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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 Form 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended March 31, 2005oro
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from          to
 Commission File No. 000-23467 Penwest Pharmaceuticals Co. 
 (Exact name of registrant as specified in its charter)
 Washington
    
    91-1513032(State of Incorporation)
    
    (I.R.S. Employer Identification No.)39 Old Ridgebury Road, Suite 11,
Danbury, Connecticut
    
    06810-5120(Address of principal executive offices)
    
    (Zip Code)
 (877) 736-9378(Registrants telephone number, including area code.) Indicate by a 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 the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act).
Yes þ No o Indicate the number of shares outstanding of each of the issuers classes of common
stock, as of May 6, 2005 Class
    
    OutstandingCommon stock, par value $.001
    
    
    21,727,201
   - 1 -




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PENWEST PHARMACEUTICALS CO.
TABLE OF CONTENTS  
 PagePART I  FINANCIAL INFORMATIONItem 1.
    
    Condensed Financial Statements (Unaudited)Condensed Balance Sheets
    
    
    3Condensed Statements of Operations
    
    
    4Condensed Statements of Cash Flows
    
    
    5Notes to Condensed Financial Statements
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    30Item 4.
    
    Controls and Procedures
    
    
    30PART II  OTHER INFORMATIONItem 6.
    
    Exhibits
    
    
    31Signature
    
    
    32Exhibit Index
    
    
    33Ex-10.1 Severance and Settlement Agreement and ReleaseEx-10.2 Supplemental Executive Retirement PlanEx-10.3 Deferred Compensation PlanEx-10.4 Offer Letter to Robert J. HennesseyEx-31.1 Section 302 Certification of the C.E.O.Ex-31.2 Section 302 Certification of the C.F.O.EX-32.1 SECTION 906 CERTIFICATION OF CEOEx-32.2 Section 906 Certification of the C.F.O.
  TIMERx® is a registered trademark of the Company. Geminex® and SyncroDose are also trademarks
of the Company. Other tradenames and trademarks appearing in this quarterly report are the property
of their respective owners. 2




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PART I  FINANCIAL INFORMATION 
 Item 1.Condensed Financial Statements (Unaudited) PENWEST PHARMACEUTICALS CO. 
 CONDENSED BALANCE SHEETS
 March 31,
    
    
    December 31,2005
    
    
    2004(Unaudited)
    
    
    (Note 2)(In thousands,except share amounts)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    18,255
    
    
    $
    14,249Marketable securities
    
    
    48,499
    
    
    
    60,121Trade accounts receivable
    
    
    1,042
    
    
    
    1,126Inventories:Raw materials and other
    
    
    120
    
    
    
    134Finished goods
    
    
    457
    
    
    
    509Total inventories
    
    
    577
    
    
    
    643Prepaid expenses and other current assets
    
    
    778
    
    
    
    1,143Total current assets
    
    
    69,151
    
    
    
    77,282Fixed assets, net
    
    
    3,468
    
    
    
    3,674Patents, net
    
    
    3,470
    
    
    
    3,504Cash surrender value of life insurance policies
    
    
    3,101
    
    
    
    3,062Total assets
    
    $
    79,190
    
    
    $
    87,522LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,066
    
    
    $
    2,396Accrued expenses
    
    
    1,500
    
    
    
    1,966Accrued development costs
    
    
    630
    
    
    
    974Deferred compensation  current portion
    
    
    278
    
    
    
    Total current liabilities
    
    
    3,474
    
    
    
    5,336Other liabilities
    
    
    152
    
    
    
    Deferred revenues
    
    
    67
    
    
    
    71Deferred compensation
    
    
    3,086
    
    
    
    3,314Total liabilities
    
    
    6,779
    
    
    
    8,721Shareholders equity:Preferred stock, par value $.001, authorized 1,000,000 shares, none outstanding
    
    
    
    
    
    
    Common stock, par value $.001, authorized 60,000,000 shares, issued and
outstanding 21,725,254 shares at March 31, 2005 and 21,692,730 shares at
December 31, 2004
    
    
    22
    
    
    
    22Additional paid in capital
    
    
    199,733
    
    
    
    197,097Accumulated deficit
    
    
    (127,165
    )
    
    
    (118,218
    )Accumulated other comprehensive loss
    
    
    (179
    )
    
    
    (100
    )Total shareholders equity
    
    
    72,411
    
    
    
    78,801Total liabilities and shareholders equity
    
    $
    79,190
    
    
    $
    87,522
 See accompanying notes to condensed financial statements. 3




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PENWEST PHARMACEUTICALS CO. 
 CONDENSED STATEMENTS OF OPERATIONS
 Three Months EndedMarch 31,2005
    
    
    2004(Unaudited)(In thousands, exceptper share data)Revenues:Royalties and licensing fees
    
    $
    982
    
    
    $
    1,261Product sales
    
    
    
    
    
    
    222Total revenues
    
    
    982
    
    
    
    1,483Cost of revenues
    
    
    8
    
    
    
    49Gross profit
    
    
    974
    
    
    
    1,434Operating expenses:Selling, general and administrative
    
    
    5,292
    
    
    
    2,336Research and product development
    
    
    5,065
    
    
    
    4,089Total operating expenses
    
    
    10,357
    
    
    
    6,425Loss from operations
    
    
    (9,383
    )
    
    
    (4,991
    )Investment income
    
    
    436
    
    
    
    213Loss before income tax expense
    
    
    (8,947
    )
    
    
    (4,778
    )Income tax expense
    
    
    
    
    
    
    Net loss
    
    $
    (8,947
    )
    
    $
    (4,778
    )Net loss per common share
    
    $
    (0.41
    )
    
    $
    (0.26
    )Weighted average shares of common stock outstanding
    
    
    21,656
    
    
    
    18,410
 See accompanying notes to condensed financial statements. 4




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PENWEST PHARMACEUTICALS CO. 
 CONDENSED STATEMENTS OF CASH FLOWS
 Three Months EndedMarch 31,2005
    
    
    2004(Unaudited)(In thousands)Operating activities:Net loss
    
    $
    (8,947
    )
    
    $
    (4,778
    )Adjustments to reconcile net loss to net cash used in operating activities
    
    
    1,425
    
    
    
    (1,970
    )Net cash used in operating activities
    
    
    (7,522
    )
    
    
    (6,748
    )Investing activities:Acquisitions of fixed assets, net
    
    
    (66
    )
    
    
    (218
    )Patent costs
    
    
    (82
    )
    
    
    (129
    )Proceeds from maturities of marketable securities
    
    
    6,153
    
    
    
    10,370Proceeds from sales of marketable securities
    
    
    23,850
    
    
    
    4,000Purchases of marketable securities
    
    
    (18,426
    )
    
    
    (11,400
    )Net cash provided by investing activities
    
    
    11,429
    
    
    
    2,623Financing activities:Issuance of common stock, net
    
    
    99
    
    
    
    923Net cash provided by financing activities
    
    
    99
    
    
    
    923Net increase in cash and cash equivalents
    
    
    4,006
    
    
    
    (3,202
    )Cash and cash equivalents at beginning of period
    
    
    14,249
    
    
    
    8,241Cash and cash equivalents at end of period
    
    $
    18,255
    
    
    $
    5,039
 See accompanying notes to condensed financial statements. 5




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PENWEST PHARMACEUTICALS
CO. 
 NOTES TO CONDENSED
FINANCIAL STATEMENTS
 (Unaudited)
 1. Business Penwest
Pharmaceuticals Co. (the Company or Penwest) develops pharmaceutical products based on
innovative proprietary oral drug delivery technologies. The Company is focusing its development
efforts principally on products that address diseases of the central nervous system. The two most
advanced products in the Companys drug development pipeline are oxymorphone ER, an extended
release formulation of oxymorphone, a narcotic analgesic being developed for twice-a-day dosing in
patients with moderate to severe pain requiring continuous around-the-clock opioid therapy for an
extended period of time, and PW2101, a beta blocker intended for the treatment of hypertension and
angina. The Company is also developing additional product candidates in areas such as edema,
epilepsy, schizophrenia, depression and pain. The Company is subject to the risks and uncertainties associated with drug development. These
risks and uncertainties include, but are not limited to, a history of net losses, technological
changes, dependence on collaborators and key personnel, the successful completion of development
efforts and of obtaining regulatory approval, the successful commercialization of TIMERx controlled
release products, compliance with government regulations, patent infringement litigation and
competition from current and potential competitors, some with greater resources than the Company,
dependence on third party manufactures and a requirement for additional funding. 2. Basis of Presentation The accompanying unaudited condensed financial statements have been prepared in accordance
with U.S. generally accepted accounting principles for interim financial information and with the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by U.S. generally accepted accounting principles for
complete financial statements. In the opinion of management, all adjustments considered necessary
for a fair presentation for the interim periods presented have been included. All such adjustments
are of a normal recurring nature, except for a $3.0 million compensation charge recorded in the
three months ended March 31, 2005 (see Note 7). Operating results for the quarter ended March 31,
2005 are not necessarily indicative of the results that may be expected for the year ending
December 31, 2005. For further information, refer to the financial statements and footnotes thereto
included in the Companys Annual Report on Form 10-K for the year ended December 31, 2004. The balance sheet at December 31, 2004, has been derived from the audited financial statements
at that date but does not include all of the information and footnotes required by U.S. generally
accepted accounting principles for complete financial statements. Certain prior year amounts have been reclassified to conform to the current year presentation,
including the reclassification of approximately $24.5 million of auction rate securities at March
31, 2004 as marketable securities, rather than cash equivalents as previously reported. These
reclassifications had no impact on the Companys financial position or results of operations. 3. Summary of Significant Accounting Policies Revenue Recognition Royalties and licensing fees- The Company recognizes revenues from non-refundable upfront
licensing fees received under collaboration agreements ratably over the development period of the
related collaboration agreement when this period involves development risk associated with the
incomplete stage of a products development, or over the estimated or contractual licensing and
supply term when there exists an obligation to supply inventory for manufacture. Non-refundable
milestone fees received for the development funding of a product are partially 6




