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-UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-K  x
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 2004
OR o
    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.  Washington
(State or other jurisdiction of
incorporation or organization)
    
    91-1513032
(I.R.S. Employer
Identification No.)
 39 Old Ridgebury Road
Suite 11
Danbury, Connecticut
(Address of principal Executive Offices)
    
    06810-5120
(Zip Code)
 Registrants telephone number, including area code: (877) 736-9378 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, $.001 par value
(Including Associated Preferred Stock Purchase Rights) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the Registrant was required to file such reports), and (2) has been
subject to such filing requirements for at least the past 90 days. Yes x No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of registrants knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act
Rule 12b-2). Yes x No o The aggregate market value of the Registrants Common Stock held by non-affiliates as of June 30,
2004 was approximately
$237,517,000 based on the last sale price of the Registrants Common Stock on the Nasdaq National
Market on June 30, 2004. The number of shares of the Registrants Common Stock outstanding as of
March 11, 2005 was 21,714,891. DOCUMENTS INCORPORATED BY REFERENCE Portions of our definitive Proxy Statement relating to the 2005 Annual Meeting of Shareholders
to be held on June 1, 2005 are incorporated by reference into Part III of this Form 10-K.




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PENWEST PHARMACEUTICALS CO.
INDEX TO FORM 10-K PagePART IItem 1. Business
    
    
    1Item 2. Properties
    
    
    12Executive Officers of the Registrant
    
    
    12PART IIItem 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities
    
    
    14Item 6. Selected Financial Data
    
    
    15Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    16Item 7a. Quantitative and Qualitative Disclosures About Market Risk
    
    
    35Item 8. Financial Statements and Supplementary Data
    
    
    35Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    35Item 9a. Controls and Procedures
    
    
    35PART IIIItem 10. Directors and Executive Officers of the Registrant
    
    
    38Item 11. Executive Compensation
    
    
    38Item 12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters
    
    
    38Item 13. Certain Relationships and Related Transactions
    
    
    38Item 14. Principal Accounting Fees and Services
    
    
    38PART IVItem 15. Exhibits and Financial Statement Schedules
    
    
    38Signatures
    
    
    40Ex-10.19 Summary Description of Directors CompensationEx-10.22 Form of Option Agreement for 1997 Incentive PlanEx-23 Consent of Ernst & Young LLPEx-31.1 Sect. 302 Certification of the C.E.O.Ex-31.2 Sect. 302 Certification of the C.F.O.Ex-32.1 Sect. 906 Certification of the C.E.O.Ex-32.2 Sect. 906 Certification of the C.F.O.
  i




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PART I 
 ITEM 1: BUSINESS Overview We develop pharmaceutical products based on innovative proprietary oral drug delivery
technologies. We are focusing our development efforts principally on products that address
diseases of the central nervous system. The two most advanced products in our drug development
pipeline are oxymorphone ER, an extended release formulation of oxymorphone, a narcotic analgesic
being developed for twice-a-day dosing in patients with moderate to
severe pain requiring continuous, around-the-clock opioid therapy for an extended period of time, and PW2101, a
beta blocker intended for the treatment of hypertension and angina. We are also developing several
additional product candidates in areas such as edema, epilepsy, schizophrenia and depression. Oxymorphone ER.We are developing oxymorphone ER under a collaboration agreement with Endo
Pharmaceuticals, Inc. In October 2003, Endo received an approvable letter from the United States
Food and Drug Administration, or FDA, for oxymorphone ER. In the letter, the FDA requested that
Endo address certain questions, provide additional clarification and information, and conduct
additional clinical trials to further confirm the safety and efficacy of oxymorphone ER before the
FDA would approve Endos New Drug Application, or NDA, for oxymorphone ER. In November 2004, Endo
announced that the FDA had granted under the FDAs special protocol assessment, or SPA, process
final approval for the protocol for a clinical trial designed to provide the additional safety and
efficacy data requested by the FDA. Endo has reported that, based on the duration of the trial and the number of patients to be
enrolled, and assuming the data is favorable, Endo expects to submit a complete response letter to
the FDA in early 2006. We expect that Endo will receive a further action letter from the FDA within
six months of submission of the complete response letter. PW2101.We are currently developing PW2101 on our own but are seeking a collaborator to market
the product. In October 2004, the FDA accepted for filing a section 505(b)(2) NDA that we submitted
for PW2101. Our initial submission covered three strengths of the product. Subsequently, we
submitted supplemental data to the NDA to cover a lower strength of PW2101. We believe that the
FDA will consider the lower strength in the original filing for the higher strengths. Drug Delivery Technology.The foundation of our technology platform is TIMERx®, an extended
release delivery system that is adaptable to soluble and insoluble drugs and that is flexible for a
variety of controlled release profiles. Our proprietary TIMERx drug delivery technology is
utilized in four products that were developed with collaborators that have been approved, as well
as in oxymorphone ER and PW2101. We have also developed three additional oral drug delivery
systems, Geminex®, SyncroDose and a gastroretentive system. Geminex is a dual drug delivery system
that is designed to provide independent release of different active ingredients contained in a
drug. SyncroDose is a drug delivery system that is designed to release the active ingredient of a
drug at the desired site and time in the digestive tract. The gastroretentive system is a drug
delivery system that is designed to provide controlled release delivery of drugs that are absorbed
in the stomach and certain portions of the gastrointestinal, or GI, tract, namely the upper GI
tract, without a loss of bioavailability Prior to February 27, 2003, we also developed, manufactured and distributed branded
pharmaceutical excipients, which are the inactive ingredients in tablets and capsules, primarily
consisting of binders, disintegrants and lubricants. On February 27, 2003, we sold substantially
all of the assets used in our excipient business to subsidiaries and affiliates of Josef
Rettenmaier Holding GmbH & Co. KG for approximately $41.8 million in cash. Our Strategy Our strategy is to develop pharmaceutical products utilizing proprietary oral drug delivery
technologies primarily for diseases of the central nervous system as follows: 1




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
    Expand our product development pipeline with products to treat diseases of the
central nervous system.We intend to aggressively seek to expand our development pipeline
with product candidates for the treatment of diseases of the central nervous system by
developing products internally or by acquiring products from third parties. Historically,
we have formulated product candidates and then relied upon third party collaborators to
complete the remainder of the clinical development program and market the drugs. Although
we still expect that we will out-license a portion of our product portfolio prior to
regulatory submission, we intend to develop a significant portion of these products on our
own and retain the right to market, co-market, or co-promote these products.
    Selectively develop product candidates for diseases outside of the central nervous
system.We will also selectively develop product candidates for diseases outside of the
central nervous system if we believe the product could have significant value. We expect
that we will develop these products through at least pilot scale biostudies and
proof-of-concept data and then seek a collaborator to finish development and eventually
market the product.
    Leverage drug delivery technologies into a portfolio of product candidates for
development.We believe that we have significant expertise in drug formulation and in oral
drug delivery technologies. Our proprietary drug delivery technologies, TIMERx extended
release, Geminex dual delivery, SyncroDose chronotherapeutic delivery and the
gastroretentive system are applicable to a wide range of drugs with different physical and
chemical properties including water soluble and insoluble drugs as well as high dose and
low dose drugs. Using these technologies, we can formulate drugs with precise release
profiles. In selecting product candidates for development, we focus on opportunities in
which our drug delivery technologies, or drug delivery technologies that we can access, can
provide benefits to patients and result in branded, proprietary products. We intend to
continue to develop our core technologies as well as to seek to develop, in-license or
acquire new technologies as may be required for our product development candidates.
    Establish collaborations for development, manufacturing and marketing.We
expect that we will continue to seek to enter into collaborations to develop and market
some of our products, particularly for product candidates outside of the central nervous
system. In addition, we may also seek to enter into agreements for the manufacturing of our
products. We are a party to a number of collaborative agreements including our agreements
with Endo and Mylan Pharmaceuticals Inc. Drug Delivery Technologies  TIMERx Extended Release Delivery Systems We developed our TIMERx delivery system to address the limitations of other oral extended
release delivery systems. We believe that the TIMERx system has advantages over other oral drug
delivery technologies as it is readily manufactured, adaptable to soluble and insoluble drugs and
flexible for a variety of controlled release profiles. Pharmaceutical products containing TIMERx
have been approved and are being marketed, and we are developing additional products in our
pipeline using TIMERx. The patented TIMERx drug delivery system is based on a hydrophilic matrix combining a
heterodispersed mixture primarily composed of two polysaccharides, xanthan and locust bean gums, in
the presence of dextrose. These gums are also used in our Geminex, SyncroDose, and gastrorententive
drug delivery systems. 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 GI 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 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. 2




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Geminex We developed our patented Geminex dual release technology to provide for the independent
release of the same active ingredient or different active ingredients contained in one
pharmaceutical product at different rates. The release of the active ingredients can each involve
two different controlled release profiles, or involve controlled release and immediate release
profiles. The technology is based on a bi-layer tablet that utilizes TIMERx in the controlled
release layer. We are utilizing Geminex technology in several product candidates that are currently
in our portfolio.  SyncroDose We developed our patented SyncroDose drug delivery system to deliver drugs
chronotherapeutically in the body or to deliver a drug within a specific site in the GI tract.
SyncroDose is a technology based on our underlying TIMERx platform. We believe that there are
several disease states that can benefit from chronotherapeutic delivery including: arthritis,
cardiovascular disorders, asthma, neurological disorders and site-specific diseases including GI
cancers. The SyncroDose technology utilizes the TIMERx gum matrix in
the coating, combined with the
active and various other excipients in the core.  Gastroretentive We developed our gastroretentive drug delivery system to deliver drugs in the upper GI tract.
We believe this technology can provide controlled delivery of drugs that are absorbed in the
stomach and the upper portions of the GI tract. By targeting delivery in the part of the stomach
where the drug is absorbed, we believe we can increase the bioavailability of the drug, which could
result in increased efficacy or a lower dose of the drug being required. Products  Approved Products To date, several drug formulations utilizing the TIMERx system have received regulatory
approval:  
    Cystrin CR, an extended release version of oxybutynin for the treatment of urge
urinary incontinence, is being marketed in Finland by Schering Oy.
    Slofedipine XL, an extended release version of nifedipine for the treatment of
angina, is being marketed in the United Kingdom and Italy by Sanofi-Synthelabo S.A.
    Cronodipin, an extended release version of nifedipine for the treatment of
angina was licensed to Merck S.A. Industries Quimicas for marketing in Brazil. In December 1999, the FDA approved the 30 mg strength of Nifedipine XL, a generic version of
Procardia XL that we developed with Mylan for the treatment of hypertension and angina and that
utilizes the TIMERx system. The 30 mg strength of Nifedipine XL is not being marketed
by 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 and 90 mg, of Pfizers Procardia
XL. In connection with that agreement, Mylan agreed to pay us a
royalty on Mylans net sales of Pfizers 30
mg strength of generic Procardia XL. The royalties are comparable to those called for in our
original agreement with Mylan for Nifedipine XL. Mylan has retained the marketing rights to the 30
mg strength of Nifedipine XL.  Products in Our Pipeline We also have a number of TIMERx products in our development pipeline. The table below
summarizes each of the principal products in this pipeline, including the therapeutic use, the
development status and our collaborator, if any, for each product: 3




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PRODUCT
    
    THERAPEUTIC
    
    DEVELOPMENT STATUS
    
    COLLABORATOROXYMORPHONE ER
    
    Moderate to Severe Pain
    
    Approvable Letter/Phase III
    
    Endo PharmaceuticalsPW2101
    
    Hypertension/Angina
    
    NDA Filed
    
    Seeking CollaboratorPW2132
    
    Edema/CHF
    
    Phase II
    
    Internal DevelopmentPW4102
    
    Epilepsy
    
    Phase I
    
    Internal DevelopmentPW4110
    
    Schizophrenia
    
    Phase I
    
    Internal DevelopmentPW4112
    
    Depression
    
    Phase I
    
    Internal DevelopmentPW4142
    
    Acute/Chronic Benign Pain
    
    Phase I
    
    Internal DevelopmentPW4123
    
    Schizophrenia
    
    Phase I
    
    Internal Development
  Oxymorphone ER The most advanced of the products in our development pipeline is an extended release
formulation of oxymorphone incorporating TIMERx technology which we are developing with Endo.
Oxymorphone ER, a narcotic analgesic, is being developed for twice-a-day dosing in patients with
moderate to severe pain requiring continuous, around-the-clock opioid therapy for an extended
period of time. Oxymorphone, which is currently given in the parenteral and suppository dosage
form, is marketed by Endo and had sales in the United States in 2004 of approximately $375,000.
Oxymorphone ER, if successfully developed, would represent the first oral extended release version
of oxymorphone and would compete in the moderate to severe long acting opioid market with branded
and generic products such as MS Contin, Purdue Pharmas OxyContin, Johnson & Johnsons Duragesic
patch, and Ligands Avinza, which had aggregate sales in the United States in 2004 of approximately
$4.0 billion. Endo, which is responsible for conducting the clinical trials and seeking regulatory approval
of the product, submitted an NDA for oxymorphone ER to the FDA in December 2002. In October 2003,
Endo received an approvable letter for oxymorphone ER. In the letter, the FDA requested that Endo
address certain questions, provide additional clarification and information, and conduct some form
of additional clinical trials to further confirm the safety and efficacy of oxymorphone ER, before
the FDA would approve Endos NDA for oxymorphone ER. In discussions with Endo, the FDA advised
Endo of its concern that the outcome of two of the three Phase III efficacy trials submitted in the
NDA that met their predefined primary end-points may have been favorably biased by the statistical
handling of data from patients who did not complete the trials. The design of this additional
clinical trial is intended to address this issue. In November 2004, Endo announced that the FDA
had granted under the FDAs SPA process, final approval of the protocol for a clinical trial in
patients with chronic low back pain and without recent treatment with
opioid analgesics, designed to
provide the additional safety and efficacy data for oxymorphone ER
requested by the FDA. The clinical trial is also intended to address
the FDAs concern regarding data from patients who do not
complete the trial. The new trial is intended to complement the completed Phase III pivotal trial that Endo
believes has demonstrated efficacy in the intended patient population. The trial will be a 12-week,
multicenter double-blinded, placebo-controlled Phase III trial of oxymorphone ER. Endo expects to
recruit approximately 250 patients for this trial. Endo has commenced patient enrollment and
expects to announce the results of the trial in the fourth quarter of 2005. Endo has also reported
that based on the duration of the trial and the number of patients to be enrolled, and assuming the
data is favorable, Endo expects to submit a complete response letter to the FDA in early 2006. We
expect that Endo will receive a further action letter from the FDA within six months of the
submission of the complete response letter.  PW2101 We are currently developing PW2101, a beta blocker intended for the treatment of hypertension
and angina, which we have formulated using our TIMERx technology. We have developed PW2101 on our
own but are seeking a collaborator to market the product. We submitted a section 505(b)(2) to the
FDA for PW2101 on August 31, 2004, and the FDA accepted this NDA for filing on October 29, 2004.
The original filing of the NDA covered three strengths of the product. In the fourth quarter of
2004, we completed a clinical trial of a lower strength of the product. The results, while
positive, were not statistically significant at a p-value of 0.05. The low dose strength, however,
did meet most of the trials key secondary endpoints. As a result, in the first quarter of 2005,
we submitted the data from the clinical trial to the FDA as a supplement to our NDA. We believe
the data will be included in the review of the original NDA. 4




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PW2101 is a controlled release formulation of an immediate release beta blocker, the active
ingredient which is no longer subject to patents in the United States. There is currently a
similar branded controlled release beta blocker product that is marketed for hypertension, angina,
and congestive heart failure. This branded product had U.S. sales of approximately $1.2 billion in
2004. There are also currently filings for generic versions of the branded controlled release beta
blocker product, and the sponsors are engaged in patent litigation. If the sponsors of the generic
products prevail in such litigation, and PW2101 is approved, PW2101 would compete with the branded
product and the generic versions of the branded product. We are currently in discussions with the
FDA regarding the appropriate patent certifications required to be made for PW2101. If we are
required to file a paragraph IV certification and the patent holder sues us for infringement, the
FDA may not approve our NDA for up to 30 months.  PW2132 We are currently developing PW2132, a drug candidate intended for the treatment of edema
related to congestive heart failure, which we formulated using our Geminex technology. We
conducted a pilot scale biostudy of PW2132 in approximately 20 healthy volunteers in the fourth
quarter of 2004. In the study, PW2132 achieved the blood level curves we had targeted as endpoints
of the study and we believe may improve the efficacy of the drug. Based on the results of the
pilot biostudy, we are planning to file an Investigational New Drug Application, or IND, for PW2132
and then commence a Phase II single dose ranging study in patients in mid 2005. We are developing
the protocol for this study based on input we received from the FDA at the pre IND meeting held
with the FDA in the first quarter of 2005.  Phase I Products We are currently conducting pilot scale Phase I biostudies of several product candidates
primarily for drugs to treat diseases of the central nervous system. In these studies, we are
seeking to obtain proof of principle data in humans. If the pilot scale biostudies of any of these
product candidates show proof of principle and the commercial returns appear attractive, we will
most likely seek to advance the product candidate into further clinical trials on our own. The
decision to develop the product candidate on our own will be based on our available resources after
consideration of a number of factors, including the size of the potential market, competitors in
the potential market, the availability of intellectual property protection, the regulatory pathway
and the development status of our other product candidates. Collaborative Agreements We enter into collaborative agreements with pharmaceutical companies to develop, market or
manufacture some of our products. We currently are parties to two types of collaborative agreements. In revenue sharing
collaborative agreements, we jointly fund research and development with our collaborator, and we
receive no up-front licensing fees or milestone payments. In these arrangements, we share in a
pre-determined percentage of the net operating profits. Technology licensing collaborative
agreements involve the straight licensing of our technology to a collaborator. Under these
arrangements, we have no obligation to fund the ongoing clinical development or marketing costs of
the product. We also receive up-front license fees and milestone payments and are entitled to
receive royalties on our collaborators sales of the products covered by such collaborative
arrangements and payments for the purchase of formulated TIMERx material. Our principal
collaborative agreements are described below. In the future, we expect that any collaborative agreements into which we will enter will
likely involve the licensing of an NDA to a marketing partner after we complete the development of
a product and submit the application to the FDA. Under this type of collaborative agreement, we
anticipate that we would fund the development work on a product and in return receive up-front
license fees, milestone payments and royalties. 5




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Revenue Sharing Collaborative Agreements  Endo Pharmaceuticals, Inc. In September 1997, we entered into a strategic alliance agreement with Endo with respect to
the development of oxymorphone ER, an extended release formulation of oxymorphone based on our
TIMERx technology. This agreement was amended and restated in April 2002. Endo is a fully
integrated specialty pharmaceutical company with a market leadership position in pain management.
Endo has a broad product line, including established brands such as Percodan, Percocet and
Lidoderm. Endo is registered with the United States Drug Enforcement Administration as a developer,
manufacturer and marketer of controlled narcotic substances. Under our agreement with Endo, our responsibilities and the responsibilities of Endo with
respect to oxymorphone ER are determined by a committee comprised of an equal number of members
from both Endo and Penwest, which we refer to as the Alliance Committee. During the development of
the product, we formulated oxymorphone ER and Endo conducted all clinical studies and prepared and
filed all regulatory applications. We have agreed to supply TIMERx material to Endo, and Endo has
agreed to manufacture and market oxymorphone ER in the United States. The manufacture and marketing
of oxymorphone ER outside of the United States may be conducted by Endo, us or a third party, as
determined by the Alliance Committee. The commercialization of oxymorphone ER outside of the
United States is currently being discussed by the Alliance Committee. Prior to April 17, 2003, we shared with Endo the costs involved in the development and
pre-marketing of oxymorphone ER. On April 17, 2003, we discontinued our participation in the
funding of the development and pre-marketing of oxymorphone ER. We took this action because we
believed that our strategic focus should be on funding other products in our development pipeline.
As a result of this termination of funding, Endo has the right to complete the development of
oxymorphone ER and recoup the portion of development and pre-marketing costs incurred by Endo that
otherwise would have been funded by us. Endo may recoup such development costs through a temporary
adjustment in the royalty rate payable to us, which will return to its pre-adjustment level once
Endo has recovered such costs. Endo may also allow us to reimburse Endo directly for the unfunded
amounts. We estimate that through January 31, 2005, these unfunded costs approximated $15.0
million. We expect these costs to increase as Endo completes the ongoing pivotal trial and incurs
pre-launch marketing costs. We have agreed with Endo that the party marketing oxymorphone ER will
pay the other party royalties initially equal to 50% of the net
realization, as defined in the
agreement between Endo and us, subject to adjustment for unfunded development costs. This
percentage will decrease if the aggregate U.S. net realization exceeds pre-determined thresholds.
In general, the royalty payable by the marketing party to the other party will not drop below 40%.
However, the royalty will be reduced by one-third in limited circumstances, including termination
of the agreement based on uncured material breaches of the agreement by the royalty receiving party
and specified bankruptcy and insolvency events involving the royalty receiving party. Under the
agreement, Endo will purchase formulated TIMERx material for use in oxymorphone ER exclusively from
us at specified prices, and include these purchases in cost of goods sold of the product prior to
determining net realization, on which the royalty payment is
calculated.  Technology Licensing Collaborative Agreements  Mylan Pharmaceuticals Inc. In August 1994, we entered into product development and supply agreements with Mylan with
respect to the development of Nifedipine XL, a generic version of
Procardia XL, based on our TIMERx
technology. Procardia XL is a branded drug for the treatment of hypertension and angina that
utilizes nifedipine as its active ingredient. Under the agreement, we were responsible for the
formulation, manufacture and supply of TIMERx material for use in the product, and Mylan was
responsible for conducting all bioequivalence studies, preparing all regulatory applications and
submissions, and manufacturing and marketing Nifedipine XL in North America. In December 1999,
the FDA approved the 30 mg strength of Nifedipine XL. 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 and 90 mg, of Pfizers
Procardia XL. In connection with that agreement, Mylan decided not to market Nifedipine XL and
agreed to pay us 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 our 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 2004 of the 30 mg dosage strength
version of Pfizers generic Procardia XL totaled approximately $40.2 million. The term of this
agreement continues until such time as Mylan permanently ceases to market generic Procardia XL. In
2004, 2003 and 2002, 6




