40.3 million in 2001, or 65.0%, over the $62.0 million reported in 2000. As a percentage of revenue, selling, general and administrative expense from continuing operations has increased to 66.5% in 2002, from 65.5% in 2001 and 46.0% in 2000.
Selling, general and administrative expense for each of the operating segments was:
2002 2001 2000
---- ---- ----
(AMOUNTS IN THOUSANDS)
Advanced Technology $12,100 $ 12,273 $10,570
Digital Angel Corporation 15,615 9,595 7,810
InfoTech USA, Inc. 4,171 5,451 4,075
All Other 1,504 28,876 23,041
Corporate (1) 33,060 46,121 16,500
--------------------------------------------------------------------------------------------------------
$66,450 $102,316 $61,996
========================================================================================================
Selling, general and administrative expense as a percentage of
revenue for each of the operating segments was:
2002 2001 2000
---- ---- ----
% % %
---- ---- ----
Advanced Technology 28.9 27.5 32.7
Digital Angel Corporation 46.4 26.8 35.1
InfoTech USA, Inc. 18.4 16.0 14.9
All Other 108.4 69.9 43.7
Corporate (1) 33.1 29.5 12.2
-------------------------------------------------------------------------------------------------------
66.5 65.5 46.0
=======================================================================================================
(1) Corporate's percentage has been calculated as a percentage of total revenue.
Changes during the years were:
Our Advanced Technology segment's selling, general and administrative expense decreased $0.2 million, or 1.4%, to $12.1 million in 2002 from $12.3 million in 2001. We attribute the decrease primarily to the reduction in revenues and the corresponding overhead for the majority of the businesses within this segment. As a percentage of revenue, selling, general and administrative expense increased 1.4% in 2002 as compared to 2001. Selling, general and administrative expense increased $1.7 million, or 16.1%, to $12.3 million in 2001 from $10.6 million in 2000. The acquisition of Computer Equity in June 2000 contributed $2.6 million of the increase and $1.2 million resulted from bad debt reserves. The increases were partially offset by staff reductions and other cost saving measures. Selling expense decreased as a percentage of revenue in 2001 as compared to 2000, as companies acquired in 2000 incurred less selling, general and administrative expenses as a percentage of revenue than the existing businesses.
Our Digital Angel Corporation segment's selling, general and administrative expense increased by $6.0 million, or 62.7%, to $15.6 million in 2002 from $9.6 million in 2001. As a percentage of revenue, selling, general and administrative expense increased to 46.4% as compared to 26.8% in 2001. The increase in 2002 relates to expenses associated with the merger of pre-merger Digital Angel and MAS during the first quarter of 2002, of approximately $2.1 million, approximately
$2.5 million in expenses associated with the introduction of the Digital Angel product, approximately $0.6 million of additional commission and marketing expense in the GPS and Radio Communications division, and approximately $0.8 million of expense attributable to the Medical Systems division which was acquired in March 2002. Selling, general and administrative expense increased by $1.8 million, or 23.1% to $9.6 million in 2001 from $7.8 million in 2000. The increase in 2001 was the result of the acquisitions during 2000 of Destron Fearing Corporation, which contributed $2.9 million of the increase, and Timely Technology Corp., which contributed $0.4 million of the increase. These increases were partially offset by a decrease in selling, general and administrative expense from our one existing business in this segment.
Our InfoTech USA, Inc. segment's selling, general and administrative expense decreased $1.3 million, or 23.5%, to $4.2 million in 2002 from $5.5 million in 2001. The decrease in expense was due to several cost savings measures taken in 2002 including the centralization of the service and administrative operations, and the closure of two other small offices, which contributed $0.2 million of the decrease. Also, we reduced our work force and payments of sales commissions, both of which were related to the decline in revenue, which contributed $0.8 million of the decrease. Selling, general and administrative expense increased to $5.5 million in 2001 from $4.1 million in 2000. The increase in 2001 was due to the acquisition of InfoTech USA, Inc. in the fourth quarter of 2000.
Our All Other's selling, general and administrative expense decreased $27.4 million, or 94.8%, to $1.5 million in 2002 from $28.9 million in 2001. The decrease resulted from the sale or closure of all of the business units comprising this group during the last half of 2001 and the first half of 2002. Selling, general and administrative expense increased $5.8 million, or 25.3%, to $28.9 million in 2001 from $23.0 million in 2000. We attribute the increase to the acquisition of a software provider in December 2000.
Corporate/Eliminations selling, general and administrative expense decreased $13.1 million, or 28.3%, to $33.1 million in 2002 from $46.1 million in 2001. We attribute the decrease in 2002 primarily to the one-time costs incurred during 2001, as more fully discussed below, and to a reduction in legal fees of approximately $1.7 million. Partially offsetting the decrease were increases related to the following factors:
o Pursuant to the terms of the pre-merger Digital Angel
and MAS merger agreement, which became effective March
27, 2002, options to acquire shares of pre-merger
Digital Angel common stock were converted into options
to acquire shares of MAS common stock. The transaction
resulted in a new measurement date for the options and,
as a result, we recorded non-cash compensation expense
of approximately $18.7 million during 2002. As all of
the option holders were our employees or directors,
these options were considered fixed awards under APB
Opinion No. 25 and expense was recorded for the
intrinsic value of the options converted;
o We incurred an increase in professional fees associated
with accounting and auditing services during 2002 of
approximately $1.2 million; and
o We incurred non-cash compensation expense of
approximately $0.5 million associated with interest
payments that were due on September 27, 2001 and
September 27, 2002. We have chosen not to pay the
interest and related tax gross-up. We, therefore,
consider such notes to be in default and have begun
steps to foreclose on the underlying collateral (all of
the stock) in satisfaction of the notes. Our decision to
take this action relates in part to the passage of the
recent corporate reform legislation under the
Sarbanes-Oxley Act of 2002, which, among other things,
prohibits further extension of credit to officers and
directors.
Corporate/Eliminations selling, general and administrative expenses increased $29.6 million, or 179.5% to $46.1 million in 2001 from $16.5 million in 2000. The significant increase was primarily as a result of an increase in bad debt reserves on notes and other receivables of $21.9 million. The reserves were considered necessary based upon several factors that occurred during the third and fourth quarters of 2001. These included:
o A debtor declared bankruptcy, which resulted in a reserve of
$2.5 million;o A $6.2 million note receivable, plus accrued interest,
associated with a business sold in December 2000 was deemed
uncollectible as the debtor has experienced significant
business interruptions to a business located in New York
directly related to September 11, 2001;
o Three debtors are delinquent under required payment
obligations resulting in a reserve of $3.4 million; ando A $9.0 million note received for issuance of shares of the
Company's common stock was deemed uncollectible based upon
the financial condition of the debtor.
