Good day, ladies and gentlemen, and welcome to the Pacific Biosciences of California, Inc. Second Quarter 2016 Earnings Conference Call. [Operator Instructions] As a reminder, this call may be recorded. 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 2016 Conference Call..

Earlier today, we issued a press release outlining the financial results we'll be discussing on today's call, a copy of which is available on the Investors section of our website at www.pacb.com or, alternatively, as furnished on the Form 10-Q 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 Securities and Exchange Commission filings, including our most recently filed report on 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 like to turn the call over to Mike. .

Thanks, Trevin. Good afternoon, and thank you for joining us today. We are pleased with our second quarter results and our continued progress in driving growth in our business. .

we received orders for 25 PacBio instruments during the second quarter. The instrument orders came from a broad range of customers and were well distributed across the U.S., Europe and Asia. We shipped 26 instruments during the second quarter. Our backlog of systems remains at more than 50. .

Total revenue for the second quarter was $20.7 million. Excluding contractual revenue related to our Roche agreement, this represents growth of 51% over Q2 2015.

We are on target with a revenue forecast of, at least, $93 million for this year, and with a significant backlog, we are well positioned to continue delivering sequential revenue growth throughout the year. .

Consumable revenue for the second quarter was $5 million, up 11% from Q2 2015. Consumable revenue for the quarter primarily reflected usage of the RS II systems as we continue to be supply constrained on Sequel chips throughout the second quarter. System utilization among RS II users has remained steady. .

Instrument revenue for the second quarter was $8.6 million, up 100% compared with Q2 2015 and reflects an increasing ramp of Sequel instrument shipments. Our gross margin for the quarter was 51%, representing a significant improvement in product margin over last year's margins.

Last year, we recorded a $10 million revenue milestone from Roche at 100% margin. Excluding that milestone, our gross margin in Q2 2015 would have been 30%. The significant increase in product margin this year reflects the higher profit margin that we generate from selling Sequel Systems compared to RS II systems.

We are pleased to see that we are tracking closer towards profitability with these improved product margins. .

Now I'll provide an update on our Sequel product launch. During Q2, we continued with our planned controlled ramp-up of instrument system shipments. Due to our limited supply of Sequel SMRT Cells from our prototype production supplier, we have restricted cell shipments to existing customers and kept new instrument shipments relatively low.

We appreciate the patience our customers have shown with this situation, and we recognize that it hasn't had an impact on their ability to use the full capabilities of the Sequel System. .

Today, we announced that as soon as customers have transitioned to our latest software release and sample prep protocols, it will no longer be on restricted SMRT Cell allocation. The chip performance from our prototype supplier has become more consistent, resulting in an increased supply from them. .

Moreover, we continue with our program to phase in production from our high-volume supplier and recently have begun shipping samples of these chips, from early pilot runs, to select customers. While we will receive chips from both suppliers for some time, we expect to be fully transitioned over to the high-volume supplier before the end of the year. .

Demand for the Sequel System continues to be robust, both from new and existing RS II customers. While we had fewer orders in Q2 than the previous quarter, the pipeline for new orders is strong across all 3 geographic regions, and we expect to see an increase in bookings in the coming quarters.

Some prospective customers have waited to place orders until they can be assured they will not be limited by the chip supply issue that has limited the amount of reference data generated by our early customers. .

We are also continuing to make progress in improving the overall performance of the Sequel System. The software upgrades we have recently released contain a number of improvements.

These include a fix for data transfer issues that have been causing problems for a number of our earlier customers, support for additional sequencing applications and increased consensus sequencing accuracy. Our improved sample prep protocol increases, both sequencing read length, sequencing yield and raw single pass accuracy.

We expect to enable all of our existing Sequel customers to take advantage of these upgrades by the end of the current quarter. We also expect to release a new chemistry designed to further increase read length and throughput by the end of the year as part of our continuing program of performance improvement. .

Now turning to other highlights. We made an announcement earlier this week that HistoGenetics, a worldwide leader in HLA typing, has recently won a large contract to process samples specifically with their PacBio systems. As background, we started working with HistoGenetics about 2 years ago when they purchased 2 of our RS II instruments.

They recognized the benefits of SMRT sequencing early, but it took them a little time to incorporate it into their production pipeline and to optimize methods to achieve higher throughput of samples on their PacBio machines. .

They have increased their system capacity and utilization over time. And more recently, they have bid for and won a very large HLA typing project to run on PacBio systems.