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royalties from Mylan were approximately $4.8 million, $4.1 million and $4.8 million,
respectively, or 94%, 88% and 87%, respectively, of our total revenue from continuing operations.  Other Agreements We are a party to the following additional technology licensing collaborative agreements
involving our TIMERx technology:  
    Sanofi-Synthelabo S.A.Our agreement with Sanofi-Synthelabo relates to
Slofedipine XL, an extended release version of nifedipine for the treatment of angina.
Slofedipine XL was approved in the United Kingdom in 1998 and Italy in 2000.
Sanofi-Synthelabo is marketing Slofedipine XL in both countries.
    Schering Oy. Our agreement with Schering Oy relates to Cystin CR, an extended
release version of oxybutynin for the treatment of urge urinary incontinence. Schering
began marketing Cystin CR in Finland after receiving approval for the product in Finland in
1997.
    E. Merck.Our agreement with E. Merck relates to Cronodipin, an extended
release version of nifedipine for the treatment of angina that was approved in Brazil and
was licensed to Merck S.A. Industries Quimicas for marketing in Brazil.
    IVAX Corporation.Our agreement with IVAX relates to the development of PW3101
for the treatment of asthma in the United States. Ivax has received an approvable letter
from the FDA for the product and is in the process of responding to the FDA.
    Ranbaxy Laboratories Ltd.Our agreement with Ranbaxy relates to the development
of an extended release version of nifedipine for the treatment of angina for India. Research and Development We conduct research and development activities on the development of product candidates
utilizing our drug delivery technologies as well as on the development of additional drug delivery
technologies. Our research and development expenses in 2004, 2003 and 2002 were $20.2 million,
$20.6 million and $17.0 million, respectively. These expenses do not include amounts incurred by our
collaborators in connection with the development of products under our collaboration agreements
such as expenses for full-scale bioequivalence studies, clinical trials performed by our
collaborators, expenses incurred on oxymorphone ER subsequent to April 17, 2003, or our
collaborators share of funding. Manufacturing Bulk TIMERx. We currently have no internal commercial scale manufacturing
capabilities. Generally, our collaborators manufacture the pharmaceutical products and we are
responsible for supplying them with bulk TIMERx. We have outsourced the commercial manufacture of
TIMERx materials to a third-party pharmaceutical company, Draxis Pharmaceuticals, Inc., under a
manufacturing agreement that expires in September 2006. The agreement automatically renews 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. We are seeking to qualify a
second contract manufacturer as a second source of supply. We have completed initial validation
work with the second contract manufacturer, however, there is additional follow-up work
required before the site is fully validated. We believe that there are a limited number of
manufacturers that operate under cGMP regulations capable of manufacturing our TIMERx materials. Our TIMERx technology is based on a hydrophilic matrix combining a heterodispersed mixture
primarily composed of two polysaccharides, xanthan and locust bean gums, in the presence of
dextrose. We purchase these gums from a primary supplier. We have also qualified alternate
suppliers with respect to these gums and to date we have not experienced difficulty acquiring these
materials. 7




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Oxymorphone ER. Under our collaboration with Endo, we supply bulk TIMERx to Endo and
Endo is responsible for the manufacture of oxymorphone ER. Endo has outsourced the commercial
manufacture of oxymorphone ER to a third party manufacturer. PW2101. We are working with Patheon, Inc. with respect to the commercial manufacture
of PW2101. Patheon manufactured PW2101 for use in our clinical trials as well as the NDA
registration batches. However, the manufacturing site at which this manufacturing was conducted
only has stability data for the higher strengths of PW2101. The stability data for the lower
strength was done at an alternative site with Patheon. As a result, we are working with Patheon to
qualify the alternative site which would consolidate the manufacturing of all the strengths of
PW2101 at a single site and would also provide greater production capacity than the original site.
In order to use this alternative site for the commercial production of PW2101, we will need to
conduct bioequivalence studies and submit them to the FDA as part of our NDA. We are currently
negotiating a commercial agreement with Patheon, however, we do not intend to sign an agreement
with Patheon until we sign an agreement with a collaborator for marketing. Marketing and Distribution Pursuant to our collaborative agreements, our collaborators have, or are expected to have,
responsibility for the marketing and distribution of any pharmaceuticals developed based on our
drug delivery technologies. Because we do not currently market any pharmaceuticals without a
collaborator, we have not developed any sales force with respect to such products. As a result, we
are substantially dependent on the efforts of our collaborators to market the products. In
selecting a collaborator for a drug candidate, some of the factors we consider include the
collaborators market presence in the therapeutic area targeted by the drug candidate and the
collaborators sales force and distribution network. If we determine to retain the rights to market one or more of the products we are developing
for diseases of the central nervous system, we will need to build or acquire a small sales force of
50 to 100 sales representatives to market these product candidates. We believe these
high-prescribing specialty physician groups can be effectively targeted with a sales force of this
size. Patents and Proprietary Rights We believe that patent and trade secret protection of our drug delivery technology and our
products are important to our business and that our success will depend in part on our ability to
maintain existing patent protection, obtain additional patents, maintain trade secret protection
and operate without infringing the proprietary rights of others.  Patents and Protection of Proprietary Information As of February 28, 2005, we owned 32 U.S. and 183 foreign patents relating to our controlled
release drug delivery technology. The U.S. patents principally cover our TIMERx technology and new
technologies based on the 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 of TIMERx technology to various active drug substances, including both methods of
treatment and methods of preparation. These patents will expire between 2008 and 2020. Based on
a patent review conducted with our patent attorneys, we believe the most important patents relating to our
TIMERx technology begin to expire in 2014. 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 our patents or any future patents we obtain
will prevent other companies from developing non-infringing similar or functionally equivalent
products or from successfully challenging the validity of our patents. Furthermore, there is no
assurance that:  
    any of our future processes or products will be patentable;
    any pending or additional patents will be issued in any or all appropriate jurisdictions;
    our processes or products will not infringe upon the patents of third parties; or 8




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
    we will have the resources to defend against charges of infringement by, or
protect our own patent rights against, third parties. Our inability to protect our patent rights, or infringement by us of the patent or proprietary
rights of others, could have a material adverse effect on our business, financial condition and
results of operations. We also rely on trade secrets and proprietary knowledge, which we generally seek 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 we will have adequate
remedies for any breach or that our 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. Under
the Waxman-Hatch Act, when an applicant files a section 505(b)(2) NDA or an ANDA with the FDA with
respect to a brand name product covered by an unexpired patent listed with the FDA, the applicant
must certify to the FDA for each of such patents that (i) final approval of the section 505(b)(2)
NDA or ANDA will not be sought until the expiration of the patent or (ii) such patent will not be
infringed by the applicants product or such patent is invalid or unenforceable. If the applicant
makes a certification as set forth in (ii) above, 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 owner files a
patent infringement lawsuit within 45 days of the receipt of such notice, the FDA will conduct a
substantive review of the section 505(b)(2) NDA or ANDA, but will not grant final marketing
approval of the product covered by the filing 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 earlier. Should a patent owner commence a
lawsuit with respect to alleged patent infringement by us or our collaborators, the uncertainties
inherent in patent litigation make the outcome of such litigation difficult to predict. We evaluate
the probability of patent infringement litigation with respect to each product we determine to
develop.  Trademarks TIMERx, Geminex and SyncroDose are our registered trademarks. Other tradenames and trademarks
appearing in this annual report on Form 10-K are the property of their respective owners. Government Regulation Government authorities in the United States and other countries extensively regulate the
research, development, testing, manufacture, labeling, promotion, advertising, distribution and
marketing of drug products. In the United States, the FDA regulates drug products under the
Federal Food, Drug, and Cosmetic Act, or FDCA, and implements
regulations and other laws.
Failure to comply with applicable U.S. requirements, both before and after approval, may subject us
to administrative and judicial sanctions, such as a delay in approving or refusal by the FDA to
approve pending applications, warning letters, product recalls, product seizures, total or partial
suspension of production or distribution, injunctions, and/or criminal prosecutions. Before our or our collaborators drug products may be marketed in the United States, each
product must be approved by the FDA. The approval process requires substantial time, effort and
financial resources, and we cannot be sure that any approval will be granted on a timely basis, or
at all. There are several kinds of NDAs that may be submitted to obtain FDA approval of our or our
collaborators drugs, including full new drug applications, or full NDAs; section 505(b)(2) NDAs;
or abbreviated new drug applications, or ANDAs. A full NDA is an NDA in which the information
required for approval, including investigations of safety and effectiveness, comes from studies
conducted by or for the sponsor or for which the sponsor has obtained a right of reference. A
section 505(b)(2) NDA is an NDA in which at least some of the information required for approval
comes from studies not conducted by or for the sponsor and for which the sponsor has not obtained a
right of reference. An Abbreviated New Drug Application (ANDA) usually utilizes for proof of
safety and effectiveness data demonstrating that the drug is bioequivalent to a drug which FDA
has previously approved. 9




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Full
NDAs: The steps required before a full NDA may be approved by the FDA include
pre-clinical laboratory and animal tests and formulation studies; submission to the FDA of an
investigational new drug exemption, or IND, for human clinical testing, which must become effective
before human clinical trials may begin; adequate and well-controlled clinical trials to establish
the safety and effectiveness of the product candidate for each indication for which approval is
sought; submission to the FDA of the NDA; satisfactory completion of an FDA inspection of the
manufacturing facility or facilities at which the drug is produced to assess compliance with
current good manufacturing practices (cGMP); and FDA review and approval of the NDA. Pre-clinical tests include laboratory evaluations of product chemistry, toxicity and
formulation, as well as animal studies. The results of the pre-clinical tests, together with
manufacturing information and analytical data, are submitted to the FDA as part of an IND, which
must become effective before human clinical trials may begin. An IND will automatically become
effective 30 days after receipt by the FDA, unless before that time the FDA raises concerns or
questions. In such a case, the FDAs concerns or questions must be resolved before clinical trials
can proceed. Clinical trials involve the administration of the investigational drug to human subjects under
the supervision of qualified physician-investigators and healthcare personnel. Clinical trials are
conducted under protocols detailing, for example, the parameters to be used in monitoring patient
safety and the safety and effectiveness criteria, or end points, to be evaluated. Clinical
trials are typically conducted in three phases, however the phases may overlap or be
combined. Each trial must be reviewed and approved by an independent Institutional Review Board
before it can begin. Phase I usually involves the initial introduction of the investigational drug
candidate into people to evaluate its safety, dosage tolerance, pharmacodynamics and, if possible,
to gain an early indication of its effectiveness. Phase II usually involves trials in a limited
patient population to evaluate dosage tolerance and appropriate dosage; identify possible adverse
side effects and safety risks; and preliminarily evaluate the effectiveness of the drug candidate
for specific indications. Phase III trials usually further evaluate clinical effectiveness and
test further for safety by administering the drug candidate in its final form in an expanded
patient population. We, our collaborators, or the FDA may suspend clinical trials at any time on
various grounds, including a finding that the patients are being exposed to an unacceptable health
risk. Assuming successful completion of the required clinical testing, the results of the
preclinical studies and the clinical studies, together with other detailed information, including
information on the manufacture and composition of the product, are submitted in an NDA requesting
approval to market the product for one or more indications. Before approving an application, the
FDA usually will inspect the facility or the facilities at which the product candidate is
manufactured, and will not approve the product unless cGMP compliance is satisfactory. If the FDA
determines the NDA is not acceptable, the FDA may outline the deficiencies in the NDA and often
will request additional information. Notwithstanding the submission of any requested additional
testing or information, the FDA ultimately may decide that the application does not satisfy the
regulatory criteria for approval. 505(b)(2) NDAs: Section 505(b)(2) NDAs may be submitted for drug products that
represent a modification of an already approved drug (e.g., a new indication or new dosage form)
and for which investigations other than bioavailability or bioequivalence studies are essential to
the drugs approval. For example, our product candidate PW2101 utilizes our TIMERx extended
release delivery system to create a modification of an already-approved drug, and was therefore
submitted as a 505(b)(2) NDA. Section 505(b)(2) NDAs rely in part on safety and effectiveness
information available for the already approved drug as well as information obtained by the
505(b)(2) applicant needed to support the modification of the already approved drug. 505(b)(2)
NDAs generally require the applicant to conduct one or more clinical studies, which must comply
with the IND requirements. Preparing a 505(b)(2) NDA is generally less costly and time-consuming
than preparing a full NDA. The FDCA provides that review and/or approval of 505(b)(2) NDAs will be delayed in various
circumstances. For example, the holder of the NDA for the already approved drug may be entitled to
a period of market exclusivity, during which the FDA will not approve, and will not even review,
the 505(b)(2) NDA. Also, if the already approved drug is claimed by an unexpired patent that has
been listed with the FDA, the 505(b)(2) NDA applicant must provide a certification regarding the
status of the patent. If the applicant certifies that the patent is invalid, unenforceable, or not
infringed by the product that is the subject of the 505(b)(2) NDA (a Paragraph IV 10




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certification), the FDA will not approve the 505(b)(2) NDA until the earlier of a court
decision favorable to the 505(b)(2) applicant or the expiration of 30 months, a period that may be
extended in some circumstances. The regulations governing marketing exclusivity and patent
protection are complex, and it is often unclear how they will be applied in particular
circumstances. ANDAs:
The FDA may approve an ANDA if the product is the same in important respects as an
already approved drug, or if the FDA has declared the drug suitable for an ANDA submission. For
example, the FDA approved the ANDA submitted by our collaborator, Mylan, for the 30 mg dosage strength of
a generic version of Procardia XL. ANDAs must contain the same manufacturing and composition
information as NDAs, but applicants need not submit preclinical and clinical safety and
effectiveness data. Instead, they must submit studies showing that the product is bioequivalent to
the already approved drug. Drugs are bioequivalent if the rate and extent of absorption of the
drug does not show a significant difference from the rate of extent of absorption of the already
approved drug. Conducting bioequivalence studies is less time-consuming and costly than conducting
pre-clinical and clinical studies necessary to support an NDA. Like 505(b)(2) NDAs, ANDA approvals may be delayed because of market exclusivity or while
patent rights are being adjudicated. Also, in circumstances in which the already approved drug is
claimed in an unexpired patent listed with FDA and the patents validity, enforceability or
applicability to the generic drug has been challenged by more than one generic applicant, the first
ANDA applicant to challenge the patent may receive a 180-day period of market exclusivity. Other FDA Requirements: After approval, certain changes to the approved product, such as adding new indications,
manufacturing changes, or additional labeling claims are subject to further FDA review and
approval. In addition, regardless of the type of approval sought, we and our collaborators are required
to comply with a number of FDA requirements both before and after approval. For example, we are
required to report certain adverse reactions and production problems, if any, to the FDA, and to
comply with certain requirements concerning advertising and promotion for our products. Also,
quality control and manufacturing procedures must continue to conform to cGMP after approval, and
the FDA periodically inspects manufacturing facilities to assess compliance with cGMP.
Accordingly, manufacturers must continue to expend time, money and effort in all areas of
regulatory compliance, including production and quality control to comply with cGMP. In addition,
discovery of problems, such as safety problems may result in changes in labeling or restrictions on
a product manufacturer or NDA holder, including removal of the product from the market. Competition The pharmaceutical industry is highly competitive and is affected by new technologies,
governmental regulations, healthcare legislation, availability of financing, litigation and other
factors. Many of our competitors have longer operating histories and greater financial, technical,
marketing, legal and other resources than us and some of our collaborators. In addition, many of
our competitors have significantly greater experience than we have in conducting clinical trials of
pharmaceutical products, obtaining FDA and other regulatory approvals of products, and marketing
and selling approved products. We expect that we will be subject to competition from numerous
other entities that currently operate or intend to operate in the pharmaceutical and specialty
pharmaceutical industry. The key factors affecting the success of our drug delivery products are likely to include,
among other things:  
    the safety and efficacy of our products;
    the relative speed with which we can develop products;
    generic competition for any product that we develop;
    our ability to differentiate our products; and
    external factors affecting pricing. Our TIMERx products in development will face competition from products with the same
indication as the TIMERx products we are developing. For instance, we expect extended release
oxymorphone ER will face 11




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competition from MS Contin, Purdue Pharmas OxyContin, Duragesic marketed by Johnson & Johnson
and generic competitors to these products. Some of the TIMERx products we are developing, such as PW2101, are branded controlled release
products, which are proprietary products that are based on active chemical ingredients that are not
subject to patents. These branded controlled release products will compete against other products
developed using the same or a similar active chemical ingredient, including branded immediate
release and branded controlled released products, as well as any generic versions of these
products, based primarily on price. In addition, our branded controlled released products will
compete against other competitive products in the therapeutic class. For instance, PW2101 is a
controlled release formulation of an immediate release beta blocker, the chemical active ingredient
for which is no longer subject to patents in the United States. There is currently a similar
branded controlled release beta blocker product that is marketed for hypertension, angina and
congestive heart failure, and against which we expect PW2101 will compete. There are also currently
filings for generic versions of the branded controlled release products and the sponsors of the
branded product and the generic products are currently in patent litigation. If the sponsors of
generic products prevail in such litigation, PW2101 would also compete against these generic
versions. Employees As of March 11, 2005, we employed approximately 69 people, of whom 47 were primarily involved
in research and development activities, and 22 were primarily involved in selling, general and
administrative activities. As of March 11, 2005, none of our employees were covered by collective
bargaining agreements. We consider our employee relations to be good. Information Available on the Internet Our internet address is www.penwest.com. We make available free of charge through our website
our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and
amendments to these reports filed or furnished pursuant to Section 12(a) or 15(d) of the Securities
Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file
such materials with the Securities and Exchange Commission (SEC). We also include on our website our
corporate governance guidelines, our code of business conduct and ethics, and the charters for our
audit committee, our compensation committee and our nominating and corporate governance committee.
In addition, we intend to disclose on our website any amendments to, or waivers from, our code of
business conduct and ethics that are required to be publicly disclosed pursuant to rules of the SEC
and the NASDAQ. 
 ITEM 2: PROPERTIES Our corporate offices, comprising approximately 21,500 square feet, are located in Danbury,
Connecticut. We lease these offices under a lease that expires
December 30, 2006; provided however, that we have
the right to extend the term of this lease through December 30, 2008. We
have also leased research facilities, comprising approximately 15,000 square feet, in
Patterson, New York, which we owned prior to the sale of our excipient business to Rettenmaier in
2003. Our agreement with Rettenmaier is scheduled to expire in
February 2006, however we have the
right to exercise two successive one-year options. The space we currently lease is adequate for
our present needs. 
 EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth the names, ages and positions of our executive officers. NAME
    
    AGE
    
    TITLE
    
    DATESRobert J. Hennessey
    
    
    63
    
    
    President and Chief Executive Officer
    
    
    2005Chairman of the Board of Genome
Therapeutics Corp., now known as Oscient
Pharmaceuticals Corp.
    
    2000  2003
 12




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##### Table of Contents



NAME
    
    AGE
    
    TITLE
    
    DATESPresident and Chief Executive Officer of
Genome Therapeutics Corp., a genomics
sequencing company
    
    1993  2000Anand R. Baichwal, Ph.D.
    
    
    50
    
    
    Senior Vice President, Research & New
Technology Development and Chief Scientific
Officer
    
    1997 - currentFerdinand Banti
    
    
    48
    
    
    Vice President, Corporate Development
    
    2003 - currentVice President, Business Development of
Novartis Oncology, a pharmaceuticals and
consumer health company
    
    2001  2002Senior Director, Infectious Disease
Licensing of Pharmacia Corp., a developer,
manufacturer and seller of pharmaceutical
products
    
    1999  2001Jennifer L. Good
    
    
    40
    
    
    Senior Vice President, Finance and Chief
Financial Officer
    
    1997  currentCorporate Controller of Penford Corp., our
former parent company, a specialty chemical
company
    
    1993  1997Audit Manager, Ernst & Young
    
    1987 - 1993Alan F. Joslyn, Ph.D.
    
    
    46
    
    
    Senior Vice President, Research & Development
    
    2004  currentVice President, Internal Medicine, Johnson &
Johnson Pharmaceutical Research & Development
    
    1995  2004Vice President, Global Drug Development,
Janssen Research Foundation
    
    2000 - 2001Executive Director, Global Clinical
Research & Development, Janssen Research
Foundation
    
    1999 - 2000Thomas Sciascia, M.D.
    
