PENWEST PHARMACEUTICALS CO - 10-Q Quarterly Report

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

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

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

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

Prior to February 27, 2003, Penwest also developed, manufactured and distributed branded pharmaceutical excipients, which are the inactive ingredients in tablets and capsules, primarily consisting of binders, disintegrants and lubricants. On February 27, 2003, Penwest sold substantially all of the assets used in the Company’s excipient business (the “Asset Sale”) to subsidiaries and affiliates of Josef Rettenmaier Holding GmbH & Co. KG. The Company received $39.5 million in cash and a promissory note for $2.25 million in consideration for the excipient business. The Company intends to use the proceeds of the sale of its excipient business to expand its drug delivery business. In the first quarter of 2003, the Company reported the operating results of the excipient business as a discontinued operation (see Note 8).

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

The Company is subject to the risks and uncertainties associated with a drug delivery company actively engaged in research and development. These risks and uncertainties include, but are not limited to, a history of net losses, a requirement for additional funding, technological changes, dependence on collaborators and key personnel, the successful completion of development efforts and of obtaining regulatory approval, the successful commercialization of TIMERx controlled release products, compliance with government regulations, patent infringement litigation and competition from current and potential competitors, some with greater resources than the Company.

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

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

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

As a result of the Asset Sale, the operating results of the excipient business have been presented as discontinued operations in the condensed consolidated statements of operations for the quarters ended

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

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

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

At March 31, 2003, the Company maintained two stock-based employee compensation plans. The Company accounts for these employee stock compensation plans in accordance with the intrinsic value-based method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” No stock-based employee compensation expense is reflected in net loss as all options granted under these plans had an exercise price equal to the fair market value of the underlying common stock on the date of grant.

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

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

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

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

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

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

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

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

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

On September 24, 2002, the Company entered into a Premium Finance Agreement (a “Finance Agreement”) through which it financed approximated $1.1 million of premiums payable in connection with the annual renewal of its general business insurance. Under the Finance Agreement, Penwest is required to repay the amount financed in equal monthly installments through June 2003, plus interest at a rate of 3.11% per annum. In addition, the Company assigned, as a security interest, any and all unearned premiums or other amounts which may become payable to the Company under the insurance policies.

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

The gain on sale of discontinued operations of approximately $9.6 million, recorded in the quarter ended March 31, 2003, is net of tax expense of $62,000, or less than 1% of the pretax gain. The tax expense is lower than the federal statutory rate of 34% primarily due to net operating losses which offset the gain. In addition, earnings from discontinued operations of $177,000 and $501,000, respectively, for the quarters ended March 31, 2003 and March 31, 2002, are net of tax expenses of $26,000 and $141,000, respectively, or 13% and 22% of pretax earnings, respectively. These tax expenses, which include foreign taxes, are lower than the federal statutory rate of 34% primarily due to overall U.S. net operating losses which offset the U.S. earnings of the discontinued operation (see Note 8).

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

Accumulated other comprehensive income (loss) equals the cumulative translation adjustment and unrealized net gains on marketable securities which are the only components of other comprehensive loss included in the Company’s financial statements. Effective on the date of the Asset Sale, accumulated other comprehensive income (loss) is comprised solely of unrealized net gains and losses on marketable securities.

On February 27, 2003, Penwest sold substantially all of the assets (the “Assets”) used in the Company’s excipient business to subsidiaries and affiliates of Josef Rettenmaier Holding GmbH & Co. KG (“Rettenmaier”) for $41.75 million, plus the assumption of specified liabilities, subject to a working capital adjustment which is not yet finalized, but is not expected to be material. The Assets of the excipient business were sold to Rettenmaier, either directly or through the sale of the outstanding capital stock of the three subsidiaries of Penwest that did business in the UK, Germany and Finland. The purchase price included $39.5 million in cash and a non-interest bearing promissory note of $2.25 million, with $1.0 million due April 25, 2003 and $1.25 million due May 25, 2004.