To prepare for this project, HistoGenetics have already ramped up their RS II production capacity to process thousands of samples per week, and they are now our largest single RS II install site. .

In addition to HLA typing, they are interested in using PacBio technology to further their research of other immunology-related genes. We were pleased to see our technology being adopted for high-volume sequencing applications such as the HistoGenetics HLA typing program --.

on the publications front, we continue to see an accelerating pace of new publications featuring SMRT sequencing. One paper recently appeared online in BioRxiv entitled SMRT Genome Assembly Corrects Reference Errors, Resolving the Genetic Basis of Virulence in Mycobacterium Tuberculosis.

The authors noted that their corrections to existing sequences based on shorter-read technologies "undermined and, in some cases, invalidated the conclusions of several previous studies." They concluded that, "our results change the picture of virulence attenuation" in this important pathogen.

Given the continued reemergence of tuberculosis as an international health problem, we are pleased that use of our technology is contributing to a better understanding of the pathogen responsible for this disease. .

Another recent paper appeared in Nature Communications at the end of June entitled Long-read sequencing and de novo assembly of a Chinese genome.

The authors of the paper from Jinan University in China and the University of Southern California described how they used SMRT sequencing of genomic DNA and Iso-Seq transcriptome analysis to create a Chinese reference genome. The results were impressive. They were able to assemble a genome with a contig N50 of 8.3 megabases.

As a reminder, previous assemblies of human genomes with the use of short-read technologies plus rigorous add-on efforts have only yielded contig N50s in the range of 100 to 200 kilobases. .

Importantly, the team found approximately 20,000 structural variance compared with the GRCh38 reference at NCBI. Using PacBio's Iso-Seq method, the scientists also analyzed the transcriptome of the individual and detected more than 58,000 isoforms.

The authorized -- authors summarized their findings stating, "while short-read-based alignment and variant calling based on reference genome remain a common practice to assay personal genomes, de novo assembly by long-read sequencing may reveal novel and complementary biological insights.

Furthermore, long-read RNA sequencing may identify novel transcripts that can be missed by short-read RNA sequencing." This paper is an indicator of the growing interest among scientists worldwide to generate high-quality reference genomes that are specific to particular ethnic populations.

The Chinese government has committed to spend approximately $10 billion over the next several years on its precision medicine program, and we believe SMRT Sequencing can play a significant role in contributing to this effort. Our business to China has been robust, and we expect this trend to continue. .

I'll conclude my opening remarks with a brief update on our Roche partnership. We and Roche continue to prepare for their Sequel-based product launch.

While Roche has targeted their launch for the latter part of this year, they may choose to delay their launch by a few additional months as they work to incorporate and validate some of the software features and assays they require for a clinical system.

We are also working to enhance our manufacturing, training and service processes to assist Roche with their launch. As part of this effort, we have recently passed the first surveillance audit of our ISO 9001 and ISO 13485 certifications. .

That concludes my initial remarks. I will turn it over to Susan to provide you with more details on our financial results. .

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, 2016. I will then provide details on our operating results for the quarter and year-to-date with a comparison to the second quarter and first half of 2015, respectively.

I will conclude my remarks with a brief discussion of our balance sheet. .

Starting with our second quarter and year-to-date financial highlights. During the second quarter, we recognized revenue of $20.7 million and incurred a net loss of $18.5 million. This brings our year-to-date total revenue to $39.9 million and our net loss to $37.9 million. We ended the quarter with $102.5 million in cash and investments. .

Turning to revenue. Total revenue from the quarter was $20.7 million, $4.2 million less than the $24.9 million recognized in Q2 of 2015, which included the recognition of $10 million of revenue associated with the achievement of a development milestone.

Year-to-date, total revenue in 2016 was $39.9 million, slightly below the $42.6 million recognized in the first half of 2015. Excluding the $10 million Roche milestone revenue in Q2 of 2015, total revenue in Q2 of 2016 was higher than Q2 of 2015 by $5.8 million or 39%.

And year-to-date, 2000 (sic) [ 2016 ] revenue was higher than the similar period in 2015 by $7.3 million or 22%. .

Breaking down our revenue. Instrument revenue quarter-over-quarter doubled to $8.6 million recognized in Q2 2016 compared to $4.3 million recognized in Q2 of 2015. Year-to-date instrument revenue was $16.3 million, a 44% increase over the $11.3 million recognized during the same period last year. .

