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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

Form 10-K

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

For the fiscal year ended December 31, 2002
Commission file number 000-19495

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

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.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

As of June 28, 2002, the aggregate market value of the voting and non-voting common stock held by non-affiliates was $170.7 million, based on 8,161,004 of outstanding common shares and a price per common share of $20.92 at the close of business on that date. 

As of February 28, 2003, there were 8,171,993 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

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INDEX

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PART I

ITEM 1.  BUSINESS

GENERAL

Embrex, Inc. (“Embrex” or the “Company”) is an international agricultural biotechnology company engaged in the development of innovative in ovo (“in the egg”) solutions that meet the needs of the global poultry industry. Embrex is focused on developing patented biological and mechanical products that improve bird health, help reduce production costs and provide other economic benefits to the poultry industry. The Company was incorporated in 1985 in North Carolina and is headquartered in Research Triangle Park, North Carolina area.

Embrex has developed and commercialized the Inovoject® system, a proprietary, automated in-the-egg injection system which can inoculate 20,000 to 50,000 eggs per hour and eliminates the need for manual, post-hatch injection of certain vaccines.  The Inovoject® system is designed to inject vaccines and other compounds into targeted compartments within the egg.  Embrex markets the Inovoject® system to commercial poultry producers, charging a fee for each egg injected. The Company has also introduced the Vaccine Saver® option and Egg Remover™ module to provide additional automation benefits to the poultry hatchery. The Vaccine Saver® option for the Inovoject® system identifies infertile and early-dead eggs and selectively prevents vaccination to these eggs. The Egg Remover^TM module works in conjunction with the Inovoject® system to remove infertile and early-dead eggs from incubator trays prior to inoculation through the Inovoject® system. 

In addition to the Inovoject® system and related devices, Embrex has developed and is marketing a virus-antibody complex vaccine technology, VNF®, useful in the development of certain avian vaccines.  The Company also has developed and is marketing Bursaplex®, a VNF®-based vaccine for protection against avian infectious bursal disease (“IBD”).  Embrex also is developing various other proprietary mechanical and biological products to improve bird health, reduce bird production costs and provide other economic benefits to the poultry industry.  These products are in various stages of development, and some are being developed in collaboration with major animal health companies, the United States Department of Agriculture (the “USDA”), major poultry producers and several leading universities in the field of avian science. These products are being designed to be delivered through the Inovoject® system, and some may also be administered prior to incubation as well as after hatching.

EXISTING PRODUCTS

Inovoject® Egg Injection System

Embrex has developed and commercialized a proprietary, automated in-the-egg injection system, which can inoculate 20,000 to 50,000 eggs per hour and eliminates the need for manual, post-hatch injection of certain vaccines.  This proprietary system, called the Inovoject® system, is designed to inject vaccines and other compounds in precisely calibrated volumes into targeted compartments within the egg.  Embrex markets the Inovoject® system to commercial poultry producers, charging a fee for each egg injected.

In 2002, the Company converted a number of hatcheries to the Inovoject® system and continued operating Inovoject® systems in hatcheries converted prior to 2002.  The Company estimates that its Inovoject® system inoculates in excess of 80% of all eggs produced for the United States and Canada broiler poultry markets and, therefore, expects diminished growth in the number of system installations and only minor Inovoject® system revenue growth in this market.  Therefore, the Company must expand its Inovoject® system, along with Vaccine Saver® and Egg Remover™, installations and vaccine product sales in worldwide markets in order to realize sustainable overall revenue growth.  The Company estimates that approximately 70% or more of the world broiler production occurs outside the United States and Canada.  Accordingly, the Company is continuing its strategy to further market its Inovoject® system and other products outside North America.

During 2002, the Company placed a number of Inovoject® systems for trial and on contract at locations outside the United States and Canada.  The Company’s initial expansion outside the United States and Canada was focused on Europe, the Middle East, and Africa.  In 1997, the Company began expansion efforts in Asia and, in 1998, in Latin

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America.  Currently, the Company has Inovoject® systems either operating on contract or on trial in 32countries.  Overall, the placement of Inovoject® systems outside the United States and Canada is dependent on market acceptance of various in ovo (“in the egg”) vaccines and obtaining regulatory approval of these vaccines in numerous countries.

Embrex has developed and introduced the Vaccine Saver® option for the Inovoject® system, which identifies infertile and early-dead eggs and selectively prevents vaccination to these eggs.  It is designed for use in select markets where vaccine prices are high.  The Vaccine Saver® option was introduced in Europe in 1999.  Embrex has also developed a related system, the Egg Remover ^TM that works in conjunction with the Inovoject® system to remove infertile and early-dead eggs from incubator trays.  This product has been placed in ongoing hatchery field trials and several commercial installations, primarily in North America and Europe.

