Pacific Biosciences of California, Inc. (PACB) Q3 2017 Earnings Report, Transcript and Summary

Good day ladies and gentlemen, and welcome to the Pacific Biosciences of California Inc. Third 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] I would now like to introduce your host for today’s conference Ms. Trevin Rard. Ma’am, you may begin.

Good afternoon and welcome to the Pacific Biosciences third 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 website at www.pacb.com or alternatively as furnished on the Form 8-K available on the Securities and Exchange Commission website at www.sec.gov. With me today are Mike Hunkapiller, our Chief Executive Officer; Susan Barnes, our Chief Financial Officer; Kathy Ordoñez, our Chief Commercial Officer and Ben Gong, our Vice President of Finance and Treasurer. Before we begin, I’d 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 Securities and Exchange Commission filings including our most recently filed reports on Form 10-K and Form 10-Q. 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 website 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 the live call. With that, I'd now like to turn the call over to Mike.

Thanks Trevin. Good afternoon and thank you for joining us today, starting with highlights of our Q3 financial results. Total product and service revenue for the quarter was $23.5 million, up 9% compared to $21.5 million in Q3 of last year. Year-to-date we generated $68.5 million in product and service revenue, up 26% compared with $54.2 million for the first three quarters of 2016. Consumable revenue for the third quarter was $10.6 million, up 62% from $6.5 million recorded in Q3 2016. Year-to-date we generated $26.7 million in consumable revenue, up 77% compared with 16.2 million for the first nine months of 2016. Consumable revenue growth was driven by higher installed base of instruments and growth in sequel instrument utilization. We are continuing to see growth in pull-through revenue in our sequel install base. Average annualized consumable revenue per install - sequel instrument is now over $160,000 and sequel consumable revenue for the quarter was up approximately tenfold compared with the same quarter last year. Instrument revenue for the third quarter was $9.7 million, down from $11.5 million recorded in Q3 2016, but up sequentially from $7.1 million recorded in Q2 of this year. Year-to-date instrument revenue was $29.5 million in 2017, up 6% from $27.8 million in 2016. At the end of the quarter, our installed base of sequel instruments was near 200 instruments. Turning now to recent sales highlights. We continue to see significant strength in our China business. Our sales into China last quarter exceeded 30% of our total sales. As we mentioned in our previous earnings call, Novogene has become our largest customer worldwide. The facility they operate located in Nanjing China, now houses 20 sequel systems. Another one of our large service provider customers Macrogen, located in South Korea also ordered multiple sequel instruments the past quarter. Macrogen now has a combination of six PacBio RS II and sequel instruments. Macrogen is a founding partner in the Genome Asia 100K project and they are looking - they are working to establish a database of Asian structural variation or SV. Long-term, they are interested in developing diagnostic tests based on SV information as part of the effort to accelerate Asian population specific medical advances in precision medicine. As I mentioned earlier, the average annual pull-through consumable revenue on install sequel's systems is now exceeded $160,000 and is continuing to increase. Our customers are taking on larger projects and expanding their use of the sequel system for plant and animal sequencing, human whole genome and targeted sequencing and microbial sequencing. We believe average consumable pull-through for our sequel systems is nearly $200,000 on an annualized basis and we expect to exceed that level soon. We continue to focus on utilization and pull-through revenue, as this is an important factor for us to get to profitability. We also expect it to begin to help drive instrument sales, as customers reach capacity on their existing instruments. This factor was an important one in the recent purchases by both Novagene and Macrogen. In the US, we did see some instrument purchases by government agencies in the quarter. However, we did not see a substantial above in consumer purchases from these labs as we had expected at the end of the government's fiscal year. This suggests there is still some uncertainty regarding their budget situation. Our sales in Europe have lagged significantly below our internal targets and have declined compared to last year. Several of our customers in Europe have been slow to start using their sequel systems anywhere near the level we have seen elsewhere and therefore reference's for new systems sales have been limited. Given the tendency of activity at European labs to be curtailed during the long summer vacations, we were not able to install our newer software in chemistry and most of them until late in the quarter. We believe that these installations should promote system utilization and we are starting to see a pickup in both sales and utilization this quarter, but we expect that it will take some time to recover and resume European sales growth compared to last year. As a result, we are reducing somewhat our projections for overall sales growth this year and Ben will address this later in the call. Gross margin declined in Q3 compared to last year, largely as a result of higher cost and lower margins related to our service contract business. In part, this is due to customers switching their sequencing projects from their RS II systems to the sequel systems and choosing not to renew their service contracts in RS II systems. Additionally, some of the higher service costs we have incurred recently relate to a decision to proactively replace a key component on our sequel systems in the field that have shown more rapid aging anticipated that could cause RS II [ph] systems to perform below par. Also this disproportionately affected our North American and European sites, since many of our early installations were made there and is likely responsible of some of the lower utilization rates we have seen there compared to Asia. While we would improve the overall performance of the sequel platform over the past year, particularly in the past two quarters, not