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

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

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

In September 1997, the Company entered into a strategic alliance agreement with Endo Pharmaceuticals, Inc. with respect to the development of an extended release formulation of oxymorphone a narcotic analgesic for the treatment of moderate to severe pain based on the Company’s TIMERx technology. This agreement was amended and restated in April 2002. Endo is a fully integrated specialty pharmaceutical company with a market leadership in pain management. Endo has a broad product line including 20 branded products that include the established brands such as Percodan®, Percocet®, and Lidoderm®. Endo is registered with the U.S. Drug Enforcement Administration as a developer, manufacturer and marketer of controlled narcotic substances.

Under the strategic alliance agreement, the responsibilities of the Company and Endo with respect to the oxymorphone product are determined by a committee comprised of an equal number of members from each of the Company and Endo (the “Alliance Committee”). During the development of the product, the Company formulated oxymorphone ER and Endo conducted all clinical studies and prepared and filed all regulatory applications. The Company has agreed to manufacture and supply TIMERx material to Endo, and Endo has agreed to manufacture and market oxymorphone ER in the United States. The manufacture and marketing outside of the United States may be conducted by the Company, Endo or a third party, as determined by the Alliance Committee.

Prior to March 17, 2003, the Company and Endo shared the costs involved in the development of oxymorphone ER. On March 17, 2003, the Company gave Endo notice that it was discontinuing its participation in the funding of the development and marketing of oxymorphone ER effective April 17, 2003. The Company believes that its current strategic focus should be on funding products in its development pipeline. As a result of this termination, Endo has the right to complete the development of oxymorphone ER and recoup the portion of development costs incurred by Endo that otherwise would have been funded by Penwest. Endo may recoup such development costs solely through a temporary adjustment in the royalty rate payable to Penwest which shall return to its pre-adjustment level once Endo has recovered such costs. The parties have agreed that the party marketing oxymorphone ER will pay the other party royalties initially equal to 50% of the net realization (as defined in the agreement). This percentage will decrease if the aggregate U.S. net realization exceeds pre-determined thresholds. In general, the royalty payable by the marketing party to the other party will not drop below 40%. However, the royalty will be reduced by one-third in limited circumstances, including termination of the agreement based on uncured material breaches of the agreement by the royalty receiving party and certain bankruptcy and insolvency events involving the royalty receiving party. Under the agreement, Endo will purchase formulated TIMERx material for use in oxymorphone ER exclusively from the Company at specified prices, such prices will be reflected in the determination of net profits.

On March 2, 2000, Mylan announced that it had signed a supply and distribution agreement with Pfizer to market a generic version of all three strengths (30 mg, 60 mg, 90 mg) of Pfizer’s Procardia XL. In connection with that agreement, Mylan decided not to market Nifedipine XL and agreed to pay Penwest a royalty on all future net sales of the 30 mg strength of Pfizer’s generic Procardia XL. The royalty percentage was comparable to the percentage called for in Penwest’s original agreement with Mylan for Nifedipine XL. Mylan has retained the marketing rights to the 30 mg strength of Nifedipine XL. Mylan’s sales in the United States in 2002 of the 30 mg dosage strength version of Pfizer’s generic Procardia XL totaled approximately $34.9 million. The term of this agreement continues until such time as Mylan permanently ceases to market generic Procardia XL.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements which involve risks and uncertainties. The Company’s actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those described below under “Risk Factors.”

Penwest develops pharmaceutical products based on innovative oral drug delivery technologies. The foundation of Penwest’s technology platform is TIMERx, an extended release delivery system that is adaptable to soluble and insoluble drugs, and that is flexible for a variety of controlled release profiles. The Company has also developed two additional oral drug delivery systems, Geminex and SyncroDose. Geminex is a dual drug delivery system that is designed to provide independent release of different active ingredients contained in a drug, and SyncroDose is a chronotherapeutic drug delivery system that is designed to release the active ingredient of a drug at the desired site and time in the body.

