UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

Commission File No. 000-23467

(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 [X]  No [  ]

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

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of April 29, 2004.

PENWEST PHARMACEUTICALS CO.
TABLE OF CONTENTS

PART I — FINANCIAL INFORMATION

     Item 1. Condensed Consolidated Financial Statements (Unaudited)

PENWEST PHARMACEUTICALS CO.

See accompanying notes to condensed consolidated financial statements.

3

PENWEST PHARMACEUTICALS CO.

See accompanying notes to condensed consolidated financial statements.

4

PENWEST PHARMACEUTICALS CO.

See accompanying notes to condensed consolidated financial statements.

5

PENWEST PHARMACEUTICALS CO.

1.

Business

     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. SyncroDose is a drug delivery system that is designed to release the active ingredient of a drug at the desired site and time in the digestive tract.

     Prior to February 27, 2003, Penwest also developed, manufactured and distributed branded pharmaceutical excipients, which are the inactive ingredients in tablets and capsules, primarily consisting of binders, disintegrants and lubricants. On February 27, 2003, Penwest sold substantially all of the assets used in the Company’s excipient business to subsidiaries and affiliates of Josef Rettenmaier Holding GmbH & Co. KG (the “Asset Sale”). The Company received $39.5 million in cash and a promissory note for $2.25 million in consideration for the excipient business. In April 2003, the Company received $1.0 million of the $2.25 million owed to it under the promissory note, with the balance due in May 2004. The Company used approximately $5.5 million of proceeds of the sale of its excipient business to repay debt (see Note 6). As a result of the Asset Sale, the accompanying condensed consolidated financial statements present Penwest’s excipient business as a discontinued operation for all periods presented.

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

2.

Basis of Presentation

     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, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

     As a result of the Asset Sale, the operating results of the excipient business have been presented as discontinued operations in the condensed consolidated statements of operations for the three month period ended March 31, 2003 (see Note 10).

     During the three months 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 three months ended March 31, 2003 condensed consolidated statements of operations.

     The balance sheet at December 31, 2003, has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

3.

Summary of Significant Accounting Policies

Revenue Recognition

     Revenues from product sales are recognized when title transfers and customer acceptance provisions have lapsed, provided that collections of the related accounts receivable are probable. Shipping and handling costs are included in cost of revenues. Revenues 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.

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. Certain reimbursements of costs, generally related to drug formulation on feasibility studies, are netted against research and development expense. A significant portion of the Company’s development activities are outsourced to third parties including contract research organizations, and contract manufacturers in connection with the production of clinical materials, or may be performed by the Company’s collaborators. These arrangements may require estimates be made of related service fees or the Company’s share of development costs, in which actual results could materially differ from the estimates and affect the reported amounts in the Company’s financial statements.

Stock Based Compensation

     The Company adopted the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which amends SFAS No. 123, “Accounting for Stock-Based Compensation,” in 2002. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation, which was originally provided under SFAS No. 123. 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 condensed consolidated results of operations, financial position or cash flows.

     At March 31, 2004, the Company maintained two stock-based employee compensation plans. The Company accounts for these employee stock compensation plans in accordance with the intrinsic value-based method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” During the three months ended March 31, 2004, in connection with board of directors’ retainer and meeting fees in 2004, the Company recorded $20,000 of expense associated with the issuance of discounted stock options and $37,689 of expense associated with restricted stock grants. No other stock-based employee compensation expense is reflected in net loss as all other options granted under these plans had an exercise price equal to the fair market value of the underlying common stock on the date of grant.

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PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

Note Payable to AstraZeneca AB

     As part of the Company’s agreement to acquire assets including trademarks and other intellectual property related to an excipient product, Pruv, for $3 million on October 25, 2002, the Company issued a note to the seller, 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, which included these assets, and which occurred in February 2003. As a result, this note was paid in full in February 2003.

Business Insurance Premium Financing

     On September 24, 2002, the Company entered into a Premium Finance Agreement (the “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 was 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. The amount financed under the Finance Agreement was paid in full in May 2003.

7.

Income Taxes

     For continuing operations, the effective tax rates for the three month periods ended March 31, 2004 and 2003 were zero. The effective tax rates are higher than the federal statutory rate of a 34% benefit due to valuation allowances recorded to offset deferred tax assets relating to the Company’s net operating losses.

     The gain on sale of discontinued operations of approximately $9.6 million, recorded in the three months ended March 31, 2003, is net of tax expense of $62,000, or less than 1% of the pretax gain. The tax rate is lower than the federal statutory rate of 34% primarily due to net operating losses which offset the gain. In addition, earnings from discontinued operations of $177,000 for the three months ended March 31, 2003 are net of tax expenses of $26,000, or 13% of pretax earnings. These tax rates, which include foreign taxes, are lower than the federal statutory rate of 34% primarily due to overall U.S. net operating losses which offset the U.S. earnings of the discontinued operation (see Note 10).

