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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


FORM 10-K

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

For the Fiscal Year Ended December 31, 2001

OR

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|----- |  | ----------------------------------------------------------------------------------------
|(BOX) |  | 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)


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|Washington                               |  | 91-1513032         
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|(State or other jurisdiction of          |  | (I.R.S. Employer   
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|incorporation or organization)           |  | Identification No.)
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|2981 Route 22                            |  |                    
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|Patterson, New York                      |  | 12563-2335         
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|(Address of principal Executive Offices) |  | (Zip Code)         

Registrants telephone number, including area code: (845) 878-3414

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

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|------------------- |  | -----------------------------------------
|Title of each class |  | Name of each exchange of which registered
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|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 (XBOX) |  | No (BOX)

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. (XBOX)

The aggregate market value of the Registrants Common Stock held by
non-affiliates as of March 22, 2002 was approximately $295 million based on the
closing price of $19.11 per share. The number of shares of the Registrants
Common Stock (the Registrants only outstanding class of stock) outstanding as
of March 22, 2002 was 15,450,852.

DOCUMENTS INCORPORATED BY REFERENCE

The Registrants definitive Proxy Statement relating to the 2002 Annual Meeting
of Shareholders to be held on June 5, 2002 is incorporated by reference into
Part III of this Form 10-K.





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TABLE OF CONTENTS



|                                                                                                        |                                                                                                        |  |  |  |  |  |  | 
|------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------ |  |  |  |  |  |  | 
|PART I                                                                                                 
|                                                                                                        | ITEM 1: BUSINESS                                                                                      
|                                                                                                        | ITEM 2: PROPERTIES                                                                                    
|                                                                                                        | ITEM 3: LEGAL PROCEEDINGS                                                                             
|                                                                                                        | ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                           
|PART II                                                                                                
|                                                                                                        | ITEM 5: MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANTS COMMON STOCK AND RELATED SHAREHOLDER MATTERS
|                                                                                                        | ITEM 6: SELECTED FINANCIAL DATA                                                                       
|                                                                                                        | ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS         
|                                                                                                        | ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                   
|                                                                                                        | ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                   
|                                                                                                        | ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE          
|PART III                                                                                               
|                                                                                                        | ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                           
|                                                                                                        | ITEM 11: EXECUTIVE COMPENSATION                                                                       
|                                                                                                        | ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                               
|                                                                                                        | ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                               
|PART IV                                                                                                
|                                                                                                        | ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K                             
|SIGNATURES                                                                                             
|REPORT OF INDEPENDENT AUDITORS                                                                         
|PENWEST PHARMACEUTICALS CO. CONSOLIDATED BALANCE SHEETS (in thousands, except share amounts)           
|PENWEST PHARMACEUTICALS CO. CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data)
|PENWEST PHARMACEUTICALS CO. CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY (in thousands)             
|PENWEST PHARMACEUTICALS CO. CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)                       
|PENWEST PHARMACEUTICALS CO. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                 
|INDEX TO EXHIBITS                                                                                      
|EX-23 Consent of Ernst & Young                                                                         
|EX-24 Power of Attorney                                                                                



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PART I




ITEM 1: BUSINESS

GENERAL

Penwest Pharmaceuticals Co. (Penwest or the Company) is engaged in the
research, development and commercialization of novel drug delivery
technologies. The Company is also a leader in the development, manufacture,
and distribution of branded pharmaceutical excipients which are the inactive
ingredients in tablets and capsules. Based on its fundamental expertise in
tabletting ingredients, the Company has developed its proprietary TIMERx®
controlled release drug delivery technology, which is applicable to a broad
range of orally administered drugs, and ProSolv®, a high functional excipient
based on co-processing technology, which, among other things, improves the
performance characteristics of tablets. The Company is also exploring and
developing other drug delivery technologies. The Company had revenues in 2001,
2000, and 1999 of $40.0, $42.1, and $37.3 million, respectively.

TIMERX CONTROLLED RELEASE TECHNOLOGY

The Company has developed its TIMERx delivery system to address the
limitations of currently available oral controlled release delivery systems.
The Company believes that the TIMERx system has advantages over other oral drug
delivery technology as it is readily manufactured and is applicable to a wide
variety of drug classes, including soluble drugs, insoluble drugs and drugs
with a narrow therapeutic index. Pharmaceutical products containing TIMERx
have been approved and are being marketed and the Company is developing
products in its pipeline.

The
patented 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.

To date, several drug formulations utilizing the TIMERx system have
received regulatory approval and are being marketed:



| |  |  | Cystrin CR, a controlled release version of oxybutynin for the
treatment of urge urinary incontinence, was approved in Finland in 1997
and is being marketed in Finland by Leiras OY (Leiras);                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Slofedipine XL, a controlled release version of nifedipine for the
treatment of angina, was approved in the United Kingdom in 1998 and is
being marketed in the United Kingdom by Sanofi-Synthelabo S.A. (Sanofi);                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| |  |  | The 30 mg strength of
Nifedipine XL, a generic
version of Procardia XL that is used for the treatment of hypertension
and angina, was approved by the FDA in December 1999. The 30 mg strength
of Nifedipine XL is not being marketed in the United States by the
Company's collaborator Mylan Pharmaceuticals, Inc.
(Mylan). In March 2000,
Mylan signed a supply and distribution agreement
with Pfizer, Inc. to market a generic version of all three strengths (30
mg, 60 mg, 90 mg) of Pfizers Procardia XL. As a result of the
agreement, Pfizer agreed to dismiss all pending litigation against
Mylan. In connection with that agreement, Mylan agreed to pay Penwest a
royalty on net sales of Pfizers 30 mg strength of generic Procardia XL.
The royalties are comparable to those called for in Penwests original
agreement with Mylan for Nifedipine XL, which Mylan is not marketing.
Mylan has retained the marketing rights to the 30 mg strength of
Nifedipine XL; and
|
| |  |  | Cronodipin, a controlled release version of nifedipine for the
treatment of angina, was approved in Brazil in 2001 and will be marketed
in Brazil by Merck S.A. Industries Quimicas (Merck) or
(E. Merck) in 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

The Company also has a strategic alliance with Endo Pharmaceuticals, Inc.
(Endo) to jointly develop an extended release oral version of oxymorphone
which is the most advanced product in the Companys drug
development pipeline. Endo is currently conducting
the final Phase II and Phase III trials of the product,

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which are expected to be completed in the second quarter of 2002.
Assuming that the results of the trial are consistent with the
results from previous
trials, the Company expects Endo to submit a new drug application
(NDA) for the product in the second
half of 2002. The Company and Endo have agreed to share the costs involved in
the development and commercialization of this product, and share in the net
profits from the sale of this product once it is marketed.

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 700 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.                                                                                    

EXCIPIENTS

The Company is an established leader in the development, production and
distribution of branded pharmaceutical excipients, which are the inactive
components included in tablets and capsules. Over the past 50 years, the
Company has consistently been innovative and has delivered novel products such
as Emcompress®, Explotab® and ProSolv® to the pharmaceutical industry. Each of
the excipient products carries significant brand value, representing quality,
service and performance. The Company sells 31 excipient products, which are
used in the formulation and manufacture of tablets by pharmaceutical and
nutritional companies worldwide. The excipients product line is
broadly classified into three categories: binders, disintegrants and
lubricants.

These products are sold to the branded prescription, generic prescription,
over-the-counter and nutritional supplement markets. In 2001, bulk excipients
were sold to more than 250 customers in more than forty countries worldwide,
including some of the leading pharmaceutical companies in the world.

PROSOLV®

Prosolv, a high-functionality binder for tablets, is a patented
combination of microcrystalline cellulose and colloidal silicon dioxide. These
two ingredients work together synergistically for optimal tabletting
performance. The Company has developed three products from this technology
platform: ProSolv SMCC® 50, ProSolv SMCC® 90, and ProSolv HD® as well as
customized grades of ProSolv. ProSolv SMCC® 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, it can be used to manufacture tablets with difficult active
ingredients which otherwise may not have been manufactured. ProSolv HD improves
flow and compaction, and can increase throughput by increasing production
speeds. Custom grades of ProSolv are designed to address specific formulation
or manufacturing problems. The Company is seeking to exclusively
license these custom grades to
pharmaceutical and nutritional partners.

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PENWEST STRATEGY

The Companys strategy is to develop pharmaceutical products, utilizing
the Companys drug delivery technologies, and generally to out-license these products to a
marketing partner.

Leverage the TIMERx technology through the following:



| |  |  | Create Innovative Branded Controlled Release Versions of Immediate
Release Pharmaceuticals  The Company is 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 will either complete the drug development
itself, or in some cases will seek to develop products in
collaboration with pharmaceutical companies having a market presence
in the applicable therapeutic area. Generally, the Company will
seek to out-license the product at varying stages to a corporate
collaborator for manufacturing and marketing. The development of these
controlled release drugs is subject to the 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 Branded Controlled
Release Pharmaceuticals  The Company also applies its TIMERx
technology to the development of select generic versions of branded
controlled release 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 may be difficult to replicate
and, as a result, TIMERx versions may have limited competition from
other formulations.                                                                                                                                                                                                                                                                                                                                                                                                                          

Establish Collaborations for Development, Manufacture and Marketing

The Company maintains a portfolio of drug candidates utilizing the TIMERx
technology in which it will either complete the development work itself, or in
some cases will selectively look for development partners. At varying stages
during the clinical development program, the Company will seek a partner for
the manufacturing and marketing of the drug. The Companys principal
collaborative agreements are with Mylan, Endo, Sanofi and Leiras.

The Company is seeking to enter into additional collaborations for TIMERx.
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.

TIMERx PRODUCTS

The following table provides information by therapeutic area, development
status and collaborator for each of the principal products being marketed or
under development utilizing the Companys TIMERx technology. The Company is
also conducting development activities by itself or with collaborators on
various additional controlled release formulations.

|                                  |  |                           |  |                              |  |             
|--------------------------------- |  | ------------------------- |  | ---------------------------- |  | ------------
|BRAND NAME                        |  | THERAPEUTIC               |  | DEVELOPMENT                  |  |             
|(COMPOUND)                        |  | AREA                      |  | STATUS (1)                   |  | COLLABORATOR
|                                  |  |                           |  |                              |  |             
|BRANDED CONTROLLED RELEASE (2)    |  |                           |  |                              |  |             
|                                 
|                                 
|                                 
|                                 
|Cystrin CR
(oxybutynin)           |  | Urge Urinary
Incontinence |  | Approved
and Marketed (3)    |  | Leiras      
|                                 
|                                 
|                                 
|                                 
|                                  |  |                           |  |                              |  |             
|                                 
|                                 
|                                 
|                                 
|Oxymorphone ER                    |  | Moderate to Severe Pain   |  | Phase II/III Clinical Trials |  | Endo        
|                                 
|                                 
|                                 
|                                 
|                                  |  |                           |  |                              |  |             
|                                 
|                                 
|                                 
|                                 
|GENERIC CONTROLLED RELEASE (4)    |  |                           |  |                              |  |             
|                                 
|                                 
|                                 
|                                 
|                                  |  |                           |  |                              |  |             
|                                 
|                                 
|                                 
|                                 
|Procardia XL (30 mg)
(nifedipine) |  | Hypertension,
Angina      |  | Approved (5)                 |  | Mylan       
|                                 
|                                 
|                                 
|                                 
|                                  |  |                           |  |                              |  |             
|                                 
|                                 
|                                 
|                                 
|Slofedipine XL
(nifedipine)       |  | Hypertension,
Angina      |  | Approved
and Marketed (6)    |  | Sanofi      
|                                 
|                                 
|                                 
|                                 
|                                  |  |                           |  |                              |  |             
|                                 
|                                 
|                                 
|                                 
|Cronodipin
(nifedipine)           |  | Hypertension,
Angina      |  | Approved (7)                 |  | E. Merck    

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|(1) |  | 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 Finland in January 1998.                                                                                                                                                                                                                                                                
|   
|(4) |  | Generic versions of controlled release products are developed in three
basic stages:                                                                                                                                                                                                                                                                                                                    
|   

| |  | 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 abbreviated
new drug application (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 received marketing
approval for Nifedipine XL in December 1999.
Mylan is not marketing the product.                                          
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(6) |  | Sanofi received marketing approval for, and began marketing, Slofedipine
XL in the United Kingdom in November 1998.                                
|   
|(7) |  | Merck received marketing approval in Brazil for Cronodipin in September
2001 and intends to market the product in Brazil in the first half of
2002.

Branded Controlled Release Pharmaceuticals

The Company applies 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® 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, a once-a-day version of Cystrin,
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.

OXYMORPHONE
ER. The Company and Endo are currently developing an extended
release formulation of oxymorphone incorporating TIMERx technology.
Oxymorphone is a narcotic analgesic for the treatment of moderate to severe
pain which is currently given in the parenteral and suppository dosage form.
Oxymorphone is marketed by Endo and had sales in the United States in 2001 of
approximately $250,000. Extended release Oxymorphone ER, if successfully
developed, would represent the first oral extended

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release version of oxymorphone and would compete in the severe analgesic
market with products such as MS Contin and OxyContin, which had aggregate sales
in the United States in 2001 of approximately $1.6 billion. The extended
release version is being developed for twice-a-day dosing in patients suffering
moderate to severe pain. In 2000, Endo completed a randomized, double-blind,
placebo-controlled pivotal trial in approximately 400 evaluable patients with
chronic pain resulting from osteoarthritis. The results of the study
demonstrated a statistically significant reduction in pain intensity compared
to placebo (p=0.0047). In 2001, Endo conducted a randomized, double-blind,
placebo-controlled pivotal trial in approximately 127 patients with acute
post-surgical pain. The results of the study demonstrated a statistically
significant reduction in pain intensity compared to placebo (p-0.0057). Endo
is currently completing the remaining clinical trials, which are scheduled to
be completed in the second quarter of 2002. Assuming the trial
results from this Phase III trial are consistent with the results
from previoues trials, the Company expects that Endo will
submit the NDA for this product in the second half of 2002.

The Company has also identified four compounds, primarily in the treatment of
pain and the central nervous system, that it is currently formulating. The formulation of these
compounds typically takes six to nine months and at that point a decision will
be made whether to advance these into clinical development.

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 are as
follows:

NIFEDIPINE XL. The Company and Mylan developed Nifedipine XL as the first
generic equivalent to the 30 mg strength of Procardia XL. 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 total sales in the United States in 2001 of approximately
$163.2 million.

In December 1999, Mylans ANDA for Nifedipine XL (30 mg) was approved by
the FDA. Mylans ANDA was the first ANDA for a generic version of Procardia XL
filed with the FDA for the 30 mg strength. In March 2000, Mylan signed a supply and distribution agreement with Pfizer to market
a generic version of all three strengths (30 mg, 60 mg, 90 mg) of
Pfizers Procardia XL. In connection with that agreement, Mylan decided not to
market Nifedipine XL and agreed to pay Penwest a royalty on all future net
sales of the 30 mg strength of Pfizers generic Procardia XL. The royalty
percentage was comparable to the percentage called for in Penwests original
agreement with Mylan for Nifedipine XL. Mylans sales in the United States in
2001 of the 30 mg dosage strength version of Pfizers generic Procardia XL
totaled approximately $48.2 million. The term of the royalty agreement continues
until such time as Mylan permanently ceases to market generic
Procardia XL. Mylan has retained the
marketing rights to the 30 mg strenth of Nifedipine XL.

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® (a drug marketed in Europe by Bayer) that
uses 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 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 United Kingdom in 2001 of approximately
$60 million. Sanofi has also received marketing approval in Italy for this
product.

CRONODIPIN.
The Company and E. Merck received approval in Brazil in September 2001 for Cronodipin, a
generic version of Adalat LA® (a drug marketed by Bayer) that
uses TIMERx
technology. The Company anticipates that E. Merck will begin marketing this
product in Brazil in the first half of 2002.

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PHARMACEUTICAL EXCIPIENTS

The Company sells 31 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
help 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 2001, the Company sold bulk excipients to more than
250 customers, including some of the leading pharmaceutical companies in the
world, in more than 40 countries.

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

PROSOLV SMCC® was introduced in late 1996 and the Company sells it both in
bulk and through licensing arrangements under which the Company offers exclusivity. The
Company believes that Prosolv SMCC offers numerous advantages over traditional
microcrystalline cellulose such as enhanced drug loading capability, production
of elegant, robust tablets, and has excellent disintegration properties.

PROSOLV
HDTM was introduced in late 1999 and provides superior flow
without losing compactibility in the manufacturing process. The addition of
ProSolv HD in some formulations can increase throughput and capacity in a
production line.

EMCOCEL®, 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®, or dicalcium phosphate, is a binder marketed by the Company
under an exclusive worldwide distribution agreement with the manufacturer
Rhodia. The distribution agreement is subject to automatic extension on an
annual basis unless either party gives the other party 12 months notice of its
desire to terminate the agreement. EMCOMPRESS is frequently used in vitamin
formulations as it serves as an additional source of dietary calcium.

EMDEX® AND CANDEX®, or dextrates, are binders that are used as directly
compressible excipients in both chewable and non-chewable tablets. They are
odorless with a sweet taste caused by its sugar composition. EMDEX and CANDEX
are used in, among other things, chewable antacid tablets and vitamins.

EXPLOTAB®, 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®, or sodium stearyl fumarate, is the principal lubricant marketed by
the Company. PRUV is marketed under an exclusive worldwide distribution
agreement with Astra-Zeneca. PRUV is used in several prescription
pharmaceuticals.

The Company had revenues from the sale of pharmaceutical excipients and
formulated bulk TIMERx in 2001, 2000, and 1999 of $34.8 million, $37.1 million, and
$36.8 million, respectively.

COLLABORATIVE ARRANGEMENTS

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

The Company has two primary types of collaborative agreements. In the
first type, research and development are funded by Penwest and its
collaborator and Penwest receives no up-front licensing fees or milestone
payments. In these arrangements, the Company will share in a pre-determined
percentage of the royalties. The second type of agreement involves the straight
licensing of the Companys technology to the collaborator. The Company has no
obligation to fund research and development. Under these collaborative
agreements, the Company receives up-front license fees and milestone payments.
In addition, under all its current

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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. The Companys
principal collaborative arrangements are described below.

MYLAN PHARMACEUTICALS, INC.

In August 1994, the Company entered into product development and supply
agreements with Mylan with respect to the development of generic versions of
Procardia XL (nifedipine) based on the Companys TIMERx technologies. Mylan is
one of the leading generic pharmaceutical companies in the United States.

On March 2, 2000, Mylan announced that it had signed a supply and
distribution agreement with Pfizer to market a generic version of all three
strengths (30 mg, 60 mg, 90 mg) of Pfizers Procardia XL. In connection with
that agreement, Mylan decided not to market Nifedipine XL and agreed to pay
Penwest a royalty on all future net sales of the 30 mg strength of Pfizers
generic Procardia XL. The royalty percentage was comparable to the percentage
called for in Penwests original agreement with Mylan for
Nifedipine XL. Mylan has retained the marketing rights for the 30 mg
strength of Nifedipine XL. Mylans sales in the United States in 2001 of the 30 mg dosage strength version
of Pfizers generic Procardia XL totaled approximately $48.2 million. The term
of this agreement continues until such time as Mylan permanently ceases to
market generic Procardia XL. In 2001 and 2000, Mylan accounted for approximately 12% and 19%, respectively, of the Companys
total revenue.

