Product sales decreased by approximately 6%, or $59,000, to $924,000 during the three-month period ended September 30, 2008 in comparison to $983,000 during the same period in 2007. Product sales increased by approximately 3%, or $99,000, to $3,381,000 during the nine-month period ended September 30, 2008 in comparison to $3,283,000 during the same period in 2007. Sales of our products may be influenced by the price of milk, heifers and calves. A common index used in the industry to measure the price of milk is known as the Class III milk price, which indicates the value of 100 pounds of milk sold into the cheese market. The average Class III milk price for 2007 was $18.04 per 100 pounds, which represents a 52% increase over the 2006 average of $11.89. During the first nine months of 2008, this average price level was $17.93, which represented a 2% increase over the first nine months of 2007. For a point of reference, this price level was $10.42 in 2002, which approximates the price level experienced during the 1970's. While an increase in the sales value of milk is good for our customers, some of this benefit has been offset by increases in the costs to produce milk. One measure of this relationship is known as the milk-feed price ratio, which represents the amount of feed that one pound of milk can buy. For 2007, this ratio averaged 2.80. The monthly average during the first nine months of 2008 dropped to 2.01, representing a 28% decrease compared to the first nine months of 2007. A ratio of 2.01 means that a dairy producer can buy 2.01 pounds of feed for every pound of milk sold. Whenever the ratio meets or exceeds 3.0, it is considered profitable to buy feed and produce milk. The increase in feed costs also has a negative impact on the beef industry. Another indication of the economic condition of the dairy industry is the price received by producers for milking cows. In 2007, this price is estimated to have increased to approximately $1,840, which is a 6% increase over 2006. In 2008, this price averaged approximately $1,953, which represents a 6% increase over 2007. Another factor in the demand for our product is the value of bull calves. The recent decline in the price of bull calves has reduced the return on investment from a dose of First Defense® for bull calves.

Our lead product, First Defense ®, continues to benefit from wide acceptance as an effective tool to prevent bovine enteritis (scours) in newborn calves. Sales of this product increased 2% during the nine-month period ended September 30, 2008 in comparison to the same period in 2007. We launched this product in 1991 after receiving USDA approval for its sale. During the first quarter of 2008, we sold our 8,000,000th dose of First Defense®. Sales are normally seasonal, with higher sales expected during the first and fourth quarters and lower sales expected during the second and third quarters.

During the second quarter of 2006, certain regional organic certifying agencies determined that the ingredients in First Defense ® are in compliance with the National Organic Program (NOP) and may be considered for use on organic farms. First Defense®should be considered a preventative vaccine as described in USDA-NOP regulations for organic producer consideration when establishing management plans.

Sales of Wipe Out® Dairy Wipesincreased by 3% during the nine-month period ended September 30, 2008 in comparison to the same period in 2007. Domestic sales of this premium product are challenged by less expensive competitive products and by the continuing economic pressure in the U.S. dairy industry that is forcing many small producers out of business.

Other Revenues

Given the termination of a product development and marketing agreement covering Mast Out ® during the third quarter of 2007, no technology licensing revenue was recorded during the three and nine-month periods ended September 30, 2008, respectively, in contrast to $931,000 and $1,248,000 during the three and nine-month periods ended September 30, 2007, respectively. Royalty income decreased to $33 and $5,000 during the three and nine-month periods ended September 30, 2008, respectively, in comparison to $18,000 and $36,000 during the same periods in 2007, respectively, as the result of lower sales reported by the firm that has licensed our milk protein purification technology.

Gross Margin

Changes in the gross margin on product sales are summarized in the following
table for the respective periods (in thousands, except for percentages):



                                       Three-Month Periods
                                       Ended September 30,            Decrease
                                       2007            2008        Amount       %
         Gross margin               $       506       $   303     $    203      40 %
         Percent of product sales            52 %          33 %         19 %    37 %

                                       Nine-Month Periods
                                       Ended September 30,            Decrease
                                       2007            2008        Amount       %
         Gross margin               $     1,665       $ 1,499     $    166      10 %
         Percent of product sales            51 %          44 %          7 %    14 %

                                      Twelve-Month Periods            Increase
                                       Ended September 30,           (Decrease)
                                       2007            2008        Amount       %
         Gross margin               $     2,203       $ 2,338     $    135       6 %
         Percent of product sales            51 %          48 %         (3 )%   (6 )%

