Pacific Biosciences of California, Inc. (PACB) Q1 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Pacific Biosciences of California First Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, there will be a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn the conference over to Trevin Rard. Ma’am, you may begin.

Thank you. Good afternoon and welcome to the Pacific Biosciences First Quarter 2018 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, it’s 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; 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 Securities and Exchange Commission filings, including our most recently filed reports on forms 8-K, 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. 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 the progress we made in our business during the first quarter. However, our financial results were mixed. We had strong Sequel instrument bookings in the quarter with the largest of instruments ordered in a quarter since Q4 of 2015, when we first announced the Sequel System and converted pipeline RS II orders to Sequel. The orders were highlighted by 10-unit instrument orders from both BGI and [Anna Road] in China. These orders allowed us to build up our backlog of instruments. However, we were not able to ship a majority of those 20 systems in Q1 while customer facilities were being prepared. As a result, instrument revenues for Q1 came in at $7.2 million compared to $12.6 million in Q1 of last year. As we previously noted, in Q1 of last year, we had a spike in Sequel systems shipments as we rapidly work down the backlog of Sequel instruments that we have built up in 2016 when constrain by limited supply of smart cells. Quarterly comparisons for instrument revenue can be challenging because of lumpiness in the timing of instrument orders and installs. The disproportionate impact of large multi-unit orders enhances this challenge since the timing of customers facility readiness is difficult to predict. To-date, most of our large multi-unit sequel orders have come from China, driven by planned animal sequencing projects. We expect such order activity to expand to other geographies, such as the US and Europe as the cost to smart sequencing reaches levels that enable it to use more widely in large human population genetic studies. Our overall consumables revenue for the quarter came in at $9.1 million, which was up modestly from $8.7 million in Q1 of last year. Sequel SMRT Cell usage was up three-fold, but RS II smart cell usage declined significantly, which offset the gains from Sequel consumable sales. RS II consumable sales represent approximately 20% of our total consumables for Q1 this year, compared to over half of our total consumable revenues in Q1 2017. This decline is a result of customer switching their projects over from the RS II platform to Sequel, a switch that is accelerated due to the Sequel performance enhancements we’ve introduced over the last several months. While RS II revenue is likely to decline further, it is now a much smaller portion of our total revenues. So we expect the impact of further declines to be less significant. As we have previously noted, we’ve expected Q1 2018 consumable revenue to be lower than the $12.7 million we recorded in Q4 of last year. One of the factors we noted was that we expected an impact from reduced consumable usage in Asia during the Lunar New Year, but we somewhat underestimated this effect. In fact, a significant number of our large users in Asia stopped running their instruments for an extended period of time during February of this year. Additionally, our largest customer made a large consumable purchase in late Q4 2017 and experienced facility issues that reduced the Q1 usage independent of the Lunar New Year shutdown. They are for the most part back to normal operation. However, they have not placed new Sequel consumable orders in Q1 as they have not sufficiently worked down their consumable stocks. The RS II consumable decline also effected to Q4 to Q1 comparison. Total revenue for the quarter was $19.4 million, down 22% compared with $24.9 million recorded in Q1 last year. As previously mentioned, Q1 revenues last year spiked up as we work down instrument backlog; and in Q4 of last year, we exceeded our previous forecast due to the timing of strong product shipments at the end of the year. With this in mind, we forewarned investors during our last earnings call to expect a relative decline in revenue for Q4 of this year. That said, Q1 revenue came in somewhat below our target for the reasons I mentioned earlier. Looking forward, we’re expecting to get back on track as we install the instruments that we’ve added to the backlog in Q1 and as customers begin operating those systems. Now turning to business updates. We’re seeing significant progress in applying SMRT Sequencing to key applications by our customers. HudsonAlpha, which has been using PacBio in their agricultural biology work, is now expanding our use of our products into human clinical research. They purchased another Sequel system this past quarter to add capacity to their Sequel, the first Sequel, and the RS II instruments. A project they are working on is to improve the diagnosis and intellectual and developmental disabilities and children. Already they have more than 500 children and their parents enroll in the study. They will be applying whole genome sequencing with PacBio to identify diverse types of generic variance, underlying disease in children, for which other analysis have failed to identify the cause. In reference to the project, a faculty investigator at HudsonAlpha stated, “PacBio Sequencing has made it possible for us to generate high-quality reference genomes for most plant, and we want to apply the benefits of this technology in the human disease space.” In addition to HudsonAlpha, we have engaged with numerous other customers who begun applying PacBio Sequencing toward clinical research. Radboud University Medical Center in the Netherlands, which also acquired a second Sequel instrument this past quarter, is using PacBio Sequencing to detect structural variance in rare disease as a leading participant in the SOLVE-RD European consortium that is tasked with solving unsolved rare diseases. We are also working with multiple large clinical testing centers that are interested in development tests for diseases characterized by large structural variance. At the recent American Association for Cancer Research, multiple researchers presented results of studies featuring the use of our Iso-Seq method, the full-length RNA transcript sequencing in cancer research. A recent review article in Nucleic Acids Research titled ‘Single Molecule Real-Time (NASDAQ:SMRT) Sequencing Comes of Age: Applications and Utilities for Medical Diagnostics’, written by researchers at KU Leuven and Uppsala University in Europe, offers a great overview of how SMRT Sequencing is already being used in clinically relevant applications ranging from cancer to reproductive medicine and more. The paper notes that SMRT Sequencing offers tremendous benefits because it resolves many problems with short-read platforms. The author stated, “Limitations such as GC bias, difficulties mapping to repetitive elements, trouble discriminating paralogous sequences, and difficulties in phasing alleles.” In addition, SMRT sequencing has “higher consensus accuracies and can detect epigenetic modifications from native DNA, the author has noted. We’re continuing discussions with potential clinical diagnostics partners. And then working to decide among several choices in China in particular, we have expressed strong interest SMRT Sequencing for clinical applications. In the plant and animal area, we’re continuing to work with various consortia engaged in large-scale sequencing programs to understand the the genetic diversity in Earth’s bio. Over the past year, the G10K/B10K consortium has started sequencing a relatively small number of samples across multiple sites and has generated high-quality reference genomes for a number of animals using PacBio SMRT Sequencing. We expect the volume of sequencing at these sites to increase significantly in the coming months as they expand a number and diversity of species they are studying. We’ve also seen an increase in the adoption of SMRT Sequencing by AgBio firms interested in commercial breeding programs. Turning now to our product development activities. In Q1, we released our latest sequencing enzyme and software for the Sequel System. And so this week, we've already successfully rolled it out to most of our customers. We are extremely pleased with performance that our customers have been achieving with these latest reagents and tools. Some of our customers have achieved average read lengths above 20,000 base pairs and throughput above 12 gigabases per SMRT cell sequencing, shared genomic libraries for de novo assembly. Others have achieved average read lengths above 40,000 base pairs and throughput above 20 gigabases of data for SMRT cell sequencing Amplicon-based libraries for applications such as transcriptome, isoform analysis using our Iso-Seq protocol. Furthermore, system reliability and consistency has continued to improve, which are key parameters for customers who want to conduct large projects that drives system utilization. As we mentioned in our previous call, we were planning another software chemistry release later this year with the goal of increasing throughput per SMRT cell by another factor of 2, along with further enhancements to our sequence analysis programs. Our work on a new version of the Sequel SMRT Cell that has eight times as many reaction wells as our current SMRT cell is progressing well. We continue to target completing the development of the chip by the end of this year. Our ongoing goal is to enable our customers to generate up to 150 gigabases of data from a single SMRT cell, which would then enable us to provide high-quality human size de novo genomes for approximately $1,000 and low coverage genomes for structural variant analysis for substantially less. That concludes my initial remarks. I’ll now turn it over to Susan to provide more details on the financials.