Consumable revenue continues to be strong, increasing 11% to $5 million for the current quarter, up from $4.5 million reported during the second quarter of 2015. Year-to-date, consumer revenues increased 9% to $9.7 million in 2016 compared to $8.8 million in the first half of 2015. .

Service and other revenue increased 42% to $3.5 million in the quarter compared to $2.5 million in Q2 of 2015. Year-to-date service revenue was up 28% to $6.7 million from $5.3 million in 2015. .

And finally, this quarter, we recognized $3.6 million of contractual revenue associated with the amortization of the $35 million upfront payment that we received from Roche in Q3 2013. This was $10 million lower than the $13.6 million we recognized in Q2 of 2015, which included the $10 million Roche development milestone previously mentioned. .

We generated a gross profit of $10.6 million in Q2 of 2016, representing a gross margin of 51%. This was down from the $14.5 million of gross profit and 58% gross margin recognized in Q2 of 2015.

The lower profit margin -- lower profit and margin this year were a result of the $10 million Roche development milestone recognized in Q2 of 2015 with 100% margin. Year-to-date, gross profit was $20.1 million, representing gross margin of 51% compared with the 2015 year-to-date gross profit of $20.4 million and a gross margin of 48%.

Excluding the $10 million Roche milestone revenue in the first half of 2015, gross profit and margin in 2016 increased. .

In Q2 2016, the gross profit increased to $10.1 million from $4.5 million, and margins increased to 51% from 30% year-over-year. Year-to-date profit increased to $21.1 million from $10.4 million, and margins increased to 51%, up from 32% in 2015.

These achieved increases are primarily a result of higher revenue and margins recognized from sales of the Sequel System, as Mike mentioned. .

Moving to operating expenses. Operating expenses in the second quarter of 2016 totaled $28.7 million, $2.8 million higher than the $25.9 million incurred in Q2 of 2015. Year-to-date, operating expenses increased 11% to $56.8 million from $51.1 million in 2015.

The increase in 2016 expenses has largely been the result of higher compensation expenses related to an increase in headcount, an increase in noncash stock-based compensation expense and higher R&D chip development expenses in 2016 versus 2015. .

Noncash stock-based compensation increased $1.4 million quarter-over-quarter and $2.6 million year-to-date, 2016 over 2015. .

Breaking down our operating expenses. R&D expenses during the quarter were $17.5 million, $2.5 million higher than the $15 million of expenses incurred in Q2 of 2015. Year-to-date, R&D expenses were $33.9 million, a $4.4 million increase over the $29.5 million of expenses in 2015. .

R&D expenses this quarter included $2.1 million of noncash stock-based compensation expense, a $900,000 increase over the $1.2 million expense in Q2 of 2015. Year-to-date, operating R&D noncash stock-based compensation expense was $4 million in 2016, a $1.5 million increase over the $2.5 million expense incurred in 2015. .

Sales, general and administrative expenses in this quarter were $11.2 million compared to $10.9 million in Q2 of 2015. Year-to-date, SG&A expenses increased $1.3 million to $22.9 million in 2016, up from $21.6 million in the first half of 2015.

SG&A expenses in the second quarter of 2016 included $2.3 million of noncash stock-based compensation expense up $500,000 from the $1.8 million recognized in Q2 of 2015. Year-to-date, 2016 SG&A noncash stock-based compensation expense was $4.5 million, up $1 million from the $3.5 million recognized in 2015. .

And finally, in the area of other income and expense, in Q2, we recorded $400,000 of net other expense, including the normal $700,000 of interest expense associated with the debt we took on in Q1 of 2013, partially offset by an adjustment to the value of the derivatives associated with the debt we took on in Q1 of 2013.

Year-to-date, our net other expenses have totaled $1.2 million. Ben will provide further guidance on our ongoing expense rates later in the call. .

Now turning to our balance sheet. As I mentioned at the beginning of my comments, our balance of cash and investments was $102.5 million at the end of the second quarter. This is an $11 million increase during the quarter. Our cash increase reflects $31.5 million of proceeds from our ATM facility, partially offset by our Q2 net loss of $18.5 million.

Inventory balances increased $2.1 million in the quarter to $14.2 million from $12.1 million at the end of Q1. Accounts receivable increased in Q2 to $10.4 million from $8.1 million at the end of Q2. .

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

Thank you, Susan. I will be providing an updated forecast of our 2016 financial performance. .

First of all, as Mike mentioned earlier, we booked orders for 25 systems this past quarter. Our systems shipments were about the same as our bookings for Q2, which left us with a backlog of over 50 systems at the end of the quarter. We're not providing a specific forecast for future bookings.

