The Word on L’s-worth Street

I own stock in Penwest Pharmaceuticals (PPCO). They are currently profitable via their earnings on royalties and stockholders are urging that they shut down operations in order to pay out cash value to shareholders. The main reason for this is because their future drug prospects look unpromising and it doesn’t make sense to spend all shareholder money on an off-chance of success. Two big investors are pushing this company to shut down operations and issued this letter to the board. I completely agree with everything they are advocating for. I particularly like how upfront the investors are about every aspect of Penwest’s operations. Enjoy the read.

Dear Members of the Board of Directors:

As reported in our filings with the U.S. Securities and Exchange Commission (the “SEC”), Tang Capital Partners, LP and its affiliates (“Tang Capital”) and Perceptive Life Sciences Master Fund Ltd. and its affiliates (“Perceptive”) are the two largest shareholders of Penwest Pharmaceuticals Co. (“Penwest” or the “Company”) and together own 40% of the Company’s outstanding common stock.

We write to express serious concerns about the current direction of Penwest in the hope that you will take action before it becomes too late and we are forced to pursue other measures. Specifically, for the reasons explained below, we ask that you stop wasting corporate assets and substantially wind down the Company’s operations so that we, the shareholders, may realize the full value of the Opana ER royalty income stream. We also ask that you confirm that our January 12, 2009 notice that we intend to nominate 3 persons for election to the Board of Directors at the 2009 annual meeting complies with Penwest’s advanced notice bylaw provisions. We request that you take these actions no later than March 10, 2009.

Penwest’s One Principal Asset

Penwest has one principal asset: its royalty earned on the sale of Opana ER by licensee Endo Pharmaceuticals (“Endo”). As you know, Opana ER was launched by Endo in 2006, and had net sales in 2008 of approximately $140 million-$145 million, up approximately 63-70% year-over-year. Net of the royalty holiday and development cost recoupments, Penwest will earn royalties at an effective rate of approximately 11-12% in 2009 and 21-23% in 2010, resulting in royalty income of approximately $19 million-$25 million this year and $45 million-$55 million next year, depending on sales growth.

As you also know, the duration for which this income stream will survive is uncertain. Endo and Penwest recently entered into a settlement agreement with Actavis South Atlantic LLC (“Actavis”) that will enable Actavis to launch a generic version of Opana ER on or after July 15, 2011, or earlier under certain circumstances. Litigation with the other first-to-file generic challenger, Impax Laboratories, Inc., is pending, and the results of that litigation remain uncertain.

Importantly, whether one is optimistic or pessimistic about the ultimate sustainability and value of this income stream, our position on what is the best course of action for shareholders does not change. To put this in simple terms, whether one has $100 or $200 in one’s pocket, it is equally unadvisable to waste $100.

To be clear, this income stream is substantially passive and requires negligible resources from Penwest. According to Penwest’s licensing agreement with Endo dated April 2, 2002 and amended January 7, 2007 and July 14, 2008, Penwest must supply Endo sufficient quantities of formulated TIMERx (the extended release technology for Opana ER), the fully-burdened cost of which is reimbursed by Endo. Furthermore, at the option of Penwest, a contract manufacturer may be used to produce the required supply of TIMERx, also at Endo’s cost.

In terms of Penwest’s balance sheet, we estimate that there is only $6 million-$8 million of net cash left as of December 31, 2008 after last year’s spending, based on figures provided in the Company’s December 2008 corporate presentation (the “Corporate Presentation”). This includes an estimated $16 million-$18 million in cash and cash equivalents, offset by $10 million in secured debt due over the next 21 months. Cash spend in 2008 was $30 million-$32 million, or approximately 60% of the Company’s current market capitalization, according to the Corporate Presentation.