Also contributing to the increase in 2001 were:
o $5.3 million of non-cash compensation expense due primarily
to re-pricing 19.3 million stock options in September 2001.
The re-priced options had original exercise prices ranging
from $0.69 to $6.34 per share and were modified to change
the exercise price to $0.15 per share. Due to the
modification, these options are being accounted for as
variable options under APB Opinion No. 25 and, accordingly,
fluctuations in our common stock price result in increases
and decreases of non-cash compensation expense until the
options are exercised, forfeited or expired; and
o $3.6 million in litigation reserves.
Partially offsetting the increase was a reduction in personnel related expenses of approximately $2.0 million.
RESEARCH AND DEVELOPMENT EXPENSE
Research and development expense from continuing operations for 2002 was $3.5 million, a decrease of $5.1 million, or 59.1%, over the $8.6 million reported in 2001. As a percentage of revenue, research and development expense decreased to 3.5% in 2002 from 5.5% in 2001.
Research and development expense for each of the operating segments was:
2002 2001 2000
---- ---- ----
(AMOUNTS IN THOUSANDS)
Advanced Technology $ 861 $3,321 $ 269
Digital Angel Corporation 2,422 5,071 2,235
All Other -- 218 --
Corporate 235 -- --
---------------------------------------------------------------------------------------
$3,518 $8,610 $2,504
=======================================================================================
Research and development expense relates primarily to the
development of our products, Digital Angel, Thermo Life, VeriChip and
Bio-Thermo and to software development costs. The research and development
expense associated with software development was $0.9 million, $3.3 million
and $0.3 million in 2002, 2001 and 2000, respectively.
ASSET IMPAIRMENT
Asset impairment during the years ended December 31, 2002, 2001 and 2000 was:
2002 2001 2000
---- ---- ----
(AMOUNTS IN THOUSANDS)
Goodwill:
Advanced Technology $ -- $30,453 $ --
Digital Angel Corporation 62,185 726 --
All Other -- 32,427 818
--------------------------------------------------------------------------------------
Total goodwill 62,185 63,606 818
Property and equipment 6,860 2,372 --
Investment in ATEC and Burling stock -- -- 5,565
Software and other 337 5,741 --
--------------------------------------------------------------------------------------
$69,382 $71,719 $6,383
======================================================================================
As of December 31, 2002, the net book value of our goodwill was
$67.8 million. There was no impairment of goodwill upon the adoption of FAS
142 on January 1, 2002. However, based upon our annual review for impairment
during the fourth quarter of 2002, we recorded an impairment charge of $62.2
million associated with our Digital Angel Corporation segment. The
impairment relates to the goodwill associated with the acquisition of MAS in
March 2002, and to Digital Angel Corporation's Wireless and Monitoring
segment.
Methodology for Assigning Goodwill to Reporting Units:
In accordance with FAS 142, upon adoption, we were required to allocate goodwill to our various reporting units. At January 1, 2002, our reporting units consisted of the following (our reporting units listed below are those businesses, which have goodwill and for which discrete financial information is available and upon which segment management makes operating decisions):
* Advanced Technology segment's Computer Equity Corporation; * Advanced Technology segment's P-Tech., Inc.; * Advanced Technology segment's Pacific Decision Sciences; * Pre-merger Digital Angel Corporation's Animal Applications
division;
* Pre-merger Digital Angel Corporation's Wireless and
Monitoring division;
* Pre-merger Digital Angel Corporation's GPS and Radio
Communications division; and
* InfoTech USA, Inc.
The goodwill assigned to our reporting units was based on the
goodwill resulting from our acquisition of the reporting unit, with the
goodwill attributable to the merger of Destron Fearing Corporation, which
was a publicly held company trading on the Nasdaq (Destron), and Digital
Angel.net Inc. (DA.net) allocated between the Animal Applications and the
Wireless and Monitoring reporting units. The merger of Destron and DA.net
occurred in September 2000. The goodwill resulting from the Destron and
DA.net merger was approximately $74.7 million, of which $50.7 million was
allocated to Animal Applications and $24.0 was allocated to Wireless and
Monitoring. (The Wireless and Monitoring reporting unit also included the
goodwill associated with the acquisition of Timely Technology Corp., of
approximately $7.5 million).
We believe that a portion of the goodwill resulting from the Destron and DA.net merger was due to the synergies of the combined companies. There were several potential benefits/synergies of the merger that we believed would contribute to the success of the combination. These potential benefits/synergies included:
o the acceleration of the opportunities of the Digital Angel
technology through the combination with Destron and the
current products it offers, which establishes a company
with stronger capabilities;
o the combination of Digital Angel.net Inc. and Destron, with
its injectable microchip technology and its current
products in the animal identification markets, provide
broader product offerings for the combined company;
o improvement in the purchasing power of the combined company
as compared to either company standing alone, resulting in
reduced costs;
o the management team of the combined company having greater
depth of knowledge of the injectable microchip and animal
identification industries and more business experience than
that of either company standing alone;
o the potential to expand the market presence of Digital
Angel.net and Destron's products globally through a larger
combined sales force and geographically more extensive
sales and distribution channels;
o the complementary nature of each company's product
offerings as an extension of the offerings of the other
company;
o increased product diversification and penetration of each
company's customer base;o similarities in corporate culture; and
o the opportunity for expanded research and development of
the combined product offerings, including potential new
product offerings.
Since none of the assets and liabilities resulting from the merger
had been assigned to the Wireless and Monitoring reporting unit, we
determined the allocation of the goodwill between the Animal Applications
and Wireless and Monitoring reporting units based upon guidance provided in
FAS 142. FAS 142 states that, "the methodology used to determine the amount
of goodwill to assign to a reporting unit shall be reasonable and
supportable and shall be applied in a consistent manner." Since Destron was
a publicly held company at the time of the merger, and as a result, its fair
market value was readily determinable, we allocated to the Animal
Applications reporting unit the amount of goodwill equal to Destron's fair
market value prior to our public announcement of the potential merger, which
was approximately $50.7 million. This resulted in our allocation of
approximately $24.0 million to the Wireless and Monitoring reporting unit,
which we believed represented the fair market value of the unit at that
point in time, based on our belief in the market potential for the Digital
Angel product, coupled with the synergies of the combined companies, as
discussed above. On November 26, 2001, we launched the Digital Product and
during 2002, we marketed the product extensively. Despite our aggressive
marketing campaign, the Digital Angel product did not achieve our forecasted
revenues during 2002. (Sales of the Digital Angel product were affected, in
part, by the lack of GPS tracking capabilities within buildings. We are
currently working on a second-generation Digital Angel product to include
assisted GPS capabilities to enhance these "line of sight" issues).