all customers had consistently been able to generate the high quality results sequel is capable of. We are committed to providing high quality results for all of our customers. The software upgrades and investment we made in replacing parts in the field this past quarter to go a long way towards providing consistent results and we are confident that this will lead to higher system utilization broadly, and importantly more positive references which drive new instrument sales. We have recently seen better and more consistent performance across our customer base and are confident that we will deliver better gross margin results going forward. Susan, will provide additional detail on the gross margin results for Q3 later in the call. Turning now to our product development activities. We are on track to meet our goal of doubling the sequel per-cell sequencing yield this year. Our summer product releases have already enable customers performing amplicon based isoseek [ph] or targeted sequencing studies to more than double the throughput they were getting on their sequel systems. With several achieving yields of over 10 giga basis per smart cell and average read length in excess of 20 kilo basis. One of our customers in Europe sent multiple tweets to their colleagues describing their exciting results in the first set of such runs using the software upgrades. Another European customer, one who had experienced erratic performance before the updated software release has already started the process to purchase a second sequel system. For customers who are running longer insert libraries for whole genome and structural variant sequencing, we are on track to introduce new products towards the end of this year that will enable them to achieve similar results. These include a new sample prep kit that can dramatically reduce the time and labor involved with many library prep - with library prep and improve the quality of long insert libraries. A new sequencing chemistry and protocol that can dramatically improve sequencing read lengths and hence yield, an additional software enhancements to several application specific analyses. We are continuing to work on the new version of the sequel SMRT Cell that has eight times the capacity of the existing sequel's SMRT Cell. This program is progressing well and we continue to target release of that product by the end of 2018. We mentioned previously that we are targeting to deliver a 30 fold improvement in throughput over a two year period. The improvements I just mentioned that double the throughput for this year are a good start. The similar twofold improvements planned for next year on top of the new 8 million well SMRT Cell, we are on track to meet our goal of delivering approximately 150 gigabasis of sequence on a single SMRT Cell, which would enable us to provide high quality, human sized de novo genomes for about $1000 and low coverage genomes for structural variant analysis for substantially less. Two weeks ago, we attended the annual American Society for Human genetics meeting, which brings together over 6000 researchers and vendors in their Life Science Industry. This year we saw strong and growing interest in the use of SMRT Sequencing for studying structure variation, representing genetic differences of 50 base pairs or longer. Han Brunner, head of the Clinical Genetics at the Radboud University Medical Center in the Netherlands presented a talk at our workshop entitled “long read sequencing for detecting clinically relevant structural variation.” Karen McFarland, a professor in the department of neurology at the University of Florida's College of Medicine, describe the exciting results using our Cas9 amplification-free targeting protocol, the study that linked between repeat expansion SVs and spinocerebellar ataxia and Parkinson's disease. Separately we hosted a collab session on the final day of the conference, entitled CRISPR/Cas9 enrichment and long read whole genome sequencing for structural variant discovery. These presentations attracted a sizable audience that overflowed outside the boundary of the collab theatre. We have already seen interest from clinical researchers and hope to use the SMRT Sequencing SV analyses to develop streamlined protocols for important diagnostic tests. In order to capitalize on the rapid technical advances on our sequel platform and the opportunity - excuse me, and the opportunities these open up both - in both the research and clinical markets, we are strengthening our commercial team. We have unified the field service, field applications support and technical support groups under the direction of Chris Seipert, who previously managed instrument manufacturing and field service. Chris's new organization is charged with driving rapid adoption of new capabilities and improve performance in the sequel system and we expect this to result in a continued increase in system consumable utilization. Chris works closely with our field sales organizations, led by Rahm Waxman [ph] in Asia-Pacific and Dominique Remy-Renou, North America and Europe. Rahm has led the rapid expansion of our business in Asia-Pacific for several years. Dominique joined Pac Bio in June with more than 20 years and senior sales and marketing experience in the life science research markets. Today we also announced the appointment of Kathy Ordoñez, as Chief Commercial Officer and Executive Vice President. She will have senior responsibility for our sales, support and marketing operations and remain a member of our board of directors. She brings more than 30 years of experience in the life sciences and diagnostics industries, with senior roles at Hoffmann-La Roche, Solera, Quest Diagnostics and RainDance Technologies. At Roche, Kathy was responsible for the formation of Roche Molecular Systems where she served as President and Chief Executive Officer for nine years and led the wide scale commercial application of the Polymerase Chain Reaction or PCR technology to the research, diagnostic and forensic fields. At Solaris, she oversaw the establishment of the company's diagnostic sequencing business, which achieved a leadership position and Sanger sequencing for clinical diagnostic applications. I have worked with Kathy since the early days of PCR commercialization and I am pleased that she has agreed to bring her substantial experience to our commercial endeavours. That concludes my initial remarks. I'll turn it over to Susan to provide more details on our financial results.

