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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 June 30, 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 July 30, 2004. Class
    
    OutstandingCommon stock, par value $.001
    
    
    18,541,497




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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
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Item 2.    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3.    Quantitative and Qualitative Disclosures About Market Risk
    
    
    27Item 4.    Controls and Procedures
    
    
    27PART II  OTHER INFORMATIONItem 4     Submission of Matters to a Vote of Security Holders
    
    
    28Item 6.    Exhibits and Reports on Form 8-K
    
    
    28Signature
    
    
    29Exhibit Index
    
    
    30EX-3.1 Amended and Restated Articles of IncorporationEX-10.1 Lease Amendment Dated March 15, 2004EX-31.1 Section 302 Certification of Chief Executive OfficerEX-31.2 Section 302 Certification of Chief Financial OfficerEX-32.1 Section 906 Certification of Chief Executive OfficerEX-32.2 Section 906 Certification of Chief Financial Officer
  TIMERx® is a registered trademark of the Company. Geminex® and SyncroDose
are also trademarks of the Company. Other tradenames and trademarks appearing
in this quarterly report are the property of their respective owners. 2




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PART I  FINANCIAL INFORMATION 
 Item 1.Condensed Consolidated Financial Statements (Unaudited) PENWEST PHARMACEUTICALS CO. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 June 30,
    
    December 31,2004
    
    2003(Unaudited)
    
    (Note 2)(In thousands,except share amounts)ASSETSCurrent assets:Cash and cash
equivalents
    
    $
    23,577
    
    
    $
    25,307Marketable
securities
    
    
    29,623
    
    
    
    38,586Trade accounts
receivable
    
    
    1,263
    
    
    
    1,153Inventories:Raw materials and
other
    
    
    170
    
    
    
    196Finished
goods
    
    
    515
    
    
    
    460Total
inventories
    
    
    685
    
    
    
    656Prepaid expenses and other current
assets
    
    
    628
    
    
    
    1,364Note
receivable
    
    
    
    
    
    
    1,250Total current
assets
    
    
    55,776
    
    
    
    68,316Fixed assets,
net
    
    
    3,926
    
    
    
    3,533Patents,
net
    
    
    3,417
    
    
    
    3,689Cash surrender value of life insurance
policies
    
    
    3,042
    
    
    
    2,965Total
assets
    
    $
    66,161
    
    
    $
    78,503LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts
payable
    
    $
    1,290
    
    
    $
    2,804Accrued
expenses
    
    
    1,752
    
    
    
    2,133Accrued development
costs
    
    
    3,153
    
    
    
    2,682Total current
liabilities
    
    
    6,195
    
    
    
    7,619Deferred
revenue
    
    
    71
    
    
    
    84Deferred
compensation
    
    
    3,209
    
    
    
    3,104Total
liabilities
    
    
    9,475
    
    
    
    10,807Shareholders equity:Preferred stock, par value $.001, authorized 1,000,000 shares, none
outstanding
    
    
    
    
    
    
    Common stock, par value $.001, authorized 60,000,000 shares, issued and outstanding
18,496,497 shares at June 30, 2004 and 18,362,523 shares at December 31,
2003
    
    
    18
    
    
    
    18Additional paid in
capital
    
    
    163,491
    
    
    
    162,068Accumulated
deficit
    
    
    (106,721
    )
    
    
    (94,433
    )Accumulated other comprehensive (loss)
income
    
    
    (102
    )
    
    
    43Total shareholders
equity
    
    
    56,686
    
    
    
    67,696Total liabilities and shareholders
equity
    
    $
    66,161
    
    
    $
    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 EndedJune 30,2004
    
    2003(Unaudited)(In thousands, exceptper share data)Revenues:Royalties and licensing fees
    
    $
    1,266
    
    
    $
    1,019Product sales
    
    
    
    
    
    
    230Total revenues
    
    
    1,266
    
    
    
    1,249Cost of revenues
    
    
    29
    
    
    
    63Gross profit
    
    
    1,237
    
    
    
    1,186Operating expenses:Selling, general and administrative
    
    
    2,528
    
    
    
    3,226Research and product development
    
    
    6,422
    
    
    
    5,559Total operating expenses
    
    
    8,950
    
    
    
    8,785Operating loss from continuing operations
    
    
    (7,713
    )
    
    
    (7,599
    )Investment income
    
    
    204
    
    
    
    79Interest expense
    
    
    
    
    
    
    2Loss from continuing operations
    
    
    (7,509
    )
    
    
    (7,522
    )Working capital adjustment on sale of discontinued operations, net of tax benefit of $11
    
    
    
    
    
    
    (83
    )Net loss
    
    $
    (7,509
    )
    
    $
    (7,605
    )Basic and diluted loss per common share:Continuing operations
    
    $
    (0.41
    )
    
    $
    (0.48
    )Discontinued operations
    
    
    
    
    
    
    (0.01
    )Net loss per common share
    
    $
    (0.41
    )
    
    $
    (0.49
    )Weighted average shares of common stock outstanding
    
    
    18,484
    
    
    
    15,572
 See accompanying notes to condensed consolidated financial statements. 4




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PENWEST PHARMACEUTICALS CO.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS Six Months EndedJune 30,2004
    
    2003(Unaudited)(In thousands, exceptper share data)Revenues:Royalties and licensing fees
    
    $
    2,527
    
    
    $
    1,966Product sales
    
    
    222
    
    
    
    455Total revenues
    
    
    2,749
    
    
    
    2,421Cost of revenues
    
    
    78
    
    
    
    144Gross profit
    
    
    2,671
    
    
    
    2,277Operating expenses:Selling, general and administrative
    
    
    4,864
    
    
    
    5,530Research and product development
    
    
    10,511
    
    
    
    9,142Total operating expenses
    
    
    15,375
    
    
    
    14,672Operating loss from continuing operations
    
    
    (12,704
    )
    
    
    (12,395
    )Investment income
    
    
    417
    
    
    
    120Interest expense
    
    
    
    
    
    
    34Loss from continuing operations
    
    
    (12,287
    )
    
    
    (12,309
    )Earnings from discontinued operations, net of tax expense of $26
    
    
    
    
    