Therefore, during the fourth quarter of 2002, we recorded an impairment
charge of approximately $31.5 of the goodwill associated with the Wireless
and Monitoring reporting unit as more fully discussed below.
We engaged an independent valuation firm to review and evaluate the goodwill of Digital Angel Corporation, as reflected on our books for the year-ended December 31, 2002. Independently, the valuation firm reviewed the goodwill of the various reporting units (Animal Applications, Wireless and Monitoring, GPS and Radio Communications and Medical Systems) at the request of Digital Angel Corporation. Digital Angel Corporation's management compiled the cash flow forecasts, growth rates, gross margin, fixed and variable cost structure, depreciation and amortization expenses, corporate overhead, tax rates, and capital expenditures, among other data and assumptions related to the financial projections upon which the valuation reports were based. The valuation firm's
methodology including residual or terminal enterprise values were based on the following factors: risk free rate of 10 years; current leverage (E/V); leveraged beta - Bloomberg; unleveraged beta; risk premium; cost of equity; after-tax cost of debt; and weighted average cost of capital. These variables generated a discount rate calculation.
Residual or Terminal Enterprise Value Calculation:
The independent valuation firm was engaged by Digital Angel Corporation to perform a company comparable analysis utilizing financial and market information on publicly traded companies that are considered to be generally comparable to the Animal Applications, Wireless and Monitoring, GPS and Radio Communications and Medical Systems reporting units. Each analysis provided a benchmark for determining the terminal values for each business unit to be utilized in its discounted cash flow analysis. The analysis generated a multiple for each reporting unit, which was incorporated into the appropriate business unit's discounted cash flow model.
Discounted Cash Flows:
Discounted cash flow analyses were prepared for each of the reporting units, to compare their carrying values with the discounted present values of their cash flows, which indicated that the goodwill associated with Digital Angel Corporation was impaired.
These analyses were subjected to tests of reasonableness by our independent auditors in light of the operating history of the respective business units, the newness of the technology, particularly with respect to the Digital Angel product, and the reliability of achieving forecast results and growth expectations. Neither we nor Digital Angel Corporation had a historical track record of achieving forecasts for new or existing technology products. The Digital Angel watch and pager is the primary revenue driver for the Digital Angel Corporation's Wireless and Monitoring division. The Digital Angel product itself had minimal sales despite an intensive marketing campaign for the product. The poor sales are partly explained by continuing R&D development efforts to enhance the product to make it user friendly, and an over estimation of consumer demand as a result of a challenging economic environment (i.e. consumers considered the Digital Watch a discretionary luxury item) and an uncertain marketplace (we overestimated consumer demand for an innovative and new technology to be introduced into the consumer marketplace). As a result of such evaluation, an impairment charge of approximately $62.2 million was determined by us to be reasonable, of which $30.7 million was associated with Digital Angel Corporation's Medical Systems division, which was acquired on March 27, 2002, and $31.5 million was associated with Digital Angel Corporation's Wireless and Monitoring division. Future goodwill impairment reviews may result in additional write-downs. Such determination involves the use of estimates and assumptions, which may be difficult to accurately measure or value.
In addition, Digital Angel Corporation impaired $6.4 million of software associated with its Wireless and Monitoring segment. The write off related to an exclusive license to a digital encryption and distribution software system. The charge is included in the Consolidated Statements of Operations under the caption Asset Impairment.
As a result of the economic slowdown during 2001, we experienced deteriorating sales for certain of our businesses. In addition, management concluded that a full transition to an advanced technology company required the sale or closure of all units that did not fit into our new business model or were not cash-flow positive. This resulted in the shutdown of several of our businesses during the third and fourth quarters of 2001 and the first quarter of 2002. Also, letters of intent that we had received during the last half of 2001 and the first quarter of 2002 related to the sales of certain of our businesses indicated a decline in their fair values. The sales of these businesses did not comprise the sale of an entire business segment. Based upon these developments, we reassessed our
future expected operating cash flows and business valuations and at December 31, 2001, we performed undiscounted cash flows analyses by business unit to determine if an impairment existed. For purposes of these analyses, earnings before interest, taxes, depreciation and amortization were used as the measure of cash flow. When an impairment was determined to exist, any related impairment loss was calculated based on fair value. Fair value was determined based on discounted cash flows. The discount rate utilized by us was the rate of return expected from the market or the rate of return for a similar investment with similar risks. This reassessment resulted in the asset impairments listed above during 2001.
As a result of the restructuring and revision to our business model, the plan to implement an enterprise wide software system purchased in 2000 was discontinued during the third quarter of 2001, at which time the associated software costs were fully written off and the computer hardware was written down to its estimated net realizable value. During 2002, the remaining value of the equipment, which was no longer deemed saleable of approximately $0.5 million, was written off.
In addition to the impairments above, during 2002 and 2001, we recorded inventory reserves of $1.4 million and $4.0 million, respectively, and bad debt reserves of $1.3 million and $26.0 million, respectively. The inventory reserves are included in our financial statements in cost of products and the bad debt reserves are included in selling, general and administrative expense.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization expense from continuing operations for 2002 was $4.8 million, a decrease of $24.1 million, or 83.5%, over the $28.9 million reported in 2001. The 2001 expense represents an increase of $17.8 million, or 161.0% over the $11.1 million reported in 2000. As a percentage of revenue, depreciation and amortization expense was 4.8%, 18.5% and 8.2% in 2002, 2001 and 2000, respectively.
Under FAS 142, which we adopted on January 1, 2002, goodwill and certain other intangible assets are no longer amortized. We incurred $22.5 million and $9.4 million in goodwill and equity method investment amortization during 2001 and 2000, respectively.
