<PAGE>   1

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

                                    FORM 10-K

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

                   For the Fiscal Year Ended December 31, 1998

                                       OR

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

For the transition period from ___________________ to _______________________

                        Commission File Number 000-23467

                           PENWEST PHARMACEUTICALS CO.

             (Exact name of registrant as specified in its charter)

            WASHINGTON                                          91-1513032
     -------------------------------                 ---------------------------
     (State or other jurisdiction of                      (I.R.S. Employer
     incorporation or organization)                      Identification No.)

                  2981 Route 22
           PATTERSON, NEW YORK                                 12563-9970
     ---------------------------------------------           -------------------
     (Address of principal Executive Offices)                    (Zip Code)

     Registrant's telephone number, including area code:

                                 (914) 878-3414

           SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

     TITLE OF EACH CLASS               NAME OF EACH EXCHANGE OF WHICH REGISTERED
     NONE                                                    NONE
                     SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

                          Common Stock, $.001 par value
                          COMMON STOCK PURCHASE RIGHTS

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 at least the past 90 days.

                                    Yes  [X]    No  [ ]

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. [X]
<PAGE>   2

                                  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

(continued)

The aggregate market value of the Registrant's Common Stock held by
non-affiliates as of March 20, 1999 was approximately $115 million. The number
of shares of the Registrant's Common Stock (the Registrant's only outstanding
class of stock) outstanding as of March 20, 1999 was 11,121,904.

                       DOCUMENTS INCORPORATED BY REFERENCE

The Registrant's definitive Proxy Statement relating to the 1999 Annual Meeting
of Shareholders is incorporated by reference into Part III of this Form 10-K.


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PART I

ITEM 1: BUSINESS

GENERAL

      The Company is engaged in the research, development and commercialization 
of novel drug delivery technologies. Based on its extensive expertise in
developing and manufacturing tabletting ingredients for the pharmaceutical
industry, the Company has developed its proprietary TIMERx(R) controlled release
drug delivery technology, which is applicable to a broad range of orally
administered drugs, and Prosolv SMCC(TM), another drug delivery technology.

TIMERX CONTROLLED RELEASE TECHNOLOGY

      The Company has developed the TIMERx delivery system, a novel drug
delivery technology, which is based on the Company's knowledge of excipients, to
address the limitations of currently available oral controlled release delivery
systems. The Company believes that the TIMERx system is a major advancement in
oral drug delivery that represents the first easily-manufactured oral controlled
release drug delivery system that is applicable to a wide variety of drug
classes, including soluble drugs, insoluble drugs and drugs with a narrow
therapeutic index. The Company intends to utilize the TIMERx system to formulate
generic versions of controlled release drugs, controlled release formulations of
currently-marketed immediate release drugs and New Chemical Entities ("NCE's").

      The TIMERx drug delivery system is a hydrophilic matrix combining
primarily a heterodispersed mixture, usually polysaccharides xanthan and locust
bean gums, in the presence of dextrose. The physical interaction between these
components works to form a strong, binding gel in the presence of water. Drug
release is controlled by the rate of water penetration from the gastrointestinal
tract into the TIMERx gum matrix, which expands to form a gel and subsequently
releases the active drug substance. The TIMERx system can precisely control the
release of the active drug substance in a tablet by varying the proportion of
the gums, together with the third component, the tablet coating and the tablet
manufacturing process. Drugs using TIMERx technology are formulated by combining
the active drug substance, the TIMERx drug delivery system and additional
excipients and compressing such materials into a tablet.

      Each of the TIMERx formulations developed by the Company to date has been
developed under a collaborative arrangement with a pharmaceutical company. The
Company's collaborator, Leiras OY, a Finnish subsidiary of Schering AG
("Leiras"), received marketing approval in Finland for Cystrin CR(R) , a
controlled release version of oxybutynin utilizing Penwest's TIMERx technology
for the treatment of urge urinary incontinence and began marketing the product
in Finland in January 1998. The Company's collaborator, Sanofi Winthrop
International S.A. ("Sanofi"), received marketing approval in the United Kingdom
in November, 1998 for Slofedipine XL, a controlled release version of nifedipine
utilizing Penwest's TIMERx technology for the treatment of angina. The Company's
collaborator, Mylan Pharmaceuticals Inc. ("Mylan"), received a tentative
approval in March 1999 of an Abbreviated New Drug Application ("ANDA") from the
U.S. Food and Drug Administration (the "FDA") for the first generic version of
the 30 mg dosage strength of Procardia(R) XL (nifedipine), a leading
cardiovascular drug for angina and hypertension.


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<PAGE>   4

      The Company believes that the TIMERx controlled release system has several
advantages over other oral controlled release systems.

      *     Broad Applicability as a Drug Delivery System. The TIMERx system is
            adaptable to a wide range of drugs with different physical and
            chemical properties. For instance, the TIMERx system can be used to
            deliver both low dose (less than 5 mg) and high dose (greater than
            500 mg) drugs as well as water soluble and insoluble drugs. Because
            of the high affinity of xanthan and locust bean gums, the TIMERx
            system permits a formulation with a high drug to gum ratio, which
            permits tablets to include a higher dosage of the active drug
            substance.

      *     Flexible Pharmacokinetic Profile. The Company formulates the TIMERx
            material to optimize the desired kinetic profile of the active drug
            substance. In this manner, the TIMERx system can be designed to
            enhance the therapeutic effect of the active drug substance.
            Depending on the desired release profile, the Company can formulate
            the drug to be released in the body (i) at a constant amount or
            linear rate over time, (ii) at a decreasing amount over time where
            the rate is dependent on drug concentration, or (iii) at a varied
            release rate.

      *     Ease of Manufacture. Drugs formulated using the TIMERx system are
            designed for production on standard pharmaceutical processing
            equipment. The TIMERx technology is easily and reproducibly
            scaled-up in a commercial manufacturing environment often utilizing
            the cost-effective direct compression tabletting process.

      *     Cost-Effective System. The TIMERx system is a cost-effective drug
            delivery system. It involves fewer and less complex ingredients than
            other systems and does not require the manufacturer to purchase
            specialized equipment. The Company believes that drug formulations
            using the TIMERx system can be developed more rapidly than drugs
            formulated with alternative controlled delivery systems and that the
            time to scale up to commercial quantities is minimized.

PROSOLV SMCC(TM)

      Prosolv, which is silicified microcrystalline cellulose, is a patented
combination of microcrystalline cellulose and colloidal silicon dioxide. These
two ingredients work together synergistically for optimal tabletting
performance. ProSolv can be used by manufacturers to produce harder tablets and
can enable manufacturers to reduce the amount of binders used in the tablet,
thereby reducing the size and cost of the tablet. Additionally, ProSolv can be
used to manufacture tablets with difficult active ingredients which otherwise
may not have been manufactured.

PENWEST STRATEGY

      The Company's strategy is to become a premier oral drug delivery company
for the pharmaceutical 


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industry. The Company has extensive expertise in formulating tablets for
pharmaceutical applications. The Company's strategy consists of the following
principal elements:

Leverage the TIMERx technology through the following:

*     Create Innovative Branded Controlled Release Versions of Immediate Release
      Pharmaceuticals. The Company is increasingly focused on the application
      of its TIMERx technology to the development of controlled release
      formulations of immediate release drugs, which will be marketed as brand
      name pharmaceuticals. In developing these controlled release formulations,
      the Company intends to seek collaborations with developers of the
      immediate release drugs or with pharmaceutical companies having a market
      presence in the applicable therapeutic area. The development of these
      controlled release drugs is subject to the New Drug Application ("NDA")
      approval process, although the Company and its collaborators may be
      permitted to rely on existing safety and efficacy data with respect to the
      immediate release drug in submitting the NDA.

*     Apply TIMERx Technology to Generic Versions of Controlled Release
      Pharmaceuticals. The Company is also focused on the application of its
      TIMERx technology to the development of generic versions of controlled
      release drugs. The Company has focused its development efforts on these
      drugs in order to accelerate the commercialization of the TIMERx delivery
      system, since generic drugs are regulated through the less expensive and
      abbreviated ANDA regulatory process applicable to generic drugs. In
      selecting generic controlled release pharmaceutical candidates to develop,
      the Company targets high sales volume, technically-complex controlled
      release pharmaceuticals. The Company believes these drug candidates are
      difficult to replicate and, as a result, TIMERx versions may have limited
      competition from other formulations.

*     Apply TIMERx Technology to the Development of New Chemical Entities. The
      Company believes that its TIMERx technology may be applicable to the
      development of products containing NCEs by pharmaceutical companies. The
      development of such NCE's is subject to the full NDA approval process,
      including conducting preclinical studies, filing an Investigational New
      Drug ("IND") application, conducting clinical trials and submitting an
      NDA.

Establish Collaborations for Development, Manufacture and Marketing. The
Company's principal collaborative agreements are with Mylan, Leiras, Sanofi and
Endo Pharmaceuticals, Inc. ("Endo"). The Company is seeking to enter into
additional collaborative agreements for both TIMERx and Prosolv. The Company's
existing and potential future collaborations enable the Company to secure
additional financial support for its research and development activities, to
obtain access to the clinical, manufacturing and regulatory resources and
expertise of its collaborators and to rely on them for the sales and marketing,
distribution and promotion.

Continue Research in Excipients to Add Additional Products to the Company's
Portfolio. The Company's product portfolio consists of many excipients which are
basic in many tablet formulations, as well as other more sophisticated
technologies used in tablet formulations that are typically licensed. The
Company intends to develop additional excipients which it believes addresses
formulation issues or needs in tabletting.

      The achievement of the Company's strategy is subject to various risks and
uncertainties. In particular, there can be no assurance that the Company's
capital resources will be sufficient to fully implement its strategy. The costs
of implementing the Company's strategy are difficult to predict and 


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will depend on numerous factors. If the Company's capital resources are
insufficient to fully implement its strategy, the Company may be required to
modify its strategy. See "Item 7 Management's Discussion and Analysis of
Financial Condition and Results of Operations."

TIMERX PRODUCT DEVELOPMENT

      The following table provides information relating to our principal
products by therapeutic area, the development status and the collaborator for
each of the principal products being marketed or under development utilizing the
Company's TIMERx technology and is qualified by reference to the more detailed
descriptions included elsewhere in this Annual Report on Form 10-K. The Company
is also conducting other development activities with respect to various
additional controlled release formulations.

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------
BRAND NAME                    THERAPEUTIC             DEVELOPMENT
(COMPOUND)                       AREA                    STATUS                     COLLABORATOR(1)
----------                       ----                    ------                     ---------------

BRANDED CONTROLLED RELEASE(2)

<S>                            <C>                       <C>                             <C>           
Cystrin CR                     Urge Urinary              Approved (3)                    Leiras
  (oxybutynin)                 Incontinence

Numorphan TRx                  Pain Relief               Formulation                     Endo
  (oxymorphone)

GENERIC CONTROLLED RELEASE(4)

Procardia XL                   Hypertension,             ANDA tentatively (5)            Mylan
  (nifedipine)                 Angina                    approved

Adalat CC                      Hypertension              Bioequivalence Studies          Mylan
  (nifedipine)

Adalat LA                      Hypertension,             Approved (6)                    Sanofi
  (nifedipine)                 Angina

Glucotrol XL                   Diabetes                  Bioequivalence Studies          Mylan
  (glipizide)
-------------------------------------------------------------------------------------------------------
</TABLE>

(1) The Company's collaborators typically provide research and development
support and are responsible for conducting full scale bioequivalence studies or
clinical trials, obtaining regulatory approvals and manufacturing, marketing and
selling the product. There can be no assurance that the results obtained in
bioequivalence studies or preclinical studies will be obtained in full scale
bioequivalence studies and other late stage clinical studies or that the Company
or its collaborators will receive regulatory approvals to continue clinical
studies of such products or to market any such products.

(2) Controlled release formulations of immediate release products are subject to
the NDA regulatory process. To the extent that the controlled release product is
an extension of an FDA-approved immediate release version of the same chemical
entity, the Company's collaborators may be permitted to rely on existing
clinical data as to the safety and efficacy of the chemical entity in filing
NDAs.

(3) Leiras received marketing approval for Cystrin CR in Finland in October 1997
and began marketing the product in January 1998.

(4) Generic versions of controlled release products are developed in three basic
stages:


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      FORMULATION. Involves the utilization or adaptation of drug delivery
      technologies to the product candidate and evaluation in in vitro
      dissolution studies.

      BIOEQUIVALENCE STUDIES. (a) Pilot bioequivalence studies involve testing
      in 10 to 15 human subjects to determine if the formulation yields a blood
      level comparable to the existing controlled release drug; (b) Full scale
      bioequivalence studies involve the manufacture of at least 10% of the
      intended commercial lot size and the analysis of plasma concentrations of
      the drug in 24 or more human subjects under fasting conditions and
      multiple dose conditions and 18 or more human subjects under fed
      conditions to determine whether the rate and extent of the absorption of
      the drug are substantially equivalent to that of the existing drug.

      ANDA FILING. An ANDA is submitted to the FDA with results of
      bioequivalence studies and other data such as in vitro specifications for
      the formulation, stability data, analytical data, methods validation and
      manufacturing procedures and controls.

(5) Mylan has filed an ANDA for the 30 mg dosage strength of Nifedipine XL,
which ANDA has received tentative approval from the FDA, and is conducting full
scale bioequivalence studies of the 60 and 90 mg dosage strengths of Nifedipine
XL. Final approval on the 30 mg strength will not be granted until certain
legal issues including the patent lawsuit brought by Bayer AG ("Bayer") and
Pfizer, Inc. ("Pfizer") against Mylan have been resolved.

(6) Sanofi received marketing approval for and began marketing Slofedipine XL in
the United Kingdom in November 1998.

BRANDED CONTROLLED RELEASE PHARMACEUTICALS

      The Company is increasingly applying its TIMERx technology to the
development of controlled release formulations of immediate release
pharmaceuticals. The Company's principal branded controlled release
pharmaceuticals being marketed or in development are as follows:

      CYSTRIN CR. The Company and Leiras have developed a controlled release
formulation of Cystrin(R) incorporating TIMERx technology, which is being
marketed in Finland by Leiras under the tradename Cystrin CR. Leiras received
marketing approval in Finland for Cystrin CR in October 1997 and began marketing
the product in Finland in January 1998. Cystrin is a two to three times-a-day
immediate release version of the anticholinergic drug oxybutynin indicated for
the treatment of urge urinary incontinence. Oxybutynin is marketed in Finland by
Leiras under the trademark Cystrin.

      NUMORPHAN TRX. The Company and Endo are currently developing a controlled
release formulation of Numorphan(R) incorporating TIMERx technology. Numorphan
is a parenteral and suppository dosage form of oxymorphone, a narcotic analgesic
for the treatment of moderate to severe pain. Numorphan is marketed by Endo and
had sales in the United States in 1997 of approximately $10 million. Numorphan
TRx, if successfully developed, would represent the first oral controlled
release version of Numorphan and would compete in the severe analgesic market
with products such as MS Contin and Oxycontin, which had sales in the United
States in 1998 of approximately $450 million. The Company is currently in the
process of developing TIMERx-based formulations and no clinical studies on such
formulations have been conducted to date.




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GENERIC CONTROLLED RELEASE PHARMACEUTICALS

      Generic controlled release pharmaceuticals are therapeutic equivalents of
brand name drugs for which patents or marketing exclusivity rights have expired.
Generic controlled release pharmaceuticals are typically difficult to replicate
because of: (i) formulation complexity; (ii) analytical complexity; and/or (iii)
manufacturing complexity. The Company believes that such generic controlled
release pharmaceuticals are less likely to suffer the same price erosion as
other generic pharmaceuticals because of the difficulty in replicating
controlled release pharmaceuticals and the resulting limits on competition.

      When developing generic pharmaceuticals, the drug developer is required to
demonstrate that the generic product candidate will exhibit in vivo release and
absorption characteristics equivalent to those of the branded pharmaceutical
without infringing on any unexpired patents. During the formulation of generic
pharmaceuticals, drug developers create their own version of the branded drug by
using or adapting drug delivery technologies to the product candidate.

      The Company's principal generic controlled release pharmaceuticals being
marketed or in development are as follows:

      NIFEDIPINE XL. The Company and Mylan are currently developing different
dosage strengths of Nifedipine XL, a generic version of Procardia XL
incorporating TIMERx technology. Procardia XL is a once-a-day controlled release
formulation of nifedipine, a calcium channel blocking agent indicated for
hypertension, vasospastic angina and chronic stable angina, which uses the OROS
delivery system. Procardia XL is marketed in three dosage strengths (30 mg, 60
mg and 90 mg) by the Pratt Pharmaceuticals division of Pfizer and had sales in
the United States in 1998 of approximately $700 million.

      In March 1999, Mylan's ANDA for Nifedipine XL (30 mg) was tentatively
approved by the FDA. Final approval of the ANDA is subject to the resolution of
pending patent infringement litigation and other matters. Mylan's ANDA was the
first ANDA for a generic version of Procardia XL filed with the FDA for the 30
mg strength. Mylan is currently conducting full scale bioequivalence studies of
the 60 mg and 90 mg dosage strengths of Nifedipine XL. The Company is aware that
Biovail Corporation International ("Biovail") filed an ANDA for the 30 mg and 60
mg dosage strength of a generic version of Procardia XL and is aware of a number
of other companies that are developing generic versions of Procardia XL.

NIFEDIPINE CC. The Company and Mylan are currently developing Nifedipine CC, a
generic version of Adalat CC(R) incorporating TIMERx technology. Adalat CC is a
once-a-day controlled release formulation of nifedipine, a calcium channel
blocking agent indicated for hypertension. Adalat CC is marketed in three dosage
strengths (30 mg, 60 mg and 90 mg) by Bayer and had sales in the United States
in 1998 of approximately $357 million. Mylan is conducting full scale
bioequivalence studies of the 30 mg dosage strength of Nifedipine CC. Warner
Chilcott and Biovail have filed ANDAs for generic versions of Adalat CC.

      SLOFEDIPINE XL. The Company and Sanofi received approval for and began
marketing in the United Kingdom in November 1998 Slofedipine XL, a generic
version of Adalat LA(R) (a drug marketed in Europe that utilizes the same
controlled release technology as Procardia XL) incorporating TIMERx technology.
Adalat LA is a once-a-day controlled release formulation of nifedipine, a
calcium channel blocking agent indicated for hypertension, vasospastic angina
and chronic stable angina, which uses 


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the OROS delivery system. Adalat LA is marketed in two dosage strengths (30 mg
and 60 mg) by Bayer in Europe and had sales in the UK in 1998 of approximately
$60 million.

      GLIPIZIDE XL. The Company and Mylan are currently developing Glipizide XL,
a generic version of Glucotrol XL(R) incorporating TIMERx technology. Glucotrol
XL is a once-a-day controlled release formulation of glipizide, a blood-glucose
lowering agent indicated as an adjunct to diet for the control of hyperglycemia
in diabetes patients, which uses the OROS delivery system. Glucotrol XL is
marketed in 5 mg and 10 mg dosage strengths by the Pratt Pharmaceuticals
division of Pfizer and had sales in the United States in 1998 of approximately
$198 million. Mylan is conducting full scale bioequivalence studies of the 5 mg
and 10 mg dosage strengths of Glipizide XL. The Company is aware of a number of
other companies that are developing generic formulations of Glucotrol XL.

      ALBUTEROL. The Company is engaged in the development of other TIMERx-based
products, including a generic version of Volmax for the treatment of asthma.

PHARMACEUTICAL EXCIPIENTS

      The Company sells 28 excipient products which are used in the manufacture
of tablets by pharmaceutical and nutritional companies worldwide. The Company's
product line is broadly classified into three distinct categories: binders,
disintegrants and lubricants. Binders, working in conjunction with other
products, are the primary tablet-forming component of excipients. Disintegrants
function to help make a tablet fall apart when consumed by drawing water into
the dosage form, a necessary precursor to dissolution and ultimately absorption
of the drug. Lubricants help facilitate the ease of manufacture of drugs so that
they emerge from a tabletting machine with the desired physical characteristics.

      The Company's excipients are sold to the prescription, over-the-counter
and nutritional markets. In 1998, the Company sold bulk excipients to more than
300 customers, including some of the leading pharmaceutical companies in the
world such as the Perrigo Company (which accounted for approximately 11% of the
Company's revenues in 1998), Bristol-Myers Squibb Company, McNeil Consumer
Products Company and SmithKline Beecham, plc ("SmithKline"), in more than 40
countries.

      The following is a list of excipient products currently being marketed in
bulk by the Company:

     PROSOLV was introduced in late 1996 and the Company sells it both in bulk
and through licensing arrangements when exclusivity is offered. The Company
believes that Prosolv offers numerous advantages over traditional
microcrystalline cellulose and intends to develop additional combination
products which offer advantages to the customer.

      EMCOCEL(R), or microcrystalline cellulose (MCC), the Company's largest
selling product, is a tabletting binder used in pharmaceutical formulations
worldwide. EMCOCEL is utilized in a number of products including ethical and
over-the-counter brands.

      EMCOMPRESS(R), or dicalcium phosphate, is a binder marketed by the Company
under an exclusive worldwide distribution agreement with the manufacturer
Albright and Wilson Americas Inc. The distribution agreement expires on December
31, 2000, subject to automatic extension on an annual basis unless either party
gives the other party 12 months notice of its desire to terminate the 


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<PAGE>   10

agreement. EMCOMPRESS is frequently used in vitamin formulations as it serves as
an additional source of dietary calcium.

      EMDEX(R), or dextrates, is a binder that is used as a directly
compressible excipient in both chewable and non-chewable tablets. EMDEX is
odorless with a sweet taste caused by its sugar composition. EMDEX is used in,
among other things, chewable antacid tablets and vitamins. EMDEX is manufactured
by Penford Corporation ("Penford").

      EXPLOTAB(R), or sodium starch glycolate, is the principal disintegrant
marketed by the Company. EXPLOTAB is distributed by the Company under an
exclusive worldwide distribution agreement with the manufacturer, Roquette
America, Inc. The distribution agreement is automatically renewable on an annual
basis unless either party gives the other party 12 months notice of its desire
to terminate the agreement. EXPLOTAB is used in a number of products and is an
essential component of the Tylenol family of products.

      PRUV(R), or sodium stearyl fumarate, is the principal lubricant marketed
by the Company. PRUV is marketed under an exclusive worldwide distribution
agreement with the manufacturer, Astra Pharmaceutical Production AB. In February
1999, Astra notified the Company that the distribution agreement will be
terminated effective February 2000. The Company is currently seeking an
alternative supplier. PRUV is used in several prescription pharmaceuticals.

      The Company had revenues from the sale of pharmaceutical excipients in
1996, 1997 and 1998 of $25.0 million, $26.0 million and $28.7 million,
respectively.

COLLABORATIVE ARRANGEMENTS

      The Company enters into collaborative arrangements with pharmaceutical
companies to facilitate and expedite the commercialization of its TIMERx drug
delivery technology.

      Under most of its collaborative arrangements, the Company has received
upfront fees and milestone payments and is entitled to receive additional
milestone payments. In addition, under all its current collaborative
arrangements, the Company is entitled to receive royalties on the sale of the
products covered by such collaborative arrangements and payments for the
purchase of formulated TIMERx material. Assuming that all milestones are
achieved under its current collaborative arrangements, the Company would be
entitled to receive up to an aggregate of $4.7 million in upfront fees and
milestone payments, of which $2.4 million have been received to date. There can
be no assurance that future milestone payments will be received. The Company's
principal collaborative arrangements are described below.

MYLAN PHARMACEUTICALS INC.

      In August 1994, August 1995 and March 1996, the Company entered into
product development and supply agreements with Mylan with respect to the
development of generic versions of Procardia XL (nifedipine), Adalat CC
(nifedipine) and Glucotrol XL (glipizide), based on the Company's TIMERx
technologies (the "Mylan Products"). Mylan is one of the leading generic
pharmaceutical companies in the United States.

