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**UNITED STATES   SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549**

**Form 10-Q**

**QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the Quarterly Period Ended June 30, 2006**

**Commission File No. 000-19495**

| **Embrex,   Inc.**                                         |
|------------------------------------------------------------|
|                                                            |
| *(Exact   name of registrant as specified in its charter)* |

| **North   Carolina**                                                  |   | **56-1469825**                           |
|-----------------------------------------------------------------------|--------|------------------------------------------|
|                                                                       |   |                                          |
| *(State   or other jurisdiction of    incorporation or organization)* |   | *(I.R.S.   Employer Identification No.)* |
|                                                                  |   |                                     |
| **1040   Swabia Court, Durham, NC**                                   |   | **27703**                                |
|                                                                       |   |                                          |
| *(Address   of principal executive offices)*                          |   | *(Zip   Code)*                           |

**Registrant’s telephone number, including area code:  (919) 941-5185**

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

|   | Yes | x |   | No | o |   |
|--------|-----|---|--------|----|---|--------|

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one): 

| Large accelerated filer  o | Accelerated Filer  x | Non-accelerated Filer  o |
|--------------------------------------|--------------------------------|------------------------------------|

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):

|   | Yes | o |   | No | x |   |
|--------|-----|---|--------|----|---|--------|

The number of shares of Common Stock, $0.01 par value, outstanding as of July 26, 2006 was 8,340,384. 

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EMBREX, INC.

INDEX

|    |                   |          |                                                                                         | **Page** |
|---------|------------------------|---------------|----------------------------------------------------------------------------------------------|----------|
|    |                   |          |                                                                                         |          |
| Part I  |                   |
|    |                   |          |                                                                                         |     |
|    | Financial Information: |          |
|    |                   |          |                                                                                         |     |
|    |                   | Item 1:       | Consolidated Financial Statements   (unaudited)                                              |     |
|    |                   |          |                                                                                         |     |
|    |                   |          | Consolidated Balance Sheets                                                                  | 3 of 46  |
|    |                   |          |                                                                                         |     |
|    |                   |          | Consolidated Statements of   Operations                                                      | 4 of 46  |
|    |                   |          |                                                                                         |     |
|    |                   |          | Consolidated Statements of Cash   Flows                                                      | 5 of 46  |
|    |                   |          |                                                                                         |     |
|    |                   |          | Notes to Interim Consolidated   Financial Statements                                         | 6 of 46  |
|    |                   |          |                                                                                         |     |
|    |                   | Item 2:       | Management’s Discussion and   Analysis of Financial Condition and Results of Operations | 19 of 46 |
|    |                   |          |                                                                                         |     |
|    |                   | Item 3:       | Quantitative and Qualitative   Disclosures About Market Risk                                 | 29 of 46 |
|    |                   |          |                                                                                         |     |
|    |                   | Item 4:       | Controls and Procedures                                                                      | 30 of 46 |
|    |                   |          |                                                                                         |     |
| Part II |                   |
|    |                   |          |                                                                                         |     |
|    | Other Information:     |          |
|    |                   |          |                                                                                         |     |
|    |                   | Item 1:       | Legal Proceedings                                                                            | 31 of 46 |
|    |                   |          |                                                                                         |     |
|    |                   | Item 1A:      | Risk Factors                                                                                 | 32 of 46 |
|    |                   |          |                                                                                         |     |
|    |                   | Item 2:       | Unregistered Sales of Equity   Securities and Use of Proceeds                                | 43 of 46 |
|    |                   |          |                                                                                         |     |
|    |                   | Item 3:       | Defaults Upon Senior Securities                                                              | 43 of 46 |
|    |                   |          |                                                                                         |     |
|    |                   | Item 4:       | Submission of Matters to a Vote of   Security Holders                                        | 43 of 46 |
|    |                   |          |                                                                                         |     |
|    |                   | Item 5:       | Other Information                                                                            | 43 of 46 |
|    |                   |          |                                                                                         |     |
|    |                   | Item 6:       | Exhibits                                                                                     | 43 of 46 |
|    |                   |          |                                                                                         |     |
|    |                   | Signatures    | 44 of 46                                                                                     |
|    |                   |          |                                                                                         |     |
|    |                   | Exhibit Index | 45 of 46                                                                                     |

2

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PART I - FINANCIAL INFORMATION

| Item 1. | Consolidated   Financial Statements |
|---------|-------------------------------------|

Embrex, Inc.

**Consolidated Balance Sheets****(In thousands, except share and per share amounts)****(*Unaudited)**

|                                                                                                                                                                                                                |   | **June 30,   2006*** |    | **December   31,   2005** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|---------|---------------------------|--------|
|                                                                                                                                                                                                                |   |                      |    |                           |   |
| **ASSETS**                                                                                                                                                                                                          |   |                 |    |                      |   |   |   |
| **Current Assets**                                                                                                                                                                                                  |   |                 |    |                      |   |   |   |
| Cash   and cash equivalents                                                                                                                                                                                         |   | $                    | 1,647   |                      | $      | 1,975 |   |
| Restricted   cash                                                                                                                                                                                                   |   |                 | 122     |                      |   | 116 |   |
| Accounts   receivable – trade (net of allowance of $472 and $332 in 2006 and 2005,   respectively)                                                                                                             |   |                 | 7,852   |                      |   | 7,815 |   |
| Inventories:                                                                                                                                                                                                        |   |                 |    |                      |   |   |   |
| Materials   and supplies                                                                                                                                                                                            |   |                 | 2,908   |                      |   | 2,927 |   |
| Product                                                                                                                                                                                                             |   |                 | 1,434   |                      |   | 1,377 |   |
| Current   deferred tax asset                                                                                                                                                                                        |   |                 | 1,026   |                      |   | 1,149 |   |
| Other   current assets                                                                                                                                                                                              |   |                 | 1,583   |                      |   | 1,970 |   |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
| **Total Current Assets**                                                                                                                                                                                            |   |                 | 16,572  |                      |   | 17,329 |   |
| **Land**                                                                                                                                                                                                            |   |                 | 741     |                      |   | 336 |   |
| **Devices under construction**                                                                                                                                                                                      |   |                 | 4,145   |                      |   | 3,368 |   |
| **Devices**                                                                                                                                                                                                         |   |                 | 57,495  |                      |   | 52,998 |   |
| Less   accumulated depreciation                                                                                                                                                                                     |   |                 | (35,177 | )                         |   | (32,653 | ) |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
|                                                                                                                                                                                                                |   |                 | 22,318  |                      |   | 20,345 |   |
| **Plant and Equipment**                                                                                                                                                                                             |   |                 | 32,538  |                      |   | 31,869 |   |
| Less   accumulated depreciation and amortization                                                                                                                                                                    |   |                 | (12,329 | )                         |   | (11,371 | ) |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
|                                                                                                                                                                                                                |   |                 | 20,209  |                      |   | 20,498 |   |
| **Other Assets**                                                                                                                                                                                                    |   |                 |    |                      |   |   |   |
| Intangible   assets (net of accumulated amortization of $813 in 2006 and $682 in 2005)                                                                                                                              |   |                 | 6,244   |                      |   | 5,371 |   |
| Long-term   deferred tax asset                                                                                                                                                                                      |   |                 | 271     |                      |   | 45 |   |
| Other   long-term assets                                                                                                                                                                                            |   |                 | 516     |                      |   | 182 |   |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
| **Total Other Assets**                                                                                                                                                                                              |   |                 | 7,031   |                      |   | 5,598 |   |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
| **Total Assets**                                                                                                                                                                                                    |   | $                    | 71,016  |                      | $      | 67,474 |   |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                       |   |                 |    |                      |   |   |   |
| **Current Liabilities**                                                                                                                                                                                             |   |                 |    |                      |   |   |   |
| Accounts   payable                                                                                                                                                                                                  |   | $                    | 740     |                      | $      | 949 |   |
| Accrued   expenses                                                                                                                                                                                                  |   |                 | 4,950   |                      |   | 4,647 |   |
| Deferred   revenue                                                                                                                                                                                                  |   |                 | 756     |                      |   | 668 |   |
| Product   warranty accrual                                                                                                                                                                                          |   |                 | 168     |                      |   | 149 |   |
| Notes   payable – current portion                                                                                                                                                                              |   |                 | 541     |                      |   | 463 |   |
| Current   portion of capital lease obligations                                                                                                                                                                      |   |                 | 5       |                      |   | 7 |   |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
| **Total Current Liabilities**                                                                                                                                                                                       |   |                 | 7,160   |                      |   | 6,883 |   |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
| **Long-term debt, less current portion**                                                                                                                                                                            |   |                 | 7,939   |                      |   | 8,133 |   |
| **Capital Lease Obligations**, less current portion                                                                                                                                                                 |   |                 | 8       |                      |   | 11 |   |
| **Shareholders’ Equity**                                                                                                                                                                                       |   |                 |    |                      |   |   |   |
| Common Stock, $0.01 par   value per share:                                                                                                                                                                          |   |                 |    |                      |   |   |   |
| Authorized - 30,000,000   shares; Issued and outstanding – 8,306,609 net of 1,674,666 treasury shares   and 8,134,447 net of 1,674,666 treasury shares at June 30, 2006 and December   31, 2005, respectively. |   |                 | 99      |                      |   | 97 |   |
| Additional   paid-in capital                                                                                                                                                                                        |   |                 | 68,103  |                      |   | 67,854 |   |
| Accumulated   other comprehensive income                                                                                                                                                                            |   |                 | 800     |                      |   | 349 |   |
| Deferred   compensation                                                                                                                                                                                             |   |                 | -0-     |                      |   | (1,318 | ) |
| Retained   earnings                                                                                                                                                                                                 |   |                 | 6,754   |                      |   | 5,312 |   |
| Treasury   stock                                                                                                                                                                                                    |   |                 | (19,847 | )                         |   | (19,847 | ) |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
| **Total Shareholders’ Equity**                                                                                                                                                                                 |   |                 | 55,909  |                      |   | 52,447 |   |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |
| **Total Liabilities and Shareholders’ Equity**                                                                                                                                                                 |   | $                    | 71,016  |                      | $      | 67,474 |   |
|                                                                                                                                                                                                                |   |                      |         |                      |        |  |   |

See accompanying notes.

3

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Embrex, Inc.

