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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 Form 10-Q [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended March 31, 2004or[  ]
    
    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,
    
    06810-5120Danbury, Connecticut
    
    (Zip Code)(Address of principal executive offices)
 (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
[X]  No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes
[X]  No [  ] Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of April 29, 2004. Class
    
    OutstandingCommon stock, par value $.001
    
    
    18,528,898




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PENWEST PHARMACEUTICALS
CO.TABLE OF
CONTENTS


PagePART I  FINANCIAL INFORMATIONItem 1.
    

Condensed
Consolidated Financial Statements (Unaudited)Condensed
Consolidated Balance Sheets
    
    
    3Condensed
Consolidated Statements of Operations
    
    
    4Condensed
Consolidated Statements of Cash Flows
    
    
    5Notes
to Condensed Consolidated Financial Statements
    
    
    6Item 2.
    
    Management's Discussion and Analysis of Financial Condition and Results of Operations
    
    
    11Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    24Item 4.
    
    Controls and Procedures
    
    
    24PART II  OTHER INFORMATIONItem 6.
    
    Exhibits and Reports on Form 8-K
    
    
    25Signature
    
    
    26Exhibit Index
    
    
    27Ex-31.1 CEO Certification Pursuant to Section 302Ex-31.2 CFO Certification Pursuant to Section 302Ex-32.1 CEO Certification Pursuant to Section 906Ex-32.2 CFO Certification Pursuant to Section 906




TIMERx® is a registered trademark of the Company. Geminex® and
SyncroDoseTM 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 Consolidated Financial Statements (Unaudited) PENWEST PHARMACEUTICALS CO. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 March 31,
    
    December 31,2004
    
    2003(Unaudited)
    
    (Note 2)(In thousands,except share amounts)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    29,553
    
    
    $
    25,307Marketable securities
    
    
    28,277
    
    
    
    38,586Trade accounts receivable
    
    
    1,336
    
    
    
    1,153Inventories:Raw materials and other
    
    
    172
    
    
    
    196Finished goods
    
    
    576
    
    
    
    460Total inventories
    
    
    748
    
    
    
    656Prepaid expenses and other current assets
    
    
    1,104
    
    
    
    1,364Note receivable
    
    
    1,250
    
    
    
    1,250Total current assets
    
    
    62,268
    
    
    
    68,316Fixed assets, net
    
    
    3,522
    
    
    
    3,533Intangible assets, net
    
    
    3,757
    
    
    
    3,689Cash surrender value of life insurance policies
    
    
    3,002
    
    
    
    2,965Total assets
    
    $
    72,549
    
    
    $
    78,503LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    808
    
    
    $
    2,804Accrued expenses
    
    
    1,359
    
    
    
    2,133Accrued development costs
    
    
    3,120
    
    
    
    2,682Total current liabilities
    
    
    5,287
    
    
    
    7,619Deferred revenue
    
    
    71
    
    
    
    84Deferred compensation
    
    
    3,167
    
    
    
    3,104Total liabilities
    
    
    8,525
    
    
    
    10,807Shareholders equity:Preferred stock, par value $.001, authorized
1,000,000 shares, none outstanding
    
    
    
    
    
    
    Common stock, par value $.001, authorized
29,640,000 shares, issued and outstanding
18,463,648 shares at March 31, 2004 and
18,362,523 shares at December 31, 2003
    
    
    18
    
    
    
    18Additional paid in capital
    
    
    163,141
    
    
    
    162,068Accumulated deficit
    
    
    (99,211
    )
    
    
    (94,433
    )Accumulated other comprehensive income
    
    
    76
    
    
    
    43Total shareholders equity
    
    
    64,024
    
    
    
    67,696Total liabilities and shareholders equity
    
    $
    72,549
    
    
    $
    78,503
 See accompanying notes to condensed consolidated financial statements. 3




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PENWEST PHARMACEUTICALS CO. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 Three Months EndedMarch 31,2004
    
    2003(Unaudited)(In thousands,except per share data)Revenues:Royalties and licensing fees
    
    $
    1,261
    
    
    $
    947Product sales
    
    
    222
    
    
    
    225Total revenues
    
    
    1,483
    
    
    
    1,172Cost of revenues
    
    
    49
    
    
    
    81Gross profit
    
    
    1,434
    
    
    
    1,091Operating expenses:Selling, general and administrative
    
    
    2,336
    
    
    
    2,298Research and product development
    
    
    4,089
    
    
    
    3,583Total operating expenses
    
    
    6,425
    
    
    
    5,881Operating loss from continuing operations
    
    
    (4,991
    )
    
    
    (4,790
    )Investment income
    
    
    213
    
    
    
    41Interest expense
    
    
    
    
    
    
    32Loss from continuing operations before income taxes
    
    
    (4,778
    )
    
    
    (4,781
    )Income tax expense
    
    
    
    
    
    
    6Loss from continuing operations
    
    
    (4,778
    )
    
    
    (4,787
    )Earnings from discontinued operations, net of
income tax expense of $26
    
    
    
    
    
    
    177Gain on sale of discontinued operations
    
    
    
    
    
    
    9,580Net (loss) income
    
    $
    (4,778
    )
    
    $
    4,970Basic and diluted (loss) earnings per common share:Continuing operations
    
    $
    (0.26
    )
    
    $
    (0.31
    )Discontinued operations
    
    
    
    
    
    
    0.63Net (loss) income per common share
    
    $
    (0.26
    )
    
    $
    0.32Weighted average shares of common stock outstanding
    
    
    18,410
    
    
    
    15,508
 See accompanying notes to condensed consolidated financial statements. 4




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PENWEST PHARMACEUTICALS CO. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 Three Months EndedMarch 31,2004
    
    2003(Unaudited)(In thousands)Net cash used in operating activities:Net (loss) income
    
    $
    (4,778
    )
    
    $
    4,970Less earnings from discontinued operations, net of tax
    
    
    
    
    
    
    (177
    )Less gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    (9,580
    )Loss from continuing operations
    
    
    (4,778
    )
    
    
    (4,787
    )Adjustments to reconcile loss from continuing operations to
net cash used in continuing operations operating activities
    
    
    (1,970
    )
    
    
    (2,004
    )Net cash used in continuing operations operating activities
    
    
    (6,748
    )
    
    
    (6,791
    )Net cash provided by discontinued operations operating activities
    
    
    
    
    
    
    874Net cash used in operating activities
    
    
    (6,748
    )
    
    
    (5,917
    )Investing activities:Proceeds from sale of discontinued operations, net of
transaction costs paid of $1,351
    
    
    
    
    
    
    35,901Acquisitions of fixed assets, net
    
    
    (218
    )
    
    
    (109
    )Intangible asset costs
    
    
    (129
    )
    
    
    (236
    )Proceeds from maturities of marketable securities
    
    
    12,318
    
    
    
    1,000Purchases of marketable securities
    
    
    (1,900
    )
    
    
    (7,938
    )Net cash provided by continuing operations investing activities
    
    
    10,071
    
    
    
    28,618Net cash used in discontinued operations investing activities
    
    
    
    
    
    
    (97
    )Net cash provided by investing activities
    
    
    10,071
    
    
    
    28,521Financing activities:Proceeds from loans
    
    
    
    
    
    
    1,354Repayments of loans
    
    
    
    
    
    
    (6,792
    )Issuance of common stock, net
    
    
    923
    
    
    
    87Net cash provided by discontinued operations
    
    
    
    
    
    
    2,249Net cash provided by (used in) financing activities
    
    
    923
    
    
    
    (3,102
    )Effect of exchange rate changes on cash and cash equivalents of
discontinued operations
    
    
    
    
    
    
    32Net increase in cash and cash equivalents
    
    
    4,246
    
    
    
    19,534Cash and cash equivalents at beginning of period
    
    
    25,307
    
    
    
    1,629Cash and cash equivalents at end of period
    
    $
    29,553
    
    
    $
    21,163
 See accompanying notes to condensed consolidated financial statements. 5




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PENWEST PHARMACEUTICALS CO. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
  1.
    
    Business Penwest develops pharmaceutical products based on innovative oral drug
delivery technologies. The foundation of Penwests technology platform is
TIMERx®, an extended release delivery system that is adaptable to soluble and
insoluble drugs and that is flexible for a variety of controlled release
profiles. The Company has also developed two additional oral drug delivery
systems, Geminex® and SyncroDose. Geminex is a dual drug delivery system that
is designed to provide independent release of different active ingredients
contained in a drug. SyncroDose is a drug delivery system that is designed to
release the active ingredient of a drug at the desired site and time in the
digestive tract. Prior to February 27, 2003, Penwest also developed, manufactured and
distributed branded pharmaceutical excipients, which are the inactive
ingredients in tablets and capsules, primarily consisting of binders,
disintegrants and lubricants. On February 27, 2003, Penwest sold substantially
all of the assets used in the Companys excipient business to subsidiaries and
affiliates of Josef Rettenmaier
Holding GmbH & Co. KG (the Asset Sale). The Company received $39.5 million in
cash and a promissory note for $2.25 million in consideration for the excipient
business. In April 2003, the Company received $1.0 million of the
$2.25 million owed to it
under the promissory note, with the balance due in May 2004. The
Company used approximately $5.5 million of proceeds of the sale of its
excipient business to repay debt (see Note 6). As a result of the Asset Sale,
the accompanying condensed consolidated financial statements present Penwests
excipient business as a discontinued operation for all periods presented. The Company is subject to the risks and uncertainties associated with a
drug delivery company actively engaged in research and development. These risks
and uncertainties include, but are not limited to, a history of net losses,
technological changes, dependence on collaborators and key personnel, the
successful completion of development efforts and of obtaining regulatory
approval, the successful commercialization of TIMERx controlled release
products, compliance with government regulations, patent infringement
litigation and competition from current and potential competitors, some with
greater resources than the Company, and a requirement for additional funding.  2.
    
