ITEM 1. BUSINESS
Unless the context otherwise provides, when we refer to the “Company,” “we,” “Digital Angel,” or “us,” we are referring to Digital Angel Corporation and its subsidiaries (either wholly- or majority-owned).
Overview
As of December 31, 2010, our business operations consisted primarily of the operations of our wholly-owned subsidiary, Destron Fearing Corporation and its wholly-owned subsidiaries, which collectively we refer to in this Annual Report as Destron Fearing, and our 98.5% owned subsidiary, Signature Industries Limited (“Signature”). Currently we operate in two business segments: Animal Identification, which comprises the operations of Destron Fearing; and Emergency Identification, which comprises the operations of Signature.
We currently engage in the following principal business activities:
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Our Animal Identification segment develops, manufactures and markets visual and electronic identification tags and implantable radio frequency identification (“RFID”) microchips, primarily for identification, tracking and location of companion pets, livestock (e.g., cattle and hogs), horses, fish and wildlife worldwide, and, more recently, for animal bio-sensing applications, such as temperature reading for companion pet applications; and
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Our Emergency Identification segment develops, manufactures and markets global position systems (“GPS”) and GPS-enabled products used for emergency location and tracking of pilots, aircraft and maritime vehicles in remote locations.
Discontinued Operations
During the years ended December 31, 2010 and 2009, we sold several non-core businesses. On November 20, 2009, we sold the assets of one of Signature’s business units, McMurdo Limited (“McMurdo”). On January 21, 2010, we sold Thermo Life Energy Corp. (“Thermo Life”), on January 25, 2010, we sold substantially all of the assets of a division known as the Control Products Group within the Clifford & Snell business unit of Signature, and on April 30, 2010, we sold the assets of Clifford & Snell. Accordingly, the financial results of these businesses are now classified as discontinued operations for all periods presented in this Annual Report. Our decision to sell these businesses was a result of management’s strategy to streamline operations. Going forward, our strategy is to focus our efforts on the business operations of our Animal Identification segment. Discontinued operations are more fully discussed in Note 13 to our consolidated financial statements.
Internet Website
Our Internet website address is www.digitalangel.com. Our segments’ internet website addresses are: www.destronfearing.com and www.signatureindustries.com. The information on these websites is not incorporated by reference into this Annual Report on Form 10-K. We make available free of charge through our website annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, Forms 3, 4 and 5 filings, and all amendments to those reports and filings as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”).
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Effective April 20, 2007, we became a Delaware corporation. We initially incorporated in the state of Missouri on May 11, 1993. Our principal executive offices are located at 490 Villaume Avenue, South Saint Paul, Minnesota 55075 (651-455-1621).
Recent Events
16% Senior Secured Debenture and Warrants
On February 24, 2011, we entered into a Securities Purchase Agreement (the “Agreement”) with certain investors, including Hillair Capital Investments LLC (the "Investors") whereby we issued and sold (the “Offering”) to the Investors (i) $2.0 million of senior secured Debentures (the “Debentures”), (ii) Series A warrants (the “Series A Warrants”) to purchase up to 4,000,000 shares of our common stock and (iii) Series B warrants (the “Series B Warrants” and collectively with the Series A Warrants, the “Warrants”) to purchase up to 4,000,000 shares of our common stock.
We will be obligated to redeem the Debentures on a quarterly basis beginning on October 1, 2011, in an amount equal to $0.5 million each quarter, until the Debentures maturity date of July 1, 2012. The Debentures accrue interest at a rate of 16% per annum which is due on a quarterly basis beginning on April 1, 2011. Upon any event of default, 125% of the then outstanding principal amount of the Debentures and any accrued interest would become immediately due and payable at the Investors’ election and the annual interest rate would increase to 18%. During the first six months after closing, we may not prepay any portion of the principal amount of the Debentures without the consent of the Investors. After the six month anniversary, we may elect to redeem some or all of the then principal amount outstanding with notice to the Investors at an amount equal to 120% of the then outstanding principal amount. We are subject to certain non-financial covenants under the Agreement.
The 4,000,000 Series A Warrants may be exercised at any time through the maturity date of the Debentures at an exercise price of $0.45 per share and the 4,000,000 Series B Warrants may be exercised at any time for a period of five years at an exercise price of $0.45 per share. If at any time after six months subsequent to the date of the Agreement there is no effective registration statement registering the resale of the shares of common stock underlying the Warrants, the holder of the Warrants may elect to exercise using a net exercise (i.e., cashless exercise) mechanism. If we sell or grant any option to purchase, or sell or grant any right to reprice, or otherwise dispose of or issue any common stock or common stock equivalents at an effective price per share less than $0.45, then simultaneously with the consummation of each dilutive issuance, the Warrant exercise price for both of the Warrants shall be reduced to the lower price. In addition, the number of shares of common stock underlying the Series B Warrants will be increased such that the aggregate value of the Series B Warrants, after taking into account the decrease in the exercise price, shall be equal to the value prior to such adjustment. If we enter into a fundamental transaction that (i) is an all cash transaction, (ii) is a Rule 13e-3 transaction as defined in Rule 13e-3 under the Exchange Act, or (iii) involves a person or entity not traded on a national securities exchange, we or any successor entity must, at the holder’s request within thirty days after each fundamental transaction (“Holder Option Period”), purchase the Warrants from the holder for an amount of cash equal to the value of the unexercised portion of the warrants that remain as of the time of such fundamental transaction based on the Black Scholes Option Pricing Model obtained from the “OV” function on Bloomberg, L.P (“the Black Scholes Value”). The maximum amount payable under the Black Scholes Value shall be (i) $0.5 million if the fundamental transaction is consummated prior to the six month anniversary of the issuance date or (ii) $1.0 million if the fundamental transaction is consummated subsequent to the six month anniversary but prior to the first anniversary of the issuance date. The Warrants are not exercisable by a holder to the extent that such holder or any of its affiliates would beneficially own in excess of 4.9% of our common stock. We have estimated the initial value of the warrants to be approximately $2.3 million based on a valuation model considering a sensitivity analysis performed to evaluate the impact on value of a potential down round, and using the following assumptions: dividend yield of 0.0%; expected life of sixteen months for the Series A Warrants and five years for the Series B warrants; volatility of 77.58% and 98.09%, respectively; and a risk free rate of 0.26% and 2.19%, respectively.
To secure our obligations under the Debentures, we and Destron Fearing have pledged our ownership interests in Signature. In addition, Signature, Destron Fearing and its wholly-owned subsidiaries Digital Angel Technology Corporation and Digital Angel International, collectively and individually have guaranteed the Debentures.
Mortgage Loan Modification Agreement
On February 25, 2011, we entered into a Loan Modification Agreement (the “Mortgage Agreement”) with the mortgage lender extending the mortgage loan’s term to November 1, 2011, with the option to extend the maturity date for an additional six months. If we elect to extend the maturity date, we must notify the current mortgage lender by September 30, 2011 and pay a fee of $25 thousand which would be applied to the outstanding principal. Under the Mortgage Agreement, the interest rate and monthly payments will remain the same as prior to the mortgage loan maturity. Upon closing, we were required to pay an additional principal payment of $25 thousand plus certain other closing fees. We are also required to make an extension payment of approximately $25 thousand which will be paid ratably over four months beginning March 1, 2011.
Industry Overview
Our principal activities encompass the development and marketing of RFID and GPS-enabled identification and location products.
RFID technology continues to grow in its importance to the animal identification industry. RFID systems identify objects using radio frequency transmissions, typically achieved with communication between a microchip or tag and a scanner or reader. Historically, RFID has been used to identify objects in security, retail, transportation and logistics industries, as well as to identify, track and locate livestock and companion pets. Prior to the adoption of RFID, users identified and tracked objects manually as well as through the use of bar code technology. These solutions were limited because of the need for ongoing human intervention and the lack of instantaneous location capabilities. RFID technology possesses greater range, accuracy, speed and lower line-of-sight requirements than bar code technology.
Our RFID businesses focus on companion pet identification and retrieval, equine identification, livestock food safety and traceability, and fish tracking through the network of dams in the Columbia River Basin.
The basic components of an RFID system consist of:
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a “tag,” containing a microchip-equipped transponder, an antenna and a capacitor, attached to the item to be identified, located or tracked, which wirelessly transmits stored information to a receiver;
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one or more receivers, also referred to as “readers” or “scanners”, which are devices that read the tag by sending out an RF signal to which a tag, in the range of the signal, responds; and
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the equipment, cabling, computer network and software applications to use the processed data for one or more applications.
Most RFID systems use either “active” or “passive” tags, with the choice reflecting the different characteristics of the tags and the nature of the RFID system application. The key difference in the technology is that active RFID systems deploy tags with battery-powered microchips that emit a signal at regular intervals or continuously and do not rely on power from the reader to operate, while passive RFID systems deploy tags with microchips that have no attached power supply and receive an activating charge from the reader’s signal. Applications that require receipt of signals between the tag and the reader beyond approximately 10 meters in range usually require a battery in the tags. Currently, we sell passive RFID tags, with active tags under development.
Pet Identification and Retrieval
Pet identification and retrieval systems involve the insertion of a microchip with identifying information in the animal. Readers at animal shelters, veterinary clinics and other locations can determine the animal’s owner and other information with the use of RFID scanners and a registry database. The pet identification and retrieval market is expanding at accelerated levels. In the U.S., more and more shelters promote the use of microchipping as a way to insure that a lost pet can be reunited with its owner. With only an estimated 10% of pets chipped, the U.S. pet market has significant growth potential. As a result of the recent expansion of the capabilities of the electronic chips (e.g., providing feedback on the health of the animal, such as a temperature reading), we believe the market will expand even further. In Europe, microchips are required for any pets traveling across borders. These “pet passports” allow the animal to travel freely throughout Europe without quarantine, and in some European countries, as many as 40% of the pets have electronic identification.
Livestock Identification and Tracking and Food Safety and Traceability
The use of RFID technology in the tracking of livestock in the U.S. is currently limited to utilization for herd management (breeding, performance, etc), United States Department of Agriculture (“USDA”) disease control programs (Brucellosis, Tuberculosis, etc.) and Marketing programs (Non-Hormone Treated Cattle and limited use for the Beef Export Verification Program). Recently the US federal government announced that it would discontinue the USDA’s National Animal Identification System (“NAIS”), moving traceability responsibilities to the state and tribal levels. The USDA will work with the states to establish a common system for animals transported across state lines. While NAIS at the federal level has been discontinued, 48-hour trace-back, and age and source verification will remain a central part of the livestock industry’s processes. Destron Fearing products have been widely adopted for these requirements, and we continue to see more opportunities from growth in these segments. At Destron Fearing, our business model has always been to develop and sell innovative herd management products to producers that add value to their businesses. We have developed programs that make it easier for producers to do business with us, and to provide them with products that enhance their productivity and business success. Our RFID products are focused on gaining information, such as monitored animal behavior, and yielding data that can achieve early detection of potential illnesses in their herds.
Internationally, the market place for electronic identification tags continues to grow. The need to combat animal disease has the European Union (“EU”) focusing on improved traceability of livestock. Beginning on December 31, 2009, the EU has mandated the use of electronic tags for all sheep and goats, which is believed to be a forerunner to eventually requiring all large animal livestock to have electronic tags in the future. It is planned to be implemented in the entire European herd over the next few years. In South America, Brazil, with approximately 200 million cattle, implemented mandatory electronic identification of all feed lot cattle in 2010. Soon all new born cattle in Brazil will be required to have electronic tags, with the objective to move the entire herd to electronic tags over the next two years. Similar implementations are occurring in other South American countries, such as Colombia and Chile. These are all favorable signs for our Animal Identification segment, and the outlook shows signs of growth.
Emergency Identification
Global Navigation Satellite System (“GNSS”) is the standard generic term for satellite navigation systems that provide autonomous geospatial positioning with global coverage. The Navigation Satellite Timing and Ranging Global Position System (“NAVSTAR GPS”), which was developed by the U.S. Department of Defense, is the only fully operational GNSS. The satellite constellation is managed by the U.S. Air Force 50th Space Wing. Although the cost of maintaining the system is approximately $400 million per year, including the replacement of aging satellites, GPS is free for civilian use as a public good. In addition to NAVSTAR GPS, there is some indication that other nations may begin deploying GNSS. The Russian GLONASS is a GNSS in the process of being restored to full operation. The European Union Galileo positioning system is a next generation GNSS in the initial deployment phase, scheduled to be operational in a few years, and China has indicated it may expand its regional Beidou navigation system into a global system.
A GPS receiver calculates its position by measuring the distance between itself and three or more GPS satellites. Measuring the time delay between transmission and reception of each GPS radio signal gives the distance to each satellite, since the signal travels at a known speed. The signals also carry information about the satellites’ location. By determining the position of, and distance to, at least three satellites, the receiver can compute its position using trilateration. Receivers typically do not have perfectly accurate clocks and, therefore, track one or more additional satellites to correct the receiver’s clock error.
The original motivation for satellite navigation was for military applications. Today, GNSS systems have a wide variety of civilian uses such as:
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navigation, ranging from personal hand-held devices for trekking, to devices fitted to cars, trucks, ships and aircraft;
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synchronization;
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location-based services such as enhanced 911;
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surveying;
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entering data into a geographic information system;
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search and rescue;
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geophysical sciences; and
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tracking devices used in wildlife management.
Our focus is in the areas of search and rescue and locator beacons and tracking systems which include mobile satellite data communications service and software for messaging for a variety of markets including the military, law enforcement and energy market. We believe that there is excellent growth potential in each of our markets and particularly, for us, in sales of our military personal location beacons due to recent technology improvements. However, each market in which we compete is highly competitive.
Operating Segments
Financial Information About Our Segments
Revenues from our two segments over the past two years were as follows:
Refer to the segment information in Note 18 to our consolidated financial statements.
Animal Identification Segment
Principal Products and Services
Our Animal Identification segment develops, manufactures and markets visual and electronic identification tags and implantable RFID microchips, primarily for identification, tracking and location of companion pets, livestock (e.g., cattle and hogs), horses, fish and wildlife worldwide, and, for animal bio-sensing applications, such as temperature reading for companion pet applications. Our Animal Identification segment’s proprietary products focus on pet identification and safeguarding, as well as the positive identification and tracking of livestock and fish, which is crucial for asset management, disease control, food safety, and environmental impact analysis. This segment’s principal products are visual and electronic ear tags for livestock; and implantable microchips and RFID scanners for the companion pet, livestock, horses, fish and wildlife industries.
The Animal Identification segment consists of Destron Fearing’s operations located in Minnesota and its wholly-owned subsidiaries: DSD Holding A/S and Destron Fearing A/S and its subsidiaries, which have operations in Denmark and Poland (collectively referred to as “Destron Fearing A/S”); and Digital Angel International, Inc. and its subsidiaries located in Argentina, Brazil, Chile, Paraguay and Uruguay.
We hold patents on our syringe-injectable microchip for use in animals. Each microchip is individually inscribed and programmed to store a unique, permanent 10 to 16-digit alphanumeric identification code. These microchips are tiny, passive electronic devices ranging in size from 8 to 28 millimeters in length and 2.1 to 3.5 millimeters in diameter. The smallest microchip is about the size of a grain of rice. The microchip is coupled with an antenna and placed either in a two-piece plastic button RFID tag or in a glass-like injectable capsule. The button RFID tag is typically affixed to the ear of the animal. The implantable microchip is injected under the skin using a hypodermic syringe, without requiring surgery. Each capsule is coated with a polymer, BioBondTM, to form adherence to tissue, thereby preventing migration in the host’s body. An associated scanner device uses radio frequency to interrogate the microchips and read the code. Our patented Bio-Thermo® implantable microchip product provides temperature readings of animals by simply passing an RFID handheld scanner over the animal.
Our pet identification and location system involves the insertion of a microchip, with identifying information, in the animal. Scanners located at animal shelters, veterinary clinics and other locations can read the RFID tag ID which is then queried in a database to determine the animal’s owner. Presently, there is an established infrastructure with RFID scanners placed in approximately 70,000 global animal shelters and veterinary clinics. We believe that approximately 4.0 million companion animals in the U.S. have been enrolled in our distributor’s database, and a pet is recovered in the U.S. by that system approximately every six minutes.
Our miniature RFID microchips are also used for the tagging of fish, especially salmon, for identification by biologists and governments in environmental programs and studies, migratory studies and other purposes. These microchips are accepted as a safe, reliable alternative to traditional identification methods because once the fish are implanted with the microchips, they can be identified without recapturing or sacrificing the fish. In 2006, we installed what is believed to be the world’s largest RFID ready system, a 17-foot by 17-foot RFID antenna designed to electronically track indigenous salmon populations. In addition, we launched our next generation transponders. These updated transponders are designed to provide greater reader reliability while increasing reader range.
In addition to pursuing the market for permanent identification of companion animals and tracking microchips for fish, we also produce visual and RFID identification products, for livestock producers. The tracking of cattle and hogs is crucial in order to provide security both for asset management and for disease control and food safety. Destron Fearing has marketed visual identification products for livestock since the 1940s. Visual identification products typically include numbered ear tags. Electronic identification products for livestock are currently being utilized for herd management (breeding, performance, etc), United States Department of Agriculture (“USDA”) disease control programs (Brucellosis, Tuberculosis, etc.) and Marketing programs (Non-Hormone Treated Cattle and limited use for the Beef Export Verification Program). Currently, sales of visual products represent a substantial percentage of our sales to livestock producers.
Growth Strategy
The principal components of our Animal Identification segment’s growth strategy are to:
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focus on animal identification products in the growing livestock, fish and wildlife industries;
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become a major support player in the food source traceability and safety tracking systems arena;
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increase our market share in the pet identification and equine markets with enhanced products such as our temperature-sensing Bio-Thermo® product, and
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the development of high frequency tags both passive and active for longer read range - rTAG product development.
Through our Animal Identification segment, we are one of the leading suppliers in the U.S. of RFID-enabled implantable microchip products for companion animals, laboratory animals, wildlife, and visual identification tags for livestock. The “chipping” of companion pets has increased in Europe, in part, because in 2004, several European countries began requiring that all pets crossing their borders be identified with a either a tattoo or a microchip. In addition, world-wide standardization of the frequency on which the microchips operate will most likely lead to higher world-wide chipping rates. Our chips can be read by the world standard, which is 134.2 kilohertz.
During 2010, we continued our national initiative to target the use of our microchips to address the more than $100 million estimated U.S. equine market for identification products. There are approximately 9.2 million horses in the U.S. We believe that approximately 6.0 million are competition horses requiring identification by local and state equine animal health rules and regulations. In addition, USDA’s NAIS business plan categorizes equines as medium priority for permanent identification. Since late 2005, the California Horseracing Board, a division of the California Department of Agriculture, has been implanting all new, in-coming young horses entering their racing career with our microchips, which we call LifeChips®. The State of Louisiana has also been utilizing our LifeChips® to identify horses that have been Coggins tested which checks for Equine Infectious Anemia. The New York State Horse Health Assurance Program implemented a comprehensive health campaign that utilizes our microchips, and other state agencies are expected to launch similar programs. In addition, in March 2008, we entered into a non-exclusive distribution agreement with The Jockey Club, the official registry for North American Thoroughbred horses. Additional growth in LifeChip sales is expected to come from the recent requirement in Mexico, where all horses entering their country must have microchips.
New Products
In the second quarter of 2010, we launched a family of HDX (Half Duplex) products. This launch positions us to globally compete in markets that require this specialized technology. We have seen good growth in the US throughout 2010 and have developed beachheads in other key countries that will develop over the next one to three years.
Throughout 2010 we made progress on a number of new fishery antennas and readers:
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FishTracker IS1001TM is a standalone RFID Antenna Control Node (ACN) designed to be a low cost, highly adaptable system for a variety of Passive Integrated Transponder (PIT) tag interrogation sites. The IS1001TM is capable of operating antennas sized up to 4 feet by 20 feet, with low coil inductance and advance auto-tuning circuitry that is tolerant of changing environmental conditions.
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FishTracker FS2020 is a powerful, high speed ISO compliant stationary transceiver designed as a direct replacement for existing single channel transceivers currently installed throughout the Columbia River Basin.
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FishTracker FS3001 will be the most advanced PIT tag detection system yet to be deployed in the Columbia River Basin. This interrogation system will be integrated into the spillway of the hydroelectric dams, and will be capable of tracking and identifying fish moving at over 60 miles per hour.
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FishTracker IS1001-MTS is a distributed Multiplexing Transceiver System (MTS). It is a high performance RFID detection system that is specifically designed for adaptability to environmental changes.
In addition, in the fourth quarter of 2010, we completed development of the next generation Destron Fearing PIT tag providing a 15% performance improvement over the previous standard SST-1 PIT tag.
In 2010 we announced our long range, active RFID system called rTAG. Active tags have applications for livestock in cow/calf, feed lot, and dairy applications. We anticipate rTAG will be developed for market availability in late 2011.
Sales, Marketing and Distribution
Our companion pet identification and location system is marketed in the U.S. by Intervet/Schering-Plough Animal Health Corporation (“Intervet/Schering-Plough”) under the brand name Home Again® Pet Recovery Service. In February 2007, we signed an exclusive product supply and distribution agreement with Intervet/Schering-Plough Home Again LLC, a wholly owned subsidiary of Intervet/Schering-Plough, to provide electronic identification microchips and scanners as part of the Home Again® Proactive Pet Recovery Network. Intervet/Schering-Plough’s network, which markets the complete electronic pet identification system under the brand name HomeAgain®, is the nation’s first comprehensive system to assist in the search for lost pets. We helped Intervet/Schering-Plough develop this system in the late 90’s. In December, 2010, we entered into an amendment to the February 2007 agreement, which extends our agreement to provide Intervet/Schering-Plough electronic identification microchips and scanners as part of the Home Again® Proactive Pet Recovery Network through December 2011. During the term of the amended agreement, we will exclusively manufacture, supply and sell to Intervet/Schering-Plough and Intervet/Schering-Plough will exclusively purchase from us certain products (as defined in the amended agreement). The amended agreement contains, among other things, minimum purchase requirements by Intervet/Schering-Plough. The amended agreement also prohibits us from manufacturing, supplying or selling the products to any other person, governmental authority or entity in the territory (as defined in the amended agreement). The amended agreement also grants to Intervet/Schering-Plough exclusive distribution, marketing and sale rights to our RFID products in the companion animal market in the U.S. and non-exclusive distribution, marketing and sale rights to our RFID Bio Thermo product in the designated animal markets and territories, subject to a maximum amount of units of such RFID Bio Thermo products.
Currently our companion pet/equine product is also marketed by various other companies, including, but not limited to, (i) in some countries in Europe by Merial Pharmaceutical under the Indexel® brand; (ii) in the United Kingdom (U.K.) and Ireland by Animalcare under the idENTICHIP® brand; and (iii) in other European countries and in Australia, New Zealand and Japan by various distributors under the LifeChip® brand.
BioMark, Inc. is our primary U.S. distributor for our fish and wildlife RFID microchip products. Electronic identification products for livestock are sold directly to our customers under the Destron brand. Our principal customers for electronic identification devices for fish are Pacific States Marine and the U.S. Army Corps of Engineers. The loss of, or a significant reduction in, orders from either of these customers could have a material adverse effect on our financial condition and results of operations.
