Equity compensation expense included in R&D expenses amounted to $114 thousand in the first six-months of 2006 and $40 thousand in the first six-months of 2005. Depreciation expense of the Embrex Poultry Health facility and related manufacturing equipment was $0.2 million in the first half of 2006. $0.5 million of this department’s expenses were capitalized in 2005 related to validation costs for USDA pre-licensing serials of Inovocox™ vaccine for the Embrex Poultry Health facility. Without this capitalization, R&D expenses for the first half of 2006 would have shown a decrease of an additional $0.5 million, for a reduction of 15% from the first half of 2005.
Net other income decreased from $216 thousand in the first-half of 2005 to $84 thousand in the first-half of 2006. The reduction results primarily from interest expense related to the term loan for construction of Embrex Poultry Health, which was not reflected in the second quarter 2005 interest expense totals, as that interest cost was capitalized as part of the construction cost of the facility.
Interest income totaled $112 thousand for the first six-months of 2006, a $48 thousand increase in comparison to the same period of 2005. The increase in interest income is mainly due to higher cash balances held in non-U.S. regions, where higher interest rates prevail.
Interest expense in the first six-months of 2006 increased four-fold over the same period of 2005 to $125 thousand. This increase is primarily due to interest for the Embrex Poultry Health construction term loan that was previously capitalized prior to licensure of the EPH facility and Inovocox™ vaccine.
Other income totaled $97 thousand in the first half of 2006, an $80 thousand decrease in comparison to the same period one year ago. The other income in both periods is primarily related to foreign currency transaction gains and losses.
Income taxes totaled $590 thousand for the first half of 2006, a $108 thousand decrease from $698 thousand for the same period in 2005. The reported tax rate for the first half of 2006 was 29% in comparison to the 27% reported tax rate for the first half of 2005. In the first six months of 2006, withholding taxes were $243 thousand, and accounted for 12 percentage points of the 29% effective tax rate. U.S. and non-U.S. income taxes were $347 thousand and accounted for 17 percentage points of the 29% effective tax rate. In the first six months of 2005, withholding taxes amounted to $316 thousand, or 12 percentage points of the 27% effective tax rate. U.S. and non-U.S. income taxes were $382 thousand, or 15 percentage points of the 27% effective tax rate.
First-half 2006 income tax expense decreased $0.1 million in comparison to the first half of 2005. This was primarily due to lower pre-tax net income and reduced foreign withholding taxes from the first six months of 2005 to the same period of 2006. Partially offsetting these reductions was an income tax increase caused by a difference between individual discrete events that occurred in both the first half of 2006 and 2005. During the first six months of 2006 the Company filed an election to change the U.S. tax classification of one of its subsidiaries. As a result of this election, an adjustment was recorded that increased the deferred tax asset and reduced the provision for income taxes. The tax benefit related to this adjustment was approximately $0.4 million and was recorded as a discrete benefit in the first half of 2006. In the first half of 2005 a tax benefit of $0.5 million was recorded from the filing of amended tax returns. The returns were amended to reflect the Company’s claim for the extraterritorial income exclusion in 2001 and 2002.
LIQUIDITY AND CAPITAL RESOURCES
At June 30, 2006, the Company’s cash and cash equivalents balances totaled $1.6 million compared to $2.0 million at December 31, 2005.
During the first six-months of 2006, more than $6.1 million of cash flow was generated by operating activities. Of this, $1.4 million was generated by net income and $3.8 million in cash flows from operations was related to depreciation and amortization. Non-cash equity-based compensation charges provided $0.5 million, and the balance was primarily a result of reductions in working capital.
Cash from operations was invested in $7.9 million of capital expenditures, of which $4.5 million or approximately 57% was used to acquire revenue generating devices, such as Inovoject® and Egg Remover® systems. Approximately $0.7 million was invested in Embrex Poultry Health equipment, another $0.9 million was invested in patents and intellectual property protection, and the remainder was invested in other capital items.
Approximately $0.9 million was provided from the issuance of Common Stock related to the exercise of stock options and purchases under the Company’s Employee Stock Purchase Plan. In addition, the Company recognized a $0.2 million income tax benefit related to equity-based compensation.
Drawdown on the short-term revolving line of credit provided $0.1 million, while repayments of long-term debt used to fund most of the Inovocox™ manufacturing facility consumed $0.2 million.
Consequently, the Company consumed $0.8 million of cash during the second quarter of 2006.
