Penwest Pharmaceuticals 10Q 2005 Q3 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q


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

For the quarterly period ended September 30, 2005


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

For the transition period from to

Commission File No. 000-23467

Penwest Pharmaceuticals Co.

(Exact name of registrant as specified in its charter)


Washington		91-1513032

(State of Incorporation)		(I.R.S. Employer Identification No.)


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

(Address of principal executive offices)		(Zip Code)

(877) 736-9378

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

Indicate by a check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes þ No o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of November 7, 2005.


Class		Outstanding

Common stock, par value $.001		21,855,075

PENWEST PHARMACEUTICALS CO.

TABLE OF CONTENTS


		Page
	PART I — FINANCIAL INFORMATION

Item 1.	Condensed Financial Statements (Unaudited)
	Condensed Balance Sheets		3
	Condensed Statements of Operations		4
	Condensed Statements of Cash Flows		5
	Notes to Condensed Financial Statements		6

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk		31

Item 4.	Controls and Procedures		31

	PART II — OTHER INFORMATION

Item 6.	Exhibits		32

Signature			33

Exhibit Index			34
EX-31.1 SECTION 302 CERTIFICATION OF CEO
EX-31.2 SECTION 302 CERTIFICATION OF CFO
EX-32.1 SECTION 906 CERTIFICATION OF CEO
EX-32.2 SECTION 906 CERTIFICATION OF CFO

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 Financial Statements (Unaudited)

PENWEST PHARMACEUTICALS CO.

CONDENSED BALANCE SHEETS


	September 30,			December 31,
	2005			2004
	(Unaudited)			(Note 2)
	(In thousands,
	except share amounts)
ASSETS
Current assets:
Cash and cash equivalents	$	25,209		$	14,249
Marketable securities		36,062			60,121
Trade accounts receivable		739			1,126
Inventories:
Raw materials and other		127			134
Finished goods		78			509

Total inventories		205			643
Prepaid expenses and other current assets		1,329			1,143

Total current assets		63,544			77,282
Fixed assets, net		3,083			3,674
Patents, net		3,331			3,504
Cash surrender value of life insurance policies		3,121			3,062

Total assets	$	73,079		$	87,522


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	874		$	2,396
Accrued expenses		2,059			1,966
Accrued development costs		1,747			974
Deferred compensation — current portion		291			—

Total current liabilities		4,971			5,336
Deferred revenue		60			71
Deferred compensation		2,958			3,314

Total liabilities		7,989			8,721
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 21,839,802 shares at September 30, 2005 and 21,692,730 shares at December 31, 2004		22			22
Additional paid in capital		201,061			197,097
Accumulated deficit		(135,836	)		(118,218	)
Accumulated other comprehensive loss		(157	)		(100	)

Total shareholders’ equity		65,090			78,801

Total liabilities and shareholders’ equity	$	73,079		$	87,522

See accompanying notes to condensed financial statements.

PENWEST PHARMACEUTICALS CO.

CONDENSED STATEMENTS OF OPERATIONS


	Three Months Ended
	September 30,
	2005			2004
	(Unaudited)
	(In thousands, except
	per share data)
Revenues:
Royalties and licensing fees	$	3,004		$	1,206
Product sales		¾			4

Total revenues		3,004			1,210
Cost of revenues		8			15

Gross profit		2,996			1,195
Operating expenses:
Selling, general and administrative		2,554			2,323
Research and product development		3,950			4,103

Total operating expenses		6,504			6,426

Loss from operations		(3,508	)		(5,231	)
Investment income		522			228

Loss before income tax expense		(2,986	)		(5,003	)
Income tax expense		¾			5

Net loss	$	(2,986	)	$	(5,008	)


Net loss per common share	$	(0.14	)	$	(0.27	)


Weighted average shares of common stock outstanding		21,714			18,496


	Nine Months Ended
	September 30,
	2005			2004
	(Unaudited)
	(In thousands, except
	per share data)
Revenues:
Royalties and licensing fees	$	5,282		$	3,733
Product sales		¾			226

Total revenues		5,282			3,959
Cost of revenues		30			93

Gross profit		5,252			3,866
Operating expenses:
Selling, general and administrative		10,318			7,187
Research and product development		13,980			14,614

Total operating expenses		24,298			21,801

Loss from operations		(19,046	)		(17,935	)
Investment income		1,427			645

Loss before income tax expense		(17,619	)		(17,290	)
Income tax expense		¾			5

Net loss	$	(17,619	)	$	(17,295	)


Net loss per common share	$	(0.81	)	$	(0.94	)


Weighted average shares of common stock outstanding		21,683			18,464

See accompanying notes to condensed financial statements

PENWEST PHARMACEUTICALS CO.

CONDENSED STATEMENTS OF CASH FLOWS


	Nine Months Ended
	September 30,
	2005			2004
	(Unaudited)
	(In thousands)
Operating activities:
Net loss	$	(17,619	)	$	(17,295	)
Adjustments to reconcile net loss to net cash used in operating activities		3,578			(2,436	)

Net cash used in operating activities		(14,041	)		(19,731	)

Investing activities:
Proceeds from sale of discontinued operations		¾			1,250
Acquisitions of fixed assets, net		(164	)		(1,052	)
Patent costs		(303	)		(390	)
Proceeds from maturities of marketable securities		38,883			15,261
Proceeds from sales of marketable securities		25,450			28,000
Purchases of marketable securities		(39,943	)		(29,049	)

Net cash provided by investing activities		23,923			14,020

Financing activities:
Issuance of common stock, net		1,078			1,273

Net cash provided by financing activities		1,078			1,273

Net increase (decrease) in cash and cash equivalents		10,960			(4,438	)
Cash and cash equivalents at beginning of period		14,249			8,241

Cash and cash equivalents at end of period	$	25,209		$	3,803

See accompanying notes to condensed financial statements.

PENWEST PHARMACEUTICALS CO.

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)

1. Business

Penwest Pharmaceuticals Co. (the “Company” or “Penwest”) develops pharmaceutical products based on innovative proprietary drug delivery technologies. The Company is focusing its development efforts principally on products that address diseases of the central nervous system. The most advanced product in the Company’s drug development pipeline is oxymorphone ER, an extended release formulation of oxymorphone, a narcotic analgesic being developed for twice-a-day dosing in patients with moderate to severe pain requiring continuous around-the-clock opioid therapy for an extended period of time. The Company is also developing additional product candidates in areas such as epilepsy, schizophrenia, depression, pain and edema.