We now experience lower gross margin percentages in comparison to those achieved in the past. The gross margin as a percentage of product sales was 33% and 52% during the three-month periods ended September 30, 2008 and 2007, respectively. The gross margin as a percentage of product sales was 44% and 51% during the nine-month periods ended September 30, 2008 and 2007, respectively. The gross margin as a percentage of product sales was 48% and 51% during the twelve-month periods ended September 30, 2008 and 2007, respectively. This compares to gross margin percentages of 52%, 56% and 61% for the years ended December 31, 2007, 2006 and 2005, respectively. Our current annual target for gross margin percentage is 50%, a level consistent with our experience for the year ended December 31, 2007 and for the twelve-month periods ended September 30, 2008 and 2007. The gross margin percentage was unusually low during the three-month period ended September 30, 2008. We expect some fluctuations in gross margin percentages from quarter to quarter. A number of factors account for the relative increase in costs and for their variability. Biological yields from the raw material used in the production of First Defense ® do fluctuate over time. Like most manufacturers in the U.S., we have been experiencing increases in the cost of raw materials that we purchase. Product mix also affects gross margin in that we earn a

higher gross margin on First Defense® and a lower gross margin on Wipe Out ® Dairy Wipes. Because First Defense® customers are price sensitive, we had held its selling price without significant increase for about seven years, believing that we could benefit more from higher unit sales volume than through a higher average selling price per unit. However, during the first quarter of 2008, we did implement a modest increase to the selling price of First Defense®.

Product Development and Licensing

Product development expenses decreased by approximately 18%, or $104,000, to $485,000 during the three-month period ended September 30, 2008 in comparison to the same period in 2007. Product development expenses aggregated 53% and 31% of total revenues during the three-month periods ended September 30, 2008 and 2007, respectively. Product development expenses increased by approximately 8%, or $91,000, to $1,241,000 during the nine-month period ended September 30, 2008 in comparison to the same period in 2007. Product development expenses aggregated 37% and 25% of total revenues during the nine-month periods ended September 30, 2008 and 2007, respectively. During the three and nine-month periods ended September 30, 2007, product development expenses included approximately $329,000 and $439,000, respectively, in non-cash amortization expense pertaining to a technology asset that was written off during the third quarter of 2007 when the associated product development and marketing agreement covering Mast Out ® was terminated. The increased cash expenses (excluding the non-cash amortization in the 2007 periods) during the three and nine-month periods ended September 30, 2008 principally reflect the costs of funding the development of Mast Out® internally.

In April 2000, we acquired an exclusive license from Nutrition 21, Inc. to develop and market Nisin-based products for animal health applications, which allowed us to initiate the development of Mast Out®. In November 2004, we paid Nutrition 21 approximately $965,000 to buy out this royalty and milestone-based license to Nisin, thereby acquiring control of the animal health applications of Nisin. Nisin, the same active ingredient contained in Wipe Out®Dairy Wipes, is an antibacterial peptide that is commonly used as a preservative in dairy food products. Nisin is known to have activity against most gram positive and some gram negative bacteria. Mast Out ®, an intramammary infusion product containing Nisin, is being developed as an alternative to traditional antibiotics used in the treatment of mastitis in lactating dairy cows. The use of antibiotics in food-producing animals may be a contributing factor to the rising human public health problem of bacterial drug resistance. Mast Out® could potentially reduce the use of traditional antibiotics in the treatment of mastitis.

Traditional antibiotic products currently on the market for use in the treatment of mastitis are sold subject to a requirement to discard milk from treated cows during the course of and for a period following antibiotic treatment (the milk discard requirement). Currently, it is common practice to treat only clinical cases (cows producing abnormal milk) since that milk already is unsuitable for commercial sale. Because milk from cows with subclinical mastitis (cows with infected udders but still producing normal milk) can be sold, dairy producers generally do not treat subclinical mastitis in order to avoid the milk discard requirement. The safety profile of Nisin and its long history as a food preservative may allow for the sale of Mast Out ® in the U.S. without a milk discard requirement, which would be a significant competitive advantage. No other intramammary mastitis treatment product has such a "zero discard" claim. Without the milk discard requirement, we believe Mast Out® could expand the subclinical mastitis treatment market niche. Regulations in the European Union will likely require that Mast Out ® be sold subject to a milk discard requirement in that territory.

