Good day, ladies and gentlemen, and welcome to the Pacific Biosciences of California Incorporated First Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time [Operator Instructions]. As a reminder, this conference call may be recorded. I would now like to introduce your host for today's conference, Mr. Trevin Rard. You may begin.

Thank you, Sheena. Good afternoon and welcome to the Pacific Biosciences first quarter 2017 conference call. Earlier today, we issued a press release outlining the financial results we'll be discussing on today's call, a copy of which is available on the Investors section of our Web site at www.pacb.com, or alternatively as furnished on our most recent filing available on the Securities and Exchange Commission Web site at www.sec.gov. With me today are Mike Hunkapiller, our Chief Executive Officer; Susan Barnes, our Chief Financial Officer; and Ben Gong, our Vice President of Finance and Treasurer. Before we begin, I would like to remind you that on today's call, we may be making forward-looking statements, including plans and expectations relating to our financial projections, products and other future events. You should not place undue reliance on forward-looking statements because they are subject to assumptions, risks and uncertainties, and may differ materially from actual results. These risks and uncertainties are more fully described in our most recent filings with the Securities and Exchange Commission. Pacific Biosciences undertakes no obligation to update forward-looking statements. In addition, please note that today's call is being recorded and will be available for audio replay on the Investors section of our Web site shortly after the call. Investors electing to use the audio replay are cautioned that forward-looking statements made on today's call may differ or change materially after the completion of our live call. I'd now like to turn the call over to Mike.

Thanks, Trevin. Good afternoon and thank you for joining us today. We are pleased with our first quarter results and our continued progress in driving growth in our business. The highlights of our Q1 financial results were as follows. Total product and service revenue for the quarter was approximately $25 million, up 60% compared with $15.5 million in Q1 of last year. We recorded no contractual revenue for the first quarter compared with $3.6 million recorded in Q1 2016 as we had completed in Q4 of last year amortization of cash received under our Roche collaboration agreement. We generated $12.6 million in instrument revenue for the quarter, up 63% from $7.8 million in Q1 2016. Instrument revenue has grown steadily this past year as we have increased shipments for Sequel systems. We ended the quarter with an installed base of over 300 total PacBio systems worldwide. Consumable revenue for the first quarter was $8.7 million, up 88% from $4.6 million recorded in Q1 2016. Consumable revenue growth was driven by a higher installed base of instruments and growth in Sequel instrument utilization. For Q1 we estimate that the average annualized pull-through revenue of Sequel systems was as high the average pull-through revenue on RS II systems. Turning now to recent sales highlights. We have been seeing significant strength in our China business. Over the past two quarters, we sold 15 Sequel systems to just two customer sites. We placed numerous additional systems to China with both new and existing customers. Altogether, over 20% of our sales over the past two quarters has originated out of China. We continue to see momentum in the plant and animal sequencing market as more users are adopting PacBio for whole genome sequencing of these organisms. The recent cover article published in the April issue…

Thank you, Mike and good afternoon. I will begin my remarks today with a financial overview of our first quarter that ended March 31, 2017. I will then provide details on our operating results for the quarter with a comparison to Q1 of 2016. I will conclude my remarks with a brief discussion of our balance sheet. Starting with our first quarter 2017 financial highlights. During the quarter we recognized revenue of $24.9 million and incurred a net loss of $23.9 million. We ended the quarter with $56.1 million in cash and investments. Turning to revenue. The $20.9 million of product service and other revenue in Q1 of 2017 was 60% or $9.4 million higher than the $15.5 million of product service and other revenue in Q1 of 2016. In Q1 2016, we also recognized $3.6 million of Roche amortized revenue. The total Q1 2017 revenue was $24.9 million which compared to $19.1 million in Q1 2016, which did include a contractual revenue amortization. Breaking down the revenue. Instrument revenue quarter over quarter grew 62% with $12.6 million recognized in Q1 2017 compared to $5.8 million recognized in Q1 of 2016. Consumable revenue continued to be strong, increasing 88% to $8.7 million for the quarter, up from $4.6 million reported during the first quarter of 2016. This substantial year-over-year revenue increase highlights the recent consumable sales momentum that has resulted in five consecutive quarters of consumable revenue increases. Service and other revenue increased 15% to $3.6 million in the quarter compared to $3.1 million in Q1 of 2016. With regards to gross profit and margins, in Q1 2017 we generated gross profit of $8.9 million resulting in a gross margin of approximately 36%. During the quarter we took a charge of $1.3 million to cost of revenue related to RS…