The Company is subject to the risks and uncertainties associated with drug 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 products based on the Company’s proprietary TIMERx controlled release technology and other technologies, 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 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. The following non-recurring items are included in the interim periods presented: $2.25 million of licensing revenue recognized in the third quarter of 2005 (see Note 10); a $3.0 million compensation charge recognized in the first quarter of 2005 (see Note 7); a write-off of inventory in the second quarter of 2005 of approximately $395,000 relating primarily to a change in specifications for TIMERx; and impairment losses related to patent costs which were recorded as discussed below. Operating results for the three and nine month periods ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. For further information, refer to the financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

During the second quarter of 2005, the Company recognized impairment losses of $118,000, net of accumulated amortization, related to patents covering PW2101, a beta blocker intended for the treatment of hypertension and angina, which the Company determined to no longer have value. In addition, during the second quarter of 2004, the Company recognized impairment losses of $410,000, net of accumulated amortization, related to patents covering its inhalation technology, which the Company determined to no longer have value. Such write-downs are reflected in research and product development expenses in the statements of operations.

The balance sheet at December 31, 2004, 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.

Certain prior year amounts have been reclassified to conform to the current year presentation, including the reclassification of auction rate securities at September 30, 2004 as marketable securities, rather than cash equivalents as previously reported. These reclassifications had no impact on the Company’s financial position or results of operations.

- 6 -

PENWEST PHARMACEUTICALS CO.

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)

(Unaudited)

3. Summary of Significant Accounting Policies

Revenue Recognition

Royalties and licensing fees- The Company recognizes revenues from non-refundable up-front licensing fees received under collaboration agreements 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 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. Upon termination of a collaboration agreement, any remaining non-refundable licensing fees received by the Company, which had been deferred, are generally recognized in full. Product royalty fees are recognized when earned, as reported by the Company’s collaborators, and are generally subject to review or audit by the Company.

Product sales —The Company recognizes revenues from product sales 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 to 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. These arrangements may also require the Company to pay termination costs to the third parties for reimbursement of costs and expenses incurred in the orderly termination of contractual services.

Income Taxes

The liability method, prescribed by Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes,” is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities. The Company recognized no income tax benefits relating to the net operating losses generated during the three and nine month periods ended September 30, 2005 and 2004, as such losses were offset by valuation allowances. Valuation allowances are established against the recorded deferred income tax assets to the extent that management believes it is more likely than not that a portion of the deferred income tax assets are not realizable.

Impairment of Long-Lived Assets

The Company reviews the recoverability of its long-lived assets, including definite-lived intangible assets whenever facts and circumstances indicate that the carrying amount may not be fully recoverable. For purposes of

PENWEST PHARMACEUTICALS CO.

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)

(Unaudited)

recognizing and measuring impairment, the Company evaluates long-lived assets based upon the lowest level of independent cash flows ascertainable to evaluate impairment. If the sum of the undiscounted future cash flows expected over the remaining asset life is less than the carrying value of the assets, the Company may recognize an impairment loss. The impairment related to long-lived assets is measured as the amount by which the carrying amount of the assets exceeds the fair value of the asset. When fair values are not readily available, the Company estimates fair values using expected discounted future cash flows.

Stock-Based Compensation

The Company follows the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which amended SFAS No. 123, “Accounting for Stock-Based Compensation”. 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 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,
	2005			2004			2005			2004
	(unaudited)						(unaudited)
	(in thousands, except						(in thousands, except
	per share data)						per share data)
Net loss reported	$	(2,986	)	$	(5,008	)	$	(17,619	)	$	(17,295	)
Stock-based compensation expense included in reported net loss		144			78			2,804			211
Stock-based compensation under fair value method		(894	)		(946	)		(3,403	)		(2,709	)

Net loss — pro forma after stock - based compensation under fair value method	$	(3,736	)	$	(5,876	)	$	(18,218	)	$	(19,793	)


Net loss per share, basic and diluted — as reported	$	(0.14	)	$	(0.27	)	$	(0.81	)	$	(0.94	)
Net loss per share, basic and diluted — pro forma after stock-based compensation under fair value method	$	(0.17	)	$	(0.32	)	$	(0.84	)	$	(1.07	)

4. Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 123 (revised 2004), “Share-Based Payment”, which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS 123R supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends SFAS No. 95, “Statement of Cash Flows”. The approach to quantifying stock-based compensation expense in SFAS 123R is similar to SFAS 123. However, the revised statement requires all share-based payments to employees, including grants of employee stock options as well as compensatory employee stock purchase plans, to be recognized as an expense in the statement of operations based on their fair values as they are earned by the employees under the vesting terms. Pro forma disclosure of stock-based compensation expense, as is the Company’s practice under SFAS 123, (see Stock-Based Compensation above) will not be permitted after 2005, since SFAS 123R must be adopted no later than the first annual period beginning after June 15, 2005. As a result, the Company will adopt SFAS 123R effective January 1, 2006.

As permitted by SFAS 123, the Company currently accounts for share-based compensation to employees under the APB 25 intrinsic value method and generally recognizes no compensation expense for employee stock options. Accordingly, the adoption of the SFAS 123R fair value method will impact the Company’s results of operations, although it will have no impact on its overall financial position. The impact of the adoption of SFAS 123R will also depend on levels of share-based compensation granted in the future and the fair values assigned thereto. Although the Company has not determined whether the adoption of SFAS 123R will result in amounts that are similar to the current pro forma disclosures under SFAS 123, the Company is evaluating the requirements under SFAS 123R

PENWEST PHARMACEUTICALS CO.

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)

including the valuation methods and support for the assumptions that underlie the valuation of the awards, as well as the transition methods (modified prospective transition method or the modified retrospective transition method) and expects the adoption to have a significant impact on the Company’s statements of operations and net loss per share.

In June 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3”. This standard replaces APB Opinion No. 20, “Accounting Changes",and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements”, and changes the requirements for the accounting and reporting of a change in accounting principle. SFAS No. 154 applies to all voluntary changes in accounting principle and to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS No. 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 requires that the change in accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings for that period, rather than being reported in an income statement. Such a change would require a Company to restate its previously issued financial statements to reflect the change in accounting principle to prior periods presented. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS No. 154 will not have a material impact on the Company’s results of operations and financial position.

5. Registration of Securities

On July 27, 2005, the Company filed a registration statement on Form S-3 with the Securities and Exchange Commission (the “SEC”), which became effective on August 17, 2005. This shelf registration statement covers the issuance and sale by the Company of any combination of common stock, preferred stock, debt securities and warrants having an aggregate purchase price of up to $75 million.

6. Income Taxes

The Company’s effective tax rates for the three and nine month periods ended September 30, 2005 were zero, and for the three and nine month periods ended September 30 2004 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.