Certain poultry diseases are more prevalent in some geographic regions than in others.  For example, Marek’s disease, for which the Inovoject® system primarily is used in the United States, is not as widespread in Europe as in North America.  Infectious Bursal Disease (also known as Gumboro disease) is prevalent in Northern Europe, the Middle East, Asia, parts of Latin America and, to a lesser extent, in the United States.  The Company expects that the primary usage of its Inovoject® systems will vary by geographic region according to the prevailing diseases as well as regulatory approval and market acceptance of vaccines for in ovo delivery.  There are a number of poultry vaccines marketed by various animal health companies in the United States and other markets, which can be used with the Inovoject® system or after hatch. The relative demand and cost for these vaccines and customer willingness to use in ovo delivery or substitute in ovo vaccines for after hatch vaccines will influence Inovoject® system, Vaccine Saver® and Egg Remover ^TM usage.

VNF® (Viral Neutralizing Factor)

Embrex has developed, patented and commercialized a virus-antibody complex vaccine technology, VNF®, which permits single-dose immunization of the avian embryo effective for the life of the bird.  By using the VNF® technology to form a virus-antibody complex, immunization is provided in a single step, reducing or eliminating many of the multiple vaccinations carried out in the industry.  The presence of the VNF® antibody delays the onset of virus replication allowing the safe in ovo administration of moderately attenuated vaccine viruses.  By using VNF® in this manner, certain virulent vaccine viruses can be made into a safe and effective vaccine, which can be used in ovo or after hatch.

The VNF® technology is the subject of five issued U.S. patents and several foreign patents and foreign patent applications.  The U.S. patents are owned by the University of Arkansas and exclusively licensed to Embrex for avian use on a royalty basis for the life of the patents.  The last of these U.S. patents will expire during 2012. VNF® is a component in the Company’s Infectious Bursal Disease vaccine, Bursaplex®, described below.  Embrex has also applied VNF® technology to other avian disease vaccines, including Newcastle disease, which is currently under registration review by the USDA. There is no assurance that the Company’s research will result in product opportunities.

Infectious Bursal Disease (IBD) Vaccines

VNF® technology has been used in a vaccine against avian IBD, which weakens a bird’s immune system.  Birds infected by IBD typically exhibit poor growth or can succumb to other diseases because of a compromised immune system.  This disease is currently widespread in Northern Europe, the Middle East, Asia, parts of Latin America and, to a lesser extent, in the United States.  To date, IBD has been treated post-hatch via manually delivered vaccines or in drinking water.  Existing vaccines are associated with certain limitations, and some IBD vaccines cannot be used safely or effectively in ovo.  The Company estimates the worldwide market for IBD vaccines is approximately $60 million annually.

Embrex currently is seeking regulatory approval in selected Latin American, Middle Eastern and Asian markets for in ovo and post-hatch use of Bursaplex®.  Regulatory approval and market acceptance of various in ovo vaccines can facilitate the placement of Inovoject® systems in certain markets. To date, regulatory approval for Bursaplex® has been received in 24 countries besides the United States, and regulatory approval is temporary or pending in

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seven countries. Currently, Bursaplex® is being marketed in most of these countries where regulatory approval has been obtained.

The Company’s VNF® technology has been used in an IBD vaccine produced by Fort Dodge Animal Health, a division of Wyeth, formerly American Home Products, which was to be marketed by Fort Dodge in certain European countries under Fort Dodge’s trade name Bursamune®.  During the second quarter of 2001, Fort Dodge advised its distributors that certain other Fort Dodge products, which compete with Bursamune®, could potentially be used in ovo in place of Bursamune®.  Also, Fort Dodge has informed Embrex that it has discontinued manufacturing and does not intend to market or seek further regulatory approvals for Bursamune®.  Embrex believes Fort Dodge remains obligated under its agreements with Embrex.  After discussions with Fort Dodge to reach resolution on this matter were unsuccessful, the Company filed a complaint in April 2002 in Wake County Superior Court, North Carolina against Fort Dodge Australia, Pty. Ltd. and Wyeth, alleging breach of contractual obligations to develop, register and market Bursamune® in the territories of Europe, the Middle East and Africa; unfair and deceptive trade practices; and related claims.  In May 2002, the case was moved to the United States District Court for the Eastern District of North Carolina.  In July 2002, Wyeth asserted a counterclaim against Embrex alleging breach of contract and related claims, which Embrex intends to vigorously defend.  Embrex does not expect to generate further revenues from either the sales of VNF® to Fort Dodge or the royalties generated from Fort Dodge’s Bursamune® sales.  January of 2003 Embrex amended its complaint to add seven entities that are subsidiaries of or otherwise affiliated with Wyeth as additional defendants.  In responding to the amended complaint, the original defendants withdrew five of seven counterclaims.