    
    51
    
    
    Vice President, Clinical Operations and
Chief Medical Officer
    
    2001  currentMedical Director of Quintiles, Inc., a
provider of contract product development
and commercialization services
    
    1997  2000
 13




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##### Table of Contents



PART II 
 ITEM 5: MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF
EQUITY SECURITIES Our common stock, $.001 par value, is listed with and trades on the Nasdaq National Market
under the symbol PPCO. The high and low sale prices of our common stock during 2004 and 2003 are
set forth below. These prices reflect inter-dealer prices, without retail mark-up, mark-down or
commission and may not necessarily represent actual transactions. HIGH
    
    
    LOWPERIOD 2004Quarter Ended March 31
    
    $
    19.40
    
    
    $
    13.80Quarter Ended June 30
    
    $
    18.20
    
    
    $
    10.00Quarter Ended September 30
    
    $
    13.90
    
    
    $
    8.88Quarter Ended December 31
    
    $
    13.17
    
    
    $
    8.94PERIOD 2003Quarter Ended March 31
    
    $
    17.05
    
    
    $
    8.60Quarter Ended June 30
    
    $
    24.66
    
    
    $
    15.35Quarter Ended September 30
    
    $
    25.02
    
    
    $
    19.19Quarter Ended December 31
    
    $
    24.03
    
    
    $
    13.69
 On March 11, 2005 there were 772 shareholders of record. We have never paid cash dividends on our common stock. We presently intend to retain earnings,
if any, for use in the operation of our business, and therefore do not anticipate paying any cash
dividends in the foreseeable future. 14




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##### Table of Contents



ITEM 6: SELECTED FINANCIAL DATA The following selected financial data are derived from our consolidated financial statements.
The data should be read in conjunction with the consolidated financial statements, related notes,
and other financial information included herein. YEAR ENDED DECEMBER 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)STATEMENT OF OPERATIONS DATA:Revenues
    
    $
    5,108
    
    
    $
    4,678
    
    
    $
    5,537
    
    
    $
    5,796
    
    
    $
    8,780Cost of revenues
    
    
    104
    
    
    
    169
    
    
    
    170
    
    
    
    243
    
    
    
    2,678Gross profit
    
    
    5,004
    
    
    
    4,509
    
    
    
    5,367
    
    
    
    5,553
    
    
    
    6,102Selling, general and administrative
    
    
    9,485
    
    
    
    10,361
    
    
    
    7,568
    
    
    
    6,358
    
    
    
    5,500Research and product development
    
    
    20,205
    
    
    
    20,590
    
    
    
    16,955
    
    
    
    16,190
    
    
    
    12,103Loss from continuing operations before
cumulative effect of change in
accounting principle
    
    
    (23,785
    )
    
    
    (26,006
    )
    
    
    (19,028
    )
    
    
    (16,814
    )
    
    
    (11,459
    )Earnings from discontinued operations,
net of income tax expense
    
    
    
    
    
    
    177
    
    
    
    1,929
    
    
    
    833
    
    
    
    2,983Gain on sale of discontinued operations
    
    
    
    
    
    
    9,894
    
    
    
    
    
    
    
    
    
    
    
    Total discontinued operations
    
    
    
    
    
    
    10,071
    
    
    
    1,929
    
    
    
    833
    
    
    
    2,983Loss before cumulative effect of
change in accounting principle
    
    
    (23,785
    )
    
    
    (15,935
    )
    
    
    (17,099
    )
    
    
    (15,981
    )
    
    
    (8,476
    )Cumulative effect of change in
accounting principle (a)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (310
    )Net loss
    
    $
    (23,785
    )
    
    $
    (15,935
    )
    
    $
    (17,099
    )
    
    $
    (15,981
    )
    
    $
    (8,786
    )Basic and diluted loss per share
before cumulative effect of change in
accounting principle:Continuing operations
    
    $
    (1.28
    )
    
    $
    (1.56
    )
    
    $
    (1.23
    )
    
    $
    (1.21
    )
    
    $
    (0.93
    )Discontinued operations
    
    
    
    
    
    
    0.60
    
    
    
    0.12
    
    
    
    0.06
    
    
    
    0.24Cumulative effect of change in
accounting principle per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (0.02
    )Net loss per share
    
    $
    (1.28
    )
    
    $
    (0.96
    )
    
    $
    (1.11
    )
    
    $
    (1.15
    )
    
    $
    (0.71
    )Weighted average shares of common
stock outstanding
    
    
    18,627
    
    
    
    16,678
    
    
    
    15,462
    
    
    
    13,905
    
    
    
    12,330
 DECEMBER 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000(IN THOUSANDS)BALANCE SHEET DATA:Cash and cash equivalents
    
    $
    14,249
    
    
    $
    8,241
    
    
    $
    1,629
    
    
    $
    11,529
    
    
    $
    1,291Marketable securities
    
    
    60,121
    
    
    
    55,652
    
    
    
    2,057
    
    
    
    9,609
    
    
    
    Working capital
    
    
    71,946
    
    
    
    60,697
    
    
    
    26,355
    
    
    
    27,059
    
    
    
    11,129Total assets
    
    
    87,522
    
    
    
    78,503
    
    
    
    50,220
    
    
    
    59,613
    
    
    
    42,294Long term
obligations-deferred
compensation
    
    
    3,314
    
    
    
    3,104
    
    
    
    2,889
    
    
    
    2,711
    
    
    
    2,524Accumulated deficit
    
    
    (118,218
    )
    
    
    (94,433
    )
    
    
    (78,025
    )
    
    
    (60,926
    )
    
    
    (44,945
    )Shareholders equity
    
    $
    78,801
    
    
    $
    67,696
    
    
    $
    31,423
    
    
    $
    45,624
    
    
    $
    31,017
   (a)
    Cumulative effect of adopting Staff Accounting Bulletin No. 101 (SAB No. 101) in 2000. 15




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ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview We develop pharmaceutical products based on innovative proprietary oral drug delivery
technologies. We are focusing our development efforts principally on products that address
diseases of the central nervous system. The two most advanced products in our drug development
pipeline are oxymorphone ER, an extended release formulation of oxymorphone, a narcotic analgesic
being developed for twice-a-day dosing in patients with moderate to
severe pain requiring continuous around-the-clock opioid therapy for
an extended period of time, and PW2101, a beta blocker intended
for the treatment of hypertension and angina. We are also developing several additional product candidates in areas such as edema, epilepsy, schizophrenia and
depression. Prior to February 27, 2003, we also developed, manufactured and distributed branded
pharmaceutical excipients, which are the inactive ingredients in tablets and capsules, primarily
consisting of binders, disintegrants and lubricants. On February 27, 2003, we sold substantially
all of the assets used in our excipient business to subsidiaries and affiliates of Josef
Rettenmaier Holding GmbH & Co. KG. We received $39.5 million in cash and a promissory note for
$2.25 million in consideration for the excipient business. We received $1.0 million of the $2.25
million promissory note in April 2003 and the balance in May 2004. We used approximately $5.5
million of proceeds of the sale of our excipient business to repay outstanding debt. Commencing in
the first quarter of 2003, we reported the operating results of the excipient business as a
discontinued operation. As a result of the sale of the excipient business, our audited consolidated
financial statements included in this annual report on Form 10-K present our excipient business as
a discontinued operation for 2003 and 2002. We have incurred net losses since 1994. As of December 31, 2004, our accumulated deficit was
approximately $118.2 million. We expect operating losses and negative cash flows to continue until
substantial sales of products occur. A substantial portion of our revenues through February 27,
2003 were generated from sales of our pharmaceutical excipient product line. During 2002 and 2003
through the date that we sold our excipient business, sales of our excipient products generated
positive cash flows from operations, although as a whole we had negative cash flows from
operations. Since February 27, 2003, we have not derived any revenues from the excipient business.
Our revenues since February 27, 2003 have been generated primarily from Mylan royalties and
shipments of bulk TIMERx. Our future profitability will depend on several factors, including:  
    the successful commercialization of TIMERx controlled release products, including in particular oxymorphone ER
and PW2101;
    royalties from Mylans sales of Pfizers 30 mg generic version of Procardia XL; and
    the level of our investment in research and development activities. Our strategy includes a significant commitment to spending on research and development
targeted at identifying and developing modified release products that can be formulated using our
drug delivery technologies. We also expect to expend significant resources on the development of
new drug delivery technologies, both internally and through in-licenses or acquisitions. Our
spending in the area of new technology however, is discretionary and is subject to identifying
appropriate opportunities, as well as the availability of funds from our operations, cash
resources, collaborative research and development arrangements and external financing. Our results of operations may fluctuate from quarter to quarter depending on if and when
oxymorphone ER or PW2101 are approved, the amount and timing of royalties on Mylans sales of
Pfizers 30 mg generic version of Procardia XL, volume and timing of shipments of formulated bulk
TIMERx, and on variations in payments under our collaborative agreements, including payments upon
the achievement of specified milestones. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based
upon our consolidated financial statements, which have been prepared in accordance with U.S.
generally accepted accounting principles. 16




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The preparation of these financial statements requires us to make estimates and assumptions
that affect the reported amounts of assets and liabilities as of the date of the financial
statements, and the reported amounts of revenues and expenses during the reporting periods. We base
our estimates on historical experience and on various other factors that we believe to be
reasonable under the circumstances. We regard an accounting estimate underlying our financial
statements as a critical accounting estimate if the nature of the estimate or assumption is
material due to the level of subjectivity and judgment involved or the susceptibility of such
matter to change, and if the impact of the estimate or assumption on our financial condition or
performance may be material. On an ongoing basis, we evaluate these estimates and judgments. Actual
results may differ from these estimates under different assumptions or conditions. While our
significant accounting policies are fully described in Note 2 to our consolidated financial
statements included in this annual report, we regard the following as critical accounting
estimates.  Revenue Recognition Royalties
and Licensing Fees We recognize revenues from non-refundable upfront licensing fees received under collaboration
agreements ratably over the development period of the related 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 there exists an obligation to
supply inventory for manufacture. Non-refundable milestone fees received for the development
funding of a product are partially recognized upon receipt based on our 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. The proportionate
development efforts achieved are measured by estimating the percentage of work completed that is
required of us in the development effort for the product. This estimate is primarily derived from
the underlying project plans and timelines, developed by qualified personnel who work closely on
such projects. In particular, we review output measures such as job specifications and tasks
completed, compared to all such job specifications and tasks outlined for a particular project. Job
specifications vary with each project and primarily include development activities regarding
initial formulation work, manufacturing scale-up, proof-of-principle biostudies, clinical
development and regulatory matters. 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 as reported by our
collaborators, and are generally subject to our review or audit. Product Sales We recognize revenues from product sales when title transfers and customer acceptance
provisions have lapsed, provided that collections of the related accounts receivable are probable.
Shipping and handling costs are included in cost of revenues.  Research and Development Expenses Research and development expenses consist of costs associated with products being developed
internally as well as products being developed under collaboration agreements, and include related
salaries, benefits and other personnel related expenses, clinical trial costs, and contract and
other outside service fees. We expense research and development costs as incurred. A significant
portion of our development activities are outsourced to third parties, including contract research
organizations and contract manufacturers in connection with the production of clinical materials,
or may be performed by our collaborators. These arrangements may require estimates to be made of
related service fees or our share of development costs. These arrangements may also require us to
pay termination costs to the third parties for reimbursement of costs and expenses incurred in the
orderly termination of contractual services. These estimates involve identifying services, which have been performed on our behalf, and
estimating the level of service performed and associated cost incurred for such service as of each
balance sheet date in our consolidated financial statements. In connection with such service fees,
our estimates are most affected by our understanding of the status and timing of services provided
relative to the actual levels of service incurred by such service providers. In the event that we
do not identify specific costs which have begun to be incurred or we under- or over-estimate the
level of services performed or the costs of such services, our reported expenses for such period
could be too low or 17




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too high. The date on which services commence, the level of services performed on or before a
given date, and the cost of such services are often judgmental. We make these judgments based upon
the facts and circumstances known to us in accordance with generally accepted accounting
principles.  Deferred Taxes  Valuation Allowance We record a valuation allowance to reduce our deferred tax assets to the amount that is more
likely than not to be realized. While we may consider any potential future taxable income and
ongoing prudent and feasible tax planning strategies in assessing the need for the valuation
allowance, in the event we were to determine that we would be able to realize our deferred tax
assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset
would increase income in the period such determination was made. At December 31, 2004, we had
recorded full valuation allowances totaling approximately $40.2 million against our net deferred
tax assets.  Impairment of Long-Lived Assets For purposes of recognizing and measuring impairment to our long-lived assets, including
intangible assets such as our intellectual property, we assess the recoverability of the carrying
amount of these assets whenever facts and circumstances indicate that the carrying amount may not
be fully recoverable. We measure the impairment related to long-lived assets by the amount by which
the carrying amount of the assets exceeds the fair value of the assets. In assessing the
recoverability of our intangible assets, we must make assumptions regarding estimated future cash
flows and other factors to determine the fair value of the respective assets. Estimated cash flow
assumptions include profitability projections provided by our marketing partners or developed
internally, based upon historical revenues or projected market share for new products. If these
estimates or their related assumptions change in the future, we may be required to record
impairment charges for these assets. Results of Operations for Years Ended December 31, 2004, 2003 and 2002  Revenues PercentageIncrease
    
    
    
    
    
    
    Percentage(Decrease)
    
    
    
    
    
    
    (Decrease)2004
    
    
    from 2003
    
    
    2003
    
    
    from 2002
    
    
    2002(in thousands, except percentages)Royalty and Licensing Fees
    
    $
    4,882
    
    
    
    16
    %
    
    $
    4,223
    
    
    
    (14
    )%
    
    $
    4,918Product Sales
    
    
    226
    
    
    
    (50
    )%
    
    
    455
    
    
    
    (26
    )%
    
    
    619Total Revenues
    
    $
    5,108
    
    
    
    9
    %
    
    $
    4,678
    
    
    
    (16
    )%
    
    $
    5,537
 In 2004, 2003 and 2002, royalties and licensing fees consisted primarily of the royalties from
Mylan on its sales of Pfizers 30 mg generic version of Procardia XL. Royalties and licensing fees
increased in 2004 primarily due to Mylans increased net sales of Procardia XL and decreased in
2003 from 2002 primarily due to pricing pressure from additional generic competition. Our product sales consist of sales of formulated bulk TIMERx. The decrease in product sales in
2004 from 2003 was primarily due to a decrease in orders from a European customer. The decrease in
product sales in 2003 from 2002 was primarily due to the timing of a shipment to a European
customer of formulated bulk TIMERx that did not occur until the first quarter of 2004.  Selling, General and Administrative Expense Selling, general and administrative expenses decreased by 8% in 2004 to $9.5 million as
compared to $10.4 million for 2003. The decrease was primarily due to decreases in professional
fees, largely related to a strategic consulting project completed in 2003, and a decrease in our
share of pre-launch marketing expenses for oxymorphone ER reflecting our discontinuation of the
funding of Endos pre-launch marketing expenses for oxymorphone ER effective April 2003. 18




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Selling, general and administrative expenses increased by 37% in 2003 to $10.4 million as
compared with $7.6 million for 2002. The increase was primarily due to increased professional fees
associated with a strategic review of our product pipeline, an increase in rent and lease expense
related to office space, and increased personnel costs to support our business development and
market research capabilities. The increase also reflects certain selling, general and
administrative expenses that were incurred after February 27, 2003, the date of the sale of our
excipient business, which were previously allocated to the excipient business but did not cease
with the sale and were fully absorbed in continuing operations for the balance of 2003. On February 15, 2005, we announced that Tod R. Hamachek had resigned from his positions as
Chief Executive Officer and Chairman of the Board of Directors and as a member of the Board. In
connection with the resignation, we and Mr. Hamachek entered into a Severance and Settlement
Agreement and Release on February 14, 2005. Under the agreement, we agreed that, in consideration
of Mr. Hamacheks release and other agreements under the agreement, we would continue Mr.
Hamacheks base salary ($594,000) for eighteen months as severance pay, and pay all premium costs
relating to medical insurance continuation coverage and certain other benefits. We also agreed to
accelerate in full the vesting of all stock options held by Mr. Hamachek and to extend the period
during which he could exercise such stock options to the earlier of two years or their original
expiration date. In connection with this agreement, we expect to record a charge to selling,
general and administrative expense in our statement of operations totaling approximately $3.0
million in the first quarter of 2005, which includes a non-cash charge of approximately $2.4
million relating to the stock options noted above.  Research and Development Expense Percentage
    
    
    
    
    
    
    PercentageIncrease
    
    
    
    
    
    
    Increase(Decrease) from
    
    
    
    
    
    
    (Decrease) from2004
    
    
    2003
    
    
    2003
    
    
    2002
    
    
    2002(in thousands, except percentages)Oxymorphone ER
    
    $
    
    
    
    
    (100
    )%
    
    $
    1,947
    
    
    
    (78
    )%
    
    $
    8,914PW2101
    
    
    9,228
    
    
    
    (2
    )%
    
    
    9,443
    
    
    
    420
    %
    
    
    1,815Research and New Technology
Development
    
    
    2,818
    
    
    
    20
    %
    
    
    2,344
    
    
    
    6
    %
    
    
    2,213Phase I Products and Internal Costs
    
    
    8,159
    
    
    
    19
    %
    
    
    6,856
    
    
    
    71
    %
    
    
    4,013Total Research and Product
Development Expense
    
    $
    20,205
    
    
    
    (2
    )%
    
    $
    20,590
    
    
    
    21
    %
    
    $
    16,955
 In the preceding table, research and development expenses are set forth in the following four
categories:  
    Oxymorphone ER These expenses reflect our direct external expenses relating
to the development of oxymorphone ER. These expenses consist primarily of payments to third
parties, including payments to Endo for our share of development costs under our
collaboration agreement with Endo.
    PW2101 These expenses reflect our direct external expenses relating to the
development of PW2101. These expenses consist primarily of payments to third parties in
connection with clinical trials of PW2101, the manufacturing of PW2101 prior to regulatory
approval for clinical use and potential commercial use, and our development work related to
the qualification of an alternative manufacturing site for PW2101.
    Research and New Technology Development These expenses reflect both our
direct external expenses and our allocated internal expenses relating to the development of
new drug delivery technologies. These direct external expenses consist primarily of
payments to third parties in connection with outside laboratory and consulting fees. Our
internal expenses primarily include salaries and benefits of our research and new
technology development group, and other costs such as depreciation on purchased equipment,
and the amortization or any write-downs of patent costs.
    Phase I Products and Internal Costs These expenses reflect both our direct
external expenses and our internal expenses relating to the development of Phase I product
candidates, and also include other unallocated research and development expenses. Our
direct external expenses primarily reflect payments to third parties for the active drug
and proof-of-principle biostudies conducted for our Phase I products. Our internal
expenses include expenses such as salaries and benefits of our product development
personnel 19




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including our formulation, clinical and regulatory groups, and other costs primarily related
to our laboratory facilities. Oxymorphone ER. We did not have any research and development expenses related to
oxymorphone ER in 2004 and have not incurred any research and development expenses related to
oxymorphone ER since April 17, 2003 when we discontinued our funding of the development of
oxymorphone ER. Research and development expenses in 2002 and the beginning of 2003 related to the
costs of clinical trials of oxymorphone. We do not expect to incur any additional research and
development expenses relating to oxymorphone ER unless we resume our participation in the funding
of the expenses of oxymorphone ER. PW2101. Approximately 46% of our research and development expenses for 2004 related
to direct costs associated with clinical development, manufacturing scale-up and preparation of the
NDA for PW2101. Our 2004 PW2101 expenses were generally comparable to 2003 expenses, each of which
primarily included costs relating to the pivotal clinical trials of PW2101 in 2003 and 2004,
including payments to the clinical research organization managing the trials, and increased costs
with respect to scale-up, manufacturing and stability of PW2101. These costs in 2003 and 2004 were
significantly higher than in 2002, when our expenses for PW2101 related to proof-of-principle
biostudies and the manufacturing of clinical supplies. In 2003, we
completed a pivotal trial of four strengths of PW2101 and in 2004 we
completed a pivotal trial of a lower strength of PW2101. We have
submitted a 505(b)(2) NDA to the FDA for PW2101, which the FDA
accepted for filing in October 2004. We do not anticipate
conducting additional clinical trials for PW2101 in 2005. We have established arrangements with
Patheon for the commercial manufacture of the higher strengths of PW2101 at one manufacturing site.
We expect to continue to incur additional research and development expenses in 2005 relating to
PW2101 as we continue to work with Patheon to qualify another manufacturing site that could produce
all of the strengths of PW2101, and would have a greater production capacity than the current site.
Although we have developed PW2101 on our own, we do not intend to market this product. As a
result, we are currently seeking a marketing partner for this product. We do not intend to
manufacture commercial supply of PW2101 or conduct the necessary validation of the manufacturing
product until we obtain a marketing collaborator for the product. Research
and New Technology Development Expenses. These expenses  increased in 2004 primarily due to a $410,000
write-down recorded in the second quarter of 2004 related to the impairment of certain patents
covering our inhalation technology which we determined no longer had value, and our continued focus
on the expansion of the applications of our TIMERx technology, and legal expenses and amortization
associated with our intellectual property. Research and new technology development expenses also
increased in 2003 over 2002 due to our efforts to expand TIMER technology. We expect research and
new technology development expenses to decrease in 2005 as personnel that were previously
performing research and new technology development activities are being redirected to developing
Phase I candidates. Phase
I Products and Internal Costs. These costs increased in 2004 over 2003, and in 2003 over 2002
primarily as a result of an increase in the number of Phase I product candidates in our pipeline,
an increase in external costs incurred in connection with proof-of-principle biostudies for these
Phase I product candidates and increased costs associated with an increase in the number of
employees engaged in our product development efforts. There can be no assurance that oxymorphone ER, PW2101, or any of our products will be
successfully developed, will receive regulatory approval, or will be successfully commercialized.
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. Due to the variability in the length of time necessary to develop a
product, the uncertainties related to the estimated cost of the development projects and ultimate
ability to obtain governmental approval for commercialization, accurate and meaningful estimates of
the ultimate cost to bring our product candidates to market are not available.  Tax Rates For continuing operations, the effective tax rates for 2004, 2003 and 2002 were essentially
zero. The effective tax rates are higher than the federal statutory rate of a 34% benefit due
primarily to valuation allowances recorded to offset net deferred tax assets relating to our net
operating losses, and foreign income taxes. Liquidity and Capital Resources 20