In January 2004, we achieved positive results from an experimental field trial of Mast Out ® in 139 cows with subclinical mastitis. The placebo-controlled, blinded, multi-farm study was conducted in collaboration with researchers at Cornell University. Mast Out ® demonstrated a statistically significant overall cure rate in two separate dosage groups as compared to the placebo group. The currently proposed treatment regimen (three doses at three consecutive milkings) demonstrated a 58% efficacy rate in eliminating infection in lactating cows with culture-confirmed mastitis (compared to a placebo cure rate of 10%). This efficacy rate represents a blended average of results from cows with mastitis caused by several different pathogens. For example, Mast Out® achieved a statistically significant 100% efficacy rate in Streptococcus agalactiae cases (compared to a placebo cure rate of 25%), where antibiotics are commonly used effectively, and a statistically significant 28% efficacy rate in Staphylococcus aureus cases (compared to a placebo cure rate of 0%), where antibiotics are often not effective.

In December 2004, we entered into a product development and marketing agreement with Pfizer Animal Health, a division of Pfizer, Inc. covering Mast Out®. Under that agreement (as later amended and supplemented), we received $2,375,000 in payments from Pfizer. During 2005, Pfizer completed a study further supporting the effectiveness of Mast Out® in cows with subclinical mastitis. During 2006, Pfizer made other significant progress in the areas of effectiveness, manufacturing and pharmacokinetics. In July 2007, we received notice from Pfizer that it had elected to terminate the product development and marketing agreement. Since then, Pfizer has returned to us all rights, data, information, files, regulatory filings, materials and stocks of Nisin and Nisin producing cultures relating to the development of Mast Out®.

We believe that Pfizer's decision to terminate the product development and marketing agreement was not based on any unanticipated efficacy or regulatory issues. Rather, we believe Pfizer's decision was primarily market driven, largely relating to concerns that the use of Mast Out® may require specific treatment restrictions at the herd level, when used to treat subclinical mastitis with no milk discard. Due to its antibacterial nature, Nisin in bulk tank milk could interfere with the manufacture of certain (but not all) cultured milk products (some kinds of cheese and yogurt), if a high enough percentage of animals from a herd is treated at any one time. We believe that this risk could be eliminated by following a herd-level treatment guideline, currently estimated at approximately 2% of the herd on Mast Out® treatment in any given week. This guideline would require the subclinically mastitic cows in a herd to be treated over a period of weeks rather than all at once, in order to ensure that Nisin levels in bulk tank milk remain below levels that could affect the susceptible starter cultures. Milk that is sold exclusively for fluid milk products would not be subject to this restriction. We believe that the benefits of using Mast Out® would outweigh the management costs associated with implementing this treatment guideline. Over time and with market acceptance of Mast Out®, Nisin-resistant starter cultures could be developed using starter development and improvement programs that are common in the cheese industry for development of desirable culture characteristics such as phage-resistance and flavor development. These activities could result in relaxation or elimination of the herd-level treatment guidance. Our decision to continue product development efforts reflects our belief that Mast Out® is approvable by the FDA without a milk discard requirement for sale in the U.S. We believe that such a product would have significant sales potential in the U.S. dairy market.

Commercial introduction of Mast Out® in the United States is subject to approval by the U.S. Food and Drug Administration (FDA), Center for Veterinary Medicine, which approval cannot be assured. It is our objective to submit the administrative New Animal Drug Application (NADA) to the FDA during the first half of 2010, unless we encounter an unanticipated number of submission-review cycles with the FDA. Foreign regulatory approvals would be required for sales in key markets outside of the United States and would involve some similar and some different requirements.

In July 2007, we began preparations for the pivotal effectiveness study. Such preparations included the production of registration batches of Mast Out® drug product to fulfill the pivotal regulatory requirements of effectiveness, target animal safety, and stability. In June 2008, we initiated the pivotal effectiveness study. We are working with more than twelve investigators across the U.S. to complete this study. As of October 2008, we had enrolled approximately 40% of the qualified cases required to reach our targeted study size. Achieving the enrollment of the total number of cases meeting our clinical requirements will take the study into the first half of 2009. Upon completion of the treatment phase, we will commence orderly close out of the clinical sites, analysis of the data and discussion of the results with the FDA before a public announcement can be made.