Thank you, Mike and good afternoon everyone. I will give my remarks today with financial overview of our third quarter that ended September 30, 2017. I will then provide details on our operating results for the quarter and the year with a comparison to Q3 of 2016 and 2016 year-to-date respectively. I will conclude my remarks with a brief discussion of our Q3 and of course the balance sheet. Starting with our third quarter 2017 and year-to-date financial highlights. During the quarter we recognized revenue of $23.5 million and incurred a net loss of $22 million. We ended the quarter with $84 million in cash and investments. Turning to revenues, the $23.5 million of product service and other revenue in Q3 of 2017 was $2 million higher than the $21.5 million the product service and other revenue in Q3 of 2016. In Q3 of 2016, we also recognized $3.6 million of Roche related contractual revenue, including this contractual revenue total revenue was $25.1 million in 2016. Year-to-date, product service and other revenue in 2017 was $68.5 million, up 26% compared to $54.2 million recognized year-to-date in 2016. Year-to-date 2016 total revenue was $65 million, which included $10.8 million of Roche contractual revenue. Breaking down the revenue, instrument revenue recognized in Q3 2017 was $9.7 million, down $1.8 million from $11.5 million recognized – of 2016. Year-to-date instrument revenue was $29.5 million in 2017, $1.7 million higher than the $27.8 million recognized during the same period last year. Consumable revenue continues to be strong increasing 52% to $10.6 million for the quarter, up from $6.5 million reported during the third quarter of 2016. This substantial year-over-year revenue increased - highlights the continued consumable sales momentum that is now resulted in a seven consecutive quarters of consumable revenues growth. Year-to-date, consumable revenue has increased 77% to $28.7 million in 2017 compared to $16.2 million year-to-date in 2016. Service and other revenue was $3.2 million in the quarter, down slightly compared to the $3.5 million in Q3 of 2016. Year-to-date service and other revenue was $10.3 million relatively flat compared to the $10.2 million year-to-date in 2016. With regards to gross profit and margins, in Q3 of 2017, we generated gross profit of $8.2 million resulting in a gross margin of 35%. This compares to a gross profit of $12.6 million in Q3 of 2016, excluding the $3.6 million dollars of Roche contractual revenue, the adjusted gross profit was $9 million and 42% gross margin in Q3 of 2016. Year-to-date gross profit in 2017 was $25.2 million with a gross margin of 37%. This compares to gross profit of $32.8 million year-to-date 2016. Excluding the $10.8 million of Roche contractual revenue recognized year-to-date in 2016, the adjusted gross profit year-to-date in 2016 was $22 million with a gross margin of 41%. While regional and product mix contributes to quarterly gross margin variances, in 2017 a consistent contributor to our gross margin decrease has been a decrease in service margin. 2017 service margins have been affected negatively due to the transition from the RS II to the sequel product line. Year over year, our service revenue has been flat, as the higher price RS service contracts are being replaced with lower price sequel contract. This is occurred while our service costs have increased. In part due to an early build up of our field personnel to ensure our early sequel customers are successful. Also as we have stated in previous calls, we incurred $1.6 million in charges related to the change in the use of life of RS II lease instruments early this year. The leased RS II instruments helped the number of our customers experience a smooth transition to their sequel instrument. And finally as Mike mentioned previously, our proactive replacement of a critical part in the sequel installed base is added to the service cost in 2017. Moving to operating expenses. Operating expenses in the third quarter of 2017 totalled $29.8 million, compared to $29.4 million in Q3 of 2016. Year-to-date operating expenses in 2017 were $94.4 million, $8.2 million higher than the $86.2 million in first year to date in 2016. Non-cash stock based compensation included in operating expenses was $4.4 million in Q3 of 2017 versus $4.6 million in Q3 of 2016. Breaking down our operating expenses, R&D expenses in the quarter was $$15.8 million, down from $17.5 million incurred in Q3 of 2016. Most of this decrease is related to the higher chip development costs in 2016. R&D expenses year-to-date was $29.7 million in 2017, down from $51.4 million incurred year-to-date in 2016. R&D expenses in the quarter included $2.1 million of non-cash stock based compensation expense, flat compared to the $2.2 million of expense in Q3 2016. Sales, general and administrative expenses in the quarter were $40 [ph] million, compared to $11.9 million in Q3 of 2016. Year-to-date SG&A expenses were $44.7 million compared to $34.8 million for the same period in 2016. As we mentioned in the last two quarters, the move to our new facility in Menlo Park in Q1 impacted expenses in SG&A. Additionally SG&A expenses were higher year-over-year as a result of increased legal and compensation costs. Compensation cost rose primarily due to our hiring and sales and field support organizations. SG&A expenses in third quarter of 2017 included $2.5 million of non-cash stock based compensation expense, relatively flat compared to the $2.4 million of non-cash, stock based compensation expense recognized in Q3 of 2016. Finally in Q3 of 2017, we recorded $400,000 of net interest and other expense compared to $700,000 recorded in Q3 of 2016. The pay down of $4.5 million in debt in June contributed to the reduction. Year-to-date we recorded $2.2 million of net interest and other expense, compared to $2 million year-to-date in 2016. Turning to our balance sheet. As I mentioned at the beginning of my comments, our balance of cash investments was $84 million at the end of the third quarter compared to $102.6 million at the end of second quarter. Inventory balances were higher in the quarter $18.2 million in Q3, up from $17.3 million at the end of Q2. Accounts receivable decreased in Q3 to $8.9 million from 9.5 at the end of Q2. This concludes my remarks on the financial results for the quarter. I'd like to turn the call over to Ben.

Thank you Susan. I'll be providing an updated forecast of our 2017 financial performance. Starting with revenue, we are revising our forecast for the year due to a shortfall in recent revenue results against our previous projections. We now expect our total revenue for the year to come in at approximately $90 million. It is worth noting that our consumable revenue has grown 77% year to date and we continue to expect the high growth rate in consumables as the average pull through revenue on sequel systems increases. Moving on to gross margin. We expect service revenue and service related costs to level out and improve, resulting in improved gross margin going forward. For the fourth quarter, we expect gross margin to recover back towards 37% to 40%. Beyond the fourth quarter, we expect gross margin to continue to improve as revenue increases because a fair amount of our cost of sales were comprised of costs that are fixed. Now moving on to operating expenses. Our operating declined sequentially in the past quarter, as some of our legal expenses have moderated and we are generally controlling our costs. We're lowering our forecast for operating expenses this year. We expect operating expense this year to grow 8% to 10% over last year. Previously we had forecasts year over year operating expense to grow between 13% and 15%. As a reminder, we started recognizing rent and depreciation expense associated with our new facility in Q1. And as anticipated this drove a significant increase in operating expense for this year. These incremental expenses are largely fixed and the majority of this increase represents non-cash expense. Regarding cash with $84 million in cash and investments on hand, we have no immediate plans for raising additional capital. That concludes our prepared remarks and we'll now open the call up for questions.

Thank you. [Operator Instructions] Our first question comes from Amanda Murphy from William Blair. Your line is now open.

