##### Table of Contents



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, 2003
|OR                                         
|[  ]                                        |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
|For the transition period from  to         

Commission File Number 000-23467

PENWEST PHARMACEUTICALS CO.

(Exact name of registrant as specified in its charter)


|                                         |  |                    
|---------------------------------------- |  | -------------------
|Washington                               |  | 91-1513032         
|(State or other jurisdiction of          |  | (I.R.S. Employer   
|incorporation or organization)           |  | Identification No.)
|                                         |  |                    
|39 Old Ridgebury Road                    |  |                    
|Suite 11                                 |  |                    
|Danbury, Connecticut                     |  | 06810-5120         
|(Address of principal Executive Offices) |  | (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 [  ]

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

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [  ]

The aggregate market value of the Registrants Common Stock held by
non-affiliates as of June 30, 2003 was approximately $381 million based on the
last sale price of the Registrants Common Stock on the Nasdaq National Market.
The number of shares of the Registrants Common Stock outstanding as of
February 29, 2004 was 18,446,648.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our definitive Proxy Statement relating to the 2004 Annual Meeting
of Shareholders to be held on June 2, 2004 is incorporated by reference into
Part III of this Form 10-K.





---

TABLE OF CONTENTS



|                                     |                                                                                                                      |  |  |  |  |  |  | 
|------------------------------------ | -------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I                              
|                                     | ITEM 1: BUSINESS                                                                                                    
|                                     | ITEM 2: PROPERTIES                                                                                                  
|                                     | EXECUTIVE OFFICERS OF THE REGISTRANT                                                                                
|PART II                             
|                                     | ITEM 5: MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
|                                     | ITEM 6: SELECTED FINANCIAL DATA                                                                                     
|                                     | ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                       
|                                     | ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                 
|                                     | ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                 
|                                     | ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                        
|                                     | ITEM 9A. CONTROLS AND PROCEDURES                                                                                    
|PART III                            
|                                     | ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                                         
|                                     | ITEM 11: EXECUTIVE COMPENSATION                                                                                     
|                                     | ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS             
|                                     | ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                             
|                                     | ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                     
|PART IV                             
|                                     | ITEM 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K                                           
|SIGNATURES                          
|INDEX TO EXHIBITS                   
|EX-23 CONSENT OF ERNST AND YOUNG LLP
|EX-31.1 CERTIFICATION OF CEO        
|EX-31.2 CERTIFICATION OF CFO        
|EX-32.1 CERTIFICATION OF CEO        
|EX-32.2 CERTIFICATION OF CFO        



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
INDEX TO FORM 10-K

|           |  |                                                                                                              |  |  |    |      |    | 
|---------- |  | ------------------------------------------------------------------------------------------------------------ |  |  | -- | ---- | -- | 
|           |  |                                                                                                              |  |  |    | Page
|           |  |                                                                                                              |  |  |    |     
|PART I     |  |                                                                                                              |  |  |    |      |    | 
|Item 1.    |  | Business                                                                                                     |  |  | 1  |     
|Item 2.    |  | Properties                                                                                                   |  |  | 10 |     
|           |  | Executive Officers of the Registrant                                                                         |  |  | 11 |     
|PART II    |  |                                                                                                              |  |  |    |      |    | 
|Item 5.    |  | Market for
Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  |  | 11 |     
|Item 6.    |  | Selected Financial Data                                                                                      |  |  | 12 |     
|Item 7.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  |  | 13 |     
|Item 7a.   |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  |  | 28 |     
|Item 8.    |  | Financial Statements and Supplementary Data                                                                  |  |  | 28 |     
|Item 9.    |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         |  |  | 28 |     
|Item 9a.   |  | Controls and Procedures                                                                                      |  |  | 29 |     
|PART III   |  |                                                                                                              |  |  |    |      |    | 
|Item 10.   |  | Directors and Executive Officers of the Registrant                                                           |  |  | 29 |     
|Item 11.   |  | Executive Compensation                                                                                       |  |  | 29 |     
|Item 12.   |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               |  |  | 29 |     
|Item 13.   |  | Certain Relationships and Related Transactions                                                               |  |  | 29 |     
|Item 14.   |  | Principal Accountant Fees and Services                                                                       |  |  | 29 |     
|PART IV    |  |                                                                                                              |  |  |    |      |    | 
|Item 15.   |  | Exhibits, Financial Statement Schedules and Reports on Form 8-K                                              |  |  | 30 |     
|Signatures |  |                                                                                                              |  |  |    |      | 31 | 

i





---



##### Table of Contents






PART I




ITEM 1: BUSINESS

Overview

We
develop pharmaceutical products based on innovative proprietary oral drug delivery
technologies. 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. We have also
developed two additional oral drug delivery systems, Geminex and SyncroDose.
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.

Our proprietary TIMERx drug delivery technology is utilized in four
products that were developed with collaborators and have been approved and are
for sale in various countries. In addition, we have a number of product
candidates in our drug development pipeline. The most advanced of these is
oxymorphone ER, an extended release formulation of oxymorphone, a narcotic
analgesic being developed for the treatment of moderate to severe pain. We are
developing oxymorphone ER with Endo Pharmaceuticals, Inc. In October 2003, the
United States Food and Drug Administration, or FDA, issued to Endo 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 New Drug Application, or NDA, for oxymorphone ER. Endo has stated it
expects to meet with the FDA during the first quarter of 2004 to clarify the
issues raised in the letter, review the necessity for additional trials and
discuss its responses to the approvable letter. We anticipate that Endo will
receive information at that meeting about the final path to regulatory approval
and whether any additional trials will be required by the FDA. We are also
developing PW2101, a branded product for the treatment of hypertension, which
we have formulated using our TIMERx technology. We completed a pivotal
clinical trial of this product candidate in the fourth quarter of 2003, and
anticipate releasing results of this study in the first quarter of 2004. We
expect to file an NDA for this product by the end of 2004.

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.

Our Strategy

Our strategy is to develop pharmaceutical products utilizing our
innovative extended release oral drug delivery technologies.



| |  |  | Leverage our 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 and SyncroDose chronotherapeutic delivery, 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 can provide benefits to patients and result in branded,
proprietary products. We do not limit the products we develop by
therapeutic area.                                                                                                                                                                                      
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Expand our product development pipeline to include drugs in various
stages of development.We intend to aggressively add product candidates
into our development pipeline and control more of the clinical
development process than we have in the past. 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 greater portion of our products on
our own. We believe that by controlling development we will be better
able to control the development timelines of our product candidates and
retain more of their economic value. We expect to continue to seek
collaborators earlier in the process for product candidates for which we
believe that the development process is too expensive or too risky and
for product candidates that require specialized marketing input.

1



---



##### Table of Contents





| |  |  | Increase participation in the funding of drug development to capture
an increased share of the economic value of the product if and when it
is marketed.Developing pharmaceutical products is expensive. If we
develop products on our own or jointly with third parties, we will need
to devote significant resources to the costs of development of the
products. However, we believe that by assuming a larger role in the
funding of a products development, we will be able to receive a greater
share of any returns from the product.                                                  
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Expand the core drug delivery technologies.Our expertise is in oral
drug delivery technologies and drug formulation. We intend to continue
to develop our core technologies as well as to seek to develop,
in-license or acquire new technologies that are synergistic with our
product development capabilities.                                                                                                                                                                                                                                                                              
|
| |  |  | Establish collaborations for development, manufacturing and
marketing.We expect that we will continue to seek to enter into
collaborations to develop some of our products. In addition, because we
do not anticipate establishing manufacturing or sales and marketing
capabilities within the next few years, we also expect that we will seek
to enter into collaborations for the manufacturing and the selling and
marketing of our products. We are a party to a number of collaborative
agreements including agreements with Endo, Mylan Pharmaceuticals Inc.
and Sanofi-Synthelabo S.A.

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 and SyncroDose 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 gastrointestinal tract into the TIMERx gum matrix, which expands to
form a gel and subsequently releases the active drug substance. The TIMERx
system can precisely control the release of the active drug substance in a
tablet by varying the proportion of the gums, together with the 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.

Geminex Dual Release Technology

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 the formulation stage.

SyncroDose Drug Delivery

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 gastrointestinal 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. The SyncroDose technology utilizes the TIMERx gum matrix in the
coating combined with the active and various other excipients in the core.

2



---



##### Table of Contents



Products

Marketed and 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.
|
| |  |  | 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 is used for the treatment of hypertension
and angina. The 30 mg strength of Nifedipine XL is not being marketed in the
United States by our collaborator 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 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:

|               |  |                                             |  |                    |  |                                          
|-------------- |  | ------------------------------------------- |  | ------------------ |  | -----------------------------------------
|PRODUCT        |  | INDICATION                                  |  | DEVELOPMENT STATUS |  | COLLABORATOR                             
|               |  |                                             |  |                    |  |                                          
|OXYMORPHONE ER |  | Moderate to Severe
Pain                     |  | Approvable Letter  |  | Endo Pharmaceuticals                     
|PW3101         |  | Asthma                                      |  | Approvable Letter  |  | IVAX Corporation                         
|PW2101
PW2134  |  | Hypertension
Edema/Congestive
Heart Failure |  | Phase III
Phase I  |  | Internal Development
Internal Development
|PW2134 Combo   |  | Hypertension                                |  | Phase I            |  | Internal Development                     
|PW4102         |  | Central Nervous System                      |  | Phase I            |  | Internal Development                     
|PW4142         |  | Acute Chronic Benign
Pain                   |  | Phase I            |  | Internal Development                     
|PW4155         |  | Acute Benign Pain                           |  | 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. Oxymorphone, which is currently given in the parenteral and suppository
dosage form, is marketed by Endo and had sales in the United States in 2003 of
approximately $536,000. 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 products such
as MS Contin, Purdue Pharmas OxyContin and Johnson & Johnsons Duragesic
patch, which had aggregate sales in the United States in 2003 of approximately
$3.3 billion.

Endo, which is responsible for conducting the clinical trials and seeking
regulatory approval of the product, submitted the NDA to the FDA in December
2002. In October 2003, the FDA issued to Endo 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.
Endo has stated it expects to meet with the FDA during the first quarter of
2004 to clarify the issues raised in the letter, review the necessity for
additional trials and discuss its responses to the approvable letter. We
anticipate that Endo will receive information at that meeting about the final
path to regulatory approval and whether any additional trials will be required
by the FDA.

3



---



##### Table of Contents



PW3101

PW3101 is an oral asthma product that we are developing in collaboration
with IVAX Corporation based on our TIMERx technology. PW3101 is a
reformulation of a branded product that is marketed for oral asthma. The
branded product had U.S. sales of approximately $20 million in 2003. IVAX
filed an NDA for PW3101 in late 2002. IVAX received an approvable letter from
the FDA for PW3101 in the second half of 2003 and resubmitted the NDA to the
FDA in the first quarter of 2004.

PW2101

PW2101 is a formulation of a competitive product candidate to a branded
product that is marketed for hypertension. This product is being developed
utilizing our TIMERx technology. The branded product had U.S. sales of
approximately $1 billion in 2003. We intend to file a 505(b)2 NDA with the FDA
for PW2101 by the end of 2004. We are also developing a lower strength of
PW2101. In order to obtain marketing approval of this lower strength dosage
form, we will need to conduct additional clinical trials. We believe that we
can complete these additional trials and submit an NDA for the lower strength
dosage form in early 2005. We are currently seeking a marketing partner for
PW2101 and expect to out-license the marketing rights by mid-2004.

Phase I Products

We are currently conducting pilot scale biostudies of several product
candidates. In these studies, we are seeking to obtain proof of principal data
in humans. If the pilot scale biostudies of any of these product candidates
shows proof of principal 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 Arrangements

We enter into collaborative agreements with pharmaceutical companies to
develop, market or manufacture products developed with our drug delivery
technologies.

We currently have two primary 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.
We have no obligation to fund the ongoing clinical development or marketing
costs of the product. Under these collaborative agreements, we receive up-front
license fees and milestone payments. In addition, under all our current
collaborative arrangements, we 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 arrangements are described below.

In the future, we expect that our collaborative agreements are likely to
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 receive up-front
license fees, milestone payments and royalties.

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.

4



---



##### Table of Contents



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 each of Endo and us,
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.

Prior to March 17, 2003, we shared with Endo the costs involved in the
development of oxymorphone ER. On March 17, 2003, we notified Endo that we were
discontinuing our participation in the funding of the development and marketing
of oxymorphone ER effective April 17, 2003. 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 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 December 31, 2003,
these unfunded development costs approximated $6.7 million. We expect these
costs to increase as Endo continues to invest in oxymorphone ER. 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.

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
the 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 2003 of the 30 mg dosage strength version of Pfizers
generic Procardia XL totaled approximately $36.8 million. The term of this
agreement continues until such time as Mylan permanently ceases to market
generic Procardia XL. In 2003, 2002 and 2001, royalties from Mylan accounted
for approximately 88%, 87% and 82%, respectively, of our total revenue.

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 1997.                                               
|
| |  |  | E. Merck.Our agreement with E. Merck relates to an extended release
version of nifedipine for the treatment of angina that was licensed to
Merck S.A. Industries Quimicas for marketing in Brazil.                                                                                                        

5



---



##### Table of Contents





| |  |  | IVAX Corporation.Our agreement with IVAX relates to the development
of PW3101 for the treatment of asthma.                                              
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | Ranbaxy Laboratories Ltd.Our agreement with Ranbaxy relates to the
development of an extended release version of nifedipine for the
treatment of angina.

Research and Development

We conduct research and development activities on the development of
product candidates utilizing our drug delivery technologies and on the
development of additional drug delivery technologies. Our research and
development expenses in 2003, 2002, and 2001 were $20.6 million, $17.0 million
and $16.2 million. 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
development, clinical trials performed by our collaborators, expenses incurred
on oxymorphone ER subsequent to April 17, 2003, or our collaborators share of
funding.

Manufacturing

We currently have no internal 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 2004. The agreement will automatically renew 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. During
the year, we also completed initial validation work on a second contract
manufacturer. However, there is some 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. There can be no assurance that Draxis or any other third
parties upon which we rely for supply of our TIMERx material 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, or
otherwise impair our competitive position, which could have a material adverse
effect on our business, financial condition and results of operations.

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. Although we have qualified alternate suppliers with respect
to these gums and to date we have not experienced difficulty acquiring these
materials, there can be no assurance that interruptions in supplies will not
occur in the future or that we will not have to obtain substitute suppliers.
Any of these events could have a material adverse effect on our ability to
manufacture bulk TIMERx for delivery to our collaborators, which could have a
material adverse effect on our business, financial condition and results of
operations.

In those cases where we are developing products on our own and have not
entered into any collaboration agreements with respect to such products, we
rely on third party contract manufacturers. For instance, Patheon, Inc.
manufactured PW2101 for use in our clinical trials and also manufactured the
commercial batches for stability studies. We believe there are many companies
which are capable of manufacturing these products.

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.

Patents and Proprietary Rights

We believe that patent and trade secret protection of our drug delivery
technology is 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.

6



---



##### Table of Contents



Patents and Protection of Proprietary Information

As of February 29, 2004, we owned 31 U.S. and 177 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. All these
patents will expire between 2008 and 2020. Based on a patent review conducted
in 2003, 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                                                
|
| |  |  | 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. Some of the controlled release products that we
are developing with our collaborators are generic versions of brand name
controlled release products that are covered by one or more patents. Under the
Waxman-Hatch Act, when an applicant files an ANDA with the FDA for a generic
version of a brand name product covered by an unexpired patent listed with the
FDA, the applicant must certify to the FDA that such patent will not be
infringed by the applicants product or that such patent is invalid or
unenforceable. Notice of such certification must be given to the patent owner
and the sponsor of the NDA for the brand name product. If a patent infringement
lawsuit is filed within 45 days of the receipt of such notice, the FDA will
conduct a substantive review of the ANDA, but will not grant final marketing
approval of the generic product until a final judgment on the patent suit is
rendered in favor of the applicant or until 30 months (or such longer or
shorter period as a court may determine) have elapsed from the date of the
certification, whichever is 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. Our collaborators are responsible for all legal costs
under Waxman-Hatch lawsuits. We evaluate the probability of patent infringement
litigation with respect to our collaborators ANDA submissions on a case by
case basis. The delay in obtaining FDA approval to market our products as a
result of litigation, whether or not we are successful, could have a material
adverse effect on our business, financial condition and results of operations.

Trademarks

TIMERx and Geminex are our registered trademarks. SyncroDose is also our
trademark. Other tradenames and trademarks appearing in this annual report on
Form 10-K are the property of their respective owners.

7



---



##### Table of Contents



Government Regulation

FDA Regulation of Pharmaceutical Products

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

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

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

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

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

Although the FDA has approved the ANDA filed by our collaborator Mylan for
the 30 mg dosage strength of a generic version of Procardia XL and Endo has
received an approvable letter for oxymorphone ER and Ivax for PW3101, there can
be no assurance that applications filed by our collaborators with respect to
other products will receive FDA approval on a timely basis.