**Consolidated Statements of Operations****(Unaudited)****(In thousands, except per share amounts)**

|                                                |   | **Three   Months Ended   June 30** |   | **Six Months   Ended   June 30** |   |
|-----------------------------------------------------|--------|------------------------------------|--------|----------------------------------|--------|
|                                                |   |                                    |   |                                  |   |
|                                                |   | **2006**                           |   | **2005**                         |   | **2006** |   | **2005** |   |
|                                                |   |                                    |   |                                  |   |  |   |  |   |
| **Revenues**                                        |   |                               |   |                             |   |   |   |   |   |   |   |   |   |
| Device   revenues                                   |   | $                                  | 12,202 |                             | $      | 12,172 |   | $ | 24,462 |   | $ | 24,094 |   |
| Product   sales                                     |   |                               | 860    |                             |   | 724 |   |   | 1,532 |   |   | 1,423 |   |
| Other   revenues                                    |   |                               | 227    |                             |   | 122 |   |   | 498 |   |   | 264 |   |
|                                                |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |
| **Total Revenues**                                  |   |                               | 13,289 |                             |   | 13,018 |   |   | 26,492 |   |   | 25,781 |   |
| **Cost of Device Revenues and Product Sales**       |   |                               | 5,477  |                             |   | 5,487 |   |   | 10,834 |   |   | 10,980 |   |
|                                                |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |
| **Gross Profit**                                    |   |                               | 7,812  |                             |   | 7,531 |   |   | 15,658 |   |   | 14,801 |   |
| **Operating Expenses**                              |   |                               |   |                             |   |   |   |   |   |   |   |   |   |
| General   and administrative                        |   |                               | 2,909  |                             |   | 2,694 |   |   | 5,798 |   |   | 5,268 |   |
| Sales   and marketing                               |   |                               | 1,626  |                             |   | 1,216 |   |   | 3,261 |   |   | 2,195 |   |
| Research   and development                          |   |                               | 2,163  |                             |   | 2,249 |   |   | 4,651 |   |   | 5,000 |   |
|                                                |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |
| **Total Operating Expenses**                        |   |                               | 6,698  |                             |   | 6,159 |   |   | 13,710 |   |   | 12,463 |   |
| **Operating Income**                                |   |                               | 1,114  |                             |   | 1,372 |   |   | 1,948 |   |   | 2,338 |   |
| **Other Income (Expense)**                          |   |                               |   |                             |   |   |   |   |   |   |   |   |   |
| Interest   income                                   |   |                               | 47     |                             |   | 42 |   |   | 112 |   |   | 64 |   |
| Interest   expense                                  |   |                               | (122   | )                                |   | (19 | ) |   | (125 | ) |   | (25 | ) |
| Other   Income                                      |   |                               | 21     |                             |   | 50 |   |   | 97 |   |   | 177 |   |
|                                                |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |
| **Total Other Income (Expense)**                    |   |                               | (54    | )                                |   | 73 |   |   | 84 |   |   | 216 |   |
|                                                |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |
| **Income Before Income Tax Expense**                |   |                               | 1,060  |                             |   | 1,445 |   |   | 2,032 |   |   | 2,554 |   |
| **Income Tax Expense**                              |   |                               | 527    |                             |   | 199 |   |   | 590 |   |   | 698 |   |
|                                                |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |
| **Net Income**                                      |   | $                                  | 533    |                             | $      | 1,246 |   | $ | 1,442 |   | $ | 1,856 |   |
|                                                |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |
| **Net Income per share of Common Stock:**           |   |                               |   |                             |   |   |   |   |   |   |   |   |   |
| Basic                                               |   | $                                  | 0.06   |                             | $      | 0.16 |   | $ | 0.18 |   | $ | 0.23 |   |
| Diluted                                             |   | $                                  | 0.06   |                             | $      | 0.15 |   | $ | 0.17 |   | $ | 0.22 |   |
| **Number of Shares Used in Per Share Calculation:** |   |                               |   |                             |   |   |   |   |   |   |   |   |   |
| Basic                                               |   |                               | 8,254  |                             |   | 7,964 |   |   | 8,216 |   |   | 7,950 |   |
| Diluted                                             |   |                               | 8,446  |                             |   | 8,278 |   |   | 8,467 |   |   | 8,275 |   |

See accompanying notes.

4

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Embrex, Inc.

**Consolidated Statements of Cash Flows****(Unaudited)****(In thousands)**

|                                                                                     |   | **Six Months   Ended June 30** |   |
|------------------------------------------------------------------------------------------|--------|--------------------------------|--------|
|                                                                                     |   |                                |   |
|                                                                                     |   | **2006**                       |   | **2005** |   |
|                                                                                     |   |                                |   |  |   |
| Operating Activities                                                                     |   |                           |   |   |   |   |   |
| Net   income                                                                             |   | $                              | 1,442  |   | $ | 1,856 |   |
| Adjustments   to reconcile net income to net cash provided by operating   activities:    |   |                           |   |   |   |   |   |
| Depreciation   and amortization                                                          |   |                           | 3,764  |   |   | 3,117 |   |
| Loss   on sale of fixed assets                                                           |   |                           | 23     |   |   | 15 |   |
| Change   in restricted cash                                                              |   |                           | (6     | ) |   | (1 | ) |
| Change   in deferred tax asset                                                           |   |                           | (104   | ) |   | (48 | ) |
| Restricted   Stock Amortization                                                          |   |                           | -0-    |   |   | 271 |   |
| Equity   compensation                                                                    |   |                           | 482    |   |   | -0- |   |
| Changes   in operating assets and liabilities:                                           |   |                           |   |   |   |   |   |
| Accounts   receivable, inventories and other current assets                              |   |                           | 312    |   |   | 1,484 |   |
| Accounts payable, accrued   expenses, deferred revenue and warranty accrual              |   |                           | 217    |   |   | (1,508 | ) |
|                                                                                     |   |                                |        |   |  |  |   |
| **Net Cash Provided By Operating Activities**                                            |   |                           | 6,130  |   |   | 5,186 |   |
| Investing   Activities                                                                   |   |                           |   |   |   |   |   |
| Purchases   of devices, equipment, furniture and fixtures                                |   |                           | (6,540 | ) |   | (7,266 | ) |
| Cash   proceeds from sale of devices, equipment, furniture and fixtures                  |   |                           | 11     |   |   | 10 |   |
| Investment   in patents and other non-current assets                                     |   |                           | (1,331 | ) |   | (905 | ) |
|                                                                                     |   |                                |        |   |  |  |   |
| **Net Cash Used In Investing Activities**                                                |   |                           | (7,860 | ) |   | (8,161 | ) |
| Financing Activities                                                                     |   |                           |   |   |   |   |   |
| Issuance   of common stock                                                               |   |                           | 913    |   |   | 381 |   |
| Tax   benefit of equity-based compensation                                               |   |                           | 175    |   |   | -0- |   |
| Net   change in the line of credit                                                       |   |                           | 89     |   |   | -0- |   |
| Repayment   of long-term debt, capital lease obligations and other long-term liabilities |   |                           | (226   | ) |   | (209 | ) |
|                                                                                     |   |                                |        |   |  |  |   |
| **Net Cash Provided By Financing Activities**                                            |   |                           | 951    |   |   | 172 |   |
| Decrease in cash and cash   equivalents                                                  |   |                           | (779   | ) |   | (2,803 | ) |
| Currency translation   adjustments                                                       |   |                           | 451    |   |   | 224 |   |
| Cash and cash equivalents   at beginning of period                                       |   |                           | 1,975  |   |   | 4,469 |   |
|                                                                                     |   |                                |        |   |  |  |   |
| **Cash And Cash Equivalents At End Of Period**                                           |   | $                              | 1,647  |   | $ | 1,890 |   |
|                                                                                     |   |                                |        |   |  |  |   |

See accompanying notes.

5

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FORM 10-QJune 30, 2006

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 1 - Basis of Presentation

The accompanying unaudited consolidated financial statements include the accounts of Embrex, Inc. and its wholly owned subsidiaries, Embrex Europe Limited, Embrex France s.a.s., Embrex Iberica, Embrex BioTech Trade (Shanghai) Co., Ltd., Inovoject do Brasil Ltda., Embrex Poultry Health, LLC, Embrex de Mexico S. de R.L. de C.V. and Vaccination Services S. de R.L. de C.V. (“Embrex” or the “Company”) and have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, these consolidated financial statements do not include all of the information and notes required by accounting principles generally accepted in the United States.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of financial condition andresults of operations have been included.  Operating results for the three-month and six-month periods ended June 30, 2006 are not necessarily indicative of the results that may be attained for the entire year.  For further information, refer to the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2005.

Note 2 – Critical Accounting Policies

The preparation of these consolidated financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates including but not limited to those related to:

|   | • | Allowance   for uncollectible accounts               |
|--------|--------|------------------------------------------------------|
|   | • | Warranty   accruals                                  |
|   | • | Inventory   obsolescence                             |
|   | • | Deferred   tax assets                                |
|   | • | Employee   fringe benefit plan accrual               |
|   | • | Employee   short-term incentive compensation accrual |

The Company bases its estimates on historical experience and on various other assumptions, including planned results, that are believed to be reasonable under the circumstances, the results of which form the basis of making judgments about carrying values of assets and liabilities that are not readily discernible from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The Company believes the following critical accounting policies are material to the preparation of its consolidated financial statements.  

6

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Revenue Recognition

Revenues for devices subject to lease agreements are recognized based on eggs processed during the period in accordance with lease terms.  Product sales are recognized upon delivery, as that is when title passes to the customer.  Contract research revenue is recognized as services are performed or as milestones are met over the term of the contract.  Grant revenue is recognized as expenses related to the specific grants are incurred.  Revenue received, but not yet earned, is classified as deferred revenue.  Revenue received from sales of devices to vaccine manufacturers is recognized when the device has been installed and has passed on-site testing.  These sales frequently include a maintenance agreement for which the revenue is recognized over the period covered by the agreement.  All revenues are recognized net of any applicable sales, use or rental taxes.

The revenues section of the consolidated statements of operations divides revenues into three sections: device revenues, which include device lease fees and device sales; product sales, all or most of which are derived from sales of the Company’s vaccine, Bursaplex®; and other revenues, which include income derived from contract research and development, and grant sources. 

Allowance for Uncollectible Accounts

To date, the Company has not experienced any material trade accounts receivable collection issues.  However, based on a review of cumulative balances, industry experience and the current economic environment, the Company ordinarily reserves from 2% to 4% of trade accounts receivable, depending on the credit terms in various markets, as an allowance for uncollectible accounts. In addition, adjustments due to the financial stability of individual customers will affect the overall percentage reserved. Once the Company determines an account is uncollectible it writes off the receivable balance against the reserve. Accounts are written off based on individual circumstances and only after all reasonable efforts of collection have been exhausted.  The consolidated balance reserved for uncollectible accounts as of June 30, 2006 was $0.5 million, which represents 6% of the trade accounts receivable balance as of June 30, 2006.  The current reserve percentageof 6% exceeds the range described above primarily due to the Company’s concerns regarding avian influenza outbreaks overseas and the potential impact on the operations and financial condition of the Company’s customers in the U.S. and abroad.  The reserve amount has increased $0.2 million since December 31, 2005.  

Warranty Accruals

To date, the Company has not experiencedany material device or product warranty issues in excess of amountsreserved.  Based on the sale and lease of devices and sale of products, theCompany has established a reserve for future claims.  The reserve is basedon the estimated damages that a customer would experience if an Inovoject®system or batch of Bursaplex® should fail to perform to productspecifications. The consolidated balance reserved for warranties as of June 30,2006 was $0.2 million.

Inventory Obsolescence

To date, the Company has not experienced any material inventory obsolescence.  However, based on a percentage of the current product and device parts inventory levels, the Company has established a reserve against future device parts obsolescence due to technological improvements and limited shelf life of product inventories.  The percentage used to calculate the reserve is based on a historical percentage rate adjusted for anticipated technological advances on devices and shelf life of existing vaccine product inventories.  The consolidated balance reserved for product and parts obsolescence as of June 30, 2006 was $0.3 million.

7

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Deferred Tax Assets

The Company records deferred tax assets based upon amounts that are likely to be realized. Based on the Company’s recent profitability and belief that 2006 will result in an overall profit, the Company has recorded net current deferred tax assets of $1.0 million.  The Company has also recorded a long-term tax asset of $0.3 million due to research and development (“R&D”) tax credits and depreciation timing differences.  The Company’s net deferred tax assets include a valuation allowance for two items that the Company may not be able to realize in future periods. The two items are R&D tax credits and deferred tax assets in foreign subsidiaries. This determination is based, in part, on historical operating performance as well as the likelihood of future income. The valuation allowance will be reduced when the Company believes that the likelihood of realizing the related assets is more likely than not. In the event the Companydetermines that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the valuation allowance would increase income in the period such determination was made. However, in the event the Company determines that it would not be able to realize its net recorded deferred tax asset in the future, an adjustment to the valuation allowance would decrease income in the period such determination was made.