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited) recognized upon receipt based on the Companys proportionate development efforts achieved to
date relative to the total expected development efforts and the remainder is generally recognized
ratably over the remaining expected development period. The proportionate development efforts
achieved are measured by estimating the percentage of work completed that is required of the
Company in the development effort for the product. This estimate is primarily derived from the
underlying project plans and timelines, developed by qualified personnel who work closely on such
projects. In particular, the Company reviews output measures such as job specifications and tasks
completed, compared to all such job specifications and tasks outlined for a particular project. Job
specifications vary with each project and primarily include development activities regarding
initial formulation work, manufacturing scale-up, proof-of-principle biostudies, clinical
development and regulatory matters. Other contractual fees received in connection with a
collaborators launch of a product are also recognized ratably over the estimated or contractual
licensing and supply term. Product royalty fees are recognized when earned, as reported by the
Companys collaborators, and are generally subject to review or audit by the Company. Product sales The Company recognizes revenues from product sales when title transfers and
customer acceptance provisions have lapsed, provided that collections of the related accounts
receivable are probable. Shipping and handling costs are included in cost of revenues. Research and Development Expenses Research and development expenses consist of costs associated with products being developed
internally as well as products being developed under collaboration agreements and include related
salaries, benefits and other personnel related expenses, clinical trial costs, and contract and
other outside service fees. Research and development costs are expensed as incurred. A significant
portion of the Companys development activities are outsourced to third parties including contract
research organizations, and contract manufacturers in connection with the production of clinical
materials, or may be performed by the Companys collaborators. These arrangements may require
estimates to be made of related service fees or the Companys share of development costs, in which
actual results could materially differ from the estimates and affect the reported amounts in the
Companys financial statements. These arrangements may also require the Company to pay termination
costs to the third parties for reimbursement of costs and expenses incurred in the orderly
termination of contractual services. Income Taxes The liability method, prescribed by Statement of Financial Accounting Standards (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 the three month periods ended March 31, 2005 and 2004, 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. Impairment of Long-Lived Assets 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. Stock-Based Compensation The
Company follows the disclosure provisions of SFAS No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure, which amended SFAS No. 123, Accounting for Stock-Based
Compensation. 7




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited) SFAS No. 148 provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation, which was originally
provided under SFAS No. 123. SFAS No. 148 also improves the timeliness of disclosures by requiring
the information to be included in interim as well as annual financial statements. At March 31, 2005, the Company maintained three stock-based employee compensation plans. The
Company accounts for these employee stock compensation plans in accordance with the intrinsic
value-based method prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting
for Stock Issued to Employees. Prior to October 1, 2004, non-employee members of the Companys
board of directors could elect to receive retainer and meeting fees in either cash or in the form
of discounted stock options. On October 1, 2004, the Company adopted a new compensation program for
non-employee directors. Under the new program, non-employee directors are offered the opportunity
to receive retainer and meeting fees in cash, unrestricted common stock or both, instead of
discounted stock options. In addition, under both non-employee director compensation programs,
non-employee directors were periodically granted restricted stock that vests over four years as
long as the director continues to be a member of the Companys board of directors. During the
three month periods ended March 31, 2005 and 2004, in connection with the non-employee director
compensation programs and fees earned by members of the Companys scientific advisory board, the
Company recognized $0 and $20,000, respectively, of expense associated with the issuance of
discounted stock options; $27,000 and $0 respectively, of expense associated with unrestricted
stock grants; and $112,000 and $38,000, respectively, of expense associated with restricted stock
grants. In addition, during the three months ended March 31,
2005, the Company recognized $2.4
million in compensation expense in connection with the accelerated vesting and extension of
exercise periods of certain stock options (see Note 7). 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, or were
otherwise non-compensatory in accordance with APB Opinion No. 25, as with respect to employee
purchases of Common Stock under the Companys Employee Stock Purchase Plan. 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: Three Months EndedMarch 31,2005
    
    
    2004(Unaudited)(in thousands, exceptper share data)Net loss  as reported
    
    $
    (8,947
    )
    
    $
    (4,778
    )Stock-based compensation expense included in reported net loss
    
    
    2,537
    
    
    
    58Stock-based compensation under fair value method
    
    
    (1,604
    )
    
    
    (853
    )Net loss  pro forma after stockbased compensation under
fair value method
    
    $
    (8,014
    )
    
    $
    (5,573
    )Net loss per share, basic and diluted  as reported
    
    $
    (0.41
    )
    
    $
    (0.26
    )Net loss per share, basic and diluted  pro forma after
stock-based compensation under fair value method
    
    $
    (0.37
    )
    
    $
    (0.30
    )
 4. Recent Accounting Pronouncements In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123R,
Share-Based Payment (Revised 2004), which requires companies to recognize in the income statement
the fair value of all employee share-based payments, including grants of employee stock options as
well as compensatory employee stock purchase plans. Accordingly, SFAS 123R eliminates the ability
to account for share-based compensation using APB Opinion No. 25, and the pro forma disclosures
previously permitted under SFAS 123 no longer will be an alternative to financial statement
recognition. See Stock Based Compensation above for the pro forma net loss and net loss per share
amounts for the three month periods ended March 31, 2005 and 2004, as if the Company had used a
fair-value-based method similar to the methods required under SFAS 123R to measure compensation
expense for employee stock incentive awards. In April 2005, the Securities and Exchange Commission
(the SEC) deferred the 8




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited) required implementation date of SFAS 123R. As a result, the Company anticipates implementing
SFAS No. 123R effective January 1, 2006, rather than the initial implementation date of July 1,
2005. Although the Company has not determined whether the adoption of SFAS 123R will result in
amounts that are similar to the current pro forma disclosures under SFAS 123, the Company is
evaluating the requirements under SFAS 123R including the valuation methods and support for the
assumptions that underlie the valuation of the awards, as well as the transition methods (modified
prospective transition method or the modified retrospective transition method) and expects the
adoption to have a significant impact on the Companys statements of operations and net loss per
share. In November 2004, the FASB issued SFAS No. 151, Inventory Costs  an amendment of ARB No. 43,
Chapter 4. This Statement amends the guidance in Accounting Research Bulletin (ARB) No. 43,
Chapter 4, Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility
expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4,
previously stated that ...under some circumstances, items such as idle facility expense, excessive
spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as
current period charges... SFAS No. 151 requires that those items be recognized as current-period
charges regardless of whether they meet the criterion of so abnormal. In addition, SFAS No. 151
requires that allocation of fixed production overheads to the costs of conversion be based on the
normal capacity of the production facilities. The provisions of SFAS No. 151 shall be effective for
inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of SFAS
No. 151 is not expected to have a material effect on the Companys results of operations, financial
position or cash flows. Other pronouncements issued by the FASB or other authoritative accounting standards groups
with future effective dates are either not applicable or not significant to the financial
statements of the Company. 5. Issuance of Common Stock On December 14, 2004, the Company completed the sale of a total of 3,125,000 shares of common
stock through a private placement to selected institutional investors, resulting in net proceeds to
the Company, after fees and expenses, of approximately $32.8 million. The Company intends to use
the net proceeds to fund the continued research, development, marketing and commercialization of its products
and technologies, and for general corporate purposes. 6. Income Taxes The Companys effective tax rates for the three month periods ended March 31, 2005 and 2004
were zero. The effective tax rates are higher than the federal statutory rate of a 34% benefit
primarily due to valuation allowances recorded to offset deferred tax assets relating to the
Companys net operating losses. 7. Compensation Charge On February 14, 2005, Tod R. Hamachek resigned from his positions as the Companys Chief
Executive Officer and Chairman of the Board of Directors and as a member of the Board, and entered
into a Severance and Settlement Agreement and Release with the Company (the Agreement). Under the
Agreement, the Company agreed that, in consideration of Mr. Hamacheks release and other agreements
under the Agreement, it would pay Mr. Hamachek eighteen months base salary ($594,000) as severance
pay, pay all premium costs relating to medical insurance continuation coverage and provide certain
other benefits. The Company also agreed to accelerate in full the vesting of all stock options held
by Mr. Hamachek and to extend the period during which he could exercise his stock options to the
earlier of two years or their original expiration date. In connection with this Agreement, the
Company recorded a charge to its statement of operations totaling approximately $3.0 million in the
three months ended March 31, 2005. This charge, included in selling, general and administrative
expense in the Companys condensed statements of operations, includes a non-cash charge of
approximately $2.4 million relating to the stock options noted above. As of February 14, 2005, Mr.
Hamachek had options to purchase approximately 820,000 shares of common stock, of which the vesting
of stock options to purchase approximately 146,000 were accelerated. 9




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited) 8. Employment Agreement On February 15, 2005, the Company and Robert J. Hennessey, a director of the Company, entered
into an Offer Letter (the Offer Letter) in connection with the Companys appointment of Mr.
Hennessey as Chief Executive Officer and President of the Company. Under the Offer Letter, the
Company agreed to pay Mr. Hennessey an annual base salary of $400,000 and grant to Mr. Hennessey
non-statutory stock options to purchase 100,000 shares of the Companys common stock under the
Companys 1997 Equity Incentive Plan at an exercise price equal to $10.10, the fair market value of
the common stock on February 15, 2005. Mr. Hennesseys stock options vest in 12 equal monthly
installments and will become fully vested on February 15, 2006, subject to acceleration upon the
occurrence of a change in control of the Company. 9. Supplemental Executive Retirement Plan and Deferred Compensation Plan The Company has a Supplemental Executive Retirement Plan (SERP), a nonqualified plan, which
covers the Companys former Chairman and Chief Executive Officer, Mr. Hamachek. On February 14,
2005, Mr. Hamachek resigned from his positions as Chairman and Chief Executive Officer (see Note
7). Under the SERP, Mr. Hamachek is eligible for benefit payments. Accordingly, under the SERP,
commencing in May 2005, the Company will pay Mr. Hamachek approximately $12,600 per month over the
lives of Mr. Hamachek and his spouse, in accordance with Mr. Hamacheks elections. The actuarially
determined liability for the SERP was approximately $2,334,000 and $2,303,000 as of March 31, 2005
and December 31, 2004, respectively, including the current portion of approximately $139,000 at
March 31, 2005, and is included in deferred compensation in the Companys condensed balance sheets.
The Company has not funded this liability and no assets are held by the SERP. The Company uses a
measurement date of December 31 for its SERP. The following disclosures summarize information
relating to the SERP: Components of net periodic benefit cost: Three Months EndedMarch 31,2005
    
    
    2004(in thousands)Service cost
    
    $
    
    
    
    $
    (8
    )Interest cost
    
    
    30
    
    
    
    31Amortization of net obligation at transition
    
    
    
    
    
    
    10Amortization of prior service cost
    
    
    1
    
    
    
