##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549


Form 10-Q

|   |  |                                                                                             
|-- |  | --------------------------------------------------------------------------------------------
|þ  |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|  
|   |  | For the quarterly period ended March 31,
    2003                                           
|  
|or
|  
|o  |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|  
|   |  | For the transition period
    from           to                                             

Commission File No. 000-23467

Penwest Pharmaceuticals Co.

(Exact name of registrant as specified in its
charter)


|                                                                                             |  |                                     
|-------------------------------------------------------------------------------------------- |  | ------------------------------------
|Washington                                                                                   |  | 91-1513032                          
|(State of Incorporation)                                                                     |  | (I.R.S. Employer Identification No.)
|                                                                                            
|39 Old Ridgebury Road, Suite 11,
    Danbury, CT(Address of principal executive
    offices) |  | 06810-5120(Zip Code)                

(877) 736-9378

(Registrants telephone number, including
area code.)


Indicate by a check mark whether the registrant
(1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the
past
90 days.     Yes þ          No o

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

Indicate the number of shares outstanding of each
of the issuers classes of common stock, as of May 12,
2003.

|                              |  |             |            | 
|----------------------------- |  | ----------- | ---------- | 
|Class                         |  | Outstanding
|                              |  |            
|Common stock, par value $.001 |  |             | 15,546,464 | 



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TABLE OF CONTENTS



|                                                     |                                                                                               |  |  |  |  |  |  | 
|---------------------------------------------------- | --------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I -- FINANCIAL INFORMATION                     
|                                                     | Item 1. Financial Statements                                                                 
|CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|                                                     | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                                                     | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|                                                     | Item 4. Controls and Procedures                                                              
|PART II -- OTHER INFORMATION                        
|                                                     | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURE                                           
|CERTIFICATIONS                                      
|EXHIBIT INDEX                                       
|EX-10.1 LEASE AGREEMENT DATED FEBRUARY 3, 2003      
|Certification of CEO                                
|Certification of CEO                                



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##### Table of Contents



PENWEST PHARMACEUTICALS CO.

TABLE OF CONTENTS

|                                   |  |                                                                                           |    |      |    | 
|---------------------------------- |  | ----------------------------------------------------------------------------------------- | -- | ---- | -- | 
|                                   |  |                                                                                           |    | Page
|                                   |  |                                                                                           |    |     
|PART I  FINANCIAL
    INFORMATION
|Item 1                             |  | Condensed Consolidated Financial Statements
    (Unaudited)                               |    |      |    | 
|                                   |  | Condensed Consolidated Balance Sheets                                                     |    |      | 2  | 
|                                   |  | Condensed Consolidated Statements of Operations                                           |    |      | 3  | 
|                                   |  | Condensed Consolidated Statements of Cash Flows                                           |    |      | 4  | 
|                                   |  | Notes to Condensed Consolidated Financial
    Statements                                  |    |      | 5  | 
|Item 2                             |  | Managements Discussion and Analysis of
    Financial Condition and Results of Operations |    |      | 11 | 
|Item 3                             |  | Quantitative and Qualitative Disclosures About
    Market Risk                            |    |      | 24 | 
|Item 4                             |  | Controls and Procedures                                                                   |    |      | 24 | 
|PART II  OTHER
    INFORMATION   
|Item 6                             |  | Exhibits and Reports on Form 8-K                                                          |    |      | 25 | 
|Signature                          |  |                                                                                           | 26 |     
|Certifications                     |  |                                                                                           | 27 |     
|Exhibit Index                      |  |                                                                                           | 29 |     

1



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##### Table of Contents






PART I  FINANCIAL
INFORMATION






|        |                     
|------- | --------------------
|Item 1. | Financial Statements

PENWEST PHARMACEUTICALS CO.

CONDENSED CONSOLIDATED BALANCE
SHEETS

|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |        |         |        | 
|---------------------------------------- | ----------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | ------------ | ------- | ------ | ----- | ------ | ------- | ------ | 
|                                         |                                           | March 31,                                                                                                                                                                      |                                            | December 31,
|                                         |                                           | 2003                                                                                                                                                                           |                                            | 2002        
|                                         |                                           |                                                                                                                                                                                |                                            |             
|                                         |                                           | (Unaudited)                                                                                                                                                                    |                                            | (Note 2)    
|                                         |                                           |                                                                                                                                                                               
|                                         |                                           | (In thousands,                                                                                                                                                                
|                                         |                                           | except share amounts)                                                                                                                                                         
|ASSETS                                  
|Current assets:                          |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         | Cash and cash equivalents                 |                                                                                                                                                                                | $                                          | 21,163       |         |        | $     | 1,629  |        
|                                         | Marketable securities                     |                                                                                                                                                                                |                                            | 9,136        |         |        |       | 2,057  |        
|                                         | Trade accounts receivable                 |                                                                                                                                                                                |                                            | 969          |         |        |       | 1,078  |        
|                                         | Inventories:                              |                                                                                                                                                                                |                                            |              |         |        |       |        |        
|                                         |                                           | Raw materials and other                                                                                                                                                        |                                            |              | 366     |        |       |        | 149     |       
|                                         |                                           | Finished goods                                                                                                                                                                 |                                            |              | 248     |        |       |        | 312     |       
|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         |                                           |                                                                                                                                                                                | 614                                        |              |         |        | 461   |       
|                                         | Prepaid expenses and other current assets |                                                                                                                                                                                |                                            | 1,951        |         |        |       | 1,902  |        
|                                         | Deferred transaction costs                |                                                                                                                                                                                |                                            |             |         |        |       | 1,741  |        
|                                         | Note receivable                           |                                                                                                                                                                                |                                            | 1,000        |         |        |       |       |        
|                                         | Assets held for sale                      |                                                                                                                                                                                |                                            |             |         |        |       | 33,143 |        
|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         |                                           | Total current assets                                                                                                                                                           |                                            |              | 34,833  |        |       |        | 42,011  |       
|Fixed assets, net                        |                                           |                                                                                                                                                                                | 2,404                                      |              |         |        | 2,406 |       
|Intangible assets, net                   |                                           |                                                                                                                                                                                | 3,133                                      |              |         |        | 2,947 |       
|Other assets                             |                                           |                                                                                                                                                                                | 4,145                                      |              |         |        | 2,856 |       
|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         |                                           | Total assets                                                                                                                                                                   |                                            | $            | 44,515  |        |       | $      | 50,220  |       
|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|LIABILITIES AND SHAREHOLDERS
    EQUITY
|Current liabilities:                     |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         | Accounts payable                          |                                                                                                                                                                                | $                                          | 896          |         |        | $     | 880    |        
|                                         | Accrued expenses                          |                                                                                                                                                                                |                                            | 1,490        |         |        |       | 2,886  |        
|                                         | Accrued development costs                 |                                                                                                                                                                                |                                            | 1,729        |         |        |       | 2,785  |        
|                                         | Taxes payable                             |                                                                                                                                                                                |                                            | 318          |         |        |       | 258    |        
|                                         | Loans and notes payable                   |                                                                                                                                                                                |                                            | 255          |         |        |       | 5,693  |        
|                                         | Deferred revenue                          |                                                                                                                                                                                |                                            |             |         |        |       | 150    |        
|                                         | Liabilities held for sale                 |                                                                                                                                                                                |                                            |             |         |        |       | 3,004  |        
|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         |                                           | Total current liabilities                                                                                                                                                      |                                            |              | 4,688   |        |       |        | 15,656  |       
|Deferred income taxes                    |                                           |                                                                                                                                                                                | 118                                        |              |         |        | 118   |       
|Deferred revenue                         |                                           |                                                                                                                                                                                | 128                                        |              |         |        | 134   |       
|Deferred compensation                    |                                           |                                                                                                                                                                                | 2,942                                      |              |         |        | 2,889 |       
|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         |                                           | Total liabilities                                                                                                                                                              |                                            |              | 7,876   |        |       |        | 18,797  |       
|Shareholders equity:                    |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         |                                           | Preferred stock, par value $.001, authorized
    1,000,000 shares, none outstanding                                                                                            |                                            |              |        |        |       |        |        |       
|                                         |                                           | Common stock, par value $.001, authorized
    39,000,000 shares, issued and outstanding 15,527,463 shares at
    March 31, 2003 and 15,506,259 shares at December 31,
    2002 |                                            |              | 16      |        |       |        | 16      |       
|                                         |                                           | Additional paid in capital                                                                                                                                                     |                                            |              | 110,137 |        |       |        | 110,000 |       
|                                         |                                           | Accumulated deficit                                                                                                                                                            |                                            |              | (73,529 | )      |       |        | (78,025 | )     
|                                         |                                           | Accumulated other comprehensive income (loss)                                                                                                                                  |                                            |              | 15      |        |       |        | (568    | )     
|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         |                                           |                                                                                                                                                                                | Total shareholders equity                 |              |         | 36,639 |       |        |         | 31,423 | 
|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       
|                                         |                                           |                                                                                                                                                                                | Total liabilities and shareholders equity |              | $       | 44,515 |       |        | $       | 50,220 | 
|                                         |                                           |                                                                                                                                                                                |                                            |              |         |        |       |       

See accompanying notes to condensed consolidated
financial statements.