    
    177Gain on sale of discontinued operations, net of tax expense of $51
    
    
    
    
    
    
    9,497Net loss
    
    $
    (12,287
    )
    
    $
    (2,635
    )Basic and diluted (loss) earnings per common share:Continuing operations
    
    $
    (0.67
    )
    
    $
    (0.79
    )Discontinued operations
    
    
    
    
    
    
    0.62Net loss per common share
    
    $
    (0.67
    )
    
    $
    (0.17
    )Weighted average shares of common stock
outstanding
    
    
    18,447
    
    
    
    15,540
 See accompanying notes to condensed consolidated financial statements. 5




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PENWEST PHARMACEUTICALS CO. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 Six Months EndedJune 30,2004
    
    2003(Unaudited)(In thousands)Net cash used in operating activities:Net loss
    
    $
    (12,287
    )
    
    $
    (2,635
    )Less earnings from discontinued operations, net of tax
    
    
    
    
    
    
    (177
    )Less gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    (9,497
    )Loss from continuing operations
    
    
    (12,287
    )
    
    
    (12,309
    )Adjustments to reconcile loss from continuing operations to net
cash used in continuing operations operating activities
    
    
    344
    
    
    
    225Net cash used in continuing operations operating activities
    
    
    (11,943
    )
    
    
    (12,084
    )Net cash provided by discontinued operations operating activities
    
    
    
    
    
    
    874Net cash used in operating activities
    
    
    (11,943
    )
    
    
    (11,210
    )Investing activities:Proceeds from sale of discontinued operations, net of
transaction costs paid of $1,351 in 2003
    
    
    1,250
    
    
    
    36,900Acquisitions of fixed assets, net
    
    
    (908
    )
    
    
    (635
    )Patent costs
    
    
    (280
    )
    
    
    (386
    )Proceeds from maturities of marketable securities
    
    
    17,677
    
    
    
    1,000Purchases of marketable securities
    
    
    (8,799
    )
    
    
    (9,035
    )Net cash provided by continuing operations investing activities
    
    
    8,940
    
    
    
    27,844Net cash used in discontinued operations investing activities
    
    
    
    
    
    
    (97
    )Net cash provided by investing activities
    
    
    8,940
    
    
    
    27,747Financing activities:Proceeds from loans
    
    
    
    
    
    
    1,354Repayments of loans
    
    
    
    
    
    
    (7,047
    )Issuance of common stock, net
    
    
    1,273
    
    
    
    885Net cash provided by discontinued operations
    
    
    
    
    
    
    2,249Net cash provided by (used in) financing activities
    
    
    1,273
    
    
    
    (2,559
    )Effect of exchange rate changes on cash and cash equivalents of
discontinued operations
    
    
    
    
    
    
    32Net (decrease) increase in cash and cash equivalents
    
    
    (1,730
    )
    
    
    14,010Cash and cash equivalents at beginning of period
    
    
    25,307
    
    
    
    1,629Cash and cash equivalents at end of period
    
    $
    23,577
    
    
    $
    15,639
 See accompanying notes to condensed consolidated financial statements. 6




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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 under the promissory note, and received the balance of
$1.25 million in May 2004. The Company used approximately $5.5 million of
proceeds of the Asset Sale to repay debt. 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, competition from current and potential competitors, some with
greater resources than the Company, dependence on third party
manufacturers and
a requirement for additional funding. 2. Basis of Presentation The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with U.S. generally accepted accounting
principles for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by U.S. generally accepted accounting
principles for complete financial statements. In the opinion of management, all
adjustments considered necessary for a fair presentation for the interim
periods presented have been included. All such adjustments are of a normal
recurring nature. Operating results for the three and six month periods ended
June 30, 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 and six month periods ended
June 30, 2003 (see Note 10). 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 U.S. generally accepted accounting principles for
complete financial statements. 3. Summary of Significant Accounting Policies Revenue Recognition Revenue from product sales  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. Royalties and licensing fees  Revenues received from non-refundable upfront
licensing fees are recognized ratably over the 7




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited) development period of the related collaboration agreement, when this period
involves development risk associated with the incomplete stage of a products
development or over the estimated or contractual licensing and supply term when
there exists an obligation to supply inventory for manufacture. Non-refundable
milestone fees received for the development funding of a product are partially
recognized upon receipt based on the Companys proportionate development
efforts achieved to date relative to the total expected development efforts and
the remainder is generally recognized ratably over the remaining expected
development period. The proportionate development efforts achieved are measured
by estimating the percentage of work completed that is required of the Company
in the development effort for the product. This estimate is primarily derived
from the underlying project plans and timelines, developed by qualified
personnel who work closely on such projects. In particular, the Company reviews
output measures such as job specifications and tasks completed, compared to all
such job specifications and tasks outlined for a particular project. Job
specifications vary with each project and primarily include development
activities regarding initial formulation work, manufacturing scale-up,
proof-of-principle biostudies, clinical development and regulatory matters.
Other contractual fees received in connection with a collaborators launch of a
product are also recognized ratably over the estimated or contractual licensing
and supply term. Product royalty fees are recognized when earned. Research and Development Expenses Research and development expenses consist of costs associated with
products being developed internally as well as products being developed under
collaboration agreements and include related salaries, benefits and other
personnel related expenses, clinical trial costs, and contract and other
outside service fees. Research and development costs are expensed as incurred.
A significant portion of the Companys development activities are outsourced to
third parties including contract research organizations, and contract
manufacturers in connection with the production of clinical materials, or may
be performed by the Companys collaborators. These arrangements may require
estimates 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 June 30, 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 and six month periods ended June 30, 2004, in
connection with board of directors and scientific advisory board retainer and
meeting fees in 2004, the Company recorded $20,000 and $40,000, respectively,
of expense associated with the issuance of discounted stock options and $55,000
and $92,000, respectively, 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. 8




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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 Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(Unaudited)
    
    (Unaudited)(in thousands, except per share
    
    (in thousands, except per sharedata)
    
    data)Net loss  as
reported
    
    $
    (7,509
    )
    
    $
    (7,605
    )
    
    $
    (12,287
    )
    
    $
    (2,635
    )Stock options fair value
effect
    
    
    (846
    )
    