Thank you, Susan. I will be providing an updated forecast of our 2017 financial performance. We were pleased with our first quarter revenue results and we are continuing to drive year-over-year growth in product and service revenue. As Mike mentioned earlier, we are cautious about instrument sales in the near-term as some of our U.S. customers are subject to delays or uncertainty in government funding. As a result, we are revising our growth projection for this year for product and service revenue to 35% to 45%, compared with our previous forecast of 40% to 60% growth. Roughly speaking, this translates to a total revenue for the year of between $105 million and $115 million. In the near-term, we expect our Q2 2017 revenue to be lower than our Q1 2017 revenue. However, we expect it to be significantly higher than our Q2 revenues for 2016. Moving on to gross margin. Excluding the $1.3 million in cost associated with the RS II instruments, our Q1 gross margin came in as expected. Transition from the RS II instrument to Sequel is now largely behind us. Going forward, we continue to expect gradual improvement in gross margin. Reiterating our previous guidance, in the near-term we expect our gross margin percentage to be in the low 40s and assuming our revenues increase during the year as anticipated, we expect our gross margin percentage to gradually increase and get to the mid-40s by the end of the year. Now moving to operating expenses. As we had indicated in our previous call, we started recognizing rent and depreciation expenses associated with our new facility in Q1, and as anticipated, this drove most of the incremental increase in operating expense. Since these incremental expenses are largely fixed, we expect our total operating expenses to generally remain at a similar level throughout the year resulting in year-over-year growth in operating expense of 13% to 15%. However, as we mentioned in our last call the majority of this increase represents non-cash expense. Finally, with regard to cash use, we are on track to reduce our cash burn rates significantly this year compared to last year. We ended the first quarter with $56 million in cash and investments which represents over a year's worth of our estimated cash needs. We did not use our at the market facility last quarter but we do anticipate raising some capital this year through the use of the ATM. And with that we will open the call to your questions.

[Operator Instructions] And our first question comes from the line of Amanda Murphy of William Blair. Your line is now open.

So I just had a quick question. So obviously I understand the comments on U.S. funding concern. I know a few companies here have cited that as well. But just curious though, obviously you had it [living out] [ph] with some strong order numbers [indiscernible] and realizing that's not a competitive platform to you. I just was wondering if there's potentially any issue around just allocation of dollars, just given that there's only so many to go around per se? And then also, I was curious, obviously, you've outlined an improvement in performance that you're expecting over the next year and then going forward in a meaningful way. Do you think there's some level of pause at all just as people want to see that ramp, particularly maybe with the second generation chip on the Sequel?

This is Mike. Let me take the latter question first. I mean I don’t think that people are holding back on something we will be introducing in almost two years, their Cell. They still have an upgrade path to get to that system performance when we come out with that Cell. Relative to our resources, I think we actually sell to difference markets in a sense and my understanding is from talking to a few customers and a lot of those new orders for their big systems, the new ones, are in large facilities that are kind of going through a switch. We don’t sell to a large number of those. The agencies that hurt us the most are the ones that do a lot of government surveillance. So the USDA, the Department of Energy, the FDA, the CDC are all but big users of ours. And those are government entities that are on the hook for doing a lot of different things, particularly in the microbial and the plant and animal space, but not necessarily big human genome re-sequencing projects. So I think there is sort of an apples and oranges comparison there.

Okay. Fair enough. And obviously you have talked about expectations for the year. I just was wondering if you could get a little bit of context around, you are not giving order number say but just given in terms of how you are thinking about guidance for the rest of your demand. What kind of conversations you are having with U.S. customers that gives you some level of comfort that it will all come through at some point in Q2 to Q4., I think would be helpful.

