Embrex, Inc (EMBX) - Description of business

Symbol:	EMBX
SIC:	2836 - Biological Products, (No Disgnostic Substances)
Type:	NASDAQ
State location:	NC
State of Inc:	NC
Business Address:	1040 SWABIA COURT DURHAM NC 27703 9199415185
Mailing Address:	PO BOX 13989 RESEARCH TRIANGLE PK NC 27709

GENERAL

Embrex, Inc., the In Ovo Company® (“Embrex” or the “Company”), is an international biotechnology company engaged in the development of innovative in ovo (“in the egg”) solutions that meet the needs of the global poultry industry. The Company’s unique integration of several scientific and engineering disciplines enables it to be the leading provider of in ovo , value-added solutions with its automated injection and detection devices as well as certain select vaccines. Embrex is focused on developing patented biological and mechanical products that improve bird health, help reduce production costs and provide other economic benefits to the poultry industry. The Company was incorporated in 1985 in North Carolina and is headquartered in the Research Triangle Park, North Carolina area.

Embrex has developed and commercialized the Inovoject® system, a proprietary, automated in-the-egg injection system that can process 20,000 to 70,000 eggs per hour and eliminates the need for manual, post-hatch injection of certain vaccines. The Inovoject® system is designed to inject vaccines and other compounds into targeted compartments within the egg. Some of these in ovo vaccines are marketed by Embrex while others are marketed by third parties. Embrex primarily markets the Inovoject® system through lease arrangements with commercial poultry producers, charging a fee for each egg processed. The Company is also marketing the Egg Remover® system and Vaccine Saver® option to provide additional automation benefits to the poultry hatchery. The Egg Remover® system works alone or in conjunction with the Inovoject® system to remove infertile and early-dead eggs from incubator trays prior to transfer to the hatching incubator or inoculation through the Inovoject® system. The Vaccine Saver® option for the Inovoject® system identifies infertile and early-dead eggs and selectively prevents vaccination of these eggs.

In addition to the Inovoject® system and related devices, Embrex has developed an antigen-antibody complex technology (“AAC”), formerly known as VNF®, a concept that has been useful in the development of certain avian vaccines. Based on AAC, the Company has developed and is marketing Bursaplex® for protection against avian infectious bursal disease (“IBD”). The Company has developed Newplex™ for protection against Newcastle disease, which is also based on AAC technology. Embrex is also developing various other proprietary mechanical and biological products to improve bird health, reduce bird production costs and provide other economic benefits to the poultry industry, including Inovocox™ for protection against coccidiosis. These products are in various stages of development, and some are being developed or manufactured in collaboration with major animal health companies, federal agencies, major poultry producers and leading universities in the field of avian science. All biological products are designed for in ovo application.

EXISTING PRODUCTS

Inovoject® Egg Injection System and Other Devices

Embrex has developed and commercialized a proprietary, automated in-the-egg injection system, which can process 20,000 to 70,000 eggs per hour and eliminates the need for manual, post-hatch injection of certain vaccines. This proprietary system, called the Inovoject® system, is designed to inject vaccines and other compounds in precisely calibrated volumes into targeted compartments within the egg. Embrex primarily markets the Inovoject® system through lease arrangements with commercial poultry producers, charging a fee for each egg processed. Vaccines and other compounds injected using the Inovoject® system may be produced or distributed to the commercial poultry producers by Embrex, in which case Embrex receives additional compensation for such compounds. Currently, substantially all of the vaccines and other compounds injected using the Inovoject® system are supplied to producers directly by third parties.

In 2005, the Company installed the Inovoject® system in a number of hatcheries and continued operating Inovoject® systems in substantially all of the hatcheries converted prior to 2005. The Company estimates that its Inovoject® system inoculates approximately 85% of all eggs produced for the United States and Canadian broiler poultry markets, and it expects limited growth in the number of egg injections and only minor Inovoject® system revenue growth in this market. Therefore, the Company is expanding its Inovoject® system, Egg Remover® system and Vaccine Saver® option installations and vaccine product sales in worldwide markets to realize sustainable overall revenue growth. The Company estimates that approximately 75% or more of the world broiler production occurs outside the United States.

During 2005, the Company placed a number of Inovoject® systems for trial and on contract at locations outside the United States and Canada. Currently, the Company has Inovoject® systems either operating on contract or on trial in 34 countries, including the U.S. and Canada. Overall, the placement of Inovoject® systems outside the United States and Canada is dependent on market acceptance of various in ovo vaccines and obtaining regulatory approval of these vaccines in numerous countries.

The Company’s revenues attributable to international operations in 2005, 2004 and 2003 were 37%, 34% and 32% of the Company’s consolidated revenues, respectively. The Company’s identifiable assets attributable to international operations in 2005, 2004 and 2003 were 23%, 22% and 18% of the Company’s consolidated assets, respectively. The Company’s gross profit attributable to international operations in 2005, 2004 and 2003 was 26%, 15% and 14% of the Company’s consolidated gross profit, respectively. See “Segments” under Note 1 of “Notes to Consolidated Financial Statements” for further discussion of the Company’s revenues from international operations. See “Our Future Growth Depends on Expansion of International Revenues and We Will Be Subject to Increased Risks in the International Marketplace” under Item 1A, “Risk Factors,” for additional information on the risks associated with international operations.

Embrex developed the Egg Remover® system that works alone or in conjunction with the Inovoject® system to remove infertile and early-dead eggs from incubator trays. The Egg Remover® system continued to have commercial success with installation and revenue growth in all of the Company’s marketing regions in 2005. The Company anticipates continued growth in Egg Remover® system revenues during 2006. Embrex’s Vaccine Saver® option for the Inovoject® system identifies infertile and early-dead eggs and selectively prevents vaccination of these eggs. It is designed for use in select markets where vaccine prices are high.

Certain poultry diseases are more prevalent in some geographic regions than in others, and in those regions, the prevalence of particular diseases may fluctuate from year to year. For example, Marek’s disease, for which the Inovoject® system primarily is used in the United States, is not as widespread in Europe as in North America. Infectious bursal disease (also known as Gumboro disease) is prevalent in Northern Europe, the Middle East, Asia, parts of Latin America and, to a lesser extent, the United States. The Company expects that the primary usage of its Inovoject® systems will vary by geographic region according to the prevailing diseases. Regulatory approval and market acceptance of vaccines for in ovo delivery are other factors that affect the usage of Inovoject® system by region. There are a number of poultry vaccines and other compounds marketed by various animal health companies in the United States and other markets that can be used with the Inovoject® system or post-hatch. Usage of the Inovoject® system, Egg Remover® system and Vaccine Saver® option is influenced by the relative cost and demand for these vaccines, customer willingness to use in ovo delivery of vaccines, as well as willingness to replace post-hatch vaccines with in ovo vaccines.

Device revenues from the Company’s Inovoject® system, Egg Remover® system and Vaccine Saver® option were $48.7 million, $46.2 million and $43.5 million during 2005, 2004 and 2003, respectively.

AAC Technology (Antigen-Antibody Complex Technology)

AAC technology is a concept that allows safe in ovo administration of moderately attenuated viruses. By using the AAC technology to form virus-antibody complex vaccines, safe and effective immunization is generally possible in a single step, thus reducing or eliminating the need for multiple vaccinations. The presence of the antibody delays onset of virus replication without compromising the virus’s ability to stimulate the immune system. Prior to 2004, Embrex referred to the AAC technology as virus neutralizing factor, or VNF®. The Company believes AAC more accurately describes the technology and has used that terminology since 2004.

The AAC technology is the subject of five issued U.S. patents and several foreign patents and foreign patent applications. The U.S. patents are owned by the University of Arkansas and exclusively licensed to Embrex for avian use on a royalty basis for the life of the patents. See “Patents and Proprietary Rights” below for additional information on the Company’s AAC patents. The Company’s vaccine for infectious bursal disease, Bursaplex®, and the Company’s Newcastle disease vaccine, Newplex ™ , described below, were developed based on the AAC technology.