    
    (778
    )
    
    
    (1,652
    )
    
    
    (1,586
    )Net loss  pro forma after stock options fair value effect
    
    $
    (8,355
    )
    
    $
    (8,383
    )
    
    $
    (13,939
    )
    
    $
    (4,221
    )Net loss per share, basic and diluted  as reported
    
    $
    (0.41
    )
    
    $
    (0.49
    )
    
    $
    (0.67
    )
    
    $
    (0.17
    )Net loss per share, basic and diluted  pro forma after stock
options fair value
effect
    
    $
    (0.45
    )
    
    $
    (0.54
    )
    
    $
    (0.76
    )
    
    $
    (0.27
    )
 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. Patents Patents include costs to secure patents on technology and products
developed by the Company. Patents are amortized on a straight-line basis over
their estimated useful lives of 17 to 20 years. Patents are evaluated for
potential impairment whenever events or circumstance indicate that future
undiscounted cash flows may not be sufficient to recover their carrying
amounts. An impairment loss is recorded to the extent the patents carrying
value is in excess of its fair value. When fair values are not readily
available, the Company estimates fair values using expected discounted future
cash flows. During the second quarter of 2004, the Company recorded a write-down of
$410,000, net of accumulated amortization, related to the impairment of certain
patents covering its inhalation technology which the Company determined to no
longer have value. Such write-down is reflected in research and product
development expense in the condensed consolidated statements of operations. 6. 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 and six
month periods ended June 30, 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. 9




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited) The working capital adjustment on the sale of discontinued operations of
$83,000 (expense), recorded in the three months ended June 30, 2003, is net of
a tax benefit of $11,000. The gain on sale of discontinued operations of
approximately $9.5 million, recorded in the six months ended June 30, 2003, is
net of tax expense of $51,000, or less than 1% of the pretax gain. The tax
expense 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 six months ended June 30, 2003 is net of tax
expense of $26,000, or 13% of pretax earnings. This tax expense, which
includes foreign taxes, is lower than the federal statutory rate of 34%
primarily due to overall U.S. net operating losses that 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 Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(in thousands)
    
    (in thousands)Service cost
    
    $
    (8
    )
    
    $
    (7
    )
    
    $
    (16
    )
    
    $
    (14
    )Interest cost
    
    
    31
    
    
    
    31
    
    
    
    63
    
    
    
    61Amortization of net obligation at transition
    
    
    10
    
    
    
    15
    
    
    
    20
    
    
    
    30Amortization of prior service cost
    
    
    1
    
    
    
    3
    
    
    
    1
    
    
    
    7Amortization of net gain
    
    
    
    
    
    
    (6
    )
    
    
    
    
    
    
    (13
    )Net periodic benefit cost
    
    $
    34
    
    
    $
    36
    
    
    $
    68
    
    
    $
    71
 9. Comprehensive Loss The components of comprehensive loss for the three and six month periods
ended June 30, 2004 and 2003 are as follows (in thousands): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(Unaudited)
    
    (Unaudited)Net loss
    
    $
    (7,509
    )
    
    $
    (7,605
    )
    
    $
    (12,287
    )
    
    $
    (2,635
    )Foreign currency translation adjustments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    109Change in unrealized net gains and losses on marketable securities
    
    
    (178
    )
    
    
    (6
    )
    
    
    (145
    )
    
    
    (6
    )Comprehensive loss
    
    $
    (7,687
    )
    
    $
    (7,611
    )
    
    $
    (12,432
    )
    
    $
    (2,532
    )
 Accumulated other comprehensive income (loss) equals the cumulative
translation adjustment and unrealized net gains and losses 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 paid in May 2004. 10




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited) 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 for a total gain of $9.5 million, net of tax expense of $51,000 for the
six months ended June 30, 2003. 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 was 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)
through a temporary adjustment in the royalty rate payable to Penwest that will
return to its pre-adjustment level once Endo has recovered such costs. Endo may
also allow the Company to reimburse Endo directly for the Unfunded Development
Costs and, as a result, to receive the full royalty rate from Endo without
adjustment. The Company estimates that through May 31, 2004, Unfunded
Development Costs approximated $10.1 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 11




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




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Item 2.Managements Discussion and Analysis of Financial Condition and Results of Operations The following Managements Discussion and Analysis of Financial Condition
and Results of Operations contains forward-looking statements that involve
risks and uncertainties. Our actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including those described below under Risk Factors. Overview We develop pharmaceutical products based on innovative 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. 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. 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 July
2004, Endo reached an agreement with the FDA on the design of the new
trial. Under the terms of a Special Protocol Assessment agreed upon by
the FDA, Endo will initiate a 12-week, multicenter, double-blinded,
placebo-controlled trial of oxymorphone ER. This pivotal study will
complement the Phase III pivotal trial that Endo believes has demonstrated
efficacy in the intended patient population. Endo also reported that
based on the duration of the trial and the number of patients to be
enrolled, and assuming the data is favorable, Endo expects to submit a
complete response to the FDA late in the third quarter or in the fourth
quarter of 2005. We expect that Endo will receive a further action letter
from the FDA within six months of Endo submitting the complete response
letter.  
    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 the second
quarter of 2004, we commenced a pivotal clinical trial of this lower
strength dosage and expect to complete this additional trial by the end
of 2004. Assuming that this trial is successful, we expect that we would
submit these results as supplemental data for the NDA 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 Pfizers generic version of
all three strengths (30 mg, 60 mg, 90 mg) of Procardia XL. In connection with
that agreement, Mylan decided not to market Nifedipine XL, and agreed to pay us
a royalty on all future net sales of the 30 mg strength of Pfizers generic
Procardia XL. Prior to February 27, 2003, we also developed, manufactured and
distributed branded pharmaceutical excipients, which are the inactive
ingredients in tablets and capsules, primarily consisting of binders,
disintegrants and lubricants. On February 27, 2003, we sold substantially all
of the assets used in our excipient business to subsidiaries and affiliates of
Josef Rettenmaier Holding GmbH & Co. KG. We received $39.5 million in cash and
a promissory note for $2.25 million in consideration for the excipient
business. This note was paid in two installments with the final balance of
$1.25 million paid 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 13