    1Net periodic benefit cost
    
    $
    31
    
    
    $
    34
 In addition, the Company has a Deferred Compensation Plan (DCP), a nonqualified plan, which
covers Mr. Hamachek. The interest expense for the DCP totaled $19,000 and $18,000, for the three
month periods ended March 31, 2005 and 2004, respectively. The liability for the DCP was
approximately $1,030,000 and $1,011,000 as of March 31, 2005 and December 31, 2004, respectively,
including the current portion of approximately $139,000 at March 31, 2005, and is included in
deferred compensation on the Companys condensed balance sheets. The Company has not funded this
liability and no assets are held by the DCP. In connection with the resignation and retirement of
Mr. Hamachek in February 2005 (see Note 7), commencing in May 2005, the Company will pay Mr.
Hamachek approximately $140,000 per year including interest under the DCP in ten annual
installments. The Company has two whole-life insurance policies in a rabbi trust, the cash surrender value
or death benefits of which are held in trust for the SERP and DCP liabilities. The Company is
entitled to borrow against these policies to fund these liabilities as provided by the terms of the
trust. The cash surrender value of these polices totaled $3,101,000 as of March 31, 2005, and is
presented separately on the Companys condensed balance sheets. 10




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited) 10. Comprehensive Loss The components of comprehensive loss for the three month periods ended March 31, 2005 and 2004
are as follows: Three Months EndedMarch 31,2005
    
    
    2004(Unaudited)(in thousands)Net loss
    
    $
    (8,947
    )
    
    $
    (4,778
    )Change in unrealized net gains and losses
on marketable securities
    
    
    (79
    )
    
    
    33Comprehensive loss
    
    $
    (9,026
    )
    
    $
    (4,745
    )
 Accumulated other comprehensive loss equals the cumulative unrealized net gains and losses on
marketable securities, which are the only components of other comprehensive loss included in the
Companys condensed financial statements. 11. Licensing Agreements The Company enters into collaborative arrangements with pharmaceutical companies to develop,
manufacture or market products formulated with its drug delivery technologies. Endo Pharmaceuticals, Inc. In September 1997, the Company entered into a strategic alliance agreement with Endo
Pharmaceuticals, Inc. with respect to the development of oxymorphone ER, an extended release
formulation of oxymorphone, based on the Companys TIMERx technology. Oxymorphone ER is a narcotic
analgesic for the treatment of moderate to severe pain in patients requiring continuous
around-the-clock opioid therapy for an extended period of time. This agreement was amended and
restated in April 2002. Endo has a broad product line including established brands such as
Percodan®, Percocet®, and Lidoderm®. Endo is registered with the U.S. Drug Enforcement
Administration as a developer, manufacturer and marketer of controlled narcotic substances. Under the strategic alliance agreement, the responsibilities of the Company and Endo with
respect to the oxymorphone product are determined by a committee comprised of an equal number of
members from each of the Company and Endo (the Alliance Committee). During the development of the
product, the Company formulated oxymorphone ER, and Endo conducted all clinical studies and
prepared and filed all regulatory applications. The Company has agreed to supply TIMERx material to
Endo, and Endo has agreed to manufacture and market oxymorphone ER in the United States. The
manufacture and marketing outside of the United States may be conducted by the Company, Endo or a
third party, as determined by the Alliance Committee. Prior to April 17, 2003, the Company shared with Endo the costs involved in the development
and pre-marketing of oxymorphone ER. On April 17, 2003, the Company discontinued its participation
in the funding of the development and pre-marketing of oxymorphone ER. The Company took this action
because the Company believed that its strategic focus should be on funding other products in its
development pipeline. As a result of this termination of funding, Endo has the right to complete
the development of oxymorphone ER and recoup the portion of development and pre-marketing costs
incurred by Endo that otherwise would have been funded by Penwest. Endo may recoup such development
costs through a temporary adjustment in the royalty rate payable to the Company, which will return
to its pre-adjustment level once Endo has recovered such costs. Endo may also allow Penwest to
reimburse them directly for the unfunded amounts. The Company estimates that through January 31,
2005, these unfunded costs approximated $15.0 million. The Company expects these costs to increase
as Endo completes the ongoing pivotal trial as well as other studies and incurs pre-launch
marketing costs. The Company has agreed with Endo that the party marketing oxymorphone ER will pay
the other party royalties initially equal to 50% of the net realization as defined in the agreement
between Endo and Penwest, subject to adjustment for unfunded development costs. This percentage
will decrease if the aggregate U.S. net realization exceeds pre-determined thresholds. In 11




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited) general, the royalty payable by the marketing party to the other party will not drop below
40%. However, the royalty will be reduced by one-third in limited circumstances, including
termination of the agreement based on uncured material breaches of the agreement by the royalty
receiving party and specified bankruptcy and insolvency events involving the royalty receiving
party. Under the agreement, Endo will purchase formulated TIMERx material for use in oxymorphone ER
exclusively from the Company at specified prices, and include these purchases in cost of goods sold
of the product prior to determining net realization, on which the royalty payment is calculated. Mylan Pharmaceuticals Inc. On March 2, 2000, Mylan Pharmaceuticals Inc. announced that it had signed a supply and
distribution agreement with Pfizer to market a generic version of all three strengths (30 mg, 60
mg, 90 mg) of Pfizers Procardia XL. In connection with that agreement, Mylan decided not to market
Nifedipine XL, a product the Company had developed in collaboration with Mylan, and agreed to pay
Penwest a royalty on all future net sales of the 30 mg strength of Pfizers generic Procardia XL.
The royalty percentage was comparable to the percentage called for in Penwests original agreement
with Mylan for Nifedipine XL. Mylan has retained the marketing rights to the 30 mg strength of
Nifedipine XL. Mylans sales in the United States in 2004 of the 30 mg dosage strength version of
Pfizers generic Procardia XL totaled approximately $40.2 million. The term of this agreement
continues until such time as Mylan permanently ceases to market generic Procardia XL. 12. Subsequent Event On April 26, 2005, the Company entered into a licensing agreement with Prism Pharmaceuticals,
Inc. (Prism) granting Prism exclusive rights to market Penwests PW2101 in the United States and
Canada. Under the terms of the agreement, the Company has agreed to continue to be responsible for
certain pre-launch development activities relating to PW2101, including those activities related to
the United States Food and Drug Administration (FDA) application and review. Prism has agreed to
be responsible for the commercialization and marketing of PW2101 in the United States and Canada.
Prism has also agreed to be responsible for the manufacturing of validation batches to support
commercial launch, including the costs thereof. Prism made a non-refundable $4.0 million payment to
the Company upon signing the agreement. The Company may also receive up to $9.5 million in
milestone payments upon the achievement of milestones relating to FDA approval and launch of
PW2101. The Company is also entitled to receive royalties ranging from 15% to 18% (subject to
reduction under certain circumstances) upon net sales, if any, of PW2101, depending on sales
levels. The Company would also receive a portion of payments received by Prism, if any, if Prism
sublicenses rights under the agreement. 12




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Item 2.Managements Discussion and Analysis of Financial Condition and Results of Operations The following Managements Discussion and Analysis of Financial Condition and Results of
Operations contains forward-looking statements that involve risks and uncertainties. Our actual
results could differ materially from those anticipated in these forward-looking statements as a
result of certain factors, including those described below under Risk Factors. Overview We develop pharmaceutical products based on innovative proprietary oral drug delivery
technologies. We are focusing our development efforts principally on products that address diseases
of the central nervous system. The two most advanced products in our drug development pipeline are
oxymorphone ER, an extended release formulation of oxymorphone, a narcotic analgesic being
developed for twice-a-day dosing in patients with moderate to severe pain requiring continuous,
around-the-clock opioid therapy for an extended period of time, and PW2101, a beta blocker intended
for the treatment of hypertension and angina currently under review by the United States Food and
Drug Administration, or FDA. We are also developing several additional product candidates in areas
such as epilepsy, schizophrenia, depression, edema and pain.  
    Oxymorphone ER.Oxymorphone ER is an extended release formulation of oxymorphone
incorporating TIMERx technology that we are developing with Endo Pharmaceuticals, Inc.
Oxymorphone ER, a narcotic analgesic, is being developed for twice-a-day dosing in
patients with moderate to severe pain requiring continuous, around-the-clock opioid
therapy for an extended period of time. Oxymorphone, which is currently given in the
parenteral and suppository dosage form, is marketed by Endo and had sales in the United
States in 2004 of approximately $375,000. Oxymorphone ER, if successfully developed,
would represent the first oral extended release version of oxymorphone and would compete
in the moderate to severe long acting opioid market with branded and generic products
such as MS Contin, Purdue Pharmas OxyContin, Johnson & Johnsons Duragesic patch, and
Ligands Avinza, which had aggregate sales in the United States in 2004 of approximately
$4.0 billion.Endo, which is responsible for conducting the clinical trials and seeking regulatory
approval of the product, submitted a New Drug Application, or NDA, for oxymorphone ER to
the FDA in December 2002. In October 2003, Endo received an approvable letter for
oxymorphone ER. In the letter, the FDA requested that Endo address certain questions,
provide additional clarification and information, and conduct some form of additional
clinical trials to further confirm the safety and efficacy of oxymorphone ER, before the
FDA would approve Endos NDA for oxymorphone ER. In discussions with Endo, the FDA advised
Endo of its concern that the outcome of two of the three Phase III efficacy trials
submitted in the NDA that met their predefined primary end-points may have been favorably
biased by the statistical handling of data from patients who did not complete the trials.
The design of this additional clinical trial is intended to address this issue. In November
2004, Endo announced that the FDA had granted under the FDAs Special Protocol Assessment,
or SPA, process, final approval of the protocol for a clinical trial in patients with
chronic low back pain and without recent treatment with opioid analgesics, designed to
provide the additional safety and efficacy data for oxymorphone ER requested by the FDA.
The clinical trial is also intended to address the FDAs concern regarding data from
patients who do not complete the trial.The new trial is intended to complement the completed Phase III pivotal trial that Endo
believes has demonstrated efficacy in the intended patient population. Endo has advised us
that the trial will be a 12-week, multicenter double-blinded, placebo-controlled Phase III
trial of oxymorphone ER. Endo expects to recruit approximately 250 patients for this trial.
Endo has commenced patient enrollment and expects to announce the results of the trial in
the fourth quarter of 2005. Endo has also reported that based on the duration of the trial
and the number of patients to be enrolled, and assuming the data is favorable, Endo expects
to submit a complete response letter to the FDA in early 2006. We expect that Endo will
receive a further action letter from the FDA within six months of the submission of the
complete response letter. 13