Thank you, Mike, and good afternoon, everyone. I will give my remarks today with financial overview of our first quarter that ended March 31, 2018. I will then provide details on our operating results for the quarter with a comparison to Q1 of 2017. I will conclude my remarks with a brief discussion of the March 31, 2018 balance sheet. Starting with our first quarter 2018 financial highlights. During the quarter, we recognized revenue of $19.4 million and incurred a net loss of $24.2 million. We ended the quarter with $79.3 million in unrestricted cash and investment. Turning into revenues. The $19.4 million of revenue recognized in Q1 2018 was $5.5 million lower than the $24.9 million of revenue in Q1 of 2017, primarily as result of lower instrument revenue in the quarter. Instrument revenue recognized in Q1 2018 was $7.2 million, down $5.4 million from $12.6 million recognized in Q1 of 2017. As a reminder, in the first half of 2016, we were installing a low number of instruments while we worked out our Sequel chip production challenges. This staggered instrument rollout created a large backlog that was worked out during the second half of 2016 and into early 2017. This consequently led to a higher numbers of instruments recognize into revenue during that timeframe. Consumer revenue in Q1 2018 increased to $9.1 million, up $400,000 over the $8.7 million reported during the first quarter of 2017. Service and other revenue was $3.1 million in the quarter, down from $3.6 million in Q1 2017. While Sequel service revenue from a growing installed base continues to increase, the decrease in the higher-price RS II service revenue has all stripped the Sequel revenue on a year-over-year basis. With regards to gross profit and margins. In Q1 2018, we generated gross profit of $7.3 million resulting in a gross margin of 38%, compared with the gross profit of $8.9 million and a gross margin of 36% recognize in Q1 of 2017. In Q1 2017, we recorded a $1.3 million charge to cost of revenue to write down the value of certain leased RS II instruments, which negatively affected our gross margin by approximately 5%. Moving to operating expenses. Operating expenses in the first quarter of 2018 totaled $31.2 million, down slightly from $32.2 million in Q1 of 2017. Non-cash stock-based compensation included in operating expenses was $4.6 million in Q1 of 2018 versus $4.5 million in Q1 of 2017. Breaking down our operating expenses. R&D expenses in the quarter were $16.3 million, $700,000 less than the $70 million incurred in Q1 of 2017. R&D expenses in the quarter included $2.2 million of non-cash stock-based compensation expense, slightly higher than the $2 million expense in Q1 2017. Sales, general and administrative expenses in the quarter were $14.9 million, slightly lower than the $15.2 million in Q1 of 2017. SG&A expenses for the first quarter of 2018 and for the $2.4 million of non-cash stock-based compensation expense, slightly lower than the $2.5 million of non-cash stock-based compensation expense recognize in Q1 of 2017. Turning to our balance sheet. As I mentioned at the beginning of my comments, our balance of unrestricted cash investments was $79.3 million at the end of the first quarter, $16.4 million higher than the $62.9 million at the end of fourth quarter 2017. In February, we issued 14.4 million new shares of common stock at a market price of $2.40 per share, generating net proceeds of $33.1 million. Excluding proceeds and related costs on the following offering, we used a $16.5 million in cash during the quarter. Additionally, in line with our lower revenue in Q1, our accounts receivable balances decreased $5 million to $8.4 million in Q1, and we increased our inventory balance $2.8 million to $25.9 million in Q1. This concludes my remarks from a financial results for the quarter, and I’d like to turn the call over to Ben.