PRODUCTS UNDER DEVELOPMENT

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

In Ovo Products for Control of Coccidiosis and Newcastle Disease

The Company is developing a novel in ovo biological control method for coccidiosis.  Coccidiosis is caused by a protozoan parasite, which attacks the gut of the chicken, causing significant problems with the intake and digestion of feed and, therefore, the physical and economic performance of the bird.  Currently, virtually all broiler chickens, and most poultry in general, receive anti-coccidiosis compounds called coccidiostats incorporated into poultry feed.  Over the years, coccidia have developed levels of resistance to these coccidiostats and thus effectiveness has been somewhat reduced.  Additionally, environmental and food safety groups, especially in Europe, are lobbying to have coccidiostats removed from the market. While Embrex believes that these factors will lead to a change in the market where coccidiosis vaccines are favored over coccidiostats, this cannot be guaranteed. Currently, a limited number of live vaccines have been developed and are administered orally soon after hatch.  However, due to difficulties in providing a precise oral dose to each bird, growth depression and non-uniformity can occur in broiler flocks.  Therefore, such live vaccines are used primarily in parent stock.  Using its Inovoject® system technology and its knowledge of avian embryology, the Company is developing a novel, efficacious and cost-effective means of preventing coccidiosis in broiler chickens.  This program is aimed at overcoming many of the problems associated with current practices.  The Company estimates that the worldwide market for products that control coccidiosis is approximately $350 million per year.

In 1997, the Company established the feasibility of an in ovo biological control method for coccidiosis.  In late 1997 the Company began working with Pfizer Inc. and in 1999 the two companies entered into a collaborative research and development program to research and develop a live coccidiosis vaccine for in ovo delivery to poultry.  During 2000 and 2001, Embrex conducted large-scale field trials, coordinated with two major U.S. poultry producers that demonstrated that Inovocox™, Embrex’s in ovo coccidiosis vaccine under development, is safe and efficacious, with performance equivalent to the commonly used coccidiostats.  Although these field trials have been positive, there is no assurance that ongoing research and development will result in a marketable product.  In June of 2001, the Company announced that it had acquired an exclusive worldwide license from Pfizer Inc. to all pending patents relating to in ovo poultry coccidiosis vaccines.  Under the license agreement, Pfizer will receive milestone payments from Embrex and a royalty on future sales of the vaccine. Two patents covering the process of vaccination in ovo,

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against coccidiosis, issued in the United States in December 2002.  Collectively these patent rights, held by Pfizer and licensed exclusively to Embrex, cover the use of various life stages of the parasite for immunization in ovo.  In January 2003, Embrex broke ground on construction of a biological manufacturing facility located near Laurinburg, North Carolina for the purpose of manufacturing Inovocox™ - the Company’s proprietary in ovo coccidiosis vaccine.  Continued development of this project will involve further clinical and field trials. There can be no assurances that any of these development efforts will be successful.  Embrex has initiated the USDA regulatory approval process with respect to these development efforts, and does not expect any coccidiosis product developed by the Company to reach the market until USDA approval is obtained. Although this product has been submitted for registration there is no assurance that USDA approval will be obtained.

The registration application for Newplex™, Embrex’s Newcastle disease in ovo vaccine which like Bursaplex® is based on VNF® technology, was submitted to the USDA during July 2001.  Following an initial positive response, the USDA allowed the manufacture of pre-licensing serials (vaccine lots), which were used in field trials required for product registration.  Reports on the field trials and label texts were supplied to the USDA in September and November of 2002. Although this product has been submitted for registration there is no assurance that the USDA approval will be obtained.

Gender Sorting Device

During 2002, Embrex continued its efforts to automate avian gender sorting.  The Company believes that the economical and efficient in ovo determination of a bird’s gender before it hatches will lead to an increase in the practice of raising birds separately by gender.  In a number of independent studies, gender-separate rearing has been shown to increase the efficiency of feed utilization, improve processing plant operations and ultimately provide consumers with more uniform and economic poultry. In 1999, Embrex received a Phase I Small Business Innovation Research (SBIR) grant to support the development of an automated device to sort poultry eggs by gender and, in 2000, Embrex was awarded a $270,000 follow-on Phase II SBIR grant to support development of an automated device for sorting poultry eggs by gender.  The USDA’s Cooperative State Research, Education and Extension Service (CSREES) supported the grants. 