      Under these product development and supply agreements, the Company is
responsible for the 


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formulation, manufacture and supply of TIMERx material for use in the Mylan
Products, and Mylan is responsible for conducting all bioequivalence studies,
preparing all regulatory applications and submissions and manufacturing and
marketing the Mylan Products in the United States, Canada and Mexico. Each
product development and supply agreement is terminable by either party upon 90
days prior written notice at any time (i) prior to the submission of the ANDA
for the product covered by such agreement if such party reasonably determines
that no further development efforts are likely to lead to the successful
development of such product and (ii) prior to approval by the FDA of such ANDA
if such party reasonably determines that such ANDA is not likely to be approved.
Following approval of the ANDA, the product development and supply agreement
will extend for a term of 20 years from the date on which the ANDA is approved,
subject to earlier termination by either party upon specified circumstances,
including termination by the Company if Mylan fails to meet minimum sales volume
requirements and termination by either party upon a material breach by the other
party of the agreement. If the Company does not satisfy its obligations under
any of these agreements, the Company will be in breach of such agreement and
Mylan will be entitled to terminate such agreement.

      The Company has received milestone payments under each of the product
development and supply agreements and is entitled to additional milestone
payments under such agreements upon the continued development of the Mylan
Products. The Company is also entitled to royalties on the sale of each Mylan
Product, which royalties will be reduced with respect to such Mylan Product if
there are on the market and available for retail sale any other generic
controlled release formulations of the drug of which such Mylan Product is a
generic controlled release formulation. The Company is aware of one ANDA filed
for the 30 mg and two ANDA's filed on the 60 mg dosage strength of a generic
version of Procardia XL and two ANDAs filed for the 30 mg dosage strength of a
generic version of Adalat CC. In addition, Mylan has agreed that during the term
of the product development and supply agreements it will purchase formulated
TIMERx material for use in the Mylan Products exclusively from the Company at
specified prices.

      The Company and Mylan also entered into a sales and distribution agreement
in January 1997 (the "Mylan Distribution Agreement") with respect to Nifedipine
XL pursuant to which Mylan agreed to manufacture and supply Nifedipine XL to the
Company for distribution by the Company and one or more distributors (as to
which the Company and Mylan must mutually agree) in certain specified European
and Latin American countries. This agreement expires in January 2007, subject to
automatic extension on an annual basis. Under this agreement, the Company has
agreed to purchase Nifedipine XL exclusively from Mylan at specified prices or
to pay Mylan 50% of any royalties received by the Company from its distributors
if Mylan licenses its manufacturing technology to the Company for use by the
Company's distributors instead of manufacturing the product for distribution.
Under this agreement, Mylan is entitled to 50% of any royalties or milestone
payments received by the Company under the Company's product development and
supply agreement with Sanofi described below.

SANOFI WINTHROP INTERNATIONAL S.A.

      In February 1997, the Company entered into a product development and
supply agreement with Sanofi with respect to the development of a generic
version of Adalat LA based on the Company's TIMERx technology (the "Sanofi
Product"), a drug that utilizes the same controlled release technology as
Procardia XL. Sanofi is a research-based international pharmaceutical company,
based in Paris, France, which has a European infrastructure from which to
develop, register and market


                                                                              11
<PAGE>   12

prescription pharmaceuticals.

      Under the product development and supply agreement, the Company is
responsible for conducting pilot bioequivalence studies of the Sanofi Product
and for manufacturing and supplying TIMERx material to Sanofi, and Sanofi is
responsible for conducting all full scale bioequivalence and clinical studies,
preparing all regulatory applications and submissions and manufacturing and
marketing the Sanofi Product in specified countries in Europe and in South
Korea. This drug was approved and Sanofi began marketing the drug in the U.K. in
November 1998.

      The product development and supply agreement expires with respect to each
specified country on the 10th, 13th, 16th or 19th anniversary of the date on
which the Sanofi Product is approved by the relevant regulatory authority in
such country for commercial sale if notice is provided by either party prior to
any of such anniversary dates that the agreement will expire with respect to
such country on such anniversary date. The agreement is also subject to earlier
termination by either party under specified circumstances, including termination
by the Company if Sanofi fails to meet minimum sales volume requirements and
termination by either party upon a material breach of the agreement by the other
party. If the Company does not satisfy its obligations under the agreement, the
Company will be in breach of the agreement and Sanofi will be entitled to
terminate the agreement.

      The Company is entitled to milestone payments under the product
development and supply agreement upon the continued development of the Sanofi
Product. The Company is also entitled to royalties upon the sale of the Sanofi
Product. One half of such payments will be paid to Mylan in accordance with the
Mylan Distribution Agreement. In addition, Sanofi has agreed that, during the
term of the product development and supply agreement, it will purchase
formulated TIMERx material for use in the Sanofi Product exclusively from the
Company at specified prices.

LEIRAS OY

      In July 1992, the Company entered into an agreement with Leiras with
respect to the development and commercialization of Cystrin CR, a controlled
release formulation of Cystrin based on the Company's TIMERx technology. In May
1995, the Company entered into a second agreement with Leiras clarifying certain
matters with respect to the collaboration. Leiras is a Finnish subsidiary of
Schering AG. Leiras is developing products focused in the areas of reproductive
health care, urology, oncology and inhalation technology.

      Under the agreements, the Company is responsible for the development and
formulation of Cystrin CR and for manufacturing and supplying TIMERx material to
Leiras for use in the manufacture of Cystrin CR, and Leiras is responsible for
preparing all regulatory applications and submissions and manufacturing and
marketing Cystrin CR on a worldwide basis. Leiras has the right to transfer its
rights and responsibilities under the agreements and its related product rights
for specified territories, subject in certain circumstances to the approval of
the Company.

      The agreements terminate upon the expiration of the TIMERx patents
licensed to Leiras (which will occur in the year 2014), subject to earlier
termination by either party under specified circumstances, including upon a
material breach of the agreement by a party or upon the bankruptcy of a party.
If the Company does not satisfy its obligations under either of these
agreements, the Company will be in breach of such agreement and Leiras will be
entitled to terminate such agreement. Leiras has also agreed to pay the Company
royalties on the sale of Cystrin CR and to purchase 


                                                                              12
<PAGE>   13

formulated TIMERx material exclusively from the Company at specified prices.

ENDO PHARMACEUTICALS INC.

      In September 1997, the Company entered into a strategic alliance agreement
with Endo with respect to the development of controlled release formulations of
oxymorphone based on the Company's TIMERx technology (the "Endo Products"). Endo
is a research-based and generic pharmaceutical company formed from a management
buyout of a division of DuPont Merck Pharmaceuticals ("DuPont Merck"). Endo has
a broad product line including 25 drugs in the generic product division and 12
established (formerly DuPont Merck) brand products, including Percodan and
Percocet. Endo is registered with the U.S. Drug Enforcement Administration as a
developer, manufacturer and marketer of controlled narcotic substances.

      Under the strategic alliance agreement, the responsibilities of the
Company and Endo with respect to any Endo Product will be determined by a
committee comprised of an equal number of members from each of the Company and
Endo (the "Alliance Committee"). However, the Company expects that it will
formulate each drug candidate and that Endo will conduct all clinical studies
and prepare and file all regulatory applications and submissions. In addition,
under the agreement, the Company has agreed to manufacture and supply TIMERx
material to Endo, and Endo has agreed to manufacture and market the Endo
Products in the United States. The manufacture and marketing of Endo Products
outside of the United States may be conducted by the Company, Endo or a third
party, as determined by the Alliance Committee.

      The strategic alliance agreement is terminable with respect to an Endo
Product by either party upon 30 days prior written notice at any time (i) prior
to the completion of development activities with respect to such Endo Product if
such party determines that further development efforts are not likely to lead to
the successful development of such Endo Product and (ii) prior to obtaining
approval by the FDA (or equivalent regulatory authority) of an NDA (or
equivalent regulatory filing) with respect to such Endo Product if such party
determines that further efforts are not likely to lead to such approval,
although the non-terminating party would have the right to continue the
agreement with respect to such Endo Product for a specified period and the
royalties that might otherwise have been payable to the terminating party would
be reduced. Following regulatory approval of the marketing and sale of such Endo
Product, the term of the strategic alliance agreement will extend for up to 20
years from the date of such regulatory approval, subject to earlier termination
under specified circumstances, including failure to launch full-scale marketing
of such Endo Product when required or material breach of the agreement by a
party.

      The Company and Endo have agreed to share the costs involved in the
development and commercialization of the Endo Products and that the party
marketing the Endo Products (which the Company expects will be Endo) will pay
the other party royalties equal to 50% of net marketing revenues after
fully-burdened costs (although this percentage will decrease as the total U.S.
marketing revenues from an Endo Product increase), subject to each party's right
to terminate its participation with respect to any Endo Product described above.
If the Company does not satisfy its funding and other obligations under the
agreement, the Company will be in breach of the agreement and Endo will be
entitled to terminate the agreement. Endo will purchase formulated TIMERx
material for use in the Endo Products exclusively from the Company at specified
prices. Such prices will be reflected in the determination of fully-burdened
costs.


                                                                              13
<PAGE>   14

RESEARCH AND DEVELOPMENT

      The Company conducts research and development activities with respect to
additional applications of TIMERx technology, advances in the TIMERx technology
and additional novel excipients such as Prosolv. The Company's research and
development expenses in 1996, 1997 and 1998 were $3.4 million, $3.7 million and
$6.1 million, respectively. These expenses do not include amounts incurred by
the Company's collaborators in connection with the development of products under
the collaboration agreements such as expenses for full scale bioequivalence
studies performed by the collaborators.

MANUFACTURING

      The Company currently has a laboratory and pilot manufacturing facility
covering approximately 55,000 square feet contiguous to its executive offices in
Patterson, New York. However, the Company does not have commercial-scale
facilities to manufacture its TIMERx material in accordance with cGMP
requirements prescribed by the FDA. As a result, to date, the Company has relied
on a large third-party pharmaceutical company, Boehringer Ingelheim
Pharmaceuticals, Inc. ("Boehringer Ingelheim"), for the bulk manufacture of its
TIMERx material for delivery to its collaborators under an agreement that
expired in June 1998.

      The Company believes that there are a limited number of manufacturers that
operate under cGMP regulations capable of manufacturing the Company's products.
During the fourth quarter of 1998, experimental batches of TIMERx were run in a
third party manufacturer's facility and commercial terms were agreed to. As a
result, the Company has determined they will outsource TIMERx manufacturing
rather than building a new facility. However, there can be no assurance that the
Company will enter into a manufacturing agreement with such manufacturer or as
to the terms of such manufacturing agreement. In the event that the Company is
unable to obtain contract manufacturing, or obtain such manufacturing on
commercially reasonable terms, it may not be able to commercialize its products
as planned. There can be no assurance that third parties upon which the Company
relies for supply of its TIMERx material will perform and any failures by third
parties may delay development or the submission of products for regulatory
approval, impair the Company's collaborators' ability to commercialize products
as planned and deliver products on a timely basis, or otherwise impair the
Company's competitive position, which could have a material adverse effect on
the Company's business, financial condition and results of operations. See "Item
7. Management's Discussion and Analysis of Financial Condition and Result of
Operations."

      The Company's TIMERx drug delivery system is a hydrophilic matrix
combining primarily a heterodispersed mixture, usually polysaccharides, xanthan
and locust bean gums, in the presence of dextrose. The Company purchases these
gums from a sole source supplier. Although the Company has qualified alternate
suppliers with respect to these gums and to date the Company has not experienced
difficulty acquiring these materials, there can be no assurance that
interruptions in supplies will not occur in the future or that the Company will
not have to obtain substitute suppliers. Any of these events could have a
material adverse effect on the Company's ability to manufacture bulk TIMERx for
delivery to its collaborators, which could have a material adverse effect on the
Company's business, financial condition and results of operations.

      The Company currently has two cGMP-approved manufacturing facilities for
its MCC products, 


                                                                              14
<PAGE>   15

including EMCOCEL and ProSolv. These facilities are located in Cedar Rapids,
Iowa and Nastola, Finland and cover approximately 35,000 square feet and 15,000
square feet, respectively. The Company's MCC products are primarily made from a
specialty grade of wood pulp. Although the Company obtains wood pulp primarily
from two suppliers, wood pulp is widely available from a number of suppliers.

      All manufacturing operations of the Company are subject to federal, state
and local laws and regulations governing the use, manufacture, storage, handling
and disposal of certain materials and waste products.

MARKETING AND DISTRIBUTION

      Pursuant to the Company's collaborative agreements, the Company's
collaborators have responsibility for the marketing and distribution of any
controlled release pharmaceuticals developed based on the Company's TIMERx
technology. Because the Company does not plan on developing any of such
pharmaceuticals without a collaborator, the Company has not developed and does
not intend to develop any sales force with respect to such products. As a
result, the Company is substantially dependent on the efforts of its
collaborators to market the products. In selecting a collaborator for a drug
candidate, some of the factors the Company considers include the collaborator's
market presence in the therapeutic area targeted by the drug candidate and the
collaborator's sales force and distribution network.

      The Company has an in-house sales force of nine employees who market the
Company's products in the United States. This sales force focuses primarily on
pharmaceutical and nutritional companies. The Company also markets its products
worldwide through the use of distributors located in over 40 countries. The
Company typically sells its excipients to its largest customers under multi-year
supply agreements.

PATENTS AND PROPRIETARY RIGHTS

      The Company believes that patent and trade secret protection, particularly
of its drug delivery technology, is important to its business and that its
success will depend in part on its ability to maintain existing patent
protection, obtain additional patents, maintain trade secret protection and
operate without infringing the proprietary rights of others.

      The Company has been issued 24 U.S. and 48 foreign patents and one U.S.
patent application has been allowed, principally relating to the Company's
controlled release drug delivery technology. The U.S. patents issued to the
Company and the allowed U.S. patent application principally cover the Company's
TIMERx technology, including the combination of the xanthan and locust bean
gums, the oral solid dosage form of TIMERx and the method of preparation, as
well as the application (and combination) of TIMERx technology to various active
drug substances, including both method of treatment and methods of preparation.
All these patents and the allowed U.S. patent application, if issued, will
expire between 2008 and 2015.

      The issuance of a patent is not conclusive as to its validity or as to the
enforceable scope of the claims of the patent. There is no assurance that the
Company's patents or any future patents will prevent other companies from
developing non-infringing similar or functionally equivalent products or from
successfully challenging the validity of the Company's patents. Furthermore,
there is no 


                                                                              15
<PAGE>   16

assurance that (i) any of the Company's future processes or products will be
patentable; (ii) any pending or additional patents will be issued in any or all
appropriate jurisdictions; (iii) the Company's processes or products will not
infringe upon the patents of third parties; or (iv) the Company will have the
resources to defend against charges of infringement by or protect its own patent
rights against third parties. The inability of the Company to protect its patent
rights or infringement by the Company of the patent or proprietary rights of
others could have a material adverse effect on the Company's business, financial
condition and results of operations.

      The Company also relies on trade secrets and proprietary knowledge, which
it generally seeks to protect by confidentiality and non-disclosure agreements
with employees, consultants, licensees and pharmaceutical companies. There can
be no assurance, however, that these agreements have or in all cases will be
obtained, that these agreements will not be breached, that the Company will have
adequate remedies for any breach or that the Company's trade secrets will not
otherwise become known by competitors.

      There has been substantial litigation in the pharmaceutical industry with
respect to the manufacture, use and sale of new products that are the subject of
conflicting patent rights. Most of the controlled release products that the
Company is developing with its collaborators are generic versions of brand name
controlled release products that are covered by one or more patents. Under the
Waxman-Hatch Act when an applicant files an ANDA with the FDA for a generic
version of a brand name product covered by an unexpired patent listed with the
FDA, the applicant must certify to the FDA that such patent will not be
infringed by the applicant's product or that such patent is invalid or
unenforceable. Notice of such certification must be given to the patent owner
and the sponsor of the NDA for the brand name product. If a patent infringement
lawsuit is filed within 45 days of the receipt of such notice, the FDA will
conduct a substantive review of the ANDA, but will not grant final marketing
approval of the generic product until a final judgment on the patent suit is
rendered in favor of the applicant or until 30 months (or such longer or shorter
period as a court may determine) have elapsed from the date of the
certification, whichever is sooner. Should a patent owner commence a lawsuit
with respect to alleged patent infringement by the Company or its collaborators,
the uncertainties inherent in patent litigation make the outcome of such
litigation difficult to predict. To date, one such action has been commenced
against one of the Company's collaborators and it is anticipated that additional
actions will be filed as the Company's collaborators file additional ANDAs. The
Company evaluates the probability of patent infringement litigation with respect
to its collaborators' ANDA submissions on a case by case basis. The delay in
obtaining FDA approval to market the Company's product candidates as a result of
litigation, as well as the expense of such litigation, whether or not the
Company is successful could have a material adverse effect on the Company's
business, financial condition and results of operations.

      In March 1999, the Company's collaborator, Mylan, received tentative
approval from the FDA for the 30 mg. generic version of Procardia XL, a
controlled release formulation of nifedipine. The final approval of this
application is subject to resolution of certain legal issues, including the
lawsuit filed by Bayer and Pfizer against Mylan alleging patent infringement.
See "Mylan Litigation."

      In 1994, Boots Company PLC ("Boots") filed in the European Patent Office
("EPO") an opposition to a patent granted by the EPO to the Company relating to
its TIMERx technology. In June 1996, the EPO dismissed Boots' opposition,
leaving intact all claims included in the patent. Boots has appealed this
decision to the EPO Board of Appeals. There can be no assurance that the Company
will prevail in this matter. An unfavorable outcome could have a material
adverse effect on 


                                                                              16
<PAGE>   17

the Company's business, financial condition and results of operations.

      TIMERx, Emcocel, Explotab, Emdex, Emcompress and Candex are registered
trademarks of the Company. Other tradenames and trademarks appearing in this
Annual Report on Form 10-K are the property of their respective owners.

GOVERNMENT REGULATION

FDA REGULATION OF PHARMACEUTICAL PRODUCTS

      All pharmaceutical manufacturers are subject to extensive regulation by
the federal government, principally the FDA, and, to a lesser extent, by state
and local governments. The Federal Food, Drug and Cosmetic Act (the "FDCA") and
other federal statutes and regulations govern or influence the development,
testing, manufacture, safety, labeling, storage, record keeping, approval,
advertising, promotion, sale and distribution of prescription products.
Pharmaceutical manufacturers are also subject to certain record keeping and
reporting requirements, establishment registration, product listing and FDA
inspections.

      Drugs can be approved by the FDA based on three types of marketing
applications: an NDA, an ANDA or a license application under the Public Health
Service Act. A full NDA must include complete reports of preclinical, clinical
and other studies to prove adequately that the product is safe and effective for
its intended use. The FDCA also provides for NDA submissions that may rely in
whole or in part on publicly available clinical and other data on safety and
efficacy under section 505(b)(2) of the FDCA. These types of NDAs may be
appropriate for certain drugs containing previously approved active ingredients
but differing with regard to other characteristics such as indications for use,
dosage form or method of delivery.

      As an initial step in the FDA regulatory approval process for an NDA,
preclinical studies are typically conducted in animal models to assess the
drug's efficacy and to identify potential safety problems. The results of these
studies must be submitted to the FDA as part of an IND application, which must
be reviewed by the FDA before proposed clinical testing can begin. Typically
clinical testing involves a three-phase process. Phase I trials are conducted
with a small number of subjects and are designed to provide information about
both product safety and the expected dose of the drug. Phase II trials are
designed to provide additional information on dosing and preliminary evidence of
product efficacy. Phase III trials are large scale studies designed to provide
statistical evidence of efficacy and safety in humans. The results of the
preclinical testing and clinical trials of a pharmaceutical product are then
submitted to the FDA in the form of an NDA for approval to commence commercial
sales. Preparing such applications involves considerable data collection,
verification, analysis and expense. In responding to an NDA, the FDA may grant
marketing approval, request additional information or deny the application if it
determines that the application does not satisfy its regulatory approval
criteria.

      This regulatory process can require many years and the expenditure of
substantial resources. Data obtained from preclinical testing and clinical
trials are subject to varying interpretations, which can delay, limit or prevent
FDA approval. In addition, changes in FDA approval policies or requirements may
occur or new regulations may be promulgated which may result in delay or failure
to receive FDA approval.


                                                                              17
<PAGE>   18

      ANDAs may be submitted for generic versions of brand name drugs ("Listed
Drugs") where the generic drug is the "same" as the Listed Drug with respect to
active ingredient(s) and route of administration, dosage form, strength, and
conditions of use recommended in the labeling. ANDAs may also be submitted for
generic drugs that differ with regard to certain changes from a Listed Drug if
the FDA has approved a petition from a prospective applicant permitting the
submission of an ANDA for the changed product.

      Rather than safety and efficacy studies, the FDA requires data
demonstrating that the ANDA drug formulation is bioequivalent to the Listed
Drug. The FDA also requires labeling, chemistry and manufacturing information.
FDA regulations define bioequivalence as the absence of a significant difference
in the rate and the extent to which the active ingredient becomes available at
the site of drug action when administered at the same molar dose under similar
conditions in an appropriately designed study. If the approved generic drug is
both bioequivalent and pharmaceutically equivalent to the Listed Drug, the
agency will assign a code to the product in an FDA publication entitled
"Approved Drug Products With Therapeutic Equivalence Evaluation." These codes
will indicate whether the FDA considers the product to be therapeutically
equivalent to the Listed Drug. The codes will be considered by third parties in
determining whether the generic drug is therapeutically equivalent and fully
substitutable for the Listed Drug and are relied upon by Medicaid and Medicare
formularies for reimbursement.

      Although the FDA has tentatively approved the ANDA filed by the Company's
collaborator Mylan, for the 30 mg dosage strength of a generic version of
Procardia XL, there can be no assurance that ANDAs filed by the Company's
collaborators with respect to other products will be suitable or available for
such products, or that such products will receive FDA approval on a timely
basis.

      Certain ANDA procedures for generic versions of controlled release
products are the subject of petitions filed by brand name drug manufacturers,
which seek changes from the FDA in the approval process for generic drugs. These
requested changes include, among other things, tighter standards for certain
bioequivalence studies and disallowance of the use by a generic drug
manufacturer in its ANDA of proprietary data submitted by the original
manufacturer as part of an original new drug application. The Company is unable
to predict at this time whether the FDA will make any changes to its ANDA
procedures as a result of such petitions or any future petitions filed by brand
name drug manufacturers or the effect that such changes may have on the Company.
Any changes in FDA regulations which make ANDA approvals more difficult could
have a material adverse effect on the Company's business, financial condition
and results of operations.

      Some products containing the Company's TIMERx formulation, such as
controlled release formulations of approved immediate release drugs, will
require the filing of an NDA. The FDA will not accept ANDAs when the delivery
system or duration of drug availability differs significantly from the Listed
Drug. However, the Company may be able to rely on existing publicly available
safety and efficacy data to support section 505(b)(2) NDAs for controlled
release products when such data exists for an approved immediate release version
of the same chemical entity. However, there can be no assurance that the FDA
will accept such section 505(b)(2) NDAs, or that the Company will be able to
obtain publicly available data that is useful. The section 505(b)(2) NDA process
is a highly uncertain avenue to approval because the FDA's policies on section
505(b)(2) NDAs have not yet been fully developed. There can be no assurance that
an application submitted under section 505(b)(2) will be approved, or will be
approved in a timely manner.


                                                                              18
<PAGE>   19

      Sponsors of ANDAs and section 505(b)(2) NDAs, with the exception of
applications for certain antibiotic drugs, must include, as part of their
applications, certifications with respect to certain patents on Listed Drugs
that may result in significant delays in obtaining FDA approvals. Sponsors who
believe that patents that are listed in an FDA publication entitled "Approved
Drug Products With Therapeutic Equivalence Evaluations" are invalid,
unenforceable, or not infringed, must notify the patent owner. If the patent
owner initiates an infringement lawsuit against the sponsor within 45 days of
the notice, the FDA's final approval of the ANDA or section 505(b)(2) NDA may be
delayed for a period of thirty months or longer. This delay may also apply to
other ANDAs or 505(b)(2) NDAs for the same Listed Drug. Moreover, the approval
of an ANDA involved in such a patent lawsuit may under certain circumstances
require a further delay in the final approval of other ANDAs for the same Listed
Drug for an additional 180 days. In addition, recent court decisions have raised
the possibility that, under some circumstances, ANDAs other than the first ANDA
for a Listed Drug may be delayed indefinitely and thereby effectively denied
approval if the drug that is the subject of the first ANDA is not brought to
market.