However, based on our existing pipeline, we expect our bookings rate to increase in the second half of the year compared with the first half. .

Now moving onto revenue. Our Q2 revenue of $20.7 million was in line with our previous forecast, and therefore, we continue to expect our total revenue for the year to be, at least, $93 million. Excluding Roche contractual revenue, this represents a 70% increase in product and service revenue year-over-year.

In the near term, we expect Q3 revenue to grow sequentially compared with Q2. .

As we mentioned in last quarter's earnings call, we do not have milestone revenue to recognize this year. So quarterly comparisons of revenue from last year will vary. In Q2 of last year, we recognized a $10 million revenue milestone, and in Q4 of last year, we recognized a $20 million revenue milestone.

In addition, the quarterly amortization of the Roche contractual revenue is scheduled to change later this year. .

For Q3, the quarterly amortization should remain the same as Q2 at roughly $3.6 million. For Q4 and going forward, the quarterly amortization is scheduled to drop to less than $100,000. .

Despite a year-over-year reduction of over $33 million in contractual revenue, we continue to forecast total revenue this year to be greater than last year based on our growth estimates for product and service revenue. .

Moving on to gross margin. We were pleased to again see the improvement in gross margin up to 51% this past quarter compared with gross margin, excluding milestone revenue, of 30% in Q2 of last year. The margin improvement we have seen this year is driven by sales of our new Sequel System. We expect to see similar gross margins in Q3.

However, as a reminder, the $3.6 million in quarterly contractual revenue will just about go away after Q3 of this year. And since this is recorded at 100% gross margin, our overall gross margin percentage will likely decrease somewhat in Q4 this year. .

Our operating expense in Q2 increased by 11% compared with Q2 of last year, driven primarily by continued development cost for our Sequel SMRT Cells and increased noncash stock compensation expense. Stock compensation expense this past quarter increased by approximately 48% over last year.

And for the rest of this year, we expect to continue to record stock compensation expense at this level. .

We expect our total operating expense to grow by roughly 12% for the year, which is a little higher than our previous estimate of 10% growth. This comparison excludes the onetime $23 million gain we recognized in Q3 last year associated with the amendment to our property leases.

We estimate our combined noncash stock compensation expense and depreciation expense to be between $6 million and $7 million per quarter for the remainder of the year. Regarding our interest expense, we continue to expect to record approximately $3 million for the year. .

To sum up our forecast update, we expect to record a net loss of approximately $74 million for the year, which includes over $23 million of noncash expense. .

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

[Operator Instructions] And our first question comes from Amanda Murphy with William Blair. .

So I just had a question on Roche. Obviously, there's a lot of discussion around the timing of their launch and whatnot.

So to the extent that you can help us understand the mechanics there for you guys -- so obviously, you maintain your guidance -- I guess, if there's a delay into '17, does that affect your numbers this year? And then, how do we think about that going forward just in terms of modeling and the risk around the launch push as it relates to your numbers?.

I'll take a first shot at that, Amanda. So we have not changed our forecast for the year for revenues. It's still, at least, $93 million. So -- and we continue to sell small number of systems to Roche as we have in the past quarters. After they launch we do expect to sell more to them.

But with the significant backlog that we have, and as I said before of 50 systems in the backlog, we feel pretty secure about the forecast we gave for this year. .

Got it. Okay. And then, in terms of the orders you have in the pipeline that you mentioned, it sounds like they're pretty broad based, but you also brought up the Chinese PMI efforts.

Is there any context you can give around kind of -- or do you have any orders from that initiative at this point? Or is that something that could sort of flow-through at some point over the next few months here? And then, just in terms of the Roche comments you just made, I guess, same question in terms of the orders.

Is it -- do you expect to kind of have a similar number of shipments to them through the rest of the year as you did in the first half?.

I'll take a crack at that. So the Chinese genome project or the personal medicine initiative is kind of the like U.S. one. It's a long-term process. It's not a short-term thing. So what we have seen broadly, as we tried to mention, is that we do pretty well in China already in various sundry government, academic and commercial sites.

And we expect that to continue. And as they get more business from bigger initiatives, we would expect to be able to share in that.

Relative to Roche, as Ben tried to point out, we've been shipping for actually the last 3 quarters a limited number of systems to Roche for their assay development program and some of their training operations for their subsidiary sites.