The approval of several additional "Technical Sections" under the FDA's phased review of a NADA is also required before any U.S. product sales would be allowed. Included among the additional Technical Sections required for NADA final approval are: 1) Environmental Impact, 2) Target Animal Safety, 3) Human Food Safety, 4) Chemistry, Manufacturing and Controls and 5) several administrative requirements. During the third quarter of 2008, we received the Environmental Impact Technical Section Complete Letter from the FDA. Work required for the Target Animal Safety Technical Section has been initiated, and critical studies are planned for 2009. The Human Food Safety data will determine the milk discard period. The Human Food Safety Technical Section includes several subsections such as residue chemistry (which is in progress), total metabolism (which is in progress), effects of drug residues in food on human intestinal microbiology (which is under FDA review), effects on bacteria of human health concern or antimicrobial resistance (which is under FDA review) and toxicology (which is complete). Toxicology studies establish an Acceptable Daily Intake (ADI) level for humans, and the toxicological ADI for Nisin supports a zero milk and meat withhold claim. The toxicology studies are similar to the studies performed by others that affirmed the Generally Regarded As Safe (GRAS) status of Nisin for use as a food preservative. All of these subsections must be completed before a Human Food Safety Technical Section Complete Letter can be issued by the FDA.

Commercial-scale manufacturing of Mast Out® will need to comply with current Good Manufacturing Practice (cGMP) regulations and will be subject to FDA approval and inspection. With assistance from outside consultants, we are examining contract manufacturing options for the Active Pharmaceutical Ingredient (API) at this time. We have not yet made a determination of the cost or location of the commercial API manufacturing facility. We do have a commercial manufacturing relationship with an FDA-approved drug product manufacturer to formulate the API into drug product, conduct sterile-fill of syringes and perform final packaging.

In addition to our work on Mast Out ®, we are actively exploring further improvements, extensions or additions to our current product line. For example, we currently are investigating therapies that could prevent scours in calves caused by enteric pathogens other than E. coli K99 and coronavirus (the current First Defense® claims). In connection with that effort, during the second quarter of 2006 we obtained an option to an exclusive license from Baylor College of Medicine covering certain rotavirus vaccine technology. Additionally, during the second quarter of 2007, we acquired an option to an exclusive license from Ohio State University covering certain rotavirus technology. If the studies and development that we have planned over the next six months proceed effectively, we could conduct the pivotal effectiveness study in 2009, which could position us for USDA approval by the first half of 2010.

Wipe Out ® Dairy Wipes are manufactured in compliance with cGMP regulations, as required by federal law. We are investing in the process improvements, facility modifications, new equipment, staffing changes and increased documentation required to become compliant with cGMP regulations for our other products, where compliance is not required. We expect that the implementation of these increased standards will result in improved overall quality and consistency in our manufacturing operations. We completed certain related facility renovations and new equipment purchases during 2007 to facilitate this compliance effort. It is our objective to have implemented the process improvements and enhanced process documentation necessary to comply with cGMP regulations across our entire product line by the fourth quarter of 2009. Our initial target date for compliance (the end of 2008) has been extended, consistent with our decision to postpone initiation of a second facility investment project from September 2008 to at least the spring of 2009. See "Liquidity and Capital Resources", below.

We believe that market opportunities for growth of First Defense ® sales exist in foreign territories. Regulatory authorities in some foreign territories may require that our manufacturing operations be compliant with cGMP regulations. We are working with in-country consultants in key markets to help us through the process of seeking foreign regulatory approvals. Because of import restrictions, in-country production may be required to gain regulatory approval to sell First Defense ® in Australia and New Zealand. In March 2008, we entered into a license agreement with Anadis, Ltd. of Australia. Under this agreement, we gained access to relevant production technology and capabilities of Anadis in Australia. We are obligated to pay Anadis a royalty on any sales of First Defense® manufactured in Australia in collaboration with Anadis.