2



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##### Table of Contents



PENWEST PHARMACEUTICALS CO.






CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS


|                                                                              |                   |                                     |                          |              |       |       |        |       |       |       |       | 
|----------------------------------------------------------------------------- | ----------------- | ----------------------------------- | ------------------------ | ------------ | ----- | ----- | ------ | ----- | ----- | ----- | ----- | 
|                                                                              |                   |                                    
|                                                                              |                   | Three Months Ended                 
|                                                                              |                   | March 31,                          
|                                                                              |                   |                                    
|                                                                              |                   | 2003                                |                          | 2002        
|                                                                              |                   |                                     |                          |             
|                                                                              |                   |                                    
|                                                                              |                   | (Unaudited)                        
|                                                                              |                   |                                    
|                                                                              |                   | (In thousands,                     
|                                                                              |                   | except per share data)             
|Revenues                                                                      |                   |                                     |                          |              |       |       |        |      
|                                                                              |                   | Product sales                       |                          | $            | 225   |       |        | $     | 75    |      
|                                                                              |                   | Royalties and licensing fees        |                          |              | 947   |       |        |       | 1,040 |      
|                                                                              |                   |                                     |                          |              |       |       |        |      
|                                                                              |                   |                                     | Total revenues           |              |       | 1,172 |        |       |       | 1,115 |      
|Cost of revenues                                                              |                   |                                     | 81                       |              |       |       | 26     |      
|                                                                              |                   |                                     |                          |              |       |       |        |      
|                                                                              |                   |                                     |                          | Gross profit |       |       | 1,091  |       |       |       | 1,089 | 
|Operating expenses                                                            |                   |                                     |                          |              |       |       |        |      
|                                                                              |                   | Selling, general and administrative |                          |              | 2,298 |       |        |       | 1,523 |      
|                                                                              |                   | Research and product development    |                          |              | 3,583 |       |        |       | 4,451 |      
|                                                                              |                   |                                     |                          |              |       |       |        |      
|                                                                              |                   |                                     | Total operating expenses |              |       | 5,881 |        |       |       | 5,974 |      
|                                                                              |                   |                                     |                          |              |       |       |        |      
|Operating loss from continuing operations                                     |                   |                                     | (4,790                   | )            |       |       | (4,885 | )    
|Investment income                                                             |                   |                                     | 41                       |              |       |       | 130    |      
|Interest expense                                                              |                   |                                     | 32                       |              |       |       | 58     |      
|                                                                              |                   |                                     |                          |              |       |       |        |      
|Loss from continuing operations before income
    taxes                       |                   |                                     | (4,781                   | )            |       |       | (4,813 | )    
|Income tax expense                                                            |                   |                                     | 6                        |              |       |       | 6      |      
|                                                                              |                   |                                     |                          |              |       |       |        |      
|Loss from continuing operations                                               |                   |                                     | (4,787                   | )            |       |       | (4,819 | )    
|Earnings from discontinued operations, net of tax
    expense of $26 and $141 |                   |                                     | 177                      |              |       |       | 501    |      
|Gain on sale of discontinued operations, net of
    tax expense of $62        |                   |                                     | 9,580                    |              |       |       |       |      
|                                                                              |                   |                                     |                          |              |       |       |        |      
|Net income (loss)                                                             |                   | $                                   | 4,970                    |              |       | $     | (4,318 | )    
|                                                                              |                   |                                     |                          |              |       |       |        |      
|Basic and diluted (loss) earnings per common
    share:                       |                   |                                     |                          |              |       |       |        |      
|Continuing operations                                                         |                   | $                                   | (0.31                    | )            |       | $     | (0.31  | )    
|Discontinued operations                                                       |                   |                                     | 0.63                     |              |       |       | 0.03   |      
|                                                                              |                   |                                     |                          |              |       |       |        |      
|                                                                              | Net Income (loss) |                                     | $                        | 0.32         |       |       | $      | (0.28 | )    
|                                                                              |                   |                                     |                          |              |       |       |        |      
|Weighted average shares of common stock
    outstanding                       |                   |                                     | 15,508                   |              |       |       | 15,398 |      
|                                                                              |                   |                                     |                          |              |       |       |        |      

See accompanying notes to condensed consolidated
financial statements.

3



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PENWEST PHARMACEUTICALS CO.






CONDENSED CONSOLIDATED STATEMENTS OF CASH
FLOWS


|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |        |  
|------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------- | ------------------ | ------ | ------ | - | - | ------ | ------ | -
|                                                                                            |                                                                                                                                 |                   
|                                                                                            |                                                                                                                                 | Three Months Ended
|                                                                                            |                                                                                                                                 | March 31,         
|                                                                                            |                                                                                                                                 |                   
|                                                                                            |                                                                                                                                 | 2003               |        | 2002  
|                                                                                            |                                                                                                                                 |                    |        |       
|                                                                                            |                                                                                                                                 |                   
|                                                                                            |                                                                                                                                 | (Unaudited)       
|                                                                                            |                                                                                                                                 |                   
|                                                                                            |                                                                                                                                 | (In thousands)    
|Net cash used in operating activities:                                                      |                                                                                                                                 |                    |        |        |   |   |        |       
|Net Income (Loss)                                                                           |                                                                                                                                 | $                  | 4,970  |        |   | $ | (4,318 | )     
|Less earnings from discontinued operations, net
    of tax                                  |                                                                                                                                 |                    | (177   | )      |   |   | (501   | )     
|Less gain on sale of discontinued operations, net
    of tax                                |                                                                                                                                 |                    | (9,580 | )      |   |   |       |       
|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |       
|Loss from continuing operations                                                             |                                                                                                                                 |                    | (4,787 | )      |   |   | (4,819 | )     
|                                                                                            | Adjustments to reconcile loss from continuing
    operations to net cash used in continuing operations operating
    activities |                    |        | (2,004 | ) |   |        | 3,531  |  
|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |       
|Net cash used in continuing operations operating
    activities                             |                                                                                                                                 |                    | (6,791 | )      |   |   | (1,288 | )     
|Net cash provided by (used in) discontinued
    operations operating activities             |                                                                                                                                 |                    | 874    |        |   |   | (109   | )     
|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |       
|Net cash used in operating activities                                                       |                                                                                                                                 |                    | (5,917 | )      |   |   | (1,397 | )     
|Investing activities:                                                                       |                                                                                                                                 |                    |        |        |   |   |        |       
|                                                                                            | Proceeds from sale of discontinued operations, net                                                                              |                    |        | 37,251 |   |   |        |       |  
|                                                                                            | Transaction costs paid                                                                                                          |                    |        | (1,350 | ) |   |        |       |  
|                                                                                            | Acquisitions of fixed assets, net                                                                                               |                    |        | (109   | ) |   |        | (85    | )
|                                                                                            | Intangible asset costs                                                                                                          |                    |        | (236   | ) |   |        | (266   | )
|                                                                                            | Proceeds from maturities of marketable securities                                                                               |                    |        | 1,000  |   |   |        | 2,250  |  
|                                                                                            | Purchases of marketable securities                                                                                              |                    |        | (7,938 | ) |   |        |       |  
|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |       
|Net cash provided by continuing operations
    investing activities                         |                                                                                                                                 |                    | 28,618 |        |   |   | 1,899  |       
|Net cash used in discontinued operations
    investing activities                           |                                                                                                                                 |                    | (97    | )      |   |   | (64    | )     
|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |       
|Net cash provided by investing activities                                                   |                                                                                                                                 |                    | 28,521 |        |   |   | 1,835  |       
|Financing activities:                                                                       |                                                                                                                                 |                    |        |        |   |   |        |       
|                                                                                            | Proceeds from loans                                                                                                             |                    |        | 1,354  |   |   |        | 6,055  |  
|                                                                                            | Repayments of loans                                                                                                             |                    |        | (6,792 | ) |   |        | (5,925 | )
|                                                                                            | Issuance of common stock, net                                                                                                   |                    |        | 87     |   |   |        | 1,431  |  
|                                                                                            | Net cash provided by discontinued operations                                                                                    |                    |        | 2,249  |   |   |        |       |  
|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |       
|Net cash (used in) provided by financing
    activities                                     |                                                                                                                                 |                    | (3,102 | )      |   |   | 1,561  |       
|Effect of exchange rate changes on cash and cash
    equivalents of discontinued operations |                                                                                                                                 |                    | 32     |        |   |   | (30    | )     
|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |       
|Net increase in cash and cash equivalents                                                   |                                                                                                                                 |                    | 19,534 |        |   |   | 1,969  |       
|Cash and cash equivalents at beginning of period                                            |                                                                                                                                 |                    | 1,629  |        |   |   | 11,530 |       
|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |       
|Cash and cash equivalents at end of period                                                  |                                                                                                                                 | $                  | 21,163 |        |   | $ | 13,499 |       
|                                                                                            |                                                                                                                                 |                    |        |        |   |   |        |       

See accompanying notes to condensed consolidated
financial statements.

