-UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

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

For the Fiscal Year Ended December 31, 2004
OR

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

For the transition period from _______to ________

Commission File Number 000-23467

PENWEST PHARMACEUTICALS CO.

Registrant’s telephone number, including area code: (877) 736-9378

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

None

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:

Common Stock, $.001 par value
(Including Associated Preferred Stock Purchase Rights)

Indicate by 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 at least the past 90 days. Yes x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

The aggregate market value of the Registrant’s Common Stock held by non-affiliates as of June 30, 2004 was approximately $237,517,000 based on the last sale price of the Registrant’s Common Stock on the Nasdaq National Market on June 30, 2004. The number of shares of the Registrant’s Common Stock outstanding as of March 11, 2005 was 21,714,891.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our definitive Proxy Statement relating to the 2005 Annual Meeting of Shareholders to be held on June 1, 2005 are incorporated by reference into Part III of this Form 10-K.

PENWEST PHARMACEUTICALS CO.
INDEX TO FORM 10-K

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PART I

ITEM 1: BUSINESS

Overview

     We develop pharmaceutical products based on innovative proprietary oral drug delivery technologies. We are focusing our development efforts principally on products that address diseases of the central nervous system. The two most advanced products in our drug development pipeline are oxymorphone ER, an extended release formulation of oxymorphone, a narcotic analgesic being developed for twice-a-day dosing in patients with moderate to severe pain requiring continuous, around-the-clock opioid therapy for an extended period of time, and PW2101, a beta blocker intended for the treatment of hypertension and angina. We are also developing several additional product candidates in areas such as edema, epilepsy, schizophrenia and depression.

     Oxymorphone ER. We are developing oxymorphone ER under a collaboration agreement with Endo Pharmaceuticals, Inc. In October 2003, Endo received an approvable letter from the United States Food and Drug Administration, or FDA, for oxymorphone ER. In the letter, the FDA requested that Endo address certain questions, provide additional clarification and information, and conduct additional clinical trials to further confirm the safety and efficacy of oxymorphone ER before the FDA would approve Endo’s New Drug Application, or NDA, for oxymorphone ER. In November 2004, Endo announced that the FDA had granted under the FDA’s special protocol assessment, or SPA, process final approval for the protocol for a clinical trial designed to provide the additional safety and efficacy data requested by the FDA.

     Endo has reported that, based on the duration of the trial and the number of patients to be enrolled, and assuming the data is favorable, Endo expects to submit a complete response letter to the FDA in early 2006. We expect that Endo will receive a further action letter from the FDA within six months of submission of the complete response letter.

     PW2101. We are currently developing PW2101 on our own but are seeking a collaborator to market the product. In October 2004, the FDA accepted for filing a section 505(b)(2) NDA that we submitted for PW2101. Our initial submission covered three strengths of the product. Subsequently, we submitted supplemental data to the NDA to cover a lower strength of PW2101. We believe that the FDA will consider the lower strength in the original filing for the higher strengths.

     Drug Delivery Technology. 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. Our proprietary TIMERx drug delivery technology is utilized in four products that were developed with collaborators that have been approved, as well as in oxymorphone ER and PW2101. We have also developed three additional oral drug delivery systems, Geminex®, SyncroDose™ and a gastroretentive system. 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. The gastroretentive system is a drug delivery system that is designed to provide controlled release delivery of drugs that are absorbed in the stomach and certain portions of the gastrointestinal, or GI, tract, namely the upper GI tract, without a loss of bioavailability

     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 for approximately $41.8 million in cash.

Our Strategy

     Our strategy is to develop pharmaceutical products utilizing proprietary oral drug delivery technologies primarily for diseases of the central nervous system as follows:

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	•	Expand our product development pipeline with products to treat diseases of the central nervous system. We intend to aggressively seek to expand our development pipeline with product candidates for the treatment of diseases of the central nervous system by developing products internally or by acquiring products from third parties. Historically, we have formulated product candidates and then relied upon third party collaborators to complete the remainder of the clinical development program and market the drugs. Although we still expect that we will out-license a portion of our product portfolio prior to regulatory submission, we intend to develop a significant portion of these products on our own and retain the right to market, co-market, or co-promote these products.
	•	Selectively develop product candidates for diseases outside of the central nervous system. We will also selectively develop product candidates for diseases outside of the central nervous system if we believe the product could have significant value. We expect that we will develop these products through at least pilot scale biostudies and proof-of-concept data and then seek a collaborator to finish development and eventually market the product.
	•	Leverage drug delivery technologies into a portfolio of product candidates for development. We believe that we have significant expertise in drug formulation and in oral drug delivery technologies. Our proprietary drug delivery technologies, TIMERx extended release, Geminex dual delivery, SyncroDose chronotherapeutic delivery and the gastroretentive system are applicable to a wide range of drugs with different physical and chemical properties including water soluble and insoluble drugs as well as high dose and low dose drugs. Using these technologies, we can formulate drugs with precise release profiles. In selecting product candidates for development, we focus on opportunities in which our drug delivery technologies, or drug delivery technologies that we can access, can provide benefits to patients and result in branded, proprietary products. We intend to continue to develop our core technologies as well as to seek to develop, in-license or acquire new technologies as may be required for our product development candidates.
	•	Establish collaborations for development, manufacturing and marketing. We expect that we will continue to seek to enter into collaborations to develop and market some of our products, particularly for product candidates outside of the central nervous system. In addition, we may also seek to enter into agreements for the manufacturing of our products. We are a party to a number of collaborative agreements including our agreements with Endo and Mylan Pharmaceuticals Inc.

Drug Delivery Technologies

TIMERx Extended Release Delivery Systems

     We developed our TIMERx delivery system to address the limitations of other oral extended release delivery systems. We believe that the TIMERx system has advantages over other oral drug delivery technologies as it is readily manufactured, adaptable to soluble and insoluble drugs and flexible for a variety of controlled release profiles. Pharmaceutical products containing TIMERx have been approved and are being marketed, and we are developing additional products in our pipeline using TIMERx.

     The patented TIMERx drug delivery system is based on 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, SyncroDose, and gastrorententive drug delivery systems. The physical interaction between these components works to form a strong, binding gel in the presence of water. Drug release is controlled by the rate of water penetration from the GI tract into the TIMERx gum matrix, which expands to form a gel and subsequently releases the active drug substance. The TIMERx system can precisely control the release of the active drug substance in a tablet by varying the proportion of the gums, together with the tablet coating and the tablet manufacturing process. Drugs using TIMERx technology are formulated by combining the active drug substance, the TIMERx drug delivery system and additional excipients, and compressing such materials into a tablet.

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Geminex

     We developed our patented Geminex dual release technology to provide for the independent release of the same active ingredient or different active ingredients contained in one pharmaceutical product at different rates. The release of the active ingredients can each involve two different controlled release profiles, or involve controlled release and immediate release profiles. The technology is based on a bi-layer tablet that utilizes TIMERx in the controlled release layer. We are utilizing Geminex technology in several product candidates that are currently in our portfolio.

SyncroDose

     We developed our patented SyncroDose drug delivery system to deliver drugs chronotherapeutically in the body or to deliver a drug within a specific site in the GI tract. SyncroDose is a technology based on our underlying TIMERx platform. We believe that there are several disease states that can benefit from chronotherapeutic delivery including: arthritis, cardiovascular disorders, asthma, neurological disorders and site-specific diseases including GI cancers. The SyncroDose technology utilizes the TIMERx gum matrix in the coating, combined with the active and various other excipients in the core.

Gastroretentive

     We developed our gastroretentive drug delivery system to deliver drugs in the upper GI tract. We believe this technology can provide controlled delivery of drugs that are absorbed in the stomach and the upper portions of the GI tract. By targeting delivery in the part of the stomach where the drug is absorbed, we believe we can increase the bioavailability of the drug, which could result in increased efficacy or a lower dose of the drug being required.

Products

Approved Products

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

	•	Cystrin CR, an extended release version of oxybutynin for the treatment of urge urinary incontinence, is being marketed in Finland by Schering Oy.
	•	Slofedipine XL, an extended release version of nifedipine for the treatment of angina, is being marketed in the United Kingdom and Italy by Sanofi-Synthelabo S.A.
	•	Cronodipin, an extended release version of nifedipine for the treatment of angina was licensed to Merck S.A. Industries Quimicas for marketing in Brazil.

     In December 1999, the FDA approved the 30 mg strength of Nifedipine XL, a generic version of Procardia XL that we developed with Mylan for the treatment of hypertension and angina and that utilizes the TIMERx system. The 30 mg strength of Nifedipine XL is not being marketed by Mylan. In March 2000, Mylan signed a supply and distribution agreement with Pfizer, Inc. to market a generic version of all three strengths, 30 mg, 60 mg and 90 mg, of Pfizer’s Procardia XL. In connection with that agreement, Mylan agreed to pay us a royalty on Mylan’s net sales of Pfizer’s 30 mg strength of generic Procardia XL. The royalties are comparable to those called for in our original agreement with Mylan for Nifedipine XL. Mylan has retained the marketing rights to the 30 mg strength of Nifedipine XL.

Products in Our Pipeline

     We also have a number of TIMERx products in our development pipeline. The table below summarizes each of the principal products in this pipeline, including the therapeutic use, the development status and our collaborator, if any, for each product:

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Oxymorphone ER

     The most advanced of the products in our development pipeline is an extended release formulation of oxymorphone incorporating TIMERx technology which we are developing with Endo. Oxymorphone ER, a narcotic analgesic, is being developed for twice-a-day dosing in patients with moderate to severe pain requiring continuous, around-the-clock opioid therapy for an extended period of time. Oxymorphone, which is currently given in the parenteral and suppository dosage form, is marketed by Endo and had sales in the United States in 2004 of approximately $375,000. Oxymorphone ER, if successfully developed, would represent the first oral extended release version of oxymorphone and would compete in the moderate to severe long acting opioid market with branded and generic products such as MS Contin, Purdue Pharma’s OxyContin, Johnson & Johnson’s Duragesic patch, and Ligand’s Avinza, which had aggregate sales in the United States in 2004 of approximately $4.0 billion.

     Endo, which is responsible for conducting the clinical trials and seeking regulatory approval of the product, submitted an NDA for oxymorphone ER to the FDA in December 2002. In October 2003, Endo received an approvable letter for oxymorphone ER. In the letter, the FDA requested that Endo address certain questions, provide additional clarification and information, and conduct some form of additional clinical trials to further confirm the safety and efficacy of oxymorphone ER, before the FDA would approve Endo’s NDA for oxymorphone ER. In discussions with Endo, the FDA advised Endo of its concern that the outcome of two of the three Phase III efficacy trials submitted in the NDA that met their predefined primary end-points may have been favorably biased by the statistical handling of data from patients who did not complete the trials. The design of this additional clinical trial is intended to address this issue. In November 2004, Endo announced that the FDA had granted under the FDA’s SPA process, final approval of the protocol for a clinical trial in patients with chronic low back pain and without recent treatment with opioid analgesics, designed to provide the additional safety and efficacy data for oxymorphone ER requested by the FDA. The clinical trial is also intended to address the FDA’s concern regarding data from patients who do not complete the trial.

     The new trial is intended to complement the completed Phase III pivotal trial that Endo believes has demonstrated efficacy in the intended patient population. The trial will be a 12-week, multicenter double-blinded, placebo-controlled Phase III trial of oxymorphone ER. Endo expects to recruit approximately 250 patients for this trial. Endo has commenced patient enrollment and expects to announce the results of the trial in the fourth quarter of 2005. Endo has also reported that based on the duration of the trial and the number of patients to be enrolled, and assuming the data is favorable, Endo expects to submit a complete response letter to the FDA in early 2006. We expect that Endo will receive a further action letter from the FDA within six months of the submission of the complete response letter.