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

8



---



##### Table of Contents



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

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

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

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

Other Regulations.We are governed by federal, state and local laws of
general applicability, such as laws regulating working conditions and
environmental protection. Oxymorphone ER and other drugs that we are developing
are subject to regulations under the Controlled Substances Act and related
statutes.

Competition

The pharmaceutical industry is highly competitive and is affected by new
technologies, governmental regulations, health care legislation, availability
of financing, litigation and other factors. Many of 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 competitive 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.                   

9



---



##### Table of Contents



Most of our products under development are extended release versions of
existing immediate release drugs. Our products will face competition from
existing products with the same indication, as well as other products that may
be developed in the future. For example, if oxymorphone ER receives marketing
approval, it will compete against MS Contin, Purdue Pharmas OxyContin and
Johnson & Johnsons Duragesic patch, as well as any generic competitors to
those products. If PW2101 receives marketing approval, it will compete against
the extended release product being marketed by the original developer of the
branded product and any approved generic competitors. In addition, PW2101
would also compete against other drugs that have been developed for the
treatment of hypertension.

Employees

As of February 29, 2004, we employed approximately 71 people, of whom 46
were primarily involved in research and development activities, and 25 were
primarily involved in selling, general and administrative activities. As of
February 29, 2004, 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 web site, 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. 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 11,000 square feet, are
located in Danbury, Connecticut. We lease these offices under a lease that
expires on January 31, 2006, with renewal options through December 30, 2006. We
are currently negotiating for additional office space in this same building.
If acquired, we expect that the additional space will have the same cost per
square foot as the existing lease, and that the lease term may extend to
December 2006, plus renewal options.

We also have research facilities, comprising approximately 14,000 square
feet, in Patterson, New York, which we owned prior to the sale of our excipient
business. Under our agreement with Rettenmaier, we have the right to occupy
this laboratory and office space until February 2005 on a rent-free basis and
then pursuant to three successive one-year options at a rental rate of $12 per
square foot.

The space we currently lease is adequate for our current needs, but we are
beginning to plan for the additional laboratory space that we will need when
our Patterson lease expires.

10



---



##### Table of Contents






EXECUTIVE OFFICERS OF THE REGISTRANT

The following table sets forth the names, ages and positions of our
executive officers.

|                         |  |     |    |       |  |                                                                                                                                   |  |               
|------------------------ |  | --- | -- | ----- |  | --------------------------------------------------------------------------------------------------------------------------------- |  | --------------
|NAME                     |  | AGE |    | TITLE |  | DATES                                                                                                                            
|                         |  |     |    |       |  |                                                                                                                                  
|Tod R. Hamachek          |  |     | 58 |       |  | Chairman of the Board and Chief Executive Officer                                                                                 |  | 1997 - current
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|                         |  |     |    |       |  | President and Chief Executive Officer of Penford Corp., our
former parent company                                                 |  | 1985 - 1997   
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|Anand R. Baichwal,
Ph.D. |  |     | 49 |       |  | Senior Vice President, Research & New Technology Development
and Chief Scientific Officer                                         |  | 1997 - current
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|                         |  |     |    |       |  | Vice President, Technology of Penwest Pharmaceuticals Co., a
division of Penford Corp.                                            |  | 1994 - 1997   
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|Jennifer L. Good         |  |     | 39 |       |  | Senior Vice President, Finance and Chief Financial Officer                                                                        |  | 1997  current
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|                         |  |     |    |       |  | Corporate Controller of Penford Corp., our former parent company                                                                  |  | 1993 - 1997   
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|Thomas Sciascia          |  |     | 50 |       |  | Vice President, Clinical Operations and Chief Medical Officer                                                                     |  | 2001 - current
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|                         |  |     |    |       |  | Medical Director of Quintiles, Inc., a provider of contract
product development and commercialization services                    |  | 1997 - 2000   
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|Ferdinand Banti          |  |     | 46 |       |  | Vice President, Corporate Development                                                                                             |  | 2003 - current
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|                         |  |     |    |       |  | Vice President, Business Development of Novartis Oncology, a
pharmaceuticals and consumer health company                          |  | 2001 - 2002   
|                         |  |     |    |       |  |                                                                                                                                   |  |               
|                         |  |     |    |       |  | Senior Director, Infectious Disease Licensing of Pharmacia
Corp., a developer, manufacturer and seller of pharmaceutical
products |  | 1999 - 2001   




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 2003 and 2002 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 |       | LOW
|                           |  |      |       |    
|PERIOD 2003                |  |      |       |     |  |   |       | 
|Quarter Ended March 31     |  | $    | 17.05 |     |  | $ | 8.60  | 
|Quarter Ended June 30      |  | $    | 24.66 |     |  | $ | 15.35 | 
|Quarter Ended September 30 |  | $    | 25.02 |     |  | $ | 19.19 | 
|Quarter Ended December 31  |  | $    | 24.03 |     |  | $ | 13.69 | 
|PERIOD 2002                |  |      |       |     |  |   |       | 
|Quarter Ended March 31     |  | $    | 19.75 |     |  | $ | 17.20 | 
|Quarter Ended June 30      |  | $    | 20.99 |     |  | $ | 17.00 | 
|Quarter Ended September 30 |  | $    | 17.25 |     |  | $ | 7.89  | 
|Quarter Ended December 31  |  | $    | 10.98 |     |  | $ | 7.01  | 

On February 29, 2004 there were 787 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.

11



---



##### 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,                  
|                                                                                             |                         |   |                                          
|                                                                                             |                         |   | 2003                                      |       | 2002 |   | 2001    |       | 2000 |   | 1999   
|                                                                                             |                         |   |                                           |       |      |   |         |       |      |   |        
|                                                                                             |                         |   | (IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
|STATEMENT OF OPERATIONS DATA:                                                                |                         |   |                                           |       |      |   |         |       |      |   |         |       |   |   |         |       |   |   |         |      
|Revenues (a)                                                                                 |                         | $ | 4,678                                     |       |      | $ | 5,537   |       |      | $ | 5,796   |       |   | $ | 8,780   |       |   | $ | 1,914   |      
|Cost of revenues (a)                                                                         |                         |   | 169                                       |       |      |   | 170     |       |      |   | 243     |       |   |   | 2,678   |       |   |   | 371     |      
|Gross profit                                                                                 |                         |   | 4,509                                     |       |      |   | 5,367   |       |      |   | 5,553   |       |   |   | 6,102   |       |   |   | 1,543   |      
|Selling, general and administrative                                                          |                         |   | 10,361                                    |       |      |   | 7,568   |       |      |   | 6,358   |       |   |   | 5,500   |       |   |   | 6,025   |      
|Research and product development                                                             |                         |   | 20,590                                    |       |      |   | 16,955  |       |      |   | 16,190  |       |   |   | 12,103  |       |   |   | 6,474   |      
|Loss from continuing operations before cumulative
effect of change in accounting
principle   |                         |   | (26,006                                   | )     |      |   | (19,028 | )     |      |   | (16,814 | )     |   |   | (11,459 | )     |   |   | (11,327 | )    
|Earnings from discontinued operations, net of income
tax expense                             |                         |   | 177                                       |       |      |   | 1,929   |       |      |   | 833     |       |   |   | 2,983   |       |   |   | 3,646   |      
|Gain on sale of discontinued operations                                                      |                         |   | 9,894                                     |       |      |   |        |       |      |   |        |       |   |   |        |       |   |   |        |      
|                                                                                             |                         |   |                                           |       |      |   |         |       |      |   |         |       |   |   |         |       |   |   |         |      
|Total discontinued operations                                                                |                         |   | 10,071                                    |       |      |   | 1,929   |       |      |   | 833     |       |   |   | 2,983   |       |   |   | 3,646   |      
|Loss before cumulative effect of change in accounting
principle                              |                         |   | (15,935                                   | )     |      |   | (17,099 | )     |      |   | (15,981 | )     |   |   | (8,476  | )     |   |   | (7,681  | )    
|Cumulative effect of change in accounting principle (b)                                      |                         |   |                                          |       |      |   |        |       |      |   |        |       |   |   | (310    | )     |   |   |        |      
|Net loss                                                                                     |                         | $ | (15,935                                   | )     |      | $ | (17,099 | )     |      | $ | (15,981 | )     |   | $ | (8,786  | )     |   | $ | (7,681  | )    
|                                                                                             |                         |   |                                           |       |      |   |         |       |      |   |         |       |   |   |         |       |   |   |         |      
|Basic and diluted loss per share before cumulative
effect of change in accounting principle: |                         |   |                                           |       |      |   |         |       |      |   |         |       |   |   |         |       |   |   |         |      
|                                                                                             | Continuing operations   |   | $                                         | (1.56 | )    |   | $       | (1.23 | )    |   | $       | (1.21 | ) |   | $       | (0.93 | ) |   | $       | (1.02 | )
|                                                                                             | Discontinued operations |   |                                           | 0.60  |      |   |         | 0.12  |      |   |         | 0.06  |   |   |         | 0.24  |   |   |         | 0.33  |  
|Cumulative effect of change in accounting principle
per share                                |                         |   |                                          |       |      |   |        |       |      |   |        |       |   |   | (0.02   | )     |   |   |        |      
|                                                                                             |                         |   |                                           |       |      |   |         |       |      |   |         |       |   |   |         |       |   |   |         |      
|Net loss per share                                                                           |                         | $ | (0.96                                     | )     |      | $ | (1.11   | )     |      | $ | (1.15   | )     |   | $ | (0.71   | )     |   | $ | (0.69   | )    
|                                                                                             |                         |   |                                           |       |      |   |         |       |      |   |         |       |   |   |         |       |   |   |         |      
|Weighted average shares of common stock outstanding                                          |                         |   | 16,678                                    |       |      |   | 15,462  |       |      |   | 13,905  |       |   |   | 12,330  |       |   |   | 11,103  |      
|                                                                                             |                         |   |                                           |       |      |   |         |       |      |   |         |       |   |   |         |       |   |   |         |      

|                          |  |                |         |      |  |      |         |      |  |      |         |   |  |   |         |   |  |   |         |  
|------------------------- |  | -------------- | ------- | ---- |  | ---- | ------- | ---- |  | ---- | ------- | - |  | - | ------- | - |  | - | ------- | -
|                          |  | DECEMBER 31,  
|                          |  |               
|                          |  | 2003           |         | 2002 |  | 2001 |         | 2000 |  | 1999
|                          |  |                |         |      |  |      |         |      |  |     
|                          |  | (IN THOUSANDS)
|BALANCE SHEET DATA:       |  |                |         |      |  |      |         |      |  |      |         |   |  |   |         |   |  |   |         |  
|Cash and cash equivalents |  | $              | 25,307  |      |  | $    | 1,629   |      |  | $    | 11,529  |   |  | $ | 1,291   |   |  | $ | 204     |  
|Marketable securities     |  |                | 38,586  |      |  |      | 2,057   |      |  |      | 9,609   |   |  |   |        |   |  |   |        |  
|Working capital           |  |                | 60,697  |      |  |      | 26,355  |      |  |      | 27,059  |   |  |   | 11,129  |   |  |   | 7,713   |  
|Total assets              |  |                | 78,503  |      |  |      | 50,220  |      |  |      | 59,613  |   |  |   | 42,294  |   |  |   | 38,120  |  
|Long-term debt            |  |                |        |      |  |      |        |      |  |      |        |   |  |   |        |   |  |   | 6,700   |  
|Accumulated deficit       |  |                | (94,433 | )    |  |      | (78,025 | )    |  |      | (60,926 | ) |  |   | (44,945 | ) |  |   | (36,159 | )
|Shareholders equity      |  | $              | 67,696  |      |  | $    | 31,423  |      |  | $    | 45,624  |   |  | $ | 31,017  |   |  | $ | 22,509  |  



|(a) |  | Reclassification recorded of amounts in 1999 for the adoption of EITF No.
00-10 Accounting for Shipping and Handling Fees and Costs.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------
|   
|(b) |  | Cumulative effect of adopting Staff Accounting Bulletin No. 101 (SAB No.
101) in 2000.                                              

12



---



##### Table of Contents






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

Overview

We develop pharmaceutical products based on innovative oral drug delivery
technologies. 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. We have also
developed two additional oral drug delivery systems, Geminex and SyncroDose.
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.

Our proprietary controlled release drug delivery technology is utilized in
four products that were developed with collaborators and have been approved in
various countries. In addition, we have a number of product candidates in our
drug development pipeline. The most advanced of these is oxymorphone ER, an
extended release formulation of oxymorphone, a narcotic analgesic being
developed for the treatment of moderate to severe pain. We are developing
oxymorphone ER with Endo Pharmaceuticals, Inc. In October 2003, Endo received
an approvable letter from the FDA 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. Endo has stated it expects to meet with the FDA
during the first quarter of 2004 to clarify the issues raised in the letter,
review the necessity for additional trials and discuss its responses to the
approvable letter. We anticipate that Endo will receive information at that
meeting about the final path to regulatory approval and whether any additional
trials will be required by the FDA. We are also developing PW2101, a branded
product for the treatment of hypertension that we have formulated using our
TIMERx technology. In the fourth quarter of 2003, we completed a pivotal
clinical trial of this product candidate and anticipate releasing results of
this study in the first quarter of 2004. We expect to file an NDA for this
product by the end of 2004.

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 with the balance due 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 all periods presented.

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 expired on December 9, 2003 without being
exercised.

We have incurred net losses since 1994. As of December 31, 2003, our
accumulated deficit was approximately $94.4 million. We expect operating losses
and negative cash flows to continue until substantial sales of products
commercialized utilizing TIMERx technology occur. A substantial portion of our
revenues through February 27, 2003 were generated from sales of our
pharmaceutical excipient product line. During 2001, 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. Our revenues for 2003 were 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;
|- |  | ---------------------------------------------------------------------------------------------------------------
| 
| |  | 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.                                            

13



---



##### Table of Contents



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 is 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 accounting principles generally accepted in
the United States. 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

Revenues received from non-refundable upfront licensing fees are
recognized ratably over the development period of the collaboration agreement,
when this period involves development risk associated with the incomplete stage
of a products development or over the estimated or contractual licensing and
supply term when 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 review or audit.

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

14



---



##### Table of Contents



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 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, 2003, we had recorded full valuation allowances totaling
approximately $26.5 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, 2003, 2002 and 2001

Revenues

|                               |  |                                    |       |           |  |            |     |           |  |      |       |            |  |  |     |    |  |   |       | 
|------------------------------ |  | ---------------------------------- | ----- | --------- |  | ---------- | --- | --------- |  | ---- | ----- | ---------- |  |  | --- | -- |  | - | ----- | 
|                               |  |                                    |       |           |  | Percentage |     |           |  |      |       | Percentage |  |  |     |   
|                               |  |                                    |       |           |  | (Decrease) |     |           |  |      |       | (Decrease) |  |  |     |   
|                               |  | 2003                               |       | from 2002 |  | 2002       |     | from 2001 |  | 2001
|                               |  |                                    |       |           |  |            |     |           |  |     
|                               |  | (in thousands, except percentages)
|Product Sales                  |  | $                                  | 455   |           |  |            | (26 | )%        |  | $    | 619   |            |  |  | (24 | )% |  | $ | 814   | 
|Royalty and
Licensing Revenues |  |                                    | 4,223 |           |  |            | (14 | )%        |  |      | 4,918 |            |  |  | (1  | )% |  |   | 4,982 | 
|                               |  |                                    |       |           |  |            |     |           |  |      |       |            |  |  |     |    |  |   |       | 
|Total Revenues                 |  | $                                  | 4,678 |           |  |            | (16 | )%        |  | $    | 5,537 |            |  |  | (4  | )% |  | $ | 5,796 | 

The decreases in total revenues in 2003 and 2002 from the prior year were
the result of decreases during each period for both components of our total
revenues, product sales revenues, and royalty and licensing revenues. Our
product sales consist of sales of formulated bulk TIMERx. Our royalty and
licensing revenues primarily consist of royalties from Mylan.

The decrease in product sales in 2003 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. The decrease in product sales in 2002 was
primarily due to decreased orders for formulated bulk TIMERx from a European
customer, believed to be due to their lower sales as a result of additional
generic entrants to the marketplace.

In 2003, 2002 and 2001, royalties and licensing revenues consisted
primarily of the royalties from Mylan on their sales of Pfizers 30 mg generic
Procardia XL. Royalties and licensing revenues decreased in 2003 and 2002
primarily due to pricing pressure from additional generic competition.

15



---



##### Table of Contents



Selling, General and Administrative Expense

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.

Selling, general and administrative expenses increased by 19% in 2002 to
$7.6 million as compared with $6.4 million in 2001. The increase was primarily
due to an increase in our share of marketing expenses on oxymorphone ER,
increased compensation expense primarily due to hiring additional personnel and
increased business insurance costs.