We continue to do that independent per se of their broader customer launch, and we weren't planning on that customer launch to be done other than sometime late in the year anyway.

So it wasn't a significant part of the revenue forecast that we've given you, other than the ones that we've been shipping in sort of early development systems to them, and we plan to do that. Obviously, once they launch, we would expect to ramp up pretty quickly. .

Got it, okay. And then I just had one more on the chemistry upgrade or update that you rolled out.

So there's also been a decent amount of discussion, I think, around kind of the performance of the platform as it's evolved here -- the Sequel, as you've introduced updates both software and chemistry -- so just -- can you just kind of refresh us at this point where we stand in terms of, obviously, there's variability I'm sure on the customer side, but kind of what people are generally getting in terms of performance with the new chemistry update relative to the spec? And you've also laid out a roadmap over time.

So do you feel comfortable that the targets that you laid out over the longer term are achievable?.

Well, we announced the upgrade today, and we have quotes from 2 of the -- they're actually 2 of our original test sites, beta sites, in the system who've kind of watched the development of the technology over a 6 months-plus period now, and I'll let what they said speak for themselves in a sense. We feel pretty comfortable.

This is really kind of the first sort of chemistry/sample prep upgrade really that we've done, of importance, and it continues a series of software, both for instrument operation as well as data processing. And we think we're in pretty good shape from that perspective, but it's an ongoing process.

We continue, as we've done for the last 5 years or so, on the RS to continue to plan to roll out a series of upgrades, both in application support as well as sequencing performance, and we've announced today that -- in my presentation that we would expect to have a relatively substantial sequencing chemistry release around the end of the year.

This system has consistently performed.

The issue that we've had from day one -- and we tried to make this clear going back to the end of September, early October last year -- that we would be operating in the first half of this year with prototype cells, manufactured during a development process by our Belgian supplier and would expect to have relatively low yields that we would have available to ship to customers, and we tried to make that clear to customers as well.

But that the performance of those cells would be -- given that they're in the development process, still relatively erratic. We feel pretty comfortable now that the development process has kind of ironed itself out.

And certainly in terms of the yield of the cells, we feel comfortable enough to take people off of restricted allocation as soon as they have upgraded to the latest software, which is key to those cells.

So we would expect to see much more use of the system just because we're allowing them more use with more cells, but also the performance has substantially improved versus what it was with the early versions of the cells.

So we will see, but we've had a relatively limited field experience of that since we've just rolled that upgrade out -- really to beta sites -- in the last 2 to 3 weeks. .

Our next question from Bryan Brokmeier with Cantor Fitzgerald. .

How many -- I'm sorry.

Have you made any updates to the RS II over the last quarter or so?.

I would say no substantial ones. We are working with some of the customers in terms of beginning to give them access to what's called super Poisson loading, which allows them to get more usable ZMWs per run.

We're also working on that internally to put it on the Sequel System as well, and that's the major thing that we've focused on for the RS this year in terms of increasing throughput. .

Okay.

And have you received many requests from customers to upgrade their RS IIs to the Sequel? And how are you managing those requests?.

Well, we've -- as we pointed out, we've received orders from a fairly substantial number of existing RS II customers for Sequels. Have we received requests for upgrades? Yes. We have not offered any specific upgrade program for trading in RS IIs for Sequels. Despite what you may have read from comments from an individual. .

Okay. And bookings were ahead of what many people were expecting.

I apologize if I missed this, but where do you believe that the source of the greatest out-performance was? Where -- did you receive orders from any types of accounts quicker than expected? Or from any regions such as Asia? Did those start to come in that maybe people weren't factoring into their outlook?.

So you're asking about the existing pipeline, Bryan?.

Right, yes, the bookings in the quarter were better than a lot of people anticipated. And it's now a couple of quarters in a row when your bookings have exceeded expectations.

So where do you believe that you're seeing the most upside versus expectation?.

Well, I don't know that they've necessarily exceeded our expectations. I mean, it's pretty much in line with what we've been expecting. As Mike mentioned, the demand is coming from a broad set of customers and pretty well distributed across the U.S., Europe and Asia.

And then we did mention on the call that the pipeline is pretty strong, and so we actually think the bookings that we're going to have in the second half of the year are going to exceed what we had in the first half. .

Okay.

And that's regardless of whether Roche launches this year or next year?.

Yes. .

And our next question comes from Tycho Peterson with JPMorgan. .

Mike, can you comment on the HistoGenetics, what the new contract means potentially in terms of both new instruments and consumables?.