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
    PW2101.We are currently developing PW2101, a beta blocker intended for the
treatment of hypertension and angina, which we have formulated using our TIMERx
technology. We have developed PW2101 on our own, and we submitted a section 505(b)(2) NDA
to the FDA for PW2101 on August 31, 2004. On October 29, 2004, the FDA accepted this
application for filing. Our initial submission covered three strengths of the product. In
the fourth quarter of 2004, we completed a clinical trial of a lower strength of the
product. The results, while positive, were not statistically significant at a p-value of
0.05. The low dose strength, however, did meet most of the trials key secondary
endpoints. As a result, in the first quarter of 2005, we submitted supplemental data from
the clinical trial to the FDA to cover the lower strength of PW2101. We believe that the
FDA will consider the lower strength in the initial submission for the higher strengths.On April 26, 2005, we entered into a licensing agreement with Prism Pharmaceuticals, Inc.,
pursuant to which we granted Prism exclusive rights to market PW2101 in the United States
and Canada. Under the terms of the agreement, we agreed to continue to be responsible for
expenses related to specific pre-launch development activities relating to PW2101,
including those activities related to the FDA application and review. Prism has agreed to
be responsible for expenses related to the commercialization and marketing of PW2101 in the
United States and Canada. Prism has also agreed to be responsible for the manufacturing of
validation batches to support commercial launch, including the costs thereof.Prism made a non-refundable $4.0 million payment to us upon signing the agreement. In
addition, we may receive up to $9.5 million in milestone payments upon the achievement of
milestones relating to FDA approval and launch of PW2101. We are also entitled to receive
royalties ranging from 15% to 18%, subject to reduction under certain circumstances, upon
net sales, if any, of PW2101, depending on sales levels.PW2101 is a controlled release formulation of an immediate release beta blocker, the active
ingredient of which is no longer subject to patents in the United States. There is
currently a similar branded controlled release beta blocker product that is marketed for
hypertension, angina, and congestive heart failure. This branded product had sales in the
United States of approximately $1.2 billion in 2004. There are also currently filings for
generic versions of the branded controlled release beta blocker product, and the sponsors
are engaged in patent litigation. If the sponsors of the generic products prevail in such
litigation, and PW2101 is approved, PW2101 would compete with the branded product and the
generic versions of the branded product. We are currently in discussions with the FDA
regarding the appropriate patent certifications required to be made for PW2101. If we are
required to file a paragraph IV certification and the patent holder sues us for
infringement, the FDA may not approve our NDA for up to 30 months. We are also currently developing PW2132, a drug candidate intended for the treatment of edema
related to congestive heart failure, which we formulated using our Geminex technology. We conducted
a pilot scale biostudy of PW2132 in approximately 20 healthy volunteers in the fourth quarter of
2004. In the study, PW2132 achieved the blood level curves we had targeted as endpoints of the
study and that we believe may improve the efficacy of the drug. Based on the results of the pilot
biostudy, in April 2005, we held a pre-IND meeting with the FDA and filed an Investigational New
Drug Application, or IND, for PW2132. We expect to commence a Phase II single dose, dose ranging
study in patients in the second quarter of 2005, and expect data from the study in the fourth
quarter of 2005. In addition, we are currently conducting pilot scale Phase I biostudies of several product
candidates primarily for drugs to treat diseases of the central nervous system. In these studies,
we are seeking to obtain proof of principle data in humans. If the pilot scale biostudies of any of
these product candidates show proof of principle and the commercial returns appear attractive, we
will most likely seek to advance the product candidate into further clinical trials on our own. The
decision to develop the product candidate on our own will be based on our available resources after
consideration of a number of factors, including the size of the potential market, competitors in
the potential market, the availability of intellectual property protection, the regulatory pathway
and the development status of our other product candidates. Under a collaboration agreement with Mylan Pharmaceuticals Inc., we developed Nifedipine XL, a
generic version of Procardia XL based on our TIMERx technology. In March 2000, Mylan announced that
it had signed a supply and distribution agreement with Pfizer, Inc. to market Pfizers generic
version of all three strengths (30 mg, 14




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60 mg, 90 mg) of 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. Prior to February 27, 2003, we also developed, manufactured and distributed branded
pharmaceutical excipients, which are the inactive ingredients in tablets and capsules, primarily
consisting of binders, disintegrants and lubricants. On February 27, 2003, we sold substantially
all of the assets used in our excipient business to subsidiaries and affiliates of Josef
Rettenmaier Holding GmbH & Co. KG for approximately $41.8 million in cash. We have incurred net losses since 1994. As of March 31, 2005, our accumulated deficit was
approximately $127.2 million. We expect operating losses and negative cash flows to continue until
substantial sales of products occur. , We generate revenues primarily from royalties from Mylans
sales of Pfizers 30 mg generic version of Procardia XL and shipments of bulk TIMERx to our
collaborators. Our future profitability will depend on several factors, including:  
    the successful commercialization of TIMERx controlled release products, including in
particular oxymorphone ER and PW2101;  
    royalties from Mylans sales of Pfizer 30 mg generic version of Procardia XL; and  
    the level of our investment in research and development activities. Our results of operations may fluctuate from quarter to quarter depending on if and when
oxymorphone ER or PW2101 are approved, the amount and timing of royalties on Mylans sales of
Pfizers 30 mg generic version of Procardia XL, volume and timing of shipments of formulated bulk
TIMERx, and on variations in payments under our collaborative agreements, including payments upon
the achievement of specified milestones. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based
upon our condensed financial statements, which have been prepared in accordance with U.S. generally
accepted accounting principles. 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. Areas where significant judgments are made include, but are not limited to: revenue
recognition, research and development expenses, deferred taxes-valuation allowance and impairment
of long-lived assets. For a more detailed explanation of the judgments we make in these areas,
refer to Managements Discussion and Analysis of Financial Condition and Results of Operations in
our Annual Report on Form 10-K for the year ended December 31, 2004. Results of Operations for Quarter Ended March 31, 2005 and 2004 Revenues Quarter ended
    
    
    
    
    
    
    Quarter endedMarch 31,
    
    
    Percentage
    
    
    March 31,2005
    
    
    Decrease
    
    
    2004(in thousands, except percentages)Royalties and Licensing Fees
    
    $
    982
    
    
    
    (22
    )%
    
    $
    1,261Product Sales
    
    
    
    
    
    
    (100
    )%

    
    
    222Total Revenues
    
    $
    982
    
    
    
    (34
    )%
    
    $
    1,483
 15




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Our royalties and licensing fees primarily consist of royalties from Mylan on its sales of
Pfizers 30 mg generic version of Procardia XL. These royalties decreased in the quarter ended
March 31, 2005 compared to the comparable quarter for 2004 due to a decrease in Mylans net sales
of Procardia XL. Our product sales consist of sales of formulated bulk TIMERx to our collaborators. We had no
sales of formulated bulk TIMERx in the quarter ended March 31, 2005. We anticipate shipping
formulated bulk TIMERx to Prism in the second half of 2005 to support the manufacturing of
validation batches as well as commercial launch quantities. The selling price of formulated bulk
TIMERx to Prism will approximate cost. Selling, General and Administrative Expense Selling, general and administrative, or SG&A, expenses for the quarter ended March 31, 2005
were $5.3 million as compared to $2.3 million for the comparable quarter in 2004. The increase of
$3.0 million in SG&A expenses for the quarter ended March 31, 2005 compared to the comparable
quarter in 2004 primarily reflects a one-time charge of $3.0 million that arose in connection with
the agreement we entered into with Mr. Hamachek, our former Chairman of the Board of Directors and
Chief Executive Officer, upon his resignation in February 2005. This one-time charge included a
non-cash charge of $2.4 million relating to the accelerated vesting and extension of exercise
periods of stock options held by Mr. Hamachek. Research and Product Development Expense Quarter ended
    
    
    Percentage
    
    
    Quarter endedMarch 31,
    
    
    Increase
    
    
    March 31,2005
    
    
    (Decrease)
    
    
    2004(in thousands, except percentages)PW2101
    
    $
    1,326
    
    
    
    (24
    )%
    
    $
    1,743Research and New
Technology
Development
    
    
    452
    
    
    
    (14
    )%
    
    
    524Phase I Products and
Internal Costs
    
    
    3,287
    
    
    
    80
    %
    
    
    1,822Total Research and
Product Development
    
    $
    5,065
    
    
    
    24
    %
    
    $
    4,089
 In the preceding table, research and development expenses are set forth in the following three
categories:  
    PW2101 These expenses reflect our direct external expenses relating to the development of
PW2101. These expenses consist primarily of payments to third parties in connection with
clinical trials of PW2101, the manufacturing of PW2101 prior to regulatory approval for
clinical use and potential commercial use, and our development work related to the
qualification of an alternative manufacturing site for PW2101.  
    Research and New Technology Development These expenses reflect both our direct external
expenses and our allocated internal expenses relating to the development of new drug delivery
technologies. These direct external expenses consist primarily of payments to third parties in
connection with outside laboratory and consulting fees. Our internal expenses primarily
include salaries and benefits of our research and new technology development group, and other
costs such as depreciation on purchased equipment, and the amortization or any write-downs of
patent costs.  
    Phase I Products and Internal Costs These expenses reflect both our direct external
expenses and our internal expenses relating to the development of Phase I product candidates,
and also include other unallocated research and development expenses. Our direct external
expenses primarily reflect payments to third parties for the active drug and
proof-of-principle biostudies conducted for our Phase I products. Our internal expenses
include expenses such as salaries and benefits of our product development personnel including
our formulation, clinical and regulatory groups, and other costs primarily related to our
laboratory facilities. PW2101. Approximately 26% of our research and development expenses for the quarter
ended March 31, 2005 related to direct costs primarily associated with clinical development,
manufacturing scale-up and preparation of the 16




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NDA for PW2101. Our PW2101 expenses were lower than the comparable period in 2004 primarily
because our research and development expense in the first quarter of 2004 included costs associated
with the pivotal clinical trials of PW2101. We have not conducted and do not anticipate conducting
additional pivotal trials for PW2101 in 2005. We have submitted a 505(b)(2) NDA to the FDA for