Research and Product Development Expense

|                                               |  |                                    |        |      |  |                 |     |      |  |      |        |                 |  |  |     |    |  |   |        | 
|---------------------------------------------- |  | ---------------------------------- | ------ | ---- |  | --------------- | --- | ---- |  | ---- | ------ | --------------- |  |  | --- | -- |  | - | ------ | 
|                                               |  |                                    |        |      |  | Percentage      |     |      |  |      |        | Percentage      |  |  |     |   
|                                               |  |                                    |        |      |  | Increase        |     |      |  |      |        | Increase        |  |  |     |   
|                                               |  |                                    |        |      |  | (Decrease) from |     |      |  |      |        | (Decrease) from |  |  |     |   
|                                               |  | 2003                               |        | 2002 |  | 2002            |     | 2001 |  | 2001
|                                               |  |                                    |        |      |  |                 |     |      |  |     
|                                               |  | (in thousands, except percentages)
|Oxymorphone ER                                 |  | $                                  | 1,947  |      |  |                 | (78 | )%   |  | $    | 8,914  |                 |  |  | 3   | %  |  | $ | 8,657  | 
|PW2101                                         |  |                                    | 9,443  |      |  |                 | 420 | %    |  |      | 1,815  |                 |  |  | 32  | %  |  |   | 1,372  | 
|Research and New Technology Development        |  |                                    | 2,344  |      |  |                 | 6   | %    |  |      | 2,213  |                 |  |  | 61  | %  |  |   | 1,378  | 
|Phase I Products and Internal Costs            |  |                                    | 6,856  |      |  |                 | 71  | %    |  |      | 4,013  |                 |  |  | (16 | )% |  |   | 4,783  | 
|                                               |  |                                    |        |      |  |                 |     |      |  |      |        |                 |  |  |     |    |  |   |        | 
|Total Research and Product Development
Expense |  | $                                  | 20,590 |      |  |                 | 21  | %    |  | $    | 16,955 |                 |  |  | 5   | %  |  | $ | 16,190 | 
|                                               |  |                                    |        |      |  |                 |     |      |  |      |        |                 |  |  |     |    |  |   |        | 

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 and the
manufacturing of products prior to regulatory approval for clinical use
and for commercial use;                                                                                                                                                                                                              
|
| |  |  | Research and New Technology Development These expenses reflect both
our direct external expenses and our 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, and other costs such as
depreciation on purchased equipment and amortization 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 reflect 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 and
laboratory facility costs.

Total research and product development expenses increased in 2003
primarily due to increased costs relating to the development of PW2101, as well
as increased costs relating to the development of phase I product candidates
and new drug delivery technologies, partially offset by decreased costs
relating to the development of oxymorphone ER. Total research and product
development expenses increased in 2002 due to increased costs relating to the
development of oxymorphone ER, PW2101 and new drug delivery technologies,
partially offset by decreased costs related to the development of phase I
product candidates.

Oxymorphone ER, which we are developing with Endo, is the most advanced of
our product candidates. Endo, which is responsible for conducting the clinical
trials and seeking regulatory approval of the product, completed the clinical
trials for this product in 2002, and the FDA accepted for filing the NDA for
oxymorphone ER in February 2003. In October 2003, the FDA issued to Endo 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

16



---



##### Table of Contents



Endos NDA for oxymorphone
ER. Endo has stated it expects to meet with the FDA during the first quarter
of 2004 to clarify the issues raised in the letter and discuss its responses.
We anticipate that Endo will receive information at that meeting about the
final path to regulatory approval and whether any additional trials will be
required by the FDA. Research and development expenses related to oxymorphone
ER decreased in 2003, due to the discontinuation of our funding of the
development of oxymorphone ER effective April 17, 2003. Research and
development expenses related to oxymorphone ER increased in 2002 as a result of
increased costs of clinical trials for oxymorphone ER. We have not incurred
any research and development expenses related to oxymorphone ER since April 17,
2003, and 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.

Approximately 46% of the research and development spending in 2003 related
to the direct costs associated with clinical development and manufacturing
scale-up of PW2101. We have recently completed a pivotal trial of PW2101 for
the treatment of hypertension and expect to release those results in the first
quarter of 2004. In this trial we dosed 163 patients. The remainder of the
development program includes additional work on a manufacturing site change,
stability, and the compilation of the NDA. Assuming that the trials and the
rest of the development work are successful, we expect that we would submit an
NDA for this product in late 2004. Research and development expenses related
to PW2101 increased in 2003 as a result of clinical trials and the scale-up and
manufacturing of commercial batches, and increased in 2002 as a result of
proof-of-principle biostudies and the manufacturing of clinical supplies.
Although we have developed PW2101 on our own, we do not intend to market
PW2101. As a result, we are currently seeking a marketing partner for this
product.

There can be no assurance that 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.

Research and new technology development expenses increased in 2003 due
primarily to our focus during the period on the expansion of the applications
of our TIMERx technology and the intellectual property underlying our TIMERx
technology. The increase in research and new technology development in 2002
was primarily due to our completion of the development of our SyncroDose
technology.

Phase I products and internal costs increased in 2003 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 an
increase in the number of employees engaged in our research and development
efforts and the costs associated with such employees.

Tax Rates

For continuing operations, the effective tax rates for 2003, 2002 and 2001
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

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.

We are a party to an agreement with Endo with respect to the development
of oxymorphone ER. On April 17, 2003, we discontinued our participation in the
funding of the development and marketing of oxymorphone ER. Accordingly, our
research and development, and selling, general and administrative expenses with
respect to oxymorphone ER decreased significantly in the second,
third and fourth quarters of 2003 compared to the corresponding periods in
2002. We do not expect any expenses relating to oxymorphone ER in 2004 unless
we resume our participation in the funding of the development and marketing of
oxymorphone ER. We estimate that through December 31, 2003, the
unfunded development costs under our agreement with Endo
approximated $6.7 million.

17



---



##### Table of Contents



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.

Cash Flows

As of December 31, 2003, we had cash, cash equivalents, and short-term
investments of $63.9 million. We have no committed sources of capital other
than Rettenmaiers commitment to repay us $1.25 million in May 2004, pursuant
to a promissory note in connection with the sale of the excipient business.

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, 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. We had negative cash flow from operations for
2002 of $14.8 million, primarily due to the loss from continuing operations of
$19.0 million in the period, partially offset by net cash provided by
discontinued operations operating activities of $2.2 million, and net increases
in payables and accrued expenses of $1.6 million. Our cash flow in 2003 has
differed from our cash flow during 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 $2.7 million for 2003,
primarily reflecting our receipt of cash proceeds from the sale of our
excipient business of $36.9 million, net of transaction costs paid of $1.4
million, and our net investment in marketable securities of $36.7 million. In
addition, investing activities also reflected $1.8 million in capital
expenditures for the acquisitions of fixed assets primarily related to the
second phase of an implementation project relating to our information system
and laboratory equipment for drug development activities. Funds expended for
intangible assets totaled $1.0 million and include costs to secure patents on
technology developed by us.

Financing activities provided $48.5 million in cash, primarily due to the
cash received from the private placement of our common stock in August 2003, as
well as $2.2 million in cash provided by discontinued operations, which was
offset by the net repayment of approximately $5.7 million in loans, primarily
in connection with the sale of our excipient business.

Funding Requirements

We anticipate that, excluding any 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 financings through at least 2005. We
expect to continue to invest in capital expenditures in 2004 at levels similar
to 2003 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 is approved on a timely basis, or at all;                                      
|- |  | ------------------------------------------------------------------------------------------------------
| 
| |  | whether we resume our participation in the funding of the development and marketing of oxymorphone ER;

18



---



##### Table of Contents





| |  | the timing and amount of payments received under existing and possible future collaborative agreements, in particular
oxymorphone ER;                                                      
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | the structure 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;
| 
| |  | the costs and timing of adding drug development capabilities;                                                                                                                              
| 
| |  | royalties received from Mylan; and                                                                                                                                                         
| 
| |  | the prosecution, defense and enforcement of potential patent claims and other intellectual property rights.                                                                                

If our existing resources are insufficient to satisfy our need for capital
due to a delay in the approval for oxymorphone ER, lower than expected revenues
from oxymorphone ER or otherwise, or if we acquire additional product
candidates or technologies, we may need to sell additional equity or debt
securities or seek additional financing through other arrangements. If we
determine to seek additional funding, we may do so through collaborative
agreements or research and development arrangements and public or private
financings. Additional financing may not be available to us on acceptable
terms, if at all.

If we raise additional funds by issuing equity or debt securities, further
dilution to our then existing shareholders may result. In addition, the terms
of the financing may adversely affect the holdings or the rights of such
shareholders. We cannot be certain that additional public or private 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.

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,
2003:

|                     |  |                |       |          |  |           |     |       |  |       |     |         |  |   |   |  |  |   |   | 
|-------------------- |  | -------------- | ----- | -------- |  | --------- | --- | ----- |  | ----- | --- | ------- |  | - | - |  |  | - | - | 
|                     |  |                |       |          |  | Less than |     | 1-3   |  | 4-5   |     | After 5
|                     |  | Total          |       | One Year |  | Years     |     | Years |  | Years
|                     |  |                |       |          |  |           |     |       |  |      
|                     |  | (in thousands)
|Operating Leases     |  | $              | 615   |          |  | $         | 296 |       |  | $     | 319 |         |  | $ |  |  |  | $ |  | 
|Purchase Obligations |  |                | 699   |          |  |           | 699 |       |  |       |    |         |  |   |  |  |  |   |  | 
|                     |  |                |       |          |  |           |     |       |  |       |     |         |  |   |   |  |  |   |   | 
|Total                |  | $              | 1,314 |          |  | $         | 995 |       |  | $     | 319 |         |  | $ |  |  |  | $ |  | 
|                     |  |                |       |          |  |           |     |       |  |       |     |         |  |   |   |  |  |   |   | 

Net Operating Loss Carryforwards

At December 31, 2003, we had federal net operating loss, or NOL,
carryforwards of approximately $63.8 million for income tax purposes, of which
approximately $6.2 million, $8.4 million, $9.1 million, $17.7 million, $19.3
million and $3.1 million expire in 2018, 2019, 2020, 2021, 2022, and 2023,
respectively. In addition, we had research and development tax credit
carryforwards of approximately $2.2 million of which $299,000, $306,000,
$777,000, and $828,000 expire in 2019, 2020, 2021, and 2022 respectively. The
use of the NOL carryforwards and research and development tax credit
carryforwards are limited to our future taxable earnings. For financial
reporting purposes, at December 31, 2003 a valuation allowance of $26.5 million
has been recognized to offset net deferred tax assets, primarily attributable
to the NOL carryforwards. Utilization of the operating losses are subject to a
limitation due to the ownership change provisions of the Internal Revenue Code.

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.

19



---



##### Table of Contents



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 restrictions on maturities and
concentration by issuer.

At December 31, 2003, marketable securities consisted primarily of
corporate debt, U.S. Government-agency backed discounted notes and certificates
of deposit, and approximated $38.6 million. These securities have contractual
maturity dates of up to twenty-three months. Due to the relatively short-term
maturities of these 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.

At December 31, 2002, marketable securities consisted of corporate debt
and approximated $2.1 million. These securities had contractual maturity dates
of up to eleven months. At December 31, 2002, market values approximated
carrying values. At December 31, 2002, the Company had approximately $6.5
million in cash, cash equivalents and investments in marketable securities, and
accordingly, a sustained decrease in the rate of interest earned of 1% would
cause a decrease in the annual amount of interest earned of up to approximately
$65,000.

Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force, or EITF, finalized its
tentative consensus on EITF Issue 00-21, Revenue Arrangements with Multiple
Deliverables, which provides guidance on the timing and method of revenue
recognition for arrangements that include the delivery of more than one product
or service. EITF 00-21 is effective prospectively for arrangements entered into
in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did
not have an effect on our financial position or results of operations.

In June 2002, the Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards, or SFAS, No. 146, Accounting for
Costs Associated with Exit or Disposal Activities. The statement addresses
financial accounting and reporting for costs associated with exit or disposal
activities and nullifies EITF Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring). SFAS No. 146 states
that a liability for a cost associated with an exit or disposal activity shall
be recognized and measured initially at its fair value in the period in which
the liability is incurred, except for a liability for one-time termination
benefits that are incurred over a period of time. The statement is effective
for exit or disposal activities initiated after December 31, 2002. The adoption
of SFAS 146 did not have an effect on our financial position or results of
operations.

In December 2003, the FASB issued SFAS No. 132 (revised 2003) Employers
Disclosures about Pensions and Other Postretirement Benefits an amendment of
FASB Statements No. 87, 88, and 106. This Statement revises employers
disclosures about pension plans and other postretirement benefit plans. It
does not change the measurement or recognition of those plans required by FASB
Statements No. 87, Employers Accounting for Pensions, No. 88, Employers
Accounting for Settlements and Curtailments of Defined Benefit Pension Plans
and for Termination Benefits, and No. 106, Employers Accounting for
Postretirement Benefits Other Than Pensions. This Statement retains the
disclosure requirements contained in FASB Statement No. 132, Employers
Disclosures about Pensions and Other Postretirement Benefits, which it
replaces. It requires additional disclosures to those in the original
Statement No. 132 about the assets, obligations, cash flows, and net periodic
benefit cost of defined benefit pension plans and other defined benefit
postretirement plans. The adoption of SFAS No. 132 (revised 2003) had no
impact on the Companys financial position or results of operations.

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

20



---



##### Table of Contents



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. 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
occur, our business, financial condition or results of operations would likely
suffer. 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 $15.9
million, $17.1 million and $16.0 million, during 2003, 2002, and 2001,
respectively. We had a loss from continuing operations of $26.0 million, $19.0
million, and $16.8 million in 2003, 2002, and 2001, respectively. As of
December 31, 2003, our accumulated deficit was approximately $94.4 million.

We expect net losses to continue until substantial sales of products
commercialized utilizing TIMERx technology occur. If we are unable to
successfully develop and commercialize these products, or generate substantial
sales from these products, we may never achieve profitability.

A substantial portion of our revenues since 1994 has been generated from
the sales of our pharmaceutical excipients. Our net losses in 2003, 2002 and
2001 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 exclusively on our drug
delivery and drug development business.

Our future profitability will depend on several factors, including:



| |  |  | the successful commercialization of TIMERx controlled release
products, including in particular oxymorphone ER, a narcotic analgesic
for the treatment of moderate to severe pain, being developed with Endo;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | royalties from Mylans sales of Pfizers 30 mg generic version of Procardia XL; and                                                                                                                          
|
| |  |  | the level of 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 TIMERx and other 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 acquisition.
Our spending in the area of new technology, however, is discretionary and is
subject to the availability of appropriate opportunities and funding.

We are dependent on collaborators to conduct clinical trials, obtain
regulatory approvals for, and manufacture, market, and sell our TIMERx
controlled release products

Many 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.

21



---



##### Table of Contents



Our collaborators may not devote the resources necessary or may otherwise
be unable to complete development and commercialization of these potential
products. Our existing collaborations are subject to termination 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 we cannot maintain our existing collaborations or establish new
collaborations, we would be required to terminate the commercialization of
products or undertake commercialization activities at our own expense.
Moreover, we have limited experience in conducting full-scale clinical trials,
preparing and submitting regulatory applications and manufacturing, marketing
and selling the pharmaceutical products. We may not be successful in
performing these activities.

Our existing collaborations and any future collaborations with third
parties may not be scientifically or commercially successful.

Factors that may affect the success of our collaborations include the
following:



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

We face significant competition, which may result in others discovering,
developing or commercializing products before or more successfully than we do

The pharmaceutical industry is highly competitive and is affected by new
technologies, governmental regulations, health care legislation, availability
of financing, litigation and other factors. Many of our competitors have
longer operating histories and greater financial, marketing, legal and other
resources than we have and than some of our collaborators have.

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 K-V 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 Duragesic marketed by Johnson &
Johnson.

In addition to developing controlled release versions of immediate and
other controlled release products, we also selectively develop generic versions
of branded controlled release products. In development, we utilize our TIMERx
technology and generic active ingredients to formulate product candidates. The
success of these product candidates 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.

22



---



##### Table of Contents



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 controlled release versions of immediate release
products and branded generic products, we or our collaborators will be required
to complete clinical trials in humans to demonstrate the safety and efficacy of
the products. We or our collaborators may not be able to obtain authority from
the FDA or other regulatory agencies to commence or complete these clinical
trials.

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

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

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

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



| |  |  | we or our collaborators are unable to complete a clinical trial of one of our potential products;
| | - |  | -------------------------------------------------------------------------------------------------
|
| |  |  | the results of any clinical trial are unfavorable; or                                            
|
| |  |  | the time or cost of completing the trial exceeds our expectations.                               