PW2101

     We are currently developing PW2101, a beta blocker intended for the treatment of hypertension and angina, which we have formulated using our TIMERx technology. We have developed PW2101 on our own but are seeking a collaborator to market the product. We submitted a section 505(b)(2) to the FDA for PW2101 on August 31, 2004, and the FDA accepted this NDA for filing on October 29, 2004. The original filing of the NDA covered three strengths of the product. In the fourth quarter of 2004, we completed a clinical trial of a lower strength of the product. The results, while positive, were not statistically significant at a p-value of 0.05. The low dose strength, however, did meet most of the trial’s key secondary endpoints. As a result, in the first quarter of 2005, we submitted the data from the clinical trial to the FDA as a supplement to our NDA. We believe the data will be included in the review of the original NDA.

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     PW2101 is a controlled release formulation of an immediate release beta blocker, the active ingredient which is no longer subject to patents in the United States. There is currently a similar branded controlled release beta blocker product that is marketed for hypertension, angina, and congestive heart failure. This branded product had U.S. sales of approximately $1.2 billion in 2004. There are also currently filings for generic versions of the branded controlled release beta blocker product, and the sponsors are engaged in patent litigation. If the sponsors of the generic products prevail in such litigation, and PW2101 is approved, PW2101 would compete with the branded product and the generic versions of the branded product. We are currently in discussions with the FDA regarding the appropriate patent certifications required to be made for PW2101. If we are required to file a paragraph IV certification and the patent holder sues us for infringement, the FDA may not approve our NDA for up to 30 months.

PW2132

     We are currently developing PW2132, a drug candidate intended for the treatment of edema related to congestive heart failure, which we formulated using our Geminex technology. We conducted a pilot scale biostudy of PW2132 in approximately 20 healthy volunteers in the fourth quarter of 2004. In the study, PW2132 achieved the blood level curves we had targeted as endpoints of the study and we believe may improve the efficacy of the drug. Based on the results of the pilot biostudy, we are planning to file an Investigational New Drug Application, or IND, for PW2132 and then commence a Phase II single dose ranging study in patients in mid 2005. We are developing the protocol for this study based on input we received from the FDA at the pre IND meeting held with the FDA in the first quarter of 2005.

Phase I Products

     We are currently conducting pilot scale Phase I biostudies of several product candidates primarily for drugs to treat diseases of the central nervous system. In these studies, we are seeking to obtain proof of principle data in humans. If the pilot scale biostudies of any of these product candidates show proof of principle and the commercial returns appear attractive, we will most likely seek to advance the product candidate into further clinical trials on our own. The decision to develop the product candidate on our own will be based on our available resources after consideration of a number of factors, including the size of the potential market, competitors in the potential market, the availability of intellectual property protection, the regulatory pathway and the development status of our other product candidates.

Collaborative Agreements

     We enter into collaborative agreements with pharmaceutical companies to develop, market or manufacture some of our products.

     We currently are parties to two types of collaborative agreements. In revenue sharing collaborative agreements, we jointly fund research and development with our collaborator, and we receive no up-front licensing fees or milestone payments. In these arrangements, we share in a pre-determined percentage of the net operating profits. Technology licensing collaborative agreements involve the straight licensing of our technology to a collaborator. Under these arrangements, we have no obligation to fund the ongoing clinical development or marketing costs of the product. We also receive up-front license fees and milestone payments and are entitled to receive royalties on our collaborators’ sales of the products covered by such collaborative arrangements and payments for the purchase of formulated TIMERx material. Our principal collaborative agreements are described below.

     In the future, we expect that any collaborative agreements into which we will enter will likely involve the licensing of an NDA to a marketing partner after we complete the development of a product and submit the application to the FDA. Under this type of collaborative agreement, we anticipate that we would fund the development work on a product and in return receive up-front license fees, milestone payments and royalties.

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Revenue Sharing Collaborative Agreements

Endo Pharmaceuticals, Inc.

     In September 1997, we entered into a strategic alliance agreement with Endo with respect to the development of oxymorphone ER, an extended release formulation of oxymorphone based on our TIMERx technology. This agreement was amended and restated in April 2002. Endo is a fully integrated specialty pharmaceutical company with a market leadership position in pain management. Endo has a broad product line, including established brands such as Percodan, Percocet and Lidoderm. Endo is registered with the United States Drug Enforcement Administration as a developer, manufacturer and marketer of controlled narcotic substances.

     Under our agreement with Endo, our responsibilities and the responsibilities of Endo with respect to oxymorphone ER are determined by a committee comprised of an equal number of members from both Endo and Penwest, which we refer to as the Alliance Committee. During the development of the product, we formulated oxymorphone ER and Endo conducted all clinical studies and prepared and filed all regulatory applications. We have 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 of oxymorphone ER outside of the United States may be conducted by Endo, us or a third party, as determined by the Alliance Committee. The commercialization of oxymorphone ER outside of the United States is currently being discussed by the Alliance Committee.

     Prior to April 17, 2003, we shared with Endo the costs involved in the development and pre-marketing of oxymorphone ER. On April 17, 2003, we discontinued our participation in the funding of the development and pre-marketing of oxymorphone ER. We took this action because we believed that our strategic focus should be on funding other products in our development pipeline. As a result of this termination of funding, Endo has the right to complete the development of oxymorphone ER and recoup the portion of development and pre-marketing costs incurred by Endo that otherwise would have been funded by us. Endo may recoup such development costs through a temporary adjustment in the royalty rate payable to us, which will return to its pre-adjustment level once Endo has recovered such costs. Endo may also allow us to reimburse Endo directly for the unfunded amounts. We estimate that through January 31, 2005, these unfunded costs approximated $15.0 million. We expect these costs to increase as Endo completes the ongoing pivotal trial and incurs pre-launch marketing costs. We have agreed with Endo that the party marketing oxymorphone ER will pay the other party royalties initially equal to 50% of the net realization, as defined in the agreement between Endo and us, subject to adjustment for unfunded development costs. This percentage will decrease if the aggregate U.S. net realization exceeds pre-determined thresholds. In general, the royalty payable by the marketing party to the other party will not drop below 40%. However, the royalty will be reduced by one-third in limited circumstances, including termination of the agreement based on uncured material breaches of the agreement by the royalty receiving party and specified bankruptcy and insolvency events involving the royalty receiving party. Under the agreement, Endo will purchase formulated TIMERx material for use in oxymorphone ER exclusively from us at specified prices, and include these purchases in cost of goods sold of the product prior to determining net realization, on which the royalty payment is calculated.

Technology Licensing Collaborative Agreements

Mylan Pharmaceuticals Inc.

     In August 1994, we entered into product development and supply agreements with Mylan with respect to the development of Nifedipine XL, a generic version of Procardia XL, based on our TIMERx technology. Procardia XL is a branded drug for the treatment of hypertension and angina that utilizes nifedipine as its active ingredient. Under the agreement, we were responsible for the formulation, manufacture and supply of TIMERx material for use in the product, and Mylan was responsible for conducting all bioequivalence studies, preparing all regulatory applications and submissions, and manufacturing and marketing Nifedipine XL in North America. In December 1999, the FDA approved the 30 mg strength of Nifedipine XL.

     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 and 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. The royalty percentage was comparable to the percentage called for in our original agreement with Mylan for Nifedipine XL. Mylan has retained the marketing rights for the 30 mg strength of Nifedipine XL. Mylan’s sales in the United States in 2004 of the 30 mg dosage strength version of Pfizer’s generic Procardia XL totaled approximately $40.2 million. The term of this agreement continues until such time as Mylan permanently ceases to market generic Procardia XL. In 2004, 2003 and 2002,

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royalties from Mylan were approximately $4.8 million, $4.1 million and $4.8 million, respectively, or 94%, 88% and 87%, respectively, of our total revenue from continuing operations.

Other Agreements

     We are a party to the following additional technology licensing collaborative agreements involving our TIMERx technology:

	•	Sanofi-Synthelabo S.A. Our agreement with Sanofi-Synthelabo relates to Slofedipine XL, an extended release version of nifedipine for the treatment of angina. Slofedipine XL was approved in the United Kingdom in 1998 and Italy in 2000. Sanofi-Synthelabo is marketing Slofedipine XL in both countries.
	•	Schering Oy. Our agreement with Schering Oy relates to Cystin CR, an extended release version of oxybutynin for the treatment of urge urinary incontinence. Schering began marketing Cystin CR in Finland after receiving approval for the product in Finland in 1997.
	•	E. Merck. Our agreement with E. Merck relates to Cronodipin, an extended release version of nifedipine for the treatment of angina that was approved in Brazil and was licensed to Merck S.A. Industries Quimicas for marketing in Brazil.
	•	IVAX Corporation. Our agreement with IVAX relates to the development of PW3101 for the treatment of asthma in the United States. Ivax has received an approvable letter from the FDA for the product and is in the process of responding to the FDA.
	•	Ranbaxy Laboratories Ltd. Our agreement with Ranbaxy relates to the development of an extended release version of nifedipine for the treatment of angina for India.

Research and Development

     We conduct research and development activities on the development of product candidates utilizing our drug delivery technologies as well as on the development of additional drug delivery technologies. Our research and development expenses in 2004, 2003 and 2002 were $20.2 million, $20.6 million and $17.0 million, respectively. These expenses do not include amounts incurred by our collaborators in connection with the development of products under our collaboration agreements such as expenses for full-scale bioequivalence studies, clinical trials performed by our collaborators, expenses incurred on oxymorphone ER subsequent to April 17, 2003, or our collaborators’ share of funding.

Manufacturing

     Bulk TIMERx. We currently have no internal commercial scale manufacturing capabilities. Generally, our collaborators manufacture the pharmaceutical products and we are responsible for supplying them with bulk TIMERx. We have outsourced the commercial manufacture of TIMERx materials to a third-party pharmaceutical company, Draxis Pharmaceuticals, Inc., under a manufacturing agreement that expires in September 2006. The agreement automatically renews 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 seeking to qualify a second contract manufacturer as a second source of supply. We have completed initial validation work with the second contract manufacturer, however, there is additional follow-up work required before the site is fully validated. We believe that there are a limited number of manufacturers that operate under cGMP regulations capable of manufacturing our TIMERx materials.

     Our TIMERx technology is based on a hydrophilic matrix combining a heterodispersed mixture primarily composed of two polysaccharides, xanthan and locust bean gums, in the presence of dextrose. We purchase these gums from a primary supplier. We have also qualified alternate suppliers with respect to these gums and to date we have not experienced difficulty acquiring these materials.

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     Oxymorphone ER. Under our collaboration with Endo, we supply bulk TIMERx to Endo and Endo is responsible for the manufacture of oxymorphone ER. Endo has outsourced the commercial manufacture of oxymorphone ER to a third party manufacturer.

     PW2101. We are working with Patheon, Inc. with respect to the commercial manufacture of PW2101. Patheon manufactured PW2101 for use in our clinical trials as well as the NDA registration batches. However, the manufacturing site at which this manufacturing was conducted only has stability data for the higher strengths of PW2101. The stability data for the lower strength was done at an alternative site with Patheon. As a result, we are working with Patheon to qualify the alternative site which would consolidate the manufacturing of all the strengths of PW2101 at a single site and would also provide greater production capacity than the original site. In order to use this alternative site for the commercial production of PW2101, we will need to conduct bioequivalence studies and submit them to the FDA as part of our NDA. We are currently negotiating a commercial agreement with Patheon, however, we do not intend to sign an agreement with Patheon until we sign an agreement with a collaborator for marketing.

Marketing and Distribution

     Pursuant to our collaborative agreements, our collaborators have, or are expected to have, responsibility for the marketing and distribution of any pharmaceuticals developed based on our drug delivery technologies. Because we do not currently market any pharmaceuticals without a collaborator, we have not developed any sales force with respect to such products. As a result, we are substantially dependent on the efforts of our collaborators to market the products. In selecting a collaborator for a drug candidate, some of the factors we consider include the collaborator’s market presence in the therapeutic area targeted by the drug candidate and the collaborator’s sales force and distribution network.