Infectious Bursal Disease (“IBD”) Vaccine - Bursaplex®

AAC technology has been used in the Company’s Bursaplex® vaccine, which combats IBD, an infectious disease that weakens a bird’s immune system. Birds infected by IBD virus typically exhibit poor growth or can succumb to other diseases because of a compromised immune system. This disease is currently widespread in Northern Europe, the Middle East, Asia, Latin America and, to a lesser extent, the United States. Various existing IBD vaccines can be administered in ovo , post-hatch via day of age injection or by drinking water. The Company estimates the worldwide market for IBD vaccines is approximately $55 million annually.

To date, approval to sell Bursaplex® has been received in 33 countries. Currently, Bursaplex® vaccine is being marketed in most of the countries where regulatory approval has been obtained. Pending regulatory approvals are being sought in Latin American, Middle Eastern and Asian markets for in ovo and post-hatch use of Bursaplex® vaccine.

Newcastle Disease (“ND”) Vaccine - Newplex™

The registration application for Newplex™, Embrex’s in ovo vaccine that immunizes against ND, was also developed based on AAC technology and received U.S. Department of Agriculture (“USDA”) approval in May 2003. ND is a contagious and sometimes fatal viral respiratory disease affecting all species of birds. Birds infected with ND typically exhibit respiratory problems, lower egg production and increased flock mortality. Currently, ND vaccines containing live or dead viruses are used as an important part of the programs to manage ND. These vaccines are typically administered by several methods including spray cabinets in the hatchery, drinking water, eye drop and hand-held sprayers in the field. To date, approval to sell Newplex™ has been received in nine countries. Embrex is pursuing additional approvals for Newplex™ in key markets worldwide, particularly in Asia, Latin America, the Middle East and South Africa, where ND is more prevalent. Although this product has received approval for sale in countries outside the U.S., there is no assurance that approvals in other markets will be granted, that supplies will be available or that Newplex™ will be sold in commercial quantities in the U.S. or in any of the other countries where approval has been obtained. The Company estimates that the worldwide market for products that control ND is approximately $40 million per year.

PRODUCTS UNDER DEVELOPMENT

Embrex is developing, independently and in collaboration with others, additional products and devices which address poultry health and performance needs in ovo . These additional products are in various stages of development. There can be no assurance that Embrex will successfully develop or market any of these products. Also, there is no assurance regulatory approval will be obtained. Marketing products developed jointly with others may require royalty or other payments by Embrex to its co-developers.

Coccidiosis Vaccine – Inovocox™

The Company is developing a novel in ovo vaccine, Inovocox™, for immunization against coccidiosis. Coccidiosis is caused by a protozoan parasite, which attacks the gut of the chicken, causing significant problems with intake and digestion of feed and, therefore, the physical and economic performance of the bird. Currently, virtually all broiler chickens, and most poultry in general, receive treatments using compounds called anticoccidials, which are incorporated into poultry feed. Over the years, coccidia have developed levels of resistance to many of these

compounds, which have not only reduced their effectiveness, but have forced the poultry industry to continually evaluate and modify treatment programs. Additionally, in certain countries and regions, environmental and food safety groups are lobbying to have anticoccidials removed from the market. Embrex believes that these factors will lead to a change in the market such that coccidiosis vaccines will be favored over anticoccidials, but there is no assurance that such a change will occur. Currently, a limited number of live vaccines have been developed and are administered orally soon after hatch. However, due to difficulties in providing a precise oral dose to each bird, growth depression and non-uniformity can occur in broiler flocks. Using its Inovoject ® system technology and its knowledge of avian embryology, the Company is developing a novel, efficacious and cost-effective vaccine for coccidiosis control in broiler chickens. This program is aimed at overcoming many of the problems associated with current practices. The Company estimates that the worldwide market for products that control coccidiosis is approximately $300-350 million per year.

In March 2004, Embrex substantially completed construction of a $14.7 million coccidiosis vaccine manufacturing facility located in Scotland County, North Carolina for the purpose of manufacturing Inovocox™. USDA approval will be necessary for both the Inovocox™ vaccine and the coccidiosis vaccine manufacturing facility. In December 2005, the Company submitted its application to the USDA for approval of the Inovocox™ vaccine. Delays in obtaining either the vaccine or manufacturing facility approval may adversely affect the marketing of and the ability to receive revenues from Inovocox™. Marketing this product outside the U.S. will also require Embrex to pursue separate approvals from regulatory agencies in other countries. See “Production—Inovocox™ In Ovo Coccidiosis Vaccine” below for further discussion of Inovocox™ production.

Gender Sorting Device

As previously announced during the second quarter of 2005, Embrex determined to scale back its efforts to automate avian gender sorting. Embrex believes that the market opportunity for its gender sorting technology is substantial, and that steady progress has been made on a very complex project, with key targets achieved in sampling, hatch and assay on a laboratory basis and limited egg numbers in its multi egg prototype. However, the cost and time associated with scale-up to a commercial device and process remain unclear. After weighing the opportunities provided in the near term by Embrex’s vaccine market, the Company’s current and future investment on Inovocox™, and international expansion, particularly in Latin America, against the uncertainty of successful commercialization of Gender Sort, Embrex believes it is in the Company’s best interests to suspend this project for the time being so that Embrex can focus its efforts and financial resources on those other opportunities. Embrex will continue to monitor technological developments potentially applicable to Gender Sort and will reevaluate Gender Sort’s financial prospects from time to time as compared to the Company’s other opportunities.

The Company’s financial statements in Item 8 reflect the impact of a Credit Agreement with Advanced Automation, Inc. (“AA”) of Greenville, S.C., which Embrex entered into in April 2001. Under that agreement, Embrex agreed to loan AA up to $3.4 million in connection with development and construction of a gender sorting automation multi-egg system (“Gender Sort system”). The Company also entered into a Development and Supply agreement with AA in September 2001 and a Services Agreement in April 2003. In April 2003, Embrex and AA agreed to rollover the $2.5 million outstanding principal and accrued interest under the Credit Agreement that had matured April 1, 2003 into a seven-year 6% fixed-rate collateralized term loan (the “Term Loan”). Subsequently, in December 2003, the Company acquired the first Gender Sort system developed exclusively for Embrex by AA for $2.3 million, AA repaid the Term Loan in the same amount and the related Services Agreement between Embrex and AA to build the first Gender Sort system was terminated. A related Development and Supply Agreement between the two companies remains in effect. The Company accounted for the purchase of the Gender Sort system as a write-down and recorded it as a research and development expense of $2.3 million.

PATENTS AND PROPRIETARY RIGHTS

Embrex controls (either through direct ownership or exclusive license) 47 issued U.S. patents, 15 pending U.S. patent applications, 174 issued foreign patents and 100 pending foreign patent applications. The Inovoject® system utilizes a process of injecting viral, bacterial or fungal vaccines into avian eggs that was patented in the United States by the USDA in 1984 (the “Sharma Patent”). Embrex held the exclusive license to this patent through its expiration in June 2002. Embrex has supplemented this process with seven additional issued U.S. patents (and numerous foreign patents and patent applications) covering specific design features of the Inovoject® system as well as Embrex’s Egg Remover® system and Vaccine Saver® option. The last of these patents will expire in 2018.