      Under the Waxman-Hatch Act, an applicant who files the first ANDA with a
certification of patent invalidity or non-infringement with respect to a product
may be entitled to receive, if such ANDA is approved by the FDA, 180-day
marketing exclusivity (a 180-day delay in approval of other ANDAs for the same
drug) from the FDA. However, there can be no assurance that the FDA will not
approve an ANDA filed by another applicant with respect to a different dosage
strength prior to or during such 180-day marketing exclusivity period. For
example, although Mylan has filed an ANDA for the 30 mg dosage strength of a
generic version of Procardia XL, there can be no assurance that the ANDA filing
by Biovail for the 60 mg dosage strength of a generic version of Procardia XL
will not be approved prior to or during Mylan's 180-day marketing exclusivity
period, if obtained for its ANDA.

      ANDAs and section 505(b)(2) NDAs are also subject to so-called market
exclusivity provisions that delay the submission or final approval of the
applications. The submission of ANDAs and section 505(b)(2) NDAs may be delayed
for five years after approval of the Listed Drug if the Listed Drug contains a
new active molecular entity. The final approval of ANDAs and section 505(b)(2)
NDAs may also be delayed for three years where the Listed Drug or a modification
of the Listed Drug was approved based on new clinical investigations. The
three-year marketing exclusivity period would potentially be applicable to
Listed Drugs with novel drug delivery systems.

      Sponsors of drug applications affected by patents may also be adversely
affected by patent term extensions provided under the FDCA to compensate for
patent protection lost due to time taken in conducting FDA required clinical
studies or during FDA review of data submissions. Patent term extensions may not
exceed five additional years nor may the total period of patent protection
following FDA marketing approval be extended beyond 14 years. In addition, by
virtue of the Uruguay Round Agreements Act of 1994 that ratified the General
Agreement on Tariffs and Trade ("GATT"), certain brand name drug patent terms
have been extended to 20 years from the date of filing of the pertinent patent
applications (which can be longer than the former 17-year patent term starting
from the date of patent issuance). Patent term extensions may delay the ability
of the Company and its collaborators to use the Company's proprietary technology
in the future, market new controlled release products, file section 505(b)(2)
NDAs referencing approved products, or file ANDAs based on Listed Drugs when
those approved products or Listed Drugs have acquired patent term extensions.

      Manufacturers of marketed drugs must conform to the FDA's cGMP standard or
risk sanctions 


                                                                              19
<PAGE>   20

such as the suspension of manufacturing or the seizure of drug products and the
refusal to approve additional marketing applications. The FDA conducts periodic
inspections to implement these rules. There can be no assurance that a
manufacturer's facility will be found to be in compliance with cGMP or other
regulatory requirements. Failure to comply could result in significant delays in
the development, testing and approval of products manufactured at such facility,
as well as increased costs.

            Noncompliance with applicable requirements can also result in total 
or partial injunctions against production and/or distribution, refusal of the
government to enter into supply contracts or to approve NDAs, ANDAs or biologics
applications, criminal prosecution and product recalls. The FDA also has the
authority to revoke for cause drug or biological approvals previously granted.

FDA REGULATION OF EXCIPIENTS

      Products sold for use as excipients in finished drug products are subject
to regulation by the FDA with regard to labeling, product integrity and
manufacturing. The FDA will not approve a drug for marketing without adequate
assurances that the excipients are safe for use in the product. The FDA presumes
certain excipients that are present in approved drug products currently marketed
for human use to be safe. These excipients are listed by the FDA in a document
known as the Inactive Ingredient Guide, or "IIG." All of the Company's
pharmaceutical excipients other than ProSolv are listed in the IIG. While the
FDA does not ordinarily require applicants for NDAs or ANDAs to submit data
demonstrating the safety of excipients listed in the IIG, it may require
evidence of safety in certain circumstances, such as when evidence is required
to demonstrate that such excipients interact safely with other components of a
drug product. For excipients not listed in the IIG, the FDA will generally
require data, which may include clinical data, demonstrating the safety of the
excipient for use in the product at issue. In the case of generic drug products
approved based on bioequivalence to a reference drug, the FDA may in some cases
(e.g., products for parenteral, ophthalmic, otic or topical use) require
excipients that are identical to the excipients in the reference drug. There can
be no assurance that the FDA will not require new clinical safety data to
approve an application for a product with a Penwest excipient or that the FDA
will approve such an application even if such clinical data are submitted.

FOREIGN REGULATORY APPROVAL

      Whether or not FDA approval has been obtained, approval of a
pharmaceutical product by comparable governmental regulatory authorities in
foreign countries must be obtained prior to the commencement of clinical trials
and subsequent marketing of such product in such countries. The approval
procedure varies from country to country, and the time required may be longer or
shorter than that required for FDA approval.

      Under European Union ("EU") law, either of two approval procedures may
apply to the Company's products: a centralized procedure, administered by the
EMEA (the European Medicines Evaluation Agency); or a decentralized procedure,
which requires approval by the medicines agency in each EU Member State where
the Company's products will be marketed. The centralized procedure is mandatory
for certain biotechnology products and available at the applicant's option for
certain other products. Although the decentralized procedure requires approval
by the medicines agency in each EU Member State where the products will be
marketed, there is a mutual recognition procedure under which the holder of
marketing approval from one EU Member State may submit an application 


                                                                              20
<PAGE>   21

to one or more other EU Member States, including a certification to the effect
that the application is identical to the application which was originally
approved or setting forth the differences between the two applications. Within
90 days of such application, each EU Member State will be required to determine
whether to recognize the prior approval.

      Whichever procedure is used, the safety, efficacy and quality of the
Company's products must be demonstrated according to demanding criteria under EU
law and extensive nonclinical tests and clinical trials are likely to be
required. In addition to premarket approval requirements, national laws in EU
Member States will govern clinical trials of the Company's products, adherence
to good manufacturing practice, advertising and promotion and other matters. In
certain EU Member States, pricing or reimbursement approval may be a legal or
practical precondition to marketing.

      A procedure for abridged applications for generic products also exists in
the EU. The general effect of the abridged application procedure is to give
scope for the emergence of generic competition once patent protection has
expired and the original product has been on the market for at least six or ten
years. Independent of any patent protection, under the abridged procedure, new
products benefit in principle from a basic six or ten year period of protection
(commencing with the date of first authorization in the EU) from abridged
applications for a marketing authorization. The period of protection in respect
of products derived from certain biotechnological processes or other
high-technology medicinal products viewed by the competent authorities as
representing a significant innovation is ten years. Further, each EU Member
State has discretion to extend the basic six-year period of protection to a
ten-year period to all products marketed in its territory. Certain EU Member
States have exercised such discretion. The protection does not prevent another
company from making a full application supported by all necessary
pharmacological, toxicological and clinical data within the period of
protection. Abridged applications can be made principally for medicinal products
which are essentially similar to medicinal products which have been authorized
for either six or ten years. Under the abridged application procedure, the
applicant is not required to provide the results of pharmacological and
toxicological tests or the results of clinical trials. For such abridged
applications, all data concerning manufacturing quality and bioavailability are
required. The applicant submitting the abridged application generally must
provide evidence or information that the drug product subject to this
application is essentially similar to that of the referenced product in that it
has the same qualitative and quantitative composition with respect to the active
ingredient and the same dosage form, and is similar in bioavailability as the
referenced drug.

      The Company's European excipients manufacturing operations are subject to
a variety of laws and regulations, including environmental and good
manufacturing practices regulations.

OTHER REGULATIONS

      The Company is governed by federal, state and local laws of general
applicability, such as laws regulating working conditions and environmental
protection. Certain drugs that the Company is developing are subject to
regulations under the Controlled Substances Act and related statutes.

COMPETITION

      The pharmaceutical industry is highly competitive and is affected by new
technologies, governmental regulations, health care legislation, availability of
financing, litigation ad other factors. Many of the Company's competitors have
longer operating histories and greater financial, marketing, 


                                                                              21
<PAGE>   22

legal and other resources than the Company and certain of its collaborators. The
company expects that it will be subject to competition from numerous other
entities that currently operate or intend to operate in the pharmaceutical
industry, including companies that engage in the development of controlled
release technologies. The Company's TIMERx business faces competition from
numerous public and private companies and their controlled release technologies,
including Alza Corporation's ("Alza") Oros technology, multiparticulate systems
marketed by Elan Corporation PLC ("Elan") and Biovail, traditional matrix
systems marketed by SkyePharma, plc and other controlled release technologies
marketed and under development by Andrx Corporation, among others.

      The Company's entry strategy in drug delivery was to concentrate
development efforts on generic versions of controlled release pharmaceuticals.
Typically, selling prices of immediate release drugs have declined and profit
margins have narrowed after generic equivalents of such drugs are first
introduced and the number of competitive products has increased. Similarly, the
success of generic versions of controlled release products based on the
Company's TIMERx technology will depend, in large part, on the intensity of
competition from currently marketed drugs and technologies that compete with the
branded pharmaceutical, as well as the timing of product approvals. However, the
Company believes that generic versions of controlled release pharmaceuticals
based on TIMERx technology are less likely to suffer the same degree of price
erosion as other generic pharmaceuticals because of formulation, analytical and
manufacturing complexity of the generic versions may be difficult for other
companies to replicate, which could limit competition. Competition may also
arise from therapeutic products that are functionally equivalent but produced by
other methods. In addition, under several of the Company's collaborative
arrangements, the payments due to the Company with respect to the controlled
release products covered by such collaborative arrangements will be reduced in
the event that there are competing generic controlled release versions of such
products. The Company is now focusing its business development efforts and new
R&D projects on controlled release versions of existing immediate release drugs.
These drugs will be filed as New Drug Applications.

      In its excipients business, the Company competes with a number of large
manufacturers and other distributors of excipient products, many of which have
substantially greater financial, marketing and other resources than the Company.
The Company's principal competitor in this market is FMC Corporation, which
markets its own line of MCC excipient products.

MYLAN LITIGATION

      In May 1997, one of the Company's collaborators, Mylan, filed an ANDA with
the FDA for the 30 mg dosage strength of Nifedipine XL, a generic version of
Procardia XL, a controlled release formulation of nifedipine. Bayer AG and Alza
own patents listed for Procardia XL, and Pfizer is the sponsor of the NDA and
markets the product. In connection with the ANDA filing, Mylan certified in May
1997 to the FDA that Nifedipine XL does not infringe these Bayer or Alza patents
and notified Bayer, Alza and Pfizer of such certification. Bayer and Pfizer sued
Mylan in the United States District Court for the Western District of
Pennsylvania, alleging that Nifedipine XL infringes Bayer's patent. The Company
has been informed by Mylan that Alza does not believe that the notice given to
it complied with the requirements of the Waxman-Hatch Act, and there can be no
assurance that Alza will not sue Mylan for patent infringement or take any other
actions with respect to such notice. Mylan has advised the Company that it
intends to contest vigorously the allegations made in the lawsuit. However,
there can be no assurance that Mylan will prevail in this litigation or that it
will continue to contest the lawsuit. If the litigation results in a
determination that 


                                                                              22
<PAGE>   23

Nifedipine XL infringes Bayer's patent, Nifedipine XL could not be marketed in
the United States until such patent expired. An unfavorable outcome or
protracted litigation for Mylan would materially adversely affect the Company's
business, financial condition and results of operations.

      The FDA granted tentative approval of Nifedipine XL in March 1999, but
final marketing approval will not be granted until certain legal issues
including the patent lawsuit brought by Bayer and Pfizer against Mylan has been
resolved.

      In 1993, Pfizer filed a "citizen's petition" with the FDA, claiming that
its Procardia XL formulation constituted a unique delivery system and that a
drug with a different release mechanism such as the TIMERx controlled release
system cannot be considered the same dosage form and approved in an ANDA as
bioequivalent to Procardia XL. In August 1997, the FDA rejected Pfizer's
citizen's petition. In July 1997, Pfizer also sued the FDA in the District Court
of the District of Columbia, claiming that the FDA's acceptance of Mylan's ANDA
filing for Nifedipine XL was contrary to the law, based primarily on the
arguments stated in its citizen's petition. Mylan and the Company intervened as
defendants in this suit. In April 1998, the District Court of the District of
Columbia rejected Pfizer's claim, and in May 1998, Pfizer appealed the court's
decision. In February 1999, arguments were heard on the appeal, but there has
been no decision. There can be no assurance that the FDA, Mylan and the Company
will prevail in this litigation. An outcome in this litigation adverse to Mylan
and the Company would result in Mylan being required to file a suitability
petition in order to continue the ANDA or to file and NDA with respect to
Nifedipine XL, each of which would be expensive and time consuming. An adverse
outcome also would result in Nifedipine XL becoming ineligible for an "AB"
rating from the FDA. Failure to obtain an AB rating from the FDA would indicate
that for certain purposes Nifedipine XL would not be deemed to be
therapeutically equivalent to the referenced branded drug, would not be fully
substitutable for the referenced branded drug and would not be relied upon by
Medicaid and Medicare formularies for reimbursement. Any such failure would have
a material adverse effect on the Company's business, financial condition and
results of operations. If any of such events occur, Mylan may terminate its
efforts with respect to Nifedipine XL, which would have a material adverse
effect on the Company's business, financial condition and results of operations.

EMPLOYEES

      As of December 31, 1998, the Company employed 125 persons, of which 75
were involved in research and development, administration and sales and
marketing activities in Patterson, New York, 25 were involved in manufacturing
operations at the Company's facility in Nastola, Finland, 19 were involved in
manufacturing operations at the Company's facility in Cedar Rapids, Iowa and 6
were involved in sales activities in the Company's European sales offices.

      Other than the Company's employees in Finland who are covered by a
national collective bargaining agreement, none of the Company's employees are
covered by collective bargaining agreements. The Company considers its employee
relations to be good.

FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS

      For financial information about the Company's foreign and domestic
operations see Note 15 of the notes to consolidated financial statements.


                                                                              23
<PAGE>   24

ITEM 2: PROPERTIES

      The Company's executive, administrative, research, small-scale production
and warehouse facilities, comprising approximately 55,000 square feet, currently
are located in a single facility on a 15 acre site owned by the Company in
Patterson, New York.

      The Company owns a facility in Cedar Rapids, Iowa where it manufactures
and packages pharmaceutical excipients. The facility is a 35,000 square foot
building containing manufacturing and administrative space. The Company also
manufactures pharmaceutical excipients in a 15,000 square foot facility leased
by the Company in Nastola, Finland, which lease renews annually with a two year
notification of termination period for either party.

      The Company believes that all its present facilities are well maintained
and in good operating condition.

ITEM 3: LEGAL PROCEEDINGS

      None.


                                                                              24
<PAGE>   25

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

      No matter was submitted to a vote of shareholders during the fourth
quarter of fiscal 1998.

EXECUTIVE OFFICERS OF THE REGISTRANT

<TABLE>
<CAPTION>
           NAME           AGE                TITLE
           ----           ---                -----
<S>                       <C>   <C>                               <C>
Tod R. Hamachek           53    Chairman of the Board and Chief
                                Executive Officer                 1997 - current

                                President and Chief Executive     1985 - 1997
                                Officer - Penford Corp.

Anand R. Baichwal, Ph.D.  44    Senior Vice President, Research
                                & Development                     1997 - current

                                Vice President, Technology        1994 - 1997

Stephen J. Berte, Jr.     43    Vice President, Marketing &       1995 - current
                                Sales
                                                                 
                                Sr. Director, New Product         1992 - 1995
                                Development - Sanofi

Jennifer L. Good          34    Vice President, Finance and
                                Chief Financial Officer           1997 - current

                                Corporate Director of Finance &
                                Secretary - Penford Corp.         1996 - 1997

                                Corporate Controller - Penford    1993 - 1996
                                Corp.

Paul K. Wotton, Ph.D.     38    Vice President, Business          1994 - current
                                Development
</TABLE>


                                                                              25
<PAGE>   26

PART II

ITEM 5: MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS

      Penwest's common stock, $.001 par value, is listed with and trades on the
Nasdaq National Market under the symbol "PPCO." On August 31, 1998, the
Company's former parent, Penford Corporation ("Penford"), distributed to the
shareholders of record of Penford common stock on August 10, 1998 all of the
shares of the Company's common stock (the "Distribution"). In connection with
the Distribution, the Company's common stock was listed and began trading on the
Nasdaq National Market on August 10, 1998. The high and low closing prices of
the Company's common stock during the last two quarters of 1998 are set forth
below. The quotations reflect inter-dealer prices, without retail mark-up,
mark-down or commission and may not necessarily represent actual transactions.

<TABLE>
<CAPTION>
PERIOD 1998                                                HIGH         LOW
-----------                                                ----         ---
     <S>                                                   <C>         <C>  
     Quarter Ended September 30 (commencing August 10)     $7.50       $3.50
     Quarter Ended December 31                             $9.44       $3.75
</TABLE>

On March 8, 1999 there were 1,040 shareholders of record.

The Company has never paid cash dividends on its common stock. The Company
presently intends to retain earnings, if any, for use in the operation of its
business, and therefore does not anticipate paying any cash dividends in the
foreseeable future. The Company is prohibited from paying dividends on its
common stock under its credit facility.

ITEM 6:  SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                                  YEAR ENDED DECEMBER 31,
                                                                                  -----------------------
                                                         1994             1995             1996             1997             1998
                                                       --------         --------         --------         --------         --------
STATEMENT OF OPERATIONS DATA:                                            (IN THOUSANDS EXCEPT FOR PER SHARE DATA)
<S>                                                    <C>              <C>              <C>              <C>              <C>     
Revenues ......................................        $ 23,146         $ 25,089         $ 26,089         $ 26,941         $ 29,011
Cost of product sales .........................          15,910           17,267           19,062           20,357           21,045
Gross profit ..................................           7,236            7,822            7,027            6,584            7,966
Selling, general and administrative ...........           7,021            7,676            6,776            8,708           11,354
Asset write-off (a) ...........................              --               --               --               --            1,341
IPO transaction costs (b) .....................              --               --               --            1,367               --
Research and product development ..............           2,322            2,719            3,351            3,681            6,054
Net loss ......................................        $ (2,629)        $ (3,252)        $ (3,864)        $ (7,316)        $ (8,829)
                                                       ========         ========         ========         ========         ========
Basic and diluted net
    loss per share ............................        $  (0.24)        $  (0.29)        $  (0.35)        $  (0.66)        $  (0.80)
                                                       ========         ========         ========         ========         ========
Weighted average shares of
   common stock outstanding ...................          11,037           11,037           11,037           11,037           11,037
                                                       ========         ========         ========         ========         ========

<CAPTION>
                                                                                       DECEMBER 31,
                                                       -----------------------------------------------------------------------------
                                                         1994             1995             1996             1997            1998(C)
                                                       --------         --------         --------         --------         --------
BALANCE SHEET DATA:                                                                  (IN THOUSANDS)
<S>                                                    <C>              <C>              <C>              <C>              <C>     
Cash and cash equivalents .....................        $    668         $    290         $    695         $    938         $  1,476
Working capital ...............................         (14,592)         (19,461)         (23,362)         (33,049)           7,648
Total assets ..................................          27,000           31,671           35,083           37,820           41,082
Accumulated deficit ...........................          (5,217)          (8,469)         (12,333)         (19,649)         (28,478)
Total shareholder's equity (deficit) ..........           2,641             (477)          (4,412)         (12,297)          30,032
</TABLE>

(a) A one time charge relating to the write-off of costs associated with the
decision to outsource certain manufacturing as opposed to constructing a new
facility.

(b) The write-off of transaction costs associated with an abandoned initial
public offering.

(c) In conjunction with the August 31, 1998 Distribution, Penford contributed to
the Company's capital, all existing intercompany indebetness.


                                                                              26
<PAGE>   27

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

      The following Management's Discussion and Analysis of Financial Condition
and Results of Operations contains forward-looking statements which involve
risks and uncertainties. The Company's actual results could differ materially
from those anticipated in these forward-looking statements as a result of
certain factors, including those set forth below under "Risk Factors."

OVERVIEW

      Penwest Pharmaceuticals Co. ("Penwest" or the "Company"), is engaged in
the research, development and commercialization of novel drug delivery
technologies. The Company has extensive experience in developing and
manufacturing tabletting ingredients for the pharmaceutical industry. The
Company's product portfolio ranges from excipients that are sold in bulk, to
more technically advanced and patented excipients that are licensed to
customers. On August 31, 1998 (the "Distribution Date"), Penwest became an
independent, publicly owned company when Penford Corporation ("Penford"), the
Company's former parent, distributed (the "Distribution") to the shareholders of
record of Penford common stock on August 10, 1998 all of the shares of the
Company's common stock. Pursuant to the Distribution, each Penford shareholder
of record received three shares of the Company's Common Stock for every two
shares of Penford common stock held by them.

      The Company has incurred net losses since 1994. As of December 31, 1998,
the Company's accumulated deficit was approximately $28.5 million. The Company
expects net losses to continue at least into early 2000. A substantial portion
of the Company's revenues to date have been generated from the sales of the
Company's pharmaceutical excipients. The Company's future profitability will
depend on several factors, including the successful commercialization of TIMERx
controlled release products, and, to a lesser extent, an increase in sales of
its pharmaceutical excipients products. There can be no assurance that the
Company will achieve profitability or that it will be able to sustain
profitability on a quarterly basis, if at all.

      Except for Cystrin CR, which received marketing approval in Finland in
October 1997, and Slofedipine XL, which received marketing approval in the U.K.
in November 1998, no product based on TIMERx technology has ever received
regulatory approval for commercial sale. In March 1999, Mylan was notified that
the ANDA for 30 mg dosage strength Nifedipine XL had received tentative
approval. However, the Company does not expect that final marketing approval
will be granted until certain legal issues surrounding the patent dispute
between Mylan and Bayer and Pfizer have been resolved. Under most of the
Company's collaborative agreements, the Company is entitled to receive milestone
payments, royalties on the sale of the products covered by such collaborative
agreements and payments for the purchase of formulated TIMERx material.
Substantially all the TIMERx revenues generated to date have been milestone fees
received for products under development as well as sales of formulated TIMERx.
There can be no assurance that the Company's controlled release product
development efforts will be successfully completed, that required regulatory
approvals will be obtained or that approved products will be successfully
manufactured or marketed.

      The Company's results of operations may fluctuate from quarter to quarter
depending on the volume and timing of orders of the Company's pharmaceutical
excipients and on variations in 


                                                                              27
<PAGE>   28

payments under the Company's collaborative agreements including payments upon
the achievement of specified milestones. The Company's quarterly operating
results may also fluctuate depending on other factors, including variations in
gross margins of the Company's products, the mix of products sold, competition,
regulatory actions, litigation and currency exchange rate fluctuations.

RESULTS OF OPERATIONS

      YEARS ENDED DECEMBER 31, 1998 AND 1997

      Total revenues increased by 7.7% in 1998 to $29.0 million from $26.9
million in 1997. Product sales increased to $28.7 million in 1998 from $26.0
million in 1997 representing an increase of 10.3%. The increase in product sales
was primarily due to increased sales volumes of Emcocel. The Company added one
significant Emcocel customer early in 1998 and two additional large
pharmaceutical companies in December 1998 which took some shipments of Emcocel
late in December 1998. Royalties and licensing fees relating to the TIMERx drug
delivery system decreased to $302,000 for the year ended December 31, 1998 from
$911,000 for the year ended December 31, 1997 due to the timing of when
development milestones were earned.