Competition
The animal identification market is highly competitive. The principal competitors in the U.S. visual identification market are Allflex USA, Inc. and Y-Tex Corporation, and the principal competitors in the U.S. RFID identification market are Allflex USA, Inc., Datamars SA and Avid Identification Systems, Inc. We believe that our intellectual property position and our reputation for high quality products are our competitive advantages.
Our principal competitor in other global markets is Allflex, with the remainder of the market quite fragmented with regional players. We believe that our efficient low cost production, reputation for high quality ear tags and our clear focus on the market are our competitive advantages. We expect our competitors to continue to improve the performance of and support for their current products. We also expect that, like us, they will introduce new products, technologies or services. Our competitors’ new or upgraded products could adversely affect sales of our current and future products.
Manufacturing; Supply Arrangements
Our Animal Identification segment has not been materially or adversely affected by the inability to obtain raw materials or products during the past three years. We rely on a production arrangement with Raytheon Microelectronics Espana (“RME”), a subsidiary of Raytheon Company, for the assembly of certain of our patented syringe-injectable transponders. The term of that agreement ends in December 2013, subject to earlier termination by either party if, among other things, the other party breaches the agreement and does not remedy the breach within 30 days of receiving notice. Under the agreement, RME is our preferred supplier of the glass encapsulated, syringe-implantable transponders, provided that RME’s pricing remains market competitive. Certain of the automated equipment and tooling used in the production of the transponders are owned by us; other automated equipment and tooling is owned by RME.
Besides RME, our Animal Identification segment’s other principal suppliers are TSI Molding, Inc., Feature Products and Creation Technologies. We generally do not enter into contracts with these suppliers.
Emergency Identification Segment
Principal Products and Services
Our Emergency Identification segment’s proprietary products provide emergency location and tracking of pilots, aircraft and maritime vehicles in remote locations. This segment’s principal products are GPS enabled search and rescue equipment and intelligent communications products and services for mobile data and radio communications applications, including our SARBETM brand which serves commercial and military markets.
GPS Enabled Search and Rescue Equipment and Intelligent Communications Products
Our personal locator beacons (“PLBs”) are sold under the SARBE™ brand name. SARBE products are primarily used by military air crew in the event of an ejection or other event requiring emergency evacuation of an aircraft in a remote, possibly hostile location. SARBE equipment is also used by land and naval forces. Signature is based in the U.K. and has been developing and manufacturing PLBs for five decades. Reports of Second World War airmen and sailors at sea awaiting rescue with little more than the faint hope that a passing ship would find them was the catalyst that inspired Signature to develop a new way of saving lives by making the search part of search and rescue more effective. Today, we believe that we are a world-leading supplier of PLBs and our SARBE trademark is a common term for these devices, which are now found on ships, aircraft and submarines in the armed forces of over 40 countries. U.K. airmen were among the first to carry these lifesaving devices. Today every U.K. Royal Air Force, Royal Navy and Army airman carries a SARBE. PLBs are also packed in the survival packs of life rafts on military ships. Our latest generation SARBE for military personnel is the software programmable SARBE G2R, which provides true global reach and recovery. This flexible radio features peacetime and combat modes. As with previous PLBs, G2R can be configured to operate with any fast jet ejection seat and incorporates a specially designed system that automatically activates the beacon and deploys the antenna to the optimum position. This ensures that even if aircrew are unconscious or injured, the SARBE transmission will be initiated immediately as no human intervention is required, reducing the time it takes to initiate a search. Our SARBE G2R has been approved to operate on the Cospas-Sarsat Satellite System. Cospas-Sarsat is the internationally funded satellite system operator that detects activated search and rescue beacons and is responsible for approving all rescue beacons. Beginning February 1, 2009, Cospas-Sarsat ceased monitoring beacons using 121.5 MHz and 243 MHz satellite frequencies. The outdated beacons were replaced by the new generation of 406 MHz beacons, such as our SARBE G2R.
We are also a distributor of two-way communications equipment in the U.K. Our products range from conventional radio systems for the majority of radio users, for example, safety and security, construction, manufacturing, to trunked radio systems for large scale users, such as local authorities and public utilities. We also offer marine radios, air band radios and satellite communication equipment for use on a global basis.
Growth Strategy
We believe that our SARBE PLBs offer the greatest source of growth for our Emergency Identification segment. Cospas-Sarsat forecasts that the global population of the new generation of digital beacons will grow to 900,000 by 2012, providing us with opportunities to upgrade existing customers’ equipment and sell into new markets. We expect to see an increase in the demand for our beacons as air forces upgrade their PLBs to new digital standards. Air forces in the U.K. and the U.S. will be required to replace their existing beacons with the new generation 406 MHz beacons in the future. SARBE has developed a specific new product, the AAPLB, which we believe is a superior next generation search and rescue beacon that addresses this market well. The UK MoD selected our AAPLB for tri-service use in 2008, and we expect to begin shipping our AAPLBs to the MoD in 2011. We have also shipped this new, next generation product to a second customer, Spain, during the first quarter of 2011.
Sales and Distribution
We sell our PLBs directly to our customers worldwide through a direct sales force of approximately four personnel and through supply and distribution agreements, which have varying expiration dates. The remaining terms of such agreements are between one and three years. We are also a distributor of two-way communication equipment in the U.K. Our agreements with these distributors have varying expiration dates.
Competition
Principal methods of competition in our Emergency Identification segment include geographic coverage, service and product performance. The principal competitors for our PLBs are Boeing North American Inc., General Dynamics Decision Systems, Tadiran, Spectralink Ltd., and Becker Avionic Systems. We believe that introducing new leading edge products in the search and rescue beacon market and the use of our search and rescue beacons in over forty countries are competitive advantages. In addition, the barriers to entry in this market are high due to the technical demands of the market.
Manufacturing; Supply Arrangements
Our Emergency Identification segment has not been materially or adversely affected by the inability to obtain raw materials or products during the past three years. This segment’s principal suppliers are C.I.L. Ltd., Motorola Ltd., and Base Ltd. We generally do not enter into contracts with these suppliers.
Government Regulation
Animal Identification Laws and Regulations
Our passive RFID systems rely on low-power, localized use of the radio frequency spectrum to operate. As a result, we must comply with U.S. Federal Communications Commission (“FCC”) and Industry Canada (“IC”) regulations, as well as the laws and regulations of other jurisdictions in which we sell our products, governing the design, testing, marketing, operation and sale of RFID devices. Accordingly, all of our products and systems have the FCC equipment authorization, the IC equipment authorization, or other jurisdictions’ authorizations, as appropriate.
U.S. Federal Communications Commission Regulations
Under FCC rules and regulations and Section 302 of the Communications Act, RFID devices, including those we market and sell, must be authorized and comply with all applicable technical standards and labeling requirements prior to being marketed in the U.S. The FCC’s rules prescribe technical, operational and design requirements for devices that operate on the electromagnetic spectrum at very low power levels. The rules ensure that such devices do not cause interference to licensed spectrum services, mislead consumers regarding their operational capabilities or produce emissions that are harmful to human health. Our RFID devices are intentional radiators, as defined in the FCC’s rules. As such, our devices may not cause harmful interference to licensed services and must accept any interference received. Additionally, we must construct all equipment in accordance with good engineering design and manufacturers’ practices. The FCC rules also establish standards for labeling, user manuals, recordkeeping and testing. We believe that we are in substantial compliance with all FCC requirements applicable to our products and systems.
Industry Canada Regulations
Industry Canada regulates the design, sale and use of radio communications devices in accordance with its Radio Standards Specifications (“RSS”) and Radio Standards Procedures (“RSP”). As intentional emitters, our RFID devices are subject to Industry Canada’s RSP-100, which establishes the procedures by which RFID communications equipment receives certification by Industry Canada. The RSP-100 certification procedure and RSS standards ensure that RFID radio devices do not cause interference to licensed spectrum services and that the devices do not produce emissions that are harmful to human health.
Manufacturers of RFID devices must demonstrate compliance with RSP-100 and RSS-210, which establish standards for obtaining certification of services, obtaining unique certification/registration numbers, display and label requirements on the equipment, user manuals, recordkeeping and testing. We believe we are in substantial compliance with all Industry Canada requirements applicable to our products and systems.
Emergency Identification Laws and Regulations
The manufacture and distribution of our emergency identification products are subject to compliance with applicable regulatory requirements in both the country of manufacture and in those countries where these products are sold. We must comply with local, state, federal/national, and international laws and regulations in the countries in which we do business, including environmental, technical, communications, and other laws and regulations governing the manufacture of our products, their technical specifications, their labeling and communications protocols, user manuals, and recordkeeping and testing. We believe that we are in substantial compliance with all FCC requirements applicable to our emergency identification products and systems.
Intellectual Property
In both our Animal Identification and Emergency Identification segments, we rely on a combination of patents, copyrights, trademarks, trade secrets (including know-how), employee intellectual property agreements, and third-party agreements to establish and protect proprietary rights in our products and technologies. It is our practice to seek protections in all jurisdictions where such protections are deemed useful and desirable to our business and competitive interests.
We believe our global patent portfolio will continue to provide a competitive advantage in protecting innovation, although our competitors in each business are actively seeking patent protection as well.
In the Animal Identification segment, some of our more important patents and intellectual property rights include those relating to the design and manufacture of RFID tags and readers, including their communications protocols, reader scanning algorithms, reader self testing methods, manufacturing methods for unitary antenna cores, improved antenna designs, injection molding techniques, and temperature sensing and communication capabilities. No one patent is considered material to this business segment.
In the Emergency Identification segment, some of our more important patents and intellectual property rights include those relating to the design and manufacture of locator beacons and their communications protocols. No one patent is considered material to this business segment.
Our trademarks include the following: Digital Angel, Destron Fearing, Bio-Thermo and SARBE.
Seasonality
No significant portion of our business is considered to be seasonal; however, our Animal Identification and Emergency Identification segments’ revenue, while not considered to be seasonal, may vary significantly based on government procurement cycles and technological development, and our Animal Identification segment’s revenues and operating income can be affected by the timing of animal reproduction cycles.
Employees
At March 23, 2011, we and our subsidiaries employed approximately 167 employees, of which 162 are full-time. Our Animal Identification segment’s production workforce located in South Saint Paul, Minnesota is party to a collective bargaining agreement covering wage rates and benefits to certain union employees, which expires on April 30, 2011. Our Emergency Identification segment has employees who are members of the G.M.B. and Amicus trade unions. Upon termination there are no future obligations other than payments of accrued wages. We believe we have positive relationships with our employees.
Geographic Areas
We have operations and sales in various regions of the world. Additionally, we export and import to and from other countries. Our operations may, therefore, be subject to volatility because of currency fluctuations, inflation and changes in political and economic conditions in these countries. Sales and expenses are denominated in local currencies and may be affected as currency fluctuations affect our product prices and operating costs or those of our competitors.
Currently, we operate in three geographic areas: the U.S. and Europe (both of which comprise the majority of our operations) and South America. The majority of our revenues and expenses in each geographic area were generated in the same currencies during the two-years ended December 31, 2010, and accordingly, we did not incur any significant foreign currency gains or losses during those years.
Revenues from continuing operations are attributed to geographic areas based on the location of the assets producing the revenue. Information concerning revenues by principal geographic areas as of and for the years ended December 31, 2010 and 2009 was as follows (in thousands):
For a discussion of risks associated with our foreign operations, please see Item 1A.
ITEM 1A. RISK FACTORS
We have a history of operating losses and we may not become profitable in the future, which could ultimately result in our inability to continue operations in the normal course of business.
We incurred a consolidated loss from continuing operations of $7.3 million and $17.0 million in the years ended December 31, 2010 and 2009, respectively. Our consolidated operating activities used cash of $(0.5) million and $(3.9) million during the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010, we had an accumulated deficit of approximately $577.5 million. There is no assurance that our operating activities will be able to fund our cash requirements in the future if our investing and/or financing activities cannot.
Our independent registered public accounting firm, in their audit report related to our financial statements for the year ended December 31, 2010, expressed substantial doubt about our ability to continue as a going concern.
Our consolidated financial statements as of December 31, 2010 and 2009 and for the two years in the period ended December 31, 2010 were prepared on a “going concern” basis; however, as a result of our continued losses, negative working capital and significant cash flow commitments, our independent auditors have included an explanatory paragraph in their report on our financial statements for the fiscal year ended December 31, 2010, expressing substantial doubt as to our ability to continue as a going concern. Our consolidated financial statements do not include any adjustments to reflect the possible future effects on the recovery and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.
Historical losses and maturity of debt have raised concerns about our ability to continue operations at the current level.
Our historical sources of liquidity have included proceeds from the sale of common stock and preferred shares, proceeds from the issuance of debt, proceeds from the sale of businesses, and proceeds from the exercise of stock options and warrants. In addition to these sources, other sources of liquidity may include the raising of capital through additional private placements or public offerings of debt or equity securities. However, going forward some of these sources may not be available, or if available, they may not be on favorable terms especially if we continue to incur losses. We will be required to generate funds to repay certain of our debt obligations during 2011. As of December 31, 2010, we had a working capital deficiency, which is partially due to a number of our debt obligations becoming due or potentially due within the next twelve months. Our credit facility with Danske Bank, which is more fully discussed in Note 8 to our consolidated financial statements, is due on demand in addition to our requirement to make monthly principal payments of approximately $0.1 million. Our factoring lines may be amended or terminated at any time by the lenders, and our mortgage loan of approximately $2.0 million is due on November 1, 2011, although we have the option to extend the loan an additional six months. In February, 2011 we issued $2.0 million Debentures which we are obligated to redeem in an amount equal to $0.5 million each quarter beginning October 1, 2011 as well as make quarterly interest payments beginning April 1, 2011 (see recent events for further discussion). These conditions indicate that substantial doubt exists about our ability to continue operations as a going concern, as we may be unable to generate the funds necessary to pay our obligations in the ordinary course of business. The accompanying financial statements do not include any adjustments related to the recoverability and classification of asset carrying amounts or the amounts and classification of liabilities that may result from the outcome of this uncertainty. Our ability to continue operations at the current level is also discussed below in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Our ability in the future to achieve or sustain profitability is based on a number of factors, many of which are beyond our control, including the future demand for our RFID and GPS satellite-based systems and the technical requirements associated with the manufacture of our GPS products. If demand for such systems does not reach anticipated levels, or if we fail to manage our cost structure or to develop technologically viable products, we may not achieve profitability.
Our capital requirements depend on a variety of factors, including but not limited to, the rate of increase or decrease in our existing business base; the success, timing, and amount of investment required to bring new products on-line; revenue growth or decline; and potential acquisitions or divestitures. We have established a management plan to guide us in achieving profitability and positive cash flows from operations during 2011. No assurance can be given that we will be successful in implementing the plan. Failure to generate positive cash flow from operations will have a material adverse effect on our business, financial condition and results of operations.
We have substantial debt and debt service.
As of December 31, 2010, our indebtedness totaled approximately $5.7 million, in addition to advances on our factoring lines of approximately $0.5 million. As a result, we incur significant interest expense. We are obligated on our factoring lines, our revolving lines of credit, which had an aggregate outstanding balance of approximately $3.3 million at December 31, 2010, and our outstanding mortgage debt of approximately $2.0 million which matures on November 1, 2011, although we have the option to extend the loan for six additional months. We are also obligated to make monthly principal payments of approximately $0.1 million on our outstanding credit line with Danske Bank. In February, 2011 we issued $2.0 million Debentures which we are obligated to redeem in an amount equal to $0.5 million each quarter beginning October 1, 2011 as well as make quarterly interest payments beginning April 1, 2011 (see recent events for further discussion). For further discussion on our debt, see Note 8 to the consolidated financial statements.
Our debt agreements contain certain events of default, including, among other things, failure to pay, violation of covenants, and certain other expressly enumerated events. Additionally, we guaranteed Destron Fearing’s debt with TCI Corporation (approximately $1.7 million at December 31, 2010) as well as granted TCI Corporation a security interest in certain of our intellectual property to secure such debt.
The degree to which we are leveraged could have important consequences, including the following:
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our ability to obtain additional or replacement financing in the future for operations, capital expenditures, potential acquisitions, and other purposes may be limited, or financing may not be available on terms favorable to us or at all;
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a substantial portion of our cash flows from operations must be used to pay our interest expense and repay our debt, which reduces the funds that would otherwise be available to us for our operations and future business opportunities; and
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our ability to continue operations at the current level could be negatively affected if we cannot refinance our obligations before their due date.
A default under any of our debt agreements could result in acceleration of debt payments and it could permit the lender to foreclose on our assets and the stock we have pledged in our subsidiaries. We cannot assure you that we will be able to maintain compliance with these covenants. Failure to maintain compliance could have a material adverse impact on our financial position, results of operations and cash flow.
We have effected or entered into (and will likely continue to effect or enter into) capital raising transactions, acquisitions, legal settlements and contracts for services that involve the issuance of shares of our common stock (or securities convertible into or exchangeable for such shares) and, if such transactions occur, investments in our common stock will be further diluted.
We currently have a legal settlement of approximately $0.3 million which we currently intend to settle in unregistered shares of our common stock. On February 24, 2011, we issued 8,000,000 warrants to purchase our common stock at an exercise price of $0.45, as more fully discussed in Note 22 to our consolidated financial statements. Such share issuances have in the past been and we expect will in the future be dilutive to the value of our common stock. As a result, your investment in our common stock will be further diluted if such transactions occur.
Certain events over which you will have no control could result in the issuance of additional shares of our common stock or other securities, which could dilute the value of shares of our common stock. We may issue additional shares of common stock:
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to raise additional capital;
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upon the exercise of outstanding options and stock purchase warrants or additional options and warrants issued in the future;
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in connection with severance agreements;
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in connection with loans or other capital raising transactions; and
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in connection with acquisitions of other businesses or assets.
Each of these transactions would result in further dilution or result in ratchet of existing warrants.
As of March 23, 2011, there were 9,504,444 outstanding warrants, with exercise prices per share of $0.45, and 2,581,225 options to acquire additional shares of our common stock, with exercise prices per share ranging from $0.52 to $42.48. If exercised, these securities could dilute the value of shares of our common stock. In addition, we have the authority to issue up to a total of 50,000,000 shares of common stock and up to 5,000,000 shares of preferred stock without further shareholder approval, including shares that could be convertible into our common stock, subject to applicable requirements for issuing additional shares of stock. Were we to issue any such shares, or enter into any other financing transactions, the terms may have the effect of significantly diluting or adversely affecting the holdings or the rights of the holders of our common stock.
Volatility in economic conditions and the financial markets may adversely affect our industry, business and financial performance.
We have witnessed unprecedented disruptions in financial markets, including volatility in asset values and constraints on the availability of credit. In response to these developments, the U.S. government has taken, and may take further, steps designed to stabilize markets generally and strengthen financial institutions in particular. The impact, if any, that these financial market events or these governmental actions might have on us and our business is uncertain and cannot be estimated at this time. If current economic conditions deteriorate or legislation or regulatory action adversely affects the U.S. economy, there could be an adverse impact on our access to capital and to our results of operations.
Our stock price has reflected a great deal of volatility, including a significant decrease over the past few years. The volatility may mean that, at times, our stockholders may be unable to resell their shares at or above the price at which they acquired them.
From January 1, 2007 to March 23, 2011, the price per share of our common stock has ranged from a high of $18.00 to a low of $0.32. The price of our common stock has been, and may continue to be, highly volatile and subject to wide fluctuations. The market value of our common stock has declined in the past, in part, due to our operating performance. In the future, broad market and industry factors may decrease the market price of our common stock, regardless of our actual operating performance. Recent declines in the market price of our common stock could affect our access to capital, and may, if continuing, impact our ability to continue operations at the current level. In addition, any continuation of the recent declines in the price of our common stock may harm employee morale and retention, curtail investment opportunities presented to us, and negatively impact other aspects of our business. As a result of any such declines, many stockholders have been or may become unable to resell their shares at or above the price at which they acquired them.
We rely heavily on revenues derived from sales to various governmental agencies, and the loss of, or a significant reduction in, orders from government agencies could result in significant losses and negative changes to cash flows from operations.
Our principal customers for electronic identification devices for fish are Pacific States Marine, a government contractor that relies on funding from the U.S. government, and the U.S. Army Corps of Engineers. Our Emergency Identification segment is heavily dependent on contracts with domestic government agencies and foreign governments, including the U.K., primarily relating to military applications. Because we rely on revenues and cash flows generated from contracts, directly or indirectly, with governmental agencies, the loss of any such contract would result in a decrease in revenues and cash flows, and such a decrease may be significant and thereby have a material adverse effect on our financial condition and results of operations.
Our Animal Identification segment relies heavily on revenue from a principal distributor and two customers and the loss of the principal distributor and customers could negatively affect our revenue, cash flows and results of operations.
Our pet identification and location system is marketed in the U.S. by Intervet/Schering-Plough. For the years ended December 31, 2010 and 2009, Intervet/Schering-Plough accounted for approximately 12% and 8%, respectively, of our Animal Identification segment’s revenues. It may be difficult and time-consuming for us to arrange for distribution of the implantable microchip by a third party. The loss of Intervet/Schering-Plough as our exclusive distributor could negatively affect future sales. In December 2010, we amended our exclusive product supply and distribution agreement with Intervet/Schering-Plough to extend the agreement through December 31, 2011. There is no assurance that Intervet/Schering-Plough and Destron Fearing will extend the contract beyond December 31, 2011. Our principal customers for electronic identification devices for fish are Pacific States Marine and the U.S. Army Corps of Engineers. The loss of, or a significant reduction in, orders from these customers could have a material adverse effect on our financial condition and results of operations.
We depend on a small team of senior management and key employees, and we may have difficulty attracting and retaining additional personnel.
Our future success will depend in large part upon the continued services and performance of key senior management and other key personnel. If we lose the services of any key member of our senior management team, our overall operations could be materially and adversely affected. In addition, our future success will depend on our ability to identify, attract, hire, train, retain and motivate other highly skilled technical, managerial, marketing, purchasing and customer service personnel when they are needed. Competition for qualified individuals to fill these positions is intense. We cannot ensure that we will be able to successfully attract, integrate or retain sufficiently qualified personnel when the need arises. Any failure to attract and retain the necessary technical, managerial, marketing, purchasing and customer service personnel could have a material adverse effect on our financial condition and results of operations.
The loss of any key senior executive could materially adversely affect our financial results. Our senior executives, in many cases, have strong relationships with our customers, suppliers and lenders. Therefore, the loss of the services of such senior executives or any general instability in the composition of our senior management could have a negative impact on our relationship with these customers and suppliers.
Over the past few years, we have made significant changes in the nature and scope of our businesses.
If we are not successful in implementing our business model and developing and marketing our products or if these products do not gain sufficient market acceptance, we may not be able to achieve or sustain profitable operations. In that case, the market price of our stock would likely decrease.
Management continues to review strategic alternatives to increase shareholder value, which may result in a further decrease in consolidated revenue and the overall size of our operations.
Management is focusing on various strategic alternatives, which include the possibility of selling additional business units in our Emergency Identification segment. If we are successful in further streamlining our business to focus our attention solely on our Animal Identification business segment, it would, at least in the short term, result in a further decrease in our revenue and the size of our operations. Such a decrease could negatively impact the price of our common stock.
Technological change could cause our products and technology to become obsolete or require the redesign of our products, which could have a material adverse effect on our businesses.