Hi, good afternoon. So I guess just starting out, I think one of the things that we're trying to get our arms around is you know, the size of the market just in terms of long-term you know, what long resequencing might look like from a box placement perspective, I know that's a hard question to answer. But I suppose, I'm just curious. Is it - so obviously you sighted some dynamics vacation timing and that all make sense. Should we expect you know, placements to kind of slow here as you work to - you know towards the [indiscernible] that the new chip, is that the right way to think about it, kind of you’ve barring that capacity points you made and some customers were kind of seeing maybe a bit of a pause here or maybe you could just help characterize, you know, how is the book over the next couple of years in terms of placements and orders?

I’ll take a stab at that. So you know, what we said is that at our current cost structure for genome level sequencing and where we are with transcriptome sequencing and some other targeted things, that we can legitimately compete in roughly 10% of the market, with the biggest part of the market relating to sort of whole genome resequencing in the human space that we don't directly compete with. And we think that we don't compete in that until we get the sort of thousand dollar roughly cost, where thousand dollars you get a really complete genome not a very high density snap map. And we don't get there until we've got that system out. On the other hand, we still incrementally increase we think our market opportunities between now and then, as we ramp up on a more modest basis, the throughput performance of the system and we've seen that already as we've gotten more people up to where they should be in terms of the current sequencing software and kits. And as we go through the incremental changes over the next six months or the next year and a half before we get to the really high usage of the higher volume ship, we expect to see incrementally increasing opportunity for a lot of labs that are kind of on the borderline relative to the cost of the projects that they have to do. And maybe I misunderstood what you said Amanda, but what we're seeing is that those customers who have the applications that are in our wheelhouse, whether it's in microbial analysis, it's in - beginning to look at some of the structural variance projects where the total cost of that experiment isn't so high as it is with thermo [ph] sequencing. And particularly as in the plant and animal space, then we're already seeing that a lot of these big commercial service labs in particular are expanding their capacity because they've got the business to expand into using our technology and that's been a good part of why we've seen such successful growth for example in Asia.

Right. Yeah, that's helpful. I think it's just trying to figure out, you know, obviously there's the question of how niche the market is or it sounds like you're saying as the cost comes down just like we've seen with other - and other sequencing technologies It's an elastic market and therefore you should be able to expand into new applications and that's how to think about it?

Well, it's expanding into markets that already exist and some of those cases that we just don’t exceed it.

Yeah, understood.

And it's in some it's creating and broadening markets where we've kind of created ourselves, the plant and animal and all those sequencing market to a large degree was relatively small because the concept of resequencing is you know, kind of a fictitious one until you've got a good reference to resequence against And so now we're seeing more and more people recognizing that. And that's been as we've stated for the last almost two years now, roughly half of the utilization of our system. And there we do very well because the cost of that de novo sequencing with short reads is in many cases more expensive than it is with long reads and far more complete. So there we've done quite well.

And I think you said that Kathy was on the phone. I would love to get a perspective if that’s possible from Kathy just in terms of you know having been on the board of directors for a number of years kind of how you view the opportunities coming in the Pac Bio as the Chief Commercial Officer at this point, kind of what do you see as opportunities and potential, I don’t if risk is the right word that challenges maybe? Kathy Ordoñez: Well, I think the key point that I'd like to make is that, the company has evolved and the sequel has moved forward to a point where we've reached a stage where we need a vastly increased focus on commercial execution. And that's what I'm here to do and I'm very eager to take on that task. I think as Mike pointed out, as the cost of performing the sequencing goes down, the application of the technology will expand. And of course, with my background, I'm very excited about the diagnostic opportunities.

Okay. And then just last one. And welcome Kathy. The last one for me then is just - I guess focus on maybe your commentary on Europe. And so it sounds like that’s driven a bit by just vacation timing as you said. But what's the strategy there to drive sales forward from a commercial perspective. Obviously you’ve had a lot of success in China. Is there anything you can do to you know, to mirror that in Europe? Is that a function of as you said just kind of getting people to use the platform that's like preference - act as references or is there anything that you can do as a company to sort of accelerate the adoption in Europe, specifically? Kathy Ordoñez: As Mike mentioned in the script, we've recently brought on a very strong individual Dominique, who is focusing both in Europe and the United States, but providing enhanced training and looking very closely at the skills of the people. And I think that that is - that basic blocking and tackling is the first thing that we have to do to get things back on track especially in Europe.

