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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 Form 10-Q  ý
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF
THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended September 30, 2004oro
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF
THE SECURITIES EXCHANGE ACT OF 1934For the transition period from            to Commission File No. 000-23467  Penwest Pharmaceuticals Co.(Exact name of registrant as specified in its charter)
 Washington
    
    91-1513032(State of Incorporation)
    
    (I.R.S. Employer Identification No.)
 39 Old Ridgebury Road, Suite 11,
    
    06810-5120Danbury, Connecticut
    
    (Zip Code)(Address of principal executive offices)
    
    (Delete)
 (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  ý   
No  o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes  ý   
No  o Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of November 4, 2004 Class
    
    OutstandingCommon stock, par value $.001
    
    
    18,548,867




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PENWEST PHARMACEUTICALS CO.
TABLE OF CONTENTS PagePART I  FINANCIAL INFORMATIONItem 1.
    
    Condensed Consolidated Financial Statements (Unaudited)Condensed Consolidated Balance Sheets
    
    
    3Condensed Consolidated Statements of Operations
    
    
    4Condensed Consolidated Statements of Cash Flows
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    28Item 4.
    
    Controls and Procedures
    
    
    28PART II  OTHER INFORMATIONItem 6.
    
    Exhibits
    
    
    30Signature

    
    
    31Exhibit Index
    
    
    32EX-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.
  TIMERx® is a registered trademark of the Company. Geminex® and SyncroDose
are also trademarks of the Company. Other tradenames and trademarks appearing
in this quarterly report are the property of their respective owners. 2




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PART I  FINANCIAL INFORMATION 
 Item 1.Condensed Consolidated Financial Statements (Unaudited) 
 PENWEST PHARMACEUTICALS CO.
CONDENSED CONSOLIDATED BALANCE SHEETS September 30,
    
    December 31,2004
    
    2003(Unaudited)
    
    (Note 2)(In thousands,except share amounts)ASSETSCurrent assets:Cash and cash
equivalents
    
    $
    16,664
    
    
    $
    25,307Marketable
securities
    
    
    28,295
    
    
    
    38,586Trade accounts receivable
    
    
    1,183
    
    
    
    1,153Inventories:Raw materials and
other
    
    
    155
    
    
    
    196Finished
goods
    
    
    511
    
    
    
    460Total
inventories
    
    
    666
    
    
    
    656Prepaid expenses and other current
assets
    
    
    1,937
    
    
    
    1,364Note
receivable
    
    
    
    
    
    
    1,250Total current
assets
    
    
    48,745
    
    
    
    68,316Fixed assets,
net
    
    
    3,800
    
    
    
    3,533Patents,
net
    
    
    3,335
    
    
    
    3,689Cash surrender value of life insurance policies
    
    
    3,022
    
    
    
    2,965Total
assets
    
    $
    58,902
    
    
    $
    78,503LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts
payable
    
    $
    662
    
    
    $
    2,804Accrued
expenses
    
    
    2,120
    
    
    
    2,133Accrued development
costs
    
    
    1,066
    
    
    
    2,682Total current
liabilities
    
    
    3,848
    
    
    
    7,619Deferred
revenue
    
    
    71
    
    
    
    84Deferred
compensation
    
    
    3,262
    
    
    
    3,104Total
liabilities
    
    
    7,181
    
    
    
    10,807Shareholders equity:Preferred stock, par value $.001, authorized 1,000,000 shares, none outstanding
    
    
    
    
    
    
    Common stock, par value $.001, authorized 60,000,000 shares, issued and outstanding
18,496,497 shares at September 30, 2004 and 18,362,523 shares at December 31, 2003
    
    
    18
    
    
    
    18Additional paid in
capital
    
    
    163,491
    
    
    
    162,068Accumulated
deficit
    
    
    (111,729
    )
    
    
    (94,433
    )Accumulated other comprehensive (loss) income
    
    
    (59
    )
    
    
    43Total shareholders
equity
    
    
    51,721
    
    
    
    67,696Total liabilities and shareholders
equity
    
    $
    58,902
    
    
    $
    78,503
 See accompanying notes to condensed consolidated financial statements. 3




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PENWEST PHARMACEUTICALS CO.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS Three Months EndedSeptember 30,2004
    
    2003(Unaudited)(In thousands, exceptper share data)Revenues:Royalties and licensing fees
    
    $
    1,206
    
    
    $
    1,016Product sales
    
    
    4
    
    
    
    Total revenues
    
    
    1,210
    
    
    
    1,016Cost of revenues
    
    
    15
    
    
    
    11Gross profit
    
    
    1,195
    
    
    
    1,005Operating expenses:Selling, general and administrative
    
    
    2,323
    
    
    
    2,276Research and product development
    
    
    4,103
    
    
    
    4,413Total operating expenses
    
    
    6,426
    
    
    
    6,689Loss from operations
    
    
    (5,231
    )
    
    
    (5,684
    )Investment income
    
    
    228
    
    
    
    147Loss before income tax expense
    
    
    (5,003
    )
    
    
    (5,537
    )Income tax expense
    
    
    5
    
    
    
    Net loss
    
    $
    (5,008
    )
    
    $
    (5,537
    )Net loss per common share
    
    $
    (0.27
    )
    
    $
    (0.32
    )Weighted average shares of common stock outstanding
    
    
    18,496
    
    
    
    17,254
 See accompanying notes to condensed consolidated financial statements. 4




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PENWEST PHARMACEUTICALS CO.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS Nine Months EndedSeptember 30,2004
    
    2003(Unaudited)(In thousands, exceptper share data)Revenues:Royalties and licensing fees
    
    $
    3,733
    
    
    $
    2,982Product
sales
    
    
    226
    
    
    
    455Total revenues
    
    
    3,959
    
    
    
    3,437Cost of revenues
    
    
    93
    
    
    
    155Gross profit
    
    
    3,866
    
    
    
    3,282Operating expenses:Selling, general and administrative
    
    
    7,187
    
    
    
    7,806Research and product development
    
    
    14,614
    
    
    
    13,555Total operating expenses
    
    
    21,801
    
    
    
    21,361Operating loss from continuing operations
    
    
    (17,935
    )
    
    
    (18,079
    )Investment income
    
    
    645
    
    
    
    267Interest expense
    
    
    
    
    
    
    34Loss from continuing operations before income taxes
    
    
    (17,290
    )
    
    
    (17,846
    )Income tax expense
    
    
    5
    
    
    
    Loss from continuing operations
    
    
    (17,295
    )
    
    
    (17,846
    )Earnings from discontinued operations, net of tax expense of $26
    
    
    
    
    
    
    177Gain on sale of discontinued operations, net of tax expense of $51
    
    
    
    
    
    
    9,497Net loss
    
    $
    (17,295
    )
    
    $
    (8,172
    )Basic and diluted (loss) earnings per common share:Continuing operations
    
    $
    (0.94
    )
    
    $
    (1.11
    )Discontinued operations
    
    
    
    
    
    
    0.60Net loss per common share
    
    $
    (0.94
    )
    
    $
    (0.51
    )Weighted average shares of common stock outstanding
    
    
    18,464
    
    
    
    16,118
 See accompanying notes to condensed consolidated financial statements. 5




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PENWEST PHARMACEUTICALS CO
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months EndedSeptember 30,2004
    
    2003(Unaudited)(In thousands)Net cash used in operating activities:Net loss
    
    $
    (17,295
    )
    
    $
    (8,172
    )Less earnings from discontinued operations, net of tax
    
    
    
    
    
    
    (177
    )Less gain on sale of discontinued operations, net of tax
    
    
    
    
    
    
    (9,497
    )Loss from continuing operations
    
    
    (17,295
    )
    
    
    (17,846
    )Adjustments to reconcile loss from continuing operations to net
cash used in continuing operations operating activities
    
    
    (2,436
    )
    
    
    606Net cash used in continuing operations operating activities
    
    
    (19,731
    )
    
    
    (17,240
    )Net cash provided by discontinued operations operating activities
    
    
    
    
    
    
    874Net cash used in operating activities
    
    
    (19,731
    )
    
    
    (16,366
    )Investing activities:Proceeds from sale of discontinued operations, net of
transaction costs paid of $1,351 in 2003
    
    
    1,250
    
    
    
    36,900Acquisitions of fixed assets, net
    
    
    (1,052
    )
    
    
    (1,820
    )Patent costs
    
    
    (390
    )
    
    
    (554
    )Proceeds from maturities of marketable securities
    
    
    19,206
    
    
    
    3,994Purchases of marketable securities
    
    
    (9,199
    )
    
    
    (30,816
    )Net cash provided by continuing operations investing activities
    
    
    9,815
    
    
    
    7,704Net cash used in discontinued operations investing activities
    
    
    
    
    
    
    (97
    )Net cash provided by investing activities
    
    
    9,815
    
    
    
    7,607Financing activities:Proceeds from loans
    
    
    
    
    
    
    1,354Repayments of loans
    
    
    
    
    
    
    (7,047
    )Issuance of common stock, net
    
    
    1,273
    
    
    
    51,248Net cash provided by discontinued operations
    
    
    
    
    
    
    2,249Net cash provided by financing activities
    
    
    1,273
    
    
    
    47,804Effect of exchange rate changes on cash and cash equivalents of
discontinued operations
    
    
    
    
    
    
    32Net (decrease) increase in cash and cash equivalents
    
    
    (8,643
    )
    
    
    39,077Cash and cash equivalents at beginning of period
    
    
    25,307
    
    
    
    1,629Cash and cash equivalents at end of period
    
    $
    16,664
    
    
    $
    40,706
 See accompanying notes to condensed consolidated financial statements. 6




