UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

(Mark One)

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013

Or

¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from             to             

Commission File Number 001-34899

 

Pacific Biosciences of California, Inc.

(Exact name of registrant as specified in its charter)

 

 

(650) 521-8000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No   x

Number of shares outstanding of the issuer’s common stock as of October 31, 2013: 66,152,099  

 

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TABLE OF CONTENTS

 

 

 

 

 

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PART I. FINANCIAL INFORMATION

Item 1.Financial Statements

PACIFIC BIOSCIENCES OF CALIFORNIA, INC.

Condensed Consolidated Balance Sheets

(Unaudited)

 

See accompanying notes to the condensed consolidated financial statements.

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PACIFIC BIOSCIENCES OF CALIFORNIA, INC.

Condensed Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

 

 

 

See accompanying notes to the condensed consolidated financial statements.

 

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PACIFIC BIOSCIENCES OF CALIFORNIA, INC.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

 

 

See accompanying notes to the condensed consolidated financial statements.

 

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PACIFIC BIOSCIENCES OF CALIFORNIA, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

NOTE 1. OVERVIEW

Pacific Biosciences of California, Inc., (“Pacific Biosciences”, the “Company”, “we”, “us”) has commercialized the PacBio RS High Resolution Genetic Analyzer and the PacBio RS II Sequencing System to help scientists solve genetically complex problems.  Based on our novel Single Molecule, Real-Time (SMRT) technology, our products enable scientists to increase their understanding of biological systems through targeted sequencing and insight into genetic variations.

The names “Pacific Biosciences,” “PacBio,” “SMRT,” “SMRTbell” and our logo are our trademarks.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

In the opinion of management, the accompanying unaudited Condensed Consolidated Financial Statements (“financial statements”) of Pacific Biosciences of California, Inc. and its wholly-owned subsidiaries have been prepared on a consistent basis with the December 31, 2012 audited Consolidated Financial Statements and include all adjustments, consisting of only normal recurring adjustments, necessary to fairly state the information set forth herein. Certain prior year amounts in the financial statements and notes thereto have been reclassified to conform to the current year’s presentation. The financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”) and, therefore, omit certain information and footnote disclosures necessary to present the statements in accordance with U.S. generally accepted accounting principles (“GAAP”). These financial statements should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012, which was filed with the SEC on March 15, 2013. The results of operations for the first nine months of fiscal 2013 are not necessarily indicative of the results to be expected for the entire fiscal year or any future periods.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expense during the reporting periods. Our estimates include, but are not limited to, useful lives assigned to long-lived assets, assumptions used to compute stock-based compensation expense and valuing warrants, value the financing derivative and long-term notes, value and recognize revenue elements, determine delivery periods for revenue recognition, and to compute provisions for income taxes, inventory, and contingencies. Actual results could differ from our estimates, and such differences could be material to our financial position and results of operations.

Fair Value of Financial Instruments

Assets and liabilities measured at fair value on a recurring basis

The following table sets forth the fair value of our financial assets and liabilities that were measured on a recurring basis as of September 30, 2013 and December 31, 2012, respectively:

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All of our cash deposits and money market funds are classified within Level 1 of the fair value hierarchy because they are valued using bank balances or quoted market prices. Our investments are classified as Level 2 instruments based on market pricing and other observable inputs. None of our investments are classified within Level 3 of the fair value hierarchy.

During the nine-month periods ended September 30, 2013 and 2012, realized gains and losses on the sale of investments were immaterial and there were no material impairments of our investments.

The fair value of the Financing Derivative (as defined in Note 7.  Debt Facility) liability resulting from the debt facility we entered into during the first quarter of 2013 was determined using Level 3 inputs, or significant unobservable inputs.  Refer to Note 7.  Debt Facility for a detailed description and valuation approach.  The following table provides the changes in the fair value of the Financial Derivative during the nine-month period ended September 30, 2013 (in thousands):

 

 

For the nine-month period ended September 30, 2013 there were no transfers between Level 1, Level 2, or Level 3 assets or liabilities reported at fair value on a recurring basis and valuation techniques did not change compared to the prior quarter.