Technological changes within the industries in which we conduct business may require us to expend substantial resources in an effort to develop new products and technology. We may not be able to anticipate or respond to technological changes in a timely manner, and our response may not result in successful product development and timely product introductions. If we are unable to anticipate or respond to technological changes, our businesses could be adversely affected.
We may be subject to costly product liability claims from the use of our systems, which could damage our reputation, impair the marketability of our systems and force us to pay costs and damages that may not be covered by adequate insurance.
Manufacturing, marketing, selling, testing and operation of our systems entail a risk of product liability. We could be subject to product liability claims in the event our systems fail to perform as intended. Even unsuccessful claims against us could result in the expenditure of funds in litigation, the diversion of management time and resources, damage to our reputation and impairment in the marketability of our systems. While we maintain liability insurance, it is possible that a successful claim could be made against us, that the amount of our insurance coverage would not be adequate to cover the costs of defending against or paying such a claim, or that damages payable by us would harm our business.
If others assert that our products infringe their intellectual property rights, we may be drawn into costly disputes and risk paying substantial damages or losing the right to sell our products.
We face the risk of adverse claims and litigation alleging infringement of the intellectual property rights of others. If infringement claims are brought against us or our suppliers, these assertions could distract management and necessitate our expending potentially significant funds and resources to defend or settle such claims. We cannot be certain that we will have the financial resources to defend ourselves against any patent or other intellectual property litigation. If we or our suppliers are unsuccessful in any challenge to our rights to market and sell our products, we may, among other things, be required to:
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pay actual damages, royalties, lost profits and/or increased damages and the third party’s attorneys’ fees, which may be substantial;
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cease the development, manufacture, use and/or sale of products that use the intellectual property in question through a court-imposed sanction called an injunction;
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expend significant resources to modify or redesign our products, manufacturing processes or other technology so that it does not infringe others’ intellectual property rights or to develop or acquire non-infringing technology, which may not be possible; or
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obtain licenses to the disputed rights, which could require us to pay substantial upfront fees and future royalty payments and may not be available to us on acceptable terms, if at all, or to cease marketing the challenged products.
Ultimately, we could be prevented from selling a product or otherwise be forced to cease some aspect of our business operations as a result of any intellectual property litigation. Even if we or our suppliers are successful in defending an infringement claim, the expense, time delay, and burden on management of litigation and negative publicity could have a material adverse effect on our business.
We obtain the implantable microchip used in certain of our Animal Identification segment’s products from a single supplier, making us vulnerable to supply disruptions that could constrain our sales of such systems and/or increase the per-unit cost of production of the microchip.
At present, we source the microchip for certain of our products from Raytheon Microelectronics España S.A. (“RME”), the actual manufacturer, under a supply agreement between us and RME for use in our Animal Identification segment’s products. We and RME each own certain of the automated equipment and tooling used in the manufacture of the microchip. Accordingly, it would be difficult for us to arrange for a third party other than RME to manufacture the implantable microchip to satisfy our requirements. Even if we were able to arrange to have the implantable microchip manufactured in another facility, we believe that making such arrangements and commencement of production could take at least three to six months. A supply disruption of this length could cause customers to cancel orders, negatively affect future sales and damage our business reputation. In addition, the per-unit cost of production at another facility could be more than the price per unit that we currently pay.
The expiration or invalidation of patents covering products and technologies in our Animal Identification segment could expose us to potential competition that may have a material adverse effect on our sales and results of operations.
We rely on various patents covering microchip and reader products used in our Animal Identification segment. Without patent protection, our competitors may be able to independently develop similar technology or duplicate our systems, or the value of our products could be diminished which could have a material adverse effect on our sales and results of operations.
Our inability to safeguard our intellectual property may adversely affect our business by causing us to lose a competitive advantage or by forcing us to engage in costly and time-consuming litigation to defend or enforce our rights.
We rely on copyrights, trademarks, trade secret protections, know-how and contractual safeguards to protect our non-patented intellectual property, including our software technologies. Our employees, consultants and advisors are required to enter into confidentiality agreements that prohibit the disclosure or use of our confidential information. We also have entered into confidentiality agreements to protect our confidential information delivered to third parties for research and other purposes. There can be no assurance that we will be able to effectively enforce these agreements, the confidential information will not be disclosed, others will not independently develop substantially equivalent confidential information and techniques or otherwise gain access to our confidential information, or that we can meaningfully protect our confidential information. Costly and time-consuming litigation could be necessary for enforcement and failure to maintain the confidentiality of our confidential information could adversely affect our business by causing us to lose a competitive advantage maintained through such confidential information.
Disputes may arise in the future with respect to the ownership of rights to any technology developed with third parties. These and other possible disagreements could lead to delays in the collaborative research, development or commercialization of our systems, or could require or result in costly and time-consuming litigation that may not be decided in our favor. Any such event could have a material adverse effect on our business, financial condition and results of operations by delaying our ability to commercialize innovations or by diverting our resources away from revenue-generating projects.
We compete with other companies in the visual and electronic identification and locator markets, and the products sold by our competitors could become more popular than our products or render our products obsolete.
The markets for visual and electronic identification and beacon products are highly competitive. We believe that our principal competitors in the visual identification market for livestock are AllFlex USA and Y-Tex Corporation, that our principal competitors in the electronic identification market are AllFlex USA, Datamars SA and Avid Identification Systems, Inc., and that our principal competitors in the beacon market are Boeing North American Inc., General Dynamics Decision Systems, Tadiran Spectralink Ltd., and Becker Avionic Systems.
In addition, other companies could enter these lines of business in the future. Many of our competitors have substantially greater financial and other resources than us. We may not be able to compete successfully with our competitors, and our competitors may develop or market technologies and products that are more widely accepted than our products or that would render our products obsolete or noncompetitive.
Infringement by third parties on our intellectual property or development of substantially equivalent proprietary technology by our competitors could negatively affect our businesses.
Our success depends significantly on our ability to:
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maintain patent and trade secret protection;
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obtain future patents and licenses; and
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operate without infringing on the proprietary rights of third parties.
There can be no assurance that the measures we have taken to protect our intellectual property will prevent the misappropriation or circumvention of our intellectual property. In addition, there can be no assurance that any patent application, when filed, will result in an issued patent, or that our existing patents, or any patents that may be issued in the future, will provide us with significant protection against competitors. Moreover, there can be no assurance that any patents issued to or licensed by us will not be infringed upon or circumvented by others. Litigation to establish the validity of patents and to assert infringement claims against others can be expensive and time-consuming, even if the outcome, which is often uncertain, is in our favor. Infringement of our intellectual property or the development of substantially equivalent technology by competitors could have a material adverse effect on our business.
Our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the U.S.
The laws of some foreign countries do not protect intellectual property to as great an extent as do the laws of the U.S. Policing unauthorized use of the intellectual property utilized in our systems and system components is difficult, and there is a risk that our means of protecting our intellectual property may prove inadequate in these countries. Our competitors in these countries may independently develop similar technology or duplicate our systems, which would likely reduce our sales in these countries. Furthermore, some of our patent rights may be limited in enforceability to the U.S. or certain other select countries, which may limit our intellectual property protection abroad.
Domestic and foreign government regulation and other factors could impair our ability to develop and sell our products in certain markets.
The electronic animal identification market can be negatively affected by such factors as food safety concerns, price, consumer perceptions regarding cost and efficacy, international technology standards, government regulation and slaughterhouse removal of microchips.
We are also subject to federal, state and local regulation in the U.S., including regulation by the FDA, the FCC and the USDA, and similar regulatory bodies in other countries. We cannot predict the extent to which we may be affected by further legislative and regulatory developments concerning our products and markets. We are required to obtain regulatory approval before marketing most of our products. The regulatory process can be very time-consuming and costly, and there is no assurance that we will receive the regulatory approvals necessary to sell our products under development. Regulatory authorities also have the authority to revoke approval of previously approved products for cause, to request recalls of products and to close manufacturing plants in response to violations. Any such regulatory action, including the failure to obtain such approval, could prevent us from selling, or materially impair our ability to sell, our products in certain markets and could negatively affect our businesses.
Our results of operations may be adversely affected if we write-off additional goodwill and other intangible assets.
During the fourth quarter of 2009, we recorded an impairment charge of $7.1 million for goodwill and intangible assets associated with our Emergency Identification reporting unit. As of December 31, 2010, we had approximately $13.1 million of goodwill and intangible assets, all related to the Animal Identification segment. We assess the fair value of our goodwill and other intangible assets annually or earlier if events occur or circumstances change that would more likely than not reduce the fair value of these assets below their carrying value. If we determine that significant additional impairment has occurred, we will be required to write off the impaired portion of goodwill and our other intangible assets. Additional impairment charges could have a material adverse effect on our operating results and financial condition.
We face the risk that the value of our inventory may decline before it is sold or that our inventory may not be able to be sold at anticipated prices.
On December 31, 2010, the book value of our inventory was $8.9 million. Our inventory could decline in value as a result of technological obsolescence or a change in the product. Our success depends in part on our ability to minimize the cost to purchase/produce inventory and turn that inventory rapidly through sales. The failure to turn such inventory may require us to sell such inventory at a discount or at a loss or write down its value, which could result in significant losses and decreases in our cash flows.
Our foreign operations pose additional risks.
We operate our businesses and market our products internationally. During the years ended December 31, 2010 and 2009, approximately 39% and 53% of our sales were to private and public businesses in non U.S. countries. Our foreign operations are subject to the risks described herein, as well as risks related to compliance with foreign laws and other economic or political uncertainties. International sales are subject to risks related to general economic conditions, currency exchange rate fluctuations, imposition of tariffs, quotas, trade barriers and other restrictions, enforcement of remedies in foreign jurisdictions and compliance with applicable foreign laws and foreign corrupt practices act, and other economic and political uncertainties. All of these risks could result in increased costs or decreased revenues, which could have an adverse effect on our financial results.
Currency exchange rate fluctuations could have an adverse effect on our sales and financial results.
During the years ended December 31, 2010 and 2009, we generated approximately 38% and 56%, respectively, of our sales and incurred a portion of our expenses in currencies other than U.S. dollars. We incurred approximately $0.1 million and $0.6 million of other comprehensive income due to fluctuations in foreign currency exchange rates. To the extent that going forward we are unable to match revenues received in foreign currencies with costs paid in the same currency, exchange rate fluctuations in any such currency could have an adverse effect on our financial results.
If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements could be impaired, which could adversely affect our operating results, our ability to operate our business and our stock price.
During the course of our testing of our internal controls, we may identify, and have to disclose, material weaknesses or significant deficiencies in our internal controls that will have to be remediated. Implementing any appropriate changes to our internal controls may require specific compliance training of our directors, officers and employees, entail substantial costs in order to modify our existing accounting systems, and take a significant period of time to complete. Such changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business. In addition, investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements may negatively affect our stock price.
ITEM 2.
ITEM 2. PROPERTIES
At December 31, 2010, we were obligated under leases for approximately 77,824 square feet of facilities, of which 25,035 square feet was for office facilities and 52,789 square feet was for factory and warehouse space. These leases expire at various dates through 2042. In addition, we own 31,892 square feet of office space and 47,800 square feet of factory and warehouse facilities at the locations below. Our owned property is subject to a mortgage as discussed in Note 8 to our consolidated financial statements.
The following table sets forth our owned and leased properties by business segment (amounts in square feet):
The following table sets forth the principal locations of our properties (amounts in square feet):
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are involved in legal proceedings from time to time. We have accrued to the extent practicable our estimate of the probable costs for the resolution of these claims. Our 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. It is possible, however, that future results of operations or cash flows for any particular quarterly or annual period could be materially affected by changes in our estimates. See Note 17 to our consolidated financial statements for a description of certain legal proceedings.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded on the OTC Bulletin Board under the symbol “DIGA.” The following table lists the high and low price for our common stock as quoted, in U.S. dollars, on the internet tracking services during each quarter within the last two fiscal years:
The quotations set forth above reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not necessarily represent actual transactions. On March 23, 2011, the closing sale price of our common stock on the OTC Bulletin Board was $0.39 per share.
On June 9, 2010, we received a Staff Determination Letter from Nasdaq indicating that we failed to comply with the $1.00 bid price requirement for continued listing set forth in Nasdaq Listing Rule 5550(a)(2). Our common stock was therefore subject to delisting from The Nasdaq Capital Market, unless we requested a hearing before a Nasdaq Listing Qualifications Panel (the “Panel”). Accordingly, we requested a hearing before the Panel and presented our plan for regaining compliance with the Nasdaq bid price requirement. Following a hearing held on July 22, 2010, the Panel granted our request for continued listing. However, we did not comply with the terms of the Panel's decision, which was conditioned upon the Company filing a proxy for a special meeting of shareholders to approve implementation of a reverse stock split if bid price compliance had not been regained. On October 1, 2010, we announced that trading in our common stock on the Nasdaq Capital Market was suspended prior to the opening of trading on October 5, 2010. Beginning with the opening of trading October 5, 2010, our common stock began to trade under the symbol "DIGA" on the OTC Bulletin Board.
Holders
According to the records of our transfer agent, as of March 23, 2011, there were approximately 1,487 holders of record of our common stock.
Dividends
We have never paid cash dividends on our common stock and do not anticipate paying any cash dividends on our common stock in the foreseeable future.
Securities Authorized for Issuance Under Equity Compensation Plans
During 2010, we did not grant any shares of restricted common stock or stock options for executive compensation As of December 31, 2010, the following shares of our common stock were authorized for issuance under our equity compensation plans:
(1)
A narrative description of the material terms of our equity compensation plans is set forth in Note 10 to our consolidated financial statements.
(2)
Includes 24,787 shares available for future issuance under our 1999 Employees Stock Purchase Plan.
(3)
We have made grants outside of our equity plans and have outstanding options exercisable for shares of our common stock. These options were granted as an inducement for employment or for the rendering of consulting services.
Recent Sales of Unregistered Securities / Recent Purchases of Securities
We did not repurchase any shares of our common stock during the year ended December 31, 2010.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This Annual Report on Form 10-K contains forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that reflect our current estimates, expectations and projections about our future results, performance, prospects and opportunities. Forward-looking statements include, without limitation, statements about our market opportunities, our business and growth strategies, our projected revenue and expense levels, possible future consolidated results of operations, the adequacy of our available cash resources, our financing plans, our competitive position and the effects of competition and the projected growth of the industries in which we operate. This Annual Report on Form 10-K also contains forward-looking statements attributed to third parties relating to their estimates regarding the size of the future market for products and systems such as our products and systems, and the assumptions underlying such estimates. Forward-looking statements are only predictions based on our current expectations and projections, or those of third parties, about future events and involve risks and uncertainties.
Although we believe that the expectations reflected in the forward-looking statements contained in this Annual Report on Form 10-K are based upon reasonable assumptions, no assurance can be given that such expectations will be attained or that any deviations will not be material. In light of these risks, uncertainties and assumptions, the forward-looking statements, events and circumstances discussed in this Annual Report on Form 10-K may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. Important factors that could cause our actual results, level of performance or achievements to differ materially from those expressed or forecasted in, or implied by, the forward-looking statements we make in this Annual Report on Form 10-K are discussed under “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K and include:
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our ability to fund our operations;
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our growth strategies including, without limitation, our ability to deploy our products and services including Bio-Thermo™ and rTAG™;
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anticipated trends in our business and demographics;
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the ability to hire and retain skilled personnel;
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relationships with and dependence on technological partners;
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our reliance on government contractors;
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uncertainties relating to customer plans and commitments;
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our future profitability and liquidity;
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our ability to continue operations at the current level;
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our ability to maintain compliance with covenants under our credit facilities and Debentures, including our ability to make principal and interest payments when due;
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our ability to obtain patents, enforce those patents, preserve trade secrets and operate without infringing on the proprietary rights of third parties;
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governmental export and import policies, global trade policies, worldwide political stability and economic growth;
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expectations about the outcome of litigation and asserted claims;
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regulatory, competitive or other economic influences;
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our ability to successfully mitigate the risks associated with foreign operations;
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our ability to successfully implement our business strategy;
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our ability to perform on MoD contract;
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our expectation that we can achieve profitability in the future;
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borrowings under Destron Fearing’s and Destron Fearing A/S’s existing bank and credit facilities as well as Signature’s invoice discounting facility are payable on demand and/or the facilities could be terminated at any time without notice;
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our reliance on third-party dealers to successfully market and sell our products;
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our reliance on a single source of supply for our implantable microchip;
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we may become subject to costly product liability claims and claims that our products infringe the intellectual property rights of others;
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our ability to comply with current and future regulations relating to our businesses;
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the potential for patent infringement claims to be brought against us asserting that we hold no rights for the use of the implantable microchip technology and that we are violating another party’s intellectual property rights. If any such a claim is successful, we could be enjoined from engaging in activities to market the systems that utilize the implantable microchip and be required to pay substantial damages;
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our ability to comply with the obligations in our various registration rights agreements;
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the impact of new accounting pronouncements;
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our ability to establish and maintain proper and effective internal accounting and financial controls; and
•
our actual results may differ materially from those reflected in forward-looking statements as a result of (i) the risk factors described under the heading “Risk Factors” beginning on page 12 of this Annual Report and in our other public filings, (ii) general economic, market or business conditions, (iii) the opportunities (or lack thereof) that may be presented to and pursued by us, (iv) competitive actions by other companies, (v) changes in laws, and (vi) other factors, many of which are beyond our control.
Forward-looking statements include all statements that are not historical facts and can be identified by forward-looking words such as “will likely result,” “are expected to,” “will continue,” “is anticipated,” “projects,” “target,” “goal,” “plans,” “objective,” “may,” “should,” “could,” “would,” “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “hopes,” and similar expressions intended to identify forward-looking statements. These forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties (including those described under “Risk Factors” in this Annual Report) that could cause actual results to differ materially from estimates or forecasts contained in the forward-looking statements. Also, these forward-looking statements represent our estimates and assumptions only as of the date of this Annual Report. Other than as required by law, we do not undertake any obligation to publicly update or correct any forward-looking statements to reflect events or circumstances that subsequently occur or of which we hereafter become aware.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the accompanying consolidated financial statements and related notes included in this Annual Report.
Overview
We currently engage in the following principal business activities:
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developing, manufacturing and marketing of visual and electronic identification tags and implantable RFID microchips, primarily for identification, tracking and location of companion pets, livestock (e.g., cattle and hogs), horses, fish and wildlife worldwide, and, for animal bio-sensing applications, such as temperature reading for companion pet applications; and
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developing, manufacturing and marketing global position systems (“GPS”) and GPS-enabled products used for emergency location and tracking of pilots, aircraft and maritime vehicles in remote locations.
Discontinued Operations
During the years ended December 31, 2010 and 2009, we sold several non-core businesses. On November 20, 2009, we sold the assets of one of Signature’s business units, McMurdo Limited (“McMurdo”). On January 21, 2010, we sold Thermo Life Energy Corp. (“Thermo Life”), on January 25, 2010, we sold substantially all of the assets of a division known as the Control Products Group within the Clifford & Snell business unit of Signature, and on April 30, 2010, we sold the assets of Clifford & Snell. Accordingly, the financial results of these businesses are now classified as discontinued operations for all periods presented in this Annual Report. Our decision to sell these businesses was a result of management’s strategy to streamline operations. Going forward, our strategy is to focus our efforts on the business operations of our Animal Identification segment. Discontinued operations are more fully discussed in Note 13 to our consolidated financial statements.
Recent Events
16% Senior Secured Debenture and Warrants
On February 24, 2011, we entered into a Securities Purchase Agreement (the “Agreement”) with certain investors, including Hillair Capital Investments LLC (the "Investors") whereby we issued and sold (the “Offering”) to the Investors (i) $2.0 million of senior secured Debentures (the “Debentures”), (ii) Series A warrants (the “Series A Warrants”) to purchase up to 4,000,000 shares of our common stock and (iii) Series B warrants (the “Series B Warrants” and collectively with the Series A Warrants, the “Warrants”) to purchase up to 4,000,000 shares of our common stock.
We will be obligated to redeem the Debentures on a quarterly basis beginning on October 1, 2011, in an amount equal to $0.5 million each quarter, until the Debentures maturity date of July 1, 2012. The Debentures accrue interest at a rate of 16% per annum which is due on a quarterly basis beginning on April 1, 2011. Upon any event of default, 125% of the then outstanding principal amount of the Debentures and any accrued interest would become immediately due and payable at the Investors’ election and the annual interest rate would increase to 18%. During the first six months after closing, we may not prepay any portion of the principal amount of the Debentures without the consent of the Investors. After the six month anniversary, we may elect to redeem some or all of the then principal amount outstanding with notice to the Investors at an amount equal to 120% of the then outstanding principal amount. We are subject to certain non-financial covenants under the Agreement.
The 4,000,000 Series A Warrants may be exercised at any time through the maturity date at an exercise price of $0.45 per share and the 4,000,000 Series B Warrants may be exercised at any time for a period of five years at an exercise price of $0.45 per share. If at any time after six months subsequent to the date of the Agreement there is no effective registration statement registering the resale of the shares of common stock underlying the Warrants, the holder of the Warrants may elect to exercise using a net exercise (i.e., cashless exercise) mechanism. If we sell or grant any option to purchase, or sell or grant any right to reprice, or otherwise dispose of or issue any common stock or common stock equivalents at an effective price per share less than $0.45, then simultaneously with the consummation of each dilutive issuance, the Warrant exercise price for both of the Warrants shall be reduced to the lower price. In addition, the number of shares of common stock underlying the Series B Warrants will be increased such that the aggregate value of the Series B Warrants, after taking into account the decrease in the exercise price, shall be equal to the value prior to such adjustment. If we enter into a fundamental transaction that (i) is an all cash transaction, (ii) is a Rule 13e-3 transaction as defined in Rule 13e-3 under the Exchange Act, or (iii) involves a person or entity not traded on a national securities exchange, we or any successor entity shall, at the holder’s request within thirty days after each fundamental transaction (“Holder Option Period”), purchase the Warrants from the holder for an amount of cash equal to the value of the unexercised portion of the warrants that remain as of the time of such fundamental transaction based on the Black Scholes Option Pricing Model obtained from the “OV” function on Bloomberg, L.P (“the Black Scholes Value”). The maximum amount payable under the Black Scholes Value shall be (i) $0.5 million if the fundamental transaction is consummated prior to the six month anniversary of the issuance date or (ii) $1.0 million if the fundamental transaction is consummated subsequent to the six month anniversary but prior to the first anniversary of the issuance date. The Warrants are not exercisable by a holder to the extent that such holder or any of its affiliates would beneficially own in excess of 4.9% of our common stock. We have estimated the initial value of the warrants to be approximately $2.3 million based on a valuation model considering a sensitivity analysis performed to evaluate the impact on value of a potential down round, and using the following assumptions: dividend yield of 0.0%; expected life of sixteen months for the Series A Warrants and five years for the Series B warrants; volatility of 77.58% and 98.09%, respectively; and a risk free rate of 0.26% and 2.19%, respectively.
To secure our obligations under the Debentures, we and Destron Fearing have pledged our ownership interests in Signature. In addition, Signature, Destron Fearing and its wholly-owned subsidiaries Digital Angel Technology Corporation and Digital Angel International, collectively and individually have guaranteed the Debentures.
Rodman & Renshaw, LLC, a subsidiary of Rodman & Renshaw Capital Group, Inc. (NASDAQ:RODM) acted as the exclusive placement agent in connection with the Offering.