8.

Supplemental Executive Retirement Plan

     The Company has a Supplemental Executive Retirement Plan (“SERP”), a nonqualified plan, which covers the Chairman and Chief Executive Officer of Penwest. The Company does not fund this liability and no assets are held by the Plan. The Company uses a measurement date of December 31 for its SERP. The following disclosures summarize information relating to the Plan.

Components of net periodic benefit cost:

9.

Comprehensive Loss

     The components of comprehensive loss for the three month periods ended March 31, 2004 and 2003 are as follows (in thousands):

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     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 income (loss) included in the Company’s financial statements. Effective on the date of the Asset Sale, accumulated other comprehensive income (loss) is comprised solely of unrealized net gains and losses on marketable securities.

10.

Discontinued Operations

     On February 27, 2003, Penwest sold substantially all of the assets (the “Assets”) used in the Company’s excipient business to subsidiaries and affiliates of Josef Rettenmaier Holding GmbH & Co. KG (“Rettenmaier”) for $41.75 million, plus the assumption of specified liabilities, subject to a working capital adjustment. The Assets of the excipient business were sold to Rettenmaier, either directly or through the sale of the outstanding capital stock of the three subsidiaries of Penwest that did business in the UK, Germany and Finland. The purchase price included $39.5 million in cash and a non-interest bearing promissory note of $2.25 million, with $1.0 million paid in April 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.” In the second quarter of 2003, the Company recorded an expense of $83,000 for the working capital adjustment, net of a tax benefit of $11,000. The net carrying amount of the assets and liabilities on the date of the Asset Sale was approximately $29.5 million. The approximate carrying values of the major classes were: property, plant and equipment of $11.4 million; inventory of $8.3 million; receivables of $6.0 million; and intangible assets of $4.3 million offset by other net liabilities. The gain on the Asset Sale is net of transaction related costs totaling $3.1 million, primarily consisting of professional and advisory fees. Revenues and pretax profits for the excipient business approximated $6.1 million and $203,000, respectively, for the period January 1, 2003 through the Asset Sale date of February 27, 2003.

     Prior to the sale of the excipient business, the Company owned 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.

11.

Licensing Agreements

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

Endo Pharmaceuticals, Inc.

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

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

     Prior to April 17, 2003, the Company and Endo shared the costs involved in the development of oxymorphone ER. On March 17, 2003, the Company notified Endo that it was discontinuing its participation in the funding of the development and marketing of oxymorphone ER effective April 17, 2003. As a result of this termination of funding, Endo has the right to complete the development of oxymorphone ER and recoup the portion of development costs incurred by Endo that otherwise would have been funded by Penwest (“Unfunded Development Costs”). Endo may recoup such development costs through a temporary adjustment in the royalty rate payable to Penwest that will return to its pre-adjustment level once Endo has recovered such costs. Endo may also allow the

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Company to reimburse Endo directly for the unfunded amounts. The Company estimates that through March 31, 2004 “Unfunded Development Costs” approximated $8.8 million. The parties have agreed that the party marketing oxymorphone ER will pay the other party royalties initially equal to 50% of the net realization (as defined in the agreement) subject to adjustment for the Unfunded Development Costs. This percentage will decrease if the aggregate U.S. net realization exceeds pre-determined thresholds. In general, the royalty payable by the marketing party to the other party will not drop below 40%. However, the royalty will be reduced by one-third in limited circumstances, including termination of the agreement based on uncured material breaches of the agreement by the royalty receiving party and certain bankruptcy and insolvency events involving the royalty receiving party. Under the agreement, Endo will purchase formulated TIMERx material for use in oxymorphone ER exclusively from the Company at specified prices, and include these purchases in cost of goods sold of the product prior to determining net realization.

Mylan Pharmaceuticals Inc.

     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, a product the Company had developed in collaboration with Mylan, and agreed to pay Penwest a royalty on all future net sales of the 30 mg strength of Pfizer’s generic Procardia XL. The royalty percentage was comparable to the percentage called for in Penwest’s original agreement with Mylan for Nifedipine XL. Mylan has retained the marketing rights to the 30 mg strength of Nifedipine XL. Mylan’s sales in the United States in 2003 of the 30 mg dosage strength version of Pfizer’s generic Procardia XL totaled approximately $36.8 million. The term of this agreement continues until such time as Mylan permanently ceases to market generic Procardia XL.

12.