Financial assets and liabilities not measured at fair value on a recurring basis

The carrying amount of our accounts receivable, prepaid expenses, other current assets, accounts payable, accrued expenses and other current liabilities, are determined to approximate fair value due to their short maturities. The carrying value of our facility financing obligation approximates fair value due to the time to maturity and prevailing market rates.

We determined the fair value of the Notes (as defined in Note 7.  Debt Facility) from the debt facility we entered into during the first quarter of 2013 using Level 3 inputs, or significant unobservable inputs.  The value of the Notes was determined by comparing the difference between the fair value of the Notes with and without the Financing Derivative by calculating the respective present values from future cash flows using a 20.8% weighted average market yield. Refer to Note 7.  Debt Facility for additional details regarding the Notes. The estimated fair value and carrying value of the Notes are as follows (in thousands):

 

 

 

Net Loss per Share

The following table presents the computation of our basic and diluted net loss per share (in thousands, except per share amounts):

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The following were excluded from the computation of our diluted net loss per share for the periods presented because including them would have had an anti-dilutive effect:

 

 

 

 

 

NOTE 3. AGREEMENT WITH ROCHE

On September 24, 2013, we entered into a Development, Commercialization and License Agreement (the “Roche Agreement”) with F. Hoffman-La Roche Ltd (“Roche”), pursuant to which we: (i) will develop diagnostic products for clinical use including sequencing systems and consumables based on our proprietary SMRT technology; (ii) granted to Roche an exclusive right to commercialize, and an exclusive license to sell, the developed diagnostic products for clinical use; and (iii) will manufacture and supply certain products intended for clinical use as the exclusive supplier to Roche. We received a non-refundable up-front payment of $35.0 million and may receive up to an additional $40.0 million based upon the achievement of development milestones. The Roche Agreement has an initial term of thirteen years and provisions allowing Roche 5-year renewals.

The Roche Agreement contains multiple elements, and the deliverables under the Roche Agreement consist of intellectual property licenses,  research and development services, and participation on the joint steering committee (as defined in the Roche Agreement) with Roche. These deliverables are non-contingent in nature. We evaluated whether there is standalone value for each of the non-contingent deliverables and allocated the upfront payment of $35.0 million to each unit of accounting based on our best estimates of selling prices pursuant to Accounting Standard Codification (ASC) Topic 605-25, Revenue Recognition — Multiple Element Arrangements (ASC 605-25). We consider the intellectual property licenses and research and development services to be a combined unit of accounting. The intellectual property licenses do not have standalone value since the diagnostic products to which the license relates are in a very early stage of development. In addition, we believe that the joint steering committee obligation has standalone value and thus, is a separate unit of accounting.  

The amount allocated to the intellectual property licenses and research and development services will be recognized as revenue based on the proportional performance method over the expected development period, and the amount allocated to the deliverable of our participation on the joint steering committee will be recognized as revenue based on the proportional performance method over the term of the Roche Agreement, which represents the estimated obligation period of the joint steering committee. Revenue will be recognized on a straight-line basis over the delivery period to the extent that the pattern of performance is not expected to significantly differ from recognition using a proportional performance model. As of September 30, 2013, revenue relating to the $35.0 million upfront cash payment was deferred with $6.8 million and $28.2 million allocated to current and long-term deferred revenue, respectively.   

Our process for determining estimates of selling prices involves management’s judgment. Our process considers multiple factors such as estimated headcount, annual research and development budget, estimated length of the research and development period and estimated transfer price on cost, which may vary over time, depending upon the circumstances, and relate to each deliverable. If the estimated obligation period of one or more deliverables should change, the future amortization of the revenue would also change.

In addition to the non-contingent deliverables above, the Roche Agreement includes contingent deliverables relating to the receipt of additional payments totaling $40.0 million upon the achievement of certain development milestones. Based on ASC Topic 605-28, Revenue Recognition — Milestone Method, we evaluate contingent milestones at inception of the agreement, and recognize consideration that is contingent upon the achievement of a milestone in its entirety as revenue in the period in which the milestone is

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achieved only if the milestone is considered substantive in its entirety. Milestones are considered substantive if the consideration earned from the achievement of the milestone (i) is consistent with performance required to achieve the milestone or the increase in value to the delivered item, (ii) relates solely to past performance and (iii) is reasonable relative to all of the other deliverables and payments within the arrangement. The milestone payments of $40.0 million will be recognized as revenue in their entirety upon our achievement of each substantive milestone.  