Employee Fringe Benefit Plan Accrual 

The Company has established a reserve related to its employee fringe benefit plan.  The most significant component of the accrual is the amount reserved for the employee self-insured health plan. The amount of the reserve is based on management’s estimate of future employee health claims.  The reserve covers expected short-term claims and is based on historical data adjusted for major events and anticipated changes in headcount or participation. The net balance reserved for the employee self-insured health plan as of June 30, 2006 was $0.2 million.

Employee Short-Term Incentive Compensation Accrual 

The Company accrues for payments to employees under a short-term incentive plan.  The accrual is based upon the Company’s net income performance against a target established by the Board of Directors.  The accrual is recorded monthly and re-evaluated quarterly based upon the Company’s projections for the year.  Payments to employees are based upon the Company’s performance against targets as well as the employees’ contribution as measured against their individual contribution plan.  The net balance accrued for the employee short-term incentive compensation plan as of June 30, 2006 was $0.5 million.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”).  SFAS 123(R), a revision of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees (“APB 25”) and amends SFAS No. 95, “Statement of Cash Flows.”  SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values.  SFAS 123(R) is effective for the beginning of the first interim or annual period beginning after December 31, 2005.  Therefore, the Company adopted SFAS 123(R) on January 1, 2006.  The impact of the adoption of SFAS 123(R)is described below under the heading “SHARE-BASED COMPENSATION PLANS.”

8

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In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APB Opinion No. 20, “Accounting Changes” (“APB 20”), and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements.”  SFAS 154 applies to all voluntary changes in accounting principle and modifies the requirements for accounting for and reporting a change in accounting principle.  SFAS 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable.   SFAS 154 requires that a change in method of depreciation, amortization or depletion for long-lived, non-financial assets be accounted for as a change in accounting estimate that is affected by a change in accounting principle. APB 20 previously required that such a change be reported as a change in accounting principle. The adoption of SFAS 154 is not expected to have a material impact on the financial statements of the Company.  

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”) which provided clarification of the accounting under SFAS No. 109, “Accounting for Income Taxes.”  The interpretation provides a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  The interpretation is effective for fiscal years beginning after December 15, 2006.  Therefore, the Company plans to adopt FIN 48 on January 1, 2007.  The Company is currently evaluating the details of the interpretation, but it has not yet determined the impact it will have on the Company’s consolidated financial statements.

SHARE-BASED COMPENSATION PLANS

Employee Stock Purchase Plan   

The Company maintains an Employee Stock Purchase Plan for its U.S.-based employees (the “U.S. Purchase Plan”) and a similar plan for some of its employees outside the U.S. (the “Non-U.S. Purchase Plan,” and together with the U.S. Purchase Plan, the “Purchase Plans”).  Under the terms of each of the Purchase Plans, all regular full-time employees of the Company (or the Company’s subsidiaries) may make voluntary payroll contributions, thereby enabling them to purchase Common Stock. Contributions are limited to 20% of an employee’s compensation. As of June 30, 2006, the number of shares that may be issued under the Purchase Plans together shall not exceed 500,000. Of this amount, 221,039 shares are available for future purchases. The purchase price of the Common Stock is the lesser of 85% of the fair market value on the first business day of the plan year, which runs from July 1 in one year to June 30 in thesucceeding year, or 85% of the fair market value on the date of exercise, which can occur at any time during the plan year, as determined by each participating employee.  During the three months ended June 30, 2006 and 2005, there were 29,832 and 23,490 shares, respectively, of Common Stock purchased. The weighted-average purchase price of these shares was $8.75 and $9.52, respectively. During the six months ended June 30, 2006 and 2005, 34,545 shares and 27,409 shares, respectively, of Common Stock were purchased. The weighted-average purchase price of these shares was $8.86 and $9.64, respectively.

*Other Share-Based Compensation Plans*

In addition to the Purchase Plans, the Company maintains other share-based compensation plans (the “Share Plans”) under which it may provide to eligible employees and directors share-based compensation in the form of restricted stock-type awards (i.e., restricted stock and restricted stock units) and option-type awards (i.e., stock appreciation rights, incentive stock options and non-qualified stock options).  Option-type awards are granted with an exercise price equal to the market price of the Company’s Common Stock on the date of grant, and vest based on four years of continuous service with ten-year contractual terms.  Restricted stock-type awards do not have an exercise price and vest over four years as well.  Certain awards under the Share Plans provide for accelerated vesting if there is a change in control of the Company.  As of June 30, 2006, a total of 2,092,258 shares of Common Stock were reserved for future issuanceunder the Share Plans. Of this amount, 610,596 shares were available for future awards. 

9

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The following table summarizes the activity of restricted stock awards: 

|                             |   | **Shares** |    | **Weighted-   Average   Grant-Date   Fair Value** |   |
|----------------------------------|--------|------------|---------|---------------------------------------------------|--------|
|                             |   |            |    |                                                   |   |
| Nonvested   at December 31, 2004 |   |       | 87,025  |                                              | $      | 10.91 |   |
| Granted                          |   |       | -0-     |                                              |   | —   |   |
| Vested                           |   |       | (24,975 | )                                                 | $      | 10.67 |   |
| Forfeited                        |   |       | -0-     |                                              |   | —   |   |
|                             |   |            |         |                                              |        |  |   |
| Nonvested   at December 31, 2005 |   |       | 62,050  |                                              | $      | 11.01 |   |
| Granted                          |   |       | -0-     |                                              |   | —   |   |
| Vested                           |   |       | (23,725 | )                                                 | $      | 10.75 |   |
| Forfeited                        |   |       | (4,550  | )                                                 | $      | 10.55 |   |
|                             |   |            |         |                                              |        |  |   |
| Nonvested   at June 30, 2006     |   |       | 33,775  |                                              | $      | 11 .24 |   |
|                             |   |            |         |                                              |        |  |   |

The aggregate pre-tax, vest-date intrinsic value of restricted stock-type awards that vested during the three months ended June 30, 2006 and 2005 was $11.77 and $11.70, respectively. The aggregate pre-tax, vest-date intrinsic value of restricted stock-type awards that vested during the six months ended June 30, 2006 and 2005 was $12.03 and $11.73, respectively.

The following table summarizes the activity of restricted stock unit awards: 

|                             |   | **Shares** |    | **Weighted-   Average   Grant-Date   Fair Value** |   |
|----------------------------------|--------|------------|---------|---------------------------------------------------|--------|
|                             |   |            |    |                                                   |   |
| Nonvested   at December 31, 2004 |   |       | -0-     |                                              |   | —   |   |
| Granted                          |   |       | 114,940 |                                              | $      | 11.25 |   |
| Vested                           |   |       | -0-     |                                              |   | —   |   |
| Forfeited                        |   |       | (480    | )                                                 | $      | 11.25 |   |
|                             |   |            |         |                                              |        |  |   |
| Nonvested   at December 31, 2005 |   |       | 114,460 |                                              | $      | 11.25 |   |
| Granted                          |   |       | -0-     |                                              |   | —   |   |
| Vested                           |   |       | (37,990 | )                                                 | $      | 11.25 |   |
| Forfeited                        |   |       | (6,720  | )                                                 | $      | 11.25 |   |
|                             |   |            |         |                                              |        |  |   |
| Nonvested   at June 30, 2006     |   |       | 69,750  |                                              | $      | 11.25 |   |
|                             |   |            |         |                                              |        |  |   |

No restricted stock unit awards vested during the three months ended June 30, 2006 and 2005. The aggregate pre-tax, vest-date intrinsic value of restricted stock unit awards that vested during the six months ended June 30, 2006 was $13.86. No restricted stock unit awards vested during the six months ended June 30, 2005.

10

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The following table summarizes the activity of stock option awards: 

|                                             |   | **Shares** |      | **Weighted-   Average    Exercise Price   Per Share** |   | **Weighted-   Average   Remaining   Contractual   Life (Years)** |   | **Aggregate   Pre-Tax   Intrinsic   Value** |   |
|--------------------------------------------------|--------|------------|-----------|-------------------------------------------------------|--------|------------------------------------------------------------------|--------|---------------------------------------------|--------|
|                                             |   |            |      |                                                       |   |                                                                  |   |                                             |   |
| Outstanding   at December 31, 2004               |   |       | 1,772,932 |                                                  | $      | 11.50                                                            |   |                                        |   |   |   |   |   |
| Granted                                          |   |       | 2,000     |                                                  | $      | 11.57                                                            |   |                                        |   |   |   |   |   |
| Exercised                                        |   |       | (151,594  | )                                                     | $      | 6.86                                                             |   |                                        |   |   |   |   |   |
| Forfeited or expired                             |   |       | (32,510   | )                                                     | $      | 14.80                                                            |   |                                        |   |   |   |   |   |
|                                             |   |            |           |                                                  |   |                                                             |   |                                        |   |   |   |   |   |
| Outstanding   at December 31, 2005               |   |       | 1,590,828 |                                                  | $      | 11.88                                                            |   |                                        |   |   |   |   |   |
| Granted                                          |   |       | -0-       |                                                  |   | —                                                 |   |                                        |   |   |   |   |   |
| Exercised                                        |   |       | (90,552   | )                                                     | $      | 6.69                                                             |   |                                        |   |   |   |   |   |
| Forfeited or expired                             |   |       | (103,014  | )                                                     | $      | 15.38                                                            |   |                                        |   |   |   |   |   |
|                                             |   |            |           |                                                  |   |                                                             |   |                                        |   |   |   |   |   |
| Outstanding   at June 30, 2006                   |   |       | 1,397,262 |                                                  | $      | 11.96                                                            |   |                                        | 4.5    |   | $ | 1,515,438 |   |
| Vested   & expected to vest at June 30, 2006 |   |       | 1,387,403 |                                                  | $      | 11.96                                                            |   |                                        | 4.5    |   | $ | 1,514,181 |   |
| Exercisable   at June 30, 2006                   |   |       | 1,282,415 |                                                  | $      | 11.96                                                            |   |                                        | 4.2    |   | $ | 1,498,323 |   |

The following table summarizes significant ranges of exercise prices of outstanding and exercisable options as of June 30, 2006: 

|                         |   | **Options   Outstanding** |      | **Options   Exercisable**                                        |   |
|------------------------------|--------|---------------------------|-----------|------------------------------------------------------------------|--------|
|                         |   |                           |      |                                                                  |   |
| **Range of Exercise Prices** |   | **Shares**                |      | **Weighted-   Average   Remaining   Contractual   Life (Years)** |   | **Weighted-   Average   Exercise   Price Per   Share** |   | **Shares** |   | **Weighted-   Average Exercise   Price Per   Share** |   |
|                              |   |                           |      |                                                                  |   |  |   |  |   |  |   |
| $5.13   - $9.66              |   |                      | 496,876   |                                                             |   | 3.1 |   | $ | 7.04 |   |   | 458,477 |   | $ | 6.82 |   |
| $10.50   - $13.09            |   |                      | 367,975   |                                                             |   | 5.5 |   | $ | 11.70 |   |   | 295,277 |   | $ | 11.37 |   |
| $13.25   - $17.25            |   |                      | 276,491   |                                                             |   | 4.7 |   | $ | 15.56 |   |   | 272,741 |   | $ | 15.59 |   |
| $17.99                       |   |                      | 255,920   |                                                             |   | 5.6 |   | $ | 17.99 |   |   | 255,920 |   | $ | 17.99 |   |
|                         |   |                           |           |                                                             |   |   |   |   |   |   |  |  |   |   |   |   |
| Total                        |   |                      | 1,397,262 |                                                             |   | 4.5 |   | $ | 11.96 |   |   | 1,282,415 |   | $ | 11.96 |   |
|                         |   |                           |           |                                                             |   |   |   |   |   |   |  |  |   |   |   |   |

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*Share-Based Compensation Expense*

On January 1, 2006, the Company adopted SFAS 123(R), which requires the measurement and recognition of compensation expense for all share-based compensation awards made to employees and directors based on estimated fair values.  SFAS 123(R) supersedes the Company’s previous accounting under APB 25 for periods beginning on or after January 1, 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R). 