Subsequent Event

     In April 2004, the Company signed a lease amendment to its February 3, 2003 lease agreement (“Agreement”) for approximately 21,000 square feet of office space in Danbury, Connecticut within the same building as the Company’s corporate offices. Under this amendment, the new office space was substituted for the previous space leased in the building. This lease has an initial term expiring December 30, 2006, with renewal options through December 30, 2008, and requires that monthly base rents be paid, including escalation clauses, in amounts ranging from $37,000 to $40,000 through the initial lease term. The Company moved its corporate offices to the new office space on April 30, 2004.

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

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

Overview

     We develop pharmaceutical products based on innovative oral drug delivery technologies. The foundation of our technology platform is TIMERx, an extended release delivery system that is adaptable to soluble and insoluble drugs, and that is flexible for a variety of controlled release profiles. We have also developed two additional oral drug delivery systems, Geminex and SyncroDose. Geminex is a dual drug delivery system that is designed to provide independent release of different active ingredients contained in a drug. SyncroDose is a drug delivery system that is designed to release the active ingredient of a drug at the desired site and time in the digestive tract. Our proprietary TIMERx drug delivery technology is utilized in four products that were developed with collaborators and have been approved in various countries. In addition, we have a number of product candidates in our drug development pipeline.

     The two most advanced products in our drug development pipeline are oxymorphone ER, an extended release formulation of oxymorphone, a narcotic analgesic being developed for the treatment of moderate to severe pain, and PW2101, a branded product for the treatment of hypertension that we have formulated using our TIMERx technology.

•

Oxymorphone ER. We are developing oxymorphone ER under a collaboration agreement with Endo Pharmaceuticals, Inc. In February 2003, the FDA accepted for filing a New Drug Application, or NDA, for oxymorphone ER. In October 2003, Endo received an approvable letter from the U.S. Food and Drug Administration, or FDA, for oxymorphone ER. In the letter, the FDA requested that Endo address certain questions, provide additional clarification and information, and conduct 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 the first quarter of 2004, Endo had a meeting with the FDA to clarify issues raised in the letter, review the necessity for additional trials and discuss its responses to the approvable letter. Endo, in reporting the outcome of this meeting, stated that the status of the FDA’s request for additional clinical trials related to the drug has not been resolved and that the FDA indicated it needed more time to adequately review Endo’s additional analyses of certain data. In addition,

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Endo stated that the FDA committed to respond to Endo as soon as possible, which Endo believes will be during the second quarter of 2004.

•

PW2101. We are currently developing PW2101 on our own. In the fourth quarter of 2003, we completed a pivotal clinical trial of this product candidate. This pivotal clinical trial was a randomized, double-blind, parallel-group study comparing PW2101 to placebo. A total of 163 subjects were evaluated for efficacy compared to placebo based upon primary end points agreed upon with the FDA. The primary end points of the trial were met, and the clinical development program is now complete. We expect to file a 505(b)(2) NDA for PW2101 by the end of 2004. We are also developing a lower strength of PW2101. In order to obtain marketing approval of this lower strength dosage form, we will need to conduct an additional clinical trial. We commenced this trial in the second quarter of 2004 and expect to complete this additional trial by the end of 2004. Assuming that this trial is successful, we expect that we would submit an NDA for the lower dosage form of PW2101 in the first 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 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 us a royalty on all future net sales of the 30 mg strength of Pfizer’s generic Procardia XL.

     Prior to February 27, 2003, we also developed, manufactured and distributed branded pharmaceutical excipients, which are the inactive ingredients in tablets and capsules, primarily consisting of binders, disintegrants and lubricants. On February 27, 2003, we sold substantially all of the assets used in our excipient business to subsidiaries and affiliates of Josef Rettenmaier Holding GmbH & Co. KG. We received $39.5 million in cash and a promissory note for $2.25 million in consideration for the excipient business. We received $1.0 million of the $2.25 million promissory note in April 2003 with the balance due in May 2004. We used approximately $5.5 million of proceeds of the sale of our excipient business to repay outstanding debt. Commencing in the first quarter of 2003, we reported the operating results of the excipient business as a discontinued operation.

     We have incurred net losses since 1994. As of March 31, 2004, our accumulated deficit was approximately $99.2 million. We expect operating losses and negative cash flows to continue until substantial sales of products commercialized utilizing TIMERx technology occur. A substantial portion of our revenues through February 27, 2003 were generated from sales of our pharmaceutical excipient product line. Since the sale of the excipient business, our revenues have been generated primarily from royalties from Mylan’s sales of the 30 mg generic version of Pfizer’s Procardia XL and shipments of bulk TIMERx to our collaborators. Our future profitability will depend on several factors, including:

•

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

•

royalties from Mylan; and

•

the level of our investment in research and development activities.

     Our strategy includes a significant commitment to spending on research and development targeted at identifying and developing products that can be formulated using our drug delivery technologies. We also expect to expend significant resources on the development of new drug delivery technologies, both internally and through in-licenses or acquisitions. Our spending in the area of new technology, however, is discretionary and is subject to identifying appropriate opportunities, as well as the availability of funds from our operations, cash resources, collaborative research and development arrangements and external financing.

