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Edited Transcript of PACB earnings conference call or presentation 26-Apr-17 8:30pm GMT

Thomson Reuters StreetEvents

Q1 2017 Pacific Biosciences of California Inc Earnings Call

MENLO PARK Apr 28, 2017 (Thomson StreetEvents) -- Edited Transcript of Pacific Biosciences of California Inc earnings conference call or presentation Wednesday, April 26, 2017 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Ben Gong

* Michael W. Hunkapiller

Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President

* Susan K. Barnes

Pacific Biosciences of California, Inc. - CFO, Principal Accounting Officer and EVP

* Trevin Rard

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Conference Call Participants

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* Alexander David Nowak

Piper Jaffray Companies, Research Division - Research Analyst

* Amanda Louise Murphy

William Blair & Company L.L.C., Research Division - Healthcare Analyst

* Bryan Paul Brokmeier

Cantor Fitzgerald & Co., Research Division - Senior Equity Research Analyst

* David Michael Westenberg

CL King & Associates, Inc., Research Division - SVP and Senior Equity Analyst

* Tycho W. Peterson

JP Morgan Chase & Co, Research Division - Senior Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Pacific Biosciences of California Incorporated First Quarter 2017 Earnings Conference Call. (Operator Instructions) As a reminder, this conference call may be recorded. I would now like to introduce your host for today's conference, Ms. Trevin Rard. You may begin.

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Trevin Rard, [2]

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Thank you, Chanel. Good afternoon and welcome to the Pacific Biosciences First Quarter 2017 Conference Call. Earlier today, we issued a press release outlining the financial results we'll be discussing on today's call, a copy of which is available on the Investors section of our website at www.pacb.com, or alternatively, as furnished on our most recent filling 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'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're subject to assumptions, risks and uncertainties and may differ materially from actual results. These risks and uncertainties are more fully described in our most recent filings with the Securities and Exchange Commission. Pacific Biosciences undertakes no obligation to update forward-looking statements.

In addition, please note that today's call is being recorded and will be available for audio replay on the Investors section of our 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 our live call.

I'd now like to turn the call over to Mike.

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [3]

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Thanks, Trevin. Good afternoon and thank you, for joining us today. We are pleased with our first quarter results and our continued progress in driving growth in our business. Highlights of our Q1 financial results are as follows:

Total product and service revenue for the quarter was approximately $25 million, up 60% compared with $15.5 million in Q1 of last year. We recorded no contractual revenue for the first quarter compared with $3.6 million recorded in Q1 2016 as we had completed in Q4 of last year amortization of cash received under our Roche collaboration agreement.

We generated $12.6 million in instrument revenue for the quarter, up 63% from $7.8 million in Q1 2016. Instrument revenue has grown steadily this past year as we've increased shipment of Sequel Systems. We ended the quarter with an installed base of over 300 total PacBio systems worldwide.

Consumable revenue for the first quarter was $8.7 million, up 88% from $4.6 million recorded in Q1 2016. Consumable revenue growth was driven by a higher installed base of instruments and growth in Sequel instrument utilization. For Q1, we estimate that the average annualized pull-through revenue on Sequel Systems was as high as the average pull-through revenue on RS II systems.

Turning now to recent sales highlights. We've been seeing significant strength in our China business. Over the past 2 quarters, we sold 15 Sequel Systems to just 2 customer sites, and we placed numerous additional systems in China with both new and existing customers. All together, over 20% of our sales over the past 2 quarters has originated out of China.

We continue to seek momentum in the plant and animal sequencing market as more users are adopting PacBio for whole-genome sequencing of these organisms. The recent cover article published in the April issue of Nature Genetics describes the de novo reference assembly of the domestic goat genome based on PacBio SMRT Sequencing, in combination with chromosome level scaffolding by optical and chromatin interaction mapping techniques. The authors representing an international collaboration led by scientists at the U.S. Department of Agriculture, concluded, "These combined technologies produce what is, to our knowledge, the most continuous de novo mammalian assembly to date."