4



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PENWEST PHARMACEUTICALS CO.






NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS


(Unaudited)




|   |         
|-- | --------
|1. | Business

Penwest Pharmaceuticals Co. (Penwest
or the Company) develops pharmaceutical products
based on innovative oral drug delivery technologies. Based on
its fundamental expertise in tabletting ingredients, the Company
has developed its proprietary TIMERx® controlled release
drug delivery technology, which is applicable to a broad range
of orally administered drugs.

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 (the Asset Sale) to subsidiaries
and affiliates of Josef Rettenmaier Holding GmbH & Co.
KG. The Company received $39.5 million in cash and a
promissory note for $2.25 million in consideration for the
excipient business. The Company intends to use the proceeds of
the sale of its excipient business to expand its drug delivery
business. In the first quarter of 2003, the Company reported the
operating results of the excipient business as a discontinued
operation (see Note 8).

Prior to the sale of its excipient business, the
Company had manufacturing facilities in Iowa and Finland.

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, a requirement for additional funding, technological
changes, dependence on collaborators and key personnel, the
successful completion of development efforts and of obtaining
regulatory approval, the successful commercialization of TIMERx
controlled release products, compliance with government
regulations, patent infringement litigation and competition from
current and potential competitors, some with greater resources
than the Company.



|   |                      
|-- | ---------------------
|2. | Basis of Presentation

The accompanying unaudited condensed consolidated
financial statements have been prepared in accordance with
accounting principles generally accepted in the United States
for interim financial information and with the instructions to
Form 10-Q and Rule 10-01 of Regulation S-X.
Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted
in the United States for complete financial statements. In the
opinion of management, all adjustments considered necessary for
a fair presentation for the interim periods presented have been
included. All such adjustments are of a normal recurring nature.
Operating results for the three-month period ended
March 31, 2003 are not necessarily indicative of the
results that may be expected for the year ending
December 31, 2003. 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, 2002.

During the quarter ended March 31, 2003, the
Company recorded an impairment loss of approximately $214,000,
net of accumulated depreciation, relating to equipment of its
excipient business. The impaired equipment primarily related to
a pulp shredding transfer system which did not function as
planned, resulting in the eventual abandonment of the related
project and full write-down of its carrying value. This
impairment loss is included in earnings from discontinued
operations in the condensed consolidated statements of
operations.

The balance sheet at December 31, 2002 has
been derived from the audited financial statements at that date
but does not include all of the information and footnotes
required by accounting principles generally accepted in the
United States for complete financial statements.

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 quarters ended

5



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##### Table of Contents



PENWEST PHARMACEUTICALS CO.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Unaudited)


March 31, 2003 and 2002 (see Note 8).
In order to conform with the current period presentation,
certain reclassifications have been made in the prior period
financial statements.



|   |                                               
|-- | ----------------------------------------------
|3. | Summary of Significant Accounting
    Policies



| |                    
| | -------------------
| | Revenue Recognition

Revenues from product sales are recognized when
title transfers and customer acceptance provisions have lapsed,
provided collections of the related accounts receivable are
probable. Revenue received from non-refundable upfront licensing
fees are recognized ratably over the development period of the
collaboration agreement, when this period involves development
risk associated with the incomplete stage of a products
development or over the estimated or contractual licensing and
supply term when there exists an obligation to supply inventory
for manufacture. Non-refundable milestone fees received for the
development funding of a product are partially recognized upon
receipt based on the Companys proportionate development
efforts achieved to date relative to the total expected
development efforts and the remainder is generally recognized
ratably over the remaining expected development period. The
proportionate development efforts achieved are measured by
estimating the percentage of work completed that is required of
the Company in the development effort for the product. This
estimate is primarily derived from the underlying project plans
and timelines, developed by qualified personnel who work closely
on such projects. In particular, the Company reviews output
measures such as job specifications and tasks completed,
compared to all such job specifications and tasks outlined for a
particular project. Job specifications vary with each project
and primarily include development activities regarding initial
formulation work, manufacturing scale-up, proof-of-principle
biostudies, clinical development and regulatory matters. Other
contractual fees received in connection with a
collaborators launch of a product are also recognized
ratably over the estimated or contractual licensing and supply
term. Product royalty fees are recognized when earned.



| |              
| | -------------
| | Stock Options

The Company adopted the disclosure provisions of
Statement of Financial Accounting Standards (SFAS)
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure, which
amends SFAS No. 123, Accounting for Stock-Based
Compensation, in 2002. SFAS No. 148 provides
alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee
compensation, which was originally provided under SFAS
No. 123. The Statement also improves the timeliness of
disclosures by requiring the information to be included in
interim as well as annual financial statements. The adoption of
these disclosure provisions had no impact on the Companys
2003 consolidated results of operations, financial position or
cash flows.

At March 31, 2003, 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. No
stock-based employee compensation expense is reflected in net
loss as all 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.

Consistent with the method described in SFAS
No. 123, if compensation expense for the Companys
plans had been determined based on the fair value at the grant
dates for awards under its plans, net income

6



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##### Table of Contents



PENWEST PHARMACEUTICALS CO.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Unaudited)


(loss) and income (loss) per share would have
been increased to the pro forma amounts indicated below (in
thousands, except per share data):

|                                                                 |  |                    |       |      |  |   |        |  
|---------------------------------------------------------------- |  | ------------------ | ----- | ---- |  | - | ------ | -
|                                                                 |  |                   
|                                                                 |  | Three Months Ended
|                                                                 |  | March 31,         
|                                                                 |  |                   
|                                                                 |  | 2003               |       | 2002
|                                                                 |  |                    |       |     
|Net income (loss)  as reported                                  |  | $                  | 4,970 |      |  | $ | (4,318 | )
|Net income (loss)  pro forma                                    |  | $                  | 3,632 |      |  | $ | (5,377 | )
|Net income (loss) per share, basic and
    diluted  as reported |  | $                  | 0.32  |      |  | $ | (0.28  | )
|Net income (loss) per share, basic and
    diluted  pro forma   |  | $                  | 0.23  |      |  | $ | (0.35  | )



|   |                                 
|-- | --------------------------------
|4. | Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force
(EITF) finalized its tentative consensus on EITF
Issue 00-21, Revenue Arrangements with Multiple
Deliverables, which provides guidance on the timing and
method of revenue recognition for arrangements that include the
delivery of more than one product or service. EITF 00-21 is
effective prospectively for arrangements entered into in fiscal
periods beginning after June 15, 2003. The Company is
currently evaluating the impact of the adoption of this
consensus on the Companys financial statements.

In April 2002, the Financial Accounting Standards
Board (FASB) issued SFAS No. 145,
Rescission of FASB Statements No. 4, 44, and 64,
Amendment of FASB Statement No. 13, and Technical
Corrections. SFAS No. 145 updates, clarifies and
simplifies existing accounting pronouncements and is generally
effective for transactions occurring after May 15, 2002.
The adoption of this statement did not have a material impact on
the Companys financial position or results of operations.

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

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



|   |                        
|-- | -----------------------
|5. | Loans and Notes Payable



| |                  
| | -----------------
| | Credit Facilities

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

7



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##### Table of Contents



PENWEST PHARMACEUTICALS CO.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Unaudited)


Company paid off the outstanding balance of
$3.3 million and terminated the Revolver in connection with
the Asset Sale (see Note 8).



| |                               
| | ------------------------------
| | Note Payable to AstraZeneca AB

On October 25, 2002, the Company entered
into an agreement with AstraZeneca AB to acquire from
AstraZeneca AB assets related to the excipient product, Pruv,
including trademarks and other intellectual property, for a
total purchase price of $3 million. Pursuant to this
agreement, the Company issued a note to AstraZeneca AB in the
principal amount of $2.25 million. Under the agreement, the
note required the Company to pay all indebtedness outstanding
under the note upon the closing of the Asset Sale. As a result,
the Company paid off the note in full in February 2003
in connection with the Asset Sale (see Note 8).



| |                                     
| | ------------------------------------
| | Business Insurance Premium Financing

On September 24, 2002, the Company entered
into a Premium Finance Agreement (a Finance
Agreement) through which it financed approximated
$1.1 million of premiums payable in connection with the
annual renewal of its general business insurance. Under the
Finance Agreement, Penwest is 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.



|   |             
|-- | ------------
|6. | Income Taxes

For continuing operations, the effective tax
rates for the quarters ended March 31, 2003 and 2002 were
essentially zero. The effective tax rates are higher than the
federal statutory rate of a 34% benefit due primarily to
valuation allowances recorded to offset deferred tax assets
relating to the Companys net operating losses, and state
income taxes.