In conjunction with our review for impairment of goodwill and other intangible assets in the fourth quarter of 2000, we reviewed the useful lives assigned to acquisitions and, effective October 1, 2000, changed the lives to periods ranging from 5 to 10 years, down from periods ranging from 10 to 20 years to reflect current economic trends associated with the nature of recent acquisitions made. This change in the fourth quarter of 2000 increased amortization expense by $7.2 million and $3.5 million in 2001 and 2000, respectively.
Depreciation and amortization expense from continuing operations by segments was as follows:
2002 2001 2000
---- ---- ----
(AMOUNTS IN THOUSANDS)
Advanced Technology $ 569 $ 9,088 $ 2,990 Digital Angel Corporation 3,638 12,298 2,962 InfoTech USA, Inc. 261 503 176 All Other 9 4,768 3,366 Corporate 296 2,242 1,579 ----------------------------------------------------------------------------------------------- Total $4,773 $28,899 $11,073 ===============================================================================================We attribute the decreases in 2002 primarily to a reduction in goodwill amortization as a result of the adoption of FAS 142. In addition, All Other's depreciation and amortization expense decreased due to the sale or closure of all of the business units comprising this group during the last half of 2001 and the first half of 2002. "Corporate / Eliminations" depreciation and amortization expense decreased primarily as a result of the impairment and sale of software and other corporate assets during the last half of 2001.
The increases in 2001 as compared to 2000 reflect the increased goodwill amortization associated with the business acquisitions during 2000, and the change in goodwill lives noted above.
LOSS/GAIN ON SALES OF SUBSIDIARIES AND BUSINESS ASSETS
The gain (loss) on sale of subsidiaries and business assets was $0.1 million, $(6.1) million, and $0.5 million for the years ended December 31, 2002, 2001 and 2000, respectively. The loss on the sales of subsidiaries and business assets of $6.1 million for 2001 was due to sales of the business assets of our wholly-owned subsidiaries as follows: ADS Retail Inc., Signal Processors, Limited, ACT Wireless Corp. and our ATI Communications companies. In addition, we sold our 85% ownership interest in Atlantic Systems, Inc. Proceeds from the sales were $3.5 million and were used primarily to repay debt.
INTEREST INCOME AND EXPENSE
Interest income was $2.4 million, $2.1 million and $1.1 million for 2002, 2001 and 2000, respectively. Interest income is earned primarily from short-term investments and notes receivable.
Interest expense was $17.5 million, $8.6 million and $5.9 million for 2002, 2001 and 2000, respectively. Interest expense is a function of the level of outstanding debt and is principally associated with notes payable and term loans.
INCOME TAXES
We had effective income tax (benefit) rates of 0.3%, 11.8%, and (14.8)% in 2002, 2001 and 2000, respectively. Differences in the effective income tax rates from the statutory federal income tax rate arise from goodwill amortization associated with acquisitions, state taxes net of federal benefits and the increase or reduction of valuation allowances related to net operating loss carry forwards and other deferred tax assets. As of December 31, 2002, we have provided a valuation allowance to fully reserve our net operating loss carry forwards and our other existing net deferred tax assets. Our tax provision for 2001 was primarily the result of an increase in the valuation allowance due to the losses incurred during the year ended December 31, 2001, as well as our projections of future taxable income.
NET LOSS ON CAPITAL TRANSACTIONS OF SUBSIDIARY AND LOSS ATTRIBUTABLE
TO CHANGES IN MINORITY INTEREST AS A RESULT OF CAPITAL TRANSACTIONS OF
SUBSIDIARY
Gains where realizable and losses on issuance of shares of stock by our consolidated subsidiary, Digital Angel Corporation, are reflected in the consolidated statement of operations. We determined that such recognition of gains and losses on issuances of shares of stock by Digital Angel Corporation was appropriate since the shares issued to date were not sales of unissued shares in a public offering, we do not plan to reacquire the shares issued and the value of the proceeds could be objectively determined. During 2002, we recorded a net loss of $2.4 million comprised of a loss of approximately $5.1 million resulting from the exercise of 1.5 million pre- merger Digital Angel options (representing the difference between the carrying amount of our pro-rata share of our investment in pre-merger Digital Angel and the exercise price of the options), a gain of approximately $4.7 million from the deemed sale of 22.85% of the AWG, as a result of the merger with MAS, and a loss of approximately $2.0 million on the issuance of 1.1 million shares of Digital Angel Corporation common stock resulting primarily from the exercise of stock options. The loss represents the difference between the carrying amount of our pro-rata share of our investment in Digital Angel Corporation and the net proceeds from the issuances of the stock. In addition, during 2002, we recorded a loss of $2.0 million attributable to changes in our minority interest ownership of Digital Angel Corporation as a result of the stock issuances. We anticipate that in the future we will continue to realize gains and losses on the issuances of stock by Digital Angel Corporation.
EXTRAORDINARY GAIN/LOSS
As a result of settling certain disputes between us, the former owners of Bostek, Inc. and an affiliate of Bostek, as more fully discussed in Note 19 to the Consolidated Financial Statements, the parties agreed to forgive a $9.5 million payable provided we registered approximately 3.0 million common shares by June 15, 2001. We were successful in meeting the June 15, 2001 deadline and, accordingly, the extinguishment of the $9.5 million payable was recorded in June 2001 as an extraordinary gain.
