##### 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 June 30, 2006
 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, Connecticut
    
    06810-5120(Address of principal executive offices)
    
    (Zip Code)
 (877) 736-9378  (Registrants telephone number, including area code.)
  þ o
  o þ o
  o þ
  Class
    
    OutstandingCommon stock, par value $.001
    
    22,985,928




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##### 



PENWEST PHARMACEUTICALS CO.
TABLE OF CONTENTS
 PagePART I  FINANCIAL INFORMATIONItem 1.
    
    Condensed Financial Statements (Unaudited)Condensed Balance Sheets
    
    
    3Condensed Statements of Operations
    
    
    4Condensed Statements of Cash Flows
    
    
    5Notes to Condensed Financial Statements
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial
Condition and Results of Operations
    
    
    16Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    25Item 4.
    
    Controls and Procedures
    
    
    25PART II  OTHER INFORMATIONItem 1A.
    
    Risk Factors
    
    
    26Item 4.
    
    Submission of Matters to a Vote of Securities Holders
    
    
    35Item 6.
    
    Exhibits
    
    
    35Signature

    
    
    
    36Exhibit Index

    
    
    
    37EX-10.1 Offer Letter Benjamin L. PalleikoEX-31.1 Section 302 Certification of C.E.O.EX-31.2 Section 302 Certification of C.F.O.EX-32.1 Section 906 Certification of C.E.O.EX-32.2 Section 906 Certification of C.F.O.
  ® ® ®
 Forward-Looking Statements
  2




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##### Table of Contents



PART I  FINANCIAL INFORMATION
 
 Item 1. Condensed Financial Statements (Unaudited)
 PENWEST PHARMACEUTICALS CO.
 
 CONDENSED BALANCE SHEETS
 June 30,
    
    
    December 31,2006
    
    
    2005(Unaudited)
    
    
    (Note 2)(In thousands,except share amounts)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    33,581
    
    
    $
    15,917Marketable securities
    
    
    19,756
    
    
    
    39,377Trade accounts receivable
    
    
    1,039
    
    
    
    942Inventories:Raw materials and other
    
    
    71
    
    
    
    44Finished goods
    
    
    128
    
    
    
    96Total inventories
    
    
    199
    
    
    
    140Prepaid expenses and other current assets
    
    
    939
    
    
    
    1,112Total current assets
    
    
    55,514
    
    
    
    57,488Fixed assets, net
    
    
    2,834
    
    
    
    2,990Patents, net
    
    
    3,172
    
    
    
    3,383Other assets
    
    
    2,770
    
    
    
    3,160Total assets
    
    $
    64,290
    
    
    $
    67,021LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,626
    
    
    $
    1,064Accrued expenses
    
    
    1,704
    
    
    
    1,722Accrued development costs
    
    
    278
    
    
    
    499Deferred compensation  current portion
    
    
    294
    
    
    
    291Total current liabilities
    
    
    3,902
    
    
    
    3,576Deferred revenue
    
    
    50
    
    
    
    57Deferred compensation
    
    
    2,864
    
    
    
    2,977Total liabilities
    
    
    6,816
    
    
    
    6,610Shareholders equity:Preferred stock, par value $.001, authorized 1,000,000 shares, none outstandingCommon stock, par value $.001, authorized 60,000,000 shares, issued and
outstanding 22,917,374 shares at June 30, 2006 and 21,889,940 shares at
December 31, 2005
    
    
    23
    
    
    
    22Additional paid in capital
    
    
    212,373
    
    
    
    201,659Accumulated deficit
    
    
    (154,834
    )
    
    
    (141,116
    )Accumulated other comprehensive loss
    
    
    (88
    )
    
    
    (154
    )Total shareholders equity
    
    
    57,474
    
    
    
    60,411Total liabilities and shareholders equity
    
    $
    64,290
    
    
    $
    67,021
  3




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PENWEST PHARMACEUTICALS CO.
 