Got it. Okay. Thanks very much.

I mean – let me just add a little bit to what both I and Kathy has said. So we tried to say over and over because we firmly believe that this is a field where your customers do most of your selling for you in the long run, because the scientific world is so self-reference from one individual to another. People look to their peers, sometimes their competitors for guidance as to whether their technology is going to be right for them or safe for them to invest a substantial amount of money in. And until you get to the point where you have those references it's sometimes very hard to really move forward rapidly in your sales growth and all technologies protecting the sequencing space have undergone this. And we've seen successful realization that’s SMRT Sequencing is particularly valuable, scientific technology and we see that by the ballooning number of scientific publications that people have been able to craft using our technology. On the other hand, every time you change that technology, they always go back and was very [indiscernible] And - until you get to that point where they're convinced to enough about their use of an instrument or technology to recommend it to their colleagues, things will go slowly. And that's been the worst for us in Europe to a lesser degree in the US. Partly I think because of what I mentioned in my script, those were where we made the earliest placements and it takes the longest time, sometimes to get over your mistakes early on and particularly when you didn't realize as in the case of an instrument part sort of degrading over time faster than you thought. That's not always easy to pick out. And that's why we've kind of reinvigorated our whole effort, not just as Kathy pointed out in the sales process, but also how we deal with those kinds of issues and helping people be very successful. And we're just starting that process in Europe later than others. We started a little earlier in the U.S. because not everybody in the US goes on vacation for six weeks during the summer, whereas they do in Europe. And what we saw was a fairly substantial improvement in reliability and performance overall, once we started getting the installation of the upgraded software and sequencing kits back in mid to early July when we started the process. And as we've done more of that in the last month in Europe where people at least have had it installed at the end of Q3 and now they are starting to use the system. We're starting to see what we think a pretty favorable trend. But that message doesn't happen overnight. And so it does take a little while.

Okay. Make sense. Thank you.

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

Great. Good afternoon, everyone. This is Alex [ph] for Bill today. So this was just a follow up to Amanda's question and you touched a bit on the outsourcing component here, but I was just curious is competition playing a factor here at all. I mean is a competition taking a - would be sequel installed away or at least a minimum expand the time to go sequel order?

Well, we talked before that it does – and particularly in places like Europe where the tender process is invariably a long drawn out process anyway. Deal with slowing down the pace you get orders. That's less of an issue in Asia, where although you have frequently tender programs to a much shorter duration. You know, I don't know we can identify that we've lost specific sales because of competition. I mean, other than in a broader sense, I mean obviously Illumina. dominates the market and you’re competing in dollars but not head to head on a particular technology.. With the other long read technologies, we said have a hard time identifying where we lost sales in that regard. It clearly has influenced the timing of getting orders. But invariably we wind up getting the orders it just takes sometimes, a long time to go through the process.

Okay…

So we don’t know, that there can be cases clearly where people have bought other technologies and never contacted us. That is a different issue, but we think we do very well head to head against certainly any of the long read technologies and even against short reads in the cases where there is a clear qualitative difference in the performance of our SMRT Sequencing versus the short reads. We clearly do not compete on a lot of – as I said the basic human resequencing projects that are really cost driven right now.

Okay, that's helpful. And then what was the component that you were placing on the existing sequel's, just what was the actual component and have most of the sequels in the U.S. and Europe been repaired at this point and then just real quick on average how many days that a repair knocked the sequel off line?

Well, it wasn't so much that they knocked it off line for a while, although it wasn't a trivial replacement part. It's a without going into detail, it's a component that takes the output of the lasers and splits it appropriately to get it into the smart cells. And so it's a fairly sophisticated optical component. You know, I don't know that we've gotten all this - so we had - we changed the process that was causing the problem. And so a lot of the newer instruments went out without that problem in there, just the older ones in particular where it was an aging problem. It had to do with out gassing of glue of all things was causing us an increasing amount of issues, it took us a while to figure that out. There still are some that are out there on instruments that hadn't been used very much that need to be replaced. So we haven't finished that process, but like we've done it at the ones where the usage was becoming a problem because of that that issue.