A0001 – Not Worthy of Continued Investment

We understand that substantially all of the Company’s development efforts are focused on A0001 for the potential treatment of several Orphan diseases collectively referred to as mitochondrial diseases. The Company recently announced that it has begun a Phase 1b clinical trial of A0001, in which safety will be evaluated in healthy volunteers. The Company also announced that it has initiated long-term animal toxicology studies. If A0001’s safety is demonstrated, Penwest would next conduct a Phase 2a trial evaluating the effect of short-term treatment of A0001 on biomarkers of oxidative stress in patients with mitochondrial respiratory chain disease in the second half of 2009. We understand that success in these studies then would be followed by Phase 2b or Phase 3 studies, which could commence in the second half of 2010 and potentially be completed in the 2012 time frame. According to the Corporate Presentation, the Phase 2a biomarker study, if successful, would demonstrate proof-of-concept and serve as a “value creation point” for Penwest.

As participants in the biopharmaceutical industry, you do not need to be reminded by us how risky and capital intensive drug development is, or how only an estimated 11% of compounds in Phase 1 clinical trials make it to market.¹ Nor should you need to be told that the capital markets have all but shut down for early-stage biopharmaceutical companies and that preserving cash is of utmost importance in these unprecedented economic times. We thought it might be helpful, however, to discuss the program-specific reasons why we believe that the development of A0001 faces even greater-than-usual challenges.

• Vitamin E? Rights to A0001 were acquired through a July 16, 2007 licensing agreement with privately-owned Edison Pharmaceuticals, Inc. (“Edison”). Under this agreement, Penwest has paid Edison $7.5 million, including a $1.0 million upfront payment, a $1.0 million loan to Edison that Penwest immediately wrote off through an impairment charge for its full value, and $5.5 million in research funding over the past 18 months. While management has told us that it is not prepared to disclose the chemical identity of A0001, publicly available information would seem to indicate that it is alpha-tocopheryl quinone², which is a chemical name for vitamin E.³ Because alpha-tocopheryl quinone qualifies as a dietary supplement under FDA regulations⁴, it at any time could be made commercially available by dietary supplement manufacturers through nutritional health stores and websites. Furthermore, the intellectual property position for A0001 is tenuous at best: (a) there is no composition-of-matter patent covering alpha-tocopheryl quinone; (b) Penwest/Edison has no issued U.S. patent with any claims covering even the use of alpha-tocopheryl quinone; and (c) a competitor, Santhera Pharmaceuticals (“Santhera”), has a U.S. patent that issued more than 8 years ago that claims the use of a class of molecules encompassing alpha-tocopheryl quinone for the treatment of mitochondrial diseases.⁵ To be commercially viable as a potential treatment for an Orphan disease affecting only a few thousand individuals, A0001 would need to achieve and sustain reimbursement and market acceptance at a very high price point. We do not see how this would be possible in light of the facts discussed above.
• If Santhera succeeds, Penwest will be many years behind the competition. As you know, Santhera is developing idebenone, a compound that Penwest indicates is chemically similar to A0001, for mitochondrial diseases. Santhera announced that it achieved full recruitment of its U.S. and European pivotal Phase 3 trials in October 2008 and December 2008, respectively, and that, if the outcome of its U.S. trial is positive in the middle of this year, it would be in a position to make regulatory filings in 2009. As one benchmark of time, idebenone completed Phase 1 trials fully 4 years ago and Phase 3 results are still forthcoming. While one can always hope to be faster than others, Penwest will have to contend with the countervailing headwind that, if idebenone is successful, developing A0001 would likely be more, not less, challenging because: (a) it would be more difficult to enroll patients into a trial of an investigational agent if a proven agent is available; and (b) it is likely that the FDA would require a pivotal trial that compares A0001 to that proven agent, which would require far more patients than a placebo-controlled trial. From a commercial standpoint, while it is often argued that being second or third to market can be sufficiently lucrative, we believe that this is not the case for an Orphan condition affecting only a few thousand patients.
• If Santhera fails, there will be no basis to continue. Since A0001 is chemically similar to idebenone and both A0001 and idebenone are chemical analogues of the same prototype molecule (coenzyme Q), there would be little rationale to continue A0001’s development if idebenone does not demonstrate efficacy in its Phase 3 trials.
• A time line for proof of concept that will not be met. As mentioned above, Penwest hopes to generate proof-of-concept through its planned Phase 2a biomarker study in the second half of 2009, and that this, in turn, will serve as a “value creation point” for the Company. Unfortunately, existing data indicate that this will not be the case. There are no validated surrogate end points for mitochondrial diseases. A validated surrogate end point is a laboratory measurement, or “biomarker,” that, through a clinical trial of a pharmacologic agent, has been shown to predict a change in clinical outcome. The premise is that, if this link is established, then future clinical trials need only show an effect on the surrogate end point, rather than the clinical outcome itself, to establish proof of concept. In point of fact, not only are there no validated surrogate end points for mitochondrial diseases, but the class of biomarkers that Penwest is putting forward as candidate surrogate end points for this class of diseases, namely markers of oxidative stress, have actually been invalidated by Santhera’s clinical experience with idebenone. Specifically, in an October 2007 review of Santhera’s Phase 2 clinical trial of idebenone in Freidrich’s Ataxia (“FA”), a mitochondrial disease, in the peer-reviewed journal Lancet Neurology, it was reported that idebenone failed to show an effect on any markers of oxidative stress despite some trends suggesting potential activity on clinical outcomes. The authors note:

“The exact mechanism of idebenone’s effect in FA is unclear. In the absence of a detectable effect based on the hypothesized mechanism (i.e., reduced oxidative stress), a non-specific effect of idebenone cannot be excluded.” ⁶

Where Is All of Our Money Going?

We are concerned about the continued level of spend at Penwest and the complete lack of value that this spend is creating.

• 2008: $30 million in, zero out. Based on the Corporate Presentation, Penwest’s cash spend in 2008 was $30 million-$32 million, consisting of $12 million-$13 million for “programs” and $18 million-$19 million for “overhead.” These “programs” consisted of nalbuphine ER, which failed in a Phase 2a trial, PW4153, which failed in a Phase 1 trial, and A0001, discussed above. As for the “overhead,” we are shocked by this dollar range. Mr. Tang has served on the boards of several public companies and Tang Capital and Perceptive are investors in many more. What are often termed “public company costs,” which include director and officer insurance, audit costs, and certain legal costs, typically approximate $1 million annually. So where did the remaining $17 million-$18 million go? It did not go toward supporting the receipt of the Opana ER royalty, since, as discussed earlier, this is a passive income stream.
• 2009: A similar theme? In the Corporate Presentation, Penwest has provided an outlook for 2009 that cash spend will be in the range of $21 million-$22 million. This consists of $4 million for “programs,” which are down to one given last year’s failure of nalbuphine ER and PW4153, and “overhead” of a remarkably similar (and similarly shocking) $17 million-$18 million. If this is truly overhead and, by its definition, cannot be tied to any activity that is creating value for shareholders, we urge you to eliminate it immediately. If, however, these dollars have been mischaracterized as overhead and are, in fact, necessary to progress A0001, then they would serve as further support that A0001 is a negative-return proposition, and should be eliminated anyways.

Lottery Ticket Strategy?

Based on the lack of rational explanation for the Company’s enthusiasm behind A0001 and the remarkable magnitude of spending at the Company, others have begun to speculate on what the strategy of the Company actually is, and whether there are other motives, which are perhaps diametrically opposed to that of creating shareholder value, afoot. As one of the four equity research analysts who provide coverage on the Company recently wrote:

“Lottery ticket strategy. Management continues to manage for the pipedream (our opinion) that is referred to as A0001 (for mitochondrial diseases). To run a whole company for a single product that is not even beyond proof of concept is a profound disservice to shareholders…The overhead is just too heavy to maintain this expensive endeavor. Note that the PPCO management team has very little impact on the true share price driver (the Opana ER pain drug royalty stream – our opinion) beyond signing royalty checks (and management should not be given credit for its marketing success, again our opinion).