 CONDENSED STATEMENTS OF OPERATIONS
 Three Months EndedJune 30,2006
    
    
    2005(Unaudited)(In thousands, exceptper share data)Revenues:Royalties and licensing fees
    
    $
    929
    
    
    $
    1,296Product sales
    
    
    146
    
    
    
    Total revenues
    
    
    1,075
    
    
    
    1,296Cost of revenues
    
    
    33
    
    
    
    14Gross profit
    
    
    1,042
    
    
    
    1,282Operating expenses:Selling, general and administrative
    
    
    3,849
    
    
    
    2,472Research and product development
    
    
    5,221
    
    
    
    4,965Total operating expenses
    
    
    9,070
    
    
    
    7,437Loss from operations
    
    
    (8,028
    )
    
    
    (6,155
    )Investment income
    
    
    612
    
    
    
    469Loss before income tax expense
    
    
    (7,416
    )
    
    
    (5,686
    )Income tax expense
    
    
    
    
    
    
    Net loss
    
    $
    (7,416
    )
    
    $
    (5,686
    )Net loss per common share
    
    $
    (0.33
    )
    
    $
    (0.26
    )Weighted average shares of common stock outstanding
    
    
    22,796
    
    
    
    21,676
 Six Months EndedJune 30,2006
    
    
    2005(Unaudited)(In thousands, exceptper share data)Revenues:Royalties and licensing fees
    
    $
    1,860
    
    
    $
    2,278Product sales
    
    
    180
    
    
    
    Total revenues
    
    
    2,040
    
    
    
    2,278Cost of revenues
    
    
    55
    
    
    
    22Gross profit
    
    
    1,985
    
    
    
    2,256Operating expenses:Selling, general and administrative
    
    
    7,312
    
    
    
    7,764Research and product development
    
    
    9,565
    
    
    
    10,030Total operating expenses
    
    
    16,877
    
    
    
    17,794Loss from operations
    
    
    (14,892
    )
    
    
    (15,538
    )Investment income
    
    
    1,173
    
    
    
    905Loss before income tax expense
    
    
    (13,719
    )
    
    
    (14,633
    )Income tax expense
    
    
    
    
    
    
    Net loss
    
    $
    (13,719
    )
    
    $
    (14,633
    )Net loss per common share
    
    $
    (0.61
    )
    
    $
    (0.68
    )Weighted average shares of common stock outstanding
    
    
    22,522
    
    
    
    21,666
  4




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PENWEST PHARMACEUTICALS CO.
 
 CONDENSED STATEMENTS OF CASH FLOWS
 Six Months EndedJune 30,2006
    
    
    2005(Unaudited)(In thousands)Operating activities:Net loss
    
    $
    (13,719
    )
    
    $
    (14,633
    )Adjustments to reconcile net loss to net cash used in operating activities
    
    
    3,833
    
    
    
    6,994Net cash used in operating activities
    
    
    (9,886
    )
    
    
    (7,639
    )Investing activities:Acquisitions of fixed assets, net
    
    
    (350
    )
    
    
    (111
    )Patent costs
    
    
    (247
    )
    
    
    (182
    )Proceeds from maturities of marketable securities
    
    
    21,715
    
    
    
    20,760Proceeds from sales of marketable securities
    
    
    1,600
    
    
    
    23,850Purchases of marketable securities
    
    
    (3,736
    )
    
    
    (29,064
    )Proceeds from cash surrender value of life insurance policy withdrawal
    
    
    446
    
    
    
    Net cash provided by investing activities
    
    
    19,428
    
    
    
    15,253Financing activities:Issuance of common stock, net
    
    
    8,122
    
    
    
    185Net cash provided by financing activities
    
    
    8,122
    
    
    
    185Net increase in cash and cash equivalents
    
    
    17,664
    
    
    
    7,799Cash and cash equivalents at beginning of period
    
    
    15,917
    
    
    
    14,249Cash and cash equivalents at end of period
    
    $
    33,581
    
    
    $
    22,048
  5




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PENWEST PHARMACEUTICALS CO.
 