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) 1. Business Penwest Pharmaceuticals Co. (the Company) develops pharmaceutical
products based on innovative oral drug delivery technologies. The foundation of
Penwests technology platform is TIMERx®, an extended release delivery system
that is adaptable to soluble and insoluble drugs and that is flexible for a
variety of controlled release profiles. The Company has also developed two
additional oral drug delivery systems, Geminex® and SyncroDose. Geminex is a
dual drug delivery system that is designed to provide independent release of
different active ingredients contained in a drug. SyncroDose is a drug delivery
system that is designed to release the active ingredient of a drug at the
desired site and time in the digestive tract. Prior to February 27, 2003, Penwest also developed, manufactured and
distributed branded pharmaceutical excipients, which are the inactive
ingredients in tablets and capsules, primarily consisting of binders,
disintegrants and lubricants. On February 27, 2003, Penwest sold substantially
all of the assets used in the Companys excipient business to subsidiaries and
affiliates of Josef Rettenmaier Holding GmbH & Co. KG (the Asset Sale). The
Company received $39.5 million in cash and a promissory note for $2.25 million
in consideration for the excipient business. In April 2003, the Company
received $1.0 million under the promissory note, and received the balance of
$1.25 million in May 2004. The Company used approximately $5.5 million of
proceeds of the Asset Sale to repay debt. As a result of the Asset Sale, the
accompanying condensed consolidated financial statements present Penwests
excipient business as discontinued operations for all periods presented. The Company is subject to the risks and uncertainties associated with a
drug delivery company actively engaged in research and development. These risks
and uncertainties include, but are not limited to, a history of net losses,
technological changes, dependence on collaborators and key personnel, the
successful completion of development efforts and of obtaining regulatory
approval, the successful commercialization of TIMERx extended release products,
compliance with government regulations, patent infringement litigation,
competition from current and potential competitors, some with greater resources
than the Company, dependence on third party manufacturers and a requirement for
additional funding. 2. Basis of Presentation The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with U.S. generally accepted accounting
principles for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by U.S. generally accepted accounting
principles for complete financial statements. In the opinion of management, all
adjustments considered necessary for a fair presentation for the interim
periods presented have been included. All such adjustments are of a normal
recurring nature. Operating results for the three and nine month periods ended
September 30, 2004 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2004. For further information, refer
to the consolidated financial statements and footnotes thereto included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2003. As a result of the Asset Sale, the operating results of the excipient
business have been presented as discontinued operations in the condensed
consolidated statements of operations for the nine month period ended September
30, 2003, (see Note 9). The balance sheet at December 31, 2003, has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by U.S. generally accepted accounting principles for
complete financial statements. 3. Summary of Significant Accounting Policies Revenue Recognition Royalties and licensing fees  Revenues from non-refundable upfront
licensing fees received under collaboration agreements are recognized ratably
over the development period of the related collaboration agreement when this
period involves development risk associated with the incomplete stage of a
products development or over the estimated or contractual licensing and supply
term when there exists an obligation to supply inventory for manufacture.
Non-refundable milestone fees received for the development funding of a product
are partially 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 7




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited) 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. Product sales  Revenues from product sales are recognized when title
transfers and customer acceptance provisions have lapsed, provided that
collections of the related accounts receivable are probable. Shipping and
handling costs are included in cost of revenues. Research and Development Expenses Research and development expenses consist of costs associated with
products being developed internally as well as products being developed under
collaboration agreements and include related salaries, benefits and other
personnel related expenses, clinical trial costs, and contract and other
outside service fees. Research and development costs are expensed as incurred.
A significant portion of the Companys development activities are outsourced to
third parties including contract research organizations, and contract
manufacturers in connection with the production of clinical materials, or may
be performed by the Companys collaborators. These arrangements may require
estimates be made of related service fees or the Companys share of development
costs, in which actual results could materially differ from the estimates and
affect the reported amounts in the Companys financial statements. Stock-Based Compensation The Company adopted the disclosure provisions of Statement of Financial
Accounting Standards (SFAS) No. 148, Accounting for Stock-Based Compensation
 Transition and Disclosure, which amends SFAS No. 123, Accounting for
Stock-Based Compensation, in 2002. SFAS No. 148 provides alternative methods
of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation, which was originally provided
under SFAS No. 123. SFAS No. 148 also improves the timeliness of disclosures by
requiring the information to be included in interim as well as annual financial
statements. The adoption of these disclosure provisions had no impact on the
Companys condensed consolidated results of operations, financial position or
cash flows. On October 13, 2004, the Financial Accounting Standards Board
concluded that SFAS 123R, Share-Based Payment, which would require all
companies to measure compensation cost for all share-based payments (including
employee stock options) at fair value, would be effective for public companies
for interim or annual periods beginning after June 15, 2005. The Company has
not yet determined the impact that SFAS 123R will have on its financial
statements. At September 30, 2004, the Company maintained two stock-based employee
compensation plans. The Company accounts for these employee stock compensation
plans in accordance with the intrinsic value-based method prescribed by
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees. During the three and nine month periods ended September 30, 2004,
in connection with retainer and meeting fees earned by members of the Companys
board of directors and scientific advisory board in 2004, the Company recorded
$20,000 and $60,000, respectively, of expense associated with the issuance of
discounted stock options and $58,000 and $151,000, respectively, of expense
associated with restricted stock grants. No other stock-based employee
compensation expense is reflected in net loss as all other options granted
under these plans had an exercise price equal to the fair market value of the
underlying common stock on the date of grant. 8




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited) The following table reflects pro forma net loss and loss per share had the
Company elected to adopt the fair value approach of SFAS No. 123: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(Unaudited)
    
    (Unaudited)(in thousands, except
    
    (in thousands, exceptper share data)
    
    per share data)Net loss  as reported
    
    $
    (5,008
    )
    
    $
    (5,537
    )
    
    $
    (17,295
    )
    
    $
    (8,172
    )Stock-based compensation expense included in reported net loss
    
    
    78
    
    
    
    55
    
    
    
    211
    
    
    
    146Stock-based compensation under fair value method
    
    
    (946
    )
    
    
    (806
    )
    
    
    (2,709
    )
    
    
    (2,482
    )Net loss  pro forma after stockbased compensation under fair value
method
    
    $
    (5,876
    )
    
    $
    (6,288
    )
    
    $
    (19,793
    )
    
    $
    (10,508
    )Net loss per share, basic and diluted  as reported
    
    $
    (0.27
    )
    
    $
    (0.32
    )
    
    $
    (0.94
    )
    
    $
    (0.51
    )Net loss per share, basic and diluted  pro forma after stock-based
compensation under fair value method
    
    $
    (0.32
    )
    
    $
    (0.36
    )
    
    $
    (1.07
    )
    
    $
    (0.65
    )
 4. Issuance of Common Stock On August 5 and August 6, 2003, the Company completed the sale of a total
of 2,507,762 shares of common stock through a private placement to selected
institutional investors (the Private Placement), resulting in net proceeds to
the Company, after fees and expenses, of approximately $49.3 million. As part
of the Private Placement, the Company granted the institutional investors
additional rights to purchase up to an additional 501,552 shares of common
stock at a price of $26.00 per share. These additional investment rights became
exercisable on September 12, 2003, and expired on December 9, 2003. None of
these additional investment rights were exercised. 5. Patents Patents include costs to secure patents on technology and products
developed by the Company. Patents are amortized on a straight-line basis over
their estimated useful lives of from 17 to 20 years. Patents are evaluated for
potential impairment whenever events or circumstance indicate that future
undiscounted cash flows may not be sufficient to recover their carrying
amounts. An impairment loss is recorded to the extent the patents carrying
value is in excess of its fair value. When fair values are not readily
available, the Company estimates fair values using expected discounted future
cash flows. During the second quarter of 2004, the Company recorded a write-down of
$410,000, net of accumulated amortization, related to the impairment of certain
patents covering its inhalation technology which the Company determined to no
longer have value. Such write-down is reflected in research and product
development expense in the condensed consolidated statements of operations. 6. Income Taxes For continuing operations, the effective tax rates for the three and nine
month periods ended September 30, 2004 and 2003 were less than 1%. The
effective tax rates are higher than the federal statutory rate of a 34% benefit
primarily due to valuation allowances recorded to offset deferred tax assets
relating to the Companys net operating losses. The gain on sale of discontinued operations of approximately $9.5 million,
recorded in the nine months ended September 30, 2003, is net of tax expense of
$51,000, or less than 1% of the pretax gain. The tax expense is lower than the
federal statutory rate of 34% primarily due to net operating losses which
offset the gain. In addition, earnings from discontinued operations of $177,000
for the nine months ended September 30, 2003 is net of tax expense of $26,000,
or 13% of pretax earnings. This tax expense, which includes foreign taxes, is
lower than the federal statutory rate of 34% primarily due to overall U.S. net
operating losses that offset the U.S. earnings of the discontinued operation
(see Note 9). 9




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited) 7. Supplemental Executive Retirement Plan The Company has a Supplemental Executive Retirement Plan (SERP), a
nonqualified plan, which covers the Chairman and Chief Executive Officer of
Penwest. The Company does not fund this liability and no assets are held by the
SERP. The Company uses a measurement date of December 31 for its SERP. The
following disclosures summarize information relating to the SERP: Components of net periodic benefit cost: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(in thousands)
    
    (in thousands)Service cost
    
    $
    (8
    )
    
    $
    (7
    )
    
    $
    (24
    )
    
    $
    (20
    )Interest cost
    
    
    32
    
    
    
    31
    
    
    
    94
    
    
    
    92Amortization of net obligation at transition
    
    
    10
    
    
    
    15
    
    
    
    30
    
    
    
    45Amortization of prior service cost
    
    
    
    
    
    
    4
    
    
    
    1
    
    
    
    10Amortization of net gain
    
    
    
    
    
    
    (7
    )
    
    
    
    
    
    
    (20
    )Net periodic benefit cost
    
    $
    34
    
    
    $
    36
    
    
    $
    101
    
    
    $
    107
 8. Comprehensive Loss The components of comprehensive loss for the three and nine month periods
ended September 30, 2004 and 2003 are as follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(Unaudited)
    
    (Unaudited)(in thousands)
    
    (in thousands)Net loss
    
    $
    (5,008
    )
    
    $
    (5,537
    )
    
    $
    (17,295
    )
    
    $
    (8,172
    )Foreign currency translation adjustments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    109Change in unrealized net gains and losses on marketable securities
    
    
    43
    
    
    
    55
    
    
    
    (102
    )
    
    
    49Comprehensive loss
    
    $
    (4,965
    )
    
    $
    (5,482
    )
    
    $
    (17,397
    )
    
    $
    (8,014
    )
 Accumulated other comprehensive income (loss) equals the cumulative
translation adjustment and unrealized net gains and losses on marketable
securities, which are the only components of other comprehensive income (loss)
included in the Companys financial statements. Effective on the date of the
Asset Sale, accumulated other comprehensive income (loss) is comprised solely
of unrealized net gains and losses on marketable securities. 9. Discontinued Operations On February 27, 2003, Penwest sold substantially all of the assets (the
Assets) used in the Companys excipient business to subsidiaries and
affiliates of Josef Rettenmaier Holding GmbH & Co. KG (Rettenmaier) for
$41.75 million, plus the assumption of specified liabilities, subject to a
working capital adjustment. The Assets of the excipient business were sold to
Rettenmaier, either directly or through the sale of the outstanding capital
stock of the three subsidiaries of Penwest that did business in the UK, Germany
and Finland. The purchase price included $39.5 million in cash and a
non-interest bearing promissory note of $2.25 million, with $1.0 million paid
to Penwest in April 2003 and $1.25 million paid to Penwest in May 2004. In the first quarter of 2003, the Company recorded a gain on the Asset
Sale of approximately $9.6 million, net of taxes of $62,000, and has reported
the operating results of the excipient business as a discontinued operation in
accordance with SFAS No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets. In the second quarter of 2003, the Company recorded an
expense of $83,000 for the working capital adjustment, net of a tax benefit of
$11,000 for a total gain of $9.5 million, net of tax expense of $51,000 for the
nine months ended September 30, 2003. The net carrying amount of the assets and
liabilities on the date of the Asset Sale was approximately $29.5 million. The
approximate carrying values of the major classes were: property, plant and
equipment of $11.4 million; inventory of $8.3 million; receivables of $6.0
million; and intangible assets of $4.3 million offset by other net liabilities.
The gain on the Asset Sale was net of transaction related costs totaling $3.1
million, primarily consisting of professional and advisory fees. 10