Thank you, Susan. I'll be providing an update to our forecast for 2018 based on our results in Q1. As Mike mentioned earlier, we shipped fewer instruments and consumables resulting in lower revenues than we previously expected for the first quarter. We believe this is a short-term issue. However, the timing of customer site readiness for installing new systems, particularly for multi-unit orders, and variable customer ordering patterns for consumables have made it difficult for us to predict revenue timing. As a result, we are not providing a revenue forecast for the year. However, we will provide other information about the business to assist you in evaluating or performance. While customer ordering patterns can cause consumable revenues to vary in the short term, revenues in the long term are ultimately driven by system utilization. Despite the impact of the Lunar New Year celebrated in Asia in February, Sequel System utilization in Q1 was very strong. Compared with Q1 of last year, the usage of Sequel chips for our customers tripled. We expect consumable revenues to increase year-over-year, but we may experience some variation from quarter-to-quarter. With regards to instrument sales. We ended the second quarter with a larger backlog than we had at the beginning of the first quarter. We also had a healthy pipeline for new instrument orders, and we generally expect to record higher instrument revenues for each of the subsequent quarters this year. Moving on to gross margin. Our Q1 gross margin was in line with our previous forecast. We're focused on improving gross margins this year by driving top line growth, while keeping our fixed costs flat and by gradually reducing our service costs. As our revenue increases during the year, we expect our gross margin percentage to gradually increase and to get into the low to mid-40s by the fourth quarter of this year. Now moving to operating expenses. We are managing our expenses closely and we expect our total operating expense for the year to come in a little lower than last year's operating expense total of $124 million. Our net loss for Q1 included $7.1 million of non-cash stock compensation and depreciation expense. And we expect to continue to record a similar amount of non-cash expenses for each quarter this year. We expect our quarterly operating expense pattern to be similar to what we saw in 2017, but Q1 and Q2 operating expense higher than Q3 and Q4. We ended the quarter with $79 million in unrestricted cash and investments on hand after raising $33 million in net proceeds from our follow-on offering and burning $16.5 million in cash during the quarter. We expect to reduce our cash burn significantly this year, primarily through increasing sales and gross profit and by controlling expenses. That concludes our prepared remarks, and we'll now open the call out for questions.