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006. The Company’s Consolidated Financial Statements as of and for the three and six months ended June 30, 2006 reflect the impact of SFAS 123(R).  In accordance with the modified prospective transition method, the Company’s Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recognized under SFAS 123(R) for the three and six months ended June 30, 2006 was $241 thousand and $482 thousand, respectively.  Share-based compensation expense of $84 thousand and $271 thousand was recognized under previous accounting standards for the three and six months ended June 30, 2005, respectively.  As of June 30, 2006, there was $1.2 million of total unrecognized compensation costrelated to outstanding awards that are expected to vest in the future; the weighted-average period over which that cost is expected to be recognized is 1.9  years.  The actual tax benefit realized from tax deductions relating to stock option exercises for the three-months ended June 30, 2006 and 2005, was $87 thousand and $4 thousand, respectively. The actual tax benefit realized from tax deductions relating to stock option exercises for the six-months ended June 30, 2006 and 2005, was $175 thousand and $13 thousand, respectively.

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s Consolidated Statements of Operations. Prior to the adoption of SFAS 123(R), the Company accounted for share-based awards to employees and directors using the intrinsic value method in accordance with APB 25 as allowed under SFAS 123.  

Share-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Share-based compensation expense recognized in the Company’s Consolidated Statement of Operations for the three months ended June 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123.  Compensation expense for all stock option-type awards granted on or prior to December 31, 2005 has been and will continue to be recognized using the accelerated multiple-option approach while compensation expense for all restricted stock-type awards granted on or prior to December 31, 2005 has been and will continue to be recognized using the straight-line single-option method.  Both restricted stock-type andoption-type awards granted subsequent to December 31, 2005 will be recognized using the straight-line single-option method.  

Prior to the Company’s adoption of SFAS 123(R) on January 1, 2006, the Company accounted for forfeitures as they occurred.  SFAS 123(R), however, requires forfeitures to be estimated at the time of grant and revised in subsequent periods if actual forfeitures differ, or are expected to differ, from those estimates.  Estimated forfeitures differ among award type and among grantee groups that have significantly different historical forfeiture behavior.  As share-based compensation expense recognized in the Consolidated Statement of Operations for the first six months of 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures.

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On November 10, 2005, the FASB issued FASB Staff Position No. FAS 123(R)-3 “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards.” The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of share-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee share-based compensation awards that are outstanding upon adoption of SFAS 123(R).   

The Company computed the fair value of option-type awards granted under the Share Plans and Purchase Plans option elements using the Black-Scholes-Merton closed-form option pricing model. The weighted-average assumptions used in this model to estimate fair value and resulting values are as follows: 

|                                               |   | **Three   Months Ended June 30** |   | **Six Months   Ended June 30** |   |
|----------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                               |   |                                  |   |                                |   |
|                                               |   | **2006**                         |   | **2005**                       |   | **2006** |   | **2005** |   |
|                                               |   |                                  |   |                                |   |  |   |  |   |
| **Option-Type Awards under the   Share Plans**     |   |                             |   |                           |   |   |   |   |   |   |   |   |   |
| Expected   dividend yield (1)                      |   |                             | *      |                           |   | * |   |   | * |   |   | 0.0 | % |
| Risk-free   interest rate (2)                      |   |                             | *      |                           |   | * |   |   | * |   |   | 3.5 | % |
| Expected   volatility (3)                          |   |                             | *      |                           |   | * |   |   | * |   |   | 57.0 | % |
| Expected   life (in years) (4)                     |   |                             | *      |                           |   | * |   |   | * |   |   | 4.5 |   |
| Weighted-average   grant-date fair value per share |   |                             | *      |                           |   | * |   |   | * |   | $ | 5.70 |   |
| **Purchase Plans**                                 |   |                             |   |                           |   |   |   |   |   |   |   |   |   |
| Expected   dividend yield (1)                      |   |                             | *      |                           |   | 0.0 | % |   | 0.0 | % |   | 0.0 | % |
| Risk-free   interest rate (2)                      |   |                             | *      |                           |   | 3.0 | % |   | 4.5 | % |   | 2.8 | % |
| Expected   volatility (3)                          |   |                             | *      |                           |   | 57.0 | % |   | 42.7 | % |   | 57.0 | % |
| Expected   life (in years) (4)                     |   |                             | *      |                           |   | .1 |   |   | 0.4 |   |   | 0.3 |   |
| Weighted-average   grant-date fair value per share |   |                             | *      |                           | $      | 2.74 |   | $ | 3.53 |   | $ | 3.52 |   |

|        |
|--------|
|   | * | Not   applicable, since there were no related awards granted in this period. |
|   | 1. | The   Company has no plans to pay a dividend during the expected life of the   option-type awards or Purchase Plans option elements. |
|   | 2. | Represents   the risk-free interest rate based on the U.S. Treasury yield curve in effect   at the time of grant. |
|   | 3. | Based   on the historical daily percentage change in the price of the Company’s   Common Stock. Beginning as of January 1, 2006, the historical period   referenced for this purpose is the most recent period of time equal to the   length of the expected life of the applicable option-type award or Purchase   Plans option element. |
|   | 4. | Represents   the weighted-average period of time that the option-type awards or Purchase   Plans option elements are expected to be outstanding.  Where relevant, the expected term for   option-type awards differs among grantee groups with similar, historical   exercise behavior. |

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*Pro Forma Information Under SFAS 123 for Periods Ending on or before December 31, 2005*

Pro forma information regarding share-based compensation is as follows (in thousands, except per share amounts): 

|                                                                                                                                   |   | **Three Months Ended   June 30, 2005   (unaudited)** |   | **Six Months Ended   June 30, 2005   (unaudited)** |   |
|----------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------|--------|--------------------------------------------------------------|--------|
|                                                                                                                                   |   |                                                                |   |                                                              |   |
| Net   income, as reported                                                                                                              |   | $                                                              | 1,246  |                                                         | $      | 1,856 |   |
| Add:   Non-cash share-based compensation included in net income, net of related tax   effects                                          |   |                                                           | 151    |                                                         |   | 197 |   |
| Deduct:   Total share-based compensation expense determined under fair value based   method for all awards, net of related tax effects |   |                                                           | (315   | )                                                            |   | (501 | ) |
| Pro   forma net income                                                                                                                 |   | $                                                              | 1,082  |                                                         | $      | 1,552 |   |
| Earnings   per share:                                                                                                                  |   |                                                           |   |                                                         |   |   |   |
| Basic—as reported                                                                                                                 |   | $                                                              | 0.16   |                                                         | $      | 0.23 |   |
| Basic—pro forma                                                                                                                   |   | $                                                              | 0.14   |                                                         | $      | 0.20 |   |
| Diluted—as reported                                                                                                               |   | $                                                              | 0.15   |                                                         | $      | 0.22 |   |
| Diluted—pro forma                                                                                                                 |   | $                                                              | 0.13   |                                                         | $      | 0.19 |   |

Note 3 - Revenues

Device revenues include device-relatedincome, which consists of Inovoject® system lease fees,Inovoject® system sales, Egg Remover® fees, EggRemover® sales, Vaccine Saver® fees, VaccineSaver® sales and Inovoject® system distributorroyalties. Product sales include sales of Bursaplex®, theCompany’s *in ovo* infectious bursal disease vaccine.  The item“other revenues” includes revenues derived from contract research anddevelopment, and grant sources**.**

Note 4 – Plant and Equipment

Plant and equipment are recorded at cost.  Depreciation is computed principally by using straight-line methods over the estimated useful lives of the assets placed in service, generally three to seven years.  Manufacturing buildings and equipment are depreciated using the same methodology, but could be depreciated over a period spanning from 5 years to 40 years.  The Company’s total depreciation expense for plant and equipment for the six months ended June 30, 2006 was $1.2 million. Plant and equipment, at cost, consist of (in thousands):

| **(*unaudited)**                           |   | **June 30,   2006*** |    | **December   31,   2005** |   |
|--------------------------------------------|--------|----------------------|---------|---------------------------|--------|
|                                            |   |                      |    |                           |   |
| Plant   and equipment                      |   |                 |    |                      |   |   |   |
| Office buildings                           |   | $                    | 274     |                      | $      | 122 |   |
| Building and land improvements             |   |                 | 8,161   |                      |   | 299 |   |
| Manufacturing equipment                    |   |                 | 6,497   |                      |   | 1,011 |   |
| Construction in progress                   |   |                 | -0-     |                      |   | 13,225 |   |
| Leasehold improvements                     |   |                 | 5,626   |                      |   | 5,613 |   |
| Furniture, office and lab equipment, other |   |                 | 9,475   |                      |   | 9,164 |   |
| Vehicles                                   |   |                 | 2,505   |                      |   | 2,435 |   |
|                                       |   |                      |         |                      |        |  |   |
| Total plant and equipment                  |   | $                    | 32,538  |                      | $      | 31,869 |   |
| Less:   accumulated depreciation           |   |                 | (12,329 | )                         |   | (11,371 | ) |
|                                       |   |                      |         |                      |        |  |   |
| Net   plant and equipment                  |   | $                    | 20,209  |                      | $      | 20,498 |   |
|                                       |   |                      |         |                      |        |  |   |

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Note 5 – Intangible Assets

The Company capitalizes legal costs incurred in conjunction with the application for and filing of U.S. patents on internally developed technology, as well as the costs incurred to acquire exclusive licenses of U.S. patents. Exclusive license agreements are amortized over the period of the license, and patents are amortized over the shorter of the useful or legal life of the patent.  In some cases, patent infringement lawsuit expenses are capitalized and then amortized using the straight-line method upon successful defense and over the remaining life of the related patent.  In the second quarter of 2006, approximately $0.3 million of expenses related to patent infringement lawsuits were capitalized. As of June 30, 2006, an aggregate of $2.5 million of legal expenses related to patent infringement lawsuits currently pending were capitalized.  If the lawsuits covered by these expenses are not resolved in the Company’s favor, either via settlementor judgment by the applicable court, the capitalized cost will be expensed at the earlier of the time of resolution or when the Company determines that the lawsuits will not be resolved in the Company’s favor.   In addition, capitalized costs incurred to obtain patents on internally developed technology would be expensed at the time the Company decides to abandon a patent application or a patent is denied. The Company’s total amortization expense of intangible assets for the six-month periods ended June 30, 2006 and 2005 was approximately $0.1 million.  The Company estimates amortization of intangible assets will be approximately $0.2 million per year over the next five years based on current asset values and remaining lives.  Trademarks and goodwill are not amortized, but analyzed for impairment annually, in accordance with SFAS No. 142 “Goodwill and Other Intangible Assets”.  Net intangible assets consist of (in thousands):  

| **(*unaudited)**                      |   | **June 30,   2006*** |   | **December   31,   2005** |   |
|---------------------------------------|--------|----------------------|--------|---------------------------|--------|
|                                       |   |                      |   |                           |   |
| Intangible   assets                   |   |                 |   |                      |   |   |   |
| Patents and exclusive patent licenses |   | $                    | 5,404  |                      | $      | 4,583 |   |
| Goodwill                              |   |                 | 632    |                      |   | 587 |   |
| Trademarks                            |   |                 | 174    |                      |   | 163 |   |
| Other intangibles                     |   |                 | 34     |                      |   | 38 |   |
|                                  |   |                      |        |                      |        |  |   |
| Net intangible assets                 |   | $                    | 6,244  |                      | $      | 5,371 |   |
|                                  |   |                      |        |                      |        |  |   |

Note 6 – 401(k) Retirement Savings Plan

The Company has a 401(k) Plan that is available to all U.S.-based employees who are at least 18 years of age.  Employer contributions are voluntary at the discretion of the Company.  Historically, under its 401(k) Plan, the Company has based participant and employer contributions on participants’ salary. In the third quarter of 2005, the Company discovered that the 401(k) Plan documents prepared by its third party administrator provide (and the Company believes incorrectly) that other elements of compensation be included when determining the appropriate contributions. The Company’s intent always has been that contributions be based only on base salary. The Company intends to seek approval to conform the 401(k) Plan document retroactively to its intent and practice. Should this relief not be granted, the Company believes it would be required to make additional contributions to the 401(k) Plan for participants who had not already reached themaximum contribution.  The Company is unable to estimate at this time the amount of additional contributions that potentially could be required and for what time periods.