 NOTES TO CONDENSED FINANCIAL STATEMENTS
 (Unaudited)
 1. Business
 ®
  2. Basis of Presentation
   3. Summary of Significant Accounting Policies
 Revenue Recognition
 Royalties and licensing fees
 6




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
  Product sales 
 Research and Development Expenses
  Income Taxes
  Impairment of Long-Lived Assets
  Share-Based Compensation
  7




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
  
    
    the stock option exercise price;
    
    the expected term of the option;
    
    the grant date price of the Companys common stock, which is issuable upon
exercise of the option;
    
    the expected volatility of the Companys common stock;
    
    expected dividends on the Companys common stock (the Company does not
anticipate paying dividends for the foreseeable future); and
    
    the risk free interest rate for the expected option term.
    4. Recent Accounting Pronouncements
 ,
 8




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
    5. Share-Based Compensation
   9




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
 Three Months Ended
    
    
    Six Months EndedJune 30, 2005
    
    
    June 30, 2005(unaudited)(in thousands, except per share data)Net loss  as reported
    
    $
    (5,686
    )
    
    $
    (14,633
    )Stock-based compensation expense included in reported net loss
    
    
    123
    
    
    
    2,648Stock-based compensation under fair value method
    
    
    (905
    )
    
    
    (2,498
    )Net loss  pro forma after stockbased compensation under
fair value method
    
    $
    (6,468
    )
    
    $
    (14,483
    )Net loss per share, basic and diluted  as reported
    
    $
    (0.26
    )
    
    $
    (0.68
    )Net loss per share, basic and diluted  pro forma after
stock-based compensation under fair value method
    
    $
    (0.30
    )
    
    $
    (0.67
    )
     10




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
  Weighted-AverageWeighted
    
    Remaining
    
    AggregateAverage
    
    Contractual Terms
    
    IntrinsicShares
    
    Exercise Price
    
    in Years
    
    ValueBALANCE, DECEMBER 31, 2005
    
    
    3,015,563
    
    
    $
    10.88Options Exercisable
    
    
    2,120,947
    
    
    $
    9.99Granted
    
    
    530,250
    
    
    $
    20.41Exercised
    
    
    (996,034
    )
    
    $
    8.08Forfeited
    
    
    (146,201
    )
    
    $
    13.65Expired
    
    
    (750
    )
    
    $
    15.74BALANCE, JUNE 30, 2006
    
    
    2,402,828
    
    
    $
    13.97
    
    
    
    6.3
    
    
    $
    19,213,326Options Exercisable
    
    
    1,425,005
    
    
    $
    11.97
    
    
    
    4.6
    
    
    $
    14,103,897
   Six Months EndedJune 30,2006
    

2005Expected dividend yield
    
    None
    
    NoneRisk free interest rate
    
    
    4.7
    %
    
    
    4.0
    %Expected volatility
    
    
    58
    %
    
    
    50
    %Expected life of options
    
    5.6 years
    
    7.5 years
  Weighted-Average
    
    
    AggregateGrant-Date
    
    
    IntrinsicShares
    
    
    Fair Value
    
    
    ValueRestricted stock outstanding at December 31, 2005
    
    
    68,000
    
    
    $
    11.37
    
    
    $
    1,308,660Granted
    
    
    24,000
    
    
    $
    19.41Vested
    
    
    (40,500
    )
    
    $
    11.17Restricted stock outstanding at June 30, 2006
    
    
    51,500
    
    
    $
    15.24
    
    
    $
    1,126,048
    11




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
  6. Income Taxes
  7. Compensation Charge
  8. Supplemental Executive Retirement Plan and Deferred Compensation Plan
   Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(unaudited)(in thousands)Interest cost
    
    $
    30
    
    
    $
    31
    
    
    $
    60
    
    
    $
    61Amortization of net obligation at transition
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Amortization of prior service cost
    
    
    1
    
    
    
    
    
    
    
    1
    
    
    
    1Net periodic benefit cost
    
    $
    31
    
    
    $
    31
    
    
    $
    61
    
    
    $
    62
  12




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
   9. Comprehensive Loss
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(unaudited)(in thousands)Net loss
    
    $
    (7,416
    )
    
    $
    (5,686
    )
    
    $
    (13,719
    )
    