Embrex has made substantial progress in developing a gender sorting prototype and in laboratory scale trials has determined gender in a series of eggs with 100% accuracy.  In April 2001, Embrex entered into a Credit Agreement with Advanced Automation, Inc. under which Embrex agreed to loan Advanced Automation up to $3.4 million in connection with development and construction of a gender sorting automation module for the Inovoject® system. In July 2001, Embrex entered into a Research, Development and Marketing Agreement with LifeSensors, Inc. under which Embrex and LifeSensors are collaborating in the development and production of a gender sorting biosensor module for the Inovoject® system. The Company also entered into a Beta License and Non-Disclosure Agreement with Luminex Corporation for evaluation of an alternative assay for gender sorting in August 2002.

In July 2001, Embrex entered into an agreement with Cobb-Vantress, a world leader in broiler breeding, under which Cobb-Vantress agreed to provide funds for Embrex’s ongoing development of patented technology and a device to determine the gender of poultry in ovo.  Embrex subsequently received initial funding from Cobb-Vantress.  Upon the achievement of certain milestones in the development and commercialization of Embrex’s gender sort device technology, to the mutual satisfaction of the parties, Embrex anticipates receiving additional non-refundable payments from Cobb-Vantress. In return, Cobb-Vantress will receive favorable commercial terms upon adopting the gender sort device, if and when the device is ultimately commercialized.  Embrex estimates that the worldwide market potential for the new gender sorting technology is in excess of $300 million annually.

In June 2002, the gender sort prototype was placed in a commercial hatchery for further field development. Although the Company believes that this prototype placement and the Cobb-Vantress arrangement are positive steps forward, no assurances can be made that Embrex’s development work will lead to a commercial device.

Other Products Under Development

In June 2000, Embrex announced that it had embarked on a research collaboration with Origen Therapeutics, Inc., a privately held biotechnology company based in Burlingame, California, aimed at combining Origen’s avian embryonic stem (ES) cell technology with Embrex’s in ovo technology.  The goal of the collaboration is to develop

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methods that enhance poultry production economics through intervention early in embryonic development. In July of 2001, Embrex along with Origen Therapeutics, Inc. was awarded an Advanced Technology Program (ATP) grant totaling $4.7 million from the National Institute of Science and Technology (NIST), a division of the U.S. Department of Commerce.  The four-year grant will help fund a project, with a proposed budget of $9.7 million, for development of technology aimed at the large-scale production of poultry utilizing avian embryonic stem (ES) cells and in ovo technology.  Although the Company believes that this arrangement and this grant are positive steps forward, no assurances can be made that Embrex’s development work will lead to a commercial technology.

Embrex routinely enters into collaborative agreements with various animal health companies, pharmaceutical companies as well as research and academic institutions to evaluate the utility of certain of their compounds, technologies and devices when delivered or applied in ovo.  Depending upon the outcome of these evaluations, Embrex may or may not proceed with these collaborations for further development.  There is no assurance that these efforts will yield products or further collaborations.

PATENTS AND PROPRIETARY RIGHTS

Embrex controls (either through direct ownership or exclusive license) 41 issued U.S. patents, 20 pending U.S. patent applications, 126 issued foreign patents and 155 pending foreign patent applications. In addition, Embrex has executed confidentiality agreements with its collaborators, subcontractors, employees and directors. 

The Inovoject® system utilizes a process of injecting viral, bacterial or fungal vaccines into avian eggs that was patented in the United States by the USDA in 1984 (the “Sharma Patent”).  Embrex held the exclusive license to this patent through its expiration in June 2002 and Embrex has supplemented this patent with seven additional issued U.S. patents (and numerous foreign patents and patent applications) covering specific design features of the Inovoject® system. See Item 3, “Legal Proceedings”, below.

Embrex also owns or licenses method-of-use patents for the in ovo administration of VNF® vaccines and other compounds to elicit various beneficial responses in poultry.  Two U.S. patents issued in 1995 for methods of treating IBD virus infections using VNF® vaccines, including in ovo administration, are owned by the University of Arkansas and licensed exclusively to Embrex.  A U.S. patent claiming the use of VNF® viral vaccines in all non-primate animals was issued in February 1999.  A U.S. patent claiming the use of VNF® bacterial vaccines issued in 2002. These patents and additional patent applications encompass the use of VNF® vaccine compounds regardless of the source of the VNF®.  These VNF® patents additionally include composition-of-matter claims to VNF® vaccines against IBD virus disease and composition-of-matter claims to VNF® vaccines for combating viral diseases in non-primate animals.  These patent claims cover the vaccine preparation, regardless of the manner in which the preparation is used. 