The gain on sale of discontinued operations of
approximately $9.6 million, recorded in the quarter ended
March 31, 2003, is net of tax expense of $62,000, 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 and $501,000, respectively,
for the quarters ended March 31, 2003 and March 31,
2002, are net of tax expenses of $26,000 and $141,000,
respectively, or 13% and 22% of pretax earnings, respectively.
These tax expenses, which include foreign taxes, are lower than
the federal statutory rate of 34% primarily due to overall U.S.
net operating losses which offset the U.S. earnings of the
discontinued operation (see Note 8).



|   |                            
|-- | ---------------------------
|7. | Comprehensive Income (Loss)

The components of comprehensive income (loss) for
the three-month periods ended March 31, 2003 and 2002 are
as follows (in thousands):

|                                                            |  |                    |       |      |  |   |        |  
|----------------------------------------------------------- |  | ------------------ | ----- | ---- |  | - | ------ | -
|                                                            |  |                   
|                                                            |  | Three Months Ended
|                                                            |  | March 31,         
|                                                            |  |                   
|                                                            |  | 2003               |       | 2002
|                                                            |  |                    |       |     
|                                                            |  |                   
|                                                            |  | (Unaudited)       
|Net income (loss)                                           |  | $                  | 4,970 |      |  | $ | (4,318 | )
|Foreign currency translation adjustments                    |  |                    | 109   |      |  |   | (114   | )
|Change in unrealized net gains on marketable
    securities |  |                    |      |      |  |   | (17    | )
|                                                            |  |                    |       |      |  |   |        |  
|Comprehensive income (loss)                                 |  | $                  | 5,079 |      |  | $ | (4,449 | )
|                                                            |  |                    |       |      |  |   |        |  

8



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##### Table of Contents



PENWEST PHARMACEUTICALS CO.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Unaudited)


Accumulated other comprehensive income (loss)
equals the cumulative translation adjustment and unrealized net
gains on marketable securities which are the only components of
other comprehensive 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.



|   |                        
|-- | -----------------------
|8. | 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 which is not yet finalized, but is not
expected to be material. 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 due April 25, 2003 and $1.25 million
due May 25, 2004.

In the first quarter of 2003, the Company
recorded a gain on the Asset Sale of approximately
$9.6 million, net of taxes of $62,000, and has reported the
operating results of the excipient business as a discontinued
operation in accordance with SFAS No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. The
net carrying amount of the assets and liabilities on the date of
the Asset Sale was approximately $29.5 million. The
approximate carrying values of the major classes were: property,
plant and equipment of $11.4 million; inventory of
$8.3 million; receivables of $6.0 million; and
intangible assets of $4.3 million, offset by other net
liabilities. The Company restated its December 31, 2002
balance sheet in the consolidated financial statements to
reflect the excipient business as a discontinued operation, and
accordingly, the assets and liabilities of the excipient
business are shown separately as assets held for sale and
liabilities held for sale. The estimated gain on the Asset Sale
is net of transaction related costs totaling $3.1 million,
primarily consisting of professional and advisory fees. As of
December 31, 2002 these costs approximated
$1.7 million and were reflected as deferred transaction
costs on the condensed consolidated balance sheet. Revenues and
pretax profits for the excipient business approximated
$6.1 million and $203,000, respectively, for the period
January 1, 2003 through the Asset Sale date of
February 27, 2003, and approximated $9.2 million and
$642,000, respectively, for the quarter ended March 31,
2002.

Prior to the sale of the excipient business, the
Company owned its office, laboratory and warehouse facility in
Patterson, New York, as well as a facility in Cedar Rapids,
Iowa, where it manufactured pharmaceutical excipients. As part
of the Asset Sale, the Company transferred these properties and
assigned its lease of a pharmaceutical excipient manufacturing
facility in Nastola, Finland to Rettenmaier. Under a lease
agreement signed with Rettenmaier on February 27, 2003, the
Company has the right to occupy approximately 14,000 square feet
of office and research and development space in the Patterson
facility until February 2008, initially on a rent-free basis
(plus operating expenses) for two years and then pursuant to
three successive one-year options at monthly rent payments
approximating $14,000, plus operating expenses. In addition, in
February 2003, the Company signed a lease agreement for
approximately 11,000 square feet of office space in Danbury,
Connecticut. This lease has an initial term expiring
January 31, 2006, with renewal options through
December 30, 2006, and requires that monthly base rents of
approximately $20,000 be paid through the initial lease term.
The Company moved its corporate offices to Danbury, Connecticut
on March 31, 2003.



|   |                     
|-- | --------------------
|9. | Licensing Agreements

The Company enters into collaborative
arrangements with pharmaceutical companies to develop,
manufacture or market products formulated with its drug delivery
technologies.

9



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##### Table of Contents



PENWEST PHARMACEUTICALS CO.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

(Unaudited)


In September 1997, the Company entered into a
strategic alliance agreement with Endo Pharmaceuticals, Inc.
with respect to the development of 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 is a fully integrated specialty pharmaceutical
company with a market leadership in pain management. Endo has a
broad product line including 20 branded products that include
the 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 manufacture
and supply TIMERx material to Endo, and Endo has agreed to
manufacture and market oxymorphone ER in the United States. The
manufacture and marketing outside of the United States may be
conducted by the Company, Endo or a third party, as determined
by the Alliance Committee.

Prior to March 17, 2003, the Company and
Endo shared the costs involved in the development of oxymorphone
ER. On March 17, 2003, the Company gave Endo notice that it
was discontinuing its participation in the funding of the
development and marketing of oxymorphone ER effective
April 17, 2003. The Company believes that its current
strategic focus should be on funding products in its development
pipeline. As a result of this termination, 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. Endo may recoup such
development costs solely through a temporary adjustment in the
royalty rate payable to Penwest which shall return to its
pre-adjustment level once Endo has recovered such costs. 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). This percentage will
decrease if the aggregate U.S. net realization exceeds
pre-determined thresholds. In general, the royalty payable by
the marketing party to the other party will not drop below 40%.
However, the royalty will be reduced by one-third in limited
circumstances, including termination of the agreement based on
uncured material breaches of the agreement by the royalty
receiving party and certain bankruptcy and insolvency events
involving the royalty receiving party. Under the agreement, Endo
will purchase formulated TIMERx material for use in oxymorphone
ER exclusively from the Company at specified prices, such prices
will be reflected in the determination of net profits.

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 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
2002 of the 30 mg dosage strength version of Pfizers
generic Procardia XL totaled approximately
$34.9 million. The term of this agreement continues until
such time as Mylan permanently ceases to market generic
Procardia XL.

10



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##### Table of Contents








|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|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 which involve risks and
uncertainties. The Companys 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

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, and SyncroDose is a chronotherapeutic drug
delivery system that is designed to release the active
ingredient of a drug at the desired site and time in the body.

Penwests product portfolio includes four
products utilizing its proprietary controlled release drug
delivery technology, that were developed with collaborators and
have been approved in various countries. In addition, the
Company has a number of product candidates in its drug
development pipeline. The most advanced of these is oxymorphone
ER, an extended release formulation of oxymorphone incorporating
TIMERx technology. The Company is developing oxymorphone ER with
Endo. The FDA accepted for filing a new drug application, or
NDA, submitted by Endo for oxymorphone ER in February 2003.

Prior to February 27, 2003, Penwest also
developed, manufactured and distributed branded pharmaceutical
excipients, which are the inactive ingredients in tablets and
capsules, primarily consisting of binders, disintegrants and
lubricants. On February 27, 2003, Penwest sold
substantially all of the assets used in the Companys
excipient business to subsidiaries and affiliates of Josef
Rettenmaier Holding GmbH & Co. KG (the Asset
Sale). The Company received $39.5 million in cash and
a promissory note for $2.25 million in consideration for
the excipient business. The Company received $1.0 million
of the $2.25 million in April 2003. The Company intends to
use the proceeds of the sale of its excipient business to expand
its drug delivery business. In the first quarter of 2003, the
Company reported the operating results of the excipients
business as a discontinued operation.

The Company has incurred net losses since 1994.
As of March 31, 2003, the Companys accumulated
deficit was approximately $74 million. The Company expects
operating losses and negative cash flows to continue until
substantial sales of products commercialized utilizing TIMERx
technology occur. A substantial portion of the Companys
revenues through February 27, 2003 were generated from
sales of the Companys pharmaceutical excipient product
line. The Company expects that the balance of its revenues for
2003 will be generated primarily from Mylan royalties, shipments
of bulk TIMERx and payments under collaboration agreements. The
Companys future profitability will depend on several
factors, including the successful commercialization of TIMERx
controlled release products, including in particular oxymorphone
ER; the Companys ability to use net proceeds from the sale
of its excipient business to expand its drug development and
delivery business; royalties from Mylan sales of Pfizer 30 mg
generic version of Procardia XL; and the level of the
Companys investment in research and development activities.

The Companys strategy includes a
significant commitment to spending on research and development
targeted at identifying and developing extended release products
which can be formulated using the Companys TIMERx
technologies. The Company also expects to expend significant
resources on the development of new drug delivery technologies,
both internally and through in-licenses or acquisition. The
Companys spending in the area of new technology, however,
is discretionary and is subject to the Company identifying
appropriate opportunities, as well as the availability of funds
from the Companys operations, cash resources,
collaborative research and development arrangements and external
financing. There can be no assurance when or if the Company will
achieve profitability or if it will be able to sustain
profitability on a quarterly basis, if at all.

