(FORTUNE Magazine) – On Dec. 7, Sepracor announced terrific news: Eli Lilly had agreed to pay up to $90 million, plus future royalties, for the Boston biotech's new and improved version of the legendary antidepressant Prozac. Wall Street seemed elated. Financial news shows gushed. Analysts raced to upgrade estimates. In the meantime, mutual funds like Putnam boosted their positions. Not only that, but the deal topped off a sizzling year that saw Sepracor's stock nearly double, to 84 5/8 per share, in three months.

So why has short-selling also doubled, from 9.8% in January to an alarming 19.7% in mid-November? Clearly, some of the shorts are hedge funds that were betting the Lilly deal would bomb. Others were probably investors hedging against the company's convertible bonds. But there are also longer-range reasons for pessimism--which is why the battle between the bulls and the shorts is still raging. "There are two camps on this stock," says one short-seller: "The Boston mafia buys the stock, and New York traders keep shorting it."

The story Sepracor pitches to the Street is intriguing: It improves blockbuster drugs by cleaning out unwanted molecules (see "Drug Pirates Make Good," Oct. 12). After obtaining a patent, it usually sells its improved version back to the drug company that developed the original. So the original company gets both a better product and the ability to extend its patent, thus staving off pesky generic competition for years.

In return, Sepracor expects to earn revenues from licensing fees and royalties. So far it has lined up deals with, among others, Schering-Plough, for its antihistamine Claritin, and Johnson & Johnson, for its heartburn medicine Propulsid. "Most biotechs focus on little niches," says analyst Richard Vietor of Merrill Lynch. "But Sepracor works with proven entities. There's a lot of potential there."

Thus, it's hardly surprising that Fidelity has been loading up on the stock for several years and, as of this fall, owned about 10.5% of the 28.5 million shares. As the year's end approaches, managers like Harris Leviton of Fidelity Advisor Strategic Opportunities may buy more. With Strategic Opportunities' returns down 2.9%, Sepracor was one of the fund's biggest winners. So by purchasing a few more shares, Leviton could boost Sepracor's price and drive up his returns too.

Among other Boston investors, Putnam recently increased its position to 12.6%. John Hancock, Fleet Investment Advisors, MFS, and hedge fund manager Mike DiCarlo also own shares. And Boston College and the Boston Museum of Fine Arts had some convertible bonds--an aggressive choice for such staid institutions.

The analysts can get even more carried away. In late October, Morgan Stanley's Douglas Lind was predicting that the company could go from losing $3.23 per share in 1998 to earning as much as $10.66 by 2003. Salomon Smith Barney predicts the stock price will rise some 30% in the next 12 months.

Of course, it's hardly unknown for analysts to have ulterior reasons for pushing a stock. Sepracor recently sold $300 million worth of convertible bonds, underwritten by Lind's very own Morgan Stanley, and may issue more stock in the future. (Lind declined to comment because of the SEC's "quiet period" rules.) By contrast, Bear Stearns' David Maris says Sepracor has frozen him out ever since he downgraded the stock in October. Sepracor failed to return numerous calls requesting comment on this and other issues.

The shorts also have some strong reasons to be skeptical about Sepracor. At $84 per share it's 154 times revenues, so the stock certainly seems overvalued. What's more, not one of the outstanding deals is set in stone. The drug companies, after all, have to pay Sepracor royalties only if they actually launch its product. That's a concern with the company's sole product on the market, Allegra--a version of Hoechst's antihistamine Seldane--as the two companies wrangle over patent rights.

And Sepracor's strategy may have its limits. The FDA is now pushing drug companies to clean out unneeded molecules themselves, which would shut out Sepracor. In response, the company is trying to launch its own products. It hopes to begin selling an asthma product called Xoponex and recently completed studies on a urinary incontinence medicine.

So Sepracor can't rest on its Prozac laurels. The shorts will be watching like hawks for missteps.

--Amy Kover