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<DAILY TROUBLE>
Friday, May 14, 1999

Zonagen
(Nasdaq: ZONA)
Website: http://www.zonagen.com
Phone:  281-367-5892
Price  (5/13/99): $13 7/16

HOW DID IT FIND TROUBLE?

A year ago, shares of Zonagen swelled to $40 as Viagra fever sent speculators looking for other companies with a potential fix for male erectile dysfunction.

That ecstasy couldn't last, but the stock was still hanging around the mid-$20s in July when Zonagen and partner Schering-Plough (NYSE: SGP) announced they had submitted a new drug application (NDA) to the Food and Drug Administration (FDA) for Vasomax, their Viagra wannabe. In September, the FDA accepted the application for review.

However, this titillating foreplay led to a disappointing climax on May 10. That's when Zonagen announced that the two firms were suffering performance anxiety and would forego a scheduled June appearance before an FDA advisory panel. That's usually the last major hurdle before negotiating the details of a formal marketing approval. The company has basically accepted an FDA thumbs-down for now.

The data from Zonagen's two Phase III trials apparently didn't present the kind of safety and efficacy profile Schering-Plough needs to win broad marketing approval -- and Vasomax needs such approval to have a chance against Viagra. The plan now is for Schering-Plough to submit data from some additional clinical trials as part of an amended NDA. This data "should maximize our product's potential in the marketplace," according to Zonagen CEO Joseph Podolski.

However, investors who thought they might see Vasomax marketed this year in the U.S. will now have to wait until at least next year. That news neutered many Zonagen bulls, who have repeatedly confronted serious doubts from short-sellers. Left impotent by the news, many investors sold, cutting Zonagen's share price in half in one day.

BUSINESS DESCRIPTION

Started in 1987 with money from Texas investors like Ross Perot and Lloyd Bentsen III, Zonagen is a money-losing, development-stage biotech company with a somewhat dubious history outlined in a lengthy article by Brian Wallstin in the Houston Press.

The company was launched to exploit work conducted by Baylor University researcher Dr. Bonnie Dunbar on a contraceptive vaccine that could be used on animals, and potentially, humans. Germany's Schering AG (not affiliated with Schering-Plough) agreed in 1993 to help develop the vaccine, but that agreement came to naught and was terminated in June 1998.

In recent years, Zonagen has concentrated nearly all of its resources on Vasomax, an oral formulation of phentolamine mesylate that opens blood vessels in smooth muscles, enhancing blood flow to the penis.

Two Phase III trials studied men who had mild to moderate problems achieving an erection. These studies concluded that 51% of men taking a 40 mg dose and 53% on an 80 mg dose had an erection sufficient for penetration on 75% of attempts. Only 38% of men receiving a placebo managed this feat.

A more recent study of 2,000 patients reportedly found that 69% of men studied responded well. Though phentolamine can trigger a drop in blood pressure, the clinical trials of Vasomax have found its major side effect to be a stuffy nose, experienced by no more than 18% of patients.

Response rates to Pfizer's (NYSE: PFE) Viagra, however, have been in the 70% to 80% range. Despite concerns about Viagra's safety, Pfizer recently reported that data from 6,500 patients showed that use of Viagra didn't increase the risk of a heart attack.

In 1997, Schering-Plough signed up to market Vasomax, paying Zonagen $10 million at the time plus an additional $10 million during 1998 for achieving certain development milestones. Zonagen will also receive royalty payments amounting to around 22% of sales.

The drug was launched in Mexico last June and in Brazil last month. In August, Schering-Plough applied for approval in the United Kingdom.

Insiders own 1.5 million shares, or 12.3% of the company.

FINANCIAL FACTS

Income Statement
12-month sales:     $12.9 million 
12-month income:   ($10.9 million)*
12-month EPS:       ($0.98)*
Profit margins:        N/A
Capitalization:    $150.8 million 
(*From continuing operations)

Balance Sheet
Cash:               $48.1 million
Current Assets:     $51.8 million
Current Liabilities: $3.9 million 
Long-Term Debt:      None     

Ratios
Price-to-earnings: N/A
Price-to-sales:       11.7

HOW COULD YOU HAVE SEEN IT COMING?

Some have argued that the terms of the co-marketing deal with Schering-Plough weren't so great. Yet, the deal itself was a positive, as was last year's progress on the road toward FDA approval. As money from these milestone payments arrived, Zonagen's board decided to shell out $6.2 million to buy back stock at $17.52 per share, another vote of confidence.

However, reason for skepticism abounded. Well-known short-seller Manuel Asensio issued a series of negative reports in support of his "strong sell" recommendation. In a typical note, Asensio charged that, "Vasomax's secret formulation is merely and simply nothing more than plain 45 year old, generic phentolamine."

Wallstin, of the Houston Press, echoed the skepticism, arguing that "under Podolski, Zonagen is a phantom company, a make-believe outfit that manufactures myths and stories for investors."

Short-sellers piled on and stayed on. The latest data show 2.46 million shares, or 38% of the float, has been shorted, good for a days-to-cover ratio of 11.7. These high numbers should have suggested that professional shorts were making a big bet against Vasomax. That's always a potential red flag for the cautious investor.

Then there were the lawsuits charging that Zonagen officials had, among other things, failed to disclose the fact that some scientific studies showed phentolamine isn't an effective treatment for impotence. Although a U.S. District Court dismissed these suits with prejudice in April, these lawsuits raised further questions about Vasomax.

WHERE TO FROM HERE ?

Of the $13.4 million in revenues Zonagen generated last year, $10 million came from Schering-Plough in the form of milestone payments that won't be repeated this year. Nearly all the rest came from interest on Zonagen's cash ($4.60 per share as of December), which accounted for most of the company's $50 million book value at the end of March. With the quarterly burn rate down to $4.7 million, Zonagen appears to have ample cash to stay afloat for another 10 quarters.

While that's good news for Zonagen shareowners, it's disappointing news for other investors since Zonagen would otherwise look like a compelling short. When biotech stocks move from engorged to flaccid due to weak clinical trials data, it often suggests the company needs more than a magic pill to spruce it up.

Indeed, even Viagra sales have been relatively disappointing given the stunning initial demand. Some patients not helped by Viagra may find new life in Vasomax, but there's little data to support informed speculation on the potential numbers. It's also quite unlikely that patients suffering from erectile dysfunction will opt to try Vasomax first when it's apparently less effective than Viagra and perhaps no safer.

Of course, Zonagen has been a story stock for years now, rising and falling with the hype (and the company's ability to attract new financing). Although tests of Viagra on women have thus far yielded mixed results, some researchers think that what works for a man might work for a woman. Along those lines, Zonagen started a Phase I trial of Vasofem, a vaginal gel form of phentolamine mesylate that may help women with sexual dysfunction. It's easy to imagine upbeat press releases following up on this trial.

Even so, Zonagen probably ought to trade like a long-term call option (worth maybe a dollar or two per share) on Vasomax plus its ever-decreasing cash value. If other investors agree, then the stock could easily trade down to $6 a share in the near term. Longer term, though, Zonagen's fate depends on that additional Schering-Plough data.

-- Louis Corrigan (TMFSeymor@aol.com)

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