Good day, ladies and gentlemen. And welcome to the Pacific Biosciences of California Inc. Fourth Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions].

I would now like to introduce your host for today’s conference Ms. Trevin Rard. Ma’am, you may begin..

Thank you. Good afternoon and welcome to the Pacific Biosciences fourth quarter and year ending 2017 conference call.

Earlier today, we issued a press release outlining the financial results we will be discussing on today's call, a copy of which is available on the Investors section of our website at www.pacb.com or alternatively as furnished on the Form 8-K available on the Securities and Exchange Commission website at www.sec.gov.

With me today are Mike Hunkapiller, our Chief Executive Officer; Susan Barnes, our Chief Financial Officer; and Ben Gong, our Vice President of Finance and Treasurer.

Before we begin, I would like to remind you that on today's call, we may be making forward-looking statements, including plans and expectations relating to our financial projections, products and other future events.

You should not place undue reliance on forward-looking statements because they are subject to assumptions, risks and uncertainties, and may differ materially from actual results.

These risks and uncertainties are more fully described in our Securities and Exchange Commission filings including our most recently filed reports on forms 8-k, 10-K and Form 10-Q. Pacific Biosciences undertakes no obligation to update forward-looking statements.

In addition, please note that today's call is being recorded and will be available for audio replay on the Investors section of our website shortly after the call. Investors electing to use the audio replay are cautioned that forward-looking statements made on today's call may differ or change materially after the completion of our live call.

I will now turn the call over to Mike..

Thanks Trevin. Good afternoon and thank you for joining us today. We are pleased with our fourth quarter results and our progress in driving growth in our business. Highlights of our Q4 and full-year 2017 financial results are as follows. We generated $24.9 million in product and service revenue for the fourth quarter up 2% from Q4 2016.

For the year our product and service revenue grew 19% from $78.6 million in 2016 to $93.5 million in 2017. Consumable revenue for the fourth quarter was $12.7 million up 70% from the $7.5 million recorded in Q4 2016. For the year our consumable revenue increased by 75%.

The dramatic growth in consumable revenue was driven by increased utilization on our growing installed base of sequel systems. Consumable revenue generated from sequel systems grew more than eight fold year-over-year and represented approximately 80% of the Q4 total.

The average annualized pull through revenue on sequel instruments during the fourth quarter was over $180,000 and is approaching $200,000. Instrument revenue for the quarter was $9.2 million compared with $13.1 million in Q4 2016. For the year instrument revenue totaled $38.6 million compared with $41 million in 2016.

The decrease in instrument revenue year-over-year stems from higher shipments of instruments in the latter part of 2016 and early 2017 as we work down the initial backlog of sequel orders that had built up while we were eliminating shipments until we had moved to our high volumes smart sale supplier in 2016.

Most of that backlog was depleted after Q1 2017. We ended the year with an install base of over 370 PacBio systems. Gross margin for the fourth quarter was 38%, representing a recovery from the different gross margin that we saw in the third quarter.

We mentioned in our previous call that our gross margin have been hindered this past year by higher service related costs.

While margins on our service business are still not where we would like them to be, we expect gradual improvement in our service margins as we continue to work through upgrades of parts which are shorter than expected life time which we discussed in our Q3 conference call.

Turning now to recent sales highlights, we continue to see significant growth for our business in China. For the year, our sales into China exceeded 30% of our total sales, compared with about 10% of our sales in 2016. Our sales momentum in this region continues as we recently received an order for 10 sequel systems from BGI in China.

BGI had previously purchased one RS II instrument in 2015 and two sequel instruments in 2017. As one of the premier sequencing service providers in the world they are seeing significant in demand for PacBio sequencing services.

We are particularly pleased that BGI chose a significant additional investment in our long read sequencing technology even after careful evaluation of alternatives. They intend to use this additional capacity to satisfy their demand for plant, animal and bacterial sequencing and to embark on new projects in areas such as conservation biology.

We expect to receive an order of similar size from another Chinese service provider in the next couple of months. Other sales highlights for the quarter apart from our business in China, include repeat orders in several sizes in the U.S.

and Europe, that previously have been holding off on these orders until system reliability and performance were at the level they expected. We have also started to see a pickup in system utilization across numerous types such as these as our customers have been achieving more consistent results with their sequel systems.

A few weeks ago, we attended the Annual Plant & Animal Genome Conference or PAG in San Diego, which brings together over 3,000 researchers in the space each year. The first PAG Conference report of a Plant Genome Assembly based on smart sequencing occurred in 2014. Thus forward to 2018 and PacBio is now leading player in plant and animal sequencing.