The Board represents who? Shareholders or management? You decide. In November 2008, the Board implemented a retention package that rewards management for a change of control (200% of salary and highest bonus since at the Company). Jennifer Good took control as CEO in June 2006, and the stock has fallen from the $15-20/share range to currently under $2/share. Why compensate this performance for a takeout that could be in the $5/share range? Shareholders deserve a Board response to this question. Ironically, the Company is getting rid of CFO Ben Palleiko, who is the one person we would have chosen to keep.” ⁷

Management and Board Have Not Invested in Penwest Stock

Tang Capital and Perceptive have invested more than $45 million of their money in the stock of Penwest. Based on our review of SEC filings, the current officers and directors have invested substantially zero dollars in the Company’s stock since July 1, 2003, the date on which the SEC began requiring electronic reporting of insider transactions. In point of fact, over this time period, this group has actually realized $2.2 million in profits through the sale of Penwest stock obtained through the exercise of incentive and non-statutory stock options and restricted stock grants. This is in addition to the more than $6.5 million in cash compensation through salaries, bonuses and board fees that this group has received during this time.

While there is no legal requirement that management or board members personally invest in any company that they run, we are concerned that the lack of investment here may be unduly influencing the decisions being made (or not being made) by Penwest’s officers and directors because there is not a strong alignment of interests between these individuals and Penwest’s shareholders.

A Win-Win Proposition

If management and members of the Board are truly committed to A0001, we would welcome the Company entering into a transaction with these insiders whereby Penwest grants them or an entity they create rights to A0001 and any follow-on compounds, free of charge, in return for the spending reductions we are seeking. As owners of 40% of the Company’s stock, we pledge to support such a transaction.

Our Final Plea that You Act Now

We again implore the Board to act swiftly and decisively to preserve shareholder value. If you are unwilling to do so by March 10, 2009, we plan to take the following actions to protect our interests and the interests of all shareholders.

• Inspection of books and records. Pursuant to Washington law, we plan to deliver to the Company’s Corporate Secretary a demand to inspect the Company’s books and records so that we may better understand your actions, or lack thereof, as Board members. In particular, we will request, and expect to be provided with access to, all corporate documentation, including all materials reviewed by each of you as directors of the Company, related to, among other things:

1. the licensing of the A0001 program from Edison;
2. your decision to continue developing A0001 despite its weak scientific foundation;
3. your decision to continue employing a workforce much larger than needed to develop a single compound in Phase 1 trials;
4. your failure to take appropriate steps as fiduciaries to protect the Company’s remaining value and return that value to shareholders; and
5. the reasons for and circumstances surrounding the recent departure of your Chief Financial Officer.

• Judicial confirmation of our Board nominations. On January 12, 2009, we wrote a letter to Penwest’s Corporate Secretary notifying you that we intend to nominate 3 persons for election to the Board of Directors. In this letter, we requested that you confirm that our notice complies with Penwest’s notice provisions in its bylaws. To date, although 7 weeks have passed since the date of that request, you have refused to provide the requested confirmation. We are, again, requesting that you confirm, no later than March 10, 2009, that our January 12, 2009 notice complies with Penwest’s bylaws, and that we, therefore, will be permitted to make our nominations and submit votes in favor of our nominees at the 2009 annual meeting of shareholders. Alternatively, if it is your opinion that our notice does not comply with Penwest’s notice provisions, please identify all deficiencies in our notice. If you do not respond, we will promptly seek judicial enforcement of our rights in the Washington State courts.
• Referendum vote. To publicly demonstrate in a highly quantitative and rigorous manner how overwhelmingly Penwest’s shareholders are in favor of the actions we are advocating, we intend to notify the Company, in compliance with its bylaw provisions, of our intention to bring to a vote of the shareholders at the 2009 annual meeting a referendum on the future direction of the Company. Specifically, we will ask shareholders whether they believe that Penwest should take prompt and thoughtful action to preserve shareholder value by immediately winding down substantially all of the Company’s operations so that the full value of the Opana ER royalty income stream will be retained by the Company.
• Bylaw amendments. We plan to propose bylaw amendments that will require the Board to be more responsive and accountable to the wishes of its shareholders.
• Legal action against the Company’s officers and directors. In light of the facts set forth above, as well as information to be obtained by way of our books and records request, we intend to vigorously pursue all of our shareholder rights by way of litigation against the officers and directors of the Company, including, but not limited to, claims of breach of fiduciary duty.