Thank you. [Operator instructions] Our first question comes from Amanda Murphy with William Blair. You may begin. Q –Unidentified Analyst: This is actually Max on for Amanda. Just had a quick question one -- I know that you aren't providing specific platform numbers, but just wanted to get a sense, and there is some general commentary about how we should think about the progression of the instrument sales throughout the year, maybe some commentary around placements to new versus existing customers and some trends that you're seeing from an average order-size perspective?

Yeah, Max. This is Ben. So one thing I would like to again repeat, which I just said is the backlog at the beginning of the second quarter here is certainly bigger than we had at the beginning of Q1 driven by, largely driven anyway some of these large tenured ordered. And as Mike mentioned, we did not install majority of those last quarter. So we will expect those to be installed this year certainly in already start installing some of those quarter. So Q1 was probably in a pretty low point in terms of instrument shipments. So we’re expecting, as I mentioned, higher instrument shipments in each of the quarters throughout this year. The timing, though, is certainly going to be subject to, as I mentioned and Mike mentioned, these larger orders tending to add more sort of fluctuation in the installs, because if you have a tenured order that doesn’t get installed in one quarter and does get installed the next can cause quite a bit of fluctuation quarter-to-quarter.

Got it and certainly appreciate the commentary there. And then I know you also talked about the legacy installed based as well. In the prior quarter, you discussed the transition for some customers in the US and Europe specifically from the legacy install bases. Just wondering if we can update as to how the progress -- how that’s progressing and what we can expect moving to the rest of the year?

Yes. I think we are definitely seeing, what I would say fairly rapid transition for some of our customers, who have both RS IIs ecosystems to be doing more sequencing on their sequel systems, and therefore, spending less on their RS IIs? And that’s why the reasons why we saw a pretty healthy decline in RS II consumable revenues year-over-year. Again, a quote that the percentage of the consumable revenues in Q1 was about 20% RS II consumables whereas, in Q1 of last year, it was 50%. So we definitely have that transition going on. And it’s going to continue in our opinion, the percentage change might not be as big just because you’re working with a smallc number now. But the good news, is we are transitioning over the Sequel by its nature generates more revenues in RS II. And so we expect to see benefits from that transition.

Our next question comes from David Westenberg with CL King. You may begin.

It’s a little bit of continuation of max’s question here. Can you just talk – it’s the previous question. Can you just talk about the instrument backlog? So then should we expect in instrument catch-up then in Q2. I just wanted to know a little bit more about cadence of what our expectation to be there?

Yes. I mean, we wish we could give you specifics quarter by quarter, but I think we’re learning at least from experience we had in Q1, so recent, that these things can vary. That certainly is going to even out over time and having a bigger backlog going into the quarters certainly going to be a benefit for future quarters. Calling the specifics of which quarter, you’re going to see significant installs versus other ones who can have fewer, I think it’s going to be tough. So one thing that we are pointing out. Since Q1 was a pretty low quarter in terms of installs compared to even the last few, it's probably a low point. So in subsequent quarters this year, we expect to do better than we did in Q1.