There were 66 program presentations and 50 poster presentations at this year’s PAG Conference featuring PacBio. Over the past few years PacBio has enabled researchers in the AgBio space to produce over 350 high quality reference genomes for a wide range of important plant crops and animals.

Interestingly the generic variation in plants and animals is significantly higher than humans. And therefore, in order effectively study this variation it also requires more than just a single referenced genome for each species.

Leading up the conference, multiple customers recently sighted that they are embarking on generating many more referenced genomes with PacBio. For example, Rod Wing from University of Arizona stated that he is aiming to build high quality reference genomes for 23 additional species of rice using SMRT Sequencing.

At DuPont Pioneer, researchers have started creating high quality reference genomes for several of their lead reading lines as well as select wild strains.

Kevin Fengler from the Data Science and Informatics Group at DuPont Pioneer stated that having multiple genome assemblies of the same high standard for several genotypes to be increasingly important as researchers try to achieve a greater understanding of the impacts of structural variation on plant genomes.

He went on to say “We want to focus on true structural variation and have confidence in new discoveries we find in these genomes. Until now focusing on one reference genome has limited our view.

We are just beginning to explore what we have been missing all along.” Shortly after the conference, researcher at the Max Planck Institute in Dresden published a nature the assemblies of axolotl and planaria, two of the major model organisms for studying tissue regeneration.

The axolotl genome is 10 times the size of the human genome and is now the largest assembled genome.

Referring to MPI Dresden’s axolotl study, one recent tweet stated “A study in complex repeats, this large & important genome assembly done with @PacBio long read technology, will unlock mechanisms of genome regulation, limb regeneration and species evolution.” I don’t use this type tweets in these conference calls, but this one simply states the importance of this study.

Importance also illustrated by the axolotl assembly report making the cover of the Journal Nature this week. Turning now to our product development activities.

We are currently performing fewer beta testing on new enzyme and software for the Sequel Systems which we expect to provide significant performance improvements across all of our customer applications. Early results shows experiments using large libraries can yield up to twice as much data for smart cell compared to a year ago.

And experiment with shorter amplicon-based libraries can yield up to four times as much data compared to a year ago.

In addition, new software provides further capabilities and streamlining for applications such as structural variation analysis and Iso-Seq, which is becoming a popular PacBio solution for taking RNA sequencing beyond gene expression to characterizing isoforms.

We are planning to start the full commercial release of these improvements in a couple of weeks. Later this year, we are planning to release a new chemistry that will again increase read links and throughput in the sequel system. Our target is to at least double the throughput through chemistry, sample prep and software improvements again this year.

We are continuing to work also on the new version of the eight million ZMW SMRT Cell. This program is progressing well and we continue to target completing the developmental chip by the end of this year.

Our ongoing goal is to enable our customers to generate high quality human sized de novo genomes that cover the full range of genetic diversity from single nucleotide variants to structural variants to the haplotype phasing for the costs comparable to short read based analyses of single nucleotide variants alone.

On the publications front, a very interesting article made the cover of Nature Biotechnology this month, entitled metagenomic binning and association of plasmids with bacterial host genomes using DNA methylation. In this study, researchers from Mount Sinai used PacBio to generate medigenome sequences from human microbiome samples.

The biggest challenge in interpreting these sequences has been developing binning methods to identify the various genomes present in each sample, especially when they are multiply closely related species or strands present.

The researchers in this study took advantage of PacBio's unique capability to recognize DNA methylation signatures in bacteria to resolve individual reads and [contagious] (Ph) into species and strain level bins. In addition to binning, the researchers were able to link plasmids and other mobile genetic elements to their host bacterial species.

These genetic elements are frequently the source of changes to these organisms bacterial virulence and resistance to antibiotics. That concludes my initial remarks. I will now turn it over to Susan to provide 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 fourth quarter that ended December 31, 2017. I will then provide details on our operating results for the quarter and the year with the comparison to Q4 of 2016 and the full-year of 2016 respectively.

I will conclude my remarks with the reads discussion of the 2017 end of year balance sheet. Starting with our fourth quarter 2017 and 2017 full-year financial highlights. During the quarter, we recognized revenue of $24.9 million and incurred a net loss of $20.8 million.

For the full-year of 2017, we recognized revenue of $93.5 million and incurred a net loss of $92.2 million. We ended the year with $62.9 million in cash and investments. Turning to revenue, a $24.9 million of product, service and other revenue in Q4 of 2017 was $500,000 higher than the $24.4 million of product, service and other revenue in Q4 of 2016.

In Q4 of 2016, we also recognized $1.3 million of Roche contractual revenue. Including this contractual revenue, total revenue was $25.7 million in Q4 2016. For the year, products, and service and other revenue in 2017 was $93.5 million up 19%, compared to $78.6 million recognized during 2016.