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

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

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

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

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

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

The Company’s discussion and analysis of its financial condition and results of operations are based upon its condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The Company’s significant accounting policies are more fully described in the notes to the consolidated financial statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. These policies are important to the portrayal of the Company’s financial condition and results of operations. The preparation of these financial statements requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Areas where significant judgments are made include, but are not limited to, revenue recognition, deferred taxes-valuation allowance and impairment of long-lived assets. Actual results could differ materially from these estimates. For a more detailed explanation of the judgments made in these areas, refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2002.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


	•	the ongoing costs under the Company’s collaboration agreements;

	•	the structure of any future collaborative or development agreements;

	•	the progress of the Company’s collaborative and independent development projects and funding obligations with respect to the projects;

	•	the costs to the Company of clinical studies for its products;

	•	the costs and timing of adding drug development capabilities;

	•	royalties received from Mylan;

	•	royalties from sales of TIMERx products;


	•	the timing and amount of payments received under existing and possible future collaborative agreements; and

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

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


	•	significantly curtail its product commercialization efforts, including terminating existing collaborative agreements;

	•	obtain funds through one or more arrangements with collaborators or others on adverse terms to Penwest that may require Penwest to relinquish rights to certain of its technologies, product candidates, or products which Penwest would otherwise pursue on its own or that would significantly dilute the Company’s stockholders;

	•	significantly scale back or terminate operations; and/or

	•	seek relief under the applicable bankruptcy laws.

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

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

This annual report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or incorporated in this report regarding our strategy, future operations, financial position, future revenues, projected costs, prospects, plans and objectives of management are forward-looking statements. The words “believes,” “anticipates,” “estimates,” “plans,” “expects,” “intends,”

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

There are a number of important factors that could cause our actual results to differ materially from those indicated or implied by forward-looking statements. We believe that the material factors that we discuss below could cause or contribute to such material differences.

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

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

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


	•	the successful commercialization of TIMERx controlled release products, including in particular oxymorphone ER, a narcotic analgesic for the treatment of moderate to severe pain, being developed with Endo;

	•	our ability to use the net proceeds from the sale of our excipient business to expand our drug development and delivery business;

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

	•	the level of investment in research and development activities.

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

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

Many of our TIMERx controlled release products have been or are being developed and commercialized in collaboration with pharmaceutical companies. Under these collaborations, depending on the structure of the collaboration, we are dependent on our collaborators to fund some portion of development, to conduct full-scale bioequivalence studies and clinical trials, obtain regulatory approvals for, and manufacture, market and sell products utilizing our TIMERx controlled release technology. For instance, we are dependent on Endo to obtain the regulatory approvals required to market oxymorphone ER and will be dependent on Endo to

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

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

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

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

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


	•	our collaborators may be pursuing alternative technologies or developing alternative products, either on their own or in collaboration with others, that may be competitive with the product as to which they are collaborating with us, which could affect our collaborator’s commitment to the collaboration with us;

	•	reductions in marketing or sales efforts or a discontinuation of marketing or sales of our products by our collaborators would reduce our revenues, which may be based on a percentage of net sales by the collaborator;

	•	our collaborators may terminate their collaborations with us, which could make it difficult for us to attract new collaborators or adversely affect our perception in the business and financial communities; and

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

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

Our TIMERx business faces competition from numerous public and private companies and their controlled release technologies, including Johnson & Johnson’s oral osmotic pump (OROS®) technology, multiparticulate systems marketed by Elan and Biovail, traditional matrix systems marketed by SkyePharma, plc and other controlled release technologies marketed or under development by Andrx Corporation, among others.

Our TIMERx products in development will face competition from products with the same indication as the TIMERx products being developed by Penwest. For instance, we expect extended release oxymorphone ER will face competition from Purdue Pharma’s OxyContin®.

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

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.