SANOFI-SYNTHELABO

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

Under the product development and supply agreement, the Company was
responsible for conducting pilot bioequivalence studies of the Sanofi Product
and is responsible for manufacturing and supplying TIMERx material to Sanofi. Sanofi was
responsible for conducting all full scale bioequivalence and clinical studies,
preparing all regulatory applications and submissions and is
responsible for manufacturing and
marketing the Sanofi Product in specified countries in Europe and in South
Korea. The Sanofi Product was approved and Sanofi began marketing
the Sanofi Product in the United
Kingdom in November 1998. Sanofi also received regulatory approval in
Italy in 2000, but is not marketing the Sanofi Product.

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 received milestone payments under the product development and
supply agreement. The Company is receiving royalties upon the sale of the
Sanofi Product. One-half of such payments will be paid to Mylan in accordance
with a distribution agreement signed with Mylan. In addition, Sanofi has agreed
that, during the term of the product development and supply agreement, it will
purchase, and Sanofi is purchasing, 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. In addition, during 2001,
the Company reacquired the North American marketing rights to this product.

Under the agreements, the Company was responsible for the development and
formulation of Cystrin CR and is now responsible for  supplying TIMERx material
to Leiras for use in the manufacture of Cystrin CR. Leiras is responsible
for preparing all regulatory

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applications and submissions and manufacturing and marketing Cystrin CR on
a worldwide basis, except for the marketing rights in North America which have
been licensed back to Penwest. 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. Leiras transferred the European rights to Sanofi who is
currently not marketing the product. Leiras received marketing approval for Cystrin CR in Finland in October 1997 and began marketing the product in Finland in 1998.

The agreements terminate upon the expiration of the TIMERx patents
licensed to Leiras (which will occur in 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 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 an extended release formulation of
oxymorphone based on the Companys TIMERx technology (the Endo Product). Endo
is a fully integrated specialty pharmaceutical company with a market leadership
in pain management. Endo has a broad product line including 12 branded products
that include the established brands such as 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 the Endo Product are determined by a committee
comprised of an equal number of members from each of the Company and Endo (the
Alliance Committee). However, the Company formulated the Endo Product and
Endo is conducting all clinical studies and will prepare and file all
regulatory applications and submissions. The Company has agreed to manufacture
and supply TIMERx material to Endo, and Endo has agreed to manufacture and
market the Endo Product in the United States. The manufacture and marketing of
the Endo Product 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 may be terminated upon a material breach of
the agreement by a party.

The Company and Endo share the costs involved in the development and
commercialization of the Endo Product and have agreed that the party marketing
the Endo Product will pay the other
party royalties initially equal to 50% of net profits (as defined in the
agreement). This percentage will decrease if the total U.S. net profits exceed
pre-determined thresholds. This cost-sharing is subject to each partys right to terminate its participation in the funding of development and commercialization of the Endo Product.
In general, the royalty payable by the marketing party to the other party
will not drop below 40%; however, a one-third royalty reduction provision does
apply in limited circumstances, including material breaches of the agreement by
the royalty receiving party and certain bankruptcy and insolvency events
involving the royalty receiving party. Endo will purchase formulated TIMERx material for
use in the Endo Product exclusively from the Company at specified prices. Such
prices will be reflected in the determination of net profits.

RESEARCH AND DEVELOPMENT

The Company conducts research and
development activities with respect to
additional applications of TIMERx technology, advances in the TIMERx
technology, for additional drug delivery technologies and additional novel excipients such
as Prosolv. The Companys research and development expenses in 2001, 2000, and
1999 were $17.0 million, $12.8 million, and $7.4 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 or clinical trials
performed by the collaborators.

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MANUFACTURING

The Company currently has a laboratory and pilot manufacturing facility
contiguous to its
executive offices in Patterson, New York. The pilot manufacturing
facility is currently used to produce one of the excipients sold by
the Company. 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, the Company has
contracted with a third-party pharmaceutical company, Draxis
Pharmaceuticals, Inc. (Draxis), for the bulk manufacture of its TIMERx
material for delivery to its collaborators under an agreement that expires in
September 2004.

The Company believes that there are a limited number of manufacturers that
operate under cGMP regulations capable of manufacturing the Companys products.
There can be no assurance that Draxis or any other 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.

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 operates two cGMP-approved manufacturing facilities
for its microcrystalline cellulose (MCC) products, 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. The Company obtains wood pulp primarily from two
suppliers, however, wood pulp is widely available from a number of suppliers.

The Company has several key excipient products that are manufactured
exclusively by a third-party supplier for Penwest:

|                   |  |                      
|------------------ |  | ---------------------
|Product            |  | Contract Manufacturer
|                   |  |                      
|Emcompress®        |  | Rhodia, SA           
|                  
|                  
|                  
|                  
|Emdex® and Candex® |  | Penford Products Co. 
|                  
|                  
|                  
|                  
|Explotab®          |  | Roquette, Inc.       
|                  
|                  
|                  
|                  
|Pruv®              |  | AstraZeneca plc      

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, or are expected to 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 currently market any such pharmaceuticals without a collaborator, the Company has not
developed 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 eleven employees who market the
Companys excipient products in the United States and in Europe. This sales
force focuses primarily on pharmaceutical and nutritional companies. The
Company also markets excipients

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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 27 U.S. and 139 foreign patents, relating to
the Companys controlled release drug delivery technology. The U.S. patents
issued to the Company 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 will expire between 2008 and 2018. The Company also has been issued an
additional 15 U.S. patents and 30 foreign patents covering its ProSolv
technology. These patents will expire between 2010 and 2019.

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 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. Some 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. The Companys collaborators are
responsible for all legal costs under Waxman-Hatch lawsuits. 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, whether or not the Company is successful could have a material
adverse effect on the Companys business, financial condition and results of
operations.

TIMERx, Emcocel, Multicel-N, Celpac, ProSolv, Explotab, Emdex, Emdex Plus,
Emcompress, Compactrol, Emcosoy, Lubritab, 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

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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 Investigational
New Drug Application (INDA), 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.

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 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 applications 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

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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.

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.

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 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

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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. 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 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

14



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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 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 Johnson & Johnsons 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 or under development by Andrx Corporation, among others.

A number of the products that the Company has developed or is working on are generic
versions of branded 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, and the fact
that 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.

The Company is also focusing its business development efforts and research
and development projects on controlled release versions of existing immediate
release drugs. These drugs will face competition from products with the same
indication as the product developed by Penwest. For instance, the Company
expects that Oxymorphone ER will face competition from Purdue Pharmas
OxyContin®.

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 competitors in this market are FMC Corporation,
which markets its own line of MCC excipient products, and J. Rettenmaier &
Sohne GmbH, which also competes with the Companys MCC and sodium starch
glycolate products.

EMPLOYEES

As of December 31, 2001, the Company employed 148 persons, of which 84
were involved in research and development, administration and sales and
marketing activities in Patterson, New York; 23 were involved in manufacturing
operations at the Companys facility in Nastola, Finland; 30 were involved in
manufacturing operations at the Companys facility in Cedar Rapids, Iowa; and
11 were involved in sales activities in the Companys European sales offices.

None of the Companys employees are covered by collective bargaining
agreements other than the Companys employees in Finland who are covered by a
national collective bargaining agreement. The Company considers its employee
relations to be good.

15



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##### Table of Contents






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. The Company is currently exploring options to
add additional laboratory space.




ITEM 3: LEGAL PROCEEDINGS

None.




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 2001.

ITEM 4a: EXECUTIVE OFFICERS OF THE REGISTRANT

|                         |  |     |    |       |  |                                                                                                         |  |                             
|------------------------ |  | --- | -- | ----- |  | ------------------------------------------------------------------------------------------------------- |  | ----------------------------
|NAME                     |  | AGE |    | TITLE |  | DATES                                                                                                  
|                         |  |     |    |       |  |                                                                                                        
|Tod R. Hamachek          |  |     | 56 |       |  | Chairman of the Board and Chief
Executive Officer
President
and Chief Executive
Officer  Penford Corp. |  | 1997  current
 
1985  1997
|                        
|                        
|                        
|                        
|Anand R. Baichwal, Ph.D. |  |     | 47 |       |  | Senior Vice President, Research &
New Technology
Development and Chief Scientific Officer               |  | 1997  current
 
1994  1997
|                        
|                        
|                        
|                        
|Stephen J. Berte, Jr.    |  |     | 46 |       |  | General Manager, Excipients Business
Vice
President, Global Sales                                       |  | 2000  current
 
1995  2000
|                        
|                        
|                        
|                        
|Jennifer L. Good         |  |     | 37 |       |  | Senior Vice President, Finance and
Chief Financial Officer
Corporate Controller  Penford Corp.         |  | 1997  current
 
1993  1997

16



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##### Table of Contents






PART II




ITEM 5: MARKET PRICE OF AND DIVIDENDS ON 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. The high and low closing prices
of the Companys common stock during 2001 and 2000 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.

|                           |  |      |       |     |  |   |       | 
|-------------------------- |  | ---- | ----- | --- |  | - | ----- | 
|PERIOD 2001                |  | HIGH |       | LOW
|                           |  |      |       |    
|Quarter Ended March 31     |  | $    | 14.63 |     |  | $ | 9.81  | 
|                          
|                          
|                          
|                          
|Quarter Ended June 30      |  | $    | 16.05 |     |  | $ | 11.06 | 
|                          
|                          
|                          
|                          
|Quarter Ended September 30 |  | $    | 20.30 |     |  | $ | 14.20 | 
|                          
|                          
|                          
|                          
|Quarter Ended December 31  |  | $    | 20.19 |     |  | $ | 15.00 | 

|                           |  |      |       |     |  |   |       | 
|-------------------------- |  | ---- | ----- | --- |  | - | ----- | 
|PERIOD 2000                |  | HIGH |       | LOW
|                           |  |      |       |    
|Quarter Ended March 31     |  | $    | 19.50 |     |  | $ | 12.25 | 
|                          
|                          
|                          
|                          
|Quarter Ended June 30      |  | $    | 13.63 |     |  | $ | 8.75  | 
|                          
|                          
|                          
|                          
|Quarter Ended September 30 |  | $    | 13.25 |     |  | $ | 8.63  | 
|                          
|                          
|                          
|                          
|Quarter Ended December 31  |  | $    | 12.94 |     |  | $ | 8.13  | 

On March 22, 2002 there were 861 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 existing credit facility with the CIT Group/Business
Credit, Inc.




ITEM 6: SELECTED FINANCIAL DATA

The following selected financial data are derived from the consolidated
financial statements of Penwest Pharmaceuticals Co., which have been audited by
Ernst & Young LLP, independent auditors. The data should be read in
conjunction with the consolidated financial statements, related notes, and
other financial information included herein.

|                                                                                            |  |                                          |         |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ------- | ---- |  | ---- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | - |  | - | ------ | -
|                                                                                            |  | YEAR ENDED DECEMBER 31,                 
|                                                                                            |  |                                         
|                                                                                            |  | 2001                                     |         | 2000 |  | 1999 |        | 1998 |  | 1997
|                                                                                            |  |                                          |         |      |  |      |        |      |  |     
|STATEMENT OF OPERATIONS DATA:                                                               |  | (IN THOUSANDS EXCEPT FOR PER SHARE DATA)
|Revenues (a)                                                                                |  | $                                        | 40,003  |      |  | $    | 42,058 |      |  | $    | 37,307 |   |  | $ | 29,149 |   |  | $ | 26,999 |  
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Cost of product sales (a)                                                                   |  |                                          | 24,810  |      |  |      | 25,303 |      |  |      | 25,889 |   |  |   | 21,183 |   |  |   | 20,415 |  
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Gross profit                                                                                |  |                                          | 15,193  |      |  |      | 16,755 |      |  |      | 11,418 |   |  |   | 7,966  |   |  |   | 6,584  |  
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Selling, general and administrative                                                         |  |                                          | 13,855  |      |  |      | 12,054 |      |  |      | 11,425 |   |  |   | 11,354 |   |  |   | 8,708  |  
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Research and product development                                                            |  |                                          | 17,003  |      |  |      | 12,820 |      |  |      | 7,371  |   |  |   | 6,054  |   |  |   | 3,681  |  
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Asset write-off (b)                                                                         |  |                                          |        |      |  |      |       |      |  |      |       |   |  |   | 1,341  |   |  |   |       |  
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|IPO transaction costs (c)                                                                   |  |                                          |        |      |  |      |       |      |  |      |       |   |  |   |       |   |  |   | 1,367  |  
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Loss before cumulative effect of
change in accounting principle                             |  |                                          | (15,981 | )    |  |      | (8,376 | )    |  |      | (7,681 | ) |  |   | (8,829 | ) |  |   | (7,316 | )
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Cumulative effect of change in
accounting principle (d)                                     |  |                                          |        |      |  |      | (410   | )    |  |      |       |   |  |   |       |   |  |   |       |  
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Net loss                                                                                    |  | $                                        | (15,981 | )    |  | $    | (8,786 | )    |  | $    | (7,681 | ) |  | $ | (8,829 | ) |  | $ | (7,316 | )
|                                                                                            |  |                                          |         |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |        |  
|                                                                                            |  |                                          |         |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |        |  
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Basic and diluted loss per share
before cumulative effect of change
in accounting principle |  | $                                        | (1.15   | )    |  | $    | (0.68  | )    |  | $    | (0.69  | ) |  | $ | (0.80  | ) |  | $ | (0.66  | )
|                                                                                           
|                                                                                           
|                                                                                           
|                                                                                           
|Cumulative effect of change in
accounting principle per share                               |  |                                          |        |      |  |      | (0.03  | )    |  |      |       |   |  |   |       |   |  |   |       |  
|                                                                                            |  |                                          |         |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |        |  
|Net loss per share                                                                          |  | $                                        | (1.15   | )    |  | $    | (0.71  | )    |  | $    | (0.69  | ) |  | $ | (0.80  | ) |  | $ | (0.66  | )
|                                                                                            |  |                                          |         |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |        |  
|Weighted average shares of
common stock outstanding                                         |  |                                          | 13,905  |      |  |      | 12,330 |      |  |      | 11,103 |   |  |   | 11,037 |   |  |   | 11,037 |  
|                                                                                            |  |                                          |         |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   |        |  

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|                               |  |                |         |      |  |      |         |          |  |      |         |   |  |   |         |   |  |   |         |  
|------------------------------ |  | -------------- | ------- | ---- |  | ---- | ------- | -------- |  | ---- | ------- | - |  | - | ------- | - |  | - | ------- | -
|                               |  | DECEMBER 31,  
|                               |  |               
|                               |  | 2001           |         | 2000 |  | 1999 |         | 1998 (e) |  | 1997
|                               |  |                |         |      |  |      |         |          |  |     
|BALANCE SHEET DATA:            |  | (IN THOUSANDS)
|Cash and cash equivalents      |  | $              | 12,903  |      |  | $    | 2,204   |          |  | $    | 739     |   |  | $ | 1,476   |   |  | $ | 938     |  
|                              
|                              
|                              
|                              
|Marketable
securities          |  |                | 9,609   |      |  |      |        |          |  |      |        |   |  |   |        |   |  |   |        |  
|                              
|                              
|                              
|                              
|Working capital                |  |                | 27,059  |      |  |      | 11,129  |          |  |      | 7,713   |   |  |   | 7,648   |   |  |   | (33,049 | )
|                              
|                              
|                              
|                              
|Total assets                   |  |                | 59,613  |      |  |      | 42,294  |          |  |      | 38,120  |   |  |   | 41,082  |   |  |   | 37,820  |  
|                              
|                              
|                              
|                              
|Long-term debt                 |  |                |        |      |  |      |        |          |  |      | 6,700   |   |  |   |        |   |  |   |        |  
|                              
|                              
|                              
|                              
|Accumulated deficit            |  |                | (60,926 | )    |  |      | (44,945 | )        |  |      | (36,159 | ) |  |   | (28,478 | ) |  |   | (19,649 | )
|                              
|                              
|                              
|                              
|Shareholders equity (deficit) |  |                | 45,624  |      |  |      | 31,017  |          |  |      | 22,509  |   |  |   | 30,032  |   |  |   | (12,297 | )



|(a) |  | Reclassification recorded of amounts prior to 2000 for the adoption of
EITF No. 00-10 Accounting for Shipping and Handling Fees and Costs.                                                                                                                                                                                                                    
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(b) |  | Represents 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.                                                                                                                                                                                      
|   
|(c) |  | Represents a write-off of transaction costs associated with an abandoned
initial public offering.                                                                                                                                                                                                                                                               
|   
|(d) |  | Cumulative effect of adopting Staff Accounting Bulletin No. 101 (SAB
No. 101).                                                                                                                                                                                                                                                                                
|   
|(e) |  | In conjunction with the August 31, 1998 distribution, in which the
Companys former parent, Penford Corporation, 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), Penford
contributed to the Companys capital, all existing intercompany
indebtedness.




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 is engaged in the
research, development and commercialization of novel drug delivery
technologies. The Company is also a leader in the development, manufacture,
and distribution of branded pharmaceutical excipients which are the inactive
ingredients in tablets and capsules. Based on its fundamental expertise in
tabletting ingredients, the Company has developed its proprietary TIMERx®
controlled release drug delivery technology, which is applicable to a broad
range of orally administered drugs, and ProSolv® a high functional excipient
based on co-processing technology, which, among other things, improves the
performance characteristics of tablets. The Company is also exploring and
developing other drug delivery technologies. The Company had revenues in 2001,
2000, and 1999 of $40.0, $42.1, and $37.3 million, respectively.

The Company has incurred net losses since 1994. As of December 31, 2001,
the Companys accumulated deficit was approximately $60.9 million. Management
expects operating losses and negative cash flows during 2002 and 2003. 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, including in
particular Oxymorphone ER, royalties from Mylans sales of Pfizers 30 mg generic version of Procardia XL, sales
growth of the Companys pharmaceutical excipients products, as well as the
level of investment in research and development activities. The Companys
strategy includes a significant commitment to spending on research and
development targeted at identifying and developing extended release products
which will be formulated using the Companys drug delivery technologies. The
Company also expects to expend significant resources on the
development of new drug delivery technologies, both
internally and through in-licenses or
acquisition. The Company's spending in this area, however, is discretionary and is dependent on identifying good
opportunities and the availability of funds from the Companys operations, cash
resources, collaborative research and development arrangements, as well as
external financing. 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.

On March 2, 2000, Mylan announced that it had signed a supply and
distribution agreement with Pfizer to market a generic version of all three
strengths (30 mg, 60 mg, 90 mg) of Pfizers Procardia XL. As a result of the
agreement, Pfizer agreed to dismiss all pending

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litigation against Mylan. In connection with that agreement, Mylan agreed
to pay Penwest a royalty on all future net sales of Pfizers 30 mg strength of
generic Procardia XL, which Mylan launched at the end of March 2000. The
royalty percentage is comparable to those called for in Penwests original
agreement with Mylan for Nifedipine XL, the TIMERx-based generic equivalent to
Procardia XL. Mylan has retained the marketing rights to the 30 mg strength of
Nifedipine XL.

The Companys collaborative agreements include licensing arrangements in
which 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, as well as licensing arrangements
which include revenue and cost sharing components in which the Company shares
in the costs and profitability in predetermined percentages, but does not
generally receive milestone payments. 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 business is conducted internationally and may be affected by
fluctuations in currency exchange rates, as well as by governmental controls
and other risks associated with international sales (such as export licenses,
collectibility of accounts receivable, trade restrictions, and changes in
tariffs). 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.

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, royalties on Mylans sales of the 30 mg strength of generic Procardia XL, and on
variations in 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.

19



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##### Table of Contents



CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The consolidated financial statements of the Company are prepared in
accordance with accounting principles generally accepted in the United States,
which requires us to make estimates and assumptions. The Companys significant
accounting policies are more fully described in the notes to the consolidated
financial statements. These policies are important to the portrayal of the
Companys financial condition and results of operations. Application of these
policies requires the Company to make significant judgments and estimates about matters that are inherently uncertain.