We may not obtain regulatory approval; the approval process can be
time-consuming and expensive

We are not able to market any of our products in the United States, Europe
or in any other jurisdiction without marketing approval from the FDA, the
European Agency for the Evaluation of Medicinal Products, or an equivalent
foreign regulatory agency. The regulatory process to obtain market approval
for a new drug takes many years and requires the expenditure of substantial
resources. We have had only limited experience in preparing applications and
obtaining regulatory approvals.

We also have a number of TIMERx products in our development pipeline. The
most advanced of these is oxymorphone ER, which we are developing with Endo. In
February 2003, the FDA accepted for filing an NDA for oxymorphone ER. In
October 2003, the FDA issued to Endo 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. Endo intends to
communicate with the FDA throughout the final approval process in order to
address the issues raised in the approvable letter and determine the
appropriate course of action. 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.

We may encounter delays or rejections during any stage of the regulatory
approval process based upon the failure of clinical data to demonstrate
compliance with, or upon the failure of the product to meet, the FDAs
requirements for safety, efficacy and quality; and those requirements may
become more stringent due to changes in regulatory agency policy or the
adoption of new regulations. After submission of a marketing application, in
the form of an NDA or an abbreviated new drug application, or ANDA, the FDA may
deny the application, may require additional testing or data and/or may require
post marketing testing and surveillance to monitor the safety or efficacy of a
product. While the U.S. Food, Drug and Cosmetic Act, or FDCA, provides for a
180-day review period, the FDA commonly takes one to two years to grant final
approval to a marketing application.

23



---



##### Table of Contents



Further, the terms of approval of any marketing application, including the
labeling content, may be more restrictive than we desire and could affect the
marketability of products incorporating our controlled release technology.

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, we may be able to rely on existing publicly available safety and
efficacy data to support an NDA for controlled release products under Section
505(b)(2) of the FDCA when such data exists for an approved immediate release
version of the same chemical entity. However, we can provide no assurance that
the FDA will accept such section 505(b)(2) NDA, or that we will be able to
obtain publicly available data that is useful. The section 505(b)(2) NDA
process is a highly uncertain avenue to approval because the FDAs policies on
section 505(b)(2) NDAs have not yet been fully developed. There can be no
assurance that the FDA will approve an application submitted under section
505(b)(2) in a timely manner or at all.

The FDA also has the authority to revoke or suspend approvals of
previously approved products for cause, to debar companies and individuals from
participating in the drug-approval process, to request recalls of allegedly
volatile products, to seize allegedly volatile products, to obtain injunctions
to close manufacturing plants allegedly not operating in conformity with
current Good Manufacturing Practices and to stop shipments of allegedly
volatile products. The FDA may seek to impose pre-clearance requirements on
products currently being marketed without FDA approval, and there can be no
assurance that we or our third-party manufacturers or collaborators will be
able to obtain approval for such products within the time period specified by
the FDA.

Even if we obtain marketing approval, our products will be subject to ongoing
regulatory review

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

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

We may require additional funding, which may be difficult to obtain

As of December 31, 2003, we had cash, cash equivalents, and short-term
investments of $63.9 million. We have no committed sources of capital other
than Rettenmaier Holding GmbH & Co. KGs commitment to repay us $1.25 million
due in May 2004, in connection with the sale of the excipient business.

We anticipate that, excluding any 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 financings through at least 2005.

We have had negative cash flows and net losses since 1994. See We have
not been profitable and expect to continue to incur substantial losses for a
discussion of our risk of continued losses. We expect negative cash flows from
operations to continue until substantial sales of products commercialized
utilizing TIMERx technology occur, particularly because we expect our operating
expenses to continue to increase in the future, including our research and
development expenses, as our product development efforts accelerate.

The proceeds from the sale of our excipient business provided us with
significant funding, but we have lost the positive cash flows generated by our
excipient business.

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



| |  |  | whether oxymorphone ER is approved on a timely basis, or at all;
| | - |  | ----------------------------------------------------------------

24



---



##### Table of Contents





| |  |  | 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;                                                      
|
| |  |  | the structure 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;
|
| |  |  | the costs and timing of adding drug development capabilities;                                                                                                                              
|
| |  |  | royalties received from Mylan; and                                                                                                                                                         
|
| |  |  | the prosecution, defense and enforcement of potential patent claims and other intellectual property rights.                                                                                

If our existing resources are insufficient to satisfy our need for capital
due to a delay in the approval for oxymorphone ER, lower than expected revenues
from oxymorphone ER or otherwise, or if we acquire additional product
candidates or technologies, we may need to sell additional equity or debt
securities or seek additional financing through other arrangements. If we
determine to seek additional funding, we may do so through collaborative
agreements or research and development arrangements and public or private
financings. Additional financing may not be available to us on acceptable
terms, if at all.

If we raise additional funds by issuing equity securities, further
dilution to our then existing shareholders may result. In addition, the terms
of the financing may adversely affect the holdings or the rights of such
shareholders. Any sale of additional equity or debt securities may result in
additional dilution to our shareholders, and we cannot be certain that
additional public or private 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.

Our controlled release products that are generic versions of branded controlled
release products that are covered by one or more patents may be subject to
litigation

We expect 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 was developed with Mylan. Any significant delay in obtaining
FDA approval to market our product candidates as a result of litigation, as
well as the expense of such litigation, whether or not we or our collaborators
are successful, could have a material adverse effect on our business, financial
condition and results of operations.

The market may not be receptive to products incorporating our 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.

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



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

25



---



##### Table of Contents



Our success depends on our protecting our patents and patented rights

Our success depends in significant part on our ability to develop
patentable products, to obtain patent protection for our products, both in the
United States and in other countries, and to enforce these patents. The patent
positions of pharmaceutical firms, including us, are generally uncertain and
involve complex legal and factual questions. As a result, patents may not
issue from any patent applications that we own or license. If patents
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 success also depends on our not infringing patents issued to
competitors or others. We are aware of patents and patent applications
belonging to competitors and others that may require us to alter our products
or processes, pay licensing fees or cease certain activities.

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

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

We may become involved in patent litigation or other intellectual property
proceedings relating to our products or processes which could result in
liability for damage or stop our development and commercialization efforts

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 their
substantially greater resources. Uncertainties resulting from the initiation
and continuation of patent litigation or other proceedings could have a
material adverse effect on our ability to compete in the marketplace. Patent
litigation and other proceedings may also absorb significant management time.

26



---



##### Table of Contents



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 2004. The agreement shall be automatically renewed for
successive one year periods, unless either party gives notice of its intent
not to renew the contract, at least six months prior to the end of the
then-current term.

We believe that there are a limited number of manufacturers that operate
under cGMP regulations capable of manufacturing our TIMERx materials. 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, we may be unable to obtain alternative contract manufacturing, or
obtain such manufacturing on commercially reasonable terms. There can be no
assurance that Draxis or any other third parties upon which we rely for supply
of our TIMERx material 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, 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.

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 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.

27



---



##### Table of Contents



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 the
minimum amounts of $1 million per occurrence and $2.0 million annually in the
aggregate on a claims-made basis and by umbrella liability insurance in excess
of $25.0 million which can also be used for product liability insurance. This
coverage may not be adequate to cover any product liability claims. Product
liability coverage is expensive. In the future, we may not be able to maintain
or obtain such product liability insurance at a reasonable cost or in
sufficient amounts to protect us against losses due to liability claims. Any
claims that are not covered by product liability insurance could have a
material adverse effect on our business, financial condition and results of
operations.

The market price of our common stock may be volatile

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

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.

28



---



##### Table of Contents






ITEM 9A. CONTROLS AND PROCEDURES

(a)  Evaluation of Disclosure Controls and Procedures. Our management, with
the participation of our Chief Executive Officer, or CEO, and Chief Financial
Officer, or CFO, evaluated the effectiveness of our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act) as of December 31, 2003. Based on this evaluation, our CEO and
CFO concluded that, as of December 31, 2003, our disclosure controls and
procedures were (1) designed to ensure that material information relating to
us, is made known to our CEO and CFO by others within our company, particularly
during the period in which this report was being prepared and (2) effective, in
that they provide reasonable assurance that information required to be
disclosed by us in the reports that we file or submit under the Securities
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commissions rules and forms.

(b)  Changes in Internal Controls. 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,
2003 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.




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 2004 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 2004 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 2004 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 2004 Annual Meeting of Shareholders is
incorporated herein by reference.




ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information set forth under Independent Auditor Fees and Other
Matters in our definitive Proxy Statement for the 2004 Annual Meeting of
Shareholders is incorporated herein by reference.

29



---



##### Table of Contents






PART IV




ITEM 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K



|(a) |  | (1) Financial Statements and Financial Statement Schedule                                                                                                                                                                                                           
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|    |  | The following documents are filed as Appendix A hereto and are included as part of this Annual Report on Form 10-K.                                                                                                                                                 
|   
|    |  | The consolidated balance sheets as of December 31, 2003 and 2002 and the related statements of operations, cash flows
and shareholders equity for each of the three years in the period ended December 31, 2003.                                                   
|   
|    |  | 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 containing each management contract, compensatory
plan, or arrangement required to be filed as an exhibit to this
report.                                                                                
|   
|(b) |  | Reports on Form 8-K.                                                                                                                                                                                                                                                                                                                                                                                                        
|   
|    |  | On October 20, 2003, we filed a report on Form 8-K announcing that the
United States Food and Drug Administration had issued to Endo
Pharmaceuticals Inc. an approvable letter for oxymorphone ER.                                                                                                                                                                                                                          
|   
|    |  | On October 30, 2003, we filed a report on Form 8-K announcing our results
for the third quarter ended September 30, 2003.                                                                                                                                                                                                                                                                                                   
|   
|    |  | On November 21, 2003, we filed a report on Form 8-K announcing that in its
Quarterly Report on Form 10-Q for the quarter ended September 20, 2003,
Endo addressed the status of the FDA approval process for oxymorphone ER
and stated that it no longer believed that the launch date of the product
would be the first quarter of 2004.                                                                                   
|   
|    |  | On December 22, 2003, we filed a report on Form 8-K announcing that in a
press release issued on December 18, 2003, Endo stated that it expected to
meet with the FDA prior to the end of the first quarter of 2004 to discuss
the approvable letter it received for oxymorphone ER and that it
anticipated having further clarity as to the path required to obtain final
approval from the FDA subsequent to such meeting.

30



---



##### Table of Contents






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 9, 2004 |  | /s/ Tod R. Hamachek                   
|                    |  | Tod R. Hamachek, Chairman of the Board
|                    |  | and Chief Executive Officer           
|                    |  | (Principal Executive Officer)         

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

|                    |  |                                              
|------------------- |  | ---------------------------------------------
|Date: March 9, 2004 |  | /s/ Tod R. Hamachek                          
|                    |  | Tod R. Hamachek, Chairman of the Board,      
|                    |  | Chief Executive Officer and Director         
|                    |  | (Principal Executive Officer)                
|                    |  |                                              
|Date: March 9, 2004 |  | /s/ Jennifer L. Good                         
|                    |  | Jennifer L. Good, Sr. Vice President, Finance
|                    |  | and Chief Financial Officer                  
|                    |  | (Principal Financial and Accounting Officer) 
|                    |  |                                              
|Date: March 9, 2004 |  | /s/ Paul E. Freiman                          
|                    |  | Paul E. Freiman, Director                    
|                    |  |                                              
|Date: March 9, 2004 |  | /s/ Jere E. Goyan                            
|                    |  | Jere E. Goyan, Ph.D., Director               
|                    |  |                                              
|Date: March 9, 2004 |  | /s/ Rolf H. Henel                            
|                    |  | Rolf H. Henel, Director                      
|                    |  |                                              
|Date: March 9, 2004 |  | /s/ Robert J. Hennessey                      
|                    |  | Robert J. Hennessey, Director                
|                    |  |                                              
|Date: March 9, 2004 |  | /s/ John N. Staniforth                       
|                    |  | John N. Staniforth, Ph.D., Director          
|                    |  |                                              
|Date: March 9, 2004 |  | /s/ Anne M. VanLent                          
|                    |  | Anne M. VanLent, Director                    

31



---



##### Table of Contents



APPENDIX A

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

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

F-1



---



##### Table of Contents



REPORT OF INDEPENDENT AUDITORS

To the Board of Directors and Shareholders
Penwest Pharmaceuticals Co.

We have audited the accompanying consolidated balance sheets of Penwest
Pharmaceuticals Co. as of December 31, 2003 and 2002, and the related
consolidated statements of operations, shareholders equity, and cash flows for
each of the three years in the period ended December 31, 2003. 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 auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Penwest
Pharmaceuticals Co. at December 31, 2003 and 2002, and the consolidated results
of its operations and its cash flows for each of the three years in the period
ended December 31, 2003, in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the related financial
statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.

/s/ ERNST & YOUNG LLP

Stamford, Connecticut
February 6, 2004

F-2



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)

|                                              |                                                                                                                                                                       |                                            |       |                        |        |      |       |         |        | 
|--------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | ---------------------- | ------ | ---- | ----- | ------- | ------ | 
|                                              |                                                                                                                                                                       |                                            |       | DECEMBER 31,          
|                                              |                                                                                                                                                                       |                                            |       |                       
|                                              |                                                                                                                                                                       |                                            |       | 2003                   |        | 2002
|                                              |                                                                                                                                                                       |                                            |       |                        |        |     
|                                              |                                                                                                                                                                       |                                            |       | (see Note 2 - Basis of
|                                              |                                                                                                                                                                       |                                            |       | Presentation)         
|ASSETS                                        |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|Current assets:                               |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|                                              | Cash and cash equivalents                                                                                                                                             |                                            | $     | 25,307                 |        |      | $     | 1,629   |       
|                                              | Marketable securities                                                                                                                                                 |                                            |       | 38,586                 |        |      |       | 2,057   |       
|                                              | Trade accounts receivable                                                                                                                                             |                                            |       | 1,153                  |        |      |       | 1,078   |       
|                                              | Inventories                                                                                                                                                           |                                            |       | 656                    |        |      |       | 461     |       
|                                              | Prepaid expenses and other current assets                                                                                                                             |                                            |       | 1,364                  |        |      |       | 1,902   |       
|                                              | Deferred transaction costs                                                                                                                                            |                                            |       |                       |        |      |       | 1,741   |       
|                                              | Note receivable                                                                                                                                                       |                                            |       | 1,250                  |        |      |       |        |       
|                                              | Assets held for sale                                                                                                                                                  |                                            |       |                       |        |      |       | 33,143  |       
|                                              |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|                                              |                                                                                                                                                                       | Total current assets                       |       |                        | 68,316 |      |       |         | 42,011 | 
|Fixed assets, net                             |                                                                                                                                                                       |                                            | 3,533 |                        |        |      | 2,406 |        
|Patents, net                                  |                                                                                                                                                                       |                                            | 3,689 |                        |        |      | 2,947 |        
|Cash surrender value of life insurance policy |                                                                                                                                                                       |                                            | 2,965 |                        |        |      | 2,856 |        
|                                              |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|                                              |                                                                                                                                                                       | Total assets                               |       | $                      | 78,503 |      |       | $       | 50,220 | 
|                                              |                                                                                                                                                                       |                                            |       |                        |        |      |       |         |       
|LIABILITIES AND SHAREHOLDERS EQUITY          |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|Current liabilities:                          |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|                                              | Accounts payable                                                                                                                                                      |                                            | $     | 2,804                  |        |      | $     | 880     |       
|                                              | Accrued expenses                                                                                                                                                      |                                            |       | 2,133                  |        |      |       | 2,886   |       
|                                              | Accrued development costs                                                                                                                                             |                                            |       | 2,682                  |        |      |       | 2,785   |       
|                                              | Taxes payable                                                                                                                                                         |                                            |       |                       |        |      |       | 258     |       
|                                              | Loans and notes payable                                                                                                                                               |                                            |       |                       |        |      |       | 5,693   |       
|                                              | Deferred revenue                                                                                                                                                      |                                            |       |                       |        |      |       | 150     |       
|                                              | Liabilities held for sale                                                                                                                                             |                                            |       |                       |        |      |       | 3,004   |       
|                                              |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|                                              |                                                                                                                                                                       | Total current liabilities                  |       |                        | 7,619  |      |       |         | 15,656 | 
|Deferred income taxes                         |                                                                                                                                                                       |                                            |      |                        |        |      | 118   |        
|Deferred revenue                              |                                                                                                                                                                       |                                            | 84    |                        |        |      | 134   |        
|Deferred compensation                         |                                                                                                                                                                       |                                            | 3,104 |                        |        |      | 2,889 |        
|                                              |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|                                              |                                                                                                                                                                       | Total liabilities                          |       |                        | 10,807 |      |       |         | 18,797 | 
|Shareholders equity:                         |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|                                              | Preferred stock, par value $.001, authorized 1,000,000 shares, none outstanding                                                                                       |                                            |       |                       |        |      |       |        |       
|                                              | Common
stock, par value $.001, authorized 29,640,000 shares, issued and
outstanding 18,362,523 shares at December 31, 2003 and 15,506,259 shares at
December 31, 2002 |                                            |       | 18                     |        |      |       | 16      |       
|                                              | Additional paid in capital                                                                                                                                            |                                            |       | 162,068                |        |      |       | 110,000 |       
|                                              | Accumulated deficit                                                                                                                                                   |                                            |       | (94,433                | )      |      |       | (78,025 | )     
|                                              | Accumulated other comprehensive income (loss)                                                                                                                         |                                            |       | 43                     |        |      |       | (568    | )     
|                                              |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|                                              |                                                                                                                                                                       | Total shareholders equity                 |       |                        | 67,696 |      |       |         | 31,423 | 
|                                              |                                                                                                                                                                       |                                            |       |                        |        |      |       |        
|                                              |                                                                                                                                                                       | Total liabilities and shareholders equity |       | $                      | 78,503 |      |       | $       | 50,220 | 
|                                              |                                                                                                                                                                       |                                            |       |                        |        |      |       |         |       