     If we determine to retain the rights to market one or more of the products we are developing for diseases of the central nervous system, we will need to build or acquire a small sales force of 50 to 100 sales representatives to market these product candidates. We believe these high-prescribing specialty physician groups can be effectively targeted with a sales force of this size.

Patents and Proprietary Rights

     We believe that patent and trade secret protection of our drug delivery technology and our products are important to our business and that our success will depend in part on our ability to maintain existing patent protection, obtain additional patents, maintain trade secret protection and operate without infringing the proprietary rights of others.

Patents and Protection of Proprietary Information

     As of February 28, 2005, we owned 32 U.S. and 183 foreign patents relating to our controlled release drug delivery technology. The U.S. patents principally cover our TIMERx technology and new technologies based on the TIMERx technology, including the combination of the xanthan and locust bean gums, the oral solid dosage form of TIMERx and the method of preparation, as well as the application of TIMERx technology to various active drug substances, including both methods of treatment and methods of preparation. These patents will expire between 2008 and 2020. Based on a patent review conducted with our patent attorneys, we believe the most important patents relating to our TIMERx technology begin to expire in 2014.

     The issuance of a patent is not conclusive as to its validity or as to the enforceable scope of the claims of the patent. There is no assurance that our patents or any future patents we obtain will prevent other companies from developing non-infringing similar or functionally equivalent products or from successfully challenging the validity of our patents. Furthermore, there is no assurance that:

	•	any of our future processes or products will be patentable;
	•	any pending or additional patents will be issued in any or all appropriate jurisdictions;
	•	our processes or products will not infringe upon the patents of third parties; or

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•

we will have the resources to defend against charges of infringement by, or protect our own patent rights against, third parties.

     Our inability to protect our patent rights, or infringement by us of the patent or proprietary rights of others, could have a material adverse effect on our business, financial condition and results of operations.

     We also rely on trade secrets and proprietary knowledge, which we generally seek to protect by confidentiality and non-disclosure agreements with employees, consultants, licensees and pharmaceutical companies. There can be no assurance, however, that these agreements have or in all cases will be obtained, that these agreements will not be breached, that we will have adequate remedies for any breach or that our trade secrets will not otherwise become known by competitors.

     There has been substantial litigation in the pharmaceutical industry with respect to the manufacture, use and sale of new products that are the subject of conflicting patent rights. Under the Waxman-Hatch Act, when an applicant files a section 505(b)(2) NDA or an ANDA with the FDA with respect to a brand name product covered by an unexpired patent listed with the FDA, the applicant must certify to the FDA for each of such patents that (i) final approval of the section 505(b)(2) NDA or ANDA will not be sought until the expiration of the patent or (ii) such patent will not be infringed by the applicant’s product or such patent is invalid or unenforceable. If the applicant makes a certification as set forth in (ii) above, notice of such certification must be given to the patent owner and the sponsor of the NDA for the brand name product. If a patent owner files a patent infringement lawsuit within 45 days of the receipt of such notice, the FDA will conduct a substantive review of the section 505(b)(2) NDA or ANDA, but will not grant final marketing approval of the product covered by the filing until a final judgment on the patent suit is rendered in favor of the applicant or until 30 months (or such longer or shorter period as a court may determine) have elapsed from the date of the certification, whichever is earlier. Should a patent owner commence a lawsuit with respect to alleged patent infringement by us or our collaborators, the uncertainties inherent in patent litigation make the outcome of such litigation difficult to predict. We evaluate the probability of patent infringement litigation with respect to each product we determine to develop.

Trademarks

     TIMERx, Geminex and SyncroDose are our registered trademarks. Other tradenames and trademarks appearing in this annual report on Form 10-K are the property of their respective owners.

Government Regulation

     Government authorities in the United States and other countries extensively regulate the research, development, testing, manufacture, labeling, promotion, advertising, distribution and marketing of drug products. In the United States, the FDA regulates drug products under the Federal Food, Drug, and Cosmetic Act, or FDCA, and implements regulations and other laws. Failure to comply with applicable U.S. requirements, both before and after approval, may subject us to administrative and judicial sanctions, such as a delay in approving or refusal by the FDA to approve pending applications, warning letters, product recalls, product seizures, total or partial suspension of production or distribution, injunctions, and/or criminal prosecutions.

     Before our or our collaborators’ drug products may be marketed in the United States, each product must be approved by the FDA. The approval process requires substantial time, effort and financial resources, and we cannot be sure that any approval will be granted on a timely basis, or at all. There are several kinds of NDA’s that may be submitted to obtain FDA approval of our or our collaborators’ drugs, including full new drug applications, or full NDAs; section 505(b)(2) NDAs; or abbreviated new drug applications, or ANDAs. A “full” NDA is an NDA in which the information required for approval, including investigations of safety and effectiveness, comes from studies conducted by or for the sponsor or for which the sponsor has obtained a right of reference. A section “505(b)(2)” NDA is an NDA in which at least some of the information required for approval comes from studies not conducted by or for the sponsor and for which the sponsor has not obtained a right of reference. An Abbreviated New Drug Application (“ANDA”) usually utilizes for proof of safety and effectiveness data demonstrating that the drug is “bioequivalent” to a drug which FDA has previously approved.

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     Full NDAs: The steps required before a full NDA may be approved by the FDA include pre-clinical laboratory and animal tests and formulation studies; submission to the FDA of an investigational new drug exemption, or IND, for human clinical testing, which must become effective before human clinical trials may begin; adequate and well-controlled clinical trials to establish the safety and effectiveness of the product candidate for each indication for which approval is sought; submission to the FDA of the NDA; satisfactory completion of an FDA inspection of the manufacturing facility or facilities at which the drug is produced to assess compliance with current good manufacturing practices (cGMP); and FDA review and approval of the NDA.

     Pre-clinical tests include laboratory evaluations of product chemistry, toxicity and formulation, as well as animal studies. The results of the pre-clinical tests, together with manufacturing information and analytical data, are submitted to the FDA as part of an IND, which must become effective before human clinical trials may begin. An IND will automatically become effective 30 days after receipt by the FDA, unless before that time the FDA raises concerns or questions. In such a case, the FDA’s concerns or questions must be resolved before clinical trials can proceed.

     Clinical trials involve the administration of the investigational drug to human subjects under the supervision of qualified physician-investigators and healthcare personnel. Clinical trials are conducted under protocols detailing, for example, the parameters to be used in monitoring patient safety and the safety and effectiveness criteria, or end points, to be evaluated.

     Clinical trials are typically conducted in three phases, however the phases may overlap or be combined. Each trial must be reviewed and approved by an independent Institutional Review Board before it can begin. Phase I usually involves the initial introduction of the investigational drug candidate into people to evaluate its safety, dosage tolerance, pharmacodynamics and, if possible, to gain an early indication of its effectiveness. Phase II usually involves trials in a limited patient population to evaluate dosage tolerance and appropriate dosage; identify possible adverse side effects and safety risks; and preliminarily evaluate the effectiveness of the drug candidate for specific indications. Phase III trials usually further evaluate clinical effectiveness and test further for safety by administering the drug candidate in its final form in an expanded patient population. We, our collaborators, or the FDA may suspend clinical trials at any time on various grounds, including a finding that the patients are being exposed to an unacceptable health risk.

     Assuming successful completion of the required clinical testing, the results of the preclinical studies and the clinical studies, together with other detailed information, including information on the manufacture and composition of the product, are submitted in an NDA requesting approval to market the product for one or more indications. Before approving an application, the FDA usually will inspect the facility or the facilities at which the product candidate is manufactured, and will not approve the product unless cGMP compliance is satisfactory. If the FDA determines the NDA is not acceptable, the FDA may outline the deficiencies in the NDA and often will request additional information. Notwithstanding the submission of any requested additional testing or information, the FDA ultimately may decide that the application does not satisfy the regulatory criteria for approval.

     505(b)(2) NDAs: Section 505(b)(2) NDAs may be submitted for drug products that represent a modification of an already approved drug (e.g., a new indication or new dosage form) and for which investigations other than bioavailability or bioequivalence studies are essential to the drug’s approval. For example, our product candidate PW2101 utilizes our TIMERx extended release delivery system to create a modification of an already-approved drug, and was therefore submitted as a 505(b)(2) NDA. Section 505(b)(2) NDAs rely in part on safety and effectiveness information available for the already approved drug as well as information obtained by the 505(b)(2) applicant needed to support the modification of the already approved drug. 505(b)(2) NDAs generally require the applicant to conduct one or more clinical studies, which must comply with the IND requirements. Preparing a 505(b)(2) NDA is generally less costly and time-consuming than preparing a full NDA.

     The FDCA provides that review and/or approval of 505(b)(2) NDAs will be delayed in various circumstances. For example, the holder of the NDA for the already approved drug may be entitled to a period of market exclusivity, during which the FDA will not approve, and will not even review, the 505(b)(2) NDA. Also, if the already approved drug is claimed by an unexpired patent that has been listed with the FDA, the 505(b)(2) NDA applicant must provide a certification regarding the status of the patent. If the applicant certifies that the patent is invalid, unenforceable, or not infringed by the product that is the subject of the 505(b)(2) NDA (a Paragraph IV

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certification), the FDA will not approve the 505(b)(2) NDA until the earlier of a court decision favorable to the 505(b)(2) applicant or the expiration of 30 months, a period that may be extended in some circumstances. The regulations governing marketing exclusivity and patent protection are complex, and it is often unclear how they will be applied in particular circumstances.

     ANDA’s: The FDA may approve an ANDA if the product is the same in important respects as an already approved drug, or if the FDA has declared the drug suitable for an ANDA submission. For example, the FDA approved the ANDA submitted by our collaborator, Mylan, for the 30 mg dosage strength of a generic version of Procardia XL. ANDAs must contain the same manufacturing and composition information as NDAs, but applicants need not submit preclinical and clinical safety and effectiveness data. Instead, they must submit studies showing that the product is bioequivalent to the already approved drug. Drugs are bioequivalent if the rate and extent of absorption of the drug does not show a significant difference from the rate of extent of absorption of the already approved drug. Conducting bioequivalence studies is less time-consuming and costly than conducting pre-clinical and clinical studies necessary to support an NDA.

     Like 505(b)(2) NDAs, ANDA approvals may be delayed because of market exclusivity or while patent rights are being adjudicated. Also, in circumstances in which the already approved drug is claimed in an unexpired patent listed with FDA and the patent’s validity, enforceability or applicability to the generic drug has been challenged by more than one generic applicant, the first ANDA applicant to challenge the patent may receive a 180-day period of market exclusivity.

Other FDA Requirements:

     After approval, certain changes to the approved product, such as adding new indications, manufacturing changes, or additional labeling claims are subject to further FDA review and approval.

     In addition, regardless of the type of approval sought, we and our collaborators are required to comply with a number of FDA requirements both before and after approval. For example, we are required to report certain adverse reactions and production problems, if any, to the FDA, and to comply with certain requirements concerning advertising and promotion for our products. Also, quality control and manufacturing procedures must continue to conform to cGMP after approval, and the FDA periodically inspects manufacturing facilities to assess compliance with cGMP. Accordingly, manufacturers must continue to expend time, money and effort in all areas of regulatory compliance, including production and quality control to comply with cGMP. In addition, discovery of problems, such as safety problems may result in changes in labeling or restrictions on a product manufacturer or NDA holder, including removal of the product from the market.

Competition

     The pharmaceutical industry is highly competitive and is affected by new technologies, governmental regulations, healthcare legislation, availability of financing, litigation and other factors. Many of our competitors have longer operating histories and greater financial, technical, marketing, legal and other resources than us and some of our collaborators. In addition, many of our competitors have significantly greater experience than we have in conducting clinical trials of pharmaceutical products, obtaining FDA and other regulatory approvals of products, and marketing and selling approved products. We expect that we will be subject to competition from numerous other entities that currently operate or intend to operate in the pharmaceutical and specialty pharmaceutical industry.