Total revenue in 2016 was $90.7 million, which includes $12.1 million of Roche contractual revenue. Breaking down the revenue, instrument revenue recognized in Q4 2017 was $9.2 million, down $3.9 million from the $13.1 million recognized in Q4 of 2016.

Full-year instrument revenue was $38.6 million in 2017, $2.4 million lower than the $41 million recognized during 2016. Consumable revenue continues to be strong increasing 70% to $12.7 million for the quarter, up $5.2 million from the $7.5 million reported during the fourth quarter of 2016.

This substantial year-over-year revenue increase highlights the continued consumable sales momentum that has now resulted in eight consecutive quarters of consumable revenue growth. For the year, consumable revenue increased 75% to $41.4 million in 2017 compared to $23.7 million in 2016.

Service and other revenue was $3.1 million in the quarter, down from $3.8 million in Q4 2016. For the year, service and other revenue was $13.4 million, down from $14 million in 2016. With regards to gross profit and margins in Q4 2017, we generated a gross profit of $9.5 million resulting in a gross margin of 38%.

This compares to a gross profit of $11.4 million in Q4 of 2016. Excluding the $1.3 million of Roche contractual revenue, the adjusted gross profit was $10.1 million and 41% gross margin in Q4 2016. For the year, gross profit in 2017 was $34.7 million and gross margin was 37%. This compares to gross profit of $44.2 million in 2016.

Excluding the $12.1 million of Roche contractual revenue recognized in 2016, the adjusted gross profit in 2016 was $32.1 million with a gross margin of 41%. Our regional and product mix contribute to quarterly gross margin variances in 2017, a consistent contributor to our total gross margin decrease, has been decreased in service margins.

2017 service margins have been affected negatively due to the transition from the RS II to the Sequel product line. Year-over-year, our service revenue has been slightly down as the higher priced RS service contracts are being replaced with lower priced sequel contracts.

This has occurred while our service costs have increased, in part due to an early buildup of our field personnel to ensure that our early sequel customers are successful. Also, as we have stated in previous calls, we incurred $1.6 million in charges related to the change in the use of life of RS II lease instruments earlier this year.

The leased RS II instruments helped a number of our customers experience a smooth transition to their sequel instrument and as we have previously mentioned, our proactive replacement of certain parts in the sequel installed base has added to the service cost in 2017. Moving to operating expenses.

Operating expenses in the fourth quarter of 2017 totaled $30 million compared to $29.2 million in Q4 of 2016. For the full-year, operating expenses in 2017 were $124.4 million, $9 million higher than the $115.4 million incurred in 2016.

Noncash stock-based compensation including the operating expenses was $4.8 million in Q4 of 2017, versus $4.3 million in Q4 of 2016. Breaking down our operating expenses, R&D expenses in the quarter were $15.6 million down from $16.2 million incurred in Q4 of 2016.

R&D expenses were $65.3 million in 2017, down $2.3 million from the $67.6 million incurred in 2016. Most of this decrease year-over-year was related to the higher shift development costs incurred in 2016.

R&D expenses in the quarter included $2.4 million of noncash stock-based compensation expense slightly higher than the $2.1 million of expense in Q4 of 2016. Sales, general and administrative expenses in the quarter were $14.4 million, compared to $13 million in Q4 of 2016.

For the full-year 2017, SG&A expenses were $59.1 million, compared to $47.8 million incurred in 2016. As we mentioned throughout last year, we moved to our new facility in Menlo Park in Q1 2017, 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 primarily due to the hiring in our sales and sales support organization. SG&A expenses in the fourth quarter of 2017 included $2.4 million of noncash stock-based compensation expense relatively flat compared to the $2.2 million of noncash stock-based compensation expense recognized in Q4 of 2016.

Finally in Q4 of 2017, we recorded $200,000 of net interest and other expense, compared to $1.1 million recorded in Q4 of 2016. The primary reason for the reduction was 700,000 and more favorable foreign exchange movement in Q4 of 2017 in contrast to less favorable foreign exchange movement in Q4 of 2016.

Lower interest expense in 2017, a consequential pay down of $12.5 million in debt in June of 2017, also contributed to the reduction of other income and expense in 2017. For the year, we reported $2.4 million in net interest and other expense, compared to $3.2 million in 2016.

Turning to our balance sheet, as I mentioned at the beginning of my comments, our balance of cash investments was $62.9 million at the end of the fourth quarter, $21.1 million lower than $84 million at the end of third quarter. While cash flow could always fluctuate as a result of balance sheet changes.

In Q4 of 2017, we experienced particularly large changes in the balances of both inventory and accounts receivable that contributed to the increase in cash burn in the quarter. Our inventory balance was substantially higher at the end of the quarter, $23.1 million in Q4, up from $18.2 million at the end of Q3.