     Gross profit increased to $8.0 million or 27.5% of total revenues in 1998
from $6.6 million or 24.4% of total revenues in 1997. The increase in gross
profit percentage was primarily due to improved product mix within product
sales.  This increase, however, was partially offset by a decrease in royalties
and licensing fees for the year. Gross profit percentage on product sales
increased to 26.7% in 1998 from 21.8% in 1997. This improvement in gross profit
percentage on product sales was due to increasing sales of formulated TIMERx and
Prosolv, which have higher margins than traditional excipients, as well as
increasing margins on Emcocel products due to volume manufacturing efficiencies.

       Selling, general and administrative expenses increased by 30.4% in 1998
to $11.4 million from $8.7 million in 1997. The higher expenses in 1998 were due
to higher compensation expenses and relocation expenses associated with the
hiring of additional employees, accruals of compensation expense for severance
arrangements and higher depreciation on a new computer system. In addition, 1997
expenses reflected unusually low general and administrative expenses as a result
of a property tax refund recorded in the second quarter of 1997 on the Patterson
facility. The 1998 expenses included a one-time charge of $1.3 million relating
to the write-off of costs associated with the decision to outsource certain
manufacturing as opposed to constructing a new manufacturing facility. The 1997
expenses included a one-time charge of $1.4 million for the write-off of
transaction costs associated with the Company's decision to abandon an initial
public offering of its common stock in 1997.

      Research and development expenses increased by 64.5% in 1998 to $6.1
million from $3.7 million in 1997. The increased spending in 1998 relates
primarily to additional biostudy activity related to the development of TIMERx
controlled release products as well as increased funding under the Company's
collaborative agreement with Endo.

      For 1998 the Company recorded an income tax benefit of 19% principally as
a result of operating losses generated by the Company in the period prior
to August 31, 1998 that were utilized by Penford, without any compensation being
paid to the Company.


                                                                              28
<PAGE>   29

YEARS ENDED DECEMBER 31, 1997 AND 1996

      Total revenues increased by 3.3% in 1997 to $26.9 million from $26.1
million in 1996. Product sales increased to $26.0 million in 1997 from $25.0
million in 1996, primarily due to an increase in the second half of 1997 in
North American sales of Emcocel. These increased sales were partially offset by
a decrease in average selling price for some excipients in Europe due to
competitive pricing pressures. Royalties and licensing fees relating to the
TIMERx drug delivery system decreased to $911,000 in 1997 from $1.1 million in
1996 due to the timing of when development milestones were earned.

      Gross profit decreased to $6.6 million or 24.4% of total revenues in 1997
from $7.0 million or 26.9% of total revenues in 1996. This decrease in gross
profit was primarily attributable to an increase in sales of Emcocel products,
which have lower overall gross margins than the Company's other excipients. The
margins on these products are expected to improve as manufacturing economies of
scale are achieved. The decrease is also attributable to inventory write-offs of
excipient products in the fourth quarter of 1997 and the decrease in royalties
and licensing fees in 1997. Excipient product write-offs of approximately
$100,000 were primarily due to quality reasons. Future write-offs are not
expected to materially affect results of operations, liquidity or capital
resources.

      Selling, general and administrative expenses increased by 28.5% in 1997 to
$8.7 million from $6.8 million in 1996. This increase reflected additional
business development expenses of $327,000, employee benefit consulting
associated with the Distribution of $311,000, additional incentive compensation
expenses of $222,000, an increase in management fees of $210,000 and a property
tax refund recorded in 1996 of $150,000. The balance of the increase is
primarily attributable to increases in administrative staff in anticipation of
planned business growth. Business development expenses are primarily comprised
of payroll and related benefits and staff recruiting, relocation, travel,
professional and promotional expenses.

      In October 1997, Penford's Board of Directors approved the sale of
approximately 20% of the Company's Common Stock in an initial public offering
(the "IPO"). The IPO was initially intended to be completed during December
1997. Due to market conditions, the IPO was initially postponed and during May
1998, after further evaluation of the market opportunities, Penford's Board of
Directors decided to distribute 100% of the Common Stock to Penford's
shareholders and forego the IPO at such time. Based on this decision, the
Company wrote-off approximately $1.4 million of transaction costs, principally
legal, accounting and printing, associated with the preparation for the IPO
during the year ended December 31, 1997.

      Research and development expenses increased by 9.8% in 1997 to $3.7
million from $3.4 million in 1996. This increase was due to increased spending
in the development of the TIMERx drug delivery system and its applications as
well as increased spending on developing high performance excipients such as
Prosolv.

      For 1997 and 1996, the Company did not record a benefit for federal or
state taxes because net operating losses were utilized by Penford in the year
they were generated, and the Company was not compensated for these losses. In
addition, the Company's provision for income taxes includes foreign taxes and
federal and state deferred tax liabilities that exceed deferred tax assets,
which will reverse when losses are not expected to be available.


                                                                              29
<PAGE>   30

LIQUIDITY AND CAPITAL RESOURCES

      Prior to the Distribution Date, the Company funded its operations, capital
expenditures and the original acquisition of the Company's predecessor, through
intercompany advances from Penford in an aggregate amount equal to $50.9
million. On the Distribution Date Penford contributed this outstanding
intercompany indebtedness and certain other assets and liabilities to the
capital of the Company. Subsequent to the Distribution Date, the Company is
funding its operations and capital expenditures from cash from operations and
advances from its Credit Facility ("Credit Facility"). The Company has an
available Credit Facility which is a revolving Loan Facility with a maximum
principal amount of $15.0 million of unsecured financing. On August 31, 2000,
all outstanding amounts under the Credit Facility will become automatically due
and payable. Penford has agreed that, for a period ending August 31, 2000, it
will guarantee the Company's indebtedness under the Credit Facility. Borrowings
under the Credit Facility bear interest at a rate equal to LIBOR, plus 1.25%.
The Credit Facility contains a number of non-financial covenants that are
applicable to Penwest, including without limitation, restrictions on the
incurrence of additional debt and on the payment of dividends. Any breach of
these covenants by the Company would constitute a default by the Company under
the Credit Facility. In addition, the Credit Facility provides that a breach by
Penford of its guarantee of the Company's indebtedness under the Credit Facility
or the occurrence of a default under any credit agreement with Penford under
which the lender is either the sole or a participating lender, including without
limitation an event of default arising from the failure of Penford to satisfy
certain financial conditions requiring, among other things, the maintenance of a
minimum net worth and of certain financial ratios, would constitute a default by
the Company under the Credit Facility. Accordingly, the Company is substantially
dependent on Penford in order to access and maintain the Credit Facility. Any
default under the Credit Facility would have a material adverse effect on the
Company's business, financial condition and result of operations.

      Although Penford has guaranteed the Company's indebtedness under the
Credit Facility, in no other respects is Penford providing financial support to
the Company.

      As of December 31, 1998, the Company had cash and cash equivalents of $1.5
million, and had outstanding borrowings under the Credit Facility of $2.2
million. The Company has no indebtedness to any third or related parties other
than under the Credit Facility. As of December 31, 1998, the Company did not
have any material commitments for capital expenditures.

      The Company had negative cash flow from operations in each of the periods
presented primarily due to net losses for the period as well as increasing
inventory in 1996 and 1997. In 1998, there was an increase in cash due to the
timing of payments of accounts payable.

      Funds expended for the acquisition of fixed assets in 1998 were primarily
related to the expansion and improvement of the Company's manufacturing
facilities and laboratory space as well as the purchase of equipment used
principally for research and development efforts. Funds expended for intangible
assets in 1998 include costs to secure and defend patents on technology
developed by the Company and secure trademarks. In the fourth quarter of 1998,
the Company wrote off $1.3 million of costs associated with the decision to
outsource certain manufacturing as opposed to constructing a new manufacturing
facility. This decision was made because a qualified third party manufacturer
offering favorable pricing terms was identified in the fourth quarter of 1998.


                                                                              30
<PAGE>   31

      The Company anticipates that its existing capital resources, together with
the funds available under the Credit Facility and internally generated funds,
will enable it to maintain currently planned operations through at least 1999.
However, this expectation is based on the Company's current operating plan,
which could change as a result of many factors and the Company could require
additional funding sooner than anticipated. The Company's requirements for
additional capital could be substantial and will depend on many factors,
including the timing and amount of payments received under existing and possible
future collaborative agreements; the structure of any future collaborative or
development agreements; the progress of the Company's collaborative and
independent development projects; revenues from the Company's excipients
business, the costs to the Company of bioequivalence studies for the Company's
products; the prosecution, defense and enforcement of patent claims and other
intellectual property rights; and the development of manufacturing, marketing
and sales capabilities. The Company has no committed sources of capital other
than the Credit Facility. There can be no assurance that the Company will be
able to access the Credit Facility at such times as it desires or needs capital.

      To the extent capital resources are insufficient to meet future
requirements, the Company will have to raise additional funds to continue the
development of its technologies. There can be no assurance that such funds will
be available on favorable terms, if at all. The Credit Facility restricts the
incurrence of additional indebtedness by the Company and provides that the
maximum amount available to Penwest under the Credit Facility, $15.0 million,
will be reduced by the amount of any net proceeds from any financing conducted
by the Company and that the Company will repay any outstanding amounts under the
Credit Facility in excess of the new maximum amount. To the extent that
additional capital is raised through the sale of equity or convertible debt
securities, the issuance of such securities could result in dilution to the
Company's shareholders. If adequate funds are not available, the Company may be
unable to comply with its obligations under its collaborative agreements, which
could result in the termination of such collaborative agreements. In addition,
the Company may be required to curtail operations significantly or obtain funds
through entering into collaborative agreements on unfavorable terms. The
Company's inability to raise capital would have a material adverse effect on the
Company's business, financial condition and results of operations.

      Under the Company's strategic alliance agreement with Endo, the Company
expects to expend approximately $7 million, primarily in 1999, 2000 and early
2001. The Company expects to rely on funds available under the Credit Facility
and cash from operations to fund these expenditures. However, as noted above the
Company may be required to raise additional funds to continue its development
activities, including its activities under the Endo agreement. The Company or
Endo may terminate the agreement upon 30 days' prior written notice, at which
time the Company's funding obligations would cease.

MARKET RISK AND RISK MANAGEMENT POLICIES

      The operations of the Company are exposed to financial market risks,
including changes in interest rates and foreign currency exchange rates. The
Company's interest rate risk consists of cash flow risk associated with
borrowing under its variable rate Credit Facility. The Company's international
subsidiaries transact a substantial portion of their sales and purchases in
European currencies other than their functional currency, which can result in
the Company having gains or losses from currency exchange rate fluctuations. The
Company does not use derivatives to hedge the impact of fluctuations in foreign
currencies or interest rates. The Company does not believe that the potential
exposure is significant in light of the size of the Company and its business.


                                                                              31
<PAGE>   32

YEAR 2000

      The Year 2000 Issue is the result of computer programs being written using
two digits rather than four digits to define the applicable year. Any of the
Company's computer programs or hardware or other equipment that have
date-sensitive software or embedded chips may recognize a date using "00" as the
year 1900 rather than the year 2000. This could result in a system failure or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices, or engage
in similar normal business activities.

      The Company's plan to resolve the Year 2000 Issue involves the following
four phases: assessment, remediation, testing and contingency planning. The
Company has completed approximately 85% of its overall anticipated assessment of
programs, hardware or other equipment that could be significantly affected by
the Year 2000. The completed assessment indicated that most of the Company's
significant information technology systems will not be affected. The Company
recently installed a new integrated computer system for all domestic operations
that is Year 2000 compliant. The underlying hardware is also Year 2000 compliant
according to vendor certification. The international information technology
system primarily consists of personal computers, the majority of which will
require replacement. The assessment also indicated that software and hardware
(embedded chips) used in production and manufacturing systems (hereafter also
referred to as operating equipment) in North America are compliant, however, the
Company's Finland operations may be Year 2000 non-compliant. Affected systems
include process control software used at the Company's Finland manufacturing
plants, which produce the Company's European Emcocel products. The Company has
engaged process control consultants to evaluate this situation. Such evaluation
is expected to be completed in June. A failure in Finland could cause disruption
to such operations, which could have a material adverse effect on the Company's
business, financial position, results of operations or cash flows.

      Although the Company has not completed its Year 2000 assessment, it has
begun the remediation and testing phases with respect to the Year 2000 issues it
has identified with respect to its information technology systems. The Company
has completed approximately 75% of the required remediation and expects to
complete replacement of personal computers no later than June 30, 1999. The
Company also needs to complete testing of its software and hardware systems to
ensure compliance. The Company estimates that it has tested approximately 30% of
such systems. The Company expects completion of the testing phase for all
significant systems by June 1999.

      The required remediation of operating equipment primarily relates to
manufacturing and laboratory equipment. The Company estimates that it is
approximately 85% complete with this assessment, that the assessment will be
completed by April 1999 and that any required remediation will be completed by
June 1999.

      The Company does not have any system interfaces with third party vendors,
manufacturers or customers. The Company is in the process of identifying and
obtaining documentation from its significant suppliers and subcontractors none
of which share information systems with the Company to determine the extent to
which such suppliers and subcontractors will be affected by any significant Year
2000 issues. The Company needs to obtain documentation from its strategic
customers. To date, the Company is not aware of any supplier, manufacturer,
subcontractor or strategic customers with a Year 2000 issue that could have a
material adverse effect on the Company's business, financial 


                                                                              32
<PAGE>   33

position, results of operations or cash flows. The Company has sent
correspondence to all its major suppliers, subcontractors and manufacturers and
has received approximately 60% of the responses back.

      There can be no guarantee, however, that third parties of business
importance to the Company will successfully and timely evaluate and address
their own Year 2000 issues. The failure of any of these third parties to achieve
Year 2000 compliance in a timely fashion could have a material adverse effect on
the Company's business, financial position, results of operations or cash flows.

      The costs of the Company's worldwide Year 2000 compliance efforts are
being funded with cash flows from operations as well as the Company's Credit
Facility. Although the Company has not completed the Year 2000 assessment of its
computer systems and software, based upon its assessment efforts to date, the
Company does not anticipate that the costs of becoming Year 2000 compliant will
have a material adverse effect upon the Company's business, financial position,
results of operations or cash flows. The Company does not expect that the costs
of replacing or modifying the computer equipment and software will be
substantially different, in the aggregate, from the normal, recurring costs
incurred by the Company for systems development, implementation and maintenance
in the ordinary course of business. In this regard, in the ordinary course of
replacing computer equipment and software, the Company attempts to obtain
replacements that are Year 2000 compliant. For example, the Company recently
installed a computer system, which was purchased and installed irrespective of
Year 2000 and cost approximately $4.0 million. As of December 31, 1998,
additional costs incurred by the Company for the replacement of computer
equipment and software that was not Year 2000 compliant (i.e. the costs incurred
in excess of the costs that would have been incurred by the Company in the
ordinary course of replacing computer equipment and software) have not been
material. The Company expects to incur total worldwide costs of less than
$100,000 to become Year 2000 compliant on its hardware, software and operating
equipment.

      The Company does not presently believe that the Year 2000 issue will pose
significant operational problems for the Company. However, if all Year 2000
issues are not properly identified, or assessment, remediation and testing are
not effected timely with respect to Year 2000 problems that are identified,
there can be no assurance that the Year 2000 issue will not have a material
adverse effect on the Company's business, financial position, results of
operations or cash flows or adversely affect the Company's relationships with
customers, suppliers or others.

      The Company has not yet developed a contingency plan for dealing with
operational problems and costs (including loss of revenues) that would be
reasonably likely to result from failure by the Company and certain third
parties to achieve Year 2000 compliance on a timely basis. The Company currently
plans to complete its analysis of the problems and costs associated with the
failure to achieve Year 2000 compliance and to establish a contingency plan in
the event of such failure by August 31, 1999.

      The foregoing assessment of the impact of the Year 2000 issue on the
Company is based on management's best estimates as of the date of this Annual
Report on Form 10-K, which are based on numerous assumptions as to future
events. There can be no assurance that these estimates will prove accurate and
actual results could differ materially from those estimated if these assumptions
prove inaccurate.


                                                                              33
<PAGE>   34

EURO CONVERSION

      On January 1, 1999, certain member countries of the European Union adopted
the Euro as their common legal currency. Between January 1, 1999 and January 1,
2002, transactions may be conducted in either the Euro or the participating
countries national currency. However, by July 1, 2002, the participating
countries will withdraw their national currency as legal tender and complete the
conversion to the Euro.

      The Company conducts business in Europe and does not expect the conversion
to the Euro to have an adverse effect on its competitive position or
consolidated financial position. The Company's existing systems allow the
company to conduct business transactions in both the Euro as well as other
foreign currencies.

      This Annual Report on Form 10-K contains certain 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. For this purpose, any
statements contained herein that are not statements of historical fact may be
deemed to be forward-looking statements. Without limiting the foregoing, the
words "believes", "anticipates", "plans", "expects", "intends", "may", and other
similar expressions are intended to identify forward-looking statements. There
are a number of important factors that could cause the Company's actual results
to differ materially from those indicated by forward-looking statements
contained in this report and presented elsewhere by management from time to
time. These factors include the risk factors listed below.

RISK FACTORS

CERTAIN RISKS AND LITIGATION RELATING TO NIFEDIPINE  XL

      In May 1997, one of the Company's collaborators, Mylan, filed an ANDA with
the FDA for the 30 mg dosage strength of Nifedipine XL, a generic version of
Procardia XL, a controlled release formulation of nifedipine. Nifedipine XL is
the first product using the Company's TIMERx controlled release technology for
which an ANDA has been filed in the United States. In March 1999, Mylan was
notified that the ANDA had received tentative approval from the FDA. The Company
expects that final marketing approval will not be granted until the legal issues
surrounding the patent dispute have been resolved.

      In an ANDA filing, the FDA generally requires data demonstrating that the
drug formulation is bioequivalent to the branded drug. In addition, under the
Waxman-Hatch Act when an applicant files an ANDA for a generic version of a
brand name product covered by an unexpired patent listed with the FDA, the
applicant must certify to the FDA that such patent will not be infringed by the
applicant's product or that such patent is invalid or unenforceable. Notice of
such certification must be given to the patent owner and the sponsor of the NDA
for the brand name product.

      Bayer and ALZA own patents listed for Procardia XL, and Pfizer is the
sponsor of the NDA and markets the product. In connection with the ANDA filing,
Mylan certified in May 1997 to the FDA that Nifedipine XL does not infringe
these Bayer or ALZA patents and notified Bayer, ALZA and Pfizer of such
certification. Bayer and Pfizer sued Mylan in the United States District Court
for the Western District of Pennsylvania, alleging that Nifedipine XL infringes
Bayer's patent. The Company 


                                                                              34
<PAGE>   35

has been informed by Mylan that ALZA does not believe that the notice given to
it complied with the requirements of the Waxman-Hatch Act, and there can be no
assurance that ALZA will not sue Mylan for patent infringement or take any other
actions with respect to such notice. Mylan has advised the Company that it
intends to contest vigorously the allegations made in the lawsuit. However,
there can be no assurance that Mylan will prevail in this litigation or that it
will continue to contest the lawsuit. If the litigation results in a
determination that Nifedipine XL infringes Bayer's patent, Nifedipine XL could
not be marketed in the United States until such patent expired. An unfavorable
outcome or protracted litigation for Mylan would materially adversely affect the
Company's business, financial condition and results of operations. Delays in the
commercialization of Nifedipine XL could also occur because the FDA will not
grant final marketing approval of Nifedipine XL until a final judgment on the
patent suit is rendered in favor of Mylan by the district court, or in the event
of an appeal, by the court of appeals, or until 30 months (or such longer or
shorter period as the court may determine) have elapsed from the date of Mylan's
certification, whichever is sooner.

      In 1993, Pfizer filed a "citizen's petition" with the FDA, claiming that
its Procardia XL formulation constituted a unique delivery system and that a
drug with a different release mechanism such as the TIMERx controlled release
system cannot be considered the same dosage form and approved in an ANDA as
bioequivalent to Procardia XL. In August 1997, the FDA rejected Pfizer's
citizen's petition. In July 1997, Pfizer also sued the FDA in the District Court
of the District of Columbia, claiming that the FDA's acceptance of Mylan's ANDA
filing for Nifedipine XL was contrary to the law, based primarily on the
arguments stated in its citizen's petition. Mylan and the Company intervened as
defendants in this suit. In April 1998, the District Court of the District of
Columbia rejected Pfizer's claim, and in May 1998, Pfizer appealed the District
Court's decision. In February 1999, the case was heard in appeals court but no
decision has been rendered. There can be no assurance that the FDA, Mylan and
the Company will prevail in this litigation. An outcome in this litigation
adverse to Mylan and the Company would result in Mylan being required to file a
suitability petition in order to continue the ANDA or to file an NDA with
respect to Nifedipine XL, each of which would be expensive and time consuming.
An adverse outcome also would result in Nifedipine XL becoming ineligible for an
"AB" rating from the FDA. Failure to obtain an AB rating from the FDA would
indicate that for certain purposes Nifedipine XL would not be deemed to be
therapeutically equivalent to the referenced branded drug, would not be fully
substitutable for the referenced branded drug and would not be relied upon by
Medicaid and Medicare formularies for reimbursement. Any such failure would have
a material adverse effect on the Company's business, financial condition and
results of operations. If any of such events occur, Mylan may terminate its
efforts with respect to Nifedipine XL, which would have a material adverse
effect on the Company's business, financial condition and results of operations.

      There can be no assurance that Pfizer will not pursue additional
regulatory initiatives and lawsuits with respect to Procardia XL and Nifedipine
XL.

      Most of the controlled release products that the Company is developing
with its collaborators are generic versions of brand name controlled release
products that are covered by one or more patents. The Company expects its
collaborators will file ANDAs for such product candidates. There can be no
assurance that if ANDAs are filed for any of such products, the owners of the
patents covering the brand name product or the sponsors of the NDA with respect
to the brand name product will not sue or undertake regulatory initiatives to
preserve marketing exclusivity. Any significant delay in obtaining FDA approval
to market the Company's product candidates as a result of litigation, as well as
the expense of such litigation, whether or not the Company or its collaborators
are successful, 


                                                                              35
<PAGE>   36

could have a material adverse effect on the Company's business, financial
condition and results of operations.

      In addition to filing an ANDA with respect to the 30 mg dosage strength of
Nifedipine XL, Mylan is conducting full scale bioequivalence studies of the 60
mg and 90 mg dosage strengths of Nifedipine XL. There can be no assurance,
however, that Mylan will file ANDAs with respect to the 60 mg and 90 mg dosage
strengths or that these formulations would be otherwise approvable by the FDA.
The Company is aware that Biovail has filed an ANDA with respect to a 30 mg and
60 mg dosage strength generic version of Procardia XL. Under the Waxman-Hatch
Act, an applicant who files the first ANDA with a certification of patent
invalidity or non-infringement with respect to a product may be entitled to
receive, if such ANDA is approved by the FDA, a 180-day marketing exclusivity (a
180-day delay in approval of other ANDAs for the same drug) from the FDA. There
can be no assurance that the FDA will not approve Biovail's ANDA or another ANDA
filed by another applicant with respect to a different dosage strength prior to
or during Mylan's 180-day marketing exclusivity period, if obtained, for the 30
mg dosage strength of Nifedipine XL.

DEPENDENCE ON COLLABORATIVE AGREEMENTS

      The Company intends to develop and commercialize its TIMERx controlled
release products in collaboration with pharmaceutical companies. The Company is
a party to collaborative agreements with Mylan, Leiras, Sanofi and Endo, among
others. The Company is particularly dependent on its collaboration with Mylan,
which covers three of the Company's products under development. Under its
current collaborative agreements, the Company's collaborators are generally
responsible for conducting full scale bioequivalence studies and clinical
trials, preparing and submitting all regulatory applications and submissions and
manufacturing, marketing and selling the TIMERx controlled release products.