See accompanying notes

F-3



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |        |        | 
|-------------------------------------------------------------------------------------- | ----------------------------------- | ------------------------ | ------- | ------------------------------------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                                                                       |                                     |                          |         | YEAR ENDED DECEMBER 31,             
|                                                                                       |                                     |                          |         |                                     
|                                                                                       |                                     |                          |         | 2003                                 |        | 2002 |         | 2001  
|                                                                                       |                                     |                          |         |                                      |        |      |         |       
|                                                                                       |                                     |                          |         | (see Note 2 - Basis of Presentation)
|Revenues                                                                               |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|                                                                                       | Product sales                       |                          | $       | 455                                  |        |      | $       | 619    |        |   | $       | 814    |       
|                                                                                       | Royalties and licensing fees        |                          |         | 4,223                                |        |      |         | 4,918  |        |   |         | 4,982  |       
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|                                                                                       |                                     | Total revenues           |         |                                      | 4,678  |      |         |        | 5,537  |   |         |        | 5,796  | 
|Cost of revenues                                                                       |                                     |                          | 169     |                                      |        |      | 170     |        |        |   | 243     |       
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|                                                                                       |                                     | Gross profit             |         |                                      | 4,509  |      |         |        | 5,367  |   |         |        | 5,553  | 
|Operating expenses                                                                     |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|                                                                                       | Selling, general and administrative |                          |         | 10,361                               |        |      |         | 7,568  |        |   |         | 6,358  |       
|                                                                                       | Research and product development    |                          |         | 20,590                               |        |      |         | 16,955 |        |   |         | 16,190 |       
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|                                                                                       |                                     | Total operating expenses |         |                                      | 30,951 |      |         |        | 24,523 |   |         |        | 22,548 | 
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|Operating loss from continuing operations                                              |                                     |                          | (26,442 | )                                    |        |      | (19,156 | )      |        |   | (16,995 | )     
|Investment income                                                                      |                                     |                          | 476     |                                      |        |      | 379     |        |        |   | 477     |       
|Interest expense                                                                       |                                     |                          | 34      |                                      |        |      | 243     |        |        |   | 290     |       
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|Loss from continuing operations before income tax expense                              |                                     |                          | (26,000 | )                                    |        |      | (19,020 | )      |        |   | (16,808 | )     
|Income tax expense                                                                     |                                     |                          | 6       |                                      |        |      | 8       |        |        |   | 6       |       
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|Loss from continuing operations                                                        |                                     |                          | (26,006 | )                                    |        |      | (19,028 | )      |        |   | (16,814 | )     
|Earnings from discontinued operations, net of income tax expense of
$26, $369 and $467 |                                     |                          | 177     |                                      |        |      | 1,929   |        |        |   | 833     |       
|Gain on sale of discontinued operations                                                |                                     |                          | 9,894   |                                      |        |      |        |        |        |   |        |       
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|Total discontinued operations                                                          |                                     |                          | 10,071  |                                      |        |      | 1,929   |        |        |   | 833     |       
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|Net loss                                                                               |                                     | $                        | (15,935 | )                                    |        | $    | (17,099 | )      |        | $ | (15,981 | )     
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |        |       
|Basic and diluted (loss) earnings per common share:                                    |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|                                                                                       | Continuing operations               |                          | $       | (1.56                                | )      |      | $       | (1.23  | )      |   | $       | (1.21  | )     
|                                                                                       | Discontinued operations             |                          |         | 0.60                                 |        |      |         | 0.12   |        |   |         | 0.06   |       
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       
|Net loss                                                                               |                                     | $                        | (0.96   | )                                    |        | $    | (1.11   | )      |        | $ | (1.15   | )     
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |        |       
|Weighted average shares of common stock outstanding                                    |                                     |                          | 16,678  |                                      |        |      | 15,462  |        |        |   | 13,905  |       
|                                                                                       |                                     |                          |         |                                      |        |      |         |        |        |   |         |       

See accompanying notes

F-4



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY
(in thousands)

|                            |                                                                                      |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        |             |   |   |        |         |         |  
|--------------------------- | ------------------------------------------------------------------------------------ | ------------------ | ------ | ------ |  | ------ | -- | ------- |  | ---------- | ------- | ------------- |  | ------------- | ------- | ------- | - | - | ------ | ----------- | - | - | ------ | ------- | ------- | -
|                            |                                                                                      |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        | ACCUMULATED |   |   |        |        
|                            |                                                                                      |                    |        | COMMON |  |        |    |         |  | ADDITIONAL |         |               |  |               |         | OTHER   |   |   |        |            
|                            |                                                                                      |                    |        | STOCK  |  |        |    |         |  | PAID-IN    |         | ACCUMULATED   |  | COMPREHENSIVE |         |         |   |  
|                            |                                                                                      |                    |        | SHARES |  | AMOUNT |    | CAPITAL |  | DEFICIT    |         | INCOME (LOSS) |  | TOTAL        
|                            |                                                                                      |                    |        |        |  |        |    |         |  |            |         |               |  |              
|Balances, December 31, 2000 |                                                                                      |                    | 12,670 |        |  | $      | 13 |         |  | $          | 77,276  |               |  | $             | (44,945 | )       |   | $ | (1,327 | )           |   | $ | 31,017 |        
|                            | Net loss                                                                             |                    |        |        |  |        |    |         |  |            |         |               |  |               |         | (15,981 | ) |   |        |             |   |   |        | (15,981 | )      
|                            | Translation adjustments                                                              |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        | (244        | ) |   |        | (244    | )      
|                            | Unrealized gain on marketable
securities                                             |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        | 52          |   |   |        | 52      |        
|                            |                                                                                      |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        |             |   |   |        |        
|                            |                                                                                      | Comprehensive loss |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        |             |   |   |        |         | (16,173 | )
|                            | Issuance of common stock -
private placement                                         |                    |        | 2,447  |  |        |    | 2       |  |            |         | 29,669        |  |               |         |         |   |   |        |             |   |   |        | 29,671  |        
|                            | Issuance of common stock
pursuant
to stock compensation plans                        |                    |        | 149    |  |        |    |        |  |            |         | 985           |  |               |         |         |   |   |        |             |   |   |        | 985     |        
|                            | Issuance of common stock
pursuant
to Stock Purchase Plan                             |                    |        | 11     |  |        |    |        |  |            |         | 124           |  |               |         |         |   |   |        |             |   |   |        | 124     |        
|                            |                                                                                      |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        |             |   |   |        |        
|Balances, December 31, 2001 |                                                                                      |                    | 15,277 |        |  |        | 15 |         |  |            | 108,054 |               |  |               | (60,926 | )       |   |   | (1,519 | )           |   |   | 45,624 |        
|                            | Net loss                                                                             |                    |        |        |  |        |    |         |  |            |         |               |  |               |         | (17,099 | ) |   |        |             |   |   |        | (17,099 | )      
|                            | Translation adjustments                                                              |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        | 988         |   |   |        | 988     |        
|                            | Changes 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         |  |               |         |         |   |   |        |             |   |   |        | 1,800   |        
|                            | Issuance of common stock
pursuant
to Stock Purchase Plan                             |                    |        | 12     |  |        |    |        |  |            |         | 147           |  |               |         |         |   |   |        |             |   |   |        | 147     |        
|                            |                                                                                      |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        |             |   |   |        |        
|Balances, December 31, 2002 |                                                                                      |                    | 15,506 |        |  |        | 16 |         |  |            | 110,000 |               |  |               | (78,025 | )       |   |   | (568   | )           |   |   | 31,423 |        
|                            | Net loss                                                                             |                    |        |        |  |        |    |         |  |            |         |               |  |               |         | (15,935 | ) |   |        |             |   |   |        | (15,935 | )      
|                            | Translation adjustments                                                              |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        | 110         |   |   |        | 110     |        
|                            | Accumulated foreign currency
translation adjustments of
discontinued operations sold |                    |        |        |  |        |    |         |  |            |         |               |  |               |         | (473    | ) |   |        | 473         |   |   |        |        |        
|                            | Changes in unrealized gain on
marketable securities                                  |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        | 28          |   |   |        | 28      |        
|                            |                                                                                      |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        |             |   |   |        |        
|                            |                                                                                      | Comprehensive loss |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        |             |   |   |        |         | (15,797 | )
|                            | Issuance of common stock -
private placement                                         |                    |        | 2,508  |  |        |    | 2       |  |            |         | 49,302        |  |               |         |         |   |   |        |             |   |   |        | 49,304  |        
|                            | Issuance of common stock
pursuant
to stock compensation plans                        |                    |        | 340    |  |        |    |        |  |            |         | 2,662         |  |               |         |         |   |   |        |             |   |   |        | 2,662   |        
|                            | Issuance of common stock
pursuant
to Stock Purchase Plan                             |                    |        | 9      |  |        |    |        |  |            |         | 104           |  |               |         |         |   |   |        |             |   |   |        | 104     |        
|                            |                                                                                      |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        |             |   |   |        |        
|Balances, December 31, 2003 |                                                                                      |                    | 18,363 |        |  | $      | 18 |         |  | $          | 162,068 |               |  | $             | (94,433 | )       |   | $ | 43     |             |   | $ | 67,696 |        
|                            |                                                                                      |                    |        |        |  |        |    |         |  |            |         |               |  |               |         |         |   |   |        |             |   |   |        |        

See accompanying notes

F-5



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |   |         |   | 
|---------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------- | ------- | - | ------------------------------------ | - | ------- | - | ------- | - | ------- | - | ------- | - | 
|                                                                                               |  |                                                                                        |         |   | YEAR ENDED DECEMBER 31,             
|                                                                                               |  |                                                                                        |         |   |                                     
|                                                                                               |  |                                                                                        |         |   | 2003                                 |   | 2002    |   | 2001   
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |        
|                                                                                               |  |                                                                                        |         |   | (see Note 2 - Basis of Presentation)
|Operating activities:                                                                          |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|Net loss                                                                                       |  | $                                                                                      | (15,935 | ) |                                      | $ | (17,099 | ) |         | $ | (15,981 | )
|Less earnings from discontinued operations,
net of tax expense                                 |  |                                                                                        | (177    | ) |                                      |   | (1,929  | ) |         |   | (833    | )
|Less gain on sale of discontinued operations                                                   |  |                                                                                        | (9,894  | ) |                                      |   |        |   |         |   |        |  
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|Loss from continuing operations                                                                |  |                                                                                        | (26,006 | ) |                                      |   | (19,028 | ) |         |   | (16,814 | )
|Adjustments to reconcile net loss to net cash used
in operating activities:                    |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|                                                                                               |  | Depreciation                                                                           |         |   | 679                                  |   |         |   | 222     |   |         |   | 264     |  
|                                                                                               |  | Amortization                                                                           |         |   | 219                                  |   |         |   | 166     |   |         |   | 154     |  
|                                                                                               |  | Deferred income taxes                                                                  |         |   | (118                                 | ) |         |   |        |   |         |   |        |  
|                                                                                               |  | Deferred revenue                                                                       |         |   | (53                                  | ) |         |   | (84     | ) |         |   | (10     | )
|                                                                                               |  | Deferred compensation                                                                  |         |   | 215                                  |   |         |   | 178     |   |         |   | 187     |  
|                                                                                               |  | Stock compensation                                                                     |         |   | 110                                  |   |         |   | 105     |   |         |   | 119     |  
|Changes in operating assets and liabilities:                                                   |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|                                                                                               |  | Trade accounts receivable                                                              |         |   | (35                                  | ) |         |   | 115     |   |         |   | 1,866   |  
|                                                                                               |  | Inventories                                                                            |         |   | (195                                 | ) |         |   | (270    | ) |         |   | 275     |  
|                                                                                               |  | Accounts payable, accrued expenses and other                                           |         |   | 2,117                                |   |         |   | 1,609   |   |         |   | (48     | )
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|Net cash used in continuing operations
operating activities                                    |  |                                                                                        | (23,067 | ) |                                      |   | (16,987 | ) |         |   | (14,007 | )
|Net cash provided by discontinued operations
operating activities                              |  |                                                                                        | 874     |   |                                      |   | 2,230   |   |         |   | 2,494   |  
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|Net cash used in operating activities                                                          |  |                                                                                        | (22,193 | ) |                                      |   | (14,757 | ) |         |   | (11,513 | )
|Investing activities:                                                                          |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|                                                                                               |  | Proceeds from sale of discontinued operations,
net of transaction costs paid of $1,351 |         |   | 36,900                               |   |         |   |        |   |         |   |        |  
|                                                                                               |  | Acquisitions of fixed assets, net                                                      |         |   | (1,810                               | ) |         |   | (1,359  | ) |         |   | (544    | )
|                                                                                               |  | Intangible asset costs                                                                 |         |   | (965                                 | ) |         |   | (650    | ) |         |   | (813    | )
|                                                                                               |  | Transaction costs                                                                      |         |   |                                     |   |         |   | (1,741  | ) |         |   |        |  
|                                                                                               |  | Purchases of marketable securities                                                     |         |   | (44,004                              | ) |         |   |        |   |         |   | (11,511 | )
|                                                                                               |  | Proceeds from maturities of marketable securities                                      |         |   | 7,299                                |   |         |   | 7,255   |   |         |   | 2,000   |  
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|Net cash (used in) provided by continuing
operations                      investing activities |  |                                                                                        | (2,580  | ) |                                      |   | 3,505   |   |         |   | (10,868 | )
|Net cash used in discontinued
operations investing activities                                  |  |                                                                                        | (97     | ) |                                      |   | (3,822  | ) |         |   | (676    | )
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|Net cash used in investing activities                                                          |  |                                                                                        | (2,677  | ) |                                      |   | (317    | ) |         |   | (11,544 | )
|Financing activities:                                                                          |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|                                                                                               |  | Proceeds from loans and notes payable                                                  |         |   | 1,354                                |   |         |   | 28,983  |   |         |   | 29,616  |  
|                                                                                               |  | Repayments of loans and notes payable                                                  |         |   | (7,047                               | ) |         |   | (25,958 | ) |         |   | (26,947 | )
|                                                                                               |  | Issuance of common stock, net                                                          |         |   | 51,960                               |   |         |   | 1,841   |   |         |   | 30,661  |  
|                                                                                               |  | Net cash provided by discontinued operations
financing activities                      |         |   | 2,249                                |   |         |   |        |   |         |   |        |  
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|Net cash provided by financing activities                                                      |  |                                                                                        | 48,516  |   |                                      |   | 4,866   |   |         |   | 33,330  |  
|Effect of exchange rate changes on cash and cash
equivalents of discontinued operations        |  |                                                                                        | 32      |   |                                      |   | 308     |   |         |   | (35     | )
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|Net increase (decrease) in cash and cash equivalents                                           |  |                                                                                        | 23,678  |   |                                      |   | (9,900  | ) |         |   | 10,238  |  
|Cash and cash equivalents at beginning of year                                                 |  |                                                                                        | 1,629   |   |                                      |   | 11,529  |   |         |   | 1,291   |  
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  
|Cash and cash equivalents at end of year                                                       |  | $                                                                                      | 25,307  |   |                                      | $ | 1,629   |   |         | $ | 11,529  |  
|                                                                                               |  |                                                                                        |         |   |                                      |   |         |   |         |   |         |  

See accompanying notes

F-6



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BUSINESS

Penwest develops pharmaceutical products based on innovative oral drug
delivery technologies. The foundation of Penwests 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. The Company has also developed two additional oral drug delivery
systems, Geminex® and SyncroDose. 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.

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. The Company received $1.0 million
of the $2.25 million promissory note in April 2003 with the balance due 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 all periods presented.