15

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Note 7 - Income Tax Expense

The reported tax rate for second quarter 2006 was 50% in comparison to the 14% reported tax rate for second quarter 2005.  The reported tax rate for the six-months ended June 30, 2006 was 29% in comparison to the 27% reported tax rate for the same period in 2005.  The reported tax rate for the second-quarter of 2006 increased over the same period in 2005 primarily due to the tax benefit of $0.5 million recorded from the filing of amended tax returns for 2001 and 2002 in the second quarter of 2005.   The returns were amended to reflect the Company’s claim for extraterritorial income exclusion.  The filings of these amended returns represent discrete events that provided the Company tax benefits in the second quarter of 2005.  The reported tax rates for the second quarter of 2005 and the six-months ended June 30, 2005 would have been 48% and 47%, respectively, if the tax returns were not amended.  

In addition, the Company filed an election during the first quarter of 2006 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 quarter 2006, resulting in a lower tax rate in the first six-months of 2006.  The reported tax rate for the six-months ended June 30, 2006 would have been 49% if the election had not been filed.

In the second quarter of 2006, withholding taxes accounted for 11 percentage points of the 50% tax rate, and U.S. and non-U.S. income taxes represented the remaining 39 percentage points.  In the same period of 2005, the 14% reported tax rate included 7 percentage points of withholding tax and 7 percentage points due to income taxes.  Withholding taxes are assessed on revenues in non-U.S. markets, regardless of taxable income position. 

In the first half of 2006, withholding taxes accounted for 12 percentage points of the 29% tax rate, and U.S. and non-U.S. income taxes represented the remaining 17 percentage points.  In the same period of 2005, the 27% reported tax rate included 12 percentage points of withholding tax and 15 percentage points due to income taxes.  

Note 8 - Net Income Per Share

The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share amounts): 

|                                                                                                                |   | **Three   Months Ended   June 30   (unaudited)** |   | **Six Months   Ended June 30   (unaudited)** |   |
|---------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------|--------|----------------------------------------------|--------|
|                                                                                                                |   |                                                  |   |                                              |   |
|                                                                                                                |   | **2006**                                         |   | **2005**                                     |   | **2006** |   | **2005** |   |
|                                                                                                                |   |                                                  |   |                                              |   |  |   |  |   |
| Numerator:                                                                                                          |   |                                             |   |                                         |   |   |   |   |   |   |   |   |   |
| Net Income                                                                                                          |   | $                                                | 533    |                                         | $      | 1,246 |   | $ | 1,442 |   | $ | 1,856 |   |
|                                                                                                                |   |                                                  |        |                                         |        |  |   |  |  |   |  |  |   |
| Denominator:                                                                                                        |   |                                             |   |                                         |   |   |   |   |   |   |   |   |   |
| Denominator for basic net   income per share—weighted-average                                                  |   |                                             | 8,254  |                                         |   | 7,964 |   |   | 8,216 |   |   | 7,950 |   |
| Effect of Dilutive   Securities: Stock Options, Restricted Stock and Restricted Stock Units                         |   |                                             | 192    |                                         |   | 314 |   |   | 251 |   |   | 325 |   |
| Denominator for diluted net   income per share—adjusted weighted-average shares and assumed option   exercises |   |                                             | 8,446  |                                         |   | 8,278 |   |   | 8,467 |   |   | 8,275 |   |
|                                                                                                                |   |                                                  |        |                                         |        |  |   |  |  |   |  |  |   |
| Basic net income per share                                                                                          |   | $                                                | 0.06   |                                         | $      | 0.16 |   | $ | 0.18 |   | $ | 0.23 |   |
|                                                                                                                |   |                                                  |        |                                         |        |  |   |  |  |   |  |  |   |
| Diluted net income per   share                                                                                      |   | $                                                | 0.06   |                                         | $      | 0.15 |   | $ | 0.17 |   | $ | 0.22 |   |
|                                                                                                                |   |                                                  |        |                                         |        |  |   |  |  |   |  |  |   |

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Basic net income per share was determined by dividing net income by the weighted-average number of shares of Common Stock outstanding during each period presented. Diluted net income per share is based on the average number of shares used for the basic net income per share calculation, adjusted for the dilutive effect of stock options, restricted stock and restricted stock units.  The dilutive effect of these securities was calculated using the Treasury Stock Method.  For the diluted net income per share denominator 742,259 and 813,688 shares underlying outstanding stock options were excluded from the calculation for the three months ended June 30, 2006 and June 30, 2005, respectively, because the exercise price of such options exceeded the average closing price of the Company’s Common Stock during the applicable period and, thus, are non-dilutive.

For the diluted net income per share denominator, 761,222 and 813,061 shares underlying outstanding stock options were excluded from the calculation for the six months ended June 30, 2006 and June 30, 2005, respectively, for the same reason as listed above.

Note 9 - Comprehensive Income

SFAS No. 130, “Reporting Comprehensive Income” (“SFAS 130”), establishes standards for reporting and display of comprehensive income and its components in the financial statements.  In accordance with SFAS 130, the Company has determined total comprehensive income net of tax to be $0.7 million and $1.5 million for the quarters ended June 30, 2006 and 2005, respectively.  For the six-month period ended June 30, 2006 and 2005, the Company has determined total comprehensive income net of tax to be $1.9 million and $2.1 million, respectively.  The Company’s total comprehensive income represents net income plus the effect of foreign currency translation adjustments for the periods presented as summarized below (in thousands):  

|                               |   | **Three   Months Ended   June 30   (unaudited)** |   | **Six Months   Ended   June 30   (unaudited)** |   |
|------------------------------------|--------|--------------------------------------------------|--------|------------------------------------------------|--------|
|                               |   |                                                  |   |                                                |   |
|                               |   | **2006**                                         |   | **2005**                                       |   | **2006** |   | **2005** |   |
|                               |   |                                                  |   |                                                |   |  |   |  |   |
| Net Income                         |   | $                                                | 533    |                                           | $      | 1,246 |   | $ | 1,442 |   | $ | 1,856 |   |
| Currency Translation   Adjustments |   |                                             | 126    |                                           |   | 291 |   |   | 451 |   |   | 224 |   |
|                               |   |                                                  |        |                                           |        |  |   |  |  |   |  |  |   |
| Comprehensive Income               |   | $                                                | 659    |                                           | $      | 1,537 |   | $ | 1,893 |   | $ | 2,080 |   |
|                               |   |                                                  |        |                                           |        |  |   |  |  |   |  |  |   |

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Note 10 - Segments

The Company operates in a single segment.  The table below presents the Company’s operations by geographic area (in thousands):

| **(* unaudited)**            |   | **Three Months   Ended   June 30** |   | **Six Months   Ended   June 30** |   |
|------------------------------|--------|------------------------------------|--------|----------------------------------|--------|
|                              |   |                                    |   |                                  |   |
|                         |   | **2006 ***                         |   | **2005 ***                       |   | **2006 *** |   | **2005 *** |   |
|                         |   |                                    |   |                                  |   |  |   |  |   |
| U.S.   Revenues:             |   |                               |   |                             |   |   |   |   |   |   |   |   |   |
| Device Revenues              |   | $                                  | 8,074  |                             | $      | 8,317 |   | $ | 16,165 |   | $ | 16,351 |   |
| Product Sales                |   |                               | -0-    |                             |   | -0- |   |   | -0- |   |   | -0- |   |
| Other Revenues               |   |                               | 180    |                             |   | 96 |   |   | 413 |   |   | 210 |   |
|                         |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |
| Total U.S. Revenues          |   | $                                  | 8,254  |                             | $      | 8,413 |   | $ | 16,578 |   | $ | 16,561 |   |
| International Revenues:      |   |                               |   |                             |   |   |   |   |   |   |   |   |   |
| Device Revenues              |   | $                                  | 4,128  |                             | $      | 3,854 |   | $ | 8,297 |   | $ | 7,743 |   |
| Product Sales                |   |                               | 860    |                             |   | 724 |   |   | 1,532 |   |   | 1,423 |   |
| Other Revenues               |   |                               | 47     |                             |   | 27 |   |   | 85 |   |   | 54 |   |
|                         |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |
| Total International Revenues |   | $                                  | 5,035  |                             | $      | 4,605 |   | $ | 9,914 |   | $ | 9,220 |   |
| Total Revenues               |   | $                                  | 13,289 |                             | $      | 13,018 |   | $ | 26,492 |   | $ | 25,781 |   |
|                         |   |                                    |        |                             |        |  |   |  |  |   |  |  |   |

| **Total Assets:** |   | **June 30,   2006 *** |   | **December   31,   2005** |   |
|-------------------|--------|-----------------------|--------|---------------------------|--------|
|                   |   |                       |   |                           |   |
| United States     |   | $                     | 53,956 |                      | $      | 51,885 |   |
| International     |   |                  | 17,060 |                      |   | 15,589 |   |
|              |   |                       |        |                      |        |  |   |
| Total             |   | $                     | 71,016 |                      | $      | 67,474 |   |
|              |   |                       |        |                      |        |  |   |

| **Depreciation and Amortization Expense:**    |   | **June 30,   2006 *** |   | **December 31, 2005** |   |
|-----------------------------------------------|--------|-----------------------|--------|-----------------------|--------|
|                                               |   |                       |   |                       |   |
| United States                                 |   |                  | 2,495  |                  | $      | 3,914 |   |
| International                                 |   |                  | 1,269  |                  |   | 2,549 |   |
|                                          |   |                       |        |                  |        |  |   |
| Total Depreciation and   Amortization Expense |   | $                     | 3,764  |                  | $      | 6,463 |   |
|                                          |   |                       |        |                  |        |  |   |

Note 11 - Debt

The Company obtained a $9.0 million construction/term loan from its bank, Branch Banking and Trust Company (“BB&T”), in August 2003 to be used for construction and equipping of Embrex Poultry Health, LLC, the Company’s InovocoxTM vaccine manufacturing facility located in Scotland County, North Carolina.  The interest rate of the loan is based on the one-month LIBOR plus 1.50%, which is a 15 basis point reduction since the first quarter 2006.  The loan has a term of 139 months, or 11.5 years, with payments of interest only for the first 18 months.  Principal repayment on the loan began in March 2005 at the end of the interest only period and equal monthly installments of principal plus interest are payable over the remainder of the loan term.  At June 30, 2006, $8.4 million of the construction/term loan was outstanding.  

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Note 12 – Commitments and Contingencies

The Company has certain contractual obligations due to mortgage financing of the InovocoxTM manufacturing facility, capital leases, operating leases related to office and storage space rentals and purchase obligations related to the manufacturing of devices, serum and vaccines and the purchase of other miscellaneous supplies. The terms of these obligations vary from less than a year to 10 years. 

The Company is engaged in certain legal and administrative proceedings incidental to its normal business activities.  While it is not possible to determine the ultimate outcome of those actions, in the opinion of management, after discussion with legal counsel, it is unlikely that the outcome of such litigation and other proceedings will have a material adverse effect on the results of the Company’s operations or its financial position, except that capitalized costs related to lawsuits could be expensed in future periods.  See Note 5, “Intangible Assets,” above. 