This was primarily a result of our stocking up of chip inventory to ensure we can meet the high growth we are experiencing in consumables revenue. Accounts receivable balance also increased substantially in Q4 to $13.4 million from $8.9 million at the end of Q3.

This was a result of a higher proportion of quarter’s shipments occurring during the latter part of Q4. Specifically between the two aforementioned accounts, we increased our working capital by $9.4 million and consequently increased our cash usage above normal rates in the quarter.

Going forward, we expect to reduce our working capital requirements and bring our cash usage levels below our historic numbers. This concludes my remarks on the financial results for the quarter. I'd like to turn the call over to Ben..

Thank you, Susan. I will be providing a forecast of our 2018 financial performance. Starting with revenue, we are pleased with our fourth quarter revenues which came in above our previous forecast. Building on this momentum, we expect our 2018 revenues to grow 20% over our 2017 revenues, which translates to approximately $112 million in total revenue.

A significant driver of our revenue growth continues to be consumables as our annualized average pull through revenue per sequel instrument boosted over $180,000 this past quarter. In the near-term, we expect our Q1 2018 revenues to be a little lower than our Q4 2017 revenue due to seasonality.

As Mike mentioned earlier, our revenue in China represented over 30% of our total revenue last year. During Chinese New Year, which occurs in the middle of Q1, we expect many of sites in Asia to stop running their systems for one to two weeks. As a result, our consumable revenues for Q1 are likely to be slightly down compared with Q4.

We expect significant sequential growth in consumables after Q1. Moving on to gross margin. We are focused on improving gross margins this year by driving top-line growth while keeping our fixed cost flat and by gradually reducing our service costs.

We will likely start off the year with gross margin that is relatively flat compared with Q4 which is a little less than 40%. If our revenue increases during the year as anticipated, we expect our gross margin percentage to gradually increase and to get to the mid 40s by the fourth quarter of this year.

Moving on to operating expenses, we are targeting to keep our operating expenses relatively flat year-over-year at approximately $125 million. We expect our quarterly operating expense pattern to be similar to what we saw in 2017, with Q1 and Q2 operating expenses higher than Q3 and Q4.

Adding up our revenue, gross margin and operating expense estimates for the year, we are forecasting a net loss of approximately $81 million for the year. However, our net loss estimate includes approximately $27 million of non-cash stock compensation and depreciation expense. And we expect to burn significantly less cash in 2018 compared with 2017.

We ended the year with about $63 million in unrestricted cash and investments on hand and while we expect to consume less than that amount this year, we plan to raise additional capital this year. That concludes our prepared remarks and we will now open the call up to questions..

[Operator Instructions]. We have a question from Amanda Murphy from William Blair. And your line is open..

Hi good afternoon. Thanks for taking the question. So I guess a quick one on the consumable side, obviously you have had good success there in ramping.

Can you just remind us where - maybe even just the highest use customers kind of where they sit or what is the theoretical mix is on the sequel kind of an annualized basis and then to the extent that you can give us some sense of how you are thinking a that 180 going to 200 et cetera through 2018, should we sort of expect it to continue to ramp or are we kind of running into sort of an average max at this point?.

This is Mike Amanda. The very high end customers were some of the big service labs particularly in China, can run north of $400,000 per year and a couple of them are. We don't expect to be able to get anywhere close to that as an average for the system I think right now.

On the other hand what we are trying to do is push the overall average up by moving up the people who are at the lower end of spectrum usage, near to the high one and we think we haven't reached the average max on yet.

But what happens once you get beyond a certain point is people have to ramp up their throughput by buying more instruments and that's what we have seen in China and we are starting to see now in the U.S.

and Europe, which keeps the average from going up too high, but it gives your total a big boost, because you get more instruments upon which to apply that average usage per instrument per year. So, that the consumables kind of particularly with high usage drive instrument purchases and instrument purchases drive more absolute consumable dollars..

And then I guess I know you are trying to get away from the idea of getting specific platform numbers and all that but I guess thinking about this year as it is now 2018, and instrument revenue, it seems like you have been kind of ramping up on that 10 million number for a couple of quarters and you have about to see that a couple of pretty large orders that has been closed.

So I guess how do we think about that for the year especially as you come into the potential for a mute shift, do you think that might drive an acceleration or just trying to get a sense of the year progressed on the instrument side?.

Well this is Ben.

Quarter-to-quarter instrument revenue forecasting is just a challenging thing to do, so we are seeing a lot of interest and as you mentioned we have a good start here with the 10 unit order from BGI, but since it is a little bit choppy, we would probably refrain from giving you some quarterly forecast with the instrument revenue are going to be.