     The key factors affecting the success of our drug delivery products are likely to include, among other things:

	•	the safety and efficacy of our products;
	•	the relative speed with which we can develop products;
	•	generic competition for any product that we develop;
	•	our ability to differentiate our products; and
	•	external factors affecting pricing.

     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

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competition from MS Contin, Purdue Pharma’s OxyContin, Duragesic marketed by Johnson & Johnson and generic competitors to these products.

     Some of the TIMERx products we are developing, such as PW2101, are branded controlled release products, which are proprietary products that are based on active chemical ingredients that are not subject to patents. These branded controlled release products will compete against other products developed using the same or a similar active chemical ingredient, including branded immediate release and branded controlled released products, as well as any generic versions of these products, based primarily on price. In addition, our branded controlled released products will compete against other competitive products in the therapeutic class. For instance, PW2101 is a controlled release formulation of an immediate release beta blocker, the chemical active ingredient for which is no longer subject to patents in the United States. There is currently a similar branded controlled release beta blocker product that is marketed for hypertension, angina and congestive heart failure, and against which we expect PW2101 will compete. There are also currently filings for generic versions of the branded controlled release products and the sponsors of the branded product and the generic products are currently in patent litigation. If the sponsors of generic products prevail in such litigation, PW2101 would also compete against these generic versions.

Employees

     As of March 11, 2005, we employed approximately 69 people, of whom 47 were primarily involved in research and development activities, and 22 were primarily involved in selling, general and administrative activities. As of March 11, 2005, none of our employees were covered by collective bargaining agreements. We consider our employee relations to be good.

Information Available on the Internet

     Our internet address is www.penwest.com. We make available free of charge through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports filed or furnished pursuant to Section 12(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after we electronically file such materials with the Securities and Exchange Commission (SEC). We also include on our website our corporate governance guidelines, our code of business conduct and ethics, and the charters for our audit committee, our compensation committee and our nominating and corporate governance committee. In addition, we intend to disclose on our website any amendments to, or waivers from, our code of business conduct and ethics that are required to be publicly disclosed pursuant to rules of the SEC and the NASDAQ.

ITEM 2: PROPERTIES

     Our corporate offices, comprising approximately 21,500 square feet, are located in Danbury, Connecticut. We lease these offices under a lease that expires December 30, 2006; provided however, that we have the right to extend the term of this lease through December 30, 2008.

     We have also leased research facilities, comprising approximately 15,000 square feet, in Patterson, New York, which we owned prior to the sale of our excipient business to Rettenmaier in 2003. Our agreement with Rettenmaier is scheduled to expire in February 2006, however we have the right to exercise two successive one-year options. The space we currently lease is adequate for our present needs.

EXECUTIVE OFFICERS OF THE REGISTRANT

     The following table sets forth the names, ages and positions of our executive officers.

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PART II

ITEM 5: MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

     Our common stock, $.001 par value, is listed with and trades on the Nasdaq National Market under the symbol “PPCO.” The high and low sale prices of our common stock during 2004 and 2003 are set forth below. These prices reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

     On March 11, 2005 there were 772 shareholders of record.

     We have never paid cash dividends on our common stock. We presently intend to retain earnings, if any, for use in the operation of our business, and therefore do not anticipate paying any cash dividends in the foreseeable future.

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ITEM 6: SELECTED FINANCIAL DATA

     The following selected financial data are derived from our consolidated financial statements. The data should be read in conjunction with the consolidated financial statements, related notes, and other financial information included herein.

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

     We develop pharmaceutical products based on innovative proprietary oral drug delivery technologies. We are focusing our development efforts principally on products that address diseases of the central nervous system. The two most advanced products in our drug development pipeline are oxymorphone ER, an extended release formulation of oxymorphone, a narcotic analgesic being developed for twice-a-day dosing in patients with moderate to severe pain requiring continuous around-the-clock opioid therapy for an extended period of time, and PW2101, a beta blocker intended for the treatment of hypertension and angina. We are also developing several additional product candidates in areas such as edema, epilepsy, schizophrenia and depression.

     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 and the balance 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. As a result of the sale of the excipient business, our audited consolidated financial statements included in this annual report on Form 10-K present our excipient business as a discontinued operation for 2003 and 2002.

     We have incurred net losses since 1994. As of December 31, 2004, our accumulated deficit was approximately $118.2 million. We expect operating losses and negative cash flows to continue until substantial sales of products occur. A substantial portion of our revenues through February 27, 2003 were generated from sales of our pharmaceutical excipient product line. During 2002 and 2003 through the date that we sold our excipient business, sales of our excipient products generated positive cash flows from operations, although as a whole we had negative cash flows from operations. Since February 27, 2003, we have not derived any revenues from the excipient business. Our revenues since February 27, 2003 have been generated primarily from Mylan royalties and shipments of bulk TIMERx. Our future profitability will depend on several factors, including:

•	the successful commercialization of TIMERx controlled release products, including in particular oxymorphone ER and PW2101;
•	royalties from Mylan’s sales of Pfizer’s 30 mg generic version of Procardia XL; 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 modified release 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 or PW2101 are approved, the amount and timing of royalties on Mylan’s sales of Pfizer’s 30 mg generic version of Procardia XL, volume and timing of shipments of formulated bulk TIMERx, 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 consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles.

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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. While our significant accounting policies are fully described in Note 2 to our consolidated financial statements included in this annual report, we regard the following as critical accounting estimates.

Revenue Recognition

     Royalties and Licensing Fees

     We recognize revenues from non-refundable upfront licensing fees received under collaboration agreements ratably over the development period of the related collaboration agreement when this period involves development risk associated with the incomplete stage of a product’s development, or over the estimated or contractual licensing and supply term when there exists an obligation to supply inventory for manufacture. Non-refundable milestone fees received for the development funding of a product are partially recognized upon receipt based on our 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 us 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, we review 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 as reported by our collaborators, and are generally subject to our review or audit.

     Product Sales

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

Research and Development Expenses

     Research and development expenses consist of costs associated with products being developed internally as well as products being developed under collaboration agreements, and include related salaries, benefits and other personnel related expenses, clinical trial costs, and contract and other outside service fees. We expense research and development costs as incurred. A significant portion of our 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 our collaborators. These arrangements may require estimates to be made of related service fees or our share of development costs. These arrangements may also require us to pay termination costs to the third parties for reimbursement of costs and expenses incurred in the orderly termination of contractual services.

     These estimates involve identifying services, which have been performed on our behalf, and estimating the level of service performed and associated cost incurred for such service as of each balance sheet date in our consolidated financial statements. In connection with such service fees, our estimates are most affected by our understanding of the status and timing of services provided relative to the actual levels of service incurred by such service providers. In the event that we do not identify specific costs which have begun to be incurred or we under- or over-estimate the level of services performed or the costs of such services, our reported expenses for such period could be too low or

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too high. The date on which services commence, the level of services performed on or before a given date, and the cost of such services are often judgmental. We make these judgments based upon the facts and circumstances known to us in accordance with generally accepted accounting principles.

Deferred Taxes — Valuation Allowance

     We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we may consider any potential future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. At December 31, 2004, we had recorded full valuation allowances totaling approximately $40.2 million against our net deferred tax assets.

Impairment of Long-Lived Assets

     For purposes of recognizing and measuring impairment to our long-lived assets, including intangible assets such as our intellectual property, we assess the recoverability of the carrying amount of these assets whenever facts and circumstances indicate that the carrying amount may not be fully recoverable. We measure the impairment related to long-lived assets by the amount by which the carrying amount of the assets exceeds the fair value of the assets. In assessing the recoverability of our intangible assets, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. Estimated cash flow assumptions include profitability projections provided by our marketing partners or developed internally, based upon historical revenues or projected market share for new products. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.

Results of Operations for Years Ended December 31, 2004, 2003 and 2002

Revenues

     In 2004, 2003 and 2002, royalties and licensing fees consisted primarily of the royalties from Mylan on its sales of Pfizer’s 30 mg generic version of Procardia XL. Royalties and licensing fees increased in 2004 primarily due to Mylan’s increased net sales of Procardia XL and decreased in 2003 from 2002 primarily due to pricing pressure from additional generic competition.

     Our product sales consist of sales of formulated bulk TIMERx. The decrease in product sales in 2004 from 2003 was primarily due to a decrease in orders from a European customer. The decrease in product sales in 2003 from 2002 was primarily due to the timing of a shipment to a European customer of formulated bulk TIMERx that did not occur until the first quarter of 2004.

Selling, General and Administrative Expense

     Selling, general and administrative expenses decreased by 8% in 2004 to $9.5 million as compared to $10.4 million for 2003. The decrease was primarily due to decreases in professional fees, largely related to a strategic consulting project completed in 2003, and a decrease in our share of pre-launch marketing expenses for oxymorphone ER reflecting our discontinuation of the funding of Endo’s pre-launch marketing expenses for oxymorphone ER effective April 2003.

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     Selling, general and administrative expenses increased by 37% in 2003 to $10.4 million as compared with $7.6 million for 2002. The increase was primarily due to increased professional fees associated with a strategic review of our product pipeline, an increase in rent and lease expense related to office space, and increased personnel costs to support our business development and market research capabilities. The increase also reflects certain selling, general and administrative expenses that were incurred after February 27, 2003, the date of the sale of our excipient business, which were previously allocated to the excipient business but did not cease with the sale and were fully absorbed in continuing operations for the balance of 2003.

     On February 15, 2005, we announced that Tod R. Hamachek had resigned from his positions as Chief Executive Officer and Chairman of the Board of Directors and as a member of the Board. In connection with the resignation, we and Mr. Hamachek entered into a Severance and Settlement Agreement and Release on February 14, 2005. Under the agreement, we agreed that, in consideration of Mr. Hamachek’s release and other agreements under the agreement, we would continue Mr. Hamachek’s base salary ($594,000) for eighteen months as severance pay, and pay all premium costs relating to medical insurance continuation coverage and certain other benefits. We also agreed to accelerate in full the vesting of all stock options held by Mr. Hamachek and to extend the period during which he could exercise such stock options to the earlier of two years or their original expiration date. In connection with this agreement, we expect to record a charge to selling, general and administrative expense in our statement of operations totaling approximately $3.0 million in the first quarter of 2005, which includes a non-cash charge of approximately $2.4 million relating to the stock options noted above.

Research and 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 our share of development costs under our collaboration agreement with Endo.
	•	PW2101 – These expenses reflect our direct external expenses relating to the development of PW2101. These expenses consist primarily of payments to third parties in connection with clinical trials of PW2101, the manufacturing of PW2101 prior to regulatory approval for clinical use and potential commercial use, and our development work related to the qualification of an alternative manufacturing site for PW2101.
	•	Research and New Technology Development – These expenses reflect both our direct external expenses and our allocated internal expenses relating to the development of new drug delivery technologies. These direct external expenses consist primarily of payments to third parties in connection with outside laboratory and consulting fees. Our internal expenses primarily include salaries and benefits of our research and new technology development group, and other costs such as depreciation on purchased equipment, and the amortization or any write-downs of patent costs.
	•	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

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including our formulation, clinical and regulatory groups, and other costs primarily related to our laboratory facilities.

     Oxymorphone ER. We did not have any research and development expenses related to oxymorphone ER in 2004 and have not incurred any research and development expenses related to oxymorphone ER since April 17, 2003 when we discontinued our funding of the development of oxymorphone ER. Research and development expenses in 2002 and the beginning of 2003 related to the costs of clinical trials of oxymorphone. 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.