The Company has incurred net losses since 1994. As of December 31, 2003,
the Companys accumulated deficit was approximately $94.4 million. The Company
expects operating losses and negative cash flows to continue until substantial
sales of products commercialized utilizing TIMERx technology 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 2001, 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. Effective February 27, 2003,
the Company will not derive any revenues from the excipient business.
Accordingly, the Companys revenues for 2003 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 royalties from Mylans sales of Pfizers 30 mg
generic version of Procardia ER, and the level of our research and development
activities.

The Company is subject to the risks and uncertainties associated with a
drug delivery company actively engaged in research and development. These risks
and uncertainties include, but are not limited to, a history of net losses,
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, 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 all periods presented. All wholly
owned subsidiaries were included in the Asset Sale (see note
13).

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.

Cash and Cash Equivalents

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

F-7



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 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 88%,
87% and 82% of total revenues in 2003, 2002 and 2001, respectively. Another
customer of the Company accounted for approximately 11% and 16% of total
revenues for 2003 and 2001, respectively.

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

The carrying value of financial instruments, which includes cash, cash
equivalents, marketable securities, receivables, obligations under the
Companys loans and notes payable, and accounts payable, approximates fair
value due to the short term nature of these instruments.

Long-Lived Assets

Fixed assets are recorded at cost and depreciated 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 years
|Office furniture, equipment and software |  | 3-10 years
|Leasehold improvements                   |  | 3-4 years 

Effective January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets (SFAS No. 144). SFAS No. 144 supercedes Statement of
Financial Accounting Standards No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the
accounting and reporting provisions of Accounting Principles Boards No. 30,
Reporting the Results of Operations  Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions. SFAS No 144 provides updated guidance concerning the
recognition and measurement of an impairment loss for certain types of
long-lived assets and expands the scope of a discontinued operation to include
a component of an entity. The adoption of SFAS No. 144 did not impact the
Companys financial position or results of operations.

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 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.

F-8



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

Foreign Currencies

The assets and liabilities, and operating results of the Companys foreign
operations are 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 income (loss) includes the cumulative translation adjustments, which is a
component of other comprehensive loss included in the Companys financial
statements. Realized gains and losses from foreign currency transactions are
reflected in the consolidated statements of operations. Foreign currency
transaction gains and losses were not significant in each year in the three
year period ended December 31, 2003.

Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive
income (loss) at December 31, 2003, 2002 and 2001
consists of the Companys foreign currency translation adjustment and a net
unrealized gain on marketable securities (see Note 17).

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 2003,
2002, and 2001, as such losses were offset by valuation allowances. Valuation
allowances are established against the recorded deferred income tax assets to
the extent that management believes it is more likely than not that a portion
of the deferred income tax assets are not realizable.

Revenue Recognition

Revenues from product sales are recognized when title transfers and
customer acceptance provisions have lapsed, provided collections of the related
accounts receivable are probable. Shipping and handling costs are included in
cost of revenues. Revenues received from non-refundable upfront licensing
fees are recognized ratably over the development period of the collaboration
agreement, when this period involves development risk associated with the
incomplete stage of a products development or over the estimated or
contractual licensing and supply term when 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.

Research and Development

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

F-9



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 2003, 2002,
and 2001 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. The Statement 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 2003 consolidated results of operations, financial position or
cash flows.

At December 31, 2003, 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 Opinion No. 25, Accounting for Stock
Issued to Employees. During the year ended December 31, 2003, the Company
recorded $106,000 in compensation expense in connection with the acceleration
of the vesting date of certain stock options. In addition, in connection with
board of directors retainer and meeting fees in 2003, the Company recorded
$68,000 of expense associated with the issuance of discounted stock options and
$132,000 of expense associated with restricted stock grants. No other
stock-based employee compensation expense is reflected in net loss as all other
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.

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,              
|                                                                                         |  |                                      
|                                                                                         |  | 2003                                  |         | 2002 |  | 2001
|                                                                                         |  |                                       |         |      |  |     
|                                                                                         |  | (in thousands, except per share data)
|Net loss  as reported                                                                   |  | $                                     | (15,935 | )    |  | $    | (17,099 | ) |  | $ | (15,981 | )
|Stock options fair value effect                                                         |  |                                       | (3,350  | )    |  |      | (2,804  | ) |  |   | (1,621  | )
|                                                                                         |  |                                       |         |      |  |      |         |   |  |   |         |  
|Net loss  pro forma after stock
options fair value effect                              |  | $                                     | (19,285 | )    |  | $    | (19,903 | ) |  | $ | (17,602 | )
|                                                                                         |  |                                       |         |      |  |      |         |   |  |   |         |  
|Net
loss per share, basic and diluted 
as reported                                      |  | $                                     | (0.96   | )    |  | $    | (1.11   | ) |  | $ | (1.15   | )
|Net
loss per share, basic and diluted 
pro forma after stock options fair
value effect |  | $                                     | (1.16   | )    |  | $    | (1.29   | ) |  | $ | (1.27   | )

3. RECENT ACCOUNTING PRONOUNCEMENTS

In November 2002, the Emerging Issues Task Force (EITF) finalized its
tentative consensus on EITF Issue 00-21, Revenue Arrangements with Multiple
Deliverables, which provides guidance on the timing and method of revenue
recognition for arrangements that include the delivery of more than one product
or service. EITF 00-21 is effective prospectively for arrangements entered into
in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 did
not have an effect on the Companys financial position or results of
operations.

In June 2002, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 146, Accounting for
Costs Associated with Exit or Disposal Activities. The statement addresses
financial accounting and reporting for costs associated with exit or disposal
activities and nullifies EITF Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring). SFAS No. 146 states
that a liability for a cost associated with an exit or disposal activity shall
be recognized and measured initially at its fair value in the period in which
the liability is incurred, except for a liability for one-time termination
benefits that are incurred over a

F-10



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

period of time. The statement is effective for exit or disposal activities
initiated after December 31, 2002. The adoption of SFAS 146 did not have an
effect on the Companys financial position or results of operations.

In December 2003, the FASB issued SFAS No. 132 (revised 2003) Employers
Disclosures about Pensions and Other Postretirement Benefits an amendment of
FASB Statements No. 87, 88, and 106. This Statement revises employers
disclosures about pension plans and other postretirement benefit plans. It
does not change the measurement or recognition of those plans required by FASB
Statements No. 87, Employers Accounting for Pensions, No. 88, Employers
Accounting for Settlements and Curtailments of Defined Benefit Pension Plans
and for Termination Benefits, and No. 106, Employers Accounting for
Postretirement Benefits Other Than Pensions. This Statement retains the
disclosure requirements contained in FASB Statement No. 132, Employers
Disclosures about Pensions and Other Postretirement Benefits, which it
replaces. It requires additional disclosures to those in the original
Statement No. 132 about the assets, obligations, cash flows, and net periodic
benefit cost of defined benefit pension plans and other defined benefit
postretirement plans. The adoption of SFAS No. 132 (revised 2003) had no
impact on the Companys financial position or results of operations (see Note
12).

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.

4. MARKETABLE SECURITIES

The amortized costs and estimated fair values of marketable securities are
as follows:

|                  |                             |                                                |   |                |        |            |   |            |    |       |   |           |   |  |   |        |        | 
|----------------- | --------------------------- | ---------------------------------------------- | - | -------------- | ------ | ---------- | - | ---------- | -- | ----- | - | --------- | - |  | - | ------ | ------ | 
|                  |                             |                                                |   |                |        |            |   | Gross      |    | Gross |   | Estimated
|                  |                             |                                                |   | Amortized      |        | Unrealized |   | Unrealized |    | Fair 
|                  |                             |                                                |   | Cost           |        | Gains      |   | Losses     |    | Value
|                  |                             |                                                |   |                |        |            |   |            |    |      
|                  |                             |                                                |   | (in thousands)
|December 31, 2003 |                             |                                                |   |                |        |            |   |            |    |       |   |           |   |  |   |       
|                  |                             | Corporate debt securities                      |   | $              | 23,522 |            |   | $          | 27 |       |   | $         | 6 |  |   | $      | 23,543 | 
|                  |                             | U.S. government
agency-backed
discounted notes |   |                | 14,044 |            |   |            | 25 |       |   |           |  |  |   |        | 14,069 | 
|                  |                             | Certificates of deposit                        |   |                | 977    |            |   |            |   |       |   |           | 3 |  |   |        | 974    | 
|                  |                             |                                                |   |                |        |            |   |            |    |       |   |           |   |  |   |       
|                  | Total marketable securities |                                                | $ | 38,543         |        |            | $ | 52         |    |       | $ | 9         |   |  | $ | 38,586 |       
|                  |                             |                                                |   |                |        |            |   |            |    |       |   |           |   |  |   |        |        | 
|December 31, 2002 |                             |                                                |   |                |        |            |   |            |    |       |   |           |   |  |   |       
|                  |                             | Corporate debt securities                      |   | $              | 2,042  |            |   | $          | 15 |       |   | $         |  |  |   | $      | 2,057  | 
|                  |                             |                                                |   |                |        |            |   |            |    |       |   |           |   |  |   |        |        | 

Maturities of marketable securities at fair value as of December 31, 2003,
are as follows (in thousands):

|                            |                                           |   |        |        | 
|--------------------------- | ----------------------------------------- | - | ------ | ------ | 
|Contractual maturity:       |                                           |   |        |       
|                            | Maturing in one year or less              |   | $      | 14,167 | 
|                            | Maturing after one year through two years |   |        | 24,419 | 
|                            |                                           |   |        |       
|Total marketable securities |                                           | $ | 38,586 |       
|                            |                                           |   |        |       

The primary objectives for the Companys investment portfolio are
liquidity and safety of principal. Investments are made to achieve the highest
rate of return to the Company, consistent with these two objectives. The
Companys investment policy limits investments to certain types of instruments
issued by institutions with investment grade credit ratings and places
restrictions on maturities, and concentration by issuer (see Note 2, Credit
Risk and Fair Value of Financial Instruments).

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.

F-11



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

Inventories are summarized as follows:

|                  |                   |   |                |     |      |   |     |     | 
|----------------- | ----------------- | - | -------------- | --- | ---- | - | --- | --- | 
|                  |                   |   | DECEMBER 31,  
|                  |                   |   |               
|                  |                   |   | 2003           |     | 2002
|                  |                   |   |                |     |     
|                  |                   |   | (in thousands)
|Raw materials     |                   | $ | 196            |     |      | $ | 149 |    
|Finished products |                   |   | 460            |     |      |   | 312 |    
|                  |                   |   |                |     |      |   |     |    
|                  | Total inventories |   | $              | 656 |      |   | $   | 461 | 
|                  |                   |   |                |     |      |   |     |    

The Company periodically reviews and quality tests its inventory to
identify obsolete, slow moving or otherwise unsaleable inventories. Inventories
at December 31, 2003 and 2002 are net of allowances of $82,000 and $16,000,
respectively.

In September 1999, the Company entered into a five-year contract (plus
automatic renewals of one year each) for the manufacturing of TIMERx material
with another third party pharmaceutical company. There are a limited number of
third party manufacturers capable of producing the TIMERx material. There can
be no assurance that third parties upon which the Company relies for supply of
its TIMERx material will perform, and any failures by third parties may delay
development or the submission of products for regulatory approval, impair the
Companys collaborators ability to commercialize products as planned and
deliver products on a timely basis, or otherwise impair the Companys
competitive position, which could have a material adverse effect on the
Companys business, financial condition, cash flows and results of operations.

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. Any of these events could have a material adverse
effect on the Companys ability to manufacture bulk TIMERx for
delivery to its collaborators, which could have a material adverse effect on the Companys
business, financial condition, cash flows and results of operations.

6. FIXED ASSETS

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

|                                     |  |                |       |      |  |   |       | 
|------------------------------------ |  | -------------- | ----- | ---- |  | - | ----- | 
|                                     |  | DECEMBER 31,  
|                                     |  |               
|                                     |  | 2003           |       | 2002
|                                     |  |                |       |     
|                                     |  | (in thousands)
|Equipment and leasehold improvements |  | $              | 4,602 |      |  | $ | 3,615 | 
|Software                             |  |                | 1,540 |      |  |   |      | 
|Projects in progress                 |  |                |      |      |  |   | 831   | 
|                                     |  |                |       |      |  |   |       | 
|                                     |  |                | 6,142 |      |  |   | 4,446 | 
|Less: accumulated depreciation       |  |                | 2,609 |      |  |   | 2,040 | 
|                                     |  |                |       |      |  |   |       | 
|                                     |  | $              | 3,533 |      |  | $ | 2,406 | 
|                                     |  |                |       |      |  |   |       | 

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 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.

F-12



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

7. PATENTS

Patents, net of accumulated amortization, consist of the following:

|                                                          |  |                |       |      |  |   |       | 
|--------------------------------------------------------- |  | -------------- | ----- | ---- |  | - | ----- | 
|                                                          |  | DECEMBER 31,  
|                                                          |  |               
|                                                          |  | 2003           |       | 2002
|                                                          |  |                |       |     
|                                                          |  | (in thousands)
|Patents, net of accumulated amortization of $904 and $690 |  | $              | 3,689 |      |  | $ | 2,947 | 
|                                                          |  |                |       |      |  |   |       | 

Patents include costs to secure patents on technology 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 $219,000, $166,000, and
$154,000 was recorded in the years ended December 31, 2003, 2002, and 2001,
respectively. Estimated amortization expense on existing patent costs is
approximately $243,000 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 fourth quarters of 2003,
2002, and 2001, for continuing operations, the Company recorded impairment
losses of $5,000, $121,000, and $108,000, respectively, net of accumulated
amortization, relating to its patents. Such impairment losses are reflected in
research and product development expense on the consolidated statements of
operations.

8. LOANS AND NOTES PAYABLE

Amounts outstanding under loans and notes payable are summarized below:

|                                     |  |                |   |      |  |   |       | 
|------------------------------------ |  | -------------- | - | ---- |  | - | ----- | 
|                                     |  | DECEMBER 31,  
|                                     |  |               
|                                     |  | 2003           |   | 2002
|                                     |  |                |   |     
|                                     |  | (in thousands)
|Revolving line of credit             |  | $              |  |      |  | $ | 2,807 | 
|Note payable to AstraZeneca AB       |  |                |  |      |  |   | 2,250 | 
|Business insurance premium financing |  |                |  |      |  |   | 636   | 
|                                     |  |                |   |      |  |   |       | 
|                                     |  | $              |  |      |  | $ | 5,693 | 
|                                     |  |                |   |      |  |   |       | 

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).

The Revolver bore interest at a specified banks prime rate plus 1% per
annum, on the greater of $3.0 million or on the average outstanding balance.
The Revolver also required fees be paid of 0.5% per annum on unused portions of
the Line of Credit and provided for early termination fees of up to 0.75% upon
termination of the Revolver prior to the end of the initial term. As of
December 31, 2002, the interest rate on the Revolver was 5.25% and
approximately $2.8 million was outstanding.

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

F-13



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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, $243,000, and $214,000, of total interest was paid
in 2003, 2002, and 2001, respectively.

9. SHAREHOLDERS EQUITY

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 Private Placement), resulting in net proceeds to
the Company, after fees and expenses, of approximately $49.3 million. As part
of the 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. The Company intends to use
the net proceeds from the Private Placement to fund the research, development,
marketing and commercialization of its products and technologies, and for
general corporate purposes.

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

In 1997, the Company effected a 0.76-for-1 reverse split of its common
stock. Prior to the effectiveness of the reverse stock split, the number of
authorized shares of common stock equaled 39,000,000. The reverse split was
effected by means of an amendment to the Companys Articles of Incorporation
which left the number of authorized shares of common stock at 39,000,000.
Consequently, following the effectiveness of the reverse stock split, the
Company continued to report that it had 39,000,000 shares of common stock
authorized for issuance. The Company understands that under an interpretation
of the Washington Business Corporation Act, the number of shares of common
stock authorized for issuance under the Companys Articles of Incorporation may
have been required to be adjusted to reflect the reverse stock split. Based on
this interpretation, the Company is reporting on the accompanying consolidated balance sheet
29,640,000 shares of common stock authorized for issuance (0.76 x
39,000,000).

Penwest Stock Option Plans

As of
December 31, 2003 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. In 2003, a total of 60,000 restricted shares were granted. No such
shares were granted in 2002 or 2001.

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.