11



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##### Table of Contents



The Companys collaborative agreements
include licensing arrangements in which the Company is entitled
to receive milestone payments, royalties on the sale of the
products covered by such collaborative agreements and payments
for the purchase of formulated TIMERx material, as well as
licensing arrangements which include revenue and cost sharing
components in which the Company shares in the costs and
profitability at predetermined percentages, but does not
generally receive milestone payments. There can be no assurance
that the Companys controlled release product development
efforts will be successfully completed, that required regulatory
approvals will be obtained or that approved products will be
successfully manufactured or marketed.

The Companys results of operations may
fluctuate from quarter to quarter depending on the volume and
timing of orders of formulated bulk TIMERx, royalties on
Mylans sales of Pfizers 30 mg generic version
of Procardia XL, and on variations in payments under the
Companys collaborative agreements, including payments upon
the achievement of specified milestones. The Companys
quarterly operating results may also fluctuate depending on
other factors, including variations in gross margins of the
Companys products, the mix of product sales
and royalties and licensing fees, competition and regulatory actions.

Critical Accounting Policies and
Estimates

The Companys discussion and analysis of its
financial condition and results of operations are based upon its
condensed consolidated financial statements, which have been
prepared in accordance with accounting principles generally
accepted in the United States. The Companys significant
accounting policies are more fully described in the notes to the
consolidated financial statements in the Companys Annual
Report on Form 10-K for the year ended December 31,
2002. These policies are important to the portrayal of the
Companys financial condition and results of operations.
The preparation of these financial statements requires the
Company 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. Areas where significant
judgments are made include, but are not limited to, revenue
recognition, deferred taxes-valuation allowance and impairment
of long-lived assets. Actual results could differ materially
from these estimates. 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, 2002.

Results of Operations  Continuing
Operations



| |                                           
| | ------------------------------------------
| | Quarters Ended March 31, 2003 and
    2002

Total revenues increased by $57,000 or 5% for the
first quarter ended March 31, 2003 to $1.2 million,
from $1.1 million for the quarter ended March 31,
2002. Product sales increased to $225,000 for the quarter ended
March 31, 2003 from $75,000 for the quarter ended
March 31, 2002. The increase in product sales was primarily
due to the timing of shipments of formulated bulk TIMERx by
customers. Royalties and licensing fees decreased by $93,000 for
the first quarter of 2003 to $947,000 from $1.0 million in
the first quarter of 2002, primarily due to lower royalties from
Mylan attributable to Mylans decreased sales of
Pfizers 30 mg generic version of Procardia XL.

Gross profit was essentially flat at
$1.1 million, or 93% of total revenues, for the first
quarter of 2003 as compared to $1.1 million or 98% of total
revenues, for the first quarter of 2002. The gross profit
percentage on revenues decreased primarily due to revenue mix,
with proportionately lower royalties than product sales in the
first quarter of 2003 as compared with the first quarter of 2002.

Selling, general and administrative expenses
increased by $775,000 to $2.3 million for the first quarter
of 2003 as compared to $1.5 million in the first quarter of
2002. The increase in selling, general and administrative
expenses was primarily due to the Companys share of
marketing costs incurred in preparation for the launch of
oxymorphone ER being developed with Endo, an increase in
premiums for business insurance, higher market research costs,
and an increase in legal and professional fees. On
March 17, 2003, the Company gave Endo notice that it is
discontinuing its participation in the funding of the
development of oxymorphone ER, effective April 17, 2003. As
of result, the first quarter of 2003 includes a full quarter of

12



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##### Table of Contents



expenses for oxymorphone ER, but subsequent to
April 17, 2003 the Company will not record expenses related
to oxymorphone ER.


Research and product development expenses
decreased by $868,000 to $3.6 million for the first quarter
of 2003 as compared to $4.5 million in the first quarter of
2002. The Company spent approximately $1.5 million on the
development of oxymorphone ER in the first quarter of 2003. This
was a decrease of approximately $500,000 due to lower
development costs on oxymorphone ER as clinical activity
declined in the first quarter of 2003 related to the submission
of the NDA for oxymorphone ER in December 2002. The remainder of
the decrease was due to the timing of clinical studies for the
Companys other programs. As of March 31, 2003, the
Company had several product candidates utilizing TIMERx
technology in various stages of clinical trials, the lead
candidate being its product for hypertension. 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.

The most advanced of the Companys product
candidates is oxymorphone ER, which the Company is developing
with Endo. Endo, which is responsible for conducting the
clinical trials and seeking regulatory approval of the product,
completed the clinical trials for this product in 2002 and the
FDA accepted for filing the NDA for oxymorphone ER in February
2003. On March 17, 2003, the Company gave Endo notice that
it is discontinuing its participation in the funding of the
development of oxymorphone ER, effective April 17, 2003.
Accordingly, the Company anticipates it research and development
expenses with respect to oxymorphone ER will decrease after
April 17, 2003. The Company anticipates using the funds
that otherwise would have been expended on oxymorphone ER to
increase its investment in the development of additional
products utilizing TIMERx technology, and in research and
development involving new drug delivery technologies.

There can be no assurance that any of the
Companys products will be successfully developed, will
receive regulatory approval, or will be successfully
commercialized.

The effective tax rates for the quarters ended
March 31, 2003 and 2002 were essentially zero. The
effective tax rates are higher than the federal statutory rate
of a 34% benefit due primarily to valuation allowances recorded
to offset deferred tax assets relating to the Companys net
operating losses, and state income taxes.

The gain on sale of discontinued operations of
approximately $9.6 million, recorded in the quarter ended
March 31, 2003, is net of tax expense of $62,000, 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 and $501,000, respectively,
for the quarters ended March 31, 2003 and March 31,
2002, are net of tax expenses of $26,000 and $141,000,
respectively, or 13% and 22% of pretax earnings, respectively.
These tax expenses, 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

Subsequent to August 31, 1998, the date the
Company became an independent, publicly-owned company, the
Company has funded its operations and capital expenditures with
cash flows from the sale of excipients, sales of formulated bulk
TIMERx, royalties and milestone payments from Mylan and other
collaborators, advances under credit facilities and proceeds
from the sale and issuance of shares of common stock.

The Company is a party to an agreement with Endo
with respect to the development of oxymorphone ER. On
March 17, 2003, the Company gave Endo notice that the
Company is discontinuing its participation in the funding of the
development and marketing of oxymorphone ER, effective
April 17, 2003. Accordingly, the Company anticipates its
research and development, and selling, general and
administrative expenses with respect to oxymorphone ER will
decrease significantly in 2003 after the first quarter. The
Company anticipates using the funds that otherwise would have
been expended on oxymorphone ER to increase its

13



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investment in the development of additional
products utilizing TIMERx technology, and in research and
development involving new drug delivery technologies.


On February 27, 2003, the Company
consummated the sale of its excipient business to Rettenmaier.
As a result of the sale, the Company had approximately
$35 million of net cash proceeds available after the
closing, which the Company plans to use to fund development of
products in its pipeline as well as the rest of the
Companys operations. However, as a result of the Asset
Sale, the Company will no longer derive cash flow from the sale
of excipients.

Prior to the sale of the excipient business, the
Company had a revolving line of credit with a financial
institution. A portion of the net proceeds from the sale of the
excipient business was used to pay the $3.3 million of
outstanding borrowings under the line of credit, which was
terminated on February 27, 2003.

As of March 31, 2003, the Company had cash,
cash equivalents, and short-term investments of
$30.3 million, which includes the net cash proceeds from
the sale of the Companys excipient business. The Company
has no committed sources of capital other than
Rettenmaiers commitment to repay the Company pursuant to
promissory notes, of which $1.0 million was received in
April 2003 and $1.25 million is due in May 2004, in
connection with the sale of the excipient business.

As part of the Companys agreement to
acquire assets including trademarks and other intellectual
property related to the excipient product, Pruv, for
$3.0 million, on October 25, 2002, the Company issued
a note to the seller, AstraZeneca AB, in the principal amount of
$2.25 million. The indebtedness under the note did not bear
interest. Under the agreement, the indebtedness outstanding
under the note was repaid upon the closing of the sale of the
excipient business.

The Company had negative cash flow from
operations for the quarter ended March 31, 2003 of $5.9
million, primarily due to a loss from continuing operations
in the period of $4.8 million. The Company had negative cash flow from
operations for the quarter ended March 31, 2002 of
$1.4 million, primarily due to the loss from continuing
operations of $4.8 million, partially offset by increases in accounts
payable and accrued expenses of $2.3 million.
The Company also had the cash proceeds from the Asset Sale of
$39.5 million, less cash of $2.2 million, included in the net
assets sold, in the first quarter of 2003, partially
offset by the repayments of loans related to the excipients
business as well as the payment of transaction costs related to
the Asset Sale. Funds expended for intangible assets includes
the cost to secure patents on technology developed by the
Company. The Company expects that its cash flow in 2003 will
differ from its cash flow during 2002 because the
Company will no longer derive revenues from sales of its
excipient products nor will it incur expenses in connection with
its excipient business, except for the revenues and expenses
during the period ended February 26, 2003.

