Penwest Pharmaceuticals 10Q 2004 Q3 Quarterly report

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 1934

		For the quarterly period ended September 30, 2004

		or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the transition period from to

Commission File No. 000-23467


Penwest Pharmaceuticals Co.
(Exact name of registrant as specified in its charter)


Washington		91-1513032
(State of Incorporation)		(I.R.S. Employer Identification No.)


39 Old Ridgebury Road, Suite 11,		06810-5120
Danbury, 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	Outstanding

Common stock, par value $.001		18,548,867

PENWEST PHARMACEUTICALS CO.
TABLE OF CONTENTS


		Page
	PART I — FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements (Unaudited)
	Condensed Consolidated Balance Sheets		3
	Condensed Consolidated Statements of Operations		4
	Condensed Consolidated Statements of Cash Flows		6
	Notes to Condensed Consolidated Financial Statements		7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		13

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		28

Item 4.	Controls and Procedures		28

	PART II — OTHER INFORMATION

Item 6.	Exhibits		30

Signature			31

Exhibit Index			32

EX-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.

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)
ASSETS
Current assets:
Cash and cash equivalents	$	16,664		$	25,307
Marketable securities		28,295			38,586
Trade accounts receivable		1,183			1,153
Inventories:
Raw materials and other		155			196
Finished goods		511			460

Total inventories		666			656
Prepaid expenses and other current assets		1,937			1,364
Note receivable		—			1,250

Total current assets		48,745			68,316
Fixed assets, net		3,800			3,533
Patents, net		3,335			3,689
Cash surrender value of life insurance policies		3,022			2,965

Total assets	$	58,902		$	78,503

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	662		$	2,804
Accrued expenses		2,120			2,133
Accrued development costs		1,066			2,682

Total current liabilities		3,848			7,619
Deferred revenue		71			84
Deferred compensation		3,262			3,104

Total liabilities		7,181			10,807
Shareholders’ 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			18
Additional paid in capital		163,491			162,068
Accumulated deficit		(111,729	)		(94,433	)
Accumulated other comprehensive (loss) income		(59	)		43

Total shareholders’ equity		51,721			67,696

Total liabilities and shareholders’ equity	$	58,902		$	78,503

See accompanying notes to condensed consolidated financial statements.

PENWEST PHARMACEUTICALS CO.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


	Three Months Ended
	September 30,
	2004			2003
	(Unaudited)
	(In thousands, except
	per share data)
Revenues:
Royalties and licensing fees	$	1,206		$	1,016
Product sales		4			—

Total revenues		1,210			1,016
Cost of revenues		15			11

Gross profit		1,195			1,005
Operating expenses:
Selling, general and administrative		2,323			2,276
Research and product development		4,103			4,413

Total operating expenses		6,426			6,689

Loss from operations		(5,231	)		(5,684	)
Investment income		228			147

Loss 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.

PENWEST PHARMACEUTICALS CO.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


	Nine Months Ended
	September 30,
	2004			2003
	(Unaudited)
	(In thousands, except
	per share data)
Revenues:
Royalties and licensing fees	$	3,733		$	2,982
Product sales		226			455

Total revenues		3,959			3,437
Cost of revenues		93			155

Gross profit		3,866			3,282
Operating expenses:
Selling, general and administrative		7,187			7,806
Research and product development		14,614			13,555

Total operating expenses		21,801			21,361

Operating loss from continuing operations		(17,935	)		(18,079	)
Investment income		645			267
Interest expense		—			34

Loss 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		—			177
Gain on sale of discontinued operations, net of tax expense of $51		—			9,497

Net loss	$	(17,295	)	$	(8,172	)

Basic and diluted (loss) earnings per common share:
Continuing operations	$	(0.94	)	$	(1.11	)
Discontinued operations		—			0.60

Net 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.

PENWEST PHARMACEUTICALS CO
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


	Nine Months Ended
	September 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	)		606

Net cash used in continuing operations operating activities		(19,731	)		(17,240	)
Net cash provided by discontinued operations operating activities		—			874

Net 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			36,900
Acquisitions of fixed assets, net		(1,052	)		(1,820	)
Patent costs		(390	)		(554	)
Proceeds from maturities of marketable securities		19,206			3,994
Purchases of marketable securities		(9,199	)		(30,816	)

Net cash provided by continuing operations investing activities		9,815			7,704
Net cash used in discontinued operations investing activities		—			(97	)

Net cash provided by investing activities		9,815			7,607
Financing activities:
Proceeds from loans		—			1,354
Repayments of loans		—			(7,047	)
Issuance of common stock, net		1,273			51,248
Net cash provided by discontinued operations		—			2,249

Net cash provided by financing activities		1,273			47,804
Effect of exchange rate changes on cash and cash equivalents of discontinued operations		—			32

Net (decrease) increase in cash and cash equivalents		(8,643	)		39,077
Cash and cash equivalents at beginning of period		25,307			1,629

Cash and cash equivalents at end of period	$	16,664		$	40,706

See accompanying notes to condensed consolidated financial statements.

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

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.

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 Ended
	September 30,						September 30,
	2004			2003			2004			2003
	(Unaudited)						(Unaudited)
	(in thousands, except						(in thousands, except
	per 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			146
Stock-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).

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 Ended
	September 30,						September 30,
	2004			2003			2004			2003
	(in thousands)						(in thousands)

Service cost	$	(8	)	$	(7	)	$	(24	)	$	(20	)
Interest cost		32			31			94			92
Amortization of net obligation at transition		10			15			30			45
Amortization of prior service cost		—			4			1			10
Amortization 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 Ended
	September 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		—			—			—			109
Change in unrealized net gains and losses on marketable securities		43			55			(102	)		49

Comprehensive 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.

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.

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.

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.

		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.

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 ended
	September 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	%	$	2,982
Product Sales		4		n/a			—		226		(50	)%		455

Total 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 ended
	September 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	%)	$	1,931
PW2101		1,319		(46	%)		2,421			6,130		16	%		5,288
Research and New Technology Development		628		29	%		485			2,222		35	%		1,645
Phase I Products and Internal Costs		2,156		22	%		1,773			6,262		33	%		4,691

Total 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.

•		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

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

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 5
	Total		One Year		Years		Years		Years
			(in thousands)

Operating Leases	$	1,122	$	504	$	618	$	—	$	—
Purchase Obligations		887		837		50		—		—

Total	$	2,009	$	1,341	$	668	$	—	$	—

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.

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.

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

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

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,

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;

•		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.

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,

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.

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

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.

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.

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. Good Senior Vice President, Finance and Chief Financial Officer (Principal Financial Officer)

EXHIBIT INDEX


Exhibit
Number		Description

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of The Sarbanes-Oxley Act of 2002

31.2		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 2002

32.1		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 2002

32.2		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

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	H.S. sophomore Avg

Penwest Pharmaceuticals (PPCO) Inactive 10-Q2004 Q3 Quarterly report

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Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents

Table of Contents