PW2101, which the FDA accepted for filing in October 2004. We
have established arrangements with Patheon, Inc.
(Patheon) for the commercial manufacture of the higher
strengths of PW2101 at one manufacturing site. We expect to continue to incur additional research
and development expenses in 2005 relating to PW2101 as we continue to seek an approval from the FDA
for PW2101, and to work with Prism and Patheon to qualify another manufacturing site that could
produce all of the strengths of PW2101, and that would have a greater production capacity than the
current site. On April 26, 2005, we entered into a licensing agreement with Prism granting it exclusive
rights to market PW2101 in the United States and Canada. Under the agreement, we have agreed to
continue to be responsible for expenses for certain pre-launch development activities relating to
PW2101, including activities related to the FDA application and review, and Prism has agreed to be
responsible for expenses relating to the commercialization and marketing of PW2101 in the United
States and Canada. Prism is also responsible for the manufacturing of validation batches to
support commercial launch, including the costs thereof. Research and New Technology Development Expenses. These expenses decreased for the
quarter ended March 31, 2005 compared to the comparable period in 2004 primarily due to lower
personnel costs associated with redirecting personnel that were previously performing research and
new technology development activities to developing Phase I candidates. Phase I Products and Internal Costs. These costs increased in the quarter ended March
31, 2005 compared to the comparable period in 2004 primarily as a result of an increase in the
number of Phase I product candidates in our pipeline, an increase in external costs incurred in
connection with proof-of-principle biostudies for these Phase I product candidates and increased
costs associated with an increase in the number of employees engaged in our product development
efforts. There can be no assurance that oxymorphone ER, PW2101, PW2132, or any of our other products
will be successfully developed, will receive regulatory approval, or will be successfully
commercialized. Completion of clinical trials and commercialization of these product candidates may
take several years, and the length of time can vary substantially according to the type, complexity
and novelty of a product candidate. Due to the variability in the length of time necessary to
develop a product, the uncertainties related to the estimated cost of the development projects and
ultimate ability to obtain governmental approval for commercialization, accurate and meaningful
estimates of the ultimate cost to bring our product candidates to market are not available. Tax Rates The effective tax rates for the quarters ended March 31, 2005 and 2004 were zero. The
effective tax rates are higher than the federal statutory rate of a 34% benefit primarily due to
valuation allowances recorded to offset net deferred tax assets relating to our net operating
losses. 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. As of March 31, 2005, we had cash, cash equivalents and
short-term investments of $66.8 million. We have no committed sources of capital. We are a party to an agreement with Endo with respect to the development and commercialization
of oxymorphone ER. On April 17, 2003, we discontinued our participation in the funding of the
development and pre- 17




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launch marketing of oxymorphone ER. We did not incur any expenses relating to oxymorphone ER
in the three months ended March 31, 2005, and we do not expect to incur any significant expenses
relating to oxymorphone ER in 2005, unless we resume our participation in the funding of the
development and marketing of oxymorphone ER. As a result of this termination of funding, Endo has
the right to complete the development of oxymorphone ER and recoup the portion of development costs
incurred by Endo that otherwise would have been funded by us, through a temporary adjustment in the
royalty rate payable to us that will return to its pre-adjustment level once Endo has recovered
such unfunded development and pre-launch marketing costs. Endo may also allow us to reimburse Endo
directly for these unfunded amounts and, as a result, to receive the full royalty rate from Endo
without adjustment. We estimate that through January 31, 2005, these unfunded costs approximated
$15.0 million. We expect this unfunded amount to increase as Endo completes the required pivotal
study and incurs pre-launch marketing costs. On April 26, 2005, we entered into an agreement with Prism pursuant to which we granted Prism
exclusive rights to market PW2101 in the United States and Canada. Under the terms of the
agreement, we agreed to continue to be responsible for expenses related to specific pre-launch
development activities relating to PW2101, including those activities related to the FDA
application and review, and Prism agreed to be responsible for expenses related to the
commercialization and marketing of PW2101 in the United States and Canada. Prism made a
non-refundable $4.0 million payment to us upon signing the agreement. On December 14, 2004, we completed the sale of a total of 3,125,000 shares of common stock
through a private placement to selected institutional investors, resulting in net proceeds to us,
after fees and expenses, of approximately $32.8 million. Cash Flows We had negative cash flow from operations for the quarter ended March 31, 2005 of $7.5
million, primarily due to a net loss of $8.9 million in the period. In addition, we expended
approximately $2.0 million in the net reduction of accounts payable and accrued expenses during the
first quarter of 2005. Investing activities provided $11.4 million in cash for the quarter ended
March 31, 2005, primarily reflecting sales and maturities of marketable securities, net of
purchases, of $11.6 million. Net cash provided by investing activities also reflected funds
expended for the acquisition of laboratory equipment for drug development activities, and funds
expended to secure patents on technology developed by us. Funding Requirements We anticipate that, based on our current operating plan and excluding any potential revenues
from oxymorphone ER, our existing capital resources, including $4.0 million that we received from
Prism in April 2005, and anticipated internally generated funds from the sale of formulated bulk
TIMERx, royalties from Mylan and other payments from collaborators will be sufficient to fund our
operations on an ongoing basis without requiring us to seek external financing through at least the
first half of 2007. We expect to continue to invest in capital expenditures in 2005 at levels
similar to 2004 capital spending, primarily for laboratory equipment for our drug development
activities and for patents on technology and products developed by us. Our requirements for capital in our business are substantial and will depend on many factors,
including:  
    whether oxymorphone ER or PW2101 are approved on a timely basis, or at all;  
    the costs and timing of adding product candidates or technologies;  
    whether we resume our participation in the funding of the development and marketing of oxymorphone ER;  
    the timing and amount of payments received under collaborative agreements, including in particular with respect to
oxymorphone ER and PW2101;  
    our ability to qualify the alternative manufacturing site for PW2101 on a timely basis or at all, and the costs of doing so; 18




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
    the structure and terms of any future collaborative or development agreements;  
    the progress of our collaborative and independent development projects, funding obligations with respect to the projects,
and the related costs to us of clinical studies for our products;  
    royalties received from Mylan; and  
    the prosecution, defense and enforcement of potential patent claims and other intellectual property rights. If we determine to resume our participation in the funding of oxymorphone ER, or to acquire
additional product candidates or technologies, we may need to seek additional funding through
collaborative agreements or research and development arrangements, or through public or private
financings of equity or debt securities. If we raise additional funds by issuing equity securities, further dilution to our
then-existing shareholders may result. Debt financing, if available, may involve agreements that
include covenants limiting or restricting our ability to take specific actions, such as incurring
additional debt, making capital expenditures or declaring dividends. Any debt or equity financing
may contain terms, such as liquidation and other preferences, that are not favorable to us or our
shareholders. If we raise additional funds through collaboration and licensing arrangements with
third parties, it may be necessary to relinquish valuable rights to our technologies, research
programs or potential product, or grant licenses on terms that may not be favorable to us. We
cannot be certain that additional financing will be available in amounts or on terms acceptable to
us, if at all. If we are unable to obtain this additional financing, we may be required to delay,
reduce the scope of, or eliminate one or more of our planned research, development and
commercialization activities, which could harm our financial condition and operating results. 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 purchase obligations, as of March 31, 2005 (in
thousands): Less than
    
    
    1-3
    
    
    4-5
    
    
    After 5Total
    
    
    One Year
    
    
    Years
    
    
    Years
    
    
    YearsOperating Leases
    
    $
    1,072
    
    
    $
    673
    
    
    $
    399
    
    
    $
    
    
    
    $
    Purchase Obligations
    
    
    496
    
    
    
    471
    
    
    
    25
    
    
    
    
    
    
    
    Total
    
    $
    1,568
    
    
    $
    1,144
    
    
    $
    424
    
    
    $
    
    
    
    $
    
 We are also subject to the commitments described below that are not included in the table
above. We have a Supplemental Executive Retirement Plan, or SERP, a nonqualified plan, which covers
our former Chairman and Chief Executive Officer, Tod R. Hamachek. On February 14, 2005, Mr.
Hamachek resigned from his positions as Chairman and Chief Executive Officer. Under the SERP, Mr.
Hamachek is eligible for benefit payments. Accordingly, under the SERP, commencing in May 2005, we
will pay Mr. Hamachek approximately $12,600 per month over the lives of Mr. Hamachek and his
spouse, in accordance with Mr. Hamacheks elections. We also have a Deferred Compensation Plan, or DCP, a nonqualified plan which covers Mr.
Hamachek. Under the DCP, Mr. Hamachek is eligible for benefit payments. In connection with the
resignation and retirement of Mr. Hamachek in February 2005, commencing in May 2005 we will pay
Mr. Hamachek approximately $140,000 per year including interest under the DCP in ten annual
installments. 19




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We expect the following benefit payments, including interest for the DCP, to be made under the
SERP and DCP over the next ten years, as of March 31, 2005 (in thousands): SERP
    
    
    DCP
    
    
    TotalYear 1
    
    $
    139
    
    
    $
    140
    
    
    $
    279Year 2
    
    
    151
    
    
    
    140
    
    
    
    291Year 3
    
    
    151
    
    
    
    140
    
    
    
    291Year 4
    
    
    151
    
    
    
    140
    
    
    
    291Year 5
    
    
    151
    
    
    
    140
    
    
    
    291Years 6-10
    
    
    753
    
    
    
    700
    
    
    
    1,453
 We do not fund these liabilities and no assets are held by the plans. However, we have two
whole-life insurance policies in a rabbi trust, the cash surrender value or death benefits of which
are held in trust for the SERP and DCP liabilities. We are entitled to borrow against these
policies to fund these liabilities as provided by the terms of the trust. The cash surrender value
of these polices totaled $3.1 million as of March 31, 2005. Net Operating Loss Carryforwards At December 31, 2004, we had federal net operating loss, or NOL, carryforwards of
approximately $96.7 million for income tax purposes, of which approximately $6.2 million, $8.4
million, $9.1 million, $17.7 million, $19.3 million, $12.6 million and $23.4 million expire in
2018, 2019, 2020, 2021, 2022, 2023 and 2024, respectively. In addition, we had research and
development tax credit carryforwards of approximately $3.2 million of which $67,000, $359,000,
$341,000, $777,000, $828,000 and $858,000 expire in 2018, 2019, 2020, 2021, 2022 and 2023,
respectively. The use of the NOLs, and research and development tax credit carryforwards are
limited to our future taxable earnings. For financial reporting purposes, at December 31, 2004 we
recognized a valuation allowance of $40.2 million to offset net deferred tax assets, primarily
attributable to the NOL carryforward. Utilization of the operating losses is subject to limitation
due to the ownership change provisions of the Internal Revenue Code. Forward-Looking Statements This quarterly report contains forward-looking statements within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements,
other than statements of historical facts, included or incorporated in this report regarding our
strategy, future operations, financial position, future revenues, projected costs, prospects, plans
and objectives of management are forward-looking statements. The words believes, anticipates,
estimates, plans, expects, intends, may, projects, will, and would and similar
expressions are intended to identify forward-looking statements, although not all forward-looking
statements contain these identifying words. We cannot guarantee that we actually will achieve the
plans, intentions or expectations disclosed in our forward-looking statements and you should not
place undue reliance on our forward-looking statements. There are a number of important factors
that could cause our actual results to differ materially from those indicated or implied by
forward-looking statements. These important factors include those set forth below under Risk
Factors. In addition, any forward-looking statements represent our estimates only as of the date
this quarterly report is filed with the SEC and should not be relied upon as representing our
estimates as of any subsequent date. We do not assume any obligation to update any forward-looking
statements. Risk Factors Investing in our common stock involves a high degree of risk. You should carefully consider
the risks and uncertainties described below in addition to the other information included or
incorporated by reference in this prospectus before purchasing our common stock. If any of the
following risks actually occurs, our business, financial condition or results of operations would
likely suffer, possibly materially. In that case, the trading price of our common stock could fall,
and you may lose all or part of the money you paid to buy our common stock. We have not been profitable and expect to continue to incur substantial losses We have incurred net losses since 1994, including net losses of $23.8 million, $15.9 million
and $17.1 million during 2004, 2003 and 2002, respectively. For the quarter ended March 31, 2005,
we incurred a net loss of $8.9 20