7. Compensation Charge

On February 14, 2005, Tod R. Hamachek resigned from his positions as the Company’s Chief Executive Officer and Chairman of the Board of Directors and as a member of the Board, and entered into a Severance and Settlement Agreement and Release with the Company (the “Agreement”). Under the Agreement, the Company agreed that, in consideration of Mr. Hamachek’s release and other agreements under the Agreement, it would pay Mr. Hamachek eighteen months base salary ($594,000) as severance pay, pay all premium costs relating to medical insurance continuation coverage and provide certain other benefits. The Company also agreed to accelerate in full the vesting of all unvested stock options (146,000 shares) held by Mr. Hamachek, and to extend the period during which he could exercise his stock options to the earlier of two years or their original expiration date. In connection with the Agreement, the Company recorded a charge to its statement of operations totaling approximately $3.0 million in the three months ended March 31, 2005. This charge, included in selling, general and administrative expense, includes a non-cash charge of approximately $2.4 million relating to the stock options noted above.

8. Supplemental Executive Retirement Plan and Deferred Compensation Plan

The Company has a Supplemental Executive Retirement Plan (“SERP”), a nonqualified plan, which covers the Company’s former Chairman and Chief Executive Officer, Mr. Hamachek. On February 14, 2005, Mr. Hamachek resigned from his positions as Chairman and Chief Executive Officer (see Note 7). As a result, under the terms of the SERP, commencing in May 2005, the Company began paying Mr. Hamachek approximately $12,600 per month, payable over the lives of Mr. Hamachek and his spouse, in accordance with Mr. Hamachek’s elections. The

PENWEST PHARMACEUTICALS CO.

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)

actuarially determined liability for the SERP was approximately $2,324,000 and $2,303,000 as of September 30, 2005 and December 31, 2004, respectively, including the current portion of approximately $151,000 at September 30, 2005, and is included in deferred compensation in the Company’s condensed balance sheet. The Company has not funded 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,
	2005		2004			2005		2004
	(unaudited)					(unaudited)
	(in thousands)					(in thousands)
Service cost	$	¾	$	(8	)	$	¾	$	(24	)
Interest cost		31		32			92		94
Amortization of net obligation at transition		¾		10			¾		30
Amortization of prior service cost		¾		¾			1		1

Net periodic benefit cost	$	31	$	34		$	93	$	101

In addition, the Company has a Deferred Compensation Plan (“DCP”), a nonqualified plan, which covers Mr. Hamachek. Under the DCP, the Company recognized interest expense of $16,000 and $19,000 for the three month periods ended September 30, 2005 and 2004, respectively, and $53,000 and $57,000 for the nine month periods ended September 30, 2005 and 2004, respectively. The liability for the DCP was approximately $924,000 and $1,011,000 as of September 30, 2005 and December 31, 2004, respectively, including the current portion of approximately $140,000 at September 30, 2005, and is included in deferred compensation on the Company’s condensed balance sheets. The Company has not funded this liability and no assets are held by the DCP. In connection with the resignation of Mr. Hamachek in February 2005 (see Note 7), commencing in May 2005, the Company is paying Mr. Hamachek approximately $140,000 per year including interest under the DCP in ten annual installments.

The Company has two whole-life insurance policies in a rabbi trust, the cash surrender value or death benefits of which are held in trust for the SERP and DCP liabilities. The Company is entitled to borrow against these policies to fund these liabilities as provided by the terms of the trust. The cash surrender value of these polices totaled $3,121,000 as of September 30, 2005 and $3,062,000 as of December 31, 2004.

9. Comprehensive Loss

The components of comprehensive loss for the three and nine month periods ended September 30, 2005 and 2004 are as follows:


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2005			2004			2005			2004
	(unaudited)						(unaudited)
	(in thousands)						(in thousands)
Net loss	$	(2,986	)	$	(5,008	)	$	(17,619	)	$	(17,295	)
Change in unrealized net gains and losses on marketable securities		(19	)		43			(57	)		(102	)

Comprehensive loss	$	(3,005	)	$	(4,965	)	$	(17,676	)	$	(17,397	)

Accumulated other comprehensive loss equals the cumulative unrealized net gains and losses on marketable securities, which are the only components of other comprehensive loss included in the Company’s condensed financial statements.

10. Licensing Agreements

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

PENWEST PHARMACEUTICALS CO.

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)

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, based on the Company’s TIMERx technology. Oxymorphone ER is a narcotic analgesic for the treatment of moderate to severe pain in patients requiring continuous around-the-clock opioid therapy for an extended period of time. 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 shared with Endo the costs involved in the development and pre-marketing of oxymorphone ER. On April 17, 2003, the Company discontinued its participation in the funding of the development and pre-marketing of oxymorphone ER. The Company took this action because the Company believed that its strategic focus should be on funding other products in its development pipeline. 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 and pre-marketing costs incurred by Endo that otherwise would have been funded by Penwest. Endo may recoup such development costs through a temporary adjustment in the royalty rate payable to the Company, which will return to its pre-adjustment level once Endo has recovered such costs. Endo may also allow Penwest to reimburse them directly for the unfunded amounts. The Company estimates that through August 31, 2005, these unfunded costs approximated $19.7 million. The Company expects these costs to increase for the additional costs of the pivotal trials which Endo completed in October 2005, and as Endo prepares its complete response to the United States Food and Drug Administration’s (“FDA”) New Drug Application (“NDA”) approvable letter and incurs pre-launch marketing costs. The Company has agreed with Endo 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 between Endo and Penwest, subject to adjustment for 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 specified 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, on which the royalty payment is calculated.

Mylan Pharmaceuticals Inc.

On March 2, 2000, Mylan Pharmaceuticals Inc. announced that it had signed a supply and distribution agreement with Pfizer, Inc. (“Pfizer”) to market a generic version of all three strengths (30 mg, 60 mg, 90 mg) of Pfizer’s Procardia XL. In connection with that agreement, Mylan decided not to market Nifedipine XL, a product the Company had developed in collaboration with Mylan, and agreed to pay Penwest a royalty on all future net sales of the 30 mg strength of Pfizer’s generic Procardia XL. The royalty percentage was comparable to the percentage called for in Penwest’s original agreement with Mylan for Nifedipine XL. Mylan has retained the marketing rights to the 30 mg strength of Nifedipine XL. Mylan’s sales in the United States in 2004 of the 30 mg dosage strength version of Pfizer’s generic Procardia XL totaled approximately $40.2 million. The term of this agreement continues until such time as Mylan permanently ceases to market generic Procardia XL.

PENWEST PHARMACEUTICALS CO.

NOTES TO CONDENSED FINANCIAL STATEMENTS (continued)
(Unaudited)

Prism Pharmaceuticals, Inc.