The Company obtained a $9.0 million construction/term loan from BB&T in August 2003 that was used for building and equipping the Embrex Poultry Health coccidiosis vaccine manufacturing facility located in Scotland County, North Carolina. At June 30, 2006, $8.4 million of the construction/term loan was outstanding.
The Company has a $6.0 million secured revolving line of credit with BB&T, which may be used for working capital purposes. The term of this line of credit has been extended to May 2007, and the Company anticipates BB&T will renew this credit facility for a renewal term beyond May 2007. The line of credit carries an interest rate of the current LIBOR plus 1.45%, which has been reduced 15 basis points since the first quarter of 2006. At June 30, 2006, the Company’s outstanding borrowings under this credit facility were $0.1 million.
Based on its current operations, management believes that the Company’s available cash and cash equivalents, together with cash flow from operations and its bank line of credit, will be sufficient to meet its cash requirements as these currently exist. However, Embrex may continue to explore additional alternative funding opportunities with respect to collaborative ventures and product expansion and would evaluate its cash requirements as appropriate.
Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
Market risk is the risk of potential loss arising from adverse changes in market rates and prices. The Company’s primary market risk exposure is in changes in foreign currency exchange rates. Approximately 37%, 34% and 32% of Embrex’s revenues for the years ended December 31, 2005, 2004 and 2003, respectively, were derived from the Company’s operations outside the United States. The Company’s consolidated financial statements are denominated in U.S. Dollars and, accordingly, changes in the exchange rates between foreign currencies and the U.S. Dollar will affect the translation of the Company’s subsidiaries’ financial results into U.S. Dollars for purposes of reporting the Company’s consolidated financial results. From December 31, 2005 to June 30, 2006, the Pound Sterling and Euro appreciated 8% and 6% against the U.S. Dollar, respectively.
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Certain Asian and Latin American currencies appreciated against the U.S. Dollar as well, particularly the Brazilian Real, which appreciated 3% against the U.S. Dollar during the same period. If average exchange rates during first-half 2006 had remained the same as the average exchange rates for these currencies during the first-half 2005, the Company’s revenues for the first six-months of 2006 would have been approximately $26.4 million instead of $26.5 million, representing a year-to-year growth rate of 2% as compared to the actual exchange-adjusted growth rate of 3%.
Accumulated currency translation adjustments recorded as a separate component of shareholders’ equity were $0.8 million at June 30, 2006 as compared with $0.3 million at December 31, 2005. This increase was mainly attributable to the overall weakening of the U.S. Dollar with respect to the currencies in which the Company has an exchange rate risk. The primary contributor to the change in currency translation adjustments was the Latin America region, specifically Brazil.
In addition to currency translation risk described above, the Company is subject to transaction risk. Transaction risk is the risk of potential loss arising from adverse changes in exchange rates from the date invoices are issued until the receipts are collected. Most of Embrex’s transaction risk resides in the Company’s largest subsidiary, Embrex Europe, where accrued revenues are recorded in the functional currency, British Pounds. However, most of Embrex Europe’s revenues are invoiced in U.S. Dollars or Euros. When revenues are collected, there is a risk that changes in the respective exchange rates could cause the amount collected (when converted to British Pounds) to be less than originally accrued. As the Company’s business grows in other markets, such as Brazil, it expects that transaction and translation risk may increase in these markets. To date, the Company has not utilized any derivative financial instruments or other hedging instruments to affect this exposure.
As of June 30, 2006, the Company’s exposure to market risk for a change in interest rates is related to debt outstanding under the term loan used for construction and equipping of the Inovocox ™ manufacturing facility and the short-term revolving line of credit. At June 30, 2006, the variable rate debt outstanding that was exposed to fluctuations in the market rate of interest under the term loan totaled $8.4 million. The variable rate debt outstanding that was exposed to fluctuations in the market rate of interest under the line of credit totaled $0.1 million. The definitive extent of the Company’s interest rate risk under this term loan is not quantifiable or predictable because of the variability of future interest rates and business financing requirements. Based on the current balance outstanding, an increase in the LIBOR of 100 basis points would increase the Company’s annualized interest expense by approximately $0.1 million.
Item 4. | Controls and Procedures |
Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to provide reasonable assurances that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to management, including the Company’s Chief Executive Officer and Vice President, Finance and Administration (the Company’s Chief Financial Officer), as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable assurances of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
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An evaluation was carried out under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer believe, as of the end of the period covered by this report, the Company’s disclosure controls and procedures are effective in that they provide reasonable assurances that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms.