The Company operates in multiple tax jurisdictions and significant judgment is required in determining its worldwide provision for income taxes.  In the ordinary course of a global business, there are many transactions for which the ultimate tax outcome is uncertain.  Although the Company believes its approach to determining its various tax provisions is reasonable, no assurance can be given that the final outcome will not be materially different than that which is reflected in the Company’s historical income tax provision and accruals upon review by taxing authorities.  Management believes that adequate amounts of tax and related interest and penalties, if any, have been reserved for any adjustments that may result from years open to examination from taxing authorities. As of June 30, 2006, $0.9 million has been reserved.  

| Item 2. | Management’s Discussion and Analysis of Financial   Condition and Results of Operations |
|---------|----------------------------------------------------------------------------------------------|

FORWARD-LOOKING STATEMENTS

Information set forth in this Quarterly Report on Form 10-Q of Embrex, Inc. contains various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements represent the Company’s judgment concerning the future and are subject to risks and uncertainties that could cause the Company’s actual operating results and financial position to differ materially. Such forward-looking statements can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “plan,” “intend,” “target,” “anticipate,” “estimate,” “believe” or “continue,” or the negative thereof or other variations thereof or comparable terminology. 

The Company cautions that any suchforward-looking statements include statements with respect to future products,services, markets and financial results.  These statements involve risksand uncertainties that could cause actual results to differ materially. Risks include, without limitation, the degree of growth in the poultry industryin the U.S. and globally, competition arising within the United States andelsewhere, possible decreases in production by the Company’s customers,avian disease outbreaks in the Company’s markets, and market acceptance andcost of expansion in new geographic markets.  Additional risks include theCompany’s ability to penetrate new markets and the degree of marketacceptance of new products, the complete development and commercialization ofpotential future products and approved products on a cost effective basis,including NewplexTM and Inovocox TM, the availability of adequateproduct supplies, the ability of the Company’s contract manufacturers tosupport its products, and the ability to obtain regulatory approval ofproducts.  Such approval is dependent upon a number of factors, such asresults of trials, the discretion of regulatory officials and potential changesin regulations.  Additional information on these risks and other factorsthat could affect the Company’s consolidated financial results aredescribed in Part II, Item 1A, “Risk Factors,” below and in theCompany’s other filings with the Securities and Exchange Commission,including the Company’s Forms 10-Q, 10-K and 8-K.

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The following discussion and analysis should be read in conjunction with the Company’s consolidated financial statements and related notes appearing elsewhere in this report.  The notes to the consolidated financial statements include Note 1, which describes the basis for presentation, and Note 2, which describes the Company’s critical accounting policies, including the Company’s SFAS 123(R) disclosure.

INTRODUCTION

Embrex, the In Ovo Company®, is aninternational biotechnology company engaged in the development of innovative*in ovo* solutions that meet the needs of the global poultryindustry.  The Company derives most of its global revenues from lease feesfor the number of eggs processed by its Inovoject® systems. Other revenuesources for the Company come from lease fees related to its Egg Remover®systems and Vaccine Saver® option installations. In addition to thesesources, the Company may sell each of these devices to distributors underspecial circumstances in selected countries and to human flu vaccinemanufacturers. Revenues from these sources are categorized as device revenues inthe Company’s financial statements. Another source of revenue for theCompany is product sales, which currently consist of sales of Bursaplex®,an *in ovo* vaccine for infectious bursal disease.  The Company alsoderives some revenues fromcontract research and development, and grant sources.  The Company’s cost of revenues is primarily attributable to the costs of supporting the Company’s devices at customer locations around the world.  These costs include the labor, travel and parts necessary to ensure proper biological and mechanical operation, as well as maintenance of Embrex’s devices located at hatcheries of the Company’s customers.  These costs also include associated depreciation, as well as sales and property tax expenses. The Company has also built the Embrex Poultry Health, LLC (Embrex Poultry Health or “EPH”) vaccine manufacturing facility.  In April 2006, the United States Department of Agriculture (“USDA”) granted product and manufacturing facility approvals for the Company to produce InovocoxTM, an *in ovo* vaccine for the control of coccidiosis, at EPH. 

RESULTS OF OPERATIONS

Three Months Ended June 30, 2006 and 2005

CONSOLIDATED NET INCOME

(dollars in thousands except per share amounts)

|                                |   | **Three   Months Ended   June 30   (unaudited)** |   |
|-------------------------------------|--------|--------------------------------------------------|--------|
|                                |   |                                                  |   |
|                                |   | **2006**                                         |   | **2005** |   | **Change** |   | **Change** |   |
|                                |   |                                                  |   |  |   |  |   |  |   |
| Total Revenue                       |   | $                                                | 13,289 |   | $ | 13,018 |   | $ | 271 |   |   | 2 | % |
| Gross Profit                        |   | $                                                | 7,812  |   | $ | 7,531 |   | $ | 281 |   |   | 4 | % |
| Operating Income                    |   | $                                                | 1,114  |   | $ | 1,372 |   | $ | (258 | ) |   | -19 | % |
| Net Income                          |   | $                                                | 533    |   | $ | 1,246 |   | $ | (713 | ) |   | -57 | % |
| Earnings per share – basic     |   | $                                                | 0.06   |   | $ | 0.16 |   | $ | 0.10 |   |   | -63 | % |
| Earnings per share –   diluted |   | $                                                | 0.06   |   | $ | 0.15 |   | $ | 0.09 |   |   | -60 | % |

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Consolidated net income was $0.5 millionfor the second quarter of 2006, a $0.7 million, or 57% reduction in comparisonto the same period in 2005. Diluted earnings per share were $0.06 for secondquarter 2006 and $0.15 for the same period in 2005.   Second-quarter 2006 earnings per share of $0.06 includes $0.04 of depreciationand term loan interest that the Company began to expense for Embrex PoultryHealth after the InovocoxTM vaccine and the facility were approved by theUSDA in April.  Second-quarter 2005 earnings per share of $0.15 includes$0.10 of capitalized InovocoxTM pre-licensure serials amounting to $0.5million and extraterritorial income exclusions from the filing of 2001 and 2002amended tax returns that amounted to another $0.5 million.

OUTSTANDING SHARES

(in thousands except percentages)

|                                          |   | **Three   Months Ended   June 30   (unaudited)** |   |
|-----------------------------------------------|--------|--------------------------------------------------|--------|
|                                          |   |                                                  |   |
|                                          |   | **2006**                                         |   | **2005** |   | **Change** |   | **Change** |   |
|                                          |   |                                                  |   |  |   |  |   |  |   |
| Basic Weighted Average   Shares Outstanding   |   |                                             | 8,254  |   |   | 7,964 |   |   | 290 |   |   | 4 | % |
| Diluted Weighted Average   Shares Outstanding |   |                                             | 8,446  |   |   | 8,278 |   |   | 168 |   |   | 2 | % |

The basic weighted average shares outstanding increased by 290 thousand shares, or 4%, from second quarter 2005 to the same period in 2006. The diluted weighted-average shares outstanding increased by 168 thousand shares, or 2% in the second quarter of 2006 over the same period in 2005.  These increases are primarily attributable to stock option exercises and the vesting of restricted stock grants. 

CONSOLIDATED REVENUES

(dollars in thousands)

|            |   | **Three   Months Ended   June 30   (unaudited)** |   |
|-----------------|--------|--------------------------------------------------|--------|
|            |   |                                                  |   |
|            |   | **2006**                                         |   | **2005** |   | **Change** |   | **Change** |   |
|            |   |                                                  |   |  |   |  |   |  |   |
| Device revenues |   | $                                                | 12,202 |   | $ | 12,172 |   | $ | 30 |   |   | 0 | % |
| Product sales   |   |                                             | 860    |   |   | 724 |   |   | 136 |   |   | 19 | % |
| Other revenues  |   |                                             | 227    |   |   | 122 |   |   | 105 |   |   | 86 | % |
|            |   |                                                  |        |   |  |  |   |  |  |   |  |  |   |
| Total revenues  |   | $                                                | 13,289 |   | $ | 13,018 |   | $ | 271 |   |   | 2 | % |
|            |   |                                                  |        |   |  |  |   |  |  |   |  |  |   |

Consolidated revenues for the second quarter of 2006 totaled $13.3 million, representing an increase of 2% over consolidated revenues of $13.0 million for the same period in 2005.

In the second quarter of 2006, device revenues were essentially unchanged.  An increase in installed Inovoject® systems, particularly in Latin America, and new Egg Remover® installations were somewhat offset by reduced egg sets as customers adjusted to supply and demand factors in both domestic and export markets.  The 2006 second quarter device revenues include an increase of $0.1 million in device lease fees derived from single- and multi-year contracts and paid trials from the second quarter of 2005. These recurring fees generally contribute more than 90% of the device revenues in most quarters.    Device revenues also include sales of Inovoject® and Egg Remover® systems to distributors and human flu vaccine manufacturers. The sporadic nature of Inovoject® and Egg Remover® system sales to distributors and human flu vaccine companies may cause variability in revenue and gross profit on an annual andquarterly basis.  For the second quarter of 2006, device sales were unchanged at $0.1 million when compared to the same period of 2005.  Overall, device revenues totaled $12.2 million for both the second quarter of 2006 and 2005. 

21

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Product sales consisted of revenues fromsales of Bursaplex®, the Company’s proprietary vaccine for avianinfectious bursal disease (“IBD”).  Bursaplex® is aproduct that uses the Company’s antigen-antibody complex (“AAC”)technology.  To date, approval to sell Bursaplex® has been received in33 countries.  Currently, Bursaplex® vaccine is being marketed in mostof the countries where regulatory approval has been obtained.  Regulatoryapprovals are being sought in various Latin American, Middle Eastern and Asianmarkets for in ovo and post-hatch use of Bursaplex® vaccine.  Productsales for the second quarter of 2006 totaled $0.9 million, representing anincrease of 19% over product sales of $0.7 million for the same period in2005.  This was primarily due to increased Bursaplex® sales in Asiathat occurred as the effects of avian influenza outbreaks subsided and poultryproduction in the region increased.

Other revenues increased from $0.1 million in the second quarter of 2005 to $0.2 million for the same period in 2006.  The majority of other revenues in the second quarter of 2006 consisted of funding from contract research and development, and grant sources.  The increase in other revenues was caused mainly by variability in grant income from the second-quarter of 2005 to the same period in 2006.

COST OF REVENUE

Gross margin improved one percentage point to 59% for the second quarter of 2006 compared to 58% for the same period of 2005. This is primarily due to certain sales and marketing expenses that were previously allocated to cost of revenue in 2005 have been retained in sales and marketing expenses in 2006 because such expenses are now primarily related to the support of the Company’s installed product base rather than the sale of the Company’s products.  Additional sales and marketing expenses may continue to be recorded under this classification rather than allocated to cost of revenue as infrastructure expands and matures. 

As fully depreciated devices are replaced with new devices, increased depreciation expenses could cause gross margins to decrease in the future.  Downward pressure on device lease fees, upward changes in other input costs, and regional and product mix could also cause gross margins to decrease in the future.  Depreciation expense included in cost of revenue amounted to $1.2 million and $1.1 million in the second quarters of 2006 and 2005, respectively.  Equity compensation expense included in cost of revenue amounted to $12 thousand in the second quarter of 2005.  There was no equity compensation included in cost of revenue in the second quarter of 2006.