    $
    (14,633
    )Changes in unrealized net
gains and losses on
marketable
securities
    
    
    46
    
    
    
    41
    
    
    
    66
    
    
    
    (38
    )Comprehensive loss
    
    $
    (7,370
    )
    
    $
    (5,645
    )
    
    $
    (13,653
    )
    
    $
    (14,671
    )
  10. Licensing Agreements
  Endo Pharmaceuticals Inc.
   13




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
   Mylan Pharmaceuticals Inc.
  Prism Pharmaceuticals, Inc.
   14




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)
 11. Contingencies
   15




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 Overview
 ®
 Opana ER.
 ® ®
 Product Candidates.
 
    
    Nalbuphine ER(PW4142). We are developing nalbuphine ER, a controlled release
formulation of nalbuphine hydrochloride, for the treatment of mild to moderate chronic
pain, which is designed to be taken as a tablet twice daily. We expect that nalbuphine ER, if
approved, would compete in the mild to moderate pain market with products such as tramadol,
codeine and propoxyphene. We have completed a Phase I pharmacokinetic study of nalbuphine
ER that confirmed that our formulation achieved the targeted blood levels and a Phase IIa
trial in which nalbuphine ER positively reduced mean pain intensity in a dose-dependent
manner over the 12-hour study period when compared to placebo. We are currently conducting
additional Phase I studies to optimize the formulation. We plan to commence a Phase IIb
study in an appropriate patient population in the first half of 2007.
    
    Torsemide ER(PW2132). We are developing torsemide ER, a loop diuretic in a controlled
release formulation, for the management of chronic edema, a condition involving excess
fluid accumulation, resulting from congestive heart failure, or CHF. Torsemide ER is being
developed using our Geminex dual drug delivery technology. Our formulation is designed to
be taken as a tablet once daily. We expect that torsemide ER, if approved, would compete
with the immediate release formulations of furosemide and other loop diuretics. We are
developing this product using a 505(b)(2) regulatory strategy referencing torsemide. We
have completed Phase I pharmacokinetic studies of torsemide ER that confirmed that our
formulation achieved the targeted plasma profiles and completed a Phase IIa study that
confirmed the proof of concept that torsemide ER would cause prolonged urinary sodium
excretion in CHF patients. We are currently planning additional Phase I work to optimize
the formulation. Simultaneously, we are working on the study designs for a Phase II study
to establish the appropriate dose range for torsemide ER, which we intend to commence in
the first half of 2007. Following completion of the Phase II study, we intend to discuss
with the FDA the design of the required phase III pivotal
trial(s), along with the possibility that
only one Phase III pivotal safety and efficacy trial would be necessary for approval of
torsemide ER product because we are using the 505(b)(2) drug development route. We intend to complete
the clinical development of torsemide ER and file an NDA ourselves. We expect that
following the completion of the Phase III pivotal trial(s), we will seek a collaborator to
market this product.
 16




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
    
    the commercial success of Opana ER, and the timing and amount of royalties from Endos sales
of Opana ER;
 
    
    the level of our investment in research and development activities;
 
    
    the successful development and commercialization of product candidates in our portfolio; and
 
    
    royalties from Mylans sales of Pfizers 30 mg generic version of Procardia XL.
   17




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Critical Accounting Policies and Estimates
   Share-Based Compensation
   
    
    the stock option exercise price;
    
    the expected term of the option;
    
    the grant date price of our common stock, which is issuable upon exercise of the option;
    
    the expected volatility of our common stock;
    
    expected dividends on our common stock (we do not anticipate paying
dividends for the foreseeable future); and
    
    the risk free interest rate for the expected option term.
  18




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Results of Operations for the Three and Six Month Periods Ended June 30, 2006 and 2005
 Three months
    
    
    
    
    
    
    Three months
    
    
    Six months
    
    
    
    
    
    
    Six monthsended
    
    
    Percentage
    
    
    ended
    
    
    ended
    
    
    Percentage
    
    
    endedJune 30,
    
    
    Increase
    
    
    June 30,
    
    
    June 30,
    
    
    Increase
    
    
    June 30,2006
    
    
    (decrease)
    