Embrex has exclusive rights to method-of-use patents for the in ovo administration of AAC vaccines and other compounds to elicit various beneficial responses in poultry. The AAC technology is the subject of five issued U.S. patents and numerous foreign patents and foreign patent applications. These patents and applications are owned by the University of Arkansas and exclusively licensed to Embrex for avian use on a royalty basis for the life of the

patents. The last of these U.S. patents for AAC viral vaccines will expire in 2012. Of these U.S. patents, one was issued in 1991 and two were issued in 1995 for methods of treating IBD virus infections using AAC technology, including in ovo administration; one patent claiming the use of AAC vaccines in non-human primates was issued in 1999; and a further U.S. patent claiming use of AAC vaccines in any animal was issued in 2001 These patents and additional patent applications encompass the use of AAC vaccine compounds regardless of the source of the AAC. These AAC patents and patent applications additionally include composition-of-matter claims to AAC vaccines against IBD virus disease, and composition-of-matter claims to AAC vaccines for combating viral diseases in any animal.

The Company acquired an exclusive worldwide license from Pfizer, Inc. (“Pfizer”) to three patent families owned by Pfizer that cover the process of vaccination in ovo against coccidiosis. Two patents were issued in the European Union in March and June 2001, two were issued in the United States in December 2002, and two further patents were issued in the United States in September 2003 and January 2006. Embrex made initial payments to Pfizer in 2004 to acquire the license and is obligated to make future royalty payments to Pfizer based on actual product sales. Since then, Embrex has filed patent applications related to additional process improvements in vaccine production. Continued development of the product has demonstrated that Inovocox™ can be simultaneously delivered to the embryo with Marek’s disease vaccine or Bursaplex® bursal disease vaccine. Additionally, the vaccine is delivered uniformly due to the use of the Inovoject® system.

Embrex continues its efforts to patent methods of delivering compounds in ovo , including early intervention methods and devices. During the years 2000 through 2005, 30 U.S. patents were issued or allowed, further expanding Embrex’s proprietary position with respect to in ovo technology. The Company filed nine new U.S. patent applications in 2002, nine new U.S. patent applications in 2003, three new U.S. applications and nine U.S. provisional patent applications in 2004 and six new U.S. patent applications and eight U.S. provisional patent applications in 2005. During 2005, Embrex also filed numerous foreign patent applications. Each application covered various aspects of in ovo technology. Embrex’s competitors or potential competitors may have filed for, or may have received, U.S. and foreign patents and may obtain additional patents and proprietary rights relating to in ovo technology, vaccines, uses or processes that may compete with Embrex’s existing products and products under development. Accordingly, there can be no assurance that Embrex’s patent applications will result in patents being issued or that, if issued, the claims of the patents will afford protection against competitors with similar technology; nor can Embrex be sure that others will not obtain patents that Embrex would need to license or circumvent in order to practice Embrex’s inventions.

In addition to patent rights, Embrex has registered the trademarks Embrex®, Inovoject®, VNF®, Bursaplex®, Vaccine Saver®, Egg Remover®, and The In Ovo Company®, in the United States and certain foreign countries. Embrex has also applied for U.S. and several foreign registrations of other trademarks and service marks including Newplex™, Inovocox™ and Inovometrix™. In addition, Embrex has executed confidentiality agreements with its collaborators, subcontractors and employees.

See “Competition” below and Item 3, “Legal Proceedings,” below for further discussion of the Company’s efforts to use its patents and proprietary rights to protect its market position.

COMPETITION

The Company estimates that its Inovoject® system inoculates approximately 85% of all eggs produced for the U.S. and Canadian broiler poultry markets. In addition, the Company has Inovoject® systems either operating on a contract or trial basis in 32 additional countries. The competition for the Inovoject® system primarily is the manual, post-hatch administration of biological products, which was the primary method of administration prior to market acceptance of the Inovoject® system. Post-hatch administration remains the primary method of delivery of biological products in many foreign markets. In addition, Embrex is aware of four companies that are marketing in ovo injection systems to poultry companies. Although there has not been widespread commercial acceptance of any of these competing systems, the Company is aware of direct competition for customers and limited commercial placements by some of these companies, including with some of our customers. Embrex believes that it will continue to compete effectively against other companies based on performance of products, pricing, quality, product features and customer service. In order for the Company to expand placements of the Inovoject® system worldwide, the Inovoject® system and in ovo products must continue to be accepted within the foreign markets and perform as intended under long-term commercial conditions.

The Inovoject® system utilizes a process that was patented in the United States by the USDA in 1984. Embrex held the exclusive license to this Sharma Patent until June 2002, when the Sharma Patent expired. Embrex owns seven additional issued U.S. patents and numerous foreign patents covering specific design features of the Inovoject® system as well as Embrex’s Egg Remover® system and Vaccine Saver® option. Embrex relies on these patents to

protect its intellectual properties and to afford a competitive advantage. In the event that Embrex believes that a competitive system infringes any Embrex patent, the Company plans to take all appropriate steps to protect its patent rights. These matters are discussed in more detail under “Patents and Proprietary Rights” above and Item 3, “Legal Proceedings,” below.

The majority of Embrex’s revenues are derived from lease fees received from commercial poultry producers for use of its Inovoject® system, rather than from sales of Embrex’s vaccines. In marketing its vaccines, the Company competes with much larger animal health companies that typically market a broad range of vaccines and other animal products. Embrex’s strategy is to develop and market in ovo delivered vaccines which compete effectively against other vaccines based on factors such as efficacy and cost-effectiveness. Competition for the Company’s in ovo vaccines comes primarily from vaccines that are administered post-hatch. Embrex’s Bursaplex® vaccine for IBD primarily competes with vaccines that are administered post-hatch either manually through injections or in drinking water. Newplex™, Embrex’s vaccine for Newcastle disease, is designed to compete with vaccines that are administered through drinking water, eye drop or spraying. Embrex’s Inovocox™ vaccine for coccidiosis, for which USDA approval is pending, would compete with anticoccidials that are incorporated into poultry feed and to a lesser extent with vaccines that are administered after hatch. The Company completed construction of a vaccine manufacturing facility for Inovocox™ in March 2004. Embrex believes that the marketplace is developing such that sales of coccidiosis vaccines could grow, but there is no assurance that this will occur or that Embrex will obtain necessary regulatory approvals for Inovocox™ and the manufacturing facility. Overall, in order for the Company to expand sales of its in ovo vaccines, these vaccines must obtain necessary regulatory approvals and be commercially accepted worldwide, and the Inovoject® system must also continue to be accepted in the marketplace.

PRODUCTION

General

Embrex currently outsources production of nearly all its mechanical devices and vaccines and expects to continue to do so for the foreseeable future. The Company believes that alternative sources of manufacturing and supply generally exist for products currently manufactured for Embrex by contract manufacturers. In addition, the Company expects to begin to manufacture Inovocox™ in its Embrex Poultry Health LLC coccidiosis vaccine manufacturing facility in Scotland County, North Carolina, once the USDA approves the Inovocox™ vaccine and grants facility licensure to manufacture Inovocox™.

Inovoject® System, Egg Remover® System and Vaccine Saver® Option

Embrex’s in-house engineering staff designs the Inovoject® system, Egg Remover® system and Vaccine Saver® option, which incorporate certain proprietary mechanical, pneumatic and electronic sub-systems and concepts. The Company uses one contract manufacturer, Precision Automation Company, Inc. (“Precision”), to fabricate its Inovoject® and Egg Remover® systems. While other machine fabricators exist and have constructed limited numbers of these devices, a change in fabricators could cause a delay in manufacturing and a possible delay in the timing of future Inovoject® and Egg Remover® system installations and revenues from those installations. The Vaccine Saver® option is assembled in the manufacturing area at the Company’s corporate headquarters from components that are purchased from multiple vendors.