    Basis of Presentation The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States 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 accounting
principles generally accepted in the United States 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. Operating results for
the three month period ended March 31, 2004 are not necessarily indicative of
the results that may be expected for the year ending December 31, 2004. For
further information, refer to the consolidated financial statements and
footnotes thereto included in the Companys Annual Report on Form 10-K for the
year ended December 31, 2003. As a result of the Asset Sale, the operating results of the excipient
business have been presented as discontinued operations in the condensed
consolidated statements of operations for the three month period ended March
31, 2003 (see Note 10). During the three months ended March 31, 2003, the Company recorded an
impairment loss of approximately $214,000, net of accumulated depreciation,
relating to equipment of its excipient business. The impaired equipment
primarily related to a pulp shredding transfer system which did not function as
planned, resulting in the eventual abandonment of the related project and full
write-down of its carrying value. This impairment loss is included in earnings
from discontinued operations in the three months ended March 31, 2003 condensed
consolidated statements of operations. The balance sheet at December 31, 2003, has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by accounting principles generally accepted in the
United States for complete financial statements. 6




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)  3.
    
    Summary of Significant Accounting Policies Revenue Recognition Revenues from product sales are recognized 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. Revenues received from non-refundable upfront
licensing fees are recognized ratably over the development period of the
collaboration agreement, when this period involves development risk associated
with the incomplete stage of a products development or over the estimated or
contractual licensing and supply term when there exists an obligation to supply
inventory for manufacture. Non-refundable milestone fees received for the
development funding of a product are partially recognized upon receipt based on
the Companys proportionate development efforts achieved to date relative to
the total expected development efforts and the remainder is generally
recognized ratably over the remaining expected development period. The
proportionate development efforts achieved are measured by estimating the
percentage of work completed that is required of the Company in the development
effort for the product. This estimate is primarily derived from the underlying
project plans and timelines, developed by qualified personnel who work closely
on such projects. In particular, the Company reviews output measures such as
job specifications and tasks completed, compared to all such job specifications
and tasks outlined for a particular project. Job specifications vary with each
project and primarily include development activities regarding initial
formulation work, manufacturing scale-up, proof-of-principle biostudies,
clinical development and regulatory matters. Other contractual fees received in
connection with a collaborators launch of a product are also recognized
ratably over the estimated or contractual licensing and supply term. Product
royalty fees are recognized when earned. Research and Development Expenses Research and development expenses consist of costs associated with
products being developed internally as well as products being developed under
collaboration agreements and include related salaries, benefits and other
personnel related expenses, clinical trial costs, and contract and other
outside service fees. Research and development costs are expensed as incurred.
Certain reimbursements of costs, generally related to drug formulation on
feasibility studies, are netted against research and development expense. A
significant portion of the Companys development activities are outsourced to
third parties including contract research organizations, and contract
manufacturers in connection with the production of clinical materials, or may
be performed by the Companys collaborators. These arrangements may require
estimates be made of related service fees or the Companys share of development
costs, in which actual results could materially differ from the estimates and
affect the reported amounts in the Companys financial statements. Stock Based Compensation The Company adopted the disclosure provisions of Statement of Financial
Accounting Standards (SFAS) No. 148, Accounting for Stock-Based Compensation
 Transition and Disclosure, which amends SFAS No. 123, Accounting for
Stock-Based Compensation, in 2002. SFAS No. 148 provides alternative methods
of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation, which was originally provided
under SFAS No. 123. The Statement also improves the timeliness of disclosures
by requiring the information to be included in interim as well as annual
financial statements. The adoption of these disclosure provisions had no impact
on the Companys condensed consolidated results of operations, financial
position or cash flows. At March 31, 2004, the Company maintained two 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 Opinion No. 25, Accounting for Stock Issued to
Employees. During the three months ended March 31, 2004, in connection with
board of directors retainer and meeting fees in 2004, the Company recorded
$20,000 of expense associated with the issuance of discounted stock options and
$37,689 of expense associated with restricted stock grants. No other
stock-based employee compensation expense is reflected in net loss as all other
options granted under these plans had an exercise price equal to the fair
market value of the underlying common stock on the date of grant. 7




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


The following table reflects proforma net loss and loss per share had the
Company elected to adopt the fair value approach of SFAS No. 123:

Three Months EndedMarch 31,2004
    
    2003(Unaudited)(in thousands, except pershare data)Net (loss) income as reported
    
    $
    (4,778
    )
    
    $
    4,970Stock options fair value
effect
    
    
    (773
    )
    
    
    (1,325
    )Net (loss) income  pro forma after stock options fair value effect
    
    $
    (5,551
    )
    
    $
    3,645Net (loss) income per share, basic and diluted  as reported
    
    $
    (0.26
    )
    
    $
    0.32Net (loss) income per share, basic and diluted  pro forma after stock
options fair value
effect
    
    $
    (0.30
    )
    
    $
    0.24




|4. |  | Issuance of Common Stock
|-- |  | ------------------------

On August 5 and August 6, 2003, the Company completed the sale of a total
of 2,507,762 shares of common stock through a private placement to selected
institutional investors (the Private Placement), resulting in net proceeds to
the Company, after fees and expenses, of approximately $49.3 million. As part
of the Private Placement, the Company granted the institutional investors
additional rights to purchase up to an additional 501,552 shares of common
stock at a price of $26.00 per share. These additional investment rights became
exercisable on September 12, 2003, and expired on December 9, 2003. None of
these additional investment rights were exercised.



|5. |  | Recent Accounting Pronouncements
|-- |  | --------------------------------

In December 2003, the FASB issued SFAS No. 132 (revised 2003) Employers
Disclosures about Pensions and Other Postretirement Benefits an amendment of
FASB Statements No. 87, 88, and 106. This Statement revises employers
disclosures about pension plans and other postretirement benefit plans. It does
not change the measurement or recognition of those plans required by FASB
Statements No. 87, Employers Accounting for Pensions, No. 88, Employers
Accounting for Settlements and Curtailments of Defined Benefit Pension Plans
and for Termination Benefits, and No. 106, Employers Accounting for
Postretirement Benefits Other Than Pensions. This Statement retains the
disclosure requirements contained in FASB Statement No. 132, Employers
Disclosures about Pensions and Other Postretirement Benefits, which it
replaces. It requires additional disclosures to those in the original Statement
No. 132 about the assets, obligations, cash flows, and net periodic benefit
cost of defined benefit pension plans and other defined benefit postretirement
plans. The adoption of SFAS No. 132 (revised 2003) had no impact on the
Companys financial position or results of operations (see Note 8).

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



|6. |  | Loans and Notes Payable
|-- |  | -----------------------

Credit Facilities

On January 17, 2001, the Company completed arrangements for a revolving
line of credit (Revolver) with a financial institution. Under the terms of
the Revolver, the Company could borrow up to $10.0 million (Line of Credit)
as determined by a formula based on the Companys Eligible Accounts Receivable
and Eligible Saleable Inventory, as defined in the agreement. Under the
formula, generally 85% of the Companys U.S. and Canadian receivables, as well
as generally 60% of the Companys U.S. saleable inventories, were included in
the borrowing base. Amounts outstanding under the Revolver were collateralized
by the Companys U.S. and Canadian accounts receivable, and its inventory and
general intangibles. The Revolver had an initial term of three years, and
provided for annual renewals thereafter. On February 27, 2003, the Company paid
off the outstanding balance of $3.3 million and terminated the Revolver in
connection with the Asset Sale (see Note 10).

8



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Note Payable to AstraZeneca AB As
part of the Companys agreement to acquire assets including
trademarks and other intellectual property related to an excipient
product, Pruv, for $3 million on October 25, 2002, the
Company issued a note to the seller, AstraZeneca AB, in the principal
amount of $2.25 million. Under the agreement, the note required
the Company to pay all indebtedness outstanding under the note upon
the closing of the Asset Sale, which included these assets, and which
occurred in February 2003. As a result, this note was paid in full in
February 2003. Business Insurance Premium Financing On September 24, 2002, the Company entered into a Premium Finance
Agreement (the Finance Agreement) through which it
financed approximated $1.1 million of premiums payable in connection with the
annual renewal of its general business insurance. Under the Finance Agreement,
Penwest was required to repay the amount financed in equal monthly installments
through June 2003,
plus interest at a rate of 3.11% per annum. In addition, the Company assigned,
as a security interest, any and all unearned premiums or other amounts which
may become payable to the Company under the insurance policies. The amount
financed under the Finance Agreement was paid in full in May 2003.  7.
    