     PW2101. Approximately 46% of our research and development expenses for 2004 related to direct costs associated with clinical development, manufacturing scale-up and preparation of the NDA for PW2101. Our 2004 PW2101 expenses were generally comparable to 2003 expenses, each of which primarily included costs relating to the pivotal clinical trials of PW2101 in 2003 and 2004, including payments to the clinical research organization managing the trials, and increased costs with respect to scale-up, manufacturing and stability of PW2101. These costs in 2003 and 2004 were significantly higher than in 2002, when our expenses for PW2101 related to proof-of-principle biostudies and the manufacturing of clinical supplies. In 2003, we completed a pivotal trial of four strengths of PW2101 and in 2004 we completed a pivotal trial of a lower strength of PW2101. We have submitted a 505(b)(2) NDA to the FDA for PW2101, which the FDA accepted for filing in October 2004. We do not anticipate conducting additional clinical trials for PW2101 in 2005. We have established arrangements with Patheon for the commercial manufacture of the higher strengths of PW2101 at one manufacturing site. We expect to continue to incur additional research and development expenses in 2005 relating to PW2101 as we continue to work with Patheon to qualify another manufacturing site that could produce all of the strengths of PW2101, and would have a greater production capacity than the current site. Although we have developed PW2101 on our own, we do not intend to market this product. As a result, we are currently seeking a marketing partner for this product. We do not intend to manufacture commercial supply of PW2101 or conduct the necessary validation of the manufacturing product until we obtain a marketing collaborator for the product.

     Research and New Technology Development Expenses. These expenses increased in 2004 primarily due to a $410,000 write-down recorded in the second quarter of 2004 related to the impairment of certain patents covering our inhalation technology which we determined no longer had value, and our continued focus on the expansion of the applications of our TIMERx technology, and legal expenses and amortization associated with our intellectual property. Research and new technology development expenses also increased in 2003 over 2002 due to our efforts to expand TIMER technology. We expect research and new technology development expenses to decrease in 2005 as personnel that were previously performing research and new technology development activities are being redirected to developing Phase I candidates.

     Phase I Products and Internal Costs. These costs increased in 2004 over 2003, and in 2003 over 2002 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 product development efforts.

     There can be no assurance that oxymorphone ER, PW2101, or 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.

Tax Rates

     For continuing operations, the effective tax rates for 2004, 2003 and 2002 were essentially zero. The effective tax rates are higher than the federal statutory rate of a 34% benefit due primarily to valuation allowances recorded to offset net deferred tax assets relating to our net operating losses, and foreign income taxes.

Liquidity and Capital Resources

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Sources of Liquidity

     Subsequent to August 31, 1998, the date we became an independent, publicly-owned company, we have funded our operations and capital expenditures from the proceeds from the sale and issuance of shares of common stock, the sale of our excipient business, the sale of excipients, sales of formulated bulk TIMERx, royalties and milestone payments from Mylan and other collaborators, and advances under credit facilities. As of December 31, 2004, we had cash, cash equivalents, and short-term investments of $74.4 million. We have no committed sources of capital.

     We are a party to an agreement with Endo with respect to the development and commercialization of oxymorphone ER. On April 17, 2003, we discontinued our participation in the funding of the development and pre-launch marketing of oxymorphone ER. We did not incur any expenses relating to oxymorphone ER in 2004 and we do not expect to incur any significant expenses relating to oxymorphone ER in 2005, unless we resume our participation in the funding of the development and marketing of oxymorphone ER. As a result of this termination of funding, Endo has the right to complete the development of oxymorphone ER and recoup the portion of development costs incurred by Endo that otherwise would have been funded by us, through a temporary adjustment in the royalty rate payable to us that will return to its pre-adjustment level once Endo has recovered such unfunded development and pre-launch marketing costs. Endo may also allow us to reimburse Endo directly for these unfunded amounts and, as a result, to receive the full royalty rate from Endo without adjustment. We estimate that through January 31, 2005 these unfunded costs approximated $15.0 million. We expect this unfunded amount to increase as Endo completes the required pivotal study and incurs pre-launch marketing costs.

     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 repay 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 our 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.

     On December 14, 2004, we completed the sale of a total of 3,125,000 shares of common stock through a private placement to selected institutional investors, resulting in net proceeds to us, after fees and expenses, of approximately $32.8 million.

Cash Flows

     We had negative cash flow from operations for 2004 of $22.9 million, primarily due to the net loss of $23.8 million we had in the period. We had negative cash flow from operations for 2003 of $22.2 million, primarily due to the loss from continuing operations of $26.0 million in the period, which was partially offset by net cash provided by discontinued operations operating activities of $874,000 for the period prior to the sale of our excipient business on February 27, 2003, and net increases in payables and accrued expenses of $2.1 million. Our cash flow in 2004 and 2003 differed from our cash flow in 2002 primarily 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 from January 1, 2003 through February 26, 2003.

     Net cash used in investing activities totaled $5.4 million for 2004, primarily due to our net investment in marketable securities of $4.7 million. In addition, investing activities in 2004 also reflected $1.2 million in capital expenditures for the acquisitions of fixed assets primarily related to laboratory equipment for drug development activities as well as costs incurred for information technology and leasehold improvements made to our office facility in Danbury, CT. Funds expended for patents totaled $643,000 and include costs to secure patents on

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technology and products developed by us. In addition in 2004, we received $1.2 million for the remaining balance on the promissory note issued in consideration for the excipient business.

     Financing activities provided $34.2 million in cash, primarily due to net cash proceeds from the private placement of our common stock in December 2004.

Funding Requirements

     We anticipate that, based on our current operating plan and excluding any potential revenues from oxymorphone ER, our existing capital resources and anticipated internally generated funds from the sale of formulated bulk TIMERx, royalties from Mylan and other payments from collaborators will be sufficient to fund our operations on an ongoing basis without requiring us to seek external financing through at least the first half of 2007. We expect to continue to invest in capital expenditures in 2005 at levels similar to 2004 capital spending, primarily for laboratory equipment for our drug development activities and for patents on technology and products developed by us.

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

•	whether oxymorphone ER or PW2101 are approved on a timely basis, or at all;
•	the costs and timing of adding product candidates or technologies;
•	whether we resume our participation in the funding of the development and marketing of oxymorphone ER;
•	the timing and amount of payments received under existing and possible future collaborative agreements, in particular oxymorphone ER;
•	our success in entering into a marketing collaboration for PW2101;
•	our ability to qualify the alternative manufacturing site for PW2101 on a timely basis or at all, and the costs of doing so;
•	the structure and terms of any future collaborative or development agreements;
•	the progress of our collaborative and independent development projects, funding obligations with respect to the projects, and the related costs to us of clinical studies for our products;
•	royalties received from Mylan; and
•	the prosecution, defense and enforcement of potential patent claims and other intellectual property rights.

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

     If we raise additional funds by issuing equity securities, further dilution to our then existing shareholders may result. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Any debt or equity financing may contain terms, such as liquidation and other preferences, that are not favorable to us or our shareholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish valuable rights to our technologies, research programs or potential product, or grant licenses on terms that may not be favorable to us. We cannot be certain that additional financing will be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain this additional financing, we may be required to delay, reduce the scope of, or eliminate one or more of our planned research, development and commercialization activities, which could harm our financial condition and operating results.

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Contractual Obligations

     Our outstanding contractual cash obligations relate to our operating leases, primarily for facilities, and purchase obligations relating to capital expenditures and clinical development. Below is a table summarizing our contractual cash obligations under our operating leases having initial lease terms of more than one year and our purchase obligations, as of December 31, 2004 (in thousands).

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

     We have a Supplemental Executive Retirement Plan, or SERP, a nonqualified plan, which covers our former Chairman and Chief Executive Officer, Tod Hamachek. Effective February 14, 2005, Mr. Hamachek resigned from his positions as Chairman and Chief Executive Officer. Under the SERP, Mr. Hamachek, now 59, is eligible for benefit payments to commence with his retirement effective February 15, 2005. These benefits, based on 55% of Final Average Compensation, as defined, and elections made by Mr. Hamachek, will be reduced as a result of his early retirement.

     We also have a Deferred Compensation Plan or DCP, a non-qualified plan which covers Mr. Hamachek. Under the DCP, Mr. Hamachek is eligible for benefit payments to commence with his retirement effective February 15, 2005. These benefits are fully vested and may include retirement benefits, lump sum payout less a 10% forfeiture after a change in control or termination of employment, and/or death benefits. Based on elections made by Mr. Hamachek, benefits are expected to be paid in annual installments over ten years.

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

     We do not fund these liabilities and no assets are held by the plans. However, we have two whole-life insurance policies in a rabbi trust, the cash surrender value or death benefits of which are held in trust for the SERP and DCP liabilities. We are entitled to borrow against these policies to fund these liabilities as provided by the terms of the trust. The cash surrender value of these polices totaled $3.1 million as of December 31, 2004.

Net Operating Loss Carryforwards

     At December 31, 2004, we had federal net operating loss or NOL carryforwards of approximately $96.7 million for income tax purposes, of which approximately $6.2 million, $8.4 million, $9.1 million, $17.7 million, $19.3 million, $12.6 million and $23.4 million expire in 2018, 2019, 2020, 2021, 2022, 2023 and 2024, respectively. In addition, we had research and development tax credit carryforwards of approximately $3.2 million of which $67,000, $359,000, $341,000, $777,000, $828,000 and $858,000 expire in 2018, 2019, 2020, 2021, 2022 and 2023, respectively. The use of the NOLs, and research and development tax credit carryforwards are limited to our future taxable earnings. For financial reporting purposes, at December 31, 2004 we recognized a valuation allowance of $40.2 million to offset net deferred tax assets, primarily attributable to the NOL carryforward. Utilization of the operating losses are subject to limitation due to the ownership change provisions of the Internal Revenue Code.

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Market Risk and Risk Management Policies

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

     The primary objectives for our investment portfolio are liquidity and safety of principal. Investments are made to achieve the highest rate of return to us, consistent with these two objectives. Our investment policy limits investments to specific types of instruments issued by institutions with investment grade credit ratings and places certain restrictions on maturities and concentration by issuer.

     At December 31, 2004, marketable securities consisted primarily of corporate debt, U.S. Government-agency backed discounted notes and municipal securities, and approximated $60.1 million. Marketable securities include auction rate securities totaling $30.2 million with contractual maturity dates of up to forty one years. Liquidity in these instruments is provided from third parties (buyers and sellers in an auction system) generally every one to three months at which time their interest rates, or dividend rates for preferred securities, are reset. All of our other marketable securities have maturity dates of up to sixteen months. Due to the relatively short-term maturities of these securities, or auction system liquidity in the case of the auction rate securities, management believes there is no significant market risk. At December 31, 2004, market values approximated carrying values. At December 31, 2004, we had approximately $74.4 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 $744,000.

     At December 31, 2003, marketable securities consisted primarily of corporate debt, U.S. Government-agency backed discounted notes, municipal securities and certificates of deposit, and approximated $55.7 million. Marketable securities included auction rate securities totaling $20.3 million with contractual maturity dates of up to forty years. Liquidity in these instruments is provided from third parties (buyers and sellers in an auction system) as noted above. All of our other marketable securities had maturity dates of up to twenty-four months. Due to the relatively short-term maturities of these securities, or auction system liquidity in the case of the auction rate securities, management believes there is no significant market risk. At December 31, 2003, market values approximated carrying values. At December 31, 2003 we had approximately $63.9 million in cash, cash equivalents and investments in marketable securities, and accordingly, a sustained decrease in the rate of interest earned of 1% would have caused a decrease in the annual amount of interest earned of up to approximately $639,000.