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Sources of Liquidity Subsequent to August 31, 1998, the date we became an independent, publicly-owned company, we
have funded our operations and capital expenditures from the proceeds from the sale and issuance of
shares of common stock, the sale of our excipient business, the sale of excipients, sales of
formulated bulk TIMERx, royalties and milestone payments from Mylan and other collaborators, and
advances under credit facilities. As of December 31, 2004, we had cash, cash equivalents, and
short-term investments of $74.4 million. We have no committed sources of capital. We are a party to an agreement with Endo with respect to the development and commercialization
of oxymorphone ER. On April 17, 2003, we discontinued our participation in the funding of the
development and pre-launch marketing of oxymorphone ER. We did not incur any expenses relating to
oxymorphone ER in 2004 and we do not expect to incur any significant expenses relating to
oxymorphone ER in 2005, unless we resume our participation in the funding of the development and
marketing of oxymorphone ER. As a result of this termination of funding, Endo has the right to
complete the development of oxymorphone ER and recoup the portion of development costs incurred by
Endo that otherwise would have been funded by us, through a temporary adjustment in the royalty
rate payable to us that will return to its pre-adjustment level once Endo has recovered such
unfunded development and pre-launch marketing costs. Endo may also allow us to reimburse Endo
directly for these unfunded amounts and, as a result, to receive the full royalty rate from Endo
without adjustment. We estimate that through January 31, 2005 these unfunded costs approximated
$15.0 million. We expect this unfunded amount to increase as Endo completes the required pivotal
study and incurs pre-launch marketing costs. On February 27, 2003, we completed the sale of our excipient business to Rettenmaier. As a
result of the sale of our excipient business, we had approximately $35 million of net cash proceeds
available after the closing. However, as a result of the sale of our excipient business, we no
longer derive cash flow from the sale of excipients. A portion of the proceeds from the sale of our
excipient business was used to repay the $3.3 million of outstanding borrowings under our line of
credit, which was terminated on February 27, 2003. In addition, we used the proceeds from the sale
of our excipient business to repay in full a $2.25 million note payable to AstraZeneca AB, incurred
in connection with our acquisition of specified intellectual property related to the excipient
business. On August 5 and August 6, 2003, we completed the sale of a total of 2,507,762 shares of common
stock through a private placement to selected institutional investors, resulting in net proceeds to
us, after fees and expenses, of approximately $49.3 million. As part of this transaction, we
granted the institutional investors additional rights to purchase up to an additional 501,552
shares of common stock at a price of $26.00 per share. These additional investment rights became
exercisable on September 12, 2003, and expired on December 9, 2003. None of these additional
investment rights were exercised. On December 14, 2004, we completed the sale of a total of 3,125,000 shares of common stock
through a private placement to selected institutional investors, resulting in net proceeds to us,
after fees and expenses, of approximately $32.8 million.  Cash Flows We had negative cash flow from operations for 2004 of $22.9 million, primarily due to the net
loss of $23.8 million we had in the period. We had negative cash flow from operations for 2003 of $22.2
million, primarily due to the loss from continuing operations of $26.0 million in the period, which
was partially offset by net cash provided by discontinued operations operating activities of
$874,000 for the period prior to the sale of our excipient business on February 27, 2003, and net
increases in payables and accrued expenses of $2.1 million. Our cash flow in 2004 and 2003 differed
from our cash flow in 2002 primarily because we no longer derive revenues from sales of our
excipient products and do not incur expenses in connection with our excipient business, except for
the related revenues and expenses during the period from January 1, 2003 through February 26, 2003. Net cash used in investing activities totaled $5.4 million for 2004, primarily due to our net
investment in marketable securities of $4.7 million. In addition, investing activities in 2004 also
reflected $1.2 million in capital expenditures for the acquisitions of fixed assets primarily
related to laboratory equipment for drug development activities as well as costs incurred for
information technology and leasehold improvements made to our office facility in Danbury, CT.
Funds expended for patents totaled $643,000 and include costs to secure patents on 21




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technology and products developed by us. In addition in 2004, we received $1.2 million for the
remaining balance on the promissory note issued in consideration for the excipient business. Financing activities provided $34.2 million in cash, primarily due to net cash proceeds from
the private placement of our common stock in December 2004.  Funding Requirements We anticipate that, based on our current operating plan and excluding any potential revenues
from oxymorphone ER, our existing capital resources and anticipated internally generated funds from
the sale of formulated bulk TIMERx, royalties from Mylan and other payments from collaborators will
be sufficient to fund our operations on an ongoing basis without requiring us to seek external
financing through at least the first half of 2007. We expect to continue to invest in capital
expenditures in 2005 at levels similar to 2004 capital spending, primarily for laboratory equipment
for our drug development activities and for patents on technology and products developed by us. Our requirements for capital in our business are substantial and will depend on many factors,
including:  
    whether oxymorphone ER or PW2101 are approved on a timely basis, or at all;
    the costs and timing of adding product candidates or technologies;
    whether we resume our participation in the funding of the development and
marketing of oxymorphone ER;
    the timing and amount of payments received under existing and possible future
collaborative agreements, in particular oxymorphone ER;
    our success in entering into a marketing collaboration for PW2101;
    our ability to qualify the alternative manufacturing site for PW2101 on a timely
basis or at all, and the costs of doing so;
    the structure and terms of any future collaborative or development agreements;
    the progress of our collaborative and independent development projects, funding
obligations with respect to the projects, and the related costs to us of clinical studies for
our products;
    royalties received from Mylan; and
    the prosecution, defense and enforcement of potential patent claims and other intellectual property rights. If we determine to resume our participation in the funding of oxymorphone ER, or to acquire
additional product candidates or technologies, we may need to seek additional funding through
collaborative agreements or research and development arrangements, or through public or private
financings of equity or debt securities. If we raise additional funds by issuing equity securities, further dilution to our then
existing shareholders may result. Debt financing, if available, may involve agreements that include
covenants limiting or restricting our ability to take specific actions, such as incurring
additional debt, making capital expenditures or declaring dividends. Any debt or equity financing
may contain terms, such as liquidation and other preferences, that are not favorable to us or our
shareholders. If we raise additional funds through collaboration and licensing arrangements with
third parties, it may be necessary to relinquish valuable rights to our technologies, research
programs or potential product, or grant licenses on terms that may not be favorable to us. We
cannot be certain that additional financing will be available in amounts or on terms acceptable to
us, if at all. If we are unable to obtain this additional financing, we may be required to delay,
reduce the scope of, or eliminate one or more of our planned research, development and
commercialization activities, which could harm our financial condition and operating results. 22




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##### Table of Contents



Contractual Obligations Our outstanding contractual cash obligations relate to our operating leases, primarily for
facilities, and purchase obligations relating to capital expenditures and clinical development.
Below is a table summarizing our contractual cash obligations under our operating leases having
initial lease terms of more than one year and our purchase obligations, as of December 31, 2004 (in
thousands). Less than
    
    
    1-3
    
    
    4-5
    
    
    After 5Total
    
    
    One Year
    
    
    Years
    
    
    Years
    
    
    YearsOperating Leases
    
    $
    1,147
    
    
    $
    638
    
    
    $
    509
    
    
    $
    
    
    
    $
    Purchase Obligations
    
    
    1,766
    
    
    
    1,716
    
    
    
    50
    
    
    $
    
    
    
    $
    Total
    
    $
    2,913
    
    
    $
    2,354
    
    
    $
    559
    
    
    $
    
    
    
    $
    
 We are also subject to the commitments described below that are not included in the table
above. We have a Supplemental Executive Retirement Plan, or SERP, a nonqualified plan, which covers
our former Chairman and Chief Executive Officer, Tod Hamachek. Effective February 14, 2005, Mr.
Hamachek resigned from his positions as Chairman and Chief Executive Officer. Under the SERP, Mr.
Hamachek, now 59, is eligible for benefit payments to commence with his retirement effective
February 15, 2005. These benefits, based on 55% of Final Average Compensation, as defined, and
elections made by Mr. Hamachek, will be reduced as a result of his early retirement. We also have a Deferred Compensation Plan or DCP, a non-qualified plan which covers Mr.
Hamachek. Under the DCP, Mr. Hamachek is eligible for benefit payments to commence with his
retirement effective February 15, 2005. These benefits are fully vested and may include retirement
benefits, lump sum payout less a 10% forfeiture after a change in control or termination of
employment, and/or death benefits. Based on elections made by Mr. Hamachek, benefits are expected
to be paid in annual installments over ten years. We expect the following benefit payments, including interest for the DCP, to be made under the
SERP and DCP over the next ten years (in thousands): SERP
    
    
    DCP
    
    
    Total2005
    
    $
    125
    
    
    $
    140
    
    
    $
    2652006
    
    
    150
    
    
    
    140
    
    
    
    2902007
    
    
    150
    
    
    
    140
    
    
    
    2902008
    
    
    150
    
    
    
    140
    
    
    
    2902009
    
    
    150
    
    
    
    140
    
    
    
    2902010-2014
    
    
    747
    
    
    
    700
    
    
    
    1,447
 We do not fund these liabilities and no assets are held by the plans. However, we have two
whole-life insurance policies in a rabbi trust, the cash surrender value or death benefits of which
are held in trust for the SERP and DCP liabilities. We are entitled to borrow against these
policies to fund these liabilities as provided by the terms of the trust. The cash surrender value
of these polices totaled $3.1 million as of December 31, 2004. Net Operating Loss Carryforwards At December 31, 2004, we had federal net operating loss or NOL carryforwards of approximately
$96.7 million for income tax purposes, of which approximately $6.2 million, $8.4 million, $9.1
million, $17.7 million, $19.3 million, $12.6 million and $23.4 million expire in 2018, 2019, 2020,
2021, 2022, 2023 and 2024, respectively. In addition, we had research and development tax credit
carryforwards of approximately $3.2 million of which $67,000, $359,000, $341,000, $777,000,
$828,000 and $858,000 expire in 2018, 2019, 2020, 2021, 2022 and 2023, respectively. The use of the
NOLs, and research and development tax credit carryforwards are limited to our future taxable
earnings. For financial reporting purposes, at December 31, 2004 we recognized a valuation
allowance of $40.2 million to offset net deferred tax assets, primarily attributable to the NOL
carryforward. Utilization of the operating losses are subject to limitation due to the ownership
change provisions of the Internal Revenue Code. 23




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##### Table of Contents



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. Our operations are exposed to financial market risks, primarily changes
in interest rates. Our interest rate risk primarily relates to our investments in marketable
securities. The primary objectives for our investment portfolio are liquidity and safety of principal.
Investments are made to achieve the highest rate of return to us, consistent with these two
objectives. Our investment policy limits investments to specific types of instruments issued by
institutions with investment grade credit ratings and places certain restrictions on maturities and
concentration by issuer. At December 31, 2004, marketable securities consisted primarily of corporate debt, U.S.
Government-agency backed discounted notes and municipal securities, and approximated $60.1 million.
Marketable securities include auction rate securities totaling $30.2 million with contractual
maturity dates of up to forty one years. Liquidity in these instruments is provided from third
parties (buyers and sellers in an auction system) generally every one to three months at which time
their interest rates, or dividend rates for preferred securities, are reset. All of our other
marketable securities have maturity dates of up to sixteen months. Due to the relatively
short-term maturities of these securities, or auction system liquidity in the case of the auction
rate securities, management believes there is no significant market risk. At December 31, 2004,
market values approximated carrying values. At December 31,
2004, we had approximately
$74.4 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 $744,000. At December 31, 2003, marketable securities consisted primarily of corporate debt, U.S.
Government-agency backed discounted notes, municipal securities and certificates of deposit, and
approximated $55.7 million. Marketable securities included auction rate securities totaling $20.3
million with contractual maturity dates of up to forty years. Liquidity in these instruments is
provided from third parties (buyers and sellers in an auction system) as noted above. All of our
other marketable securities had maturity dates of up to twenty-four months. Due to the relatively
short-term maturities of these securities, or auction system liquidity in the case of the auction
rate securities, management believes there is no significant market risk. At December 31, 2003,
market values approximated carrying values. At December 31, 2003 we had approximately $63.9 million
in cash, cash equivalents and investments in marketable securities, and accordingly, a sustained
decrease in the rate of interest earned of 1% would have caused a decrease in the annual amount of
interest earned of up to approximately $639,000. Recent Accounting Pronouncements In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) 123R, Share-Based Payment (Revised 2004), which requires
companies to recognize in the income statement the fair value of all employee share-based payments,
including grants of employee stock options as well as compensatory employee stock purchase plans,
for interim periods beginning after June 15, 2005 and will
become effective for us for the
quarter ending September 30, 2005. Accordingly, SFAS 123R eliminates the ability to account for
share-based compensation using APB 25, and the pro forma disclosures previously permitted under
SFAS 123 no longer will be an alternative to financial statement recognition. Although we have not
determined whether the adoption of SFAS 123R will result in amounts that are similar to the current
pro forma disclosures under SFAS 123 presented in the notes to our consolidated financial
statements, we are evaluating the requirements under SFAS 123R including the valuation methods and
support for the assumptions that underlie the valuation of the awards, as well as the transition
methods (modified prospective transition method or the modified retrospective transition method)
and expect the adoption to have a significant impact on our consolidated statements of operations
and net loss per share. In November 2004, the FASB issued Statement No. 151, Inventory Costs  an amendment of ARB
No. 43, Chapter 4. This Statement amends the guidance in ARB No. 43, Chapter 4, Inventory
Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight,
handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously
stated that ...under some circumstances, items such as idle facility 24




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expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to
require treatment as current period charges... This Statement requires that those items be
recognized as current-period charges regardless of whether they meet the criterion of so
abnormal. In addition, this Statement requires that allocation of fixed production overheads to
the costs of conversion be based on the normal capacity of the production facilities. The
provisions of this Statement shall be effective for inventory costs incurred during fiscal years
beginning after June 15, 2005. The adoption of Statement No. 151 is not expected to have a
material effect on the Companys results of operations, financial position or cash flows. 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 contains 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. All statements,
other than statements of historical facts, included or incorporated in this report regarding our
strategy, future operations, financial position, future revenues, projected costs, prospects, plans
and objectives of management are forward-looking statements. The words believes, anticipates,
estimates, plans, expects, intends, may, projects, will, and would and similar
expressions are intended to identify forward-looking statements, although not all forward-looking
statements contain these identifying words. We cannot guarantee that we actually will achieve the
plans, intentions or expectations disclosed in our forward-looking statements and you should not
place undue reliance on our forward-looking statements. There are a number of important factors
that could cause our actual results to differ materially from those indicated or implied by
forward-looking statements. These important factors include those set forth below under Risk
Factors. In addition, any forward-looking statements represent our estimates only as of the date
this annual report is filed with the SEC and should not be relied upon as representing our
estimates as of any subsequent date. We do not assume any obligation to update any forward-looking
statements. Risk Factors Investing in our common stock involves a high degree of risk. You should carefully consider
the risks and uncertainties described below in addition to the other information included or
incorporated by reference in this prospectus before purchasing our common stock. If any of the
following risks actually occurs, our business, financial condition or results of operations would
likely suffer, possibly materially. In that case, the trading price of our common stock could fall,
and you may lose all or part of the money you paid to buy our common stock. We have not been profitable and expect to continue to incur substantial losses We have incurred net losses since 1994, including net losses of $23.8 million, $15.9 million
and $17.1 million during 2004, 2003 and 2002, respectively. We had a loss from continuing
operations of $23.8 million, $26.0 million and $19.0 million in 2004, 2003 and 2002, respectively.
As of December 31, 2004, our accumulated deficit was approximately $118.2 million. Our strategy includes a significant commitment to spending on research and development
targeted at identifying and developing products that can be formulated using our TIMERx and other
drug delivery technologies. As a result, we expect to continue to incur net losses as we continue
our research activities and conduct development of, and seek regulatory approvals for, products
utilizing TIMERx technology and other drug delivery technologies, until substantial sales of
products commercialized utilizing our TIMERx technology and other drug delivery technologies occur.
These net losses have had and will continue to have an adverse effect on, among other things, our
shareholders equity, total assets and working capital. A substantial portion of our revenues since 1994 has been generated from the sales of our
pharmaceutical excipients. Our net losses in 2003 and 2002 were reduced as a result of the
operating results of our excipient business. Since February 27, 2003, we have not generated any
revenues from the sales of excipient products and our business
depends and will depend exclusively on revenue, under our
agreement with Mylan and from products developed or acquired by us. 25




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Our future profitability will depend on several factors, including:  
    the successful commercialization of TIMERx controlled release products, including in
particular oxymorphone ER and PW2101;
    royalties from Mylans sale of Pfizers 30 mg generic version of Procardia XL; and
    the level of our investment in research and development activities. We may require additional funding, which may be difficult to obtain As of December 31, 2004, we had cash, cash equivalents, and short-term investments of $74.4
million. In addition, in December 2004, we received net proceeds of approximately $32.8 million
from a private placement of our common stock. We anticipate that, based on our current operating
plan, our existing capital resources and anticipated internally generated funds from the sale of
formulated bulk TIMERx, royalties from Mylan and other payments from collaborators will be
sufficient to fund our operations on an ongoing basis without requiring us to seek external
financing through at least the first half of 2007. Our requirements for additional capital are substantial and will depend on many factors, including:  
    whether oxymorphone ER or PW2101 are approved on a timely basis, or at all;
    the costs and timing of adding additional products or technologies;
    whether we resume our participation in the funding of the development and marketing
of oxymorphone ER;
    the timing and amount of payments received under existing and possible future
collaborative agreements, in particular with respect to oxymorphone ER;
    our success in entering into a marketing collaboration for PW2101;
    our ability to qualify the alternative manufacturing site for PW2101 on a timely
basis or at all and the costs of doing so;
    the structure and terms of any future collaborative or development agreements;
    the progress of our collaborative and independent development projects, funding
obligations with respect to the projects, and the related costs to us of clinical
studies for our products;
    royalties received from Mylan; and
    the prosecution, defense and enforcement of potential patent claims and other
intellectual property rights. Subject to these factors, we expect that we will need to sell additional equity or debt
securities or seek additional financing through other arrangements to fund operations beyond the
first half of 2007. In addition, if we determine to resume our participation in the funding of
oxymorphone ER or to acquire additional products or technologies, we also may need to seek
additional funding for such actions through collaborative agreements or research and development
arrangements, or through public or private financing. If we raise additional funds by issuing equity securities, further dilution to our
then-existing shareholders may result. Debt financing, if available, may involve agreements that
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to take specific actions, such as incurring additional debt, making capital expenditures or
declaring dividends. Any debt or equity financing may contain terms, such as liquidation and other
preferences, that are not favorable to us or our shareholders. If we raise additional funds through
collaboration and licensing arrangements with third parties, it may be necessary to relinquish
valuable rights to our technologies, research programs or potential product or grant licenses on
terms that may not be favorable to us. We cannot be certain that additional financing will be
available in amounts or on terms acceptable to us, if at all. If we are unable to obtain this
additional financing, we may be required to delay, reduce the scope of, or eliminate one or more of
our planned research, development and commercialization activities, which could harm our financial
condition and operating results.  We are dependent on collaborators to conduct clinical trials of, obtain regulatory approvals
for, and manufacture, market, and sell our TIMERx controlled release products, including, in
particular, Endo with respect to oxymorphone ER Some of our TIMERx controlled release products have been or are being developed and
commercialized in collaboration with pharmaceutical companies. Under these collaborations,
depending on the structure of the collaboration, we are dependent on our collaborators to fund some
portion of development, to conduct clinical trials, obtain regulatory approvals for, and
manufacture, market and sell products utilizing our TIMERx controlled release technology. For
instance, we are dependent on Endo to obtain the regulatory approvals required to market
oxymorphone ER and will be dependent on Endo to manufacture and market oxymorphone ER in the United
States. In addition, we are dependent on Mylan with respect to the marketing and sale of the 30 mg
strength of Pfizers generic version of Procardia XL. We have limited experience in manufacturing, marketing and selling pharmaceutical products.
Accordingly, if we cannot maintain our existing collaborations or establish new collaborations with
respect to our other products in development, we will have to establish our own capabilities or
discontinue the commercialization of the affected product. For instance, if we are unable to enter
into a collaboration for the marketing of PW2101, we are unlikely to commercially launch the
product even if we obtain FDA approval. Developing our own capabilities would be expensive and time
consuming and could delay the commercialization of the affected product. There can be no assurance
that we would be successful in developing these capabilities. Our existing collaborations are subject to termination on short notice under certain
circumstances including, for example, if the collaborator determines that the product in
development is not likely to be successfully developed or not likely to receive regulatory
approval, if we breach the agreement or upon a bankruptcy event. If any of our collaborations are
terminated, we may be required to devote additional resources to the product, seek a new
collaborator on short notice or abandon the product. The terms of any additional collaborations or
other arrangements that we establish may not be favorable to us. We are also at risk that these collaborations or other arrangements may not be 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.
    Our collaborators may reduce marketing or sales efforts, or discontinue marketing or
sales of our products. This would reduce our revenues received on the products.
    Our collaborators may terminate their collaborations with us. This could make it
difficult for us to attract new collaborators or adversely affect perception of us in
the business and financial communities.
    Our collaborators may pursue higher priority programs or change the focus of their
development programs, which could affect the collaborators commitment to us.
Pharmaceutical and 27




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biotechnology companies historically have re-evaluated their priorities from time to
time, including following mergers and consolidations, which have been common in
recent years in these industries.  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:  
    significantly greater financial, technical and human resources than we have and may
be better equipped to develop, manufacture and commercialize products;
    more extensive experience than we have in conducting preclinical studies and
clinical trials, obtaining regulatory approvals and manufacturing and marketing
pharmaceutical products;
    competing products that have already received regulatory approval or are in
late-stage development; and
    collaborative arrangements in our target markets with leading companies and research
institutions. We face competition based on the safety and effectiveness of our products, the timing and
scope of regulatory approvals, the availability and cost of supply, marketing and sales
capabilities, reimbursement coverage, price, patent position and other factors. Our competitors may
develop or commercialize more effective, safer or more affordable products, or obtain more
effective patent protection, than we are able to develop or commercialize. Accordingly, our
competitors may commercialize products more rapidly or effectively than we do, which would
adversely affect our competitive position, the likelihood that our product will achieve initial
market acceptance and our ability to generate meaningful revenues from our products. Even if our
products achieve initial market acceptance, competitive products may render our products obsolete
or noncompetitive. If our products are rendered obsolete, we may not be able to recover the
expenses of developing and commercializing those products. We face competition from numerous public and private companies and their extended release
technologies, including Johnson & Johnsons oral osmotic pump (OROS) technology, multiparticulate
systems marketed by Elan Corporation plc, Biovail Corporation and KV Pharmaceutical Company,
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 we are developing. For instance, we expect extended release
oxymorphone ER will face competition from MS Contin, Purdue Pharmas OxyContin and generic
competitors to OxyContin, Duragesic marketed by Johnson & Johnson and generic competitors to
Duragesic, and Avinza marketed by Ligand. Some of the TIMERx products we are developing, such as PW2101, are branded controlled release
products, which are proprietary products that are based on active chemical ingredients that are not
subject to patents. These branded controlled release products will compete against other products
developed using the same or a similar active chemical ingredient, including branded immediate
release and branded controlled released products, as well as any generic versions of these
products, based primarily on price. In addition, our branded controlled released products will
compete against other competitive products in the therapeutic class. For instance, PW2101 is a
controlled release formulation of an immediate release beta blocker, the chemical active ingredient
for which is no longer subject to patents in the United States. There is currently a similar
branded controlled release beta blocker product that is marketed for hypertension and against which
we expect PW2101 will compete. There are also currently filings for generic versions of the branded
controlled release products and the sponsors of the branded product and the generic products are
currently in patent litigation. If the sponsors of generic products prevail in such litigation,
PW2101 would also compete against these generic versions. 28