AAC Vaccines (Antigen-Antibody Complex Vaccines)

Since 1993, Charles River Laboratories, Inc., through its SPAFAS Avian Products Services Division (“SPAFAS”), has supplied Embrex with the bursal disease antibody (“BDA”) component for Bursaplex® vaccine. In January 2004, Embrex signed a new agreement with SPAFAS under which SPAFAS will continue to supply the Company’s requirements for BDA through 2006. In connection with this agreement, Embrex seeks to maintain appropriate inventory levels and places orders with SPAFAS to allow Embrex to satisfy anticipated customer demand for the Bursaplex® vaccine. The regulatory approval granted by the USDA for Bursaplex® vaccine in 1997 specifically covers vaccines produced with SPAFAS-manufactured BDA. Additional agreements covering the Company’s needs for Newcastle disease antibody (“NDA”) for the Company’s Newplex™ vaccine for the next four years are in negotiation with SPAFAS.

The Company has a non-exclusive manufacturing agreement with Merial Select, Inc. (“Select”) (a Merck and Sanofi-Aventis company) under which Select manufactures, in the United States, the Company’s Bursaplex® vaccine for Embrex to market worldwide. Abic Ltd. (“Abic”) has been granted similar rights to manufacture and market an IBD AAC vaccine, known as GuMBryo™, in Israel. The Company has also granted Lohmann Animal Health International (“LAHI”) non-exclusive rights to manufacture the Company’s Newcastle vaccine, Newplex™, in the United States, which is based on Embrex’s AAC technology. The manufacture of vaccines by Select, Abic

and LAHI, along with the manufacture of specific vaccine antibodies by SPAFAS, generally must be performed in licensed facilities or under approved regulatory methods. Although the Company believes that there are other manufacturers who should be capable of manufacturing Bursaplex®, Newplex™ and the related BDA and NDA components, a change of supplier for the Company could adversely affect Embrex’s future operating results due to the time it would take a new supplier to obtain regulatory approval of its production process or manufacturing facilities. The Company seeks to minimize this exposure through multi-year supply agreements and the maintenance of appropriate inventories.

Inovocox ™ In Ovo Coccidiosis Vaccine

In March 2004, the Company substantially completed construction of a coccidiosis vaccine manufacturing facility located in Scotland County, North Carolina, at a cost to date of $14.7 million. The facility is designed to manufacture the Company’s Inovocox™ in ovo coccidiosis vaccine upon approval from the USDA. The site includes a main manufacturing facility, poultry brooder houses and a facility for the initial steps of the production process. Certain aspects of the novel manufacturing process are unique and proprietary to Embrex.

See “Products Under Development—Coccidiosis Vaccine—Inovocox™” above for further discussion of Inovocox™.

MARKETING AND DISTRIBUTION

Because of the geographical and industrial concentration of the poultry industry in the United States and other global markets, Embrex markets its products and provides ongoing service directly to commercial poultry producers. Embrex’s marketing is focused principally on the broiler chicken segment of the poultry industry, but the Company also has adapted its products for use by, and initiated trials and entered into commercial contracts with, broiler breeder companies and a limited number of layer and turkey producers. Market acceptance of the Inovoject® system generally follows the large-scale integration of poultry production in a market. Therefore, the Company generally focuses on customers in markets that are currently integrating poultry production or have the potential to do so. In addition, the Inovoject® and Egg Remover® systems have been marketed to human flu vaccine producers, who use the systems to inject influenza seed strains into eggs that are used in the flu vaccine production process and to candle eggs before injection.

To protect the Company’s intellectual property, address customer needs and encourage proper use of the Inovoject® system technology within an appropriate production environment, Embrex generally leases and licenses, rather than sells, Inovoject® and Egg Remover® systems and the Vaccine Saver® option to hatcheries. The lease agreements cover the use of the mechanical equipment and ongoing field service, maintenance and technical support provided by Embrex. The agreements include a license with royalty fees payable for use of Embrex’s proprietary injection process. Also, in a very limited number of markets, under specific circumstances, Embrex may sell the Inovoject® and Egg Remover® systems to a distributor or to a human flu vaccine manufacturer. Vaccines and other compounds, which are delivered in ovo , are sold separately by Embrex, and also by third parties.

The Company has agreements with parties to distribute the product in a number of countries in which regulatory approval for Bursaplex® has been granted.Subject to these distribution agreements, the Company will also distribute Bursaplex® directly, outside the United States.

Embrex has expanded operations into selected Asian and Latin American markets and installed Inovoject® systems on a commercial or trial basis into these markets. In 1998, Embrex established Embrex BioTech Trade (Shanghai) Co., Ltd. in China, to focus on marketing and distribution of Embrex products in China. Also in 1998, Embrex established Embrex Inc. Sucursal Argentina, a branch office in Argentina, responsible for commercial development and customer service and support. In 1999, Embrex established a subsidiary in Brazil, Inovoject do Brasil Ltda. In 2001, Embrex established subsidiaries in France and Spain to market and service Inovoject® systems in those countries. In 2004, the Company established an office in Mexico and began marketing, servicing and supporting Inovoject® systems and other devices. This office is also responsible for marketing Bursaplex® and initiating the registration process for Newplex™ in Mexico.

RESEARCH AND DEVELOPMENT EXPENDITURES

Research and development (“R&D”) expense was $12.5 million in 2003, $10.5 million in 2004 and $10.7 million in 2005. The increase in R&D expense from 2004 to 2005 was due primarily to higher Embrex Poultry Health expenses related to pre-licensing serials of Inovocox™, while the decrease in R&D expense from 2003 to 2004 largely reflects the write-down of the Gender Sort system purchased from AA, which increased R&D expenses by $2.3 million in 2003.R&D is principally Company sponsored and funded primarily from internal sources and

supplemented by grant and other sources of funds as appropriate. The Company’s R&D expenses include expenditures from the following groups: R&D, which is responsible for the work on the Company’s product portfolio, particularly the Newplex™ and Inovocox™ vaccines; Global Product Development & Supply, which is responsible for development and testing of commercial machine devices and supply of vaccine products, including start-up of the Embrex Poultry Health manufacturing facility for the production of Inovocox™; and finally Engineering and Manufacturing, which makes design modifications and improvements to the Company’s devices, as well as final assembly and testing prior to installation of a Company device at a customer’s hatchery. See “Products Under Development” above for further discussion of the Company’s research and development efforts.

See “Operating Expenses” under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for additional information on R&D expenditures.

GOVERNMENTAL APPROVALS AND REGULATION

Regulation by governmental authorities in the United States and other countries is a significant factor in the production and marketing of Embrex’s products and in its on-going R&D activities. Although the use of the Inovoject® system or its other devices are not subject to regulatory approval in the United States, animal health products being developed by Embrex and other companies must receive approval for marketing from either the USDA or the Food and Drug Administration (the “FDA”) and from similar regulatory agencies in foreign countries where the Company has begun or contemplates doing business. These countries also may require approval of the Inovoject® system or its other devices. Regulatory agencies require that products be tested and demonstrate appropriate levels of safety and efficacy. Generally, with respect to animal health products in the United States, the USDA has regulatory authority over products which are biological in origin or which stimulate or affect an animal’s immune system and the FDA has authority over all other animal health products. The time and cost for USDA approvals are generally less than those for FDA approvals. FDA approvals generally require more extensive animal and toxicology testing than USDA approvals and may take five or more years to obtain, whereas USDA approvals generally take one to three years to obtain. In December 2005, the Company submitted its application to the USDA for approval of the Inovocox™ vaccine. The Company currently has no products under development that would require approval by the FDA.

The Company believes that compliance with environmental regulations currently has no material adverse effect on its capital expenditures, earnings or competitive position.

EMPLOYEES

At December 31, 2005, Embrex employed 309 persons, 304 of whom were full-time employees, an increase of 3 persons or 1% from the 301 full-time employees at December 31, 2004.

During 2005, the Company increased field service staffing levels related to expanding device installations, especially in Latin America. Similarly, the Company increased production staffing levels at its Inovocox™ manufacturing facility. The Company, however, has maintained or reduced staffing levels elsewhere in conjunction with managing mandated expenses and redefined R&D priorities.