The Company filed three new U.S. patent applications in 1998, 10 new U.S. patent applications in 1999, six new U.S. patent applications in 2000, six new U.S. patent applications in 2001 and 12 new U.S. patent applications in 2002. During 2002, Embrex also filed nine new foreign patent applications.  Each application covered various aspects of in ovo technology.

Embrex continues its efforts to patent methods of delivering compounds in ovo, including early intervention methods and devices.  During the years 1998 through 2002, 24 U.S. patents were issued or allowed, further expanding Embrex’s proprietary position with respect to in ovo technology. 

Additionally, Embrex has federally registered the trademarks Embrex®, Inovoject®, VNF®, Bursaplex® and Vaccine Saver® in the United States, and has applied for federal and foreign registration of other various trademarks including Egg Remover™, Newplex™, Inovocox™ and The In Ovo Company^SM.

COMPETITION

The competition for the Inovoject® system is presently the manual, post-hatch administration of biological products.  Since most of Embrex’s products and potential products are being designed to be administered through the Inovoject® system, the Inovoject® system must continue to be accepted within the poultry industry and operated as intended under long-term commercial conditions for these potential products to be marketed successfully.

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The Company’s exclusive license to the U.S. patent for injecting vaccines into an avian embryo, the Sharma Patent, expired in June 2002.  Embrex has supplemented this patent with seven additional U.S. patents covering specific design features of the Inovoject® system.In addition, Embrex relies on numerous foreign patents to protect its intellectual properties and to afford a competitive advantage.  See “Patents and Proprietary Rights” above.  There can be no assurance, however, that a competitive delivery method, either within or outside the United States, will not gain commercial acceptance, particularly now that the Sharma Patent has expired.  Embrex continues to monitor for the presence of any competitive in ovo administration systems worldwide.  See Item 3, “Legal Proceedings,” below.

Competitive success for Embrex will be based primarily on the current comprehensive customer service and commercial acceptance of third-party and in-house in ovo products, achieving and retaining scientific expertise and technological superiority, identifying and pursuing scientifically feasible and commercially viable opportunities, obtaining proprietary protection for its research achievements, obtaining adequate funding and timely regulatory approvals, and attracting corporate sponsors or partners in developing, testing, producing, and marketing products, none of which can be assured.  In addition, a primary competitive factor affecting Embrex is its ability to conduct research and development.  Embrex’s ability to successfully compete also is dependent on its ability to attract and retain key personnel.  Maintaining financial and human resources, therefore, are important factors for success.

PRODUCTION, MARKETING AND DISTRIBUTION

Production

Embrex currently subcontracts the production of all of its mechanical and biological products and expects to continue to do so for the foreseeable future.  The Company believes that alternative sources of manufacture and supply generally exist. 

In March 2003, the Company announced that it had broken ground on construction of an $11.0 million biological manufacturing facility located near Laurinburg, North Carolina.  The facility will be designed to manufacture the Company’s Inovocox™ in ovo coccidiosis vaccine upon approval from the USDA.  Design and construction of Embrex’s biological manufacturing facility is being managed by Lockwood Greene, a firm with extensive experience in the design and construction of pharmaceutical manufacturing facilities.  The main manufacturing facility will house vaccine purification, sterile filling, shipping and receiving, as well as quality control laboratories. The site will also include two poultry brooder houses and a building for the initial steps of the production process. Certain aspects of the novel manufacturing process are unique and proprietary to Embrex. Ground breaking occurred in January 2003 and completion of the construction of the project is expected to take approximately one year.

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

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

See “Risk Factors” filed as Exhibit 99 to this report.

VNF® (Viral Neutralizing Factor) Vaccines

In 1993, Embrex signed multi-year agreements with SPAFAS, Inc. (“SPAFAS”), a subsidiary of Charles River Laboratories, Inc., under which SPAFAS supplies the VNF® component for the bursal vaccine Bursaplex®.  In connection with this agreement, Embrex maintains appropriate inventory levels and places orders with SPAFAS to allow Embrex to satisfy anticipated customer demand for VNF®.  The regulatory approval granted by the USDA for Bursaplex® in 1997 specifically covers vaccines produced with SPAFAS-manufactured VNF®.  Additional

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agreements covering the Company’s needs of VNF® for use in Bursaplex® and other products, including the Company’s Newcastle disease vaccine, Newplex™, for the next four years are in negotiation and are expected to be finalized in the first half of 2003.