Recent Accounting Pronouncements

     In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) 123R, Share-Based Payment (Revised 2004), which requires companies to recognize in the income statement the fair value of all employee share-based payments, including grants of employee stock options as well as compensatory employee stock purchase plans, for interim periods beginning after June 15, 2005 and will become effective for us for the quarter ending September 30, 2005. Accordingly, SFAS 123R eliminates the ability to account for share-based compensation using APB 25, and the pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Although we have not determined whether the adoption of SFAS 123R will result in amounts that are similar to the current pro forma disclosures under SFAS 123 presented in the notes to our consolidated financial statements, we are evaluating the requirements under SFAS 123R including the valuation methods and support for the assumptions that underlie the valuation of the awards, as well as the transition methods (modified prospective transition method or the modified retrospective transition method) and expect the adoption to have a significant impact on our consolidated statements of operations and net loss per share.

     In November 2004, the FASB issued Statement No. 151, “Inventory Costs — an amendment of ARB No. 43, Chapter 4”. This Statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “...under some circumstances, items such as idle facility

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expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges...” This Statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement shall be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of Statement No. 151 is not expected to have a material effect on the Company’s results of operations, financial position or cash flows.

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

Forward Looking Statements

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

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 prospectus before purchasing our common stock. If any of the following risks actually occurs, our business, financial condition or results of operations would likely suffer, possibly materially. In that case, the trading price of our common stock could fall, and you may lose all or part of the money you paid to buy our common stock.

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

     We have incurred net losses since 1994, including net losses of $23.8 million, $15.9 million and $17.1 million during 2004, 2003 and 2002, respectively. We had a loss from continuing operations of $23.8 million, $26.0 million and $19.0 million in 2004, 2003 and 2002, respectively. As of December 31, 2004, our accumulated deficit was approximately $118.2 million.

     Our strategy includes a significant commitment to spending on research and development targeted at identifying and developing products that can be formulated using our TIMERx and other drug delivery technologies. As a result, we expect to continue to incur net losses as we continue our research activities and conduct development of, and seek regulatory approvals for, products utilizing TIMERx technology and other drug delivery technologies, until substantial sales of products commercialized utilizing our TIMERx technology and other drug delivery technologies occur. These net losses have had and will continue to have an adverse effect on, among other things, our shareholders’ equity, total assets and working capital.

     A substantial portion of our revenues since 1994 has been generated from the sales of our pharmaceutical excipients. Our net losses in 2003 and 2002 were reduced as a result of the operating results of our excipient business. Since February 27, 2003, we have not generated any revenues from the sales of excipient products and our business depends and will depend exclusively on revenue, under our agreement with Mylan and from products developed or acquired by us.

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     Our future profitability will depend on several factors, including:

	•	the successful commercialization of TIMERx controlled release products, including in particular oxymorphone ER and PW2101;
	•	royalties from Mylan’s sale of Pfizer’s 30 mg generic version of Procardia XL; and
	•	the level of our investment in research and development activities.

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

     As of December 31, 2004, we had cash, cash equivalents, and short-term investments of $74.4 million. In addition, in December 2004, we received net proceeds of approximately $32.8 million from a private placement of our common stock. We anticipate that, based on our current operating plan, our existing capital resources and anticipated internally generated funds from the sale of formulated bulk TIMERx, royalties from Mylan and other payments from collaborators will be sufficient to fund our operations on an ongoing basis without requiring us to seek external financing through at least the first half of 2007.

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

	•	whether oxymorphone ER or PW2101 are approved on a timely basis, or at all;
	•	the costs and timing of adding additional products or technologies;
	•	whether we resume our participation in the funding of the development and marketing of oxymorphone ER;
	•	the timing and amount of payments received under existing and possible future collaborative agreements, in particular with respect to oxymorphone ER;
	•	our success in entering into a marketing collaboration for PW2101;
	•	our ability to qualify the alternative manufacturing site for PW2101 on a timely basis or at all and the costs of doing so;
	•	the structure and terms of any future collaborative or development agreements;
	•	the progress of our collaborative and independent development projects, funding obligations with respect to the projects, and the related costs to us of clinical studies for our products;
	•	royalties received from Mylan; and
	•	the prosecution, defense and enforcement of potential patent claims and other intellectual property rights.

     Subject to these factors, we expect that we will need to sell additional equity or debt securities or seek additional financing through other arrangements to fund operations beyond the first half of 2007. In addition, if we determine to resume our participation in the funding of oxymorphone ER or to acquire additional products or technologies, we also may need to seek additional funding for such actions through collaborative agreements or research and development arrangements, or through public or private financing.

     If we raise additional funds by issuing equity securities, further dilution to our then-existing shareholders may result. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability

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to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Any debt or equity financing may contain terms, such as liquidation and other preferences, that are not favorable to us or our shareholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish valuable rights to our technologies, research programs or potential product or grant licenses on terms that may not be favorable to us. We cannot be certain that additional financing will be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain this additional financing, we may be required to delay, reduce the scope of, or eliminate one or more of our planned research, development and commercialization activities, which could harm our financial condition and operating results.

We are dependent on collaborators to conduct clinical trials of, obtain regulatory approvals for, and manufacture, market, and sell our TIMERx controlled release products, including, in particular, Endo with respect to oxymorphone ER

     Some of our TIMERx controlled release products have been or are being developed and commercialized in collaboration with pharmaceutical companies. Under these collaborations, depending on the structure of the collaboration, we are dependent on our collaborators to fund some portion of development, to conduct clinical trials, obtain regulatory approvals for, and manufacture, market and sell products utilizing our TIMERx controlled release technology. For instance, we are dependent on Endo to obtain the regulatory approvals required to market oxymorphone ER and will be dependent on Endo to manufacture and market oxymorphone ER in the United States. In addition, we are dependent on Mylan with respect to the marketing and sale of the 30 mg strength of Pfizer’s generic version of Procardia XL.

     We have limited experience in manufacturing, marketing and selling pharmaceutical products. Accordingly, if we cannot maintain our existing collaborations or establish new collaborations with respect to our other products in development, we will have to establish our own capabilities or discontinue the commercialization of the affected product. For instance, if we are unable to enter into a collaboration for the marketing of PW2101, we are unlikely to commercially launch the product even if we obtain FDA approval. Developing our own capabilities would be expensive and time consuming and could delay the commercialization of the affected product. There can be no assurance that we would be successful in developing these capabilities.

     Our existing collaborations are subject to termination on short notice under certain circumstances including, for example, if the collaborator determines that the product in development is not likely to be successfully developed or not likely to receive regulatory approval, if we breach the agreement or upon a bankruptcy event. If any of our collaborations are terminated, we may be required to devote additional resources to the product, seek a new collaborator on short notice or abandon the product. The terms of any additional collaborations or other arrangements that we establish may not be favorable to us.

     We are also at risk that these collaborations or other arrangements may not be successful. Factors that may affect the success of our collaborations include the following:

	•	Our collaborators may be pursuing alternative technologies or developing alternative products, either on their own or in collaboration with others, that may be competitive with the product as to which they are collaborating with us, which could affect our collaborator’s commitment to the collaboration with us.
	•	Our collaborators may reduce marketing or sales efforts, or discontinue marketing or sales of our products. This would reduce our revenues received on the products.
	•	Our collaborators may terminate their collaborations with us. This could make it difficult for us to attract new collaborators or adversely affect perception of us in the business and financial communities.
	•	Our collaborators may pursue higher priority programs or change the focus of their development programs, which could affect the collaborator’s commitment to us. Pharmaceutical and

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

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

     The pharmaceutical industry is highly competitive and is affected by new technologies, governmental regulations, health care legislation, availability of financing, litigation and other factors. Many of our competitors have:

	•	significantly greater financial, technical and human resources than we have and may be better equipped to develop, manufacture and commercialize products;
	•	more extensive experience than we have in conducting preclinical studies and clinical trials, obtaining regulatory approvals and manufacturing and marketing pharmaceutical products;
	•	competing products that have already received regulatory approval or are in late-stage development; and
	•	collaborative arrangements in our target markets with leading companies and research institutions.

     We face competition based on the safety and effectiveness of our products, the timing and scope of regulatory approvals, the availability and cost of supply, marketing and sales capabilities, reimbursement coverage, price, patent position and other factors. Our competitors may develop or commercialize more effective, safer or more affordable products, or obtain more effective patent protection, than we are able to develop or commercialize. Accordingly, our competitors may commercialize products more rapidly or effectively than we do, which would adversely affect our competitive position, the likelihood that our product will achieve initial market acceptance and our ability to generate meaningful revenues from our products. Even if our products achieve initial market acceptance, competitive products may render our products obsolete or noncompetitive. If our products are rendered obsolete, we may not be able to recover the expenses of developing and commercializing those products.

     We face competition from numerous public and private companies and their extended release technologies, including Johnson & Johnson’s oral osmotic pump (OROS) technology, multiparticulate systems marketed by Elan Corporation plc, Biovail Corporation and KV Pharmaceutical Company, traditional matrix systems marketed by SkyePharma, plc and other controlled release technologies marketed or under development by Andrx Corporation, among others.

     Our TIMERx products in development will face competition from products with the same indication as the TIMERx products we are developing. For instance, we expect extended release oxymorphone ER will face competition from MS Contin, Purdue Pharma’s OxyContin and generic competitors to OxyContin, Duragesic marketed by Johnson & Johnson and generic competitors to Duragesic, and Avinza marketed by Ligand.

     Some of the TIMERx products we are developing, such as PW2101, are branded controlled release products, which are proprietary products that are based on active chemical ingredients that are not subject to patents. These branded controlled release products will compete against other products developed using the same or a similar active chemical ingredient, including branded immediate release and branded controlled released products, as well as any generic versions of these products, based primarily on price. In addition, our branded controlled released products will compete against other competitive products in the therapeutic class. For instance, PW2101 is a controlled release formulation of an immediate release beta blocker, the chemical active ingredient for which is no longer subject to patents in the United States. There is currently a similar branded controlled release beta blocker product that is marketed for hypertension and against which we expect PW2101 will compete. There are also currently filings for generic versions of the branded controlled release products and the sponsors of the branded product and the generic products are currently in patent litigation. If the sponsors of generic products prevail in such litigation, PW2101 would also compete against these generic versions.

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     In addition to developing branded controlled release products, we also selectively develop generic versions of branded controlled release products using our TIMERx technology and generic active ingredients. The success of these products will depend, in large part, on the intensity of competition from the branded controlled release product, other generic versions of the branded controlled release product, and other drugs and technologies that compete with the branded controlled release product, as well as the timing of product approval.

     The generic drug industry is characterized by frequent litigation between generic drug companies and branded drug companies. Those companies with significant financial resources will be better able to bring and defend any such litigation.

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

     In order to obtain regulatory approvals for the commercial sale of our potential products, including our branded controlled release products, we or our collaborators will be required to complete clinical trials in humans to demonstrate the safety and efficacy of the products. However, we or our collaborators may not be able to commence or complete these clinical trials in any specified time period, or at all, either because the FDA or other regulatory agencies object, or for other reasons.

     Even if we complete a clinical trial of one of our potential products, the clinical trial may not indicate that our product is safe or effective to the extent required by the FDA, the European Commission, or other regulatory agencies to approve the product, and we or our collaborators may decide, or regulators may requires us or our collaborators, to conduct additional clinical trials. For example, in response to the NDA for oxymorphone ER, the FDA is requiring Endo to conduct an additional clinical trial of oxymorphone ER. In addition, on December 2, 2004, we announced that in our pivotal efficacy trial of the low dose strength we did not meet the study’s primary endpoint. Alternatively, regulators may require post marketing testing and surveillance to monitor the safety and efficacy of a product.

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

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

     If clinical trials do not show any potential product to be safe or efficacious, if we are required to conduct additional clinical trials or other testing of our products in development beyond those that we currently contemplate or if we are unable to successfully complete our clinical trials or other testing, we may:

	•	be delayed in obtaining marketing approval for our products;
	•	not be able to obtain marketing approval for our products; or
	•	obtain approval for indications that are not as broad as intended.

     Our product development costs may also increase if we experience delays in testing or approvals. In addition, significant clinical trial delays also could allow our competitors to bring products to market before we do and impair our ability to commercialize our products.