Okay. That's helpful. And then just final question for me. This was another again a follow up to Amanda’s. As we looked at 2018, should we be thinking about, I know you probably don't want to give specific guidance on 2018 as yet, but should we be thinking about sequel placements relatively similar to 2017. And then obviously consumables will be ramping on the sequel installs?

Yeah. This is Ben. We're going to just defer on any specificity for 2018. I think what bodes well for us is the continued growth in consumables, the continued growth in utilization. We said in the past that you know, the utilization of the systems not only is significant in terms of rolling growth in itself, but is actually a driver of further system sales. So you know, that certainly bodes well, but we're going to wait until next call before we give you guidance on 2018.

Okay. Thank you.

Thank you. And our next question comes from David Westenberg from CL King. Your line is now open.

Hey, guys. Thank you for taking the question. So just a really basic question, which one you - what do you think is the most important selling feature of your technologies, long read or is it consistent accuracy or is it something else, such as maybe lack of need for amplification. And with that, do you see that market changing in terms of what your most important selling point might be in the coming years?

Well, it gets all of those things. But in the end it's being able to get all of the relevant types of information that a researcher is trying to get out of doing DNA sequencing and as opposed to having a sort of partial answer or an incomplete answer or sometimes an imprecise and inaccurate answer. And so the things that you mentioned contribute to all of those. But it's that completeness and along with accuracy we think that gives us the advantage.

Great. And just another basic question, you touched on a little bit on the call, but you know, is there any concern about SMRT Sequencing centralization, particularly in Asia. And if there would be any serious concern, I mean what would you be able to do in terms of alleviating that issue?

You're referencing the size of our installs - a couple of sites I assume?

Exactly.

Well you know, I point out that at Novogene for example they also have a couple of dozen – of the high end aluminum systems. And so – and china is a big place, right. And it's - if you look at Asia in a broader sense, what you see are local competition, within China it's because the individual provinces is economically compete with each other very strongly. And we have other large installations in China, besides Novogene. And so that's actually good. You have big, established, well funded commercial sequencing service providers that compete with each other for business. That's good. You have the same sort of thing in other countries, like South Korea and Australia, even in Southeast Asia. And so it's - in one sense it’s - you know you worry if one company was 80% of your sales, they're not. But it's good to have customers that are big enough and investing enough in the technology to go out and promote the technology to their customer base and generate sequencing projects at a level that allows them to continue to reinvest in the technology and add capacity to it. They've done that with aluminium, with multiples sites around the world for a long time and we're starting to see that now with our system.

Got you. Thank you.

Yeah. Just one more thing I thought would be useful to add is, you know we do have a number of customers who start off using a service provider in the beginning and then they go ahead and they buy their own Pac-Bio system themselves, once they've gotten to a point where they want to bring that in-house You know, as long as a barrier to purchase a system or start utilizing the system themselves is not that high. Then you don't worry overly too much about you know over centralization. You know all of your products in small number of sites.

Got it. Thank you. And just one last one. I know , you had a partnership with Roche for a number of years then and now you have a product on the market. Is there any kind of strategic partnership that you could do in terms of product development, but maybe in any commercialization sense and what can do on the strategic front, is that any - you know even is that even something that’s interest to you? Thank you very much.

Well, we've mentioned several times that we are particularly looking at where we need to have distribution partners, n China is an example and it relates in that specific case to the regulations that the Chinese FDA imposes on people bringing in technology into China. You know we have entertained the concept of doing either a localized distribution agreement, along the lines of what we did with Roche, but more geographically localized, as well as the potential for finding a partner that has the sort of broad reach that Roche has. And we continue in those discussions and we wanted to be careful because we want to make sure that a, we picked the right partner who really is willing to invest in the technology long term and b is interested in the kinds of diagnostic tests that are suitable for a long range long range sequencing. And those things are still under way.

Got it. Thank you guys very much.

Thank you. [Operator Instructions] Our next question comes from Joe Munda from First Analysis. Your line is now open.

Good afternoon. Mike, real quick, can you give us a little bit more color on the U.S. government agencies, you had talked a little bit about it that the rebound or it has been a little sluggishness despite having the budget finalized for this, year next year. Could you give us a little bit more color there? And I'll respond to that.