We try to incorporate what things average out to be in the overall guidance for the year..

Okay.

And then in terms of the eight million - well shift, so can you just kind of walk through as such when we might obviously you have been working on that for a while now, I guess when kind of we can expect to see some - even internal generated data, is that something that will be closer to the end of the year or maybe this is something mid-year?.

Well I think we will stick with what we said, we expect to finish the development of it by the end of the year, we kind of consistently said that for the last year plus. And obviously in the course of that development, you are generating data internally. When we choose to release that, depends on how fast we get that done.

And as I said before, one of the frustrating things about this technology is how long it takes to get things to chip that. As a biochemist, you can make something and do the experiment really fast, but this chip - develop our process is because, though this obviously we can do really slow, take a while.

So we are trying not to get too far ahead of that. We feel that we are on-track before we thought we were going to be for the last year and a half. And still are very confident about the timeline that we have announced. And obviously as when we get data that’s appropriate, we will make that available..

Okay. China, it sounds that you have seen, and that’s pretty meaningful increase in throughput and you have obviously delivered throughput increases already that are quite meaningful.

So is that translating into new customer and obviously you have had repeat order that you talked about, is that translating into new orders at this point or are you are still sort of running it….

Yes, remember we are kind of chip - we don’t even have a chip developed so..

Well I guess I was referring to..

Thanks for the question. So well the answer is yes. Although we did a major release of software and some aspects of our chemistry back in mid-summer last year and it’s at that point that we began to see a fairly dramatic increase in the overall utilization of the Sequel System. It was a pretty hefty improvement in reliability which helped.

So people got more consistent results. And that drove up the usage and we would expect as people start to get the release that we are couple of weeks away from now that we have been in beta for a while, where they will see similar levels of performance increase.

And every time in the past even though in the old RS when we increase performance on the system that makes the system more amendable to use by larger people on larger projects. And so we think that’s unique to us.

If you look at other suppliers of sequencing systems going back 25 or 30 years, increased performance, reduced cost to do projects, drive applications and new use and increased used on technology. So we fully expect as we can continue to do what we have been doing to see that happening..

Thanks so much..

Thank you..

Thank you. And our next question comes from Tycho Peterson from JP Morgan. Your line is now open..

Hey, thanks.

Mike wanted to ask on your visibility and trying to be on kind of some of these bigger multi-system orders that are coming through, are you starting to get interest from smaller labs and customers?.

We have always had interest in smaller labs and customers and we don’t obviously announce every single unit order that we get unless the customer wants to do that, because individually they are not material to us from a reporting perspective. But we have continued to see smaller purchase, not just in China, but in several countries in Asia..

And then as we think about the legacy installed base, you still about 150 RS IIs out there. Can you may be talk on how you think about potential upgrading those overtime in the U.S.

and Europe?.

Yes Tycho this is Ben.

Yes, I think naturally some of those have been upgraded as some people have purchased sequel systems and sort of lien themselves off of the RS IIs if you will, so it continues to be a source for us in terms of targeting certain customers and now that there is more and more good data coming out on the sequel system we expect that to continue, again people who are sort of on the tail end of their lives of the RS II are looking at Sequel in terms of their next capital purchase..

And then I guess on the clinical front, just curious as to your latest thoughts on partnering up there, and yes I mean are you having active discussions with the potential partners at this point?.

We are and Kathy Ordoñez is both on our Board and Chief Commercial Officer is spearheading that and we have active negotiations with more than one potential partner there, and as we said before, we are trying to be very careful this time about matching up the needs and expectations and opportunities from these more closely with both our capabilities and what we need to be providing into that space, but maybe we did in our past experience there.

But we still feel very encouraged about the place for the technology in that space and the ability to work with the right partner there..

Okay. Thanks. I will leave with that..

Thank you..

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

Great, thanks. Good afternoon everybody.

Just a follow-up Mike with Amanda's question, do you have a timetable at this point for when the eight million feature zero-mode waveguides would be released to your users?.

Well, what we have said pretty consistently I think as that we expect to get the development done this year, so that we can produce them and then begin in 2019 to roll that out to the field. And the only reason, we have not given an exact date at this point is that it does depend how fast we can ramp up the production facility.

This is a less of an issue from an unknown than it was with the first Sequel chip, because the fundamental elements that were pretty much the same, but you are somewhat dependent upon schedules of the fabs and so forth that we use.

And we don't see any glitches at this point they are likely to delay what we are doing, but we are still a year away from being able to roll that out to a significant number of places, so we want to be a little cautious about that.

That said, we have been on-track from our schedule from day one so far, which is helpful, because it is consistent with the fact that we are not making nearly just dramatic changes in the chip as we did going from the RS type SMRT cell to the Sequel type SMRT cell..