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

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

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

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

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


	•	the structure of any future collaborative or development agreements;

	•	the progress of our collaborative and independent development projects and funding obligations with respect to the projects;

	•	the costs to us of clinical studies for our products;

	•	the costs and timing of adding drug development capabilities;

	•	royalties received from Mylan;

	•	royalties from sales of TIMERx products;

	•	the timing and amount of payments received under existing and possible future collaborative agreements; and

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

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

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

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

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

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

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

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

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

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


	•	we or our collaborators are unable to complete a clinical trial of one of our potential products;

	•	the results of any clinical trial are unfavorable; or

	•	the time or cost of completing the trial exceeds our expectations.

We are not able to market any of our products in the United States, Europe or in any other jurisdiction without marketing approval from the United States Food and Drug Administration, or FDA, the European Agency for the Evaluation of Medicinal Products, or an equivalent foreign regulatory agency. The regulatory process to obtain market approval for a new drug takes many years and requires the expenditure of substantial resources. We have had only limited experience in preparing applications and obtaining regulatory approvals.

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


	•	Cystrin CR was approved in Finland in 1997;

	•	Slofedipine XL was approved in the United Kingdom in 1998 and in Italy in 2001;

	•	The 30 mg strength of Nifedipine XL was approved by the FDA in December 1999; and

	•	Cronodipin was approved in Brazil in 2001.

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

We may encounter delays or rejections during any stage of the regulatory approval process based upon the failure of clinical data to demonstrate compliance with, or upon the failure of the product to meet, the FDA’s

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

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

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

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

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

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

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

We expect that our collaborators will file ANDAs for our controlled release products that are generic versions of branded controlled release products that are covered by one or more patents. It is likely that the owners of the patents covering the brand name product or the sponsors of the NDA with respect to the branded product will sue or undertake regulatory initiatives to preserve marketing exclusivity, as Pfizer did with respect to our generic version of Procardia XL that we developed with Mylan. Any significant delay in obtaining FDA approval to market our product candidates as a result of litigation, as well as the expense of such litigation, whether or not we or our collaborators are successful, could have a material adverse effect on our business, financial condition and results of operations.

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

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


	•	the timing of the receipt of marketing approvals and the countries in which such approvals are obtained;

	•	the safety and efficacy of the product as compared to competitive products; and

	•	the cost-effectiveness of the product and the ability to receive third party reimbursement.

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

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

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

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

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


	•	We or our collaborators may initiate litigation or other proceedings against third parties to enforce our patent rights.

	•	We or our collaborators may initiate litigation or other proceedings against third parties to seek to invalidate the patents held by such third parties or to obtain a judgment that our products or processes do not infringe such third parties’ patents.

	•	If our competitors file patent applications that claim technology also claimed by us, we or our collaborators may participate in interference or opposition proceedings to determine the priority of invention.

	•	If third parties initiate litigation claiming that our processes or products infringe their patent or other intellectual property rights, we and our collaborators will need to defend against such proceedings.

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

The cost of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. Although the legal costs of defending litigation relating to a patent infringement claim are generally the contractual responsibility of our collaborators (unless such claim relates to TIMERx in which case such costs are our responsibility), we could nonetheless incur significant unreimbursed costs in participating and assisting in the litigation. Some of our competitors may be able to sustain the cost of such litigation and proceedings more effectively than we can because of their substantially greater resources. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to complete in the marketplace. Patent litigation and other proceedings may also absorb significant management time.

We lack commercial scale facilities to manufacture our TIMERx material or any products we may develop in accordance with current GMP requirements prescribed by the FDA. We currently rely on Draxis Pharma, Inc. for the bulk manufacture of our TIMERx material for delivery to our collaborators under a contract that expires in September 2004. The agreement shall be automatically renewed for successive one-year periods, unless either party gives notice of its intent not to renew the contract, at least six months prior to the end of the then-current term.

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

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.

Our drug delivery systems are based a hydrophilic matrix combining a heterodispersed mixture primarily composed of two polysaccharides, xanthan and locust bean gums, in the presence of dextrose. These gums are also used in our Geminex and SyncroDose drug delivery systems. We purchase these gums from a sole source supplier. We have qualified alternate suppliers with respect to such materials, but we can provide no assurance that interruptions in supplies will not occur in the future or that we will not have to obtain substitute suppliers. Any interruption in these supplies could have a material adverse effect on our ability to manufacture bulk TIMERx for delivery to our collaborators.