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited) Revenues and pretax profits for the excipient business approximated $6.1
million and $203,000, respectively, for the period January 1, 2003 through the
Asset Sale date of February 27, 2003. Prior to the sale of the excipient business, the Company owned an 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. 10. Licensing Agreements The Company enters into collaborative arrangements with pharmaceutical
companies to develop, manufacture or market products formulated with the
Companys drug delivery technologies. Endo Pharmaceuticals, Inc. In September 1997, the Company entered into a strategic alliance agreement
with Endo Pharmaceuticals, Inc. with respect to the development of oxymorphone
ER, an extended release formulation of oxymorphone, a narcotic analgesic for
the treatment of moderate to severe pain, based on the Companys TIMERx
technology. This agreement was amended and restated in April 2002. Endo has a
broad product line including established brands such as Percodan®, Percocet®,
and Lidoderm®. Endo is registered with the U.S. Drug Enforcement Administration
as a developer, manufacturer and marketer of controlled narcotic substances. Under the strategic alliance agreement, the responsibilities of the
Company and Endo with respect to the oxymorphone product are determined by a
committee comprised of an equal number of members from each of the Company and
Endo (the Alliance Committee). During the development of the product, the
Company formulated oxymorphone ER, and Endo conducted all clinical studies and
prepared and filed all regulatory applications. The Company has agreed to
supply TIMERx material to Endo, and Endo has agreed to manufacture and market
oxymorphone ER in the United States. The manufacture and marketing outside of
the United States may be conducted by the Company, Endo or a third party, as
determined by the Alliance Committee. Prior to April 17, 2003, the Company and Endo shared the costs involved in
the development of oxymorphone ER. On March 17, 2003, the Company notified Endo
that it was discontinuing its participation in the funding of the development
and marketing of oxymorphone ER effective April 17, 2003. As a result of this
termination of funding, Endo has the right to complete the development of
oxymorphone ER and recoup the portion of development costs incurred by Endo
that otherwise would have been funded by Penwest (Unfunded Development Costs)
through a temporary adjustment in the royalty rate payable to Penwest that will
return to its pre-adjustment level once Endo has recovered such costs. Endo may
also allow the Company to reimburse Endo directly for the Unfunded Development
Costs and, as a result, to receive the full royalty rate from Endo without
adjustment. The Company estimates that through July 31, 2004, Unfunded
Development Costs approximated $11.5 million. The parties have agreed that the party marketing oxymorphone ER will pay the
other party royalties initially equal to 50% of the net realization (as defined
in the agreement) subject to adjustment for the Unfunded Development Costs.
This percentage will decrease if the aggregate U.S. net realization exceeds
pre-determined thresholds. In general, the royalty payable by the marketing
party to the other party will not drop below 40%. However, the royalty will be
reduced by one-third in limited circumstances, including termination of the
agreement based on uncured material breaches of the agreement by the royalty
receiving party and certain bankruptcy and insolvency events involving the
royalty receiving party. Under the agreement, Endo will purchase formulated
TIMERx material for use in oxymorphone ER exclusively from the Company at
specified prices, and include these purchases in cost of goods sold of the
product prior to determining net realization. 11




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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited) Mylan Pharmaceuticals Inc. On March 2, 2000, Mylan Pharmaceuticals Inc. announced that it had signed
a supply and distribution agreement with Pfizer, Inc to market a generic
version of all three strengths (30 mg, 60 mg, 90 mg) of Pfizers Procardia XL.
In connection with that agreement, Mylan decided not to market Nifedipine XL, a
product the Company had developed in collaboration with Mylan, and agreed to
pay Penwest a royalty on all future net sales of the 30 mg strength of Pfizers
generic Procardia XL. The royalty percentage was comparable to the percentage
called for in Penwests original agreement with Mylan for Nifedipine XL. Mylan
has retained the marketing rights to the 30 mg strength of Nifedipine XL.
Mylans sales in the United States in 2003 of the 30 mg dosage strength version
of Pfizers generic Procardia XL totaled approximately $36.8 million. The term
of this agreement continues until such time as Mylan permanently ceases to
market generic Procardia XL. 12




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##### 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 that involve
risks and uncertainties. Our actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including those described below under Risk Factors. Overview We develop pharmaceutical products based on innovative oral drug delivery
technologies. The foundation of our technology platform is TIMERx, an extended
release delivery system that is adaptable to soluble and insoluble drugs, and
that is flexible for a variety of controlled release profiles. We have also
developed two additional oral drug delivery systems, Geminex and SyncroDose.
Geminex is a dual drug delivery system that is designed to provide independent
release of different active ingredients contained in a drug. SyncroDose is a
drug delivery system that is designed to release the active ingredient of a
drug at the desired site and time in the digestive tract. Our proprietary
TIMERx drug delivery technology is utilized in four products that were
developed with collaborators and have been approved in various countries. In
addition, we have a number of product candidates in our drug development
pipeline. Our strategy includes a significant commitment to spending on
research and development targeted at identifying and developing products that
can be formulated using our drug delivery technologies. The products on which
we are currently focusing principally address diseases of the central nervous
system. The two most advanced products in our drug development pipeline are
oxymorphone ER, an extended release formulation of oxymorphone, a narcotic
analgesic being developed for the treatment of moderate to severe pain, and
PW2101, a branded beta blocker for the treatment of hypertension and angina
that we have formulated using our TIMERx technology.  
    
    Oxymorphone ER.We are developing oxymorphone ER under a collaboration
agreement with Endo Pharmaceuticals, Inc. In February 2003, the FDA
accepted for filing a New Drug Application, or NDA, for oxymorphone
ER. In October 2003, Endo received an approvable letter from the U.S.
Food and Drug Administration, or FDA, for oxymorphone ER. In the
letter, the FDA requested that Endo address certain questions, provide
additional clarification and information, and conduct additional
clinical trials to further confirm the safety and efficacy of
oxymorphone ER before the FDA would approve Endos NDA for oxymorphone
ER. In July 2004, Endo announced that it had reached agreement with
the FDA on the design of a new clinical trial, to provide additional
safety and efficacy data for oxymorphone ER to support Endos NDA for
oxymorphone ER. The trial will be a 12-week multicenter
double-blinded, placebo-controlled trial of oxymorphone ER in opioid
naïve patients. Endo expects to recruit approximately 250 patients
for this trial. Endo has advised us that the FDA has requested that
Endo clarify certain aspects of Endos proposed protocol in order to
obtain FDA approval under the FDAs special protocol assessment (SPA)
process and that Endo is currently complying with the FDAs request.
Endo has also advised us that while they are prepared to commence
patient enrollment, they do not plan to do so until the FDA grants
final approval of the protocol under the SPA process.In the interim, however, Endo has initiated and begun to enroll
patients in an alternative pivotal trial utilizing the same study
design approved by the FDA in July 2004, but will dose the alternative
trial in opioid experienced patients. Endo does not intend to seek
approval of this alternative trial under the SPA process. If the
protocol for the opioid naïve trial is approved under the SPA process,
Endo intends to amend this alternative trial for any changes agreed
upon with the FDA in the SPA process for the opioid naïve trial. Endo
expects to recruit approximately 200 patients for this alternative
trial.Endo believes that whether it completes one or both of these trials,
the completed trial or trials will complement the completed Phase III
pivotal trial that Endo believes has demonstrated efficacy in the
intended patient population. Endo has also reported that based on the
duration of the trials and the number of patients to be enrolled, and
assuming the data is favorable, Endo expects to submit a complete
response to the FDA late in the third quarter or in the fourth quarter
of 2005. We expect that Endo will receive a further action letter
from the FDA within six months of submission of the complete response
letter.
    
    PW2101.We are currently developing PW2101, a beta
blocker for the treatment of hypertension and angina. We have
developed PW2101 on
our own but are seeking a collaborative partner to market the product. We submitted
a 505(b)(2) NDA to the FDA for PW2101 on August 31, 2004, and the FDA
accepted this NDA for filing on October 29, 2004. Currently
three strengths of the product are covered by the NDA. We are also developing a
lower strength of PW2101. We are currently conducting a pivotal clinical
trial of this lower strength and we expect to complete this
trial by the end of 2004. Assuming that the results of this
trial are positive, we expect to submit these results as
supplemental data to the NDA in the first quarter of 2005 and believe the
FDA will consider the lower strength in the original filing for the higher
strengths. 13




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PW2101 is a controlled release formulation of an immediate release beta
blocker, the active ingredient which is no longer subject to patents in the
United States. There is currently a similar branded controlled release beta
blocker product that is marketed for hypertension. This branded product had
U.S. sales of approximately $1 billion in 2003. There are also
currently filings for generic versions of the branded controlled release
product, and the sponsors are engaged in patent litigation. If the
sponsors of the generic products prevail in such litigation, and
PW2102 is approved, PW2101
would compete with the branded product and the generic versions of
the branded product.In addition, we are working with Patheon, Inc. with respect to the
commercial manufacture of PW2101. Patheon manufactured PW2101 for use in our
clinical trials as well as the NDA registration batches. However, the manufacturing
site at which this manufacturing was conducted only made registration batches for the
higher strengths of PW2101. The registration batch for the lower strength was done
at an alternative site within Patheon. As a result, we are working with Patheon to
qualify the alternative site which would consolidate the manufacturing of all of the
strengths of PW2101 at a single site and would also provide greater production capacity
than the original site. In order to use this alternative site for the commercial
production of PW2101, we will need to conduct bioequivalence studies and submit them
to the FDA as part of our NDA. Under a collaboration agreement with Mylan Pharmaceuticals Inc., we
developed Nifedipine XL, a generic version of Procardia XL based on our TIMERx
technology. In March 2000, Mylan announced that it had signed a supply and
distribution agreement with Pfizer, Inc. to market Pfizers generic version of
all three strengths (30 mg, 60 mg, 90 mg) of Procardia XL. In connection with
that agreement, Mylan decided not to market Nifedipine XL, and agreed to pay us
a royalty on all future net sales of the 30 mg strength of Pfizers generic
Procardia XL. Prior to February 27, 2003, we also developed, manufactured and
distributed branded pharmaceutical excipients, which are the inactive
ingredients in tablets and capsules, primarily consisting of binders,
disintegrants and lubricants. On February 27, 2003, we sold substantially all
of the assets used in our excipient business to subsidiaries and affiliates of
Josef Rettenmaier Holding GmbH & Co. KG. We received $39.5 million in cash and
a promissory note for $2.25 million in consideration for the excipient
business. This note was paid in two installments with the final balance of
$1.25 million paid in May 2004. We used approximately $5.5 million of proceeds
of the sale of our excipient business to repay outstanding debt. Commencing in
the first quarter of 2003, we reported the operating results of the excipient
business as a discontinued operation. We have incurred net losses since 1994. As of September 30, 2004, our
accumulated deficit was approximately $112.0 million. We expect operating
losses and negative cash flows to continue until substantial sales of products
commercialized utilizing TIMERx technology occur. A substantial portion of our
revenues through February 27, 2003 were generated from sales of our
pharmaceutical excipient product line. Since the sale of our excipient
business, we have generated revenues primarily from royalties from Mylans
sales of Pfizers 30 mg generic version of Procardia XL and shipments of bulk
TIMERx to our collaborators. Our future profitability will depend on several
factors, including:  
    