RESULTS OF DISCONTINUED OPERATIONS
The following discloses the results of Intellesale and all other non-core businesses comprising discontinued operations for the period January 1 through March 1, 2001, and the year ended December 31, 2000:
DISCONTINUED INTELLESALE BUSINESS: JANUARY 1,
THROUGH MARCH 1, YEAR ENDED
2001 2000
---- ----
(amounts in thousands)
Product revenue $7,965 $ 95,666
Service revenue 370 6,826
--------------------------------------
Total revenue 8,335 102,492
Cost of products sold (exclusive of depreciation and
amortization shown separately below) 6,974 104,396
Cost of services sold -- 5,315
--------------------------------------
Total cost of products and services sold (exclusive of
depreciation and amortization shown separately below) 6,974 109,711
Selling, general and administrative expenses 1,602 32,772
Gain on sale of subsidiary -- (5,145)
Depreciation and amortization 121 2,949
Interest, net -- --
Impairment of investments -- 46,600
(Benefit) provision for income taxes (151) (13,357)
Minority interest (11) 140
--------------------------------------
(Loss) income from discontinued Intellesale businesses $ (200) $(71,178)
======================================
DISCONTINUED NON-CORE BUSINESSES: JANUARY 1,
THROUGH MARCH 1, YEAR ENDED
2001 2000
---- ----
(amounts in thousands)
Product revenue $5,074 $42,235
Service revenue 476 --
--------------------------------------
Total revenue 5,550 42,235
Cost of products sold (exclusive of depreciation and
amortization shown separately below) 3,525 33,428
Cost of services sold 259 --
--------------------------------------
Total cost of products and services sold (exclusive of
depreciation and amortization shown separately below) 3,784 33,428
Selling, general and administrative expenses 932 7,926
Loss on sale of subsidiary -- 528
Depreciation and amortization 143 1,268
Interest, net 29 187
Impairment of investments -- 3,619
(Benefit) provision for income taxes 185 (257)
Minority interest 64 61
--------------------------------------
(Loss) income from discontinued non-core businesses $ 413 $(4,525)
======================================
TOTAL DISCONTINUED OPERATIONS: JANUARY 1,
THROUGH MARCH 1, YEAR ENDED
2001 2000
---- ----
(amounts in thousands)
Product revenue $13,039 $137,901
Service revenue 846 6,826
--------------------------------------
Total revenue 13,885 144,727
Cost of products sold (exclusive of depreciation and
amortization shown separately below) 10,499 137,824
Cost of services sold 259 5,315
--------------------------------------
Total cost of products and services sold (exclusive of
depreciation and amortization shown separately below) 10,758 143,139
--------------------------------------
Selling, general and administrative expenses 2,534 40,697
Gain on sale of subsidiary -- (4,617)
Depreciation and amortization 264 4,217
Interest, net 29 187
Impairment of investments -- 50,219
(Benefit) provision for income taxes 34 (13,614)
Minority interest 53 201
--------------------------------------
(Loss) income from discontinued operations $ 213 $(75,702)
======================================
The above results do not include any allocated or common overhead
expenses. Included in Interest, net, above are interest charges based on the
debt of one of these businesses that was repaid
when the business was sold in January 2002.
As of March 27, 2003, we have sold or closed substantially all of the businesses comprising Discontinued Operations. There is one insignificant company remaining, which had revenue and net loss for the year ended December 31, 2002, of $0.7 million and $0.2 million, respectively. We anticipate selling this remaining company in the next several months. Proceeds from the sales of Discontinued Operations companies were used to repay amounts outstanding under our credit agreement with IBM Credit. Any additional proceeds on the sale of the remaining business will also be used to repay debt.
Provision for operating losses and carrying costs during the phase-out period included the estimated loss on sale of the business units as well as operating and other disposal costs incurred in selling the businesses. Carrying costs include the cancellation of facility leases, employment contract buyouts, sales tax liabilities and reserves for certain legal expenses related to on-going litigation.
During 2002 and 2001, Discontinued Operations incurred a change in estimated loss on disposal and operating losses accrued on the measurement date of $1.4 million and $(16.7) million, respectively. The primary reason for the reduction in estimated losses for 2002 was due to the settlement of litigation for an amount less than anticipated. The primary reasons for the excess losses in 2001 were due to inventory write-downs of $4.5 million during the second quarter of 2001, a decrease in estimated sales proceeds as certain of the businesses were closed in the second and third quarters of 2001, an increase in legal expenses related to ongoing litigation, additional sales tax liabilities and additional facility lease costs.
The business closures in 2001 were the result of a combination of the deteriorating market conditions for the technology sector as well as our strategic decision to reallocate funding to our core businesses. We also increased our estimated loss on the sale of Innovative Vacuum Solutions, Inc., which was sold during the second quarter of 2001, by $0.2 million, and on Ground Effects Ltd., which was sold in the first quarter of 2002, by $1.2 million.
We do not anticipate a further loss on sale of the remaining business comprising Discontinued Operations. However, actual losses could differ from our estimates and any adjustments will be reflected in our future financial statements. During the years ended December 31, 2002, 2001 and 2000, the estimated amounts recorded were as follows:
-
YEAR ENDED DECEMBER 31,
2002 2001 2000
---- ---- ----
(amounts in thousands)
Operating losses and estimated loss on the sale of business units $ 684 $13,010 $ 1,619
Carrying Costs (2,104) 3,685 6,954
Less: Benefit for income taxes -- -- (1,307)
-----------------------------------------
$(1,420) $16,695 $ 7,266
=========================================
The following table sets forth the roll forward of the liabilities for operating losses and carrying costs from December 31, 2001, through December 31, 2002:
Balance, Balance
December 31, December 31,
Type of Cost 2001 Additions Deductions 2002
----------------------------------------------------------------------------------------------------------------
Operating losses and estimated
loss on sale $ 1,173 $ 684 $1,857 $ --
Carrying costs (1) 7,218 (2,104) 206 4,908
Total $ 8,391 $(1,420) $2,063 $ 4,908
=============================================================================
(1) Carrying costs at December 31, 2002, include all estimated costs to
dispose of the discontinued businesses including $2.0 million for future
lease commitments, $1.8 million for severance and employment contract
settlements, $1.0 million for sales tax liabilities and $0.1 million for
litigation settlement.
During 2000, Intellesale refocused its business model away from the Internet segment and began concentrating on its traditional business of asset management and brokerage services and the sale of refurbished and new desktop and notebook computers, monitors and related components as a wholesale, business to business supplier. The transition resulted in significantly reduced revenues from its Bostek business unit in the first half of 2000 compared to substantial sales from this unit in the second half of 1999, contributing to the decline in revenue from 1999 to 2000. Cost of products and services sold (exclusive of depreciation and amortization) was significantly impacted by lower margin business in the first half of 2000 coupled with an inventory charge of $8.5 million, as discussed below.
In the second quarter of 2000, Intellesale recorded a pre-tax charge of $17.0 million. Included in this charge was an inventory reserve of $8.5 million for products Intellesale expected to sell below cost (included in cost of goods sold), $5.5 million related to specific accounts and other receivables, and $3.0 million related to fees and expenses incurred in connection with Intellesale's cancelled public offering and certain other intangible assets. This charge reflects the segment's decreasing revenue trend, higher quarterly cost of products and services sold (exclusive of depreciation and amortization) and the expansion of Intellesale's infrastructure into a major warehouse facility. In addition, a more competitive business environment resulting from an overall slowdown in Intellesale's business segment, and management's attention to the Bostek operational and legal issues, contributed to the negative results. The impact of the loss resulted in Intellesale restructuring its overhead and refocusing its business model away from the Internet segment and back to its traditional business lines. This restructuring was completed in the fourth quarter of 2000 and during that quarter an additional $5.5 million of inventory acquired for retail distribution was written down to realizable value.