The availability of reimbursement by governmental and other third party payors affects the market for any pharmaceutical product. These third party payors continually attempt to contain or reduce the costs of health care by challenging the prices charged for medical products and services. In certain foreign countries, particularly the countries of the European Union, the pricing of prescription pharmaceuticals is subject to governmental control.

The generic versions of controlled release products being developed by us and our collaborators may be assigned an AB rating if the FDA considers the product to be therapeutically equivalent to the branded controlled release drug. Failure to obtain an AB rating from the FDA would indicate that for certain purposes the drug would not be deemed to be therapeutically equivalent, would not be fully substitutable for the branded controlled release drug and would not be relied upon by Medicaid and Medicare formularies for reimbursement.

In both the U.S. and certain foreign jurisdictions, there have been a number of legislative and regulatory proposals to change the health care system. Further proposals are likely. The potential for adoption of these proposals may affect our ability to raise capital, obtain additional collaborative partners and market our products.

If we or our collaborators obtain marketing approvals for our products, we expect to experience pricing pressure due to the trend toward managed health care, the increasing influence of health maintenance organizations and additional legislative proposals. We may not be able to sell our products profitably if reimbursement is unavailable or limited in scope or amount.

Our business exposes us to potential product liability risks which are inherent in the testing, manufacturing, marketing and sale of pharmaceutical products. Product liability claims might be made by consumers, health care providers, pharmaceutical companies, or others that sell our products. These claims may be made even with respect to those products that are manufactured in licensed and regulated facilities or that otherwise possess regulatory approval for commercial sale.

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

The market price of our common stock, 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.

Market risk is the risk of loss to future earnings, to fair values or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, foreign currency exchange rates and other market changes. Market risk is attributed to all market sensitive financial instruments, including debt instruments. The operations of the Company are exposed to financial market risks, primarily changes in interest rates. The Company’s interest rate risk primarily relates to its investments in marketable securities.

The primary objectives for the Company’s investment portfolio are liquidity and safety of principal. Investments are made to achieve the highest rate of return to the Company, consistent with these two objectives. The Company’s investment policy limits investments to certain types of instruments issued by institutions with investment grade credit ratings and places restrictions on maturities and concentration by issuer. Marketable securities primarily consist of corporate debt, certificates of deposit and U.S. Government Agency-backed notes, and approximated $9.1 million at March 31, 2003. These securities have contractual maturity dates of up to eleven months. Due to the relatively short-term maturities of these securities, management believes there is no significant market risk. At March 31, 2003, market values approximated carrying values. At March 31, 2003, the Company had approximately $30.3 million in cash, cash equivalents and investments in marketable securities, and accordingly, a sustained decrease in the rate of interest earned of 1% would cause a decrease in the annual amount of interest earned of up to approximately $303,000.

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

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

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

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.

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

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.


	PENWEST PHARMACEUTICALS CO.

	/s/ JENNIFER L. GOOD

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

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

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

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

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


	a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date

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


	a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

	b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

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


	/s/ TOD R. HAMACHEK

	Tod R. Hamachek
	Chairman of the Board and Chief Executive Officer (Principal Executive Officer)

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


	a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date


	a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

	b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


	/s/ JENNIFER L. GOOD

	Jennifer L. Good
	Sr. Vice President, Finance and Chief Financial Officer (Principal Financial Officer)


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

		For the quarterly period ended March 31, 2003

or

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

		For the transition period from to


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

39 Old Ridgebury Road, Suite 11, Danbury, CT (Address of principal executive offices)		06810-5120 (Zip Code)


Class	Outstanding

Common stock, par value $.001		15,546,464


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


		Page

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

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				March 31,			December 31,
				2003			2002

				(Unaudited)			(Note 2)