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In addition to developing branded controlled release products, we also selectively develop
generic versions of branded controlled release products using our TIMERx technology and generic
active ingredients. The success of these products 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.  If our clinical trials are not successful or take longer to complete than we expect, we may not
be able to develop and commercialize our products In order to obtain regulatory approvals for the commercial sale of our potential products,
including our branded controlled release products, we or our collaborators will be required to
complete clinical trials in humans to demonstrate the safety and efficacy of the products. However,
we or our collaborators may not be able to commence or complete these clinical trials in any
specified time period, or at all, either because the FDA or other regulatory agencies object, or
for other reasons. Even if we complete a clinical trial of one of our potential products, the clinical trial may
not indicate that our product is safe or effective to the extent required by the FDA, the European
Commission, or other regulatory agencies to approve the product, and we or our collaborators may
decide, or regulators may requires us or our collaborators, to conduct additional clinical trials.
For example, in response to the NDA for oxymorphone ER, the FDA is requiring Endo to conduct an
additional clinical trial of oxymorphone ER. In addition, on December 2, 2004, we announced that in
our pivotal efficacy trial of the low dose strength we did not meet
the studys primary endpoint. Alternatively, regulators may
require post marketing testing and surveillance to monitor the
safety and efficacy of a product. 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, 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. If clinical trials do not show any potential product to be safe or efficacious, if we are
required to conduct additional clinical trials or other testing of our products in development
beyond those that we currently contemplate or if we are unable to successfully complete our
clinical trials or other testing, we may:  
    be delayed in obtaining marketing approval for our products;
    not be able to obtain marketing approval for our products; or
    obtain approval for indications that are not as broad as intended. Our product development costs may also increase if we experience delays in testing or
approvals. In addition, significant clinical trial delays also could allow our competitors to bring
products to market before we do and impair our ability to commercialize our products.  We are subject to extensive government regulation including the requirement of approval before
our 29




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products
may be marketed. Even if we obtain marketing approval, our
products will be subject to ongoing regulatory review. We, our collaborators, our products, and our product candidates are subject to extensive
regulation by governmental authorities in the United States and other countries. Failure to comply
with applicable requirements could result in warning letters; fines and other civil penalties; delays in approving or refusal to approve a
product candidate; product recall or seizure; withdrawal of product approvals; interruption of
manufacturing or clinical trials; operating restrictions; injunctions; and criminal prosecution. Our products cannot be marketed in the United States without FDA approval. Obtaining FDA
approval requires substantial time, effort, and financial resources, and there can be no assurance
that any approval will be granted on a timely basis, if at all. We have had only limited
experience in preparing applications and obtaining regulatory approvals. If the FDA does not
approve our product candidates in a timely fashion, or does not approve them at all, our business
and financial condition may be adversely affected. 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 our or our collaborators products. Subsequent discovery of problems
with an approved product may result in restrictions on the product or its withdrawal from the
market. In addition, both before and after regulatory approval, we, our collaborators, our products,
and our product candidates are subject to numerous FDA requirements
covering testing, manufacturing, quality control, current good manufacturing practices (cGMP), adverse event
reporting, labeling, advertising, promotion, distribution, and export. We and our collaborators
are subject to surveillance and periodic inspections to ascertain compliance with these
regulations. Further, the relevant law and regulations may change in ways that could affect us,
our collaborators, our products, and our product candidates. Failure to comply with regulatory
requirements could have a material adverse impact on our business. We
are developing oxymorphone ER under a collaboration agreement with
Endo. Endo, which is responsible for conducting the clinical trials
and seeking regulatory approval of the product, submitted an NDA for
oxymorphone ER to the FDA in December 2002. In October 2003,
Endo received an approvable letter for oxymorphone ER. In the letter, the FDA
requested that Endo address certain questions, provide additional clarification and information,
and conduct some form of additional clinical trials to further confirm the safety and efficacy of oxymorphone ER
before the FDA would approve Endos NDA for oxymorphone ER. In discussions with Endo, the FDA advised Endo of its concern
that the outcome of two of the phase III efficacy trials submitted in
the NDA that met their predefined primary end-points may have been
favorably biased by the statistical handling of data from patients
who did not complete the trials. The design of this additional
clinical trial is intended to address this issue. In November 2004, Endo announced that
the FDA had granted final approval of the protocol under the FDAs
SPA process for a clinical trial in
patients with chronic low back pain and without recent treatment with
opioid analgesics, designed to provide additional safety and efficacy
data for oxymorphone ER requested by the FDA. The clinical trial is
also intended to address the FDAs concern regarding data from
patients who did not complete the trial. The new trial is intended to complement the completed Phase III pivotal trial that Endo
believes has demonstrated efficacy in the intended patient population. Endo has also reported that
based on the duration of the trials and the number of patients to be enrolled, and assuming the
data is favorable, Endo expects to submit a complete response letter to the FDA in early 2006. We
expect that Endo will receive a further action letter from the FDA within six months of submission
of the complete response letter. If the NDA for oxymorphone ER is not approved on a timely basis or
at all, it would have a material adverse effect on our business, financial condition and results of
operations. Certain
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 and branded
controlled release drugs, such as PW2101, 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 or
controlled release version of the same active chemical ingredient.
For example, our NDA for PW2101 was filed under section 505(b)(2) and
relies on data from an immediate release drug with the same active
chemical ingredient. We can provide no assurance, however, that the
FDA will accept a 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) NDAs 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. Our application to market PW2101 is a 505(b)(2) NDA. We are currently in discussions with the
FDA regarding the appropriate patent certifications required to be made for PW2101. If we are
required to file a paragraph IV patent certification and the patent holder sues us for
infringement, the FDA may not approve our application for up to 30 months. 30




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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, which could delay FDA
approval and commercial launch of our products We expect to file or have our collaborators file ANDAs or NDAs for our controlled release
products under development that are covered by one or more patents of the branded product. 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 our generic version of Procardia XL that we
developed with Mylan. Any significant delay in obtaining FDA approval to market our products 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 drug delivery technologies The commercial success of products incorporating our extended 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 our TIMERx or other extended release technology is marketed in the United
States, so there can be no assurance as to market acceptance. 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;
    the relative convenience and ease of administration as compared to competitive products;
    the strength of marketing distribution support; 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
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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 are issued, 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 research, development and commercialization activities, as well as any products in
development or products resulting from these activities, may infringe or be claimed to infringe
patents or patent applications of competitors or other third parties. In such event, we or our
collaborators may choose or may be required to seek a license from a third party and to pay license
fees or royalties or both under such license. These licenses may not be available on acceptable
terms, or at all. Even if we or our collaborators were able to obtain a license, the rights may be
nonexclusive, which could result in our competitors gaining access to the same intellectual
property. If we or our collaborators are not able to obtain a license, we could be prevented from
commercializing a product, or be forced to cease some aspect of our business operations. 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 damages or stop our
development and commercialization efforts The pharmaceutical industry has been characterized by significant litigation, 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
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and continuation of patent litigation or other proceedings could have a material adverse
effect on our ability to compete 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 or any products we may
develop in accordance with cGMP 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 2005 and on other third party manufacturers for the
products that are currently under development, such as PW2101. The agreement with Draxis will 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. We
are not a party to any agreements with our third party manufacturers for the products that we are
currently evaluating in clinical trials, such as Patheon with respect to PW2101, except for
purchase orders or similar arrangements. We believe that there are a limited number of manufacturers that operate under cGMP
regulations capable of manufacturing our TIMERx materials and the products we are evaluating in
clinical trials. Although we have qualified alternate suppliers with respect to the xanthan and
locust bean gums used to manufacture our TIMERx material, if Draxis is unable to manufacture the
TIMERx material in the required quantities, on a timely basis or at all, or if Draxis will not
agree to renew our agreement when it expires on acceptable terms to us or at all, we may be unable
to obtain alternative contract manufacturing, or obtain such manufacturing on commercially
reasonable terms. In addition, if we are unable to enter into longer-term manufacturing
arrangements for our products, such as PW2101, on acceptable terms to us or at all, particularly as
these products advance through clinical development and move closer to regulatory approval, our
business and the clinical development and commercialization of our products could be materially
adversely effected. There can be no assurance that Draxis or any other third parties upon which we
rely for supply of our TIMERx material or our products in clinical development will perform, and
any failures by third parties may delay development or the submission of products for regulatory
approval, impair our collaborators ability to commercialize products as planned and deliver
products on a timely basis, require us or our collaborators to cease distribution or recall some or
all batches of our products or otherwise impair our competitive position, which could have a
material adverse effect on our business, financial condition and results of operations. If our third party manufacturers fail to perform their 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. The manufacture of any of our products 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. 33




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We are dependent upon a limited number of suppliers for the gums used in our TIMERx material Our drug delivery systems are based a hydrophilic matrix combining a heterodispersed mixture
primarily composed of two polysaccharides, xanthan and locust bean gums, in the presence of
dextrose. These gums are also used in our Geminex, gastroretentive, and SyncroDose drug delivery
systems. We purchase these gums from a primary supplier. 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.  If we or 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 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 specific 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 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.  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 amounts of $10 million per
occurrence and $10 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, 34




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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. Specific provisions of our Shareholder Rights Plan, Certificate of Incorporation and Bylaws and
of Washington law make a takeover of Penwest or a change in control or management of Penwest
more difficult We have adopted a shareholder rights plan, often referred to as a poison pill. The rights
issued under the plan will cause substantial dilution to a person or group that attempts to acquire
us on terms that are not approved by our board of directors, unless the board first determines to
redeem the rights. Various provisions of our Certificate of Incorporation, our Bylaws and
Washington law may also have the effect of deterring hostile takeovers or delaying or preventing
changes in control or management of our company, including transactions in which our shareholders
might otherwise receive a premium for their shares over then current market prices. In addition,
these provisions may limit the ability of shareholders 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 and are
listed under Item 15(a) included herein. 
 ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 
 ITEM 9A. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures.Our management, with the participation of
our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our
disclosure controls and procedures as of December 31, 2004. The term disclosure controls and
procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and
other procedures of a company that are designed to ensure that information required to be disclosed
by a company in the reports that it files or submits under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in the SECs rules and forms.
Disclosure controls and procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by a company in the reports that it files or
submits under the Exchange Act is accumulated and communicated to the companys management,
including its principal executive and principal financial officers, as appropriate to allow timely
decisions regarding required disclosure. Management recognizes that any controls and procedures,
no matter how well designed and operated, can provide only reasonable assurance of achieving their
objectives and management necessarily applies its judgment in evaluating the cost-benefit
relationship of possible controls and procedures. Based on the evaluation of our disclosure
controls and procedures as of December 31, 2004, our chief executive officer and chief financial
officer concluded that, as of such date, the Companys disclosure controls and procedures were
effective at the reasonable assurance level. 35




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(b) Changes in Internal Control Over Financial Reporting.No change in our internal control over
financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act)
occurred during the fiscal quarter ended December 31, 2004 that has materially affected, or is
reasonably likely to materially affect, our internal control over financial reporting. (c) Reports on Internal
Control Over Financial Reporting Managements Annual
Report on Internal Control Over Financial Reporting Our management is
responsible for establishing and maintaining adequate internal control over financial reporting.
Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) promulgated
under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of,
our principal executive and principal financial officers and effected by our board of directors,
management and other personnel, to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles and includes those policies and procedures that:  
    Pertain to the maintenance of records that in reasonable detail accurately and
fairly reflect the transactions and dispositions of our assets;
    Provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting
principles, and that our receipts and expenditures are being made only in accordance
with authorizations of our management and directors; and
    Provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use or disposition of our assets that could have a material
effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate. Our management assessed the effectiveness of our internal control over financial reporting as
of December 31, 2004. In making this assessment, our management used the criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal
Control-Integrated Framework. Based on this assessment, management believes that, as of December
31, 2004, our internal control over financial reporting is effective based on those criteria. Managements assessment of the effectiveness of our internal control over financial reporting
as of December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public
accounting firm, as stated in their report which appears below. /s/ Robert J. Hennessey          March 10, 2005
    
    /s/ Jennifer L. Good          March 10, 2005Robert J. Hennessey
    
    Jennifer L. GoodPresident and Chief Executive Officer
    
    Sr. Vice President, Finance and
Chief Financial Officer
 36




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Report of Independent Registered Public Accounting Firm The Board of Directors and Shareholders
Penwest Pharmaceuticals Co. We have audited managements assessment, included in the accompanying Management Report on Internal
Control Over Financial Reporting that Penwest Pharmaceuticals Co. maintained effective internal
control over financial reporting as of December 31, 2004, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (the COSO criteria). Penwest Pharmaceuticals Cos management is responsible for
maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility is to express an
opinion on managements assessment and an opinion on the effectiveness of the Companys internal
control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control over financial reporting was
maintained in all material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating managements assessment, testing and evaluating the
design and operating effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinion. A companys internal control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles. A
companys internal control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (2) provide reasonable assurance that
transactions are recorded as necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that receipts and expenditures of the company
are being made only in accordance with authorizations of management and directors of the company;
and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the companys assets that could have a material effect on the
financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or
detect misstatements. Also, projections of any evaluation of effectiveness to future periods are
subject to the risk that controls may become inadequate because of changes in conditions, or that
the degree of compliance with the policies or procedures may deteriorate. In our opinion, managements assessment that Penwest Pharmaceuticals Co. maintained effective
internal control over financial reporting as of December 31, 2004, is fairly stated, in all
material respects, based on the COSO criteria. Also, in our opinion, Penwest Pharmaceuticals Co.
maintained, in all material respects, effective internal control over financial reporting as of
December 31, 2004, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the consolidated balance sheets of Penwest Pharmaceuticals Co as of December
31, 2004 and 2003, and the related consolidated statements of operations, shareholders equity, and
cash flows for each of the three years in the period ended December 31, 2004 and our report dated
March 10, 2005 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Stamford, Connecticut
March 10, 2005 37




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PART III 
 ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth under Election of Directors, Committees of the Board, Code of
Ethics and Section 16(a) Beneficial Ownership Reporting Compliance in our definitive Proxy
Statement for the 2005 Annual Meeting of Shareholders is incorporated herein by reference. Information regarding our executive officers is set forth in Part I, under the caption
Executive Officers of the Registrant. 
 ITEM 11: EXECUTIVE COMPENSATION The information set forth under Executive Compensation, Director Compensation and
Compensation Committee Interlocks and Insider Participation in our definitive Proxy Statement for
the 2005 Annual Meeting of Shareholders is incorporated herein by reference. 
 ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS The information set forth under Security Ownership of Certain Beneficial Owners and
Management and Securities Authorized for Issuance Under the Equity Compensation Plans in our
definitive Proxy Statement for the 2005 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 set forth under
Certain Relationships and Related Transactions in our definitive Proxy Statement for the 2005
Annual Meeting of Shareholders is incorporated herein by reference. 
 ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES The information set forth under Independent Auditor Fees and Other Matters in our definitive
Proxy Statement for the 2005 Annual Meeting of Shareholders is incorporated herein by reference. 
 PART IV 
 ITEM 15: EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (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, 2004 and 2003 and the related statements of
operations, cash flows and shareholders equity for each of the three years in the period ended
December 31, 2004. 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. (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 reference.
This list includes a subset 38




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containing each management contract, compensatory plan, or
arrangement required to be filed as an exhibit to this report. 39




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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: March 14, 2005
    
    /s/Robert J. HennesseyRobert J. Hennessey, Presidentand Chief Executive Officer
 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the capacities and on the
dates indicated. Date: March 14, 2005
    
    /s/ Robert J. HennesseyRobert J. Hennessey, President,Chief Executive Officer and Director(Principal Executive Officer)Date: March 14, 2005
    
    /s/ Jennifer L. GoodJennifer L. Good, Sr. Vice President, Financeand Chief Financial Officer(Principal Financial and Accounting Officer)Date: March 14, 2005
    
    /s/ Paul E. FreimanPaul E. Freiman, Chairman of the BoardDate: March 14, 2005
    
    /s/ Jere E. GoyanJere E. Goyan, Ph.D., DirectorDate: March 14, 2005
    
    /s/ Rolf H. HenelRolf H. Henel, DirectorDate: March 14, 2005
    
    /s/ John N. StaniforthJohn N. Staniforth, Ph.D., DirectorDate: March 14, 2005
    
    /s/ Anne M. VanLentAnne M. VanLent, Director
 40




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APPENDIX A PENWEST PHARMACEUTICALS CO.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULE PageConsolidated Financial StatementsReport of Independent Registered Public Accounting Firm
    
    
    F-2Consolidated Balance Sheets
    
    
    F-3Consolidated Statements of Operations
    
    
    F-4Consolidated Statements of Shareholders Equity
    
    
    F-5Consolidated Statements of Cash Flows
    
    
    F-6Notes to Consolidated Financial Statements
    
    
    F-7Schedule II  Valuation and Qualifying Accounts
    
    
    S-1




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Report of Independent Registered Public Accounting Firm 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, 2004 and 2003, and the related consolidated statements of income, shareholders
equity, and cash flows for each of the three years in the period ended December 31, 2004. Our
audits also included the financial statement schedule listed in the Index at Item 15(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 the standards of the Public Company Accounting Oversight
Board (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, 2004
and 2003, and the consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule, when considered in
relation to the basic financial statements taken as a whole, present fairly in all material
respects the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of Penwest Pharmaceuticals Co.s internal control over
financial reporting as of December 31, 2004, based on criteria established in Internal
ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission and our report dated March 10, 2005 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP Stamford, Connecticut
March 10, 2005 F-2




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PENWEST PHARMACEUTICALS CO. 
 CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
 DECEMBER 31,2004
    
    
    2003(see Note 2 - Basis ofPresentation)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    14,249
    
    
    $
    8,241Marketable securities
    
    
    60,121
    
    
    
    55,652Trade accounts receivable
    
    
    1,126
    
    
    
    1,153Inventories
    
    
    643
    
    
    
    656Prepaid expenses and other current assets
    
    
    1,143
    
    
    
    1,364Note receivable
    
    
    
    
    
    
    1,250Total current assets
    
    
    77,282
    
    
    
    68,316Fixed assets, net
    
    
    3,674
    
    
    
    3,533Patents, net
    
    
    3,504
    
    
    
    3,689Cash surrender value of life insurance policy
    
    
    3,062
    
    
    
    2,965Total assets
    
    $
    87,522
    
    
    $
    78,503LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    2,396
    
    
    $
    2,804Accrued expenses
    
    
    1,966
    
    
    
    2,133Accrued development costs
    
    
    974
    
    
    
    2,682Total current liabilities
    
    
    5,336
    
    
    
    7,619Deferred revenue
    
    
    71
    
    
    
    84Deferred compensation
    
    
    3,314
    
    
    
    3,104Total liabilities
    
    
    8,721
    
    
    
    10,807Shareholders equity:Preferred stock, par value $.001, authorized 1,000,000 shares, none outstanding
    
    
    
    
    
    
    Common stock, par value $.001, authorized 60,000,000 shares, issued and
outstanding 21,692,730 shares at December 31, 2004 and 18,422,523 shares at
December 31, 2003
    
    
    22
    
    
    
    18Additional paid in capital
    
    
    197,097
    
    
    
    162,068Accumulated deficit
    
    
    (118,218
    )
    
    
    (94,433
    )Accumulated other comprehensive (loss) income
    
    
    (100
    )
    
    
    43Total shareholders equity
    
    
    78,801
    
    
    
    67,696Total liabilities and shareholders equity
    
    $
    87,522
    
    
    $
    78,503
 See accompanying notes F-3




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PENWEST PHARMACEUTICALS CO. 
 CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
 YEAR ENDED DECEMBER 31,2004
    
    
    2003
    
    
    2002(see Note 2 - Basis of Presentation)RevenuesRoyalties and licensing fees
    
    $
    4,882
    
    
    $
    4,223
    
    
    $
    4,918Product sales
    
    
    226
    
    
    
    455
    
    
    
    619Total revenues
    
    
    5,108
    
    
    
    4,678
    
    
    
    5,537Cost of revenues
    
    
    104
    
    
    
    169
    
    
    
    170Gross profit
    
    
    5,004
    
    
    
    4,509
    
    
    
    5,367Operating expensesSelling, general and administrative
    
    
    9,485
    
    
    
    10,361
    
    
    
    7,568Research and product development
    
    
    20,205
    
    
    
    20,590
    
    
    
    16,955Total operating expenses
    
    
    29,690
    
    
    
    30,951
    
    
    
    24,523Operating loss from continuing operations
    
    
    (24,686
    )
    
    
    (26,442
    )
    
    
    (19,156
    )Investment income
    
    
    906
    
    
    
    476
    
    
    
    379Interest expense
    
    
    
    
    
    
    34
    
    
    
    243Loss from continuing operations before income tax expense
    
    
    (23,780
    )
    
    
    (26,000
    )
    
    
    (19,020
    )Income tax expense
    
    
    5
    
    
    
    6
    
    
    
    8Loss from continuing operations
    
    
    (23,785
    )
    
    
    (26,006
    )
    
    
    (19,028
    )Earnings from discontinued operations, net of income tax expense of $26
and $369 for 2003 and 2002, respectively
    
    
    
    
    
    
    177
    
    
    
    1,929Gain on sale of discontinued operations
    
    
    
    
    
    
    9,894
    
    
    
    Total discontinued operations
    
    
    
    
    
    
    10,071
    
    
    
    1,929Net loss
    
    $
    (23,785
    )
    
    $
    (15,935
    )
    
    $
    (17,099
    )Basic and diluted (loss) earnings per common share:Continuing operations
    
    $
    (1.28
    )
    
    $
    (1.56
    )
    
    $
    (1.23
    )Discontinued operations
    
    
    
    
    
    
    0.60
    
    
    
    0.12Net loss
    
    $
    (1.28
    )
    
    $
    (0.96
    )
    
    $
    (1.11
    )Weighted average shares of common stock outstanding
    
    
    18,627
    
    
    
    16,678
    
    
    
    15,462
 See accompanying notes F-4




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PENWEST PHARMACEUTICALS CO. 
 CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
(in thousands)
 ACCUMULATEDADDITIONAL
    
    
    
    
    
    
    OTHERCOMMON STOCK
    
    
    PAID-IN
    
    
    ACCUMULATED
    
    
    COMPREHENSIVESHARES
    
    
    AMOUNT
    
    
    CAPITAL
    
    
    DEFICIT
    
    
    (LOSS) INCOME
    
    
    TOTALBalances, December 31, 2001
    
    
    15,277
    
    
    $
    15
    
    
    $
    108,054
    
    
    $
    (60,926
    )
    