SIGNIFICANT CUSTOMERS

Tyson Foods, Inc. (“Tyson”) accounted for approximately 17% of Embrex’s consolidated 2005 revenues. Based on millions of pounds of ready-to-cook poultry meat produced in 2005, Tyson accounted for approximately 23% of the broilers grown in the United States. The only other customer representing greater than 10% of total consolidated revenues is Pilgrim’s Pride Inc. (“Pilgrim’s”), representing 11% of consolidated 2005 revenues. Pilgrim’s accounted for approximately 15% of the broilers grown in the United States, based on millions of pounds of ready-to-cook poultry meat produced in 2005. Embrex’s three largest customers, including Tyson and Pilgrim’s, accounted for approximately 33% of consolidated 2005 revenues, down from 36% and 37% in 2004 and 2003, respectively. Revenues from Tyson and Pilgrim’s are primarily associated with the United States operations of Embrex’s business.

AVAILABLE INFORMATION

Embrex maintains an Internet website, www.embrex.com, which contains additional information concerning the Company. Although the Company endeavors to keep its Internet website current and accurate, there can be no guarantees that the information on the Internet website is up to date or correct. Embrex makes available free of charge through its Internet website its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports

on Form 8-K, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and beneficial ownership reports filed by officers, directors and principal security holders under Section 16(a) of the Securities Exchange Act of 1934 as soon as reasonably practicable after Embrex electronically files such material with, or furnishes it to, the Securities and Exchange Commission (“SEC”). Information on the Company’s Internet website is not part of or incorporated into this report on Form 10-K.

ITEM 1A. RISK FACTORS

If any of the following risks occur, our business, financial condition or results of operations could be materially adversely affected.

OUR FUTURE GROWTH DEPENDS ON EXPANSION OF INTERNATIONAL REVENUES AND WE WILL BE SUBJECT TO INCREASED RISKS IN THE INTERNATIONAL MARKETPLACE

We estimate that our Inovoject® system inoculates approximately 85% of all eggs produced for the U.S. and Canadian broiler poultry markets. Given this market penetration, we expect only limited growth in the number of system installations and only minor system revenue growth in this market. Additionally, due to our market penetration and the significance of the U.S. and Canadian poultry markets to our revenue, any adverse conditions in these markets could have a material and adverse effect on our revenues. For this reason, we must expand our device installations and product sales in markets outside the United States and Canada in order to realize revenue growth. In 2005, international sales accounted for 37% of our consolidated revenues. In 2004 and 2003, international sales accounted for 34% and 32% of our consolidated revenues, respectively. Revenue growth outside the United States and Canada depends on gaining and preserving market acceptance of our devices and in ovo administration of vaccine products in markets outside the United States and Canada to treat prevailing poultry diseases in those markets. Lack of market acceptance of our devices and in ovo products in these markets would materially adversely affect our revenue growth. Our operating expenses associated with operations outside the United States and Canada historically have been relatively higher as a percentage of revenues than similar costs for operations inside the United States and Canada. Accordingly, we believe that international sales may result in decreased gross margins for Embrex.

International sales are also subject to a variety of risks, including risks arising from the following:

• exchange rate risks (including risk associated with the translation of our subsidiaries’ financial results into U.S. Dollars and transaction risk), tariffs, trade barriers and taxes;

• adverse changes in local investment or exchange control regulations, potential restrictions on the flow of international capital and the possibility of confiscatory taxation, price controls or the taking or modification of our property rights by a country in the exercise of its sovereignty;

• economic and political conditions beyond our control, including country-specific conditions such as political instability, government corruption and civil unrest;

• the risk that we may not be granted a renewal license due to regulatory changes or other reasons with respect to current product registrations in certain foreign countries that are subject to periodic re-registration; and

• trade restrictions and economic embargoes imposed by the United States and other countries.

OUR FUTURE GROWTH ALSO DEPENDS ON THE DEVELOPMENT AND MARKET ACCEPTANCE OF NEW PRODUCTS

In addition to international expansion, we need to develop and market new products to continue to generate increased revenues and growth of our business. We currently are developing, both independently and in collaboration with others, various products that address poultry health and performance needs. These products are being designed to be delivered in ovo through the Inovoject® system or in conjunction with the Inovoject® system and are in various stages of development. We may increase, decrease or eliminate funding for any product under development at any time depending on our assessment of our priorities, available funding, the probability that the product can be successfully commercialized, potential return on investment and other factors. There is no guarantee that any new products will be successfully developed and marketed. In addition, we have not initiated the regulatory approval process for some of these potential products, and we cannot assure you that regulatory approval will be obtained. Our inability to develop new products or any delay in our development of these products may materially adversely affect our revenue growth. Because of a number of factors, a new product may not reach the market

without lengthy delays, if at all. Some of the factors that may affect our development and marketing of new products include the following:

• our research and evaluations of compounds and new technologies may not yield product opportunities;

• potential products may involve extensive and time-consuming clinical trials to demonstrate safety and effectiveness, and the results of such trials are uncertain;

• potential products may require collaborative partners and we may be unable to identify partners or enter into arrangements on terms acceptable to us;

• we may not be able to produce or contract for the manufacture of new products at a cost or in quality or quantities necessary to make them commercially viable;

• domestic and international regulatory approval of these products may not be obtained or may be obtained only with lengthy delays;

• we may not be able to secure additional financing that may be needed to bring a potential product to market;

• we may experience unexpected safety, regulatory or efficacy concerns with respect to marketed products, whether or not scientifically justified, leading to adverse public reaction, product recalls, withdrawals or declining sales;

• marketing products developed jointly with other parties may require royalty payments or other payments by us to our co-developers, which may materially adversely affect our profitability;

• we may be unable to accurately predict market requirements and evolving standards; and

• we may not be able to attract and retain sufficient numbers of qualified development personnel.

We have developed and commercialized two devices that work with the Inovoject® system: the Egg Remover® and Vaccine Saver®. The Egg Remover® can also be used without an Inovoject® system in specific situations where customers do not need injection services. These two devices have had initial success; however, there is no guarantee that acceptance of these devices will continue to grow.

In December 2005, we filed for USDA regulatory approval with respect to our in ovo coccidiosis vaccine, Inovocox ™ . Although this product is in the regulatory review process, there is no assurance that USDA approval will be obtained. Marketing this product in non-U.S. countries will require us to pursue separate approvals from foreign regulatory agencies. We completed construction of a vaccine manufacturing facility, Embrex Poultry Health, in the first quarter of 2004 to commercially produce the Inovocox ™ vaccine. Construction costs for Embrex Poultry Health to date are approximately $14.7 million. In addition to USDA approval for Inovocox ™ , our coccidiosis vaccine manufacturing facility must receive a separate USDA approval to manufacture the Inovocox ™ vaccine. We cannot assure you that the facility will receive USDA approval to manufacture Inovocox ™ . Delays in obtaining either product or manufacturing facility approvals may materially adversely affect our marketing of, and our ability to receive revenues from, Inovocox ™ . Additionally, even if we receive USDA product and facility approvals, we cannot assure you that Inovocox ™ supplies will be available, that Inovocox ™ will be sold in commercial quantities or that product sales will be sufficient to offset our investment in development of the product and construction of the Inovocox ™ vaccine manufacturing facility.

We have developed and commercialized AAC, which is technology that we use in our Bursaplex® vaccine. Bursaplex® has been sold in commercial quantities during the past six years, and we currently have approval to sell it in 33 countries. However, there is no assurance that supplies will continue to be available or that the product will continue to be sold in commercial quantities.