We are subject to extensive government regulation including the requirement of approval before our

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

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

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

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

     We are developing oxymorphone ER under a collaboration agreement with Endo. Endo, which is responsible for conducting the clinical trials and seeking regulatory approval of the product, submitted an NDA for oxymorphone ER to the FDA in December 2002. In October 2003, Endo received an approvable letter for oxymorphone ER. In the letter, the FDA requested that Endo address certain questions, provide additional clarification and information, and conduct some form of additional clinical trials to further confirm the safety and efficacy of oxymorphone ER before the FDA would approve Endo’s NDA for oxymorphone ER. In discussions with Endo, the FDA advised Endo of its concern that the outcome of two of the phase III efficacy trials submitted in the NDA that met their predefined primary end-points may have been favorably biased by the statistical handling of data from patients who did not complete the trials. The design of this additional clinical trial is intended to address this issue. In November 2004, Endo announced that the FDA had granted final approval of the protocol under the FDA’s SPA process for a clinical trial in patients with chronic low back pain and without recent treatment with opioid analgesics, designed to provide additional safety and efficacy data for oxymorphone ER requested by the FDA. The clinical trial is also intended to address the FDA’s concern regarding data from patients who did not complete the trial.

     The new trial is intended to complement the completed Phase III pivotal trial that Endo believes has demonstrated efficacy in the intended patient population. Endo has also reported that based on the duration of the trials and the number of patients to be enrolled, and assuming the data is favorable, Endo expects to submit a complete response letter to the FDA in early 2006. We expect that Endo will receive a further action letter from the FDA within six months of submission of the complete response letter. If the NDA for oxymorphone ER is not approved on a timely basis or at all, it would have a material adverse effect on our business, financial condition and results of operations.

     Certain products containing our TIMERx controlled release technology require the filing of an NDA. A full NDA must include complete reports of preclinical, clinical and other studies to prove adequately that the product is safe and effective, which involves, among other things, full clinical testing, and as a result requires the expenditure of substantial resources. In certain cases involving controlled release versions of FDA approved immediate release drugs and branded controlled release drugs, such as PW2101, we may be able to rely on existing publicly available safety and efficacy data to support an NDA for controlled release products under Section 505 (b)(2) of the FDCA when such data exists for an approved immediate release or controlled release version of the same active chemical ingredient. For example, our NDA for PW2101 was filed under section 505(b)(2) and relies on data from an immediate release drug with the same active chemical ingredient. We can provide no assurance, however, that the FDA will accept a section 505(b)(2) NDA, or that we will be able to obtain publicly available data that is useful. The section 505(b)(2) NDA process is a highly uncertain avenue to approval because the FDA’s policies on section 505(b)(2) NDA’s have not yet been fully developed. There can be no assurance that the FDA will approve an application submitted under section 505(b)(2) in a timely manner, or at all. Our application to market PW2101 is a 505(b)(2) NDA. We are currently in discussions with the FDA regarding the appropriate patent certifications required to be made for PW2101. If we are required to file a paragraph IV patent certification and the patent holder sues us for infringement, the FDA may not approve our application for up to 30 months.

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

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

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

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

	•	the timing of the receipt of marketing approvals and the countries in which such approvals are obtained;
	•	the safety and efficacy of the product as compared to competitive products;
	•	the relative convenience and ease of administration as compared to competitive products;
	•	the strength of marketing distribution support; and
	•	the cost-effectiveness of the product and the ability to receive third party reimbursement.

     Our success depends on our protecting our patents and patented rights

     Our success depends in significant part on our ability to develop patentable products, to obtain patent protection for our products, both in the United States and in other countries, and to enforce these patents. The patent positions

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of pharmaceutical firms, including us, are generally uncertain and involve complex legal and factual questions. As a result, patents may not issue from any patent applications that we own or license. If patents are issued, the claims allowed may not be sufficiently broad to protect our technology. In addition, issued patents that we own or license may be challenged, invalidated or circumvented. Our patents also may not afford us protection against competitors with similar technology.

     Our research, development and commercialization activities, as well as any products in development or products resulting from these activities, may infringe or be claimed to infringe patents or patent applications of competitors or other third parties. In such event, we or our collaborators may choose or may be required to seek a license from a third party and to pay license fees or royalties or both under such license. These licenses may not be available on acceptable terms, or at all. Even if we or our collaborators were able to obtain a license, the rights may be nonexclusive, which could result in our competitors gaining access to the same intellectual property. If we or our collaborators are not able to obtain a license, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations.

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

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

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

	•	We or our collaborators may initiate litigation or other proceedings against third parties to enforce our patent rights.
	•	We or our collaborators may initiate litigation or other proceedings against third parties to seek to invalidate the patents held by such third parties or to obtain a judgment that our products or processes do not infringe such third parties’ patents.
	•	If our competitors file patent applications that claim technology also claimed by us, we or our collaborators may participate in interference or opposition proceedings to determine the priority of invention.
	•	If third parties initiate litigation claiming that our processes or products infringe their patent or other intellectual property rights, we and our collaborators will need to defend against such proceedings.

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

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

32

and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time.

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

     We lack commercial scale facilities to manufacture our TIMERx material or any products we may develop in accordance with cGMP requirements prescribed by the FDA. We currently rely on Draxis Pharma, Inc. for the bulk manufacture of our TIMERx material for delivery to our collaborators under a contract that expires in September 2005 and on other third party manufacturers for the products that are currently under development, such as PW2101. The agreement with Draxis will be automatically renewed for successive one year periods, unless either party gives notice of its intent not to renew the contract, at least six months prior to the end of the then-current term. We are not a party to any agreements with our third party manufacturers for the products that we are currently evaluating in clinical trials, such as Patheon with respect to PW2101, except for purchase orders or similar arrangements.

     We believe that there are a limited number of manufacturers that operate under cGMP regulations capable of manufacturing our TIMERx materials and the products we are evaluating in clinical trials. Although we have qualified alternate suppliers with respect to the xanthan and locust bean gums used to manufacture our TIMERx material, if Draxis is unable to manufacture the TIMERx material in the required quantities, on a timely basis or at all, or if Draxis will not agree to renew our agreement when it expires on acceptable terms to us or at all, we may be unable to obtain alternative contract manufacturing, or obtain such manufacturing on commercially reasonable terms. In addition, if we are unable to enter into longer-term manufacturing arrangements for our products, such as PW2101, on acceptable terms to us or at all, particularly as these products advance through clinical development and move closer to regulatory approval, our business and the clinical development and commercialization of our products could be materially adversely effected. There can be no assurance that Draxis or any other third parties upon which we rely for supply of our TIMERx material or our products in clinical development will perform, and any failures by third parties may delay development or the submission of products for regulatory approval, impair our collaborators’ ability to commercialize products as planned and deliver products on a timely basis, require us or our collaborators to cease distribution or recall some or all batches of our products or otherwise impair our competitive position, which could have a material adverse effect on our business, financial condition and results of operations.

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

	•	our collaborators may not be able to meet commercial demands for our products on a timely basis;
	•	our collaborators may not be able to initiate or continue clinical trials of products that are under development; and
	•	our collaborators may be delayed in submitting applications for regulatory approvals of our products.

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

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

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

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

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

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

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

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

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

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

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

     We are currently covered by primary product liability insurance in amounts of $10 million per occurrence and $10 million annually in the aggregate on a claims-made basis and by umbrella liability insurance in excess of $25 million which can also be used for product liability insurance. This coverage may not be adequate to cover any product liability claims. Product liability coverage is expensive. In the future, we may not be able to maintain or obtain such product liability insurance at a reasonable cost or in sufficient amounts to protect us against losses due to liability claims. Any claims that are not covered by product liability insurance could have a material adverse effect on our business, financial condition and results of operations.

     The market price of our common stock may be volatile

     The market price of our common stock, like the market prices for securities of pharmaceutical, biopharmaceutical and biotechnology companies, have historically been highly volatile. The market from time to time experiences significant price and volume fluctuations that are unrelated to the operating performance of particular companies. Factors such as fluctuations in our operating results, future sales of our common stock,

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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 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     Reference is made to the disclosure under the caption “Market Risk and Risk Management Policies” in “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     All financial statements required to be filed hereunder are filed as Appendix A hereto and are listed under Item 15(a) included herein.

ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

     None.

ITEM 9A. CONTROLS AND PROCEDURES

     (a) Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2004. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2004, our chief executive officer and chief financial officer concluded that, as of such date, the Company’s disclosure controls and procedures were effective at the reasonable assurance level.

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

     (c) Reports on Internal Control Over Financial Reporting

Management’s Annual Report on Internal Control Over Financial Reporting

     Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, our principal executive and principal financial officers and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

	•	Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
	•	Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
	•	Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

     Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

     Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2004. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on this assessment, management believes that, as of December 31, 2004, our internal control over financial reporting is effective based on those criteria.

     Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2004 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which appears below.

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders
Penwest Pharmaceuticals Co.

We have audited management’s assessment, included in the accompanying Management Report on Internal Control Over Financial Reporting that Penwest Pharmaceuticals Co. maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Penwest Pharmaceuticals Co’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Penwest Pharmaceuticals Co. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Penwest Pharmaceuticals Co. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Penwest Pharmaceuticals Co as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004 and our report dated March 10, 2005 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Stamford, Connecticut
March 10, 2005

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PART III

ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The information set forth under “Election of Directors,” “Committees of the Board,” “Code of Ethics” and “Section 16(a) Beneficial Ownership Reporting Compliance” in our definitive Proxy Statement for the 2005 Annual Meeting of Shareholders is incorporated herein by reference.

     Information regarding our executive officers is set forth in Part I, under the caption “Executive Officers of the Registrant.”

ITEM 11: EXECUTIVE COMPENSATION

     The information set forth under “Executive Compensation,” “Director Compensation” and “Compensation Committee Interlocks and Insider Participation” in our definitive Proxy Statement for the 2005 Annual Meeting of Shareholders is incorporated herein by reference.

ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

     The information set forth under “Security Ownership of Certain Beneficial Owners and Management” and “Securities Authorized for Issuance Under the Equity Compensation Plans” in our definitive Proxy Statement for the 2005 Annual Meeting of Shareholders is incorporated herein by reference.

ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information relating to certain relationships and related transactions set forth under “Certain Relationships and Related Transactions” in our definitive Proxy Statement for the 2005 Annual Meeting of Shareholders is incorporated herein by reference.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

     The information set forth under “Independent Auditor Fees and Other Matters” in our definitive Proxy Statement for the 2005 Annual Meeting of Shareholders is incorporated herein by reference.

PART IV

ITEM 15: EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) (1) Financial Statements and Financial Statement Schedule

The following documents are filed as Appendix A hereto and are included as part of this Annual Report on Form 10-K.

The consolidated balance sheets as of December 31, 2004 and 2003 and the related statements of operations, cash flows and shareholders’ equity for each of the three years in the period ended December 31, 2004.

Schedule II — Valuation and Qualifying Accounts

All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are omitted because they are not applicable or because the information is presented in the financial statements or notes thereto.

(2) Exhibits

The list of Exhibits filed as part of this Annual Report on Form 10-K are set forth on the Exhibit Index immediately preceding such exhibits, and is incorporated herein by reference. This list includes a subset

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containing each management contract, compensatory plan, or arrangement required to be filed as an exhibit to this report.

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SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) 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.

     Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

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APPENDIX A

PENWEST PHARMACEUTICALS CO.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND
FINANCIAL STATEMENT SCHEDULE

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders
Penwest Pharmaceuticals Co.

We have audited the accompanying consolidated balance sheets of Penwest Pharmaceuticals Co. as of December 31, 2004 and 2003, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Penwest Pharmaceuticals Co. at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Penwest Pharmaceuticals Co.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2005 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Stamford, Connecticut
March 10, 2005

F-2

PENWEST PHARMACEUTICALS CO.

See accompanying notes

F-3

PENWEST PHARMACEUTICALS CO.