The following accounting policies meet these characteristics and are
considered most significant:

REVENUE RECOGNITION

Revenues from product sales are recognized when title transfers and
customer acceptance provisions have lapsed, provided collections of the related
accounts receivable are probable. Revenue received from non-refundable upfront
licensing fees are recognized ratably over the development period of the
collaboration agreement, when this period involves development risk associated
with the incomplete stage of a products development or over the estimated or
contractual licensing and supply term when the Company is obligated to supply
inventory for manufacture after the development risk has substantially ended.
Non-refundable milestone fees received for the development funding of a product
are partially recognized upon receipt based on the Companys proportionate
development efforts achieved to date relative to the total expected development
efforts and the remainder is generally recognized ratably over the remaining
expected development period. Other contractual fees received in connection with
a collaborators launch of a product are also recognized ratably over the
estimated or contractual licensing and supply term. Product royalty fees are
recognized when earned.

ALLOWANCE FOR DOUBTFUL ACCOUNTS

Allowances for doubtful accounts receivable are maintained based on
historical payment patterns, aging of accounts receivable and actual write-off
history.

INVENTORY

The Company writes down its inventory to net realizable value. Product
obsolescence may be caused by shelf-life expiration, replacement products in
the marketplace or other competitive situations.

DEFERRED TAXES  VALUATION ALLOWANCE

The Company records a valuation allowance to reduce its deferred tax
assets to the amount that is more likely than not to be realized. While the
Company has considered any potential future taxable income and ongoing prudent
and feasible tax planning strategies in assessing the need for the valuation
allowance, in the event the Company were to determine that it would be able to
realize its deferred tax assets in the future in excess of its net recorded
amount, an adjustment to the deferred tax asset would increase income in the
period such determination was made. At December 31, 2001, the Company had
recorded full valuation allowances totaling approximately $14.9 million against
its deferred tax assets.

IMPAIRMENT OF INTANGIBLE ASSETS

In
assessing the recoverability of the Companys intangible assets, the Company
must make assumptions regarding estimated future cash flows and other factors
to determine the fair value of the respective assets. If these estimates or
their related assumptions change in the future, the Company may be required to
record impairment charges for these assets. Effective January 1, 2002, the
Company will adopt Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets.

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RESULTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 2001 and 2000

Total revenues decreased 4.9% for the year ended December 31, 2001 to
$40.0 million from $42.1 million for the year ended December 31, 2000. Product
sales decreased to $34.8 million for 2001 compared to $37.1 million for 2000,
representing a decrease of 6.4%. The decrease in product sales was due to
lower revenues on sales of formulated bulk TIMERx during 2001, reflecting the
formulated bulk TIMERx shipments to Mylan in 2000, totaling $3.2 million, under
the Companys arrangement with Mylan relating to Nifedipine XL, which did not
recur in 2001. The lower revenues on sales of formulated bulk TIMERx was
partially offset by increased excipient sales in 2001, primarily in Europe.
Royalties and licensing revenues increased 6.4% from $4.9 million in 2000 to $5.2
million in 2001, primarily as a result of increased royalties earned on Mylans
sales of the 30 mg strength of generic Procardia XL, as Mylan captured greater
market share in 2001. This royalty, however, did trend down in the second
quarter of 2001 compared to the previous two quarters, due to the entrant of a
competitor, and remained fairly flat through the remainder of 2001.

Gross profit decreased to $15.2 million, or 38.0% of total revenues for
2001, from $16.8 million, or 39.8% of total revenues for 2000. Gross profit
percentage on product sales decreased to 28.7% for 2001, from 31.9% for 2000.
These decreases reflect competitive pressure on prices of the Companys
excipients during 2001, primarily in North America. Also contributing to the
lower gross profit in 2001 as compared with 2000, were the bulk TIMERx
shipments to Mylan in 2000, which did not recur in 2001.

Selling, general and administrative expenses increased by 14.9% for 2001,
to $13.9 million, from $12.1 million for 2000. The increase is primarily due
to increased expenses for market research, business insurance, professional
fees, including those associated with the Companys evaluation and pursuit of
financing alternatives, and increased information technology and hiring costs
associated with the Company strengthening its information technology
infrastructure to prepare for anticipated increasing drug development
activities.

The effective tax rates for 2001 and 2000, were expenses of 3% and 4%,
respectively. The effective tax rates are higher than the federal statutory
rate of a 34% benefit, due primarily to valuation allowances recorded to offset
deferred tax assets relating to the Companys net operating losses, and state
and foreign income taxes.

Research and product development expenses increased by 32.6% for 2001 to
$17.0 million from $12.8 million for 2000. This increase was partly due to the
Companys share of increased expenses associated with clinical trials being
conducted for the development of Oxymorphone ER under
the Companys collaboration with Endo. In addition, the Company increased its
investment on developing new products utilizing TIMERx technology for its drug development
pipeline and on the research of new drug delivery
technologies.

As
of December 31, 2001, the Company had ten product
candidates utilizing TIMERx technology, in various stages of clinical trials. Completion of
clinical trials and commercialization of these product candidates may take several years and the length of time can
vary substantially according to the type, complexity, and novelty of
a product candidate.

The
Companys most advanced product candidate,
Oxymorphone ER, is currently in Phase II/Phase III clinical trials. Endo is
currently conducting these clinical trials, which are scheduled to be
completed in the second quarter of 2002. The Company expects that
Endo will submit the NDA for this product in the second half of 2002.
Assuming the results of the clinical trials are consistant with the
results of previous trials, the Company expects that Endo will submit
the NDA for this product in the second half of 2002. The Company anticipates spending an additional $7.5 million on this
development program in 2002.

There are four product candidates that
the Company is developing with collaborators whereby the collaborators are
responsible for conducting and funding the clinical trials and
submitting the regulatory filings. The Company has five compounds
that are in the early stages of development whereby the Company is
either funding the development costs of the project, or they are
being shared equally with a collaborator. There can be no assurance
that any of our products will be successfully developed, will receive
regulatory approval, or will be successfully commercialized.

YEARS ENDED DECEMBER 31, 2000 and 1999

Total revenues increased 12.7% for the year ended December 31, 2000 to
$42.1 million from $37.3 million for the year ended December 31, 1999. Product
sales increased to $37.1 million for 2000 compared to $36.8 million for 1999.
The increase in product sales was primarily due to shipments of formulated bulk
TIMERx to Mylan in the first and third quarters of 2000. The first quarters
shipments to Mylan were in anticipation of their launch of Nifedipine XL, and
prior to Mylan signing the supply and distribution agreement with Pfizer. The
third quarters shipments to Mylan were made pursuant to Penwests March 2000
agreement with Mylan

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##### Table of Contents



noted above. Partially offsetting the increased sales of formulated bulk
TIMERx included in product sales was a decrease in excipients revenues during
the year ended December 31, 2000. This decrease in excipient revenues was due
to a milder-than-expected cough/cold season resulting in reduced orders from
customers, a decrease in sales volumes to two primary customers, as well as
pricing pressure on Emcocel products, primarily in Europe. Royalties and
licensing fees increased to $4.9 million for the year ended December 31, 2000
compared to $0.5 million for the year ended December 31, 1999. This increase
was due primarily to royalties from Mylan on its sales of Pfizers 30 mg
generic version of Procardia XL.

Gross profit increased to $16.7 million, or 39.8% of total revenues, for
2000 from $11.4 million, or 30.6% of total revenues, for 1999. The increase in
gross profit was primarily due to increased royalties and licensing fees noted
above. Gross profit percentage on product sales increased to 31.9% from 29.6%
for the year ended December 31, 2000 and 1999, respectively, primarily due to
increased sales of formulated bulk TIMERx and ProSolv, which have higher
overall margins than the Companys other excipient products.

Selling, general and administrative expenses increased 5.5% for the year
ended December 31, 2000 to $12.1 million from $11.4 million for the year ended
December 31, 1999. This increase was primarily due to additional personnel
hired in sales and marketing and increased professional fees.

Research and product development expenses increased 73.9% for the year
ended December 31, 2000 to $12.8 million from $7.4 million for the year ended
December 31, 1999. This increase was primarily due to the Companys share of
increased expenses associated with the recently completed Phase II clinical
trials, as well as other studies being conducted for the development of
extended release oxymorphone under the Companys collaboration with Endo, as
well as increased activity in the Companys drug development pipeline.

The effective tax rates for the year ended December 30, 2000 and 1999,
were an expense of 4% and a benefit of 1%, respectively. The effective rates
are higher than the federal statutory rate of a 34% benefit, due primarily to
the valuation allowance recorded to offset deferred tax assets relating to the
Companys net operating losses, and state and foreign income taxes.

LIQUIDITY AND CAPITAL RESOURCES

Subsequent to August 31, 1998, the date the Company became an independent,
publicly-owned company, the Company has funded its operations and capital
expenditures with revenues from the sale of excipients, sale of
formulated bulk TIMERx, royalties and milestone payments from Mylan
and other collaborators, advances under credit facilities and
proceeds from the sale and issuance of shares of common stock.

On July 11, 2001, the Company completed a private placement of 2,447,187
shares of its common stock to selected institutional investors, resulting in
proceeds of approximately $30 million, less expenses.

As of December 31, 2001, the Company had cash, cash equivalents, and
short-term investments of $22.5 million. The Company has no
committed sources of capital at year-end other than the Company's
revolving line of credit (Revolver) with CIT Group/Business Credit,
Inc. Under the Revolver, generally 85% of the Company's U.S. and
Canadian receivables, as well as generally 60% of the Company's U.S.
saleable inventories, are included in the borrowing base. Amounts
outstanding under the Revolver are collateralized by the Company's
U.S. and Canadian accounts receivable, and its inventory and general
intangibles. The Revolver has an initial term of three years, and
provides for annual renewals thereafter. The Revolver bears interest
at a specified bank's prime rate plus 1% per annum, on the greater of
$3.0 million or on the average outstanding balance. The revolver also
requires that fees be paid of .5% per annum on unused portions of the
Line of Credit. It also provides for early termination fees of up to
..75% in the event the Cmpany terminates the Revolver prior to the end
of the initial term. The Revolver contains covenants, including the
requirement that the Company maintain at all times, certain minimum
levels of tangible net worth as defined, at varying specified amounts
during the intial term of the agreement, and restrictions on the
incurrence of additional indebtedness. Under the terms of the Revolver, the Company may borrow up to $10.0
million (Line of Credit) as determined by a formula based on the Companys
Eligible Accounts Receivable and Eligible Saleable Inventory, as defined in the
agreement. As of March 22, 2002, there was approximately $2.9 million
outstanding under the terms of the Revolver.

As of December 31, 2001, the Company did not have any material
commitments for capital expenditures. As of December 31, 2001, the Companys
trade receivables were $6.2 million, a decrease of $1.9 million from the
December 31, 2000 balance of $8.2 million. This decrease
primarily reflects the trade receivable as of December 31, 2000
associated with shipments of
formulated bulk TIMERx to Mylan in 2000, which were paid by Mylan in
the first half of 2001. In connection with its strategic alliance
agreement with Endo, the Company expects to expend an additional
$7.5 million through 2002 on the development and
pre-marketing costs of

22



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##### Table of Contents



Oxymorphone ER to fund its cash needs.

The Company's major outstanding contractual obligations
relate to its Revolver and its operating leases, primarily of
equipment. Below is a table summarizing the contractual
obligations and commercial commitments as of December 31, 2001 (in
thousands):

|                                   |  |       |       |          |  |       |       |       |  |         |       |  |  |   |     |  |  |   |    | 
|---------------------------------- |  | ----- | ----- | -------- |  | ----- | ----- | ----- |  | ------- | ----- |  |  | - | --- |  |  | - | -- | 
|                                   |  |       |       | Less     |  |       |       |       |  |        
|                                   |  |       |       | than     |  | 1-3   |       | 4-5   |  | After  
|                                   |  | Total |       | One Year |  | Years |       | Years |  | 5 Years
|                                   |  |       |       |          |  |       |       |       |  |        
|Loan Payable under Revolver        |  | $     | 2,668 |          |  | $     | 2,668 |       |  | $       |      |  |  | $ |    |  |  | $ |   | 
|                                  
|                                  
|                                  
|                                  
|Operating Leases                   |  |       | 2,743 |          |  |       | 760   |       |  |         | 1,323 |  |  |   | 609 |  |  |   | 51 | 
|                                   |  |       |       |          |  |       |       |       |  |         |       |  |  |   |     |  |  |   |    | 
|Total Contractual Cash Obligations |  | $     | 5,411 |          |  | $     | 3,428 |       |  | $       | 1,323 |  |  | $ | 609 |  |  | $ | 51 | 
|                                   |  |       |       |          |  |       |       |       |  |         |       |  |  |   |     |  |  |   |    | 

At
December 31, 2001, the Company has federal net operating loss
("NOL") carryforwards of $41,482,000 for income tax
purposes, of which approximately $6,188,000, $8,407,000, $9,135,000,
and $17,752,000 expire in 2018, 2019, 2020 and 2021, respectively. In
addition, the Company has research and development tax credit
carryforwards of approximately $455,000, of which $149,000 and
$306,000 expire in 2020 and 2021, respectively. The use of the NOLs
and research and development tax credit carryforwards are limited to future
taxable earnings of the Company. Due to the degree of uncertainty
related to the ultimate realization of such carryforwards, at December
31, 2001, a valuation allowance of $14.9 million has been recognized
to offset net deferred tax assets, primarily attributable to the NOL
carry-forward. Utilization of the operating losses are subject to a
limitation due to the ownership change provisions of the Internal
Revenue Code.

The Company had negative cash flow from operations in the year
ended December 31, 2001 of $11.1 million, primarily due to the net loss in the
period, partially offset by net reductions of accounts receivable as noted
above. The Company had negative cash flow from operations in the year
ended December 31, 2000 of $7.3 million, primarily due to net losses for the
period. Funds expended in 2001 for the acquisition of fixed assets were
primarily related to additions at the Companys manufacturing facilities in
Iowa and Finland, and information technology associated with the Company
strengthening its technology infrastructure to prepare for increasing drug
development activities. Funds expended for intangible assets include costs to
secure and defend patents on technology developed by the Company and to secure
trademarks.

The Company intends to utilize available cash and short-term
investments, cash from operations, and funds available under the
Revolver. The Companys requirements for additional capital are substantial and will
depend on many factors, including (i) the timing and amount of payments
received under existing and possible future collaborative agreements; (ii) the
structure of any future collaborative or development agreements,
including the costs of funding research and development and clinical
trials as part of cost-sharing arrangements with collaborators such
as Endo; (iii) the
progress of the Companys collaborative and independent development projects;
(iv) revenues from the Companys sales of excipients; (v) the costs to the
Company of bioequivalence studies for the Companys products and
other development activities; (vi) the
prosecution, defense and enforcement of patent claims and other intellectual
property rights; and (vii) the costs and timing of adding drug development capabilities.

The Company anticipates that its existing capital resources, including
funds available under the Revolver as well as anticipated internally
generated funds from the sale of excipients and formulated bulk
TIMERx, royalties from Mylan and other payments from collaborators, will
enable the Company to maintain currently planned operations through
the first quarter of 2003. The Company may need to raise additional funds to maintain its
operations beyond such date. The Company may seek to obtain additional funds
through transactions relating to its business lines and/or debt or equity
financings. The additional financing may not be available to the Company on
acceptable terms, if at all. If adequate funds are not available, Penwest may be required to (i)
significantly curtail its product commercialization efforts, including
terminating existing collaborative agreements; (ii) obtain funds through
arrangements with collaborators or others on adverse terms to Penwest
that may
require Penwest to relinquish rights to certain of its technologies, product
candidates, or products which Penwest would otherwise pursue on its own or that
would significantly dilute the Companys stockholders; (iii) significantly
scale back or terminate operations and/or; (iv) seek relief under applicable
bankruptcy laws.

MARKET RISK AND RISK MANAGEMENT POLICIES

Market risk is the risk of loss to future earnings, to fair values or to
future cash flows that may result from changes in the price of a financial
instrument. The value of a financial instrument may change as a result of
changes in interest rates, foreign currency exchange rates and other market
changes. Market risk is attributed to all market sensitive financial
instruments, including debt instruments. 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 primarily
relates to its investments in marketable securities and its revolving line of
credit which bears interest at variable rates. The Companys foreign currency
exchange risk primarily relates to its international subsidiaries. The Company
does not use derivatives to hedge the impact of fluctuations in foreign
currencies or interest rates.

The primary objectives for the Companys investment portfolio are
liquidity and safety of principal. Investments are made to achieve the highest
rate of return to the Company, consistent with these two objectives. The
Companys investment policy limits investments to certain types of instruments
issued by institutions with investment grade credit ratings and places
restrictions on maturities and concentration by issuer. Marketable securities,
consisting of corporate debt and U.S. Government Agency-backed discounted
notes, approximated $9.6 million at December 31, 2001. These securities have
contractual maturity dates of up to two years. Due to the relatively short
term maturities of these securities, management believes there is no
significant market risk. At December 31, 2001, market values approximated
carrying values. At December 31, 2001, the Company had approximately $22.5
million in cash, cash equivalents and investments in marketable securities, and
accordingly, a sustained decrease in the rate of interest earned of 1% would
cause a decrease in the annual amount of interest earned of up to approximately
$225,000.

The Company has a revolving line of credit with a financial institution
which bears interest at a specified banks prime rate plus 1% per annum (5.75%
at December 31, 2001) on the greater of $3.0 million or on the average
outstanding balance. At December 31, 2001, there was approximately $2.7
million outstanding under the line and, accordingly, a sustained increase in
the interest rate of 1% would cause increased annual interest expense of
approximately $30,000.

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. Where practical, the Company seeks to manage
expected local currency revenues in relation to local currency costs, and
manage local currency assets in relation to local currency liabilities. The
Company does not believe that the potential exposure is significant in light of
the size of the Company and its business. The effect of an immediate 10% change
in exchange rates would not have a material effect on the Companys results of
operations, financial position or cash flows.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard (SFAS) No. 141, Business
Combinations and SFAS No. 142, Goodwill and Other Intangible Assets
effective for fiscal years beginning after December 15, 2001. Under the new
rules, goodwill will no longer be amortized but will be subject to annual
impairment tests. Other intangible assets will continue to be amortized over their estimated
useful lives. The Company will apply the new rules on accounting for goodwill
and other intangible assets beginning in the first quarter of 2002. The
adoption of the new standards is not expected to have a material effect on the
results of operations, financial position, or cash flows of the Company.

In
October 2001, the FASB issues SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. SFAS No. 144 supersedes SFAS
No. 121, Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of. The primary objectives of SFAS No. 144 are to develop one accounting model
based on the framework established in SFAS No. 121 for long-lived assets to be
disposed of by sale, and to address significant implementation issues. The
Companys adoption of SFAS No. 144 in the first quarter of 2002 is not expected to
have a material effect on the results of operations, financial position, or
cash flows of the Company.

Other pronouncements issued by the FASB or other authoritative accounting
standards groups with future effective dates are either not applicable or not
significant to the financial statements of the Company.