				(In thousands,
				except share amounts)
ASSETS
Current assets:
	Cash and cash equivalents			$	21,163		$	1,629
	Marketable securities				9,136			2,057
	Trade accounts receivable				969			1,078
	Inventories:
		Raw materials and other			366			149
		Finished goods			248			312

					614			461
	Prepaid expenses and other current assets				1,951			1,902
	Deferred transaction costs				—			1,741
	Note receivable				1,000			—
	Assets held for sale				—			33,143

		Total current assets			34,833			42,011
Fixed assets, net					2,404			2,406
Intangible assets, net					3,133			2,947
Other assets					4,145			2,856

		Total assets		$	44,515		$	50,220

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
	Accounts payable			$	896		$	880
	Accrued expenses				1,490			2,886
	Accrued development costs				1,729			2,785
	Taxes payable				318			258
	Loans and notes payable				255			5,693
	Deferred revenue				—			150
	Liabilities held for sale				—			3,004

		Total current liabilities			4,688			15,656
Deferred income taxes					118			118
Deferred revenue					128			134
Deferred compensation					2,942			2,889

		Total liabilities			7,876			18,797
Shareholders’ equity:
		Preferred stock, par value $.001, authorized 1,000,000 shares, none outstanding			—			—
		Common stock, par value $.001, authorized 39,000,000 shares, issued and outstanding 15,527,463 shares at March 31, 2003 and 15,506,259 shares at December 31, 2002			16			16
		Additional paid in capital			110,137			110,000
		Accumulated deficit			(73,529	)		(78,025	)
		Accumulated other comprehensive income (loss)			15			(568	)

			Total shareholders’ equity		36,639			31,423

			Total liabilities and shareholders’ equity	$	44,515		$	50,220



					Three Months Ended
					March 31,

					2003			2002


					(Unaudited)

					(In thousands,
					except per share data)
Revenues
		Product sales			$	225		$	75
		Royalties and licensing fees				947			1,040

			Total revenues			1,172			1,115
Cost of revenues						81			26

				Gross profit		1,091			1,089
Operating expenses
		Selling, general and administrative				2,298			1,523
		Research and product development				3,583			4,451

			Total operating expenses			5,881			5,974

Operating loss from continuing operations						(4,790	)		(4,885	)
Investment income						41			130
Interest expense						32			58

Loss from continuing operations before income taxes						(4,781	)		(4,813	)
Income tax expense						6			6

Loss from continuing operations						(4,787	)		(4,819	)
Earnings from discontinued operations, net of tax expense of $26 and $141						177			501
Gain on sale of discontinued operations, net of tax expense of $62						9,580			—

Net income (loss)					$	4,970		$	(4,318	)

Basic and diluted (loss) earnings per common share:
Continuing operations					$	(0.31	)	$	(0.31	)
Discontinued operations						0.63			0.03

	Net Income (loss)				$	0.32		$	(0.28	)

Weighted average shares of common stock outstanding						15,508			15,398


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


			Less than		1-3		4-5		After 5
	Total		One Year		Years		Years		Years

Loans and Notes Payable	$	255	$	255	$	—	$	—	$	—
Operating Leases		837		280		536		21		—

Total Contractual Obligations	$	1,092	$	535	$	536	$	21	$	—


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


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


	*We require additional funding, which may be difficult to obtain*


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


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


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


Item 1.	*Financial Statements*


1.	Business


2.	Basis of Presentation


3.	Summary of Significant Accounting Policies


	*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*


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


	*Our success depends on our protecting our patents and patented rights*


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


	*We have only limited manufacturing capabilities and will be dependent on third party manufacturers*


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


	If we or our collaborators fail to obtain an adequate level of reimbursement by third party payors for our controlled release products, they may not be able to successfully commercialize controlled release products in certain markets


	*We will be exposed to product liability claims and may not be able to obtain adequate product liability insurance*


Item 3.	*Quantitative and Qualitative Disclosures About Market Risk*


Exhibit
Number		Description

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