OPERATING EXPENSES

(dollars in thousands)

|                       |   | **Three   Months Ended   June 30   (unaudited)** |   |
|----------------------------|--------|--------------------------------------------------|--------|
|                       |   |                                                  |   |
|                       |   | **2006**                                         |   | **2005** |   | **Change** |   | **Change** |   |
|                       |   |                                                  |   |  |   |  |   |  |   |
| General and administrative |   | $                                                | 2,909  |   | $ | 2,694 |   | $ | 215 |   |   | 8 | % |
| Sales and marketing        |   |                                             | 1,626  |   |   | 1,216 |   |   | 410 |   |   | 34 | % |
| Research and development   |   |                                             | 2,163  |   |   | 2,249 |   |   | (86 | ) |   | -4 | % |
|                       |   |                                                  |        |   |  |  |   |  |  |   |  |  |   |
| Total Operating Expenses   |   | $                                                | 6,698  |   | $ | 6,159 |   | $ | 539 |   |   | 9 | % |
|                       |   |                                                  |        |   |  |  |   |  |  |   |  |  |   |

22

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Operating expenses totaled $6.7 million for the second quarter of 2006 compared to $6.2 million for the same period of 2005.  The expense categories below include additional equity compensation expenses of nearly $0.1 million in accordance with SFAS 123(R) that were incurred in the second quarter of 2006.  

General and administrative (“G&A”) expenses were $2.9 million for the second quarter of 2006, an increase of $0.2 million over the same period of 2005.  Contributing to the increase were increases in staff-related and third-party expenses to support business growth in Latin America, increased expenses related to the start-up of Embrex Poultry Health and equity compensation expense.  Depreciation and amortization expense included in G&A amounted to $0.2 million in the second quarter of 2006 and $0.1 million in the second quarter of 2005.  Equity compensation expense included in G&A amounted to $105 thousand in the second quarter of 2006 and $71 thousand during the same quarter in 2005.  

Sales and marketing expenses were $1.6 million during the second quarter of 2006, an increase of 34% or $0.4 million over the same period in 2005.  The primary reason for the overall increase was pre-launch demonstration and marketing activities of InovocoxTM.  To a lesser extent, the increase was also due to expansion in Latin American operations and the continued support of existing products. Additionally, certain sales and marketing expenses that were previously allocated to cost of revenue in 2005 have been retained in sales and marketing expenses in 2006 because such expenses are now primarily related to the support of the Company’s installed product base rather than the sale of the Company’s products.  Additional sales and marketing expenses may continue to be recorded under this classification rather than allocated to cost of revenue as infrastructure expands and matures.  Depreciation and amortization expense included insales and marketing expenses amounted to $0.2 million in the second quarter of 2006 and $0.1 million in the second quarter of 2005. Equity compensation expense included in sales and marketing expenses amounted to $80 thousand in the second quarter of 2006 and $45 thousand in the second quarter of 2005. 

Research and development (“R&D”) expenses decreased $0.1 million from the second quarter of 2005 to the second quarter of 2006.  Depreciation and amortization expense included in R&D expense amounted to $0.3 million in the second quarter of 2006 and $0.2 million for the same period in 2005.  Equity compensation expense included in R&D amounted to $55 thousand in the second quarter of 2006 and $26 thousand in the second quarter of 2005.  The Company’s overall R&D expenses reflect expenditures incurred in three distinct departments:

The first of these departments, R&D, is responsible for expenditures associated with the work on the Company’s product portfolio, particularly NewplexTM vaccine and InovocoxTM, the *in ovo* coccidiosis vaccine.  R&D expenses remained unchanged at $1.2 million from the second quarter of 2005 to the same period in 2006.  

The second of these R&D departments, Global Product Development & Supply (“GPDS”), is responsible for development and testing of commercial machine devices and supply of biological products.  During 2005 this group also was responsible for development and commercial testing related to the Gender Sort project and overseeing start-up of the Embrex Poultry Health manufacturing facility for the production of InovocoxTM. GPDS expenses were $0.7 million in the second quarter of 2005 and decreased to $0.3 million in the second quarter of 2006.  This $0.4 million reduction is primarily due to the suspension of the Gender Sort project in the third quarter of 2005.  

23

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The third R&D department isEngineering and Manufacturing, which makes design modifications and improvementsto the Inovoject® and Egg Remover® systems, as well as theVaccine Saver® option. Manufacturing costs associated with Embrex PoultryHealth are captured in Engineering and Manufacturing expenses as well. Operating expenses for this department increased from $0.3 million in the secondquarter of 2005 to $0.6 million for the second quarter of 2006, primarily due to$0.5 million of validation costs for USDA pre-licensing serials ofInovocoxTM vaccine that were capitalized in the second quarter of 2005 forthe Embrex Poultry Health facility.  Without this capitalization, R&Dexpenses in the second quarter of 2006 would have shown a decrease of anadditional $0.5 million, for a reduction of 21% in comparison to the secondquarter of 2005 as some Embrex Poultry Health expenses have transitioned frommanufacturing functions to the sales and marketing group in support ofpre-launch demonstration and marketing activities of InovocoxTMvaccine.  Depreciation expense of the Embrex Poultry Health facility andrelated manufacturing equipment was $0.2 million in the second quarter of2006.     The group to which R&D expenses are classifiedmay change as the purpose of the specific activity or activities change to meetthe Company’s strategic and operational objectives.  In particular, anumber of activities such as product portfolio work for NewplexTM andInovocoxTM may take the form of commercial support.

OTHER INCOME AND EXPENSE

Net other income decreased from income of $0.1 million in the second quarter of 2005 to an expense of $0.1 million in the second quarter of 2006.  The reduction resulted primarily from a five-fold increase in interest expense from the second quarter of 2005 to the same period in 2006 related to the term loan for construction of Embrex Poultry Health.  This expense 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 prior to USDA licensure of the EPH facility and InovocoxTM vaccine. 

Interest expense commenced in the second quarter of 2006 as the Embrex Poultry Health facility obtained USDA approval to manufacture InovocoxTM in April 2006.  It is anticipated that interest expense related to the term loan will be approximately $0.3 million for the remainder of 2006.

Interest income was less than $0.1 million, and was essentially unchanged from the second quarter of 2005 to the same period of 2006.   

Other income amounted to less than $0.1 million for both the second quarter of 2006 and 2005.  The other income in both periods is primarily related to foreign currency transaction gains and losses. 

INCOME TAX EXPENSE

Income taxes were $527 thousand in the second quarter of 2006 compared to $199 thousand in the second quarter of 2005.  The second-quarter 2006 reported tax rate was 50%, compared to 14% for the same period in 2005.  In the second quarter of 2006, withholding taxes were $119 thousand and accounted for 11 percentage points of the 50% effective tax rate.  U.S. and non-U.S. income taxes were $408 thousand, or 39 percentage points of the 50% effective tax rate.   In the second quarter of 2005, withholding taxes amounted to $128 thousand, or 9 percentage points of the 14% tax rate, while U.S. and non-U.S. income taxes were $71 thousand and accounted for 5 percentage points of the 14% tax rate.  

Income tax expense was lower in the second quarter of 2005 due to the $0.5 million tax benefit recorded in the second quarter of 2005 related to the filing of amended tax returns for 2001 and 2002.  The returns were amended to reflect the Company’s claim for extraterritorial income exclusion.  

24

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Six Months Ended June 30, 2006 and 2005

CONSOLIDATED NET INCOME

(dollars in thousands except per share amounts)

|                              |   | **Six Months   Ended  June 30 (unaudited)** |   |
|-----------------------------------|--------|--------------------------------------------------|--------|
|                              |   |                                                  |   |
|                              |   | **2006**                                         |   | **2005** |   | **Change** |   | **Change** |   |
|                              |   |                                                  |        |   |  |  |   |  |  |   |  |  |   |
| Total Revenue                     |   | $                                                | 26,492 |   | $ | 25,781 |   | $ | 711 |   |   | 3 | % |
| Gross Profit                      |   | $                                                | 15,658 |   | $ | 14,801 |   | $ | 857 |   |   | 6 | % |
| Operating Income                  |   | $                                                | 1,948  |   | $ | 2,338 |   | $ | (390 | ) |   | -17 | % |
| Net Income                        |   | $                                                | 1,442  |   | $ | 1,856 |   | $ | (414 | ) |   | -22 | % |
| Earnings per share – basic   |   | $                                                | 0.18   |   | $ | 0.23 |   | $ | (0.05 | ) |   | -22 | % |
| Earnings per share – diluted |   | $                                                | 0.17   |   | $ | 0.22 |   | $ | (0.05 | ) |   | -23 | % |

Consolidated net income for thefirst six months of 2006 was $1.4 million, a 22% decrease from $1.9 million forthe same period in 2005.  Diluted earnings per share were $0.17 for thefirst half of 2006 and $0.22 for the same period in 2005.  First-half 2006earnings per share of $0.17 includes $0.03 of severance expense, as well asdepreciation, term loan interest that the Company began to expense for EmbrexPoultry Health after the InovocoxTM vaccine and the facility were approvedby the USDA in April, as well as a one-time election for including theCompany’s Brazilian subsidiary in its consolidated federal income taxreturns.  First-half 2005 earnings per share of $0.22 includes $0.09 ofcapitalized InovocoxTM pre-licensure serials amounting to $$0.5 million andextraterritorial income exclusions from the filing of 2001 and 2002 amended taxreturns that amounted to another $0.5 million.

OUTSTANDING SHARES

(in   thousands except percentages)

|                                          |   | **Six Months   Ended June 30 (unaudited)** |   |
|-----------------------------------------------|--------|--------------------------------------------|--------|
|                                          |   |                                            |   |
|                                          |   | **2006**                                   |   | **2005** |   | **Change** |   | **Change** |   |
|                                          |   |                                            |        |   |  |  |   |  |  |   |  |  |   |
| Basic Weighted Average Shares Outstanding     |   |                                       | 8,216  |   |   | 7,950 |   |   | 266 |   |   | 3 | % |
| Diluted Weighted Average   Shares Outstanding |   |                                       | 8,467  |   |   | 8,275 |   |   | 192 |   |   | 2 | % |

The basic weighted-average shares outstanding increased 266 thousand shares, or 3%, from the first half of 2005 to the first half of 2006.  The diluted weighted-average shares outstanding increased by 192 thousand shares, or 2%, in the first half of 2006 compared to the first half of 2005.  These increases are primarily attributable to stock option exercises and the vesting of restricted stock grants.   

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CONSOLIDATED REVENUES

(dollars   in thousands)

|            |   | **Six Months   Ended June 30  (unaudited)** |   |
|-----------------|--------|--------------------------------------------------|--------|
|            |   |                                                  |   |
|            |   | **2006**                                         |   | **2005** |   | **Change** |   | **Change** |   |
|            |   |                                                  |        |   |  |  |   |  |  |   |  |  |   |
| Device revenues |   | $                                                | 24,462 |   | $ | 24,094 |   | $ | 368 |   |   | 2 | % |
| Product sales   |   |                                             | 1,532  |   |   | 1,423 |   |   | 109 |   |   | 8 | % |
| Other revenues  |   |                                             | 498    |   |   | 264 |   |   | 234 |   |   | 89 | % |
|            |   |                                                  |        |   |  |  |   |  |  |   |  |  |   |
| Total revenues  |   | $                                                | 26,492 |   | $ | 25,781 |   | $ | 711 |   |   | 3 | % |
|            |   |                                                  |        |   |  |  |   |  |  |   |  |  |   |

Consolidated revenues for the first half of 2006 totaled $26.5 million, representing an increase of 3% over consolidated revenues of $25.8 million for the same period in 2005.