    Income Taxes For continuing operations, the effective tax rates for the three month
periods ended March 31, 2004 and 2003 were zero. The effective tax rates are
higher than the federal statutory rate of a 34% benefit due to valuation
allowances recorded to offset deferred tax assets relating to the Companys net
operating losses. The gain on sale of discontinued operations of approximately $9.6 million,
recorded in the three months ended March 31, 2003, is net of tax expense of
$62,000, or less than 1% of the pretax gain. The tax rate is lower than the
federal statutory rate of 34% primarily due to net operating losses which
offset the gain. In addition, earnings from discontinued operations of $177,000
for the three months ended March 31, 2003 are net of tax expenses of $26,000,
or 13% of pretax earnings. These tax rates, which include foreign taxes,
are lower than the federal statutory rate of 34% primarily due to overall U.S.
net operating losses which offset the U.S. earnings of the discontinued
operation (see Note 10).  8.
    
    Supplemental Executive Retirement Plan The Company has a Supplemental Executive Retirement Plan (SERP), a
nonqualified plan, which covers the Chairman and Chief Executive Officer of
Penwest. The Company does not fund this liability and no assets are held by the
Plan. The Company uses a measurement date of December 31 for its SERP. The
following disclosures summarize information relating to the Plan. Components of net periodic benefit cost: Three Months EndedMarch 31,2004
    
    2003(in thousands)Service cost
    
    $
    (8
    )
    
    $
    (7
    )Interest cost
    
    
    31
    
    
    
    31Amortization of net obligation at transition
    
    
    10
    
    
    
    15Amortization of prior service cost
    
    
    1
    
    
    
    3Amortization of net gain
    
    
    
    
    
    
    (6
    )Net periodic benefit cost
    
    $
    34
    
    
    $
    36
  9.
    
    Comprehensive Loss The components of comprehensive loss for the three month periods ended
March 31, 2004 and 2003 are as follows (in thousands): Three Months EndedMarch 31,2004
    
    2003(Unaudited)Net (loss) income
    
    $
    (4,778
    )
    
    $
    4970Foreign currency translation
    
    
    
    
    
    
    109Change in unrealized net gains on marketable securities
    
    
    33
    
    
    
    Comprehensive loss
    
    $
    (4,745
    )
    
    $
    5,079
 9




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Accumulated other comprehensive income (loss) equals the cumulative
translation adjustment and unrealized net gains on marketable securities which
are the only components of other comprehensive income (loss) included in the
Companys financial statements. Effective on the date of the Asset Sale,
accumulated other comprehensive income (loss) is comprised solely of unrealized
net gains and losses on marketable securities.  10.
    
    Discontinued Operations On February 27, 2003, Penwest sold substantially all of the assets (the
Assets) used in the Companys excipient business to subsidiaries and
affiliates of Josef Rettenmaier Holding GmbH & Co. KG (Rettenmaier) for
$41.75 million, plus the assumption of specified liabilities, subject to a
working capital adjustment. The Assets of the excipient business were sold to
Rettenmaier, either directly or through the sale of the outstanding capital
stock of the three subsidiaries of Penwest that did business in the UK, Germany
and Finland. The purchase price included $39.5 million in cash and a
non-interest bearing promissory note of $2.25 million, with $1.0 million paid
in April 2003 and $1.25 million due May 25, 2004. In the first quarter of 2003, the Company recorded a gain on the Asset Sale of
approximately $9.6 million, net of taxes of $62,000, and has reported the
operating results of the excipient business as a discontinued operation in
accordance with SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets. In the second quarter of 2003, the Company recorded an
expense of $83,000 for the working capital adjustment, net of a tax benefit of
$11,000. The net carrying amount of the assets and liabilities on the date of
the Asset Sale was approximately $29.5 million. The approximate carrying values
of the major classes were: property, plant and equipment of $11.4 million;
inventory of $8.3 million; receivables of $6.0 million; and intangible assets
of $4.3 million offset by other net liabilities. The gain on the Asset Sale is
net of transaction related costs totaling $3.1 million, primarily consisting of
professional and advisory fees. Revenues and pretax profits for the excipient
business approximated $6.1 million and $203,000, respectively, for the period
January 1, 2003 through the Asset Sale date of February 27, 2003. Prior to the sale of the excipient business, the Company owned its office,
laboratory and warehouse facility in Patterson, New York, as well as a facility
in Cedar Rapids, Iowa, where it manufactured pharmaceutical excipients. As part
of the Asset Sale, the Company transferred these properties and assigned its
lease of a pharmaceutical excipient manufacturing facility in Nastola, Finland
to Rettenmaier. Under a lease agreement signed with Rettenmaier on February 27,
2003, the Company has the right to occupy approximately 14,000 square feet of
office and research and development space in the Patterson facility until
February 2008, initially on a rent-free basis (plus operating expenses) for two
years and then pursuant to three successive one-year options at monthly rent
payments approximating $14,000, plus operating expenses.  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, a narcotic analgesic for
the treatment of moderate to severe pain, based on the Companys TIMERx
technology. This agreement was amended and restated in April 2002. Endo has a
broad product line including established brands such as Percodan®, Percocet®,
and Lidoderm®. Endo is registered with the U.S. Drug Enforcement Administration
as a developer, manufacturer and marketer of controlled narcotic substances. Under the strategic alliance agreement, the responsibilities of the
Company and Endo with respect to the oxymorphone product are determined by a
committee comprised of an equal number of members from each of the Company and
Endo (the Alliance Committee). During the development of the product, the
Company formulated oxymorphone ER, and Endo conducted all clinical studies and
prepared and filed all regulatory applications. The Company has agreed to
supply TIMERx material to Endo, and Endo has agreed to manufacture and market
oxymorphone ER in the United States. The manufacture and marketing outside of
the United States may be conducted by the Company, Endo or a third party, as
determined by the Alliance Committee. Prior to April 17, 2003, the Company and Endo shared the costs involved in
the development of oxymorphone ER. On March 17, 2003, the Company notified Endo
that it was discontinuing its participation in the funding of the development
and marketing of oxymorphone ER effective April 17, 2003. As a result of this
termination of funding, Endo has the right to complete the development of
oxymorphone ER and recoup the portion of development costs incurred by Endo
that otherwise would have been funded by Penwest (Unfunded Development
Costs). Endo may recoup such development costs through a temporary adjustment
in the royalty rate payable to Penwest that will return to its pre-adjustment
level once Endo has recovered such costs. Endo may also allow the 10




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Company to reimburse Endo directly for the unfunded amounts. The Company
estimates that through March 31, 2004 Unfunded Development Costs approximated
$8.8 million. The parties have agreed that the party marketing oxymorphone ER
will pay the other party royalties initially equal to 50% of the net
realization (as defined in the agreement) subject to adjustment for the
Unfunded Development Costs. This percentage will decrease if the aggregate U.S.
net realization exceeds pre-determined thresholds. In general, the royalty
payable by the marketing party to the other party will not drop below 40%.
However, the royalty will be reduced by one-third in limited circumstances,
including termination of the agreement based on uncured material breaches of
the agreement by the royalty receiving party and certain bankruptcy and
insolvency events involving the royalty receiving party. Under the agreement,
Endo will purchase formulated TIMERx material for use in oxymorphone ER
exclusively from the Company at specified prices, and include these purchases
in cost of goods sold of the product prior to determining net realization. Mylan Pharmaceuticals Inc. On March 2, 2000, Mylan announced that it had signed a supply and
distribution agreement with Pfizer to market a generic version of all three
strengths (30 mg, 60 mg, 90 mg) of Pfizers Procardia XL. In connection with
that agreement, Mylan decided not to market Nifedipine XL, a product the
Company had developed in collaboration with Mylan, and agreed to pay Penwest a
royalty on all future net sales of the 30 mg strength of Pfizers generic
Procardia XL. The royalty percentage was comparable to the percentage called
for in Penwests original agreement with Mylan for Nifedipine XL. Mylan has
retained the marketing rights to the 30 mg strength of Nifedipine XL. Mylans
sales in the United States in 2003 of the 30 mg dosage strength version of
Pfizers generic Procardia XL totaled approximately $36.8 million. The term of
this agreement continues until such time as Mylan permanently ceases to market
generic Procardia XL.  12.
    
    Subsequent Event In April 2004, the Company signed a lease amendment to its February 3,
2003 lease agreement (Agreement) for approximately 21,000 square feet of
office space in Danbury, Connecticut within the same building as the Companys
corporate offices. Under this amendment, the new office space was substituted
for the previous space leased in the building. This lease has an initial term
expiring December 30, 2006, with renewal options through December 30, 2008, and
requires that monthly base rents be paid, including escalation clauses, in
amounts ranging from $37,000 to $40,000 through the initial lease term. The
Company moved its corporate offices to the new office space on April 30, 2004. 
 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 oral drug delivery
technologies. The foundation of our technology platform is TIMERx, an extended
release delivery system that is adaptable to soluble and insoluble drugs, and
that is flexible for a variety of controlled release profiles. We have also
developed two additional oral drug delivery systems, Geminex and SyncroDose.
Geminex is a dual drug delivery system that is designed to provide independent
release of different active ingredients contained in a drug. SyncroDose is a
drug delivery system that is designed to release the active ingredient of a
drug at the desired site and time in the digestive tract. Our proprietary
TIMERx drug delivery technology is utilized in four products that were
developed with collaborators and have been approved in various countries. In
addition, we have a number of product candidates in our drug development
pipeline. 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 the treatment of moderate to severe pain, and
PW2101, a branded product for the treatment of hypertension that we have
formulated using our TIMERx technology.  
    