See accompanying notes

F-4

PENWEST PHARMACEUTICALS CO.

See accompanying notes

F-5

PENWEST PHARMACEUTICALS CO.

See accompanying notes

F-6

PENWEST PHARMACEUTICALS CO

1. BUSINESS

     Penwest Pharmaceuticals Co. (the “Company”) develops pharmaceutical products based on innovative proprietary oral drug delivery technologies. The Company is focusing its development efforts principally on products that address diseases of the central nervous system. The two most advanced products in the Company’s drug development pipeline are oxymorphone ER, an extended release formulation of oxymorphone, a narcotic analgesic being developed for twice-a-day dosing in patients with moderate to severe pain requiring continuous around-the-clock opioid therapy for an extended period of time, and PW2101, a beta blocker intended for the treatment of hypertension and angina. The Company is also developing Phase II efficacy studies on several additional product candidates in areas such as edema, epilepsy, schizophrenia and depression.

     Prior to February 27, 2003, Penwest also developed, manufactured and distributed branded pharmaceutical excipients, which are the inactive ingredients in tablets and capsules, primarily consisting of binders, disintegrants and lubricants. On February 27, 2003, Penwest sold substantially all of the assets used in the Company’s excipient business to subsidiaries and affiliates of Josef Rettenmaier Holding GmbH & Co. KG (the “Asset Sale”). The Company received $39.5 million in cash and a promissory note for $2.25 million in consideration for the excipient business. In April 2003, the Company received $1.0 million under the promissory note and received the balance of $1.25 million in May 2004. The Company used approximately $5.5 million of proceeds of the sale of its excipient business to repay debt (see Note 8). As a result of the Asset Sale, the accompanying consolidated financial statements present Penwest’s excipient business as a discontinued operation for 2003 and 2002.

     The Company has incurred net losses since 1994. As of December 31, 2004, the Company’s accumulated deficit was approximately $118.2 million. The Company expects operating losses and negative cash flows to continue until substantial sales of products commercialized utilizing TIMERx technology or other technologies occur. A substantial portion of the Company’s revenues through February 27, 2003 were generated from sales of the Company’s pharmaceutical excipient product line. During 2002 and 2003 through the Asset Sale date, sales of its excipient products generated positive cash flows from operations although the Company as a whole had negative cash flows from operations. Since February 27, 2003, the Company has not derived any revenues from the excipient business. Accordingly, the Company’s revenues for 2003 and 2004 were generated primarily from Mylan royalties and shipments of bulk TIMERx. The Company’s future profitability will depend on several factors, including the successful commercialization of TIMERx controlled release products, including in particular oxymorphone ER and PW2101, royalties from Mylan’s sales of Pfizer’s 30 mg generic version of Procardia ER, and the level of its investment in research and development activities.

     The Company is subject to the risks and uncertainties associated with drug development. These risks and uncertainties include, but are not limited to, a history of net losses, technological changes, dependence on collaborators and key personnel, the successful completion of development efforts and of obtaining regulatory approval, the successful commercialization of 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, dependence on third party manufactures and a requirement for additional funding.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

     The accompanying consolidated financial statements include the accounts of Penwest and its wholly owned subsidiaries. Material intercompany balances and transactions have been eliminated. As a result of the Asset Sale, the accompanying consolidated financial statements present Penwest’s excipient business as a discontinued operation for 2003 and 2002. All wholly owned subsidiaries were included in the Asset Sale (see Note 13).

     The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

F-7

PENWEST PHARMACEUTICALS CO
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

     Certain prior year amounts have been reclassified to conform to the current year presentation, including the reclassification of approximately $17.1 million of auction rate securities at December 31, 2003 as marketable securities, rather than cash equivalents as previously reported. These reclassifications had no impact on the Company’s financial position or results of operations.

Cash and Cash Equivalents

     All highly liquid investments with maturities of 90 days or less when purchased are considered cash equivalents.

Marketable Securities

     The Company accounts for marketable securities in accordance with Statement of Financial Accounting Standards No. 115 (“SFAS No. 115”), “Accounting for Certain Investments in Debt and Equity Securities.” The Company classifies its marketable securities as available-for-sale securities. Such securities are stated at fair value and primarily consist of corporate bonds, commercial paper, discounted notes backed by U.S. government agencies, municipal securities and certificates of deposit. Unrealized holding gains or losses are included in shareholders’ equity as a separate component of accumulated other comprehensive income (loss). The specific identification method is used to compute the realized gains and losses, if any, on marketable securities.

Credit Risk and Fair Value of Financial Instruments

     The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Revenues from product sales and licensing fees are primarily derived from major pharmaceutical companies that have significant cash resources. The Company maintains an allowance for doubtful accounts which management believes is sufficient to cover potential credit losses. Allowances for doubtful accounts receivable are maintained based on historical payment patterns, aging of accounts receivable and actual write-off history. One customer of the Company accounted for approximately 94%, 88% and 87% of total revenues in 2004, 2003 and 2002, respectively. Another customer of the Company accounted for approximately 11% of total revenues for 2003.

     The primary objectives for the Company’s investment portfolio are liquidity and safety of principal. Investments are made to achieve the highest rate of return to the Company, consistent with these two objectives. The Company’s investment policy limits investments to certain types of instruments issued by institutions with investment grade credit ratings, and places certain restrictions on maturities and concentration by issuer.

     The carrying value of financial instruments, which includes cash, cash equivalents, marketable securities, receivables, obligations under the Company’s loans and notes payable, and accounts payable, approximates fair value due to the short term nature of these instruments or their liquidity provided in the case of auction rate securities (see Note 4).

Long-Lived Assets

     Fixed assets are recorded at cost and depreciated using the straight-line method over their estimated useful lives or over the lease term for leasehold improvements. Estimated useful lives by class of assets are substantially as follows:

     The Company reviews the recoverability of its long-lived assets, including definite-lived intangible assets whenever facts and circumstances indicate that the carrying amount may not be fully recoverable. For purposes of recognizing and measuring impairment, the Company evaluates long-lived assets based upon the lowest level of independent cash flows ascertainable to evaluate impairment. If the sum of the undiscounted future cash flows expected over the remaining asset life is less than the carrying value of the assets, the Company may recognize an impairment loss. The impairment related to long-lived assets is measured as the amount by which the carrying

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

amount of the assets exceeds the fair value of the asset. When fair values are not readily available, the Company estimates fair values using expected discounted future cash flows.

Foreign Currencies

     The assets and liabilities, and operating results of the Company’s foreign operations were reported as discontinued operations as a result of the Asset Sale. Assets and liabilities of the Company’s foreign operations were translated into U.S. dollars at year-end exchange rates, and revenue and expenses were translated at average exchange rates. For each of the foreign operations, the functional currency was the local currency. Accumulated other comprehensive (loss) income includes the cumulative translation adjustments, which is a component of other comprehensive loss included in the Company’s financial statements. Realized gains and losses from foreign currency transactions are reflected in the consolidated statements of operations. There are no foreign currency translation gains and losses in 2004, and foreign currency transaction gains and losses were not significant in each year in the three year period ended December 31, 2004.

Accumulated Other Comprehensive (Loss) Income

     Accumulated other comprehensive (loss) income at December 31, 2004 consisted of unrealized losses on marketable securities, and at December 31, 2003 and 2002, consisted of the Company’s foreign currency translation adjustment and net unrealized gains (losses) on marketable securities (see Note 18).

Income Taxes

     The liability method, prescribed by SFAS No. 109, “Accounting for Income Taxes,” is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities. The Company recorded no income tax benefits relating to the net operating losses generated during 2004, 2003 and 2002, as such losses were offset by valuation allowances. Valuation allowances are established against the recorded deferred income tax assets to the extent that management believes it is more likely than not that a portion of the deferred income tax assets are not realizable.

Revenue Recognition

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

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

Research and Development Expenses

     Research and development expenses consist of costs associated with products being developed internally as well as products being developed under collaboration agreements and include related salaries, benefits and other personnel related expenses, clinical trial costs, and contract and other outside service fees. Research and development costs are expensed as incurred. A significant portion of the Company’s development activities are outsourced to third parties including contract research organizations, and contract manufacturers in connection with the production of clinical materials, or may be performed by the Company’s collaborators. These arrangements may require estimates to be made of related service fees or the Company’s share of development costs, in which actual results could materially differ from the estimates and affect the reported amounts in the Company’s financial statements. These arrangements may also require us to pay termination costs to the third parties for reimbursement of costs and expenses incurred in the orderly termination of contractual services.

Per Share Data

     Loss per common share is computed based on the weighted average number of common shares outstanding during the period. For all years reported, diluted loss per share was the equivalent of basic loss per share due to the respective net losses. No dilution for common share equivalents is included in 2004, 2003 and 2002 as the effects would be antidilutive.

Stock Based Compensation

     The Company adopted the disclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” which amends SFAS No. 123, “Accounting for Stock-Based Compensation,” in 2002. SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation, which was originally provided under SFAS No. 123. SFAS No. 148 also improves the timeliness of disclosures by requiring the information to be included in interim as well as annual financial statements. The adoption of these disclosure provisions had no impact on the Company’s consolidated results of operations, financial position or cash flows (see Note 3).

     At December 31, 2004, the Company maintained two stock-based employee compensation plans (see Note 9). The Company accounts for these employee stock compensation plans in accordance with the intrinsic value-based method prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” During the year ended December 31, 2004, in connection with retainer and meeting fees earned by members of the Company’s board of directors and scientific advisory board in 2004, the Company recorded $60,000 of expense associated with the issuance of discounted stock options, $209,000 of expense associated with restricted stock grants and $27,000 of expense associated with unrestricted stock grants. In 2003 and 2002, the Company recorded expense associated with the issuance of discounted stock options of $61,000 and $29,000, respectively, for continuing operations, and $6,000 and $28,000, respectively, for discontinued operations. In 2003 and 2002, the Company recorded expense associated with restricted stock grants of $121,000 and $39,000, respectively, for continuing operations, and $11,000 and $39,000, respectively, for discontinued operations. In 2003, the Company recorded $106,000 in compensation expense in connection with the acceleration of the vesting date of certain stock options. No other stock-based employee compensation expense is reflected in net loss as all other stock 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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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

     The following table reflects pro forma net loss and loss per share had the Company elected to adopt the fair value approach of SFAS No. 123:

3. RECENT ACCOUNTING PRONOUNCEMENTS

     In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) 123R, Share-Based Payment (Revised 2004), which requires companies to recognize in the income statement the fair value of all employee share-based payments, including grants of employee stock options as well as compensatory employee stock purchase plans, for interim periods beginning after June 15, 2005 and will become effective for the Company for the quarter ending September 30, 2005. Accordingly, SFAS 123R eliminates the ability to account for share-based compensation using APB 25, and the pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. See “Stock Based Compensation” above for the pro forma net loss and net loss per share amounts for the years ended December 31, 2004, 2003 and 2002, as if the Company had used a fair-value-based method similar to the methods required under SFAS 123R to measure compensation expense for employee stock incentive awards. Although the Company has not determined whether the adoption of SFAS 123R will result in amounts that are similar to the current pro forma disclosures under SFAS 123, the Company is evaluating the requirements under SFAS 123R including the valuation methods and support for the assumptions that underlie the valuation of the awards, as well as the transition methods (modified prospective transition method or the modified retrospective transition method) and expect the adoption to have a significant impact on our consolidated statements of operations and net loss per share.

     In November 2004, the FASB issued Statement No. 151, “Inventory Costs — an amendment of ARB No. 43, Chapter 4”. This Statement amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4, previously stated that “...under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges...” This Statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal.” In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement shall be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The adoption of Statement No. 151 is not expected to have a material effect on the Company’s results of operations, financial position or cash flows.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

4. MARKETABLE SECURITIES

     The amortized costs and estimated fair values of marketable securities are as follows: