Zonagen

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Viagra

.

For months, shorts have been jumping on

Zonagen

(ZONA)

, a Texas company that makes an impotence pill that even the company admits is unlikely to be anything more than a poor relation to the now-famous riser from

Pfizer

(PFE) - Get Report

.

But since the beginning of the year, Zonagen has been invigorated, with the stock's 103% rise topping Pfizer's 48%. Still, the company's market cap of about $420 million is less than 0.5% of Pfizer's market cap. And, with Viagra's success off the charts, even diehard bears are now worried that Zonagen's run may continue for a while. Right now the stock isn't trading solely on the prospects for its drug's approval and market success, but the underlying impotence pill story. In a story-stock market, this means pain for the shorts.

One West Coast hedge fund manager for a dedicated short-selling fund that's short Zonagen concedes, "For a year, this stock goes up. It'll put short-term pressure on performance and make life uncomfortable." But he's not backing down: "My job is to look at things that are fundamentally not real."

If the bulls' predictions come true -- and one analyst predicts that sales of Zonagen's

Vasomax

will approach $500 million in 2002 -- Zonagen's earnings will more than justify the current price. But the West Coast hedge fund manager, along with other bears, says Zonagen's drug is less effective, and potentially less safe, than Viagra, and question whether it can get approved. They ask why Zonagen wasn't able to negotiate a better deal with its partner on the medicine,

Schering-Plough

(SGP)

.

Many investors agree. Zonagen is the ninth most heavily shorted small-capitalization stock, according to ShortALERT, a service of

Rockbridge Research

, with 2.96 million of the company's 12.4 million outstanding shares borrowed and sold. Average daily volume is about 260,000 shares.

"I've never seen anything so controversial," says

Volpe Brown Whelan

analyst David Steinberg, who rates Zonagen a buy. Volpe has been a Zonagen banker. "Until it starts selling, you can take every piece of the story and give the bull case and the bear case."

Vasomax Is No Viagra

Bulls say that Vasomax doesn't need to be as good as Viagra, which is good because the data strongly suggest it isn't.

Vasomax is an oral formulation of phentolamine, a vasodilative agent that opens blood vessels in smooth muscles. In its intravenous form, phentolamine causes a dramatic drop in blood pressure and is used on brain-dead people to facilitate removal of their organs.

Short-sellers contend that Vasomax isn't truly a new, fast-acting formulation, doesn't work much better than placebos, and has the potential for serious side effects. "Zonagen has not discovered or developed any new drug and not in any way proven it is safe and causes erections," says Manuel Asensio, who runs his own New York research firm and has a "strong sell" rating on ZONA.

Some doctors agree. Dr. Charles "Chip" Williams, a well-known urologist who runs the

Sexual Medicine Center

in Lafayette, La., says, "It's not a new idea and it's not a new drug. I used it as a resident and I started my residency in 1974. I don't think it will make any impact on the market at all." (He discloses that he was an investigator on the Viagra trials and says he has owned shares of Pfizer for two years.)

On the other hand, Viagra has a high success rate with minimal side effects. In studies in about 4,500 men, the drug was found effective in 48% to 81% of patients, according to an

Oppenheimer

report. Zonagen says in its 10-K filing with the

Securities and Exchange Commission

that its drug has an efficacy rate in "two Phase 3 pivotal studies which demonstrated clinical benefit in approximately 30% to 40% of patients tested, representing a statistically significant improvement over placebo." Zonagen concedes in the filing that "the company believes that Viagra will capture the largest share of the market for oral therapies for male erectile dysfunction."

But the West Coast short-seller says problems with Zonagen's studies on Vasomax may mean that the

Food and Drug Administration

could deny the company's application for the drug. He notes that while Pfizer tested Viagra extensively -- even in patients with severe impotence, like that caused by spinal-cord injuries -- Vasomax was studied on men with milder impotence. He contends that Zonagen assessed the results of Vasomax in a more subjective manner than Pfizer did. Zonagen stands by its studies, saying they proved Vasomax was effective.

Another potential concern for Zonagen is phentolamine's effects on blood pressure. While Viagra works only on the penis, Vasomax acts across the entire body. As a result, the West Coast short-seller argues that Zonagen's Vasomax formulation is either too weak to work or too dangerous to use.