    Oxymorphone ER.We are developing oxymorphone ER under a
collaboration agreement with Endo Pharmaceuticals, Inc. In February
2003, the FDA accepted for filing a New Drug Application, or NDA, for
oxymorphone ER. In October 2003, Endo received an approvable letter
from the U.S. Food and Drug Administration, or FDA, for oxymorphone ER.
In the letter, the FDA requested that Endo address certain questions,
provide additional clarification and information, and conduct 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 the first quarter of 2004, Endo had a meeting with the FDA to
clarify issues raised in the letter, review the necessity for additional
trials and discuss its responses to the approvable letter. Endo, in
reporting the outcome of this meeting, stated that the status of the
FDAs request for additional clinical trials related to the drug has not
been resolved and that the FDA indicated it needed more time to
adequately review Endos additional analyses of certain data. In
addition, 11




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Endo stated that the FDA committed to respond to Endo as soon as possible,
which Endo believes will be during the second quarter of 2004.  
    
    PW2101.We are currently developing PW2101 on our own. In the fourth
quarter of 2003, we completed a pivotal clinical trial of this product
candidate. This pivotal clinical trial was a randomized, double-blind,
parallel-group study comparing PW2101 to placebo. A total of 163
subjects were evaluated for efficacy compared to placebo based upon
primary end points agreed upon with the FDA. The primary end points of
the trial were met, and the clinical development program is now
complete. We expect to file a 505(b)(2) NDA for PW2101 by the end of 2004. We
are also developing a lower strength of PW2101. In order to obtain
marketing approval of this lower strength dosage form, we will need
to conduct an additional clinical trial. We commenced this trial in
the second quarter of 2004 and expect to complete this additional
trial by the end of 2004. Assuming that this trial is successful, we
expect that we would submit an NDA for the lower dosage form of
PW2101 in the first quarter of 2005. 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 a generic version of all
three strengths (30 mg, 60 mg, 90 mg) of Pfizers Procardia XL. In connection
with that agreement, Mylan decided not to market Nifedipine XL, and agreed to
pay 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. We received $39.5 million in cash and
a promissory note for $2.25 million in consideration for the excipient
business. We received $1.0 million of the $2.25 million promissory note in
April 2003 with the balance due in May 2004. We used approximately $5.5 million
of proceeds of the sale of our excipient business to repay outstanding debt.
Commencing in the first quarter of 2003, we reported the operating results of
the excipient business as a discontinued operation. We have incurred net losses since 1994. As of March 31, 2004, our
accumulated deficit was approximately $99.2 million. We expect operating losses
and negative cash flows to continue until substantial sales of products
commercialized utilizing TIMERx technology occur. A substantial portion of our
revenues through February 27, 2003 were generated from sales of our
pharmaceutical excipient product line. Since the sale of the excipient
business, our revenues have been generated primarily from royalties from Mylans
sales of the 30 mg generic version of Pfizers 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;  
    
    royalties from Mylan; and  
    
    the level of our investment in research and development activities. Our strategy includes a significant commitment to spending on research and
development targeted at identifying and developing products that can be
formulated using our drug delivery technologies. We also expect to expend
significant resources on the development of new drug delivery technologies,
both internally and through in-licenses or acquisitions. Our spending in the
area of new technology, however, is discretionary and is subject to identifying
appropriate opportunities, as well as the availability of funds from our
operations, cash resources, collaborative research and development arrangements
and external financing. Our results of operations may fluctuate from quarter to quarter depending
on if and when oxymorphone ER is approved, the amount and timing of royalties
on Mylans sales of Pfizers 30 mg generic version of Procardia XL, volume and
timing of shipments of formulated bulk TIMERx, and on variations in payments
under our collaborative agreements, including payments upon the achievement of
specified milestones. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of
operations are based upon our condensed consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements
requires us to make estimates and assumptions that affect the reported amounts
of assets and liabilities as of the date of the financial statements, and the
reported amounts of revenues and expenses during the reporting periods. We base
our estimates on historical experience and on various other factors that we
believe to be reasonable under the circumstances. We regard an accounting
estimate underlying our financial statements as a critical accounting
estimate if the nature of the estimate or assumption is material due to the
level of subjectivity and judgment involved, or the susceptibility of such
matter to change, and if the impact of the estimate or assumption on our
financial condition or performance may be material. On an ongoing basis, we
evaluate these estimates and judgments. Actual results may differ from these
estimates under different assumptions or conditions. Areas where significant
judgments are made include, but are not limited to, revenue recognition,
research and development expenses, deferred 12




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taxes-valuation allowance and impairment of long-lived assets. For a more
detailed explanation of the judgments made 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,
2003. Results of Operations for Quarters Ended March 31, 2004 and 2003 Revenues Quarter ended
    
    Percentage
    
    Quarter endedMarch
    
    Increase
    
    March31, 2004
    
    (Decrease)
    
    31, 2003(in thousands, except percentages)Royalty and Licensing Revenues
    
    $
    1,261
    
    
    
    33
    %
    
    $
    947Product Sales
    
    
    222
    
    
    
    (1
    )%
    
    
    225Total Revenues
    
    $
    1,483
    
    
    
    27
    %
    
    $
    1,172
 The increase in total revenues in the first quarter of 2004 from the first
quarter of 2003 was the result of increases in royalty and licensing revenues.
Our royalty and licensing revenues primarily consist of royalties from Mylan on
their sales of the 30 mg generic version of Pfizers Procardia XL. These
royalties increased in the first quarter of 2004 compared to the first quarter
of 2003 due to Mylans increased sales of Pfizers
Procardia XL. Our product sales consist of sales of formulated
bulk TIMERx to our collaborators. Product sales in the first quarter of 2004
remained flat as compared to the first quarter of 2003. Selling, General and Administrative Expense Selling, general and administrative (SG&A) expenses for the first quarter
of 2004 and for the first quarter of 2003 were $2.3 million. SG&A expenses in
the first quarter of 2003 included $230,000 for our share of marketing expenses
for oxymorphone ER. There were no such costs for this product in the first
quarter of 2004 as the Company opted out of funding these costs effective April
17, 2003. Partially offsetting this decrease, SG&A expenses in the first
quarter of 2004 included certain expenses which were previously allocated to
the excipient business in the first quarter of 2003, prior to February 27,
2003, the date of the sale of our excipient business, and were therefore not
included in continuing operations for the first quarter of 2003. These
expenses were ongoing after the sale and have been fully absorbed in continuing
operations following the sale of our excipient business. Research and Product Development Expense Quarter ended
    
    Percentage
    
    Quarter endedMarch
    
    Increase
    
    March31, 2004
    
    (Decrease)
    
    31, 2003(in thousands, except percentages)Oxymorphone ER
    
    $
    
    
    
    
    (100
    )%
    
    $
    1,562PW2101
    
    
    1,762
    
    
    
    320
    %
    
    
    420Research and New Technology Development
    
    
    524
    
    
    
    (3
    )%
    
    
    540Phase I Products and Internal Cost
    
    
    1,803
    
    
    
    70
    %
    
    
    1,061Total Research and Product Development Expense
    
    $
    4,089
    
    
    
    14
    %
    
    $
    3,583
 In the preceding table, research and development expenses are set forth in
the following four categories:  
    
    Oxymorphone ER These expenses reflect our direct external expenses
relating to the development of oxymorphone ER. These expenses consist
primarily of payments to third parties, including payments to Endo for
the first quarter of 2003 for our share of development costs under our
collaboration agreement with Endo;  
    
    PW2101 These expenses reflect our direct external expenses relating
to the development of PW2101. These expenses consist primarily of
payments to third parties in connection with clinical trials and the
manufacturing of product, prior to regulatory approval, for clinical use
and commercial use;  
    
    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 amortization of patent costs. 13