Mortgage Loan Modification Agreement
On February 25, 2011, we entered into a Loan Modification Agreement (the “Mortgage Agreement”) with the mortgage lender extending the mortgage loan’s term to November 1, 2011, with the option to extend the maturity date for an additional six months. If we elect to extend the maturity date, we must notify the current mortgage lender by September 30, 2011 and pay a fee of $25 thousand which would be applied to the outstanding principal. Under the Mortgage Agreement, the interest rate and monthly payments will remain the same as prior to the mortgage loan maturity. Upon closing, we were required to pay an additional principal payment of $25 thousand plus certain other closing fees. We are also required to make an extension payment of approximately $25 thousand which will be paid ratably over four months beginning March 1, 2011.
Impact of Recently Issued Accounting Standards
For information regarding recent accounting pronouncements and their expected impact on our future consolidated results of operations or financial condition, see Note 1 to our consolidated financial statements.
Business Segment Overview
We operate in two business segments: Animal Identification and Emergency Identification. Our Animal Identification segment’s revenue remained relatively constant at $30.8 million for both years ended December 31, 2010 and 2009. Our Animal Identification segment experienced operating income of $1.4 million in the year ended December 31, 2010 compared to an operating loss of $(0.8) million in the year ended December 31, 2009. Our Emergency Identification segment’s revenue decreased to $6.9 million for the year ended December 31, 2010 compared to $11.8 million for the year ended December 31, 2009 and experienced operating losses for the years ended December 31, 2010 and 2009. See pages 23 and 24 for discussions on the results of our Animal Identification and Emergency Identification segments, respectively.
The tables below provide a percentage breakdown of the significant sources of our consolidated revenues and gross profits over the past two fiscal years and reflect certain trends in the composition of such revenues and gross profits:
The table below sets forth data from our consolidated statements of operations for the past two fiscal years, expressed as a percentage of total revenues from continuing operations:
Our consolidated operating activities used cash of $0.5 million and $3.9 million during the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010, our cash and cash equivalents totaled $0.9 million compared to $1.9 million as of December 31, 2009. As of December 31, 2010, our stockholders’ equity was $12.5 million, as compared to $15.9 million as of December 31, 2009, and as of December 31, 2010, we had an accumulated deficit of $577.5 million. Our consolidated operating loss was approximately $6.9 million and $15.2 million for the years ending December 31, 2010 and 2009, respectively. The decrease in our 2010 operating loss was due, in large part, to our Animal Identification segment as discussed on page 23.
Our profitability and liquidity depend on many factors, including the success of our marketing programs, the maintenance and reduction of expenses, our ability to successfully complete existing contracts, develop and bring to market our new products and technologies and the protection of our intellectual property rights. We have established a management plan intended to guide us in achieving profitability in future periods. The major components of our plan are as follows:
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To streamline our segments’ operations and improve our supply chain management;
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To streamline and consolidate our corporate structure and minimize overhead costs;
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To divest of non-core assets and businesses;
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To attempt to produce additional cash flow and revenue from our technology products;
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To transition portions of our in-house manufacturing to lower-cost countries;
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To instill a pay for performance culture; and
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To seek growth through strategic acquisitions or partnerships.
Our management believes that the above plan can be effectively implemented.
Critical Accounting Policies and Estimates
Listed below are descriptions of the accounting policies that our management believes involve a high degree of judgment and complexity, and that, in turn, could materially affect our consolidated financial statements if various estimates and assumptions were changed significantly. The preparation of our consolidated financial statements requires that we make certain estimates and judgments that affect the amounts reported and disclosed in our consolidated financial statements and related notes. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. For more detailed information on our significant accounting policies, see Note 1 to our consolidated financial statements.
Revenue Recognition
Our revenue recognition policies, which are listed in Note 1 to our consolidated financial statements, determine the timing and recognition of certain expenses, such as sales commissions. We follow specific and detailed guidelines in measuring revenue; however, certain judgments affect the application of our revenue policy. The complexity of the estimation process and all issues related to the assumptions, risks and uncertainties inherent with our revenue recognition policies affect the amounts reported in our financial statements. A number of internal and external factors affect the timing of our revenue recognition, including estimates of customer service/warranty periods, estimates of customer returns and the timing of customer acceptance. Our revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and year to year.
Goodwill and Other Intangible Assets
As of December 31, 2010, our consolidated goodwill was $3.3 million and our intangible assets were $9.7 million. We had no intangible assets with indefinite lives. We test our goodwill and intangible assets for impairment annually as a part of our annual business planning cycle during the fourth quarter of each fiscal year or earlier depending on specific changes in conditions surrounding our business units. The determination of the value of our intangible assets requires management to make estimates and assumptions about the future operating results of our operating units. In the fourth quarter of 2009, we recorded an impairment charge of approximately $7.1 million related to our Emergency Identification reporting unit; $3.8 million relating to goodwill and $3.3 million (net of approximately $(1.4) million of related deferred tax liabilities) related to intangible assets. Future events, such as market conditions or operational performance of our businesses, could cause us to conclude that additional impairment exists, which could have a material impact on our financial condition and results of operations.
Principles of Consolidation
We consolidate all subsidiaries in which we hold a greater than 50% voting interest, which requires that we include the revenue, expenses, assets and liabilities of such subsidiaries in our financial statements. Currently, we own a majority of each of our subsidiaries. However, if in the future we were to own less than 50% but equal to or more than 20% of the voting interest of any investee, we will account for such investment under the equity method. All significant intercompany transactions and balances between or among us and our subsidiaries have been eliminated in consolidation.
Stock-Based Compensation
In accordance with the Compensation - Stock Compensation Topic of the FASB Accounting Standards Codification (“ASC” or “Codification”), stock-based awards granted are valued at fair value and compensation cost is recognized on a straight line basis over the service period of each award. See Note 10 for further information concerning our stock option plans.
In the years ended December 31, 2010 and 2009, we incurred stock-based compensation expense of approximately $0.4 million and $0.5 million, respectively. This stock-based compensation expense is reflected in our consolidated statements of operations in selling, general and administrative expense.
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 (determined by the first-in, first-out method) or market, net of writedowns for obsolete or slow-moving inventory. The estimated market value of our inventory is based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required, which could have a material adverse affect on our financial condition and results of operations.
Accounting for Income Taxes
As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax liability in each of the jurisdictions in which we do business. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items, such as deferred revenues, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We must then assess the likelihood that our net deferred tax assets in each tax jurisdiction will be recovered from future taxable income in the applicable jurisdiction and, to the extent we believe that recovery is not more likely than not or is unknown, we must establish a valuation allowance.
Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against the deferred tax assets. As of December 31, 2010 and 2009, we had recorded a full valuation allowance against our U.S. net deferred tax assets due to uncertainties related to our ability to utilize these deferred tax assets, primarily consisting of net operating losses carried forward. The valuation allowance is based on our historical operating performance and estimates of taxable income in the U.S. and the period over which our deferred tax assets will be recoverable. As of December 31, 2010, we have not provided a valuation allowance against certain of our United Kingdom deferred tax assets as we have deemed it more likely than not that these assets will be realized.
If we continue to operate at a loss or are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we may be required to increase our valuation allowance against previously recognized deferred tax assets, which could result in a material adverse impact on our operating results. Conversely, if we become profitable in the future or if we realize certain built-in-gains, we may reduce a significant portion of our valuation allowance, which could result in a significant tax benefit and a favorable impact on our financial condition and operating results. As of December 31, 2010, we had an aggregate valuation allowance against our net deferred tax assets of approximately $116.6 million.
The amount of any benefit from our US tax net operating losses is dependent on: (1) our ability to generate future taxable income and (2) the unexpired amount of net operating loss carryforwards available to offset amounts payable on such taxable income. Any greater than a fifty percent change in ownership under IRC section 382 places significant annual limitations on the use of such net operating losses to offset any future taxable income we may generate. Such limitations, in conjunction with the net operating loss expiration provisions, effectively eliminate our ability to use a substantial portion of our net operating loss carryforwards to offset future taxable income. Based on our current cumulative three-year change in ownership, we exceeded the fifty percent threshold during the year ended December 31, 2010. As a result, approximately $196.7 million of the U.S. net operating loss carryforwards is limited under IRC section 382. Certain transactions could cause an additional ownership change in the future, including (a) additional issuances of shares of common stock by us or our subsidiaries or (b) acquisitions or sales of shares by certain holders of our shares, including persons who have held, currently hold, or accumulate in the future five percent or more of our outstanding stock. See Note 12 for further information concerning our income taxes.
Results of Operations from Continuing Operations
We evaluate the performance of our two operating segments based on stand-alone segment operating income (loss), as presented below. Operating income (loss) from each of our segments during 2010 and 2009 was as follows:
(1)
Our Corporate segment includes all amounts given effect to in the consolidation of our subsidiaries, such as the elimination of inter-segment revenues, expenses, assets and liabilities. Corporate also includes certain selling, general and administrative expense and interest expense and other expenses associated with corporate activities and functions.
Animal Identification Segment
Year Ended December 31, 2010 Compared to the Year Ended December 31, 2009
Revenue - Our Animal Identification segment’s revenue remained constant at approximately $30.8 million for the years ended December 31, 2010 and 2009. There was an increase in sales related to electronic livestock products as a result of market share gains and higher sales of our LifeChip product. These increases were slightly offset by a decrease in our companion pet product sales in Europe and decreased livestock sales in Europe primarily due to a lower volume of sales to Austria.
Gross Profit and Gross Profit Margin - Our Animal Identification segment’s gross profit decreased approximately $0.1 million, or 1.0%, in the year ended December 31, 2010 compared to the year ended December 31, 2009. The decrease primarily relates to slightly higher labor costs associated with certain electronic livestock products as well as higher health insurance premiums. The gross profit margin remained relatively constant at 34.0% in the year ended December 31, 2010 compared to 34.5% in the year ended December 31, 2009. Gross profit margin may vary period-to-period because of changes in the product mix and in the ratio of fixed and variable costs.
Selling, General and Administrative Expenses - Our Animal Identification segment’s selling, general and administrative expenses decreased approximately $1.6 million, or 16.7% in the year ended December 31, 2010 compared to the year ended December 31, 2009. This was primarily attributable to decreased salaries and bonus compensation, legal and accounting costs, depreciation and amortization and travel expenses. Selling, general and administrative expenses as a percentage of revenue decreased to 26.0% in the year ended December 31, 2010 compared to 30.8% in the year ended December 31, 2009 due to the decrease in the aforementioned expenses.
Research and Development Expenses - Our Animal Identification segment’s research and development expenses decreased approximately $0.2 million in the year ended December 31, 2010 compared to the year ended December 31, 2009. The decrease was primarily due to a decrease in salaries and travel expenses slightly offset by an increase in quality testing. Research and development expenses relate to new product development associated with RFID microchips and related scanners.
Restructuring, Severance and Separation Expenses - Our Animal Identification segment’s restructuring, severance and separation expenses were approximately $0.1 million and $0.5 million in the years ended December 31, 2010 and 2009, respectively. The costs in 2010 relate to severance costs and the costs in 2009 primarily related to severance and contract termination costs for the St. Paul, Denmark and South American locations.
Goodwill and Asset Impairment Charges - Our Animal Identification segment recorded goodwill and asset impairment charges of $0.2 million for the year ended December 31, 2009. The goodwill and asset impairment charges in 2009 related to fixed asset impairments at the St. Paul location. In the future, if we fail to perform as expected, we could face additional goodwill and intangible asset impairment charges.
Outlook and Trends
We anticipate our Animal Identification segment’s sales and gross profits to increase in 2011 and our operating expenses to remain relatively constant in 2011. We believe our investment in technology and product development, such as the rTag™ and BioThermo®, will enable future growth for our Animal Identification segment. We also face favorable long-term market trends, such as the technology migration from visual to electronic identification and increased government regulation in the area of food safety and traceability.
Emergency Identification Segment
Year Ended December 31, 2010 Compared to the Year Ended December 31, 2009
Revenue - Our Emergency Identification segment’s revenue decreased approximately $4.9 million, or 41.6%, in the year ended December 31, 2010 compared to the year ended December 31, 2009. The decrease in revenue was primarily due to decreased sales of approximately $5.4 million at our Sarbe division as a result of lower PELS and G2R sales as well as decreased sales to the U.S. Air Force. The Sarbe product sales decrease was primarily related to the mandatory transition to higher satellite frequency beacons in the prior year. In addition, we experienced lower sales at our Communications division due to market conditions. We anticipate our revenues to increase provided we commence shipping on a large PELS contract, which have been delayed as a result of extended testing and customer certification requirements.
Gross Profit and Gross Profit Margin - Our Emergency Identification segment’s gross profit decreased approximately $3.3 million, or 55.3%, in the year ended December 31, 2010 as compared to the year ended December 31, 2009. The decrease was primarily attributable to the overall decrease in sales and gross profit margin. Gross profit margin was 38.6% in the year ended December 31, 2010 as compared to 50.4% during the year ended December 31, 2009. The decrease in gross profit margin relates primarily to an inventory provision of approximately $1.1 million of Sarbe inventory. The decrease was slightly offset by higher margins at our Sarbe division. We expect gross margins to return to previous levels when sales return which may vary period-to-period because of the changes in the product mix and in the ratio of fixed and variable costs.
Selling, General and Administrative Expenses - Our Emergency Identification segment’s selling, general and administrative expenses decreased approximately $2.9 million, or 31.1%, in the year ended December 31, 2010 compared to the year ended December 31, 2009. This decrease in selling, general and administrative expenses is primarily due to a decrease in personnel costs as a result of the restructuring implemented in the prior year. In addition, there were decreases in engineering consumables, advertising costs, audit and legal fees as well as corporate salaries allocated to Signature. As a percentage of revenue, selling, general and administrative expenses increased to 94.0% in the year ended December 31, 2010 from 79.7% in the year ended December 31, 2009. The increase in selling, general and administrative expenses as a percentage of revenue resulted primarily from the decrease in sales discussed above.
Restructuring, Severance and Separation Expenses - Our Emergency Identification segment’s restructuring, severance and separation expenses were approximately $0.2 million in the year ended December 31, 2009 and primarily related to severance at our U.K. locations as we continue our efforts to reduce expenses and streamline operations.
Goodwill and Asset Impairment - Our Emergency Identification segment’s goodwill and asset impairment expense of approximately $7.1 million during the year ended December 31, 2009 related to impairments of approximately $3.8 million of goodwill and approximately $3.3 million (net of approximately $(1.4) million of related deferred tax liabilities) related to intangible assets. The impairments were recorded as a result of our annual testing during the fourth quarter of 2009.
Outlook and Trends
We anticipate our Emergency Identification segment’s sales and gross profits to increase provided we commence shipping on the PELS contract, which has been delayed as a result of extended testing and certification requirements, and our operating expenses to remain relatively constant in 2011. We believe that the future will bring market opportunities due to increasing demand for recreational PLBs, expansion into the North American market and our belief that PLBs will become a highly desired product during peacetime for many of our current, and potentially new, worldwide armed forces customers. However, going forward we intend to focus on growing our Animal Identification business.
Corporate Segment
Year Ended December 31, 2010 Compared to the Year Ended December 31, 2009
Selling, General and Administrative Expenses - Our Corporate segment’s selling, general and administrative expenses decreased approximately $0.4 million in 2010 as compared to 2009. The decrease primarily relates to lower salary expense, a decrease in bonus compensation, lower insurance expense and accounting fees. Slightly offsetting the decrease were higher Nasdaq fees, investor relations fees, legal expenses and non-cash compensation expense resulting from the granting of options and restricted stock to certain executives and management in October 2009.
Restructuring Expenses - Our Corporate segment’s restructuring expense in 2010 related to the accrual of costs associated with certain headcount reductions.
Consolidated
Interest and Other Income (Expense), net
Interest and other income (expense), net decreased approximately $0.5 million to $(0.2) million in the year ended December 31, 2010 compared to $0.3 million in the year ended December 31, 2009. The decrease was primarily the result of the write off of the discounted portion of a note receivable, approximately $0.3 million, during the first quarter of 2010 and a decrease in royalty payments at our Animal Identification segment.
Interest Expense
Interest expense was $1.2 million and $2.2 million for the years ended December 31, 2010 and 2009, respectively. The decrease in interest expense from 2009 is primarily due to a final payment of $1.4 million of our Term Debt Obligations with Laurus Master Fund and affiliates on February 1, 2010. Based on our current level of debt we estimate that our interest expense will decrease slightly for the year ended December 31, 2011.
Total cash paid for interest was approximately $0.8 million and $1.5 million, or 64% and 68% of total interest expense, for the years ended December 31, 2010 and 2009, respectively.
Income Taxes
Differences in the effective income tax rates from the statutory federal income tax rate arise from 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, 2010, we have provided a valuation allowance to fully reserve our U.S. net operating losses carried forward and our other U.S. existing net deferred tax assets, primarily as a result of our recent losses. Our tax provisions for 2010 and 2009 were primarily related to our foreign operations.
Net Loss from Continuing Operations
During the years ended December 31, 2010 and 2009, we reported a loss from continuing operations of approximately $7.3 million and $17.0 million, respectively. The decrease in the loss for the year ended December 31, 2010 compared to December 31, 2009 principally relates to the company-wide reduction in selling, general and administrative expenses, interest expense and asset impairment expenses. Slightly offsetting these changes was an increase in restructuring, severance and separation expenses at Corporate as well as a decrease in gross margin at our Emergency Identification segment. Each of these items is more fully discussed above in the context of the appropriate segment.
LIQUIDITY AND CAPITAL RESOURCES FROM CONTINUING OPERATIONS
As of December 31, 2010, cash and cash equivalents totaled $0.9 million, a decrease of $1.0 million, or 47.4%, from $1.9 million at December 31, 2009.
Net cash used in operating activities totaled $0.5 million and $3.9 million in 2010 and 2009, respectively. In 2010, cash was used primarily by the net loss slightly offset by discontinued operations and the net change in operating assets and liabilities. In 2009, cash used by operating activities was primarily the net loss and the net change in operating assets and liabilities.
Adjustments to reconcile operating losses to net cash used in operating activities included the following:
•
Accounts and unbilled receivables, net of allowance for doubtful accounts, were $5.2 million and $6.4 million at December 31, 2010 and 2009, respectively. The decrease is primarily due to our Emergency Identification segment’s decrease in sales from the prior year as well as the collection on the U.S. Air Force contract in the first quarter of 2010. We anticipate accounts receivable to increase slightly going forward provided we begin shipping on a large PELS contract.
•
Inventories decreased to $8.9 million at December 31, 2010, compared to $9.0 million at December 31, 2009. The decrease was primarily due to $1.1 million of inventory write-offs recorded at our Emergency Identification segment, slightly offset by increased inventory at our Animal Identification segment due to general inventory level fluctuations. We expect inventory levels to decrease in 2011 provided we commence shipments under the PELS contract.
•
Accounts payable remained constant at $7.9 million at both December 31, 2010 and December 31, 2009. Our accounts payable balance fluctuates due to the general timing of billings and payments. We anticipate accounts payable levels to decrease throughout 2011.
•
Accrued expenses increased $0.2 million to $6.8 million at December 31, 2010, from $6.6 million at December 31, 2009. The increase was primarily related to accrued severance expenses recorded during 2010 at our Corporate segment which was slightly offset by a decrease at our Emergency Identification segment due to payments of accrued legal and professional fees and a decrease at our Animal Identification segment due to payments of certain compensation expenses. We expect accrued expenses to decrease slightly in 2011 as we make payments for accrued bonuses, severance and other accrued liabilities.
Investing activities provided cash of $2.6 million and $8.1 million in 2010 and 2009, respectively. In 2010, cash provided by investing activities was primarily related to the proceeds from the sale of Clifford & Snell, the collection of the McMurdo funds held in escrow and certain notes receivable and in 2009, cash provided by investing activities was primarily related to the sale of McMurdo.
Financing activities used cash of $(3.1) million and $(3.8) million in 2010 and 2009, respectively. In 2010, cash was primarily used for payments on debt which was partially offset by the sale of common stock to two investors for approximately $1.7 million. In 2009, we paid a total of approximately $6.6 million on our debt which was partially offset by the cash received from the issuance of shares of our common stock under the SEDA.
Financial Condition
Financing Agreements and Debt Obligations
We are party to certain financing agreements and debt obligations, which total approximately $5.7 million as of December 31, 2010, and are discussed in detail in Note 8 to our consolidated financial statements. The following is a discussion of our liquidity, and therefore, focuses on our revolving debt and advances from factors which represent approximately $3.3 million and $0.5, respectively. For discussion of our financial and non-financial covenants and outstanding debt, see Note 8 to our consolidated financial statements.
Destron Fearing’s TCI Revolving Credit Facility
On August 31, 2010, Destron Fearing entered into a $4.0 million revolving credit facility with TCI Business Capital, Inc. (“TCI”) pursuant to the Credit and Security Agreement dated August 31, 2010 (the “TCI Agreement”). Under the terms of the TCI Agreement, Destron Fearing may borrow, from time to time, up to an aggregate of the lesser of: (i) 90% of eligible account receivables, based on dilution of less than 4%, as defined, plus 25% of eligible inventory capped at $0.5 million, as may be adjusted for writedowns, or (ii) $4.0 million (the “TCI Revolving Facility”). The TCI Revolving Facility accrues interest at an annual rate equal to the prime rate as announced by Bank of America plus 8.0% (“Floating Rate”) which was 11.25% as of December 31, 2010. Upon default or early termination, the annual interest rate increases to the Floating Rate plus 4%. The TCI Revolving Facility matures on August 31, 2012, but can be terminated early by Destron Fearing upon payment of a termination fee or by TCI in accordance with the terms of the TCI Agreement. Destron Fearing is subject to certain financial and non-financial covenants under the TCI Agreement. As of December 31, 2010, we were in compliance with all covenants.
To secure Destron Fearing’s obligations under the TCI Revolving Facility, (a) Destron Fearing and its wholly-owned subsidiaries GT Acquisition Sub, Inc. and Digital Angel Technology Corporation granted TCI security interests in their ownership interests (including stock and membership interests) of their subsidiaries, excluding the stock of all foreign subsidiaries; and (b) the Company, Destron Fearing and its wholly-owned subsidiaries Digital Angel Technology Corporation, Fearing Manufacturing Co., Inc. and GT Acquisition Sub, Inc. granted TCI security interests in certain intellectual property. In addition, (i) the Company, (ii) Destron Fearing’s wholly-owned subsidiaries Digital Angel Technology Corporation, Fearing Manufacturing Co., Inc., Digital Angel International, Inc., Timely Technology Corp., and GT Acquisition Sub, Inc., and (iii) C-Scan, LLC, a wholly-owned subsidiary of GT Acquisitions Sub, Inc., collectively and individually guaranteed the TCI Revolving Facility.
The TCI Revolving Facility replaced the $6.0 million revolving facility with Kallina.