      There can be no assurance that the Company will be able to maintain
existing collaborative arrangements or establish new collaborative arrangements
on acceptable terms, if at all, or that any collaborative arrangements will be
commercially successful. To the extent that the Company is not able to maintain
or establish such arrangements, the Company would be required to undertake
product development and commercialization activities at its own expense, which
would increase the Company's capital requirements or require the Company to
limit the scope of its development and commercialization activities. Moreover,
the Company has limited or no experience in conducting full scale bioequivalence
studies and clinical trials, preparing and submitting regulatory applications
and manufacturing and marketing controlled release products. There can be no
assurance that it could be successful in performing these activities and any
failure to perform such activities could have a material adverse effect on the
Company's business, financial condition and results of operations.

      The Company cannot control the amount and timing of resources that its
collaborative partners devote to the Company's programs or potential products,
which may vary because of factors unrelated to the potential products. If any of
the Company's collaborators breach or terminate their agreements with the
Company or otherwise fail to conduct their collaborative activities in a timely
manner, the preclinical and/or clinical development and/or commercialization of
product candidates will be delayed, and the Company would be required to devote
additional resources to product development and commercialization or terminate
certain development programs. Also, these relationships generally may be
terminated at the discretion of the Company's collaborators, in some cases with
only limited notice to the Company. For instance, Mylan may terminate its
agreements with the Company 


                                                                              36
<PAGE>   37

at any time upon 90 days prior written notice under specified circumstances. The
termination of collaborative arrangements could have a material adverse effect
on the Company's business, financial condition and results of operations. There
also can be no assurance that disputes will not arise with respect to the
ownership of rights to any technology developed with third parties. These and
other possible disagreements with collaborators could lead to delays in the
development or commercialization of product candidates or could result in
litigation or arbitration, which could be time consuming and expensive and could
have a material adverse effect on the Company's business, financial condition
and results of operations.

      In addition, the Company's collaborators may develop, either alone or with
others, products that compete with the development and marketing of the
Company's potential products. Competing products of the Company's collaborators
may result in their withdrawal of support with respect to their products under
development using the Company's controlled release technology, which could have
a material adverse effect on the Company's business, financial condition and
results of operations.

UNCERTAINTY OF COMMERCIALIZATION OF TIMERX CONTROLLED RELEASE PRODUCTS

      Products using the Company's TIMERx controlled release technology are in
various stages of development. Except for Cystrin CR, which is being marketed in
Finland, and Slofedipine XL which is being marketed in the U.K., none of the
Company's other TIMERx controlled release products have been commercialized
and the period required to achieve commercialization is uncertain and may be
lengthy, if commercialization is achieved at all. Although in March 1999, Mylan
received a tentative approval on an ANDA filed with the FDA for the 30 mg dosage
strength of Nifedipine XL, no regulatory approval to market Nifedipine XL has
been received, and there can be no assurance as to when or if regulatory
approval will be received. Substantially all the revenues from controlled
release products generated to date have been milestone fees received for
products under development as well as some sales of formulated TIMERx. There can
be no assurance that the Company's controlled release product development
efforts will be successfully completed, that required regulatory approvals will
be obtained or that approved products will be successfully manufactured or
marketed.

HISTORY OF LOSSES; UNCERTAINTY OF FUTURE PROFITABILITY

      The Company incurred net losses of approximately $3.9 million, $7.3
million and $8.8 million during 1996, 1997 and 1998, respectively. As of
December 31, 1998, the Company's accumulated deficit was approximately $28.5
million. The Company expects net losses to continue at least into early 2000. A
substantial portion of the Company's revenues have been generated from the sales
of the Company's pharmaceutical excipients. The Company's future profitability
will depend on several factors, including the successful commercialization by
the Company and its collaborators of the controlled release products for which
regulatory approval currently is pending or has recently been obtained, the
completion of the development of other pharmaceuticals using the Company's
TIMERx controlled release technology and an increase in sales of its
pharmaceutical excipient products. There can be no assurance that the Company
will achieve profitability or that it will be able to sustain any profitability
on a quarterly basis, if at all.


                                                                              37
<PAGE>   38

INTENSE COMPETITION; RISK OF TECHNOLOGICAL CHANGE

      The pharmaceutical industry is highly competitive and is affected by new
technologies, governmental regulations, health care legislation, availability of
financing, litigation and other factors. Many of the Company's competitors have
longer operating histories and greater financial, marketing, legal and other
resources than the Company and certain of its collaborators. The Company expects
that it will be subject to competition from numerous other entities that
currently operate or intend to operate in the pharmaceutical industry, including
companies that engage in the development of controlled release technologies. The
Company's TIMERx business faces competition from numerous public and private
companies and their controlled release technologies, including ALZA's oral
osmotic pump (OROS(R)) technology, multiparticulate systems marketed by Elan and
Biovail, traditional matrix systems marketed by SkyePharma, plc and other
controlled release technologies marketed and under development by Andrx
Corporation, among others.

      The Company has concentrated a significant portion of its development
efforts on generic versions of controlled release pharmaceuticals. Typically,
selling prices of immediate release drugs have declined and profit margins have
narrowed after generic equivalents of such drugs are first introduced and the
number of competitive products has increased. Similarly, the success of generic
versions of controlled release products based on the Company's TIMERx technology
will depend, in large part, on the intensity of competition from currently
marketed drugs and technologies that compete with the branded controlled release
pharmaceuticals, as well as the timing of product approvals. Competition may
also arise from therapeutic products that are functionally equivalent but
produced by other methods. In addition, under several of the Company's
collaborative arrangements, the payments due to the Company with respect to the
controlled release products covered by such collaborative arrangements will be
reduced in the event that there are competing generic controlled release
versions of such products.

      The generic drug industry is characterized by frequent litigation between
generic drug companies and branded drug companies. Those companies with
significant financial resources will be more able to bring and defend any such
litigation.

      In its excipients business, the Company competes with a number of large
manufacturers and other distributors of excipient products, many of which have
substantially greater financial, marketing and other resources than the Company.
The Company's principal competitor in this market is FMC Corporation, which
markets its own line of MCC excipient products.

      The pharmaceutical industry is characterized by rapid and substantial
technological change. There can be no assurance that any products incorporating
TIMERx technology will not be rendered obsolete or non-competitive by new drugs,
treatments or cures for the medical conditions the TIMERx-based products are
addressing. Any of the foregoing could have a material adverse effect on the
Company's business, financial condition and results of operations.

NEED FOR ADDITIONAL FUNDING; UNCERTAINTY OF ACCESS TO CAPITAL

      The Company anticipates that its existing capital resources, together with
the funds available under the Credit Facility and internally generated funds,
will enable it to maintain currently planned operations through early 2000.
However, this expectation is based on the Company's current operating plan,
which could change as a result of many factors, and the Company could require


                                                                              38
<PAGE>   39

additional funding sooner than anticipated. The Company's requirements for
additional capital could be substantial and will depend on many factors,
including the timing and amount of payments received under existing and possible
future collaborative agreements; the structure of any future collaborative or
development agreements; the progress of the Company's collaborative and
independent development projects; revenues from the Company's excipients
business, the costs to the Company of bioequivalence studies for the Company's
products; the prosecution, defense and enforcement of patent claims and other
intellectual property rights; and the development of manufacturing, marketing
and sales capabilities. The Company has no committed sources of capital other
than the Credit Facility. The Credit Facility contains a number of non-financial
covenants that are applicable to Penwest. Any breach of these covenants by the
Company would constitute a default by the Company under the Credit Facility. In
addition, the Credit Facility provides that a breach by Penford of its guarantee
of the Company's indebtedness under the Credit Facility (which will continue for
a period ending August 31, 2000) or the occurrence of an event of default under
any credit agreement with Penford under which the lender is either the sole or a
participating lender would constitute a default by the Company under the Credit
Facility. Accordingly, the Company will be substantially dependent on Penford in
order to access and maintain the Credit Facility. Any default under the Credit
Facility would have a material adverse effect on the Company's business,
financial condition and results of operations.

      To the extent capital resources are insufficient to meet future
requirements, the Company will have to raise additional funds to continue the
development of its technologies. There can be no assurance that such funds will
be available on favorable terms, if at all. The Credit Facility restricts the
incurrence of additional indebtedness by the Company and provides that the
maximum amount available to Penwest under the Credit Facility (initially $15.0
million) will be reduced by the amount of any net proceeds from any financing
conducted by the Company and that the Company will repay any outstanding amounts
under the Credit Facility in excess of the new maximum amount. To the extent
that additional capital is raised through the sale of equity or convertible debt
securities, the issuance of such securities could result in dilution to the
Company's shareholders. If adequate funds are not available, the Company may be
unable to comply with its obligations under its collaborative agreements, which
could result in the termination of such collaborative agreements. In addition,
the Company may be required to curtail operations significantly or to obtain
funds through entering into collaboration agreements on unfavorable terms. The
Company's inability to raise capital would have a material adverse effect on the
Company's business, financial condition and results of operations.

UNCERTAINTIES RELATING TO PATENTS AND PROPRIETARY RIGHTS

      The Company believes that patent and trade secret protection of its drug
delivery technologies is important to its business and that its success will
depend, in part, on its ability to maintain existing patent protection, obtain
additional patents, maintain trade secret protection and operate without
infringing on the rights of others. The Company has been issued 24 U.S. and 48
foreign patents and one U.S. patent application has been allowed relating
principally to its controlled release drug delivery technology. The issuance of
a patent is not conclusive as to its validity or as to the enforceable scope of
the claims of the patent. There can be no assurance that the Company's patents
or any future patents will prevent other companies from developing similar or
functionally equivalent products or from successfully challenging the validity
of the Company's patents. Furthermore, there can be no assurance that (i) any of
the Company's future processes or products will be patentable; (ii) any pending
or additional patents will be issued in any or all appropriate jurisdictions;
(iii) the Company's processes or products will not infringe upon the patents of
third parties; or (iv) the 


                                                                              39
<PAGE>   40

Company will have the resources to defend against charges of patent infringement
or protect its own patent rights against third parties. The inability of the
Company to protect its patent rights or infringement by the Company of the
patent or proprietary rights of others could have a material adverse effect on
the Company's business, financial condition and results of operations.

      Substantial patent litigation exists in the pharmaceutical industry.
Patent litigation generally involves complex legal and factual questions, and
the outcome frequently is difficult to predict. An unfavorable outcome in any
patent litigation affecting the Company could cause the Company to pay
substantial damages, alter its products or processes, obtain licenses and/or
cease certain activities. Even if the outcome is favorable to the Company, the
Company could incur substantial litigation costs. Although the legal costs of
defending litigation relating to a patent infringement claim (unless such claim
relates to TIMERx in which case such costs are the responsibility of the
Company) are generally the contractual responsibility of the Company's
collaborators, the Company could nonetheless incur significant unreimbursed
costs in participating and assisting in the litigation.

      In 1994, the Boots Company PLC ("Boots") filed in the European Patent
Office (the "EPO") an opposition to a patent granted by the EPO to the Company
relating to its TIMERx technology. In June 1996, the EPO dismissed Boots'
opposition, leaving intact all claims included in the patent. Boots has appealed
this decision to the EPO Board of Appeals. There can be no assurance that the
Company will prevail in this matter. An unfavorable outcome could materially
adversely affect the Company's business, financial condition and results of
operations.

      The Company also relies on trade secrets and proprietary knowledge, which
it generally seeks to protect by confidentiality and non- disclosure agreements
with employees, consultants, licensees and pharmaceutical companies. There can
be no assurance, however, that these agreements have or in all cases will be
obtained, that these agreements will not be breached, that the Company will have
adequate remedies for any breach or that the Company's trade secrets will not
otherwise become known by others, any of which could have a material adverse
effect on the Company's business, financial condition and results of operations.

GOVERNMENT REGULATION; NO ASSURANCE OF REGULATORY APPROVAL

      The development, clinical testing, manufacture, marketing and sale of
pharmaceutical products are subject to extensive federal, state and local
regulation in the United States. The Company cannot predict the extent to which
it may be affected by legislative and regulatory actions and developments
concerning various aspects of its operations, its products and the health care
field generally. All new prescription drugs must be approved by the FDA before
they can be introduced into the market in the United States. These approvals are
based on manufacturing, chemistry and control data, as well as safety and
efficacy studies and/or bioequivalence studies. The generation of the required
data is regulated by the FDA and can be time-consuming and expensive without
assurance that the results will be adequate to justify approval.

      After submission of a marketing application, in the form of an NDA or an
ANDA, there can be substantial delays in obtaining FDA approval, including the
need to generate and submit additional data. Data submitted to the FDA is often
susceptible to varying interpretations that could delay, limit or prevent
regulatory approval. Also, delays or rejections may be encountered during any
stage of the regulatory approval process based upon the failure of clinical data
to demonstrate compliance with, or 


                                                                              40
<PAGE>   41

upon the failure of the product to meet, the FDA's requirements for safety,
efficacy and quality; and those requirements may become more stringent due to
changes in regulatory agency policy or the adoption of new regulations. While
the U.S. Food, Drug and Cosmetic Act provides for a 180-day review period, the
FDA commonly takes one to two years to grant final approval to a marketing
application (NDA or ANDA). Further, the terms of approval of any marketing
application, including the labeling content, may be more restrictive than the
Company desires and could affect the marketability of products incorporating the
Company's controlled release technology.

      Most of the controlled release products that the Company is developing
with its collaborators are generic versions of brand name controlled release
products, which require the filing of ANDAs. Certain ANDA procedures for generic
versions of controlled release products are the subject of petitions filed by
brand name drug manufacturers, which seek changes from the FDA in the approval
process for generic drugs. These requested changes include, among other things,
tighter standards for certain bioequivalence studies and disallowance of the use
by a generic drug manufacturer in its ANDA of proprietary data submitted by the
original manufacturer as part of an original new drug application. The Company
is unable to predict at this time whether the FDA will make any changes to its
ANDA procedures as a result of such petitions or any future petitions filed by
brand name drug manufacturers or the effect that such changes may have on the
Company. Any changes in FDA regulations that make ANDA approvals more difficult
could have a material adverse effect on the Company's business, financial
condition and results of operations.

      The FDA also has the authority to revoke or suspend approvals of
previously approved products for cause, to debar companies and individuals from
participating in the drug-approval process, to request recalls of allegedly
violative products, to seize allegedly violative products, to obtain injunctions
to close manufacturing plants allegedly not operating in conformity with current
Good Manufacturing Practices ("cGMPs") and to stop shipments of allegedly
violative products. Such delays or FDA actions could have a material adverse
effect on the Company's business, financial condition and results of operations.
The FDA may seek to subject to pre-clearance requirements products currently
being marketed without FDA approval, and there can be no assurance that the
Company or its third-party manufacturers or collaborators will be able to obtain
approval for such products within the time period specified by the FDA.

      In May 1997, one of the Company's collaborators, Mylan, filed an ANDA with
the FDA for the 30 mg dosage strength of Nifedipine XL, a generic version of
Procardia XL. In March 1999, Mylan received tentative approval of this
application. There can be no assurance that final approval can be obtained, or
be obtained in a timely manner, for such ANDA or for any other applications for
regulatory approval that may be filed.

LIMITED MANUFACTURING CAPABILITY; DEPENDENCE ON SOLE SOURCE SUPPLIERS

      The Company does not have commercial-scale facilities to manufacture its
TIMERx material in accordance with cGMP requirements prescribed by the FDA. To
date, the Company has relied on a large third-party pharmaceutical company,
Boehringer Ingelheim Pharmaceuticals, Inc. ("Boehringer Ingelheim"), for the
bulk manufacture of its TIMERx material for delivery to its collaborators under
an agreement that expired in June 1998. The Company believes that there are a
limited number of manufacturers that operate under cGMP regulations capable of
manufacturing the Company's products. The Company has identified another
third-party manufacturer to manufacture TIMERx 


                                                                              41
<PAGE>   42

material and is currently validating such manufacturer's facility and
negotiating the terms under which such manufacturer will manufacture TIMERx
material for the Company. During the fourth quarter of 1998, experimental
batches of TIMERx were run in the facility, and commercial terms were agreed
upon. However, there can be no assurance that the Company will finalize a
manufacturing agreement with such manufacturer or as to the terms of such
manufacturing agreement. In the event that the Company is unable to obtain
contract manufacturing, or obtain such manufacturing on commercially reasonable
terms, it may not be able to commercialize its products as planned. There can be
no assurance that third parties upon which the Company relies for supply of its
TIMERx materials will perform, and any failures by third parties may delay
development or the submission of products for regulatory approval, impair the
Company's collaborators' ability to commercialize products as planned and
deliver products on a timely basis, or otherwise impair the Company's
competitive position, which could have a material adverse effect on the
Company's business, financial condition and results of operations.

      The manufacture of any products by the Company (both TIMERx material and
excipients) is subject to regulation by the FDA and comparable agencies in
foreign countries. Delay in complying or failure to comply with such
manufacturing requirements could materially adversely affect the marketing of
the Company's products and the Company's business, financial condition and
results of operations.

      The Company's TIMERx drug delivery system is a hydrophilic matrix
combining primarily two polysaccharides, xanthan and locust bean gums, in the
presence of dextrose. The Company purchases these gums from a sole source
supplier. Most of the Company's excipients are manufactured from a specialty
grade of wood pulp. Although the Company has qualified alternate suppliers with
respect to these materials, there can be no assurance that interruptions in
supplies will not occur in the future or that the Company will not have to
obtain substitute suppliers. Any of these events could have a material adverse
effect on the Company's ability to manufacture bulk TIMERx for delivery to its
collaborators or to manufacture its excipients, which could have a material
adverse effect on the Company's business, financial condition and results of
operations.

NO ASSURANCE OF ADEQUATE THIRD-PARTY REIMBURSEMENT

      The commercialization of the controlled release product candidates under
development by the Company and its collaborators depends in part on the extent
to which reimbursement for the cost of such products will be available from
government health administration authorities, private health insurers and other
third party payors, such as health maintenance organizations and managed care
organizations. The generic versions of controlled release products being
developed by the Company and its collaborators may be assigned an AB rating if
the FDA considers the product to be therapeutically equivalent to the branded
controlled release drug. Failure to obtain an AB rating from the FDA would
indicate that for certain purposes the drug would not be deemed to be
therapeutically equivalent, would not be fully substitutable for the branded
controlled release drug and would not be relied upon by Medicaid and Medicare
formularies for reimbursement.

      Third party payors are attempting to control costs by limiting the level
of reimbursement for medical products, including pharmaceuticals. Cost control
initiatives could decrease the price that the Company or any of its
collaborators receive for their drugs and have a material adverse effect on the
Company's business, financial condition and results of operations. Further, to
the extent that cost control initiatives have a material adverse effect on the
Company's collaborators, the Company's


                                                                              42
<PAGE>   43

ability to commercialize its products and to realize royalties may be adversely
affected. Moreover, health care reform has been, and may continue to be, an area
of national and state focus, which could result in the adoption of measures that
adversely affect the pricing of pharmaceuticals or the amount of reimbursement
available from third party payors. There can be no assurance that changes in
health care reimbursement laws or policies will not have a material adverse
effect on the Company's business, financial condition and results of operations.

RISK OF PRODUCT LIABILITY CLAIMS; NO ASSURANCE OF ADEQUATE INSURANCE

      Testing, manufacturing, marketing and selling pharmaceutical products
entail a risk of product liability. The Company faces the risk of product
liability claims in the event that the use of its products is alleged to have
resulted in harm to a patient or subject. Such risks exist even with respect to
those products that are manufactured in licensed and regulated facilities or
that otherwise possess regulatory approval for commercial sale. Product
liability insurance coverage is expensive, difficult to obtain and may not be
available in the future on acceptable terms, if at all. The Company is currently
covered by primary product liability insurance in the amount of $1.0 million per
occurrence and $2.0 million annually in the aggregate on a claims-made basis and
by umbrella liability insurance in excess of $25 million which can also be used
for product liability insurance. This coverage may not be adequate as the
Company develops additional products. As the Company receives regulatory
approvals for products under development, there can be no assurance that
additional liability insurance coverage for any such products will be available
in the future on acceptable terms, if at all. The Company's business, financial
condition and results of operations could be materially adversely affected by
the assertion of a product liability claim.

HAZARDOUS MATERIALS

      The Company's research and development and manufacturing activities
involve the controlled use of chemicals and solvents. Although the Company
believes that its safety procedures for handling, storing and disposing of such
materials and the safety procedures of the third parties who ship such materials
for the Company comply with the standards prescribed by federal, state and local
regulations, the risk of accidental contamination or injury from these materials
cannot be completely eliminated. In the event of such an accident, the Company
could be held liable for significant damages and any such liability could have a
material adverse effect on the Company's business, financial condition and
results of operations.

RISK OF LOSS OF "TAX-FREE" TREATMENT OF DISTRIBUTION

      Penwest has received a private letter ruling from the IRS to the effect
that, among other things, the Distribution qualifies as tax-free under Sections
355 and 368 of the Code and that the receipt of shares of Common Stock in the
Distribution will not result in the recognition of income, gain or loss to
Penford's shareholders for federal income tax purposes. The continuing validity
of any such ruling is subject to certain factual representations and
assumptions. Neither Penford nor Penwest is aware of any facts or circumstances
which should cause such representations and assumptions to be untrue. Although
the Tax Allocation Agreement provides that neither Penford nor Penwest is to
take any action inconsistent with, nor fail to take any action required by, the
private letter ruling unless required to do so by law or the other party has
given its prior written consent or, in certain circumstances, a supplemental
ruling permitting such action is obtained, any of the following acts potentially
could render the Distribution taxable: (i) the transfer by Penford or Penwest of
a material 


                                                                              43
<PAGE>   44

portion of its assets (other than a transfer of assets in the ordinary course of
business); (ii) the merger of Penford or Penwest with or into another
corporation in a transaction that does not qualify as a tax-free reorganization
under Section 368 of the Code; (iii) the discontinuance by Penford or Penwest or
a material portion of its historical business activities; (iv) the conversion
(or redemption or exchange) of the Common Stock distributed in the Distribution
into or for any other stock, security, property, or cash; (v) the issuance of
additional shares of stock by Penwest pursuant to negotiations, agreements,
plans, or arrangements entered into before the Distribution; (vi) transfers of
stock of Penford and/or Penwest by shareholders of sufficient quantity to cause
the historic shareholders of Penford not to be considered to have maintained
sufficient "continuity of proprietary interest" in one or both of the companies;
and (vii) the acquisition of a 50% or greater interest in Penford and/or Penwest
pursuant to a plan (or deemed to be pursuant to a plan) in existence on the
Distribution Date. If the Distribution were rendered taxable as a result of such
an act, then (x) the corporate-level taxable gain would be recognized by the
consolidated group of which Penford is the parent (y) each of Penford and
Penwest, as a former member of that group, would be severally liable for the
corporate-level tax on such gain when such gain becomes taxable under the
consolidated return regulations, and (z) except in the case of an acquisition
described in clause (vii) of the preceding sentence, each holder of common stock
who received shares of Common Stock in the Distribution would be treated as
having received a taxable dividend in an amount equal to the fair market value
of the Common Stock received (assuming that Penford had sufficient current or
accumulated "earnings and profits"). Penford and Penwest have agreed to
indemnify each other with respect to any tax liability resulting from their
respective failures to comply with such provisions. These indemnification
obligations do not extend to shareholders of Penford.

ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

      Reference is made to the disclosure under the caption "Market Risk and
Risk Management Policies" in "Item 7 - Management's Discussion and Analysis of
Financial Condition and Results of Operations".


                                                                              44
<PAGE>   45

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

      All financial statements required to be filed hereunder are filed as
Appendix A hereto, are listed under Item 14 (a) and are incorporated herein by
reference.


                                                                              45
<PAGE>   46

ITEM 9: CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.


PART III

ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT

The information set forth under "Election of Directors" in the Company's
definitive Proxy Statement for the 1999 Annual Meeting of Shareholders is
incorporated herein by reference.

Information regarding executive officers of the Company is set forth in Part I
above and incorporated herein by reference.

ITEM 11: EXECUTIVE COMPENSATION

The information set forth under "Executive Compensation" in the Company's
definitive Proxy Statement for the 1999 Annual Meeting of Shareholders is
incorporated herein by reference.

ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information set forth under "Security Ownership of Certain Beneficial Owners
and Management" in the Company's definitive Proxy Statement for the 1999 Annual
Meeting of Shareholders is incorporated herein by reference.

ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information relating to certain relationships and related transactions of
the Company set forth under "Certain Relationships and Related Transactions" in
the Company's definitive Proxy Statement for the 1999 Annual Meeting of
Shareholders is incorporated herein by reference.

PART IV

ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)   (1)   Financial Statements

            The following documents are filed as Appendix A hereto and
            are included as part of this Annual Report on Form 10-K.

            The consolidated balance sheets as of December 31, 1997 and
            1998 and the related statements of operations, cash flows
            and shareholders' equity for each of the three years in the
            period ended December 31, 1998 and the report of
            independent auditors.

(a)   (2)   Financial Statement Schedules

            The following documents are filed as Appendix B hereto and are
            included as part of this Annual Report on Form 10-K.

            Schedule II Valuation and Qualifying Accounts

            All other schedules for which provision is made in the applicable
            accounting regulations of the Securities and Exchange Commission are
            omitted because they are not applicable or because the information
            is presented in the financial statements or notes thereto.


                                                                              46
<PAGE>   47

(a)   (3)   Exhibits

            The list of Exhibits filed as part of this Annual Report on Form
            10-K are set forth on the Exhibit Index immediately preceding such
            exhibits, and is incorporated herein by this reference. This list
            includes a subset containing each management contract, compensatory
            plan, or arrangement required to be filed as an exhibit to this
            report.

(b)         Reports on Form 8-K

            On December 10, 1998, the Company filed a report on Form 8-K
            announcing the resignation of Jack Talley as President and Chief
            Operating Officer.


                                                                              47
<PAGE>   48

                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

                                        Penwest Pharmaceuticals Co.


Date:       March 30, 1999              /s/ Tod R. Hamachek
            --------------              ----------------------------------------
                                        Tod R. Hamachek, Chairman of the Board
                                        and Chief Executive Officer
                                        (Principal Executive Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.


Date:       March 30, 1999              /s/ Tod R. Hamachek
            --------------              ----------------------------------------
                                        Tod R. Hamachek, Chairman of the Board
                                        and Chief Executive Officer
                                        (Principal Executive Officer)


Date:       March 30, 1999              /s/ Jennifer L. Good
            --------------              ----------------------------------------
                                        Jennifer L. Good, Vice President, 
                                        Finance and Chief Financial Officer  
                                        (Principal Financial Officer)

DIRECTORS

Paul E. Freiman*
Jere E. Goyan, Ph.D.*
Tod R. Hamachek*
Rolf H. Henel*                          By /s/ Jennifer L. Good
Robert J. Hennessey*                       -------------------------------------
N. Stewart Rogers*                      
John N. Staniforth, Ph.D.*              Attorney-in-Fact*                
Anne M. VanLent*                        Power of Attorney Dated          
                                                                         
                                        Date  March 30, 1999             
                                              ----------------------------------


                                                                              48
<PAGE>   49

                                   APPENDIX A

                           PENWEST PHARMACEUTICALS CO.
                          INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
Financial Statements                                                 PAGE
                                                                     ----
   <S>                                                               <C>
   Consolidated Balance Sheets                                       F-2
   Consolidated Statements of Operations                             F-3
   Consolidated Statements of Shareholders' Equity (Deficit)         F-4
   Consolidated Statements of Cash Flows                             F-5
   Notes to Consolidated Financial Statements                        F-6
</TABLE>



                                      F-1
<PAGE>   50

                           PENWEST PHARMACEUTICALS CO.

                           CONSOLIDATED BALANCE SHEETS
                      (In Thousands, Except Share Amounts)

<TABLE>
<CAPTION>
                                                                         DECEMBER 31,
                                                                      1997        1998
                                                                    --------    --------
<S>                                                                 <C>         <C>     
ASSETS
Current assets:
  Cash and cash equivalents .....................................   $    938    $  1,476
  Trade accounts receivable, net of allowance for doubtful
     accounts of  $337 and $227 .................................      3,005       4,381
  Inventories ...................................................      8,691       8,804
  Prepaid expenses and other current assets .....................        358         572
  Deferred income taxes .........................................        384         356
                                                                    --------    --------
      Total current assets ......................................     13,376      15,589
  Fixed assets, net .............................................     22,311      20,822
  Other assets ..................................................      2,133       4,671
                                                                    --------    --------
      Total assets ..............................................   $ 37,820    $ 41,082
                                                                    ========    ========
LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)
Current liabilities:
  Accounts payable and accrued expenses .........................   $  3,410    $  5,405
  Taxes payable .................................................        361         336
  Payable to Penford ............................................     42,654          --
  Loans payable .................................................         --       2,200
                                                                    --------    --------
       Total current liabilities ................................     46,425       7,941
  Deferred income taxes .........................................      3,531         932
  Other long-term liabilities ...................................        161       2,177
                                                                    --------    --------
       Total liabilities ........................................     50,117      11,050
Shareholders' equity (deficit):
  Preferred stock, par value $.001, authorized 1,000,000 shares,
    none outstanding
  Common stock, par value $.001, authorized
    39,000,000 shares, issued and outstanding 11,036,822 shares
    and 11,043,331 shares .......................................         11          11
  Additional paid in capital ....................................      8,079      59,025
  Accumulated deficit ...........................................    (19,649)    (28,478)
  Accumulated other comprehensive income ........................       (738)       (526)
                                                                    --------    --------
       Total shareholders' equity (deficit) .....................    (12,297)     30,032
                                                                    --------    --------
       Total liabilities and shareholders' equity (deficit) .....   $ 37,820    $ 41,082
                                                                    ========    ========

</TABLE>
                             See accompanying notes.


                                      F-2
<PAGE>   51

                           PENWEST PHARMACEUTICALS CO.

                      CONSOLIDATED STATEMENTS OF OPERATIONS
                      (In Thousands, Except Per Share Data)

<TABLE>
<CAPTION>
                                                                 YEAR ENDED DECEMBER 31,
                                                          --------------------------------------
                                                            1996           1997          1998
                                                          --------       --------       --------
<S>                                                       <C>            <C>            <C>     
Revenues
  Product sales .....................................     $ 25,007       $ 26,030       $ 28,709
  Royalties and licensing fees ......................        1,082            911            302
                                                          --------       --------       --------
     Total revenues .................................       26,089         26,941         29,011
Cost of product sales ...............................       19,062         20,357         21,045
                                                          --------       --------       --------
       Gross profit .................................        7,027          6,584          7,966
Operating expenses
  Selling, general and administrative ...............        6,776          8,708         11,354
  IPO transaction costs .............................           --          1,367             --
  Asset write-off ...................................           --             --          1,341
  Research and product development ..................        3,351          3,681          6,054
                                                          --------       --------       --------
     Total operating expenses .......................       10,127         13,756         18,749
                                                          --------       --------       --------
Operating loss ......................................       (3,100)        (7,172)       (10,783)
Interest expense ....................................           --             --             72
                                                          --------       --------       --------
Loss before income taxes ............................       (3,100)        (7,172)       (10,855)
Income tax expense (benefit) ........................          764            144         (2,026)
                                                          --------       --------       --------
Net loss ............................................     $ (3,864)      $ (7,316)      $ (8,829)
                                                          ========       ========       ========

Basic and diluted net loss per share ................     $  (0.35)      $  (0.66)      $  (0.80)
                                                          ========       ========       ========
Weighted average shares of common stock
    outstanding .....................................       11,037         11,037         11,037
                                                          ========       ========       ========
</TABLE>

                             See accompanying notes.


                                      F-3
<PAGE>   52

                           PENWEST PHARMACEUTICALS CO.

            CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
                                 (In Thousands)

<TABLE>
<CAPTION> 
                                                                                                           ACCUMULATED
                                                             COMMON STOCK     ADDITIONAL                         OTHER
                                                          ------------------     PAID-IN   ACCUMULATED   COMPREHENSIVE
                                                          SHARES      AMOUNT     CAPITAL       DEFICIT          INCOME       TOTAL
                                                          ------      ------     -------       -------          ------       -----
<S>                                                       <C>            <C>    <C>         <C>                 <C>       <C>     
Balances, January 1, 1996 before stock splits ..........       5         $ 5    $  8,085    $  (8,469)          $ (98)    $   (477)
Stock splits ...........................................  11,032           6          (6)
                                                          ------         ---    --------    ---------           -----     -------- 
Balances, January 1, 1996 after stock splits ...........  11,037          11       8,079       (8,469)            (98)        (477)
                                                        
Comprehensive Loss:                                     
  Net loss. ............................................                                       (3,864)                      (3,864)
  Other Comprehensive Loss - Translation adjustment ....                                                          (71)         (71)
                                                                                                                          --------
    Comprehensive Loss .................................                                                                    (3,935)
                                                          ------         ---    --------    ---------           -----     -------- 
Balances, December 31, 1996. ...........................  11,037          11       8,079      (12,333)           (169)      (4,412)
Comprehensive Loss:                                     
  Net loss .............................................                                       (7,316)                      (7,316)
  Other Comprehensive Loss - Translation adjustment ....                                                         (569)        (569)
                                                                                                                          --------
    Comprehensive Loss .................................                                                                    (7,885)
                                                          ------         ---    --------    ---------           -----     -------- 
Balances, December 31, 1997 ............................  11,037          11       8,079      (19,649)           (738)     (12,297)
Comprehensive Loss:                                     
  Net Loss. ............................................                                       (8,829)                      (8,829)
  Other Comprehensive Income - Translation adjustment ..                                                          212          212
                                                                                                                          --------
     Comprehensive Loss ................................                                                                    (8,617)
Capital contribution from Penford ......................                          50,914                                    50,914
Stock Purchase Plan activity ...........................       6          --          32                                        32
                                                          ------         ---    --------    ---------           -----     -------- 
Balances, December 31, 1998 ............................  11,043         $11     $59,025     $(28,478)          $(526)    $ 30,032
                                                          ======         ===    ========    =========           =====     ======== 
</TABLE>

                             See accompanying notes.


                                      F-4
<PAGE>   53

                           PENWEST PHARMACEUTICALS CO.

                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (In Thousands)

<TABLE>
<CAPTION>
                                                                     YEAR ENDED DECEMBER 31,
                                                       --------------------------------------------------
                                                          1996                1997                 1998
                                                       --------             --------             --------
<S>                                                    <C>                  <C>                  <C>      
Cash used in operating activities:
Net loss .........................................     $ (3,864)            $ (7,316)            $ (8,829)
Adjustments to reconcile net loss to
  net cash used in operating activities:
     Depreciation ................................        2,190                2,047                2,611
     Amortization ................................          207                  157                  162
     Asset write-off .............................           --                   --                1,341
     Deferred income taxes .......................          546                 (104)              (2,126)
Changes in operating assets:
     Trade accounts receivable ...................          470                1,805               (1,376)
     Inventories .................................       (3,218)              (1,135)                (113)
     Accounts payable, accrued expenses and
       other .....................................          224                 (345)               1,733
                                                       --------             --------             --------
Net cash used in operating activities ............       (3,445)              (4,891)              (6,597)

Net cash used in investing activities:
     Acquisitions of fixed assets, net ...........       (2,322)              (4,023)              (2,003)
     Other .......................................         (657)                (833)                (181)
                                                       --------             --------             --------
Net cash used in investing activities ............       (2,979)              (4,856)              (2,184)

Cash provided by financing activities:
     Proceeds from  Penford ......................        6,823               10,120                7,030
     Borrowings from Credit Facility .............           --                   --                3,300
     Repayments of Credit Facility ...............           --                   --               (1,100)
     Issuance of common stock ....................           --                   --                   32
                                                       --------             --------             --------
Net cash provided by Financing Activities ........        6,823               10,120                9,262
Effect of exchange rate changes on
  cash and cash equivalents ......................            6                 (130)                  57
                                                       --------             --------             --------
Net increase in cash and
  cash equivalents ...............................          405                  243                  538
Cash and cash equivalents at beginning
  of year ........................................          290                  695                  938
                                                       --------             --------             --------
Cash and cash equivalents at end of
  year ...........................................     $    695             $    938             $  1,476
                                                       ========             ========             ========
</TABLE>

                             See accompanying notes.


                                      F-5
<PAGE>   54

                           PENWEST PHARMACEUTICALS CO.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BUSINESS

      Penwest Pharmaceuticals Co. ("Penwest" or the "Company"), is engaged in
the research, development and commercialization of novel drug delivery
technologies. The Company has extensive experience in developing and
manufacturing tabletting ingredients for the pharmaceutical industry. The
Company's product portfolio ranges from excipients that are sold in bulk, to
more technically advanced and patented excipients that are licensed to
customers. The Company has manufacturing facilities in Iowa and Finland and has
customers primarily throughout North America and Europe. The Company was a
wholly-owned subsidiary of Penford Corporation ("Penford") prior to August 31,
1998 ("Distribution Date"). On August 31, 1998 Penford distributed to the
stockholders of record of Penford's common stock on August 10, 1998, all of the
shares of the Company's common stock (see Note 7).

      The Company is subject to the risks and uncertainties associated with a
drug delivery company. These risks and uncertainties include, but are not
limited to, a history of net losses, technological changes, dependence on
collaborators and key personnel, the successful completion of development
efforts and of obtaining regulatory approval, compliance with government
regulations, patent infringement litigation and competition from current and
potential competitors, some with greater resources than the Company.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

      The accompanying consolidated financial statements include the accounts of
Penwest and its wholly owned subsidiaries. Material intercompany balances and
transactions have been eliminated. The preparation of financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates. In addition, the consolidated financial statements include various
costs allocated by Penford prior to the Distribution Date. Management believes
the amounts allocated are reasonable and approximate the cost of obtaining the
service from an unrelated third party.

      Certain amounts in the financial statements for prior years have been
reclassified to conform with the current year presentation. These
reclassifications had no effect on previously reported results of operations or
financial position.

Cash and Cash Equivalents

      All highly liquid investments with a maturity of three months or less when
purchased are considered cash equivalents.


                                      F-6
<PAGE>   55
Credit Risk and Fair Value of Financial Instruments

      The Company performs ongoing credit evaluations of its customers and
generally does not require collateral. Revenues from product sales and licensing
fees are primarily derived from major pharmaceutical companies that have
significant cash resources. The Company maintains an allowance for doubtful
accounts which management believes is sufficient to cover potential credit
losses. One of the company's customers accounted for approximately 11% of total
revenues in 1998. No customer accounted for more than 10% of total revenues in
1997 or 1996.

      The carrying value of financial instruments, which includes cash,
receivables, obligations under the Company's credit facility (Note 6) and
payables, approximates market value due to their short term nature and the fact
that all borrowings are at floating interest rates.

Fixed Assets

      Property and equipment are recorded at cost and depreciated by the
straight-line method over their estimated useful lives. Estimated useful lives
by class of assets are as follows:

<TABLE>
<CAPTION>
           <S>                                                 <C>        
           Buildings.....................................      20-25 years
           Machinery and equipment.......................      10-12 years
           Office furniture, equipment and software......       5-10 years
</TABLE>

      In accordance with Statement of Financial Accounting Standards (SFAS) No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed of," the Company recognizes impairment losses on
long-lived assets used in operations when indicators of impairment are present
and the undiscounted cash flows estimated to be generated by those assets are
less than the assets' carrying amounts. SFAS No. 121 also addresses the
accounting for long-lived assets that are expected to be disposed of.

Foreign Currencies

      Assets and liabilities of the Company's foreign operations are translated
into U.S. dollars at year-end exchange rates and revenue and expenses are
translated at average exchange rates. For each of the foreign operations, the
functional currency is the local currency. Translation adjustments are disclosed
and accumulated in a separate component of other comprehensive income (loss).
Realized gains and losses from foreign currency transactions are reflected in
the consolidated statement of operations. Foreign currency transaction gains and
losses were not significant in each of the years in the three year period ended
December 31, 1998.

Income Taxes

      The Company's results of operations were included in the tax returns of
Penford through the Distribution Date. Beginning September 1, 1998, the Company
files its income taxes on a stand-alone basis. Deferred income tax benefits and
related income tax assets and liabilities are reflected as if the Company were
an independent entity for all periods presented, in accordance with SFAS No.
109, "Accounting for Income Taxes", except that the Company was not compensated
for tax losses utilized by Penford. See Note 11.


                                      F-7
<PAGE>   56

Revenue Recognition

      Royalties and licensing fees include milestone fees related to licensing
agreements for TIMERx with various collaborators and royalties when earned. To
date there have been minimal royalties recognized from the TIMERx technology.
Milestone payments are derived from reaching development milestones with
collaborators and are recognized as achieved in accordance with the contract
terms. These milestone payments are not subject to forfeiture.

      The Company receives certain nonrefundable payments upon the signing of
collaborative agreements. Up-front payments related specifically to the
achievement of certain milestones are recognized as those milestones are
achieved in accordance with the agreement. Up-front payments related solely to
the signing of agreements where additional services are not required are
recognized upon signing. Up-front payments that obligate the Company to perform
specific functions or services over the licensing term are recognized over the
term of the agreement.

      Product sales revenues are recognized when title transfers.

Advertising Costs

      Advertising costs are accounted for as expenses in the period in which
they are incurred.

Research and Development

      Research and development expenses consist of costs related to products
being developed internally as well as costs related to products subject to
licensing agreements. Research and development costs are charged to expense as
incurred.

Per Share Data

      Loss per common share is computed based on the weighted average number of
common shares and dilutive common stock equivalents outstanding during the
period after giving effect to the 0.76-for-1 reverse stock split and the
2,907.66-for-1 stock split of the common stock of the Company (see Note 9).

      The Company calculates basic and diluted earnings per share in accordance
with SFAS No. 128 "Earnings Per Share".

Accounting Developments

      As of January 1, 1998, the Company adopted for all periods presented SFAS
No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes new rules
for reporting and display of comprehensive income and its components; however,
the adoption of this Statement had no impact on the Company's net loss or
shareholders' equity (deficit). Accumulated other comprehensive income equals
the Company's cumulative translation adjustment.

For the year ended December 31, 1998, the Company adopted SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information." SFAS No.
131 supersedes SFAS No. 14, "Financial Reporting for Segments of a Business
Enterprise." SFAS No. 131 establishes new 


                                      F-8
<PAGE>   57

standards for the way that public business enterprises report information about
operating segments and related disclosures about products and services,
geographic areas, and major customers. The adoption of SFAS No. 131 did not
affect results of operations or financial position (see Note 15).

      For the year ended December 31, 1998, the Company adopted SFAS No. 132,
"Employers' Disclosures about Pension and Other Postretirement Benefits." This
Statement revises employers' disclosures about pension and other postretirement
benefit plans, but does not result in any financial statement impact. SFAS No.
132 standardizes the disclosure requirements for pensions and other
postretirement benefits to the extent practicable, requires additional
information on changes in the benefit obligations and fair values of plan assets
that will facilitate financial analysis, and eliminates certain disclosures (see
Note 12).

Stock Based Compensation

      The Company accounts for stock option grants in accordance with Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees,"
and, accordingly, recognizes no compensation expense for stock options granted
since the exercise price of the options was the same as the market price of the
Company's common stock on the date of grant. As prescribed under SFAS No. 123,
"Accounting for Stock Based Compensation," the Company has disclosed in Note 9,
the pro forma effects on net loss and loss per share of recording compensation
expense for the fair value of the options granted.

3. INVENTORIES

      Inventories, which consist of raw materials, pharmaceutical excipients
manufactured by the Company, pharmaceutical excipients held for distribution,
including manufactured bulk TIMERx, are stated at the lower of cost (first-in,
first-out) or market. Cost includes material, labor and manufacturing overhead
costs.

      Inventories are summarized as follows:

<TABLE>
<CAPTION>
                                                    DECEMBER 31,
                                                -------------------
                                                 1997          1998
                                                 ----          ----
                                                   (IN THOUSANDS)
<S>                                             <C>           <C>   
Raw materials..........................         $1,545        $1,365
Finished products......................          7,146         7,439
                                                ------        ------
     Total inventories.................         $8,691        $8,804
                                                ======        ======
</TABLE>

      Included in inventories are approximately $3,096,000 and $3,262,000 of
TIMERx raw materials and bulk TIMERx as of December 31, 1997 and 1998,
respectively. The ability to continue to sell TIMERx related inventory is
dependent, in part, upon the commercialization of products by third parties
utilizing bulk TIMERx and the continued use by the Company and third parties of
the TIMERx related inventory in existing and new research efforts. Although
third parties have products in various stages of development and the first
commercial product was launched for sale in Finland in January 1998, marketing
approval for a second product was received in the United Kingdom and launched in
November 1998, and tentative approval for a product was received in the United
States in March 1999, the period required to achieve the successful
commercialization of these and other products is uncertain if achieved at all.


                                      F-9
<PAGE>   58

      The Company periodically reviews and quality tests its inventory to
identify obsolete, slow moving or otherwise unsaleable inventories.

      The Company has relied on a large third-party pharmaceutical company for
the manufacture of its TIMERx products under an agreement that expired in June
1998. The Company is in the final stages of contract negotiation and the
qualification of another third-party manufacturer to manufacture TIMERx
material. During the fourth quarter of 1998, experimental batches of TIMERx were
run in this third party's facility and commercial terms were agreed to. There
are a limited number of third party manufacturers capable of producing the
TIMERx material. There can be no assurance that third parties upon which the
Company relies for supply of its TIMERx materials will perform and any failures
by third parties may delay development, or the submission of products for
regulatory approval, impair the Company's collaborators' ability to
commercialize products as planned and deliver products on a timely basis or
otherwise impair the Company's competitive position, which could have a material
adverse effect on the Company's business, financial condition, cash flows and
results of operations.

      The Company's TIMERx drug delivery system is a hydrophilic matrix
combining primarily two natural polysaccharides, xanthan and locust bean gums,
in the presence of dextrose. The Company purchases these gums from a sole source
supplier. Most of the Company's other excipients are manufactured from a
specialty grade of wood pulp, which the Company also purchases from a sole
source supplier. Although the Company has qualified alternate suppliers with
respect to these materials, there can be no assurance that interruptions in
supplies will not occur in the future or that the Company will not have to
obtain substitute suppliers. Any of these events could have a material adverse
effect on the Company's ability to manufacture bulk TIMERx for delivery to its
collaborators or manufacture its other excipients, which could have a material
adverse effect on the Company's results of operations, cash flows and financial
position.

4. FIXED ASSETS

      Fixed assets, at cost, summarized by major categories, consist of the
following:

<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                         -----------------------
                                                           1997            1998
                                                         -------         -------
                                                              (IN THOUSANDS)
          <S>                                            <C>             <C>    
          Buildings, equipment and software.........     $27,787         $32,740
          Land .....................................         696             696
          Construction in progress..................       3,750              34
                                                         -------         -------
                                                          32,233          33,470
          Less: accumulated depreciation............       9,922          12,648
                                                         -------          ------
                                                         $22,311         $20,822
                                                         =======         =======
</TABLE>

      During the fourth quarter of 1998, the Company decided to outsource
certain TIMERx manufacturing as opposed to constructing a new manufacturing
facility. As a result of this decision, $1,341,000 of construction in progress
related to the new manufacturing facility was written off.


                                      F-10
<PAGE>   59

5. OTHER ASSETS

      Other assets, net of accumulated amortization, consist of the following:

<TABLE>
<CAPTION>
                                                                            DECEMBER 31,
                                                                         1997         1998
                                                                        ------       ------
                                                                          (IN THOUSANDS)
          <S>                                                           <C>          <C>   
          Patents, net of accumulated amortization of
            $249 and $354.........................................      $1,888       $2,120
          Goodwill, net of accumulated amortization of
            $295 and $352.........................................         245          187
          Cash surrender value of officer's life insurance
            policies..............................................          --        2,364
                                                                        ------       ------

                                                                        $2,133       $4,671
                                                                        ======       ======
</TABLE>

      Patents include costs to secure and defend patents on technology developed
by the Company and secure trademarks. Patents are amortized over their useful
lives of 17 to 20 years. Amortization expense of $66,000, $87,000 and $105,000
was recorded in the years ended December 31, 1996, 1997 and 1998, respectively.