Okay. That’s good to hear. I appreciate the color.

And then on the potentially additional large order coming in from China, it sounded like based on your comments there Mike, it sounds like it's kind of in the final stages here, so that's something we could expect to see from an announcement standpoint here, presumably since I’m in the first quarter certainly first half of the year?.

The answer is yes, I mean that's what we are expecting. But the thing you find and negotiate in these bigger deals in China as we mentioned before, a lot of these are driven by the regional provincial governments and helping these companies set up or expand their operations dramatically.

And so you are negotiating not just with the company, who can make a decision pretty quickly once they go through the formal tender process, but you are also in the end, negotiating with the source of the cash, which is the local government.

And particularly in the case, where we have got Chinese New Year coming up in a couple of weeks, the exact timing on how soon you get through those – that lateral level of negotiations is not something we feel predicting down to the week.

That said and I would suspect most of you have seen some of the early announcement by the company of their intentions to expand a SMRT technology that was made even back in December.

We feel pretty comfortable for the process is in its various stages right now without knowing exactly the date in which we will not only sign on the dotted line with the government. But go through the process, where we could call it a full order and begin to ship the systems over there.

But the best guidance we have given you is in the next couple of months..

Sounds good. Thanks guys. I appreciate it..

You are welcome..

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

Hey congrats on a good end of the year.

So I just wanted to ask about placements to new versus existing customers and what that ratio looks like?.

Yes, this is Ben. Yes quarter-to-quarter tougher to sort of pin down, because again, it does fluctuate. But we are getting generally speaking more orders from new customers than existing customers, but you get some of these large orders like the 10 year or from BGI that kind of skews that calculation a little bit..

But I do think, it’s Susan, one of the things Mike mentioned that was important to point out on the call, especially in this last quarter, we do see with the reliability of the Sequel System release of the software that we released from the center that customers are coming back now, so there were some nice repeat orders in the base..

Got it..

Yes I mean, you could even think of the BGI orders are repeat orders, right?.

Yes, yes..

They thought too initially..

All right..

And having seen the performance over the last six months, they now ordered another 10 instruments and we are just now starting to really see that in the U.S. and Europe. This really was the first quarter, where we had a significant number of those sites that came back.

And I think it will be a driver for some of those get up to the sites or some of these big sites in China, big service providers. But the encouragement is they are starting that process now and they weren’t before, which was holding back overall sales.

But it also means that these are people, who are at the higher end of the usage spectrum, because otherwise they don’t need to buy more instruments. And so that encourages us from the perspective of the consumables growth..

Got you. I don’t know necessarily how to sort of look at this.

So, I mean you get the reason why I’m asking it, just on a go forward basis, I know this is shaking the head kind of question, but should I be looking at consumables driving instrument base or should I be looking at the instrument base being the one that’s driving consumables?.

Yes..

Yes, it is both..

Alright..

Certainly, it is both. In the long-term, we firmly believe that the utilization is going to drive instrument sales and that's because unless you have good references out there, and it is still largely reference based sale, you are not going to get those unless you have a good customer base, that's having successes with their systems.

And then for these repeat orders that we have been talking about these are people that are getting up to the capacity on their systems, because of the utilization rate and that's going to lead to further system purchases.

So, the way we like to think about it is ultimately you got to have high utilization, which translates into successful customers in order to have ongoing instrument sales..

Let me just add a little bit to that, the high usage in your existing base, drives new sales to new customers as much as it does drive new sales as repeat sales to those existing customers.

But because you really need that sort of spur of customers doing marketing for you in a sense, to their colleagues to get new people committed to doing it who are the first time users of the system and so it really plays both on the repeats and the new ones..

Got you. That’s very helpful. And then not to dwell on the exact same concept over and over again in different ways, but what about the placement mix in the U.S.

service providers versus basically versus those that are running the Sequel in-house?.

Well, I would say the service providers’ structure in the U.S. is different from China by a lot. In the U.S., you have a lot of “service providers” who are academic core facilities and who are what I would call small scale almost by necessity, service providers mostly for their local institute colleagues.

There are some reasonable size fully commercial service labs in the U.S. they are not nearly at the scale of some of the big labs in China, which rival the output from the total sequencing perspective of the big NIH funded or [indiscernible] funded genome centers.

They just don't exist here, and part of that is because of this proliferation of these smaller, academic nonprofit ones. We are starting to see and we did in some of the repeat orders in the U.S. last quarter.

They ramp up a little bit of some of those places, that if you take for example, along the business that we do in China to these core labs to these commercial sequencing sites or in plant and animal genome space. In U.S.

and Europe most of the time, we have a lot of that going on as well, but it tends to be the big agricultural bio business companies that do their own sequencing and they are our customers as opposed to a large Novogene or BGI or Nextomics level, service provider, who is servicing China or their region.