     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, volume and timing of shipments of formulated bulk TIMERx, and on variations in payments under our collaborative agreements, including payments upon the achievement of specified milestones.

Critical Accounting Policies and Estimates

     The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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

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taxes-valuation allowance and impairment of long-lived assets. For a more detailed explanation of the judgments made in these areas, refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2003.

Results of Operations for Quarters Ended March 31, 2004 and 2003

     Revenues

     The increase in total revenues in the first quarter of 2004 from the first quarter of 2003 was the result of increases in royalty and licensing revenues. Our royalty and licensing revenues primarily consist of royalties from Mylan on their sales of the 30 mg generic version of Pfizer’s Procardia XL. These royalties increased in the first quarter of 2004 compared to the first quarter of 2003 due to Mylan’s increased sales of Pfizer’s Procardia XL. Our product sales consist of sales of formulated bulk TIMERx to our collaborators. Product sales in the first quarter of 2004 remained flat as compared to the first quarter of 2003.

     Selling, General and Administrative Expense

     Selling, general and administrative (SG&A) expenses for the first quarter of 2004 and for the first quarter of 2003 were $2.3 million. SG&A expenses in the first quarter of 2003 included $230,000 for our share of marketing expenses for oxymorphone ER. There were no such costs for this product in the first quarter of 2004 as the Company opted out of funding these costs effective April 17, 2003. Partially offsetting this decrease, SG&A expenses in the first quarter of 2004 included certain expenses which were previously allocated to the excipient business in the first quarter of 2003, prior to February 27, 2003, the date of the sale of our excipient business, and were therefore not included in continuing operations for the first quarter of 2003. These expenses were ongoing after the sale and have been fully absorbed in continuing operations following the sale of our excipient business.

     Research and Product Development Expense

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

•

Oxymorphone ER – These expenses reflect our direct external expenses relating to the development of oxymorphone ER. These expenses consist primarily of payments to third parties, including payments to Endo for the first quarter of 2003 for our share of development costs under our collaboration agreement with Endo;

•

PW2101 – These expenses reflect our direct external expenses relating to the development of PW2101. These expenses consist primarily of payments to third parties in connection with clinical trials and the manufacturing of product, prior to regulatory approval, for clinical use and commercial use;

•

Research and New Technology Development – These expenses reflect both our direct external expenses and our allocated internal expenses relating to the development of new drug delivery technologies. These direct external expenses consist primarily of payments to third parties in connection with outside laboratory and consulting fees. Our internal expenses primarily include salaries and benefits of our research and new technology development group, and other costs such as depreciation on purchased equipment and amortization of patent costs.

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•

Phase I Products and Internal Costs – These expenses reflect both our direct external expenses and our internal expenses relating to the development of phase I product candidates and also include other unallocated research and development expenses. Our direct external expenses primarily reflect payments to third parties for the active drug and proof-of-principle biostudies conducted for our phase I products. Our internal expenses include expenses such as salaries and benefits of our product development personnel including our formulation, clinical and regulatory groups, and other costs primarily related to our laboratory facilities.

     Total research and product development expenses increased in the first quarter of 2004 primarily due to increased costs relating to the development of PW2101, as well as increased costs relating to the development of phase I product candidates, partially offset by decreased costs relating to the development of oxymorphone ER.

     We did not have any research and development expenses related to oxymorphone ER in the first quarter of 2004 due to the discontinuation of our funding of the development of oxymorphone ER effective April 17, 2003. We have not incurred any research and development expenses related to oxymorphone ER since April 17, 2003, and we do not expect to incur any additional research and development expenses relating to oxymorphone ER unless we resume our participation in the funding of the expenses of oxymorphone ER.

     Approximately 43% of our research and development expenses for the first quarter of 2004 related to the direct costs associated with clinical development and manufacturing scale-up of PW2101. These expenses increased from the first quarter of 2003 primarily due to expenses relating to the pivotal clinical trial of PW2101 and our increased efforts with respect to the manufacture of PW2101. In the fourth quarter of 2003, we completed a pivotal trial of PW2101 for the treatment of hypertension and announced in the first quarter of 2004 that the primary end points had been met. We do not plan to conduct any additional clinical trials prior to submitting a 505(b)(2) NDA for this product, which we anticipate filing in late 2004. However, we are also developing a lower strength of PW2101. In order to obtain marketing approval of this lower strength dosage form, we will need to conduct an additional clinical trial. We commenced this trial in the second quarter of 2004 and expect to complete this additional trial by the end of 2004. Assuming that this trial is successful, we expect that we would submit an NDA for the lower dosage form of PW2101 in the first quarter of 2005. In addition, we expect to continue to incur additional research and development expenses relating to PW2101 as we continue to work with the third party manufacturer of PW2101 with respect to supporting a manufacturing site change, as well as for the cost of stability data and the cost of preparing the NDA’s for submission. Although we have developed PW2101 on our own, we do not intend to market this product. As a result, we are currently seeking a marketing partner for this product.