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
    
    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. Total research and product development expenses increased in the first
quarter of 2004 primarily due to increased costs relating to the development of
PW2101, as well as increased costs relating to the development of phase I
product candidates, partially offset by decreased costs relating to the
development of oxymorphone ER. We did not have any research and development expenses related to
oxymorphone ER in the first quarter of 2004 due to the discontinuation of our
funding of the development of oxymorphone ER effective April 17, 2003. We have
not incurred any research and development expenses related to oxymorphone ER
since April 17, 2003, and we do not expect to incur any additional research and
development expenses relating to oxymorphone ER unless we resume our
participation in the funding of the expenses of oxymorphone ER. Approximately 43% of our research and development expenses for
the first quarter of 2004 related to the direct costs associated with
clinical development and manufacturing scale-up of PW2101. These expenses
increased from the first quarter of 2003 primarily due to expenses relating to
the pivotal clinical trial of PW2101 and our increased efforts with respect to
the manufacture of PW2101. In the fourth quarter of 2003, we completed a
pivotal trial of PW2101 for the treatment of hypertension and announced in the
first quarter of 2004 that the primary end points had been met. We do not plan
to conduct any additional clinical trials prior to submitting a
505(b)(2) NDA
for this
product, which we anticipate filing in late 2004. However, we are
also developing a lower strength of PW2101. In order to obtain
marketing approval of this lower strength dosage form, we will need
to conduct an additional clinical trial. We commenced this
trial in the second quarter of 2004 and expect to complete this
additional trial by the end of 2004. Assuming that this trial is
successful, we expect that we would submit an NDA for the lower dosage
form of PW2101 in the first quarter of 2005. In addition, we expect to
continue to incur additional research and development expenses relating to
PW2101 as we continue to work with the third party manufacturer of PW2101 with
respect to supporting a manufacturing site change, as well as for the
cost of stability data and the cost of preparing the NDAs for submission. Although we
have developed PW2101 on our own, we do not intend to market this product. As a
result, we are currently seeking a marketing partner for this product. There can be no assurance that any of our products will be successfully
developed, will receive regulatory approval, or will be successfully
commercialized. Completion of clinical trials and commercialization of these
product candidates may take several years, and the length of time can vary
substantially according to the type, complexity and novelty of a product
candidate. Due to the variability in the length of time necessary to develop a
product, the uncertainties related to the estimated cost of the development
projects and ultimate ability to obtain governmental approval for
commercialization, accurate and meaningful estimates of the ultimate cost to
bring our product candidates to market are not available. Phase I products and internal costs increased in the first quarter of 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 research and development efforts. Tax Rates For continuing operations, the effective tax rates for the quarters ended
March 31, 2004 and 2003 were zero. The effective tax rates are higher than the
federal statutory rate of a 34% benefit due primarily to valuation allowances
recorded to offset net deferred tax assets relating to our net operating
losses. The gain on sale of discontinued operations of approximately $9.6 million,
recorded in the three months ended March 31, 2003, is net of tax expense of
$62,000, or less than 1% of the pretax gain. The tax rate is lower than the
federal statutory rate of 34% primarily due to net operating losses which
offset the gain. In addition, earnings from discontinued operations of $177,000
for the three months ended March 31, 2003 are net of tax expenses of $26,000,
or 13% of pretax earnings. These tax rates, which include foreign taxes, are
lower than the federal statutory rate of 34% primarily due to overall U.S. net
operating losses which offset the U.S. earnings of the discontinued operation. 14




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Liquidity and Capital Resources Subsequent to August 31, 1998, the date we became an independent,
publicly-owned company, we have funded our operations and capital expenditures
with proceeds from the sale and issuance of shares of common stock, the sale of
our excipient business, the sale of excipients, sales of formulated bulk
TIMERx, royalties and milestone payments from Mylan and other collaborators,
and advances under credit facilities. We are a party to an agreement with Endo with respect to the development
of oxymorphone ER. On April 17, 2003, we discontinued our participation in the
funding of the development and marketing of oxymorphone ER. Accordingly, our
research and development, and selling, general and administrative expenses with
respect to oxymorphone ER decreased significantly in the first quarter of 2004
compared to the corresponding period in 2003. We do not expect to incur
any significant expenses relating to oxymorphone ER in 2004 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. Endo may recoup
these unfunded development costs 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 costs. Endo may also allow us to reimburse
Endo directly for these unfunded development costs. We estimate that through
March 31, 2004, unfunded development costs approximated $8.8 million. On February 27, 2003, we completed the sale of our excipient business to
Rettenmaier. As a result of the sale of our excipient business, we had
approximately $35 million of net cash proceeds available after the closing.
However, as a result of the sale of our excipient business, we no longer derive
cash flow from the sale of excipients. A portion of the proceeds from the sale
of our excipient business was used to pay the $3.3 million of outstanding
borrowings under our line of credit, which was terminated on February 27, 2003.
In addition, we used the proceeds from the sale of the excipient business to
repay in full a $2.25 million note payable to AstraZeneca AB, incurred in
connection with our acquisition of specified intellectual property related to
the excipient business. On August 5 and August 6, 2003, we completed the sale of a total of
2,507,762 shares of common stock through a private placement to selected
institutional investors, resulting in net proceeds to us, after fees and
expenses, of approximately $49.3 million. As part of this transaction, we
granted the institutional investors additional rights to purchase up to an
additional 501,552 shares of common stock at a price of $26.00 per share. These
additional investment rights became exercisable on September 12, 2003 and
expired on December 9, 2003. None of these additional investment rights were
exercised. As of March 31, 2004, we had cash, cash equivalents, and short-term
investments of $57.8 million. We have no committed sources of capital other
than Rettenmaiers commitment to repay us $1.25 million in May 2004 pursuant to
a promissory note in connection with the sale of the excipient business. We had negative cash flow from operations for the three months ended March
31, 2004 of $6.7 million, primarily due to a loss from continuing operations of
$4.8 million and our use of cash in reducing our accounts payable and accrued
expenses by $2.3 million in the period. We had negative cash flow from
operations for the three months ended March 31, 2003 of $5.9 million, primarily
due to the loss from continuing operations of $4.8 million, as well as a
reduction in accounts payable and accrued expenses of $2.4 million, partially
offset by cash flows from discontinued operations operating activities of
$874,000. Investing activities provided $10.1 million in cash for the three
months ended March 31, 2004, primarily reflecting proceeds from maturities of
marketable securities, net of purchases, of $10.4 million. Net cash provided
by investing activities also reflected funds expended for the acquisitions of
laboratory equipment for drug development activities, and funds expended for
intangible assets, which included costs to secure patents on technology
developed by us. In the first quarter of 2004, financing activities provided
$923,000 in cash from the issuance of common stock upon exercise of outstanding
stock options. Our cash flow in the first quarter of 2004 also differed from
our cash flow in the first quarter of 2003 because we no longer derive revenues
from sales of our excipient products and do not incur expenses in connection
with our excipient business, except for the related revenues and expenses
during the period ended February 26, 2003. We anticipate that, excluding any potential revenues from oxymorphone ER,
our existing capital resources and anticipated internally generated funds from
the sale of formulated bulk TIMERx, royalties from Mylan and other payments
from collaborators, will be sufficient to fund our operations on an ongoing
basis without requiring us to seek external financings through at least 2005.
We expect to continue to invest in capital expenditures in 2004 at levels
similar to 2003 capital spending which approximated $2.8 million, primarily for
laboratory equipment for our drug development activities, and for patents on
technology and products developed by us. Our requirements for capital in our business are substantial and will
depend on many factors, including:  
    
    whether oxymorphone ER is approved on a timely basis, or at all; 15




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
    
    whether we resume our participation in the funding of the development and marketing of oxymorphone ER;  
    
    the timing and amount of payments received under existing and possible
future collaborative agreements, in particular oxymorphone ER;  
    
    our success in entering into a marketing collaboration for PW2101;  
    
    the structure of any future collaborative or development agreements;  
    
    the progress of our collaborative and independent development projects,
funding obligations with respect to the projects, and the related costs to
us of clinical studies for our products;  
    
    the costs and timing of adding drug development capabilities;  
    
    royalties received from Mylan; and  
    
    the prosecution, defense and enforcement of potential patent claims and other intellectual property rights. If our existing resources are insufficient to satisfy our need for capital
due to a delay in the approval for oxymorphone ER, lower than expected revenues
from oxymorphone ER or otherwise, or if we acquire additional product
candidates or technologies, we may need to sell additional equity or debt
securities or seek additional financing through other arrangements. If we
determine to seek additional funding, we may do so through collaborative
agreements or research and development arrangements, and public or private
financings. Additional financing may not be available to us on acceptable
terms, if at all. If we raise additional funds by issuing equity or debt securities, further
dilution to our then existing shareholders may result. In addition, the terms
of the financing may adversely affect the holdings or the rights of such
shareholders. We cannot be certain that additional public or private financing
will be available in amounts or on terms acceptable to us, if at all. If we are
unable to obtain this additional financing, we may be required to delay, reduce
the scope of, or eliminate one or more of our planned research, development and
commercialization activities, which could harm our financial condition and
operating results. Contractual Obligations Our outstanding contractual cash obligations relate to our operating
leases, primarily for facilities, and purchase obligations primarily relating
to clinical development, contract manufacturing and capital expenditures.
Below is a table summarizing our contractual cash obligations under our
operating leases and purchase obligations, as of March 31, 2004: Less than
    
    1-3
    
    4-5
    
    After 5Total
    
    One Year
    
    Years
    
    Years
    
    Years(in thousands)Operating Leases
    
    $
    535
    
    
    $
    290
    
    
    $
    245
    
    
    $
    
    
    
    $
    Purchase Obligations
    
    
    3,137
    
    
    
    3,087
    
    
    
    50
    
    
    
    
    
    
    
    Total
    
    $
    3,672
    
    
    $
    3,377
    
    
    $
    295
    
    
    $
    
    
    