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operating results of the excipient business as a discontinued operation. We have incurred net losses since 1994. As of June 30, 2004, our
accumulated deficit was approximately $106.7 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 our excipient
business, we have generated revenues primarily from royalties from Mylans
sales of Pfizers 30 mg generic version of Procardia XL and shipments of bulk
TIMERx to our collaborators. Our future profitability will depend on several
factors, including:  
    
    the successful commercialization of TIMERx controlled release products, including in particular oxymorphone ER;
    
    royalties from Mylan; and
    
    the level of our investment in research and development activities. Our results of operations may fluctuate from quarter to quarter depending
on if and when oxymorphone ER 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 U.S. generally accepted accounting
principles. The preparation of these financial statements requires us to make
estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the financial statements, and the reported
amounts of revenues and expenses during the reporting periods. We base our
estimates on historical experience and on various other factors that we believe
to be reasonable under the circumstances. We regard an accounting estimate
underlying our financial statements as a critical accounting estimate if the
nature of the estimate or assumption is material due to the level of
subjectivity and judgment involved, or the susceptibility of such matter to
change, and if the impact of the estimate or assumption on our financial
condition or performance may be material. On an ongoing basis, we evaluate
these estimates and judgments. Actual results may differ from these estimates
under different assumptions or conditions. Areas where significant judgments
are made include, but are not limited to, revenue recognition, research and
development expenses, deferred taxes-valuation allowance and impairment of
long-lived assets. For a more detailed explanation of the judgments 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 and Six Months Ended June 30, 2004 and 2003 Revenues Quarter ended
    
    Percentage
    
    Quarter ended
    
    Six months ended
    
    Percentage
    
    Six months endedJune 30,
    
    Increase
    
    June 30,
    
    June 30,
    
    Increase
    
    June 30,2004
    
    (Decrease)
    
    2003
    
    2004
    
    (Decrease)
    
    2003(in thousands, except percentages)
    
    (in thousands, except percentages)Royalties and Licensing Fees
    
    $
    1,266
    
    
    
    24
    %
    
    $
    1,019
    
    
    $
    2,527
    
    
    
    29
    %
    
    $
    1,966Product Sales
    
    
    
    
    
    
    (100
    )%
    
    
    230
    
    
    
    222
    
    
    
    (51
    )%
    
    
    455Total Revenues
    
    $
    1,266
    
    
    
    1
    %
    
    $
    1,249
    
    
    $
    2,749
    
    
    
    14
    %
    
    $
    2,421
 The increase in total revenues for the quarter and six months ended June
30, 2004 as compared to the comparable periods for 2003 was the result of
increases in royalties and licensing fees. Our royalties and licensing fees
primarily consist of royalties from Mylan on their sales of Pfizers 30 mg
generic version of Procardia XL. These royalties increased in the quarter and
six months ended June 30, 2004 compared to the comparable periods for 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. We shipped bulk
TIMERx and recorded product sales in the first quarter of 2004, but did not
ship any bulk TIMERx or record any product sales in the second quarter of 2004.
We do not expect to ship any bulk TIMERx or record any product sales during
the remainder of 2004. 14




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Selling, General and Administrative Expense Selling, general and administrative (SG&A) expenses for the quarter and
six months ended June 30, 2004 were $2.5 million and $4.9 million,
respectively, as compared to $3.2 million and $5.5 million, respectively, for
the comparable periods of 2003. The decreases totaled $698,000 or 22% and
$666,000 or 12% for the quarter and six months ended June 30, 2004,
respectively. SG&A expenses decreased in the quarter and six months ended June
30, 2004 partly due to a decrease in our share of expenses for oxymorphone ER.
The quarter and six months ended June 30, 2003 included $185,000 and $413,000,
respectively, of SG&A expense related to our share of marketing expenses for
oxymorphone ER. There were no such costs for this product in the comparable
periods in 2004 as we opted out of funding these costs effective April 17,
2003. SG&A expenses also decreased in both periods partly due to decreases in
professional and legal fees of approximately $137,000 and $123,000,
respectively, and a reduction in compensation expense of approximately $105,000
due to a severance charge taken in the second quarter of 2003, with no similar
charge in the current year. Research and Product Development Expense Six months
    
    
    
    
    
    Six monthsQuarter ended
    
    Percentage
    
    Quarter ended
    
    ended
    
    Percentage
    
    endedJune 30,
    
    Increase
    
    June 30,
    
    June 30,
    
    Increase
    
    June 30,2004
    
    (Decrease)
    
    2003
    
    2004
    
    (Decrease)
    
    2003(in thousands, except percentages)
    
    (in thousands, except percentages)Oxymorphone ER
    
    $
    
    
    
    
    (100
    )%
    
    $
    635
    
    
    $
    
    
    
    
    (100
    )%
    
    $
    2,197PW2101
    
    
    3,068
    
    
    
    22
    %
    
    
    2,507
    
    
    
    4,811
    
    
    
    64
    %
    
    
    2,927Research and New Technology
Development
    
    
    1,070
    
    
    
    73
    %
    
    
    620
    
    
    
    1,594
    
    
    
    37
    %
    
    
    1,160Phase I Products and Internal Cost
    
    
    2,284
    
    
    
    27
    %
    
    
    1,797
    
    
    
    4,106
    
    
    
    44
    %
    
    
    2,858Total Research and Product
Development Expense
    
    $
    6,422
    
    
    
    16
    %
    
    $
    5,559
    
    
    $
    10,511
    
    
    
    15
    %
    
    $
    9,142
 In the preceding table, research and development expenses are set forth in the
following four categories:  
    
    Oxymorphone ER These expenses reflect our direct external expenses
relating to the development of oxymorphone ER. These expenses consist
primarily of payments to third parties, including payments to Endo for
our share of development costs under our collaboration agreement with
Endo;
    
    PW2101 These expenses reflect our direct external expenses relating
to the development of PW2101. These expenses consist primarily of
payments to third parties in connection with clinical trials and the
manufacturing of product, prior to regulatory approval, for clinical
use and potential 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 and any
write-downs of patent costs; and
    
