Good day, ladies and gentlemen, and welcome to the Pacific Biosciences of California Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will be a question-and-answer session, and instructions will be given at that time. [Operator Instructions]. I would now like to introduce your host for today’s conference Trevin Rard. Please go ahead.

Good afternoon and welcome to the Pacific Biosciences Second 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 overall business during the second quarter even though our financial results were somewhat mixed. Our consumables revenue for the quarter came in at $10 million, which was up 6% from $9.4 million in Q2 of last year. Sequel SMRT Cell usage in the field was up over 90%, but RS II SMRT cell usage declined by over 50%, which offset a fair amount of the gains from Sequel consumable sales. An increasing number of our RS II customers are switching from using the RS II to using Sequel. Given the aging of the RS II systems, we’ve announced that we will discontinue support for the system in 2021 and we have recently instituted a trade-in program to accelerate the customer switch to Sequel. While this is having a short-term impact on overall consumable revenue growth, Sequel consumable revenue now comprises over 80% of the total. As a result, we expect that the overall consumable growth will start reflecting more of the Sequel trend. The switch away from RS II to Sequel is affecting service contract revenue in a similar manner. Instrument revenue for the quarter increased by 20% compared with Q2 of last year. All the large estimate orders we received from BGI and [Anna Road] earlier in the year are now installed and they are beginning to ramp up their usage. We have approximately 275 Sequel instruments installed worldwide and roughly 30% of those are installed in China. Total revenue for the quarter was $21.6 million, up 7% compared with $20.1 million recorded in Q2 of last year. While this is a little below what we are expecting for the quarter, we were otherwise pleased to see increases…

Thank you, Mike and good afternoon everyone. I will begin my remarks today with the financial overview of our second quarter that ended June 30, 2018. I would then provide details on our operating results for the quarter and 2018 year to-date with a comparison to Q2 of 2017 and 2017 year to-date respectively. I will conclude my remarks with a brief discussion of our balance sheet. Starting with our second quarter 2018 in year to-date financial highlight. During the quarter we recognize revenue of $21.6 million and incurred net loss of $22.5 million. We ended the quarter with $63.5 million in cash and investments. Turning to revenue. The $21.6 million for product, service and other revenue in Q2 of 2018 was $1.5 million higher than the $20.1 million of product, service and other revenue in Q2 of 2017. Year to-date product, service and other revenue in 2018 was $40.9 million compared to $45 million recognize year to-date in 2017. As mentioned in our call last quarter this reduction in revenue was largely due to a spike in Sequel system installations in Q1 of 2017. You may recall we were working down the backside of instruments that we build up from 2016 as we will constrained by limited numbers of SMRT cells. Breaking down the revenue, instrument revenue recognized in Q2, 2018 was $8.5 million of $1.4 million or 20% from the $7.1 million recognized in Q2 of 2017. Year to-date instrument revenue was $15.7 million in 2018 compared with $19.8 million recognized during the same period last year. Consumable revenue in the second quarter of 2018 was $10 million, up from $9.5 million reported during the second quarter of 2017. Year to-date, consumable revenues have increased to $19.1 million in 2018 compared to $18.1 million in the first half…

Thank you, Susan. And I'll be providing an update to our financial forecast. So, with regard our revenue, our consumable revenues came in lighter than we expected in Q2. However we continue to see growth in Sequel SMRT Cell usage among installed systems in the field and we expect to have increasing consumable revenues through the second half of the year. Instrument revenue increased as we anticipated in Q2 and our instrument sales pipeline is healthy. However, as we get closer to launching our higher capacity 8M SMRT Cell, we believe some customers may choose to postpone their instrument purchases. This may cause some uncertainty on our instrument revenues toward the end of this year. With this in mind, we are not providing a total revenue forecast for 2018. On the other hand with the planned launched over a 8M SMRT Cell next year we expect to expand our share of the market in population scale human genome projects in clinical research and as a result we are expecting increased revenue growth in 2019. Moving on to gross margin, we were pleased to see the improvement in gross margin in Q2 as we have made progress in reducing some of our service related costs. For Q3 we are forecasting gross margin to come in between 38% and 40%. As we have mentioned on previous calls the bigger lever for improving our gross margins is to drive significant increases in top-line revenue so that our fixed costs and manufacturing and service will be absorbed across a higher volume of sales. As previously mentioned, we see significant opportunity for revenue growth in 2019, which we expect to lead to more significant margin improvement. Now moving to operating expenses. We are managing our expenses closely and we expect our total operating expenses for the year to come in at approximately $120 million compared with last year's operating expense of $124 million. Our net loss for Q2 included approximately $7 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 entered the quarter with $63.5 million non-restricted cash and investments on hand and after burning $15.8 million in cash during the second quarter. Going forward we expect to reduce our cash burn by increasing gross profit and controlling expenses. That concludes our prepared remarks and we will now open the call up for questions.