    $
    
 In addition, in April 2004 we signed a lease amendment to our February 3,
2003 lease agreement for approximately 21,000 square feet of office space in
Danbury, Connecticut within the same building as our corporate offices. Under
this amendment, the new office space was substituted for the previous space
leased in the building. As a result of this lease amendment, our cash
obligations under operating leases have increased from the amounts set forth in
the table above by $154,000 to $444,000 for the one year period ending
March 31, 2005 and by $601,000 to $846,000 for the period commencing on
April 1, 2005 and ending on March 31, 2007. Net Operating Loss Carryforwards At
March 31, 2004, we had federal net operating loss, or NOL, carryforwards of
approximately $63.8 million for income tax purposes, of which approximately
$6.2 million, $8.4 million, $9.1 million, $17.7 million, $19.3 million and $3.1
million expire in 2018, 2019, 2020, 2021, 2022, and 2023, respectively. In
addition, we had research and development tax credit carryforwards of
approximately $2.2 million of which $299,000, $306,000, $777,000, and $828,000
expire in 2019, 2020, 2021, and 2022 respectively. The use of the NOL
carryforwards and
research and development tax credit carryforwards are limited to our future
taxable earnings. For financial reporting 16




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purposes, at March 31, 2004 a valuation allowance of $26.5 million has
been recognized to offset net deferred tax assets, primarily attributable to
the NOL carryforwards. Utilization of the operating losses are subject to a
limitation due to the ownership change provisions of the Internal Revenue Code. Forward Looking Statements This quarterly report contains certain forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. All statements, other than statements of
historical facts, included or incorporated in this report regarding our
strategy, future operations or 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 quarterly
report. If any of the following risks actually occur, our business, financial
condition or results of operations would likely suffer. In that case, the
trading price of our common stock could fall. We have not been profitable and expect to continue to incur substantial
losses We have incurred net losses since 1994, including net losses of $15.9
million, $17.1 million and $16.0 million, during 2003, 2002, and 2001,
respectively. We had a loss from continuing operations of $26.0 million, $19.0
million, and $16.8 million in 2003, 2002, and 2001, respectively. For the three
months ended March 31, 2004, we had a net loss of $4.8 million. As of March
31, 2004, our accumulated deficit was approximately $99.2 million. We expect net losses to continue until substantial sales of products
commercialized utilizing TIMERx technology occur. If we are unable to
successfully develop and commercialize these products, or generate substantial
sales from these products, we may never achieve profitability. A substantial portion of our revenues since 1994 has been generated from
the sales of our pharmaceutical excipients. Our net losses in 2003, 2002 and
2001 were reduced as a result of the operating results of our excipient
business. Since February 27, 2003, we have not generated any revenues from the
sales of excipient products and our business depends exclusively on our drug
delivery and drug development business. Our future profitability will depend on several factors, including:  
    
    the successful commercialization of TIMERx controlled release products, including in particular oxymorphone ER;  
    
    royalties from Mylan; and  
    
    the level of our investment in research and development activities. Our strategy includes a significant commitment to spending on research and
development targeted at identifying and developing products that can be
formulated using our TIMERx and other drug delivery technologies. We also
expect to expend significant resources on the development of new drug delivery
technologies, both internally and through in-licenses or acquisition. Our
spending in the area of new technology, however, is discretionary and is
subject to the availability of appropriate opportunities and funding.  We are dependent on collaborators to conduct clinical trials, obtain
regulatory approvals for, and manufacture, market, and sell our TIMERx
controlled release products, including, in particular, Endo with respect to
oxymorphone ER 17




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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. Our collaborators may not devote the resources necessary or may otherwise
be unable to complete development and commercialization of these potential
products. Our existing collaborations are subject to termination on short
notice under certain circumstances including, for example, if the collaborator
determines that the product in development is not likely to be successfully
developed or not likely to receive regulatory approval, if we breach the
agreement or upon a bankruptcy event. If we cannot maintain our existing collaborations or establish new
collaborations, we would be required to terminate the commercialization of
products or undertake commercialization activities at our own expense.
Moreover, we have limited experience in conducting full-scale clinical trials,
preparing and submitting regulatory applications, and manufacturing, marketing
and selling the pharmaceutical products. We may not be successful in performing
these activities. Our existing collaborations and any future collaborations with third
parties may not be scientifically or commercially successful. Factors that may affect the success of our collaborations include the
following:  
    
    our collaborators may be pursuing alternative technologies or
developing alternative products, either on their own or in collaboration
with others, that may be competitive with the product as to which they
are collaborating with us, which could affect our collaborators
commitment to the collaboration with us;  
    
    reductions in marketing or sales efforts, or a discontinuation of
marketing or sales of our products by our collaborators would reduce our
revenues, which may be based on a percentage of net sales by the
collaborator;  
    
    our collaborators may terminate their collaborations with us, which
could make it difficult for us to attract new collaborators or adversely
affect perception of us in the business and financial communities; and  
    
    our collaborators may pursue higher priority programs or change the
focus of their development programs, which could affect the
collaborators commitment to us.  We face significant competition, which may result in others discovering,
developing or commercializing products before or more successfully than we do The pharmaceutical industry is highly competitive and is affected by new
technologies, governmental regulations, health care legislation, availability
of financing, litigation and other factors. Many of our competitors have longer
operating histories and greater financial, marketing, legal and other resources
than we have and than some of our collaborators have. We face competition from numerous public and private companies and their
extended release technologies, including Johnson & Johnsons oral osmotic pump
(OROS) technology, multiparticulate systems marketed by Elan Corporation plc,
Biovail Corporation and 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, and
Duragesic marketed by Johnson & Johnson. In addition to developing controlled release versions of immediate and
other controlled release products, we also selectively develop generic versions
of branded controlled release products. In development, we utilize our TIMERx
technology and generic active ingredients to formulate product candidates. The
success of these product candidates will depend, in large part, on the
intensity of competition from the branded controlled release product, other
generic versions of the branded controlled release product, and other drugs and
technologies that compete with the branded controlled release product, as well
as the timing of product approval. The generic drug industry is characterized by frequent litigation between
generic drug companies and branded drug companies. Those companies with
significant financial resources will be better able to bring and defend any
such litigation. 18




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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 controlled release versions of immediate
release products and branded generic products, we or our collaborators will be
required to complete clinical trials in humans to demonstrate the safety and
efficacy of the products. We or our collaborators may not be able to obtain
authority from the FDA or other regulatory agencies to commence or complete
these clinical trials. The results from preclinical testing of a product that is under
development may not be predictive of results that will be obtained in human
clinical trials. In addition, the results of early human clinical trials may
not be predictive of results that will be obtained in larger scale advanced
stage clinical trials. Furthermore, we, our collaborators or the FDA may
suspend clinical trials at any time if the subjects or patients participating
in such trials are being exposed to unacceptable health risks, or for other
reasons. The rate of completion of clinical trials is dependent in part upon the
rate of enrollment of patients. Patient accrual is a function of many factors
including the size of the patient population, the proximity of patients to
clinical sites, the eligibility criteria for the study and the existence of
competitive clinical trials. Delays in planned patient enrollment may result in
increased costs and program delays. We and our collaborators may not be able to successfully complete any
clinical trial of a potential product within any specified time period. In some
cases, we may not be able to complete the trial at all. Moreover, clinical
trials may not show any potential product to be safe or efficacious. Thus, the
FDA and other regulatory authorities may not approve any of our potential
products for any indication. Our business, financial condition, or results of operations could be materially
adversely affected if:  
    
    we or our collaborators are unable to complete a clinical trial of one of our potential products;  
    
    the results of any clinical trial are unfavorable; or  
    
    the time or cost of completing the trial exceeds our expectations.  We may not obtain regulatory approval; the approval process can be
time-consuming and expensive We are not able to market any of our products in the United States, Europe
or in any other jurisdiction without marketing approval from the FDA, the
European Agency for the Evaluation of Medicinal Products, or an equivalent
foreign regulatory agency. The regulatory process to obtain market approval for
a new drug takes many years and requires the expenditure of substantial
resources. We have had only limited experience in preparing applications and
obtaining regulatory approvals. We also have a number of TIMERx products in our development pipeline. The
most advanced of these is oxymorphone ER. In February 2003, the FDA accepted
for filing an NDA for oxymorphone ER. In October 2003, the FDA issued to Endo
an approvable letter for oxymorphone ER. In the letter, the FDA requested that
Endo address certain questions, provide additional clarification and
information, and conduct some form of additional clinical trials to further
confirm the safety and efficacy of oxymorphone ER, before the FDA would approve
Endos NDA for oxymorphone ER. In the first quarter of 2004, Endo had a meeting with the FDA
to clarify issues raised in the letter, review the necessity for additional
trials and discuss its responses to the approvable letter. Endo, in reporting
the outcome of this meeting, stated that the status of the FDAs request for
additional clinical trials related to the drug has not been resolved and that
the FDA indicated it needed more time to adequately review Endos additional
analyses of certain data. If the NDA for oxymorphone ER is not approved on a
timely basis or at all, it would have a material adverse effect on our
business, financial condition and results of operations. We may encounter delays or rejections during any stage of the regulatory
approval process based upon the failure of clinical data to demonstrate
compliance with, or upon the failure of the product to meet, the FDAs
requirements for safety, efficacy and quality; and those requirements may
become more stringent due to changes in regulatory agency policy or the
adoption of new regulations. After submission of a marketing application, in
the form of an NDA or an abbreviated new drug application, or ANDA, the FDA may
deny the application, may require additional testing or data and/or may require
post marketing testing and surveillance to monitor the safety or efficacy of a
product. While the U.S. Food, Drug and Cosmetic Act, or FDCA, provides for a
180-day review period, the FDA commonly takes one to two years to grant final
approval to a marketing application. Further, the terms of approval of any marketing application, including the
labeling content, may be more restrictive than we desire and could affect the
marketability of products incorporating our controlled release technology. 19