F-14



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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. AVERAGE
|                           |  | SHARES |           | RANGE |  | EXERCISE PRICE
|                           |  |        |           |       |  |               
|BALANCE, DECEMBER 31, 2000 |  |        | 2,263,356 |       |  | $              | 3.70-14.38  |              |  | $ | 7.77  | 
|2001                       |  |        |           |       |  |                |             |              |  |   |       | 
|Granted                    |  |        | 382,501   |       |  | $              | 8.58-18.18  |              |  | $ | 12.65 | 
|Exercised                  |  |        | (135,842  | )     |  | $              | 3.70 - 8.88 |              |  | $ | 6.38  | 
|Cancelled                  |  |        | (230,000  | )     |  | $              | 6.38-11.81  |              |  | $ | 11.72 | 
|                           |  |        |           |       |  |                |             |              |  |   |       | 
|BALANCE, DECEMBER 31, 2001 |  |        | 2,280,015 |       |  | $              | 3.70-18.18  |              |  | $ | 8.26  | 
|                           |  |        |           |       |  |                |             |              |  |   |       | 
|Options Exercisable        |  |        | 1,381,264 |       |  | $              | 3.70-14.38  |              |  | $ | 7.28  | 
|                           |  |        |           |       |  |                |             |              |  |   |       | 
|2002                       |  |        |           |       |  |                |             |              |  |   |       | 
|Granted                    |  |        | 291,087   |       |  | $              | 6.15-19.76  |              |  | $ | 15.89 | 
|Exercised                  |  |        | (163,113  | )     |  | $              | 4.06-11.81  |              |  | $ | 8.51  | 
|Cancelled                  |  |        | (8,875    | )     |  | $              | 15.47-19.76 |              |  | $ | 18.85 | 
|                           |  |        |           |       |  |                |             |              |  |   |       | 
|BALANCE, DECEMBER 31, 2002 |  |        | 2,399,114 |       |  | $              | 3.70-19.76  |              |  | $ | 9.37  | 
|                           |  |        |           |       |  |                |             |              |  |   |       | 
|Options Exercisable        |  |        | 1,566,988 |       |  | $              | 3.70-18.18  |              |  | $ | 7.66  | 
|                           |  |        |           |       |  |                |             |              |  |   |       | 
|2003                       |  |        |           |       |  |                |             |              |  |   |       | 
|Granted                    |  |        | 539,511   |       |  | $              | 7.43-21.24  |              |  | $ | 11.32 | 
|Exercised                  |  |        | (334,914  | )     |  | $              | 4.06-12.75  |              |  | $ | 7.30  | 
|Cancelled                  |  |        | (166,911  | )     |  | $              | 3.70-19.13  |              |  | $ | 9.65  | 
|                           |  |        |           |       |  |                |             |              |  |   |       | 
|BALANCE, DECEMBER 31, 2003 |  |        | 2,436,800 |       |  | $              | 3.70-21.24  |              |  | $ | 10.06 | 
|                           |  |        |           |       |  |                |             |              |  |   |       | 
|Options Exercisable        |  |        | 1,464,472 |       |  | $              | 3.70-19.76  |              |  | $ | 9.16  | 
|                           |  |        |           |       |  |                |             |              |  |   |       | 

The weighted average fair value of options granted during the years ended
December 31, 2003, 2002, and 2001, was $6.34, $11.51, and $8.03, respectively.
The weighted average remaining contractual life of options outstanding at
December 31, 2003 is 6.0 years. The weighted effect of applying SFAS No. 123
for providing pro forma disclosures for the years ended December 31, 2003,
2002, 2001, is not likely to be representative of the effects in future years
because the amounts above reflect only the options granted before 1995 that
vest over four to five years. No additional Penford shares were granted to the
Company employees subsequent to December 31, 1997.

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

|                         |  |           |     |           |  |           |     |   |  |  |     |  
|------------------------ |  | --------- | --- | --------- |  | --------- | --- | - |  |  | --- | -
|                         |  | 2003      |     | 2002      |  | 2001     
|                         |  |           |     |           |  |          
|Expected dividend yield  |  | None      |     | None      |  | None     
|Risk free interest rate  |  |           | 3.8 | %         |  |           | 4.9 | % |  |  | 5.5 | %
|Expected volatility      |  |           | 78  | %         |  |           | 69  | % |  |  | 52  | %
|Expected life of options |  | 7.5 years |     | 7.5 years |  | 7.5 years

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 8,967 shares,
12,282 shares, and 10,696 shares issued under the Plan during 2003, 2002, and
2001, 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-15



---



##### Table of Contents



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 addition, in
February 2003, the Company signed a lease agreement for approximately 11,000
square feet of office space in Danbury, Connecticut. This lease has an initial
term expiring January 31, 2006, with renewal options through December 30, 2006,
and requires that monthly base rents be paid, including escalation clauses, in
amounts ranging from approximately $20,000 to $22,000 through the initial lease
term. The Company moved its corporate offices to Danbury, Connecticut on March
31, 2003 (see Note 13).

As of December 31, 2003, certain of the Companys property and equipment
is leased under operating leases ranging from one to four years. Rental expense
under operating leases was $551,000, $91,000, and $63,000, for the years ended
December 31, 2003, 2002, and 2001, respectively. Of such amounts,
approximately $88,000 in 2003 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, 2003 for noncancellable
operating leases having initial lease terms of more than one year are as
follows:

|           |                              |   |                |     | 
|---------- | ---------------------------- | - | -------------- | --- | 
|           |                              |   | OPERATING     
|           |                              |   | LEASES        
|           |                              |   |               
|           |                              |   | (in thousands)
|2004       |                              | $ | 296            |    
|2005       |                              |   | 290            |    
|2006       |                              |   | 29             |    
|2007       |                              |   |               |    
|2008       |                              |   |               |    
|Thereafter |                              |   |               |    
|           |                              |   |                |    
|           | Total minimum lease payments |   | $              | 615 | 
|           |                              |   |                |    

11. INCOME TAXES

The provision for income taxes consists of the following:

|         |          |   |                |   |      |   |      |   |  |   |   |   | 
|-------- | -------- | - | -------------- | - | ---- | - | ---- | - |  | - | - | - | 
|         |          |   | 2003           |   | 2002 |   | 2001
|         |          |   |                |   |      |   |     
|         |          |   | (in thousands)
|Federal: |          |   |                |   |      |   |      |   |  |   |   |  
|         | Current  |   | $              |  |      |   | $    |  |  |   | $ |  | 
|         | Deferred |   |                |  |      |   |      |  |  |   |   |  | 
|Foreign: |          |   |                |   |      |   |      |   |  |   |   |  
|         | Current  |   |                | 6 |      |   |      | 8 |  |   |   | 6 | 
|         | Deferred |   |                |  |      |   |      |  |  |   |   |  | 
|State:   |          |   |                |   |      |   |      |   |  |   |   |  
|         | Current  |   |                |  |      |   |      |  |  |   |   |  | 
|         | Deferred |   |                |  |      |   |      |  |  |   |   |  | 
|         |          |   |                |   |      |   |      |   |  |   |   |   | 
|         |          | $ | 6              |   |      | $ | 8    |   |  | $ | 6 |  
|         |          |   |                |   |      |   |      |   |  |   |   |  

F-16



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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

|                    |  |      |     |      |  |      |     |    |  |  |     |   
|------------------- |  | ---- | --- | ---- |  | ---- | --- | -- |  |  | --- | --
|                    |  | 2003 |     | 2002 |  | 2001
|                    |  |      |     |      |  |     
|Statutory tax rate  |  |      | (34 | )%   |  |      | (34 | )% |  |  | (34 | )%
|Valuation allowance |  |      | 34  |      |  |      | 34  |    |  |  | 34  |   
|Foreign taxes       |  |      |    |      |  |      |    |    |  |  |    |   
|                    |  |      |     |      |  |      |     |    |  |  |     |   
|                    |  |      |    | %    |  |      |    | %  |  |  |    | % 
|                    |  |      |     |      |  |      |     |    |  |  |     |   

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

|                                                  |                                |   |                |         |      |   |         |         |  
|------------------------------------------------- | ------------------------------ | - | -------------- | ------- | ---- | - | ------- | ------- | -
|                                                  |                                |   | 2003           |         | 2002
|                                                  |                                |   |                |         |     
|                                                  |                                |   | (in thousands)
|Trade accounts receivable allowance               |                                | $ |               |         |      | $ | (68     | )      
|Inventory allowance and basis differences         |                                |   | (161           | )       |      |   | (274    | )      
|Deferred compensation and SERP liability          |                                |   | (1,199         | )       |      |   | (1,115  | )      
|Deferred revenue                                  |                                |   | (32            | )       |      |   | (110    | )      
|Tax credit carryforward                           |                                |   | (2,218         | )       |      |   | (1,396  | )      
|Net operating loss carryforwards                  |                                |   | (24,657        | )       |      |   | (23,393 | )      
|Other                                             |                                |   | (191           | )       |      |   | (151    | )      
|                                                  |                                |   |                |         |      |   |         |        
|                                                  | Total deferred tax assets      |   |                | (28,458 | )    |   |         | (26,507 | )
|                                                  |                                |   |                |         |      |   |         |        
|Depreciation and amortization                     |                                |   | 1,683          |         |      |   | 2,856   |        
|Other                                             |                                |   | 269            |         |      |   | 477     |        
|                                                  |                                |   |                |         |      |   |         |        
|                                                  | Total deferred tax liabilities |   |                | 1,952   |      |   |         | 3,333   |  
|                                                  |                                |   |                |         |      |   |         |        
|Net deferred tax asset before valuation allowance |                                |   | (26,506        | )       |      |   | (23,174 | )      
|Valuation allowance                               |                                |   | 26,506         |         |      |   | 23,292  |        
|                                                  |                                |   |                |         |      |   |         |        
|                                                  | Net deferred tax liability     |   | $              |        |      |   | $       | 118     |  
|                                                  |                                |   |                |         |      |   |         |        

For continuing operations, the Companys income tax payments, consisting
solely of foreign income taxes, approximated $6,000, $8,000, and $6,000, for
the years ended December 31, 2003, 2002, and 2001, respectively.

At December 31, 2003, the Company had federal net operating loss (NOL)
carryforwards of approximately $63.8 million for income tax purposes, of which
approximately $6.2 million, $8.4 million, $9.1 million, $17.7 million, $19.3
million and $3.1 million expire in 2018, 2019, 2020, 2021, 2022, and 2023,
respectively. In addition, the Company had research and development tax credit
carryforwards of approximately $2.2 million of which $299,000, $306,000,
$777,000, and $828,000 expire in 2019, 2020, 2021, and 2022, 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, 2003 a valuation allowance of $26.5 million has been
recognized to offset net deferred tax assets, primarily attributable to the NOL
carry-forward. Utilization of the operating losses are subject to a limitation
due to the ownership change provisions of the Internal Revenue Code.

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

F-17



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 $228,000, $148,000, and $111,000 for 2003,
2002 and 2001, 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 2003, 2002, or 2001.

Supplemental Executive Retirement Plan

The Company has a Supplemental Executive Retirement Plan (SERP), a
nonqualified plan, which covers the Chairman and Chief Executive Officer of
Penwest. For 2003, 2002 and 2001, the net expense for the SERP was $212,000,
$85,000 and $100,000, respectively, for continuing operations, and $5,000,
$21,000 and $25,000, 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:

|                                          |  |                |       |      |  |   |       |  
|----------------------------------------- |  | -------------- | ----- | ---- |  | - | ----- | -
|                                          |  | 2003           |       | 2002
|                                          |  |                |       |     
|                                          |  | (in thousands)
|Benefit obligation at beginning of period |  | $              | 1,839 |      |  | $ | 1,580 |  
|Service cost                              |  |                | (27   | )    |  |   | (22   | )
|Interest cost                             |  |                | 122   |      |  |   | 113   |  
|Actuarial gains                           |  |                | 114   |      |  |   | 168   |  
|                                          |  |                |       |      |  |   |       |  
|Benefit obligation at December 31,        |  | $              | 2,048 |      |  | $ | 1,839 |  
|                                          |  |                |       |      |  |   |       |  

Funded status:

|                                                                          |  |                |        |      |  |   |        |  
|------------------------------------------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | -
|                                                                          |  | 2003           |        | 2002
|                                                                          |  |                |        |     
|                                                                          |  | (in thousands)
|Funded status (unfunded)                                                  |  | $              | (2,048 | )    |  | $ | (1,839 | )
|Unrecognized net transition obligation                                    |  |                | 40     |      |  |   | 100    |  
|Unrecognized prior service cost                                           |  |                | 17     |      |  |   | 31     |  
|Unrecognized net actuarial gain                                           |  |                | (177   | )    |  |   | (318   | )
|                                                                          |  |                |        |      |  |   |        |  
|Net amount recognized at December 31, (included in
deferred compensation) |  | $              | (2,168 | )    |  | $ | (2,026 | )
|                                                                          |  |                |        |      |  |   |        |  

Amounts recognized in the statement of financial position consist of:

|                                         |  |                |        |      |  |   |        |  
|---------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | -
|                                         |  | 2003           |        | 2002
|                                         |  |                |        |     
|                                         |  | (in thousands)
|Accrued benefit cost (minimum liability) |  | $              | (2,168 | )    |  | $ | (2,026 | )
|                                         |  |                |        |      |  |   |        |  
|Net amount recognized at December 31,    |  | $              | (2,168 | )    |  | $ | (2,026 | )
|                                         |  |                |        |      |  |   |        |  

Information for plans with an accumulated benefit obligation in excess of
plan assets, December 31:

|                               |  |                |       |      |  |   |       | 
|------------------------------ |  | -------------- | ----- | ---- |  | - | ----- | 
|                               |  | 2003           |       | 2002
|                               |  |                |       |     
|                               |  | (in thousands)
|Projected benefit obligation   |  | $              | 2,048 |      |  | $ | 1,839 | 
|Accumulated benefit obligation |  | $              | 1,515 |      |  | $ | 1,363 | 
|Plan assets of fair value      |  | $              |      |      |  | $ |      | 

F-18



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

Components of net periodic benefit cost:

|                                                   |  |                |     |      |  |   |     |  
|-------------------------------------------------- |  | -------------- | --- | ---- |  | - | --- | -
|                                                   |  | 2003           |     | 2002
|                                                   |  |                |     |     
|                                                   |  | (in thousands)
|Service cost                                       |  | $              | (27 | )    |  | $ | (22 | )
|Interest cost                                      |  |                | 122 |      |  |   | 113 |  
|Amortization of unrecognized transition obligation |  |                | 60  |      |  |   | 60  |  
|Amortization of prior service cost                 |  |                | 14  |      |  |   | 20  |  
|Amortization of gains                              |  |                | (26 | )    |  |   | (65 | )
|                                                   |  |                |     |      |  |   |     |  
|Net periodic benefit cost                          |  | $              | 143 |      |  | $ | 106 |  
|                                                   |  |                |     |      |  |   |     |  

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:

|                              |  |      |      |      |  |  |      |  
|----------------------------- |  | ---- | ---- | ---- |  |  | ---- | -
|                              |  | 2003 |      | 2002
|                              |  |      |      |     
|Discount rate                 |  |      | 6.25 | %    |  |  | 6.75 | %
|Rate of compensation increase |  |      | 4.0  | %    |  |  | 4.0  | %

Weighted-average assumptions used to determine net periodic benefit cost
for years ended December 31:

|                              |  |      |      |      |  |  |      |  
|----------------------------- |  | ---- | ---- | ---- |  |  | ---- | -
|                              |  | 2003 |      | 2002
|                              |  |      |      |     
|Discount rate                 |  |      | 6.75 | %    |  |  | 7.25 | %
|Rate of compensation increase |  |      | 4.0  | %    |  |  | 4.0  | %

The Company expects to make no contributions to the Plan nor any benefit
payments to the Plan participant in 2004.

Health Care and Life Insurance Benefits

The Company offers health care and life insurance benefits to most active
employees. Costs incurred for these benefits for continuing operations were
$568,000, $422,000 and $327,000 in 2003, 2002 and 2001, 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 in April 2003 and $1.25 million due May 25, 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 Company has presented its December 31,
2002 balance sheet in the consolidated financial statements to reflect the
assets and liabilities of the excipient business separately as assets held for
sale and liabilities held for sale. The gain on the Asset Sale is net of
transaction related costs totaling $3.1 million, primarily consisting of
professional and advisory fees. As of December 31, 2002, these costs
approximated $1.7 million and were reflected as deferred transaction costs on
the consolidated balance sheet. 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, and $34.2 million and $1.3 million,
respectively, for 2001.

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

F-19



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

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 operating expenses) for two
years and then pursuant to three successive one-year options at monthly rent
payments approximating $14,000, plus operating expenses.

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, a narcotic analgesic for
the treatment of moderate to severe pain, based on the Companys TIMERx
technology. 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 March 17, 2003, the Company and Endo shared the costs involved in
the development of oxymorphone ER. On March 17, 2003, the Company notified Endo
that it was discontinuing its participation in the funding of the development
and marketing of oxymorphone ER effective April 17, 2003. 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 Penwest (Unfunded Development
Costs). Endo may recoup such development costs through a temporary adjustment
in the royalty rate payable to Penwest that will return to its pre-adjustment
level once Endo has recovered such costs. Endo may also allow the Company to
reimburse Endo directly for the unfunded amounts. The Company estimates that
through December 31, 2003 Unfunded Development Costs approximated $6.7
million. The parties have agreed 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) subject to adjustment for the 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 certain 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 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 2003 of the 30 mg dosage strength version of
Pfizers generic Procardia XL totaled approximately $36.8 million. The term of
this agreement continues until such time as Mylan permanently ceases to market
generic Procardia XL.