So one of the things that we are seeing is as the system output has gone up, as the reliability has gone up, as the number of applications for which the system matches well, a lot more interest in a variety of sites at expanding their capacity on the Sequel by a lot. And that's leading to more of these large multi-unit orders. And we try to point out that that's certainly been true in China, primarily driven by the plant and animal works that they're doing. But even there, they're starting to apply in a bigger way towards a human-derived samples, and we're seeing the same sort of impetus coming both from Europe and the US. And as we get more and more larger unit orders, that makes the ability that we have to predict shipments in individual quarter worse than it was when we had a lot of one-unit instruments, where one being delayed for facilities preparation, didn't matter so much, but when it's tentative whack, it makes a big difference. The good news in that is that we're starting to get a lot more activity at the higher end of unit purchases, which says people have faith in the technology, they are now deploying where they're really thinking about using it in a big way as opposed to the occasional way, which is what most of the users in the US and Europe have done. In the short term, it makes quarter-to-quarter predictions a lot more erratic.

No problem. So in terms of just the behavior of your customers that have both RS II and Sequel. Are they -- are you seeing just project types? Are you seeing a preference still for small projects and ours too and then a big projects on your Sequel? Or are they even maybe transitioning some of those smaller projects to the Sequel, and just kind of help us think about that.

So the main driver, and there are a couple of exceptions, in the RS world, I’ve got people who are focused on sequencing individual bacterial samples, where they’ve got one bacterium to sequence at a time. And the Sequel is way overkill for that. The RS is perfectly placed for it. And one of the things that will drive the – continue to drive the RS down is that we're now in the process of rolling out a protocol that allows more easily multiplex bacterial samples to be run on the sequel, which allows the cost per bacterium on the Sequel to be equal to or actually even less than what it would cost on our RS. And that will in the end drive most of the RS customers over to the sequel platform. Well, some people take time to get the money to be able to make the switch, but our goal over the next couple of years would be to move almost everybody over if not everybody to the sequel system.

Got it, thank you. That's really helpful. Your new step, your eight-fold increase in throughput, that's going to be coming in seven month. Are you starting to have that conversation with customers about maybe it's time to look into the system, because we're about to get a whole different level of throughput and whole different system capabilities. So is that -- are you selling on that feature now? Or is that something maybe back half of the year you start to talk to your customers about that?

Well, we’ve given that – we’ve given kind of a 2-year roadmap to our customers since the beginning of last year. And so it’s not that they hadn’t known about that before. What we try to do is keep them a little more focused on the shorter term in that regard and make sure that they understand that we make commitments about sort of total-two fold increase over the last year, which is slightly more than that and then another twofold increase just from a perspective of chemistry and software, and then early in the next year have available a bigger job in the context of having eightfold increase in the multiplex on the chip on top of those chemistry and software changes. And so it’s a continual progression. And some people look to make decisions because they have short-term needs to get sequencing done. Others have longer-term larger projects that they plan. And so they want to know at some level what your roadmap is all the time. And they make the decision on whether they’re dealing with short-term or long-term issues. A lot of the cases, people replaying for research grants, that process can take a year. So they need to know ahead of time how to plan their project’s scope and expenses and so forth relative to what’s going to be available when they actually start projects. And so it’s a mix.

Got it. And I’ll just ask one more. It’s interesting to hear the undiagnosed projects at the university in the Netherland. So can you talk about that potential as an application? And are you see – are you having a conversation with some of your customers or different sites going on trying to apply that in places across America? Or what’s the potential for your system in light of these [Indiscernible]?

Well, the HudsonAlpha example was very similar. And one of the strengths of our system, which certainly adds to what you can do with short-read sequencing, is to look at structural variation. And if you take strictly undiagnosed or difficult-to-diagnose things that you suspect have a genetic basis, the short-reads technologies are very good at getting a single nucleotide changes. They’re really tiny and else. They’re not good at longer structural variants. And so typically people find that they get hits using short-read sequencing alone on say 30% to 40% of those cases. And the belief is, now that people understand how much structural variant -- diversity there is, is that you’ll pick up at least that much of the remainder using structural variant analysis. And because we have a much higher hit rate and much lower false positive rate, that’s why our SMRT Sequencing technology is attractive to the people who are starting this large programs on there. Well, they know they don’t get all the answers by any stretch of imagination just for short reason alone. And so we’re seeing that not just in those 2 sites. Those are the ones that we’ve mentioned because they did public releases on what they’re going to do with the systems. But we are definitely seeing that in a variety of sites both in the US and Europe and we announce one last year in China as well.

Got it. Thank you very much, and congrats on all the orders that you received this quarter.

Thank you.

Thank you.