In May 2003, the USDA provided regulatory approval of Newplex ™ , our in ovo Newcastle Disease vaccine, within the United States. Newplex ™ vaccine is also based on AAC technology. We are now seeking regulatory approval for Newplex ™ in key markets worldwide. Although we have received approval to sell Newplex™ in nine countries, there is no assurance that approvals in other markets will be granted, that supplies will be available or that Newplex ™ will be sold in commercial quantities in the United States or in any of the other countries where approval has been obtained.

There can be no assurance that we will successfully complete the development and commercialization of any new products, or that any of these new products will meet revenue and profit expectations if developed and commercialized.

ECONOMIC FACTORS AFFECTING OUR CUSTOMERS MAY ADVERSELY AFFECT OUR FINANCIAL RESULTS

Our revenues principally come from leases and sales to the poultry industry. If there is a general economic decline in that industry, our operations and financial condition could be materially and adversely affected. Also, domestic and global economic factors beyond our control may adversely impact our customers and, as a result, our revenues and earnings. Examples of these factors include the following:

• fluctuations in the prices of energy and poultry feed;

• disease outbreaks that adversely affect poultry production, including avian influenza;

• market demand for poultry products, including the supply and pricing of alternative proteins;

• costs to comply with applicable laws and regulations, including those relating to environmental protection, food safety, market regulation and genetically modified organisms or ingredients;

• product recalls and related adverse publicity and consumer reaction;

• access to foreign markets together with foreign economic conditions, including currency fluctuations and trade restrictions; and

• the extent to which our cost of products and operating expenses increase faster than contractual price adjustments with our customers.

For example, if rising poultry feed prices increase the production costs of commercial poultry producers or a foreign government bans the importation of U.S. chicken, these producers may reduce poultry production. This decreased production could adversely impact our revenues, since a principal component of our revenues are fees charged to customers for the number of eggs injected or processed by Embrex devices.

WE FACE RISKS OF COMPETITION AND CHANGING TECHNOLOGY

The Inovoject® system uses a process that was patented in the United States by the USDA in 1984. We held the exclusive license to the Sharma Patent until June 2002, when the Sharma Patent expired. With the expiration of the Sharma Patent, competitive in ovo delivery systems are being developed and marketed. Embrex is aware of four companies that are marketing in ovo injection systems to poultry companies. Although there has not been widespread commercial acceptance of any of these competing systems, we are aware of direct competition for customers and limited commercial placements by some of these companies, including with some of our customers. Increased competition could result in lower prices for our products, reduced demand for our products and a corresponding reduction in our ability to recover development, engineering, manufacturing and service costs. Also, a significant portion of our revenues comes from a relatively small number of customers. If we lose one or more large customers due to competition, our revenues could be significantly lower. Any of these developments could have a material adverse effect on our business, results of operations and financial condition.

The poultry vaccine business is especially competitive and dominated by a few large companies with an established global presence. In order for us to expand our sales of in ovo vaccines, these products must be commercially accepted worldwide and compete effectively against the vaccines of these other companies. Our inability to compete successfully in the poultry vaccine sector could materially adversely affect our revenue growth.

Our competitors and potential competitors include independent companies that specialize in biotechnology, as well as major agricultural or animal health companies, pharmaceutical companies, chemical companies, universities and public and private research organizations. Many of these competitors are well established and have substantially greater marketing, financial, technological and other resources than we have. Competitors may succeed in developing technologies and products that are more effective than any that have been or are being developed by us or that could render our technology and products obsolete or non-competitive.

THE LOSS OF KEY CUSTOMERS COULD ADVERSELY AFFECT OUR FINANCIAL RESULTS

Historically, a significant portion of our revenues has come from a relatively small number of customers. Tyson accounted for approximately 17% and 18% of our consolidated 2005 and 2004 revenues, respectively. The only other customer representing greater than 10% of total consolidated revenues is Pilgrim’s, representing 11% and 12% of consolidated 2005 and 2004 revenues, respectively. As with many of our customers, we have short-term contracts with Tyson and Pilgrim’s. Our top three customers, including Tyson and Pilgrim’s, accounted for approximately 33% and 36% of our consolidated 2005 and 2004 revenues, respectively. We expect a similar level

of customer concentration to continue in future years. The poultry market is highly concentrated, with the largest poultry producers dominating the market. For example, in 2005, Tyson and Pilgrim’s supplied approximately 23% and 15% of all broilers grown in the United States, respectively. The concentration of our revenues with these large customers means factors affecting those customers also will impact our revenues and earnings. If we lose a large customer and fail to add new customers to replace lost revenues, our operating results will be materially and adversely affected. Also, if these customers reduce the number of eggs they incubate at hatcheries, we will receive lower device revenues since our fees are based on the number of eggs injected.

IF WE LOSE THE PROTECTION OF OUR PATENTS AND PROPRIETARY RIGHTS, OUR FINANCIAL RESULTS COULD SUFFER

Importance and Limitations of Patent and Proprietary Rights Protections

Some of our products and processes used to produce our products involve proprietary rights, including patents. We own some of the technologies employed in these processes, and some are owned by others and licensed to us. The Inovoject® system utilizes a process that was patented by the USDA in the United States. We held an exclusive license to the Sharma Patent until it expired in June 2002. We have supplemented the Sharma Patent with additional U.S. and foreign patents and have submitted additional patent applications covering specific design features of the Inovoject® system, as well as Embrex’s Egg Remover® system and Vaccine Saver® option. Our competitors or potential competitors may have filed for or received United States and foreign patents and may obtain additional patents and proprietary rights relating to in ovo technology, vaccines, uses and/or processes which may compete with our existing products and our products under development. Accordingly, we cannot assure you that our patent applications will result in patents being issued or that, if issued, the claims under our patents will afford protection against competitors with similar technology. We cannot be sure that others will not obtain patents of different technology that we would need to license or circumvent in order to practice our inventions. Even though we strive to take appropriate action to protect our intellectual property, there is a risk that competitive systems currently being developed and marketed could gain acceptance in the United States or elsewhere.

We believe that patent protection of materials or processes we develop and any products that may result from the research and development efforts of our licensors and us are important to the commercial success of our products. The loss of the protection of these patents and proprietary rights could materially adversely affect our business and our competitive position in the market. The patent position of companies such as ours generally is highly uncertain and involves complex legal and factual questions. Some of the reasons for this uncertainty include the following:

• To date, no consistent regulatory policy has emerged regarding the breadth of claims allowed in biotechnology patents. Consequently, there can be no assurance that patent applications relating to our products or technology will result in patents being issued or that, if issued, the patents will afford protection against competitors with similar technology;

• Some patent licenses held by us may be terminated upon the occurrence of specified events or become non-exclusive after a specified period;

• Companies that obtain patents claiming products or processes that are necessary for or useful to the development of our products could bring legal actions against us claiming infringement (though we currently are not the subject of any patent infringement claim);

• Issuance of a valid patent does not prevent other companies from using alternative, non-infringing technology, so we cannot be sure that any of our patents (or patents issued to others and licensed to us) will provide significant commercial protection;

• We may not have the financial resources necessary to obtain patent protection in some countries or to enforce any patent rights we may hold;

• The laws of some foreign countries may not protect proprietary rights to the same extent as the laws of the United States, and many companies have encountered significant problems in protecting their proprietary rights in these foreign countries;

• We may be required to obtain licenses from others to develop, manufacture or market our products. We may not be able to obtain these licenses on commercially reasonable terms, and we cannot be sure that the patents underlying the licenses will be valid and enforceable; and

• We also rely upon unpatented, proprietary technology, which we may not be able to protect fully if others independently develop substantially equivalent proprietary information or techniques, improperly gain access to our proprietary technology or disclose this technology to others.