And so it's a little different in terms of the nature of service sequencing companies in the U.S. and Europe versus Asia..

Perfect. Thank you very much..

You are welcome..

Thank you. And our next question comes from Joe Munda from First Analysis. Your line is now open..

Good afternoon. Thanks for taking the questions.

Mike, I was just curious, as far as the guidance is concerned for 2018, should we see China as a percentage of mix be higher off of the 2017 number or do you expect it to build over that 30% and to be a bigger percentage of the mix?.

Well, it fluctuated a little bit through 2017. It certainly went up particularly in the second half of the year, once the second big order from Novogene came in. And the usage rate is higher there on average, somewhat given the nature of the customers.

But we expected it won’t change a lot overall this year because we have begun to see finally the same kind of increase in average usage in some of the big sites that we expected to be big users in U.S. and Europe that lag behind the increase that we saw in the Chinese sites.

And so we would hope that we get faster growth rate particularly on the utilization than we have over there. In a lot of spaces in China you will be driven by the fact that you sell more instruments because they are pretty much at capacity utilization anyway. Whereas in U.S.

and Europe we have a lot of room to grow in terms of just utilization per instrument as well as placing new instrument. So we have sort of two series of growth drivers there..

And Mike following up on that comment, in regards to the U.S., I know we talked in the past about the budgets. But are you seeing that loosen up or are you seeing more - I don’t know what the word is, but are you seeing the budgets in U.S.

loosen up here and opens purchasing more products?.

What we did see a fair number of orders from U.S. Government research labs in Q4, some of which were repeat purchases which was good. We take that on a quarter-by-quarter basis because remember the government was shut down for three days, not that long ago and we have another deadline coming up in a week.

But I would say it’s at least right now less of a concern than it was at this time last year, where it became a serious issue, but we will see, I mean I think the other thing that we are seeing the U.S.

expand and even Europe even beyond the government labs that were high users of our systems before, we are seeing a little more uptick from the commercial sites in the U.S. as well which kind of balances off that.

But like I said so far Q4 for us in government institution type purchases was reasonably on-track and then NIH academic purchases were okay as well. But we still don’t have a budget, so who knows..

In terms of expenses and - I was just wondering what steps are you guys taking to keep the expenses flat and then follow-on to that Kathy Ordoñez, I know she came on last quarter. I guess what impact does she has thus far on the business, if it's measurable? Just curious..

Yes. I will take the first one, in terms of expenses I think you actually even saw in 2017 that at least our R&D expenses moderated because of you know you got past some of that bump in the sequel development, we didn't need to spend as much in R&D, but you did see that we invested in the SG&A side, in order to drive some of the revenue growth.

So, 2018 maybe some of the same sort of pattern you will see is that again we are planning to keep total operating expenses relatively flat, still make sure that we invest in the right areas that can drive the top-line growth..

And in the lot of those areas, and Kathy has helped drive this, we have moved some of the responsibility for product marketing into the individual field districts, and within Asia, where we had some already to assist our distributors, but we did not had field marketing in Europe and we didn't have it in the U.S.

and Kathy has put that in place along with our sales management teams.

Kind of as we pointed out in the last call, unified our field support organizations which were three in number, each having responsibility for somewhat different aspects of customer support into one organization and charge them with not only keeping the customers happy but helping them increase their usage.

Because as we pointed already that helps drive satisfaction of the customer and leads to new sales either from the colleagues or from the sales and having put that in place particularly in Europe and the U.S.

where we were lagging behind in Houston, we would expect that to be part of a continuing drive and increasing consumable sales in those areas in particular..

Yes and one thing I would add to that Joe is that we are in the process of adding a couple of distributors in Europe to increase our sales force power in countries where we don't have any direct representation..

Okay. Thank you..

Thank you. [Operator Instructions] The next question comes from Drew Jones from Stephens Incorporated. Your line is now open..

Hey this is [indiscernible] on for Drew, thanks for taking the question.

I want to start off with Europe, just to follow-up that last comment, I was just curious if you have worked through some of those technology and sale pickups there and what changes the new head of sales is making adding distributors in those locations?.

This is Susan, so what she has done is started to work with Kathy as she came on board in the summer to really looking at areas where she could focus the strategic selling to get involved in the kind of large studies that would result in multisite sales as well as look at areas where she could bring field marketing into play..

I think that one other lessons that we have learned from positive sense in our China sales in particular is that helping foster the success of the larger sites leads to bigger transactions both in the short-term in terms of instruments and in the long-term in terms of consumable usage.