There may be additional animal disease indications for Nisin that we decide to pursue using pharmaceutical-grade Nisin produced under cGMP. During 2006, we completed a collaborative study of Nisin susceptibility in methicillin-resistant canine staphylococcal isolates with investigators at University of Pennsylvania School of Veterinary Medicine. One hundred isolates of methicillin-resistant canine Staphylococcus aureus (MRSA), intermedius and schleiferi were tested and found to be highly susceptible to Nisin's antibacterial activity. These data were presented at the 2007 North American Veterinary Dermatology Forum in Kauai, Hawaii. During the second quarter of 2008, we completed a study in collaboration with the University of Tennessee evaluating the effectiveness of Nisin impregnated wipes used to treat skin infections in dogs. The study consisted of two separate clinical feasibility studies, each of which was defined by the severity of canine skin infections. In the first study, 10 dogs with localized surface skin infections were treated with Nisin impregnated wipes as a stand alone therapy for 2 weeks. The second study consisted of treating 20 dogs that had more severe skin infections generally located in multiple sites on the body. The skin infections in the second study were treated with Nisin impregnated wipes in conjunction with systemic antibiotics. While this study was not designed to show statistical significance, the results do suggest that Nisin could be effective against pyoderma caused by common bacteria, such as methicillin-resistant Staphylococci. The results confirmed our expectation that Nisin is not as effective against fungal and gram negative causes of pyoderma. We continue to evaluate whether further development of this or other Nisin formulations is warranted and remain open to out-licensing this product opportunity to a partner more focused on the companion animal market than we are.

While we continue to pursue internally funded product development programs, we also remain interested in acquiring new products and technologies that fit with our sales focus on the dairy and beef industries. We maintain relationships with several scientific collaborators who have particular expertise in the areas of strategic interest to us. We occasionally hire outside consultants to assist us with our development work depending upon staff availability, the technical skills required, the nature of the particular project and other considerations. As additional opportunities arise to commercialize our own technology, or licensable technology, we may begin new product development projects. All of our employees are required to execute non-disclosure, non-compete and invention assignment agreements intended to protect our rights in our proprietary products.

General and Administrative Expenses

During the three-month period ended September 30, 2008, general and administrative expenses increased by 3%, or $7,000, to $222,000 as compared to the same period in 2007. During the nine-month period ended September 30, 2008, general and administrative expenses increased by 16%, or $99,000, to $716,000 as compared to the same period in 2007. The increases result, in large part, from increased compensation expense, costs associated with complying with the Sarbanes-Oxley Act of 2002 and other costs associated with being a publicly-held company.

Product Selling Expenses

During the three-month period ended September 30, 2008, product selling expenses increased by 28%, or $32,000, to $145,000, as compared to the same period in 2007, aggregating 16% and 12% of product sales during the three-month periods ended September 30, 2008 and 2007, respectively. During the nine-month period ended September 30, 2008, product selling expenses increased by 15%, or $56,000 to $423,000, as compared to the same period in 2007, aggregating 13% and 11% of product sales during nine-month periods ended September 30, 2008 and 2007, respectively. Our objective is to maintain the ratio of product selling expenses to product sales below 15% on an annual basis.

(Loss) Income Before Income Taxes and Net (Loss) Income

Our loss before income taxes of $(500,000) during the three-month period ended September 30, 2008 contrasts to income before income taxes of $605,000 during the three-month period ended September 30, 2007. We recorded a 46% income tax benefit during the three-month period ended September 30, 2008 in contrast to income tax expense of 41% during the three-month period ended September 30, 2007. Our net loss for the three-month period ended September 30, 2008 was $(268,000) (or $(0.09) per share) in contrast to net income of $354,000 (or $0.12 per share) during the three-month period ended September 30, 2007. Our loss before income taxes of $(710,000) during the nine-month period ended September 30, 2008 contrasts to income before income taxes of $1,029,000 during the nine-month period ended September 30, 2007. We recorded a 40% income tax benefit during the nine-month period ended September 30, 2008 in contrast to income tax expense of 43% during the nine-month period ended September 30, 2007. Our net loss for the nine-month period ended September 30, 2008 was $(429,000) (or $(0.15) per share) in contrast to net income for the nine-month period ended September 30, 2007 of $590,000 (or $0.19 per diluted share).

LIQUIDITY AND CAPITAL RESOURCES

Cash, cash equivalents and short-term investments decreased by 6%, or $336,000, to $5,076,000 at September 30, 2008 from $5,412,000 at December 31, 2007. Net cash provided by operating activities amounted to $5,000 during the nine months ended September 30, 2008 as compared to $252,000 during the nine months ended . . .