    the successful commercialization of TIMERx controlled release
products, including in particular oxymorphone ER and PW2101;
    
    royalties from Mylan; and
    
    the level of our investment in research and development activities. Our results of operations may fluctuate from quarter to quarter depending
on if and when oxymorphone ER or PW2101 are approved, the amount and timing of
royalties on Mylans sales of Pfizers 30 mg generic version of Procardia XL,
volume and timing of shipments of formulated bulk TIMERx, launch of our
products currently under development and on variations in payments under our
collaborative agreements, including payments upon the achievement of specified
milestones. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of
operations are based upon our condensed consolidated financial statements,
which have been prepared in accordance with U.S. generally accepted accounting
principles. The preparation of these financial statements requires us to make
estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the financial statements, and the reported
amounts of revenues and expenses during the reporting periods. We base our
estimates on historical experience and on various other factors that we believe
to be reasonable under the circumstances. We regard an accounting estimate
underlying our financial statements as a critical accounting estimate if the
nature of the estimate or assumption is material due to the level of
subjectivity and judgment involved, or the susceptibility of such matter to
change, and if the impact of the estimate or assumption on our financial
condition or performance may be material. On an ongoing basis, we evaluate
these estimates and judgments. Actual results may differ from these estimates
under different assumptions or conditions. Areas where significant judgments
are made include, but are not limited to, revenue recognition, research and
development expenses, deferred taxes-valuation allowance and impairment of
long-lived assets. For a more detailed explanation of the judgments made in
these areas, refer to Managements Discussion and Analysis of Financial
Condition and Results of Operations in our Annual Report on Form 10-K for the
year ended December 31, 2003. 14




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Results of Operations for Quarters and Nine Months Ended September 30, 2004 and
2003 Revenues Quarter ended
    
    
    
    
    
    Quarter ended
    
    Nine months ended
    
    Percentage
    
    Nine months endedSeptember 30,
    
    Percentage
    
    September 30,
    
    September 30,
    
    Increase
    
    September 30,2004
    
    Increase
    
    2003
    
    2004
    
    (Decrease)
    
    2003(in thousands, except percentages)
    
    (in thousands, except percentages)Royalties and Licensing Fees
    
    $
    1,206
    
    
    
    19
    %
    
    $
    1,016
    
    
    $
    3,733
    
    
    
    25
    %
    
    $
    2,982Product Sales
    
    
    4
    
    
    
    n/a
    
    
    
    
    
    
    
    226
    
    
    
    (50
    )%
    
    
    455Total Revenues
    
    $
    1,210
    
    
    
    19
    %
    
    $
    1,016
    
    
    $
    3,959
    
    
    
    15
    %
    
    $
    3,437
 The increase in total revenues for the quarter and nine months ended
September 30, 2004 as compared to the comparable periods for 2003 was the
result of increases in royalties and licensing fees. Our royalties and
licensing fees primarily consist of royalties from Mylan on its sales of
Pfizers 30 mg generic version of Procardia XL. These royalties increased in
the quarter and nine months ended September 30, 2004 compared to the comparable
periods for 2003 due to Mylans increased sales of Pfizers 30 mg generic
version of Procardia XL. Our product sales consist of sales of formulated bulk
TIMERx to our collaborators. We shipped bulk TIMERx and recorded product sales
in the first quarter and a minor amount in the third quarter of 2004, but did
not ship any bulk TIMERx or record any product sales in the second quarter of
2004. Product sales were lower for the nine months ended September 30, 2004
than for the comparable period in 2003 due to reduced orders from our major
customer of bulk TIMERx. We do not expect to ship any bulk TIMERx or record
any product sales during the remainder of 2004. Selling, General and Administrative Expense Selling, general and administrative (SG&A) expenses for the quarter and
nine months ended September 30, 2004 were $2.3 million and $7.2 million,
respectively, as compared to $2.3 million and $7.8 million, respectively, for
the comparable periods in 2003. The increase of $47,000, or 2%, in SG&A
expenses in the third quarter of 2004 over the comparable period in 2003
primarily reflects lower compensation expenses in the 2003 period attributable
to internal personnel costs of $193,000 that were capitalized during the third
quarter of 2003 as part of an implementation project relating to our
information system. This increase in compensation expense was partially offset
by a decrease in professional fees as well as lower business insurance costs in
the third quarter of 2004. The decrease of $619,000 or 8% in SG&A expenses for
the nine months ended September 30, 2004 from the comparable period in 2003 was
primarily due to the inclusion in the 2003 period of $341,000 for our share of
marketing expenses for oxymorphone ER. We recorded no such costs for this
product in 2004 as we opted out of funding these costs effective April 17,
2003. The nine month period ended September 30, 2003 also included
compensation expense of approximately $105,000 due to a severance charge taken
in the second quarter of 2003, with no similar charge in the comparable period
in 2004. In addition, professional fees and costs of business insurance
decreased in the first nine months of 2004 from the first nine months of 2003
by $192,000 and $117,000, respectively. These decreases were partially offset
by personnel costs of $193,000 that were capitalized during the third quarter
of 2003, as noted above. Research and Product Development Expense Quarter ended
    
    Percentage
    
    Quarter ended
    
    Nine months ended
    
    Percentage
    
    Nine months endedSeptember 30,
    
    Increase
    
    September 30,
    
    September 30,
    
    Increase
    
    September 30,2004
    
    (Decrease)
    
    2003
    
    2004
    
    (Decrease)
    
    2003(in thousands, except percentages)
    
    (in thousands, except percentages)Oxymorphone ER
    
    $
    
    
    
    
    100
    %
    
    $
    (266
    )
    
    $
    
    
    
    
    (100
    %)
    
    $
    1,931PW2101
    
    
    1,319
    
    
    
    (46
    %)
    
    
    2,421
    
    
    
    6,130
    
    
    
    16
    %
    
    
    5,288Research and New Technology
Development
    
    
    628
    
    
    
    29
    %
    
    
    485
    
    
    
    2,222
    
    
    
    35
    %
    
    
    1,645Phase I Products and Internal Costs
    
    
    2,156
    
    
    
    22
    %
    
    
    1,773
    
    
    
    6,262
    
    
    
    33
    %
    
    
    4,691Total Research and Product Development
    
    $
    4,103
    
    
    
    (7
    %)
    
    $
    4,413
    
    
    $
    14,614
    
    
    
    8
    %
    
    $
    13,555
 In the preceding table, research and development expenses are set forth in the
following four categories:  
    
    Oxymorphone ER These expenses reflect our direct external expenses
relating to the development of oxymorphone ER. These expenses consist
primarily of payments to third parties, including payments to Endo for
our share of development costs under our collaboration agreement with
Endo. 15




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
    
    PW2101 These expenses reflect our direct external expenses relating
to the development of PW2101. These expenses consist primarily of
payments to third parties in connection with clinical trials of
PW2101, the
manufacturing of PW2101 prior to regulatory approval for clinical
use and potential commercial use, and our development work related to
the qualification of the alternative site.
    
    Research and New Technology Development These expenses reflect both
our direct external expenses and our allocated internal expenses
relating to the development of new drug delivery technologies. These
direct external expenses consist primarily of payments to third
parties in connection with outside laboratory and consulting fees. Our
internal expenses primarily include salaries and benefits of our
research and new technology development group, and other costs such as
depreciation on purchased equipment, and amortization and any
write-downs of patent costs.
    
    Phase I Products and Internal Costs These expenses reflect both our
direct external expenses and our internal expenses relating to the
development of Phase I product candidates and also include other
unallocated research and development expenses. Our direct external
expenses primarily reflect payments to third parties for the active
drug and proof-of-principle biostudies conducted for our Phase I
products. Our internal expenses include expenses such as salaries and
benefits of our product development personnel including our
formulation, clinical and regulatory groups, and other costs primarily
related to our laboratory facilities. We did not have any research and development expenses related to
oxymorphone ER in the first nine months of 2004 due to the discontinuation of
our funding of the development of oxymorphone ER effective April 17, 2003. The
third quarter of 2003 included a credit adjustment to reduce our accrual for
development costs of oxymorphone ER by $266,000. We have not incurred any
research and development expenses related to oxymorphone ER since April 17,
2003, and we do not expect to incur any additional research and development
expenses relating to oxymorphone ER unless we resume our participation in the
funding of the expenses of oxymorphone ER. Approximately 32% and 42% of our research and development expenses for the
quarter and nine months ended September 30, 2004, respectively, related to
direct costs associated with clinical development, manufacturing scale-up and
preparation of the NDA for PW2101. These expenses increased from the
corresponding periods of 2003 primarily due to costs relating to the pivotal
clinical trials of PW2101, including payments to the clinical
research organization managing the trials, and increased costs with respect to scale-up,
manufacturing and stability of PW2101. In the fourth quarter of 2003, we
completed a pivotal trial of PW2101 for the treatment of hypertension and
announced in the first quarter of 2004 that the primary end points had been
met. On August 31, 2004, the Company submitted a 505(b)(2) NDA to the FDA for
PW2101, and the FDA accepted this NDA for filing on October 29, 2004. Included
in this filing currently are three strengths of this product. We are also
developing a lower strength of PW2101. In the second quarter of 2004, we
commenced a pivotal clinical trial of this lower strength dosage and expect to
complete this additional trial by the end of 2004. Assuming that results of
this additional trial are positive, we expect to submit these results as
supplemental data to the NDA in the first quarter of 2005 and believe the FDA
will consider the lower strength in the original filing for the higher
strengths. We have established arrangements with Patheon for the
commercial manufacture of the higher strengths of PW2101 at one manufacturing
site. We expect to continue to incur additional research and development
expenses relating to PW2101 as we continue to work with Patheon to
qualify another manufacturing site that could produce all of the strengths of
PW2101 and would have a greater production capacity than the current site.
Although we have developed PW2101 on our own, we do not intend to market this
product on our own. As a result, we are currently seeking a marketing partner
for this product. Research and new technology development expenses increased for the nine
months ended September 30, 2004 primarily due to a $410,000 write-down recorded
in the second quarter of 2004 related to the impairment of certain patents
covering our inhalation technology which we determined to no longer have value.
We expect research and new technology development expenses to decrease during
the remainder of 2004 as personnel that were previously performing research and
new technology development activities are being redirected to developing Phase
I candidates. Phase I products and internal costs increased for the quarter and nine
months ended September 30, 2004 primarily as a result of an increase in the
number of Phase I product candidates in our pipeline, an increase in external
costs incurred in connection with proof-of-principle biostudies for these Phase
I product candidates and increased costs associated with an increase in the
number of employees engaged in our development efforts. We expect these costs
to increase for the remainder of 2004 as a result of the redirection of
research resources noted above. There can be no assurance that oxymorphone ER, PW2101 or any of our other
products will be successfully developed, will receive regulatory approval, or
will be successfully commercialized. Completion of clinical trials and
commercialization of these product candidates may take several years, and the
length of time can vary substantially according to the type, complexity and
novelty of a product candidate. Due to the variability in the length of time
necessary to develop a product, the uncertainties related to the 16