In the first half of 2006, device lease fees increased 2% or $0.4 million as compared to the first half of the prior year. The increase in device fees is primarily due to an increase in the Inovoject® system customer base, particularly in Latin America, as well as additional Egg Remover® installations.  Device revenues also include sales of Inovoject® and Egg Remover® systems to distributors and human flu vaccine manufacturers. The sporadic nature of Inovoject® and Egg Remover® system sales to distributors and human flu vaccine companies may cause variability in revenue and gross profit on an annual and quarterly basis. For the first half of 2006 this variability resulted in a $0.1 million decrease in device sales when compared to the first half of 2005. Overall, device revenues totaled $24.5 million for the first half of 2006 compared to $24.1 million for the same period in 2005, representing a 2% increase year overyear.

Although device revenues are up thus far in 2006 compared to 2005, the Company continues to have concerns based on the ongoing avian influenza outbreaks that may disrupt global poultry production and consumption levels, which could disrupt Inovoject® injection and/or product revenues.

Product sales increased 8% to $1.5 million in the first half of 2006 as compared to $1.4 million for the same period in 2005, due to increased Bursaplex® sales in Asia that occurred as the effects of avian influenza outbreaks subsided and poultry production in the region increased.

Other revenues increased 89% from $0.3 million for the first half of 2005 to $0.5 million for the same period of 2006.  The majority of other revenues in the second quarter of 2006 consisted of funding from contract research and development, and grant sources.  The increase in other revenues for the first half of 2006 was caused mainly by variability in grant income from the second quarter of 2005 to the same period in 2006.

COST OF REVENUE

Gross margin improved two percentage points to 59% for the first-half of 2006 compared to 57% for the first-half of 2005. This was primarily due to certain sales and marketing expenses that were previously allocated to cost of revenue in 2005 have been retained in sales and marketing expenses in 2006 because such expenses are now primarily related to the support of the Company’s installed product base rather than the sale of the Company’s products.  Additional sales and marketing expenses may continue to be recorded under this classification rather than allocated to cost of revenue as infrastructure expands and matures. 

26

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As fully depreciated devices are replaced with new devices, increased depreciation expenses could cause gross margins to decrease in the future.  Downward pressure on device lease fees, upward changes in other input costs, and regional and product mix could cause gross margins to decrease in the future.  Depreciation expense included in cost of revenue amounted to $2.3 million and $2.1 million in the first six-months of 2006 and 2005, respectively.  Equity compensation expense included in cost of revenue amounted to $12 thousand in the first six-months of 2005.  There was no equity compensation included in cost of revenue in the first six-months of 2006.

OPERATING EXPENSES

(Dollars   in thousands)

|                       |   | **Six Months   Ended  June 30  (unaudited)** |   |
|----------------------------|--------|--------------------------------------------------------|--------|
|                       |   |                                                        |   |
|                       |   | **2006**                                               |   | **2005** |   | **Change** |   | **Change** |   |
|                       |   |                                                        |        |   |  |  |   |  |  |   |  |  |   |
| General and administrative |   | $                                                      | 5,798  |   | $ | 5,268 |   | $ | 530 |   |   | 10 | % |
| Sales and Marketing        |   |                                                   | 3,261  |   |   | 2,195 |   |   | 1,066 |   |   | 49 | % |
| Research and development   |   |                                                   | 4,651  |   |   | 5,000 |   |   | (349 | ) |   | -7 | % |
|                       |   |                                                        |        |   |  |  |   |  |  |   |  |  |   |
| Total Operating Expenses   |   | $                                                      | 13,710 |   | $ | 12,463 |   | $ | 1,247 |   |   | 10.0 | % |
|                       |   |                                                        |        |   |  |  |   |  |  |   |  |  |   |

Operating expenses totaled $13.7 million for the first six months of 2006 compared to $12.5 million for the same period of 2005. The primary reason for the overall increase was to support growth in Latin American operations and prepare for the InovocoxTM pre-launch activities.  The expense categories below include additional equity compensation expenses of nearly $0.3 million in accordance with SFAS 123(R) that were incurred in the first half of 2006.  Other factors are described below.

G&A expenses were $5.8 million for the first half of 2006, up $0.5 million or 10% compared to $5.3 million for the same period of 2005.  Contributing to the increase was severance expense of $0.1 million incurred in the first quarter of 2006, increases in staff-related and third-party expenses to support business growth in Latin America, increased expenses related to the start-up of Embrex Poultry Health and equity compensation.  Depreciation and amortization expense included in G&A amounted to $0.4 million in the first six-months of 2006 and $0.2 million in the first six-months of 2005.  Equity compensation expense included in G&A amounted to $205 thousand in the first half of 2006 and $112 thousand for the first half of 2005.  

Sales and marketing expenses for the first-half of 2006 were $3.3 million, up $1.1 million compared to $2.2 million for the same period in 2005.  The primary reason for the overall increase was growth in marketing expenses related to pre-launch demonstration and marketing activities of InovocoxTM.  To a lesser extent, the increase was also due to expansion in Latin American operations and the continued support of existing products.  Additionally, certain sales and marketing expenses that were previously allocated to cost of revenue in 2005 have been retained in sales and marketing expenses in 2006 because such expenses are now primarily related to the support of the Company’s installed product base rather than the sale of the Company’s products.  Additional sales and marketing expenses may continue to be recorded under this classification rather than allocated to cost of revenue as infrastructure expands and matures. Depreciation and amortization expense included in sales and marketing expenses amounted to $0.4 million in the first half of 2006 and $0.2 million in the first half of 2005.  Equity compensation expense included in sales and marketing expenses amounted to $163 thousand in the first half of 2006 and $35 thousand in the first half of 2005. 

R&D expenses decreased $0.3 million from $5.0 million for the first sixmonths of 2005 to $4.7 million for the same period of 2006.  The decreaseis principally due to reduced expenses related to the Gender Sort project, whichwas suspended in the third quarter of 2005, although partially offsetting thiswas severance expense of $0.3 million incurred in the first half of 2006. Depreciation and amortization expense included in R&D expenses amounted to$0.6 million in the first half of 2006 and $0.5 million for the first half of2005.

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Equity compensation expense included in R&D expenses amounted to $114thousand in the first six-months of 2006 and $40 thousand in the firstsix-months of 2005. Depreciation expense of the Embrex Poultry Health facilityand related manufacturing equipment was $0.2 million in the first half of2006.  $0.5 million of this department’s expenses were capitalized in2005 related to validation costs for USDA pre-licensing serials ofInovocoxTM vaccine for the Embrex Poultry Health facility.   Without this capitalization, R&D expenses for the first half of 2006 wouldhave shown a decrease of an additional $0.5 million, for a reduction of 15% fromthe first half of 2005.

OTHER INCOME AND EXPENSE

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 InovocoxTM 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 TAX EXPENSE

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 taxreturns.  The returns were amended to reflect the Company’s claim for the extraterritorial income exclusion in 2001 and 2002.  

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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 InovocoxTM 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.  

29

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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 financialinstruments 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 InovocoxTM 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

| Item 1. | Legal Proceedings |
|---------|-------------------|

In December 2003, Embrex filed suit in theU.S. District Court for the Eastern District of North Carolina against BreuilS.A. (“Breuil”) of Landivisiau, France, and New Tech Solutions, Inc.of Gainesville, Georgia, asserting patent infringement.  Embrex allegesthat each of the defendants’ development of candling and *in ovo*selective injection devices, designed to compete with Embrex’s patentedInovoject® system injection with Vaccine Saver® option and EggRemover® system, infringes two Embrex patents related to Embrex’sproprietary apparatus and methods for distinguishing live eggs from infertile or“dead” eggs and for selectively injecting specific eggs identified assuitable for inoculation as well as the apparatus performing thisfunction.  Embrex seeks injunctive relief and monetary damages and hasasked for a jury trial.  The defendants have denied infringement andalleged that Embrex’s two patents are invalid.  Fact discovery isnearly completed. The court conducted a Markman hearing to determine the meaningand scope of the patent claims. The court issued a Markman opinion adoptingEmbrex’s claim construction.  Breuil filed a motion for summaryjudgment on patent marking.  Embrex opposed the motion.  The courtgranted Breuil’s motion as to both patents for the Vaccine Saver®option, and denied Breuil’s motion as to one patent for the EggRemover® system.  Breuil also filed a motion for leave to file asupplemental answer and counterclaims to include an alleged affirmative defenseof patent misuse, a counterclaim for alleged federal antitrust liability, and acounterclaim for alleged trade secret misappropriation.  The court grantedthe motion.  Embrex answered the supplemental counterclaims denying anyliability and asserting affirmative defenses.  Embrex filed a motion forsummary judgment of infringement, and a motion for summary judgment of patentvalidity.  Briefing on the motions is completed.  The court’sdecision is pending.  Because of this lawsuit, the Company’s resultsof operations have been impacted and will continue to be impacted by the costsof pursuing this litigation. Moreover, there can be no assurance the Companywill 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 assurancesthat any damage award will exceed the Company’s costs of pursuing thislitigation or that the Company would be able to collect any damages from eitherdefendant.  

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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 courtheard 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 courtfinds 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.

| 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 andpreserving 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;                                                                                                           |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                        |
|   | • | 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 thesepotential 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;                                    |

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|   | • | 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 April 2006, the USDA granted Embrex’s InovocoxTM 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 theInovocox TM 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 regulatoryapproval of NewplexTM, our*in ovo* Newcastle Diseasevaccine, within the United States.  NewplexTM vaccine isalso based on AAC technology.  Although we have received approval to sellNewplexTM in nine countries, we have recently discovered difficulties in theformulation and production of NewplexTM, which has affected manufacturing ona consistent basis. While we resolve these issues we may not have productsupplies available.  There is no assurance that we will resolve thesemanufacturing issues, that supplies will be available, thatNewplexTM will be sold in commercial quantities in the UnitedStates or in any of the other countries where approval has been obtained, orthat 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;                                                                                                                                            |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                |
|   | • | 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 domestic or export markets together with global 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 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 comesfrom 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 approximately23% 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 existingproducts 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; |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                     |
|   | • | 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.

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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 NEWPLEXTM ***

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.

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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 NewplexTM 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 NewplexTM 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 NewplexTM.  Although there are other manufacturers that may be capable of manufacturing AAC antibody, Bursaplex®, and NewplexTM, 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 ormanufacturing 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 NewplexTM 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 andpublic disclosure, including the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley),new Public Company Accounting Oversight Board standards and rules, new SECregulations, and new Nasdaq rules, are creating uncertainty and expense forcompanies such as ours.  These new or changed laws, regulations andstandards are complex and extensive, and as a result, their application inpractice may evolve over time as new guidance is provided by regulatory andgoverning bodies, which could result in evolving disclosure and corporategovernance practices. 

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As a result, our efforts to comply with evolving laws, regulations and standardshave resulted in, and are likely to continue to result in, increased G&Aexpenses and management time related to compliance activities.  Inparticular, our efforts to comply with Section 404 of Sarbanes-Oxley andthe related regulations regarding our assessment of our internal controls overfinancial reporting and our external auditors’ audit of that assessment hasrequired the commitment of significant financial and managerial resources. We expect these efforts to require the continued commitment of significantresources including additional outside legal, accounting and advisoryservices.  In addition, as our international operations continue to growand foreign operations become financially significant, it will be necessary forthose foreign subsidiaries to meet requirements for internal control overfinancial reporting pursuant to Section 404 of S arbanes-Oxley.  Dueto the limited staffing at some of our foreign subsidiaries, there is noassurance that we would be able to meet requirements for internal control overfinancial reporting, particularly requirements for segregation of duties. If we fail to comply with new or changed laws, regulations and standards, ourreputation may be harmed and we might be subject to sanctions or investigationby regulatory authorities, such as the SEC.  Any such action couldadversely 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 andadverse 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 theydiscover 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 substantiallyinhibiting 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  |   |

| Item 5. | Other   Information |
|---------|---------------------|

Not applicable.

| Item 6. | Exhibits |
|---------|----------|

| **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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