Destron Fearing A/S’s Line of Credit
Destron Fearing A/S is party to a credit agreement with Danske Bank (the “Credit Facility”). On June 1, 2006, Destron Fearing A/S amended the borrowing availability from DKK 12.0 million to DKK 18.0 million. In connection with the amendment, Destron Fearing executed a Letter of Support which confirms that it will maintain its holding of 100% of the share capital of Destron Fearing A/S, and will neither sell, nor pledge, nor in any way dispose of any part of Destron Fearing A/S or otherwise reduce Destron Fearing’s influence on Destron Fearing A/S without the prior consent of Danske Bank. Interest is determined quarterly and is based on the international rates Danske Bank can establish on a loan in the same currency on the international market plus 2.0%. At December 31, 2010, the annual interest rate on the Credit Facility was 7.65%. Borrowing availability under the Credit Facility considers guarantees outstanding. The Credit Facility will remain effective until further notice. Destron Fearing A/S can terminate the Credit Facility and pay the outstanding balance, or Danske Bank may demand the credit line be settled immediately at any given time, without prior notice. Beginning in July 2009, Destron Fearing A/S and Danske Bank agreed to reduce the borrowing availability on the Credit Facility each month by DKK 0.5 thousand (approximately $0.1 million). As of December 31, 2010, total availability had been reduced from DKK 18.0 million (approximately $3.2 million) to DKK 9.0 million (approximately $1.6 million). DKK 9.0 million (approximately $1.6 million) was outstanding at December 31, 2010 and there was no additional availability under the credit line.
Signature’s Invoice Discounting Factoring Agreement
In July 2009, Signature entered into an invoice discounting factoring agreement (the “Bibby Invoice Discounting Agreement”) with Bibby Financial Services (“Bibby”), which replaced a similar arrangement with the Royal Bank of Scotland. The Bibby Invoice Discounting Agreement provides for Signature to sell, with full title guarantee, certain of its receivables as defined in the Bibby Invoice Discounting Agreement. Bibby prepays 80% of the receivables sold in the U.K. and 70% of receivables sold in the rest of the world, not to exceed a balance of £2.5 million (approximately $3.9 million at December 31, 2010). Bibby repays Signature the remainder of the receivable upon collection.
Receivables which remain outstanding 90 days from the invoice date become ineligible and Signature is required to repurchase the receivable. The Bibby Invoice Discounting Agreement requires a fee of 0.25% for each U.K. receivable sold and 0.3% for each receivable sold in the rest of the world. If the total of the yearly fee is less than £60,000, Signature is required to pay Bibby the amount of such deficit. Signature is also required to pay a discounting charge of 2.0% above the higher of Barclays Bank Plc base rate or 3 month LIBOR subject to a minimum of 3.5% (5.0% at December 31, 2010). Discounting charges of approximately $41 thousand and $0.1 million are included in interest expense for the years ended December 31, 2010 and 2009, respectively. Either Signature or Bibby can terminate the Bibby Invoice Discounting Agreement by providing written notice to the other party six months prior to the intended termination date but neither party can terminate for eighteen months following the commencement date. As of December 31, 2010, we had approximately £0.3 million outstanding (approximately $0.4 million) and approximately £0.3 million available (approximately $0.5 million) for borrowing under the Bibby Invoice Discounting Agreement.
Destron Fearing A/S’s Factoring Agreements
In March 2008, our wholly-owned European subsidiary, Destron Fearing A/S, entered into a factoring agreement (the “Nordisk Factoring Agreement”) with Nordisk Factoring A/S (“Nordisk”). Under the Nordisk Factoring Agreement, Nordisk advanced 80% of Destron Fearing A/S’s eligible receivables, not to exceed a balance of DKK 6.0 million at any given time. As security, Destron Fearing A/S assigned all invoice balances to Nordisk, regardless of whether advances were made on them, and warranted payments by its customers. Destron Fearing A/S paid a factoring commission charge to Nordisk of 0.15% of the gross volume of receivables factored. The Nordisk Factoring Agreement required a minimum commission charge of DKK 36,000 per year. Discounting charges of approximately $4 thousand and $34 thousand are included in interest expense for the years ended December 31, 2010 and 2009, respectively. On September 1, 2010 we replaced the Nordisk Factoring Agreement with the AL Finans Factoring Agreement as discussed below.
On September 1, 2010, Destron Fearing A/S entered into a factoring agreement (the “AL Finans Factoring Agreement”) with AL Finans A/S (“AL Finans”) which replaced the Nordisk Factoring Agreement. Under the AL Finans Factoring Agreement, AL Finans advances 80% of Destron Fearing A/S’s eligible receivables, not to exceed a balance of DKK 6.0 million (approximately $1.1 million) at any given time. As security, Destron Fearing A/S assigns all invoice balances to AL Finans, regardless of whether advances were made on them, and warrants payments by its customers. Destron Fearing A/S pays a factoring commission charge to AL Finans of 0.15% of the gross volume of receivables factored with a minimum of DKK 40 per invoice. The AL Finans Factoring Agreement requires a minimum commission charge of DKK 36 thousand (approximately $6 thousand) per year, and AL Finans reserves the right to have recourse against Destron Fearing A/S for any losses sustained on the factored invoices. Discounting charges of approximately $13 thousand are included in interest expense for the year ended December 31, 2010. As of December 31, 2010, we had approximately DKK 0.6 million (approximately $0.1 million) outstanding and no availability for borrowing under the AL Finans Factoring Agreement.
Liquidity
As of March 23, 2011, our consolidated cash and cash equivalents totaled approximately $1.9 million. In addition, we had an aggregate of $0.2 million available under our credit facilities.
We had negative working capital at December 31, 2010. During 2008 we restructured our Animal Identification business which eliminated redundancies, improved gross margins and decreased expenses. In 2010, we initiated the next stage of restructuring of our corporate group which will result in the elimination of our corporate structure and the associated costs of a separate headquarters and several management positions. Our capital requirements depend on a variety of factors, including but not limited to, the rate of increase or decrease in our existing business base, the success, timing, and amount of investment required to bring new products on-line and perform existing contracts, revenue growth or decline, and potential acquisitions or divestitures. We have established a management plan to guide us in achieving profitability and positive cash flows from operations during 2011. Failure to generate positive cash flow from operations might require us to substantially reduce our level of operations and will have a material adverse effect on our business, financial condition and results of operations.
Our historical sources of liquidity have included proceeds from the sale of common stock and preferred shares, proceeds from the issuance of debt, proceeds from the sale of businesses, and proceeds from the exercise of stock options and warrants. In addition to these sources, other sources of liquidity may include the raising of capital through additional private placements or public offerings of debt or equity securities. However, going forward some of these sources may not be available, or if available, they may not be on favorable terms. We will be required to generate funds to repay/refinance/extend our mortgage loan obligation, and to pay principal and interest payments on our Debentures during 2011. As of December 31, 2010, we had a working capital deficiency, which is partially due to having to classify our revolving line of credit, our factoring lines and our credit facility with Danske Bank, which are more fully discussed in Note 8, as current liabilities on our consolidated balance sheet. In addition, our debt obligation to Danske Bank is due on demand and we are required to make $0.1 million a month in principal payments to reduce the credit facility. Our factoring lines may also be amended or terminated by the lenders. These conditions indicate that substantial doubt exists about our ability to continue operations as a going concern, as we may be unable to generate the funds necessary to pay our obligations in the ordinary course of business. The accompanying financial statements do not include any adjustments related to the recoverability and classification of asset carrying amounts or the amounts and classification of liabilities that may result from the outcome of this uncertainty.
Outlook
We are constantly looking for ways to maximize stockholder value. As such, we are continually seeking operational efficiencies and synergies within our operating segments as well as evaluating acquisitions of businesses and customer bases which complement our operations. These strategic initiatives may include acquisitions, raising additional funds through debt or equity offerings, refinancing existing debt obligations or the divestiture of business units or other restructuring or rationalization of existing operations. We will continue to review all alternatives to ensure maximum appreciation of our stockholders’ investments. However, initiatives may not be found, or if found, they may not be on terms favorable to us.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements included in this Annual Report are listed in Item 15 and begin immediately after the signature pages.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures.
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as of the end of the period covered by this report (the “Evaluation Date”). Based upon the evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective. Disclosure controls are controls and procedures designed to reasonably ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls include controls and procedures designed to reasonably ensure that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure. Our quarterly evaluation of disclosure controls and procedures includes an evaluation of some components of our internal control over financial reporting, and internal control over financial reporting is also separately evaluated on an annual basis for purposes of providing the management report which is set forth below.
Report of Management on Internal Control Over Financial Reporting.
Our management is responsible for establishing and maintaining a comprehensive system of internal control over financial reporting to provide reasonable assurance of the proper authorization of transactions, the safeguarding of assets and the reliability of the financial records. Our internal control system was designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements. The system of internal control over financial reporting provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees. The framework upon which management relied in evaluating the effectiveness of our internal control over financial reporting was set forth in Internal Controls - Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission.
Our internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the U.S. Our internal control over financial reporting includes those policies and procedures that:
(i)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;
(ii)
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the U.S., and that our receipts and expenditures are being made only in accordance with authorization of our management and directors; and
(iii)
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the consolidated financial statements.
Based on the results of our evaluation, our management concluded that our internal control over financial reporting was effective as of December 31, 2010. However, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in our business or other conditions, or that the degree of compliance with our policies or procedures may deteriorate.
Inherent Limitations of Disclosure Controls and Procedures and Internal Control over Financial Reporting
There are inherent limitations to the effectiveness of any control system. A control system, no matter how well conceived and operated, can provide only reasonable assurance that its objectives are met. No evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or because the degree of compliance with the policies and procedures may deteriorate.
Changes in Internal Control over Financial Reporting.
There were no changes in our internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the quarter ended December 31, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. There were no significant deficiencies or material weaknesses, and therefore no corrective actions were taken.
PART III
The information required in Item 10
ITEM 15. EXHIBITS AND FINANCIAL STATEMENTS
(a)(1)
The financial statements listed below are included in this report
Report of Independent Registered Public Accounting Firm
Financial Statements
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(a)(3)
Exhibits
See the Exhibit Index filed as part of this Annual Report on Form 10-K.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/s/ Joseph J. Grillo
President, Chief Executive Officer and
March 31, 2011
(Joseph J. Grillo)
Director (Principal Executive Officer)
/s/ Jason G. Prescott
Chief Financial Officer
March 31, 2011
(Jason G. Prescott)
/s/ Daniel E. Penni
Chairman of the Board of Directors
March 31, 2011
(Daniel E. Penni)
/s/ John R. Block
Director
March 31, 2011
(John R. Block)
/s/ Dennis G. Rawan
Director
March 31, 2011
(Dennis G. Rawan)
/s/ Michael S. Zarriello
Director
March 31, 2011
(Michael S. Zarriello)
DIGITAL ANGEL CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
CONTENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Digital Angel Corporation
We have audited the accompanying consolidated balance sheets of Digital Angel Corporation and subsidiaries (the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting as of December 31, 2010. Our audits include consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements enumerated above present fairly, in all material respects, the consolidated financial position of Digital Angel Corporation and subsidiaries as of December 31, 2010 and 2009, and the consolidated results of their operations and their consolidated cash flows for each of the years then ended, in conformity with accounting principles generally accepted in the United States.
The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has incurred recurring net losses, and at December 31, 2010 had negative working capital, and significant cash flow commitments. These circumstances raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plan in regard to these matters are also described in Note 1. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.
/s/ EisnerAmper LLP
New York, New York
March 31, 2011
Digital Angel Corporation and Subsidiaries
Consolidated Balance Sheets
(in thousands, except par value)
See the accompanying notes to consolidated financial statements.
Digital Angel Corporation and Subsidiaries
Consolidated Statements of Operations
(in thousands, except per share data)
See the accompanying notes to consolidated financial statements.
Digital Angel Corporation and Subsidiaries
Consolidated Statements of Stockholders’ Equity
For the Year Ended December 31, 2009
(in thousands)
See the accompanying notes to consolidated financial statements.
Digital Angel Corporation and Subsidiaries
Consolidated Statements of Stockholders’ Equity (continued)
For the Year Ended December 31, 2010
(in thousands)
See the accompanying notes to consolidated financial statements.
Digital Angel Corporation and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)
See the accompanying notes to consolidated financial statements.
Digital Angel Corporation and Subsidiaries
Notes to Consolidated Financial Statements
(In thousands, except per share data)
1. Organization and Summary of Significant Accounting Policies
Digital Angel Corporation, a Delaware corporation, and its subsidiaries, (referred to together as, “Digital Angel,” “the Company,” “we,” “our,” and “us”) develops innovative identification and security products for consumer, commercial and government sectors worldwide. Our unique and often proprietary products provide identification and security for people, animals, food chains and government/military assets. Included in this diverse product line are applications for radio frequency identification (“RFID”) systems, global positioning systems (“GPS”) and satellite communications.
Business Segments
We operate in two business segments: Animal Identification and Emergency Identification. Our Animal Identification segment comprises the operations of our wholly-owned subsidiary, Destron Fearing Corporation (“Destron Fearing”) and our Emergency Identification segment comprises the operations of our 98.5%-owned subsidiary, Signature Industries Limited (“Signature”).
Animal Identification Segment
Our Animal Identification segment develops, manufactures and markets visual and electronic identification tags and implantable RFID microchips, primarily for identification, tracking and location of companion pets, livestock (e.g., cattle and hogs), horses, fish and wildlife worldwide, and, for animal bio-sensing applications, such as temperature reading for companion pet applications. Our Animal Identification segment’s proprietary products focus on pet identification and safeguarding and the positive identification and tracking of livestock and fish, which we believe are crucial for asset management and for disease control and food safety. This segment’s principal products are visual and electronic ear tags for livestock; and implantable microchips and RFID scanners for the companion pet, livestock, horses, fish and wildlife industries.
Emergency Identification Segment
Our Emergency Identification segment develops, manufactures and markets GPS and GPS-enabled products used for emergency location and tracking of pilots, aircraft and maritime vehicles in remote locations. This segment’s principal products are GPS enabled search and rescue equipment and intelligent communications products and services for telemetry, and mobile data and radio communications applications, including our SARBETM brand, which serve military and commercial markets
Corporate and Eliminations
Our Corporate and Eliminations category includes all amounts recognized upon consolidation of our subsidiaries, such as the elimination of inter-segment expenses, assets and liabilities. This category also includes certain selling, general and administrative expenses associated with corporate activities, other expense reductions associated with companies whose assets were sold or closed in 2001 and 2002, and interest expense and interest and other income associated with corporate activities and functions. Included in Corporate and Eliminations as of December 31, 2010 are approximately $0.8 million of liabilities related to companies that we sold or closed in 2001 and 2002. It is expected that these liabilities will be reversed throughout 2011 to 2016, as they will no longer be considered our legal obligations.
Discontinued Operations
During the years ended December 31, 2010 and 2009, we sold several non-core businesses. On November 20, 2009, we sold the assets of one of Signature’s business units, McMurdo Limited (“McMurdo”). On January 21, 2010, we sold Thermo Life Energy Corp. (“Thermo Life”), on January 25, 2010, we sold substantially all of the assets of a division known as the Control Products Group within the Clifford & Snell business unit of Signature, and on April 30, 2010, we sold the assets of Clifford & Snell. Accordingly, the financial results of these businesses are now classified as discontinued operations for all periods presented in this Annual Report. Our decision to sell these businesses was a result of management’s strategy to streamline operations. Going forward, our strategy is to focus our efforts on the business operations of our Animal Identification segment.
Summary of Significant Accounting Policies
Basis of Presentation
Our consolidated operating activities used cash of $0.5 million and $3.9 million during the years ended December 31, 2010 and 2009, respectively. As of December 31, 2010, our cash and cash equivalents totaled $0.9 million, compared to $1.9 million as of December 31, 2009. As of December 31, 2010, we had an accumulated deficit of $577.0 million.
We had negative working capital at December 31, 2010. During 2008 we restructured our Animal Identification business which eliminated redundancies, improved gross margins and decreased expenses. In 2010, we initiated the next stage of restructuring of our corporate group which will result in the elimination of our corporate structure and the associated costs of a separate headquarters and several management positions. Our capital requirements depend on a variety of factors, including but not limited to, the rate of increase or decrease in our existing business base, the success, timing, and amount of investment required to bring new products on-line, revenue growth or decline, and potential acquisitions or divestitures. We have established a management plan to guide us in achieving profitability and positive cash flows from operations during 2011. Failure to generate positive cash flow from operations might require us to substantially reduce our level of operations and would have a material adverse effect on our business, financial condition and results of operations.
Our historical sources of liquidity have included proceeds from the sale of common stock and preferred shares, proceeds from the issuance of debt, proceeds from the sale of businesses, and proceeds from the exercise of stock options and warrants. In addition to these sources, other sources of liquidity may include the raising of capital through additional private placements or public offerings of debt or equity securities. However, going forward some of these sources may not be available, or if available, they may not be on favorable terms. We will be required to generate funds to repay/refinance/extend our mortgage loan obligation, and to pay principal and interest payments on our Debentures during 2011. As of December 31, 2010, we had a working capital deficiency, which is partially due to having to classify our revolving line of credit, our factoring lines and our credit facility with Danske Bank, which are more fully discussed in Note 8, as current liabilities on our consolidated balance sheet. In addition, our debt obligation to Danske Bank is due on demand and we are required to make $0.1 million a month in principal payments to reduce the credit facility. Our factoring lines may also be amended or terminated by the lenders. These conditions indicate that substantial doubt exists about our ability to continue operations as a going concern, as we may be unable to generate the funds necessary to pay our obligations in the ordinary course of business. The accompanying financial statements do not include any adjustments related to the recoverability and classification of asset carrying amounts or the amounts and classification of liabilities that may result from the outcome of this uncertainty.
Principles of Consolidation
The financial statements include our accounts and the accounts of our wholly-owned and majority-owned subsidiaries. The non-controlling interest represents the outstanding voting stock of the subsidiaries not wholly-owned by us. All significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) in the United States of America (“U.S.”) requires management to make certain estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Although these estimates are based on the knowledge of current events and actions we may undertake in the future, they may ultimately differ from actual results. Included in these estimates are assumptions about allowances for inventory obsolescence, bad debt reserves, lives of long lived assets, lives of intangible assets, assumptions used in Black-Scholes valuation models, estimates of the fair value of acquired assets and assumed liabilities, and the determination of whether any impairment is to be recognized on goodwill or intangibles, among others.
Foreign Currencies
We operate foreign subsidiaries in Europe and South America. Our subsidiaries domiciled in Europe and South America use their local currencies as their functional currency. Results of operations and cash flow are translated at average exchange rates during the period, and assets and liabilities are translated at end of period exchange rates. Translation adjustments resulting from this process are included in accumulated other comprehensive income (loss) in the statement of stockholders’ equity.
Other transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than a subsidiaries’ functional currency are included in our results of operations as incurred. These amounts are not material to the consolidated financial statements.
Cash and Cash Equivalents
We consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
Accounts Receivable
Accounts receivable are stated at the amount management expects to collect from outstanding balances. Management provides for probable uncollected amounts through a charge to earnings and a credit to a valuation account based on its assessment of the current status of individual accounts.
Concentration of Credit Risk
We maintained our domestic cash in one financial institution during the years ended December 31, 2010 and 2009. Balances were insured up to Federal Deposit Insurance Corporation limits of $250,000 per institution. Cash may from time to time exceed the federally insured limits.
Our trade receivables are potentially subject to credit risk. We extend credit to our customers based upon an evaluation of the customers’ financial condition and credit history and generally do not require collateral.
Inventories
Inventories consist of raw materials, work in process and finished goods. The majority of the components are plastic ear tags, electronic microchips, electronic readers and components and GPS search and rescue equipment. Inventory is valued at the lower of cost (determined by the first-in, first-out method) or market. We monitor and analyze inventory for potential obsolescence and slow-moving items based upon the aging of the inventory and the inventory turns by product. Inventory items designated as obsolete or slow moving are reduced to net realizable value.
Property and Equipment
Property and equipment are carried at cost less accumulated depreciation and amortization computed using the straight-line method. Building and leasehold improvements are depreciated and amortized over their estimated useful lives ranging from 10 to 40 years and equipment is depreciated over their estimated useful lives ranging from 3 to 10 years. Repairs and maintenance, which do not extend the useful life of the asset, are charged to expense as incurred. Gains and losses on sales and retirements are reflected in the consolidated statements of operations.
Goodwill and Intangible Assets
Goodwill represents the excess of purchase price over the fair value assigned to the net assets acquired in business combinations. Goodwill is allocated to reporting units as of the acquisition date for the purpose of goodwill impairment testing. Our reporting units are those businesses for which financial information is available and upon which segment management makes operating decisions. We account for goodwill and intangible assets in accordance with the Intangibles - Goodwill and Other Topic of the Codification. Intangible assets deemed to have an indefinite life, such as goodwill, are reviewed at least annually for impairment. Intangible assets with finite lives are amortized over their estimated useful lives. Other than goodwill, we do not have any intangible assets with indefinite lives. Annually, we test our goodwill and intangible assets for impairment as a part of our annual business planning cycle. Goodwill and intangible assets are also tested between testing dates if an impairment condition or event is determined to have occurred.
There were no impairments in 2010 but during the fourth quarter of 2009, we recorded approximately $3.8 million of goodwill impairment related to our Emergency Identification reporting unit. Future events, such as market conditions or operational performance of our acquired businesses, could cause us to conclude that additional impairment exists, which could have a material impact on our financial condition and results of operations. See Notes 5, 6 and 11 for more information.
We have other intangible assets consisting of trademarks, tradenames, patented and non-patented technologies and customer relationships. These intangible assets are amortized over their expected economic lives ranging from 2 to 14 years. The lives were determined based upon the expected use of the asset, the ability to extend or renew patents, trademarks and other contractual provisions associated with the asset, the estimated average life of the replacement parts of the reporting units products, the stability of the industry, expected changes in and replacement value of distribution networks and other factors deemed appropriate. We continually evaluate whether events or circumstances have occurred that indicate the remaining estimated useful lives of our definite-lived intangible assets warrant revision or that the remaining balance of such assets may not be recoverable. We use an estimate of the related undiscounted cash flows over the remaining life of the asset in measuring whether the asset is recoverable. In the fourth quarter of 2009, we recorded an impairment charge of approximately $3.3 million (net of approximately $(1.4) million of deferred tax liability) related to intangible assets at our Emergency Identification reporting unit.
The total impairments of goodwill and intangible assets recorded in the fourth quarter of 2010 and 2009 were approximately nil and $7.1 million. These impairments are more fully discussed in Notes 5, 6 and 11.
Advertising Costs
We expense production costs of print advertisements on the first date the advertisements take place. Other advertising costs are expensed when incurred. Advertising expense included in selling, general and administrative expense was $0.2 million and $0.4 million in 2010 and 2009, respectively.
Revenue Recognition
We follow the revenue recognition guidance in the Revenue Recognition Topic of the Codification. Our Animal Identification and Emergency Identification segments recognize product revenue at the time product is shipped and title has transferred, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed and determinable and collectability is deemed probable. If uncertainties regarding customer acceptance exist, revenue is recognized when such uncertainties are resolved. There are no significant post-contract support obligations at the time of revenue recognition. Our accounting policy regarding vendor and post contract support obligations is based on the terms of the customers’ contracts and is billable upon occurrence of the post-sale support. Costs of products sold and services provided are recorded as the related revenue is recognized. For non-fixed and fixed fee jobs, service revenue is recognized based on the actual direct labor hours in the job multiplied by the standard billing rate and adjusted to net realizable value, if necessary. Other revenue is recognized at the time services or goods are provided. It is our policy to record contract losses in their entirety in the period in which such losses are foreseeable. We enter into bill and hold arrangements with certain customers at our Emergency Identification segment representing an immaterial amount of our revenues for the years ended 2010 and 2009. Revenue for these arrangements is recognized when the following criteria are met; (i) the arrangement is requested by the buyer who has a substantial business purpose for ordering the goods, (ii) risks of ownership have passed to the buyer, (iii) there is a fixed, written commitment to purchase these goods, (iv) there is a fixed schedule (consistent with the buyer's business purpose) for delivery of the goods, (v) we do not retain any specific performance obligations, (vi) the ordered goods are kept segregated from our other inventory and are not subject to being used to fill other orders and (vii) the equipment is complete and ready for shipment.
