To see where the biotech sector is headed tomorrow, it might be helpful for investors to look back, and more importantly, forget about, the recent past.

The outlook from this perspective is sobering: Biotech valuations are only now beginning to trade below historical levels, despite what seems like a calamitous drop in stock prices. Right, you guessed it: Biotechs could still head lower.

The Amex Biotechnology Index closed Wednesday at 309.32, quite an accomplishment considering that a profit warning from drug-equipment maker Qiagen ( QGENF) and a Genentech ( DNA) downgrade sank the index to as low as 290.67 earlier in the day. The drop below the 300 level was noteworthy as a psychological, if not technical, measure of just how badly the sector is performing this year -- down 46% for the year.

But don't call a bottom yet. The BTK has retrenched back to December 1999 levels, which is an interesting time frame because, as longtime biotech investors will recall, the sector, at this time, was in the midst of a bubble, inflated by the hype over genomics and, of course, the general mania in technology-related stocks. It may seem like a distant memory, but towards the end of 2000, the BTK actually approached 800. And as one reader points out, enthusiasm was so great that one analyst at Credit Suisse First Boston, in September 2000, was actually talking up the likelihood of BTK 1000.

Forget About It

We bring this up to suggest that biotech investors might want to simply erase the roughly two-year biotech bubble from their memory, in order to better evaluate current valuations.

That's what Lazard Freres biotech analyst Joel Sendek did recently, and it suggested to him that biotech valuations are only now beginning to trade below historical levels, despite the aforementioned steep slide in stock prices since late last year.

To determine historical biotech valuations, Sendek decided to remove the 21-month bubble period from June 1999 to March 2001 from his calculations. He came up with a historic, average P/E for the biotech sector of 40 times earnings. The historic average P/E-to-growth multiple is 1.6.

At the end of June, when Sendek issued his report, the average P/E for a basket of eight profitable biotech firms was 35, while the PEG multiple was 1.47.

"Our analysis reveals that biotech valuations have only recently begun to trade within historical long-term ranges -- for the first time since" the first quarter of 1999, he writes. "Given what we believe to be weak near-term fundamentals in the biotech industry, we see further downside potential in valuations to the lower end of their historical ranges, representing 10%-20% downside from current levels, before any major rebound is likely."

The BTK was trading around 340 when Sendek issued his report on June 26. By his reckoning, the index will fall to the 275-310 range before any rally occurs.

As a result of his revised valuation analysis, Sendek lowered his Genentech rating to hold from buy. He reiterated his hold and buy ratings on Amgen ( AMGN) and Idec Pharmaceuticals ( IDPH), respectively, but he lowered price targets on each. Lazard doesn't have an existing banking relationship with any of the above-mentioned companies.

Take Genentech -- Please

Genentech offers a good example of just how fragile biotech valuations are these days. The stock fell 5% to $28.70 Wednesday after Deutsche Bank Securities biotech analyst Dennis Harp used the day before the July 4th holiday to downgrade the company to market perform (read: hold) from buy. The main reason? Valuation. By Harp's calculation, Genentech was trading at a 2003 P/E-to-growth multiple of 1.5, a significant premium to the other profitable biotechs, which as a group, trade at a 2003 P/E-to-growth multiple of 0.8.

Harp also believes that Genentech will come up short when it reports results later this summer from a Phase III trial of its experimental cancer drug, Avastin. His firm doesn't have a banking relationship with Genentech.

Earnings season is typically a good time for biotech investors, but Biogen ( BGEN) and Genzyme General ( GENZ) have already warned, which suggests that second-quarter results will not be bullish enough to provide any meaningful lift for the sector. So while the BTK's ability to stay north of the 300 level Wednesday should be taken as a victory, it may only really be a temporary reprieve.

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