    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 quarter
and six months ended June 30, 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. These increases were 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 six months 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 15




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oxymorphone ER. Approximately 48% and 46% of our research and development expenses for the
quarter and six months ended June 30, 2004, respectively, related to the direct
costs associated with clinical development, manufacturing scale-up and
preparation of the NDA for PW2101. These expenses increased from the
corresponding periods of 2003 primarily due to costs relating to the pivotal
clinical trials 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 on the higher strengths of this product
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 the second quarter of 2004, we commenced a pivotal clinical trial of
this lower strength dosage and expect to complete this additional trial by the
end of 2004. Assuming that trial results are positive, we expect that we would
submit the supplemental data for this 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
potential manufacturing site change, as well as for the cost of stability data
and the cost of preparing the NDA 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. Research and new technology development expenses increased primarily due
to a $410,000 write-down recorded in the second quarter of 2004 related to the
impairment of certain patents covering our inhalation technology which we
determined to no longer have value. We expect research and new technology
development expenses to decrease significantly during the remainder of 2004 as
personnel that were previously performing research and new technology
development activities are being redirected to developing Phase I candidates. Phase I products and internal costs increased for the quarter and six
months ended June 30, 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 development efforts. We expect these costs
to increase in the second half of 2004 as a result of the redirection of
research resources noted above. Tax Rates For continuing operations, the effective tax rates for the three and six
month periods ended June 30, 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. For discontinued operations, the gain on sale of approximately $9.5
million, recorded in the six months ended June 30, 2003, is net of tax expense
of $51,000, 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 six months ended June 30, 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. Liquidity and Capital Resources Sources of Liquidity Subsequent to August 31, 1998, the date we became an independent,
publicly-owned company, we have funded our operations and capital expenditures
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 16




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under credit facilities. As of June 30, 2004, we had cash, cash
equivalents, and short-term investments of $53.2 million. We have no other
committed sources of capital. 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. 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
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 amounts, and, as a result, to receive the full royalty rate from Endo
without adjustment. We estimate that through May 31, 2004, unfunded
development costs approximated $10.1 million. We expect this unfunded amount
to increase as Endo completes the required pivotal study and incurs pre-launch
marketing costs. Cash Flows We had negative cash flow from operations for the six months ended June
30, 2004 of $11.9 million, primarily due to a net loss of $12.3 million in the
period. We had negative cash flow from operations for the six months ended June
30, 2003 of $11.2 million, primarily due to the loss from continuing operations
of $12.3 million for the period. Investing activities provided $8.9 million in
cash for the six months ended June 30, 2004, primarily reflecting maturities of
marketable securities, net of purchases, of $8.9 million. Net cash provided by
investing activities also reflected funds expended for the acquisition of
laboratory equipment for drug development activities, and funds expended for
intangible assets, which included costs to secure patents on technology
developed by us. For the first six months of 2004, financing activities
provided $1.3 million in cash primarily from the issuance of common stock upon
exercise of outstanding stock options. Our cash flow for the first six months
of 2004 also differed from our cash flow for the first six months 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. Funding Requirements We anticipate that our existing capital resources and anticipated
internally generated funds from the sale of formulated bulk TIMERx, royalties
from Mylan and other payments from collaborators, will be sufficient to fund
our operations on an ongoing basis without requiring us to seek external
financing through at least 2005. We expect to continue to invest in capital
expenditures in 2004 at levels slightly below the 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;  
    
    whether we resume our participation in the funding of the development and marketing of oxymorphone ER;  
    
    the timing and amount of payments received under existing and possible future collaborative agreements, in particular with
respect to oxymorphone ER;  
    
    our success in entering into a marketing collaboration for PW2101;  
    
    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 additional product candidates or technologies;  
    
    royalties received from Mylan; and  
    
    the prosecution, defense and enforcement of potential patent claims and other intellectual property rights. 17




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Subject to these factors, we expect that we will need to issue additional
equity or debt securities, or seek additional financing through other
arrangements to fund operations beyond 2005. In addition, if we determine to
resume our participation in the funding of oxymorphone ER, or to acquire
additional product candidates or technologies, we will need to seek additional
funding to fund such actions through collaborative agreements or research and
development arrangements, and public or private financings. If we raise additional funds by issuing equity securities, further
dilution to our then existing shareholders may result. Debt financing, if
available, may involve agreements that include covenants limiting or
restricting our ability to take specific actions, such as incurring additional
debt, making capital expenditures or declaring dividends. Any debt or equity
financing may contain terms, such as liquidation and other preferences, that
are not favorable to us or our shareholders. If we raise additional funds
through collaboration and licensing arrangements with third parties, it may be
necessary to relinquish valuable rights to our technologies, research programs
or potential product or grant licenses on terms that may not be favorable to
us. We cannot be certain that additional financing will be available in amounts
or on terms acceptable to us, if at all. If we are unable to obtain this
additional financing, we may be required to delay, reduce the scope of, or
eliminate one or more of our planned research, development and
commercialization activities, which could harm our financial condition and
operating results. Contractual Obligations Our outstanding contractual cash obligations relate to our operating
leases, primarily for facilities, and purchase obligations 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 June 30, 2004: Less than
    
    1-3
    
    4-5
    
    After 5Total
    
    One Year
    
    Years
    
    Years
    
    Years(in thousands)Operating Leases
    
    $
    1,179
    
    
    $
    457
    
    
    $
    722
    
    
    $
    
    
    
    $
    Purchase Obligations
    
    
    1,971
    
    
    
    1,921
    
    
    
    50
    
    
    
    
    
    
    
    Total
    
    $
    3,150
    
    
    $
    2,378
    
    
    $
    772
    
    
    $
    
    
    
    $
    
 Net Operating Loss Carryforwards At June 30, 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 purposes, at June 30,
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. 18