Thank you. [Operator instruction] Our next question comes from Joe Munda with First Analysis. You may begin.

Good afternoon. Thanks for taking the questions. Mike, real quick. Can you give some sort of semblance of what the geographic breakdown would look like in sales? I know China had been leading the way for the last couple of quarters. But if you could give us some sense of what it looks like geographically, that would be great?

Well, yeah, let me talk about orders versus sales. China is still very strong market for us, and it’s got a lot of consumables as well as a lot of instrument sales. And so we've said that it represents over 30% of our total worldwide sales, and there are other areas in Asia that also add to that. And I don't -- we haven't seen that change yet. I think the opportunity for enhanced growth in Europe and the US is dependent upon our penetration into the large human population genetic-type studies, because just proportionately China has spent more money in the plant and animal space than the US and Europe, but less in the human side, at least for us. That’s probably not true necessarily for other technologies. And as we make more progress just because that's where there's more money in making our system cost effective for some of the human large studies, particularly as we’ve fold into those studies a lot more structural variant analysis, that I would expect the balance to tip more towards the US and Europe in terms of the growth.

Okay. In terms of install base, could you give us some idea of what the total install base is? I'm not asking for breakout of RS II and Sequel, just a total number or even perhaps a backlog number?

Yeah, Joe. So total install base is around 400 systems worldwide. And if you round numbers, think of it is around 250 sequels and around 150 RS IIs. We’ve had gotten to 160-ish RS IIs, but over the past couple of years, some of those have been retired. So at least the ones that we're tracking is probably down a bit from there. But the Sequel install base continues to grow. We’re not getting the exact backlog number, but it certainly is bigger now than it was three months ago.

Okay, I appreciate. That's helpful. And then I guess in terms of -- I guess I must have missed it. There was a write-down a couple of RS IIs in the quarter. Can you remind me what that was?

I'm sorry, Joe. That was last year. So what we were trying to explain as, if you look at the gross margin year-over-year, last year's gross margin did not have higher sales numbers, had a lower gross margin because it was also taking that 5% gross margin hit.

Okay, okay. I get it. Yes. And then I guess my final question. Cash runway you’ve $79.3 million on the balance sheet. I mean, I know you guys have talked about expense -- holding expenses tight. If we annualize the number in the first quarter of the decrease in cash and give the use, you get to $64 million for the year. I mean, how much of a runway you think you have based on the current cash on the balance sheet?

I’ll take a shot and then maybe Mike and Susan can chime in. Q1 is typically our biggest cash burn quarter. It’s just the quarter in which you have certain payouts and things like commissions and bonuses, and then there’s higher payroll taxes. So we don’t expect to burn as much as in rest of the quarter this year as we did in Q1. And we’re going to try to couple that with growing top line revenue. So if you put those together and then hopefully you have significantly less cash burn going forward, so you’re going to burn significantly less than that 60-plus number that you talked about. So again, there’s different ways for us to add funding to the company and our preferred way certainly is to have top-line growth and the control expenses. But there are other things that we’ve talked about in the past where we continue to explore. That would be, let’s say, less dilutive and let’s say the follow-on offering that we just did last quarter.

Our next question comes from Drew Jones with Stephens Inc. You may begin.

Good afternoon. This is James on for Drew. James Rutherford. My first question is a follow-up to the US conversation. It’s really kind of what gives you confidence that you can get into those large population studies? These conversations that you’re having with customers or potential customers in the US? Or is that a little bit further off at this point?

We’re having discussions. But what gives us confidence particularly in the human space is that the recognition of need to include structural variant analysis in those studies is becoming more and more clear. Number one. Number two, all these sites to try the other technologies, other long-read approaches, other synthetic long-read approaches, various manipulations they can do on the short-read technologies alone. I have just not gotten any answer that they want. They either have far to low sensitivity, meaning they missed a lot of structural variance. Or they have way too high false positive hits. So their specificity and their sensitivity are not where you want them to be in the big studies. They’ve done enough with our technology now to realize that we satisfy those requirements quite well. And they also know what the cost to doing with our system is. And they can afford to do relatively small projects at the current cost, and they will expand that and what they told us as the cost continues to go down. So we’ve put a lot of emphasis: a) on continuing to have them have faith that we are on track relative to kind of promises that we made over the long period of time and gradual improvement and an improve, which touch the cost down; and we kind of know where we get to that matches up to their ability to do really large numbers of samples. And so that’s why we have within a reasonable scope of figuring out what the opportunities are. Pretty good confidence that we’re right on track to be able to do that.