The Company anticipates that its existing capital
resources, including the proceeds from the sale of its excipient
business, and anticipated internally generated funds from the
sale of formulated bulk TIMERx, royalties from Mylan and other
payments from collaborators, will enable the Company to fund its
currently planned operations, including its planned increase in
drug development and commercialization efforts, through late
2004.

The Companys requirements for capital in
its business are substantial and will depend on many factors,
including:



| |   |                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------
| |  | the ongoing costs under the Companys
    collaboration agreements;                                                                           
|
| |  | the structure of any future collaborative or
    development agreements;                                                                      
|
| |  | the progress of the Companys collaborative
    and independent development projects and funding obligations
    with respect to the projects;
|
| |  | the costs to the Company of clinical studies for
    its products;                                                                            
|
| |  | the costs and timing of adding drug development
    capabilities;                                                                             
|
| |  | royalties received from Mylan;                                                                                                                
|
| |  | royalties from sales of TIMERx products;                                                                                                      

14



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| |   |                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------
| |  | the timing and amount of payments received under
    existing and possible future collaborative agreements; and
|
| |  | the prosecution, defense and enforcement of
    potential patent claims and other intellectual property rights.

If the Company needs to raise additional funds to
fund its operations, the Company may seek to obtain additional
funds through debt or equity financings. The additional
financing may not be available to the Company on acceptable
terms, if at all. If adequate funds are not available, Penwest
may be required to:



| |   |                                                                                                                                                                                                                                                                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | significantly curtail its product
    commercialization efforts, including terminating existing
    collaborative agreements;                                                                                                                                                                                                                          
|
| |  | obtain funds through one or more arrangements
    with collaborators or others on adverse terms to Penwest that
    may require Penwest to relinquish rights to certain of its
    technologies, product candidates, or products which Penwest
    would otherwise pursue on its own or that would significantly
    dilute the Companys stockholders;
|
| |  | significantly scale back or terminate operations;
    and/or                                                                                                                                                                                                                                                                                           
|
| |  | seek relief under the applicable bankruptcy laws.                                                                                                                                                                                                                                                                                                      

Contractual Obligations

The Companys major outstanding contractual
cash obligations relate to its operating leases, primarily for
facilities. Below is a table summarizing the Companys
contractual obligations and commercial commitments, including
non-cancelable operating leases having initial lease terms of
more than one year, as of March 31, 2003 (in thousands):

|                              |  |       |       |           |  |       |     |       |  |         |     |  |  |   |    |  |  |   |   | 
|----------------------------- |  | ----- | ----- | --------- |  | ----- | --- | ----- |  | ------- | --- |  |  | - | -- |  |  | - | - | 
|                              |  |       |       | Less than |  | 1-3   |     | 4-5   |  | After 5
|                              |  | Total |       | One Year  |  | Years |     | Years |  | Years  
|                              |  |       |       |           |  |       |     |       |  |        
|Loans and Notes Payable       |  | $     | 255   |           |  | $     | 255 |       |  | $       |    |  |  | $ |   |  |  | $ |  | 
|Operating Leases              |  |       | 837   |           |  |       | 280 |       |  |         | 536 |  |  |   | 21 |  |  |   |  | 
|                              |  |       |       |           |  |       |     |       |  |         |     |  |  |   |    |  |  |   |   | 
|Total Contractual Obligations |  | $     | 1,092 |           |  | $     | 535 |       |  | $       | 536 |  |  | $ | 21 |  |  | $ |  | 
|                              |  |       |       |           |  |       |     |       |  |         |     |  |  |   |    |  |  |   |   | 

Net Operating Loss Carryforwards

At March 31, 2003, the Company had federal
net operating loss (NOL) carryforwards of
approximately $60.6 million for income tax purposes, of
which approximately $6.2 million, $8.4 million,
$9.1 million, $17.8 million and $19.1 million
expire in 2018, 2019, 2020, 2021 and 2022, respectively. In
addition, the Company had research and development tax credit
carryforwards of approximately $1.4 million of which
$299,000; $306,000 and $777,000 expire in 2019, 2020, and 2021,
respectively. The use of the NOLs and research and development
tax credit carryforwards are limited to future taxable earnings
of the Company. Due to the degree of uncertainty related to the
ultimate realization of such carryforwards, at March 31,
2003, a valuation allowance of approximately $23.3 million
has been recognized to offset net deferred tax assets, primarily
attributable to the NOL carryforward. Utilization of the
operating losses may be subject to a limitation due to the
ownership change provisions of the Internal Revenue Code. The
Company expects to use approximately $1.4 million of NOL
carryforwards to offset the Companys taxable capital gains
and ordinary income from the sale of the excipient business.

Forward Looking Statements

This annual 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, financial position, future revenues, projected
costs, prospects, plans and objectives of management are
forward-looking statements. The words believes,
anticipates, estimates,
plans, expects, intends,

15



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may, projects,
will, and would and similar expressions
are intended to identify forward-looking statements, although
not all forward-looking statements contain these identifying
words. We cannot guarantee that we actually will achieve the
plans, intentions or expectations disclosed in our
forward-looking statements and you should not place undue
reliance on our forward-looking statements. In addition, any
forward-looking statements represent our estimates only as of
the date this annual report is filed with the SEC and should not
be relied upon as representing our estimates as of any
subsequent date. We do not assume any obligation to update any
forward-looking statements.


Risk Factors

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. We believe
that the material factors that we discuss below could cause or
contribute to such material differences.



| |                                                                                   
| | ----------------------------------------------------------------------------------
| | We have not been profitable and expect to
    continue to incur substantial losses

We have incurred net losses since 1994, including
net losses of $17.1 million, $16.0 million and
$8.8 million, during 2002, 2001, and 2000, respectively.
For the first quarter of 2003, we had a net loss from continuing
operations of $4.8 million, which was offset by income from
discontinued operations of $177,000 and a gain on the sale of
the excipient business of $9.6 million. This resulted in an
overall gain for the quarter of $5.0 million. As of
March 31, 2003, our accumulated deficit was approximately
$73.5 million.

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

A substantial portion of our revenues since 1994
has been generated from the sales of our pharmaceutical
excipients. Our net losses in 2000, 2001 and 2002 were reduced
as a result of the operating results of our excipient business.
Effective February 27, 2003, we no longer generate any
revenues from the sales of excipient products and our business
depends exclusively on our drug delivery business.

Our future profitability will depend on several
factors, including:



| |   |                                                                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the successful commercialization of TIMERx
    controlled release products, including in particular oxymorphone
    ER, a narcotic analgesic for the treatment of moderate to severe
    pain, being developed with Endo;
|
| |  | our ability to use the net proceeds from the sale
    of our excipient business to expand our drug development and
    delivery business;                                                                                
|
| |  | royalties from Mylans sales of
    Pfizers 30 mg generic version of Procardia XL; and                                                                                                                                  
|
| |  | the level of investment in research and
    development activities.                                                                                                                                                      

Our strategy includes a significant commitment to
spending on research and development targeted at identifying and
developing extended release products which can be formulated
using our TIMERx and other drug delivery technologies. We also
expect to expend significant resources on the development of new
drug delivery technologies, both internally and through
in-licenses or acquisition. Our spending in the area of new
technology, however, is discretionary and is subject to the
availability of appropriate opportunities and funding.

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

Many of our TIMERx controlled release products
have been or are being developed and commercialized in
collaboration with pharmaceutical companies. Under these
collaborations, depending on the structure of the collaboration,
we are dependent on our collaborators to fund some portion of
development, to conduct full-scale bioequivalence studies and
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

16



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manufacture and market oxymorphone ER in the
United States. We are also dependent on Sanofi and Leiras to
manufacture and market Slofedipine XL and Cystrin CR,
respectively. In addition, we are dependent on Mylan with
respect to the marketing and sale of the 30 mg strength of
Pfizers generic version of Procardia XL.


Our collaborators may not devote the resources
necessary or may otherwise be unable to complete development and
commercialization of these potential products. Our existing
collaborations are subject to termination on short notice under
certain circumstances including, for example, if the
collaborator determines that the product in development is not
likely to be successfully developed or not likely to receive
regulatory approval, if we breach the agreement or upon a
bankruptcy event.

If we cannot maintain our existing collaborations
or establish new collaborations, we would be required to
terminate the development and commercialization of products or
undertake product development and commercialization activities
at our own expense. Moreover, we have limited experience in
conducting full-scale bioequivalence studies and clinical
trials, preparing and submitting regulatory applications and
manufacturing, marketing and selling the pharmaceutical
products. We may not be successful in performing these
activities.

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

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



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



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

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

Our TIMERx business faces competition from
numerous public and private companies and their controlled
release technologies, including Johnson &
Johnsons oral osmotic pump (OROS®) technology,
multiparticulate systems marketed by Elan and Biovail,
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 being developed by Penwest. For instance, we expect
extended release oxymorphone ER will face competition from
Purdue Pharmas OxyContin®.

In addition to developing controlled release
versions of immediate release products, we concentrated a
significant portion of our initial development efforts on
generic versions of branded controlled release products. The
success of generic versions of branded controlled release
products based on our TIMERx technology will

17



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depend, in large part, on the intensity of
competition from the branded controlled release product, other
generic versions of the branded controlled release product and
other drugs and technologies that compete with the branded
controlled release product, as well as the timing of product
approval.