Well, it's a surprise to me that the budget's been finalized for next year it’s starting in October, because it hasn't been.

There's been numbers that have been throwing out there, right, so….

Well, there have been numbers that have been thrown out there in an overall budget portfolio, but not at individual agencies, which is what matters in the end and to me particularly with all the stuff going on with the tax cuts that whole thing is as much up in the years as ever was. But it just means that until these guys see a budget, that they're still cautious. Now as I pointed out in my scripted remarks, we did see purchases on the instruments side more in Q3 than orders anyway, more than we did in the first half of the year. But what surprised us a little bit is that typically government agencies tend to in their budget reflect over strictly for consumables heavily in September, so that they don't lose the money. And we didn't see very much if any of that this year, which is in my mind anyway suggests wrongly that they still are being very cautious until they see a real budget appropriation.

Okay. Can you give us some sense of what government agencies, what percentage of revenue they were in the quarter?

Well, I think the thing Mike want to be cautious about is, there is a difference as you know, sometimes between an order and the revenue. So to give you that wouldn't give you the insight you need on what the government orders were.

I'm just trying to figure out what the government was as a percentage of revenue for the quarter?

Well, that's a point that - we got a lot of orders say on the hardware side later in the quarter and would put out before that frequently we get orders and it's one to two quarters before you start doing those installs that a lot of those. And so that's why it's a little bit clear. It was pretty low in the first half of the year as we pointed out multiple times, but there is kind of a lag between orders and revenue, not so much on consumables obviously, but on instruments.

Yeah, I mean I don't want to parse out too much here, but I think we said in the past that government and academic combine in the U.S. - actually I should say government and NIH funded sort of purchase in the past have been you know, somewhere on the order of a third of what we've been selling in the U.S. And so government just - I guess this is a sup par of that. And we’ve also mentioned to you that these days the U.S. is less than half of our total worldwide business.

Okay. That's helpful. And then I guess Mike you know, with the addition of Kathy to the team here, I'm just I'm just curious, what did she bring to Pat Bio that you were lacking before her additions?

Well, aside from 30 years of experience in marketing related products in this space nothing…

And a lot of strength and diagnostic…

Yeah, I am joking obviously you know, she is - she has obviously far more experience in diagnostic side that any of us in the company put together. And that's a big thing because we still see a big opportunity for us in that side. But she also has that 30 years of experience managing and growing technology businesses in this arena and into commercial arena and her experience and helping guide how a sales and field organization and marketing organization puts all the pieces together, particularly when you've got the opportunity to expand your market substantially beyond early adopters. Its really key component we think of being able to utilize the capability with system and exploit appropriately.

Okay. And then just one final one, could give us an update on the ICC action with Oxford Nanopore and what's been going on there?

Well, it's going on. I'm always amazed that how the legal process is slow no matter which part of the government in the US is dealing with it. But it's progressing, and as you probably have seen we have added to our filings to support our IP position single molecule sequencing in the regular U.S. district court system for patent infringement as well. So we are progressing. We fully intend to defend vigorously our position in single molecule sequencing based on a broad portfolio of IP. And when people come in and in our view challenge that we will respond accordingly as we've done with Oxford.

Okay. Thank you.

Thank you. And it does conclude our Q&A session for today. I'd like to turn the call back over to Mike Hunkapiller, CEO for any closing remarks.

Thanks. In closing, I'd like to take a moment to provide some perspective on our current progress in growing the business. We're disappointed of course that our instrument sales have fallen short of our expectations in the near term. But we are encouraged by the substantial growth in system utilization. As we believe this is a primary indicator of the health of our business. I'm excited about the commercial opportunity we have in front of us and I'm confident the additions of Kathy Ordonez and others to our commercial team will lead to strong sales growth. As always, we remain steadfast in our commitment to bringing the unique advantages of our smart technology and products to our customers in the scientific community in general. We believe the SMRT Sequencing provides the industry's most complete and accurate picture of genomes, due with superior performance and sequencing accuracy, uniformity of coverage, extremely long read links and ability to characterize DNA based modifications. Furthermore by providing scientist 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 to our needs. Thank you for joining us and we look forward to talking again in three months time.

Ladies and gentlemen, this concludes your program for today and you may all disconnect. Everyone have a great day.