     There can be no assurance that any of our products will be successfully developed, will receive regulatory approval, or will be successfully commercialized. Completion of clinical trials and commercialization of these product candidates may take several years, and the length of time can vary substantially according to the type, complexity and novelty of a product candidate. Due to the variability in the length of time necessary to develop a product, the uncertainties related to the estimated cost of the development projects and ultimate ability to obtain governmental approval for commercialization, accurate and meaningful estimates of the ultimate cost to bring our product candidates to market are not available.

     Phase I products and internal costs increased in the first quarter of 2004 primarily as a result of an increase in the number of phase I product candidates in our pipeline, an increase in external costs incurred in connection with proof-of-principle biostudies for these phase I product candidates and increased costs associated with an increase in the number of employees engaged in our research and development efforts.

     Tax Rates

     For continuing operations, the effective tax rates for the quarters ended March 31, 2004 and 2003 were zero. The effective tax rates are higher than the federal statutory rate of a 34% benefit due primarily to valuation allowances recorded to offset net deferred tax assets relating to our net operating losses.

     The gain on sale of discontinued operations of approximately $9.6 million, recorded in the three months ended March 31, 2003, is net of tax expense of $62,000, or less than 1% of the pretax gain. The tax rate is lower than the federal statutory rate of 34% primarily due to net operating losses which offset the gain. In addition, earnings from discontinued operations of $177,000 for the three months ended March 31, 2003 are net of tax expenses of $26,000, or 13% of pretax earnings. These tax rates, which include foreign taxes, are lower than the federal statutory rate of 34% primarily due to overall U.S. net operating losses which offset the U.S. earnings of the discontinued operation.

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Liquidity and Capital Resources

     Subsequent to August 31, 1998, the date we became an independent, publicly-owned company, we have funded our operations and capital expenditures with proceeds from the sale and issuance of shares of common stock, the sale of 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.

     We are a party to an agreement with Endo with respect to the development of oxymorphone ER. On April 17, 2003, we discontinued our participation in the funding of the development and marketing of oxymorphone ER. Accordingly, our research and development, and selling, general and administrative expenses with respect to oxymorphone ER decreased significantly in the first quarter of 2004 compared to the corresponding period in 2003. We do not expect to incur any significant expenses relating to oxymorphone ER in 2004 unless we resume our participation in the funding of the development and marketing of oxymorphone ER. As a result of this termination of funding, Endo has the right to complete the development of oxymorphone ER and recoup the portion of development costs incurred by Endo that otherwise would have been funded by us. Endo may recoup these unfunded development costs through a temporary adjustment in the royalty rate payable to us that will return to its pre-adjustment level once Endo has recovered such unfunded development costs. Endo may also allow us to reimburse Endo directly for these unfunded development costs. We estimate that through March 31, 2004, unfunded development costs approximated $8.8 million.

     On February 27, 2003, we completed the sale of our excipient business to Rettenmaier. As a result of the sale of our excipient business, we had approximately $35 million of net cash proceeds available after the closing. However, as a result of the sale of our excipient business, we no longer derive cash flow from the sale of excipients. A portion of the proceeds from the sale of our excipient business was used to pay the $3.3 million of outstanding borrowings under our line of credit, which was terminated on February 27, 2003. In addition, we used the proceeds from the sale of the excipient business to repay in full a $2.25 million note payable to AstraZeneca AB, incurred in connection with our acquisition of specified intellectual property related to the excipient business.

     On August 5 and August 6, 2003, we completed the sale of a total of 2,507,762 shares of common stock through a private placement to selected institutional investors, resulting in net proceeds to us, after fees and expenses, of approximately $49.3 million. As part of this transaction, we granted the institutional investors additional rights to purchase up to an additional 501,552 shares of common stock at a price of $26.00 per share. These additional investment rights became exercisable on September 12, 2003 and expired on December 9, 2003. None of these additional investment rights were exercised.

     As of March 31, 2004, we had cash, cash equivalents, and short-term investments of $57.8 million. We have no committed sources of capital other than Rettenmaier’s commitment to repay us $1.25 million in May 2004 pursuant to a promissory note in connection with the sale of the excipient business.