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Certain products containing our TIMERx controlled release technology
require the filing of an NDA. A full NDA must include complete reports of
preclinical, clinical and other studies to prove adequately that the product is
safe and effective, which involves, among other things, full clinical testing,
and as a result requires the expenditure of substantial resources. In certain
cases involving controlled release versions of FDA-approved immediate release
drugs, we may be able to rely on existing publicly available safety and
efficacy data to support an NDA for controlled release products under Section
505(b)(2) of the FDCA when such data exists for an approved immediate release
version of the same chemical entity. However, we can provide no assurance that
the FDA will accept such section 505(b)(2) NDA, or that we will be able to
obtain publicly available data that is useful. The section 505(b)(2) NDA
process is a highly uncertain avenue to approval because the FDAs policies on
section 505(b)(2) NDAs have not yet been fully developed. There can be no
assurance that the FDA will approve an application submitted under section
505(b)(2) in a timely manner or at all. The FDA also has the authority to revoke or suspend approvals of
previously approved products for cause, to debar companies and individuals from
participating in the drug-approval process, to request recalls of allegedly
volatile products, to seize allegedly volatile products, to obtain injunctions
to close manufacturing plants allegedly not operating in conformity with
current Good Manufacturing Practices and to stop shipments of allegedly
volatile products. The FDA may seek to impose pre-clearance requirements on
products currently being marketed without FDA approval, and there can be no
assurance that we or our third-party manufacturers or collaborators will be
able to obtain approval for such products within the time period specified by
the FDA.  Even if we obtain marketing approval, our products will be subject to ongoing
regulatory review If regulatory approval of a product is granted, such approval may be
subject to limitations on the indicated uses for which the product may be
marketed or contain requirements for costly post-marketing follow-up studies.
As to products for which marketing approval is obtained, the manufacturer of
the product and the manufacturing facilities will be subject to continual
review and periodic inspections by the FDA and other regulatory authorities.
The subsequent discovery of previously unknown problems with the product,
manufacturer or facility may result in restrictions on the product or
manufacturer, including withdrawal of the product from the market. If we fail to comply with applicable regulatory requirements, we may be
subject to fines, suspension or withdrawal of regulatory approvals, product
recalls, seizure of products, operating restrictions and criminal prosecution.  We may require additional funding, which may be difficult to obtain As of March 31, 2004, we had cash, cash equivalents, and short-term
investments of $57.8 million. We have no committed sources of capital other
than Rettenmaier Holding GmbH & Co. KGs commitment to repay us $1.25 million
due in May 2004, in connection with the sale of the excipient business. We anticipate that, excluding any potential revenues from oxymorphone ER,
our existing capital resources and anticipated internally generated funds from
the sale of formulated bulk TIMERx, royalties from Mylan and other payments
from collaborators will be sufficient to fund our operations on an ongoing
basis without requiring us to seek external financings through at least 2005. We have had negative cash flows and net losses since 1994. See We have
not been profitable and expect to continue to incur substantial losses for a
discussion of our risk of continued losses. We expect negative cash flows from
operations to continue until substantial sales of products commercialized
utilizing TIMERx technology occur, particularly because we expect our operating
expenses to continue to increase in the future, including our research and
development expenses, as our product development efforts accelerate. The proceeds from the sale of our excipient business provided us with
significant funding, but we have lost the positive cash flows generated by our
excipient business. Our requirements for additional capital are substantial and will depend on many
factors, including:  
    
    whether oxymorphone ER is approved on a timely basis, or at all;  
    
    whether we resume our participation in the funding of the development and marketing of oxymorphone ER;  
    
    the timing and amount of payments received under existing and
possible future collaborative agreements, in particular oxymorphone ER;  
    
    our success in entering into a marketing collaboration for PW2101; 20




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
    
    the structure of any future collaborative or development agreements;  
    
    the progress of our collaborative and independent development
projects, funding obligations with respect to the projects, and the
related costs to us of clinical studies for our products;  
    
    the costs and timing of adding drug development capabilities;  
    
    royalties received from Mylan; and  
    
    the prosecution, defense and enforcement of potential patent claims and other intellectual property rights. If our existing resources are insufficient to satisfy our need for capital
due to a delay in the approval for oxymorphone ER, lower than expected revenues
from oxymorphone ER or otherwise, or if we acquire additional product
candidates or technologies, we may need to sell additional equity or debt
securities or seek additional financing through other arrangements. If we
determine to seek additional funding, we may do so through collaborative
agreements or research and development arrangements, and public or private
financings. Additional financing may not be available to us on acceptable
terms, if at all. If we raise additional funds by issuing equity securities, further
dilution to our then existing shareholders may result. In addition, the terms
of the financing may adversely affect the holdings or the rights of such
shareholders. Any sale of additional equity or debt securities may result in
additional dilution to our shareholders, and we cannot be certain that
additional public or private financing will be available in amounts or on terms
acceptable to us, if at all. If we are unable to obtain this additional
financing, we may be required to delay, reduce the scope of, or eliminate one
or more of our planned research, development and commercialization activities,
which could harm our financial condition and operating results.  Our controlled release products that are generic versions of branded
controlled release products that are covered by one or more patents may be
subject to litigation We expect to file or have our collaborators file ANDAs or NDAs for our
controlled release products under development that are covered by one or more
patents of the branded product. It is likely that the owners of the patents
covering the brand name product or the sponsors of the NDA with respect to the
branded product will sue or undertake regulatory initiatives to preserve
marketing exclusivity, as Pfizer did with respect to our generic version of
Procardia XL that was developed with Mylan. Any significant delay in obtaining
FDA approval to market our product candidates as a result of litigation, as
well as the expense of such litigation, whether or not we or our collaborators
are successful, could have a material adverse effect on our business, financial
condition and results of operations.  The market may not be receptive to products incorporating our drug delivery
technologies The commercial success of products incorporating our extended release
technology that are approved for marketing by the FDA and other regulatory
authorities will depend upon their acceptance by the medical community and
third party payors as clinically useful, cost-effective and safe. No product
based on our TIMERx or other extended release technology is marketed in the
United States, so there can be no assurance as to market acceptance. Other factors that we believe could materially affect market acceptance of
these products include:  
    
    the timing of the receipt of marketing approvals and the countries in which such approvals are obtained;  
    
    the safety and efficacy of the product as compared to competitive products; and  
    
    the cost-effectiveness of the product and the ability to receive third party reimbursement.  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. 21




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Our success also depends on our not infringing patents issued to
competitors or others. We are aware of patents and patent applications
belonging to competitors and others that may require us to alter our products
or processes, pay licensing fees or cease certain activities. We may not be able to obtain a license to any technology owned by a third
party that we require to manufacture or market one or more products. Even if we
can obtain a license, the financial and other terms may be disadvantageous. Our success also depends on our maintaining the confidentiality of our
trade secrets and patented know-how. We seek to protect such information by
entering into confidentiality agreements with employees, consultants, licensees
and pharmaceutical companies. These agreements may be breached by such parties.
We may not be able to obtain an adequate, or perhaps any, remedy to such a
breach. In addition, our trade secrets may otherwise become known or be
independently developed by our competitors.  We may become involved in patent litigation or other intellectual property
proceedings relating to our products or processes which could result in
liability for damage or stop our development and commercialization efforts The pharmaceutical industry has been characterized by significant
litigation, interference and other proceedings regarding patents, patent
applications and other intellectual property rights. The types of situations in
which we may become parties to such litigation or proceedings include:  
    
    We or our collaborators may initiate litigation or other proceedings
against third parties to enforce our patent rights.  
    
    We or our collaborators may initiate litigation or other proceedings
against third parties to seek to invalidate the patents held by such
third parties or to obtain a judgment that our products or processes do
not infringe such third parties patents.  
    
    If our competitors file patent applications that claim technology
also claimed by us, we or our collaborators may participate in
interference or opposition proceedings to determine the priority of
invention.  
    