The generic drug industry is characterized by
frequent litigation between generic drug companies and branded
drug companies. Those companies with significant financial
resources will be better able to bring and defend any such
litigation.



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

As of March 31, 2003, we had cash, cash
equivalents, and short-term investments of $30.3 million.
In February 2003, we received net proceeds from the sale of our
excipient business available after closing of approximately
$35 million. We have no committed sources of capital other
than Rettenmaiers commitment to pay $1.25 million in
May 2004 in connection with the sale of the excipient business.

We anticipate that our existing capital
resources, including the proceeds from the sale of the excipient
business, and anticipated internally generated funds from the
sale of formulated bulk TIMERx, royalties from Mylan and other
payments from collaborators, will enable us to fund our
currently planned operations, including the planned increase in
our drug development and commercialization efforts, through late
2004.

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

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

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



| |   |                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------
| |  | the structure of any future collaborative or
    development agreements;                                                            
|
| |  | the progress of our collaborative and independent
    development projects and funding obligations with respect to the
    projects;
|
| |  | the costs to us of clinical studies for our
    products;                                                                           
|
| |  | the costs and timing of adding drug development
    capabilities;                                                                   
|
| |  | royalties received from Mylan;                                                                                                      
|
| |  | royalties from sales of TIMERx products;                                                                                            
|
| |  | the timing and amount of payments received under
    existing and possible future collaborative agreements; and                     
|
| |  | the prosecution, defense and enforcement of
    potential patent claims and other intellectual property rights.                     

If we determine to seek additional funding, we
may do so through collaborative agreements or research and
development arrangements and public or private financings.
Additional financing may not be available to us on acceptable
terms, if at all.

If we raise additional funds by issuing equity
securities, further dilution to our then existing stockholders
will result. In addition, the terms of the financing may
adversely affect the holdings or the rights of such stockholders.

If we are unable to obtain funding on a timely
basis, we may be required to (1) significantly curtail our
product commercialization efforts, including terminating or
reducing our participation in existing collaborative agreements;
(2) obtain funds through arrangements with collaborators or
others on adverse terms to us that

18



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may require us to relinquish rights to certain of
our technologies, product candidates, or products which we would
otherwise pursue on our own or that would significantly dilute
our shareholders; (3) significantly scale back or terminate
operations; and/or (4) seek relief under applicable
bankruptcy laws.




| |                                                                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If our clinical trials are not successful
    or take longer to complete than we expect, we may not be able to
    develop and commercialize certain of our products

In order to obtain regulatory approvals for the
commercial sale of our potential products, including controlled
release versions of immediate release drugs and new chemical
entities, we or our collaborators will be required to complete
clinical trials in humans to demonstrate the safety and efficacy
of the products. We or our collaborators may not be able to
obtain authority from the FDA or other regulatory agencies to
commence or complete these clinical trials.

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

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

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

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



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



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

We are not able to market any of our products in
the United States, Europe or in any other jurisdiction without
marketing approval from the United States Food and Drug
Administration, or 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.

To date, several drug formulations utilizing the
TIMERx system have received regulatory approval:



| |   |                                                                                      
| | - | -------------------------------------------------------------------------------------
| |  | Cystrin CR was approved in Finland in 1997;                                          
|
| |  | Slofedipine XL was approved in the United
    Kingdom in 1998 and in Italy in 2001;  
|
| |  | The 30 mg strength of Nifedipine XL was
    approved by the FDA in December 1999; and
|
| |  | Cronodipin was approved in Brazil in 2001.                                           

We also have a number of TIMERx products in our
development pipeline. The most advanced of these is
oxymorphone ER, which we are developing with Endo. In
February 2003, the FDA accepted for filing an NDA for
oxymorphone ER.

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

19



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requirements for safety, efficacy and quality;
and those requirements may become more stringent due to changes
in regulatory agency policy or the adoption of new regulations.
After submission of a marketing application, in the form of an
NDA or an Abbreviated New Drug Application, or ANDA, the FDA may
deny the application, may require additional testing or data
and/or may require post marketing testing and surveillance to
monitor the safety or efficacy of a product. While the U.S.
Food, Drug and Cosmetic Act, or FDCA, provides for a 180-day
review period, the FDA commonly takes one to two years to grant
final approval to a marketing application.


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

Some of the controlled release products that we
are developing with our collaborators are generic versions of
branded controlled release products, which require the filing of
ANDAs. Certain ANDA procedures for generic versions of
controlled release products are the subject of petitions filed
by brand name drug manufacturers, which seek changes from the
FDA in the approval process for generic drugs. These requested
changes include, among other things, tighter standards for
certain bioequivalence studies and disallowance of the use by a
generic drug manufacturer in its ANDA of proprietary data
submitted by the original manufacturer as part of an original
new drug application. Any changes in FDA regulations that make
ANDA approvals more difficult may have a material adverse effect
on our business, financial condition and results of operations.

Other products containing our TIMERx controlled
release technology require the filing of an NDA. A full NDA must
include complete reports of preclinical, clinical and other
studies to prove adequately that the product is safe and
effective, which involves, among other things, full clinical
testing, and as a result requires the expenditure of substantial
resources. In certain cases involving controlled release
versions of FDA-approved immediate release drugs, we may be able
to rely on existing publicly available safety and efficacy data
to support an NDA for controlled release products under
Section 505(b)(2) of the FDCA when such data exists for an
approved immediate release version of the same chemical entity.
However, we can provide no assurance that the FDA will accept
such section 505(b)(2) NDA, or that we will be able to
obtain publicly available data that is useful. The
section 505(b)(2) NDA process is a highly uncertain avenue
to approval because the FDAs policies on
section 505(b)(2) NDAs have not yet been fully developed.
There can be no assurance that the FDA will approve an
application submitted under section 505(b)(2) in a timely
manner or at all.

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



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

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

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



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

We expect that our collaborators will file ANDAs
for our controlled release products that are generic versions of
branded controlled release products that are covered by one or
more patents. 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 product candidates as a result of
litigation, as well as the expense of such litigation, whether
or not we or our collaborators are successful, could have a
material adverse effect on our business, financial condition and
results of operations.



| |                                                                                             
| | --------------------------------------------------------------------------------------------
| | The market may not be receptive to products
    incorporating our drug delivery technologies

The commercial success of products incorporating
our extended release technology that are approved for marketing
by the FDA and other regulatory authorities will depend upon
their acceptance by the medical community and third party payors
as clinically useful, cost-effective and safe. No product based
on our TIMERx or other extended release technology is marketed
in the United States, so there can be no assurance as to market
acceptance.

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



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



| |                                                                          
| | -------------------------------------------------------------------------
| | Our success depends on our protecting our
    patents and patented rights

Our success depends in significant part on our
ability to develop patentable products, to obtain patent
protection for our products, both in the United States and in
other countries, and to enforce these patents. The patent
positions of pharmaceutical firms, including us, are generally
uncertain and involve complex legal and factual questions. As a
result, patents may not issue from any patent applications that
we own or license. If patents do issue, the claims allowed may
not be sufficiently broad to protect our technology. In
addition, issued patents that we own or license may be
challenged, invalidated or circumvented. Our patents also may
not afford us protection against competitors with similar
technology.

Our success also depends on our not infringing
patents issued to competitors or others. We are aware of patents
and patent applications belonging to competitors and others that
may require us to alter our products or processes, pay licensing
fees or cease certain activities.

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

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

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

The pharmaceutical industry has been
characterized by significant litigation and interference and
other proceedings regarding patents, patent applications and
other intellectual property rights. The types of situations in
which we may become parties to such litigation or proceedings
include:



| |   |                                                                                                                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We or our collaborators may initiate litigation
    or other proceedings against third parties to enforce our patent
    rights.                                                                                                                                           
|
| |  | We or our collaborators may initiate litigation
    or other proceedings against third parties to seek to invalidate
    the patents held by such third parties or to obtain a judgment
    that our products or processes do not infringe such third
    parties patents.
|
| |  | If our competitors file patent applications that
    claim technology also claimed by us, we or our collaborators may
    participate in interference or opposition proceedings to
    determine the priority of invention.                                                
|
| |  | If third parties initiate litigation claiming
    that our processes or products infringe their patent or other
    intellectual property rights, we and our collaborators will need
    to defend against such proceedings.                                               

An adverse outcome in any litigation or other
proceeding could subject us to significant liabilities to third
parties and require us to cease using the technology that is at
issue or to license the technology from third parties. We may
not be able to obtain any required licenses on commercially
acceptable terms or at all.