We offer a warranty on our Animal Identification and Emergency Identification segment’s products and record a liability for product warranties at the time it is probable that a warranty liability has been incurred and the amount of loss can reasonably be estimated. The warranty expense incurred during the years ended December 31, 2010 and 2009 was $0.2 million and $0.2 million, respectively.
It is our policy to approve all customer returns before issuing credit to the customer. We incurred returns of approximately $0.1 million and $0.1 million in 2010 and 2009, respectively.
Stock-Based Compensation
At December 31, 2010, we had five stock-based employee compensation plans (four of which have been terminated with respect to any new stock option grants) and Destron Fearing had two stock-based employee compensation plans (one of which has been terminated with respect to any new stock option grants), which are described more fully in Note 10.
In accordance with the Compensation - Stock Compensation Topic of the Codification, awards granted are valued at fair value and compensation cost is recognized on a straight line basis over the service period of each award. See Note 10 for further information concerning our stock option plans.
Research and Development
Research and development expense consists of personnel costs, supplies, payments to consultants, other direct costs and indirect overhead costs of developing new products and technologies and is charged to expense as incurred.
Restructuring, Severance and Separation Expenses
During 2008, we initiated a comprehensive review of our businesses to develop a strategic long-range plan focusing on restoring growth and profitability. In connection with this review, we recorded estimated expenses for severance, lease payments and other restructuring costs. During the second quarter of 2010, we determined that it was desirable and in the best interests of the Company to substantially complete the restructuring of our corporate group by the end of 2010. These actions will result in the elimination of our corporate structure and the associated costs of a separate headquarters and several management positions. In accordance with the Exit or Disposal Cost Obligations Topic of the Codification, generally costs associated with restructuring activities are recognized when they are incurred rather than at the date of a commitment to an exit or disposal plan. However, in the case of leases, the expense is estimated and accrued when the property is vacated. Given the significance of, and the timing of the execution of such activities, this process is complex and involves periodic reassessments of estimates made at the time the original decisions were made, including evaluating real estate market conditions for expected vacancy periods and sub-lease rents. In addition, post-employment benefits accrued for workforce reductions related to restructuring activities are accounted for under the Compensation - Nonretirement Postemployment Benefits Topic of the Codification. A liability for post-employment benefits is recorded when payment is probable, the amount is reasonably estimable, and the obligation relates to rights that have vested or accumulated. We continually evaluate the adequacy of the liabilities under our restructuring efforts. During the years ended December 31, 2010 and 2009, we incurred approximately $1.3 million and $0.7 million of restructuring, severance and separation expenses, respectively, and as of December 31, 2010, we had an accrued liability for restructuring, severance and separation expenses of $1.0 million.
Foreign Currency Adjustment of Intercompany Loans
In accordance with the Foreign Currency Matters Topic of the Codification, when intercompany foreign currency transactions between entities included in the consolidated financial statements are of a long-term investment nature (i.e., those for which settlement is not planned or anticipated in the foreseeable future) foreign currency transaction adjustments should not produce gains or losses that affect consolidated earnings. Gains and losses on such transactions are included in equity in the accumulated other comprehensive income (loss) - foreign currency translation account in consolidation. However, when intercompany transactions are deemed to be of a short-term nature, such gain and losses are required to affect consolidated earnings. Until July 6, 2009, management concluded that the intercompany loan from Destron Fearing to Signature was of a long-term nature. This was appropriate because management had no plans to require repayment of the intercompany loan. The funds were provided to Signature for new product development and the acquisition of McMurdo. Management of both entities verbally agreed that the intention was that the loan was not anticipated to be repaid in the foreseeable future and no loan agreement was documented. The historical and projected cash flows of Signature did not support repayment of the loan and Signature’s invoice discount facility did not permit repayment of the loan. On July 7, 2009, upon entering into the Bibby Invoice Discounting Agreement, which is more fully discussed in Note 2, Destron Fearing and Signature entered into a loan agreement, which requires Signature to make quarterly principal payments. Management determined at this time that it was appropriate to treat the intercompany loan as short-term in nature because of several factors: (i) the Bibby Invoice Discount Agreement provided Signature additional working capital; (ii) the terms of the Bibby Invoice Discount Agreement allowed for the repayment of the loan per the terms of the intercompany loan agreement; and (iii) the planned sale of McMurdo would provide the funds necessary for Signature to repay the loan. Therefore, we determined that effective July 7, 2009, it was appropriate to begin recording transaction adjustments as gains/losses in the statement of operations and, accordingly, we recorded approximately $39 thousand and $8 thousand of foreign currency transaction losses during the years ended December 31, 2010 and 2009, respectively. Going forward, changes in the foreign currency exchange rates between the U.S. dollar and the English pound will result in additional gains or losses in our consolidated earnings.
Income Taxes
We account for income taxes under the asset and liability approach for the financial accounting and reporting for income taxes. Deferred taxes are recorded based upon the tax impact of items affecting financial reporting and tax filings in different periods. A valuation allowance is provided against net deferred tax assets where we determine realization is not currently judged to be more likely than not. Income taxes include U.S. and international taxes. We and our U.S. subsidiaries file a consolidated federal income tax return. Income taxes are more fully discussed in Note 12.
We recognize and measure uncertain tax positions through a two step process in accordance with the Income Taxes Topic of the Codification. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. Accordingly, we report a liability for unrecognized tax benefits resulting from the uncertain tax positions taken or expected to be taken in a tax return and recognize interest and penalties, if any, related to uncertain tax positions in income tax expense.
Compliance with income tax regulations requires us to make decisions relating to the transfer pricing of revenue and expenses between each of our legal entities that are located in several countries. Our determinations include many decisions based on our knowledge of the underlying assets of the business, the legal ownership of these assets, and the ultimate transactions conducted with customers and other third-parties. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations in multiple tax jurisdictions. We are periodically reviewed by domestic and foreign tax authorities regarding the amount of taxes due. These reviews include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposure associated with various filing positions, we record estimated reserves for probable exposures. Such estimates are subject to change.
(Loss) Income Per Common Share and Common Share Equivalent
Basic and diluted (loss) income per common share is computed by dividing the (loss) income by the weighted average number of common shares outstanding for the period. Since we have incurred losses attributable to common stockholders during each of the two years ended December 31, 2010 and 2009, diluted loss per common share has not been computed by giving effect to all potentially dilutive common shares that were outstanding during the period. Dilutive common shares consist of restricted stock and incremental shares issuable upon exercise of stock options and warrants to the extent that the average fair value of our common stock for each period is greater than the exercise price of the derivative securities. See Note 14.
Comprehensive Income (Loss)
Our accumulated other comprehensive income (loss) consists of foreign currency translation adjustments and is reported in the consolidated statements of stockholders’ equity.
Impact of Recently Issued Accounting Standards
From time to time, the Financial Accounting Standards Board (“FASB”) or other standards setting bodies will issue new accounting pronouncements. Updates to the FASB Accounting Standards Codification (“ASC” or “Codification”) are communicated through issuance of an Accounting Standards Update (“ASU”).
In June 2008, FASB established that an entity should use a two step approach to evaluate whether an equity-linked financial instrument (or embedded feature) is indexed to its own stock, including evaluating the instrument’s contingent exercise and settlement provisions. It also clarified the impact of foreign currency denominated strike prices and market-based employee stock option valuation instruments on the evaluation. The standard was effective as of January 1, 2009. We adopted the Contracts in Entity’s Own Equity Subtopic of the Derivatives and Hedging Topic of the Codification on January 1, 2009 and as a result we have a liability associated with outstanding warrants of approximately $0.4 million and $4 thousand at December 31, 2010 and 2009, respectively, and have recorded other income of approximately $0.2 million and $53 thousand during the years ended December 31, 2010 and 2009, respectively, due to the change in values.
In April 2009, FASB established general standards of accounting for, and the disclosure of, events that occur after the balance sheet date but before financial statements are issued or are available to be issued. In particular, the Subsequent Event Topic of the Codification sets forth: (1) the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements, (2) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, and (3) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. We adopted this standard as of June 30, 2009, which did not have a material impact on our consolidated financial position, results of operations or cash flows.
In June 2009, FASB released the Codification which became the source of authoritative GAAP recognized by FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (“SEC”) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. For all financial statements issued after September 15, 2009, the Codification superseded all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification has become non-authoritative. The Codification does not change how we account for our transactions or the nature of related disclosures made. However, when referring to guidance issued by the FASB, we are required to refer to topics in the Codification rather than the superseded standards. The adoption of the Codification did not impact our consolidated financial position, results of operations, cash flows or financial statement disclosures.
In February 2010, FASB issued an update to guidance in ASU 2010-09, “Amendments to Certain Recognition and Disclosure Requirements,” which removed the requirement for an SEC registrant to disclose the date through which subsequent events are evaluated. It did not change the accounting for or disclosure of events that occur after the balance sheet date but before the financial statements are issued. This amendment was effective upon issuance.
In December 2010, FASB issued an update to guidance in ASU 2010-28, “When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” This update modifies Step 1 of the goodwill impairment test for reporting units with zero or negative carrying amounts. For these reporting units, an entity is required to perform Step 2 of the goodwill impairment test if it is more likely than not that a goodwill impairment exists. In determining whether it is more likely than not that a goodwill impairment exists, an entity should consider whether there are any adverse qualitative factors indicating that an impairment may exist. The amendments in this update are effective for fiscal years and interim periods within those years, beginning after December 15, 2010. Early adoption is not permitted. We adopted ASU 2010-28 on January 1, 2011 and do not expect a material impact on our results of operations, financial position or cash flows.
In December 2010, FASB issued ASU 2010-29, “Disclosure of Supplementary Pro Forma Information for Business Combinations,” which updates guidance in ASC 805, “Business Combinations,” that clarifies the disclosure requirements for pro forma presentation of revenue and earnings related to a business combination. The amendments in this update are effective for fiscal years and interim periods within those years, beginning after December 15, 2010, with early adoption permitted. We adopted the update on January 1, 2011 and do not expect a material impact on our results of operations, financial position or cash flows.
2. Accounts Receivable
Factoring Agreements
Descriptions of our borrowing agreements, which are reflected on our consolidated balance sheet as “advances from factors,” are as follows:
RBS Invoice Discounting Agreement
Signature had an Invoice Discounting Agreement, (as amended, the “RBS Invoice Discounting Agreement”) with The Royal Bank of Scotland Commercial Services Limited (“RBS”). The RBS Invoice Discounting Agreement provided for Signature to sell with full title guarantee most of its receivables, as defined in the RBS Invoice Discounting Agreement. Under the RBS Invoice Discounting Agreement, as amended in December 2008, RBS prepaid up to 70% of the receivables sold in the United Kingdom (“U.K.”) and up to 70% of the receivables sold in the rest of the world, not to exceed an outstanding balance of £1.5 million at any given time, subject to restrictions on the use of proceeds. RBS paid Signature the remainder of the receivable upon collection. Receivables which remained outstanding 90 days from the end of the invoice month became ineligible and RBS could require Signature to repurchase the receivable. The discounting charge accrued at an annual rate of 1.5% above the base rate as defined in the RBS Invoice Discounting Agreement. Signature paid a commission charge to RBS of 0.16% of each receivable balance sold. The RBS Invoice Discounting Agreement required a minimum commission charge of £833 per month. Discounting charges of $35 thousand are included in interest expense for the year ended December 31, 2009. In July 2009, we terminated the RBS Invoice Discounting Agreement and replaced it with the Bibby Invoice Discounting Agreement as discussed below.
Bibby Invoice Discounting Factoring Agreement
In July 2009, Signature entered into an invoice discounting factoring agreement (the “Bibby Invoice Discounting Agreement”) with Bibby Financial Services (“Bibby”), which replaced the RBS Invoice Discounting Agreement as discussed above. The Bibby Invoice Discounting Agreement provides for Signature to sell, with full title guarantee, certain of its receivables as defined in the Bibby Invoice Discounting Agreement. Bibby prepays 80% of the receivables sold in the U.K. and 70% of receivables sold in the rest of the world, not to exceed a balance of £2.5 million (approximately $3.9 million at December 31, 2010). Bibby repays Signature the remainder of the receivable upon collection.
Receivables which remain outstanding 90 days from the invoice date become ineligible and Signature is required to repurchase the receivable. The Bibby Invoice Discounting Agreement requires a fee of 0.25% for each U.K. receivable sold and 0.3% for each receivable sold in the rest of the world. If the total of the yearly fee is less than £60,000, Signature is required to pay Bibby the amount of such deficit. Signature is also required to pay a discounting charge of 2.0% above the higher of Barclays Bank Plc base rate or 3 month LIBOR subject to a minimum of 3.5% (5.0% at December 31, 2010). Discounting charges of approximately $41 thousand and $0.1 million are included in interest expense for the years ended December 31, 2010 and 2009, respectively. Either Signature or Bibby can terminate the Bibby Invoice Discounting Agreement by providing written notice to the other party six months prior to the intended termination date but neither party can terminate for eighteen months following the commencement date. As of December 31, 2010, we had approximately £0.3 million outstanding (approximately $0.4 million) and approximately £0.3 million available (approximately $0.5 million) for borrowing under the Bibby Invoice Discounting Agreement.
Nordisk Factoring Agreement
In March 2008, our wholly-owned European subsidiary, Destron Fearing A/S, entered into a factoring agreement (the “Nordisk Factoring Agreement”) with Nordisk Factoring A/S (“Nordisk”). Under the Nordisk Factoring Agreement, Nordisk advanced 80% of Destron Fearing A/S’s eligible receivables, not to exceed a balance of DKK 6.0 million (approximately $1.1 million at December 31, 2010) at any given time. As security, Destron Fearing A/S assigned all invoice balances to Nordisk, regardless of whether advances were made on them, and warranted payments by its customers. Destron Fearing A/S paid a factoring commission charge to Nordisk of 0.15% of the gross volume of receivables factored. The Nordisk Factoring Agreement required a minimum commission charge of DKK 36 thousand (approximately $6 thousand) per year. Discounting charges of approximately $4 thousand and $34 thousand are included in interest expense for the years ended December 31, 2010 and 2009, respectively. On September 1, 2010 we replaced the Nordisk Factoring Agreement with the AL Finans Factoring Agreement as discussed below.
AL Finans A/S Factoring Agreement
On September 1, 2010, Destron Fearing A/S entered into a factoring agreement (the “AL Finans Factoring Agreement”) with AL Finans A/S (“AL Finans”) which replaced the Nordisk Factoring Agreement. Under the AL Finans Factoring Agreement, AL Finans advances 80% of Destron Fearing A/S’s eligible receivables, not to exceed a balance of DKK 6.0 million (approximately $1.0 million) at any given time. As security, Destron Fearing A/S assigns all invoice balances to AL Finans, regardless of whether advances were made on them, and warrants payments by its customers. Destron Fearing A/S pays a factoring commission charge to AL Finans of 0.15% of the gross volume of receivables factored with a minimum of DKK 40 per invoice. The AL Finans Factoring Agreement requires a minimum commission charge of DKK 36 thousand (approximately $6 thousand) per year, and AL Finans reserves the right to have recourse against Destron Fearing A/S for any losses sustained on the factored invoices. Discounting charges of approximately $13 thousand are included in interest expense for the year ended December 31, 2010. As of December 31, 2010, we had approximately DKK 0.6 million (approximately $0.1 million) outstanding and no availability for borrowing under the AL Finans Factoring Agreement.
3. Inventories
Inventories, net of writedowns for excess and obsolescence, consist of the following:
4. Property and Equipment
Property and equipment consist of the following:
Included above are vehicles and equipment acquired under capital lease obligations in the amount of $1.0 million and $1.7 million at December 31, 2010 and 2009, respectively. Related accumulated depreciation amounted to $0.7 million and $0.7 million as of December 31, 2010 and 2009, respectively.
Depreciation expense charged against income amounted to $1.5 million and $1.7 million for the years ended December 31, 2010 and 2009, respectively. Accumulated depreciation related to disposals of property and equipment amounted to $0.5 million and $0.1 million in 2010 and 2009, respectively.
During the year ended December 31, 2009, we impaired approximately $0.2 million of our fixed assets at our Animal Identification segment.
5. Goodwill
Goodwill consists of the excess of cost over fair value of net tangible and identifiable intangible assets of companies purchased. We apply the principles of the Intangibles - Goodwill and Other Topic of the Codification and use the purchase method of accounting for acquisitions of wholly-owned and majority-owned subsidiaries.
Method of Accounting for Goodwill
In accordance with the principles of the Intangibles - Goodwill and Other Topic of the Codification, we do not amortize goodwill. Instead, we are required to test goodwill for impairment annually as part of our annual business planning cycle during the fourth quarter of each year or earlier depending on specific changes in conditions surrounding our business units.
We allocate goodwill to our reporting business units. At December 31, 2010 and 2009, our reporting units were Animal Identification segment and Emergency Identification segment. Our reporting units are those businesses for which discrete financial information is available and upon which segment management makes operating decisions. The business operations of our current reporting units are described in Note 1. We tested the goodwill for each of our reporting units during the fourth quarters of 2010 and 2009. If the fair value of a reporting unit exceeded its carrying value, then no further testing was required. However, if the carrying value of a reporting unit exceeded its fair value, then an impairment charge was recorded. The assumptions used in the comparable company and discounted cash flow analyses are described in Note 11. Based upon our goodwill testing, we did not record any impairment charges during the fourth quarter of 2010 but recorded approximately $3.8 million impairment charges related to our Emergency Identification reporting unit during the fourth quarter of 2009.
At December 31, 2010, all goodwill belonged to the Animal Identification segment.
6. Intangibles, net
Intangibles and other assets consist of the following (dollars in thousands):
The following is a rollforward of our intangible assets for the years ending December 31, 2010 and 2009.
Estimated amortization expense of the definite-lived assets for the years ending December 31, is as follows (in thousands):
Amortization of intangibles charged against income amounted to $1.7 million and $2.3 million for the years ended December 31, 2010 and 2009, respectively.
During our annual impairment review in the fourth quarter of 2009, we recorded an impairment charge of approximately $3.3 million (net of a deferred tax liability of approximately $(1.4) million) associated with trademarks, patents and customer relationships at our Emergency Identification reporting unit.
7. Accrued Expenses and Other Liabilities
Accrued expenses consist of the following:
Other liabilities consist of the following:
The accrued bonuses (long-term) reflect amounts due to certain members of senior management, including our chief executive officer, chief financial officer and chief operating officer, which are not due and payable until April 1, 2011. We have the right to pay some or all of such bonuses prior to April 1, 2011 at our sole discretion and contingent upon cash availability. No interest is due on the bonuses unless required by law and, if so required, will be accrued at the minimum legally required rate.
8. Notes Payable and Other Financings
Notes payable and long-term debt consists of the following:
The scheduled payments due based on maturities of current and long-term debt as of December 31, 2010 are presented in the following table (in thousands):
Interest expense on the long and short-term notes amounted to $1.2 million and $2.2 million for the years ended December 31, 2010 and 2009, respectively. The weighted average interest rate was 14.1% and 13.7% for the years ended December 31, 2010 and 2009, respectively. The weighted average interest rates exclude interest expense related to certain amortization and accretion of debt discount and issue costs, share issuances and legal expenses related to financing activities, revaluation of certain warrants and obligation to Laurus Master Fund, Ltd (“Laurus”).
Mortgage Loan
As described in Note 22, on February 25, 2011, we entered into a loan modification agreement extending the mortgage loan term from November 1, 2010 to November 1, 2011 with the option to extend the maturity date for an additional six months. Accordingly, our indebtedness under this loan has been classified as long term as of December 31, 2010.
$6.0 Million Revolving Asset-Based Facility with Kallina
On August 31, 2007, Destron Fearing and certain of its wholly-owned subsidiaries, Digital Angel Technology Corporation, Fearing Manufacturing Co., Inc. and Digital Angel International, (collectively, the “Eligible Subsidiaries”) entered into a $6.0 million revolving asset-based financing transaction with Kallina Corporation (“Kallina”) pursuant to the terms of a Security Agreement. Under the terms of the Security Agreement, Destron Fearing was able to borrow, from time to time, an amount equal to the lesser of the amount of availability under the borrowing base and $6.0 million, subject to certain reserves that the lender was authorized to take in its reasonable commercial judgment (the “Revolving Facility”). The borrowing base was calculated as a percentage of the total amount of eligible accounts and inventory owned by Destron Fearing and its Eligible Subsidiaries. Amounts outstanding under the Revolving Facility accrued interest at a rate equal to the prime rate plus 2.0%, but not less than 10.0% at any time.
Destron Fearing and its Eligible Subsidiaries had pledged all of their respective assets, excluding the stock of all foreign subsidiaries other than Signature, in support of the obligations under the Revolving Facility. In connection with the Revolving Facility, Destron Fearing issued to Kallina seven-year warrants, which, as a result of our acquisition of the minority owners’ interest in Destron Fearing in 2007, were converted into warrants to purchase shares of our common stock. The value of the warrants of approximately $1.0 million was recorded as a discount to the Revolving Facility and was amortized to interest expense over the life of the Revolving Facility. Destron Fearing paid Kallina an upfront fee equal to 3.5% of the $6.0 million Revolving Facility, which was also amortized over the life of the Revolving Facility as interest expense. The Revolving Facility matured and was paid in full on August 31, 2010.
TCI Revolving Credit Facility
On August 31, 2010, Destron Fearing entered into a $4.0 million revolving credit facility with TCI Business Capital, Inc. (“TCI”) pursuant to the Credit and Security Agreement dated August 31, 2010 (the “TCI Agreement”). Under the terms of the TCI Agreement, Destron Fearing may borrow, from time to time, up to an aggregate of the lesser of: (i) 90% of eligible account receivables, based on dilution of less than 4%, as defined, plus 25% of eligible inventory capped at $500,000, as may be adjusted for writedowns, or (ii) $4.0 million (the “TCI Revolving Facility”). The TCI Revolving Facility accrues interest at an annual rate equal to the prime rate as announced by Bank of America plus 8.0% (“Floating Rate”) which was 11.25% as of December 31, 2010. Upon default or early termination, the annual interest rate increases to the Floating Rate plus 4%. The TCI Revolving Facility matures on August 31, 2012, but can be terminated early by Destron Fearing upon payment of a termination fee or by TCI in accordance with the terms of the TCI Agreement. Destron Fearing is subject to maintaining a minimum net worth covenant and a non-financial covenant under the TCI Agreement. As of December 31, 2010, we were in compliance with all covenants.