    If third parties initiate litigation claiming that our processes or
products infringe their patent or other intellectual property rights, we
and our collaborators will need to defend against such proceedings. An adverse outcome in any litigation or other proceeding could subject us
to significant liabilities to third parties and require us to cease using the
technology that is at issue or to license the technology from third parties. We
may not be able to obtain any required licenses on commercially acceptable
terms or at all. The cost of any patent litigation or other proceeding, even if resolved in
our favor, could be substantial. Although the legal costs of defending
litigation relating to a patent infringement claim are generally the
contractual responsibility of our collaborators (unless such claim relates to
TIMERx in which case such costs are our responsibility), we could nonetheless
incur significant unreimbursed costs in participating and assisting in the
litigation. Some of our competitors may be able to sustain the cost of such
litigation and proceedings more effectively than we can because of their
substantially greater resources. Uncertainties resulting from the initiation
and continuation of patent litigation or other proceedings could have a
material adverse effect on our ability to compete in the marketplace. Patent
litigation and other proceedings may also absorb significant management time.  We have only limited manufacturing capabilities and will be dependent on third
party manufacturers We lack commercial scale facilities to manufacture our TIMERx material or
any products we may develop in accordance with cGMP requirements prescribed by
the FDA. We currently rely on Draxis Pharma, Inc. for the bulk manufacture of
our TIMERx material for delivery to our collaborators under a contract that
expires in September 2005 and on other third party manufacturers
for the products that we are currently evaluating
in clinical trials, 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 except for purchase orders or similar arrangements. We believe that there are a limited number of manufacturers that operate
under cGMP regulations capable of manufacturing our TIMERx materials
and the products we are evaluating in clinical trials. Although
we have qualified alternate suppliers with respect to the xanthan and locust
bean gums used to manufacture our TIMERx material, if Draxis is unable to
manufacture the TIMERx material in the required quantities, on a timely basis
or at all, or if Draxis will not agree to renew our agreement when it
expires on acceptable terms to us or at all, we may be unable to obtain alternative contract manufacturing, or
obtain such manufacturing on commercially reasonable terms. In
addition, if we are unable to enter into longer-term manufacturing
arrangements for our products 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, or otherwise impair our competitive position, which
could have a material adverse effect on our business, financial condition and
results of operations. 22




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If our third party manufacturers fail to perform their obligations, we may
be adversely affected in a number of ways, including:  
    
    our collaborators may not be able to meet commercial demands for our products on a timely basis;  
    
    our collaborators may not be able to initiate or continue clinical trials of products that are under development; and  
    
    our collaborators may be delayed in submitting applications for regulatory approvals of our products. We have limited experience in manufacturing TIMERx material on a
commercial scale and no facilities or equipment to do so. If we determine to
develop our own manufacturing capabilities, we will need to recruit qualified
personnel and build or lease the requisite facilities and equipment. We may not
be able to successfully develop our own manufacturing capabilities. Moreover,
it may be very costly and time consuming for us to develop such capabilities. The manufacture of any of our products is subject to regulation by the FDA
and comparable agencies in foreign countries. Any delay in complying or failure
to comply with such manufacturing requirements could materially adversely
affect the marketing of our products and our business, financial condition and
results of operations.  We are dependent upon a limited number of suppliers for the gums used in our
TIMERx material Our drug delivery systems are based a hydrophilic matrix combining a
heterodispersed mixture primarily composed of two polysaccharides, xanthan and
locust bean gums, in the presence of dextrose. These gums are also used in our
Geminex and SyncroDose drug delivery systems. We purchase these gums from a
primary supplier. We have qualified alternate suppliers with respect to such
materials, but we can provide no assurance that interruptions in supplies will
not occur in the future or that we will not have to obtain substitute
suppliers. Any interruption in these supplies could have a material adverse
effect on our ability to manufacture bulk TIMERx for delivery to our
collaborators.  If we or our collaborators fail to obtain an adequate level of reimbursement
by third party payors for our controlled release products, they may not be
able to successfully commercialize controlled release products The availability of reimbursement by governmental and other third party
payors affects the market for any pharmaceutical product. These third party
payors continually attempt to contain or reduce the costs of health care by
challenging the prices charged for medical products and services. In specific
foreign countries, particularly the countries of the European Union, the
pricing of prescription pharmaceuticals is subject to governmental control. The generic versions of controlled release products being developed may be
assigned an AB rating if the FDA considers the product to be therapeutically
equivalent to the branded controlled release drug. Failure to obtain an AB
rating from the FDA would indicate that for certain purposes the drug would not
be deemed to be therapeutically equivalent, would not be fully substitutable
for the branded controlled release drug and would not be relied upon by
Medicaid and Medicare formularies for reimbursement. In both the U.S. and certain foreign jurisdictions, there have been a
number of legislative and regulatory proposals to change the health care
system. Further proposals are likely. The potential for adoption of these
proposals may affect our ability to raise capital, obtain additional
collaborative partners and market our products. If we or our collaborators obtain marketing approvals for our products, we
expect to experience pricing pressure due to the trend toward managed health
care, the increasing influence of health maintenance organizations and
additional legislative proposals. We may not be able to sell our products
profitably if reimbursement is unavailable or limited in scope or amount.  We will be exposed to product liability claims and may not be able to obtain
adequate product liability insurance Our business exposes us to potential product liability risks which are
inherent in the testing, manufacturing, marketing and sale of pharmaceutical
products. Product liability claims might be made by consumers, health care
providers, pharmaceutical companies, or others that sell our products. These
claims may be made even with respect to those products that are manufactured in
licensed and regulated facilities or that otherwise possess regulatory approval
for commercial sale. We are currently covered by primary product liability insurance in the
minimum amounts of $1 million per occurrence and $2 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 23




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in sufficient amounts to protect us against losses due to liability
claims. Any claims that are not covered by product liability insurance could
have a material adverse effect on our business, financial condition and results
of operations. The market price of our common stock may be volatile The market price of our common stock, like the market prices for
securities of pharmaceutical, biopharmaceutical and biotechnology companies,
have historically been highly volatile. The market from time to time
experiences significant price and volume fluctuations that are unrelated to the
operating performance of particular companies. Factors such as fluctuations in
our operating results, future sales of our common stock, announcements of
technological innovations or new therapeutic products by us or our competitors,
announcements regarding collaborative agreements, clinical trial results,
government regulation, developments in patent or other proprietary rights,
public concern as to the safety of drugs developed by us or others, changes in
reimbursement policies, comments made by securities analysts and general market
conditions may have a significant effect on the market price of the common
stock.  Specific provisions of our Shareholder Rights Plan, Certificate of
Incorporation and Bylaws and of Washington law make a takeover of Penwest or a
change in control or management of Penwest more difficult We have adopted a shareholder rights plan, often referred to as a poison
pill. The rights issued under the plan will cause substantial dilution to a
person or group that attempts to acquire us on terms that are not approved by
our board of directors, unless the board first determines to redeem the rights.
Various provisions of our Certificate of Incorporation, our Bylaws and
Washington law may also have the effect of deterring hostile takeovers or
delaying or preventing changes in control or management of our company,
including transactions in which our shareholders might otherwise receive a
premium for their shares over then current market prices. In addition, these
provisions may limit the ability of shareholders to approve transactions that
they may deem to be in their best interest. 
 Item 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 restrictions on maturities and
concentration by issuer. Marketable securities primarily consist of corporate
debt, certificates of deposit and U.S. Government Agency-backed notes, and
approximated $28.3 million at March 31, 2004. These securities have contractual
maturity dates of up to twenty-four months. Due to the relatively short-term
maturities of these securities, management believes there is no significant
market risk. At March 31, 2004, market values approximated carrying values. At
March 31, 2004, we had approximately $57.8 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 $578,000. 
 Item 4.Controls and Procedures (a) Evaluation
of Disclosure Controls and Procedures - Our management,
with the participation of our Chief Executive Officer, or CEO, and Chief
Financial Officer, or CFO, evaluated the effectiveness of our disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act) as of March 31, 2004. Based on this evaluation, our
CEO and CFO concluded that, as of March 31, 2004, our disclosure controls and
procedures were (1) designed to ensure that material information relating to us
is made known to our CEO and CFO by others within our company, particularly
during the period in which this report was being prepared, and (2) effective,
in that they provide reasonable assurance that information required to be
disclosed by us in the reports that we file or submit under the Securities
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commissions rules and forms. (b) Changes
in Internal Controls - No change in our internal control over
financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the
Securities Exchange Act) occurred during the fiscal quarter ended March 31,
2004 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting. 24




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PART II  OTHER INFORMATION 
 Item 6.Exhibits and Reports on Form 8-K a. 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. b. Reports onForm 8-K. On February 19, 2004, we filed a report on Form 8-K announcing our results
for the quarter and year ended December 31, 2003. 25




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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 3, 2004
    /s/ Jennifer L. GoodJennifer L. GoodSenior Vice President, Finance and Chief Financial Officer
(Principal Financial Officer) 26




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EXHIBIT INDEX ExhibitNumber
    
    Description31.1
    
    Certification of Chief Executive Officer pursuant to Rule
13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of
1934, as adopted pursuant to Section 302 of The Sarbanes-Oxley Act
of 200231.2
    
    Certification of Chief Financial Officer pursuant to Rule
13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of
1934, as adopted pursuant to Section 302 of The Sarbanes-Oxley Act
of 200232.1
    
    Certification of Chief Executive Officer pursuant to Rule
13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934
and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
The Sarbanes-Oxley Act of 200232.2
    
    Certification of Chief Financial Officer pursuant to Rule
13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934
and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
The Sarbanes-Oxley Act of 2002
 27