FORWARD-LOOKING STATEMENTS

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

WE HAVE NOT BEEN PROFITABLE

We have incurred net losses since 1994, including net losses of
approximately $15.9 million, $8.8 million, and $7.7 million, during 2001, 2000,
and 1999, respectively. As of December 31, 2001, our accumulated deficit was
approximately $60.9 million. The Company expects net losses to continue at
least through 2003. A substantial portion of our revenues have been generated
from the sales of our pharmaceutical excipients. Our future profitability will
depend on several factors, including:



| |  |  | the successful commercialization of
TIMERx controlled release products;       
| | - |  | ------------------------------------------------------------------------------
|
| |  |  | royalties from Mylan's sales of Pfizer's 30mg generic
version of Procardia XL;
|
| |  |  | sales growth of our pharmaceutical excipient products; and                    
|
| |  |  | the level of investment in research and development
activities.               

WE ARE DEPENDENT ON COLLABORATORS TO CONDUCT FULL-SCALE BIOEQUIVALENCE STUDIES
AND CLINICAL TRIALS, OBTAIN REGULATORY APPROVALS FOR, AND MANUFACTURE, MARKET,
AND SELL OUR TIMERx CONTROLLED RELEASE PRODUCTS

We develop and commercialize our TIMERx controlled release products in
collaboration with pharmaceutical companies. We are parties to collaborative
agreements with third parties relating to most of our products. Under
these collaborations, depending on the structure of the
collaboration, we are dependent on our collaborators to fund, to conduct
full-scale bioequivalence studies and
clinical trials, obtain regulatory approvals for, and manufacture, market and
sell products utilizing our TIMERx controlled release technology. We are
also dependent on Mylan with respect to the marketing and sale of the 30 mg
strength of Pfizers generic version of Procardia XL. Our collaborators may not
devote the resources necessary or may otherwise be unable to complete
development and commercialization of these potential products. Our existing
collaborations are subject to termination without cause on short notice under
certain

23



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circumstances.

If we cannot maintain our existing collaborations or establish new
collaborations, we would be required to terminate the development and
commercialization of products or undertake product development and
commercialization activities at our own expense. Moreover, we have limited
experience in conducting full-scale bioequivalence studies and clinical trials,
preparing and submitting regulatory applications and manufacturing, marketing
and selling the TIMERx controlled release products. We may not be successful in
performing these activities.

Our existing collaborations and any future collaborations with third
parties may not be scientifically or commercially successful. Factors that may
affect the success of our collaborations include the following:



| |  |  | our collaborators may be pursuing alternative technologies or
developing alternative products, either on their own or in collaboration
with others, that may be competitive with the product as to which they
are collaborating with us, which could affect our collaborators
commitment to the collaboration with us;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | reductions in marketing or sales efforts or a discontinuation of
marketing or sales of our products by our collaborators would reduce our
revenues, which will be based on a percentage of net sales by the
collaborator;                                                                                              
|
| |  |  | our collaborators may terminate their collaborations with us, which
could make it difficult for us to attract new collaborators or adversely
affect our perception in the business and financial communities; and                                                                                                      
|
| |  |  | our collaborators may pursue higher priority programs or change the
focus of their development programs, which could affect the
collaborators commitment to us.                                                                                                                                                       

WE FACE SIGNIFICANT COMPETITION, WHICH MAY RESULT IN OTHERS DISCOVERING,
DEVELOPING OR COMMERCIALIZING PRODUCTS BEFORE OR MORE SUCCESSFULLY THAN WE DO

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 our competitors have longer
operating histories and greater financial, marketing, legal and other resources
than we do and than certain of our collaborators do.

Our TIMERx business faces competition from numerous public and private
companies and their controlled release technologies, including Johnson &
Johnsons oral osmotic pump (OROS®) technology, multiparticulate systems
marketed by Elan and Biovail, traditional matrix systems marketed by
SkyePharma, plc and other controlled release technologies marketed or under
development by Andrx Corporation, among others.

Our
TIMERx products in development will face competition from products with the same indication
as the TIMERx products being developed by Penwest. For instance, the Company expects
extended release Oxymorphone ER will face competition from Purdue Pharmas
OxyContin®.

In addition to developing controlled release versions of immediate release
products, we concentrated a significant portion of our initial development
efforts on generic versions of branded controlled release products. The success
of generic versions of branded controlled release products based on our TIMERx
technology will depend, in large part, on the intensity of competition from the
branded controlled release product, other generic versions of the branded
controlled release product and other drugs and technologies that compete with
the branded controlled release product, as well as the timing of product
approval.

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 better able to bring and defend any
such litigation.

In our excipients business, we compete 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. Our principal competitor in this market is FMC Corporation, which
markets its own line of MCC excipient products and J. Rettenmaier & Sohne GmbH,
a European manufacturer and marketer of MCC and sodium starch glycolate
products.

WE REQUIRE ADDITIONAL FUNDING

24



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Our requirements for additional capital are substantial and will depend on
many factors, including:



| |  |  | the structure of any future collaborative or development agreements;                                                        
| | - |  | ----------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the progress of our collaborative and independent development
projects and funding obligations with respect to the projects;
|
| |  |  | revenues from our excipients
products;                                                                                      
|
| |  |  | the costs to us of clinical studies for our products;                                                                       
|
| |  |  | royalties received from Mylan;                                                                                              
|
| |  |  | royalties from sales of TIMERx
products;                                                                                    
|
| |  |  | the timing and amount of payments received under existing and possible future collaborative agreements; and                 
|
| |  |  | the prosecution, defense and enforcement of patent claims and other intellectual property rights.                           

The Company has no committed sources of capital except for the CIT credit
facility. The Company anticipates its existing capital resources, including the
amount available (as determined by a formula based on the Company's
Eligible Accounts Receivable and Eligible Saleable Inventory, as
defined in the agreement,) under the $10 million financing arrangement with CIT Credit,
will be sufficient to fund operations through the first quarter of 2003.

Additional financing may not be available to Penwest on acceptable terms,
if at all. If adequate funds are not available, Penwest may be required to (i)
significantly curtail its product commercialization efforts, including
terminating existing collaborative agreements; (ii) obtain funds through
arrangements with collaborators or others on adverse terms to Penwest
that may
require Penwest to relinquish rights to certain of its technologies, product
candidates, or products which Penwest would otherwise pursue on its own or that
would significantly dilute the Companys stockholders; (iii) significantly
scale back or terminate operations and/or; (iv) seek relief under applicable
bankruptcy laws.

IF OUR CLINICAL TRIALS ARE NOT SUCCESSFUL OR TAKE LONGER TO COMPLETE THAN WE
EXPECT, WE MAY NOT BE ABLE TO DEVELOP AND COMMERCIALIZE CERTAIN OF OUR PRODUCTS

In order to obtain regulatory approvals for the commercial sale of certain
of our potential products, including controlled release versions of immediate
release drugs and new chemical entities, our collaborators will be required to
complete clinical trials in humans to demonstrate the safety and efficacy of
the products. Our collaborators may not be able to obtain authority from the
FDA or other regulatory agencies to commence or complete these clinical trials.

The results from preclinical testing of a product that is under
development may not be predictive of results that will be obtained in human
clinical trials. In addition, the results of early human clinical trials may
not be predictive of results that will be obtained in larger scale advanced
stage clinical trials. Furthermore, we, one of our collaborators, or the FDA
may suspend clinical trials at any time if the subjects or patients
participating in such trials are being exposed to unacceptable health risks, or
for other reasons.

The rate of completion of clinical trials is dependent in part upon the
rate of enrollment of patients. Patient accrual is a function of many factors
including the size of the patient population, the proximity of patients to
clinical sites, the eligibility criteria for the study and the existence of
competitive clinical trials. Delays in planned patient enrollment may result in
increased costs and program delays.

We and our collaborators may not be able to successfully complete any
clinical trial of a potential product within any specified time period. In some
cases, we may not be able to complete the trial at all. Moreover, clinical
trials may not show any potential product to be safe or efficacious. Thus, the
FDA and other regulatory authorities may not approve any of our potential
products for any indication.

Our business, financial condition, or results of operations could be
materially adversely affected if:



| |  |  | we or our collaborators are unable to complete a clinical trial of one of our potential products;
| | - |  | -------------------------------------------------------------------------------------------------

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| |  |  | the results of any clinical trial are unfavorable; or             
| | - |  | ------------------------------------------------------------------
|
| |  |  | the time or cost of completing the trial exceeds our expectations.

WE MAY NOT OBTAIN REGULATORY APPROVAL; THE APPROVAL PROCESS CAN BE
TIME-CONSUMING AND EXPENSIVE

The development, clinical testing, manufacture, marketing and sale of
pharmaceutical products are subject to extensive federal, state and local
regulation in the United States and other countries. This regulatory approval
process can be time-consuming and expensive.

We may encounter delays or rejections during any stage of the regulatory
approval process based upon the failure of clinical data to demonstrate
compliance with, or 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. After submission of a marketing application, in
the form of an NDA or an ANDA, the FDA may deny the application, may require
additional testing or data and/or may require postmarketing testing and
surveillance to monitor the safety or efficacy of a product. While the U.S.
Food, Drug and Cosmetic Act, or FDCA, 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 we
desire and could affect the marketability of products incorporating our
controlled release technology.

Some of the controlled release products that we are developing with our
collaborators are generic versions of branded 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. Any changes
in FDA regulations that make ANDA approvals more difficult may have a material
adverse effect on our business, financial condition and results of operations.

Other products containing our TIMERx controlled release technology require
the filing of an NDA. A full NDA must include complete reports of preclinical,
clinical and other studies to prove adequately that the product is safe and
effective, which involves, among other things, full clinical testing, and as a
result requires the expenditure of substantial resources. In certain cases
involving controlled release versions of FDA-approved immediate release drugs,
we may be able to rely on existing publicly available safety and efficacy data
to support an NDA for controlled release products under Section 505(b)(2) of
the FDCA when such data exists for an approved immediate release version of the
same chemical entity. However, we can provide no assurance that the FDA will
accept such section 505(b)(2) NDA, or that we 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 the FDA
will approve an application submitted under section 505(b)(2) in a timely
manner or at all.

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 volative products, to obtain injunctions
to close manufacturing plants allegedly not operating in conformity with
current Good Manufacturing Practices and to stop shipments of allegedly
violative products. The FDA may seek to impose pre-clearance requirements on
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.

EVEN IF WE OBTAIN MARKETING APPROVAL, OUR PRODUCTS WILL BE SUBJECT TO ONGOING
REGULATORY REVIEW

If regulatory approval of a product is granted, such approval may be
subject to limitations on the indicated uses for which the product may be
marketed or contain requirements for costly post-marketing follow-up studies.
As to products for which marketing approval is obtained, the manufacturer of
the product and the manufacturing facilities will be subject to continual
review and periodic inspections by the FDA and other regulatory authorities.
The subsequent discovery of previously unknown problems with the product,

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manufacturer or facility may result in restrictions on the product or
manufacturer, including withdrawal of the product from the market.

If we fail to comply with applicable regulatory requirements, we may be
subject to fines, suspension or withdrawal of regulatory approvals, product
recalls, seizure of products, operating restrictions and criminal prosecution.

OUR CONTROLLED RELEASE PRODUCTS THAT ARE GENERIC VERSIONS OF BRANDED CONTROLLED
RELEASE PRODUCTS THAT ARE COVERED BY ONE OR MORE PATENTS MAY BE SUBJECT TO
LITIGATION

We expect that our collaborators will file ANDAs for our controlled
release products that are generic versions of branded controlled release
products that are covered by one or more patents. It is likely that the owners
of the patents covering the brand name product or the sponsors of the NDA with
respect to the branded product will sue or undertake regulatory initiatives to
preserve marketing exclusivity, as Pfizer did with respect to Nifedipine XL.
Any significant delay in obtaining FDA approval to market our product
candidates as a result of litigation, as well as the expense of such
litigation, whether or not we or our collaborators are successful, could have a
material adverse effect on our business, financial condition and results of
operations.

THE MARKET MAY NOT BE RECEPTIVE TO PRODUCTS INCORPORATING OUR TIMERx CONTROLLED
RELEASE TECHNOLOGY

The commercial success of products incorporating our controlled release
technology that are approved for marketing by the FDA and other regulatory
authorities will depend upon their acceptance by the medical community and
third party payors as clinically useful, cost-effective and safe. No
product based on the TIMERx technology is marketed in the United
States, so there can be no assurance as to market acceptance.

Other factors that we believe could materially affect market acceptance of
these products include:



| |  |  | the timing of the receipt of marketing approvals and the countries in which such approvals are obtained;
| | - |  | --------------------------------------------------------------------------------------------------------
|
| |  |  | the safety and efficacy of the product as compared to competitive products; and                         
|
| |  |  | the cost-effectiveness of the product and the ability to receive third party reimbursement.             

OUR SUCCESS DEPENDS ON OUR PROTECTING OUR PATENTS AND PATENTED RIGHTS

Our success depends in significant part on our ability to develop
patentable products, to obtain patent protection for our products, both in the
United States and in other countries, and to enforce these patents. The patent
positions of pharmaceutical firms, including us, are generally uncertain and
involve complex legal and factual questions. As a result, patents may not issue
from any patent applications that we own or license. If patents do issue, the
claims allowed may not be sufficiently broad to protect our technology. In
addition, issued patents that we own or license may be challenged, invalidated
or circumvented. Our patents also may not afford us protection against
competitors with similar technology.

Our success also depends on our not infringing patents issued to
competitors or others. We are aware of patents and patent applications
belonging to competitors and others that may require us to alter our products
or processes, pay licensing fees or cease certain activities.

We may not be able to obtain a license to any technology owned by a third
party that we require to manufacture or market one or more products. Even if we
can obtain a license, the financial and other terms may be disadvantageous.

Our success also depends on our maintaining the confidentiality of our
trade secrets and patented know-how. We seek to protect such information by
entering into confidentiality agreements with employees, consultants, licensees
and pharmaceutical companies. These agreements may be breached by such parties.
We may not be able to obtain an adequate, or perhaps, any remedy to such a
breach. In addition, our trade secrets may otherwise become known or be
independently developed by our competitors.

WE MAY BECOME INVOLVED IN PATENT LITIGATION OR OTHER INTELLECTUAL PROPERTY
PROCEEDINGS RELATING TO OUR PRODUCTS OR PROCESSES WHICH COULD RESULT IN
LIABILITY FOR DAMAGE OR STOP OUR DEVELOPMENT AND COMMERCIALIZATION EFFORTS

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The pharmaceutical industry has been characterized by significant
litigation and interference and other proceedings regarding patents, patent
applications and other intellectual property rights. The types of situations in
which we may become parties to such litigation or proceedings include:



| |  |  | We or our collaborators may initiate litigation or other proceedings
against third parties to enforce our patent rights.                                                                                                                                   
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | We or our collaborators may initiate litigation or other proceedings
against third parties to seek to invalidate the patents held by such
third parties or to obtain a judgment that our products or processes do
not infringe such third parties patents.
|
| |  |  | If our competitors file patent applications that claim technology
also claimed by us, we or our collaborators may participate in
interference or opposition proceedings to determine the priority of
invention.                                            
|
| |  |  | If third parties initiate litigation claiming that our processes or
products infringe their patent or other intellectual property rights, we
and our collaborators will need to defend against such proceedings.                                           

An adverse outcome in any litigation or other proceeding could subject us
to significant liabilities to third parties and require us to cease using the
technology that is at issue or to license the technology from third parties. We
may not be able to obtain any required licenses on commercially acceptable
terms or at all.

The cost of any patent litigation or other proceeding, even if resolved in
our favor, could be substantial. Although the legal costs of defending
litigation relating to a patent infringement claim are generally the
contractual responsibility of our collaborators, (unless such claim relates to
TIMERx in which case such costs are our responsibility) we could nonetheless
incur significant unreimbursed costs in participating and assisting in the
litigation. Some of our competitors may be able to sustain the cost of such
litigation and proceedings more effectively than we can because of their
substantially greater resources. Uncertainties resulting from the initiation
and continuation of patent litigation or other proceedings could have a
material adverse effect on our ability to complete in the marketplace. Patent
litigation and other proceedings may also absorb significant management time.

WE HAVE ONLY LIMITED MANUFACTURING CAPABILITIES AND WILL BE DEPENDENT ON THIRD
PARTY MANUFACTURERS

We lack commercial scale facilities to manufacture our TIMERx material in
accordance with current GMP requirements prescribed by the FDA. We currently
rely on Draxis Pharma, Inc. for the bulk manufacture of our TIMERx material for
delivery to our collaborators under a contract that expires in September 2004.
The agreement shall be automatically renewed for successive one-year
periods, unless either party gives notice of its intent not to
renew the contract, at least six months prior to the end of the then-current term.

There are a limited number of manufacturers that operate under GMP
regulations capable of manufacturing our TIMERx material. We have not yet
qualified a second source of supply. In the event that our current manufacturer
is unable to manufacture the TIMERx material in the required quantities, on a
timely basis or at all, we may be unable to obtain alternative contract
manufacturing, or obtain such manufacturing on commercially reasonable terms.

If our third party manufacturer fails to perform its obligations, we may
be adversely affected in a number of ways, including:



| |  |  | our collaborators may not be able to meet commercial demands for our products on a timely basis;                     
| | - |  | ---------------------------------------------------------------------------------------------------------------------
|
| |  |  | our collaborators may not be able to initiate or continue clinical trials of products that are under development; and
|
| |  |  | our collaborators may be delayed in submitting applications for regulatory approvals of our products.                

We have limited experience in manufacturing TIMERx material on a
commercial scale and no facilities or equipment to do so. If we determine to
develop our own manufacturing capabilities, we will need to recruit qualified
personnel and build or lease the requisite facilities and equipment. We may not
be able to successfully develop our own manufacturing capabilities. Moreover,
it may be very costly and time consuming for us to develop such capabilities.

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

WE ARE DEPENDENT UPON A LIMITED NUMBER OF SUPPLIERS FOR THE GUMS USED IN OUR TIMERx
MATERIAL AND UPON A LIMITED NUMBER OF SUPPLIERS FOR THE WOOD PULP USED IN THE
MANUFACTURE OF OUR EXCIPIENTS

Our TIMERx drug delivery system is a hydrophilic matrix combining
primarily two polysaccharides, xanthan and locust bean gums, in the presence of
dextrose. We purchase these gums from a sole source supplier. Emcocel and
Prosolv, our two largest selling excipients, are manufactured from a specialty
grade of wood pulp. We have qualified alternate suppliers with respect to such
materials, but we can provide no assurance that interruptions in supplies will
not occur in the future or that we will not have to obtain substitute
suppliers. Any interruption in these supplies could have a material adverse
effect on our ability to manufacture bulk TIMERx for delivery to our
collaborators or to manufacture these excipients.

IF OUR COLLABORATORS FAIL TO OBTAIN AN ADEQUATE LEVEL OF REIMBURSEMENT BY THIRD
PARTY PAYORS FOR OUR CONTROLLED RELEASE PRODUCTS, THEY MAY NOT BE ABLE TO
SUCCESSFULLY COMMERCIALIZE CONTROLLED RELEASE PRODUCTS IN CERTAIN MARKETS

The availability of reimbursement by governmental and other third party
payors affects the market for any pharmaceutical product. These third party
payors continually attempt to contain or reduce the costs of health care by
challenging the prices charged for medical products and services. In certain
foreign countries, particularly the countries of the European Union, the
pricing of prescription pharmaceuticals is subject to governmental control.

The generic versions of controlled release products being developed by us
and our 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.

In both the U.S. and certain foreign jurisdictions, there have been a
number of legislative and regulatory proposals to change the health care
system. Further proposals are likely. The potential for adoption of these
proposals may affect our ability to raise capital, obtain additional
collaborative partners and market our products.

If we or our collaborators obtain marketing approvals for our products, we
expect to experience pricing pressure due to the trend toward managed health
care, the increasing influence of health maintenance organizations and
additional legislative proposals. We may not be able to sell our products
profitably if reimbursement is unavailable or limited in scope or amount.