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million. We had a loss from continuing operations of $23.8 million, $26.0 million and $19.0
million in 2004, 2003 and 2002, respectively. As of March 31, 2005, our accumulated deficit was
approximately $127.2 million. Our strategy includes a significant commitment to spending on research and development
targeted at identifying and developing products that can be formulated using our TIMERx and other
drug delivery technologies. As a result, we expect to continue to incur net losses as we continue
our research activities and conduct development of, and seek regulatory approvals for, products
utilizing TIMERx technology and other drug delivery technologies, until substantial sales of
products commercialized utilizing our TIMERx technology and other drug delivery technologies occur.
These net losses have had and will continue to have an adverse effect on, among other things, our
shareholders equity, total assets and working capital. A substantial portion of our revenues since 1994 had been generated from the sales of our
pharmaceutical excipients. Our net losses in 2003 and 2002 were reduced as a result of the
operating results of our excipient business. Since February 27, 2003, we have not generated any
revenues from the sales of excipient products and our business depends and will depend exclusively
on revenue, under our agreement with Mylan and from products developed or acquired by us. Our future profitability will depend on several factors, including:  
    the successful commercialization of TIMERx controlled release products, including in
particular oxymorphone ER and PW2101;
    royalties from Mylans sale of Pfizers 30 mg generic version of Procardia XL; and
    the level of our investment in research and development activities. We may require additional funding, which may be difficult to obtain As of March 31, 2005, we had cash, cash equivalents, and short-term investments of $66.8
million including net proceeds of approximately $32.8 million we received from a private placement
of our common stock in December 2004. We anticipate that, based on our current operating plan, our
existing capital resources, including $4.0 million that we received from Prism in April 2005, and
anticipated internally generated funds from the sale of formulated bulk TIMERx, royalties from
Mylan and other payments from collaborators will be sufficient to fund our operations on an ongoing
basis without requiring us to seek external financing through at least the first half of 2007. Our requirements for additional capital are substantial and will depend on many factors, including:  
    whether oxymorphone ER or PW2101 are approved on a timely basis, or at all;
    the costs and timing of adding additional products or technologies;
    whether we resume our participation in the funding of the development and marketing of
oxymorphone ER;
    the timing and amount of payments received under collaborative agreements, including in
particular with respect to oxymorphone ER and PW2101;
    our ability to qualify the alternative manufacturing site for PW2101 on a timely basis or
at all and the costs of doing so;
    the structure and terms of any future collaborative or development agreements;
    the progress of our collaborative and independent development projects, funding
obligations with respect to the projects, and the related costs to us of clinical studies
for our products;
    royalties received from Mylan; and 21




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
    the prosecution, defense and enforcement of potential patent claims and other intellectual property rights. Subject to these factors, we expect that we will need to sell additional equity or debt
securities or seek additional financing through other arrangements to fund operations beyond the
first half of 2007. In addition, if we determine to resume our participation in the funding of
oxymorphone ER or to acquire additional products or technologies, we also may need to seek
additional funding for such actions through collaborative agreements or research and development
arrangements, or through public or private financing. If we raise additional funds by issuing equity securities, further dilution to our
then-existing shareholders may result. Debt financing, if available, may involve agreements that
include covenants limiting or restricting our ability to take specific actions, such as incurring
additional debt, making capital expenditures or declaring dividends. Any debt or equity financing
may contain terms, such as liquidation and other preferences, that are not favorable to us or our
shareholders. If we raise additional funds through collaboration and licensing arrangements with
third parties, it may be necessary to relinquish valuable rights to our technologies, research
programs or potential product or grant licenses on terms that may not be favorable to us. We cannot
be certain that additional financing will be available in amounts or on terms acceptable to us, if
at all. If we are unable to obtain this additional financing, we may be required to delay, reduce
the scope of, or eliminate one or more of our planned research, development and commercialization
activities, which could harm our financial condition and operating results. We are dependent on collaborators to conduct clinical trials of, obtain regulatory approvals for,
and manufacture, market, and sell our TIMERx controlled release products, including, in
particular, Endo with respect to oxymorphone ER Some of our TIMERx controlled release products have been or are being developed and
commercialized in collaboration with pharmaceutical companies. Under these collaborations,
depending on the structure of the collaboration, we are dependent on our collaborators to fund some
portion of development, to conduct clinical trials, obtain regulatory approvals for, and
manufacture, market and sell products utilizing our TIMERx controlled release technology. For
instance, we are dependent on Endo to obtain the regulatory approvals required to market
oxymorphone ER and will be dependent on Endo to manufacture and market oxymorphone ER in the United
States. In addition, we are dependent on Mylan with respect to the marketing and sale of the 30 mg
strength of Pfizers generic version of Procardia XL and will be dependent on Prism with respect
tot the marketing and sale of PW2101. We have limited experience in manufacturing, marketing and selling pharmaceutical products.
Accordingly, if we cannot maintain our existing collaborations or establish new collaborations with
respect to our other products in development, we will have to establish our own capabilities or
discontinue the commercialization of the affected product. Developing our own capabilities would be
expensive and time consuming and could delay the commercialization of the affected product. There
can be no assurance that we would be successful in developing these capabilities. Our existing collaborations are subject to termination on short notice under certain
circumstances including, for example, if the collaborator determines that the product in
development is not likely to be successfully developed or not likely to receive regulatory
approval, if we breach the agreement or upon a bankruptcy event. If any of our collaborations are
terminated, we may be required to devote additional resources to the product, seek a new
collaborator on short notice or abandon the product. The terms of any additional collaborations or
other arrangements that we establish may not be favorable to us. We are also at risk that these collaborations or other arrangements may not be successful.
Factors that may affect the success of our collaborations include the following:  
    Our collaborators may be pursuing alternative technologies or developing alternative
products, either on their own or in collaboration with others, that may be competitive with
the product as to which they are collaborating with us, which could affect our
collaborators commitment to the collaboration with us.
    Our collaborators may reduce marketing or sales efforts, or discontinue marketing or
sales of our products. This would reduce our revenues received on the products. 22




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
    Our collaborators may terminate their collaborations with us. This could make it
difficult for us to attract new collaborators or adversely affect perception of us in the
business and financial communities.
    Our collaborators may pursue higher priority programs or change the focus of their
development programs, which could affect the collaborators commitment to us. Pharmaceutical
and biotechnology companies historically have re-evaluated their priorities from time to
time, including following mergers and consolidations, which have been common in recent years
in these industries. We face significant competition, which may result in others discovering, developing or
commercializing products before or more successfully than we do The pharmaceutical industry is highly competitive and is affected by new technologies,
governmental regulations, health care legislation, availability of financing, litigation and other
factors. Many of our competitors have:  
    significantly greater financial, technical and human resources than we have and may be
better equipped to develop, manufacture and commercialize products;
    more extensive experience than we have in conducting preclinical studies and clinical
trials, obtaining regulatory approvals and manufacturing and marketing pharmaceutical
products;
    competing products that have already received regulatory approval or are in late-stage development; and
    collaborative arrangements in our target markets with leading companies and research institutions. We face competition based on the safety and effectiveness of our products, the timing and
scope of regulatory approvals, the availability and cost of supply, marketing and sales
capabilities, reimbursement coverage, price, patent position and other factors. Our competitors may
develop or commercialize more effective, safer or more affordable products, or obtain more
effective patent protection, than we are able to develop or commercialize. Accordingly, our
competitors may commercialize products more rapidly or effectively than we do, which would
adversely affect our competitive position, the likelihood that our product will achieve initial
market acceptance and our ability to generate meaningful revenues from our products. Even if our
products achieve initial market acceptance, competitive products may render our products obsolete
or noncompetitive. If our products are rendered obsolete, we may not be able to recover the
expenses of developing and commercializing those products. We face competition from numerous public and private companies and their extended release
technologies, including Johnson & Johnsons oral osmotic pump (OROS) technology, multiparticulate
systems marketed by Elan Corporation plc, Biovail Corporation and KV Pharmaceutical Company,
traditional matrix systems marketed by SkyePharma, plc and other controlled release technologies
marketed or under development by Andrx Corporation, among others. Our TIMERx products in development will face competition from products with the same
indication as the TIMERx products we are developing. For instance, we expect extended release
oxymorphone ER will face competition from MS Contin, Purdue Pharmas OxyContin and generic
competitors to OxyContin, Duragesic marketed by Johnson & Johnson and generic competitors to
Duragesic, and Avinza marketed by Ligand. Some of the TIMERx products we are developing, such as PW2101, are branded controlled release
products, which are proprietary products that are based on active chemical ingredients that are not
subject to patents. These branded controlled release products will compete against other products
developed using the same or a similar active chemical ingredient, including branded immediate
release and branded controlled released products, as well as any generic versions of these
products, based primarily on price. In addition, our branded controlled released products will
compete against other competitive products in the therapeutic class. For instance, PW2101 is a
controlled release formulation of an immediate release beta blocker, the chemical active ingredient
for which is no longer subject to patents in the United States. There is currently a similar
branded controlled release beta blocker product that is marketed for hypertension and against which
we expect PW2101 will compete. There are also currently filings for generic versions of the branded
controlled release products and the sponsors of the branded product and 23