     We had negative cash flow from operations for the three months ended March 31, 2004 of $6.7 million, primarily due to a loss from continuing operations of $4.8 million and our use of cash in reducing our accounts payable and accrued expenses by $2.3 million in the period. We had negative cash flow from operations for the three months ended March 31, 2003 of $5.9 million, primarily due to the loss from continuing operations of $4.8 million, as well as a reduction in accounts payable and accrued expenses of $2.4 million, partially offset by cash flows from discontinued operations operating activities of $874,000. Investing activities provided $10.1 million in cash for the three months ended March 31, 2004, primarily reflecting proceeds from maturities of marketable securities, net of purchases, of $10.4 million. Net cash provided by investing activities also reflected funds expended for the acquisitions of laboratory equipment for drug development activities, and funds expended for intangible assets, which included costs to secure patents on technology developed by us. In the first quarter of 2004, financing activities provided $923,000 in cash from the issuance of common stock upon exercise of outstanding stock options. Our cash flow in the first quarter of 2004 also differed from our cash flow in the first quarter of 2003 because we no longer derive revenues from sales of our excipient products and do not incur expenses in connection with our excipient business, except for the related revenues and expenses during the period ended February 26, 2003.

     We anticipate that, excluding any potential revenues from oxymorphone ER, our existing capital resources and anticipated internally generated funds from the sale of formulated bulk TIMERx, royalties from Mylan and other payments from collaborators, will be sufficient to fund our operations on an ongoing basis without requiring us to seek external financings through at least 2005. We expect to continue to invest in capital expenditures in 2004 at levels similar to 2003 capital spending which approximated $2.8 million, primarily for laboratory equipment for our drug development activities, and for patents on technology and products developed by us.

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

•

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

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•

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

•

the timing and amount of payments received under existing and possible future collaborative agreements, in particular oxymorphone ER;

•

our success in entering into a marketing collaboration for PW2101;

•

the structure of any future collaborative or development agreements;

•

the progress of our collaborative and independent development projects, funding obligations with respect to the projects, and the related costs to us of clinical studies for our products;

•

the costs and timing of adding drug development capabilities;

•

royalties received from Mylan; and

•

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

     If our existing resources are insufficient to satisfy our need for capital due to a delay in the approval for oxymorphone ER, lower than expected revenues from oxymorphone ER or otherwise, or if we acquire additional product candidates or technologies, we may need to sell additional equity or debt securities or seek additional financing through other arrangements. 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 or debt securities, further dilution to our then existing shareholders may result. In addition, the terms of the financing may adversely affect the holdings or the rights of such shareholders. We cannot be certain that additional public or private financing will be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain this additional financing, we may be required to delay, reduce the scope of, or eliminate one or more of our planned research, development and commercialization activities, which could harm our financial condition and operating results.

Contractual Obligations

     Our outstanding contractual cash obligations relate to our operating leases, primarily for facilities, and purchase obligations primarily relating to clinical development, contract manufacturing and capital expenditures. Below is a table summarizing our contractual cash obligations under our operating leases and purchase obligations, as of March 31, 2004:

     In addition, in April 2004 we signed a lease amendment to our February 3, 2003 lease agreement for approximately 21,000 square feet of office space in Danbury, Connecticut within the same building as our corporate offices. Under this amendment, the new office space was substituted for the previous space leased in the building. As a result of this lease amendment, our cash obligations under operating leases have increased from the amounts set forth in the table above by $154,000 to $444,000 for the one year period ending March 31, 2005 and by $601,000 to $846,000 for the period commencing on April 1, 2005 and ending on March 31, 2007.

Net Operating Loss Carryforwards

     At March 31, 2004, we had federal net operating loss, or NOL, carryforwards of approximately $63.8 million for income tax purposes, of which approximately $6.2 million, $8.4 million, $9.1 million, $17.7 million, $19.3 million and $3.1 million expire in 2018, 2019, 2020, 2021, 2022, and 2023, respectively. In addition, we had research and development tax credit carryforwards of approximately $2.2 million of which $299,000, $306,000, $777,000, and $828,000 expire in 2019, 2020, 2021, and 2022 respectively. The use of the NOL carryforwards and research and development tax credit carryforwards are limited to our future taxable earnings. For financial reporting

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purposes, at March 31, 2004 a valuation allowance of $26.5 million has been recognized to offset net deferred tax assets, primarily attributable to the NOL carryforwards. Utilization of the operating losses are subject to a limitation due to the ownership change provisions of the Internal Revenue Code.

Forward Looking Statements

     This quarterly report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements, other than statements of historical facts, included or incorporated in this report regarding our strategy, future operations or financial position, future revenues, projected costs, prospects, plans and objectives of management are forward-looking statements. The words “believes,” “anticipates,” “estimates,” “plans,” “expects,” “intends,” “may,” “projects,” “will,” and “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guarantee that we actually will achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. There are a number of important factors that could cause our actual results to differ materially from those indicated or implied by forward-looking statements. These important factors include those set forth below under “Risk Factors.” In addition, any forward-looking statements represent our estimates only as of the date this quarterly report is filed with the SEC and should not be relied upon as representing our estimates as of any subsequent date. We do not assume any obligation to update any forward-looking statements.