 

 

 NOTE 4. CASH, CASH EQUIVALENTS AND INVESTMENTS

The following table summarizes our investments as of September 30, 2013 and December 31, 2012 (in thousands):

 

 

The estimated fair value of marketable debt securities (commercial paper, corporate debt securities, asset backed securities and U.S. government and agency securities) as of September 30, 2013, by contractual maturity, are as follows:

 

 

Actual maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations without call or prepayment penalties.

 

 NOTE 5. BALANCE SHEET COMPONENTS

As of September 30, 2013 and December 31, 2012 our inventory, net, consisted of the following components:

 

 

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NOTE 6. CONTINGENCIES

We become subject to claims and assessments from time to time in the ordinary course of business. We accrue liabilities for such matters when it is probable that future expenditures will be made and such expenditures can be reasonably estimated.

During October 2013 the Superior Court of the State of California, County of San Mateo granted final approval of a settlement of four class action lawsuits that had been consolidated as In re Pacific Biosciences of California Inc. S’holder Litig. In addition, the company has reached an agreement in principle to settle the claims of the single individual who opted out of the state court settlement. Upon its becoming final, the settlement of the state court action will have preclusive effect on claims previously asserted in the lawsuit filed in December 2011 in United States District Court for the Northern District of California, captioned Primo v. Pacific Biosciences of California, Inc., et al., Case No. 4:11-CV-06599.  All amounts payable to the plaintiffs and plaintiffs’ counsel had been previously accrued; therefore, no additional amounts were expensed during the period.

Indemnification

Pursuant to Delaware law and agreements entered into with each of our directors and officers, we may have obligations, under certain circumstances, to hold harmless and indemnify each of our directors and officers against losses suffered or incurred by the indemnified party in connection with their service to the Company, and judgments, fines, settlements and expenses related to claims arising against such directors and officers to the fullest extent permitted under Delaware law, our bylaws and certificate of incorporation. We also enter and have entered into indemnification agreements with our directors and officers that may require us to indemnify them against liabilities that arise by reason of their status or service as directors or officers, except as prohibited by applicable law.  In addition, we may have obligations to hold harmless and indemnify third parties involved with our fund raising efforts and their respective affiliates, directors, officers, employees, agents or other representatives against any and all losses, claims, damages and liabilities related to claims arising against such parties pursuant to the terms of agreements entered into between such third parties and the Company in connection with such fund raising efforts. To the extent that any such indemnification obligations apply to the lawsuits described above, any associated expenses incurred are included within the related accrued litigation expense amounts.  No additional liability associated with such indemnification obligations has been recorded at September 30, 2013.

NOTE 7. DEBT FACILITY

On February 5, 2013, we entered into a Facility Agreement (the “Facility Agreement”) with entities affiliated with Deerfield Management Company, L.P. (collectively, “Deerfield”), pursuant to which Deerfield agreed to provide $20.5 million in funding to us (the “Facility”). Under the terms of the Facility Agreement, we issued to Deerfield promissory notes in the aggregate principal amount of $20.5 million (the “Notes”). The Notes bear simple interest at a rate of 8.75% per annum, payable quarterly in arrears commencing on April 1, 2013 and on the first business day of each January, April, July and October thereafter. We received net proceeds of $20.0 million, representing $20.5 million of gross proceeds, less a $500,000 facility fee, before deducting other expenses of the transaction.

The Facility Agreement has a maximum term of seven years from inception; however it provides for the early repayment of principal in the event we have net sales (as defined in the Facility Agreement) of less than $41.0 million for the twelve-month period from the beginning of the second calendar quarter of 2014 through the first calendar quarter of 2015 (the “Milestone”). If the Milestone is not achieved, at Deerfield’s option, one-third of the original principal balance of the Facility will become due, on each of the third, fourth and fifth anniversaries of the date of the Facility Agreement.