Okay. That makes sense. And is that 8 million well chipped that we expect probably sometime in 2019 the real catalyst to getting that -- those orders actually coming through?

Well, it certainly is the catalyst in terms of getting the installs done. Let’s put it that way. Building up to that, you have to get their commitments so that they know what to expect as customers and they can plan their projects accordingly. But yes, I mean, each bid of increase in throughput makes it easier to use it for larger and larger sample sizes, and that alone is obviously a big job. But if you go back to what we were, say, in the middle of last year, just the end of this year, just on chemistry changes alone, that's a factor of four. And so the aid is important on top of that, but at that point, it’s part of a progression that gets you to the larger and larger studies that can use our technology.

Okay, understood. Now flipping over to gross margins at -- the service and other kind of gross margin was a little better than we had expected. It looks like some cost came out perhaps there. Just trying to understand what was going on and how we should model that going forward?

This is Ben. So we said before that we are working on improving the gross margins in particular in the service area. So part of that improvements stem from us reducing some costs there. Our ASPs on instruments has remained pretty constant, so we're not necessarily seeing any sort of pressure on that. So our goal here is to continue to drive the top line growth and if we able do that then we should even improve on the gross margins that we deliver in Q1.

Okay, that's helpful. And in terms of China and the utilization there, I'm just understanding that there was an impact from the Chinese New Year. Just kind of curious that you see a similar impact last year, was there that happened in this quarter that had that outsized impact to cause the year-over-year kind of growth hit?

Well, the answer is yes. We saw the impact, but it wasn't significant at that point because we have not installed very many instruments in China in Q1 of last year. We purposely have held Chinese’s shipments, actually Asia shipments, down during 2016 while we were really getting the initial bugs of the Sequel introduction out, but more importantly, because of the constraint we had on SMRT cell supply. And so it wasn't until Q1 last year that we really started to release shipments into Asia. And so relatively speaking, it didn't have as much of an impact. And it isn't that we didn't see it. We did on the instruments that were there. They just weren't nearly as bigger percentage of our installed base. It’s more-or-like less than 10% versus more than 30%. The miss that we may in this sense was that, given the size of a lot of these sizes were operating at, they shut down a little bit before the Lunar New Year started because I had to get all the stuff that was running into their computing system. And then it took them a little longer since most of these guys are service companies. To get back up and running, they had to restart the process of prepping their samples, generating the sequence libraries from the DNA samples and so forth. And so it was a little longer on the front end and fair amount longer on the back end than just the normal 10 to 12 days that you would expected them to be on vacation somewhere. And we didn't do as good a job in predicting that as we should have.

Okay, that makes sense. And my last question on the balance sheet. The inventory kind of keeps margin higher. Would you just talk about what’s happening there and how we should think about that going forward?

Yes, I’ll say something and maybe Susan can chime in too. Timing has a lot to do with that. We mentioned that we didn’t install very many of the systems that we have this large multi-unit orders for. And if we had done so, then that inventory would not have been as high. So if you kind of mute the timing out, then I think over let’s say a multiple number of quarters, you’re going to see sort of a more normal average inventory level. We have said in the past that our manufacturing cycle for chips is actually quite long, and so what by its nature causes a certain amount of inventory buildup is just the fact that we have to ramp up the production of chips. And when we do that, we start wafers months ahead of time, and that adds inventory to the balance sheet.

Thank you. And I’m showing currently no further questions at this time. I’d like to turn the call back over to Mike Hunkapiller for closing remarks.

Thanks. In closing, we are excited about the prospects for our business as our customers were gaining momentum with the use of their Sequel Systems. Our Q1 financial results were somewhat mixed, but the fundamentals to the business are healthy and robust, as evidenced by growing system utilization and the multiple large estimate orders we received during the quarter. We have a great team to people in place who are committed to delivering successful results this year and beyond. Thank you for joining us, and we look forward to talking again in three months time.

Ladies and gentlemen, this concludes today’s conference. Thank you for your participation. Have a wonderful day.