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WE WILL BE EXPOSED TO PRODUCT LIABILITY CLAIMS AND MAY NOT BE ABLE TO OBTAIN
ADEQUATE PRODUCT LIABILITY INSURANCE

Our business exposes us to potential product liability risks which are
inherent in the testing, manufacturing, marketing and sale of pharmaceutical
products. Product liability claims might be made by consumers, health care
providers, pharmaceutical companies, or others that sell our products. These
claims may be made even with respect to those products that are manufactured in
licensed and regulated facilities or that otherwise possess regulatory approval
for commercial sale.

We are currently covered by primary product liability insurance in the
amount of $1 million per occurrence and $2 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 to cover any product liability claims. Product liability
coverage is expensive. In the future, we may not be able to maintain or obtain
such product liability insurance at a reasonable cost or in sufficient amounts
to protect us against losses due to liability claims. Any claims that are not
covered by product liability insurance could have a material adverse effect on
our business, financial condition and results of operations.

THE MARKET PRICE OF OUR COMMON STOCK MAY BE VOLATILE

The market price of our common stock, like the market prices for
securities of pharmaceutical, biopharmaceutical and biotechnology companies,
have historically been highly volatile. The market from time to time
experiences significant price and volume fluctuations that are unrelated to the
operating performance of particular companies. Factors such as fluctuations in
our operating results, future sales of our common stock, announcements of
technological innovations or new therapeutic products by us or our competitors,
announcements regarding collaborative agreements, clinical trial results,
government regulation, developments in patent or other proprietary rights,
public concern as to the safety of drugs developed by us or others, changes in
reimbursement policies, comments made by securities analysts and general market
conditions may have a significant effect on the market price of the common
stock.

CERTAIN PROVISIONS OF OUR CERTIFICATE OF INCORPORATION AND BYLAWS AND OF
WASHINGTON LAW, AS WELL AS THE RIGHTS AGREEMENT TO WHICH WE ARE A PARTY, MAKE A
TAKEOVER OF PENWEST MORE DIFFICULT

Provisions of our Certificate of Incorporation, our Bylaws and Washington
law, as well as the Rights Agreement to which we are a party, may have the
effect of deterring hostile takeovers or delaying or preventing changes in
control or management of our company, including transactions in which our
stockholders might otherwise receive a premium for their shares over then
current market prices. In addition, these provisions may limit the ability of
stockholders to approve transactions that they may deem to be in their best
interest.




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.




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) included herein.




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

None.

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PART III




ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The
information set forth under Election of Directors and
Section 16(a) Beneficial Ownership Reporting Compliance in the Companys
definitive Proxy Statement for the 2002 Annual Meeting of Shareholders is
incorporated herein by reference.

Information regarding executive officers of the Company is set forth in
Part I, Item 4a above and incorporated herein by reference.




ITEM 11: EXECUTIVE COMPENSATION

The
information set forth under Executive Compensation,
 Director Compensation, Report of the Compensation
and Benefits Committee on Executive Compensation, Compensation Committee
Interlocks and Insider Participation, and Stock
Performance Graph in the Companys
definitive Proxy Statement for the 2002 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 2002
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 2002 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 and Financial Statement Schedule                                                                                                                                                                                                                                                                                            
|------ |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      
|       |  | 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, 2001 and 2000 and the
related statements of operations, cash flows and shareholders equity for
each of the three years in the period ended December 31, 2001.                                                                                                                                
|      
|       |  | 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.                                                                             
|      
|(a)(2) |  | 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 November 7, 2001, the Company filed a report on Form 8-K announcing its
results for the third quarter ended September 30, 2001.                                                                                                                                                                                                               

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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: April 1, 2002 |  | /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: April 1, 2002                 |  | /s/   Tod R. Hamachek                 
|                                    |  |                                       
|                                    |  | Tod R. Hamachek, Chairman of the Board
|                                   
|                                   
|                                   
|                                   
|                                    |  | and Chief Executive Officer           
|                                   
|                                   
|                                   
|                                   
|                                    |  | (Principal Executive Officer)         
|                                   
|                                   
|                                   
|                                   
|                                    |  |                                       
|                                   
|                                   
|                                   
|                                   
|Date: April 1, 2002                 |  | /s/   Jennifer L. Good                
|                                    |  |                                       
|                                    |  | Jennifer L. Good, Sr. 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*
Robert J. Hennessey* |  | By /s/   Jennifer L. Good             
|                                   
|                                   
|                                   
|                                   
|N. Stewart Rogers*                  |  |                                       
|                                   
|                                   
|                                   
|                                   
|John N. Staniforth, Ph.D.*          |  | Attorney-in-Fact*                     
|                                   
|                                   
|                                   
|                                   
|Anne M. VanLent*                    |  | Power of Attorney Dated March 29, 2002
|                                   
|                                   
|                                   
|                                   
|                                    |  |                                       
|                                   
|                                   
|                                   
|                                   
|                                    |  | Date: April 1, 2002                   

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APPENDIX A

PENWEST PHARMACEUTICALS CO.
INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE

|                                                |  |     
|----------------------------------------------- |  | ----
|                                                |  | Page
|Financial Statements                            |  |     
|                                               
|                                               
|                                               
|                                               
|Report of Independent Auditors                  |  | F-2 
|                                               
|                                               
|                                               
|                                               
|Consolidated Balance Sheets                     |  | F-3 
|                                               
|                                               
|                                               
|                                               
|Consolidated Statements of Operations           |  | F-4 
|                                               
|                                               
|                                               
|                                               
|Consolidated Statements of Shareholders Equity |  | F-5 
|                                               
|                                               
|                                               
|                                               
|Consolidated Statements of Cash Flows           |  | F-6 
|                                               
|                                               
|                                               
|                                               
|Notes to Consolidated Financial Statements      |  | F-7 
|                                               
|                                               
|                                               
|                                               
|Schedule II  Valuation and Qualifying Accounts |  | S-1 

F-1



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##### Table of Contents






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, 2001 and 2000, and the related
consolidated statements of operations, shareholders equity, and cash flows for
each of the three years in the period ended December 31, 2001. 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 auditing standards generally
accepted in the United States. 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 financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Penwest
Pharmaceuticals Co. at December 31, 2001 and 2000, and the consolidated results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2001, in conformity with accounting principles
generally accepted in the United States. 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.

As discussed in Note 3 to the consolidated financial statements, Penwest
Pharmaceuticals Co. changed its method of accounting for revenue recognition in
2000.



| | /s/ ERNST & YOUNG LLP
| | ---------------------

Stamford, Connecticut
March 4, 2002

F-2



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PENWEST PHARMACEUTICALS CO.

CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)

|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |        |         |        |        | 
|------------------------------------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------- | ------------------------------------------ | ------- | ------------ | ------ | ------ | ------- | ------ | ------ | 
|                                     |                                                                                                                                                                       |                      |                                            |         | DECEMBER 31,
|                                     |                                                                                                                                                                       |                      |                                            |         |             
|                                     |                                                                                                                                                                       |                      |                                            |         | 2001         |        | 2000  
|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |       
|ASSETS                               |                                                                                                                                                                       |                      |                                            |         |              |        |        |        
|                                    
|                                    
|                                    
|                                    
|Current assets:                      |                                                                                                                                                                       |                      |                                            |         |              |        |        |        
|                                    
|                                    
|                                    
|                                    
|                                     | Cash and cash equivalents                                                                                                                                             |                      | $                                          | 12,903  |              |        | $      | 2,204   |       
|                                    
|                                    
|                                    
|                                    
|                                     | Marketable securities                                                                                                                                                 |                      |                                            | 9,609   |              |        |        |        |       
|                                    
|                                    
|                                    
|                                    
|                                     | Trade accounts receivable, net of allowance for doubtful accounts
of $220 and $235                                                                                    |                      |                                            | 6,228   |              |        |        | 8,154   |       
|                                    
|                                    
|                                    
|                                    
|                                     | Inventories                                                                                                                                                           |                      |                                            | 7,857   |              |        |        | 8,196   |       
|                                    
|                                    
|                                    
|                                    
|                                     | Prepaid expenses and other current assets                                                                                                                             |                      |                                            | 1,166   |              |        |        | 745     |       
|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |        |         |       
|                                     |                                                                                                                                                                       | Total current assets |                                            |         | 37,763       |        |        |         | 19,299 |       
|                                    
|                                    
|                                    
|                                    
|Fixed assets, net                    |                                                                                                                                                                       |                      | 15,567                                     |         |              |        | 17,473 |        
|                                    
|                                    
|                                    
|                                    
|Patents, net                         |                                                                                                                                                                       |                      | 3,545                                      |         |              |        | 2,827  |        
|                                    
|                                    
|                                    
|                                    
|Other assets                         |                                                                                                                                                                       |                      | 2,738                                      |         |              |        | 2,695  |        
|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |        |         |       
|                                     |                                                                                                                                                                       | Total assets         |                                            | $       | 59,613       |        |        | $       | 42,294 |       
|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |        |         |       
|LIABILITIES AND SHAREHOLDERS EQUITY |                                                                                                                                                                       |                      |                                            |         |              |        |        |        
|                                    
|                                    
|                                    
|                                    
|Current liabilities:                 |                                                                                                                                                                       |                      |                                            |         |              |        |        |        
|                                    
|                                    
|                                    
|                                    
|                                     | Accounts payable                                                                                                                                                      |                      | $                                          | 2,174   |              |        | $      | 3,199   |       
|                                    
|                                    
|                                    
|                                    
|                                     | Accrued expenses                                                                                                                                                      |                      |                                            | 2,275   |              |        |        | 1,790   |       
|                                    
|                                    
|                                    
|                                    
|                                     | Accrued development costs                                                                                                                                             |                      |                                            | 3,139   |              |        |        | 2,911   |       
|                                    
|                                    
|                                    
|                                    
|                                     | Taxes payable                                                                                                                                                         |                      |                                            | 448     |              |        |        | 270     |       
|                                    
|                                    
|                                    
|                                    
|                                     | Loan payable                                                                                                                                                          |                      |                                            | 2,668   |              |        |        |        |       
|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |        |         |       
|                                     |                                                                                                                                                                       |                      | Total current liabilities                  |         |              | 10,704 |        |         |        | 8,170  | 
|                                    
|                                    
|                                    
|                                    
|Deferred income taxes                |                                                                                                                                                                       |                      | 205                                        |         |              |        | 205    |        
|                                    
|                                    
|                                    
|                                    
|Deferred revenue                     |                                                                                                                                                                       |                      | 369                                        |         |              |        | 378    |        
|                                    
|                                    
|                                    
|                                    
|Deferred compensation                |                                                                                                                                                                       |                      | 2,711                                      |         |              |        | 2,524  |        
|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |        |         |       
|                                     |                                                                                                                                                                       |                      | Total liabilities                          |         |              | 13,989 |        |         |        | 11,277 | 
|                                    
|                                    
|                                    
|                                    
|Shareholders equity:                |                                                                                                                                                                       |                      |                                            |         |              |        |        |        
|                                    
|                                    
|                                    
|                                    
|                                     | 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 15,276,630 shares at December 31, 2001 and 12,669,780
shares at December 31, 2000 |                      |                                            | 15      |              |        |        | 13      |       
|                                    
|                                    
|                                    
|                                    
|                                     | Additional paid in capital                                                                                                                                            |                      |                                            | 108,054 |              |        |        | 77,276  |       
|                                    
|                                    
|                                    
|                                    
|                                     | Accumulated deficit                                                                                                                                                   |                      |                                            | (60,926 | )            |        |        | (44,945 | )     
|                                    
|                                    
|                                    
|                                    
|                                     | Accumulated other comprehensive loss                                                                                                                                  |                      |                                            | (1,519  | )            |        |        | (1,327  | )     
|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |        |         |       
|                                     |                                                                                                                                                                       |                      | Total shareholders equity                 |         |              | 45,624 |        |         |        | 31,017 | 
|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |        |         |       
|                                     |                                                                                                                                                                       |                      | Total liabilities and shareholders equity |         | $            | 59,613 |        |         | $      | 42,294 | 
|                                     |                                                                                                                                                                       |                      |                                            |         |              |        |        |         |       

See accompanying notes.

F-3



---



##### Table of Contents






PENWEST PHARMACEUTICALS CO.

CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |        |  | 
|-------------------------------------------------------------------------------- | --------------------------------------------------------------- | ------------------------ | ------- | ------ | ----------------------- | - | ------ | ------ | ------ | - | ------ | ------ | ------ |  | 
|                                                                                 |                                                                 |                          |         |        | YEAR ENDED DECEMBER 31,
|                                                                                 |                                                                 |                          |         |        |                        
|                                                                                 |                                                                 |                          |         |        | 2001                    |   | 2000   |        | 1999  
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |       
|Revenues                                                                         |                                                                 |                          |         |        |                         |   |        |        |        |   |        |       
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|                                                                                 | Product sales                                                   |                          | $       | 34,778 |                         |   | $      | 37,148 |        |   | $      | 36,768 |       
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|                                                                                 | Royalties and licensing fees                                    |                          |         | 5,225  |                         |   |        | 4,910  |        |   |        | 539    |       
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|                                                                                 |                                                                 | Total revenues           |         |        | 40,003                  |   |        |        | 42,058 |   |        |        | 37,307 | 
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|Cost of product sales                                                            |                                                                 |                          | 24,810  |        |                         |   | 25,303 |        |        |   | 25,889 |       
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|                                                                                 |                                                                 | Gross profit             |         |        | 15,193                  |   |        |        | 16,755 |   |        |        | 11,418 | 
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|Operating expenses                                                               |                                                                 |                          |         |        |                         |   |        |        |        |   |        |       
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|                                                                                 | Selling, general and administrative                             |                          |         | 13,855 |                         |   |        | 12,054 |        |   |        | 11,425 |       
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|                                                                                 | Research and product development                                |                          |         | 17,003 |                         |   |        | 12,820 |        |   |        | 7,371  |       
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|                                                                                 |                                                                 | Total operating expenses |         |        | 30,858                  |   |        |        | 24,874 |   |        |        | 18,796 | 
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|Loss from operations                                                             |                                                                 |                          | (15,665 | )      |                         |   | (8,119 | )      |        |   | (7,378 | )     
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|Investment income                                                                |                                                                 |                          | 477     |        |                         |   | 217    |        |        |   |       |       
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|Interest expense                                                                 |                                                                 |                          | 290     |        |                         |   | 172    |        |        |   | 371    |       
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|Loss before income taxes and cumulative effect of change in accounting
principle |                                                                 |                          | (15,478 | )      |                         |   | (8,074 | )      |        |   | (7,749 | )     
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|Income tax expense (benefit)                                                     |                                                                 |                          | 503     |        |                         |   | 302    |        |        |   | (68    | )     
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|Loss before cumulative effect of change in accounting principle                  |                                                                 |                          | (15,981 | )      |                         |   | (8,376 | )      |        |   | (7,681 | )     
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|Cumulative effect of change in accounting principle (Note 3)                     |                                                                 |                          |        |        |                         |   | (410   | )      |        |   |       |       
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|Net loss                                                                         |                                                                 | $                        | (15,981 | )      |                         | $ | (8,786 | )      |        | $ | (7,681 | )     
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|Basic and diluted amounts per share:                                             |                                                                 |                          |         |        |                         |   |        |        |        |   |        |       
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|                                                                                 | Loss before cumulative effect of change in accounting principle |                          | $       | (1.15  | )                       |   | $      | (0.68  | )      |   | $      | (0.69  | )     
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|                                                                                 | Cumulative effect of change in accounting principle (Note 3)    |                          |         |       |                         |   |        | (0.03  | )      |   |        |       |       
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|Net loss                                                                         |                                                                 | $                        | (1.15   | )      |                         | $ | (0.71  | )      |        | $ | (0.69  | )     
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|Weighted average shares of common stock outstanding                              |                                                                 |                          | 13,905  |        |                         |   | 12,330 |        |        |   | 11,103 |       
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|Pro forma amounts assuming the accounting
change is applied retroactively:       |                                                                 |                          |         |        |                         |   |        |        |        |   |        |       
|                                                                                
|                                                                                
|                                                                                
|                                                                                
|Net loss                                                                         |                                                                 |                          |         |        |                         | $ | (8,376 | )      |        | $ | (7,733 | )     
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       
|Basic and diluted net loss per share                                             |                                                                 |                          |         |        |                         | $ | (0.68  | )      |        | $ | (0.70  | )     
|                                                                                 |                                                                 |                          |         |        |                         |   |        |        |        |   |        |        |       

See accompanying notes.

F-4



---



##### Table of Contents






PENWEST PHARMACEUTICALS CO.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
(in thousands)

|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |         |   |  |         |  
|--------------------------- | ------------------------------------------------------------- |  | ------ | ------------------ |  | ------------ | -- | ------- |  | ----------- | ------- | ------------- |  | ---------- | ------- | ------- | - | - | ------ | ----- | - | ----------- | ------ | ------- | - |  | ------- | -
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   | ACCUMULATED |        |         |   | 
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  | ADDITIONAL |         |         |   |   |        | OTHER |   |             |        |        
|                            |                                                               |  |        |                    |  | COMMON STOCK |    | PAID-IN |  | ACCUMULATED |         | COMPREHENSIVE |  |            |         |        
|                            |                                                               |  |        |                    |  | SHARES       |    | AMOUNT  |  | CAPITAL     |         | DEFICIT       |  | LOSS       |         | TOTAL  
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |        
|Balances, January 1, 1999   |                                                               |  | 11,043 |                    |  | $            | 11 |         |  | $           | 59,025  |               |  | $          | (28,478 | )       |   | $ | (526   | )     |   | $           | 30,032 |        
|                           
|                            | Net loss                                                      |  |        |                    |  |              |    |         |  |             |         |               |  |            |         | (7,681  | ) |   |        |       |   |             |        | (7,681  | )
|                           
|                           
|                           
|                           
|                            | Translation adjustments                                       |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        | (535  | ) |             |        | (535    | )
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |        
|                            |                                                               |  |        | Comprehensive loss |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |         |   |  | (8,216  | )
|                           
|                           
|                           
|                           
|                            | Issuance of common stock pursuant to stock
compensation plans |  |        | 80                 |  |              |    |        |  |             |         | 539           |  |            |         |         |   |   |        |       |   |             |        | 539     |  
|                           
|                           
|                           
|                           
|                            | Issuance of common stock pursuant to Stock
Purchase Plan      |  |        | 26                 |  |              |    |        |  |             |         | 154           |  |            |         |         |   |   |        |       |   |             |        | 154     |  
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |        
|Balances, December 31, 1999 |                                                               |  | 11,149 |                    |  |              | 11 |         |  |             | 59,718  |               |  |            | (36,159 | )       |   |   | (1,061 | )     |   |             | 22,509 |        
|                           
|                            | Net loss                                                      |  |        |                    |  |              |    |         |  |             |         |               |  |            |         | (8,786  | ) |   |        |       |   |             |        | (8,786  | )
|                           
|                           
|                           
|                           
|                            | Translation adjustments                                       |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        | (266  | ) |             |        | (266    | )
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |        
|                            |                                                               |  |        | Comprehensive loss |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |         |   |  | (9,052  | )
|                           
|                           
|                           
|                           
|                            | Issuance of common stock  private placement                  |  |        | 1,399              |  |              |    | 2       |  |             |         | 16,823        |  |            |         |         |   |   |        |       |   |             |        | 16,825  |  
|                           
|                           
|                           
|                           
|                            | Issuance of common stock pursuant to stock
compensation plans |  |        | 102                |  |              |    |        |  |             |         | 557           |  |            |         |         |   |   |        |       |   |             |        | 557     |  
|                           
|                           
|                           
|                           
|                            | Issuance of common stock pursuant to Stock
Purchase Plan      |  |        | 20                 |  |              |    |        |  |             |         | 178           |  |            |         |         |   |   |        |       |   |             |        | 178     |  
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |        
|Balances, December 31, 2000 |                                                               |  | 12,670 |                    |  |              | 13 |         |  |             | 77,276  |               |  |            | (44,945 | )       |   |   | (1,327 | )     |   |             | 31,017 |        
|                           
|                            | Net loss                                                      |  |        |                    |  |              |    |         |  |             |         |               |  |            |         | (15,981 | ) |   |        |       |   |             |        | (15,981 | )
|                           
|                           
|                           
|                           
|                            | Translation adjustments                                       |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        | (244  | ) |             |        | (244    | )
|                           
|                           
|                           
|                           
|                            | Unrealized gain on marketable securities                      |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        | 52    |   |             |        | 52      |  
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |        
|                           
|                           
|                           
|                           
|                            |                                                               |  |        | Comprehensive loss |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |         |   |  | (16,173 | )
|                           
|                           
|                           
|                           
|                            | Issuance of common stock  private placement                  |  |        | 2,447              |  |              |    | 2       |  |             |         | 29,669        |  |            |         |         |   |   |        |       |   |             |        | 29,671  |  
|                           
|                           
|                           
|                           
|                            | Issuance of common stock pursuant to stock
compensation plans |  |        | 149                |  |              |    |        |  |             |         | 985           |  |            |         |         |   |   |        |       |   |             |        | 985     |  
|                           
|                           
|                           
|                           
|                            | Issuance of common stock pursuant to Stock
Purchase Plan      |  |        | 11                 |  |              |    |        |  |             |         | 124           |  |            |         |         |   |   |        |       |   |             |        | 124     |  
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |        
|Balances, December 31, 2001 |                                                               |  | 15,277 |                    |  | $            | 15 |         |  | $           | 108,054 |               |  | $          | (60,926 | )       |   | $ | (1,519 | )     |   | $           | 45,624 |        
|                            |                                                               |  |        |                    |  |              |    |         |  |             |         |               |  |            |         |         |   |   |        |       |   |             |        |        

See accompanying notes.