Changes to Internal Control Over Financial Reporting
We routinely review our internal control over financial reporting and from time to time make changes intended to enhance the effectiveness of our internal control over financial reporting. The Company made no changes in its internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ending June 30, 2006 that have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting. The Company has comprehensively assessed its financial controls related to a subsidiary operation that has become material to its financial reporting for the fiscal year ended December 31, 2005. Activities to strengthen the control environment are underway and are anticipated to be completed during the fiscal quarter ending September 30, 2006.
PART II - OTHER INFORMATION
In December 2003, Embrex filed suit in the U.S. District Court for the Eastern District of North Carolina against Breuil S.A. (“Breuil”) of Landivisiau, France, and New Tech Solutions, Inc. of Gainesville, Georgia, asserting patent infringement. Embrex alleges that each of the defendants’ development of candling and in ovo selective injection devices, designed to compete with Embrex’s patented Inovoject® system injection with Vaccine Saver® option and Egg Remover® system, infringes two Embrex patents related to Embrex’s proprietary apparatus and methods for distinguishing live eggs from infertile or “dead” eggs and for selectively injecting specific eggs identified as suitable for inoculation as well as the apparatus performing this function. Embrex seeks injunctive relief and monetary damages and has asked for a jury trial. The defendants have denied infringement and alleged that Embrex’s two patents are invalid. Fact discovery is nearly completed. The court conducted a Markman hearing to determine the meaning and scope of the patent claims. The court issued a Markman opinion adopting Embrex’s claim construction. Breuil filed a motion for summary judgment on patent marking. Embrex opposed the motion. The court granted Breuil’s motion as to both patents for the Vaccine Saver® option, and denied Breuil’s motion as to one patent for the Egg Remover® system. Breuil also filed a motion for leave to file a supplemental answer and counterclaims to include an alleged affirmative defense of patent misuse, a counterclaim for alleged federal antitrust liability, and a counterclaim for alleged trade secret misappropriation. The court granted the motion. Embrex answered the supplemental counterclaims denying any liability and asserting affirmative defenses. Embrex filed a motion for summary judgment of infringement, and a motion for summary judgment of patent validity. Briefing on the motions is completed. The court’s decision is pending. Because of this lawsuit, the Company’s results of operations have been impacted and will continue to be impacted by the costs of pursuing this litigation. Moreover, there can be no assurance the Company will prevail in its claims against Breuil S.A. or New Tech Solutions, Inc. Even if the court finds in Embrex’s favor, the Company has no assurances that any damage award will exceed the Company’s costs of pursuing this litigation or that the Company would be able to collect any damages from either defendant.
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In August 2004, Embrex filed suit in the U.S. District Court for the Middle District of North Carolina against AviTech, LLC (“AviTech”) of Hebron, Maryland asserting patent infringement. Embrex alleges that AviTech’s injection system, designed to compete with the Company’s patented Inovoject® system, infringes one of the Company’s patents related to the Company’s proprietary apparatus and methods for accurately and precisely injecting eggs to the same depth and location when the eggs are of varying sizes and may be presented to the injection apparatus in somewhat different orientations. The Company seeks injunctive relief and monetary damages and has asked for a jury trial. The defendant denied that the North Carolina court has jurisdiction and moved to dismiss or, in the alternative, for transfer to the United States District Court in Maryland. The Company opposed the defendant’s motion. The court heard oral argument on the motion, granted the defendant’s motion in part and transferred the case to the U.S. District Court for the District of Maryland, Northern Division, where AviTech filed a complaint against Embrex for a declaratory judgment of alleged patent invalidity, patent noninfringement, patent unenforceability and monetary damages based on an alleged antitrust claim. Embrex filed a motion to dismiss AviTech’s declaratory judgment claims. The court granted the motion with respect to the antitrust claim, and allowed Avitech to file a motion to replead with the necessary particularity. Discovery is ongoing. Because of this lawsuit, the Company’s results of operations have been impacted and will continue to be affected by the costs of pursuing this litigation. Moreover, there can be no assurance the Company will prevail in its claims against AviTech or that the Company will be able to successfully defend against AviTech’s claims. Even if the court finds in the Company’s favor, the Company has no assurances that any damage award will exceed the Company’s costs of pursuing this litigation or that the Company would be able to collect any damages from the defendant.