Each of You Is Individually Accountable

We have made many attempts to present our case to you, through letters from Perceptive to you on November 21, 2008 and December 19, 2008, a meeting with Jennifer Good, the Company’s President and Chief Executive Officer, and Perceptive on December 4, 2008, a meeting with Ms. Good and Tang Capital on January 9, 2009, a meeting with Paul Freiman, the Company’s Chairman, and Tang Capital on February 2, 2009, and a meeting with Mr. Freiman and Perceptive on February 18, 2009.

Following these communications and interactions, we have received nothing more than: (a) an indication by Mr. Freiman to Kevin Tang of Tang Capital that he would be invited to present at the February Board meeting, followed by no invitation actually being extended; (b) a suggestion by Mr. Freiman to Joseph Edelman of Perceptive that he may join the Board on the condition that the Tang Capital nominees withdraw; and (c) an attempt by Mr. Freiman to persuade Mr. Edelman to consider selling Perceptive’s Penwest stock at current market prices.

We understand that you have decided to delegate the role of communicating with us to Ms. Good and Mr. Freiman. Needless to say, we are disappointed in your continued lack of response to our repeated requests for action. We do not need to remind you that, as members of the Board, each of you is individually responsible for exercising your judgment as fiduciaries to the Company’s shareholders. This is not a responsibility that can be delegated to management, nor abdicated by relying on the efforts of certain directors. Any failure to properly discharge your fiduciary duties is a failure for which each of you can be held personally responsible.

• Mr. Paul Freiman, as recently retired President and Chief Executive Officer of Neurobiological Technologies, Inc., you told Mr. Tang that you pushed for the immediate cessation of operations for the benefit of shareholders following the failure of that company’s investigational drug candidate. Should you not do the same here?
• Ms. Jennifer Good, in your first role as President and Chief Executive Officer of a public company, do you really want to pursue an agenda that is not supported by your shareholders?
• Dr. Christophe Bianchi, with your experience as Head of Commercial Operations at Millennium Pharmaceuticals, Inc., we ask that you speak up about the high probability that, even if A0001 were to survive the long development path that lies ahead of it, its commercial viability would be questionable.
• Dr. Peter Drake, as a veteran investment analyst who covered biotechnology stocks for more than a decade and now manager of Mayflower Partners, a health care investment fund, can you not identify with the analysis we lay out in this letter and empathize with the position that this management team has put us in?
• Dr. David Meeker, with your experience running the world’s largest business focused on Orphan diseases as President of the LSD Therapeutics business unit of Genzyme Corporation, you are in a unique position to explain to your colleagues how, in a world of scarce resources, A0001 is not competitive with other programs being developed for Orphan diseases.
• Ms. Anne VanLent, as former Chief Financial Officer of Barrier Therapeutics, Inc., you should have a keen appreciation for how a high cash burn rate can destroy shareholder value, even in a company that has successfully brought products to market.
• Mr. Robert Hennessey, as former President and Chief Executive Officer of Genome Therapeutics Corporation and a board member of its successor, Oscient Pharmaceuticals Corporation, you too must be acutely aware of the perils of a high cash burn rate, especially in today’s economic environment.
• Mr. James O’Shea, as former President and Chief Operating Officer of Sepracor, where you focused for many years on maximizing that company’s profit margin, are you not concerned about the amount of cash being spent on overhead that is producing no value?
• Dr. John Staniforth, as a co-inventor of the TIMERx technology that enabled Opana ER to become the commercial success that it is, are you not disappointed that all of the value that has been created by this product is being wasted on high-risk R&D gambles with weak scientific foundations?

In closing, we implore you to consider the facts discussed above and to rise to the task of taking the decisive actions outlined in this letter required to preserve shareholder value. We look forward to your prompt action.