On April 26, 2005, the Company entered into a licensing agreement (the “License Agreement”) with Prism Pharmaceuticals, Inc. (“Prism”) granting Prism exclusive rights to market Penwest’s PW2101 product in the United States and Canada. Under the terms of the License Agreement, Penwest granted Prism an exclusive license under certain Penwest intellectual property to develop, make, use and commercialize PW2101 in the United States and Canada for all indications except the treatment and/or prophylaxis of migraine. Prism made a non-refundable $4.0 million payment to the Company upon signing the License Agreement and had agreed to pay Penwest milestone payments upon achievement of milestones related to FDA approval and launch of PW2101, and royalties on net sales. Upon receipt, the Company deferred the $4.0 million received from Prism.

In June 2005, the FDA issued a non approvable letter for the Company’s NDA for PW2101. Given the FDA’s concerns expressed in the non approvable letter, the time and resources the Company expected it would take to address them, and the commercial window for this product opportunity, Penwest decided not to undertake the additional activities on PW2101 that it believed would be required to address the FDA’s concerns. On July 7, 2005, the Company was notified by Prism that Prism also did not intend to proceed with development activities on PW2101 under the License Agreement. As a result, the License Agreement terminated effective July 20, 2005. In connection with the termination, Penwest and Prism signed a settlement agreement in September 2005, and Penwest repaid Prism $1.75 million of the $4.0 million payment Penwest received from Prism, and recognized the remaining $2.25 million as licensing fee revenue in the third quarter of 2005.

11. Contingencies

The Company is a party to certain claims and proceedings in the ordinary course of business. The Company does not believe any of these matters will result, individually or in the aggregate, in a material adverse effect upon its financial condition or future results of operations.

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 proprietary drug delivery technologies. We are focusing our development efforts principally on products that address diseases of the central nervous system. The most advanced product in our drug development pipeline is oxymorphone ER, an extended release formulation of oxymorphone, that we are developing with Endo Pharmaceuticals, Inc. We are also developing several additional product candidates in areas such as epilepsy, schizophrenia, depression, pain and edema, including PW2132, a product candidate intended for the treatment of edema related to congestive heart failure.

•		Oxymorphone ER.Oxymorphone ER is an extended release formulation of oxymorphone incorporating TIMERx technology that we are developing with Endo. Oxymorphone ER, a Schedule II narcotic analgesic, is being developed for twice-a-day dosing in patients with moderate to severe pain requiring continuous, around-the-clock opioid therapy for an extended period of time.

		Endo, which is responsible for conducting the clinical trials and seeking regulatory approval of the product, submitted a New Drug Application, or NDA, for oxymorphone ER to the United States Food and Drug Administration, or FDA, in December 2002. In October 2003, Endo received an approvable letter for oxymorphone ER. In the letter, the FDA requested that Endo address certain questions, provide additional clarification and information, and conduct some form of additional clinical trials to further confirm the safety and efficacy of oxymorphone ER, before the FDA would approve Endo’s NDA for oxymorphone ER. In November 2004, Endo announced that the FDA had granted under the FDA’s Special Protocol Assessment, or SPA, process, final approval of a protocol for a 12-week, multicenter double-blinded, placebo-controlled Phase III trial of oxymorphone ER in patients with chronic low back pain and without recent treatment with opioid analgesics, designed to provide the additional safety and efficacy data for oxymorphone ER requested by the FDA.

		In August 2005, Endo reported that the results of this study demonstrated statistically significant (p<0.0001) difference in pain scores between oxymorphone ER and placebo during a 12-week treatment period, during which the drug was administered twice daily. The primary endpoint was a change in average pain intensity as measured on the Visual Analog Scale (VAS), from baseline. In addition, in October 2005, Endo reported results of a separate Phase III trial with a protocol virtually identical to the study described above, except that the patient population consisted of opioid-experienced patients. Endo reported that the results of this study also demonstrated statistically significant (p<0.0001) difference in pain scores between oxymorphone ER and placebo during a 12-week treatment period, during which the drug was administered twice daily.

•		PW2132.PW2132 is a drug candidate intended for the treatment of edema resulting from congestive heart failure, which we formulated using our Geminex technology. Geminex is a dual drug delivery system that is designed to provide independent release of the same active ingredient or different active ingredients contained in a drug. The technology is based on a bi-layer tablet that utilizes TIMERx in the controlled release layer. We conducted a pilot scale biostudy of PW2132 in approximately 20 healthy volunteers in the fourth quarter of 2004. In the study, PW2132 achieved the plasma profiles we had targeted as endpoints of the study and that we believe may improve the efficacy of the drug. Based on the results of the pilot biostudy, in April 2005, we held a pre-IND meeting with the FDA and filed an Investigational New Drug Application, or IND, for PW2132. During the third quarter of 2005, we completed a Phase IIa study, as a single-dose efficacy study, in approximately 40 patients, designed to show proof of concept and are in the process of completing the analysis of the data. Early indications suggest that the results were positive, however, we will need to complete the full analysis of the data, which we expect to do in the fourth quarter of 2005, to confirm the results.

- 13 -

•

In addition, we are currently conducting pilot scale Phase I proof of principle biostudies of several product candidates primarily for drugs to treat diseases of the central nervous system. In these studies, we are seeking to obtain preliminary pharmacokinetic data in humans. If the pilot scale biostudies of any of these product candidates meet the anticipated product profile and the commercial returns appear attractive, we will most likely seek to advance the product candidate into further clinical trials. The decision to develop a product candidate on our own or consider the option to outlicense to a potential partner will be based on, and limited by, our available resources after consideration of a number of factors, including the size of the potential market, with respect to competitors in the potential market, the availability of intellectual property protection, the regulatory pathway, the expected timing and cost of the development program, and the development status of our other product candidates.

On July 20, 2005, our licensing agreement with Prism Pharmaceuticals, Inc., or Prism, relating to PW2101 terminated. Under the terms of the license agreement, we granted Prism an exclusive license under certain of our intellectual property, to develop, make, use and commercialize PW2101 in the United States and Canada for all indications except the treatment and/or prophylaxis of migraine. Prism made a non-refundable $4.0 million payment to us upon signing the license agreement in April 2005, and agreed to pay us milestone payments upon achievement of milestones related to FDA approval and launch of PW2101, and royalties on net sales. Upon receipt, we deferred the $4.0 million received from Prism.

In June 2005, the FDA issued a non approvable letter for our NDA for PW2101. Given the FDA’s concerns expressed in the non approvable letter, the time and resources we expected it would take to address them, and the commercial window for this product opportunity, we decided not to undertake the additional activities on PW2101 that we believed would be required to address the FDA’s concerns. On July 7, 2005, we were notified by Prism that Prism also did not intend to proceed with development activities on PW2101 under the License Agreement. As a result, the License Agreement terminated effective July 20, 2005. In connection with the termination, we signed a settlement agreement with Prism in September 2005, and we repaid Prism $1.75 million of the $4.0 million payment we received from Prism and recognized the remaining $2.25 million as licensing fee revenue in the third quarter of 2005.

