A handful of short-minded biotech hedge fund managers, banking on the sad pattern in biotech for investors to bid the stocks of successful companies too high, have started to circle around

Pathogenesis

(PGNS)

.

PGNS is in its fifth week of the launch of

TOBI

, a solution of a common antibiotic meant for inhalation that treats chronic lung infections in cystic fibrosis patients. So far, the company has sold about $5 million to $5.5 million of the product, says Bill Gantz, chairman and chief executive of PGNS. Now, doctors treat those infections with intravenous antibiotics or "homebrewed" formulations of the IV drugs that can be inhaled.

There is little to take the stock higher because a good launch is already accounted for in the stock, short-sellers argue. Instead, there are only risks now that the drug won't sell as well as expected or that it won't work in other diseases, they contend. Moreover, shorts argue that compliance to the TOBI usage regimen will be a serious issue since it will be hard to get CF patients, most of whom are children, to sit down and inhale TOBI twice a day for about a half an hour each time. The alternative homebrews are cheap and widely used. And, shorts contend that the likelihood of widespread adoption of TOBI in follow-on diseases, such as severe bronchitis, is unlikely primarily because TOBI is too expensive. TOBI costs about $11,000 a year, compared with about $4,000 to $6,000 for the homebrews, according to Gantz.

Bears also wonder whether the CF patients will easily attain reimbursement for TOBI, given that the patients have such expensive health-care burdens. And the timing of the ramp-up in sales doesn't favor the longs, they argue: This quarter will have a push to fill the pharmacy shelves, but then in the summer months, the company is guiding the Street that there's likely to be a slowdown in sales since children are less monitored during summer vacation. Short-sellers wonder about this seeming oddity: If TOBI is so necessary, why would usage be vulnerable to the vagaries of seasonality, they ask. One hedge fund manager predicts the first quarter could have the strongest sales, with the following quarters slower. That's a pattern that could put fear into investors who are betting on a steadily strong launch.

According to Pathogenesis, there are about 30,000 CF patients in the U.S., with 18,000 appropriate for treatment because they are infected with pseudomonas, a bacterium. That could be a decent market for the drug, but shorts are claiming that the potential market is much smaller, primarily because those with the most serious infections receive IV treatment in the hospital, while the least serious don't need treatment. The company says that about 4,000 to 6,000 patients use the homebrews, but company critics put the estimate at about 10,000.

Amid the clinical and regulatory success of TOBI, the company's stock puffed up 50% between April and October but has stagnated since. On Wednesday it closed at 37 1/8, down 1/8, giving the company a valuation of roughly $600 million. Tom Dietz, an analyst for

Pacific Growth Equities

who's bullish on the stock, expects the company to sell $44 million of TOBI this year and lose 25 cents a share, and then $110.3 million next year, earning $1.33 a share. The Street expects the company to make 1 cent this year and $1.57 next year, according to

First Call

. The short interest, as of the most recent filings, is modest, at a little over 500,000 shares.

So are the shorts right? If so, are they nevertheless too early? Even some of the bulls concede PGNS doesn't have much upside from here based on TOBI's sales in CF. Dietz says "TOBI is fully valued

for CF, but I don't think any other indications are in the price." The company expects Phase II trial results in the second half of this year in patients with a severe form of bronchitis. That's the first of several markets the company hopes to target for TOBI.

Still, "full" valuation isn't enough to short the thing: The launch has to go badly. And PGNS and TOBI have a lot going for them. The company says reimbursement among the state Medicaid agencies is ahead of schedule and while private payors' is coming more slowly, no patient has been denied it. The company and its supporters argue that there are little data to support the homebrews, that they are inconvenient and time-consuming to mix and, most importantly, that only TOBI -- and not the homebrews -- supplies the right dose of the antibiotic, tobramycin, without serious side effects, as shown in clinical trials.

Most central to the bulls' argument are expectations of sharp earnings growth. "As we see the evolution of earnings, we will get a bias to a higher stock price," says Kris Jenner, the biotech analyst at

T. Rowe Price

, which owned 720,000 shares as of the end of September. PGNS "rapidly developed the product and it's launching very well. Give the management credit for recognizing these issues in advance," adding, "It's not a short."

The company licensed TOBI from the

CF Foundation

, for a royalty of about 1.5% of sales, according to analysts' estimates, and the two are working closely to sell the inhaler. PGNS says that the CF Foundation sponsored a meeting with CF leaders who determined in a "consensus statement" that the "only good data that can be believed, that shows safety and efficacy, is the TOBI data," says Bruce Montgomery, who heads the company's research and development. One doctor raised the issue that the homebrews were about half the price, and when "these points were brought up at a national meeting, the guy was laughed at," says Montgomery, adding, "Most patients can't tolerate

the homebrews because of the irritation to the lung. Part of the consensus statement was, 'Hey guys, wake up!'"

Pacific Growth's Dietz says that the CF Foundation was the major supplier of the tobramycin for the homebrews anyway, so the argument that they are a threat represents "a pretty uncompelling argument.

CF doctors will no longer allow patients access for reasons of liability."