    
    2005
    
    
    2006
    
    
    (decrease)
    
    
    2005(in thousands, except percentages)
    
    
    (in thousands, except percentages)Royalties and Licensing Fees
    
    $
    929
    
    
    
    (28
    )%
    
    $
    1,296
    
    
    $
    1,860
    
    
    
    (18
    )%
    
    $
    2,278Product Sales
    
    
    146
    
    
    
    n/a
    
    
    
    
    
    
    
    180
    
    
    
    n/a
    
    
    
    Total Revenues
    
    $
    1,075
    
    
    
    (17
    )%
    
    $
    1,296
    
    
    $
    2,040
    
    
    
    (10
    )%
    
    $
    2,278
 Revenues
   19




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Selling, General and Administrative Expense
   Research and Product Development Expense
   Three months
    
    
    
    
    
    
    Three months
    
    
    Six months
    
    
    
    
    
    
    Six monthsended
    
    
    Percentage
    
    
    ended
    
    
    ended
    
    
    Percentage
    
    
    endedJune 30,
    
    
    Increase
    
    
    June 30,
    
    
    June 30,
    
    
    Increase
    
    
    June 30,2006
    
    
    (Decrease)
    
    
    2005
    
    
    2006
    
    
    (Decrease)
    
    
    2005(in thousands, except percentages)
    
    
    (in thousands, except percentages)Nalbuphine ER
    
    $
    949
    
    
    
    489
    %
    
    $
    161
    
    
    $
    1,254
    
    
    
    196
    %
    
    $
    423Torsemide ER
    
    
    462
    
    
    
    (56
    )
    
    
    1,055
    
    
    
    554
    
    
    
    (50
    )
    
    
    1,099PW2101
    
    
    
    
    
    
    (100
    )
    
    
    516
    
    
    
    
    
    
    
    (100
    )
    
    
    1,842Venlafaxine ER
    
    
    214
    
    
    
    919
    
    
    
    21
    
    
    
    475
    
    
    
    110
    
    
    
    226Phase I Products and Internal Costs
    
    
    2,925
    
    
    
    2
    
    
    
    2,876
    
    
    
    6,114
    
    
    
    8
    
    
    
    5,652Research and New Technology
Development
    
    
    671
    
    
    
    100
    
    
    
    336
    
    
    
    1,168
    
    
    
    48
    
    
    
    788Total Research and Product
Development Expense
    
    $
    5,221
    
    
    
    5
    %
    
    $
    4,965
    
    
    $
    9,565
    
    
    
    (5
    )%
    
    $
    10,030
  
    
    Nalbuphine ER These expenses reflect our direct external expenses relating to the
development of nalbuphine ER. These expenses consist primarily of payments to third parties
in connection with clinical
 20




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trials of nalbuphine ER and approximated 18% and 13% of our research and development expenses
in the three and six month periods ended June 30, 2006, respectively. The expenses for this
compound increased in the 2006 periods from the 2005 periods, as we have advanced the drug
from Phase I through Phase IIa clinical trials. During the remainder of 2006, we expect our
research and product development expenses relating to nalbuphine ER to increase as we conduct
animal toxicology work and complete additional Phase I studies to optimize the formulation.
    
    Torsemide ER These expenses reflect our direct external expenses relating to the
development of torsemide ER. These expenses consist primarily of payments to third parties
in connection with clinical trials of torsemide ER and approximated 9% and 6% of our
research and development expenses in the three and six month periods ended June 30, 2006,
respectively. The expenses for this compound decreased in the 2006 periods from the 2005
period due to the timing of clinical trials. We intend to complete the clinical development
of torsemide ER and file an NDA ourselves.
    
    PW2101 These expenses reflect our direct external expenses relating to the
development of PW2101. These expenses consist primarily of payments to third parties in
connection with clinical trials of PW2101, the manufacturing of PW2101, including our
development work related to the qualification of an alternative manufacturing site and the
preparation of the NDA for PW2101. These expenses approximated 10% and 18% of our research
and development expenses for the three and six month periods ended June 30, 2005,
respectively. We received a nonapprovable letter on this drug in 2005, and we discontinued
development work on PW2101 in the second quarter of 2005. We do not expect to incur
additional research and development expenses with respect to PW2101 in future periods.
    