Under a collaboration agreement with Mylan Pharmaceuticals Inc., we developed Nifedipine XL, a generic version of Procardia XL based on our TIMERx technology. In March 2000, Mylan announced that it had signed a supply and distribution agreement with Pfizer, Inc. to market Pfizer’s generic version of all three strengths (30 mg, 60 mg, 90 mg) of Procardia XL. In connection with that agreement, Mylan decided not to market Nifedipine XL, and agreed to pay us a royalty on all future net sales of the 30 mg strength of Pfizer’s generic Procardia XL.

We have incurred net losses since 1994. As of September 30, 2005, our accumulated deficit was approximately $136 million. We expect operating losses and negative cash flows to continue until substantial sales of products occur. We generate revenues primarily from royalties from Mylan’s sales of Pfizer’s 30 mg generic version of Procardia. Our future profitability will depend on several factors, including:

•

the successful commercialization of TIMERx controlled release products, including in particular oxymorphone ER;

•

royalties from Mylan’s sales of Pfizer 30 mg generic version of Procardia XL; and

•

the level of our investment in research and development activities.

Our results of operations may fluctuate from quarter to quarter depending on, if and when oxymorphone ER is approved, the amount and timing of royalties on Mylan’s sales of Pfizer’s 30 mg generic version of Procardia XL, the volume and timing of shipments of formulated bulk TIMERx, if any, the variations in payments under our collaborative agreements, including payments upon the achievement of specified milestones, and on the amount and timing of our investment in research and development activities.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our condensed 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 we make 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, 2004.

Results of Operations for the Three and Nine Months Ended September 30, 2005 and 2004


	Three months					Three months		Nine months					Nine months
	ended					ended		ended					ended
	September 30,		Percentage			September 30,		September 30,		Percentage			September 30,
	2005		Increase			2004		2005		(Decrease)			2004
	(in thousands, except percentages)							(in thousands, except percentages)
Royalties and Licensing Fees	$	3,004		149	%	$	1,206	$	5,282		42	%	$	3,733
Product Sales		—		(100	)%		4		—		(100	)%		226

Total Revenues	$	3,004		148	%	$	1,210	$	5,282		33	%	$	3,959

Revenues

Royalties and licensing fees for the three and nine month periods ended September 30, 2005 included $2.25 million in revenue recognized under our license agreement with Prism, which was terminated in the third quarter of 2005, as noted above, and $748,000 and $3.0 million, respectively, of royalties from Mylan on its sales of Pfizer’s 30 mg generic version of Procardia XL. Substantially all of the royalties and licensing fees for the three and nine month periods ended September 30, 2004 were generated from royalties on sales by Mylan. These royalties from Mylan decreased in the three and nine month periods ended September 30, 2005 from the comparable periods for 2004 as a result of a decrease in Mylan’s net sales of Pfizer’s 30 mg generic version of Procardia XL, due primarily to a reduction in sales volume attributable to reduced purchases by a customer.

Our product sales consist of sales of formulated bulk TIMERx to our collaborators. We had no sales of formulated bulk TIMERx in the nine months ended September 30, 2005. TIMERx sold in 2004 was primarily for inclusion in Slofedipine XL, a drug marketed in the U.K. and Italy by Sanofi-Synthelabo S.A., or Sanofi. Although we believe Sanofi is continuing to market Slofedipine XL, we have not sold bulk TIMERx to Sanofi since early 2004, and it is unclear if and when they will resume ordering bulk TIMERx.

Selling, General and Administrative Expense

Selling, general and administrative, or SG&A, expenses for the three and nine month periods ended September 30, 2005 were $2.6 million and $10.3 million, respectively, as compared to $2.3 million and $7.2 million, respectively, for the comparable periods in 2004. SG&A expenses increased $231,000 in the three months ended September 30, 2005 over the comparable period in 2004, primarily due to increased directors’ and professional fees in the 2005 period. The increase of $3.1 million in SG&A expenses for the nine months ended September 30, 2005 compared to the comparable period in 2004 primarily reflects a one-time charge of $3.0 million that arose in connection with the agreement we entered into with Mr. Hamachek, our former Chairman of the Board of Directors and Chief Executive Officer, upon his resignation in February 2005. This one-time charge included a non-cash charge of $2.4 million relating to the accelerated vesting and extension of exercise periods of stock options held by

Mr. Hamachek. SG&A also included increased directors’ fees of approximately $300,000 for the 2005 nine-month period compared with the 2004 nine-month period.

Research and Product Development Expense

Total research and product development expense decreased in the three and nine month periods ended September 30, 2005 as compared to the comparable periods in 2004, as we continued to transition our research and development efforts from late stage products to earlier stage products.


	Three months					Three months		Nine months					Nine months
	ended		Percentage			ended		ended		Percentage			ended
	September 30,		Increase			September 30,		September 30,		Increase			September 30,
	2005		(Decrease)			2004		2005		(Decrease)			2004
	(in thousands, except percentages)							(in thousands, except percentages)
PW2101	$	274		(79	)%	$	1,319	$	2,116		(65	)%	$	6,130
PW2132		74		(61	)%		189		1,173		325	%		276
Phase I Products and Internal Costs		3,168		61	%		1,967		9,472		58	%		5,986
Research and New Technology Development		434		(31	)%		628		1,219		(45	)%		2,222

Total Research and Product Development Expense	$	3,950		(4	)%	$	4,103	$	13,980		(4	)%	$	14,614

In the preceding table, research and development expenses are set forth in the following four categories:

•

PW2101 —These expenses reflect our direct external expenses relating to the development of PW2101. These expenses consist primarily of payments to third parties in connection with clinical trials of PW2101, the manufacturing of PW2101, including our development work related to the qualification of an alternative manufacturing site, and the preparation of the NDA for PW2101.

•

PW2132 —These expenses reflect our direct external expenses relating to the development of PW2132. These expenses consists primarily of payments to third parties in connection with clinical trials of PW2132.

•

Phase I Products and Internal Costs —These expenses reflect both our direct external expenses and our allocated 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 on 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.

•

Research and New Technology Development —These expenses reflect both our direct external expenses and our allocated internal expenses relating to the development of new drug delivery technologies. These direct external expenses consist primarily of payments to third parties in connection with outside laboratory and consulting fees. Our internal expenses primarily include salaries and benefits of our research and new technology development group, and other costs such as depreciation on purchased equipment, and the amortization or any write-downs of patent costs, other than product patent write-offs charged directly to a product development project.