      Goodwill is being amortized over ten years and was recorded upon the
acquisition of the Company by Penford. Amortization expense approximated $57,000
for each of the years ended December 31, 1996, 1997 and 1998.

      Recorded intangibles are evaluated for potential impairment whenever
events or circumstances indicate that the undiscounted cash flows are not
sufficient to recover their carrying amounts. An impairment loss is recorded to
the extent the asset's carrying value is in excess of related discounted cash
flows.

      The cash surrender value of officer's life insurance policies was
contributed to the Company by Penford on the Distribution Date. (See Note 7).

6. CREDIT FACILITY

On July 2, 1998 the Company obtained a $15 million unsecured revolving credit
facility (the "Credit Facility") which is guaranteed by Penford. The proceeds
may be used to fund working capital and for general corporate purposes,
including capital expenditures. On August 31, 2000, all outstanding amounts
under the Credit Facility will become automatically due and payable. Penford has
agreed that, for a period ending August 31, 2000, it will guarantee the
Company's indebtedness under the Credit Facility. LIBOR Advances (available in
multiples of $1,000,000 for 1, 2 or 3 month LIBOR periods) under the Credit
Facility bear interest at a rate equal to LIBOR, plus 1.25%. Base Rate Advances
(available in minimum amounts of $100,000) bear interest at the Bank's Alternate
Base Rate. The Credit Facility also requires commitment fees to be paid of .325%
on unused portions of the commitment amount. The Credit Facility provides that
the maximum amount available to the Company under the Credit Facility will be
reduced by the amount of any net proceeds from any financing conducted by the
Company, and that the Company will be required to repay any outstanding amounts
under the Credit Facility in excess of the new maximum amount. The Credit


                                      F-11
<PAGE>   60

Facility contains a number of financial covenants that relate to Penford (and
not Penwest), including requirements that Penford maintain certain levels of
financial performance and capital structure. The Credit Facility also contains
certain covenants applicable to both Penford and Penwest including restrictions
on the incurrence of additional debt and the payment of dividends. Based upon
the terms of the Credit Facility, Penwest cannot make dividend payments.
Accordingly, the Company is substantially dependent on Penford's compliance with
such covenants in order to access and maintain the Credit Facility. Any breach
by Penford of these covenants would constitute a default by the Company under
the Credit Facility, which would have a material adverse effect on the Company's
business, financial condition and results of operations. Approximately $52,000 
of interest was paid in 1998.

Amounts outstanding under the Credit Facility are as follows:

                                                                DECEMBER 31,
                                                                    1998
                                                                    ----
                                                               (IN THOUSANDS)

LIBOR Advance - due March 3, 1999,
  6.5625% interest rate.............................               $1,000

LIBOR Advance - due March 22, 1999
  6.5% interest rate................................                1,000

Base Rate Advances, 7.75% interest rate at
  December 31, 1998.................................                  200
                                                                   ------

                                                                   $2,200
                                                                   ======
7. DISTRIBUTION AND CAPITAL CONTRIBUTION

      On August 31, 1998, Penford distributed to the shareholders of record of
Penford common stock on August 10, 1998, all of the shares of the Company's
Common Stock (the "Distribution"). Pursuant to the Distribution, each Penford
shareholder of record received three shares of the Company's Common Stock for
every two shares of Penford common stock held by them. In connection with the
Distribution (i) the Company's Common Stock was registered under the Securities
Exchange Act of 1934, as amended, pursuant to the registration statement on Form
10 which was declared effective on July 31, 1998, (ii) the Company's Common
Stock was listed with and began trading on the National Market on August 10,
1998 and (iii) Penford obtained a private letter ruling from the Internal
Revenue Service to the effect that, among other things, the Distribution
qualified as tax-free under Sections 355 and 368 of the Internal Revenue Code of
1986, as amended, and that the receipt of shares of the Company's Common Stock
in the Distribution would not result in the recognition of income, gain or loss
to Penford's shareholders for federal income tax purposes.

      In connection with the Distribution, the Company and Penford entered into
agreements that govern various interim and ongoing relationships. These
agreements include (i) a Separation and Distribution Agreement setting forth the
agreement of the parties with respect to the principal corporate transactions
which were required to effect the separation of Penford's pharmaceutical
business from its specialty carbohydrate-based chemical business and the
Distribution, including without limitation Penford's agreement to guarantee the
Company's indebtedness under the Credit Facility referred to above in Note 6;
(ii) a Services Agreement pursuant to which Penford will continue on an interim
basis to provide specified services to the Company until June 30, 1999 or until
Penwest does not need 


                                      F-12
<PAGE>   61

the services, of which costs will be charged to the Company on an actual or
allocated basis, plus a specified profit percentage; (iii) a Tax Allocation
Agreement relating to, among other things, the allocation of tax liability
between the Company and Penford in connection with the Distribution, subject to
the tax allocation agreement, all pre-distribution liabilities are the
responsibility of Penford and all post distribution liabilities are those of the
respective entities; (iv) an Excipient Supply Agreement pursuant to which
Penford will manufacture and supply exclusively to the Company, and the Company
will purchase exclusively from Penford, subject to certain exceptions, all the
Company's requirements for two excipients marketed by the Company under quantity
and pricing terms that the Company believes approximate fair market value; and
(v) an Employee Benefits Agreement setting forth the parties' agreements as to
the continuation of certain Penford benefit arrangements for the employees of
the Company. Subsequent to the Distribution, no terminating liabilities were
incurred by Penwest related to the Penford defined benefit plan.

      On August 31, 1998, in connection with the separation of its
pharmaceutical business, Penford contributed to the capital of the Company all
existing intercompany indebtedness of the Company (the "Contribution") which
approximated $50.9 million.

      Prior to deciding to distribute 100% of the Company's common stock to
Penford's shareholders, in October 1997, Penford's Board of Directors approved
the sale of approximately 20% of the Company's common stock in an initial public
offering ("IPO"). The IPO was initially intended to be completed during December
1997. Due to market conditions, the IPO was initially postponed and during May
1998, after further evaluation of the market opportunities, Penford's Board of
Directors decided to distribute 100% of the Company's common stock to Penford's
shareholders and forego the IPO at such time. Based on this decision, the
Company wrote-off approximately $1.4 million of transaction costs, principally
legal, accounting and printing associated with the IPO, during the year ended
December 31, 1997.

8. TRANSACTIONS WITH PENFORD

      The Payable to Penford that was contributed upon the Distribution
consisted solely of advances. These advances were generated primarily from the
initial acquisition of the Company, the addition of a microcrystalline cellulose
plant and the funding of operations. The Payable to Penford was a
non-interest-bearing obligation. Average balances for the years ended December
31, 1996, 1997 and the 1998 period prior to the Distribution were $29,123,000,
$37,594,000 and $46,784,000, respectively. The Company also participated in
pension and other employee benefit plans sponsored by Penford and purchases
inventory from a wholly-owned subsidiary of Penford. The inventory purchases
amounted to approximately $634,000, $367,000 and $438,000 for the years ended
December 31, 1996, 1997 and 1998, respectively. The Company believes the terms
of its employee benefit and inventory purchase transactions approximate those
that would have been reached with a third party in an arms length transaction
and represent the approximate costs the Company would have incurred on a
stand-alone basis. Penford allocated executive office salaries, bonuses and
legal fees to the Company in the form of a management fee prior to the
Distribution Date. The costs making up the management fee were allocated to the
Company based upon its pro rata portion of Penford's consolidated revenue. The
Company believes the management fees approximate the actual costs of services
provided and represent the approximate costs the Company would have incurred on
a stand-alone-basis. Included in selling, general and administrative expenses is
a management fee of $391,000, $601,000 and $219,000 for the years ended December
31, 1996, 1997 and 1998 respectively.


                                      F-13
<PAGE>   62

9. EQUITY

Penford Stock Option Plan

      Certain of the Company's employees participated in Penford's 1994 Stock
Option Plan (the "1994 Plan") for which 1,000,000 shares of common stock had
been authorized for grants of options by Penford. The 1994 Plan provided for the
granting of stock options at the fair market value of the common stock on the
date of grant. Either incentive stock options or non-qualified stock options
were granted under the 1994 Plan. The incentive stock options generally vest
over five years at the rate of 20% each year and expire 10 years from the date
of grant. The non-qualified stock options generally vest over four years at the
rate of 25% each year and expire 10 years and 10 days from the date of grant.
Changes in Penford stock options granted to employees of Penwest for the three
years ended December 31, 1996, 1997 and 1998 (through the Distribution) are as
follows:

<TABLE>
<CAPTION>
                                                                      OPTION PRICE         WTD. AVERAGE
                                                         SHARES           RANGE           EXERCISE PRICE
                                                         ------           -----           --------------
<S>                                                    <C>            <C>                         <C>   
1996
Balance, December 31, 1995 ................              85,000       $20.13 - 24.50              $21.41
Granted ...................................              80,500       $17.00 - 18.25              $17.71
Exercised .................................                  --
Cancelled .................................                  --
                                                       --------
Balance, December 31, 1996 ................             165,500       $17.00 - 24.50              $19.61
                                                       ========
Options Exercisable .......................              14,600       $20.13 - 24.50              $21.86

1997
Granted ...................................               1,000               $18.25              $18.25
Exercised .................................                (600)              $18.25              $18.25
Cancelled .................................              (1,800)              $18.25              $18.25
                                                       --------
Balance, December 31, 1997 ................             164,100       $17.00 - 24.50              $19.62
                                                       ========
Options Exercisable .......................              40,050       $17.00 - 24.50              $20.15

1998
Granted ...................................                   0                   --                  --
Exercised .................................              (4,800)      $17.00 - 18.25              $17.83
Transferred to Spin-Off Option Plan .......            (159,300)      $17.00 - 24.50              $20.15
                                                       --------
Balance, December 31, 1998 ................                   0
                                                       ========
</TABLE>

Penwest Stock Option Plans

      As of December 31, 1998 the Company had two stock option plans: the 1997
Equity Incentive Plan (the "1997 Plan"), and the 1998 Spin-off Option Plan (the
"Spin-off Plan"). The 1997 Plan provides for the grant of incentive stock
options, nonstatutory stock options, restricted stock awards and other
stock-based awards, including the grant of securities convertible into Common
Stock and the grant of stock appreciation rights (collectively "Awards"). A
total of 2,660,000 shares of Common Stock may be issued pursuant to Awards
granted under the 1997 Plan. Optionees receive the right to purchase a specified
number of shares of Common Stock at a specified option price and subject to such
other terms and conditions as are specified in connection with the option grant.
Awards may be granted at an exercise price which may be less than, equal to or
greater than the fair market value of the Common Stock on the date of grant
subject to certain limitations. All 1998 stock option grants under the 1997 Plan
were at fair market value. Restricted stock Awards entitle recipients to acquire
shares of Common Stock, subject to the right of the Company to purchase all or


                                      F-14
<PAGE>   63

part of such shares from the recipient in the event that the conditions
specified in the applicable Award are not satisfied prior to the end of the
applicable restriction period established for such Award. During 1998, 52,500
restricted shares were granted.

      The Company's 1998 Spin-off Option Plan was adopted by the Company in June
1998 to provide for the grant of stock options to employees of Penwest and
non-employee directors of Penford who held options to purchase Penford Common
Stock as of the Distribution Date and who cease to be employees of Penford under
the terms of Penford's stock option plans. As of the Distribution Date, options
to purchase 846,100 shares of Common Stock were granted to the Company's
employees and non-employee directors of Penford under the Spin-off Plan. The
exercise price and number of options was calculated so as to preserve the
Penford options' approximate value as of the Distribution Date. Generally,
outstanding vested options may be exercised during the 90-day (if an incentive
stock option) or one year period (if a nonstatutory stock option) following
termination of employment and unvested options lapse upon termination of
employment. The Board may not grant any additional options under the Spin-off
Plan. If any option expires or is terminated, surrendered, canceled or
forfeited, the unused Common Stock covered by such option will cease to be
available for grant under the Spin-off Plan.

<TABLE>
<CAPTION>
                                                                OPTION PRICE           WTD. AVERAGE
                                              SHARES                RANGE             EXERCISE PRICE
                                              ------                -----             --------------
<S>                                        <C>                  <C>                            <C>  
Balance, December 31, 1997.....                    0                      --                      --
Spin-off Option Plan...........              846,100            $4.06 - 8.67                   $5.99
Granted........................            1,035,043            $3.70 - 8.06                   $6.74
Exercised......................                   --                      --                      --
Cancelled......................             (319,739)           $5.72 - 6.75                   $6.59
                                           ---------
Balance, December 31, 1998.....            1,561,404
                                           ---------
Options Exercisable............              267,707
                                           =========
</TABLE>

Stock Compensation

      The Company has elected to follow Accounting Principals Board Opinion
(APB) No. 25 "Accounting for Stock Issued to Employees" and related
Interpretations in accounting for its employee stock options. Under APB No. 25,
the Company does not recognize compensation expense for Penford or Penwest
options granted to employees of Penwest, since the exercise price of the options
granted is equal to the market value of the common stock at the date of grant.
Statement of Financial Accounting Standard No. 123 "Accounting for Stock Based
Compensation" requires the Company to disclose the pro forma impact on net loss
and loss per share as if compensation expense associated with employee stock
options granted to employees of Penwest had been calculated under the fair value
method of Statement No. 123 for employee stock options granted to employees of
Penwest subsequent to December 31, 1994.

<TABLE>
<CAPTION>
                                                                        YEARS ENDED DECEMBER 31,
                                                              1996                1997             1998
                                                              ----                ----             ----
                                                                (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                          <C>                <C>              <C>     
Net loss - as reported                                       $ (3,864)          $(7,316)         $(8,829)
Net loss - pro forma                                         $ (4,123)          $(7,766)         $(9,712)
Net loss per share, basic and diluted - as reported          $  (0.35)          $ (0.66)         $ (0.80)
Net loss per share, basic and diluted - pro forma            $  (0.37)          $ (0.70)         $ (0.88)
</TABLE>


                                      F-15
<PAGE>   64

      The fair value of each option grant was estimated using the Black-Scholes
option-pricing model with the following weighted average assumptions:

<TABLE>
<CAPTION>
                                                       1996                1997                  1998
                                                       ----                ----                  ----
<S>                                               <C>                 <C>                   <C>      
Expected dividend yield                                None                None                  None
Risk free interest rate                                5.90%               5.90%                 5.50%
Expected volatility                                      49%                 49%                  119%
Expected life of options                          4.8 years           4.8 years             7.5 years
</TABLE>

      The weighted average fair value of options granted during the years ended
December 31, 1996, 1997  and 1998 was $9.30, $9.67 and $6.17, respectively. The
weighted effect of applying Statement No. 123 for providing pro forma
disclosures for the years ended December 31, 1996, 1997 and 1998 is not likely
to be representative of the effects in future years because the amounts above
reflect only the options granted before 1995 that vest over four to five years.
No additional Penford shares were granted to the Company employees subsequent to
December 31, 1997.

Employee Stock Purchase Plan

      The Employee Stock Purchase Plan was approved in October 1997 and enables
all employees to subscribe "during specified offering periods" to purchase
shares of common stock at the lower of 85% of the fair market value of the
shares on the first or last day of such offering period. A maximum of 228,000
shares are authorized for issuance under the Plan. On December 31, 1998 shares
totaling 6,509 were issued under the Plan at a price of $4.99 per share.

Rights Agreement

On June 25, 1998, the Board of Directors declared a dividend of one right for
each outstanding share of the Company's Common Stock (the "Right") to
shareholders of record at the close of business on July 28, 1998. Each Right
entitles the registered holder to purchase from the Company one one-thousandth
of a share of the Series A Preferred Stock, at a purchase price of $60 in cash,
subject to adjustment.

The Rights are not currently exercisable and will not be exercisable until the
earlier of (i) 10 business days (or such later date as may be determined by the
Board) following the later of (a) a public announcement that a person or group
of affiliated or associated persons (a "Rights Acquiring Person") has acquired,
or obtained the right to acquire, beneficial ownership of 15% or more of the
outstanding shares of Common Stock or (b) the first date on which an executive
officer of the Company has actual knowledge that a Rights Acquiring Person has
become such, or (ii) 10 business days (or such later date as may be determined
by the Board) following the commencement of a tender offer or exchange offer
that would result in a person or group beneficially owning 15% or more of such
outstanding shares of Common Stock. The Rights will expire upon the close of
business on July 27, 2008 unless earlier redeemed or exchanged.

In the event that any Person becomes a Rights Acquiring Person, unless the event
causing the 15% threshold to be crossed is a permitted offer, as defined in the
agreement, then, promptly following the first occurrence of such event, each
holder of a Right (except as provided below and under certain 


                                      F-16
<PAGE>   65

circumstances) shall thereafter have the right to receive, upon exercise, that
number of shares of Common Stock of the Company (or, in certain circumstances,
cash, property or other securities of the Company) which equals the exercise
price of the Right divided by 50% of the current market price per share of
Common Stock at the date of the occurrence of such event. However, Rights are
not exercisable following such event until such time as the Rights are no longer
redeemable by the Company. Notwithstanding any of the foregoing, following the
occurrence of such event, all Rights that are, or (under certain circumstances)
were, beneficially owned by any Rights Acquiring Person will be null and void.

In the event that, at any time after any Person becomes a Rights Acquiring
Person, (i) the Company is consolidated with, or merged with and into, another
entity and the Company is not the surviving entity of such consolidation or
merger (other than a consolidation or merger which follows a permitted offer) or
if the Company is the surviving entity, but shares of its outstanding common
stock are changed or exchanged for stock or securities (of any other person) or
cash or any other property, or (ii) 50% or more of the Company's assets or
earning power is sold or transferred, each holder of a Right (except Rights
which previously have been voided as set forth above) shall thereafter have the
right to receive, upon exercise, that number of shares of common stock of the
acquiring company which equals the exercise price of the Right divided by 50% of
the current market price of such common stock at the date of the occurrence of
the event.

Stock Splits

      On October 20, 1997, the Company effected a 2,907.66-for-1 stock split
transforming the Company's capital structure from 50,000 shares, $1.00 par value
per share, of common stock authorized and 5,000 shares of common stock
outstanding to 39,000,000 shares, $.001 par value per share, of common stock
authorized and 14,538,282 shares of Common Stock outstanding and 1,000,000
shares of preferred stock, $.001 par value per share, authorized, that may be
issued by the Board in one or more series. On June 19, 1998, the Company
effected a 0.76-for-1 reverse stock split, reducing the outstanding shares to
11,036,822 shares of common stock. Accordingly, all share and per share data
have been retroactively adjusted to give effect to the stock split and reverse
stock split.

10. COMMITMENTS

Leases

      The Company's manufacturing facility in Finland is leased under a two-year
operating lease which includes renewal options with annual rental expense of
$188,000 plus additional charges determined on a month-to-month basis for
equipment and warehouse usage. In addition, certain of the Company's property,
plant and equipment is leased under operating leases ranging from one to fifteen
years and includes periodic escalation clauses based on rental market conditions
as well as insurance rent payments. Rental expense under operating leases was
$216,000, $283,000 and $316,000 for the years ended December 31, 1996, 1997, and
1998, respectively. Future minimum lease payments as of December 31, 1998 for
noncancellable operating leases having initial lease terms of more than one year
are as follows:


                                      F-17
<PAGE>   66

<TABLE>
<CAPTION>
                                                           OPERATING
                                                             LEASES
                                                             ------
                                                         (IN THOUSANDS)

                    <S>                                   <C>    
                                1999                       $  301
                                2000                          278
                                2001                           78
                                2002                           70
                                2003                           61
                             Thereafter                       475
                                                           ------

                    Total minimum lease payments           $1,263
                                                           ======
</TABLE>

11. INCOME TAXES

      The provision (benefit) for federal, state and foreign income taxes
consists of the following:

<TABLE>
<CAPTION>
                               1996     1997      1998
                               ----     ----      ----
                                   (in thousands)
<S>                            <C>      <C>     <C>     
Federal:
  Deferred ................    $423     $(81)   $(1,585)
Foreign:                      
  Current .................     217      247         88
  Deferred                                         (100)
State:                        
  Current .................       1        1         12
  Deferred ................     123      (23)      (441)
                               ----     ----    -------
                               $764     $144    $(2,026)
                               ====     ====    =======     
</TABLE>

      The reconciliation between the statutory tax rate and those reflected in
the Company's income tax provision (benefit) is as follows:

<TABLE>
<CAPTION>
                                           1996      1997     1998
                                           ----      ----     ----
<S>                                        <C>       <C>      <C>  
Statutory tax rate ....................... (34)%     (34)%    (34)%
Tax benefit utilized by Penford ..........  55        36       19
Foreign taxes ............................   2        --       (1)
State taxes, net of federal benefit ......   2        --       (3)
                                           ---       ---      ---  
                                            25%        2%     (19)%
                                           ===       ===      ===  
</TABLE>

      The components of deferred income tax assets and liabilities are as
follows:

<TABLE>
<CAPTION>
                                                           1997          1998
                                                          -------       -------
                                                             (IN THOUSANDS)
<S>                                                       <C>           <C>     
Receivable allowance ...............................      $  (135)      $   (91)
Inventory reserves and basis differences ...........         (249)         (265)
                                                          -------       -------
Current deferred tax asset .........................      $  (384)      $  (356)
                                                          =======       =======

Deferred compensation and SERP liability ...........           --       $  (872)
Valuation allowance ................................           --           343
Net operating loss carryforward ....................           --        (2,282)
Accelerated depreciation and amortization ..........      $ 3,531         3,743
                                                          -------       -------
Non-current net deferred tax liability .............      $ 3,531       $   932
                                                          =======       =======
</TABLE>

      The Company has made payments for foreign income taxes of approximately
$217,000, $181,000 and $151,000 for the years ended December 31, 1996, 1997 and
1998, respectively.


                                      F-18
<PAGE>   67

      Through August 31, 1998 the Company was included in the consolidated
federal and state tax returns of Penford. In accordance with the Company's tax
sharing agreement, the Company was not compensated for tax losses that were
utilized by Penford. As a result of Penford fully utilizing all of the Company's
tax losses through the Distribution Date, the Company does not possess net
operating loss carryforwards attributable to such periods. Through August 31,
1998, Penford has utilized approximately $26,693,000 of federal net operating
loss carryforwards that the Company would have had outstanding were it a
stand-alone entity through such date, of which approximately $3,393,000,
$4,503,000, $5,084,000, $7,643,000 and $6,070,000 would have expired in 2009,
2010, 2011, 2012 and 2013, respectively. In addition, Penford is liable for any
federal, state or foreign tax adjustments assessed against the Company for
periods through the Distribution Date. Beginning September 1998, deferred tax
assets were recognized on tax losses to the extent that deferred tax liabilities
with temporary differences reversing during the loss carry-forward period will
be available to offset such losses. The valuation allowance and the deferred tax
assets related to deferred compensation and the SERP liability were recorded in
conjunction with the Contribution (see Note 7).

      The Company's policy is to permanently reinvest foreign earnings.
Accumulated foreign earnings, for which no deferred taxes have been provided,
amounted to $1,793,000, $2,230,000 and $2,580,000 as of December 31, 1996, 1997
and 1998, respectively. If such earnings were to be repatriated, the income tax
effect would not be significant.

      Included in the loss before income taxes is foreign income of $801,000,
$757,000 and $476,000 for the years ended December 31, 1996, 1997 and 1998,
respectively.

12. PENSION AND OTHER EMPLOYEE BENEFITS

Savings and Stock Ownership Plans

      The Company's employees participated, prior to the Distribution, in
Penford's Savings and Stock Ownership Plan and costs were charged to the Company
based upon actual costs incurred for the Company's employees. Seventy-five
percent (75%) of employee's contributions were matched up to 6% of the
employee's pay, in the form of Penford common stock. A similar plan was adopted
by the Company upon the Distribution. The primary changes in the new plan
include the shortening of the vesting period from five years to four years and
the Company's match is now in the form of cash. The Company's expense under the
Plans was $147,000, $161,000 and $217,000 for 1996, 1997 and 1998, respectively.