We attempt to protect our proprietary materials and processes by relying on trade secret laws and non-disclosure and confidentiality agreements with our employees and other persons with access to our proprietary materials or processes or who have licensing or research arrangements with us. We plan to continue to use these protections in the future, but we cannot be sure that these agreements will not be breached or that we would have adequate remedies for any breach. Even with these protections, others may independently develop or obtain access to these materials or processes, which may materially adversely affect our competitive position.

If we are sued for infringing the patent or other proprietary rights of a third party, we could incur substantial costs and diversion of management and technical personnel, whether or not the litigation is ultimately determined in our favor.

For a description of the patent litigations in which we have been involved, see Item 3, “Legal Proceedings.”

WE DO NOT MANUFACTURE MOST OF OUR DEVICES OR ANY OF OUR VACCINE PRODUCTS AND ARE DEPENDENT ON ONE CONTRACT MANUFACTURER FOR INOVOJECT® AND EGG REMOVER® DEVICES AND ANOTHER CONTRACT MANUFACTURER FOR AAC PRODUCTION. WE ARE ALSO DEPENDENT ON SINGLE CONTRACT MANUFACTURERS FOR PRODUCTION OF BOTH BURSAPLEX® AND NEWPLEX™

General Risks Associated with Reliance on Contract Manufacturers

We currently do not have facilities for the production of most of our devices and vaccine products. Therefore, we rely principally upon relationships with contract manufacturers. There can be no assurance that we can maintain manufacture and supply agreements on terms and at costs acceptable to us. We have various relationships with manufacturers and suppliers, including those described below. The loss of any of these relationships could materially adversely affect our operating results. There are a number of risks associated with our dependence on contract manufacturers, including:

• reduced control over delivery schedules;

• potential inability to monitor and maintain inventory levels;

• reduced control over quality assurance;

• reduced control over manufacturing yields and costs;

• potential lack of adequate capacity during periods of unanticipated demand;

• limited warranties on products supplied to us;

• increases in prices at a higher rate than our ability to recover our increased costs through contractual price adjustments with our customers;

• reduced control over regulatory efforts;

• potential misappropriation of our intellectual property;

• catastrophic loss of production capacity due to property damage, either man made or by nature;

• the loss of these contract manufacturers due to financial circumstances in their respective businesses or their exit from the business lines that manufacture our devices and products; and

• minimum purchase requirements, which could result in excessive inventories if the demand for products falls short of such minimum purchase requirements.

If our contract manufacturers failed to provide us with an adequate supply of finished devices or vaccine products, our business would be harmed. We do not have long-term contracts or arrangements with several of our vendors that guarantee product availability or the continuation of particular payment terms. In addition, we are currently dependent on a single contract manufacturer for several of our key products as described below. Although we believe our relationship with each of the manufacturers is sound, we cannot assure you that we will continue to maintain relationships with them or that they will continue to exist.

Inovoject® and Egg Remover® Systems

We rely on Precision to fabricate all of our Inovoject® and Egg Remover® systems. While other machine fabricators exist and have constructed limited numbers of Inovoject® systems, we do not currently have alternative sources for production of either the Inovoject® or Egg Remover® systems. If Precision is unable to carry out its manufacturing obligations to our satisfaction, we may be unable to obtain alternative manufacturing, or to obtain such manufacturing on commercially reasonable terms or on a timely basis. Any delays in the manufacturing process may adversely impact our ability to meet commercial demands for Inovoject® and Egg Remover® system installations and delay receipt of revenues from those installations.

Vaccines and AAC Technology

We obtain all of our requirements for the active ingredient in AAC technology from Charles River Laboratories, Inc. through SPAFAS. Under our agreement with SPAFAS, we are required to purchase minimum amounts of AAC-based antigen on an annual basis. The manufacture of AAC must be performed in licensed facilities and is subject to USDA regulation. The regulatory approvals granted by the USDA for Bursaplex® in January 1997 and for Newplex ™ in May 2003 specifically cover vaccines produced with SPAFAS-manufactured AAC. Although there are other manufacturers that may be capable of manufacturing AAC, we do not currently have alternative sources for production of AAC.

Currently our supplier for Bursaplex® is Select and our supplier of Newplex ™ is LAHI. The manufacture of all vaccine products must be performed in licensed facilities, under approved regulatory methods. As the USDA licensed manufacturers of record, Select holds the USDA permit for Bursaplex® and LAHI holds the USDA permit for Newplex ™ . Although there are other manufacturers that should be capable of manufacturing avian viral vaccines, we do not currently have alternative sources for production of either product.

If SPAFAS, Select or LAHI is unable to carry out its respective manufacturing obligations (described above) to our satisfaction, we may be unable to obtain alternative manufacturing, or to obtain such manufacturing on commercially reasonable terms or on a timely basis. A change of any of our suppliers could materially adversely affect our future operating results due to the time it would take a new supplier to obtain regulatory approval by the USDA of its production process or manufacturing facilities. Current regulatory approvals in foreign countries are or will be based on product manufactured with AAC as manufactured by SPAFAS, Bursaplex® as manufactured by Select or Newplex ™ as manufactured by LAHI. A change of manufacturer would result in the need to reapply for regulatory approval in those countries and may lead to suspended sales of that product until new approvals could be secured. Any delays in securing new approvals would have a material adverse effect on our revenues and growth prospects. We cannot guarantee that we would be able to secure new approvals in every country or that such approvals would be granted in a timely fashion.

WE FACE RISKS RELATED TO COMPLIANCE WITH LAWS IMPACTING CORPORATE GOVERNANCE AND FINANCIAL REPORTING STANDARDS

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”), new Public Company Accounting Oversight Board standards and rules, new SEC regulations, and new Nasdaq National Market rules, are creating uncertainty and expense for companies such as ours. These new or changed laws, regulations and standards are complex and extensive, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies, which could result in evolving disclosure and corporate governance practices. As a result, our efforts to comply with evolving laws, regulations and standards have resulted in, and are likely to continue to result in, increased general and administrative expenses and management time related to compliance activities. In particular, our efforts to comply with Section 404 of Sarbanes-Oxley and the related regulations regarding our assessment of our internal controls over financial reporting and our external auditors’ audit of that assessment has required the commitment of significant financial and managerial resources. We expect these efforts to require the continued commitment of significant resources including additional outside legal, accounting and advisory services. In addition, as our international operations continue to grow and foreign operations become financially significant, it will be necessary for those foreign subsidiaries to meet requirements for internal control over financial reporting pursuant to Section 404 of Sarbanes-Oxley. Due to the limited staffing at some of our foreign subsidiaries, there is no assurance that we would be able to meet requirements for internal control over financial reporting, particularly requirements for segregation of duties. If we fail to comply with new or changed laws, regulations and standards, our reputation may be harmed and we might be subject to sanctions or investigation by regulatory authorities, such as the SEC. Any such action could adversely affect our financial results and the market price of our Common Stock.

WE FACE THE RISK THAT WE MAY NEED TO MAKE ADDITIONAL CONTRIBUTIONS TO OUR 401(K) PLAN

Historically, under our 401(k) Plan, we have based participant and employer contributions on participants’ salaries. In the third quarter of 2005, we discovered that the 401(k) Plan documents prepared by our third party administrator provide (and we believe incorrectly) that other elements of compensation be included when determining the appropriate contributions. Our intent has always been that contributions be based only on base salary. We intend to seek approval to conform the 401(k) Plan document retroactively to our intent and practice. Should this relief not be granted, we believe we would be required to make additional contributions to the 401(k) Plan for participants who had not already reached the maximum contribution. We are unable to estimate at this time the amount of additional contributions that potentially could be required and for what time periods. We are not able to predict whether any additional contributions would have a material and adverse effect on our historical or future financial statements.