For a description of patent infringement proceedings initiated by the Company and related legal proceedings, see the Company’s Form 10-K for the year ended December 31, 2005 filed with the Securities and Exchange Commission on March 8, 2006, and the Company’s Form 10-Q for the quarterly period ended March 31, 2006, filed with the Securities and Exchange Commission on May 9, 2006.
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.
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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; |
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| • | 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; |
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| • | economic and political conditions beyond our control, including country-specific conditions such as political instability, government corruption and civil unrest; |
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| • | 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 |
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| • | 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; |
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| • | potential products may involve extensive and time-consuming clinical trials to demonstrate safety and effectiveness, and the results of such trials are uncertain; |
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| • | potential products may require collaborative partners and we may be unable to identify partners or enter into arrangements on terms acceptable to us; |
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| • | 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; |
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| • | domestic and international regulatory approval of these products may not be obtained or may be obtained only with lengthy delays; |
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| • | we may not be able to secure additional financing that may be needed to bring a potential product to market; |
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| • | 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; |
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| • | 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; |
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| • | we may be unable to accurately predict market requirements and evolving standards; and |
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| • | 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 April 2006, the USDA granted Embrex’s Inovocox™ coccidiosis vaccine for poultry a Veterinary Biological Product License which allows the Company to market and sell the product in the United States. Simultaneously, the USDA granted a Veterinary Biologics Establishment License to Embrex Poultry Health LLC, the Company’s manufacturing subsidiary based in Scotland County, North Carolina, where the new vaccine will be manufactured, packaged and shipped to customers. Marketing this product in non-U.S. countries will require us to pursue separate approvals from foreign regulatory agencies. There is no assurance that approvals in other markets will be granted, supplies will be available or that Inovocox will be sold in commercial quantities in the United States or in any of the other countries where approval may be obtained, 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. Although we have received approval to sell Newplex™ in nine countries, we have recently discovered difficulties in the formulation and production of Newplex™, which has affected manufacturing on a consistent basis. While we resolve these issues we may not have product supplies available. There is no assurance that we will resolve these manufacturing issues, that supplies will be available, that Newplex™ will be sold in commercial quantities in the United States or in any of the other countries where approval has been obtained, or that approvals in other markets will be granted.
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.
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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; |
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| • | disease outbreaks that adversely affect poultry production, including avian influenza; |
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| • | market demand for poultry products, including the supply and pricing of alternative proteins; |
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| • | costs to comply with applicable laws and regulations, including those relating to environmental protection, food safety, market regulation and genetically modified organisms or ingredients; |
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| • | product recalls and related adverse publicity and consumer reaction; |
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| • | access to domestic or export markets together with global economic conditions, including currency fluctuations and trade restrictions; and |
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| • | 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 any government bans the importation of U.S. chicken or chicken sourced from other key poultry producing countries, 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, and to a lesser extent products sold to customers, such as vaccines.
POULTRY HEALTH AND DISEASE FACTORS AFFECTING OUR CUSTOMERS MAY ADVERSELY AFFECT OUR FINANCIAL RESULTS
Any poultry health problem or disease outbreak, such as avian influenza in poultry, could have a negative impact on our key markets and global poultry production. Our revenues and earnings derived from the U.S. and certain key international markets, as well as the international poultry industry in general 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 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.
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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 Foods, Inc. (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 Pride Inc. (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
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.
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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; |
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| • | Some patent licenses held by us may be terminated upon the occurrence of specified events or become non-exclusive after a specified period; |
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| • | 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); |
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| • | 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; |
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| • | We may not have the financial resources necessary to obtain patent protection in some countries or to enforce any patent rights we may hold; |
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| • | 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; |
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| • | 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 |
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| • | 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.
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For a description of the patent litigations in which we have been involved, see Part II, Item 1, “Legal Proceedings,” above.
WE DO NOT MANUFACTURE MOST OF OUR DEVICES OR VACCINE PRODUCTS. WE ARE DEPENDENT ON ONE CONTRACT MANUFACTURER FOR INOVOJECT® AND EGG REMOVER® DEVICES AND ANOTHER CONTRACT MANUFACTURER FOR A KEY COMPONENT OF 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; |
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| • | potential inability to monitor and maintain inventory levels; |
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| • | reduced control over quality assurance; |
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| • | reduced control over manufacturing yields and costs; |
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| • | potential lack of adequate capacity during periods of unanticipated demand; |
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| • | limited warranties on products supplied to us; |
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| • | 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.