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estimated cost
of the development projects and ultimate ability to obtain governmental
approval for commercialization, accurate and meaningful estimates of the
ultimate cost to bring our product candidates to market are not available. Tax Rates For continuing operations, the effective tax rates for the three and nine
month periods ended September 30, 2004 and 2003 were less than 1%. The
effective tax rates are higher than the federal statutory rate of a 34% benefit
primarily due to valuation allowances recorded to offset net deferred tax
assets relating to our net operating losses. For discontinued operations, the gain on sale of approximately $9.5
million, recorded in the nine months ended September 30, 2003, is net of tax
expense of $51,000, or less than 1% of the pretax gain. The tax rate is lower
than the federal statutory rate of 34% primarily due to net operating losses
which offset the gain. In addition, earnings from discontinued operations of
$177,000 for the nine months ended September 30, 2003 are net of tax expenses
of $26,000, or 13% of pretax earnings. These tax rates, which include foreign
taxes, are lower than the federal statutory rate of 34% primarily due to
overall U.S. net operating losses which offset the U.S. earnings of the
discontinued operation. Liquidity and Capital Resources Sources of Liquidity Subsequent to August 31, 1998, the date we became an independent,
publicly-owned company, we have funded our operations and capital expenditures
with proceeds from the sale and issuance of shares of common stock, the sale of
excipients and our excipient business, sales of formulated bulk TIMERx,
royalties and milestone payments from Mylan and other collaborators, and
advances under credit facilities. As of September 30, 2004, we had cash, cash
equivalents and short-term investments of $45.0 million. We have no other
committed sources of capital. We are a party to an agreement with Endo with respect to the development
of oxymorphone ER. On April 17, 2003, we discontinued our participation in the
funding of the development and marketing of oxymorphone ER. We did not incur
any expenses relating to oxymorphone ER in the nine months ended September 30,
2004, and we do not expect to incur any significant expenses relating to
oxymorphone ER in the fourth quarter of 2004, unless we resume our
participation in the funding of the development and marketing of oxymorphone
ER. As a result of this termination of funding, Endo has the right to complete
the development of oxymorphone ER and recoup the portion of development costs
incurred by Endo that otherwise would have been funded by us, through a
temporary adjustment in the royalty rate payable to us that will return to its
pre-adjustment level once Endo has recovered such unfunded development costs.
Endo may also allow us to reimburse Endo directly for these unfunded amounts
and, as a result, to receive the full royalty rate from Endo without
adjustment. We estimate that through July 31, 2004, unfunded development costs
approximated $11.5 million. We expect this unfunded amount to increase as Endo
completes the required pivotal study and incurs pre-launch marketing costs. Cash Flows We had negative cash flow from operations for the nine months ended
September 30, 2004 of $19.7 million, primarily due to a net loss of $17.3
million in the period. In addition, we expended approximately $3.8 million to
reduce accounts payable and accrued expenses during the first nine months of
2004. We had negative cash flow from operations for the nine months ended
September 30, 2003 of $16.4 million, primarily due to the loss from continuing
operations of $17.8 million for the period. Investing activities provided $9.8
million in cash for the nine months ended September 30, 2004, primarily
reflecting maturities of marketable securities, net of purchases, of $10.0
million. Net cash provided by investing activities also reflected funds
expended for the acquisition of laboratory equipment for drug development
activities, and funds expended to secure patents on technology developed by us.
For the first nine months of 2004, financing activities provided $1.3 million
in cash primarily from the issuance of common stock upon exercise of
outstanding stock options. Our cash flow for the first nine months of 2004 also
differed from our cash flow for the first nine months of 2003 because we no
longer derive revenues from sales of our excipient products, and no longer
incur expenses in connection with our excipient business, except for the
related revenues and expenses during the period ended February 26, 2003. Funding Requirements We anticipate that
based on our current operating plan, our existing capital resources and anticipated
internally generated funds from the sale of formulated bulk TIMERx, royalties
from Mylan and other payments from collaborators, will be sufficient to fund
our operations on an ongoing basis 17




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without requiring us to seek external
financing through at least the first quarter of 2006. We expect to continue to
invest in capital expenditures in the fourth quarter of 2004 at levels below 2003 capital spending
which approximated $2.8 million, primarily for laboratory equipment for our
drug development activities, and for patents on technology and products
developed by us. Our requirements for capital in our business are substantial and will
depend on many factors, including:  
    
    whether oxymorphone ER or PW2101 are approved on a timely basis, or at all;
    
    whether we resume our participation in the funding of the development and marketing of oxymorphone ER;
    
    the timing and amount of payments received under existing and possible future collaborative agreements, in particular with
respect to oxymorphone ER;
    
    our success in entering into a marketing collaboration for PW2101;
    
    our ability to qualify the alternative manufacturing site for
PW2101 on a timely basis or at all and the costs of doing so;
    
    the structure of any future collaborative or development agreements;
    
    the progress of our collaborative and independent development projects, funding obligations with respect to the projects,
and the related costs to us of clinical studies for our products;
    
    the costs and timing of adding additional product candidates or technologies;
    
    royalties received from Mylan; and
    
    the prosecution, defense and enforcement of potential patent claims and other intellectual property rights. Subject to these factors, we expect that we will need to issue additional
equity or debt securities, or seek additional financing through other
arrangements, to fund operations beyond the first quarter of 2006. In
addition, if we determine to resume our participation in the funding of
oxymorphone ER, or to acquire additional product candidates or technologies, we
will also need to seek additional funding to fund such actions through
collaborative agreements or research and development arrangements, or through
public or private financings. If we raise additional funds by issuing equity securities, further
dilution to our then existing shareholders may result. Debt financing, if
available, may involve agreements that include covenants limiting or
restricting our ability to take specific actions, such as incurring additional
debt, making capital expenditures or declaring dividends. Any debt or equity
financing may contain terms, such as liquidation and other preferences, that
are not favorable to us or our shareholders. If we raise additional funds
through collaboration and licensing arrangements with third parties, it may be
necessary to relinquish valuable rights to our technologies, research programs
or potential product or grant licenses on terms that may not be favorable to
us. We cannot be certain that additional financing will be available in amounts
or on terms acceptable to us, if at all. If we are unable to obtain this
additional financing, we may be required to delay, reduce the scope of, or
eliminate one or more of our planned research, development and
commercialization activities, which could harm our financial condition and
operating results. Contractual Obligations Our outstanding contractual cash obligations relate to our operating
leases, primarily for facilities, and purchase obligations, primarily relating
to clinical development, contract manufacturing and capital expenditures. Below
is a table summarizing our contractual cash obligations under our operating
leases and purchase obligations, as of September 30, 2004: Less than
    
    1-3
    
    4-5
    
    After 5Total
    
    One Year
    
    Years
    
    Years
    
    Years(in thousands)Operating Leases
    
    $
    1,122
    
    
    $
    504
    
    
    $
    618
    
    
    $
    
    
    
    $
    Purchase Obligations
    
    
    887
    
    
    
    837
    
    
    
    50
    
    
    
    
    
    
    
    Total
    
    $
    2,009
    
    
    $
    1,341
    
    
    $
    668
    
    
    $
    
    
    
    $
    
 18




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We
are also subject to the commitments described below that are not
included in the table above. We
maintain a Supplemental Executive Retirement Plan (SERP) and a
Deferred Compensation Plan (DCP) for Tod R. Hamachek, our Chairman and
Chief Executive Officer. Liabilities recognized for these
plans as of September 30, 2004, totaled $3,262,000 and are reflected as
Deferred Compensation in our condensed consolidated balance sheet. We do not fund these
liabilities and no assets are held by these plans. However, we have two
whole-life insurance policies in a rabbi trust, the cash surrender value or
death benefits of which are held in trust for these future obligations. The
cash surrender value of these policies totaled $3,022,000 as of September 30,
2004, and is included in our condensed consolidated balance sheet.
The timing of payments and the ultimate amounts to be paid under the
SERP and DCP cannot be determined at this time as they will depend on
many factors such as the date of Mr. Hamacheks retirement or
termination of employment, his final average compensation as defined
in the SERP, and benefit payment elections as provided for in the
SERP and DCP. Net Operating Loss Carryforwards At December 31, 2003, we had federal net operating loss, or NOL,
carryforwards of approximately $73.3 million for income tax purposes, of which
approximately $6.2 million, $8.4 million, $9.1 million, $17.7 million, $19.3
million and $12.6 million expire in 2018, 2019, 2020, 2021, 2022, and 2023,
respectively. In addition, we had research and development tax credit
carryforwards of approximately $3.2 million of which $67,000, $359,000,
$341,000, $777,000, $828,000 and $858,000 expire in 2018, 2019, 2020, 2021,
2022 and 2023, respectively. The use of the NOL carryforwards and research and
development tax credit carryforwards are limited to our future taxable
earnings. For financial reporting purposes, at December 31, 2003 a valuation
allowance of $26.5 million has been recognized to offset net deferred tax
assets, primarily attributable to the NOL carryforwards. Utilization of the
operating losses are subject to a limitation due to the ownership change
provisions of the Internal Revenue Code. Forward-Looking Statements This quarterly report contains certain forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. All statements, other than statements of
historical facts, included or incorporated in this report regarding our
strategy, future operations or financial position, future revenues, projected
costs, prospects, plans and objectives of management are forward-looking
statements. The words believes, anticipates, estimates, plans,
expects, intends, may, projects, will, and would and similar
expressions are intended to identify forward-looking statements, although not
all forward-looking statements contain these identifying words. We cannot
guarantee that we actually will achieve the plans, intentions or expectations
disclosed in our forward-looking statements and you should not place undue
reliance on our forward-looking statements. There are a number of important
factors that could cause our actual results to differ materially from those
indicated or implied by forward-looking statements. These important factors
include those set forth below under Risk Factors. In addition, any
forward-looking statements represent our estimates only as of the date this
quarterly report is filed with the SEC and should not be relied upon as
representing our estimates as of any subsequent date. We do not assume any
obligation to update any forward-looking statements. Risk Factors Investing in our common stock involves a high degree of risk. You should
carefully consider the risks and uncertainties described below in addition to
the other information included or incorporated by reference in this quarterly
report. If any of the following risks actually occur, our business, financial
condition or results of operations would likely suffer. In that case, the
trading price of our common stock could fall. We have not been profitable and expect to continue to incur substantial
losses We have incurred net losses since 1994, including net losses of $15.9
million, $17.1 million and $16.0 million, during 2003, 2002, and 2001,
respectively. We had a loss from continuing operations of $26.0 million, $19.0
million, and $16.8 million in 2003, 2002, and 2001, respectively. For the nine
months ended September 30, 2004, we had a net loss of $17.3 million. As of
September 30, 2004, our accumulated deficit was approximately $112 million. 19