Yes. This is Ben. So we are still forecasting pretty healthy growth of 35% to 45% this year. A lot of that is predicated on we can see significant growth in our consumables revenues. A lot of that is now uptick in utilization of the Sequel systems. As Mike mentioned in his prepared remarks, it seems like the average pull-through revenue on those sequel systems has gotten to be as high as what we have seen in pull-through revenue on the RS IIs. And if that continues on, we should continue to see pretty healthy growth there. We just thought it would be a little bit prudent given what Mike had said before about some of the U.S. government purchases to trim our, let's say the higher end of those projections. And then my comment about Q2 revenue being slightly lower than Q1, that has to do with just timing of installations really. So we expect to install probably fewer instruments in Q2 rather than compare with Q1.

Well, our pipeline continues to grow. The issue for us is that a lot of those government entities wind up purchasing actually in Q3 and in Q1. It's kind of an interesting pattern. And part of that is because they get their budgets approved nominally at the beginning of Q4 of calendar year. It takes them a little while to get through the purchasing process and at the end of the year, it's looking at how much money they have left over. And that’s the thing that we have uncertainty about right now. It's not from lack of interest in those people because have talked to all those agencies there. It's not affecting our broader business but it is of concern to us as long as the whole budgeting process is up in the air as it is right now. So we just have to come back and revisit that later once we find out a lot more than what we know now.

And then I have one more question. So obviously, China has been a big driver for you and they hold large orders there. Can you maybe just talk to that opportunity more broadly? Is there a number of those that you think are -- you know potential in terms of further large unit orders? Or how are you thinking about that market going forward?

Well, we talked about this I think a little bit in the last conference call as well. There are several things driving it. There is a lot of inter-province competition that goes in. A lot of these things are funded by local governments even though there may be a commercial entity that's actually employing the technology. A lot of them tend to be contract service labs. Some of them also are doing, although a lot of their work has been plant and animal genome, a lot of them are looking at developing clinical type tests as well. And so we just see a pretty healthy pipeline in there, in Asia in general, but in China in particular. And they have announced programs in the human space in particular relative to sort of personalized medicine that are driving a lot of the impetus to get technologies to look at human clinical applications. So it's kind of a mix of both of our major market areas, both being strong.

Thank you. And our next question comes from the line of Bryan Brokmeier of Cantor Fitzgerald. Your line is now open.

So just following up on the U.S. academic uncertainty. It appears that placements in the quarter were better than what we expected. Strong revenue, particularly from instruments, but the reduction in the high end of the guidance is pretty significant. Is there anything that you can point to that gives you the confidence that those government agencies will place orders in 2018, that they haven't fallen out of your pipeline altogether?

Well, they haven't fallen out of the pipeline, but until they have money they can't buy. I think we've accounted for the downside relative to that to a large degree, but we certainly understand the quandary that they're in.

What percent of the installed base, of the RS installed base, did those government agencies represent?

That's a good question. Well, it wasn't a majority by any means, but within the U.S. it was probably our largest single segment.

Okay.

Remember, Bryan, you're sort of answering the question, that you have to be careful about extrapolating into the future on. Because again, what we've said recently is the strength of the China business when we started selling RSs, wasn't there. So we're a much more economically diversified company than we were when we started to lay the foundation on the RS installed base.

Right. And so that's why it's -- I'm trying to understand the reduction in the high end of the guidance given the explanation that it is largely due to the uncertainty with these government agencies.

Well, I mean, recognize that the government agencies are several, right. For us, it includes the agencies I mentioned before. But it also includes NIH funding. And if NIH funding actually is cut by more than 20%, that's going to affect everybody in the U.S. in the tool space, because a lot of that funding decrease comes out of the capital equipment purchases at these academic sites that are receiving the grants. And so if you combine the government entities plus the NIH funded sites, that's a nontrivial portion of our U.S. business. So that's why we're being cautious. It may not come to bear, like most people are hoping, that Congress is a lot more predisposed to some of these agencies like NIH, like the CDC and the FDAs and might appear in those initial budget proposals coming out of the administration. But if they do stick for whatever reason, that will be an issue, and that's why we pulled the number down the way we did.