Thank you. [Operator Instructions] Our first question is from Bill Quirk of Piper Jaffray. Your line is open.

Great. Thanks. Good afternoon. A couple of questions from me. First off, Ben just want to ask about the gross margin guidance for the third quarter given that you're expecting consumables to continue to rise here over the balance of the year, why – just help me think a little bit about why gross margin should be down sequentially?

Great question. Thanks for the question Bill. So Susan had mentioned earlier in the call that we had reduced our inventory [indiscernible] in Q2, and so we actually reduced our manufacturing output during the quarter. And even though this provides some benefits in the longer term it actually results in a short term impact to gross margin because we have some under-absorbed overhead now that are scheduled to be recognized in Q3. So it should be a short term issue, and gross margin should recover thereafter but as I mentioned in my remarks that the bigger improvement should happen with more significant top-line growth, which we are expecting in 2019.

Okay. Sounds good. Thank you, Ben. Can you also, I do appreciate the color around the mix shift between RS2 and Sequel. In the first quarter you had a significant slowdown and in Sequel consumables due to the Chinese New Year. Can you talk a little bit about what the sequential growth was in Sequel consumables?

In the Sequel consumables from Q1 to Q2? Yes, so the growth from Q1 to Q2 on Sequel was bigger than the total growth because we continue to see degradation in the RS consumables. So as we mentioned the RS consumables are now representing less than 20% of the total. So I mean like good news, bad news on that is that even though it's created a significant headwind let's say over this past year that the remaining amount to I guess decrease if you will, it's not as much and so going forward as Mike mentioned the consumable growth should start to reflect the Sequel consumable growth.

Very good. And then last one for me and I guess it's maybe a little longer ranging question but just thinking about the 8 million feature chip being available and Mike your comments about being able to do or being able to integrate that more with population sequencing efforts, I guess could you help ballpark for us where you think that's going to fall I mean we've certainly been tracking a number of the programs and quite candidly quite a few of them are still very much in the early stages. So it looks like it could be quite a fair amount of opportunity for you.

We agree I mean we obviously have to execute on getting our cost down, but where the total package of cost on our systems versus what you get with short read systems is more or less equal. In particular given the fact that in a single read on our system at that point in a single smart cell you can get all the data that you get on probably multiple runs on short read systems because you have to do multiple runs in order to collectively get information on steps, on structural variance and on phasing the haplotypes, and we can get to that point we think that we are a major player there. Obviously there's a lot of inertia from existing plans and so forth but we've been actively discussing and are continuing to do that with the larger centers what the capabilities are likely to be. And there's certainly a fair amount of interest in doing more and more of what they do that I got to stop doing short read sequencing in that space, but do more and more of it on our platform as the cost gets down. And what we've tried to show if you look at some of our earlier presentations that we posted on our investor website is that we expect our ability from a serviceable available market perspective to grow at probably twice the rate of the overall market during the next three or four years and most of that growth at least above market is focused into the large human population study in human biology arena.

Got it. Thanks Mike. Appreciate the color.

Thank you. Our next question is from Amanda Murphy with William Blair. Your line is open.

Hi. Thanks. So just on the upgrades that you've had on a Sequel to date I guess just one reaching them the one you talked about. [indiscernible] is there a price increase on a per smart – are you factoring in some sort of price benefit from the upgrades and then volume coming up and you say I'm sorry if I'd miss it but did you say what exactly the next update will bring in terms of performance improvements?

If I remember the numbers – I will get back to you again. So we had some modest increase in per unit cost when we did the last upgrade, but not substantial and we will probably have – we haven’t announced the price yet, so [indiscernible] details, we will have a similar modest increase on the price per smart cell or per reaction how you want to look at it when we do the next release. That's typically what we do particularly if we introduce a new product, which is a replacement for say the sequencing kit we've used before and certainly when we get to the 8 million ZMW chip we're likely to charge more for that than we do on our current chip. We typically tend to give a lot of that benefit to the customer because we are trying to pull their per project cost down but we want to make sure that we get some pick up from that as well. And in terms of the performance I think is your second part of your question?