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Our strategy includes a significant commitment to spending on research and
development targeted at identifying and developing products that can be
formulated using our TIMERx and other drug delivery technologies. As a result,
we expect to continue to incur net losses as we continue our research
activities, conduct development of, and seek regulatory approvals for, products
utilizing TIMERx technology, until substantial sales of products commercialized
utilizing our TIMERx technology occur. These net losses have had and will
continue to have an adverse effect on, among other things, our shareholders
equity, total assets and working capital. A substantial portion of our revenues since 1994 has been generated from
the sales of our pharmaceutical excipients. Our net losses in 2003, 2002 and
2001 were reduced as a result of the operating results of our excipient
business. Since February 27, 2003, we have not generated any revenues from the
sales of excipient products and our business depends exclusively on our drug
delivery and drug development business. Our future profitability will depend on several factors, including:  
    
    the successful commercialization of TIMERx controlled release
products, including in particular oxymorphone ER and PW2101;
    
    royalties from Mylan; and
    
    the level of our investment in research and development activities. We may require additional funding, which may be difficult to obtain As of September 30, 2004, we had cash, cash equivalents, and short-term
investments of $45.0 million. We anticipate that, based on our current operating plan, our existing capital resources
and anticipated internally generated funds from the sale of formulated bulk
TIMERx, royalties from Mylan and other payments from collaborators will be
sufficient to fund our operations on an ongoing basis without requiring us to
seek external financing through at least the first quarter of 2006. Our requirements for additional capital are substantial and will depend on
many factors, including:  
    
    whether oxymorphone ER or PW2101 are approved on a timely basis, or at all;
    
    whether we resume our participation in the funding of the development and marketing of oxymorphone ER;
    
    the timing and amount of payments received under existing and
possible future collaborative agreements, in particular with respect to
oxymorphone ER;
    
    our success in entering into a marketing collaboration for PW2101;
    
    our ability to qualify the alternative manufacturing site for PW2101 on a timely basis or at all and the costs of doing so;
    
    the structure and terms of any future collaborative or development agreements;
    
    the progress of our collaborative and independent development
projects, funding obligations with respect to the projects, and the
related costs to us of clinical studies for our products;
    
    the costs and timing of adding additional products or technologies;
    
    royalties received from Mylan; and
    
    the prosecution, defense and enforcement of potential patent claims and other intellectual property rights. Subject to these factors, we expect that we will need to sell additional
equity or debt securities or seek additional financing through other
arrangements to fund operations beyond the first quarter of 2006. In addition,
if we determine to resume our participation in the funding of oxymorphone ER or
to acquire additional products or technologies, we also will need to seek
additional funding for such actions through collaborative agreements or
research and development arrangements, or through public or private financing. 20




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If we raise additional funds by issuing equity securities, further
dilution to our then-existing shareholders may result. Debt financing, if
available, may involve agreements that include covenants limiting or
restricting our ability to take specific actions, such as incurring additional
debt, making capital expenditures or declaring dividends. Any debt or equity
financing may contain terms, such as liquidation and other preferences, that
are not favorable to us or our shareholders. If we raise additional funds
through collaboration and licensing arrangements with third parties, it may be
necessary to relinquish valuable rights to our technologies, research programs
or potential product or grant licenses on terms that may not be favorable to
us. We cannot be certain that additional financing will be available in amounts
or on terms acceptable to us, if at all. If we are unable to obtain this
additional financing, we may be required to delay, reduce the scope of, or
eliminate one or more of our planned research, development and
commercialization activities, which could harm our financial condition and
operating results. We are dependent on collaborators to conduct clinical trials of, obtain
regulatory approvals for, and manufacture, market, and sell our TIMERx
controlled release products, including, in particular, Endo with respect to
oxymorphone ER Some of our TIMERx controlled release products have been or are being
developed and commercialized in collaboration with pharmaceutical companies.
Under these collaborations, depending on the structure of the collaboration, we
are dependent on our collaborators to fund some portion of development, to
conduct clinical trials, obtain regulatory approvals for, and manufacture,
market and sell products utilizing our TIMERx controlled release technology.
For instance, we are dependent on Endo to obtain the regulatory approvals
required to market oxymorphone ER and will be dependent on Endo to manufacture
and market oxymorphone ER in the United States. In addition, we are dependent
on Mylan with respect to the marketing and sale of the 30 mg strength of
Pfizers generic version of Procardia XL. We have limited experience in manufacturing, marketing and selling
pharmaceutical products. Accordingly, if we cannot maintain our existing
collaborations or establish new collaborations with respect to our other
products in development, we will have to establish our own capabilities or
discontinue the commercialization of the affected product. For instance, if we
are unable to enter into a collaboration for the marketing of PW2101, we are unlikely to commercially launch the product even if we obtain FDA approval.
Developing our own capabilities would be expensive and time consuming and could
delay the commercialization of the affected product. There can be no assurance
that we would be successful in developing these capabilities. Our existing collaborations are subject to termination on short notice
under certain circumstances including, for example, if the collaborator
determines that the product in development is not likely to be successfully
developed or not likely to receive regulatory approval, if we breach the
agreement or upon a bankruptcy event. If any of our collaborations are
terminated, we may be required to devote additional resources to the product,
seek a new collaborator on short notice or abandon the product. The terms of
any additional collaborations or other arrangements that we establish may not
be favorable to us. We are also at risk that these collaborations or other arrangements may
not be successful. Factors that may affect the success of our collaborations
include the following:  
    
    Our collaborators may be pursuing alternative technologies or
developing alternative products, either on their own or in collaboration
with others, that may be competitive with the product as to which they
are collaborating with us, which could affect our collaborators
commitment to the collaboration with us.
    
    Our collaborators may reduce marketing or sales efforts, or
discontinue marketing or sales of our products. This would reduce our
revenues received on the product.
    
    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 21




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The pharmaceutical industry is highly competitive and is affected by new
technologies, governmental regulations, health care legislation, availability
of financing, litigation and other factors. Many of our competitors have:  
    
    significantly greater financial, technical and human resources than we
have and may be better equipped to develop, manufacture and commercialize
products;
    
    more extensive experience than we have in conducting preclinical studies
and clinical trials, obtaining regulatory approvals and manufacturing and
marketing pharmaceutical products;
    
    competing products that have already received regulatory approval or are in late-stage development; and
    
    collaborative arrangements in our target markets with leading companies and research institutions. We face competition based on the safety and effectiveness of our products,
the timing and scope of regulatory approvals, the availability and cost of
supply, marketing and sales capabilities, reimbursement coverage, price, patent
position and other factors. Our competitors may develop or commercialize more
effective, safer or more affordable products, or obtain more effective patent
protection, than we are able to develop or commercialize. Accordingly, our
competitors may commercialize products more rapidly or effectively than we do,
which would adversely affect our competitive position, the likelihood that our
product will achieve initial market acceptance and our ability to generate
meaningful revenues from our products. Even if our products achieve initial
market acceptance, competitive products may render our products obsolete or
noncompetitive. If our products are rendered obsolete, we may not be able to
recover the expenses of developing and commercializing those products. We face competition from numerous public and private companies and their
extended release technologies, including Johnson & Johnsons oral osmotic pump
(OROS) technology, multiparticulate systems marketed by Elan Corporation plc,
Biovail Corporation and KV Pharmaceutical Company, traditional matrix systems
marketed by SkyePharma, plc and other controlled release technologies marketed
or under development by Andrx Corporation, among others. Our TIMERx products in development will face competition from products
with the same indication as the TIMERx products we are developing. For
instance, we expect extended release oxymorphone ER will face competition from
MS Contin, Purdue Pharmas OxyContin and generic competitors to OxyContin,
Duragesic marketed by Johnson & Johnson and generic competitors to Duragesic
and Avinza marketed by Ligand. Some of the TIMERx products we are developing, such as PW2101, are branded
controlled release products, which are proprietary products that are based on active chemical ingredients that are not subject to patents. These branded controlled
release products will compete against other products developed using
the same or a similar active chemical ingredient, including branded
immediate release and branded controlled released products, as well
as any generic versions of these products, based primarily on price.
In addition, our branded controlled released products will
compete against other competitive products in the therapeutic class. For instance, PW2101 is a controlled release formulation of an immediate
release beta blocker, the chemical active ingredient for which is no longer
subject to patents in the United States. There is currently a similar branded
controlled release beta blocker product that is marketed for hypertension and
against which we expect PW2101 will compete. There are also currently filings
for generic versions of the branded controlled release products and the
sponsors of the branded product and the generic products are currently in
patent litigation. If the sponsors of generic products prevail in such
litigation, PW2101 would also compete against these generic versions. In addition to developing branded controlled release products, we also
selectively develop generic versions of branded controlled release products
using our TIMERx technology and generic active ingredients. The success of
these products will depend, in large part, on the intensity of competition from
the branded controlled release product, other generic versions of the branded
controlled release product, and other drugs and technologies that compete with
the branded controlled release product, as well as the timing of product
approval. The generic drug industry is characterized by frequent litigation between
generic drug companies and branded drug companies. Those companies with
significant financial resources will be better able to bring and defend any
such litigation. If our clinical trials are not successful or take longer to complete than
we expect, we may not be able to develop and commercialize our products In order to obtain regulatory approvals for the commercial sale of our
potential products, including our branded controlled release products, we or
our collaborators will be required to complete clinical trials in humans to
demonstrate the safety and efficacy of the products. However, we or our
collaborators may not be able to commence or complete these clinical trials in
any specified time period, or at all, either because the FDA or other
regulatory agencies object, or for other reasons. Even if we complete a clinical trial of one of our potential products, the
clinical trial may not indicate that our product is safe or 22