LIQUIDITY AND CAPITAL RESOURCES FROM CONTINUING OPERATIONS
As of December 31, 2002, cash and cash equivalents totaled $5.8 million, an increase of $2.1 million, or 56.8% from $3.7 million at December 31, 2001. Cash used in operating activities totaled $3.9 million, $18.0 million and $43.4 million in 2002, 2001 and 2000, respectively. In each year, cash was used primarily to fund operating losses. By operation of the Digital Angel Trust agreement, our share of Digital Angel Corporation's net assets is effectively restricted. Although Digital Angel Corporation and SysComm may pay dividends, access to these subsidiaries' funds is restricted.
Accounts and unbilled receivables, net of allowance for doubtful accounts, decreased by $5.4 million or 24.7% to $16.5 million at December 31, 2002, from $21.9 million at December 31, 2001. The decrease was primarily as a result of the sale and closure of businesses during 2001 and 2002. As
a percentage of 2002 and 2001 revenue, accounts and unbilled receivable were 16.6% and 14.0%, respectively.
Inventories remained relatively stable at $6.4 million at December 31, 2002, compared to $6.2 million at December 31, 2001.
Other current assets decreased by $1.9 million or 39.6% to $2.9 million at December 31, 2002, from $4.8 million at December 31, 2001. This decrease is primarily attributable to receipt of an $0.8 million tax refund in 2002 and a decrease in prepaid expenses.
Accounts payable decreased by $5.6 million or 36.4% to $9.8 million at December 31, 2002 from $15.4 million at December 31, 2001. The decrease was primarily a result of the sale and closure of businesses during the last half of 2001 and the first half of 2002.
Accrued interest and other expenses increased by $12.1 million, or 70.3%, to $29.3 million at December 31, 2002, from $17.2 million at December 31, 2001. The increase is primarily attributable to accrued interest.
Investing activities provided cash of $8.0 million, $2.7 million and $18.4 million in 2002, 2001 and 2000, respectively. In 2002, cash of $3.2 million was provided by collection of notes receivables, $4.9 million of proceeds from the sale of subsidiaries, business assets, property and equipment, and $2.6 million was received from buyers of divested subsidiaries. Cash was used primarily to purchase property and equipment and to fund Discontinued Operations. In 2001, $2.8 million was used to acquire property and equipment, offset by cash proceeds from the sale of subsidiaries and business assets of $1.7 million, proceeds from the sale of property and equipment of $1.3 million, collections of notes receivable of $1.3 million and a reduction in other assets of $0.9 million. In 2000, we collected $31.3 million from the purchaser of TigerTel included in decreases in notes receivable and $0.9 million from the sale of assets, and realized cash of $1.7 million from our Discontinued Operations. The sources were partially offset by cash of $9.1 million used to acquire businesses, $8.4 million used to acquire property and equipment, and $1.0 million for other assets.
Financing activities (used) provided cash of ($2.8) million, $10.9 million and $30.8 million in 2001, 2000 and 1999, respectively. In 2002, cash was used to pay $6.2 million in notes payable and long-term debt, offset by $1.7 million provided from issuance of common shares, $1.2 from collections of notes receivable for shares issued, and $1.3 provided by increases in notes payable. In 2001, cash of $14.0 million was obtained through notes payable, $0.6 million was provided by long-term debt and $0.7 million was provided from the issuance of common shares. Cash was used primarily for stock issuance costs of $0.8 million, and payments of long-term debt of $2.5 million. In 2000, $19.1 million was received from the issuance of Series C preferred stock, $16.0 million was obtained through long-term debt, $2.2 million was obtained from net increases in notes payable and $6.1 million was obtained through the issuance of common shares. Uses of cash in 2000 included payments of $11.6 million against long-term debt, and $0.8 million for other financing costs.
Debt, Covenant Compliance and Liquidity
On March 1, 2002, we and the Digital Angel Trust entered into the IBM Credit Agreement with IBM Credit, which became effective on March 27, 2002, the effective date of the merger between pre-merger Digital Angel and MAS. The principal amount outstanding had an annual rate of 17% and matured on February 28, 2003. If certain amounts were not repaid on or before February 28, 2003, the interest rate increased to an annual rate of 25%. On September 30, 2002, we entered into an amendment to the IBM Credit Agreement, which revised certain financial covenants relating to our financial performance and the financial position and performance of Digital Angel Corporation for the quarter ended September 30, 2002, and the fiscal year ending December 31, 2002. On November 1,
2002, we entered into another amendment to the IBM Credit Agreement, which further revised certain covenants relating to the financial performance of Digital Angel Corporation for the quarter ended September 30, 2002, and the fiscal year ending December 31, 2002. At September 30, 2002, we and Digital Angel Corporation were in compliance with the revised covenants under IBM Credit Agreement. At June 30, 2002, we were not in compliance with our Minimum Cumulative Modified EBITDA debt covenant and with other provisions of the IBM Credit Agreement, and Digital Angel Corporation was not in compliance with its Minimum Cumulative Modified EBITDA and Current Assets to Current Liabilities debt covenants. On August 21, 2002, IBM Credit provided us with a waiver of such noncompliance. As consideration for the waiver, we issued to IBM Credit a five year-warrant to acquire 2.9 million shares of our common stock at $0.15 per share, valued at approximately $1.3 million, and a five year-warrant to purchase approximately 1.8 million shares of our wholly-owned subsidiary VeriChip Corporation's common stock at $0.05 per share, valued at approximately $44 thousand. The fair value of these warrants was included in interest expense in 2002.
Under the terms of the IBM Credit Agreement we were required to repay IBM Credit Corporation $29.8 million of the $77.2 million outstanding principal balance owed to them plus $16.4 million of accrued interest and expenses (totaling approximately $46.2 million), on or before February 28, 2003. We did not make such payment by February 28, 2003, and on March 3, 2003, IBM Credit notified us that we had until March 6, 2003, to make the payment. We did not make the payment on March 6, 2003, as required. In addition, were not in compliance with the financial performance covenant under the IBM Credit Agreement as of December 31, 2002. Our failure to comply with the payment terms imposed by the IBM Credit Agreement and our failure to maintain compliance with the financial performance covenant constitute events of default under the IBM Credit Agreement. On March 7, 2003, we received a letter from IBM Credit declaring the loan in default and indicating that IBM Credit would exercise any and/or all of its remedies.