Okay. And just one more. In your prepared remarks, you mentioned the applications that you're expecting from this summer's top growing chemistry update. As you further increase the throughput by another 2x next year and then the eight-fold increase, from the increasing the number of ZMWs. What other applications do you envision that driving greater adoption of these new chemistries and software to allow greater throughput increases?

Well, it's not that that per se they're new applications. It's just it allows us to target a larger number of uses within some of those applications. So for example, as you get the cost of doing structural variant analysis down as low as we think we can get to, then people can afford to do much, much larger studies. And that drives both machine requirements as well as consumables. So that we get into projects of the size that we wouldn't necessarily get anything other than a small portion of today. And certainly, if we can get down to the cost that I mentioned relative to true high quality finished genome level human sequencing, then it allows us to participate in these very large human genome re-sequencing projects that now are served by short-read technologies but predominantly are focused on looking at snips only within that. And so it allows us to get a much bigger portion, I think, of effectively all of the markets that are out there. Mostly because people can think of doing larger numbers of samples, larger projects on our technology as opposed to just using it as a small adjunct to other studies that are ongoing.

Thank you. And our next question comes from the line of Tycho Peterson of JPMorgan. Your line is now open.

I guess, Mike, on the theme of some of the coming dynamics, any thoughts on different pricing models, reagent rental being a little bit more flexible on pricing terms?

Well, I don't think that has an issue relative to the only area that we highlighted of concern, government funding. It's hard for academic sites to be able to do reagent rentals because the grant structure doesn't support that and it's almost the same thing with these government agencies. If they can purchase it, and it's not just purchasing a new piece of equipment, they have to be able to have operators to do it. So it's a function of, do they have the money maybe to hire new people. And so it's not so much an issue of pricing. We treat most customers exactly the same as we do any of the others. And we think we've got a fairly good pricing structure given the performance that we have right now. But it's simply a matter of, are these guys going to have a budget.

And then I'm wondering if you could talk a little bit more on the clinical funnel. You highlighted, obviously, HistoGenetics and then the Netherlands. Can you maybe just talk about the scope of clinical work that's maybe opening up? And how much of the funnel right now is clinically focused orders. And then any thoughts on when you would move forward with the development of an IVD level box. Is that kind of a 2018 event or further out?

Well, for most of what's in the U.S., you don't need an IVD level box, you need a 510(k) cleared generic sequence or platform. The full IVD is more for a test that you're marketing. I don't know that we made a decision that we're going to do that. Most of the customers that we've been engaged with are ones who are looking to develop their own test on an appropriate platform. And so we're working with a number of labs, mentioned a couple of those already, that are looking at specific gene type test that they would develop where long reads are important. And it's not just HLA, there are variety of cases where that's true. As well as the Nijmegen example that I quoted, which is looking at those as well, but is also looking at using it as a generic structural variant analyzer for cases that they just cannot figure out what the cause is. And we've given some other examples of that in the past research here at Stanford as well. But we see that as a reasonable opportunity for us. If you look at cases that are, for which something like exome sequencing or even whole genome sequencing on short read platforms is there, you typically only resolve 30% to 40% of the cases. And people are fully expecting that a lot of those others are going to be structural variance that just aren't picked up by those technologies. So the hope is that if you've got a technology that can basically see both ends of the spectrum from single nucleotide changes all the way up to structural variance, that that would be a useful tool in the diagnostic space.

Okay. And then going back to the question earlier on the competitive dynamics, I understand the commentary as it relates to novo [Sequel] [ph], but with Oxford out there with GridION now and then PromethION, starting to ship instruments. Can you maybe talk as to whether there's any disruption in the channel there?

Well, I mean, those people have been out there shipping systems of one kind or another for a while. I'm not sure I've heard of any of those mid-level systems being shipped, and I've only heard of a few PromethIONs have been shipped but not so much with reagents to go along with them. What we said before, which is true, we see them as a competitor but it's primarily impact on us has been in Europe or maybe elsewhere where there is a tender process and the tender goes out for a long-read sequencing technology. And the minute that anybody applies to it, more than one, then the product gets dragged out for another 2 to 3 or 4 months. And we've certainly seen that happening, not necessarily to the point of losing orders but it certainly can drag out the order process.