The cost of any patent litigation or other
proceeding, even if resolved in our favor, could be substantial.
Although the legal costs of defending litigation relating to a
patent infringement claim are generally the contractual
responsibility of our collaborators (unless such claim relates
to TIMERx in which case such costs are our responsibility), we
could nonetheless incur significant unreimbursed costs in
participating and assisting in the litigation. Some of our
competitors may be able to sustain the cost of such litigation
and proceedings more effectively than we can because of their
substantially greater resources. Uncertainties resulting from
the initiation and continuation of patent litigation or other
proceedings could have a material adverse effect on our ability
to complete 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 current GMP requirements prescribed by the
FDA. We currently rely on Draxis Pharma, Inc. for the bulk
manufacture of our TIMERx material for delivery to our
collaborators under a contract that expires in September 2004.
The agreement shall be automatically renewed for successive
one-year periods, unless either party gives notice of its intent
not to renew the contract, at least six months prior to the end
of the then-current term.

There are a limited number of manufacturers that
operate under GMP regulations capable of manufacturing our
TIMERx material. Although the Company has qualified alternate
suppliers with respect to these gums, if our current
manufacturer is unable to manufacture the TIMERx material in the
required quantities, on a timely basis or at all, we may be
unable to obtain alternative contract manufacturing, or obtain
such manufacturing on commercially reasonable terms.

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If our third party manufacturers fail to perform
their obligations, we may be adversely affected in a number of
ways, including:



| |   |                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------
| |  | our collaborators may not be able to meet
    commercial demands for our products on a timely basis;                         
|
| |  | our collaborators may not be able to initiate or
    continue clinical trials of products that are under development;
    and
|
| |  | our collaborators may be delayed in submitting
    applications for regulatory approvals of our products.                    

We have limited experience in manufacturing
TIMERx material on a commercial scale and no facilities or
equipment to do so. If we determine to develop our own
manufacturing capabilities, we will need to recruit qualified
personnel and build or lease the requisite facilities and
equipment. We may not be able to successfully develop our own
manufacturing capabilities. Moreover, it may be very costly and
time consuming for us to develop such capabilities.

The manufacture of any of our products is subject
to regulation by the FDA and comparable agencies in foreign
countries. Any delay in complying or failure to comply with such
manufacturing requirements could materially adversely affect the
marketing of our products and our business, financial condition
and results of operations.



| |                                                                                                 
| | ------------------------------------------------------------------------------------------------
| | We are dependent upon a limited number of
    suppliers for the gums used in our TIMERx material

Our drug delivery systems are based a hydrophilic
matrix combining a heterodispersed mixture primarily composed of
two polysaccharides, xanthan and locust bean gums, in the
presence of dextrose. These gums are also used in our Geminex
and SyncroDose drug delivery systems. We purchase these gums
from a sole source 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 in
    certain markets

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 certain 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 by us and our collaborators 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.

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



| |                                                         
| | --------------------------------------------------------
| | The market price of our common stock may be
    volatile

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






|        |                                                               
|------- | --------------------------------------------------------------
|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. The
operations of the Company are exposed to financial market risks,
primarily changes in interest rates. The Companys interest
rate risk primarily relates to its investments in marketable
securities.

The primary objectives for the Companys
investment portfolio are liquidity and safety of principal.
Investments are made to achieve the highest rate of return to
the Company, consistent with these two objectives. The
Companys investment policy limits investments to certain
types of instruments issued by institutions with investment
grade credit ratings and places restrictions on maturities and
concentration by issuer. Marketable securities primarily consist
of corporate debt, certificates of deposit and
U.S. Government Agency-backed notes, and approximated
$9.1 million at March 31, 2003. These securities have
contractual maturity dates of up to eleven months. Due to the
relatively short-term maturities of these securities, management
believes there is no significant market risk. At March 31,
2003, market values approximated carrying values. At
March 31, 2003, the Company had approximately
$30.3 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 $303,000.






|        |                        
|------- | -----------------------
|Item 4. | Controls and Procedures

a) Evaluation of disclosure controls and
procedures. Based on their evaluation of the Companys
disclosure controls and procedures (as defined in
Rules 13a-14(c) and 15d-14(c) under the Securities

24



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##### Table of Contents



Exchange Act of 1934) as of a date within
90 days of the filing date of this Quarterly Report on
Form 10-Q, the Companys principal executive officer
and principal financial officer have concluded that the
Companys disclosure controls and procedures are designed
to ensure that information required to be disclosed by the
Company in the reports that it files or submits under the
Exchange Act is recorded, processed, summarized and reported
within the time periods specified in the SECs rules and
forms and are operating in an effective manner.


b) Changes in internal controls.
There were no significant changes in the Companys internal
controls or in other factors that could significantly affect
these controls subsequent to the date of their most recent
evaluation.




PART II  OTHER
INFORMATION






|        |                                     
|------- | ------------------------------------
|Item 6. | Exhibits and Reports on
    Form 8-K

a.     Exhibits.

See exhibit index below for a list of the
exhibits filed as part of this Quarterly Report on
Form 10-Q, which exhibit index is incorporated herein by
reference.

b.     Reports on
Form 8-K.

On February 27, 2003, the Company filed a
report on Form 8-K announcing it had completed its sale of
substantially all of the assets used in its excipient business
to subsidiaries and affiliates of privately held Josef
Rettenmaier Holding GmbH & Co. KG for
$39.5 million in cash and a promissory note of
$2.25 million.

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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.                                                                 
|
| | /s/ JENNIFER L. GOOD                                                                        
| |                                                                                             
| | Jennifer L. Good                                                                            
| | Senior Vice President, Finance and Chief
    Financial Officer (Principal Financial Officer)

Date: May 15, 2003

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CERTIFICATIONS

I, Tod R. Hamachek, certify that:

1) I have reviewed this quarterly report on
Form 10-Q of Penwest Pharmaceuticals Co.;

2) Based on my knowledge, this quarterly
report does not contain any untrue statement of a material fact
or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period
covered by this quarterly report;

3) Based on my knowledge, the financial
statements, and other financial information included in this
quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;

4) The registrants other certifying
officer and I are responsible for establishing and maintaining
disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and we have:



| |                                                                                                                                                                                                                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this quarterly report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this quarterly
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this quarterly report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date                                                                                                                                 

5) The registrants other certifying
officer and I have disclosed, based on our most recent
evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons
performing the equivalent functions):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6) The registrants other certifying
officer and I have indicated in this quarterly report whether or
not there were significant changes in internal controls or in
other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies
and material weaknesses.



| |                                                                                    
| | -----------------------------------------------------------------------------------
| | /s/ TOD R. HAMACHEK                                                                
| |                                                                                    
| | Tod R. Hamachek                                                                    
| | Chairman of the Board and Chief Executive
    Officer (Principal Executive Officer)

Date: May 15, 2003

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I, Jennifer L. Good, certify that:

1) I have reviewed this quarterly report on
Form 10-Q of Penwest Pharmaceuticals Co.;

2) Based on my knowledge, this quarterly
report does not contain any untrue statement of a material fact
or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period
covered by this quarterly report;

3) Based on my knowledge, the financial
statements, and other financial information included in this
quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this
quarterly report;

4) The registrants other certifying
officer and I are responsible for establishing and maintaining
disclosure controls and procedures (as defined in Exchange Act
Rules 13a-14 and 15d-14) for the registrant and we have:



| |                                                                                                                                                                                                                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) designed such disclosure controls and
    procedures to ensure that material information relating to the
    registrant, including its consolidated subsidiaries, is made
    known to us by others within those entities, particularly during
    the period in which this quarterly report is being prepared;
|
| | b) evaluated the effectiveness of the
    registrants disclosure controls and procedures as of a
    date within 90 days prior to the filing date of this quarterly
    report (the Evaluation Date); and                                                                                                      
|
| | c) presented in this quarterly report our
    conclusions about the effectiveness of the disclosure controls
    and procedures based on our evaluation as of the Evaluation Date                                                                                                                                 

5) The registrants other certifying
officer and I have disclosed, based on our most recent
evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons
performing the equivalent functions):



| |                                                                                                                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | a) all significant deficiencies in the
    design or operation of internal controls which could adversely
    affect the registrants ability to record, process,
    summarize and report financial data and have identified for the
    registrants auditors any material weaknesses in internal
    controls; and
|
| | b) any fraud, whether or not material, that
    involves management or other employees who have a significant
    role in the registrants internal controls; and                                                                                                                                                    

6) The registrants other certifying
officer and I have indicated in this quarterly report whether or
not there were significant changes in internal controls or in
other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies
and material weaknesses.



| |                                                                                          
| | -----------------------------------------------------------------------------------------
| | /s/ JENNIFER L. GOOD                                                                     
| |                                                                                          
| | Jennifer L. Good                                                                         
| | Sr. Vice President, Finance and Chief
    Financial Officer (Principal Financial Officer)

Date: May 15, 2003

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EXHIBIT INDEX

|        |      |             |  |                                                                                                                                                          
|------- | ---- | ----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |      |            
|Number  |      | Description
|        |      |            
|        | 10.1 |             |  | Lease Agreement dated as of February 3, 2003 by
    and between Union Carbide Corporation and Penwest
    Pharmaceuticals Co.                            
|        | 99.1 |             |  | Certification of Chief Executive Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of The Sarbanes-Oxley Act of 2002
|        | 99.2 |             |  | Certification of Chief Financial Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of The Sarbanes-Oxley Act of 2002

29