F-5



---



##### Table of Contents






PENWEST PHARMACEUTICALS CO.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

|                                                                            |                                                   |   |                         |         |      |   |        |        |   |   |        |        |  
|--------------------------------------------------------------------------- | ------------------------------------------------- | - | ----------------------- | ------- | ---- | - | ------ | ------ | - | - | ------ | ------ | -
|                                                                            |                                                   |   | YEAR ENDED DECEMBER 31,
|                                                                            |                                                   |   |                        
|                                                                            |                                                   |   | 2001                    |         | 2000 |   | 1999  
|                                                                            |                                                   |   |                         |         |      |   |       
|Operating activities:                                                       |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Net loss                                                                    |                                                   | $ | (15,981                 | )       |      | $ | (8,786 | )      |   | $ | (7,681 | )     
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Adjustments to reconcile net loss to
net cash used in operating activities: |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Depreciation                                      |   |                         | 2,831   |      |   |        | 2,879  |   |   |        | 2,881  |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Amortization                                      |   |                         | 265     |      |   |        | 213    |   |   |        | 189    |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Deferred income taxes                             |   |                         |        |      |   |        | (18    | ) |   |        | (353   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Deferred revenue                                  |   |                         | (10     | )    |   |        | 378    |   |   |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Deferred compensation                             |   |                         | 187     |      |   |        | 183    |   |   |        | 164    |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Stock compensation                                |   |                         | 119     |      |   |        | 105    |   |   |        | 142    |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Changes in operating assets and liabilities:                                |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Trade accounts receivable                         |   |                         | 1,926   |      |   |        | (3,111 | ) |   |        | (662   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Inventories                                       |   |                         | 340     |      |   |        | (547   | ) |   |        | 1,155  |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Accounts payable, accrued expenses and other      |   |                         | (729    | )    |   |        | 1,378  |   |   |        | 96     |  
|                                                                            |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|Net cash used in operating activities                                       |                                                   |   | (11,052                 | )       |      |   | (7,326 | )      |   |   | (4,069 | )     
|                                                                            |                                                   |   |                         |        
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Investing activities:                                                       |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Acquisitions of fixed assets, net                 |   |                         | (955    | )    |   |        | (1,412 | ) |   |        | (1,116 | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Intangible asset costs                            |   |                         | (1,078  | )    |   |        | (507   | ) |   |        | (490   | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Purchases of marketable securities                |   |                         | (11,511 | )    |   |        |       |   |   |        |       |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Proceeds from maturities of marketable securities |   |                         | 2,000   |      |   |        |       |   |   |        |       |  
|                                                                            |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|Net cash used in investing activities                                       |                                                   |   | (11,544                 | )       |      |   | (1,919 | )      |   |   | (1,606 | )     
|                                                                            |                                                   |   |                         |        
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Financing activities:                                                       |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Borrowings from credit facility                   |   |                         | 29,616  |      |   |        | 2,800  |   |   |        | 11,600 |  
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Repayments of credit facility                     |   |                         | (26,947 | )    |   |        | (9,500 | ) |   |        | (7,100 | )
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|                                                                            | Issuance of common stock, net                     |   |                         | 30,661  |      |   |        | 17,454 |   |   |        | 551    |  
|                                                                            |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|Net cash provided by financing activities                                   |                                                   |   | 33,330                  |         |      |   | 10,754 |        |   |   | 5,051  |       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Effect of exchange rate changes on
cash and cash equivalents                |                                                   |   | (35                     | )       |      |   | (44    | )      |   |   | (113   | )     
|                                                                            |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|Net increase (decrease) in cash and
cash equivalents                        |                                                   |   | 10,699                  |         |      |   | 1,465  |        |   |   | (737   | )     
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Cash and cash equivalents at beginning of year                              |                                                   |   | 2,204                   |         |      |   | 739    |        |   |   | 1,476  |       
|                                                                            |                                                   |   |                         |         |      |   |        |        |   |   |        |       
|Cash and cash equivalents at end of year                                    |                                                   | $ | 12,903                  |         |      | $ | 2,204  |        |   | $ | 739    |       
|                                                                            |                                                   |   |                         |         |      |   |        |        |   |   |        |       

See accompanying notes.

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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 is also a leader in the development, manufacture,
and distribution of branded pharmaceutical excipients which are the inactive
ingredients in tablets and capsules. Based on its fundamental expertise in
tabletting ingredients, the Company has developed its proprietary TIMERx®
controlled release drug delivery technology, which is applicable to a broad
range of orally administered drugs, and ProSolv® a high functional excipient
based on co-processing technology, which, among other things, improves the
performance characteristics of tablets. The Company is also exploring and
developing other drug delivery technologies. The Company had revenues in 2001,
2000, and 1999 of $40.0, $42.1, and $37.3 million, respectively. The Company
has manufacturing facilities in Iowa and Finland and has customers primarily
throughout North America and Europe.

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

The Company has incurred recurring operating losses and has had
negative cash flows from operations for each of the three years in the period ended
December 31, 2001 and, based on anticipated levels of operations, management
expects operating losses and negative cash flows during 2002 and 2003. Management
anticipates that its existing capital resources as well as internally generated
funds will be sufficient to fund operations through the first quarter of 2003.
The Company may require additional capital to fund its future operations and working
capital needs depending on its discretionary level of research and development spending to
develop new products for its drug development pipeline and for research of new drug delivery
technologies. Although the Company believes that it would be
successful in raising additional capital, there is no guarantee that
it will be able to raise such funds on terms that will be
satisfactory to 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 accounting principles generally accepted in the United States
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.

Certain other 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 maturities of three months or less when
purchased are considered cash equivalents.

Marketable Securities

The Company accounts for marketable securities in accordance with Statement of
Financial Accounting Standards No. 115 (SFAS No. 115), Accounting for Certain
Investments in Debt and Equity Securities. The Company classifies its
marketable securities as available-for-sale securities. Such securities are
stated at fair value and primarily consist of corporate bonds, commercial
paper, and discounted notes backed by U.S. government agencies. Unrealized
holding gains or losses are included in shareholders equity as a separate
component of accumulated other comprehensive loss. The specific identification
method is used to compute the realized gains and losses, if any, on marketable
securities.

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 customer of the Company accounted for approximately 12% and
19% of total revenues in 2001 and 2000, respectively. No customers

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of the Company accounted for 10% or more of total revenues in 1999.

The primary objectives for the Companys investment portfolio are
liquidity and safety of principal. Investments are made to achieve the highest
rate of return to the Company, consistent with these two objectives. The
Companys investment policy limits investments to certain types of instruments
issued by institutions with investment grade credit ratings and places
restrictions on maturities, and concentration by issuer.

The carrying value of financial instruments, which includes cash, cash
equivalents, marketable securities, receivables, obligations under the
Companys credit facility (see Note 10) and accounts payable, approximates fair
value due to the short term nature of these instruments.

Long-Lived Assets

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

|                                         |  |             |  | 
|---------------------------------------- |  | ----------- |  | 
|Buildings                                |  | 20-25 years
|                                        
|                                        
|                                        
|                                        
|Machinery and equipment                  |  | 10-12 years
|                                        
|                                        
|                                        
|                                        
|Office furniture, equipment and software |  | 5-10 years 

The Company systematically reviews the recoverability of its long-lived
and intangible assets by comparing the unamortized carrying value of such
assets to the related anticipated undiscounted future cash flows. Any
impairment related to long-lived assets is measured by reference to the assets
fair market value, and any impairment related to goodwill is measured against
discounted cash flows. Impairments are charged to expense when such
determination is made.

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. Accumulated other comprehensive loss
includes the cumulative translation adjustments, which is a component of other
comprehensive loss included in the Companys financial statements. Realized
gains and losses from foreign currency transactions are reflected in the
consolidated statements of operations. Foreign currency transaction gains and
losses were not significant in each year in the three year period ended
December 31, 2001.

Comprehensive Loss

Comprehensive loss is comprised of net loss and other comprehensive loss.
Other comprehensive loss includes certain changes in shareholders equity that
are excluded from net loss and include unrealized gains on marketable
securities and foreign currency translation adjustments. Comprehensive loss
for the years ended December 31, 2001, 2000, and 1999 has been reflected in the
Consolidated Statements of Shareholders Equity.

Income Taxes

The liability method, prescribed by SFAS No. 109, Accounting for Income
Taxes, is used in accounting for income taxes. Under this method, deferred
tax assets and liabilities are determined based on differences between
financial reporting and tax bases of assets and liabilities. The Company
recorded no income tax benefits relating to the net operating losses generated
during 2001, 2000, and 1999, as such losses were offset by valuation
allowances. Valuation allowances are established against the recorded deferred
income tax assets to the extent that management believes it is more likely than
not that a portion of the deferred income tax assets are not realizable.

Revenue Recognition

Revenues from product sales are recognized when title transfers and
customer acceptance provisions have lapsed, provided collections of the related
accounts receivable are probable. Revenue received from non-refundable upfront
licensing fees are recognized ratably over the development period of the
collaboration agreement, when this period involves development risk associated

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with the incomplete stage of a products development or over the estimated
or contractual licensing and supply term when the Company is obligated to
supply inventory for manufacture when the development risk has substantially
ended. Non-refundable milestone fees received for the development funding of a
product are partially recognized upon receipt based on the Companys
proportionate development efforts achieved to date relative to the total
expected development efforts and the remainder is generally recognized ratably
over the remaining expected development period. Other contractual fees received
in connection with a collaborators launch of a product are also recognized
ratably over the estimated or contractual licensing and supply term. Product
royalty fees are recognized when earned.

Shipping and Handling

Shipping and handling costs incurred by the Company in connection with
products sold are included in cost of product sales on the Consolidated
Statements of Operations.

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. Certain reimbursements of costs, generally related to drug
formulation on feasibility studies, are netted against research and development
expense.

Per Share Data

Loss per common share is computed based on the weighted average number of
common shares outstanding during the period. For all years reported, diluted
loss per share was the equivalent of basic loss per share due to the respective
net losses. No dilution for common share equivalents is included in 2001,
2000, and 1999, as the effects would be antidilutive.

Stock Based Compensation

The Company accounts for stock option grants in accordance with Accounting
Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to
Employees, and, accordingly, recognizes no compensation expense for stock
options granted for which the exercise price of the options was the same as the
market price of the Companys common stock on the date of grant. The Company
has elected to continue to account for its employee stock compensation plans
under APB No. 25. As prescribed under SFAS No. 123, Accounting for Stock Based
Compensation, the Company has disclosed in Note 11, the pro forma effects on
net loss and loss per share of recording compensation expense for the fair
value of the options granted.

3. CHANGE IN ACCOUNTING PRINCIPLE

Prior to the fourth quarter of 2000, the Company recognized revenue for upfront non-refundable fees
when received and when all contractual obligations of the Company relating to
the fees had been fulfilled. In addition, the Company previously recognized
revenue relating to development milestones and other contractual fees as
achieved, in accordance with the terms of the collaboration agreements.
Effective January 1, 2000, the Company changed its method of accounting for
upfront non-refundable fees and milestone fees. Revenue received from
non-refundable upfront licensing fees are recognized ratably over the
development period of the collaboration agreement, when this period involves
development risk associated with the incomplete state of a products
development or over the estimated or contractual licensing and supply term when
the Company is obligated to supply inventory for manufacture, when the
development risk has substantially ended. Non-refundable milestone fees
received for the development funding of a product are partially recognized upon
receipt based on the Companys proportionate development efforts achieved to
date relative to the total expected development efforts and the remainder is
generally recognized ratably over the remaining expected development period.
Other contractual fees received in connection with a collaborators launch of a
product are also recognized ratably over the estimated or contractual licensing
and supply term. The Company believes the change in accounting principle is
preferable based on guidance provided in SEC Staff Accounting Bulletin No. 101,
Revenue Recognition in Financial Statements
(SAB No. 101).

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In
the fourth quarter of 2000, the Company adopted SAB No. 101
effective January 1, 2000. The cumulative effect of
the change in accounting principle was reported as a change in the year ended
December 31, 2000. The cumulative effect was initially recorded as deferred
revenue that will be recognized as revenue over the remaining related
collaborative or licensing and supply agreements, as appropriate. For the year
ended December 31, 2000, the cumulative effect of the change on prior years was
to increase the net loss by $410,000 or $0.03 per share. The effect of the
change on loss before cumulative effect of the change for the year ended
December 31, 2000 was to decrease the net loss by $32,000. The pro forma
amounts presented on the statement of operations were calculated assuming the
accounting change was made retroactively to prior years. During the years
ended December 31, 2001 and 2000, the Company recognized $59,000 and $204,000,
respectively, of revenue/income that is included in its cumulative effect adjustment
as of January 1, 2000.

4. RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard (SFAS) No. 141, Business
Combinations and SFAS No. 142, Goodwill and Other Intangible Assets
effective for fiscal years beginning after December 15, 2001. Under the new
rules, goodwill will no longer be amortized but will be subject to annual
impairment tests. Other intangible assets will continue to be amortized over
their estimated useful lives. The Company will apply the new rules on
accounting for goodwill and other intangible assets beginning in the first
quarter of 2002. The adoption of the new standards is not expected to have a
material effect on the results of operations, financial position, or cash flows
of the Company.

In
October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. SFAS No. 144 supersedes
FAS No. 121, Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of. The primary objectives of FAS No. 144 are to develop one accounting
model based on the framework established in FAS No. 121 for long-lived assets to be
disposed of by sale, and to address significant implementation issues. The
Companys adoption of FAS No. 144 in the first quarter of 2002 is not expected to
have a material effect on the results of operations, financial position, or
cash flows of the Company.

Other pronouncements issued by the FASB or other authoritative accounting
standards groups with future effective dates are either not applicable or not
significant to the financial statements of the Company.

5. MARKETABLE SECURITIES

The amortized costs and estimated fair values of marketed securities at
December 31, 2001 are as follows:

|                                               |                       |   |                |       |            |   |            |    |       |   |           |   |  |   |       |       | 
|---------------------------------------------- | --------------------- | - | -------------- | ----- | ---------- | - | ---------- | -- | ----- | - | --------- | - |  | - | ----- | ----- | 
|                                               |                       |   |                |       |            |   | Gross      |    | Gross |   | Estimated
|                                               |                       |   | Amortized      |       | Unrealized |   | Unrealized |    | Fair 
|                                               |                       |   | Cost           |       | Gains      |   | Losses     |    | Value
|                                               |                       |   |                |       |            |   |            |    |      
|                                               |                       |   | (IN THOUSANDS)
|Corporate debt securities                      |                       | $ | 7,562          |       |            | $ | 52         |    |       | $ |          |   |  | $ | 7,614 |      
|                                              
|                                              
|                                              
|                                              
|U.S. government agency-backed discounted notes |                       |   | 1,995          |       |            |   |           |    |       |   |          |   |  |   | 1,995 |      
|                                               |                       |   |                |       |            |   |            |    |       |   |           |   |  |   |       |      
|                                               | Total debt securities |   | $              | 9,557 |            |   | $          | 52 |       |   | $         |  |  |   | $     | 9,609 | 
|                                               |                       |   |                |       |            |   |            |    |       |   |           |   |  |   |       |      

Maturities of debt securities at fair value as of December 31, 2001, are
as follows (in thousands):

|                      |                                           |                       |   |       |       | 
|--------------------- | ----------------------------------------- | --------------------- | - | ----- | ----- | 
|Contractual maturity: |                                           |                       |   |      
|                     
|                     
|                     
|                     
|                      | Maturing in one year or less              |                       | $ | 5,371 |      
|                     
|                     
|                     
|                     
|                      | Maturing after one year through two years |                       |   | 4,238 |      
|                      |                                           |                       |   |      
|                      |                                           | Total debt securities |   | $     | 9,609 | 
|                      |                                           |                       |   |      

The primary objectives for the Companys investment portfolio are
liquidity and safety of principal. Investments are made to achieve the highest
rate of return to the Company, consistent with these two objectives. The
Companys investment policy limits investments to certain types of instruments
issued by institutions with investment grade credit ratings and places
restrictions on maturities, and concentration by issuer.

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6. 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.

Inventories are summarized as follows:

|                  |                   |   |                |       |      |   |       |       | 
|----------------- | ----------------- | - | -------------- | ----- | ---- | - | ----- | ----- | 
|                  |                   |   | DECEMBER 31   
|                  |                   |   |               
|                  |                   |   | 2001           |       | 2000
|                  |                   |   |                |       |     
|                  |                   |   | (IN THOUSANDS)
|Raw materials     |                   | $ | 1,558          |       |      | $ | 2,611 |      
|                 
|                 
|                 
|                 
|Finished products |                   |   | 6,299          |       |      |   | 5,585 |      
|                  |                   |   |                |       |      |   |       |      
|                  | Total inventories |   | $              | 7,857 |      |   | $     | 8,196 | 
|                  |                   |   |                |       |      |   |       |      

Included in inventories are approximately $191,000 and $466,000 of TIMERx
raw materials and bulk TIMERx as of December 31, 2001 and 2000, 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.

The Company periodically reviews and quality tests its inventory to
identify obsolete, slow moving or otherwise unsaleable inventories. Inventories
at December 31, 2001 and 2000, are net of allowances of $255,000 and $26,000,
respectively.

In September 1999, the Company entered into a five-year contract (plus
automatic renewals of one year each) for the manufacturing of TIMERx material
with another third party pharmaceutical company. 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 business, financial condition, cash flows and
results of operations.