    Venlafaxine ER These expenses reflect our direct external expenses relating to the
development of venlafaxine ER. These expenses consist primarily of payments to third
parties in connection with the manufacture of venlafaxine ER, including the costs of the
active drug and approximated 4% and 5% of our research and development expenses in the
three and six month periods ended June 30, 2006, respectively. The expenses for this
compound increased in the 2006 periods from the 2005 periods, as the drug advanced from
Phase I clinical trials into full clinical development. During the second quarter of 2006,
we decided to cease development work on this compound. We made this decision after we
assessed market opportunity and our estimated financial returns. We do not expect to incur
significant additional research and development expenses with respect to venlafaxine ER in
future periods, as we complete the orderly termination of this project.
    
    Phase I Products and Internal Costs These expenses primarily reflect our expenses
such as salaries and benefits of our product development personnel, including our
formulation, clinical and regulatory groups, and other costs primarily related to our
laboratory facilities that are not allocated to specific programs. These expenses also
reflect both our direct external expenses and our allocated internal expenses relating to
the development of Phase I product candidates. Our direct external expenses primarily
reflect payments to third parties for the drug active and proof-of-principle biostudies
conducted on our Phase I products. These costs increased in the three and six month periods
ended June 30, 2006 over the comparable periods in 2005, primarily as a result of the
recording of compensation expense related to employee stock options, resulting from our
adoption of SFAS 123R effective January 1, 2006 of $513,000 in the 2006 three month period
and $946,000 in the 2006 six month period. These increases were partially offset by a
write-off of TIMERx inventory primarily related to a change in specifications for TIMERx in
the second quarter of 2005. We continually evaluate the Phase I product candidates we are
developing, and may terminate or accelerate development of product candidates based on
study results, product development risk, commercial opportunity, perceived time to market
and other factors.
    
    Research and New Technology Development These expenses reflect both our direct
external expenses and our allocated internal expenses relating to the development of new
drug delivery technologies. These direct external expenses consist primarily of payments to
third parties in connection with outside laboratory and consulting fees. Our internal
expenses primarily include salaries and benefits of our research and new technology
development group, and other costs such as depreciation on purchased equipment, and the
amortization or any write-downs of patent costs, other than product patent write-offs
charged directly to a product development project. These expenses increased in the three
and six month periods ended June 30,
2006 over the comparable periods in 2005, primarily due to legal expenses and amortization
associated with our intellectual property.
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Tax Rates
  Share-Based Compensation
  Liquidity and Capital Resources
 Sources of Liquidity
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Cash Flows
  Funding Requirements
   
    
    the commercial success of Opana ER;
    
    the timing and amount of payments received under collaborative agreements, including in
particular with respect to Opana ER;
    
    the progress of our collaborative and independent development projects, funding
obligations with respect to the projects, and the related costs to us of clinical studies
for our products;
    
    the costs and timing of adding product candidates or technologies;
    
    whether we reimburse Endo for unfunded costs related to the development of Opana ER;
    
    the structure and terms of any future collaborative or development agreements;
    
    royalties received from Mylan;
    
    the prosecution, defense and enforcement of potential patent claims and other
intellectual property rights; and
    
    the level of capital expenditures.
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Contractual Obligations
  Less than
    
    
    1-3
    
    
    4-5
    
    
    After 5Total
    
    
    One Year
    
    
    Years
    
    
    Years
    
    
    YearsOperating Leases
    
    $
    917
    
    
    $
    647
    
    
    $
    270
    
    
    $
    
    
    
    $
    Purchase Obligations
    
    
    2,116
    
    
    
    2,116
    
    
    
    
    
    
    
    
    
    
    
    Deferred Compensation, including current portion
    
    
    3,158
    
    
    
    294
    
    
    
    588
    
    
    
    588
    
    
    
    1,688Total
    
    $
    6,191
    
    
    $
    3,057
    
    
    $
    858
    
    
    $
    588
    
    
    $
    1,688
  
    
    We have a Supplemental Executive Retirement Plan, or SERP, a nonqualified plan which
covers our former Chairman and Chief Executive Officer, Tod R. Hamachek. Under the SERP,
effective in May 2005, we became obligated to pay Mr. Hamachek approximately $12,600 per
month over the lives of Mr. Hamachek and his spouse.
    