Yes.

Well as I said we got – we’ve talked about the one we did in this late winter, early spring before but we actually have a – as I've tried to point out a much more dramatic increase in the sequencing performance coming up with the release scheduled over the next couple of months and to be honest somewhat ahead of what we were expecting and that release when we looked at it earlier in the year thanks to just some outstanding work by our development teams and that's why I quoted some of the numbers that I did. You won't get those numbers on every kind of sample if people can produce and run because some samples are trickier than others but we're looking at a fairly substantial improvement. Being able to take human samples of certain types and get average read lengths of a hundred kilobases on those pieces of DNA is not something we would have anticipated at the beginning of the year and that's all really due to the improvements in the chemistry for the sequencing, and that translates directly into increased yield per smart cell. And so as we start to translate a lot of that increase over to eight times the number of pieces of DNA that you can look at it at once, as I pointed out, we're seeing at least on test samples and it's early yet maybe even higher numbers than we had anticipated earlier for that too because the chemistry a lot of it reports over the new system. So we'll get a better reading on that as we get out into the beta test sites, but we feel pretty good about the improvements in the chemistry that are coming.

And then in terms of the shift from our RS2 to Sequel, it feels like that accelerated quite a lot this quarter. I don't know if it is the right way of interpretation but is there something specific that happened that drove if that is the case the acceleration wasn’t the last or just kind of the ongoing improvements in performance or I don’t know, it just feels like there was a you know kind of like...

Yes, I mean we talked about a little bit last quarter as well and it kind of got started at some level near the end of last year as people saw the benefits of the – from both the reliability and the sequencing output performance with the summer release that we did last year and I got it started and then as I started to see the improvements from our early this year release that helped a lot. And it kind of builds on itself but as I pointed out very recently we've initiated a trade-in program to somewhat drive that and part of that is just because some of those RS machines are getting a little long in a tooth and it's harder and harder to get parts for them and things like that and so you have to make a decision at some point to discontinue support for the old ones as a way of helping push the transition to a newer platform particularly given the benefits both for us and the customer and being able to do that and only having one platform essentially to support us that's new and not to be easily supportable. So we've – it's a bunch of things that are ongoing and some new that relate to the recent improvement in the performance and in the fact that we're starting to nudge people along that pathway.

Okay. That makes sense and then just last one in terms of the eight million chips, obviously well presumably there will be a benefit there in terms of pricing on the chip itself but just remind me again what I know you have already said what will be required to use that chip. So is it – is it a whole new system purchase? Is it an upgrade? Is it you know, what's kind of the process to be able to utilize I mean the new chip?

So what we've told our customer base and I think we've mentioned it on these calls as well is that there will be a necessity to do an upgrade on the system. The computer is inadequate that we have now to support that much of an increase in throughput and the connection into the chip is a little different because there is a lot more pins on it than the current one. And the way that we go about carrying out that upgrade will be different probably in China than it is in the US than it is in certain places in Europe, but we got a variety of a great pass in order to carry that out.

Okay. Thank you.

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

Good afternoon Mike, Susan and Ben. Can hear me okay?

Yes.

So Mike first off I just wanted a touch base on wondering in the past you highlighted multi-unit orders in the quarters. I was wondering if do we see any multi-unit quarter – multi-unit orders in the quarter from customers particularly maybe China and maybe a little bit of color as far as the US is concerned in regard to the pace of orders that you're seeing there.

Hi, this is Ben. So those kinds of things are I guess by their nature a little bit lumpy. We didn't have any large multi-unit orders of note during the quarter but again there are some quarters in the past where we've had more than one and other quarters that we didn't have any. So in the last quarter we didn't have any for example ten unit orders.

Okay, and then I guess on the US, Mike if you could provide us with a little bit of commentary you know you talked about China being 30% of the revenue but I mean if you could give us some context of what you're seeing in the US as it relates to PacBio as well as sequencing in general?