In an accompanying editorial article entitled A golden goat genome, Dr. Kim Worley from the Baylor College of Medicine noted, "This report generates sighs of relief from researchers frustrated with the highly fragmented genome sequences available for most species. As it demonstrates methods to achieve quality approaching that of a manually finishing reference, such as the human reference genome, without the associated extraordinary cost". A key point that Dr. Worley makes in this article is that this method, due to the lowering costs and wider availability of long-read sequencing and mapping technologies, provides an affordable roadmap to high-quality references for thousands of species and the resulting potential for wide impact. Her observations are consistent with the continuing growth we have seen in both new instrument sales and increased consumable use in this market. This growth is being driven not only by commercial interest in plant and animal breeding, but also by broader research into our planet's wider plant and animal genetic diversity.

We are also seeing growing interest in the use of SMRT Sequencing and clinical sequencing applications. HistoGenetics purchased 3 additional Sequel System during the quarter to increase their capacity for HOA typing with SMRT Sequencing. HistoGenetics is currently our largest single customer with a total of 11 PacBio systems, and they continue to sequence thousands of HOA samples every week. We are also seeing the adoption of SMRT Sequencing by additional HLA-typing providers, as more labs recognize the inherent advantage of sequencing whole genes with PacBio instead of just certain parts of genes with short-read sequencers.

HLA typing is our leading clinical sequencing application, and while it can represent a significant amount of revenue going forward for us, it has also paved the way for other clinical applications. We have seen a number recent Sequel instrument sales by customers working to develop clinical sequencing applications. One of those includes the Radboud University Medical Center in Nijmegen, the Netherlands. Han G. Brunner, MD, professor and head of the Department of Human Genetics at RUMC commented, "Despite all currently available tools, including CMV micro rays, exome sequencing and short-read genome sequencing, a significant portion of patient cases remain unsolved. We believe previously undetectable structural variation, including copy number variations, can explain a significant portion of these unsolved cases.

PacBio's long-read sequencing technology will allow us to unravel these hidden variance, and in the future, may allow us to develop a test to detect all types of genetic variation."

Summarizing our recent sales activities, there's a lot for us to be excited about, but we are cautious about instrument sales growth in the near term due to the uncertainty around U.S. government funding, particularly for capital purchases.

In the first quarter, most U.S. government agencies were subject to a hiring freeze. And the administration has proposed substantial budget reductions for the remainder of the current fiscal year and the next for several agencies that we otherwise would expect to be active purchasers of our sequencing systems. We do not have any U.S. government-funded orders for Sequel Systems in the first quarter, while these agencies were unsure of their funding status.

But we believe this is likely to be a temporary issue, and that final appropriations will not reflect the proposed draconian cuts. Until Congress and the administration settle on funding levels, we have a less clear-cut view of an important part of our U.S. sales opportunities.

Turning now to our product development activities. We are fully engaged in enhancing the performance of the Sequel System through a combination of chemistry, software and sample prep improvements. As we mentioned in our last call, we introduced new sequencing chemistry kits in Q1, and customers across our installed base are seeing improved performance in throughput and relay. At the AGBT meeting in Florida, we announced significant workflow improvements to our Iso-Seq technique for the analysis of gene isoforms, improvements that provide customers with substantial time and cost savings.

This summer, we plan to release software updates that will further enhance the performance of the Sequel System for large genome assembly, structural variant detection and targeted re-sequencing. These improvements are aimed at enhancing several high-impact applications used by our customers. We also continue to work on enhancements to our sequencing chemistry, and we are planning for another new release later this year. With these product enhancements, our goal is to double the throughput of the Sequel System by the end of the year.

As we mentioned on our previous call, we are also working on a new version of the Sequel SMRT Cell that has 8x the capacity of the existing Sequel cell. We continue to target release of that product by the end of next year. If we can maintain our normal pace of releasing new chemistries and software each year, then along with the development of the higher density SMRT Cell, we'll be in position to deliver a thirty-fold improvement in throughput over the next 2 years. With such dramatic improvements in throughput planned, we are targeting to provide platinum-grade genomes for about $1,000 and low-coverage genomes for structural analysis for just a few hundred dollars. We anticipate that this will drive significant demand for our products as we will be able to address many more mainstream applications for sequencing.

That concludes my initial remarks. I'll now turn it over to Susan to provide more details on our financial results.

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Susan K. Barnes, Pacific Biosciences of California, Inc. - CFO, Principal Accounting Officer and EVP [4]

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Thank you, Mike, and good afternoon, everyone. I will begin my remarks today with the financial overview of our first quarter that ended March 31, 2017.