And the thing that Susan mentioned is that we were more focused I think in Europe in particular on one-off sales as opposed to how do we get in and participate in a larger way with some of the larger projects, one other ones that we have mentioned briefly, has been in the structural variant analysis programs that are being kicked off in Europe led by several groups.

But in particular once coming out of the [indiscernible] institute and hospital in Netherlands. But there are whole host of other country specific population genetic program going out in Europe and we weren’t really driving much success in those.

And probably that was because our sales organization is more focused on real tactical one-off sales in smaller size, and between Kathy and Dominique and Dominique’s team over there we are really pushing to get more involved with some of those bigger projects..

And then just raising awareness of the power of our technology, the cover of Nature this week is coming from an European institution..

So may be ask slightly differently, are you seeing utilization growth on the consumable side outside of China which obviously is seeing very strong growth? I guess that question apply Europe and to the U.S..

Well the answer is yes. It didn’t get there as fast as it did in China and it helps in China that is driven by this big commercial entities that they have more visibility into their project backlog which encourages them to buy more machines when they kind of run up against a delivery schedule they have to deal with.

And part of the process is helping some of the smaller service providers where we do sell systems into, get out and market their capabilities, part of it is helping the other customers in a broad sense to do it and we have seen a pick up particularly in Europe which really had lagged behind the usage per machine.

Elsewhere in the latter part of last year as we began not just to get the reliability of the systems up but to focus our support teams on helping these people get projects both acquired to sequence on our system and successfully implement it..

And then the reason we were able to get three pre-orders in the U.S.

and Europe that Mike talked about earlier was because they were getting the volume up at their sites with reliability release that we did and the software enhancements this summer and they start to use in the following to get their usage up and therefore pick into demand for another system in both U.S. and Europe..

Yes I think by the middle of last year I don’t think well with one exception in the HLA space, any of our U.S. and Europe customers would have raked into the top 15 or 20 usage sites and that’s changed in the last quarter.

We have got a lot of work to do to make it more broad-based in that sense compared to some of these big sites in Asia, but it’s definitely progress..

Okay. The last question I will ask is just whether you all have been able to quantify the additional market opportunity that you expect to be able to address when these throughput improvements are kind of done and you get 30x bump all-in a few years.

I mean what will that additional market be and then what is your confidence you can actually turn those into incremental dollars? Are your customers asking for these things, kind of question getting at?.

Well, customers are always asking for more for less. There is no doubt about that. You can do this market analyses all over the place.

I think the way that I’ve try to put it before is that if I look at what short read sequencing can do today, what long read sequencing can do today, and extrapolate as the performance changes over time, where can you rationally get to, because we are not going to take over the entire sequencing market.

There is too many things you can do with short read technologies in particular, you don't need long reads for, they are just appropriate for it, and things like looking for large studies of self read DNA, they are small pieces anyway, they are 150 base pairs long.

Our technology doesn't do much for that, particularly when you are either looking for a needle in a haystack and there is a really big haystack.

Are you just trying to count through 25 to 30 base pair reads, which pieces of DNA are coming from which chromosome in the NIPT space, and you also have some RNA quantitation type experiments, where you need to look at millions to billions of pieces of DNA in a single experiment and our technology is not amenable to that.

On the other hand as the technology throughput goes up and the cost per genome comes down, and we get to a comparable cost to what you do with short reads at the whole genome level. Situations are a little bit different.

And we would say overall that certainly that that certainly likely to be half of the overall sequencing market, which in itself is growing.

And our goal long-term is to get to the point, where the comparable cost to do a sequencing experiment at the whole genome level, gives you all the structural variations, the single nucleotide variation, the haplotype phasing.

And so on in one experiment for that amount of money that you get with the short read sequencing experiment, which gives you effectively with any kind of completeness at all, just a single nucleotide variant picture. If we do that, then we are a major player in that space and that's kind of what we are shooting for.

The other things that we think is a growing opportunity for us are in some of the targeted, particularly human sequencing applications where you just can't get the answer in certain gene families or even certain genes that are both research important and clinically relevant, and again, there is a lot of those areas where short reads are really good, and there is areas where they are not.

And we would see long-term, a split of about 50/50 in those cases as well..

Okay. Thank you very much..

Okay, I think that’s all we have for today, so..

Thank you and I see no further questions in the queue. So I would like to turn it back to the speakers' for any closing remarks..

Okay. So, in closing, we remain steadfast in our commitment to bring in 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 length and ability to characterize DNA based modifications.

Furthermore, by providing scientists, an ability to pay comprehensive set of sequence information with 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 again in three months’ time..

Ladies and gentlemen, this does conclude your program. And you may all disconnect. Everyone, have a great day..