Well, as I pointed out, they've been ramping up their RS II capacity for some time in anticipation of this, because they had to be able to validate that they could start on a pretty short time frame once they began to get samples under the contract and assuming that they won a contract.

And I think what we would say is that we would expect it once they ramped up to generate in excess of $1 million a year in consumable spending to us. .

And is there a potential upsell to Sequel to them at some point?.

There is a potential upsell to Sequel for that test although, if you remember, that falls under the purview of Roche to sell Sequel Systems into blood bank typing operations. So once Roche is launched and is in a position to supply that particular assay, should they decide to do it, then they have the right to sell Sequel Systems into that space. .

But that is -- it's Susan. If you remember from the press release, they said they're also doing research in other areas, and that research would be something that we could work with them on the Sequel System line. .

And then can you maybe just give us a sense of what the quote times are for new orders in terms of installation? I'm just trying to think a little bit about the backlog.

And as you get better at installing and validating systems, [indiscernible] can the conversion pick up there?.

Yes. Well, if you just do some back of the envelope math, Tycho -- if we have something like a little more than 50 systems in the backlog, we should be able to ship, at least, that many systems in the balance of the year. So there's a lot of -- it depends.

But if you got an order in quickly, you could probably get it in Q4 in terms of install or if not Q4, then Q1. .

Okay. And then last one for me on R&D... .

Can I add to that? I mean, doing the installs has not been the problem. The problem has been if we didn't think we have enough SMRT Cells to support these guys, which we clearly didn't, we were holding back, and some of the customers -- knowing that -- were comfortable with that process.

So we expect them to be a little more anxious to get their installs done now that we've loosened the reins a little bit. .

And the other piece I think we mentioned earlier is that we were having trouble getting into sometimes their secondary server analysis thing, and this software upgrade has some solutions that make that easier as well. .

Okay. And then last one on R&D. Understand you had both stock-based comp and chip development this quarter.

How should we think about it for the back half of the year? Did the chip development cost burn off and is it going to come down?.

Well, I'm trying to incorporate that into our guidance for the year. The stock comp is going to continue on, which is probably going to make -- that was the main difference of why we increased it from the 10% to the 12% growth, quite frankly.

The chip development costs, there will be some ongoing chip development costs not just for the stuff we've been talking about, but we have mentioned that we are working on the more, let's say, dense chips as well. So yes, there's going to be some ongoing R&D expense, and we try to incorporate all of that into that expense forecast of 12%. .

And our next question comes from Bill Quirk with Piper Jaffray. .

Great.

This first question is recognizing that, obviously, you're going to be rolling out the new software and sample prep, which is going to help Sequel performance, and Mike, you talked about a significant chemistry improvement later this year -- how are you talking to customers about expected specs and throughput and such on the instrument? There does appear to be a bit of debate in the community about where performance is, where it's going, et cetera.

.

Well, I don't know that it necessarily changed our message to customers. What we have been trying to tell them all along is that they will be operating -- even at a restricted level -- with really prototype-level chips, and our experience with those until we got through the whole development process was that was going to be somewhat erratic.

And so we were guiding people to using applications for which, let's say, they were -- the applications were more forgiving of the variation that we were seeing in the chips, and in that case, they were doing pretty well.

It wasn't quite suited yet for all the applications that people would like to do, and partly because of the performance but partly because those kinds of applications just required more chips than we could commit to individual customers.

So I think that we will -- we fully expect to see a pretty sharp uptick in both utilization and breadth of applications that people are able to do successfully on the system. Our feedback is consistent with that. .

Okay, got it. I appreciate the color, Mike.

Secondly, now that the supply constraint is up, obviously, upon adoption of the upgraded software, is it safe to assume, Mike, that you would expect to see a number of kind of the earlier customers start to move into production mode here over the balance of the year and ostensibly, obviously, see your associated Sequel consumables start to climb as well?.

Yes. If not, we would be pretty worried. So. .

And our next question comes from Joe Munda with First Analysis. .

So, Mike, just real quick, with everything going on in Europe, we were hearing ancillary talk from Brexit from certain customers. You had talked about strength in all regions.

I guess, I'm interested, particularly in Europe and the demand and the strength you're seeing there, as well as to a certain competitor, are you coming up against the same customer debating whether purchasing one of your units versus one of their units. .