    $
    (1,519
    )
    
    $
    45,624Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (17,099
    )
    
    
    
    
    
    
    (17,099
    )Translation adjustments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    988
    
    
    
    988Changes in unrealized gain
on marketable securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (37
    )
    
    
    (37
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (16,148
    )Issuance of common stock
pursuant to stock
compensation plans
    
    
    217
    
    
    
    1
    
    
    
    1,799
    
    
    
    
    
    
    
    
    
    
    
    1,800Issuance of common stock
pursuant to Stock Purchase
Plan
    
    
    12
    
    
    
    
    
    
    
    147
    
    
    
    
    
    
    
    
    
    
    
    147Balances, December 31, 2002
    
    
    15,506
    
    
    
    16
    
    
    
    110,000
    
    
    
    (78,025
    )
    
    
    (568
    )
    
    
    31,423Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (15,935
    )
    
    
    
    
    
    
    (15,935
    )Translation adjustments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    110
    
    
    
    110Accumulated foreign currency
translation adjustments of
discontinued operations sold
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (473
    )
    
    
    473
    
    
    
    Changes in unrealized gain
on marketable securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    28
    
    
    
    28Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (15,797
    )Issuance of common stock
pursuant to an equity
financing, net
    
    
    2,508
    
    
    
    2
    
    
    
    49,302
    
    
    
    
    
    
    
    
    
    
    
    49,304Issuance of common stock
pursuant to stock
compensation plans
    
    
    400
    
    
    
    
    
    
    
    2,662
    
    
    
    
    
    
    
    
    
    
    
    2,662Issuance of common stock
pursuant to Stock Purchase
Plan
    
    
    9
    
    
    
    
    
    
    
    104
    
    
    
    
    
    
    
    
    
    
    
    104Balances, December 31, 2003
    
    
    18,423
    
    
    
    18
    
    
    
    162,068
    
    
    
    (94,433
    )
    
    
    43
    
    
    
    67,696Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (23,785
    )
    
    
    
    
    
    
    (23,785
    )Changes in unrealized
gain/loss on marketable
securities
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (143
    )
    
    
    (143
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (23,928
    )Issuance of common stock
pursuant to an equity
financing, net
    
    
    3,125
    
    
    
    4
    
    
    
    32,795
    
    
    
    
    
    
    
    
    
    
    
    32,799Issuance of common stock
pursuant to stock
compensation plans
    
    
    130
    
    
    
    
    
    
    
    2,081
    
    
    
    
    
    
    
    
    
    
    
    2,081Issuance of common stock
pursuant to Stock Purchase
Plan
    
    
    15
    
    
    
    
    
    
    
    153
    
    
    
    
    
    
    
    
    
    
    
    153Balances, December 31, 2004
    
    
    21,693
    
    
    $
    22
    
    
    $
    197,097
    
    
    $
    (118,218
    )
    
    $
    (100
    )
    
    $
    78,801
 See accompanying notes F-5




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##### Table of Contents



PENWEST PHARMACEUTICALS CO. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 YEAR ENDED DECEMBER 31,2004
    
    
    2003
    
    
    2002(see Note 2 - Basis of Presentation)Operating activities:Net loss
    
    $
    (23,785
    )
    
    $
    (15,935
    )
    
    $
    (17,099
    )Less earnings from discontinued operations, net of tax expense
    
    
    
    
    
    
    (177
    )
    
    
    (1,929
    )Less gain on sale of discontinued operations
    
    
    
    
    
    
    (9,894
    )
    
    
    Loss from continuing operations
    
    
    (23,785
    )
    
    
    (26,006
    )
    
    
    (19,028
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    1,042
    
    
    
    679
    
    
    
    222Amortization
    
    
    410
    
    
    
    219
    
    
    
    166Patent impairment losses
    
    
    417
    
    
    
    5
    
    
    
    121Deferred income taxes
    
    
    
    
    
    
    (118
    )
    
    
    Deferred revenue
    
    
    (14
    )
    
    
    (53
    )
    
    
    (84
    )Deferred compensation
    
    
    211
    
    
    
    215
    
    
    
    178Stock compensation
    
    
    297
    
    
    
    110
    
    
    
    105Changes in operating assets and liabilities:Trade accounts receivable
    
    
    27
    
    
    
    (35
    )
    
    
    115Inventories
    
    
    13
    
    
    
    (195
    )
    
    
    (270
    )Accounts payable, accrued expenses and other
    
    
    (1,505
    )
    
    
    2,112
    
    
    
    1,488Net cash used in continuing operations operating activities
    
    
    (22,887
    )
    
    
    (23,067
    )
    
    
    (16,987
    )Net cash provided by discontinued operations operating activities
    
    
    
    
    
    
    874
    
    
    
    2,230Net cash used in operating activities
    
    
    (22,887
    )
    
    
    (22,193
    )
    
    
    (14,757
    )Investing activities:Proceeds from sale of discontinued operations, net of transaction
costs paid of $1,351 in 2003
    
    
    1,250
    
    
    
    36,900
    
    
    
    Acquisitions of fixed assets, net
    
    
    (1,226
    )
    
    
    (1,810
    )
    
    
    (1,359
    )Patent costs
    
    
    (643
    )
    
    
    (965
    )
    
    
    (650
    )Transaction costs
    
    
    
    
    
    
    
    
    
    
    (1,741
    )Purchases of marketable securities
    
    
    (57,681
    )
    
    
    (62,170
    )
    
    
    Proceeds from maturities of marketable securities
    
    
    17,795
    
    
    
    7,299
    
    
    
    7,255Proceeds from sales of marketable securities
    
    
    35,150
    
    
    
    1,100
    
    
    
    Net cash (used in) provided by continuing operations investing activities
    
    
    (5,355
    )
    
    
    (19,646
    )
    
    
    3,505Net cash used in discontinued operations investing activities
    
    
    
    
    
    
    (97
    )
    
    
    (3,822
    )Net cash used in investing activities
    
    
    (5,355
    )
    
    
    (19,743
    )
    
    
    (317
    )Financing activities:Proceeds from loans and notes payable
    
    
    
    
    
    
    1,354
    
    
    
    28,983Repayments of loans and notes payable
    
    
    
    
    
    
    (7,047
    )
    
    
    (25,958
    )Issuance of common stock, net
    
    
    34,250
    
    
    
    51,960
    
    
    
    1,841Net cash provided by discontinued operations financing activities
    
    
    
    
    
    
    2,249
    
    
    
    Net cash provided by financing activities
    
    
    34,250
    
    
    
    48,516
    
    
    
    4,866Effect of exchange rate changes on cash and cash equivalents of
discontinued operations
    
    
    
    
    
    
    32
    
    
    
    308Net increase (decrease) in cash and cash equivalents
    
    
    6,008
    
    
    
    6,612
    
    
    
    (9,900
    )Cash and cash equivalents at beginning of year
    
    
    8,241
    
    
    
    1,629
    
    
    
    11,529Cash and cash equivalents at end of year
    
    $
    14,249
    
    
    $
    8,241
    
    
    $
    1,629
 See accompanying notes F-6




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##### Table of Contents



PENWEST PHARMACEUTICALS CO 
  1. BUSINESS Penwest Pharmaceuticals Co. (the Company) develops pharmaceutical products based on
innovative proprietary oral drug delivery technologies. The Company is focusing its development
efforts principally on products that address diseases of the central nervous system. The two most
advanced products in the Companys drug development pipeline are oxymorphone ER, an extended
release formulation of oxymorphone, a narcotic analgesic being
developed for twice-a-day dosing in patients with moderate to severe
pain requiring continuous
around-the-clock opioid therapy for an extended period of time, and PW2101, a beta blocker intended for the treatment of hypertension and
angina. The Company is also developing Phase II efficacy studies on
several additional product candidates in areas such as edema, epilepsy, schizophrenia and
depression. Prior to February 27, 2003, Penwest also developed, manufactured and distributed branded
pharmaceutical excipients, which are the inactive ingredients in tablets and capsules, primarily
consisting of binders, disintegrants and lubricants. On February 27, 2003, Penwest sold
substantially all of the assets used in the Companys excipient business to subsidiaries and
affiliates of Josef Rettenmaier Holding GmbH & Co. KG (the Asset Sale). The Company received
$39.5 million in cash and a promissory note for $2.25 million in consideration for the excipient
business. In April 2003, the Company received $1.0 million under the promissory note and received
the balance of $1.25 million in May 2004. The Company used approximately $5.5 million of proceeds
of the sale of its excipient business to repay debt (see Note 8). As a result of the Asset Sale,
the accompanying consolidated financial statements present Penwests excipient business as a
discontinued operation for 2003 and 2002. The Company has incurred net losses since 1994. As of December 31, 2004, the Companys
accumulated deficit was approximately $118.2 million. The Company expects operating losses and
negative cash flows to continue until substantial sales of products commercialized utilizing TIMERx
technology or other technologies occur. A substantial portion of the Companys revenues through
February 27, 2003 were generated from sales of the Companys pharmaceutical excipient product line.
During 2002 and 2003 through the Asset Sale date, sales of its excipient products generated
positive cash flows from operations although the Company as a whole had negative cash flows from
operations. Since February 27, 2003, the Company has not derived any revenues from the excipient
business. Accordingly, the Companys revenues for 2003 and 2004 were generated primarily from Mylan
royalties and shipments of bulk TIMERx. The Companys future profitability will depend on several
factors, including the successful commercialization of TIMERx controlled release products,
including in particular oxymorphone ER and PW2101, royalties from Mylans sales of Pfizers 30 mg
generic version of Procardia ER, and the level of its investment in research and development
activities. The Company is subject to the risks and uncertainties associated with drug development. These
risks and uncertainties include, but are not limited to, a history of net losses, technological
changes, dependence on collaborators and key personnel, the successful completion of development
efforts and of obtaining regulatory approval, 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,
dependence on third party manufactures and a requirement for additional funding. 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. As
a result of the Asset Sale, the accompanying consolidated financial statements present Penwests
excipient business as a discontinued operation for 2003 and 2002. All wholly owned subsidiaries
were included in the Asset Sale (see Note 13). The preparation of financial statements in conformity with U.S. generally accepted accounting
principles requires management to make estimates and assumptions that affect the amounts reported
in the financial statements and accompanying notes. Actual results could differ from those
estimates. F-7




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Certain prior year amounts have been reclassified to conform to the current year presentation,
including the reclassification of approximately $17.1 million of auction rate securities at
December 31, 2003 as marketable securities, rather than cash equivalents as previously reported.
These reclassifications had no impact on the Companys financial position or results of operations. Cash and Cash Equivalents All highly liquid investments with maturities of 90 days 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, discounted notes backed by U.S. government agencies, municipal securities and
certificates of deposit. Unrealized holding gains or losses are included in shareholders equity as
a separate component of accumulated other comprehensive income (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.
Allowances for doubtful accounts receivable are maintained based on historical payment patterns,
aging of accounts receivable and actual write-off history. One customer of the Company accounted
for approximately 94%, 88% and 87% of total revenues in 2004, 2003 and 2002, respectively. Another
customer of the Company accounted for approximately 11% of total revenues for 2003. 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 certain
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 loans and notes payable, and accounts
payable, approximates fair value due to the short term nature of these instruments or their
liquidity provided in the case of auction rate securities (see Note 4). Long-Lived Assets Fixed assets are recorded at cost and depreciated using the straight-line method over their
estimated useful lives or over the lease term for leasehold improvements. Estimated useful lives by
class of assets are substantially as follows: Machinery and equipment
    
    5-10 yearsOffice furniture, equipment and software
    
    3-10 yearsLeasehold improvements
    
    1-3 years
 The Company reviews the recoverability of its long-lived assets, including definite-lived
intangible assets whenever facts and circumstances indicate that the carrying amount may not be
fully recoverable. For purposes of recognizing and measuring impairment, the Company evaluates
long-lived assets based upon the lowest level of independent cash flows ascertainable to evaluate
impairment. If the sum of the undiscounted future cash flows expected over the remaining asset life
is less than the carrying value of the assets, the Company may recognize an impairment loss. The
impairment related to long-lived assets is measured as the amount by which the carrying F-8




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) amount of
the assets exceeds the fair value of the asset. When fair values are not readily available, the
Company estimates fair values using expected discounted future cash flows. Foreign Currencies The assets and liabilities, and operating results of the Companys foreign operations were
reported as discontinued operations as a result of the Asset Sale. Assets and liabilities of the
Companys foreign operations were translated into U.S. dollars at year-end exchange rates, and
revenue and expenses were translated at average exchange rates. For each of the foreign operations,
the functional currency was the local currency. Accumulated other comprehensive (loss) income
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. There are no foreign
currency translation gains and losses in 2004, and foreign currency transaction gains and losses
were not significant in each year in the three year period ended December 31, 2004. Accumulated Other Comprehensive (Loss) Income Accumulated other comprehensive (loss) income at December 31, 2004 consisted of unrealized
losses on marketable securities, and at December 31, 2003 and 2002, consisted of the Companys
foreign currency translation adjustment and net unrealized gains (losses) on marketable securities
(see Note 18). 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 2004,
2003 and 2002, 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 Royalties and licensing fees The Company recognizes revenues from non-refundable upfront
licensing fees received under collaboration agreements ratably over the development period of the
related 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 there exists an obligation to supply inventory for manufacture. 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. The proportionate development efforts achieved are measured
by estimating the percentage of work completed that is required of the Company in the development
effort for the product. This estimate is primarily derived from the underlying project plans and
timelines, developed by qualified personnel who work closely on such projects. In particular, the
Company reviews output measures such as job specifications and tasks completed, compared to all
such job specifications and tasks outlined for a particular project. Job specifications vary with
each project and primarily include development activities regarding initial formulation work,
manufacturing scale-up, proof-of-principle biostudies, clinical development and regulatory matters.
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, as reported by our
collaborators, and are generally subject to review or audit by the Company. Product sales The Company recognizes revenues from product sales when title transfers and
customer acceptance provisions have lapsed, provided that collections of the related accounts
receivable are probable. Shipping and handling costs are included in cost of revenues. F-9




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Research and Development Expenses Research and development expenses consist of costs associated with products being developed
internally as well as products being developed under collaboration agreements and include related
salaries, benefits and other personnel related expenses, clinical trial costs, and contract and
other outside service fees. Research and development costs are expensed as incurred. A significant
portion of the Companys development activities are outsourced to third parties including contract
research organizations, and contract manufacturers in connection with the production of clinical
materials, or may be performed by the Companys collaborators. These arrangements may require
estimates to be made of related service fees or the Companys share of development costs, in which
actual results could materially differ from the estimates and affect the reported amounts in the
Companys financial statements. These arrangements may also require us to pay termination costs to
the third parties for reimbursement of costs and expenses incurred in the orderly termination of
contractual services. 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 2004, 2003 and 2002 as the effects would be antidilutive. Stock Based Compensation The Company adopted the disclosure provisions of Statement of Financial Accounting Standards
(SFAS) No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure, which
amends SFAS No. 123, Accounting for Stock-Based Compensation, in 2002. SFAS No. 148 provides
alternative methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation, which was originally provided under SFAS No. 123.
SFAS No. 148 also improves the timeliness of disclosures by requiring the information to be
included in interim as well as annual financial statements. The adoption of these disclosure
provisions had no impact on the Companys consolidated results of operations, financial position or
cash flows (see Note 3). At December 31, 2004, the Company maintained two stock-based employee compensation plans (see
Note 9). The Company accounts for these employee stock compensation plans in accordance with the
intrinsic value-based method prescribed by Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees. During the year ended December 31, 2004, in connection
with retainer and meeting fees earned by members of the Companys board of directors and scientific
advisory board in 2004, the Company recorded $60,000 of expense associated with the issuance of
discounted stock options, $209,000 of expense associated with restricted stock grants and $27,000
of expense associated with unrestricted stock grants. In 2003 and 2002, the Company recorded
expense associated with the issuance of discounted stock options of
$61,000 and $29,000,
respectively, for continuing operations, and $6,000 and $28,000, respectively, for discontinued
operations. In 2003 and 2002, the Company recorded expense associated with restricted stock grants
of $121,000 and $39,000, respectively, for continuing operations, and $11,000 and $39,000,
respectively, for discontinued operations. In 2003, the Company recorded $106,000 in compensation
expense in connection with the acceleration of the vesting date of certain stock options. No other
stock-based employee compensation expense is reflected in net loss as all other stock options
granted under these plans had an exercise price equal to the fair market value of the underlying
common stock on the date of grant. F-10




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The following table reflects pro forma net loss and loss per share had the Company elected to
adopt the fair value approach of SFAS No. 123: YEAR ENDED DECEMBER 31,2004
    
    
    2003
    
    
    2002(in thousands, except per share data)Net loss  as reported
    
    $
    (23,785
    )
    
    $
    (15,935
    )
    
    $
    (17,099
    )Stock-based compensation expense included in
reported net loss
    
    
    296
    
    
    
    305
    
    
    
    135Stock-based compensation under fair value method
    
    
    (3,575
    )
    
    
    (3,316
    )
    
    
    (3,341
    )Net loss  pro forma after stock-based
compensation under fair value method
    
    $
    (27,064
    )
    
    $
    (18,946
    )
    
    $
    (20,305
    )Net loss per share, basic and diluted  as reported
    
    $
    (1.28
    )
    
    $
    (0.96
    )
    
    $
    (1.11
    )Net loss per share, basic and diluted  pro forma
after stock-based compensation under fair value
method
    
    $
    (1.45
    )
    
    $
    (1.14
    )
    
    $
    (1.31
    )
 3. RECENT ACCOUNTING PRONOUNCEMENTS In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) 123R, Share-Based Payment (Revised 2004), which requires
companies to recognize in the income statement the fair value of all employee share-based payments,
including grants of employee stock options as well as compensatory employee stock purchase plans,
for interim periods beginning after June 15, 2005 and will become effective for the Company for the
quarter ending September 30, 2005. Accordingly, SFAS 123R eliminates the ability to account for
share-based compensation using APB 25, and the pro forma disclosures previously permitted under
SFAS 123 no longer will be an alternative to financial statement recognition. See Stock Based
Compensation above for the pro forma net loss and net loss per share amounts for the years ended
December 31, 2004, 2003 and 2002, as if the Company had used a fair-value-based method similar to
the methods required under SFAS 123R to measure compensation expense for employee stock incentive
awards. Although the Company has not determined whether the adoption of SFAS 123R will result in
amounts that are similar to the current pro forma disclosures under SFAS 123, the Company is
evaluating the requirements under SFAS 123R including the valuation methods and support for the
assumptions that underlie the valuation of the awards, as well as the transition methods (modified
prospective transition method or the modified retrospective transition method) and expect the
adoption to have a significant impact on our consolidated statements of operations and net loss per
share. In November 2004, the FASB issued Statement No. 151, Inventory Costs  an amendment of ARB
No. 43, Chapter 4. This Statement amends the guidance in ARB No. 43, Chapter 4, Inventory
Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight,
handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously
stated that ...under some circumstances, items such as idle facility expense, excessive spoilage,
double freight, and rehandling costs may be so abnormal as to require treatment as current period
charges... This Statement requires that those items be recognized as current-period charges
regardless of whether they meet the criterion of so abnormal. In addition, this Statement
requires that allocation of fixed production overheads to the costs of conversion be based on the
normal capacity of the production facilities. The provisions of this Statement shall be effective
for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of
Statement No. 151 is not expected to have a material effect on the Companys results of operations,
financial position or cash flows. 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. F-11




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 4. MARKETABLE SECURITIES The amortized costs and estimated fair values of marketable securities are as follows: Gross
    
    
    Gross
    
    
    EstimatedAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairCost
    
    
    Gains
    
    
    Losses
    
    
    Value(in thousands)December 31, 2004:Corporate debt securities
    
    $
    32,410
    
    
    $
    
    
    
    $
    64
    
    
    $
    32,346U.S. government agency-backed discounted
notes
    
    
    7,019
    
    
    
    
    
    
    
    36
    
    
    
    6,983Municipal securities
    
    
    20,792
    
    
    
    
    
    
    
    
    
    
    
    20,792Total marketable securities
    
    $
    60,221
    
    
    $
    
    
    
    $
    100
    
    
    $
    60,121December 31, 2003:Corporate debt securities
    
    $
    23,572
    
    
    $
    27
    
    
    $
    6
    
    
    $
    23,593U.S. government agency  backed
discounted notes
    
    
    14,048
    
    
    
    25
    
    
    
    
    
    
    
    14,073Municipal securities
    
    
    17,012
    
    
    
    
    
    
    
    
    
    
    
    17,012Certificates of deposit
    
    
    977
    
    
    
    
    
    
    
    3
    
    
    
    974Total marketable securities
    
    $
    55,609
    
    
    $
    52
    
    
    $
    9
    
    
    $
    55,652
 Maturities of marketable securities at fair value as of December 31, 2004, are as follows (in
thousands): Contractual maturity:Maturing in one year or less
    
    $
    32,806Maturing after one year through five years
    
    
    4,120Maturing after five years through ten years
    
    
    Maturing after ten years
    
    
    23,195Total marketable securities
    
    $
    60,121
 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 certain
restrictions on maturities, and concentration by issuer (see Note 2, Credit Risk and Fair Value of
Financial Instruments). Marketable securities include auction rate securities whose contractual
maturities are included above. Liquidity in these instruments is provided from third parties
(buyers and sellers in an auction system) generally every one to three months at which time their
interest rates, or dividend rates for preferred securities, are reset. A decline in the market value of any security below cost that is deemed to be other than
temporary results in a reduction in carrying amount to fair value. Such impairments are charged to
the results of operations and a new cost basis for the security is established. Unrealized losses
on marketable securities held at December 31, 2004 and 2003 were not deemed other than temporary,
as all such securities are investment grade, and management believes the impairments are
attributable to increased market rates. 5. INVENTORIES Inventories, which consist of raw materials and manufactured bulk TIMERx, are stated at the
lower of cost (first-in, first-out) or market. Inventories are summarized as follows: DECEMBER 31,2004
    
    
    2003(in thousands)Raw materials
    
    $
    134
    
    
    $
    196Finished products
    
    
    509
    
    
    