POULTRY HEALTH AND DISEASE FACTORS AFFECTING OUR CUSTOMERS MAY ADVERSELY AFFECT OUR FINANCIAL RESULTS

Any widespread poultry health problem or disease outbreak, such as avian influenza in poultry, could have a negative impact on global poultry production. Our revenues and earnings derived from both the U.S. and international poultry industry could be materially and adversely affected. In addition, the emergence of new disease variants, serotypes and strains in the domestic and/or global markets may reduce the efficacy of our vaccine products and result in reduced revenues and earnings.

WE ARE DEPENDENT ON DISTRIBUTORS IN CERTAIN MARKETS

We market and distribute our devices principally by leasing and licensing the systems directly to hatcheries. In some markets, such as Japan, we instead rely upon distributors for our devices. We also rely on third parties to market certain of our vaccine products, such as products containing AAC technology, and we may enter into other arrangements in the future. There can be no assurance that we can maintain these relationships on terms acceptable to us. The loss of any of these relationships could materially adversely affect our operating results. There are a number of risks associated with our dependence on distributors and other third parties including:

• reduced control over regulatory efforts, which may delay local regulatory approvals and thus market introduction;

• reduced control over marketing and sales efforts and in turn the extent of resulting market penetration or acceptance;

• reduced control over distribution and related customer satisfaction; and

• potential delays in distribution associated with securing new distributors, including the possible need to seek re-registration in markets where a distributor may hold product registration, if current relationships are not maintained.

THE LOSS OF KEY COLLABORATORS, SUPPLIERS AND OTHER KEY PARTIES COULD ADVERSELY AFFECT OUR FINANCIAL RESULTS

We currently conduct our operations with various third-party collaborators, suppliers, licensors or licensees. We plan to continue developing these relationships and believe our present and future collaborators, suppliers, licensors and licensees will perform their obligations under their agreements with us, based on an economic motivation to succeed. However, financial or other difficulties facing these parties may affect the amount and timing of funds and other resources devoted by the parties under these agreements. In addition, disagreements may arise with these third parties which could delay or lead to the termination of the development or commercialization of new products, or result in litigation or arbitration, which would be time-consuming and expensive. Thus, there is no assurance that we will develop any new products or generate any revenues from these collaborative agreements.

WE ARE SUBJECT TO AN INHERENT RISK OF PRODUCT LIABILITY

The development, manufacture, distribution and marketing of our products involve an inherent risk of product liability claims and associated adverse publicity. These claims may be made even with respect to those products that are manufactured in licensed and approved facilities or that otherwise possess regulatory approval for commercial sale. These claims could expose us to significant liabilities that could prevent or interfere with the development and marketing of our products. Product liability claims could require us to spend significant time and money in litigation or pay significant damages. Although we currently maintain liability insurance that we believe is adequate to cover our potential exposure in this area, there can be no assurance that the coverage limits of our policies will be adequate. Such insurance is expensive, difficult to obtain and may not continue to be available on acceptable terms or at all.

GOVERNMENT REGULATION AND THE NEED FOR REGULATORY APPROVAL MAY ADVERSELY AFFECT OUR BUSINESS

Regulatory approval required in various areas of our business may materially adversely affect our operations. The primary emphasis of these requirements is to assure the safety and effectiveness of our products. While the use of the Inovoject ® system is not subject to regulatory approval in the United States, it may require regulatory approval by foreign agencies. Also, research and development activities and the investigation, manufacture and sale of poultry health products are subject to regulatory approval in the United States by either the USDA or the FDA and state agencies, as well as by foreign agencies. Obtaining regulatory approval is a lengthy, costly and uncertain process. Approval by the USDA generally takes one to three years, while approval by the FDA may take five or more years. In December 2005, the Company submitted its application to the USDA for approval of the Inovocox™ vaccine. We currently have no products under development that would require approval by the FDA. Various problems may arise during the regulatory approval process and may have an adverse impact on our operations. Changes in the policies of U.S. and foreign regulatory bodies could increase the time required to obtain regulatory approval for each new product. Delays in obtaining approval may materially adversely affect the marketing of, and the ability to receive revenues and royalties from, products developed by us. There is no assurance that any future products developed by us or by our collaborative partners will receive regulatory approval without lengthy delays, if at all. Even when approved, regulators may impose limitations on the uses for which the product may be marketed and may continue to review a product after approving it for marketing. Regulators may impose restrictions and sanctions, including banning the continued sale of the product, if they discover problems with the product or its manufacturer.

Pursuant to some of our licensing or joint development agreements, the licensees or joint developers bear the costs associated with the regulatory approval process for some products. We plan to continue to enter into these types of agreements in the future. If we cannot generate sufficient funds from operations or enter into licensing or joint development agreements to develop products, we may not have the financial resources to complete the regulatory approval process with respect to all or any of the products currently under development.

Other regulations apply or may apply to research and manufacturing activities, including federal, state and local laws, regulations and recommendations relating to the following:

• safe working conditions;

• laboratory and manufacturing practices; and

• use and disposal of hazardous substances used in conjunction with research activities.

It is difficult to predict the extent to which these or other government regulations may adversely impact the production and marketing of our products.

OUR INABILITY TO ATTRACT AND RETAIN KEY PERSONNEL COULD ADVERSELY AFFECT OUR BUSINESS

We must continue to attract and retain experienced and highly educated scientific and management personnel and advisors to be able to develop marketable products and maintain a competitive research and technological position. Competition for qualified employees among biotechnology companies is intense. There can be no assurance that we will be able to continue to attract and retain qualified staff. The departure of any key executive or our inability to recruit and retain key scientific or management personnel could have an adverse effect on our business, results of operations or financial condition. Our ability to replace key individuals may be difficult and may take an extended period of time because of the limited number of individuals in the biotechnology industry with the breadth of skills and experience required to develop and commercialize products successfully. Competition to hire from this limited pool is intense, and we may be unable to hire, train, retain or motivate such individuals.

IF WE CANNOT CONTINUE TO PROVIDE TIMELY SUPPORT AND MAINTENANCE TO OUR CUSTOMERS, OUR BUSINESS MAY SUFFER

We are required to supply, support and maintain large numbers of Inovoject ® systems at our customers’ hatcheries on a timely basis at a reasonable cost to us. There can be no assurance that we will be able to continue to provide these services on a timely or cost-effective basis. If we are unable to do so, our customers may reduce their use of our products, which could materially adversely affect our operating results.

WE HAVE ANTI-TAKEOVER DEFENSES THAT COULD DISCOURAGE OR DELAY A TAKEOVER

Provisions of our certificate of incorporation and bylaws could have the effect of discouraging or delaying an acquisition of our company. For example, the Board of Directors has the authority to issue up to 15,000,000 shares of Preferred Stock in one or more series and to determine the designations, preferences and relative rights and qualifications, limitations or restrictions of the shares constituting any series of Preferred Stock. The issuance of Preferred Stock by the Board of Directors could affect the rights of the holders of Common Stock. For example, an issuance could result in a class of securities outstanding that would have preferences with respect to voting rights and dividends and in liquidation over the Common Stock and could (upon conversion or otherwise) enjoy all of the rights applicable to Common Stock. The authority of the Board of Directors to issue Preferred Stock potentially could be used to discourage attempts by others to obtain control of us through merger, tender offer, proxy contest or otherwise by making these attempts more difficult to achieve or more costly. The Board of Directors may issue the Preferred Stock without shareholder approval and such Preferred Stock could have voting and conversion rights that could materially adversely affect the voting power of the holders of Common Stock. No agreements or understandings currently exist for the issuance of Preferred Stock, and the Board of Directors has no present intention to issue any Preferred Stock. The Board adopted a shareholder rights plan that could have the effect of discouraging a takeover of us. The rights plan, if triggered, would make it more difficult to acquire us by, among other things, allowing existing shareholders to acquire additional shares of Common Stock at a substantial discount, thus substantially inhibiting the ability of an interested party to obtain control of our company.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.