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

F-20



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

responsibility of the Companys collaborators, the Company could
nonetheless incur significant unreimbursed costs in participating and assisting
in the litigation.

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. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

Accumulated other comprehensive income (loss) consisted of the following
at December 31:

|                                                                  |  |                |      |      |  |   |      |  
|----------------------------------------------------------------- |  | -------------- | ---- | ---- |  | - | ---- | -
|                                                                  |  | 2003           |      | 2002
|                                                                  |  |                |      |     
|                                                                  |  | (in thousands)
|Cumulative translation adjustment                                 |  | $              | 473  |      |  | $ | (583 | )
|Cumulative translation adjustment of discontinued operations sold |  |                | (473 | )    |  |   |     |  
|Unrealized gain on marketable securities                          |  |                | 43   |      |  |   | 15   |  
|                                                                  |  |                |      |      |  |   |      |  
|Accumulated other comprehensive income (loss)                     |  | $              | 43   |      |  | $ | (568 | )
|                                                                  |  |                |      |      |  |   |      |  

18. QUARTERLY FINANCIAL DATA (UNAUDITED)

Summarized quarterly financial data for the years ended December 31, 2003 and
2002 is as follows:

|                                                       |  |                                       |        |               |  |                |        |               |  |   |        |   |  |     |        |  
|------------------------------------------------------ |  | ------------------------------------- | ------ | ------------- |  | -------------- | ------ | ------------- |  | - | ------ | - |  | --- | ------ | -
|                                                       |  | Quarter Ended                        
|                                                       |  |                                      
|                                                       |  | Mar. 31, 2003                         |        | June 30, 2003 |  | Sept. 30, 2003 |        | Dec. 31, 2003
|                                                       |  | (Unaudited)                           |        | (Unaudited)   |  | (Unaudited)    |        | (Unaudited)  
|                                                       |  |                                       |        |               |  |                |        |              
|                                                       |  | (in thousands, except per share data)
|                                                       |  |                                       |        |               |  |                |        |               |  |   |        |   |  | (a)
|Total revenues                                         |  | $                                     | 1,172  |               |  | $              | 1,249  |               |  | $ | 1,016  |   |  | $   | 1,241  |  
|Gross profit                                           |  |                                       | 1,091  |               |  |                | 1,186  |               |  |   | 1,005  |   |  |     | 1,227  |  
|Loss from continuing operations                        |  |                                       | (4,787 | )             |  |                | (7,522 | )             |  |   | (5,537 | ) |  |     | (8,160 | )
|Earnings (loss) from
discontinued operations           |  |                                       | 9,757  |               |  |                | (83    | )             |  |   |       |   |  |     | 397    |  
|Net 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  | )             |  |   |       |   |  |     | 0.02   |  
|                                                       |  |                                       |        |               |  |                |        |               |  |   |        |   |  |     |        |  
|Net income (loss) per share                            |  | $                                     | 0.32   |               |  | $              | (0.49  | )             |  | $ | (0.32  | ) |  | $   | (0.42  | )
|                                                       |  |                                       |        |               |  |                |        |               |  |   |        |   |  |     |        |  

F-21



---



##### Table of Contents



PENWEST PHARMACEUTICALS CO.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

|                                                |  |                                       |        |               |  |                |        |               |  |   |        |   |  |     |        |  
|----------------------------------------------- |  | ------------------------------------- | ------ | ------------- |  | -------------- | ------ | ------------- |  | - | ------ | - |  | --- | ------ | -
|                                                |  | Quarter Ended                        
|                                                |  |                                      
|                                                |  | Mar. 31, 2002                         |        | June 30, 2002 |  | Sept. 30, 2002 |        | Dec. 31, 2002
|                                                |  | (Unaudited)                           |        | (Unaudited)   |  | (Unaudited)    |        | (Unaudited)  
|                                                |  |                                       |        |               |  |                |        |              
|                                                |  | (in thousands, except per share data)
|                                                |  |                                       |        |               |  |                |        |               |  |   |        |   |  | (b)
|Total revenues                                  |  | $                                     | 1,115  |               |  | $              | 1,268  |               |  | $ | 1,681  |   |  | $   | 1,473  |  
|Gross profit                                    |  |                                       | 1,089  |               |  |                | 1,233  |               |  |   | 1,622  |   |  |     | 1,423  |  
|Loss from continuing operations                 |  |                                       | (4,819 | )             |  |                | (6,024 | )             |  |   | (4,943 | ) |  |     | (3,242 | )
|Earnings from discontinued operations           |  |                                       | 501    |               |  |                | 706    |               |  |   | 467    |   |  |     | 255    |  
|Net loss                                        |  | $                                     | (4,318 | )             |  | $              | (5,318 | )             |  | $ | (4,476 | ) |  | $   | (2,987 | )
|                                                |  |                                       |        |               |  |                |        |               |  |   |        |   |  |     |        |  
|Loss from continuing operations per
share       |  | $                                     | (0.31  | )             |  | $              | (0.39  | )             |  | $ | (0.32  | ) |  | $   | (0.21  | )
|Earnings from discontinued
operations per share |  |                                       | 0.03   |               |  |                | 0.05   |               |  |   | 0.03   |   |  |     | 0.02   |  
|                                                |  |                                       |        |               |  |                |        |               |  |   |        |   |  |     |        |  
|Net loss per share                              |  | $                                     | (0.28  | )             |  | $              | (0.34  | )             |  | $ | (0.29  | ) |  | $   | (0.19  | )
|                                                |  |                                       |        |               |  |                |        |               |  |   |        |   |  |     |        |  



|(a) |  | During the fourth quarter of 2003, the following adjustments were recorded:
|--- |  | ---------------------------------------------------------------------------



| | i) |  | 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.
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(b) |  | During the fourth quarter of 2002, the following adjustments were
recorded:
|--- |  | ---------------------------------------------------------------------------



| | i)   |  | The Company recorded the reimbursement of approximately $780,000 of
costs from one of its collaborators, a reduction of research and product
development expense.
| | ---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | ii)  |  | The Company recorded an adjustment of approximately $317,000 to reduce
the accrual for 2002 bonuses.                                                             
|
| | iii) |  | The Company recorded an impairment loss of approximately $121,000, net of
accumulated amortization, relating to its patents.                                     

F-22



---



##### Table of Contents



SCHEDULE II  VALUATION AND QUALIFYING ACCOUNTS

PENWEST PHARMACEUTICALS CO.
DECEMBER 31, 2003
(in thousands)

|                             |                                 |  |   |            |  |            |   |           |   |             |   |            |  |            |   |    |     |  |   |    |  | 
|---------------------------- | ------------------------------- |  | - | ---------- |  | ---------- | - | --------- | - | ----------- | - | ---------- |  | ---------- | - | -- | --- |  | - | -- |  | 
|                             |                                 |  |   |            |  |            |   |           |   |             |   | Charged to |  |            |   |    |     |  |   |   
|                             |                                 |  |   | Balance at |  | Charged to |   | Other     |   |             |   |            |  | Balance at
|                             |                                 |  |   | Beginning  |  | Costs and  |   | Accounts- |   | Deductions- |   | End of    
|                             |                                 |  |   | of Period  |  | Expenses   |   | Describe  |   | Describe    |   | Period    
|                             |                                 |  |   |            |  |            |   |           |   |             |   |           
|Year ended December 31, 2003 |                                 |  |   |            |  |            |   |           |   |             |   |            |  |            |   |    |     |  |   |   
|                             | Allowance for Doubtful Accounts |  | $ |           |  |            | $ |          |   |             | $ |           |  |            | $ |   |     |  | $ |   | 
|                             | Inventory Allowances            |  | $ | 16         |  |            | $ | 113       |   |             | $ |           |  |            | $ | 47 | (a) |  | $ | 82 | 
|                            
|Year ended December 31, 2002 |                                 |  |   |            |  |            |   |           |   |             |   |            |  |            |   |    |     |  |   |   
|                             | Allowance for Doubtful Accounts |  | $ | 50         |  |            | $ | (50       | ) |             | $ |           |  |            | $ |   |     |  | $ |   | 
|                             | Inventory Allowances            |  | $ | 6          |  |            | $ | 12        |   |             | $ |           |  |            | $ | 2  | (a) |  | $ | 16 | 
|                            
|Year ended December 31, 2001 |                                 |  |   |            |  |            |   |           |   |             |   |            |  |            |   |    |     |  |   |   
|                             | Allowance for Doubtful Accounts |  | $ | 52         |  |            | $ | (2        | ) |             | $ |           |  |            | $ |   |     |  | $ | 50 | 
|                             | Inventory Allowances            |  | $ |           |  |            | $ | 6         |   |             | $ |           |  |            | $ |   |     |  | $ | 6  | 

(a)  Disposals of unrecoverable inventory costs.

S-1



---



##### Table of Contents






INDEX TO EXHIBITS

|           |  |                                                                                                                                                                                      
|---------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT    |  |                                                                                                                                                                                      
|NO.        |  | DESCRIPTION                                                                                                                                                                          
|           |  |                                                                                                                                                                                      
|2.1(1)     |  | Purchase Agreement by and between Penwest Pharmaceuticals Co. and Josef Rettenmaier Holding
GmBh & Co. KG, dated November 1, 2002.                                                   
|           |  |                                                                                                                                                                                      
|2.2(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.
|           |  |                                                                                                                                                                                      
|3.1(3)     |  | Amended and Restated Articles of Incorporation                                                                                                                                       
|           |  |                                                                                                                                                                                      
|3.2(4)     |  | Articles of Amendment to the Amended and Restated Articles of Incorporation filed on June
19, 1998.                                                                                  
|           |  |                                                                                                                                                                                      
|3.3(3)     |  | Amended and Restated Bylaws of the Company.                                                                                                                                          
|           |  |                                                                                                                                                                                      
|3.4(5)     |  | Designation of Rights and Preference of Series A Junior Participating Preferred Stock of
the Company filed on July 17, 1998.                                                         
|           |  |                                                                                                                                                                                      
|4.1(3)     |  | Specimen certificate representing the Common Stock.                                                                                                                                  
|           |  |                                                                                                                                                                                      
|4.2(5)     |  | Form of Rights Agreement dated as of July 27, 1998 between the Company and the Rights Agent.                                                                                         
|           |  |                                                                                                                                                                                      
|10.1(3)+   |  | Product Development and Supply Agreement dated August 17, 1994 by and between the
Registrant and Mylan Pharmaceuticals Inc.                                                          
|           |  |                                                                                                                                                                                      
|10.2(3)+   |  | Sales and Distribution Agreement dated January 3, 1997 by and between the Registrant and
Mylan Pharmaceuticals, Inc.                                                                 
|           |  |                                                                                                                                                                                      
|10.3(4)    |  | Form of Separation and Distribution Agreement entered into between Registrant and Penford
Corporation                                                                                
|           |  |                                                                                                                                                                                      
|10.4(3)+   |  | Product Development, License and Supply Agreement dated February 28, 1997 by and between
the Registrant and Sanofi Winthrop S.A., as amended.                                        
|           |  |                                                                                                                                                                                      
|10.5(3)+   |  | Agreement dated May 26, 1995 by and between the Registrant and Leiras OY.                                                                                                            
|           |  |                                                                                                                                                                                      
|10.6(3)+   |  | Agreement dated July 27, 1992 by and between the Registrant and Leiras, OY.                                                                                                          
|           |  |                                                                                                                                                                                      
|10.7(6)+   |  | Amended and Restated Strategic Alliance Agreement, dated as of April 2, 2002, by and
between Endo Pharmaceuticals Holdings Inc. and the Company                                      
|           |  |                                                                                                                                                                                      
|10.8(3)++  |  | 1997 Equity Incentive Plan.                                                                                                                                                          
|           |  |                                                                                                                                                                                      
|10.9(3)++  |  | 1997 Employee Stock Purchase Plan.                                                                                                                                                   
|           |  |                                                                                                                                                                                      
|10.10(4)++ |  | 1998 Spinoff Option Plan.                                                                                                                                                            
|           |  |                                                                                                                                                                                      
|10.11(3)   |  | Form of Excipient Supply Agreement entered into between the Registrant and Penford
Corporation.                                                                                      
|           |  |                                                                                                                                                                                      
|10.12(4)   |  | Form of Tax Allocation Agreement entered into between the Registrant and Penford Corporation                                                                                         
|           |  |                                                                                                                                                                                      
|10.13(3)   |  | Recognition and Incentive Agreement dated as of May 14, 1990 between the Registrant and
Anand Baichwal, as amended.                                                                  
|           |  |                                                                                                                                                                                      
|10.14(4)+  |  | License Agreement dated December 17, 1997 between Synthelabo and the Registrant.                                                                                                     
|           |  |                                                                                                                                                                                      
|10.15(4)+  |  | Supply Agreement dated December 17, 1997 between Synthelabo and the Registrant.                                                                                                      
|           |  |                                                                                                                                                                                      
|10.16(11)  |  | Manufacturing Agreement dated September 27, 1999 between the Company and Draxis Pharma, Inc.                                                                                         
|           |  |                                                                                                                                                                                      
|10.17(7)   |  | Royalty Agreement dated September 25, 1992 between the Company and John N. Staniforth.                                                                                               
|           |  |                                                                                                                                                                                      
|10.18(7)   |  | Confidentiality, Consulting and Noncompetition Agreement dated September 25, 1992 between
the Company and John N. Staniforth.                                                        
|           |  |                                                                                                                                                                                      
|10.19 (8)  |  | Lease Agreement dated as of February 3, 2003 by and between Union Carbide Corporation and
the Registrant.                                                                            
|           |  |                                                                                                                                                                                      
|10.20 (9)  |  | Securities Purchase Agreement dated as of August 1, 2003 by and among the Registrant and
the purchasers identified therein.                                                          
|           |  |                                                                                                                                                                                      
|10.21(10)  |  | Securities Purchase Agreement dated as of August 4, 2003 by and among the Registrant and
the purchasers identified therein.                                                          





---



##### Table of Contents



|        |  |                                                                                                                                                                                             
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT |  |                                                                                                                                                                                             
|NO.     |  | DESCRIPTION                                                                                                                                                                                 
|        |  |                                                                                                                                                                                             
|23      |  | Consent of Ernst & Young LLP                                                                                                                                                                
|        |  |                                                                                                                                                                                             
|31.1    |  | 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.                                 
|        |  |                                                                                                                                                                                             
|31.2    |  | 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.                                 
|        |  |                                                                                                                                                                                             
|32.1    |  | 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.
|        |  |                                                                                                                                                                                             
|32.2    |  | 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.



|(1)  |  | Incorporated by reference to Exhibit A to the Registrants definitive
proxy statement filed with the Securities and Exchange Commission on
January 31, 2003.                
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    
|(2)  |  | Incorporated by reference to Exhibits to the Registrants Current Report
on Form 8-K (No. 000-23467) filed with the Commission on February 28,
2003.                         
|    
|(3)  |  | Incorporated by reference to Exhibits to the Registrants Registration
Statement on Form S-1 (File No. 333-38389).                                                          
|    
|(4)  |  | Incorporated by reference to Exhibits to the Registrants Registration
Statement on Form 10 (No. 000-23467) filed with the Commission on June 22,
1998.                     
|    
|(5)  |  | Incorporated by reference to Exhibits to Amendment No. 1 to the
Registrants Registration Statement on Form 10/A (No. 000-23467) filed
with the Commission on July 17, 1998.
|    
|(6)  |  | Incorporated by reference to Exhibits to the Registrants Quarterly
Report on Form 10-Q (No. 000-23467) for the quarterly period ended June
30, 2002.                       
|    
|(7)  |  | Incorporated by reference to Exhibits to the Registrants Quarterly
Report on Form 10-Q (No. 000-23467) for the quarterly period ended March
31, 2002.                      
|    
|(8)  |  | Incorporated by reference to Exhibits to the Registrants Quarterly
Report on Form 10-Q (No. 000-23467) for the quarterly period ended March
31, 2003.                      
|    
|(9)  |  | Incorporated by reference to Exhibits to the Registrants Current Report
on Form 8-K (No. 000-23467) filed with the Commission on August 5, 2003.                           
|    
|(10) |  | Incorporated by reference to Exhibits to the Registrants Current Report
on Form 8-K (No. 000-23467) filed with the Commission on August 6, 2003.                           
|    
|(11) |  | Incorporated by reference to Exhibits to the
Registrants Annual Report
on Form 10-K (No. 000-23467) for the year ended
December 31, 1999.                                  
|    
|+    |  | Confidential treatment granted as to certain portions, which portions
are omitted and filed separately with the Commission.                                                 
|    
|++   |  | Management contract or compensatory plan or arrangement required to be
filed as an exhibit to this annual report on Form 10-K.