    460Total inventories
    
    $
    643
    
    
    $
    656
 F-12




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PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) The Company periodically reviews and quality tests its inventory to identify obsolete, slow
moving or otherwise unsaleable inventories. Inventories at December 31, 2004 and 2003 are net of
allowances of $85,000 and $82,000, respectively. The Company currently has no internal commercial scale manufacturing capabilities. Generally,
the Companys collaborators manufacture the pharmaceutical products, and the Company is responsible
for supplying them with bulk TIMERx. The Company has outsourced the commercial manufacture of
TIMERx materials to a third-party pharmaceutical company, Draxis Pharmaceuticals, Inc., under a
manufacturing agreement that expires in September 2005. The agreement automatically renews 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. The Company is seeking to
qualify a second contract manufacturer as a second source of supply. The Company has completed
initial validation work with the contract manufacturer, however, there is some additional follow-up
work required before the site is fully validated. The Companys TIMERx technology is based on a hydrophilic matrix combining a heterodispersed
mixture primarily composed of two polysaccharides, xanthan and locust bean gums, in the presence of
dextrose. The Company purchases these gums from a primary supplier. Although the Company has
qualified alternate suppliers with respect to these gums and to date 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. 6. FIXED ASSETS Fixed assets, at cost, summarized by major categories, consist of the following: DECEMBER 31,2004
    
    
    2003(in thousands)Equipment and leasehold improvements
    
    $
    5,487
    
    
    $
    4,602Software
    
    
    1,653
    
    
    
    1,540Projects in progress
    
    
    154
    
    
    
    7,294
    
    
    
    6,142Less: accumulated depreciation
    
    
    3,620
    
    
    
    2,609$
    3,674
    
    
    $
    3,533
 The Company capitalizes certain costs associated with developing or obtaining internal-use
software. These costs include external direct costs of materials and services used in developing or
obtaining the software, and payroll and payroll-related costs for employees directly associated
with the software development project. For the years ended December 31, 2003 and 2002, the Company
capitalized $923,000 and $606,000, respectively, of software development costs that are primarily
related to the development of the Companys enterprise-wide software systems. The Company did not
capitalize any such costs in 2004. The Company includes these costs within equipment and software,
and generally depreciates the software development costs over a period of five years, once the
systems are placed in service. 7. PATENTS Patents, net of accumulated amortization, consist of the following: DECEMBER 31,2004
    
    
    2003(in thousands)Patents, net of accumulated amortization of $1,234 and $904
    
    $
    3,504
    
    
    $
    3,689
 Patents include costs to secure patents on technology and products developed by the Company.
Patents are amortized on a straight-line basis over their estimated useful lives of 17 to 20 years.
Amortization expense of $410,000, $219,000, and $166,000 was recorded in the years ended December
31, 2004, 2003, and 2002, F-13




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PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) respectively. Estimated amortization expense on existing patent costs is
approximately $263,000 for each of the next five years. Patents are evaluated for potential impairment whenever events or circumstances indicate that
future undiscounted cash flows may not be sufficient to recover their carrying amounts. An
impairment loss is recorded to the extent the assets carrying value is in excess of the fair value
of the asset. When fair values are not readily available, the Company estimates fair values using
expected discounted future cash flows. During the years ended December 31, 2004, 2003 and 2002, for
continuing operations, the Company recorded impairment losses of $417,000, $5,000 and $121,000,
respectively, relating to its patents. The impairment losses recorded in 2004 primarily relate to
the write-off of patents in the second quarter of 2004 covering inhalation technology which the
Company determined no longer had value. Such impairment losses are reflected in research and
product development expense on the consolidated statements of operations. 8. LOANS AND NOTES PAYABLE 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 could
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, were included in the borrowing base. Amounts
outstanding under the Revolver were collateralized by the Companys U.S. and Canadian accounts
receivable, and its inventory and general intangibles. The Revolver had an initial term of three
years, and provided for annual renewals thereafter. On February 27, 2003, the Company paid off the
outstanding balance of $3.3 million and terminated the Revolver in connection with the sale of its
excipient business (see Note 13). Note Payable to AstraZeneca AB As part of the Companys agreement to acquire assets including trademarks and other
intellectual property related to an excipient product, Pruv, for $3 million on October 25, 2002,
the Company issued a note to the seller, AstraZeneca AB, in the principal amount of $2.25 million.
Under the agreement, the note required the Company to pay all indebtedness outstanding under the
note upon the closing of the Asset Sale, which included these assets, and which occurred in
February 2003. As a result, this note was paid in full in February 2003 (see Note 13). Business Insurance Premium Financing On September 24, 2002, the Company entered into a Premium Finance Agreement (a Finance
Agreement) through which it financed approximated $1.1 million of premiums payable in connection
with the annual renewal of its general business insurance. Under the Finance Agreement, Penwest was
required to repay the amount financed in equal monthly installments through June 2003, plus
interest at a rate of 3.11% per annum. In addition, the Company assigned, as a security interest,
any and all unearned premiums or other amounts which may become payable to the Company under the
related insurance policies. Approximately $34,000 and $243,000 of total interest was paid in 2003 and 2002, respectively.
No interest was paid by the Company in 2004. 9. SHAREHOLDERS EQUITY On December 14, 2004, the Company completed the sale of a total of 3,125,000 shares of common
stock through a private placement to selected institutional investors, resulting in net proceeds to
the Company, after fees and expenses, of approximately $32.8 million. The Company intends to use
the net proceeds to fund the research, development, marketing and commercialization of its products
and technologies, and for general corporate purposes. On August 5 and August 6, 2003, the Company completed the sale of a total of 2,507,762 shares
of common stock through a private placement to selected institutional investors (the 2003 Private
Placement), resulting in net F-14




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) proceeds to the Company, after fees and expenses, of approximately
$49.3 million. As part of the 2003 Private Placement, the Company granted the institutional
investors additional rights to purchase up to an additional 501,552 shares of common stock at a
price of $26.00 per share. These additional investment rights became exercisable on September 12,
2003, and expired on December 9, 2003. None of these additional investment rights were exercised. At the Companys Annual Meeting of Shareholders held on June 2, 2004, an amendment to the
Companys Amended and Restated Articles of Incorporation was approved, increasing the number of
authorized shares of Common Stock to 60,000,000. Penwest Stock Option Plans As of December 31, 2004 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 3,410,000 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. Restricted stock awards currently vest over a one to four year period.
As of December 31, 2004, a total of 50,000 outstanding shares remain restricted (see Note 2,
Stock Based Compensation). 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. The following table presents a summary of the Companys stock option activity and related
information for the years ended December 31: OPTION PRICE
    
    
    WTD. AVERAGESHARES
    
    
    RANGE
    
    
    EXERCISE PRICEBALANCE, DECEMBER 31, 2001
    
    
    2,280,015
    
    
    $
    3.70-18.18
    
    
    $
    8.26Options Exercisable
    
    
    1,381,264
    
    
    $
    3.70-14.38
    
    
    $
    7.282002Granted
    
    
    291,087
    
    
    $
    6.15-19.76
    
    
    $
    15.89Exercised
    
    
    (163,113
    )
    
    $
    4.06-11.81
    
    
    $
    8.51Forfeited
    
    
    (8,875
    )
    
    $
    15.47-19.76
    
    
    $
    18.85BALANCE, DECEMBER 31, 2002
    
    
    2,399,114
    
    
    $
    3.70-19.76
    
    
    $
    9.37Options Exercisable
    
    
    1,566,988
    
    
    $
    3.70-18.18
    
    
    $
    7.662003Granted
    
    
    539,511
    
    
    $
    7.43-21.24
    
    
    $
    11.32Exercised
    
    
    (334,914
    )
    
    $
    4.06-12.75
    
    
    $
    7.30Forfeited
    
    
    (68,000
    )
    
    $
    6.38-19.13
    
    
    $
    12.89Expired
    
    
    (98,911
    )
    
    $
    3.70-15.47
    
    
    $
    7.42BALANCE, DECEMBER 31, 2003
    
    
    2,436,800
    
    
    $
    3.70-21.24
    
    
    $
    10.06Options Exercisable
    
    
    1,464,472
    
    
    $
    3.70-19.76
    
    
    $
    9.16
 F-15




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) OPTION PRICE
    
    
    WTD. AVERAGESHARES
    
    
    RANGE
    
    
    EXERCISE PRICE2004Granted
    
    
    510,495
    
    
    $
    8.30-18.68
    
    
    $
    15.09Exercised
    
    
    (123,225
    )
    
    $
    5.41-15.94
    
    
    $
    10.53Forfeited
    
    
    (146,100
    )
    
    $
    9.90-21.24
    
    
    $
    16.34Expired
    
    
    (31,000
    )
    
    $
    15.47-19.13
    
    
    $
    19.01BALANCE, DECEMBER 31, 2004
    
    
    2,646,970
    
    
    $
    3.70-21.24
    
    
    $
    10.56Options Exercisable
    
    
    1,754,356
    
    
    $
    3.70-21.24
    
    
    $
    9.16
 The weighted average fair value of options granted during the years ended December 31, 2004,
2003 and 2002 was $8.12, $6.34 and $11.51, respectively. The fair value of each option grant was estimated using the Black-Scholes option-pricing model
with the following weighted average assumptions: 2004
    
    
    2003
    
    
    2002Expected dividend yield
    
    None
    
    None
    
    NoneRisk free interest rate
    
    
    3.7
    %
    
    
    3.8
    %
    
    
    4.9
    %Expected volatility
    
    
    46
    %
    
    
    46
    %
    
    
    54
    %Expected life of options
    
    7.5 years
    
    7.5 years
    
    7.5 years
 As of December 31, 2004, the Penwest stock option plans had options outstanding and
exercisable by price range as follows: Wtd. Avg.Range of
    
    Options
    
    
    Remaining Years of
    
    
    Wtd. Avg.
    
    
    Options
    
    
    Wtd. Avg.Exercise Prices
    
    Outstanding
    
    
    Contractual Life
    
    
    Exercise Price
    
    
    Exercisable
    
    
    Exercise Price$3.70 - $7.00
    
    
    946,821
    
    
    
    3.1
    
    
    $
    6.30
    
    
    
    946,821
    
    
    $
    6.30$7.01 - $11.00
    
    
    617,498
    
    
    
    7.1
    
    
    $
    9.68
    
    
    
    301,584
    
    
    $
    9.41$11.01 - $15.00
    
    
    574,611
    
    
    
    6.6
    
    
    $
    12.42
    
    
    
    381,361
    
    
    $
    12.77$15.01 - $19.00
    
    
    375,290
    
    
    
    8.9
    
    
    $
    16.75
    
    
    
    30,340
    
    
    $
    17.82$19.01 - $21.24
    
    
    132,750
    
    
    
    6.4
    
    
    $
    19.55
    
    
    
    94,250
    
    
    $
    19.722,646,970
    
    
    
    5.8
    
    
    $
    10.56
    
    
    
    1,754,356
    
    
    $
    9.16
 The following table presents a summary of the number and weighted average fair value of
restricted shares granted during the years ended December 31: #
    
    
    Wtd. Avg.Shares
    
    
    Fair Value2002
    
    
    
    
    
    
    2003
    
    
    60,000
    
    
    $
    10.052004
    
    
    5,000
    
    
    $
    16.39
 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 14,612 shares, 8,967 shares and 12,282 shares issued under
the Plan during 2004, 2003 and 2002, 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. F-16




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PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 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. 10. COMMITMENTS Leases Under a lease agreement signed with Rettenmaier on February 27, 2003, the Company has the
right to occupy approximately 14,000 square feet of office and research and development space in
the Patterson, New York facility until February 2008, initially on a rent-free basis (plus
operating expenses) for two years and then pursuant to three successive one-year options at monthly
rent payments approximating $14,000, plus operating expenses. In November 2004, Penwest exercised
the first of its one year renewal options, extending the current term to February 26, 2006. On
March 7, 2005, the Company signed an amendment to this lease, effective February 27, 2005,
increasing its leased space to approximately 15,000 square feet, bringing its monthly rent payments
to approximately $15,000 plus operating expenses. In May 2004, the Company signed a lease amendment to its corporate office lease in Danbury,
Connecticut for approximately 21,500 square feet of office space, replacing the office space
included in its lease signed in February 2003. This lease has an initial term expiring December
30, 2006, with renewal options through December 30, 2008, and requires that monthly rents be paid,
including utilities and escalation clauses, in amounts ranging from approximately $39,000 to
$42,000 through the initial lease term. As of December 31, 2004, certain of the Companys property and equipment are leased under
operating leases ranging from one to four years. Rental expense under operating leases was
$739,000, $551,000 and $91,000, for the years ended December 31, 2004, 2003 and 2002, respectively.
Of such amounts, approximately $129,000 and $88,000 in 2004 and 2003, respectively, related to
contingent rents including allocated operating expenses of the Companys leased facility in
Patterson, New York. Future minimum lease payments as of December 31, 2004 for noncancellable operating leases
having initial lease terms of more than one year are as follows: OPERATINGLEASES(in thousands)2005
    
    $
    6382006
    
    
    5092007
    
    
    2008
    
    
    2009
    
    
    Thereafter
    
    
    Total minimum lease payments
    
    $
    1,147
 F-17




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PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 11. INCOME TAXES The provision for income taxes consists of the following: 2004
    
    
    2003
    
    
    2002(in thousands)Federal:Current
    
    $
    
    
    
    $
    
    
    
    $
    Deferred
    
    
    
    
    
    
    
    
    
    
    Foreign:Current
    
    
    5
    
    
    
    6
    
    
    
    8Deferred
    
    
    
    
    
    
    
    
    
    
    State:Current
    
    
    
    
    
    
    
    
    
    
    Deferred
    
    
    
    
    
    
    
    
    
    
    $
    5
    
    
    $
    6
    
    
    $
    8
 The reconciliation between the statutory tax rate and those reflected in the Companys income
tax provision is as follows: 2004
    
    
    2003
    
    
    2002Statutory tax rate
    
    
    (34
    )%
    
    
    (34
    )%
    
    
    (34
    )%Valuation allowance
    
    
    34
    
    
    
    34
    
    
    
    34Foreign taxes
    
    
    
    
    
    
    
    
    
    
    
    %
    
    
    
    %
    
    
    
    %
 The components of deferred income tax (assets) and liabilities at December 31 are as follows: 2004
    
    
    2003(in thousands)Inventory allowance and basis differences
    
    $
    (146
    )
    
    $
    (161
    )Deferred compensation and SERP liability
    
    
    (1,280
    )
    
    
    (1,199
    )Deferred revenue
    
    
    (27
    )
    
    
    (32
    )Tax credit carryforwards
    
    
    (3,264
    )
    
    
    (2,218
    )Net operating loss carryforwards
    
    
    (37,337
    )
    
    
    (24,657
    )Other
    
    
    (109
    )
    
    
    (191
    )Total deferred tax assets
    
    
    (42,163
    )
    
    
    (28,458
    )Depreciation and amortization
    
    
    1,718
    
    
    
    1,683Other
    
    
    259
    
    
    
    269Total deferred tax liabilities
    
    
    1,977
    
    
    
    1,952Net deferred tax asset before valuation allowance
    
    
    (40,186
    )
    
    
    (26,506
    )Valuation allowance
    
    
    40,186
    
    
    
    26,506Net deferred tax liability
    
    $
    
    
    
    $
    
 For continuing operations, the Companys income tax payments, consisting solely of foreign
income taxes, approximated $5,000, $6,000 and $8,000 for the years ended December 31, 2004, 2003
and 2002, respectively. At December 31, 2004, the Company had federal net operating loss (NOL) carryforwards of
approximately $96.7 million for income tax purposes, of which approximately $6.2 million, $8.4
million, $9.1 million, $17.7 million, $19.3 million, $12.6 million and $23.4 million expire in
2018, 2019, 2020, 2021, 2022, 2023 and 2024, respectively. In addition, the Company had research
and development tax credit carryforwards of approximately $3.2 million of which $67,000, $359,000,
$341,000, $777,000, $828,000 and $858,000 expire in 2018, 2019, 2020, 2021, 2022 and 2023,
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, 2004 a valuation allowance of $40.2 million has been recognized to offset net deferred tax
assets, primarily attributable to
the NOL carryforward. Utilization of the operating losses are subject to a limitation due to
the ownership change provisions of the Internal Revenue Code. F-18




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PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) During the fourth quarter of 2003, the Company reversed $346,000 of income tax accruals to
reflect the decreased foreign tax risk that was associated with its former excipient business. In
addition, the Company reduced its tax provision on the gain on the sale of its excipient business
by $51,000 (see Note 13). The effect of these adjustments is included in the gain on sale of
discontinued operations. 12. 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. For continuing operations,
the Companys expense under the Plan was $206,000, $228,000 and $148,000 for 2004, 2003 and 2002,
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 2004, 2003, or 2002. Supplemental Executive Retirement Plan The Company has a Supplemental Executive Retirement Plan (SERP), a nonqualified plan, which
covers the former Chairman and Chief Executive Officer of Penwest. For 2004, 2003 and 2002, the net
expense for the SERP was $135,000, $138,000 and $85,000, respectively, for continuing operations,
and $5,000 and $21,000 in 2003 and 2002, respectively, for discontinued operations. The Company
does not fund this liability and no assets are held by the Plan. The Company uses a measurement
date of December 31 for its SERP. The following disclosures summarize information relating to the
Plan. Change in benefit obligation: 2004
    
    
    2003(in thousands)Benefit obligation at beginning of period
    
    $
    2,048
    
    
    $
    1,839Service cost
    
    
    (32
    )
    
    
    (27
    )Interest cost
    
    
    126
    
    
    
    122Actuarial gains
    
    
    26
    
    
    
    114Benefit obligation at December 31,
    
    $
    2,168
    
    
    $
    2,048
 Funded status: 2004
    
    
    2003(in thousands)Funded status (unfunded)
    
    $
    (2,168
    )
    
    $
    (2,048
    )Unrecognized net transition obligation
    
    
    
    
    
    
    40Unrecognized prior service cost
    
    
    16
    
    
    
    17Unrecognized net actuarial gain
    
    
    (152
    )
    
    
    (177
    )Net amount recognized at December 31, (included in deferred
compensation)
    
    $
    (2,304
    )
    
    $
    (2,168
    )
 F-19




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Amounts recognized in the statement of financial position consist of: 2004
    
    
    2003(in thousands)Accrued benefit cost (minimum liability)
    
    $
    (2,304
    )
    
    $
    (2,168
    )Net amount recognized at December 31,
    
    $
    (2,304
    )
    
    $
    (2,168
    )
 Information for plans with an accumulated benefit obligation in excess of plan assets, December 31: 2004
    
    
    2003(in thousands)Projected benefit obligation
    
    $
    2,168
    
    
    $
    2,048Accumulated benefit obligation
    
    $
    1,887
    
    
    $
    1,515Plan assets of fair value
    
    $
    
    
    
    $
    
 Components of net periodic benefit cost: 2004
    
    
    2003(in thousands)Service cost
    
    $
    (33
    )
    
    $
    (27
    )Interest cost
    
    
    126
    
    
    
    122Amortization of unrecognized transition obligation
    
    
    40
    
    
    
    60Amortization of prior service cost
    
    
    2
    
    
    
    14Amortization of gains
    
    
    
    
    
    
    (26
    )Net periodic benefit cost
    
    $
    135
    
    
    $
    143
 The amortization of prior service cost is determined using straight-line amortization of the
cost over the average remaining service period of the employee expected to receive benefits under
the Plan: Weighted-average assumptions used to determine benefit obligations as of December 31: 2004
    
    
    2003Discount rate
    
    
    6.00
    %
    
    
    6.25
    %Rate of compensation increase
    
    
    3.0
    %
    
    
    4.0
    %
 Weighted-average assumptions used to determine net periodic benefit cost for years ended
December 31: 2004
    
    
    2003Discount rate
    
    
    6.25
    %
    
    
    6.75
    %Rate of compensation increase
    
    
    4.0
    %
    
    
    4.0
    %
 The Company expects to make no contributions to the Plan in 2005.
Effective February 14, 2005, Mr. Hamachek resigned from his positions
as Chairman and Chief Executive Officer (see Note 19). Under the
SERP, Mr. Hamachek, now 59, is eligible for benefit payments to
commence with his retirement effective February 15, 2005. These
benefits, based on 55% of Final Average Compensation, as defined, and
elections made by Mr. Hamachek, will be reduced as a result of his
early retirement.