7. FIXED ASSETS

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

|                                  |  |                |        |      |  |   |        | 
|--------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | 
|                                  |  | DECEMBER 31,  
|                                  |  |               
|                                  |  | 2001           |        | 2000
|                                  |  |                |        |     
|                                  |  | (IN THOUSANDS)
|Buildings, equipment and software |  | $              | 34,264 |      |  | $ | 33,844 | 
|                                 
|                                 
|                                 
|                                 
|Land                              |  |                | 696    |      |  |   | 696    | 
|                                 
|                                 
|                                 
|                                 
|Construction in progress          |  |                | 700    |      |  |   | 441    | 
|                                  |  |                |        |      |  |   |        | 
|                                  |  |                | 35,660 |      |  |   | 34,981 | 
|                                 
|                                 
|                                 
|                                 
|Less: accumulated depreciation    |  |                | 20,093 |      |  |   | 17,508 | 
|                                  |  |                |        |      |  |   |        | 
|                                  |  | $              | 15,567 |      |  | $ | 17,473 | 
|                                  |  |                |        |      |  |   |        | 

8. INTANGIBLE ASSETS

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

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|                                                                                      |  |                |       |      |  |   |       | 
|------------------------------------------------------------------------------------- |  | -------------- | ----- | ---- |  | - | ----- | 
|                                                                                      |  | DECEMBER 31,  
|                                                                                      |  |               
|                                                                                      |  | 2001           |       | 2000
|                                                                                      |  |                |       |     
|                                                                                      |  | (IN THOUSANDS)
|Patents, net of accumulated amortization of $770 and $640                             |  | $              | 3,545 |      |  | $ | 2,827 | 
|                                                                                     
|                                                                                     
|                                                                                     
|                                                                                     
|Goodwill, (included in other assets) net of accumulated
amortization of $540 and $468 |  |                | --    |      |  |   | 72    | 

Patents include costs to secure patents on technology developed by the
Company and secure trademarks. Patents are amortized on a straight-line basis
over their useful lives of 17 to 20 years. Amortization expense of $193,000,
$155,000, and $131,000 was recorded in the years ended December 31, 2001, 2000,
and 1999, respectively.

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. During the fourth quarter of 2001, the Company recorded an impairment
loss of $167,000, net of accumulated amortization, relating to its patents.
Such impairment loss is reflected in research and product development expense
on the consolidated statement of operations.

Goodwill was amortized on a straight-line basis over ten years and was
recorded upon the acquisition of the Company by its former parent company.
Amortization expense approximated $72,000 for 2001 and $58,000 for 2000.

9. OTHER ASSETS

Other assets relate to cash surrender values of officers life insurance
policies, and totaled $2,738,000 and $2,623,000 as of December 31, 2001 and
2000, respectively.

10. CREDIT FACILITIES

On January 17, 2001, the Company completed arrangements for a revolving
line of credit (Revolver) with a financial institution. Under the terms of
the Revolver, the Company may borrow up to $10.0 million (Line of Credit) as
determined by a formula based on the Companys Eligible Accounts Receivable and
Eligible Saleable Inventory, as defined in the agreement. Under the formula,
generally 85% of the Companys U.S. and Canadian receivables, as well as
generally 60% of the Companys U.S. saleable inventories, are included in the
borrowing base. Amounts outstanding under the Revolver are collateralized by
the Companys U.S. and Canadian accounts receivable, and its inventory and
general intangibles. The Revolver has an initial term of three years, and
provides for annual renewals thereafter.

The Revolver bears interest at a specified banks prime rate plus 1% per
annum, on the greater of $3.0 million or on the average outstanding balance.
The Revolver also requires fees be paid of 0.5% per annum on unused portions of
the Line of Credit and provides for early termination fees of up to 0.75%, in
the event the Company terminates the Revolver prior to the end of the initial
term.

The Revolver contains covenants, including the requirement that the
Company maintain at all times, certain minimum levels of tangible net worth as
defined, at varying specified amounts during the initial term of the agreement,
and restrictions on the incurrence of additional indebtedness and the payment
of dividends. The Revolver includes a lockbox requirement under the control of
the lender, whereby collections of certain trade receivables are used to
immediately reduce the balance of the Revolver.

As of December 31, 2001, the interest rate on the Revolver was 5.75% and
approximately $2.7 million was outstanding.

A $15 million unsecured revolving credit facility, previously obtained
by the Company in July 1998, was repaid in March 2000 in connection with the
Companys private placement of common stock. (See Note 11).

Approximately $214,000, $147,000, and $303,000, of interest was paid in
2001, 2000, and 1999, respectively.

11. SHAREHOLDERS EQUITY

On March 6, 2000, the Company completed a private placement of its common
stock to selected institutional and other accredited investors, resulting in
the sale of 1,399,232 shares for approximately $18.2 million, less expenses.
Approximately $7.7 million was

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used to repay the existing outstanding balance under a credit facility as
required by its terms. Such credit facility is no longer available to the
Company.

On July 11, 2001, the Company completed a private placement of 2,447,187
shares of common stock to selected institutional investors, resulting in
proceeds of approximately $30 million, less expenses. The Company is using the
net proceeds of this offering primarily for the development of drug delivery
products as well as to fund the research and development of new oral drug
delivery technologies.

Penwest Stock Option Plans

As of December 31, 2001 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. 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. Restricted stock
awards entitle recipients to acquire shares of Common Stock, subject to the
right of the Company to purchase all or 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. In 1998, a total of 52,500 restricted shares were granted. No such shares were granted in 2001, 2000, or 1999.

On August 31, 1998, Penford Corporation (Penford) distributed to the
shareholders of Penford common stock, all of the outstanding shares of the
Companys common stock (the Distribution). In connection with such
transaction, the Companys 1998 Spin-off Option Plan was adopted 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 ceased to be employees of Penford
under the terms of Penfords stock option plans. As of the Distribution date,
options to purchase 1,000,722 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. 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.

|                           |  |        |           |       |  |                |              |              |  |   |       | 
|-------------------------- |  | ------ | --------- | ----- |  | -------------- | ------------ | ------------ |  | - | ----- | 
|                           |  |        |           |       |  | OPTION PRICE   |              | WTD. AVERAGE
|                           |  | SHARES |           | RANGE |  | EXERCISE PRICE
|                           |  |        |           |       |  |               
|BALANCE, DECEMBER 31, 1998 |  |        | 1,694,688 |       |  | $              | 3.70 - 8.67  |              |  | $ | 6.21  | 
|                          
|                          
|                          
|                          
|1999                       |  |        |           |       |  |                |              |              |  |   |       | 
|                          
|                          
|                          
|                          
|Granted                    |  |        | 332,307   |       |  | $              | 4.78 - 9.21  |              |  | $ | 7.33  | 
|                          
|                          
|                          
|                          
|Exercised                  |  |        | (85,160   | )     |  | $              | 5.26 - 7.03  |              |  | $ | 6.19  | 
|                          
|                          
|                          
|                          
|Cancelled                  |  |        | (35,092   | )     |  | $              | 5.26 - 6.75  |              |  | $ | 6.35  | 
|                           |  |        |           |       |  |                |              |              |  |   |       | 
|Balance, December 31, 1999 |  |        | 1,906,743 |       |  | $              | 3.70 - 9.21  |              |  | $ | 6.41  | 
|                           |  |        |           |       |  |                |              |              |  |   |       | 
|Options Exercisable        |  |        | 722,818   |       |  | $              | 3.70 - 9.21  |              |  | $ | 6.00  | 
|                           |  |        |           |       |  |                |              |              |  |   |       | 
|2000                       |  |        |           |       |  |                |              |              |  |   |       | 
|                          
|                          
|                          
|                          
|Granted                    |  |        | 597,925   |       |  | $              | 7.35 - 14.38 |              |  | $ | 11.82 | 
|                          
|                          
|                          
|                          
|Exercised                  |  |        | (105,302  | )     |  | $              | 4.06 - 8.67  |              |  | $ | 5.98  | 
|                          
|                          
|                          
|                          
|Cancelled                  |  |        | (136,010  | )     |  | $              | 5.26 - 12.75 |              |  | $ | 7.59  | 
|                           |  |        |           |       |  |                |              |              |  |   |       | 
|Balance, December 31, 2000 |  |        | 2,263,356 |       |  | $              | 3.70 - 14.38 |              |  | $ | 7.77  | 
|                           |  |        |           |       |  |                |              |              |  |   |       | 
|Options Exercisable        |  |        | 1,072,947 |       |  | $              | 3.70 - 10.78 |              |  | $ | 6.30  | 
|                           |  |        |           |       |  |                |              |              |  |   |       | 
|2001                       |  |        |           |       |  |                |              |              |  |   |       | 
|                          
|                          
|                          
|                          
|Granted                    |  |        | 382,501   |       |  | $              | 8.58 - 18.18 |              |  | $ | 12.65 | 
|                          
|                          
|                          
|                          
|Exercised                  |  |        | (135,842  | )     |  | $              | 3.70 - 8.88  |              |  | $ | 6.38  | 
|                          
|                          
|                          
|                          
|Cancelled                  |  |        | (230,000  | )     |  | $              | 6.38 - 11.81 |              |  | $ | 11.72 | 
|                           |  |        |           |       |  |                |              |              |  |   |       | 
|Balance, December 31, 2001 |  |        | 2,280,015 |       |  | $              | 3.70 - 18.18 |              |  | $ | 8.26  | 
|                           |  |        |           |       |  |                |              |              |  |   |       | 
|                          
|                          
|                          
|                          
|Options Exercisable        |  |        | 1,381,264 |       |  | $              | 3.70 - 14.38 |              |  | $ | 7.28  | 
|                           |  |        |           |       |  |                |              |              |  |   |       | 

F-13



---



##### Table of Contents



Stock Compensation

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 basic and diluted share as if compensation expense
associated with employee stock options granted to employees of Penwest had been
calculated under the fair value method of SFAS No. 123 as follows:

|                                                    |  |                                       |         |      |  |      |        |   |  |   |        |  
|--------------------------------------------------- |  | ------------------------------------- | ------- | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                    |  | YEARS ENDED DECEMBER 31,             
|                                                    |  |                                      
|                                                    |  | 2001                                  |         | 2000 |  | 1999
|                                                    |  |                                       |         |      |  |     
|                                                    |  | (IN THOUSANDS, EXCEPT PER SHARE DATA)
|Net loss  as reported                              |  | $                                     | (15,981 | )    |  | $    | (8,786 | ) |  | $ | (7,681 | )
|                                                   
|                                                   
|                                                   
|                                                   
|Net loss  pro forma                                |  | $                                     | (17,602 | )    |  | $    | (9,579 | ) |  | $ | (9,286 | )
|                                                   
|                                                   
|                                                   
|                                                   
|Net loss per share, basic and diluted  as reported |  | $                                     | (1.15   | )    |  | $    | (0.71  | ) |  | $ | (0.69  | )
|                                                   
|                                                   
|                                                   
|                                                   
|Net loss per share, basic and diluted  pro forma   |  | $                                     | (1.27   | )    |  | $    | (0.78  | ) |  | $ | (0.84  | )

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

|                         |  |           |     |           |  |           |     |   |  |  |      |  
|------------------------ |  | --------- | --- | --------- |  | --------- | --- | - |  |  | ---- | -
|                         |  | 2001      |     | 2000      |  | 1999     
|                         |  |           |     |           |  |          
|Expected dividend yield  |  | None      |     | None      |  | None     
|                        
|                        
|                        
|                        
|Risk free interest rate  |  |           | 5.5 | %         |  |           | 6.1 | % |  |  | 5.80 | %
|                        
|                        
|                        
|                        
|Expected volatility      |  |           | 52  | %         |  |           | 82  | % |  |  | 75   | %
|                        
|                        
|                        
|                        
|Expected life of options |  | 7.5 years |     | 7.5 years |  | 7.5 years

The weighted average fair value of options granted during the years ended
December 31, 2001, 2000, and 1999, was $8.03, $11.92, and $5.73, respectively.
The weighted average remaining contractual life of options outstanding at
December 31, 2001 is 8.2 years. The weighted effect of applying SFAS No.
123 for providing pro forma disclosures for the years ended December 31, 2001,
2000, and 1999, 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. There were 10,696 shares,
20,415 shares, and 25,930 shares issued under the Plan during 2001, 2000, and
1999, respectively.

Rights Agreement

On June 25, 1998, the Companys 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.

12. COMMITMENTS

Leases

F-14



---



##### Table of Contents



The Companys manufacturing facility in Finland is leased under a
three-year operating lease which includes renewal options with annual rental
expense of approximately $216,000 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 $683,000, $583,000, and $343,000 for the
years ended December 31, 2001, 2000, and 1999, respectively.

Future minimum lease payments as of December 31, 2001 for noncancellable
operating leases having initial lease terms of more than one year are as
follows:

|                             |            |      |       |                |     | 
|---------------------------- | ---------- | ---- | ----- | -------------- | --- | 
|                             |            |      |       | OPERATING     
|                             |            |      |       | LEASES        
|                             |            |      |       | (IN THOUSANDS)
|                             |            | 2002 |       | $              | 760 | 
|                            
|                            
|                            
|                            
|                             |            | 2003 |       |                | 696 | 
|                            
|                            
|                            
|                            
|                             |            | 2004 |       |                | 627 | 
|                            
|                            
|                            
|                            
|                             |            | 2005 |       |                | 307 | 
|                            
|                            
|                            
|                            
|                             |            | 2006 |       |                | 302 | 
|                            
|                            
|                            
|                            
|                             | Thereafter |      |       | 51             |    
|                             |            |      |       |               
|Total minimum lease payments |            | $    | 2,743 |               
|                             |            |      |       |               

13. INCOME TAXES

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

|         |          |   |                |     |      |   |      |     |   |   |     |      |  
|-------- | -------- | - | -------------- | --- | ---- | - | ---- | --- | - | - | --- | ---- | -
|         |          |   | 2001           |     | 2000 |   | 1999
|         |          |   |                |     |      |   |     
|         |          |   | (IN THOUSANDS)
|Federal: |          |   |                |     |      |   |      |     |   |   |     |     
|        
|        
|        
|        
|         | Deferred |   | $              |    |      |   | $    |    |   |   | $   | (218 | )
|        
|        
|        
|        
|Foreign: |          |   |                |     |      |   |      |     |   |   |     |     
|        
|        
|        
|        
|         | Current  |   |                | 473 |      |   |      | 290 |   |   |     | 283  |  
|        
|        
|        
|        
|         | Deferred |   |                |    |      |   |      | (18 | ) |   |     | (87  | )
|        
|        
|        
|        
|State:   |          |   |                |     |      |   |      |     |   |   |     |     
|        
|        
|        
|        
|         | Current  |   |                | 30  |      |   |      | 30  |   |   |     | 2    |  
|        
|        
|        
|        
|         | Deferred |   |                |    |      |   |      |    |   |   |     | (48  | )
|         |          |   |                |     |      |   |      |     |   |   |     |      |  
|         |          | $ | 503            |     |      | $ | 302  |     |   | $ | (68 | )   
|         |          |   |                |     |      |   |      |     |   |   |     |      |  

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

|                    |  |      |     |      |  |      |     |    |  |  |     |   
|------------------- |  | ---- | --- | ---- |  | ---- | --- | -- |  |  | --- | --
|                    |  | 2001 |     | 2000 |  | 1999
|                    |  |      |     |      |  |     
|Statutory tax rate  |  |      | (34 | )%   |  |      | (34 | )% |  |  | (34 | )%
|                   
|                   
|                   
|                   
|Valuation allowance |  |      | 40  |      |  |      | 36  |    |  |  | 35  |   
|                   
|                   
|                   
|                   
|Foreign taxes       |  |      | (1  | )    |  |      | 1   |    |  |  | (1  | ) 
|                   
|                   
|                   
|                   
|Other               |  |      | (2  | )    |  |      | 1   |    |  |  | (1  | ) 
|                    |  |      |     |      |  |      |     |    |  |  |     |   
|                    |  |      | 3   | %    |  |      | 4   | %  |  |  | (1  | )%
|                    |  |      |     |      |  |      |     |    |  |  |     |   

The components of deferred income tax (assets) and liabilities at December
31 are as follows:

|                                                  |                                |   |                |         |      |   |        |         |  
|------------------------------------------------- | ------------------------------ | - | -------------- | ------- | ---- | - | ------ | ------- | -
|                                                  |                                |   | 2001           |         | 2000
|                                                  |                                |   |                |         |     
|                                                  |                                |   | (IN THOUSANDS)
|Receivable allowance                              |                                | $ | (85            | )       |      | $ | (91    | )      
|                                                 
|                                                 
|                                                 
|                                                 
|Inventory reserves and basis differences          |                                |   | (331           | )       |      |   | (185   | )      
|                                                 
|                                                 
|                                                 
|                                                 
|Deferred compensation and SERP liability          |                                |   | (1,047         | )       |      |   | (975   | )      
|                                                 
|                                                 
|                                                 
|                                                 
|Deferred revenue                                  |                                |   | (142           | )       |      |   | (146   | )      
|                                                 
|                                                 
|                                                 
|                                                 
|Tax credit carryforward                           |                                |   | (467           | )       |      |   | (149   | )      
|                                                 
|                                                 
|                                                 
|                                                 
|Net operating loss carryforwards                  |                                |   | (16,021        | )       |      |   | (8,999 | )      
|                                                 
|                                                 
|                                                 
|                                                 
|Other                                             |                                |   | (164           | )       |      |   |       |        
|                                                  |                                |   |                |         |      |   |        |        
|                                                  | Total deferred tax assets      |   |                | (18,257 | )    |   |        | (10,545 | )
|                                                  |                                |   |                |         |      |   |        |        
|Depreciation and amortization                     |                                |   | 3,232          |         |      |   | 3,302  |        
|                                                 
|                                                 
|                                                 
|                                                 
|Other                                             |                                |   | 337            |         |      |   | 102    |        
|                                                  |                                |   |                |         |      |   |        |        
|                                                  | Total deferred tax liabilities |   |                | 3,569   |      |   |        | 3,404   |  
|                                                  |                                |   |                |         |      |   |        |        
|Net deferred tax asset before valuation allowance |                                |   | (14,688        | )       |      |   | (7,141 | )      

F-15



---



##### Table of Contents



|                           |  |   |                |  |      |   |       |  | 
|-------------------------- |  | - | -------------- |  | ---- | - | ----- |  | 
|                           |  |   | 2001           |  | 2000
|                           |  |   |                |  |     
|                           |  |   | (IN THOUSANDS)
|                          
|                          
|                          
|                          
|Valuation allowance        |  |   | 14,893         |  |      |   | 7,346 | 
|                           |  |   |                |  |      |   |       | 
|Net deferred tax liability |  | $ | 205            |  |      | $ | 205   | 
|                           |  |   |                |  |      |   |       | 

The Companys income tax payments, primarily comprised of foreign income
taxes, approximated $342,000, $371,000, and $243,000, for the years ended
December 31, 2001, 2000, and 1999, respectively.

At December 31, 2001, the Company has federal net operating loss (NOL)
carryforwards of $41,482,000 for income tax purposes, of which approximately
$6,188,000, $8,407,000, $9,135,000, and $17,752,000 expire in 2018, 2019, 2020,
and 2021, respectively. In addition, the Company has research and development
tax credit carryforwards of approximately $455,000, of which $149,000 and
$306,000 expire in 2020 and 2021, respectively. The use of the NOLs and
research and development tax credit carryforwards are limited to future taxable earnings of
the Company. For financial reporting purposes at December 31, 2001, a valuation
allowance of $14.9 million has been recognized to offset net deferred tax
assets, primarily attributable to the NOL carry-forward. Utilization of the operating losses
are subject to a limitation due to the ownership change provisions of
the Internal Revenue Code.