PW2101. Approximately 7% and 15% of our research and development expenses for the three and nine month periods ended September 30, 2005, respectively, related to direct costs primarily associated with clinical development, manufacturing scale-up and preparation of the NDA for PW2101. Our PW2101 expenses were lower than the comparable period in 2004 primarily because our research and development expense in the first nine months of 2004 included costs associated with the pivotal clinical trials of PW2101, and we discontinued development work on PW2101 in the second quarter of 2005. Expenses for the nine month period ended September 30, 2005 included a write-down of $118,000 relating to the impairment of patents covering PW2101 that we determined no longer had value. We do not expect to incur additional research and development expenses with respect to PW2101 in future periods.

PW2132. Approximately 2% and 8% of our research and development expenses for the three and nine months ended September 30, 2005, respectively, related to direct costs primarily associated with the clinical development of PW2132. The expenses for this compound have increased for the nine months ended September 30, 2005 from the comparable period in 2004 as the drug has advanced from Phase I into Phase IIa clinical trials.

Phase I Products and Internal Costs. These costs increased in the three and nine month periods ended September 30, 2005 from the comparable periods in 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 primarily intended for the treatment of diseases of the central nervous system, increased costs associated with an increase in the number of employees engaged in our product development efforts and a write-off of TIMERx inventory in the second quarter of 2005, primarily related to a change in specifications for TIMERx. We continually evaluate the phase I product candidates we are developing and may terminate or accelerate development of product candidates based on study results, product development risk, commercial opportunity, perceived time to market and other factors.

Research and New Technology Development Expenses. These expenses decreased for the three and nine months ended September 30, 2005 from the comparable periods in 2004, primarily due to lower personnel costs associated with redirecting personnel that were previously performing research and new technology development activities, to developing Phase I candidates, as well as a $410,000 write-down recorded in the second quarter of 2004 related to the impairment of certain patents covering our inhalation technology we determined to no longer have value.

There can be no assurance that PW2132 or any of our other products will advance through the clinical development process and 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 process and the uncertainties involved in obtaining governmental approval for commercialization, accurate and meaningful estimates of the ultimate cost to bring our product candidates to market are not available.

Tax Rates

The effective tax rates for the three and nine month periods ended September 30, 2005 were zero, and for the three and nine month periods ended September 30 2004 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 our net operating losses.

Stock Based Compensation

In December 2004, the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 123 (revised 2004), “Share-Based Payment”, which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS 123R supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends SFAS No. 95, “Statement of Cash Flows”. The approach to quantifying stock-based compensation expense in SFAS 123R is similar to SFAS 123. However, the revised statement requires all share-based payments to employees, including grants of employee stock options as well as compensatory employee stock purchase plans, to be recognized as an expense in the statement of operations based on their fair values as they are earned by the employees under the vesting terms. Pro forma disclosure of stock-based compensation expense, as is the Company’s practice under SFAS 123, will not be permitted after 2005, since SFAS 123R must be adopted no later than the first annual period beginning after June 15, 2005. As a result, the Company will adopt SFAS 123R effective January 1, 2006.

depend on levels of share-based compensation granted in the future and the fair values assigned thereto. Although the Company has not determined whether the adoption of SFAS 123R will result in amounts that are similar to the current pro forma disclosures under SFAS 123 (see Note 3 to our Condensed Financial Statements included in this Quarterly Report), the Company is evaluating the requirements under SFAS 123R including the valuation methods and support for the assumptions that underlie the valuation of the awards, as well as the transition methods (modified prospective transition method or the modified retrospective transition method) and expects the adoption to have a significant impact on the Company’s statements of operations and net loss per share.

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 from the proceeds from the sale and issuance of shares of common stock, the sale of our excipient business, the sale of excipients, sales of formulated bulk TIMERx, royalties and milestone payments from Mylan and other collaborators, and advances under credit facilities. As of September 30, 2005, we had cash, cash equivalents and short-term investments of $61.3 million. We have no committed sources of capital.

We are a party to an agreement with Endo with respect to the development and commercialization of oxymorphone ER. On April 17, 2003, we discontinued our participation in the funding of the development and pre-launch marketing of oxymorphone ER. We did not incur any expenses relating to oxymorphone ER in the three and nine month periods ended September 30, 2005, and we do not expect to incur any significant expenses relating to oxymorphone ER in 2005, 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 and pre-launch marketing 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 August 31, 2005, these unfunded costs approximated $19.7 million. We expect these costs to increase for the additional costs of the pivotal trials which Endo completed in October 2005, and as Endo prepares its complete response to the FDA’s NDA approvable letter and incurs pre-launch marketing costs.

Cash Flows

We had negative cash flow from operations for the nine months ended September 30, 2005 of $14.0 million, primarily due to a net loss of $17.6 million in the period, which included depreciation and amortization of $1.1 million and a non-cash charge of $2.4 million relating to the accelerated vesting and extension of exercise periods of stock options held by Mr. Hamachek in connection with his resignation in February 2005. Investing activities provided $23.9 million in cash for the nine months ended September 30, 2005, primarily reflecting sales and maturities of marketable securities, net of purchases, of $24.4 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.

Funding Requirements

We anticipate that, based on our current operating plan and excluding any potential revenues from oxymorphone ER, our existing capital resources and anticipated internally generated funds from royalties from Mylan will be sufficient to fund our operations on an ongoing basis without requiring us to seek external financing through 2007. We expect to continue to invest in capital expenditures during the remainder of 2005 at levels similar to capital spending for the nine months ended September 30, 2005, primarily for laboratory equipment for our drug development activities and for patents on technology and products developed by us.

Our requirements for capital in our business are substantial and will depend on many factors, including:

•

whether oxymorphone ER is approved on a timely basis, or at all;

•

the costs and timing of adding product candidates or technologies;

•

whether we resume our participation in the funding of the development and marketing of oxymorphone ER;

•

the timing and amount of payments received under collaborative agreements, including in particular with respect to oxymorphone ER;

•

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;

•

royalties received from Mylan; and

•

the prosecution, defense and enforcement of potential patent claims and other intellectual property rights.

If we determine to resume our participation in the funding of oxymorphone ER, or to acquire additional product candidates or technologies, we may need to seek additional funding through collaborative agreements or research and development arrangements, or through public or private financings of equity or debt securities.

We plan to meet our long-term cash requirements through our existing cash balance, revenues from collaborative agreements, as well as financings. On July 27, 2005, we filed a registration statement on Form S-3 with the SEC, which became effective on August 17, 2005. This shelf registration statement covers the issuance and sale by us, of any combination of common stock, preferred stock, debt securities and warrants having an aggregate purchase price of up to $75 million.