The Company has granted Merial Select, Inc. (“Select”) (a Merck and Aventis company) exclusive rights to manufacture, in the United States, an IBD vaccine containing Embrex’s VNF® product, known as Bursaplex®, for Embrex to market in North America, Latin America and Asia.  Embrex has also granted Fort Dodge (a division of Wyeth) non-exclusive rights to manufacture IBD vaccines containing the Company’s VNF® product, known as Bursamune®, to be marketed in Europe, the Middle East and Africa.  However, these rights are not being exercised pending resolution of the Fort Dodge legal matters described above.  Abic Ltd. has been granted similar rights to manufacture and market an IBD vaccine, known as GuMBryo™, in Israel.  The manufacture of the IBD vaccines produced by Select and Abic, and the Company’s VNF® product, generally must be performed in licensed facilities or under approved regulatory methods.  Although there are other manufacturers who are capable of manufacturing IBD products and producing products such as VNF®, a change of supplier for the Company could adversely affect Embrex’s future operating results due to the time it would take a new supplier to obtain regulatory approval of its production process or manufacturing facilities.  The Company seeks to minimize this exposure through multi-year supply agreements and the maintenance of adequate inventories.

Marketing and Distribution

Because of the geographical and industrial concentration of the poultry industry in the United States and other global markets, Embrex markets its products and provides ongoing service directly to the industry.  Embrex’s marketing is focused principally on the broiler chicken segment of the poultry industry, but the Company also has adapted its products for use by, and initiated trials and entered into commercial contracts with, broiler breeder companies and a limited number of layer and turkey producers. 

In order to encourage proper use of the Inovoject® system technology within an appropriate production environment, Embrex leases and licenses Inovoject® systems to hatcheries.  The lease agreements cover the use of the mechanical equipment and ongoing field service, maintenance and technical support provided by Embrex.  The agreements also include a license with royalty fees for use of Embrex’s proprietary injection process. Also, in a very limited number of markets, under specific circumstances Embrex may sell the Inovoject® system to a third party distributor or a human flu vaccine manufacturer.  Products, which are delivered in ovo, are sold separately by Embrex and also by others which may generate some royalty revenue for the Company during 2003. However due to the expiration of the Sharma Patent these separate in ovo products will no longer generate royalty revenue after 2003.

The Company has initiated arrangements for international distribution of Bursaplex®, subject in each case to the availability of required regulatory approvals.  The Company has agreements with other parties to distribute Bursaplex® in Colombia, Dominican Republic, Egypt, Japan, Lebanon, Malaysia, Peru, Pakistan, Poland, South Africa, South Korea, Syria, Taiwan, Venezuela and Vietnam.  Of these countries, all but Egypt and South Africa have granted regulatory approval for Bursaplex®. An agreement in Israel also entitles a distributor, Abic Ltd., to manufacture and market a VNF®-based IBD vaccine mentioned above.  Subject to these agreements, the Company also will conduct international marketing directly. To date, regulatory approval for Bursaplex® has been granted in 24 countries besides the United States, and regulatory approval is temporary or pending in seven countries. Embrex has also added staff for selected Asian and Latin American markets and installed Inovoject® systems on a commercial or trial basis in certain Asian markets.  In 1998, Embrex established Embrex BioTech Trade (Shanghai) Co., Ltd. in China, which will focus on marketing and distribution of Embrex products in China.  Also in 1998, Embrex established Embrex Inc. Sucursal Argentina, a branch office in Argentina, responsible for commercial development and customer service and support.  Initially, this office only served Argentina but now extends to other regional markets such as Bolivia, Chile, Paraguay or Uruguay.  In 1999, Embrex established a subsidiary in Brazil, Inovoject do Brasil Ltda.  In January 2001, Embrex established subsidiaries in France and Spain to market and service Inovoject® systems in those countries.

In Japan, Embrex has a distribution agreement with Ishii Company, Ltd. (“Ishii”), a subsidiary of I.P. Tsusho Co., Ltd., a leading chick producer and the dominant supplier of hatchery equipment in Japan. The Japanese Ministry of Agriculture, Fisheries and Forestry granted veterinary medical device regulatory approval for the Inovoject® system

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in 1999.  Ishii is marketing the Inovoject® egg injection system to poultry producers throughout Japan.  In December 2000, Boehringer Ingelheim Shionogi Vetmedica, formerly Shionogi & Co., LTD, Embrex’s exclusive distributor in Japan for Bursa-BDA [NP], the Japanese product name for Bursaplex®, successfully gained the necessary regulatory registration of the product for the Japanese market.  In December 2002, Embrex signed a distribution agreement with Kaketsuken for the development, registration and marketing of Newplex™ in Japan.

The Company’s revenues attributable to international operations in 2002, 2001, and 2000 were 31%, 31% and 29% of the Company’s consolidated revenues, respectively.  The Company’s identifiable assets attributable to international operations in 2002, 2001 and 2000 were 25%, 32%, and 36% of the Company’s consolidated assets, respectively.