Well, [indiscernible] highlight before is that for us we have what I would say an anomalously high percentage of our business in Asia, China in particular, and somewhat anomalously low percentage in the US and similar in Europe and the difference is predominantly what the match between our sequencing capacity and capabilities are for a lot of the usage in the two markets, and a lot of what goes on in Asia historically for us has been in the plant and animal space. They're just starting finally to ramp up in the human population genetic studies particularly in China, but a lot of our customer base over there has been very focused on the plant and animal space and continues to be, whereas in the US the bulk of the money is spent in human biomedical research and similar things in Europe. It's not that there aren't animal studies here. We have some big customers in that space in both places, but the overall bulk of the money that's out there that's spent in the sequencing space is in the human area and our cost structure for these large studies has just not allowed us to make inroads into that other than in the level of pilot studies that demonstrate the capability of the technology and so our effort there, and we think we're close to making it pay off really is to keep pushing our cost down per sample so that the cost of doing a human genome at high level of performance is equal to the way it's done now, but it gives you a very incomplete look at what genetic variation is from one sample to another, and that's really why people are doing these big studies. And so as we get our cost down we'd expect the US and Europe maybe to a little lesser degree to start growing faster than what we've seen in those areas by a lot and start to catch up with what you would expect to see the percentage of sales geographically for a company in this space. So that's what our strategy has been for a long time and it's why we focus so much on getting the cost per sample down particularly for these big re-sequencing projects. And we think we're well along the way towards doing that and some of the recent performance increases where we can get essentially raw data out of the machine at almost equivalent from a raw accuracy perspective of what people think they get with short reads but do it at our level of read length, which makes it much easier to discern differences from one area of genetic sequence to another in a characterized system like human.

Okay. That's helpful. Thank you. Ben, just one quick follow-up. You talked about RS being less than 20% of total consumables in this quarter, can you let us know what it was in Q2 of 2017?

Yes. It was over 40% in Q2 of 2017. So the – I think Mike even mentioned in his remarks that the RS consumables dropped by more than 50% year-over-year.

Okay. Thank you.

Thank you. Our next question is from Drew Jones with Stephens Inc. Your line is open.

Thanks. Hi, guys just piggybacking off of Amanda's second question, I think you guys have talked about pretty extensive lead times for chips right now. How do we think about that impacting the baton pass from current consumable to the new consumable when it does launch? Is there going to be a lag that is necessitated post-launch to broad adoption because of some still extensive lead times required?

That's a great question. Let me take a first crack and then Susan can handle as well because we worry about this. So the ones that we've tried to be very careful about is the ramp-up rate that we expect out of the 8M system because this is not a case like the RS where the people who have the sequels that are using it for a lot of things are left [indiscernible]. The sequel is still very good particularly as we continue to improve on the overall chemistry performance which impacts all the cells. The issue you want to make carefully is that we don't want to get to the point where we don't have enough of the new smart cells to support, however many customers that we allow to have the upgrades done and we think we're on top of that. We just – but we weren’t when we introduced the Sequel pretty clearly. That cost us a good will for a long time and it held back our ability to install a very eager set of customers’ instruments and so that's why we've been kind of careful in giving you a guidance as to how fast we expect that to ramp up. We’ll know more of that over the next several months as we go through additional passes through the fab factories of these chips, and we’ve started on prototype levels. We get really good results on those. Those were not focused on trying to get high yields out of the chips and it's not so much that you can't pick out chips that working ones that don't work. You want to have the yield to the point where you can predict how much you've got in order to ship to people. That we wanted to be careful about and that's what you learn in the early part of that chip development process. So as we get more confidence about where we're going and we feel pretty good about where we are, we're not – we haven't changed really producers of the things but it's somewhat a more complex chip. So we are being careful about that.

Right and I would just add, last time we were switching from a prototype development shop to a high production fab in Asia, this time because the chip development is not new to what we're doing we're staying within the high production shop to take the second chip forward – the second iteration of the chip to 8 million chip. So we're not doing that step and we are being cautious. We will be cautious in our betas and not go out until we know where the yield and the supply is so that we can make sure those early systems sold have the chip supply that's sustainable for them.

Got it. Thank guys.

I would say that I don't know that we're so much worried about the low level you would support with a small number of betas, but we really want to make sure we've got a good supply of them in inventory before we open the floodgates and that's where we're trying to be I think prudently cautious about giving you guidance exactly on when that happens. We expect it to happen obviously as soon as possible. Everything else will be ready when we've got a good stockpile of chips.

Okay. Thank guys.

Thank you and that is all the time we have for questions today. I'd like to turn the call back over to Mr. Mike Hunkapiller for any further remarks.

Okay. Thanks for attending the conference call. In closing we're excited about the prospects for a business as our customers are gaining momentum with the use of their Sequel systems. We were coming up on an exciting enhancement to our sequel chemistry and software and not long after that we're planning for the introduction of the higher capacity 8M SMRT Cell. We have a great team of 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, thank you for participating in today's conference. This does conclude today's program, and you may all disconnect. Everyone have a great day.