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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 six
months ended June 30, 2004, we had a net loss of $12.3, million. As of June
30, 2004, our accumulated deficit was approximately $106.7 million. Our strategy includes a significant commitment to spending on research and
development targeted at identifying and developing products that can be
formulated using our TIMERx and other drug delivery technologies. As a result,
we expect to continue to incur net losses as we continue our research
activities, conduct development of, and seek regulatory approvals for, product
utilizing TIMERx technology, until substantial sales of products commercialized
utilizing our TIMERx technology occur. These net losses have had and will
continue to have an adverse effect on, among other things, our shareholders
equity, total assets and working capital. A substantial portion of our revenues since 1994 has been generated from
the sales of our pharmaceutical excipients. Our net losses in 2003, 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. We may require additional funding, which may be difficult to obtain As of June 30, 2004, we had cash, cash equivalents, and short-term
investments of $53.2 million. We anticipate that 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. 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 with respect to
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 19




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the related costs to us of clinical studies for our products;
    
    the costs and timing of adding additional products or technologies;
    
    royalties received from Mylan; and
    
    the prosecution, defense and enforcement of potential patent claims and other intellectual property rights. Subject to these factors, we expect that we will need to sell additional
equity or debt securities or seek additional financing through other
arrangements to fund operations beyond 2005. In addition, if we determine to
resume our participation in the funding of oxymorphone ER or to acquire
additional products or technologies, we will need to seek additional funding
for such actions through collaborative agreements or research and development
arrangements, and public or private financing. If we raise additional funds by issuing equity securities, further
dilution to our then existing shareholders may result. Debt financing, if
available, may involve agreements that include covenants limiting or
restricting our ability to take specific actions, such as incurring additional
debt, making capital expenditures or declaring dividends. Any debt or equity
financing may contain terms, such as liquidation and other preferences, that
are not favorable to us or our shareholders. If we raise additional funds
through collaboration and licensing arrangements with third parties, it may be
necessary to relinquish valuable rights to our technologies, research programs
or potential product or grant licenses on terms that may not be favorable to
us. We cannot be certain that additional financing will be available in amounts
or on terms acceptable to us, if at all. If we are unable to obtain this
additional financing, we may be required to delay, reduce the scope of, or
eliminate one or more of our planned research, development and
commercialization activities, which could harm our financial condition and
operating results. We are dependent on collaborators to conduct clinical trials of, obtain
regulatory approvals for, and manufacture, market, and sell our TIMERx
controlled release products, including, in particular, Endo with respect to
oxymorphone ER Some of our TIMERx controlled release products have been or are being
developed and commercialized in collaboration with pharmaceutical companies.
Under these collaborations, depending on the structure of the collaboration, we
are dependent on our collaborators to fund some portion of development, to
conduct clinical trials, obtain regulatory approvals for, and manufacture,
market and sell products utilizing our TIMERx controlled release technology.
For instance, we are dependent on Endo to obtain the regulatory approvals
required to market oxymorphone ER and will be dependent on Endo to manufacture
and market oxymorphone ER in the United States. In addition, we are dependent
on Mylan with respect to the marketing and sale of the 30 mg strength of
Pfizers generic version of Procardia XL. We have limited experience in manufacturing, marketing and selling
pharmaceutical products. Accordingly, if we cannot maintain our existing
collaborations or establish new collaborations with respect to our other
products in development, we will have to establish our own capabilities or
discontinue the commercialization of the affected product. For instance, if we
are unable to enter into a collaboration for PW2101, we may be unable to
commercially launch the product even if we obtain FDA approval. Developing our
own capabilities would be expensive and time consuming and could delay the
commercialization of the affected product. There can be no assurance that we
would be successful in developing these capabilities. Our existing collaborations are subject to termination on short notice
under certain circumstances including, for example, if the collaborator
determines that the product in development is not likely to be successfully
developed or not likely to receive regulatory approval, if we breach the
agreement or upon a bankruptcy event. If any of our collaborations are
terminated, we may be required to devote additional resources to the product,
seek a new collaborator on short notice or abandon the product. The terms of
any additional collaborations or other arrangements that we establish may not
be favorable to us. We are also at risk that these collaborations or other arrangements may
not be successful. Factors that may affect the success of our collaborations
include the following:  
    
    Our collaborators may be pursuing alternative technologies or
developing alternative products, either on their own or in collaboration
with others, that may be competitive with the product as to which they
are collaborating with us, which could affect our collaborators
commitment to the collaboration with us
    
    Our collaborators may reduce marketing or sales efforts, or
discontinue marketing or sales of our products. This would reduce our
revenues received on the product; 20




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
    
    Our collaborators may terminate their collaborations with us. This
could make it difficult for us to attract new collaborators or adversely
affect perception of us in the business and financial communities.
    
    Our collaborators may pursue higher priority programs or change the
focus of their development programs, which could affect the
collaborators commitment to us. Pharmaceutical and biotechnology
companies historically have re-evaluated their priorities from time to
time, including following mergers and consolidations, which have been
common in recent years in these industries. We face significant competition, which may result in others discovering,
developing or commercializing products before or more successfully than we do The pharmaceutical industry is highly competitive and is affected by new
technologies, governmental regulations, health care legislation, availability
of financing, litigation and other factors. Many of our competitors have:  
    
    significantly greater financial, technical and human resources than we
have and may be better equipped to develop, manufacture and commercialize
products;
    
    more extensive experience than we have in conducting preclinical studies
and clinical trials, obtaining regulatory approvals and manufacturing and
marketing pharmaceutical products;
    
    competing products that have already received regulatory approval or are in late-stage development; and
    