The Company’s gross profit attributable to international operations in 2002, 2001 and 2000 were 21%, 19% and 16% of the Company’s consolidated gross profit respectively.  See “Notes to Consolidated Financial Statements.”

RESEARCH AND DEVELOPMENT EXPENDITURES

Research and development expense was $6.7 million in 2000, $8.1 million in 2001 and $10.2 million in 2002.  The increase in research and development expense from 2000 to 2002 largely reflects additional research activities in several areas including: increased outside contract research, analytical lab supply consumption, additional Inovoject® system, Vaccine Saver® and Egg Remover™ design and development and global technical support activity. Research and development is principally Company sponsored and funded primarily from internal sources and supplemented by grant and other sources of funds as appropriate.

GOVERNMENTAL REGULATION

Regulation by governmental authorities in the United States and other countries is a significant factor in the production and marketing of Embrex’s products and in its on-going research and development activities.  Although the use of the Inovoject® system is not subject to regulatory approval in the United States, animal health products being developed by Embrex and other companies must receive approval for marketing from either the USDA or the Food and Drug Administration (the “FDA”) and from similar regulatory agencies in foreign countries where the Company has begun or contemplates doing business.  These countries also may require approval of the Inovoject® system.  Regulatory agencies require that products be tested and demonstrate appropriate levels of safety and efficacy.  Generally, with respect to animal health products in the United States, the USDA has regulatory authority over products which are biological in origin or which stimulate or affect an animal’s immune system and the FDA has authority over all other animal health products.  The time and cost of USDA approvals are generally less than those for FDA approvals.  FDA approval generally requires more extensive animal and toxicology testing than USDA approvals and may take five or more years to obtain, whereas USDA approvals generally take one to three years to obtain.

Management believes that compliance with environmental regulations currently has no material adverse effect on the Company’s capital expenditures, earnings or competitive position.

EMPLOYEES

At December 31, 2002, Embrex employed 241 persons, 239 of whom were full-time employees, an increase of 19 persons from the 220 full-time employees at December 31, 2001.

SIGNIFICANT CUSTOMERS

Tyson Foods, Inc. (“Tyson”) accounted for approximately 19% of Embrex’s consolidated 2002 revenues.  Based on millions of pounds of ready-to-cook poultry meat produced in 2002, Tyson accounted for approximately 22% of the broilers grown in the United States.  During 1997, Tyson extended its contract with Embrex through 2004.  There are no customers besides Tyson that represent 10% or greater of total revenues.  However, Embrex’s three largest customers, including Tyson, accounted for approximately 30% of consolidated 2002 revenues, down from 32% in 2001.  The decrease in 2002 is largely the result of the expansion of the Company’s customer base.

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See “Risk Factors” filed as Exhibit 99 to this report.

AVAILABLE INFORMATION

Embrex maintains an Internet site, http://www.embrex.com, that contains additional information concerning the Company.  Embrex makes available free of charge through its Internet site its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after Embrex electronically files such material with, or furnishes it to, the Securities and Exchange Commission (SEC).  Information on the Company’s Internet site is not part of or incorporated into this report on Form 10-K.

ITEM 2.  PROPERTIES

Embrex leases its corporate headquarters and research and development facilities, which occupy approximately 48,000 square feet and are located adjacent to Research Triangle Park, North Carolina.  About one-third of the space is devoted to research and development.  The lease has an initial six-year term expiring 2005 with annual rent increases of approximately 3% and an additional six-year optional renewal term with annual rent increases of approximately 4%.  Embrex paid an annual rent of approximately $0.5 million during 2002.  In addition to research and development activities conducted at its corporate headquarters, Embrex has a 12,800 square-foot research facility near its headquarters.  The lease is a 10-year term expiring November 14, 2007, with a five-year renewal option.  The annual rent paid in 2002 was approximately $0.2 million, with annual increases of approximately 3% through the first 10 years and approximately 4% during the five-year renewal term.

In addition to the Company’s facilities in North Carolina, Embrex has leased office and warehouse space in some of its offsite and international operations.