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the generic products are currently in patent litigation. If the sponsors of generic products
prevail in such litigation, PW2101 would also compete against these generic versions. In addition to developing branded controlled release products, we also selectively develop
generic versions of branded controlled release products using our TIMERx technology and generic
active ingredients. The success of these products will depend, in large part, on the intensity of
competition from the branded controlled release product, other generic versions of the branded
controlled release product, and other drugs and technologies that compete with the branded
controlled release product, as well as the timing of product approval. The generic drug industry is characterized by frequent litigation between generic drug
companies and branded drug companies. Those companies with significant financial resources will be
better able to bring and defend any such litigation. If our clinical trials are not successful or take longer to complete than we expect, we may not be
able to develop and commercialize our products In order to obtain regulatory approvals for the commercial sale of our potential products,
including our branded controlled release products, we or our collaborators will be required to
complete clinical trials in humans to demonstrate the safety and efficacy of the products. However,
we or our collaborators may not be able to commence or complete these clinical trials in any
specified time period, or at all, either because the FDA or other regulatory agencies object, or
for other reasons. Even if we complete a clinical trial of one of our potential products, the clinical trial may
not indicate that our product is safe or effective to the extent required by the FDA, the European
Commission, or other regulatory agencies to approve the product, and we or our collaborators may
decide, or regulators may requires us or our collaborators, to conduct additional clinical trials.
For example, in response to the NDA for oxymorphone ER, the FDA is requiring Endo to conduct an
additional clinical trial of oxymorphone ER. In addition, on December 2, 2004, we announced that in
our pivotal efficacy trial of the low dose strength of PW2101, we did not meet the studys primary
endpoint. Alternatively, regulators may require post marketing testing and surveillance to monitor
the safety and efficacy of a product. The results from preclinical testing of a product that is under development may not be
predictive of results that will be obtained in human clinical trials. In addition, the results of
early human clinical trials may not be predictive of results that will be obtained in larger scale
advanced stage clinical trials. Furthermore, we, our collaborators or the FDA may suspend clinical
trials at any time if the subjects or patients participating in such trials are being exposed to
unacceptable health risks, or for other reasons. The rate of completion of clinical trials is dependent in part upon the rate of enrollment of
patients. Patient accrual is a function of many factors including the size of the patient
population, the proximity of patients to clinical sites, the eligibility criteria for the study and
the existence of competitive clinical trials. Delays in planned patient enrollment may result in
increased costs and program delays. If clinical trials do not show any potential product to be safe or efficacious, if we are
required to conduct additional clinical trials or other testing of our products in development
beyond those that we currently contemplate or if we are unable to successfully complete our
clinical trials or other testing, we may:  
    be delayed in obtaining marketing approval for our products;
    not be able to obtain marketing approval for our products; or
    obtain approval for indications that are not as broad as intended. Our product development costs may also increase if we experience delays in testing or
approvals. In addition, significant clinical trial delays also could allow our competitors to bring
products to market before we do and impair our ability to commercialize our products. 24




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We are subject to extensive government regulation including the requirement of approval before
our products may be marketed. Even if we obtain marketing approval, our products will be subject
to ongoing regulatory review. We, our collaborators, our products, and our product candidates are subject to extensive
regulation by governmental authorities in the United States and other countries. Failure to comply
with applicable requirements could result in warning letters; fines and other civil penalties;
delays in approving or refusal to approve a product candidate; product recall or seizure;
withdrawal of product approvals; interruption of manufacturing or clinical trials; operating
restrictions; injunctions; and criminal prosecution. Our products cannot be marketed in the United States without FDA approval. Obtaining FDA
approval requires substantial time, effort, and financial resources, and there can be no assurance
that any approval will be granted on a timely basis, if at all. We have had only limited experience
in preparing applications and obtaining regulatory approvals. If the FDA does not approve our
product candidates in a timely fashion, or does not approve them at all, our business and financial
condition may be adversely affected. Further, the terms of approval of any marketing application,
including the labeling content, may be more restrictive than we desire and could affect the
marketability of our or our collaborators products. Subsequent discovery of problems with an
approved product may result in restrictions on the product or its withdrawal from the market. In addition, both before and after regulatory approval, we, our collaborators, our products,
and our product candidates are subject to numerous FDA requirements covering testing,
manufacturing, quality control, current good manufacturing practices (cGMP), adverse event
reporting, labeling, advertising, promotion, distribution, and export. We and our collaborators are
subject to surveillance and periodic inspections to ascertain compliance with these regulations.
Further, the relevant law and regulations may change in ways that could affect us, our
collaborators, our products, and our product candidates. Failure to comply with regulatory
requirements could have a material adverse impact on our business. We are developing oxymorphone ER under a collaboration agreement with Endo. Endo, which is
responsible for conducting the clinical trials and seeking regulatory approval of the product,
submitted an NDA for oxymorphone ER to the FDA in December 2002. In October 2003, Endo received an
approvable letter for oxymorphone ER. In the letter, the FDA requested that Endo address certain
questions, provide additional clarification and information, and conduct some form of additional
clinical trials to further confirm the safety and efficacy of oxymorphone ER before the FDA would
approve Endos NDA for oxymorphone ER. In discussions with Endo, the FDA advised Endo of its
concern that the outcome of two of the phase III efficacy trials submitted in the NDA that met
their predefined primary end-points may have been favorably biased by the statistical handling of
data from patients who did not complete the trials. The design of this additional clinical trial is
intended to address this issue. In November 2004, Endo announced that the FDA had granted final
approval of the protocol under the FDAs SPA process for a clinical trial in patients with chronic
low back pain and without recent treatment with opioid analgesics, designed to provide additional
safety and efficacy data for oxymorphone ER requested by the FDA. The clinical trial is also
intended to address the FDAs concern regarding data from patients who did not complete the trial.
The new trial is intended to complement the completed Phase III pivotal trial that Endo believes
has demonstrated efficacy in the intended patient population. Endo has also reported that based on
the duration of the trials and the number of patients to be enrolled, and assuming the data is
favorable, Endo expects to submit a complete response letter to the FDA in early 2006. We expect
that Endo will receive a further action letter from the FDA within six months of submission of the
complete response letter. If the NDA for oxymorphone ER is not approved on a timely basis or at
all, it would have a material adverse effect on our business, financial condition and results of
operations. Certain products containing our TIMERx controlled release technology require the filing of an
NDA. A full NDA must include complete reports of preclinical, clinical and other studies to prove
adequately that the product is safe and effective, which involves, among other things, full
clinical testing, and as a result requires the expenditure of substantial resources. In certain
cases involving controlled release versions of FDA approved immediate release drugs and branded
controlled release drugs, such as PW2101, we may be able to rely on existing publicly available
safety and efficacy data to support an NDA for controlled release products under Section 505 (b)(2)
of the FDCA when such data exists for an approved immediate release or controlled release version
of the same active chemical ingredient. For example, our NDA for PW2101 was filed under section
505(b)(2) and relies on data from an immediate release drug with the same active chemical
ingredient. We can provide no assurance, however, that the 25




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FDA will accept a section 505(b)(2) NDA, or that we will be able to obtain publicly available
data that is useful. The section 505(b)(2) NDA process is a highly uncertain avenue to approval
because the FDAs policies on section 505(b)(2) NDAs have not yet been fully developed. There can
be no assurance that the FDA will approve an application submitted under section 505(b)(2) in a
timely manner, or at all. Our application to market PW2101 is a 505(b)(2) NDA. Our controlled release products that are generic versions of branded controlled release products
that are covered by one or more patents may be subject to litigation, which could delay FDA
approval and commercial launch of our products We expect to file or have our collaborators file ANDAs or NDAs for our controlled release
products under development that are covered by one or more patents of the branded product. It is
likely that the owners of the patents covering the brand name product or the sponsors of the NDA
with respect to the branded product will sue or undertake regulatory initiatives to preserve
marketing exclusivity, as Pfizer did with respect to our generic version of Procardia XL that we
developed with Mylan. Any significant delay in obtaining FDA approval to market our products as a
result of litigation, as well as the expense of such litigation, whether or not we or our
collaborators are successful, could have a material adverse effect on our business, financial
condition and results of operations. We are currently in discussions with the FDA regarding the
appropriate patent certifications required to be made for PW2101. If we are required to file a
paragraph IV patent certification and the patent holder sues us for infringement, the FDA may not
approve our application for up to 30 months. The market may not be receptive to products incorporating our drug delivery technologies The commercial success of products incorporating our extended release technology that are
approved for marketing by the FDA and other regulatory authorities will depend upon their
acceptance by the medical community and third party payors as clinically useful, cost-effective and
safe. No product based on our TIMERx or other extended release technology is marketed in the United
States, so there can be no assurance as to market acceptance. Factors that we believe could materially affect market acceptance of these products include:  
    the timing of the receipt of marketing approvals and the countries in which such approvals are obtained;
    the safety and efficacy of the product as compared to competitive products;
    the relative convenience and ease of administration as compared to competitive products;
    the strength of marketing distribution support; and
    the cost-effectiveness of the product and the ability to receive third party reimbursement. Our success depends on our protecting our patents and patented rights Our success depends in significant part on our ability to develop patentable products, to
obtain patent protection for our products, both in the United States and in other countries, and to
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 research, development and commercialization activities, as well as any products in
development or products resulting from these activities, may infringe or be claimed to infringe
patents or patent applications of competitors or other third parties. In such event, we or our
collaborators may choose or may be required to seek a license from a third party and to pay license
fees or royalties or both under such license. These licenses may not be available on acceptable
terms, or at all. Even if we or our collaborators were able to obtain a license, the rights may be
nonexclusive, which could result in our competitors gaining access to the same intellectual
property. If we or our 26