    collaborative arrangements in our target markets with leading companies and research institutions. We face competition based on the safety and effectiveness of our products,
the timing and scope of regulatory approvals, the availability and cost of
supply, marketing and sales capabilities, reimbursement coverage, price, patent
position and other factors. Our competitors may develop or commercialize more
effective, safer or more affordable products, or obtain more effective patent
protection, than we are able to develop or commercialize. Accordingly, our
competitors may commercialize products more rapidly or effectively than we do,
which would adversely affect our competitive position, the likelihood that our
product will achieve initial market acceptance and our ability to generate
meaningful revenues from our products. Even if our products achieve initial
market acceptance, competitive products may render our products obsolete or
noncompetitive. If our products are rendered obsolete, we may not be able to
recover the expenses of developing and commercializing those products. We face competition from numerous public and private companies and their
extended release technologies, including Johnson & Johnsons oral osmotic pump
(OROS) technology, multiparticulate systems marketed by Elan Corporation plc,
Biovail Corporation and KV Pharmaceutical Company, traditional matrix systems
marketed by SkyePharma, plc and other controlled release technologies marketed
or under development by Andrx Corporation, among others. Our TIMERx products in development will face competition from products
with the same indication as the TIMERx products we are developing. For
instance, we expect extended release oxymorphone ER will face competition from
MS Contin, Purdue Pharmas OxyContin and generic competitors to OxyContin, and
Duragesic marketed by Johnson & Johnson. Some of the TIMERx products we are developing, such as PW2101, are branded
controlled release products, which are based on essentially the same active
chemical ingredient as other branded controlled release products. These branded
controlled release products will compete against the original branded product
on which our product is based, as well as any generic versions of the original
branded product, based primarily on price. In addition, our product will
compete against other competitive products in the therapeutic class. In addition to developing branded controlled release products, we also
selectively develop generic versions of branded controlled release products
using our TIMERx technology and generic active ingredients. The success of these products will depend, in large part, on the
intensity of competition from the branded controlled release product, other
generic versions of the branded controlled release product, and other drugs and
technologies that compete with the branded controlled release product, as well
as the timing of product approval. The generic drug industry is characterized by frequent litigation between
generic drug companies and branded drug companies. 21




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Those companies with significant financial resources will be better able
to bring and defend any such litigation. If our clinical trials are not successful or take longer to complete than
we expect, we may not be able to develop and commercialize our products In order to obtain regulatory approvals for the commercial sale of our
potential products, including our branded controlled release products, we or
our collaborators will be required to complete clinical trials in humans to
demonstrate the safety and efficacy of the products. However, we or our
collaborators may not be able to commence or complete these clinical trials in
any specified time period, or at all, either because the FDA or other
regulatory agencies object, or for other reasons. Even if we complete a clinical trial of one of our potential products, the
clinical trial may not indicate that our product is safe or effective to the
extent required by the FDA, the European Commission, or other regulatory
agencies to approve the product, and we or our collaborators may decide, or
regulators may requires us or our collaborators, to conduct additional clinical
trials. For example, in October 2003, the FDA issued to Endo an approvable
letter for oxymorphone ER. In the letter, the FDA requested that Endo address
certain questions, provide additional clarification and information, and
conduct some form of additional clinical trials to further confirm the safety
and efficacy of oxymorphone ER, before the FDA would approve Endos NDA for
oxymorphone ER. Endo has now agreed to initiate an additional 12-week,
multicenter, double-blinded, placebo-controlled trial of oxymorphone ER. The results from preclinical testing of a product that is under
development may not be predictive of results that will be obtained in human
clinical trials. In addition, the results of early human clinical trials may
not be predictive of results that will be obtained in larger scale advanced
stage clinical trials. Furthermore, we, our collaborators or the FDA may
suspend clinical trials at any time if the subjects or patients participating
in such trials are being exposed to unacceptable health risks, or for other
reasons. The rate of completion of clinical trials is dependent in part upon the rate of
enrollment of patients. Patient accrual is a function of many factors including
the size of the patient population, the proximity of patients to clinical
sites, the eligibility criteria for the study and the existence of competitive
clinical trials. Delays in planned patient enrollment may result in increased
costs and program delays. If clinical trials do not show any potential product to be safe or
efficacious, if we are required to conduct additional clinical trials or other
testing of our products in development beyond those that we currently
contemplate or if we are unable to successfully complete our clinical trials or
other testing, we may:  
    
    be delayed in obtaining marketing approval for our products;
    
    not be able to obtain marketing approval for our products; or
    
    obtain approval for indications that are not as broad as intended. Our product development costs may also increase if we experience delays in
testing or approvals. In addition, significant clinical trial delays also could
allow our competitors to bring products to market before we do and impair our
ability to commercialize our products. We may not obtain regulatory approval for our products, which would
materially impair our ability to generate revenue 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 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. 22




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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. In February 2003, the FDA accepted for filing from Endo 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 July 2004, Endo reached an agreement with the FDA on the design of the new
trial. Under the terms of a Special Protocol Assessment agreed upon by the
FDA, Endo will initiate a 12-week, multicenter, double-blinded,
placebo-controlled trial of oxymorphone ER. This pivotal study will complement
the Phase III pivotal trial that Endo believes has demonstrated efficacy in the
intended patient population. Endo also reported that, based on the duration of
the trial and the number of patients to be enrolled, and assuming the data is
favorable, Endo expects to submit a complete response to the FDA in the fourth
quarter of 2005. We expect that Endo will receive a further action letter from
the FDA within six months of Endo submitting the complete response letter. If
the NDA for oxymorphone ER is not approved on a timely basis or at all, it
would have a material adverse effect on our business, financial condition and
results of operations. Certain products containing our TIMERx controlled release technology
require the filing of an NDA. A full NDA must include complete reports of
preclinical, clinical and other studies to prove adequately that the product is
safe and effective, which involves, among other things, full clinical testing,
and as a result requires the expenditure of substantial resources. In certain
cases involving controlled release versions of FDA-approved immediate release
drugs and branded controlled release drugs, such as PW2101, containing the same
chemical ingredient as an FDA-approved controlled release drug, we may be able
to rely on existing publicly available safety and efficacy data to support an
NDA for controlled release products under Section 505(b)(2) of the FDCA when
such data exists for an approved immediate release or controlled release
version of the same 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. 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. Later discovery of previously unknown problems with our products,
manufacturers or manufacturing processes, or failure to comply with applicable
regulatory requirements may result in:  
    
    restrictions on such products, manufacturers or manufacturing processes;
    
    warning letters;
    
    fines;
    
    suspension or withdrawal of regulatory approvals;
    
    refusal to permit the import or export of our products;
    
    product recalls;
    
    seizure of products; and
    
    injunctions or the imposition of civil or criminal prosecution. Our controlled release products that are generic versions of branded
controlled release products that are covered by one or 23