On March 27, 2003, we announced that we had executed a forbearance agreement term sheet with IBM Credit. The forbearance agreement becomes effective on or about March 31, 2003 and grants us more favorable loan repayment terms and more time in which to meet our current obligations to IBM Credit. It contains various purchase rights for us to buy back our existing indebtedness from IBM Credit, including a one-time payment on or before June 30, 2003, of $30 million. Payment of this amount will constitute complete satisfaction of any and all of our obligations to IBM Credit. Provided there has not earlier occurred a "Termination Event," as defined, at the end of the forbearance period, the provisions of the forbearance agreement shall become of no force and effect. At that time, if the repayment terms of the forbearance agreement are not met, IBM Credit shall be free to exercise and enforce, or to take steps to exercise and enforce, all rights, powers, privileges and remedies available to them under the IBM Credit Agreement, as a result of the payment and covenant defaults existing on March 24, 2003. If we are not successful in satisfying the payment obligations under the forbearance agreement or we do not comply with the terms of the forbearance agreement or the IBM Credit Agreement, and IBM Credit were to enforce its rights against the collateral securing the obligations to IBM Credit, there would be substantial doubt that we would be able to continue operations in the normal course of business.
Our ability to continue as a going concern and to continue operations in the normal course of business is also predicated upon numerous factors with varying levels of importance as follows:
o First, to the successful repayment of all of our
obligations to IBM Credit, is to successfully implement
our business plans, manage expenditures according to our
budget, and generate positive cash flow from operations so
that we can become profitable and generate sufficient cash
flow to meet our operating needs;
o Second, we must develop an effective marketing and sales
strategy in order to grow our business and compete
successfully in our markets;
o Third, we must obtain the necessary approvals to expand
the market for our VeriChip product;o Fourth, we must complete the development of the second
generation Digital Angel product in order to improve the
product's salability; and
o Finally, we must realize positive cash flow with respect
to our investment in Digital Angel Corporation in order to
provide us with an appropriate return on our investment.
We have established a management plan to mitigate the effect of our
going concern uncertainty conditions over the next twelve months. The major
components of our plan are as follows:
o To raise funds to repay a portion of our obligations to IBM Credit through the offering of up to 50 million shares of our common stock in a best efforts offering. These shares are currently being registered under a registration statement filed with the SEC on December 23, 2002 (File No. 333-102165);
o To utilize the shares of Digital Angel Corporation's common stock currently in the Digital Angel Trust and/or our receivables and inventory to secure additional funds to repay IBM Credit (noting that these assets will be released from liens by IBM Credit upon repayment in full of our obligations under the forbearance agreement);
o To borrow against Digital Angel Corporation's receivables and inventory, if necessary;
o To attempt to establish a sustainable positive cash flow business model;
o To attempt to produce additional cash flow and revenue from our advanced technology products - Digital Angel(TM), Thermo Life(TM), VeriChip(TM) and Bio-Thermo(TM); and
o To generate additional liquidity through divestiture of business units and assets that are not critical to our long-term strategy.
It is the opinion of our management that the likelihood of the above plan being effectively implemented is good. On a consolidated reporting basis, cash of $3.9 million was used by operations for the year ended December 31, 2002. Of this amount, Digital Angel Corporation used approximately $2.7 million. Our goal is to establish a sustainable positive cash flow business model.
We believe that we will be able to generate sufficient revenues and related cash flow in the year 2003 from the Advanced Technology segment to cover the operating expenses of this segment as well as our corporate overhead (exclusive of the corporate overhead of Digital Angel Corporation and InfoTech USA, Inc.). The primary source of revenue for the Advanced Technology segment is Computer Equity Corporation. For the year ended December 31, 2002, the Advanced Technology segment reported gross revenue of $41.9 million. Of this amount, Computer Equity Corporation represented $31.3 million or 74.7% of the total revenue. The future revenue outlook for Computer
Equity Corporation appears to be positive. In January 2003, Computer Equity Corporation's wholly owned subsidiary, GTI, was one of seventeen companies awarded the federal government's CONNECTIONS contract, which replaced the previous WACS contract. The CONNECTIONS contract has a three-year base term and five successive one-year renewal options. The renewal options are at the discretion of the government. The CONNECTIONS contract is similar to the WACS contract in that it will allow Computer Equity Corporation to provide government agencies with equipment and services for campus and building communications networks and related infrastructure without the need to follow the full procurement process for a new contract. During 2003 and beyond our focus will be to generate significant revenue and cash flow from our advanced technology products. We hope to realize revenue and positive cash flow in 2003 and beyond as these products gain customer acceptance and awareness throughout the world.
As of December 31, 2002, the Advanced Technology segment and "Corporate/Eliminations" had a combined cash balance $3.0 million, Digital Angel Corporation had a cash balance of $0.2 million and InfoTech USA, Inc. had a cash balance of $2.6 million. The specific components and the approximate amount of funds that we anticipate that we will need to continue operating for the next twelve months are as follows:
o To fund operations (excluding research and development) -
none, as we expect to achieve cash flow from operations
exclusive of research and development expense
o To fund research and development - $6.2 million
o To fund capital expenditures - $1.4 million
o To fund debt service - $30.5 million
The nature of our business is such that it does not require a
material cash outlay for capital expenditures, and we have no plans to make
significant investments in capital expenditures for the next twelve months.
We estimate that our Advanced Technology segment's capital expenditures for
2003 will be less than $0.4 million, that Digital Angel Corporation's
capital expenditure will be approximately $1.0 million for 2003 and that
InfoTech USA, Inc.'s capital expenditures for 2003 will be de minimus. For
the year ended December 31, 2003, we anticipate the cash outlay for our
research and development efforts relating to our advanced technology
products to approximate $0.8 million and that Digital Angel Corporation's
cash outlay for such efforts will be approximately $5.4 million. InfoTech
USA, Inc. does not incur research and development expense.
Assuming that we are successful in satisfying our obligations to IBM Credit under the terms of the forbearance agreement, that we have positive cash flow from operations and that we rely on our various other sources of liquidity as discussed below, we believe that we should have sufficient working capital to satisfy our short-term needs over the next twelve months.