Well, I mean, I'm not aware of any impact that we've seen even theoretically from a Brexit ruling -- not that there may be one, but I'm unaware of any. Europe is -- has actually been an increasing source of strength for us with the Sequel, in terms of the sales that we've already made and the orders we've gotten as well as the pipeline that we have.

And it's opened up, just because of the price of the instrument, customers that really wanted to have access to long-read technology like ours but simply didn't have the budget capabilities for an almost $1 million instrument investment; which is kind of what they faced with, with the RS II.

So I think that's from my perspective, not too much of a surprise, but it's been pleasant that Europe has really come on fairly strongly for us. Anyone in the sequencing space is going to be looking at some mix right now of long-read and short-read technologies.

And whether you count that as competition between the two or the fact that people are rightly looking into the fact that they need both kinds of technologies for a diverse set of applications in sequencing, I'm not sure I would call that competition per se, but it is a factor in terms of how much they spend on one technology versus another as opposed to an either/or scenario.

I don't think that we're seeing competition in that sense even from anyone other than the obvious market leader. .

We've brought Sequel at the right price point, at the same time, we've really brought the scientific community's understanding of SMRT read technology, what it does, not only in its length and ability to assemble, but all the other pieces it brings with it in one experiment that, that's got more and more momentum for us.

So I think that is also very much what the European community is endorsing as well. .

I mean, we -- I think we announced at the beginning of the year that we had kind of passed the 1,000 customer publication level late last year, and we're fully on track to more than double that by the end of this year, and that's a test to the uptake and understanding of the value of the technology inherent in long reads, and we're seeing rapidly approaching 5 publications per day, on a relatively small installed base of RS IIs.

And that kind of validates, to a potential customer base, the value of the long-read technology. .

That's helpful, Mike.

As far as RS II goes, so the shipments -- I might have missed this, it was strictly Sequels this quarter? Were there any RS II shipped?.

Small number. It has a very small number of RS II as well. .

Okay, and that's included in that total number of... .

Yes, it was included in the total number of 26 shipments. .

Okay.

And Mike, the breakout for Sequels to new customers, there were -- it was strictly to existing customers, correct?.

No, it was a mix. Actually I think for the first time in terms of orders, it was slightly weighted towards new customers. We said before -- it started off about 60-40 and then 50-50, and now it's about 40-60, old versus new. .

Okay, that's helpful. And then my last question, Mike. A number of labs we spoke to on clinical side really want to get their hands on Sequels.

Any concerns on your part that a potential delay -- I know you said a couple of months that, that could cause them to alter their purchasing decisions, or really not a big concern?.

Well, I mean, no if it's a short period of time. I don't know that, because Roche hasn't announced an official time on their schedule yet anyway. So I'm sure they've had discussions and are continuing to have discussions with a lot of their early target customers, many of which are not in the United States.

We've mentioned that before that it's easier for Roche to get through regulatory hurdles with assay-specific tests in places outside the U.S. than it is here. And so you have to ask them what concerns they have about potential losses.

I mean, Roche knows how to deal with product launches pretty well, and it's not atypical that things get delayed a little bit from what you would hope to get them done. But I'm sure that they have built in a reasonable amount of buffer in that with their discussions with their early customers. .

And our next question comes from David Westenberg with CL King. .

Do you have any more visibility on what the decommissioned patterns for RS IIs might look like in the coming years? I mean, with new Sequel customers?.

Well, I'm sure over time, it will do a switchover. I mean, up to now, as we pointed out, our usage on the RSs has been fairly steady, measured this quarter versus this quarter last year. Partly that's because they've been somewhat constrained as to how much work they could get done on the Sequel Systems with the chip supply.

But once you've already bought and paid for the RS, it's a really good instrument. So I don't know that they're going to junk them right away. .

Okay.

And then are there any new types of projects on the Sequel that might have surprised you that new customers are doing? I know that there's still been a chip supply issue, but are you -- have you seen anything that surprised you in terms of projects?.

Not really. I mean, we've developed a wide range of applications that people can successfully do with the RS, and the Sequel is just a souped-up version of the RS in that respect -- it has more throughput capacity than the RS does, but it doesn't qualitatively do things that you couldn't do on the RS. So I don't know if we've had any surprises there.

A lot of the applications that people have done on the RS, and we suspect will do on the Sequel as well, are ones that have been customer-developed applications, and we sometimes follow them in terms of providing explicit support for it in our canned software. But again, the Sequel is SMRT Sequencing just like the RS is SMRT Sequencing.

It's just that it can be done at a lower cost, both from an upfront perspective and on a per project basis.