ITEM 3.  LEGAL PROCEEDINGS

In 1996, Embrex filed a patent infringement suit in the U.S. District Court for the Eastern District of North Carolina against Service Engineering Corporation, a Maryland corporation, and Edward G. Bounds, Jr., a Maryland resident and officer of Service Engineering Corporation.  The suit alleged that each of the defendants’ development of an in ovo injection device, designed to compete with Embrex’s patented Inovoject® system injection method, infringes at least one claim of U.S. Patent No. 4,458,630 exclusively licensed to Embrex for the in ovo injection of vaccines into an avian embryo (the “Sharma Patent”).  Further, Embrex claimed that the defendants had violated the terms of a Consent Judgment and Settlement Agreement entered into with Embrex in November 1995 in which prior litigation was concluded with Service Engineering Corporation and Edward G. Bounds, Jr. agreeing not to engage in future activities violating the Sharma Patent.  Embrex sought injunctive relief to prevent infringement of the Sharma Patent as well as monetary damages.  In November 1996, Service Engineering Corporation and Edward G. Bounds, Jr., responded to Embrex’s patent infringement suit by asserting various affirmative defenses and denying the substantive allegations in Embrex’s complaint.  This suit concluded on July 30, 1998 with a jury verdict in favor of Embrex.  The verdict fully upheld the validity of all claims of the Sharma Patent, finding that the defendants had willingly infringed all asserted claims of the patent.  The jury also found that Service Engineering Corporation and Edward G. Bounds, Jr., had breached the 1995 Consent Judgment and Settlement Agreement and that such breach was not in good faith.  The jury awarded Embrex damages of $500,000 plus litigation expenses and court costs.  The U.S. District Court for the Eastern District of North Carolina entered a Judgment in favor of Embrex on September 28, 1998, which included a monetary award of $2,612,885 and an injunction prohibiting Service Engineering Corporation and Edward G. Bounds, Jr., from practicing methods claimed in, or otherwise infringing, the Sharma Patent.  That injunction expired with the expiration of the Sharma Patent in June of 2002. Following an appeal by Service Engineering Corporation and Edward G. Bounds, Jr. to the U.S. Court of Appeals for the Federal Circuit seeking a reversal of the Judgment, in July 2000, the United States Court of Appeals for the Federal Circuit affirmed the district court’s decision to award to Embrex litigation expenses plus interest valued at approximately $1.5 million.  In addition, the appeals court upheld the finding that Service Engineering Corporation and Edward G. Bounds, Jr. had willfully infringed all asserted claims of the Sharma Patent.  However, the appeals court vacated the award of direct infringement damages finding that the district court erroneously awarded direct damages without proper evidence to support the award.  Therefore, the appeals court remanded that award ($500,000 which was trebled) to the district court for further proceedings for determination of a reasonable royalty for the infringement of

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the patented method by Service Engineering Corporation and Edward G. Bounds, Jr.  These proceedings were opened on August 28, 2000, but were stayed early in 2001 pending the conclusion of a bankruptcy proceeding initiated by Edward G. Bounds, Jr.

During the second quarter of 2001, Fort Dodge advised its distributors that certain other Fort Dodge products, which compete with Bursamune® in ovo IBD vaccine, could potentially be used in ovo in place of Bursamune®.  Also, Fort Dodge has informed Embrex that it has discontinued manufacturing and does not intend to market or seek further regulatory approvals for Bursamune®.  Embrex believes Fort Dodge remains obligated under its agreements with Embrex.  After discussions with Fort Dodge to reach resolution on this matter were unsuccessful, the Company filed a complaint in April 2002 in Wake County Superior Court, North Carolina against Fort Dodge Australia, Pty. Ltd. and Wyeth, alleging breach of contractual obligations to develop, register and market Bursamune® in the territories of Europe, the Middle East and Africa; unfair and deceptive trade practices; and related claims.  In May 2002, the case was moved to the United States District Court for the Eastern District of North Carolina.  In July 2002, Wyeth asserted a counterclaim against Embrex alleging breach of contract and related claims, which Embrex intends to vigorously defend.  Embrex does not expect to generate further revenues from either the sales of VNF® to Fort Dodge or the royalties generated from Fort Dodge’s Bursamune® sales.  January of 2003 Embrex amended its complaint to add seven entities that are subsidiaries of or otherwise affiliated with Wyeth as additional defendants.  In responding to the amended complaint, the original defendants withdrew five of seven counterclaims.

See “Risk Factors” filed as Exhibit 99 to this report.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2002.

PART II

ITEM 5.  MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company’s Common Stock trades on the Nasdaq National Market under the symbol EMBX.  The quarterly trading ranges of the sales prices of the Company’s Common Stock (based on each day’s closing prices during the specified quarter) for the last two fiscal years were as shown in the table below:

At February 28, 2003, there were 400 holders of record of the Common Stock.  The Company has paid no dividends on any stock since inception and has no plans to pay dividends on its Common Stock in the foreseeable future.

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ITEM 6.  SELECTED FINANCIAL DATA

SUMMARY OF OPERATIONS BY QUARTERS (UNAUDITED)

The selected financial data below should be read in conjunction with the Company’s consolidated financial statements and related notes appearing elsewhere in this report.

(In Thousands, Except Per Share Amounts)