      The Plans also include an annual profit-sharing component that is awarded
by Penford's Board of Directors prior to the Spin-off and Penwest's Board of
Directors subsequent to the spin-off based on achievement of predetermined
corporate goals. This feature is available to all employees who meet the
eligibility requirements of the Plans. The profit sharing expense related to the
Company's employees was $38,000, $95,000 and $125,000 for 1996, 1997 and 1998,
respectively.

Supplemental Executive Retirement Plan

      Penford sponsored a Supplemental Executive Retirement Plan (SERP), a
nonqualified plan, which covers one employee of Penwest. For 1996, 1997 and 1998
the net expense for the SERP incurred by 


                                      F-19
<PAGE>   68

Penwest was $35,000, $22,000 and $56,000, respectively. The allocated costs
represent the costs attributable to the Company's employees. As part of the
Distribution, the SERP liability was assumed by the Company. The Company does
not fund this liability and no assets are held by the Plan. The following
disclosures represent information subsequent to the Distribution.

     Change in benefit obligation (in thousands):

<TABLE>
<CAPTION>
                                                                          1998
                                                                          ----
<S>                                                                      <C>    
Benefit obligation at September 1 .............................          $1,362
Service cost ..................................................              (5)
Interest cost .................................................              32
Actuarial gains ...............................................              (1)
                                                                         ------
     Benefit obligation at December 31 ........................          $1,388
                                                                         ======

<CAPTION>
     Funded status (in thousands):
                                                                           1998
                                                                           ----
<S>                                                                     <C>     
Funded status .................................................         $(1,388)
Unrecognized transition liability .............................             340
Unrecognized prior service cost ...............................             225
Unrecognized net gain .........................................            (708)
                                                                        -------
     Net amount recognized at December 31,
(Included in other  long term liabilities)  ...................         $(1,531)
                                                                        =======

     Components of net periodic benefit cost (in thousands):

<CAPTION>
                                                                           1998
                                                                           ----
<S>                                                                        <C>  
Service cost ......................................................        $ (4)
Interest cost .....................................................          32
Amortization of unrecognized transition liability .................          19
Amortization of prior service cost ................................          21
Amortization of gains .............................................         (21)
                                                                           ----
     Net periodic benefit cost ....................................        $ 47
                                                                           ====
</TABLE>

The plan's accumulated benefit obligation at December 31, 1998 was $1,088,000.
The Company's benefit obligation was measured using a weighted average discount
rate of 7% and a compensation increase of 3%. The amortization of prior service
cost is determined using a straight-line amortization of the cost over the
average remaining service period of the employee expected to receive benefits
under the Plan.

Health Care and Life Insurance Benefits

      The Company offers health care and life insurance benefits to most active
employees. Costs incurred for these benefits were $212,000, $343,000 and
$496,000 in 1996, 1997 and 1998, respectively.

      Pension Plan

      Prior to the Distribution, Penwest participated in a noncontributory
defined benefit pension plan (the Plan) that covered substantially all
employees. The Plan was sponsored by Penford and costs 


                                      F-20
<PAGE>   69

were allocated based upon actual costs incurred for the Company's employees. In
addition to the employees of the Company, employees of Penford and its other
subsidiaries participated in the Plan. The Company has accounted for its
involvement in the overall Plan as a participant in a multi-employer pension
plan. Under this method, the Company recognized as net periodic pension costs
its allocated contribution for the period. The Company recognized a liability to
the Parent for any contributions due and unpaid.

      Under the terms of the Employee Benefits Agreement between Penford and
Penwest, Penford froze all benefits to employees of Penwest under the Plan as of
the Distribution and distributed to each employee his or her fully vested
interest in the form of a lump sum payment or an annuity. Based upon the terms
of the agreement, there were no termination gains or losses as a result of the
freezing of Plan benefits, the termination of the right of employees of the
Company to participate in the Plan or the subsequent distribution.

      Benefits for employees are primarily related to years of credited service
and final average five-year earnings. Employees generally become eligible to
participate in the Plan after attaining age 21 and benefits become vested after
five years of credited service.

      Pension expense of $74,000, $66,000 and $50,000 was recorded for the years
ended December 31, 1996, 1997 and 1998, respectively, for this Plan.

13. LICENSING AGREEMENTS

      The Company has entered into collaborative arrangements with several
pharmaceutical companies to facilitate and expedite the commercialization of its
TIMERx drug delivery technology.

      In August 1994, August 1995 and March 1996, the Company entered into
product development and supply agreements with Mylan Pharmaceuticals, Inc.
("Mylan") with respect to the development of generic versions of Procardia XL
(nifedipine), Adalat CC (nifedipine) and Glucotrol XL (glipizide), based on the
Company's TIMERx technologies (the "Mylan Products"). Under these product
development and supply agreements, the Company is responsible for the
formulation, manufacture and supply of TIMERx material for use in the Mylan
Products, and Mylan is responsible for conducting all bioequivalence studies,
preparing all regulatory applications and submissions and manufacturing and
marketing the Mylan Products in the United States, Canada and Mexico. The
Company has received non-refundable milestone payments under each of the product
development and supply agreements and is entitled to additional milestone
payments under such agreements upon the continued development of the Mylan
Products. The Company is also entitled to royalties on the sale of each Mylan
Product, which royalties will be reduced with respect to such Mylan Product if
there are on the market and available for retail sale any other generic
controlled release formulations of the drug of which such Mylan Product is a
generic controlled release formulation. In addition, Mylan has agreed that
during the term of the product development and supply agreements it will
purchase formulated TIMERx material for use in the Mylan Products exclusively
from the Company at specified prices.

      Penwest and Mylan also entered into a sales and distribution agreement in
January 1997 (the "Mylan Distribution Agreement") with respect to Nifedipine XL
pursuant to which Mylan agreed to manufacture and supply Nifedipine XL to
Penwest for distribution by Penwest and one or more distributors (as to which
the Company and Mylan must mutually agree) in certain specified European 


                                      F-21
<PAGE>   70

and Latin American countries. Under this agreement, the Company has agreed to
purchase Nifedipine XL exclusively from Mylan at specified prices or to pay
Mylan 50% of any royalties received by the Company from its distributors if
Mylan licenses its manufacturing technology to the Company for use by the
Company's distributors instead of manufacturing the product for distribution.
Under this agreement, Mylan is entitled to 50% of any royalties or milestone
payments received by the Company under the Company's product development and
supply agreement with Sanofi described below.

      In February 1997, the Company entered into a product development and
supply agreement with Sanofi Winthrop International S.A. ("Sanofi") with respect
to the development of a generic version of Adalat LA based on the Company's
TIMERx technology (the "Sanofi Product"), a drug that utilizes the same
controlled release technology as Nifedipine XL. Under the product development
and supply agreement, the Company is responsible for conducting pilot
bioequivalence studies of the Sanofi Product and for manufacturing and supplying
TIMERx material to Sanofi, and Sanofi is responsible for conducting all full
scale bioequivalence studies, preparing all regulatory applications and
submissions and manufacturing and marketing the Sanofi Product in specified
countries in Europe and in South Korea. The Company is entitled to
non-refundable milestone payments under the product development and supply
agreement upon the continued development of the Sanofi Product. The Company is
also entitled to royalties upon the sale of the Sanofi Product. One half of such
payments will be paid to Mylan in accordance with the Mylan Distribution
Agreement. In addition, Sanofi has agreed that, during the term of the product
development and supply agreement, it will purchase formulated TIMERx material
for use in the Sanofi Product exclusively from the Company at specified prices.

      In July 1992, the Company entered into an agreement with Leiras Oy
("Leiras") with respect to the development and commercialization of Cystrin CR,
a controlled release formulation of oxybutynin based on the Company's TIMERx
technology. In May 1995, the Company entered into a second agreement with Leiras
clarifying certain matters with respect to the collaboration. Leiras is a
Finnish subsidiary of Schering AG. Leiras is developing products focused in the
areas of reproductive health care, urology, oncology and inhalation technology.
Under the agreements, the Company is responsible for the development and
formulation of Cystrin CR and for manufacturing and supplying TIMERx material to
Leiras for use in the manufacture of Cystrin CR, and Leiras is responsible for
preparing all regulatory applications and submissions and manufacturing and
marketing Cystrin CR on a worldwide basis. Leiras has the right to transfer its
rights and responsibilities under the agreement and its related product rights
to third parties for specified territories, subject in certain circumstances to
the approval of the Company.

      In September 1997, the Company entered into a strategic alliance agreement
with Endo Pharmaceuticals Inc. ("Endo") with respect to the development of
controlled release formulations of oxymorphone based on the Company's TIMERx
technology (the "Endo Products"). Under the agreement, the Company has agreed to
manufacture and supply TIMERx material to Endo, and Endo has agreed to
manufacture and market the Endo Products in the United States. The manufacture
and marketing of Endo Products outside of the United States may be conducted by
the Company, Endo or a third party, as determined by a committee comprised of an
equal number of members from each of the Company and Endo. The Company and Endo
have agreed to share the costs involved in the development and commercialization
of the Endo Products and that the party marketing the Endo Products (which the
Company expects will be Endo) will pay the other party royalties equal to 50% of
their respective net marketing revenues after fully-burdened costs (although
this percentage will decrease as the total U.S. marketing revenues from an Endo
Product increase), subject to each party's 


                                      F-22
<PAGE>   71

right to terminate its participation with respect to any Endo Product described
above. Endo will purchase formulated TIMERx material for use in the Endo
Products exclusively from the Company at specified prices. Such prices will be
reflected in the determination of fully-burdened costs. Under the Company's
strategic alliance agreement with Endo, the Company expects to incur expenses of
approximately $7.0 million, primarily in 1999, 2000 and early 2001.

      Royalties and licensing fees revenue consist solely of payments received
under TIMERx collaborative agreements. Included in royalties and licensing
revenue are approximately $1,082,000, $50,000 and $80,000 for the years ended
December 31, 1996, 1997 and 1998, respectively, of payments received upon the
signing of collaborative agreements. These up-front payments relate principally
to the performance of pilot bioequivalence studies and have been recognized upon
the delivery of the results of such studies to the collaborators. In addition,
approximately $861,000 and $190,000 of non-refundable milestone payments were
recognized as the milestones were achieved during the years ended December 31,
1997 and 1998, respectively. Approximately $2,819,000, $3,075,000 and $5,084,000
for the years ended December 31, 1996, 1997 and 1998, respectively, of research
and development expense principally related to applications of TIMERx technology
to products covered by the Company's collaborative agreements. Since the
collaborative agreements can be terminated by either party, the costs associated
with such agreements could be discontinued by the Company. Such costs are
typically incurred prior to the receipt of milestones, royalties and other
payments.

14. CONTINGENCIES

      In May 1997, one of the Company's collaborators, Mylan, filed an
Abbreviated New Drug Application ("ANDA") with the U.S. Food and Drug
Administration ("FDA") for the 30 mg dosage strength of Nifedipine XL, a generic
version of Procardia XL, a controlled release formulation of nifedipine. See
Note 13 for a description of the Company's collaborative agreements with Mylan.
Bayer AG ("Bayer") and ALZA Corporation ("Alza") own patents listed for
Procardia XL (the last of which expires in 2010), and Pfizer, Inc. ("Pfizer").
Pfizer is the sponsor of the New Drug Application ("NDA") and markets the
product. In connection with the ANDA filing, Mylan certified to the FDA that
Nifedipine XL does not infringe these Bayer or ALZA patents and notified Bayer,
ALZA and Pfizer of such certification. Bayer and Pfizer sued Mylan in the United
States District Court for the Western District of Pennsylvania, alleging that
Mylan's product infringes Bayer's patent. The company has been informed by Mylan
that ALZA does not believe that the notice given to it complied with the
requirements of the Waxman-Hatch Act, and there can be no assurance that ALZA
will not sue Mylan for patent infringement or take any other actions with
respect to such notice. Mylan has advised the Company that it intends to contest
vigorously the allegations made in the lawsuit. However, there can be no
assurance that Mylan will prevail in this litigation or that it will continue to
contest the lawsuit. An unfavorable outcome or protracted litigation for Mylan
would materially adversely affect the Company's business, financial condition,
cash flows and results of operations. Delays in the commercialization of
Nifedipine XL could also occur because although the FDA granted tentative
approval, it will not grant final marketing approval of Nifedipine XL until a
final judgment on the patent suit is rendered in favor of Mylan by the district
court, or in the event of an appeal, by the court of appeals, or until 30 months
(or such longer or shorter period as the court may determine) have elapsed from
the date of Mylan's certification, whichever is sooner.

      In 1993, Pfizer filed a "citizen's petition" with the FDA, claiming that
its Procardia XL formulation constituted a unique delivery system and that a
drug with a different release mechanism 


                                      F-23
<PAGE>   72

such as the TIMERx controlled release system cannot be considered the same
dosage form and approved in an ANDA as bioequivalent to Procardia XL. In August
1997, the FDA rejected Pfizer's citizen's petition. In July 1997, Pfizer also
sued the FDA in the District Court of the District of Columbia, claiming that
the FDA's acceptance of Mylan's ANDA filing for Nifedipine XL was contrary to
law, based primarily on the arguments stated in its citizen's petition. Mylan
and the Company intervened as defendants in this suit. In April 1998 the
District Court of the District of Columbia rejected Pfizer's claim, and in May
1998, Pfizer appealed the District Court's decision. This case was heard in
February 1999 but no decision has been rendered. There can be no assurance that
the FDA, Mylan and the Company will prevail in this litigation. An outcome in
this litigation adverse to Mylan and the Company would result in Mylan being
required to file a suitability petition in order to maintain the ANDA filing or
to file an NDA with respect to Nifedipine XL, each of which would be expensive
and time consuming. An adverse outcome also would result in Nifedipine XL
becoming ineligible for an "AB" rating from the FDA. Failure to obtain an AB
rating from the FDA would indicate that for certain purposes Nifedipine XL would
not be deemed to be therapeutically equivalent to the referenced branded drug,
would not be fully substitutable for the referenced branded drug and would not
be relied upon by Medicaid and Medicare formularies for reimbursement. Any such
failure would have a material adverse effect on the Company's business,
financial condition, cash flows and results of operations. If any of such events
occur, Mylan may terminate its efforts with respect to Nifedipine XL, which
would have a material adverse effect on the Company's business, financial
condition, cash flows and results of operations.

      In 1994, the Boots Company PLC ("Boots") filed an opposition to a patent
granted by the EPO, European Patent Office (the "EPO") to the Company relating
to its TIMERx technology. In June 1996, the EPO dismissed Boots' opposition,
leaving intact all claims included in the patent. Boots has appealed this
decision to the EPO Board of Appeals. There can be no assurance that the Company
will prevail in this matter. An unfavorable outcome could materially adversely
affect the Company's business, financial condition, cash flows and results of
operations.

      Substantial patent litigation exists in the pharmaceutical industry.
Patent litigation generally involves complex legal and factual questions, and
the outcome frequently is difficult to predict. An unfavorable outcome in any
patent litigation affecting the Company could cause the Company to pay
substantial damages, alter its products or processes, obtain licenses and/or
cease certain activities. Even if the outcome is favorable to the Company, the
Company could incur substantial litigation costs. Although the legal costs of
defending litigation relating to a patent infringement claim (unless such claim
relates to TIMERx) are generally the contractual responsibility of the Company's
collaborators, the Company could nonetheless incur significant unreimbursed
costs in participating and assisting in the litigation.

      Testing, manufacturing, marketing and selling pharmaceutical products
entail a risk of product liability. The Company faces the risk of product
liability claims in the event that the use of its products is alleged to have
resulted in harm to a patient or subject. Such risks exist even with respect to
those products that are manufactured in licensed and regulated facilities or
that otherwise possess regulatory approval for commercial sale. Product
liability insurance coverage is expensive, difficult to obtain and may not be
available in the future on acceptable terms, if at all. The Company has primary
product liability insurance in the amount of $1.0 million per occurrence and
$2.0 million annually in the aggregate on a claims-made basis and by umbrella
liability insurance in excess of $25.0 million which can also be used for
product liability insurance. There can be no assurance that this coverage is
adequate to cover potential liability claims. Furthermore, this coverage may not
be adequate as the 


                                      F-24
<PAGE>   73

Company develops additional products. As the Company receives regulatory
approvals for products under development, there can be no assurance that
additional liability insurance coverage for any such products will be available
in the future on acceptable terms, if at all. The Company's business, financial
condition, cash flows and results of operations could be materially adversely
affected by the assertion of a product liability claim.

15. SEGMENT INFORMATION

      The Company is engaged in the research, development and commercialization
of novel drug delivery technologies. The Company has extensive experience in
developing and manufacturing tabletting ingredients for the pharmaceutical
industry. The Company's product portfolio ranges from excipients that are sold
in bulk, to more technically advanced and patented excipients that are licensed
to customers and conducts its business primarily in North America and Europe.
The European operations consist of a manufacturing facility in Nastola, Finland
and sales offices in Reigate, England and Bodenheim, Germany. None of the
European locations, other than Finland, is individually significant.
Intercompany sales include a profit component for the selling company.
Intercompany sales and profits are eliminated in consolidation. Corporate
operating expenses are not allocated to the European operations. Operating
profit represents gross profit less selling, general and administrative expenses
and, for North America, research and development expense.

<TABLE>
<CAPTION>
                                            UNITED
                                            STATES       FINLAND        OTHER         ELIMINATIONS         TOTAL
                                            ------       -------        -----         ------------         -----
                                                           (IN THOUSANDS)
<S>                                        <C>           <C>            <C>              <C>              <C>    
DECEMBER 31, 1998
Total Revenues........................     $27,716       $ 3,844        $3,411           $(5,960)         $29,011
Long-lived Assets.....................     $24,572       $   855        $   66                            $25,493

DECEMBER 31, 1997
Total Revenues........................     $24,818       $ 3,470        $2,993           $(4,340)         $26,941
Long-lived Assets.....................     $23,411       $   899        $  134                            $24,444

DECEMBER 31, 1996
Total Revenues........................     $25,400       $ 4,751        $2,166           $(6,228)         $26,089
Long-lived Assets.....................     $20,832       $ 1,108          $141                            $22,081
</TABLE>

      Neither the revenues nor long-lived assets of the operations in Germany or
the United Kingdom, individually or in the aggregate, exceed 10% of total
revenues or long-lived assets of the Company.


                                      F-25
<PAGE>   74

                         REPORT OF INDEPENDENT AUDITORS

TO THE BOARD OF DIRECTORS AND SHAREHOLDERS
PENWEST PHARMACEUTICALS CO.

We have audited the accompanying consolidated balance sheets of Penwest
Pharmaceuticals Co. as of December 31, 1998 and 1997, and the related
consolidated statements of operations, shareholders' equity (deficit), and cash
flows for each of the three years in the period ended December 31, 1998. Our
audits also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Penwest
Pharmaceuticals Co. at December 31, 1998 and 1997, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.


                                                        /s/ Ernst & Young LLP

Stamford, Connecticut
March 19, 1999


                                      F-26
<PAGE>   75

                                   APPENDIX B

                           PENWEST PHARMACEUTICALS CO.
                     INDEX TO FINANCIAL STATEMENT SCHEDULES

<TABLE>
<CAPTION>
                                                       PAGE
                                                       ----
<S>                                                    <C>
Schedule II - Valuation and Qualifying Accounts        S-2
</TABLE>


                                      S-1
<PAGE>   76

SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS

                           PENWEST PHARMACEUTICALS CO.
                                DECEMBER 31, 1998

                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                     Charged to
                                                    Balance at      Charged to            Other                      Balance at   
                                                     Beginning       Costs and         Accounts      Deductions          End of 
                                                     Of Period        Expenses         Describe        Describe          Period
                                                     ---------        --------         --------        --------          ------
<S>                                                      <C>             <C>                <C>         <C>               <C> 
Year ended December 31, 1998
  Allowance for Doubtful Accounts                        $337            $ 74               --          $(184)(a)         $227
                                                         ====            ====               ==          =====             ====

Year ended December 31, 1997
  Allowance for Doubtful Accounts                        $237            $100               --             --             $337
                                                         ====            ====               ==          =====             ====

Year ended December 31, 1996
  Allowance for Doubtful Accounts                        $200            $ 37               --             --             $237
                                                         ====            ====               ==          =====             ====
</TABLE>

(a) Uncollectible accounts written off, net of recoveries.


                                      S-2
<PAGE>   77

                                INDEX TO EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NO.            DESCRIPTION
---            -----------
<S>            <C>                                                       
3.1*           Amended and Restated Articles of Incorporation
3.2**          Articles of Amendment to the Amended and Restated Articles of
               Incorporation filed on June 19, 1998.
3.3*           Amended and Restated Bylaws of the Company.
3.4**          Designation of Rights and Preference of Series A Junior
               Participating Preferred Stock of the Company filed on July 17,
               1998.
4.1*           Specimen certificate representing the Common Stock.
4.2**          Form of Rights Agreement dated as of July 27, 1998 between the
               Company and the Rights Agent.
+10.1*         Product Development and Supply Agreement dated August 17, 1994 by
               and between the Registrant and Mylan Pharmaceuticals Inc.
               ("Mylan").
+10.2*         Product Development and Supply Agreement dated August 3, 1995 by
               and between the Registrant and Mylan.
+10.3*         Product Development and Supply Agreement dated March 22, 1996 by
               and between the Registrant and Mylan.
+10.4*         Sales and Distribution Agreement dated January 3, 1997 by and
               between the Registrant and Mylan.
10.5**         Form of Separation and Distribution Agreement entered into
               between Registrant and Penford Corporation ("Penford").
+10.6*         Product Development and Supply Agreement dated August 30, 1996 by
               and between the Registrant and Kremers Urban Development Company.
+10.7*         Product Development, License and Supply Agreement dated February
               28, 1997 by and between the Registrant and Sanofi Winthrop S.A.,
               as amended.
+10.8*         Agreement dated May 26, 1995 by and between the Registrant and
               Leiras OY.
+10.9*         Agreement dated July 27, 1992 by and between the Registrant and
               Leiras, OY.
+10.10*        Strategic Alliance Agreement dated as of September 17, 1997 by
               and between the Registrant and Endo Pharmaceuticals Inc.
10.11*++       1997 Equity Incentive Plan.
10.12*++       1997 Employee Stock Purchase Plan.
10.13*++       1998 Spinoff Option Plan.
10.14*         Form of Excipient Supply Agreement to be entered into between the
               Registrant and Penford.
10.15**        Form of Services Agreement to be entered into between the
               Registrant and  Penford.
10.16**        Form of Tax Allocation Agreement to be entered into between the
               Registrant and Penford.
10.17**        Form of Employee Benefits Agreement to be entered into between
               the Registrant and Penford.
10.18*         Recognition and Incentive Agreement dated as of May 14, 1990
               between the Registrant and Anand Baichwal, as amended.
+10.19**       License Agreement dated December 17, 1997 between Synthelabo and
               the Registrant.
+10.20**       Supply Agreement dated December 17, 1997 between Synthelabo and
               the Registrant.
</TABLE>

<PAGE>   78

<TABLE>
<S>            <C>                   
10.21**        Revolving Term Credit Facility dated July 2, 1998 by and between
               the Company and the Bank of Nova Scotia.
21.1*          Subsidiaries.
23             Consent of Ernst & Young, LLP.
24             Power of Attorneys.
27.1           Financial Data Schedule (December 31, 1998)
</TABLE>

*Incorporated by reference to Exhibits to the Registrant's Registration
Statement on Form S-1 (File No. 333-38389).

**Incorporated by reference to Exhibits to the Company's Registration Statement
on Form 10 filed with the Commission on June 22, 1998 and July 31, 1998.

+Confidential treatment granted as to certain portions, which portions are
omitted and filed separately with the Commission.

++Management contract or compensatory plan or arrangement required to be filed
as an exhibit to this annual report on Form 10-K.