Risk Factors

     Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below in addition to the other information included or incorporated by reference in this quarterly report. If any of the following risks actually occur, our business, financial condition or results of operations would likely suffer. In that case, the trading price of our common stock could fall.

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

     We have incurred net losses since 1994, including net losses of $15.9 million, $17.1 million and $16.0 million, during 2003, 2002, and 2001, respectively. We had a loss from continuing operations of $26.0 million, $19.0 million, and $16.8 million in 2003, 2002, and 2001, respectively. For the three months ended March 31, 2004, we had a net loss of $4.8 million. As of March 31, 2004, our accumulated deficit was approximately $99.2 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 2003, 2002 and 2001 were reduced as a result of the operating results of our excipient business. Since February 27, 2003, we have not generated any revenues from the sales of excipient products and our business depends exclusively on our drug delivery and drug development business.

     Our future profitability will depend on several factors, including:

•

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

•

royalties from Mylan; and

•

the level of our investment in research and development activities.

     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. 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 clinical trials, obtain regulatory approvals for, and manufacture, market, and sell our TIMERx controlled release products, including, in particular, Endo with respect to oxymorphone ER

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     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.

     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 commercialization of products or undertake commercialization activities at our own expense. Moreover, we have limited experience in conducting full-scale 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 perception of us 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.

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 longer operating histories and greater financial, marketing, legal and other resources than we have and than some of our collaborators have.

     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, and Duragesic marketed by Johnson & Johnson.

     In addition to developing controlled release versions of immediate and other controlled release products, we also selectively develop generic versions of branded controlled release products. In development, we utilize our TIMERx technology and generic active ingredients to formulate product candidates. The success of these product candidates 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.

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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 controlled release versions of immediate release products and branded generic products, 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 may not obtain regulatory approval; the approval process can be time-consuming and expensive

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

     We also have a number of TIMERx products in our development pipeline. The most advanced of these is oxymorphone ER. In February 2003, the FDA accepted for filing an NDA for oxymorphone ER. In October 2003, the FDA issued to Endo 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 the first quarter of 2004, Endo had a meeting with the FDA to clarify issues raised in the letter, review the necessity for additional trials and discuss its responses to the approvable letter. Endo, in reporting the outcome of this meeting, stated that the status of the FDA’s request for additional clinical trials related to the drug has not been resolved and that the FDA indicated it needed more time to adequately review Endo’s additional analyses of certain data. 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.

     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.

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     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, 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 we or our third-party manufacturers or collaborators will be able to obtain approval for such products within the time period specified by the FDA.

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

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

     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 may require additional funding, which may be difficult to obtain

     As of March 31, 2004, we had cash, cash equivalents, and short-term investments of $57.8 million. We have no committed sources of capital other than Rettenmaier Holding GmbH & Co. KG’s commitment to repay us $1.25 million due in May 2004, in connection with the sale of the excipient business.

     We anticipate that, excluding any potential revenues from oxymorphone ER, our existing capital resources and anticipated internally generated funds from the sale of formulated bulk TIMERx, royalties from Mylan and other payments from collaborators will be sufficient to fund our operations on an ongoing basis without requiring us to seek external financings through at least 2005.

     We have had negative cash flows and net losses since 1994. See “We have not been profitable and expect to continue 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:

•

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

•

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

•

the timing and amount of payments received under existing and possible future collaborative agreements, in particular oxymorphone ER;

•

our success in entering into a marketing collaboration for PW2101;

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•

the structure of any future collaborative or development agreements;

•

the progress of our collaborative and independent development projects, funding obligations with respect to the projects, and the related costs to us of clinical studies for our products;

•

the costs and timing of adding drug development capabilities;

•

royalties received from Mylan; and

•

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

     If our existing resources are insufficient to satisfy our need for capital due to a delay in the approval for oxymorphone ER, lower than expected revenues from oxymorphone ER or otherwise, or if we acquire additional product candidates or technologies, we may need to sell additional equity or debt securities or seek additional financing through other arrangements. 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 shareholders may result. In addition, the terms of the financing may adversely affect the holdings or the rights of such shareholders. Any sale of additional equity or debt securities may result in additional dilution to our shareholders, and we cannot be certain that additional public or private 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.

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

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

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

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 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.

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     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.