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collaborators are not able to obtain a license, we could be prevented from commercializing a
product, or be forced to cease some aspect of our business operations. Our success also depends on our maintaining the confidentiality of our trade secrets and
patented know-how. We seek to protect such information by entering into confidentiality agreements
with employees, consultants, licensees and pharmaceutical companies. These agreements may be
breached by such parties. We may not be able to obtain an adequate, or perhaps any, remedy to such
a breach. In addition, our trade secrets may otherwise become known or be independently developed
by our competitors. We may become involved in patent litigation or other intellectual property proceedings relating
to our products or processes, which could result in liability for damages or stop our development
and commercialization efforts The pharmaceutical industry has been characterized by significant litigation, interference and
other proceedings regarding patents, patent applications and other intellectual property rights.
The types of situations in which we may become parties to such litigation or proceedings include:  
    We or our collaborators may initiate litigation or other proceedings against third
parties to enforce our patent rights.
    We or our collaborators may initiate litigation or other proceedings against third
parties to seek to invalidate the patents held by such third parties or to obtain a judgment
that our products or processes do not infringe such third parties patents.
    If our competitors file patent applications that claim technology also claimed by us, we
or our collaborators may participate in interference or opposition proceedings to determine
the priority of invention.
    If third parties initiate litigation claiming that our processes or products infringe
their patent or other intellectual property rights, we and our collaborators will need to
defend against such proceedings. An adverse outcome in any litigation or other proceeding could subject us to significant
liabilities to third parties and require us to cease using the technology that is at issue or to
license the technology from third parties. We may not be able to obtain any required licenses on
commercially acceptable terms or at all. The cost of any patent litigation or other proceeding, even if resolved in our favor, could be
substantial. Although the legal costs of defending litigation relating to a patent infringement
claim are generally the contractual responsibility of our collaborators unless such claim relates
to TIMERx in which case such costs are our responsibility, we could nonetheless incur significant
unreimbursed costs in participating and assisting in the litigation. Some of our competitors may be
able to sustain the cost of such litigation and proceedings more effectively than we can because of
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. 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 2006, and on other third party manufacturers for the
products that are currently under development, such as PW2101. The agreement with Draxis will be
automatically renewed for successive one year periods, unless either party gives notice of its
intent not to renew the contract, at least six months prior to the end of the then-current term. We
are not a party to any agreements with our third party manufacturers for the products that we are
currently evaluating in clinical trials, such as Patheon with respect to PW2101, except for
purchase orders or similar arrangements. 27




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We believe that there are a limited number of manufacturers that operate under cGMP
regulations capable of manufacturing our TIMERx materials and the products we are evaluating in
clinical trials. Although we have qualified alternate suppliers with respect to the xanthan and
locust bean gums used to manufacture our TIMERx material, if Draxis is unable to manufacture the
TIMERx material in the required quantities, on a timely basis or at all, or if Draxis will not
agree to renew our agreement when it expires on acceptable terms to us or at all, we may be unable
to obtain alternative contract manufacturing, or obtain such manufacturing on commercially
reasonable terms. In addition, if we are unable to enter into longer-term manufacturing
arrangements for our products, such as PW2101, on acceptable terms to us or at all, particularly as
these products advance through clinical development and move closer to regulatory approval, our
business and the clinical development and commercialization of our products could be materially
adversely effected. There can be no assurance that Draxis or any other third parties upon which we
rely for supply of our TIMERx material or our products in clinical development will perform, and
any failures by third parties may delay development or the submission of products for regulatory
approval, impair our collaborators ability to commercialize products as planned and deliver
products on a timely basis, require us or our collaborators to cease distribution or recall some or
all batches of our products or otherwise impair our competitive position, which could have a
material adverse effect on our business, financial condition and results of operations. If our third party manufacturers fail to perform their obligations, we may be adversely
affected in a number of ways, including:  
    our collaborators may not be able to meet commercial demands for our products on a timely
basis;
    our collaborators may not be able to initiate or continue clinical trials of products
that are under development; and
    our collaborators may be delayed in submitting applications for regulatory approvals of
our products. We have limited experience in manufacturing TIMERx material on a commercial scale and no
facilities or equipment to do so. If we determine to develop our own manufacturing capabilities, we
will need to recruit qualified personnel and build or lease the requisite facilities and equipment.
We may not be able to successfully develop our own manufacturing capabilities. Moreover, it may be
very costly and time consuming for us to develop such capabilities. The manufacture of any of our products is subject to regulation by the FDA and comparable
agencies in foreign countries. Any delay in complying or failure to comply with such manufacturing
requirements could materially adversely affect the marketing of our products and our business,
financial condition and results of operations. We are dependent upon a limited number of suppliers for the gums used in our TIMERx material Our drug delivery systems are based a hydrophilic matrix combining a heterodispersed mixture
primarily composed of two polysaccharides, xanthan and locust bean gums, in the presence of
dextrose. These gums are also used in our Geminex, gastroretentive, and SyncroDose drug delivery
systems. We purchase these gums from a primary supplier. We have qualified alternate suppliers with
respect to such materials, but we can provide no assurance that interruptions in supplies will not
occur in the future or that we will not have to obtain substitute suppliers. Any interruption in
these supplies could have a material adverse effect on our ability to manufacture bulk TIMERx for
delivery to our collaborators. If we or our collaborators fail to obtain an adequate level of reimbursement by third party
payors for our controlled release products, they may not be able to successfully commercialize
controlled release products The availability of reimbursement by governmental and other third party payors affects the
market for any pharmaceutical product. These third party payors continually attempt to contain or
reduce the costs of health care by challenging the prices charged for medical products and
services. In specific foreign countries, particularly the countries of the European Union, the
pricing of prescription pharmaceuticals is subject to governmental control. 28




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The generic versions of controlled release products being developed may be assigned an AB
rating if the FDA considers the product to be therapeutically equivalent to the branded controlled
release drug. Failure to obtain an AB rating from the FDA would indicate that for certain purposes
the drug would not be deemed to be therapeutically equivalent, would not be fully substitutable for
the branded controlled release drug and would not be relied upon by Medicaid and Medicare
formularies for reimbursement. In both the U.S. and certain foreign jurisdictions, there have been a number of legislative
and regulatory proposals to change the health care system. Further proposals are likely. The
potential for adoption of these proposals may affect our ability to raise capital, obtain
additional collaborative partners and market our products. If we or our collaborators obtain marketing approvals for our products, we expect to
experience pricing pressure due to the trend toward managed health care, the increasing influence
of health maintenance organizations and additional legislative proposals. We may not be able to
sell our products profitably if reimbursement is unavailable or limited in scope or amount. We will be exposed to product liability claims and may not be able to obtain adequate product
liability insurance Our business exposes us to potential product liability risks which are inherent in the
testing, manufacturing, marketing and sale of pharmaceutical products. Product liability claims
might be made by consumers, health care providers, pharmaceutical companies, or others that sell
our products. These claims may be made even with respect to those products that are manufactured in
licensed and regulated facilities or that otherwise possess regulatory approval for commercial
sale. We are currently covered by primary product liability insurance in amounts of $10 million per
occurrence and $10 million annually in the aggregate on a claims-made basis and by umbrella
liability insurance in excess of $25 million which can also be used for product liability
insurance. This coverage may not be adequate to cover any product liability claims. Product
liability coverage is expensive. In the future, we may not be able to maintain or obtain such
product liability insurance at a reasonable cost or in sufficient amounts to protect us against
losses due to liability claims. Any claims that are not covered by product liability insurance
could have a material adverse effect on our business, financial condition and results of
operations. The market price of our common stock may be volatile The market price of our common stock, like the market prices for securities of pharmaceutical,
biopharmaceutical and biotechnology companies, have historically been highly volatile. The market
from time to time experiences significant price and volume fluctuations that are unrelated to the
operating performance of particular companies. Factors such as fluctuations in our operating
results, future sales of our common stock, 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. 29




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Item 3.Quantitative and Qualitative Disclosures About Market Risk Market Risk and Risk Management Policies Market risk is the risk of loss to future earnings, to fair values or to future cash flows
that may result from changes in the price of a financial instrument. The value of a financial
instrument may change as a result of changes in interest rates, foreign currency exchange rates and
other market changes. Market risk is attributed to all market-sensitive financial instruments,
including debt instruments. Our operations are exposed to financial market risks, primarily changes
in interest rates. Our interest rate risk primarily relates to our investments in marketable
securities. The primary objectives for our investment portfolio are liquidity and safety of principal.
Investments are made to achieve the highest rate of return to us, consistent with these two
objectives. Our investment policy limits investments to specific types of instruments issued by
institutions with investment grade credit ratings and places certain restrictions on maturities and
concentration by issuer. At March 31, 2005, marketable securities consisted primarily of corporate
debt, U.S. Government-agency backed discounted notes and municipal securities, and approximated
$48.5 million. Marketable securities include auction rate securities totaling $5.3 million with
contractual maturity dates of up to thirty years. Liquidity in these instruments is provided from
third parties (buyers and sellers in an auction system) generally every one to three months at
which time their interest rates, or dividend rates for preferred securities, are reset. All of our
other marketable securities have maturity dates of up to twenty-two months. Due to the relatively
short-term maturities of these securities, or auction system liquidity in the case of the auction
rate securities, management believes there is no significant market risk. At March 31, 2005, market
values approximated carrying values. At March 31, 2005, we had approximately $66.8 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 $668,000. 
 Item 4.Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures.Our management, with the participation
of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our
disclosure controls and procedures as of March 31, 2005. The term disclosure controls and
procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and
other procedures of a company that are designed to ensure that information required to be disclosed
by a company in the reports that it files or submits under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in the SECs rules and forms. Disclosure
controls and procedures include, without limitation, controls and procedures designed to ensure
that information required to be disclosed by a company in the reports that it files or submits
under the Exchange Act is accumulated and communicated to the companys management, including its
principal executive and principal financial officers, as appropriate to allow timely decisions
regarding required disclosure. Management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of achieving their objectives
and management necessarily applies its judgment in evaluating the cost-benefit relationship of
possible controls and procedures. Based on the evaluation of our disclosure controls and procedures
as of March 31, 2005, our Chief Executive Officer and Chief Financial Officer concluded that, as of
such date, our disclosure controls and procedures were effective at the reasonable assurance level. (b) Changes in Internal Control Over Financial Reporting.No change in our internal control
over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange
Act) occurred during the fiscal quarter ended March 31, 2005 that has materially affected, or is
reasonably likely to materially affect, our internal control over financial reporting. 30




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PART II  OTHER INFORMATION 
 Item 6.Exhibits See exhibit index below for a list of the exhibits filed as part of this Quarterly Report on
Form 10-Q, which exhibit index is incorporated herein by reference. 31




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SIGNATURE Pursuant to the requirements 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: May 6, 2005
    
    /s/ Jennifer L. GoodJennifer L. GoodSenior Vice President, Finance and Chief Financial Officer(Principal Financial Officer)
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EXHIBIT INDEX ExhibitNumber
    
    Description10.1+
    
    Severance and Settlement Agreement and Release, by and between
Penwest Pharmaceuticals Co. and Tod R. Hamachek, effective
February 14, 2005.10.2+
    
    Penwest Pharmaceuticals Co. Supplemental Executive Retirement Plan.10.3+
    
    Penwest Pharmaceuticals Co. Deferred Compensation Plan.10.4+
    
    Offer letter from Penwest Pharmaceuticals Co. to Robert J.
Hennessey, dated February 15, 2005.31.1
    
    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.+
    
    Management contract, or compensatory plan or arrangement.
 33