The company says the safety profile of the drug is good. In two pivotal trials covering almost 800 patients, Zonagen says only two Vasomax users suffered serious adverse events. OpCo analyst Matthew Geller, who rates the company a buy, says in a report the data "suggests the drug is extremely safe." OpCo has not participated in any underwriting for Zonagen.

Dr. Ira Sharlip, the incoming secretary for the

Society for the Study of Impotence

and a urologist at the

University of California at San Francisco

says that "if you deliver enough drug to create vasodilation in the corpus cavernosum

of the penis, it would cause vasodilation in other parts of the circulatory system and you might run into complications."

Indeed, the FDA has requested that Zonagen compile additional safety data showing the drug is safe for up to one year of use before it could officially submit Vasomax for approval. As a result, the company has not yet submitted its filing, called a new drug application (NDA). "As life evolved, it became apparent that a lot of folks would use these drugs, all these drugs," explains Jean Anne Mire, Zonagen's spokeswoman. She says there was a shift in perception at the agency, which now views patients as likely to use the drugs regularly rather than only once in a while. Mire says there was nothing unusual about the request and that she knows of no serious adverse events in the follow-up trial.

Changing Story

The Zonagen story has changed over the years. Last year, the story was that Zonagen would get to the market before Viagra and establish a position before Viagra launched. Now, after the FDA's request for more information, the company plans to file the NDA sometime before July, with the help of Schering-Plough, a $60 billion drug company that makes everything from the antihistamine

Claritin

to

Dr. Scholl's

insoles.

The Schering deal is undoubtedly a vote of confidence in Zonagen. But bears say that if the drug is truly the blockbuster seller that Zonagen bulls would have investors believe, Schering would have paid more than $10 million up-front and would have given better than an estimated 22.5%-23% royalty. (SGP's total payments could give ZONA $47.5 million more.) Often, a company gets a higher royalty and bigger up-front payment for a drug that has completed Phase III trials. Bulls counter that having Schering-Plough involved at all puts a stamp of approval on the drug.

Even if Vasomax is approved, doctors disagree whether the drug will sell. Dr. Sharlip says, "There is a segment of the population that it could be used for." He adds, "My patients have done so well on Viagra. In my patient population, I would think that less than 10% need to try something other than Viagra. But it's really early." (Sharlip has no investments in any of the impotence companies but has been an investigator on Vasomax, as well as on other impotence drugs.)

Even 10% of a multibillion market is a pretty handsome product. OpCo sees Vasomax selling $31.1 million next year, after a first-half launch, going up to $478.3 million in 2002. In 2002, that would give $90.6 million in product revenue to Zonagen, OpCo estimates, producing $45.2 million in net income and $3.62 a share in earnings.

Dr. Williams is less sanguine. He views oral phentolamine as having "less activity and more side effects" than Viagra. "I just don't think there's any way for people who don't respond to Viagra to respond to phentolamine."

The Game's Afoot

But right now, the phenomenal success of Viagra seems to have left the fundamentals almost besides the point. In a surprising move that both recognized the potential for a short-squeeze and helped spawn it, Geller, a top biotech analyst, picked up coverage of Zonagen with a buy on April 16. Geller's report infuriated the shorts because the analyst is known for whispering short advice into the ears of some of his clients, sometimes on companies he doesn't cover.

This time, though, Geller has gone the other way. Since recommending the stock, Geller has weighed in again, raising his price target. Shorts have reportedly called to complain that Geller is betraying his friends by fighting the surge in Zonagen's stock price. One portfolio manager said Geller told him that he'd received complaints, but he wasn't overly concerned. The portfolio manager, who rode Zonagen from 14 into the 30s, said Geller responded with: "My style is to make people money." Geller couldn't be reached for comment.

But make money he has -- so far. Indeed, as Zonagen's stock rose from the mid-20s to close to 40, Geller upped his target on the stock from $40 to $50. It closed Thursday at 35 7/8, down 1 5/16.

"You really, really don't want to be short. I've had my gonads squeezed

in similar situations and it sucks. It's not worth going out of business," says one New York biotech hedge fund manager who recently bought Zonagen stock. He adds, somewhat sheepishly, "Absolutely, it has junky aspects to it, but Schering-Plough spent $10 million for an option on this thing. The thing about flyers is that sometimes they take off."

And if they do, they can take a long time to crash.