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

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

•

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

•

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

•

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

•

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

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

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

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

     We lack commercial scale facilities to manufacture our TIMERx material or any products we may develop in accordance with cGMP requirements prescribed by the FDA. We currently rely on Draxis Pharma, Inc. for the bulk manufacture of our TIMERx material for delivery to our collaborators under a contract that expires in September 2005 and on other third party manufacturers for the products that we are currently evaluating in clinical trials, such as PW2101. The agreement with Draxis will be automatically renewed for successive one year periods, unless either party gives notice of its intent not to renew the contract, at least six months prior to the end of the then-current term. We are not a party to any agreements with our third party manufacturers for the products that we are currently evaluating in clinical trials 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, or otherwise impair our competitive position, which could have a material adverse effect on our business, financial condition and results of operations.

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

•

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

•

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

•

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

     We have limited experience in manufacturing TIMERx material on a commercial scale and no facilities or equipment to do so. If we determine to develop our own manufacturing capabilities, we will need to recruit qualified personnel and build or lease the requisite facilities and equipment. We may not be able to successfully develop our own manufacturing capabilities. Moreover, it may be very costly and time consuming for us to develop such capabilities.

     The manufacture of any of our products is subject to regulation by the FDA and comparable agencies in foreign countries. Any delay in complying or failure to comply with such manufacturing requirements could materially adversely affect the marketing of our products and our business, financial condition and results of operations.

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

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

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

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

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

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

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

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

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

     We are currently covered by primary product liability insurance in the minimum amounts of $1 million per occurrence and $2 million annually in the aggregate on a claims-made basis and by umbrella liability insurance in excess of $25 million which can also be used for product liability insurance. This coverage may not be adequate to cover any product liability claims. Product liability coverage is expensive. In the future, we may not be able to maintain or obtain such product liability insurance at a reasonable cost or

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in sufficient amounts to protect us against losses due to liability claims. Any claims that are not covered by product liability insurance could have a material adverse effect on our business, financial condition and results of operations.

The market price of our common stock may be volatile

     The market price of our common stock, like the market prices for securities of pharmaceutical, biopharmaceutical and biotechnology companies, have historically been highly volatile. The market from time to time experiences significant price and volume fluctuations that are unrelated to the operating performance of particular companies. Factors such as fluctuations in our operating results, future sales of our common stock, announcements of technological innovations or new therapeutic products by us or our competitors, announcements regarding collaborative agreements, clinical trial results, government regulation, developments in patent or other proprietary rights, public concern as to the safety of drugs developed by us or others, changes in reimbursement policies, comments made by securities analysts and general market conditions may have a significant effect on the market price of the common stock.

Specific provisions of our Shareholder Rights Plan, Certificate of Incorporation and Bylaws and of Washington law make a takeover of Penwest or a change in control or management of Penwest more difficult

     We have adopted a shareholder rights plan, often referred to as a poison pill. The rights issued under the plan will cause substantial dilution to a person or group that attempts to acquire us on terms that are not approved by our board of directors, unless the board first determines to redeem the rights. Various provisions of our Certificate of Incorporation, our Bylaws and Washington law may also have the effect of deterring hostile takeovers or delaying or preventing changes in control or management of our company, including transactions in which our shareholders might otherwise receive a premium for their shares over then current market prices. In addition, these provisions may limit the ability of shareholders to approve transactions that they may deem to be in their best interest.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market Risk and Risk Management Policies

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

     The primary objectives for our investment portfolio are liquidity and safety of principal. Investments are made to achieve the highest rate of return to us, consistent with these two objectives. Our investment policy limits investments to specific types of instruments issued by institutions with investment grade credit ratings and places restrictions on maturities and concentration by issuer. Marketable securities primarily consist of corporate debt, certificates of deposit and U.S. Government Agency-backed notes, and approximated $28.3 million at March 31, 2004. These securities have contractual maturity dates of up to twenty-four months. Due to the relatively short-term maturities of these securities, management believes there is no significant market risk. At March 31, 2004, market values approximated carrying values. At March 31, 2004, we had approximately $57.8 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 $578,000.

Item 4. Controls and Procedures

     (a) Evaluation of Disclosure Controls and Procedures - Our management, with the participation of our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act) as of March 31, 2004. Based on this evaluation, our CEO and CFO concluded that, as of March 31, 2004, our disclosure controls and procedures were (1) designed to ensure that material information relating to us is made known to our CEO and CFO by others within our company, particularly during the period in which this report was being prepared, and (2) effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

     (b) Changes in Internal Controls - No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) occurred during the fiscal quarter ended March 31, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

     a. 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.

     b. Reports on Form 8-K.

     On February 19, 2004, we filed a report on Form 8-K announcing our results for the quarter and year ended December 31, 2003.

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SIGNATURE

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

	PENWEST PHARMACEUTICALS CO.
Date: May 3, 2004	/s/ Jennifer L. Good
	Jennifer L. Good
	Senior Vice President, Finance and Chief Financial Officer (Principal Financial Officer)

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EXHIBIT INDEX

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