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 relating to clinical development and capital expenditures. Below is a table summarizing our contractual cash obligations under our operating leases having initial lease terms of more than one year and our purchase obligations, as of September 30, 2005 (in thousands):


			Less than		1-3		4-5		After 5
	Total		One Year		Years		Years		Years
Operating Leases	$	694	$	573	$	121	$	—	$	—
Purchase Obligations		2,444		2,419		25		—		—


Total	$	3,138	$	2,992	$	146	$	—	$	—

We are also subject to the commitments described below that are not included in the table above.

We have a Supplemental Executive Retirement Plan, or SERP, a nonqualified plan which covers our former Chairman and Chief Executive Officer, Tod R. Hamachek. Under the SERP, effective in May 2005, we became obligated to pay Mr. Hamachek approximately $12,600 per month over the lives of Mr. Hamachek and his spouse.

We also have a Deferred Compensation Plan, or DCP, a nonqualified plan which covers Mr. Hamachek. Under the DCP, effective in May 2005 we became obligated to pay Mr. Hamachek approximately $140,000 per year, including interest, in ten annual installments.

We expect the following benefit payments, including interest for the DCP, to be made under the SERP and DCP over the next ten years, as of September 30, 2005 (in thousands):


	SERP		DCP		Total
Year 1	$	151	$	140	$	291
Year 2		151		140		291
Year 3		151		140		291
Year 4		151		140		291
Year 5		151		140		291
Years 6-10		756		560		1,316

We do not fund these liabilities and no assets are held by the 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 the SERP and DCP liabilities. We are entitled to borrow against these policies to fund these liabilities as provided by the terms of the trust. The cash surrender value of these polices totaled approximately $3.1 million as of September 30, 2005 and December 31, 2004.

Net Operating Loss Carryforwards

We estimate that as of September 30, 2005, we had federal net operating loss, or NOL, carryforwards of approximately $111 million for income tax purposes, which expire beginning in 2018 through 2025. The use of the NOLs are limited to our future taxable earnings. Utilization of the operating losses is subject to limitation due to the ownership change provisions of the Internal Revenue Code.

Forward-Looking Statements

This quarterly report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or incorporated in this report regarding our strategy, future operations, financial position, future revenues, projected costs, prospects, plans and objectives of management are forward-looking statements. The words “believes,” “anticipates,” “estimates,” “plans,” “expects,” “intends,” “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, and you should carefully consider the risks and uncertainties described below in addition to the other information included or incorporated by reference in this quarterly report. If any of the following risks actually occurs, our business, financial condition or results of operations would likely suffer, possibly materially. In that case, the trading price of our common stock could fall.

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

We have incurred net losses since 1994, including net losses of $23.8 million, $15.9 million and $17.1 million during 2004, 2003 and 2002, respectively. For the nine months ended September 30, 2005, we incurred a net loss of

$17.6 million. We had losses from continuing operations of $23.8 million, $26.0 million and $19.0 million in 2004, 2003 and 2002, respectively. As of September 30, 2005, our accumulated deficit was approximately $136 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 and conduct development of, and seek regulatory approvals for, products utilizing TIMERx technology and other drug delivery technologies, until substantial sales of products commercialized utilizing our TIMERx technology and other drug delivery technologies 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 had been generated from the sales of our pharmaceutical excipients. Our net losses in 2003 and 2002 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 and will depend exclusively on revenue, under our agreement with Mylan and from products developed or acquired by us.

Our future profitability will depend on several factors, including:

	•		the successful commercialization of TIMERx controlled release products, including in particular oxymorphone ER;

	•		royalties from Mylan’s sale of Pfizer’s 30 mg generic version of Procardia XL; 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, 2005, we had cash, cash equivalents and short-term investments of $61.3 million. We anticipate that, based on our current operating plan and excluding any potential revenues from oxymorphone ER, our existing capital resources and anticipated internally generated funds from royalties from Mylan will be sufficient to fund our operations on an ongoing basis without requiring us to seek external financing through 2007.

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

	•		whether oxymorphone ER is approved on a timely basis, or at all;

	•		the costs and timing of adding additional products or technologies;

	•		whether we resume our participation in the funding of the development and marketing of oxymorphone ER;

	•		the timing and amount of payments received under collaborative agreements, including in particular with respect to oxymorphone ER;

	•		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;

	•		royalties received from Mylan; and

	•		the prosecution, defense and enforcement of potential patent claims and other intellectual property rights.

Subject to these factors, we may need to sell additional equity or debt securities or seek additional financing through other arrangements to fund operations beyond 2007. In addition, if we determine to resume our participation in the funding of oxymorphone ER or to acquire additional products or technologies, we also may 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. 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 products.

	•		Our collaborators may terminate their collaborations with us. This could make it difficult for us to attract new collaborators or adversely affect perception of us in the business and financial communities.

	•		Our collaborators may pursue higher priority programs or change the focus of their development programs, which could affect the collaborator’s commitment to us. Pharmaceutical and biotechnology companies

historically have re-evaluated their priorities from time to time, including following mergers and consolidations, which have been common in recent years in these industries.

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

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, Avinza marketed by Ligand and Kadian marketed by Alpharma.

Some of the TIMERx products we are developing 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.

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 require us or our collaborators, to conduct additional clinical trials. For example, in response to the NDA for oxymorphone ER, the FDA is requiring Endo to conduct an additional clinical trial of oxymorphone ER. In addition, in order to address the concerns expressed in the non-approvable letter that we received from the FDA in June 2005, we believe we would have been required to conduct additional trials if we had chosen to continue the development of PW2101. Alternatively, regulators may require post marketing testing and surveillance to monitor the safety and efficacy of a product.

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.

Oxymorphone ER contains a narcotic ingredient. As a result of reports of misuse or abuse of prescription narcotics, the sale of oxymorphone ER may be subject to new regulations, including the development and implementation of risk management programs which may prove difficult or expensive to comply with, and we and Endo may face lawsuits.

Oxymorphone ER contains a narcotic ingredient. Misuse or abuse of such drugs can lead to physical or other harm. Specifically, in the past two years, reportedly widespread misuse or abuse of OxyContin®, a product containing the narcotic oxycodone, resulted in the strengthening of warnings on its labeling, and in

the sponsor of OxyContin® facing numerous lawsuits, including class action lawsuits, related to OxyContin® misuse or abuse. Misuse or abuse of oxymorphine ER could lead to additional regulations of oxymorphine ER, or subject us and Endo to litigation.

On July 13, 2005, the FDA asked Purdue Frederick to withdraw its product Palladone (hydromorphone hydrochloride extended-release capsules) from the market after acquiring new information that serious and potentially fatal adverse reactions can occur when the product is taken together with alcohol. The data, gathered from a study testing the potential effects of alcohol use, showed that when Palladone is taken with alcohol, the extended-release mechanism is harmed, which can lead to dose-dumping. Dose-dumping is a term that describes the rapid release of the active ingredient from an extended-release product into the blood stream, resulting in serious, even fatal, adverse events in some patients. Oxymorphone ER is not comprised of a formulation similar to Purdue’s Palladone. However, we cannot predict what, if any, new regulations or restrictions may result from the FDA’s concerns with dose-dumping, and what effect such regulations or restrictions would have on obtaining regulatory approval of oxymorphine ER, or on the commercial success of oxymorphine ER.