Thank you. And our next question comes from the line of Bill Quirk of Piper Jaffray. Your line is now open.

This is Alex Nowak on for Bill today. Another way of asking about the Q2 guide, did you see a sequential increase in Sequel orders during Q1?

Well, Alex, this is Ben. We're trying not to report on the bookings. And just to recap, we did that for a short period of time because it kind of made sense from a product transition standpoint to give people insight on bookings. But for the longer term, I think the better measure is really the revenues that we report every single quarter. So we're going to try to wean people off of that reporting on the bookings. So we're not going to report the specifics on the bookings, but anyway, we did highlight at least during the quarter, that we had some pretty good highlights. The HistoGenetics report that Mike mentioned earlier, that happened during the quarter and then also, we had this pretty large order out of China that we had talked about earlier in that quarter as well.

Okay, understood. And then I just want to be clear. If we split up the government orders that you maybe anticipated to receive during the quarter or even during Q2, were the non-U.S. government agency orders pretty much inline with expectations?

Yes.

Okay. That's good. And then I guess just last question, I just want to get an update on a couple of litigation topics. Just any comment on the recent Oxford Nanopore lawsuit against you and maybe any update on the litigation against them?

Well, I'm not going to give an update on the litigation that's going through the process as it is. I think it's scheduled for initial hearing sometime in late summer, early fall. In terms of them suing us, we feel pretty strongly that the patents that they've challenged us on is not something that we even come close to infringing, so we feel it's not a material issue for us.

[Operator Instructions] Our next question comes from the line of David Westenberg of CL King. Your line is now open.

So just kind of a continuation of Amanda's question. Can you talk a little bit more about the big installed base in China? Are you seeing an uptick in utilization there? Or if not, how long do you think before you see a big utilization ramp there?

Well, on the instruments that were installed earlier in the quarter, they've been very heavily used. Several of the instruments weren't installed till fairly late in the quarter but they are already gearing up to be for potential users. They had the projects lined up to go as far as we could tell, before they got the instruments. So we anticipate them, because they are service providers, being fairly heavily used instruments.

Right. And the instruments installed earlier in the quarter as you remember were ones that were follow on to an original Sequel, so they were familiar with the technology as well.

Great. Thanks. And have you seen any of your current customers decide to switch almost the majority of their projects over to Sequel from RS II yet?

Yes, certainly. There have been some. I will kind of go back to the reason why we took that one time charge in the quarter and that was really a pretty well played out transition plan for some of those guys who wanted to be able to do work on a PacBio platform, let's say over the course of this past year and then be able to transition over to the Sequel in a sort of organized fashion, and we helped them do that. So the ability for them to actually return those RS IIs and then focus in on their Sequels was actually a pretty good transition.

Got you. And then for the Sequels that are up and running, do you have sort of an average utilization? I mean any sort of ballpark would be good.

David, it's a moving target but one metric that we think is worth noting is, these are our estimates, that in Q1 we estimate that the average pull-through on installed Sequel Systems was as high as the average pull-through on the installed RS II systems, which means they've actually come up quite a bit on average, because starting off they were not that way.

Thank you. And I'm showing no further questions at this time. I would now like to turn the call over to Mr. Mike Hunkapiller for closing remarks.

Thanks. In closing, I'd like to reiterate our enthusiasm around momentum in the business and the increasing demand we're seeing for our products. We're very pleased with the uptick we have seen in our China business for example, and we are well positioned to take advantage of the heightened interest for our products in that region. As always, we remain steadfast in our commitment to bringing the unique advantages of our SMRT technology and products to our customers and the scientific community in general. We believe that SMRT Sequencing provides the industry's most complete and accurate picture of genomes due to its superior performance in sequencing accuracy, uniformity of coverage, extremely long read lengths and ability to characterize DNA-based modifications. Furthermore, by providing scientists with an ability to obtain a comprehensive set of sequence information within a single experiment, SMRT Sequencing is often the lowest cost and only research tool available to meet their needs. Thank you for joining us and we look forward to talking to you again in three months time.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone have a great day.