So it -- our feeling is that we've established a broad range of applications and now, it's up to us to make sure that we can exploit the fact that an increasing number of those applications, an increasing number of projects for each one of those can rationally be done on our technology. .

Got it, and then one thing that I've heard from -- excitement from new customers of Sequel is its potential in doing whole plant genomes.

Can you talk about some of the size of that Ag market and its potential to you?.

Well, it's not just plant, it's also animals in a broad sense. Well, it -- we've -- I think we said for a reasonable period of time, plant and animal, meaning nonhuman, nonmicrobial samples accounted for roughly half to slightly over half of total usage on the RS.

So it's been a big source of opportunity for us for quite a while, and we would expect that the Sequel continues that trend, making it even amenable to larger and larger projects.

And I think people -- just as the group that I mentioned working with a microorganism that's been studied a long time -- tuberculosis, if you build all of your studies based on incomplete or even incorrect sequences, you can really go down the garden path and get yourself in trouble.

And people actually woke up to that in the plant space more than they did even in the human or earlier than they did because the short-read technologies, even the old Sanger methods were just not very good with dealing with a, particularly first-time sequence of an organism and one that you didn't really have the resources when those were done to go back and do all the add-ons that helped fill in, at least, some of the gaps.

And so they were more quick to recognize the value of doing it right the first time. And it's opened up the possibilities in a broadening array of, particularly, agriculturally important plants and animals, and we certainly see that trend continuing. .

Right, and it's very hard to get a market size on that because what we think is happening is people who didn't sequence before, because the answers were so incomplete and that data was so useless for their projects, that we're seeing time people, first, for the core labs and the service providers and now in some cases, directly with the Sequel at its entry point coming into the market that really didn't exist before in sequencing.

.

And the final question comes from Jonathan Abodeely with X.L.C.R. Capital. .

Mike, this one is for you. Roche recently commented earlier this week at their Analyst Day that they were very pleased with some of the early customer reaction at some of the beta sites in Europe. And specifically, the commentary about the launch in Spain.

There was some public commentary about some of the indications that they were targeting, specifically, in hereditary and nonhereditary cancer and infectious disease.

And I was just wondering if you could give some feedback based on what they have commented publicly, what you see the clinical potential of their sequencer to be?.

Well, thanks for the question, Jonathan, but we've been pretty clear about we're going to let Roche do their announcements of the applications that they're going to support for a couple of reasons.

One, it is their business; and two, they're going to make the valuation -- the evaluation of what they're going to support as an assay and when they're going to support it. And we just don't want to get in the way of that process and cause any confusion with their affiliates or their customers in that regard.

So we really would respectfully ask you to direct those questions to Roche. It really is their prerogative to make that. Now that said, what they have said in the broad sense is they're interested in infectious disease testing. They're interested in things like HLA. They're interested in other genetic-type diseases.

I think some of those were mentioned in that report that they gave versus their program in Spain. But specific tests and when they might be available, I would really ask you to inquire of them. .

Understood. And secondarily, just on the active loading initiative. I'm under the assumption it's a pretty big driver for you in the near term to enhance the cost competitiveness of the system.

Just wondering if you could share some comments about the progress you're making on the active loading initiative?.

Well, I mentioned that we've initiated a trial with one large customer. We might have even mentioned who that was in other circumstances, who has a very large application.

It's specifically really very good in targeted applications, where you're going after specific gene sets because it increases the multiplexing that you can get in terms of number of samples you can run in a single cell, whether it's on the RS or Sequel. And that's been the primary focus of that.

But it does -- I mean, it increases the number of ZMWs that you can load with a single DNA molecule, and the reason that's important is that you can only get, by Poisson statistics, around 37% single molecule loading in any random number of ZMWs.

You can -- and the more you try to load, you just start loading more holes with more than one piece of DNA, which will give you confounding results, if one of those happens to die. And so you wind up, on average, getting longer reads, and you get more reads. And so the throughput can go up pretty substantially.

And the longer reads, particularly, if you're in a CCS-type mode, where you're trying to get very high accuracy on an individual molecule becomes really important because you get more turns around an individual molecule. So the read lengths goes up, the number of reads go up, both of which can be very important. .

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

Well, okay. We'd like to thank you for tuning into the conference call today. We look forward to speaking to you again in 3 months. .

Ladies and gentlemen, thank you for your participation in today's conference call. This does conclude today's program. You may all disconnect. Everyone, have a great day..