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effective to the
extent required by the FDA, the European Commission, or other regulatory
agencies to approve the product, and we or our collaborators may decide, or
regulators may requires us or our collaborators, to conduct additional clinical
trials. For example, in response to the NDA for oxymorphone ER, the
FDA required Endo to conduct an additional clinical trial for oxymorphone ER. The results from preclinical testing of a product that is under
development may not be predictive of results that will be obtained in human
clinical trials. In addition, the results of early human clinical trials may
not be predictive of results that will be obtained in larger scale advanced
stage clinical trials. Furthermore, we, our collaborators or the FDA may
suspend clinical trials at any time if the subjects or patients participating
in such trials are being exposed to unacceptable health risks, or for other
reasons. The rate of completion of clinical trials is dependent in part upon the
rate of enrollment of patients. Patient accrual is a function of many factors
including the size of the patient population, the proximity of patients to
clinical sites, the eligibility criteria for the study and the existence of
competitive clinical trials. Delays in planned patient enrollment may result in
increased costs and program delays. If clinical trials do not show any potential product to be safe or
efficacious, if we are required to conduct additional clinical trials or other
testing of our products in development beyond those that we currently
contemplate or if we are unable to successfully complete our clinical trials or
other testing, we may:  
    
    be delayed in obtaining marketing approval for our products;
    
    not be able to obtain marketing approval for our products; or
    
    obtain approval for indications that are not as broad as intended. Our product development costs may also increase if we experience delays in
testing or approvals. In addition, significant clinical trial delays also could
allow our competitors to bring products to market before we do and impair our
ability to commercialize our products. We may not obtain regulatory approval for our products, which would
materially impair our ability to generate revenue We are not able to market any of our products in the United States, Europe or
in any other jurisdiction without marketing approval from the FDA, the European
Agency for the Evaluation of Medicinal Products, or an equivalent foreign
regulatory agency. The regulatory process to obtain market approval for a new
drug takes many years and requires the expenditure of substantial resources. We
have had only limited experience in preparing applications and obtaining
regulatory approvals. We may encounter delays or rejections during any stage of the regulatory
approval process based upon the failure of clinical data to demonstrate
compliance with, or upon the failure of the product to meet, the FDAs
requirements for safety, efficacy and quality; and those requirements may
become more stringent due to changes in regulatory agency policy or the
adoption of new regulations. After submission of a marketing application, in
the form of an NDA or an abbreviated new drug application, or ANDA, the FDA may
deny the application, may require additional testing or data and/or may require
post marketing testing and surveillance to monitor the safety or efficacy of a
product. While the U.S. Food, Drug and Cosmetic Act, or FDCA, provides for a
180-day review period, the FDA commonly takes one to two years to grant final
approval to a marketing application. 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. We are
developing oxymorphone ER under a collaboration agreement with
Endo. In February 2003, the FDA accepted for filing a NDA, for oxymorphone ER. In October 2003, Endo received an
approvable letter from the FDA for
oxymorphone ER. In the letter, the FDA requested that Endo address certain
questions, provide additional clarification and information, and conduct some
form of additional clinical trials to further confirm the safety and efficacy
of oxymorphone ER before the FDA would approve Endos NDA for oxymorphone ER.
In July 2004, Endo announced that it had reached agreement with the FDA on the
design of a new clinical trial, to provide additional safety and efficacy data
for oxymorphone ER to support Endos NDA for oxymorphone ER. Endo has advised
us that the FDA has requested that Endo clarify certain aspects of Endos
proposed protocol in order to obtain FDA approval under the FDAs SPA process
and that Endo is currently complying with the FDAs request. Endo has also
advised us that while they are prepared to commence patient enrollment, 23




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they do
not plan to do so until the FDA grants final approval of the protocol under the
SPA process. In the interim, however, Endo has initiated and begun to enroll patients
in an alternative pivotal trial utilizing the same study design approved by the
FDA in July 2004, except that the alternative trial will be dosed in opioid
experienced patients. Endo does not intend to seek approval of this
alternative trial under the SPA process. If the protocol for the opioid naïve
trial is approved under the SPA process, Endo intends to amend this alternative
trial for any changes agreed upon with the FDA in the SPA process for the
opioid naïve trial. Endo believes that whether it completes one or both of these trials, the
completed trial or trials will complement the completed Phase III pivotal trial
that Endo believes has demonstrated efficacy in the intended patient
population. Endo has also reported that based on the duration of the trials
and the number of patients to be enrolled, and assuming the data is favorable,
Endo expects to submit a complete response to the FDA late in the third quarter
or in the fourth quarter of 2005. We expect that Endo will receive a further
action letter from the FDA within six months of submission of the complete
response letter. If the NDA for oxymorphone ER is not approved on a timely
basis or at all, it would have a material adverse effect on our business,
financial condition and results of operations. Certain products containing our TIMERx controlled release technology
require the filing of an NDA. A full NDA must include complete reports of
preclinical, clinical and other studies to prove adequately that the product is
safe and effective, which involves, among other things, full clinical testing,
and as a result requires the expenditure of substantial resources. In certain
cases involving controlled release versions of FDA-approved immediate release
drugs and branded controlled release drugs, such as PW2101, we may be able to
rely on existing publicly available safety and efficacy data to support an NDA
for controlled release products under Section 505(b)(2) of the FDCA when such
data exists for an approved immediate release or controlled release version of
the same active chemical ingredient. For example, our NDA for PW2101 was filed under section 505(b)(2) and relies on data
from an immediate release drug with the same active chemical
ingredient. We can provide no assurance, however, that the FDA
will accept a section 505(b)(2) NDA, or that we will be able to obtain
publicly available data that is useful. The section 505(b)(2) NDA process is a
highly uncertain avenue to approval because the FDAs policies on section
505(b)(2) 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. For instance, the FDA has raised a question with
respect to the appropriate patent certifications to be made by companies filing
an NDA under 505(b)(2) and we are currently in discussions with the FDA
regarding the appropriate patent certifications required to be made for PW2101.
If we are required to file a paragraph IV patent certification on PW2101, we
may become engaged in patent litigation and approval of PW2101 could be
postponed for up to 30 months. Even if we obtain marketing approval, our products will be subject to
ongoing regulatory review If regulatory approval of a product is granted, such approval may be
subject to limitations on the indicated uses for which the product may be
marketed or contain requirements for costly post-marketing follow-up studies.
As to products for which marketing approval is obtained, the manufacturer of
the product and the manufacturing facilities will be subject to continual
review and periodic inspections by the FDA and other regulatory authorities.
The subsequent discovery of previously unknown problems with the product,
manufacturer or facility may result in restrictions on the product or
manufacturer, including withdrawal of the product from the market. Later discovery of previously unknown problems with our products,
manufacturers or manufacturing processes, or failure to comply with applicable
regulatory requirements may result in:  
    
    restrictions on such products, manufacturers or manufacturing processes;
    
    warning letters;
    
    fines;
    
    suspension or withdrawal of regulatory approvals;
    
    refusal to permit the import or export of our products; 24




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
    
    product recalls;
    
    seizure of products; and
    
    injunctions or the imposition of civil or criminal prosecution. Our controlled release products that are generic versions of branded
controlled release products that are covered by one or more patents may be
subject to litigation, which could delay FDA approval and commercial launch of
our products We expect to file or have our collaborators file ANDAs or NDAs for our
controlled release products under development that are covered by one or more
patents of the branded product. It is likely that the owners of the patents
covering the brand name product or the sponsors of the NDA with respect to the
branded product will sue or undertake regulatory initiatives to preserve
marketing exclusivity, as Pfizer did with respect to our generic version of
Procardia XL that we developed with Mylan. Any significant delay in obtaining
FDA approval to market our products as a result of litigation, as well as the
expense of such litigation, whether or not we or our collaborators are
successful, could have a material adverse effect on our business, financial
condition and results of operations. The market may not be receptive to products incorporating our drug
delivery technologies The commercial success of products incorporating our extended release
technology that are approved for marketing by the FDA and other regulatory
authorities will depend upon their acceptance by the medical community and
third party payors as clinically useful, cost-effective and safe. No product
based on our TIMERx or other extended release technology is marketed in the
United States, so there can be no assurance as to market acceptance. Factors that we believe could materially affect market acceptance of these
products include:  
    
    the timing of the receipt of marketing approvals and the countries in which such approvals are obtained;
    
    the safety and efficacy of the product as compared to competitive products;
    
    the relative convenience and ease of administration as compared to competitive products;
    
    the strength of marketing distribution support; and
    
    the cost-effectiveness of the product and the ability to receive third party reimbursement. Our success depends on our protecting our patents and patented rights Our success depends in significant part on our ability to develop
patentable products, to obtain patent protection for our products, both in the
United States and in other countries, and to enforce these patents. The patent
positions of pharmaceutical firms, including us, are generally uncertain and
involve complex legal and factual questions. As a result, patents may not issue
from any patent applications that we own or license. If patents are issued, the
claims allowed may not be sufficiently broad to protect our technology. In
addition, issued patents that we own or license may be challenged, invalidated
or circumvented. Our patents also may not afford us protection against
competitors with similar technology. Our research, development and commercialization activities, as well as any
products in development or products resulting from these activities, may
infringe or be claimed to infringe patents or patent applications of
competitors or other third parties. In such event, we or our collaborators may
choose or may be required to seek a license from a third party and to pay
license fees or royalties or both under such license. These licenses may not be
available on acceptable terms, or at all. Even if we or our collaborators were
able to obtain a license, the rights may be nonexclusive, which could result in
our competitors gaining access to the same intellectual property. If we or our
collaborators are not able to obtain a license, we could be prevented from
commercializing a product, or be forced to cease some aspect of our business
operations. Our success also depends on our maintaining the confidentiality of our
trade secrets and patented know-how. We seek to protect such information by
entering into confidentiality agreements with employees, consultants, licensees
and pharmaceutical companies. These agreements may be breached by such parties.
We may not be able to obtain an adequate, or perhaps any, remedy to such a
breach. In addition, our trade secrets may otherwise become known or be
independently developed by our competitors. 25




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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 The pharmaceutical industry has been characterized by significant
litigation, interference and other proceedings regarding patents, patent
applications and other intellectual property rights. The types of situations in
which we may become parties to such litigation or proceedings include:  
    
    We or our collaborators may initiate litigation or other proceedings
against third parties to enforce our patent rights.
    
    We or our collaborators may initiate litigation or other proceedings
against third parties to seek to invalidate the patents held by such
third parties or to obtain a judgment that our products or processes do
not infringe such third parties patents.
    
    If our competitors file patent applications that claim technology
also claimed by us, we or our collaborators may participate in
interference or opposition proceedings to determine the priority of
invention.
    