We are subject to extensive government regulation including the requirement of approval before our products may be marketed. Even if we obtain marketing approval, our products will be subject to ongoing regulatory review.

We, our collaborators, our products, and our product candidates are subject to extensive regulation by governmental authorities in the United States and other countries. Failure to comply with applicable requirements could result in warning letters; fines and other civil penalties; delays in approving or refusal to approve a product candidate; product recall or seizure; withdrawal of product approvals; interruption of manufacturing or clinical trials; operating restrictions; injunctions; and criminal prosecution.

Our products cannot be marketed in the United States without FDA approval. Obtaining FDA approval requires substantial time, effort, and financial resources, and there can be no assurance that any approval will be granted on a timely basis, if at all. We have had only limited experience in preparing applications and obtaining regulatory approvals. If the FDA does not approve our product candidates in a timely fashion, or does not approve them at all, our business and financial condition may be adversely affected. 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 our or our collaborator’s products. Subsequent discovery of problems with an approved product may result in restrictions on the product or its withdrawal from the market.

In addition, both before and after regulatory approval, we, our collaborators, our products, and our product candidates are subject to numerous FDA requirements covering testing, manufacturing, quality control, current good manufacturing practices (cGMP), adverse event reporting, labeling, advertising, promotion, distribution, and export. We and our collaborators are subject to surveillance and periodic inspections to ascertain compliance with these regulations. Further, the relevant law and regulations may change in ways that could affect us, our collaborators, our products, and our product candidates. Failure to comply with regulatory requirements could have a material adverse impact on our business.

We are developing oxymorphone ER under a collaboration agreement with Endo. Endo, which is responsible for conducting the clinical trials and seeking regulatory approval of the product, submitted an NDA for oxymorphone ER to the FDA in December 2002. In October 2003, Endo received an approvable letter for oxymorphone ER. In the letter, the FDA requested that Endo address certain questions, provide additional clarification and information, and conduct some form of additional clinical trials to further confirm the safety and efficacy of oxymorphone ER before the FDA would approve Endo’s NDA for oxymorphone ER. In discussions with Endo, the FDA advised Endo of its concern that the outcome of two of the phase III efficacy trials submitted in the NDA that met their predefined primary end-points may have been favorably biased by the statistical handling of data from patients who did not complete the trials. In November 2004, Endo announced that the FDA had granted final approval of the protocol under the FDA’s SPA process for a clinical trial in patients with chronic low back pain and without recent treatment with opioid analgesics, designed to provide additional safety and efficacy data for oxymorphone ER requested by the FDA. The clinical trial is also intended to address the FDA’s concern regarding data from patients who did not complete the trial. In August 2005, Endo reported that the results of this study demonstrated statistically significant (p<0.0001) difference in pain scores between oxymorphone ER and placebo during a 12-week treatment period, during which the drug was administered twice daily. The primary endpoint was a change in average pain intensity as measured on the Visual Analog Scale (VAS), from baseline. This study will supplement a previously submitted

trial that Endo believes the FDA has already accepted as demonstrating efficacy in the intended patient population. Endo has also reported that Endo expects to submit a complete response letter to the FDA’s NDA approvable letter in early 2006. 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, 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. 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) NDA’s 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.

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 any of our products 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 our 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 2006, and on other third party manufacturers for the products that are currently under development. 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 currently in discussions with Draxis to extend this agreement. We are not a party to any agreements with our third party manufacturers for the products that we are currently evaluating in clinical trials, except for purchase orders or similar arrangements.

We believe that there are a limited number of manufacturers that operate under cGMP regulations capable of manufacturing our TIMERx materials and the products we are evaluating in clinical trials. Although we have qualified alternate suppliers with respect to the xanthan and locust bean gums used to manufacture our TIMERx material, if Draxis is unable to manufacture the TIMERx material in the required quantities, on a timely basis or at all, or if Draxis will not agree to renew our agreement when it expires on acceptable terms to us or at all, we may be unable to obtain alternative contract manufacturing, or obtain such manufacturing on commercially reasonable terms. In addition, if we are unable to enter into longer-term manufacturing arrangements for our products on acceptable terms to us or at all, particularly as these products advance through clinical development and move closer to regulatory approval, our business and the clinical development and commercialization of our products could be materially adversely effected. There can be no assurance that Draxis or any other third parties upon which we rely for supply of our TIMERx material or our products in clinical development will perform, and any failures by third parties may delay development or the submission of products for regulatory approval, impair our collaborators’ ability to commercialize products as planned and deliver products on a timely basis, require us or our collaborators to cease distribution or recall some or all batches of our products or otherwise impair our competitive position, which could have a material adverse effect on our business, financial condition and results of operations.

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

	•		our collaborators may not be able to meet commercial demands for our products on a timely basis;

	•		our collaborators may not be able to initiate or continue clinical trials of products that are under development; and

	•		our collaborators may be delayed in submitting applications for regulatory approvals of our products.

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, gastroretentive, 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 access to managed care or government formularies is restricted or denied, or 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 $15 million per occurrence and $15 million annually in the aggregate on a claims-made basis, and by excess product liability insurance in the amount of $10 million. 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 certain restrictions on maturities and concentration by issuer. At September 30, 2005, marketable securities consisted primarily of corporate debt, U.S. Government-agency backed discounted notes and municipal securities, and approximated $36.1 million. Marketable securities include auction rate securities totaling $1.6 million with contractual maturity dates of up to four months. Liquidity in these instruments is provided from third parties (buyers and sellers in an auction system) generally every one to three months at which time their interest rates, or dividend rates for preferred securities, are reset. All of our other marketable securities have maturity dates of up to seventeen months. Due to the relatively short-term maturities of these securities, or auction system liquidity in the case of the auction rate securities, management believes there is no significant market risk. At September 30, 2005, market values approximated carrying values. At September 30, 2005, we had approximately $61.3 million in cash, cash equivalents and investments in marketable securities, and accordingly, a sustained decrease in the rate of interest earned of 1% would cause a decrease in the annual amount of interest earned of up to approximately $613,000.

Item 4.Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures.Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2005. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of September 30, 2005, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.

(b) Changes in Internal Control Over Financial Reporting.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, 2005 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.

- 32 -

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 7, 2005		/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 Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

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

Penwest Pharmaceuticals (PPCO) Inactive 10-Q2005 Q3 Quarterly report

Content analysis

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

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

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