Sources of Liquidity
While we anticipate that our operations will provide positive cash flow during 2003, our operating activities did not provide positive cash flow during 2002 and 2001. In addition, during 2003, we are required to make substantial debt payments under the terms of the forbearance agreement term sheet with IBM Credit. Accordingly, there can be no assurance that we will have access to funds necessary to provide for our ongoing operations or to make the required debt payments. Our sources of liquidity may include proceeds from the sale of common stock and preferred shares, proceeds from the sale of businesses, proceeds from the sale of the Digital Angel Corporation common stock held in the Digital Angel Trust, proceeds from the exercise of stock options and warrants, and the raising of other forms of debt or equity through private placement or public offerings. These options may not be available, or if available, may not be on favorable terms.
Our capital requirements depend on a variety of factors, including but not limited to, repayment obligations under the IBM Credit Agreement, the rate of increase or decrease in our existing business base; the success, timing, and amount of investment required to bring new products on-line; revenue growth or decline; and potential acquisitions.
Failure to obtain additional funding, to generate positive cash flow from operations and to comply with the payment and other provisions of the forbearance agreement with IBM Credit will have a materially adverse effect on our business, financial condition and results of operations.
Contractual Obligations
The following table shows the aggregate of our contractual cash obligations at December 31, 2002:
Less Than After 5
Contractual Cash Obligations Total 1 Year 1-3 Years 4-5 Years Years
-------------------------------------------------------------------------------------------------------------------
(amounts in thousands)
Notes payable, long-term debt and other
long-term liabilities $ 86,280 $81,879 $1,088 $ 81 $ 3,232
Operating leases 15,039 1,385 1,061 696 11,897
Employment contracts 5,398 2,483 1,404 789 722
-----------------------------------------------------------------
Total contractual cash obligations $106,717 $85,747 $3,553 $1,566 $15,851
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Outlook
We are constantly looking for ways to maximize shareholder value. As such, we are continually seeking operational efficiencies and synergies within our operating segment as well as evaluating acquisitions of businesses and customer bases which complement our operations. These strategic initiatives may include acquisitions, raising additional funds through debt or equity offerings, or the divestiture of business units that are not critical to our long-term strategy or other restructuring or rationalization of existing operations. We will continue to review all alternatives to ensure maximum appreciation of our shareholders' investments. There can be no assurance, however, that any initiatives will be found, or if found, that they will be on terms favorable to us.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In July 2001, the FASB issued FAS No. 141 Business Combinations and FAS No. 142 Goodwill and Other Intangible Assets. FAS 141 requires business combinations initiated after June 30, 2001, to be accounted for using the purchase method of accounting, and broadens the criteria for recording intangible assets separate from goodwill. Recorded goodwill and intangibles will be evaluated against these new criteria and may result in certain intangibles being included in goodwill, or alternatively, amounts initially recorded as goodwill may be separately identified and recognized apart from goodwill. FAS 142 requires the use of a non-amortization approach to account for purchased goodwill and certain intangibles. Under a non-amortization approach, goodwill and certain intangibles will not be amortized into results of operations, but instead would be reviewed for impairment and written down and charged to results of operations only in the periods in which the recorded value of goodwill and certain intangibles is more than its fair value. We adopted the provisions of each statement, which apply to goodwill and certain intangibles acquired prior to June 30, 2001, on January 1, 2002. The adoption of these standards had the impact of reducing our amortization of goodwill commencing January 1, 2002. There was no impairment of goodwill upon adoption of FAS 142. We recorded an impairment charged of $62.2 million based upon our annual review of our goodwill during the fourth quarter of 2002. Future impairment reviews may result in additional periodic write-downs.
In June 2001, the FASB issued SFAS 143, Accounting for Asset Retirement Obligations, which is effective for fiscal years beginning after June 15, 2002. SFAS 143 requires legal obligations associated with the retirement of long-lived assets to be recognized at their fair value at the time the obligations are incurred. Upon initial recognition of a liability, that cost should be capitalized as part of the related long-lived asset and allocated to expense over the useful life of the asset. We will adopt FAS 143 on January 1, 2003. Application of the new rules is not expected to have a significant impact on our financial position and results of operations.
In August 2001, the FASB issued SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This standard supersedes SFAS 121, Accounting for the Impairment of Long-Lived Assets to Be Disposed Of, and provides a single accounting model for long-lived assets to be disposed of. This standard significantly changes the criteria that would have to be met to classify an asset as held-for-sale. This distinction is important because assets to be disposed of are stated at the lower of their fair values or carrying amounts and depreciation is no longer recognized. The new rules will also supercede the provisions of APB Opinion 30, Reporting the Results of OperationsReporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, with regard to reporting the effects of a disposal of a segment of a business and will require expected future operating losses from Discontinued Operations to be displayed in Discontinued Operations in the period in which the losses are incurred, rather than as of the measurement date as presently required by APB 30. This statement is effective for fiscal years beginning after December 15, 2001. We adopted this statement on January 1, 2002. The adoption of FAS 144 did not have a material impact on our operations or financial position.
In May 2002, the FASB issued SFAS 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS 145 eliminates Statement 4 (and Statement 64, as it amends Statement 4), which requires gains and losses from extinguishments of debt to be aggregated and, if material, classified as an extraordinary item, and thus, also the exception to applying Opinion 30 is eliminated as well. This statement is effective for years beginning after May 2002, for the provisions related to the rescission of Statements 4 and 64, and for all transactions entered into beginning May 2002, for the provision related to the amendment of Statement 13. The adoption of FAS 145 did not have material effect on our operations or financial position.
In June 2002, the FASB issued Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This statement requires recording costs associated with exit or disposal activities at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management's commitment to an exit plan. Adoption of this Statement is required with the beginning of fiscal year 2003. We have not yet determined what impact the adoption of FAS 146 will have on our operations and financial position.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure an amendment of FASB Statement No. 123. This Statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of that Statement to require prominent disclosure about the effects on reported net income of an entity's accounting policy decisions with respect to stock-based employee compensation. Finally, this Statement amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. We intend to continue to account for stock-based compensation based on the provisions of APB Opinion No. 25. SFAS 148's amendment of the transition and annual disclosure provisions of SFAS 123 are effective for fiscal years ending after December 15, 2002, and the disclosure requirements for interim financial statements are effective for
interim periods beginning after December 15, 2002. We have adopted the disclosure provisions of SFAS 148 at December 31, 2002.
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