The Companys policy is to permanently reinvest foreign earnings.
Accumulated foreign earnings, for which no deferred taxes have been provided,
amounted to $5,043,000, $3,794,000, and $3,372,000 as of December 31, 2001,
2000, and 1999, 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 $1,651,000,
$977,000, and $971,000, for the years ended December 31, 2001, 2000, and 1999,
respectively.

14. RETIREMENT PLANS AND OTHER EMPLOYEE BENEFITS

Savings Plan

Company employees participate in the Penwest Pharmaceuticals Co. Savings
Plan, a defined contribution plan generally covering all of its U.S. employees.
Under the Plan, the Company may make quarterly employer matching contributions
as defined in the Plan agreement, in an amount equal to a percentage of each
participants pre-tax contributions to the Plan up to 6% of earnings.
Participants are immediately vested in their contributions, as well as any
earnings thereon. Vesting in the employer contribution portion of their
accounts, as well as any earnings thereon is based on years of credited service
and vest over a four-year period. The Companys expense under the Plan was
$227,000, $237,000, and $212,000 for 2001, 2000, and 1999, respectively.

The Plan also includes a discretionary annual profit-sharing component
that is awarded by Penwests Board of Directors generally based on achievement
of predetermined corporate goals. This feature is available to all employees
who meet the eligibility requirements of the Plan. There was no profit sharing
expense in 2001, 2000, or 1999.

Supplemental Executive Retirement Plan

The Company has a Supplemental Executive Retirement Plan (SERP), a
nonqualified plan, which covers the Chairman and Chief Executive Officer of
Penwest. For 2001, 2000, and 1999, the net expense for the SERP incurred by
Penwest was $125,000, $122,000, and $141,000, respectively. The Company does
not fund this liability and no assets are held by the Plan. The following
disclosures summarize information relating to the Plan.

Change in benefit obligation (in thousands):

|                                          |  |      |       |      |  |   |       |  
|----------------------------------------- |  | ---- | ----- | ---- |  | - | ----- | -
|                                          |  | 2001 |       | 2000
|                                          |  |      |       |     
|Benefit obligation at beginning of period |  | $    | 1,453 |      |  | $ | 1,318 |  
|                                         
|                                         
|                                         
|                                         
|Service cost                              |  |      | (19   | )    |  |   | (16   | )
|                                         
|                                         
|                                         
|                                         
|Interest cost                             |  |      | 108   |      |  |   | 97    |  
|                                         
|                                         
|                                         
|                                         
|Actuarial gains                           |  |      | 38    |      |  |   | 54    |  
|                                          |  |      |       |      |  |   |       |  
|Benefit obligation at December 31         |  | $    | 1,580 |      |  | $ | 1,453 |  
|                                          |  |      |       |      |  |   |       |  

Funded status (in thousands):

|                                       |                                     |   |        |        |      |   |        |        |  
|-------------------------------------- | ----------------------------------- | - | ------ | ------ | ---- | - | ------ | ------ | -
|                                       |                                     |   | 2001   |        | 2000
|                                       |                                     |   |        |        |     
|Funded status (unfunded)               |                                     | $ | (1,580 | )      |      | $ | (1,453 | )     
|                                      
|                                      
|                                      
|                                      
|Unrecognized net transition obligation |                                     |   | 160    |        |      |   | 220    |       
|                                      
|                                      
|                                      
|                                      
|Unrecognized prior service cost        |                                     |   | 51     |        |      |   | 99     |       
|                                      
|                                      
|                                      
|                                      
|Unrecognized net actuarial gain        |                                     |   | (550   | )      |      |   | (661   | )     
|                                       |                                     |   |        |        |      |   |        |       
|Net amount recognized at December 31,  |                                     |   |        |        |      |   |        |       
|                                       | (included in deferred compensation) |   | $      | (1,919 | )    |   | $      | (1,795 | )
|                                       |                                     |   |        |        |      |   |        |       

F-16



---



##### Table of Contents



Components of net periodic benefit cost (in thousands):

|                                                   |                           |   |      |     |      |   |     |     | 
|-------------------------------------------------- | ------------------------- | - | ---- | --- | ---- | - | --- | --- | 
|                                                   |                           |   | 2001 |     | 2000
|                                                   |                           |   |      |     |     
|Service cost                                       |                           | $ | (19  | )   |      | $ | (16 | )  
|                                                  
|                                                  
|                                                  
|                                                  
|Interest cost                                      |                           |   | 108  |     |      |   | 97  |    
|                                                  
|                                                  
|                                                  
|                                                  
|Amortization of unrecognized transition
obligation |                           |   | 60   |     |      |   | 60  |    
|                                                  
|                                                  
|                                                  
|                                                  
|Amortization of prior service cost                 |                           |   | 49   |     |      |   | 63  |    
|                                                  
|                                                  
|                                                  
|                                                  
|Amortization of gains                              |                           |   | (73  | )   |      |   | (82 | )  
|                                                   |                           |   |      |     |      |   |     |    
|                                                   | Net periodic benefit cost |   | $    | 125 |      |   | $   | 122 | 
|                                                   |                           |   |      |     |      |   |     |    

The Plans accumulated benefit obligation at December 31, 2001 and 2000
was $1,356,000 and $1,216,900, respectively. The Companys benefit obligation
was measured using a weighted average discount rate of 7.25% and 7.50% in 2001
and 2000, respectively, and a compensation increase of 4% and 3%, in 2001 and
2000, respectively. 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 $732,000, $682,000, and
$491,000, in 2001, 2000, and 1999, respectively.

15. LICENSING AGREEMENTS

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

In September 1997, the Company entered into a strategic alliance agreement
with Endo with respect to the development of an extended release formulation of
oxymorphone based on the Companys TIMERx technology (the Endo Product). Endo
is a fully integrated specialty pharmaceutical company with a market leadership
in pain management. Endo has a broad product line including 12 branded products
that include the established brands such as 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 the Endo Product are determined by a committee
comprised of an equal number of members from each of the Company and Endo (the
Alliance Committee). However, the Company formulated the Endo Product and
Endo is conducting all clinical studies and will prepare and file all
regulatory applications and submissions. 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
the Endo Product 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 may be terminated upon a material breach of
the agreement by a party.

The Company and Endo share the costs involved in the development and
commercialization of the Endo Product and have agreed that the party marketing
the Endo Product will pay the other
party royalties initially equal to 50% of net profits (as defined in the
agreement). This percentage will decrease if the total U.S. net profits exceed
pre-determined thresholds. This cost-sharing is subject to each partys right to terminate its participation in the funding of development and commercialization of the Endo Product. In general, the royalty payable by the marketing party to the other party
will not drop below 40%; however, a one-third royalty reduction provision does
apply in limited circumstances, including material breaches of the agreement by
the royalty receiving party and certain bankruptcy and insolvency events
involving the royalty receiving party. Endo will purchase formulated TIMERx material for
use in the Endo Product exclusively from the Company at specified prices. Such
prices will be reflected in the determination of net profits.

F-17



---



##### Table of Contents



On March 2, 2000, Mylan announced that it had signed a supply and
distribution agreement with Pfizer to market a generic version of all three
strengths (30 mg, 60 mg, 90 mg) of Pfizers Procardia XL. In connection with
that agreement, Mylan decided not to market Nifedipine XL and agreed to pay
Penwest a royalty on all future net sales of the 30 mg strength of Pfizers
generic Procardia XL. The royalty percentage was comparable to the percentage
called for in Penwests original agreement with Mylan for Nifedipine XL.
Mylan has retained the marketing rights to the 30 mg strength of
Nifedipine XL. Mylans sales in the United States in 2001 of the 30 mg dosage strength version
of Pfizers generic Procardia XL totaled approximately $48.2 million. The term
of this agreement continues until such time as Mylan permanently ceases to
market generic Procardia XL.

Approximately $16,093,000, $12,102,000, and $6,429,000, for the years
ended December 31, 2001, 2000, and 1999, 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.

16. CONTINGENCIES

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.

17. SEGMENT INFORMATION

The Company is engaged in the research, development and commercialization
of novel oral drug delivery products and technologies, and has extensive
expertise in developing, manufacturing, and selling excipient 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.

The Companys geographic area data for each of the three fiscal years
ended December 31, 2001, 2000, and 1999 were as follows:

|                  |  |                |        |         |  |       |       |              |  |       |       |  |  |   |        |   |  |   |        | 
|----------------- |  | -------------- | ------ | ------- |  | ----- | ----- | ------------ |  | ----- | ----- |  |  | - | ------ | - |  | - | ------ | 
|                  |  | NORTH          |        |         |  |       |       |              |  |       |       |  |  |   |        |   |  |  
|                  |  | AMERICA        |        | FINLAND |  | OTHER |       | ELIMINATIONS |  | TOTAL
|                  |  |                |        |         |  |       |       |              |  |      
|                  |  | (IN THOUSANDS)
|DECEMBER 31, 2001 |  |                |        |         |  |       |       |              |  |       |       |  |  |   |        |   |  |   |        | 
|                 
|                 
|                 
|                 
|Total Revenues    |  | $              | 38,412 |         |  | $     | 6,912 |              |  | $     | 3,650 |  |  | $ | (8,971 | ) |  | $ | 40,003 | 
|                 
|                 
|                 
|                 
|Long-lived Assets |  | $              | 21,268 |         |  | $     | 557   |              |  | $     | 25    |  |  |   |        |   |  | $ | 21,850 | 
|                 
|                 
|                 
|                 
|DECEMBER 31, 2000 |  |                |        |         |  |       |       |              |  |       |       |  |  |   |        |   |  |   |        | 
|                 
|                 
|                 
|                 
|Total Revenues    |  | $              | 40,922 |         |  | $     | 5,708 |              |  | $     | 2,948 |  |  | $ | (7,520 | ) |  | $ | 42,058 | 
|                 
|                 
|                 
|                 
|Long-lived Assets |  | $              | 22,371 |         |  | $     | 604   |              |  | $     | 20    |  |  |   |        |   |  | $ | 22,995 | 
|                 
|                 
|                 
|                 
|DECEMBER 31, 1999 |  |                |        |         |  |       |       |              |  |       |       |  |  |   |        |   |  |   |        | 
|                 
|                 
|                 
|                 
|Total Revenues    |  | $              | 35,290 |         |  | $     | 5,490 |              |  | $     | 4,038 |  |  | $ | (7,511 | ) |  | $ | 37,307 | 
|                 
|                 
|                 
|                 
|Long-lived Assets |  | $              | 23,377 |         |  | $     | 650   |              |  | $     | 34    |  |  |   |        |   |  | $ | 24,061 | 

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

F-18



---



##### Table of Contents



total revenues or long-lived assets, respectively, of the Company.

18. QUARTERLY FINANCIAL DATA (UNAUDITED)

Summarized quarterly financial data for the years ended December 31, 2001 and
2000 is as follows (in thousands, except per share data):

|                   |  |                |        |               |  |                |        |               |  |   |        |   |  |   |        |  
|------------------ |  | -------------- | ------ | ------------- |  | -------------- | ------ | ------------- |  | - | ------ | - |  | - | ------ | -
|                   |  | Quarter Ended 
|                   |  |               
|                   |  | March 31, 2001 |        | June 30, 2001 |  | Sept. 30, 2001 |        | Dec. 31, 2001
|                   |  | (Unaudited)    |        | (Unaudited)   |  | (Unaudited)    |        | (Unaudited)  
|Total revenues     |  | $              | 10,939 |               |  | $              | 9,515  |               |  | $ | 9,801  |   |  | $ | 9,748  |  
|                  
|                  
|                  
|                  
|Gross profit       |  |                | 4.376  |               |  |                | 3,698  |               |  |   | 3,633  |   |  |   | 3,486  |  
|                  
|                  
|                  
|                  
|Net loss           |  | $              | (2,123 | )             |  | $              | (3,166 | )             |  | $ | (4,125 | ) |  | $ | (6,567 | )
|                   |  |                |        |               |  |                |        |               |  |   |        |   |  |   |        |  
|Net loss per share |  | $              | (0.17  | )             |  | $              | (0.25  | )             |  | $ | (0.28  | ) |  | $ | (0.43  | )
|                   |  |                |        |               |  |                |        |               |  |   |        |   |  |   |        |  

|                                                                          |  |                |        |               |  |                |        |               |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------- |  | -------------- | ------ | ------------- |  | -------------- | ------ | ------------- |  | - | ------ | - |  | - | ------ | -
|                                                                          |  | Quarter Ended 
|                                                                          |  |               
|                                                                          |  | March 31, 2000 |        | June 30, 2000 |  | Sept. 30, 2000 |        | Dec. 31, 2000
|                                                                          |  | (Unaudited)    |        | (Unaudited)   |  | (Unaudited)    |        | (Unaudited)  
|Total revenues                                                            |  | $              | 11,375 |               |  | $              | 8,903  |               |  | $ | 11,224 |   |  | $ | 10,556 |  
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Gross profit                                                              |  |                | 4.558  |               |  |                | 3,619  |               |  |   | 4,144  |   |  |   | 4,434  |  
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Loss before cumulative effect of change in
accounting principle           |  |                | (1,309 | )             |  |                | (2,108 | )             |  |   | (2,145 | ) |  |   | (2,812 | )
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Cumulative effect of change in accounting principle                       |  |                | (410   | )             |  |                |       |               |  |   |       |   |  |   |       |  
|                                                                          |  |                |        |               |  |                |        |               |  |   |        |   |  |   |        |  
|Net loss                                                                  |  | $              | (1,719 | )             |  | $              | (2,108 | )             |  | $ | (2,145 | ) |  | $ | (2,812 | )
|                                                                          |  |                |        |               |  |                |        |               |  |   |        |   |  |   |        |  
|Basic and diluted amounts per share:                                      |  |                |        |               |  |                |        |               |  |   |        |   |  |   |        |  
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Loss per share before cumulative effect of change
in accounting principle |  | $              | (0.11  | )             |  | $              | (0.17  | )             |  | $ | (0.17  | ) |  | $ | (0.22  | )
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Cumulative effect of change in accounting
principle                       |  |                | (0.04  | )             |  |                |       |               |  |   |       |   |  |   |       |  
|                                                                          |  |                |        |               |  |                |        |               |  |   |        |   |  |   |        |  
|Net loss per share                                                        |  | $              | (0.15  | )             |  | $              | (0.17  |               |  | $ | 0.17   | ) |  | $ | (0.22  | )
|                                                                          |  |                |        |               |  |                |        |               |  |   |        |   |  |   |        |  

F-19



---



##### Table of Contents



SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS

PENWEST PHARMACEUTICALS CO.
DECEMBER 31, 2001

(IN THOUSANDS)

|                             |                                 |  |            |     |            |  |           |     |             |  |            |   |  |  |        |     |            |     |  |  |  |  |   |     | 
|---------------------------- | ------------------------------- |  | ---------- | --- | ---------- |  | --------- | --- | ----------- |  | ---------- | - |  |  | ------ | --- | ---------- | --- |  |  |  |  | - | --- | 
|                             |                                 |  |            |     |            |  |           |     |             |  | Charged to |   |  |  |        |     |            |     |  |  |  |  |  
|                             |                                 |  | Balance at |     | Charged to |  | Other     |     |             |  |            |   |  |  |        |     | Balance at
|                             |                                 |  | Beginning  |     | Costs and  |  | Accounts- |     | Deductions- |  |            |   |  |  | End of
|                             |                                 |  | of Period  |     | Expenses   |  | Describe  |     | Describe    |  |            |   |  |  | Period
|                             |                                 |  |            |     |            |  |           |     |             |  |            |   |  |  |       
|Year ended December 31, 2001 |                                 |  |            |     |            |  |           |     |             |  |            |   |  |  |        |     |            |     |  |  |  |  |   |    
|                            
|                            
|                            
|                            
|                             | Allowance for Doubtful Accounts |  | $          | 235 |            |  | $         | 25  |             |  |            |  |  |  | $      | 40  |            | (a) |  |  |  |  | $ | 220 | 
|                            
|                            
|                            
|                            
|                             | Inventory Allowances            |  | $          | 26  |            |  | $         | 324 |             |  |            |  |  |  | $      | 95  |            | (b) |  |  |  |  | $ | 255 | 
|                            
|                            
|                            
|                            
|Year ended December 31, 2000 |                                 |  |            |     |            |  |           |     |             |  |            |   |  |  |        |     |            |     |  |  |  |  |   |    
|                            
|                            
|                            
|                            
|                             | Allowance for Doubtful Accounts |  | $          | 245 |            |  | $         | (31 | )           |  |            |  |  |  | $      | (21 | )          | (a) |  |  |  |  | $ | 235 | 
|                            
|                            
|                            
|                            
|                             | Inventory Allowances            |  | $          | 277 |            |  | $         | 334 |             |  |            |  |  |  | $      | 585 |            | (b) |  |  |  |  | $ | 26  | 
|                            
|                            
|                            
|                            
|Year ended December 31, 1999 |                                 |  |            |     |            |  |           |     |             |  |            |   |  |  |        |     |            |     |  |  |  |  |   |    
|                            
|                            
|                            
|                            
|                             | Allowance for Doubtful Accounts |  | $          | 227 |            |  | $         | 32  |             |  |            |  |  |  | $      | 14  |            | (a) |  |  |  |  | $ | 245 | 
|                            
|                            
|                            
|                            
|                             | Inventory Allowances            |  | $          | 132 |            |  | $         | 243 |             |  |            |  |  |  | $      | 98  |            | (b) |  |  |  |  | $ | 277 | 



|(a) |  | Uncollectible accounts written off, net of recoveries.
|--- |  | ------------------------------------------------------
|   
|   
|   
|   
|(b) |  | Disposals of unrecoverable inventory costs.           

S-1



---



##### Table of Contents






INDEX TO EXHIBITS

|         |  |                                                                                                                                              
|-------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT  |  |                                                                                                                                              
|NO.      |  | DESCRIPTION                                                                                                                                  
|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     |  | Intentionally Omitted.                                                                                                                       
|        
|        
|        
|        
|         |  |                                                                                                                                              
|        
|        
|        
|        
|+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     |  | Intentionally Omitted.                                                                                                                       
|        
|        
|        
|        
|         |  |                                                                                                                                              
|        
|        
|        
|        
|+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 entered into between the Registrant and Penford.                                                          
|        
|        
|        
|        
|         |  |                                                                                                                                              
|        
|        
|        
|        
|10.16**  |  | Form of Tax Allocation Agreement 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 of Contents



|         |  |                                                                                             
|-------- |  | --------------------------------------------------------------------------------------------
|EXHIBIT  |  |                                                                                             
|NO.      |  | DESCRIPTION                                                                                 
|        
|        
|        
|        
|10.22*** |  | Manufacturing Agreement dated September 27, 2001 between the Company and Draxis Pharma, Inc.
|        
|        
|        
|        
|         |  |                                                                                             
|        
|        
|        
|        
|21.1*    |  | Subsidiaries.                                                                               
|        
|        
|        
|        
|         |  |                                                                                             
|        
|        
|        
|        
|23       |  | Consent of Ernst & Young LLP.                                                               
|        
|        
|        
|        
|         |  |                                                                                             
|        
|        
|        
|        
|24       |  | Power of Attorney.                                                                          



|*   |  | 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.
|   
|   
|   
|   
|*** |  | Incorporated by reference to Exhibits to the Companys Quarterly Report
on Form 10Q (No.000-23467) for the quarterly period ended September 30,
2001. 
|   
|   
|   
|   
|+   |  | 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.