    If third parties initiate litigation claiming that our processes or
products infringe their patent or other intellectual property rights, we
and our collaborators will need to defend against such proceedings. An adverse outcome in any litigation or other proceeding could subject us
to significant liabilities to third parties and require us to cease using the
technology that is at issue or to license the technology from third parties. We
may not be able to obtain any required licenses on commercially acceptable
terms or at all. The cost of any patent litigation or other proceeding, even if resolved in
our favor, could be substantial. Although the legal costs of defending
litigation relating to a patent infringement claim are generally the
contractual responsibility of our collaborators unless such claim relates to
TIMERx in which case such costs are our responsibility, we could nonetheless
incur significant unreimbursed costs in participating and assisting in the
litigation. Some of our competitors may be able to sustain the cost of such
litigation and proceedings more effectively than we can because of their
substantially greater resources. Uncertainties resulting from the initiation
and continuation of patent litigation or other proceedings could have a
material adverse effect on our ability to compete in the marketplace. Patent
litigation and other proceedings may also absorb significant management time. We have only limited manufacturing capabilities and will be dependent on
third party manufacturers We lack commercial scale facilities to manufacture our TIMERx material or
any products we may develop in accordance with cGMP requirements prescribed by
the FDA. We currently rely on Draxis Pharma, Inc. for the bulk manufacture of
our TIMERx material for delivery to our collaborators under a contract that
expires in September 2005 and on other third party manufacturers for the
products that are currently under development, such as PW2101. The agreement
with Draxis will be automatically renewed for successive one year periods,
unless either party gives notice of its intent not to renew the contract, at
least six months prior to the end of the then-current term. We are not a party to any agreements with our third party
manufacturers for the products that we are currently evaluating in clinical
trials, such as Patheon with respect to PW2101, except for purchase orders or similar arrangements. We believe that there are a limited number of manufacturers that operate
under cGMP regulations capable of manufacturing our TIMERx materials and the
products we are evaluating in clinical trials. Although we have qualified
alternate suppliers with respect to the xanthan and locust bean gums used to
manufacture our TIMERx material, if Draxis is unable to manufacture the TIMERx
material in the required quantities, on a timely basis or at all, or if Draxis
will not agree to renew our agreement when it expires on acceptable terms to us
or at all, we may be unable to obtain alternative contract manufacturing, or
obtain such manufacturing on commercially reasonable terms. In addition, if we
are unable to enter into longer-term manufacturing arrangements for our
products, such as PW2101, on acceptable terms to us or at all, particularly as these products
advance through clinical development and move closer to regulatory approval,
our business and the clinical development and commercialization of our products
could be materially adversely effected. There can be no assurance that Draxis
or any other third parties upon which we rely for supply of our TIMERx material
or our products in clinical development will perform, and any failures by third
parties may delay development or the submission of products for regulatory
approval, impair our collaborators ability to commercialize products as
planned and deliver products on a timely basis, require us or our collaborators
to cease distribution or recall some or all batches of our products or
otherwise impair our competitive position, 26




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which could have a material adverse
effect on our business, financial condition and results of operations. If our third party manufacturers fail to perform their obligations, we may
be adversely affected in a number of ways, including:  
    
    our collaborators may not be able to meet commercial demands for our products on a timely basis;
    
    our collaborators may not be able to initiate or continue clinical trials of products that are under development; and
    
    our collaborators may be delayed in submitting applications for regulatory approvals of our products. We have limited experience in manufacturing TIMERx material on a
commercial scale and no facilities or equipment to do so. If we determine to
develop our own manufacturing capabilities, we will need to recruit qualified
personnel and build or lease the requisite facilities and equipment. We may not
be able to successfully develop our own manufacturing capabilities. Moreover,
it may be very costly and time consuming for us to develop such capabilities. The manufacture of any of our products is subject to regulation by the FDA
and comparable agencies in foreign countries. Any delay in complying or failure
to comply with such manufacturing requirements could materially adversely
affect the marketing of our products and our business, financial condition and
results of operations. We are dependent upon a limited number of suppliers for the gums used in
our TIMERx material Our drug delivery systems are based a hydrophilic matrix combining a
heterodispersed mixture primarily composed of two polysaccharides, xanthan and
locust bean gums, in the presence of dextrose. These gums are also used in our
Geminex and SyncroDose drug delivery systems. We purchase these gums from a
primary supplier. We have qualified alternate suppliers with respect to such
materials, but we can provide no assurance that interruptions in supplies will
not occur in the future or that we will not have to obtain substitute
suppliers. Any interruption in these supplies could have a material adverse
effect on our ability to manufacture bulk TIMERx for delivery to our
collaborators. If we or our collaborators fail to obtain an adequate level of
reimbursement by third party payors for our controlled release products, they
may not be able to successfully commercialize controlled release products The availability of reimbursement by governmental and other third party
payors affects the market for any pharmaceutical product. These third party
payors continually attempt to contain or reduce the costs of health care by
challenging the prices charged for medical products and services. In specific
foreign countries, particularly the countries of the European Union, the
pricing of prescription pharmaceuticals is subject to governmental control. The generic versions of controlled release products being developed may be
assigned an AB rating if the FDA considers the product to be therapeutically
equivalent to the branded controlled release drug. Failure to obtain an AB
rating from the FDA would indicate that for certain purposes the drug would not
be deemed to be therapeutically equivalent, would not be fully substitutable
for the branded controlled release drug and would not be relied upon by
Medicaid and Medicare formularies for reimbursement. In both the U.S. and certain foreign jurisdictions, there have been a
number of legislative and regulatory proposals to change the health care
system. Further proposals are likely. The potential for adoption of these
proposals may affect our ability to raise capital, obtain additional
collaborative partners and market our products. If we or our collaborators obtain marketing approvals for our products, we
expect to experience pricing pressure due to the trend toward managed health
care, the increasing influence of health maintenance organizations and
additional legislative proposals. We may not be able to sell our products
profitably if reimbursement is unavailable or limited in scope or amount. We will be exposed to product liability claims and may not be able to
obtain adequate product liability insurance Our business exposes us to potential product liability risks which are
inherent in the testing, manufacturing, marketing and sale of pharmaceutical
products. Product liability claims might be made by consumers, health care
providers, pharmaceutical companies, or others that sell our products. These
claims may be made even with respect to those products that are manufactured in
licensed and regulated facilities or that otherwise possess regulatory approval
for commercial sale. 27




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We are currently covered by primary product liability insurance in amounts
of $10 million per occurrence and $10 million annually in the aggregate on a
claims-made basis and by umbrella liability insurance in excess of $25 million
which can also be used for product liability insurance. This coverage may not
be adequate to cover any product liability claims. Product liability coverage
is expensive. In the future, we may not be able to maintain or obtain such
product liability insurance at a reasonable cost or in sufficient amounts to
protect us against losses due to liability claims. Any claims that are not
covered by product liability insurance could have a material adverse effect on
our business, financial condition and results of operations. The market price of our common stock may be volatile The market price of our common stock, like the market prices for
securities of pharmaceutical, biopharmaceutical and biotechnology companies,
have historically been highly volatile. The market from time to time
experiences significant price and volume fluctuations that are unrelated to the
operating performance of particular companies. Factors such as fluctuations in
our operating results, future sales of our common stock, announcements of
technological innovations or new therapeutic products by us or our competitors,
announcements regarding collaborative agreements, clinical trial results,
government regulation, developments in patent or other proprietary rights,
public concern as to the safety of drugs developed by us or others, changes in
reimbursement policies, comments made by securities analysts and general market
conditions may have a significant effect on the market price of the common
stock. Specific provisions of our Shareholder Rights Plan, Certificate of
Incorporation and Bylaws and of Washington law make a takeover of Penwest or a
change in control or management of Penwest more difficult We have adopted a shareholder rights plan, often referred to as a poison
pill. The rights issued under the plan will cause substantial dilution to a
person or group that attempts to acquire us on terms that are not approved by
our board of directors, unless the board first determines to redeem the rights.
Various provisions of our Certificate of Incorporation, our Bylaws and
Washington law may also have the effect of deterring hostile takeovers or
delaying or preventing changes in control or management of our company,
including transactions in which our shareholders might otherwise receive a
premium for their shares over then current market prices. In addition, these
provisions may limit the ability of shareholders to approve transactions that
they may deem to be in their best interest. 
 Item 3.Quantitative and Qualitative Disclosures About Market Risk Market Risk and Risk Management Policies Market risk is the risk of loss to future earnings, to fair values or to
future cash flows that may result from changes in the price of a financial
instrument. The value of a financial instrument may change as a result of
changes in interest rates, foreign currency exchange rates and other market
changes. Market risk is attributed to all market-sensitive financial
instruments, including debt instruments. Our operations are exposed to
financial market risks, primarily changes in interest rates. Our interest rate
risk primarily relates to our investments in marketable securities. The primary objectives for our investment portfolio are liquidity and safety of
principal. Investments are made to achieve the highest rate of return to us,
consistent with these two objectives. Our investment policy limits investments
to specific types of instruments issued by institutions with investment grade
credit ratings and places restrictions on maturities and concentration by
issuer. Marketable securities primarily consist of corporate debt and U.S.
Government Agency-backed notes, and approximated $28.3 million at September 30,
2004. As of September 30, 2004, these securities have contractual maturity
dates of up to nineteen months. Due to the relatively short-term maturities of
these securities, management believes there is no significant market risk. At
September 30, 2004, market values approximated carrying values. At September
30, 2004, we had approximately $45.0 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 $450,000. 
 Item 4.Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures  Our management,
with the participation of our Chief Executive Officer, or CEO, and Chief
Financial Officer, or CFO, evaluated the effectiveness of our disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act) as of September 30, 2004. Based on this evaluation,
our CEO and CFO concluded that, as of September 30, 2004, our disclosure
controls and procedures were (1) designed to ensure that material information
relating to us is made known to our CEO and CFO by others within our company,
particularly during the period in which this report was being prepared, and (2)
effective, in that they provide reasonable assurance that information required
to be disclosed by 28




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us in the reports that we file or submit under the
Securities Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the Securities and Exchange Commissions rules
and forms. (b) Changes in Internal Controls  No change in our internal control over
financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the
Securities Exchange Act) occurred during the fiscal quarter ended September 30,
2004 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting. 29




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PART II  OTHER INFORMATION 
 Item 6.Exhibits See exhibit index below for a list of the exhibits filed as part of this
Quarterly Report on Form 10-Q, which exhibit index is incorporated herein by
reference. 30




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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized. PENWEST PHARMACEUTICALS CO.Date: November 4, 2004
    
    /s/ Jennifer L. Good
Jennifer L. GoodSenior Vice President, Finance and Chief Financial Officer
(Principal Financial Officer)
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EXHIBIT INDEX ExhibitNumber
    
    Description31.1
    
    Certification of Chief Executive Officer pursuant to Rule
13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of
1934, as adopted pursuant to Section 302 of The Sarbanes-Oxley
Act of 200231.2
    
    Certification of Chief Financial Officer pursuant to Rule
13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of
1934, as adopted pursuant to Section 302 of The Sarbanes-Oxley
Act of 200232.1
    
    Certification of Chief Executive Officer pursuant to Rule
13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of
1934 and 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of The Sarbanes-Oxley Act of 200232.2
    
    Certification of Chief Financial Officer pursuant to Rule
13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of
1934 and 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of The Sarbanes-Oxley Act of 2002
 32