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more patents may be subject to litigation, which could delay FDA approval and
commercial launch of our products We expect to file or have our collaborators file ANDAs or NDAs for our
controlled release products under development that are covered by one or more
patents of the branded product. It is likely that the owners of the patents
covering the brand name product or the sponsors of the NDA with respect to the
branded product will sue or undertake regulatory initiatives to preserve
marketing exclusivity, as Pfizer did with respect to our generic version of
Procardia XL that we developed with Mylan. Any significant delay in obtaining
FDA approval to market our products as a result of litigation, as well as the
expense of such litigation, whether or not we or our collaborators are
successful, could have a material adverse effect on our business, financial
condition and results of operations. The market may not be receptive to products incorporating our drug
delivery technologies The commercial success of products incorporating our extended release
technology that are approved for marketing by the FDA and other regulatory
authorities will depend upon their acceptance by the medical community and
third party payors as clinically useful, cost-effective and safe. No product
based on our TIMERx or other extended release technology is marketed in the
United States, so there can be no assurance as to market acceptance. Factors that we believe could materially affect market acceptance of these
products include:  
    
    the timing of the receipt of marketing approvals and the countries in which such approvals are obtained;
    
    the safety and efficacy of the product as compared to competitive products;
    
    the relative convenience and ease of administration as compared to competitive products;
    
    the strength of marketing distribution support; and
    
    the cost-effectiveness of the product and the ability to receive third party reimbursement. Our success depends on our protecting our patents and patented rights Our success depends in significant part on our ability to develop
patentable products, to obtain patent protection for our products, both in the
United States and in other countries, and to enforce these patents. The patent
positions of pharmaceutical firms, including us, are generally uncertain and
involve complex legal and factual questions. As a result, patents may not issue
from any patent applications that we own or license. If patents are issued, the
claims allowed may not be sufficiently broad to protect our technology. In
addition, issued patents that we own or license may be challenged, invalidated
or circumvented. Our patents also may not afford us protection against
competitors with similar technology. Our research, development and commercialization activities, as well as any
products in development or products resulting from these activities, may
infringe or be claimed to infringe patents or patent applications of
competitors or other third parties. In such event, we or our collaborators may
choose or may be required to seek a license from a third party and to pay
license fees or royalties or both under such license. These licenses may not be
available on acceptable terms, or at all. Even if we or our collaborators were
able to obtain a license, the rights may be nonexclusive, which could result in
our competitors gaining access to the same intellectual property. If we or our
collaborators are not able to obtain a license, we could be prevented from
commercializing a product, or be forced to cease some aspect of our business
operations. Our success also depends on our maintaining the confidentiality of our
trade secrets and patented know-how. We seek to protect such information by
entering into confidentiality agreements with employees, consultants, licensees
and pharmaceutical companies. These agreements may be breached by such parties.
We may not be able to obtain an adequate, or perhaps any, remedy to such a
breach. In addition, our trade secrets may otherwise become known or be
independently developed by our competitors. We may become involved in patent litigation or other intellectual property
proceedings relating to our products or processes, which could result in
liability for damages or stop our development and commercialization efforts The pharmaceutical industry has been characterized by significant
litigation, interference and other proceedings regarding patents, patent
applications and other intellectual property rights. The types of situations in
which we may become parties to such litigation or proceedings include: 24




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
    
    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, require us or our collaborators
to cease distribution or recall some or all batches of our products or
otherwise impair our competitive position, which could have a material adverse
effect on our business, financial condition and results of operations. If our third party manufacturers fail to perform their obligations, we may
be adversely affected in a number of ways, including:  
    
    our collaborators may not be able to meet commercial demands for our products on a timely basis;
    
    our collaborators may not be able to initiate or continue clinical trials of products that are under development; and
    
    our collaborators may be delayed in submitting applications for regulatory approvals of our products. 25




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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 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 26




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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 $29.6 million at June 30, 2004. As of June 30, 2004, these
securities have contractual maturity dates of up to twenty-two months. Due to
the relatively short-term maturities of these securities, management believes
there is no significant market risk. At June 30, 2004, market values
approximated carrying values. At June 30, 2004, we had approximately $53.2
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
$532,000. 
 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 June 30, 2004. Based on this evaluation, our CEO
and CFO concluded that, as of June 30, 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 June 30, 2004
that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting. 27




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PART II  OTHER INFORMATION 
 Item 4.Submission of Matters to a Vote of Security Holders At our Annual Meeting of Shareholders held on June 2, 2004, the following
proposals were adopted by the vote specified below:  a.
    
    Election of Class I Directors for a term of three years: For
    
    WithholdPaul E. Freiman
    
    
    14,555,811
    
    
    
    1,742,819Rolf H. Henel
    
    
    14,649,158
    
    
    
    1,649,472
 The following directors did not stand for reelection as their terms
in office continued after the Annual Meeting: Jere E. Goyan, Tod R.
Hamachek, Robert J. Hennessey, Dr. John Staniforth and Anne M.
VanLent.
  b.
    
    Approval of an amendment to our Amended and Restated Articles of
Incorporation increasing the number of authorized shares of our Common
Stock to 60,000,000: For
    
    Against
    
    Abstain
    
    Broker Non-Votes14,147,263
    
    
    957,046
    
    
    
    1,194,321
    
    
    NONE
  c.
    
    Ratification of the selection of Ernst & Young LLP as our
independent auditors for the current year: For
    
    Against
    
    Abstain
    
    Broker Non-Votes15,004,559
    
    
    119,545
    
    
    
    1,174,526
    
    
    NONE
 
 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 April 5, 2004, we filed a report on Form 8-K announcing the outcome
of a meeting Endo had with the FDA on oxymorphone ER. On April 29, 2004, we filed a report on Form 8-K announcing our results
for the first quarter ended March 31, 2004. On May 6, 2004, we filed a report on Form 8-K announcing the results of
Endos FDA meeting on oxymorphone ER. 28




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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: July 30, 2004
    
    /s/ Jennifer L. GoodJennifer L. GoodSenior Vice President, Finance and Chief Financial Officer(Principal Financial Officer)
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EXHIBIT INDEX ExhibitNumber
    
    Description3.1
    
    Amended and Restated Articles of Incorporation.10.1
    
    Lease Amendment and Attornment Agreement dated March 15, 2004 by
and among Danbury Buildings Co., L.P., Union Carbide Corporation
and the Registrant.31.1
    
    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
 30