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Inovoject® and Egg Remover® Systems
We rely on Precision Automation Company, Inc. (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 one of the active ingredients in AAC technology from Charles River Laboratories, Inc. through its SPAFAS Avian Products Services Divisions (SPAFAS). Currently our sole manufacturer for Bursaplex® is Merial Select, Inc. (Select), and our sole manufacturer for Newplex™ is a subsidiary of Lohmann Animal Health International (LAHI). The manufacture of AAC antibody and all vaccines 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 antibody.
As the USDA licensed manufacturers of record, Select holds the USDA license for Bursaplex® and LAHI holds the USDA license for Newplex™. Although there are other manufacturers that may be capable of manufacturing AAC antibody, Bursaplex®, and Newplex™, we do not currently have alternative sources for production.
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. We have received notice from Select that it does not intend to renew its contract to manufacture Bursaplex®. Select remains obligated to Embrex to provide a cross license, sub license or sell the USDA product license to an alternative producer of Embrex’s choice, which the Company is evaluating. However, there is no assurance that we will be able to arrange continued supply of Bursaplex® on a timely basis or on commercially reasonable terms. 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 AAC-antibody 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 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.
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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 G&A 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 S arbanes-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.
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 may enter into other such distribution arrangements in the future. 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. |
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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, R&D 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 Food and Drug Administration (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. Approval by foreign governments can take one to five years for an application submitted after U.S. approval. 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.
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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, technical 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
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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 has 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 2. | Unregistered Sales of Equity Securities and Use of Proceeds |
Not applicable.
Item 3 | Defaults Upon Senior Securities |
Not applicable.
Item 4. | Submission of Matters to a Vote of Security Holders |
On May 18, 2006, the Annual Meeting of Shareholders was held and the following matter was submitted to the shareholders for a vote. There were 7,294,658 shares represented at the meeting in person or by proxy, representing 88.48% of the 8,244,344 shares outstanding. Set forth below is a brief description of the matter voted on and the number of votes cast for, against or withheld. There were no broker non-votes or abstentions regarding the election of directors.
Election of Board of Directors:
Director | | | Votes For | | | Votes Withheld | | | Totals | |
| |
|
| |
|
| |
|
| |
C. Daniel Blackshear | | | 6,066,393 | | | 1,228,265 | | | 7,294,658 | |
David Castaldi | | | 6,064,836 | | | 1,229,822 | | | 7,294,658 | |
Peter J. Holzer | | | 5,861,814 | | | 1,432,844 | | | 7,294,658 | |
Ganesh M. Kishore, Ph.D. | | | 6,066,197 | | | 1,228,461 | | | 7,294,658 | |
John E. Klein | | | 6,066,519 | | | 1,228,139 | | | 7,294,658 | |
Randall L. Marcuson | | | 5,895,188 | | | 1,399,470 | | | 7,294,658 | |
Not applicable.
Exhibit Number | | Description of Document |
| |
|
31.1 | | Certification of Principal Executive Officer of Periodic Report Pursuant to Rule 13a-14(a) or Rule 15d-14(a) |
31.2 | | Certification of Principal Financial Officer of Periodic Report Pursuant to Rule 13a-14(a) or Rule 15d-14(a) |
32.1 | | Certification of Principal Executive Officer of Periodic Report Pursuant to Rule 13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350 |
32.2 | | Certification of Principal Financial Officer of Periodic Report Pursuant to Rule 13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350 |
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SIGNATURES
Pursuant to the requirements 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.
Date: August 7, 2006
| EMBREX, INC. |
| | |
| | |
| By: | /s/ Randall L. Marcuson |
| |
|
| | Randall L. Marcuson |
| | President and Chief Executive Officer |
| | |
| By: | /s/ Don T. Seaquist |
| |
|
| | Don T. Seaquist |
| | Vice President, Finance and Administration |
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EXHIBIT INDEX
Exhibit Number | | Description of Document |
| |
|
31.1 | | Certification of Principal Executive Officer of Periodic Report Pursuant to Rule 13a-14(a) or Rule 15d-14(a) |
31.2 | | Certification of Principal Financial Officer of Periodic Report Pursuant to Rule 13a-14(a) or Rule 15d-14(a) |
32.1 | | Certification of Principal Executive Officer of Periodic Report Pursuant to Rule 13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350 |
32.2 | | Certification of Principal Financial Officer of Periodic Report Pursuant to Rule 13a-14(b) or Rule 15d-14(b) and 18 U.S.C. Section 1350 |
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