To secure Destron Fearing’s obligations under the TCI Revolving Facility, (a) Destron Fearing and its wholly-owned subsidiaries GT Acquisition Sub, Inc. and Digital Angel Technology Corporation have granted TCI security interests in their ownership interests (including stock and membership interests) of their subsidiaries, excluding the stock of all foreign subsidiaries; and (b) the Company, Destron Fearing and its wholly-owned subsidiaries Digital Angel Technology Corporation, Fearing Manufacturing Co., Inc. and GT Acquisition Sub, Inc. have granted TCI security interests in certain intellectual property. In addition, (i) the Company, (ii) Destron Fearing’s wholly-owned subsidiaries Digital Angel Technology Corporation, Fearing Manufacturing Co., Inc., Digital Angel International, Inc., Timely Technology Corp., and GT Acquisition Sub, Inc., and (iii) C-Scan, LLC, a wholly-owned subsidiary of GT Acquisitions Sub, Inc., collectively and individually have guaranteed the TCI Revolving Facility.
The TCI Revolving Facility replaced the $6.0 million revolving facility with Kallina.
Senior Secured Term Notes
In August 2006, we entered into a term note (“2006 Note”) with Laurus in the original principal amount of $13.5 million. The 2006 Note, as amended, accrued interest at a rate of 12% per annum, was payable monthly and had a maturity date of February 1, 2010. In August 2007, we entered into a $7.0 million term note (“2007 Note”) with Kallina Corporation (“Kallina”) pursuant to the terms of a Securities Purchase Agreement between us and Kallina. The 2007 Note, as amended, accrued interest at a rate of 12% per annum, was payable monthly and had a maturity date of February 1, 2010. In October 2008, we entered into a letter agreement with Laurus, Kallina, Valens U.S. SPV I, LLC, Valens Offshore SPV I Ltd., Valens Offshore SPV II Corp and PSource Structured Debt Limited (collectively referred to as the “Lenders”) and issued a $2.0 million senior secured, non-convertible term note (the “2008 Note”) to the Lenders which accrued interest at a rate equal to 12% and was due in full on February 1, 2010. The 2006 Note, the 2007 Note and the 2008 Note (collectively the “Debt Obligations”) allowed for optional redemption without a prepayment penalty. On February 1, 2010, the maturity date, we paid the final balance of approximately $1.4 million on the Debt Obligations.
Registered Direct Offering
On February 9, 2010, we sold, in a registered direct offering, 3,385,000 shares of our common stock and warrants to purchase 1,354,000 shares of common stock to two institutional investors pursuant to the terms of a securities purchase agreement we entered into on February 3, 2010. The purchase price of the securities was $1.7 million in the aggregate. We entered into a placement agent agreement with Chardan Capital Markets, LLC (“Chardan”) relating to our registered direct offering where we agreed to pay Chardan a placement agent fee of 6.0% of the gross proceeds from the sale. The net proceeds from the sale, after deducting the placement agent fee and other offering expenses, were approximately $1.6 million and were used primarily to cover the repayment of the Debt Obligations discussed above.
The initial exercise price of the warrants was $0.50 per share, and the warrants may be immediately exercised and expire seven years from the date of issuance. The warrants are not exercisable by a holder to the extent that such holder or any of its affiliates would beneficially own in excess of 4.9% of our common stock. If at the time of exercise, the registration statement relating to the shares underlying the warrants is not effective, or if the related prospectus is not available for use, then a holder of warrants may elect to exercise warrants using a net exercise (i.e., cashless exercise) mechanism. The warrants are entitled to “full-ratchet” anti-dilution protection. If we grant, issue or sell any options, convertible securities or rights to purchase stock, warrants, other securities or other property pro rata to the record holders of any class of the shares of common stock (the “Purchase Rights”), the holders of warrants are entitled to acquire such Purchase Rights which the holders could have acquired if the holders had held the number of shares of Common Stock acquirable upon the complete exercise of the holder’s warrants. We may not enter into certain fundamental transactions, such as a merger, consolidation, sale of substantially all assets, tender offer or exchange offer with respect to our common stock or reclassification of our common stock, unless the successor entity assumes in writing all of our obligations under the warrants. If certain fundamental transactions occur with respect to us or our “significant subsidiaries” as defined by Rule 1-02 of Regulation S-X, at the holder’s request within fifteen days after each fundamental transaction (“Holder Option Period”), we or the successor entity shall purchase the warrants from the holder for an amount equal to the value of the unexercised portion of the warrants that remain as of the time of such fundamental transaction based on the Black Scholes Option Pricing Model obtained from the “OV” function on Bloomberg, L.P. If such redemption option is not exercised by the holder during the Holding Option Period, we have an option to repurchase the unexercised portion of the warrants for the same amount within ten days after the expiration of the Holder Option Period. We have estimated the initial value of the warrants to be approximately $0.5 million based on a valuation model considering a sensitivity analysis performed to evaluate the impact on value of a potential down round, and using the following assumptions: dividend yield of 0.0%; volatility of 124.14%; expected life of seven years; and a risk-free rate of 3.08%.
The value of the warrants is reflected in our consolidated balance sheet as a liability and the warrants are required to be revalued at each reporting period. Based on the valuation at December 31, 2010, we recorded other income (expense) of approximately $0.2 million during the year ended December 31, 2010, respectively. We determined the value at December 31, 2010 to be approximately $0.4 million, based on a valuation model considering a sensitivity analysis performed to evaluate the impact on value of a potential down round, and using the following assumptions: dividend yield of 0.0%; volatility of 93.2%; expected life of 6.0 years and a risk-free rate of 2.0%. Going forward, changes in the value of the warrants will result in additional increases or decreases in other income (expense) in our consolidated statement of operations.
Termination of Standby Equity Distribution Agreement
On July 10, 2009, we entered into a Standby Equity Distribution Agreement (the “SEDA”) with YA Global Master SPV Ltd. (“YA SPV”), an affiliate of Yorkville Advisors, for the sale of up to $5.0 million of shares of our common stock over a two-year commitment period. Under the terms of the SEDA, we could from time to time, at our discretion, sell newly-issued shares of our common stock to YA SPV. We issued shares of our common stock under the SEDA pursuant to a Registration Statement on Form S-3.
The SEDA required payment of a commitment fee to YA SPV in an amount equal to $125,000 for which we delivered approximately 88 thousand shares of common stock under the Registration Statement to pay the commitment fee. The price of the shares delivered was the average of the daily volume weighted average price for the three trading days after the date of the Agreement. We issued an aggregate of approximately 3.0 million shares of our common stock and received an aggregate of approximately $2.9 million in cash under the SEDA, of which 0.1 million shares of our common stock were issued and approximately $0.1 million in cash was received during the first quarter of 2010. In connection with the registered direct offering discussed above, we terminated the SEDA effective February 4, 2010.
Destron Fearing A/S’s Line of Credit
Destron Fearing A/S is party to a credit agreement with Danske Bank (the “Credit Facility”). On June 1, 2006, Destron Fearing A/S amended the borrowing availability from DKK 12.0 million to DKK 18.0 million. In connection with the amendment, Destron Fearing executed a Letter of Support which confirms that it will maintain its holding of 100% of the share capital of Destron Fearing A/S, and will neither sell, nor pledge, nor in any way dispose of any part of Destron Fearing A/S or otherwise reduce Destron Fearing’s influence on Destron Fearing A/S without the prior consent of Danske Bank. Interest is determined quarterly and is based on the international rates Danske Bank can establish on a loan in the same currency on the international market plus 2.0%. At December 31, 2010, the annual interest rate on the Credit Facility was 7.65%. Borrowing availability under the Credit Facility considers guarantees outstanding. The Credit Facility will remain effective until further notice. Destron Fearing A/S can terminate the Credit Facility and pay the outstanding balance, or Danske Bank may demand the credit line be settled immediately at any given time, without prior notice. Beginning in July 2009, Destron Fearing A/S and Danske Bank agreed to reduce the borrowing availability on the Credit Facility each month by DKK 0.5 million (approximately $0.1 million). As of December 31, 2010, total availability had been reduced from DKK 18.0 million (approximately $3.2 million) to DKK 9.0 million (approximately $1.6 million). DKK 9.0 million (approximately $1.6 million) was outstanding at December 31, 2010 and there was no additional availability under the credit line.
9. Fair Value of Financial Instruments
Cash and Cash Equivalents
The carrying amount approximates fair value because of the short maturity of those instruments.
Notes Payable and Long-Term Debt
The carrying amount approximates fair value because of the short-term nature of the debt, its underlying collateral and certain interest rates which are reset periodically to reflect current market conditions.
Accounts Payable and Accrued Expenses
The carrying amount approximates fair value.
10. Stockholders’ Equity
Warrants
We have issued warrants convertible into shares of common stock for consideration, as follows (in thousands, except exercise price):
The Series B warrant was issued in connection with a securities purchase agreement effective April 16, 2004 and was exercisable for approximately 83 thousand shares of our common stock. The exercise price of the Series B warrant, which was originally $26.40 per share, was reduced to $16.91 per share as a result of our issuances of common stock for financings and severance payments, which triggered the anti-dilution provisions in the Series B warrant agreement. The Series B warrant vested on April 16, 2005 and expired on April 16, 2010. The Series B warrant agreement provided for anti-dilution provisions that required that the exercise price be adjusted if we issue certain securities at a price below the exercise price then in effect and the number of warrants and the exercise price was required to be adjusted upon the declaration or payment of a dividend or other distribution of our common stock. The total number of shares that could have been issued under such provisions were subject to a ceiling.
The Series D warrants were issued in connection with a securities purchase agreement effective October 21, 2004 and exercisable into approximately 83 thousand shares of our common stock. The exercise price of the Series D warrant, which was originally $40.40 per share, was reduced to $25.443 per share as a result of our issuances of common stock for financings and severance payments, which triggered the anti-dilution provisions in the warrant agreement. The Series D warrant vested on October 21, 2005 and expired on October 21, 2010. The Series D warrant agreement provided for anti-dilution provisions similar to those outlined above for the Series B warrant and the total number of shares that could be issued under such provisions was also subject to a ceiling.
The Series E warrants were issued in connection with a financing completed on June 10, 2005. Warrants to acquire approximately 92 thousand and 55 thousand shares of our common stock were issued to two investors, respectively. The warrants are exercisable at any time at exercise prices ranging from $29.632 to $32.28 per share. The exercise prices of the warrants were reduced to prices ranging from $19.104 to $20.759 per share as a result of our issuances of common stock for financings and severance payments, which triggered the anti-dilution provisions in the warrant agreements. The warrants vested on June 10, 2005 and expired on June 10, 2010. The Series E warrant agreement provided for anti-dilution provisions similar to those outlined above for the Series B warrant and the total number of shares that could be issued under such provisions was also subject to a ceiling.
The Iroquois/Alpha warrants were issued in connection with a registered direct offering on February 9, 2010. Warrants to purchase 1,354,000 shares of our common stock were issued to two institutional investors pursuant to the terms of a securities purchase agreement as discussed in Note 9. The exercise price of the warrants is $0.50 per share, and the warrants may be immediately exercised, but expire seven years from the date of issuance. The warrants are entitled to “full-ratchet” anti-dilution protection. If we grant, issue or sell any options, convertible securities or rights to purchase stock, warrants, other securities or other property pro rata to the record holders of any class of the shares of common stock (the “Purchase Rights”), the holders of warrants are entitled to acquire such Purchase Rights which the holders could have acquired if the holders had held the number of shares of Common Stock acquirable upon the complete exercise of the holder’s warrants. Upon the issuance of 8,000,000 warrants to certain investors in February 2011 (as more fully discussed in Note 22), the full-ratchet anti-dilution provision was triggered. As a result, we reduced the exercise price of the Iroquois/Alpha warrants to $0.45 per share and increased the number of warrants outstanding to 1,504,444. There was no change in the value of the warrants to the investors.
The valuation of warrants utilized the following assumptions in the Black-Scholes valuation model:
Stock Option Plans
In accordance with the Compensation - Stock Compensation Topic of the Codification, awards granted are valued at fair value and compensation cost is recognized on a straight line basis over the service period of each award. We currently use the Black-Scholes option pricing model to calculate the compensation cost to be recognized. During the year ended December 31, 2010, we recorded approximately $0.2 million in compensation expense related to stock options granted to our and our subsidiary employees, directors and consultants. A summary of the status of our and our subsidiary’s stock options as of December 31, 2010, and changes during the two years then ended, is presented below.
During 1996, we adopted a nonqualified stock option plan (“1996 Option Plan”). During 2000, we adopted the 1999 Flexible Stock Plan. With the 2000 acquisition of Destron Fearing Corporation, we acquired one additional stock option plan referred to as the 1999 Employees’ Stock Purchase Plan. During 2003, we adopted the 2003 Flexible Stock Plan. With the acquisition of the minority owners’ interest in Destron Fearing in December 2007, we acquired two additional stock option plans, referred to as the Destron Fearing MAS Plan and the Destron Fearing Stock Option Plan.
The Destron Fearing MAS Plan, was terminated on February 23, 2006 thus no new options can be granted under the terminated plan. However, all outstanding options will remain in effect until they are exercised, forfeited or expired. As of December 31, 2010, awards consisting of options to purchase approximately 62 thousand shares were outstanding under the Destron Fearing MAS Plan.
As of December 31, 2010, the Destron Fearing Stock Option Plan had approximately 1.9 million shares of common stock reserved for issuance, of which approximately 1.6 million shares have been issued and approximately 0.3 million remain available for issuance, subject to certain restrictions regarding eligible participants. As of December 31, 2010, awards consisting of options to purchase approximately 1.2 million shares were outstanding under the Destron Fearing Stock Option Plan. Option awards are generally granted with exercise prices between market price and 110% of the market price of our stock at the date of grant, generally vest over three to nine years and have ten-year contractual terms.
Under the 1996 Option Plan, options for approximately 0.1 million common shares were authorized for issuance to certain of our officers, directors and employees. As of December 31, 2010, approximately 0.1 million options have been issued, net of forfeitures, and approximately 2 thousand are outstanding under the 1996 Option Plan. The options vest as determined by our board of directors and are exercisable over a period of five years. The 1996 Option Plan has been discontinued with respect to any future grant of options.
Under the 1999 Flexible Plan, the number of shares which may be issued or sold, or for which options, Stock Appreciation Rights (“SARs”), or Performance Shares may be granted to our officers, directors and employees is approximately 0.5 million. As of December 31, 2010, 0.4 million options have been granted, net of forfeitures, and 0.1 million are outstanding. The options vest as determined by our board of directors and are exercisable over a period of five years.
Under the 2003 Flexible Plan, the number of shares which may be issued or sold, or for which options, SARs, or performance shares may be granted to our officers, directors and employees is approximately 4.0 million. As of December 31, 2010, 2.5 million options have been granted and 1.1 million are outstanding and 1.5 million shares are available for future issuances. The options vest as determined by our board of directors and are exercisable over a period of three to ten years.
The 1999 Employees’ Stock Purchase Plan authorizes the grant of options to employees who purchase shares of common stock. As of December 31, 2010, approximately 0.1 million options have been granted, 45 thousand are outstanding and 25 thousand shares are available for grant.
In addition, as of December 31, 2010, we have granted approximately 0.2 million options, net of forfeitures, and have outstanding approximately 0.2 million options which were granted outside of the above plans as an inducement to employment.
A summary of the stock option activity for our stock options plans for 2010 and 2009 is as follows (in thousands, except per share price data):
(1)
The intrinsic value of a stock option is the amount by which the fair value of the underlying stock exceeds the exercise price of the option. The fair value of our common stock was $0.37 at December 31, 2010 based upon the closing price on the OTC Bulletin Board. As of December 31, 2010 and 2009, the aggregate intrinsic value of options outstanding, exercisable and vested or expected to vest was nil and $0.1 million, respectively.
A summary of the status of our nonvested stock options as of December 31, 2010 is presented below (in thousands, except per share amounts):
In addition to the stock options presented above, Thermo Life has approximately 4.4 million fully vested stock options outstanding. These stock options have no intrinsic value as of December 31, 2010 and Thermo Life’s two options plans have been discontinued with respect to future grants. On January 21, 2010, we sold the assets of Thermo Life as more fully discussed in Note 13.
As of December 31, 2010, there was approximately $0.1 million of total unrecognized compensation cost related to unvested share-based compensation arrangements granted under our plans. That cost is expected to be recognized over a weighted-average period of approximately 1.5 years.
The following table summarizes information about our stock options at December 31, 2010 (in thousands, except per share price data):
The weighted average per share fair value of grants made in 2009 under our incentive plans was $0.97. We did not grant any stock options during 2010. The weighted average per share fair value of options granted or modified by us was estimated on the grant date using the Black-Scholes option-pricing model based on the following weighted average assumptions.
Restricted Stock Grants
The stock-based compensation charges associated with restricted stock are included in the consolidated statements of operations in selling, general and administrative expense.
In June 2009 and August 2009, we issued approximately 14 thousand shares and 0.1 million shares, respectively, of our restricted stock to consultants. We determined the value of the stock to be approximately $16 thousand and $0.1 million, respectively, based on the closing price of our stock on the date of the grants. The value of the restricted stock for each grant, which was fixed as a result of the price protection provisions, was amortized as consulting expense over the vesting period of six months.
In October 2009, we issued approximately 0.5 million shares of our restricted common stock to our directors and executive and senior management. We determined the value of the stock to be approximately $0.5 million based on the closing price of our stock on the date of the grant. The value of the restricted stock is being amortized as compensation expense over the vesting period which is three years. In January 2008, we issued approximately 31 thousand shares of our restricted common stock to our directors. We determined the value of the stock to be approximately $0.2 million based on the closing price of our stock on the date of the grant. The value of the restricted stock is being amortized as compensation expense over the vesting period which is five years. As a result, we recorded compensation expense of approximately $0.2 million and $0.1 million in 2010 and 2009, respectively, associated with such restricted stock grants.
11. Asset Impairment Testing
As of December 31, 2010, the net carrying value of our goodwill was $3.3 million. We test our goodwill and intangible assets for impairment as a part of our annual business planning cycle. Goodwill and intangible assets are also tested between testing dates if an impairment condition or event is determined to have occurred. Based upon our annual testing, we did not record a goodwill impairment charge in 2010 but recorded a goodwill impairment charge of approximately $3.8 million in the fourth quarter of 2009 at our Emergency Identification reporting unit.
During the fourth quarters of 2010 and 2009, we determined the fair value of our reporting units using discounted cash flow analyses and a company comparable analysis. If the fair value of a reporting unit exceeded its carrying value, then no further testing was required. However, if the carrying value of a reporting unit exceeded its fair value, then an impairment charge was recorded. Management compiled the revenue forecasts, growth rates, gross margin, corporate overhead and tax rates, among other data and assumptions related to the financial projections upon which the valuations were based. The methodology used to determine the residual or terminal enterprise values included the following factors: current leverage, risk premium, cost of equity, after-tax cost of debt, and weighted average cost of capital, which were used in the discount rate calculations. The assumptions used in the determination of fair value using discounted cash flows were as follows:
•
Earnings before interest, taxes, depreciation and amortization were used as the measure of cash flow;
•
Cash flows were projected for five years and added to the present value of the terminal value; and
•
Discount rate used was 20%. The rate was determined based on the level of risk associated with a reporting units’ operations and the related degree of certainty of generating future cash flows.
The company comparable analysis was performed utilizing financial and market information on publicly traded companies that are considered to be generally comparable to our reporting units. Each analysis provided a benchmark to compare to the values of each business unit.
Future goodwill impairment reviews may result in write-downs. Such determination involves the use of estimates and assumptions, which may be difficult to accurately measure or value.
During the year ended December 31, 2010, we did not record any goodwill or asset impairments. During the year ended December 31, 2009, we recorded approximately $7.3 million of goodwill and asset impairments; $3.8 million impairment of goodwill and $3.3 million impairment (net of a deferred tax liability of approximately $1.4 million) of intangible assets at our Emergency Identification reporting unit as well as approximately $0.2 million related to the impairment of fixed assets at our Animal Identification reporting unit. See Notes 4, 5 and 6 for further discussion.
12. Income Taxes
The benefit (provision) for income taxes consists of:
In addition to the 2009 income tax benefit above, which related primarily to the amortization of deferred tax liabilities arising from acquisitions, we recorded income tax expense in 2009 associated with our discontinued operations. A portion of current operating losses of foreign continuing operations have been applied to reduce taxable income from foreign discontinued operations and a portion carried back to offset existing liabilities of foreign discontinued operations. See Note 13.
Destron Fearing has operations in Europe and South America. We consider earnings from our foreign entities to be indefinitely reinvested and, accordingly, no provision for U.S. federal and state income taxes has been made for these earnings. Upon distribution of foreign subsidiary earnings, we may be subject to U.S. income taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to the foreign jurisdiction.
The tax effects of temporary differences and carryforwards that give rise to significant portions of deferred tax assets and liabilities consist of the following:
The valuation allowance for deferred tax assets increased by $1.2 million and $2.8 million in 2010 and 2009, respectively, due primarily to the generation of net operating losses. The valuation allowance was provided for net deferred tax assets that exceeded the level of existing deferred tax liabilities and our projected pre-tax income. Our goodwill is not deductible for tax purposes.
Approximate domestic and international (loss) income from continuing operations before provision for income taxes consists of (in thousands):
At December 31, 2010, we had aggregate net operating loss carryforwards of approximately $281.5 million for income tax purposes that expire in various amounts from 2014 through 2030. Of the aggregate U.S. net operating loss carryforwards of $269.0 million, $69.2 million relate to Destron Fearing.
Based upon the change of ownership rules under IRC section 382, approximately $196.7 million of our separate U.S. net operating loss carryforwards experienced a more than 50% ownership change during the year ended December 31, 2009 and therefore are significantly limited as to the amount of use in any particular year. The ownership change was due to the issuance of sufficient common stock which resulted in our ownership change exceeding the 50% limitation threshold imposed by that section. The $69.2 million of operating loss carryforwards related to Destron Fearing were not impacted by this ownership change and are not currently subject to limitation under IRC section 382.
Of the total aggregate net operating loss carryforwards, foreign loss carryforwards are approximately $12.5 million. These net operating loss carryforwards are available to only offset future taxable income earned in the home country of the foreign entity and do not expire.
The reconciliation of the effective tax rate with the statutory federal income tax (benefit) rate is as follows:
(1)
Substantially attributed to net operating losses.
Liabilities for Uncertain Tax Positions
A reconciliation of the beginning and ending balances of gross unrecognized tax benefits for 2010 and 2009 is as follows (in thousands):
Included in the balance of unrecognized tax benefits at December 31, 2010 and 2009 are $0.2 and $0.2 million, respectively, of tax benefits that, if recognized, would affect the effective tax rate. We recognize interest and penalties related to uncertain tax positions in income tax expense. As of January 1 and December 31, 2010, we had accrued $24 thousand and $32 thousand, respectively, of interest related to uncertain tax positions and have accrued no penalties. Our unrecognized tax benefits are largely related to certain state filing positions and are included in other long-term liabilities.
We, in combination with our consolidated subsidiary, Destron Fearing, file income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions in which we operate. In general, we and Destron Fearing are no longer subject to U.S. federal, state or local income tax examinations for years before 2007, Danish tax examinations for years before 2006 and U.K. tax examinations for years before 2006. We do not currently have any examinations ongoing.