I will then provide details on our operating results for the quarter with a comparison of Q1 of 2016. I will conclude my remarks with a brief discussion of our balance sheet.

Starting with our first quarter 2017 financial highlights. During the quarter, we recognized revenue of $24.9 million and incurred a net loss of $23.9 million. We ended the quarter with $56.1 million in cash and investments.

Turning to revenue. The $20.9 million in product, service and other revenue in Q1 of 2017 was 60% or $9.4 million higher than the $15.5 million of product service and other revenue in Q1 of 2016.

In Q1 2016, we also recognized $3.6 million of Roche amortized revenue, the total Q1 2017 revenue was $24.9 million, which compared to $19.1 million in Q1 2016, which did include the contractual revenue amortization.

Breaking down the revenue. Instrument revenue quarter-over-quarter grew 62% with $12.6 million recognized in Q1 2017 compared to $5.8 million recognized in Q1 of 2016.

Consumable revenue continued to be strong, increasing 88% to $8.7 million for the quarter, up from $4.6 million reported during the first quarter of 2016. This substantial year-over-year revenue increase highlights the recent consumable sales momentum that has resulted in 5 consecutive quarters of consumable revenue increases.

Service and other revenue increased 15% to $3.6 million in the quarter compared to $3.1 million in Q1 of 2016.

With regards to gross profit and margins. In Q1 2017, we generated gross profit of $8.9 million, resulting in a gross margin of approximately 36%. During the quarter, we took a charge of $1.3 million to cost of revenue related to RS II instruments, primarily due to a change in the estimated useful life of RS II instruments. As a reminder, shortly after our launching the Sequel platform in Q4 2015, we entered into a number of RS II instrument arrangements to enable some of our customers a more smooth transition from the RS II platform to the Sequel platform. A majority of these leases have expired, with customers returning the RS II systems to us as they converted to their Sequel Systems. As a result, we took a charge to reduce the remaining book value of those instruments. Excluding the $1.3 million charge in gross -- adjusted gross margin in Q1 2017 would have been approximately 41%.

In 2016, gross profit in the first quarter was $9.5 million with a gross margin of 50%. This, as previously mentioned, included contractual revenue of $3.6 million, representing the quarterly revenue amortization of the upfront payment related to the Roche collaboration agreement. Excluding contractual revenue, which was recorded at 100% margin, our gross margin in Q1 of 2016 was approximately 38%. Comparing the quarters, after excluding the RS II instrument charge in Q1 of 2017 and the contractual revenue in Q1 of 2016, adjusted gross profit was $10.3 million and 41% margin in Q1 of 2017 versus $5.8 million of adjusted gross profit and 38% margin in Q1 of 2016. The improvement year-over-year was due to a higher mix of Sequel instrument sales, which have a higher gross margin than the RS II instruments.

Moving to operating expenses. Operating expenses in the first quarter of 2017 totaled $32.2 million compared to $28.1 million in Q1 of 2016. Noncash stock-based compensation included in operating expenses increased $400,000 quarter-over-quarter from $4.1 million in Q1 of 2016 to $4.5 million in Q1 of 2017.

Breaking down our operating expenses. R&D expenses in the quarter were $17 million, up from $16.4 million incurred in Q1 of 2016. Most of this increase was related to the allocation of higher facility expenses that are now include recognition of rent and depreciation expense as a result of the move to our new facility in Q1 of 2017. As a reminder, in 2016, we were not incurring rent expense in our previous Menlo Park facilities because of our transition agreement with the landlord, and we incurred significantly lower depreciation facility-related expenses then.

R&D expenses in the quarter included $2 million of noncash stock-based compensation expense, relatively flat to the $1.9 million expense in Q1 of 2016.

Sales, general and administrative expenses in the quarter were $15.2 million compared to $11.7 million in Q1 of 2016. The move to our new facility in Menlo Park also impacted expenses and SG&A. Additionally, SG&A expenses were higher year-over-year as a result of increased legal and compensation costs. Compensation costs rose due to hiring in our sales and sales support organization.

SG&A expenses for the first quarter of 2017 included $2.5 million of noncash stock-based compensation expense, higher than the $2.2 million of noncash stock-based compensation expense recognized in Q1 of 2016.