    We also have a Deferred Compensation Plan, or DCP, a nonqualified plan which covers Mr.
Hamachek. Under the DCP, effective in May 2005, we became obligated to pay Mr. Hamachek
approximately $140,000 per year, including interest, in ten annual installments; however,
these installments are recalculated annually based on market interest rates as provided for
under the DCP.
  Net Operating Loss Carryforwards
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
 Market Risk and Risk Management Policies
    
 Item 4. Controls and Procedures
 (a) Evaluation of Disclosure Controls and Procedures.
 (b) Changes in Internal Control Over Financial Reporting.
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PART II  OTHER INFORMATION
 
 Item 1A. Risk Factors
 Investing in our common stock involves a high degree of risk, and you should carefully
consider the risks and uncertainties described below in addition to the other information included
or incorporated by reference in this quarterly report. If any of the following risks actually
occurs, our business, financial condition or results of operations would likely suffer, possibly
materially. In that case, the trading price of our common stock could fall.
 We have not been profitable and expect to continue to incur substantial losses
    
    
    the commercial success of Opana ER, and the timing and amount of royalties from Endos
sales of Opana ER;
    
    the level of our investment in research and development activities;
    
    the successful development and commercialization of product candidates in our portfolio; and
    
    royalties from Mylans sale of Pfizers 30 mg generic version of Procardia XL.
 We may require additional funding, which may be difficult to obtain
   
    
    the commercial success of Opana ER;
    
    the timing and amount of payments received under collaborative agreements, including in
particular under our agreement with Endo with respect to Opana ER;
    
    the progress of our collaborative and internal development projects, funding
obligations with respect to the projects, and the related costs to us of clinical studies
for our product candidates;
    
    the costs and timing of adding additional products or technologies;
    
    whether we reimburse Endo for unfunded Opana ER costs;
    
    the structure and terms of any future collaborative or development agreements;
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
    
    royalties received from Mylan;
    
    the prosecution, defense and enforcement of potential patent claims and other
intellectual property rights; and
    
    the level of our investments in capital expenditures.
   We depend heavily on the success of Opana ER, which may not be widely accepted by physicians,
patients, third-party payors, or the medical community in general
  
    
    the safety and efficacy of Opana ER as compared to competitive products;
    
    the advantages and disadvantages of Opana ER compared to alternative therapies;
    
    Endos ability to educate the medical community about the safety and effectiveness of Opana ER;
    
    the strength of Endos marketing distribution support;
    
    Endos ability to manufacture and maintain suitable inventory for sale on an ongoing basis;
    
    the cost-effectiveness of the product and the ability to receive third party reimbursement for Opana ER;
    
    the reimbursement policies of government and third party payors with respect to Opana ER; and
    
    the market price of Opana ER.
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We are dependent on our collaborator Endo, to market and sell Opana ER, and are, and in the
future expect to be, dependent on other collaborators with respect to manufacturing, marketing, and
selling additional products
     
    
    Our collaborators may be pursuing alternative technologies or developing alternative
products, either on their own or in collaboration with others, that may be competitive to
the product on which we are collaborating, which could affect our collaborators commitment
to our collaboration.
    
    Our collaborators may reduce marketing or sales efforts, or discontinue marketing or
sales of our products. This would reduce our revenues received on the products.
    
    Our collaborators may terminate their collaborations with us. This could make it
difficult for us to attract new collaborators or adversely affect perception of us in the
business and financial communities.
    