The following benefit payments are expected to be paid over the next ten years (in
thousands): 2005
    
    $
    1252006
    
    
    1502007
    
    
    1502008
    
    
    1502009
    
    
    150Years 2010-2014
    
    
    747
 F-20




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Deferred Compensation Plan The Company has a Deferred Compensation Plan (DCP), a non-qualified plan which covers the
former Chairman and Chief Executive Officer of Penwest, Mr. Hamachek. No amounts were contributed
to the Plan during 2004, 2003 and 2002. The interest expense for the DCP totaled $76,000, $73,000 and
$71,000 for 2004, 2003 and 2002, respectively. The liability for the DCP was approximately
$1,011,000 and $935,000 as of December 31, 2004 and 2003, respectively, and is included in
deferred compensation on the Companys consolidated balance sheet. The Company does not fund this
liability and no assets are held by the DCP. In connection with the resignation and retirement of
Penwests Chairman and Chief Executive Officer in February 2005 (see Note 19), the following
benefit payments, including interest, are expected to be paid under
the DCP in ten annual installments (in thousands): 2005
    
    $
    1402006
    
    
    1402007
    
    
    1402008
    
    
    1402009
    
    
    140Years 2010-2014
    
    
    700
 The Company has two whole-life insurance policies in a rabbi trust, the cash surrender value
or death benefits of which are held in trust for the SERP and DCP liabilities. The Company is
entitled to borrow against these policies to fund these liabilities as provided by the terms of the
trust. The cash surrender value of these polices totaled $3,062,000 and $2,965,000 as of December
31, 2004 and 2003, respectively, and is presented separately on the Companys consolidated balance
sheet. Health Care and Life Insurance Benefits The Company offers health care and life insurance benefits to its active employees. Costs
incurred for these benefits for continuing operations were $643,000, $568,000 and $422,000 in 2004,
2003 and 2002, respectively. 13. DISCONTINUED OPERATIONS On February 27, 2003, Penwest sold substantially all of the assets (the Assets) used in the
Companys excipient business to subsidiaries and affiliates of Josef Rettenmaier Holding GmbH & Co.
KG (Rettenmaier) for $41.75 million, plus the assumption of specified liabilities. The Assets of
the excipient business were sold to Rettenmaier, either directly or through the sale of the
outstanding capital stock of the three subsidiaries of Penwest that did business in the UK, Germany
and Finland. The purchase price included $39.5 million in cash and a non-interest bearing
promissory note of $2.25 million, with $1.0 million paid to Penwest in April 2003 and $1.25 million
paid to Penwest in May 2004. In 2003, the Company recorded a gain on the Asset Sale of approximately $9.9 million (no tax
effect), and has reported the operating results of the excipient business as a discontinued
operation in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets. The net carrying amount of the assets and liabilities on the date of the Asset Sale was
approximately $29.5 million. The approximate carrying values of the major classes were: property,
plant and equipment of $11.4 million; inventory of $8.3 million; receivables of $6.0 million; and
intangible assets of $4.3 million offset by other net liabilities. The gain on the Asset Sale is
net of transaction related costs totaling $3.1 million, primarily consisting of professional and
advisory fees. Revenues and pretax profits for the excipient business approximated $6.1 million
and $203,000, respectively, for the period January 1, 2003 through the Asset Sale date of February
27, 2003. Revenues and pretax profits for the excipient business approximated $36.4 million and
$2.3 million, respectively, for 2002. Prior to the sale of the excipient business, the Company owned its office, laboratory and
warehouse facility in Patterson, New York, as well as a facility in Cedar Rapids, Iowa, where it
manufactured pharmaceutical excipients. As part of the Asset Sale, the Company transferred these
properties and assigned its lease of a pharmaceutical excipient manufacturing facility in Nastola,
Finland to Rettenmaier. Under a lease agreement signed with Rettenmaier on February 27, 2003, the
Company has the right to occupy approximately 14,000 square feet of office and research and
development space in the Patterson facility until February 2008, initially on a rent-free basis
(plus F-21




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) operating expenses) for two years and then pursuant to three successive one-year options at
monthly rent payments approximating $14,000, plus operating expenses (see Note 10). 14. LICENSING AGREEMENTS The Company enters into collaborative arrangements with pharmaceutical companies to develop,
manufacture or market products formulated with its drug delivery technologies. In September 1997, the Company entered into a strategic alliance agreement with Endo
Pharmaceuticals, Inc. with respect to the development of oxymorphone ER, an extended release
formulation of oxymorphone, based on the Companys TIMERx technology. Oxymorphone ER is a
narcotic analgesic for the treatment of moderate to severe pain in patients requiring continuous
around-the-clock opioid therapy for an extended period of time. This agreement was amended and
restated in April 2002. Endo has a broad product line including established brands such as
Percodan®, Percocet®, and Lidoderm®. 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 oxymorphone product are determined by a committee comprised of an equal number of
members from each of the Company and Endo (the Alliance Committee). During the development of the
product, the Company formulated oxymorphone ER, and Endo conducted all clinical studies and
prepared and filed all regulatory applications. The Company has agreed to supply TIMERx material to
Endo, and Endo has agreed to manufacture and market oxymorphone ER in the United States. The
manufacture and marketing outside of the United States may be conducted by the Company, Endo or a
third party, as determined by the Alliance Committee. Prior to April 17, 2003, the Company shared with Endo the costs involved in the development
and pre-marketing of oxymorphone ER. On April 17, 2003, the Company discontinued its participation
in the funding of the development and pre-marketing of oxymorphone ER. The Company took this
action because the Company believed that its strategic focus should be on funding other products in
its development pipeline. As a result of this termination of funding, Endo has the right to
complete the development of oxymorphone ER and recoup the portion of development and pre-marketing
costs incurred by Endo that otherwise would have been funded by Penwest. Endo may recoup such
development costs through a temporary adjustment in the royalty rate payable to the Company, which
will return to its pre-adjustment level once Endo has recovered such costs. Endo may also allow
Penwest to reimburse them directly for the unfunded amounts. The Company estimates that through
January 31, 2005, these unfunded costs approximated $15.0 million. The Company expects these costs
to increase as Endo completes the ongoing pivotal trial as well as other studies and incurs
pre-launch marketing costs. The Company has agreed with Endo that the party marketing oxymorphone
ER will pay the other party royalties initially equal to 50% of the net realization as defined in
the agreement between Endo and Penwest, subject to adjustment for unfunded development costs. This
percentage will decrease if the aggregate U.S. net realization exceeds pre-determined thresholds.
In general, the royalty payable by the marketing party to the other party will not drop below 40%.
However, the royalty will be reduced by one-third in limited circumstances, including termination
of the agreement based on uncured material breaches of the agreement by the royalty receiving party
and specified bankruptcy and insolvency events involving the royalty receiving party. Under the
agreement, Endo will purchase formulated TIMERx material for use in oxymorphone ER exclusively from
the Company at specified prices, and include these purchases in cost of goods sold of the product
prior to determining net realization, on which the royalty payment is calculated. 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, a
product the Company had developed in collaboration with Mylan, 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 2004 of the 30 mg dosage strength version of Pfizers generic
Procardia XL totaled approximately $40.2 million. The term of this agreement continues until such
time as Mylan permanently ceases to market generic Procardia XL. In 2004, 2003 and 2002, royalties
from Mylan were approximately $4.8 million, $4.1 million and $4.8 million, respectively, or 94%,
88% and 87%, respectively, of the Companys total revenue from continuing operations. F-22




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 15. 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. The Company is a party to certain claims and proceedings in the ordinary course of business.
The Company does not believe any of these matters will result, individually or in the aggregate, in
a material adverse effect upon its financial condition or future results of operations 16. SEGMENT INFORMATION The Company is engaged in the research, development and commercialization of novel oral drug
delivery products and technologies. The Companys product portfolio consists of technically
advanced and patented excipients that may be licensed to customers or collaborators, and conducts
its business primarily in North America and Europe. Prior to the Asset Sale (see Note 13) the
Company had European operations consisting of a manufacturing facility in Nastola, Finland and
sales offices in Reigate, England, and Bodenheim, Germany. 17. RELATED PARTY TRANSACTIONS Under a Recognition and Incentive Agreement (as amended, the Baichwal Agreement) with Anand
Baichwal, the Companys Senior Vice President of Research and New Technology Development and Chief
Scientific Officer, the Company is obligated to pay to Dr. Baichwal on an annual basis in arrears,
royalties for (i) one-half of one percent of the Companys Net Sales (as defined in the Baichwal
Agreement) of TIMERx® Material (as defined in the Baichwal Agreement) to third parties, (ii)
one-half of one percent of royalties received by the Company under licenses, collaborations or
other exploitation agreements with third parties with respect to the sale, license, use or
exploitation by such third parties of products based on or incorporating the TIMERx® Material, and
(iii) one-half of one percent of payments made in lieu of such Net Sales or royalties and received
by the Company. Such payments cease in the event that Dr. Baichwals employment is terminated for
cause. The Baichwal Agreement also contains non-competition and non-solicitation provisions that
expire two years after the termination of Dr. Baichwals employment. These royalties for Dr.
Baichwal totaled approximately $25,000, $23,000 and $27,000 for 2004, 2003 and 2002, respectively. Under a Royalty Agreement with John N. Staniforth (the Staniforth Agreement), a member of
the Companys Board of Directors, the Company is obligated to pay Dr. Staniforth on an annual basis
in arrears one-half of one percent of the Companys Net Sales (as defined in the Staniforth
Agreement) of TIMERx® Material (as defined in the Staniforth Agreement) related to the products
covered by the TIMERx® patents. These royalties for Dr. Staniforth totaled approximately $25,000,
$23,000 and $27,000 for 2004, 2003 and 2002, respectively. Dr. Staniforth also has an annual consulting agreement with the Company for which he is paid
$80,000 per year, payable in quarterly payments. The consulting agreement is automatically renewed
each year and is cancelable by either the Company or Dr. Staniforth upon thirty days prior notice.
Any invention that results from this consulting agreement is legally owned by Penwest. Dr.
Staniforth also serves on the Scientific Advisory Board of the Company and is paid $1,500 for each
meeting attended. F-23




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) 18. ACCUMULATED OTHER COMPREHENSIVE (LOSS) INCOME Accumulated other comprehensive (loss) income consisted of the following at December 31: 2004
    
    
    2003(in thousands)Cumulative translation adjustment
    
    $
    
    
    
    $
    473Cumulative translation adjustment of discontinued operations sold
    
    
    
    
    
    
    (473
    )Unrealized (loss) gain on marketable securities
    
    
    (100
    )
    
    
    43Accumulated other comprehensive (loss) income
    
    $
    (100
    )
    
    $
    43
 19. SUBSEQUENT EVENTS On February 15, 2005, the Company announced that Tod R. Hamachek had resigned from his
positions as Chief Executive Officer and Chairman of the Board of Directors and as a member of the
Board. In connection with the resignation, the Company and Mr. Hamachek entered into a Severance
and Settlement Agreement and Release (the Agreement) on February 14, 2005. Under the Agreement,
the Company agreed that, in consideration of Mr. Hamacheks release and other agreements under the
Agreement, it would pay Mr. Hamachek eighteen months base salary ($594,000) as severance pay, and
pay all premium costs relating to medical insurance continuation coverage and certain other
benefits. The Company also agreed to accelerate in full the vesting of all stock options held by
Mr. Hamachek and to extend the period during which he could exercise his stock options to the
earlier of two years or their original expiration date. In connection with this Agreement, the
Company expects to record a charge to its statement of operations totaling approximately $3.0
million in the first quarter of 2005, which includes a non-cash charge of approximately $2.4
million relating to the stock options noted above. Mr. Hamachek has approximately 820,000 stock
options, of which approximately 146,000 were accelerated. On February 15, 2005, the Company and Robert J. Hennessey, a director of the Company, entered
into an Offer Letter (the Offer Letter) in connection with the Companys appointment of Mr.
Hennessey as Chief Executive Officer and President of the Company. Under the Offer Letter, the
Company agreed to pay Mr. Hennessey an annual base salary of $400,000 and grant to Mr. Hennessey
non-statutory stock options to purchase 100,000 shares of the Companys common stock under the
Companys 1997 Equity Incentive Plan at an exercise price equal to $10.10, the fair market value of
the common stock on February 15, 2005. Mr. Hennesseys stock options vest in 12 equal monthly
installments and will become fully vested on February 15, 2006, subject to acceleration upon the
occurrence of a change in control of the Company. 20. QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data for the years ended December 31, 2004 and 2003 is as follows: Quarter EndedJune 30, 2004Mar. 31, 2004
    
    
    (Unaudited)
    
    
    Sept. 30, 2004
    
    
    Dec. 31, 2004(Unaudited)
    
    
    (a)
    
    
    (Unaudited)
    
    
    (Unaudited)(in thousands, except per share data)Total revenues
    
    $
    1,483
    
    
    $
    1,266
    
    
    $
    1,210
    
    
    $
    1,149Gross profit
    
    
    1,434
    
    
    
    1,237
    
    
    
    1,195
    
    
    
    1,138Net loss
    
    $
    (4,778
    )
    
    $
    (7,509
    )
    
    $
    (5,008
    )
    
    $
    (6,490
    )Net loss per share
    
    $
    (0.26
    )
    
    $
    (0.41
    )
    
    $
    (0.27
    )
    
    $
    (0.34
    )
 F-24




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##### Table of Contents



PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) Quarter EndedDec. 31, 2003Mar. 31, 2003
    
    
    June 30, 2003
    
    
    Sept. 30, 2003
    
    
    (Unaudited)(Unaudited)
    
    
    (Unaudited)
    
    
    (Unaudited)
    
    
    (b)(in thousands, except per share data)Total revenues
    
    $
    1,172
    
    
    $
    1,249
    
    
    $
    1,016
    
    
    $
    1,241Gross profit
    
    
    1,091
    
    
    
    1,186
    
    
    
    1,005
    
    
    
    1,227Loss from continuing operations
    
    
    (4,787
    )
    
    
    (7,522
    )
    
    
    (5,537
    )
    
    
    (8,160
    )Earnings (loss) from discontinued operations
    
    
    9,757
    
    
    
    (83
    )
    
    
    
    
    
    
    397Net income (loss)
    
    $
    4,970
    
    
    $
    (7,605
    )
    
    $
    (5,537
    )
    
    $
    (7,763
    )Loss from continuing operations per share
    
    $
    (0.31
    )
    
    $
    (0.48
    )
    
    $
    (0.32
    )
    
    $
    (0.44
    )Earnings (loss) from discontinued operations per share
    
    
    0.63
    
    
    
    (0.01
    )
    
    
    
    
    
    
    0.02Net income (loss) per share
    
    $
    0.32
    
    
    $
    (0.49
    )
    
    $
    (0.32
    )
    
    $
    (0.42
    )
   (a)
    During the second quarter of 2004,
the Company recorded a write-down of $410,000, net of accumulated amortization, related to the
impairment of certain patents covering its inhalation technology which the Company determined no
longer had value. Such write-down is reflected in research and product development expense.(b)
    During the fourth quarter of 2003, the
Company reversed $346,000 of income tax accruals to reflect the decreased foreign tax risk that
was associated with its former excipient business. In addition, the Company reduced its tax
provision on the gain on sale of its excipient business by $51,000. The effect of these
adjustments is included in the gain on sale of discontinued operations. F-25




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##### Table of Contents



SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS PENWEST PHARMACEUTICALS CO.
DECEMBER 31, 2004
(in thousands) Charged toBalance at
    
    
    Charged to
    
    
    Other
    
    
    
    
    
    
    Balance atBeginning
    
    
    Costs and
    
    
    Accounts-
    
    
    Deductions-
    
    
    End ofof Period
    
    
    Expenses
    
    
    Describe
    
    
    Describe
    
    
    PeriodYear ended December 31, 2004Allowance for Doubtful Accounts
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Inventory Allowances
    
    $
    82
    
    
    $
    75
    
    
    $
    
    
    
    $
    72
    (a)
    
    $
    85Year ended December 31, 2003Allowance for Doubtful Accounts
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Inventory Allowances
    
    $
    16
    
    
    $
    113
    
    
    $
    
    
    
    $
    47
    (a)
    
    $
    82Year ended December 31, 2002Allowance for Doubtful Accounts
    
    $
    50
    
    
    $
    (50
    )
    
    $
    
    
    
    $
    
    
    
    $
    Inventory Allowances
    
    $
    6
    
    
    $
    12
    
    
    $
    
    
    
    $
    2
    (a)
    
    $
    16
    S-1




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##### Table of Contents



Exhibit Index Filed withExhibit
    
    
    
    this Form
    
    Form or
    
    Filing Date
    
    SEC FileNumber
    
    Description
    
    10-K
    
    Schedule
    
    with SEC
    
    Number2.1
    
    Purchase Agreement by and between
Penwest Pharmaceuticals Co. and
Josef Rettenmaier Holding GmBh &
Co. KG, dated November 1, 2002.
    
    
    
    Schedule 14A
    
    1/31/2003
    
    000-234672.2
    
    Amendment to Purchase Agreement
made as of February 26, 2003, by
and among Penwest Pharmaceuticals
Co., Josef Rettenmaier Holding
GmbH & Co. KG, and the other
parties named therein.
    
    
    
    
    8-K
    
    
    2/28/2003
    
    000-234673.1
    
    Amended and Restated Articles of
Incorporation
    
    
    
    
    10-Q
    
    
    8/3/2004
    
    000-234673.2
    
    Amended and Restated Bylaws of
the Company.
    
    
    
    
    S-1
    
    
    10/21/1997
    
    333-383893.3
    
    Designation of Rights and
Preference of Series A Junior
Participating Preferred Stock of
the Company filed on July 17,
1998.
    
    
    
    
    10/A
    
    
    7/17/1998
    
    000-234674.1
    
    Specimen certificate representing
the Common Stock.
    
    
    
    
    S-1/A
    
    
    12/17/1997
    
    333-383894.2
    
    Form of Rights Agreement dated as
of July 27, 1998 between the
Company and the Rights Agent.
    
    
    
    
    10/A
    
    
    7/17/1998
    
    000-2346710.1+
    
    Product Development and Supply
Agreement dated August 17, 1994
by and between the Registrant and
Mylan Pharmaceuticals Inc.
    
    
    
    
    S-1
    
    
    10/21/1997
    
    333-3838910.2+
    
    Sales and Distribution Agreement
dated January 3, 1997 by and
between the Registrant and Mylan
Pharmaceuticals, Inc.
    
    
    
    
    S-1
    
    
    10/21/1997
    
    333-3838910.3
    
    Form of Separation and
Distribution Agreement entered
into between Registrant and
Penford Corporation
    
    
    
    
    10
    
    
    6/22/1998
    
    000-2346710.4+
    
    Product Development, License and
Supply Agreement dated February
28, 1997 by and between the
Registrant and Sanofi Winthrop
S.A., as amended.
    
    
    
    
    S-1
    
    
    10/21/1997
    
    333-3838910.5+
    
    Agreement dated May 26, 1995 by
and between the Registrant and
Leiras OY.
    
    
    
    
    S-1
    
    
    10/21/1997
    
    333-3838910.6+
    
    Agreement dated July 27, 1992 by
and between the Registrant and
Leiras, OY.
    
    
    
    
    S-1
    
    
    10/21/1997
    
    333-3838910.7+
    
    Amended and Restated Strategic
Alliance Agreement, dated as of
April 2, 2002, by and between
Endo Pharmaceuticals Holdings
Inc. and the Company
    
    
    
    
    10-Q
    
    
    8/14/2002
    
    000-2346710.8++
    
    1997 Equity Incentive Plan.
    
    
    
    
    S-1
    
    
    10/21/1997
    
    333-3838910.9++
    
    1997 Employee Stock Purchase Plan.
    
    
    
    
    S-1
    
    
    10/21/1997
    
    333-3838910.10++
    
    1998 Spinoff Option Plan.
    
    
    
    
    10/A
    
    
    7/7/1998
    
    000-2346710.11
    
    Form of Excipient Supply
Agreement entered into between
the Registrant and Penford
Corporation.
    
    
    
    
    S-1/A
    
    
    11/10/1997
    
    333-38389




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##### Table of Contents



Filed withExhibit
    
    
    
    this Form
    
    Form or
    
    Filing Date
    
    SEC FileNumber
    
    Description
    
    10-K
    
    Schedule
    
    with SEC
    
    Number10.12
    
    Form of Tax Allocation Agreement
entered into between the
Registrant and Penford
Corporation
    
    
    
    
    10
    
    
    6/22/1998
    
    000-2346710.13
    
    Recognition and Incentive
Agreement dated as of May 14,
1990 between the Registrant and
Anand Baichwal, as amended.
    
    
    
    
    S-1/A
    
    
    11/10/1997
    
    333-3838910.14+
    
    License Agreement dated December
17, 1997 between Synthelabo and
the Registrant.
    
    
    
    
    10
    
    
    6/22/1998
    
    000-2346710.15+
    
    Supply Agreement dated December
17, 1997 between Synthelabo and
the Registrant.
    
    
    
    
    10
    
    
    6/22/1998
    
    000-2346710.16
    
    Manufacturing Agreement dated
September 27, 1999 between the
Company and Draxis Pharma, Inc.
    
    
    
    
    10-K
    
    
    3/21/2000
    
    000-2346710.17
    
    Royalty Agreement dated September
25, 1992 between the Company and
John N. Staniforth.
    
    
    
    
    10-Q
    
    
    5/15/2002
    
    000-2346710.18
    
    Confidentiality, Consulting and
Noncompetition Agreement dated
September 25, 1992 between the
Company and John N. Staniforth.
    
    
    
    
    10-Q
    
    
    5/15/2002
    
    000-2346710.19
    
    Summary Description of Directors
Compensation
    
    X10.20
    
    Lease Agreement dated as of
February 3, 2003 by and between
Union Carbide Corporation and the
Registrant.
    
    
    
    
    10-Q
    
    
    5/15/2003
    
    000-2346710.21
    
    Lease Amendment and Attornment
Agreement, dated March 15, 2004,
by and between Union Carbide
Corporation and the Registrant.
    
    
    
    
    10-Q
    
    
    8/3/2004
    
    000-2346710.22
    
    Form of Option Agreement for 1997
Incentive Plan
    
    X10.23
    
    Securities Purchase Agreement
dated as of August 1, 2003 by and
among the Registrant and the
purchasers identified therein.
    
    
    
    
    8-K
    
    
    8/5/2003
    
    000-2346710.24
    
    Securities Purchase Agreement
dated as of August 4, 2003 by and
among the Registrant and the
purchasers identified therein.
    
    
    
    
    8-K
    
    
    8/6/2003
    
    000-2346710.25
    
    Share Purchase Agreement dated as
of December 10, 2004 by and among
the Registrant and the purchasers
identified therein.
    
    
    
    
    8-K
    
    
    12/15/2004
    
    000-2346723
    
    Consent of Ernst & Young LLP
    
    X31.1
    
    Certification of Chief Executive
Officer pursuant to Exchange Act
Rules 13a-14 or 15d-14, as
adopted pursuant to Section 302
of Sarbanes-Oxley Act of 2002.
    
    X31.2
    
    Certification of Chief Financial
Officer pursuant to Exchange Act
Rules 13a-14 or 15d-14, as
adopted pursuant to Section 302
of Sarbanes-Oxley Act of 2002.
    
    X




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##### Table of Contents



Filed withExhibit
    
    
    
    this Form
    
    Form or
    
    Filing Date
    
    SEC FileNumber
    
    Description
    
    10-K
    
    Schedule
    
    with SEC
    
    Number32.1
    
    Certification of Chief Executive
Officer pursuant to Exchange Act
Rules 13a-14(b) or 15d-14(b) and
18 U.S.C. Section 1350, as
adopted pursuant to Section 906
of Sarbanes-Oxley Act of 2002
    
    X32.2
    
    Certification of Chief Financial
Officer pursuant to Exchange Act
Rules 13a-14(b) or 15d-14(b) and
18 U.S.C. Section 1350 as adopted
pursuant to Section 906 of
Sarbanes-Oxley Act of 2002
    
    X
   
    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 the Annual Report on Form 10-K.