Finally, in Q1, we reported $600,000 of net interest and other expense, primarily as a result of the incurred interest and derivative expenses associated with the debt we took on in Q1 of 2013.

Now turning to our balance sheet. As I mentioned at the beginning of my comments, our balance sheet of cash investments was $56.1 million at the end of the first quarter. This represents a $15.9 million decrease during the quarter. Inventory balances were slightly lower in the quarter, down to $15.3 million in Q1 from $15.6 million at the end of Q4. Accounts receivable decreased $1 million in Q1 to $10.4 million from $11.4 million at the end of Q4. Property and equipment increased approximately $28 million from $14.6 million at the end of Q4 to $42.4 million at the end of Q1. The increase was primarily related to improvements to our new facility that were placed into service during the quarter.

Finally, it should be noted that $3.1 million of the $20.5 million of notes payable was reclassified from long to short-term, an anticipation of a portion of the principal repayment that will become due in Q1 of 2018. The majority of the remaining principal will be come due in 2020.

This concludes my remarks on the financial results for the quarter. I'd like to now turn the call over to Ben.

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Ben Gong, [5]

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Thank you, Susan. I will be providing an updated forecast of our 2017 financial performance.

We were pleased with our first quarter revenue results, and we are continuing to drive year-over-year growth in product and service revenue. As Mike mentioned earlier, we are cautious about instrument sales in the near term as some of our U.S. customers are subject to delays or uncertainty in government funding. As a result, we are revising our growth projection for this year for product and service revenue to 35% to 45%, compared with our previous forecast of 40% to 60% growth. Roughly speaking, this translates to a total revenue for the year of between $105 million and $115 million. In the near term, we expect our Q2 2017 revenue to be lower than our Q1 2017 revenue. However, we expect it to be significantly higher than our Q2 revenues for 2016.

Moving on to gross margin. Excluding the $1.3 million in cost associated with the RS II instruments, our Q1 gross margin came in as expected. The transition from the RS II instrument to Sequel is now largely behind us. Going forward, we continue to expect gradual improvement in gross margin. Reiterating our previous guidance, in the near term, we expect our gross margin percentage to be in the low-40s. And assuming our revenues increased during the year, as anticipated, we expect our gross margin percentage to gradually increase and get to the mid-40s by the end of the year.

Now moving to operating expenses. As we had indicated in our previous call, we started recognizing rent and depreciation expenses associated with our new facility in Q1. And as anticipated, this drove most of the incremental increase in operating expense. Since these incremental expenses are largely fixed, we expect our total operating expenses to generally remain at a similar level throughout the year, resulting in year-over-year growth in operating expense of 13% to 15%. However, as we mentioned in our last call, the majority of this increase represents noncash expense.

Finally, with regard to cash use, we are on track to reduce our cash burn rate significantly this year compared to last year. We ended the first quarter with $56 million in cash and investments, which represents over a year's worth of our estimated cash needs. We did not use our at-the-market facility last quarter, but we do anticipate raising some capital this year through the use of the ATM.

And with that, we will open the call to your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Amanda Murphy of William Blair.

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Amanda Louise Murphy, William Blair & Company L.L.C., Research Division - Healthcare Analyst [2]

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So I just had a quick question. So obviously, I understand the comments on U.S. funding. I think there has been a few companies here that cited that as well. But just curious, so obviously, you had it living out with some strong order numbers [out of '16] and realizing that's not a competitive platform to you. I just was wondering if there's potentially any issue around just allocation of dollars just given that there's only so many to go around per se? And then also, I was curious, do you -- obviously, you've outlined an improvement in performance that you're expecting over the next year and then going forward in a meaningful way. Do you think there's some level of pause at all just as people want to see that ramp, particularly maybe with the second-generation chip on the Sequel?

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [3]

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This is Mike. Let me take the latter question first. I mean, I don't think that people are holding back on something we'd be introducing in almost 2 years. They still have an upgrade path to get to that system performance when we come out with that cell. Relative to our resources, I think we actually sell to different markets in a sense. And my understanding, at least when I'm talking to a few customers, that a lot of those new orders for their big system, their new one, are in large facilities that are kind of going through a switch. We don't sell to a large number of those. The agencies that hurt us the most are the ones that do a lot of government surveillance. So the USDA, the Department of Energy, the FDA, the CDC have all been big users of ours. And those are government entities that are on a hook for doing a lot of different things, particularly in the microbial and plant and animal space, but not necessarily big human genome re-sequencing projects. So I think there's a sort of an apples and oranges comparison there.