    Our collaborators may pursue higher priority programs or change the focus of their
development programs, which could affect the collaborators commitment to us.
Pharmaceutical and biotechnology companies historically have re-evaluated their priorities
from time to time, including following mergers and consolidations, which have been common
in recent years in these industries.
  We face significant competition, which may result in others discovering, developing or
commercializing products before or more successfully than we do
  
    
    significantly greater financial, technical and human resources than we have and may be
better equipped to develop, manufacture and commercialize products;
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
    
    more extensive experience than we have in conducting preclinical studies and clinical
trials, obtaining regulatory approvals, and manufacturing and marketing pharmaceutical
products;
    
    competing products that have already received regulatory approval or are in late-stage development; and
    
    collaborative arrangements in our target markets with leading companies and research institutions.
     If our clinical trials are not successful or take longer to complete than we expect, we may
not be able to develop and commercialize our products
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
    
    be delayed in obtaining marketing approval for our products;
    
    not be able to obtain marketing approval for our products; or
    
    obtain approval for indications that are not as broad as intended.
  Our drug delivery technologies rely on the ability to control the release of the active drug
ingredient and our business would be harmed if it was determined that there were circumstances
under which the active ingredient from one of our extended release products would be released
rapidly into the blood stream
  in vitro in vitro
 We are subject to extensive government regulation including the requirement of approval before
our products may be marketed. Even if we obtain marketing approval, our products will be subject
to ongoing regulatory review
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Opana ER contains a narcotic ingredient. As a result of reports of misuse and abuse of
prescription narcotics, the sale of Opana ER is subject to regulations, including the compliance
with risk management programs which may prove difficult or expensive to comply with, and we and
Endo may face lawsuits
  Our controlled release products that are generic versions of approved products that are
covered by one or more patents may be subject to litigation, which could delay FDA approval and
commercial launch of our products
  Our success depends on our protecting our patents and patented rights
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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 damages or stop our
development and commercialization efforts
  
    
    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.
   We have only limited manufacturing capabilities and will be dependent on third party
manufacturers
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
    
    we or our collaborators may not be able to meet commercial demands for Opana ER or any
of our other products on a timely basis;
    
    we may not be able to initiate or continue clinical trials of products that are under development; and
    
    we may be delayed in submitting applications for regulatory approvals of our products.
   We are dependent upon a limited number of suppliers for the gums used in our TIMERx material
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If we or our collaborators fail to obtain an adequate level of reimbursement by third party
payors for Opana ER or any other products we develop, we may not be able to successfully
commercialize the affected product
     We will be exposed to product liability claims and may not be able to obtain adequate product
liability insurance
   The market price of our common stock may be volatile
  Specific provisions of our Shareholder Rights Plan, Certificate of Incorporation and Bylaws
and of Washington law make a takeover of Penwest or a change in control or management of Penwest
more difficult
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Item 4. Submission of Matters to a Vote of Security Holders
  a.
    
    Election of Class III Directors for a term of three years:
 For
    
    WithholdRobert J. Hennessey
    
    
    17,931,483
    
    
    
    1,306,210John N. Staniforth
    
    
    18,345,178
    
    
    
    893,515
  b.
    
    Ratification of the selection of Ernst & Young LLP as our independent registered public
accounting firm for the current year:
 For
    
    Against
    
    Abstain
    
    Broker Non-Votes19,194,045
    
    
    28,577
    
    
    
    15,071
    
    
    none
 
 Item 6. Exhibits
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SIGNATURE
  PENWEST PHARMACEUTICALS CO.Date: August 7, 2006
    /s/ Benjamin L. PalleikoBenjamin L. PalleikoSenior Vice President, Corporate Development and
Chief Financial Officer
(Principal Financial Officer) 36




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EXHIBIT INDEX
 ExhibitNumber
    
    Description10.1
    
    Offer Letter, between Penwest Pharmaceuticals Co. and
Benjamin L. Palleiko, effective June 19, 2006.31.1
    
    Certification of Principal Executive Officer pursuant to
Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to
Section 302 of Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Principal Financial Officer pursuant to
Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to
Section 302 of Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Principal Executive Officer pursuant to
Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of
Sarbanes-Oxley Act of 200232.2
    
    Certification of Principal Financial Officer pursuant to
Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of
Sarbanes-Oxley Act of 2002
 37