13. Discontinued Operations
We sold our ownership of McMurdo during the three-months ended December 31, 2009, our Control Products Group and Thermo Life during the three-months ended March 31, 2010 and Clifford & Snell during the three-months ended June 30, 2010. McMurdo is a manufacturer of emergency locator beacons; Thermo Life is a development stage company with patented rights to a thin-film thermoelectric generator; Control Products Group manufactures and distributes electronic relay switches for nuclear power applications; and Clifford & Snell manufactures electronic alarm sounders which are used to provide audible and or visual signals which alert personnel in hazardous areas, including the oil and petrochemical industry and in the fire and security market. The decisions to sell these businesses were made as part of management’s strategy to streamline our operations to focus our efforts on the Animal Identification segment.
As a result of the board of directors’ decision to sell, and the subsequent sales of the operations of Thermo Life, McMurdo, Control Products Group and Clifford & Snell, the financial condition, results of operations and cash flows of each of these businesses have been reported as discontinued operations in our financial statements, and prior period information has been reclassified accordingly.
Sale of McMurdo
On November 2, 2009, we, together with Signature and McMurdo, entered into a definitive agreement to sell substantially all of the assets of Signature’s U.K.-based McMurdo business unit for $10.0 million in cash (“the McMurdo Purchase Agreement”). The purchaser was France-based Orolia Group (“Orolia”), a high-technology firm specializing in positioning, navigation and timing solutions for critical operations.
On November 20, 2009, pursuant to the terms of the McMurdo Purchase Agreement, we completed the sale of McMurdo. At closing, the parties amended the McMurdo Purchase Agreement to reduce the amount to be held in escrow to $1.0 million, to assign to the buyer the obligation for certain trade and vendor payables in existence at the time of closing, and to exclude certain product lines and related assets from the transaction (which product lines and assets were retained by Signature in exchange for a $250,000 credit against the purchase price). As a result of these amendments and the adjustment for actual inventory levels at the time of closing, the consideration paid at closing totaled approximately $9.6 million, of which approximately $8.8 million was paid to Signature in cash and approximately $0.8 million was retained by the buyer to pay the retained trade and vendor payables. In the fourth quarter of 2009, we recorded a gain on the sale of McMurdo of approximately $2.1 million, net of U.K. income taxes of $0.5 million. The remaining $1.0 million of the proceeds, less claims, was held in escrow for 12 months, of which we received approximately $0.7 million in November 2010 and recorded as a gain on sale. The proceeds were used to pay debt obligations and to fund working capital. Both the Company and Orolia guaranteed performance to the other, thus we have guaranteed Signature’s obligations under the McMurdo Purchase Agreement on a fully subordinated basis. The Company’s guarantee will continue until all liabilities have been paid, discharged or satisfied in full.
Sale of Thermo Life
On January 21, 2010, we entered into agreements with Ingo Stark, the employee and scientist who was chiefly responsible for the development of Thermo Life’s patented technology, to sell him the remaining assets of Thermo Life for nil and granting him a license on the patents in exchange for any future royalty payments on any products that become commercialized using the patents. Thermo Life has never generated any revenue and has been included in our discontinued operations since 2008. The loss on this transaction was not significant.
Sale of Control Products Group
On January 25, 2010, we entered into an agreement to sell substantially all of the assets of a division known as the Control Products Group, a group within the Clifford & Snell business unit of Signature. The buyer, C&S Controls Limited, is a U.K. entity controlled by Gary Lawrence, the former manager of the Control Products Group for the past several years, and another former employee. The purchase price of £0.4 million (approximately $0.6 million) was represented, in part, by a non-interest bearing promissory note in the original principal amount of £0.4 million (approximately $0.6 million) issued from the buyer to Signature, which calls for monthly cash payments for approximately 5 years. As of December 31, 2010, approximately $53 thousand has been collected on the promissory note. The promissory note is collateralized but subordinated to a £30 thousand (approximately $45 thousand) working capital loan issued by a third party to the buyers. We have imputed interest at a rate of 8.0% per annum which represents a discount of £67 thousand (approximately $0.1 million) which is being amortized as additional interest income as cash is collected over the life of the promissory note. Based on the small scale of this entity, we believe that our treatment of this transaction as a sale for accounting purposes is not materially different from treatment that does not recognize the legal transfer of the ownership of the business. The gain on sale of approximately $0.1 million was deferred and will be recognized in the future when circumstances have changed sufficiently to so warrant.
Sale of Clifford & Snell
On April 30, 2010, we entered into a definitive agreement to sell the assets of Clifford & Snell for £2.3 million in cash (approximately $3.5 million) (“the Clifford & Snell Purchase Agreement”). The purchaser was R.Stahl Ltd., a subsidiary of R.Stahl AG, a public company based in Waldenburg, Germany (“R.Stahl”). R.Stahl develops, manufactures and markets explosion-protection products worldwide for industrial customers. During the three-months ended March 31, 2010 and the year ended December 31, 2009, Clifford & Snell’s revenues were approximately £0.5 million (approximately $0.8 million) and approximately £3.7 million (approximately $5.8 million), respectively, and did not represent a significant disposition in accordance with Article 1 of Regulation S-X.
Clifford & Snell’s assets were sold for a cash consideration of £2.3 million (approximately $3.5 million). The purchase price was structured into two payments; £2.1 million (approximately $3.1 million) upon closing of the Clifford & Snell Purchase Agreement and £0.2 million (approximately $0.4 million) on October 30, 2010 following a six-month supply agreement during which R.Stahl purchased products from Signature. On April 30, 2010, we received approximately £1.2 million (approximately $1.7 million) in net cash proceeds, which represented the first payment of £2.1 million less £0.3 million (approximately $0.5 million) of repayment on our Bibby invoice discounting line, £0.2 million (approximately $0.3 million) in closing and transaction costs and £0.4 million (approximately $0.6 million) which is to be held in escrow and paid out in two equal installments, net of any claims, on January 30, 2011 and October 31, 2011. On September 30, 2010, we received approximately £0.1m (approximately $0.2 million) of the second purchase price and on November 1, 2010, we received the remaining £0.1m (approximately $0.2 million). In February 2011, we received £0.1 million (approximately $0.2 million) of the first escrow payment. Both the Company and R.Stahl AG issued guarantees of subsidiary performance to the other. The Company’s guarantee will continue until all liabilities have been paid, discharged or satisfied in full.
In the second quarter of 2010, we recorded a gain on the sale of Clifford & Snell of approximately £0.7 million (approximately $1.0 million) and in the first quarter of 2011, we recorded a gain on sale of approximately £0.1 million (approximately $0.2 million) upon the receipt of the first escrow payment. Upon the receipt of the second escrow payment in connection with the Clifford & Snell sale, if any, such proceeds will be recorded as additional gain on sale.
The financial condition, results of operations and cash flows of the businesses discussed above have been reported as discontinued operations in our financial statements, and prior period information has been reclassified accordingly. Results of discontinued operations for each of the years ended December 31, 2010 and 2009 are presented below.
The results above do not include any allocated or common overhead expenses.
The net liabilities of discontinued operations as of December 31, 2010 and 2009 were comprised of the following:
In addition, Thermo Life has granted options under its two plans which have been discontinued with respect to future grants. As of December 31, 2010, 4.4 million options have been granted net of forfeitures and all are outstanding. These stock options have no intrinsic value as of December 31, 2010.
14. Loss Per Share
A reconciliation of the numerator and denominator of basic and diluted (loss) income per share is provided as follows, in thousands, except per share amounts:
(1)
The following stock options and warrants outstanding as of December 31, 2010 and 2009 were not included in the computation of dilutive loss per share because the net effect would have been anti-dilutive:
15. Commitments and Contingencies
Rentals of space, vehicles, and office equipment under operating leases amounted to approximately $0.8 million and $0.8 million for the years ended December 31, 2010 and 2009, respectively. The approximate minimum payments required under operating leases that have initial or remaining terms in excess of one year at December 31, 2010, are as follows (in thousands):
We have written employment arrangements with certain of our officers, some of which provide for bonus, severance and change of control payments. During the year ended December 31, 2010, salaries under the agreements amounted to $0.9 million. All of our employment agreements are for “at will” employment.
Annual Incentive Plan
The Compensation Committee of our board establishes the Annual Targets for fiscal years for our Annual Incentive Plan (the “Plan”). The targets are based on the following metrics: revenue, operating income, cash generation and achievement of individual targets outlined in a Management By Objectives record for each participant. Under the Plan, the Compensation Committee determines the participants entitled to participate in the Plan. The category of eligible participants remains the same as previous years, except the Chief Executive Officer is not eligible to participate in the plan, and incentive compensation determined instead by reference to contracted terms. Each participant’s bonus amount is calculated based on an analysis of performance based on the established targets and individual performance objectives and is subject to the discretion of the Chief Executive Officer. The maximum award under the Plan varies based upon the participant’s level and performance. Target bonuses have been set for the various senior executives participating in the Plan at 60% of their base salary, and executives participating in the Plan at 15% to 30% of their base salary. In no event can amounts awarded under the Plan exceed 200% of each executive’s target bonus. Under the Plan, determination of awards and actual performance is the responsibility of the Compensation Committee, which reserves the right, in its sole discretion, to increase or decrease awards to participants. We have not yet finalized the incentive compensation to be paid under the Plan for 2010; however, the bonus accrual was estimated based on the achievement of the various targets. In addition, we have not yet determined the parameters of our 2011 Annual Incentive Plan.
Amendment to Intervet/Schering-Plough Supply and Distribution Agreement
On January 5, 2008, Destron Fearing entered into Amendment No. 1 to the Product Supply and Distribution Agreement dated February 13, 2007 (the “Amended Agreement”), by and between Destron Fearing and Intervet/Schering-Plough Home Again LLC (“Intervet/Schering-Plough”). The Amended Agreement governs the terms pursuant to which Destron Fearing has agreed to provide Intervet/Schering-Plough electronic identification microchips and scanners as part of the Home Again® Proactive Pet Recovery Network. During the term of the Amended Agreement, Destron Fearing will exclusively manufacture, supply and sell to Intervet/Schering-Plough and Intervet/Schering-Plough will exclusively purchase from Destron Fearing certain Products (as defined in the Amended Agreement). The Amended Agreement contains, among other things, minimum purchase requirements by Intervet/Schering-Plough. The Amended Agreement prohibits Destron Fearing from manufacturing, supplying or selling the Products to any other person, governmental authority or entity in the Territory (as defined in the Amended Agreement). The initial term began February 13, 2007 for a period of 24 months with an option for Intervet/Schering-Plough to extend the term for an additional 12 months. The Amended Agreement also grants to Intervet/Schering-Plough exclusive distribution, marketing and sale rights to Destron Fearing’s RFID products in the Companion Animal market in the Territory and non-exclusive distribution, marketing and sale rights to Destron Fearing’s RFID Biothermo Product in certain markets subject to a maximum amount of units. In March 2009, the Amended Agreement was extended to June 30, 2009. In January 2010, the Amended Agreement was extended until June 2010 and in December 2010 the agreement was extended to December 31, 2011. There were no material modifications in the extensions.
Destron Fearing’s RME Supply Agreement
Destron Fearing relies on a sole source production agreement with RME, a subsidiary of Raytheon Company for the manufacture of certain of its microchip products. The subsidiary utilizes both Destron Fearing’s and its own equipment in the production of the microchips. On December 15, 2010, Destron Fearing entered into a new production agreement with RME related to the manufacture and distribution of certain of its glass-encapsulated syringe-implantable transponders which expires in December 2013.
GTC Earn Out
On January 14, 2008, we entered into an Agreement and Plan of Merger (“the GTC Agreement”) to acquire Geissler Technologies. Pursuant to the GTC Agreement, there is an earn out payment schedule based on cumulative gross margin over a three year period ending January 14, 2011. The ending calculation of cumulative gross margin resulted in no further earn out payments due under the GTC Agreement. The sellers of Geissler Technologies have notified us that they may request an audit of the cumulative gross margin calculation. If it is subsequently determined that the next cumulative gross margin threshold was met, an earn out payment of $0.5 million would be due. Pursuant to the GTC Agreement, earn out payments can be made in cash or stock at Digital Angel’s option.
16. Profit Sharing Plan
We have a retirement savings plan under section 401(k) of the Internal Revenue Code for the benefit of eligible United States employees. Our employees are eligible to participate in this plan and may elect to contribute a percentage of their salaries. In 2009, we and Destron Fearing discontinued the employer match but have the option of reinstating it when deemed appropriate.
17. Legal Proceedings
For pending legal matters, 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 the outcome of these proceedings will have a material adverse effect on our consolidated financial position.
Rutherford Suit
In October 2010, Andrea Rutherford filed a lawsuit in the District Court of Massachusetts against us and Merck Sharp & Dohme Corporation, affiliated with Intervet/Schering-Plough Animal Health, our exclusive distributor in the U.S. of our companion pet implantable microchips. The lawsuit raises a variety of claims, including breach of implied warranty of merchantability and breach of contract relating to alleged illness caused by implantation of the microchip in plaintiff's companion pet. The plaintiff is seeking compensatory damages and injunctive relief. We believe that the claims are frivolous and without merit and intend to vigorously defend against this claim. Any defense costs are expected to be covered under existing insurance coverage.
Former Officer
On June 19, 2009, Michael Krawitz, a former executive officer, filed a lawsuit (Michael Krawitz v. Digital Angel Corporation Case No. 09-80910-CIV-RYSKAMP/VITUNAC in the U.S. District Court for the Southern District of Florida) against us and several members of our board of directors. The lawsuit alleged a variety of claims relating to the amounts owed to him under his employment agreement. We filed a Motion to Dismiss all claims except the breach of contract claim. In December 2009, the federal court granted our Motion to Dismiss in its entirety and granted Mr. Krawitz leave to re-file his lawsuit in light of the court’s decision. In January 2010, Mr. Krawitz amended his Complaint and re-filed the breach of contract claim against us and filed notice that he voluntarily dismissed all other claims against us and the members of our board of directors. In December 2010, the matter was tried to a jury and the jury found no breach of contract and no damages were awarded. No appeal was filed challenging the jury’s verdict in our favor.
Chemring Suit
In July 2008, our subsidiary Signature filed a claim (number 2008 FOLIO 687 in the London Mercantile Court, Royal Courts of Justice) against Chemring, the seller of the McMurdo business, which was acquired by Signature in April 2007. The three part claim included: an indemnity claim in relation to the costs of repairing faulty McMurdo products sold under Chemring’s ownership, claims for breach of warranty, and a claim that had Chemring disclosed concerns being raised by a major customer for the particular McMurdo product, Signature would not have agreed to waive a minimum purchase obligation on the requirement. We then did not pay the final deferred purchase price payment of approximately £0.5 million on the McMurdo acquisition pending resolution on these warranty claims. Chemring counterclaimed against both Signature and us (as the parent of Signature) (number 2008 FOLIO 718 in the Commercial Court, Royal Courts of Justice), for the deferred purchase price, plus costs and interest, claiming that there is no right to set off warranty claims against the deferred purchase price. In June 2009, the parties agreed upon a mutually satisfactory settlement of this dispute, and a definitive settlement agreement was finalized. As a result of the resolution, the warranty claims were offset against the deferred purchase price and we recorded approximately $0.5 million of other income included in our results from discontinued operations during the year ended December 31, 2009.
Additionally, we are a party to various legal actions, as either plaintiff or defendant, arising in the ordinary course of business, none of which is expected to have a material adverse effect on our business, financial condition or results of operations.
18. Segment Information
We currently operate in two business segments: Animal Identification and Emergency Identification. For further information on our segments and their principal products and services, refer to Note 1.
The accounting policies of our operating segments are the same as those described in the summary of significant accounting policies, except that intersegment sales and transfers are generally accounted for as if the sales or transfers were to third parties at current market. It is on this basis that management utilizes the financial information to assist in making internal operating decisions. We evaluate performance based on stand-alone segment operating income as presented below.
(1)
Depreciation and amortization includes $0.6 million and $1.7 million included in cost of sales in 2010 and 2009, respectively.
For the years ended December 31, 2010 and 2009, Destron Fearing had one customer, Intervet/Schering-Plough which accounted for approximately 12% and 8% of its revenues, respectively.
Goodwill by segment for the years ended December 31, 2010 and 2009 was as follows (in thousands):
Revenues are attributed to geographic areas based on the location of the assets producing the revenue. Information concerning principal geographic areas as of and for the years ended December 31, was as follows (in thousands):
19. Related Party Transactions
Private Placement Sale with Certain Directors
On January 19, 2009, several of our directors agreed to purchase an aggregate of approximately 0.3 million shares of our common stock in exchange for an aggregate of approximately $0.1 million in cash in accordance with the terms of a Private Placement. The purchase price of the shares was $0.50 per share, based on the closing price of our common stock on the prior business day, which was January 16, 2009. The sales were closed on January 20, 2009.
Sale of Thermo Life
On January 21, 2010, we entered into a purchase agreement and licensing agreement with Mr. Ingo Stark, the employee and scientist who was chiefly responsible for the development of Thermo Life’s patented technology, to sell him the remaining assets of Thermo Life for nil and granting him a license on the patents in exchange for any future royalty payments on any products that become commercialized using the patents. Thermo Life has never generated any revenue and has been included in our discontinued operations since 2008. The loss on this transaction was not significant.
Sale of Control Products Group
On January 25, 2010, we entered into an agreement to sell substantially all of the assets of a division known as the Control Products Group, a group within the Clifford & Snell business unit of Signature. The buyer, C&S Controls Limited, is a UK entity controlled by Gary Lawrence, the manager of the Control Products division for the past several years. The purchase price of £0.4 million was represented, in part, by a secured promissory note in the original principal amount of £0.4 million issued from the buyer to Signature, which calls for monthly cash payments for approximately 5 years. Gain recognition may be deferred based on applicable accounting guidance.
20. Restructuring, Severance and Separation Expenses
During 2008, we initiated restructuring efforts to develop a strategic long-range plan focusing on restoring growth and profitability. With our restructuring, we seek to generate annual costs savings by exiting some costly facilities, outsourcing some manufacturing to lower cost suppliers, moving some operations to lower cost countries and headcount reductions. Our purpose in taking these actions is to increase profitability at the gross margin level, which management believes is necessary to competitively price products and achieve positive earnings. Restructuring activities were recorded in accordance with the Exit or Disposal Cost Obligation Topic and the Compensation - Nonretirement Postemployment Benefit Topic of the Codification.
Restructuring charges and asset impairments were (in thousands):
As of December 31, 2010, our restructuring accrual was as follows:
We anticipate the remaining accrual to be paid over the next 15 months.
21. Supplemental Cash Flow Information
The changes in operating assets and liabilities are as follows (in thousands):
We had the following non-cash operating, investing and financing activities (in thousands):
22. Subsequent Events
16% Senior Secured Debenture and Warrants
On February 24, 2011, we entered into a Securities Purchase Agreement (the “Agreement”) with certain investors, including Hillair Capital Investments LLC (the "Investors") whereby we issued and sold (the “Offering”) to the Investors (i) $2.0 million of senior secured Debentures (the “Debentures”), (ii) Series A warrants (the “Series A Warrants”) to purchase up to 4,000,000 shares of our common stock and (iii) Series B warrants (the “Series B Warrants” and collectively with the Series A Warrants, the “Warrants”) to purchase up to 4,000,000 shares of our common stock.
We will be obligated to redeem the Debentures on a quarterly basis beginning on October 1, 2011, in an amount equal to $0.5 million each quarter, until the Debentures maturity date of July 1, 2012. The Debentures accrue interest at a rate of 16% per annum which is due on a quarterly basis beginning on April 1, 2011. Upon any event of default, 125% of the then outstanding principal amount of the Debentures and any accrued interest would become immediately due and payable at the Investors’ election and the annual interest rate would increase to 18%. During the first six months after closing, we may not prepay any portion of the principal amount of the Debentures without the consent of the Investors. After the six month anniversary, we may elect to redeem some or all of the then principal amount outstanding with notice to the Investors at an amount equal to 120% of the then outstanding principal amount. We are subject to certain non-financial covenants under the Agreement.
The 4,000,000 Series A Warrants may be exercised at any time through the maturity date at an exercise price of $0.45 per share and the 4,000,000 Series B Warrants may be exercised at any time for a period of five years at an exercise price of $0.45 per share. If at any time after six months subsequent to the date of the Agreement there is no effective registration statement registering the resale of the shares of common stock underlying the Warrants, the holder of the Warrants may elect to exercise using a net exercise (i.e., cashless exercise) mechanism. If we sell or grant any option to purchase, or sell or grant any right to reprice, or otherwise dispose of or issue any common stock or common stock equivalents at an effective price per share less than $0.45, then simultaneously with the consummation of each dilutive issuance, the Warrant exercise price for both of the Warrants shall be reduced to the lower price. In addition, the number of shares of common stock underlying the Series B Warrants will be increased such that the aggregate value of the Series B Warrants, after taking into account the decrease in the exercise price, shall be equal to the value prior to such adjustment. If we enter into a fundamental transaction that (i) is an all cash transaction, (ii) is a Rule 13e-3 transaction as defined in Rule 13e-3 under the Exchange Act, or (iii) involves a person or entity not traded on a national securities exchange, we or any successor entity shall, at the holder’s request within thirty days after each fundamental transaction (“Holder Option Period”), purchase the Warrants from the holder for an amount of cash equal to the value of the unexercised portion of the warrants that remain as of the time of such fundamental transaction based on the Black Scholes Option Pricing Model obtained from the “OV” function on Bloomberg, L.P (“the Black Scholes Value”). The maximum amount payable under the Black Scholes Value shall be (i) $500,000 if the fundamental transaction is consummated prior to the six month anniversary of the issuance date or (ii) $1,000,000 if the fundamental transaction is consummated subsequent to the six month anniversary but prior to the first anniversary of the issuance date. The Warrants are not exercisable by a holder to the extent that such holder or any of its affiliates would beneficially own in excess of 4.9% of our common stock. We have estimated the initial value of the warrants to be approximately $2.3 million based on a valuation model considering a sensitivity analysis performed to evaluate the impact on value of a potential down round, and using the following assumptions: dividend yield of 0.0%; expected life of sixteen months for the Series A Warrants and five years for the Series B warrants; volatility of 77.58% and 98.09%, respectively; and a risk free rate of 0.26% and 2.19%, respectively.
To secure our obligations under the Debentures, we and Destron Fearing have pledged our ownership interests in Signature. In addition, Signature, Destron Fearing and its wholly-owned subsidiaries Digital Angel Technology Corporation and Digital Angel International, collectively and individually have guaranteed the Debentures.
Mortgage Loan Modification Agreement
On February 25, 2011, we entered into a Loan Modification Agreement (the “Mortgage Agreement”) with our mortgage lender extending the mortgage loan’s term from November 1, 2010 to November 1, 2011, with the option to extend the maturity date for an additional six months. If we elect to extend the maturity date, we must notify the current mortgage lender by September 30, 2011 and pay a fee of $25 thousand which would be applied to the outstanding principal. Under the Mortgage Agreement, the interest rate and monthly payments will remain the same as prior to the mortgage loan maturity. Upon closing, we were required to pay an additional principal payment of $25 thousand plus certain other closing fees. We are also required to make an extension payment of approximately $25 thousand which will be paid ratably over four months beginning March 1, 2011.
Amounts due during the year ending December 31, 2011 are classified as current debt.
We have evaluated subsequent events through the date the Form 10-K was filed.
Exhibit Index