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Amanda Louise Murphy, William Blair & Company L.L.C., Research Division - Healthcare Analyst [4]

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

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Ben Gong, [5]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [6]

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

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Amanda Louise Murphy, William Blair & Company L.L.C., Research Division - Healthcare Analyst [7]

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And then one more question. And so obviously, China's been a big driver for you and [they hold] large orders there. Can you maybe just talk to that (inaudible) that opportunity more broadly? Is there a number of those that you think are potential in terms of further large unit orders? Or how are you thinking about that market going forward?

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [8]

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

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Operator [9]

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And our next question comes from the line of Bryan Brokmeier of Cantor Fitzgerald.

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Bryan Paul Brokmeier, Cantor Fitzgerald & Co., Research Division - Senior Equity Research Analyst [10]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [11]

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

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Bryan Paul Brokmeier, Cantor Fitzgerald & Co., Research Division - Senior Equity Research Analyst [12]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [13]

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

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Susan K. Barnes, Pacific Biosciences of California, Inc. - CFO, Principal Accounting Officer and EVP [14]

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

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Bryan Paul Brokmeier, Cantor Fitzgerald & Co., Research Division - Senior Equity Research Analyst [15]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [16]

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

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Bryan Paul Brokmeier, Cantor Fitzgerald & Co., Research Division - Senior Equity Research Analyst [17]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [18]

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

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Operator [19]

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And our next question comes from the line of Tycho Peterson of JPMorgan.

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Tycho W. Peterson, JP Morgan Chase & Co, Research Division - Senior Analyst [20]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [21]

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

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Tycho W. Peterson, JP Morgan Chase & Co, Research Division - Senior Analyst [22]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [23]

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

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Tycho W. Peterson, JP Morgan Chase & Co, Research Division - Senior Analyst [24]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [25]

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

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Operator [26]

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And our next question comes from the line of Bill Quirk of Piper Jaffray.

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Alexander David Nowak, Piper Jaffray Companies, Research Division - Research Analyst [27]

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

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Ben Gong, [28]

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

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Alexander David Nowak, Piper Jaffray Companies, Research Division - Research Analyst [29]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [30]

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Yes.

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Alexander David Nowak, Piper Jaffray Companies, Research Division - Research Analyst [31]

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

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Ben Gong, [32]

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

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Operator [33]

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(Operator Instructions) Our next question comes from the line of David Westenberg of CL King.

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David Michael Westenberg, CL King & Associates, Inc., Research Division - SVP and Senior Equity Analyst [34]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [35]

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

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Susan K. Barnes, Pacific Biosciences of California, Inc. - CFO, Principal Accounting Officer and EVP [36]

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

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David Michael Westenberg, CL King & Associates, Inc., Research Division - SVP and Senior Equity Analyst [37]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [38]

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

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David Michael Westenberg, CL King & Associates, Inc., Research Division - SVP and Senior Equity Analyst [39]

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

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Ben Gong, [40]

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

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Operator [41]

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

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Michael W. Hunkapiller, Pacific Biosciences of California, Inc. - Executive Chairman, CEO and President [42]

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Thanks. In closing, I'd like to reiterate our enthusiasm around momentum in the business and the increasing demand we're seeing for our products. We're very pleased with the uptick we have seen in our China business for example, and we are well positioned to take advantage of the heightened interest for our products in that region.

As always, we remain steadfast in our commitment to bringing the unique advantages of our SMRT technology and products to our customers and the scientific community in general. We believe that SMRT Sequencing provides the industry's most complete and accurate picture of genomes due to its superior performance in sequencing accuracy, uniformity of coverage, extremely long read lengths and ability to categorize DNA-based modifications.

Furthermore, by providing scientists with an ability to obtain a comprehensive set of sequence information within a single experiment, SMRT Sequencing is often the lowest cost and only research tool available to meet their needs.

Thank you for joining us, and we look forward to talking to you again in 3 months' time.

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Operator [43]

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