From and after the date of the Facility Agreement, at the election of the holders of Notes representing a majority of the aggregate principal amount of the outstanding Notes, we shall apply 25% of the net proceeds from any financing that includes an equity component, including without limitation, the sale or issuance of our common stock, options, warrants or other securities convertible or exchangeable for shares of our common stock, to the payment of the Notes. This right is subject to certain exceptions set forth in the Facility Agreement, including that the right will not apply until we have issued 15.0 million shares (as adjusted for any stock split or reverse stock split) of our common stock or rights to acquire our capital stock following the date of the Facility Agreement.

Deerfield has the option to require us to repay the Notes if we complete a Major Transaction (as defined in the Facility Agreement), including a change of control or a sale of all or substantially all of our assets. Additionally, the principal balance of the Facility may become immediately due and payable upon an Event of Default (as defined in the Facility Agreement), in which case Deerfield would have the right to require us to repay 100% of the principal amount of the loan, plus any accrued and unpaid interest thereon. The Facility Agreement does not provide for a prepayment of the Notes at our option.

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The Facility Agreement also contains various representations and warranties, and affirmative and negative covenants, customary for financings of this type, including restrictions on the ability of the Company and its subsidiaries to incur additional indebtedness or liens on its assets, except as permitted under the Facility Agreement. In addition, we are required to maintain consolidated cash and cash equivalents on the last day of each calendar quarter of not less than $2.0 million. As security for our repayment of our obligations under the Facility Agreement, we granted to Deerfield a security interest in substantially all of our property and interests in property.

Financing Derivative

A number of features embedded in the Notes to the Facility Agreement required accounting for as a derivative, including the indemnification of certain withholding taxes and the acceleration of debt upon (a) a qualified financing, (b) an Event of Default, (c) a Major Transaction, and (d) the exercise of the Warrant via offset to debt principal.  These features represent a single derivative (the “Financing Derivative”) that was bifurcated from the debt instrument and accounted for as a liability at fair value, with changes in fair value between reporting periods recorded in other income (expense), net.  The fair value of the Financing Derivative as of February 5, 2013 and September 30, 2013, was $1.0 million and $0.9 million, respectively.

The value of the Financing Derivative as of February 5, 2013 and September 30, 2013 was determined by comparing the difference between the fair value of the Notes with and without the Financing Derivative by calculating the respective present values from future cash flows using a 20.8%  weighted average market yield.

Warrants

In connection with the execution of the Facility Agreement, on February 5, 2013, we issued to Deerfield warrants to purchase an aggregate of 5,500,000 shares of common stock immediately exercisable at an exercise price per share initially equal to $2.63 (the “Warrants”). The number of shares of common stock into which the Warrants are exercisable and the exercise price will be adjusted to reflect any stock splits, payment of stock dividends, recapitalizations, reclassifications or other similar adjustments in the number of outstanding shares of common stock. The exercise price may also be adjusted to reflect certain dividends or other distributions, including distributions of stock or other securities, property or options by way of a dividend, spin off, reclassification, corporate rearrangement, scheme of arrangement or similar transaction.

The Warrants are classified within additional paid-in capital and reported at their grant date fair value on February 5, 2013 of $6.4 million.  We estimated the fair value of the Warrants using the Black-Scholes option pricing model using the following assumptions:

 

 

Notes

The Notes and Warrants were initially recorded at a value of $14.1 million and $6.4 million, respectively, based upon the relative fair value allocation of the $20.5 million of proceeds.  Additionally, facility fees and other issuance costs were allocated based on the relative fair value of the Facility and the Warrants.  The amount allocated to the Notes was then reduced by the $1.0 million fair value of the Financing Derivative, such that the Financing Derivative was recorded at its absolute fair value.  As a result, the carrying value of the Notes at the inception of the debt was $12.8 million, resulting in an original issue discount of $7.7 million. The discount is being accreted to the $20.5 million face value of the Notes over the expected maturity period of seven years using the effective interest method, with an effective interest rate of 20.6%.

NOTE 8. STOCKHOLDERS’ EQUITY

Stock Offering

During April 2012, we filed a shelf registration statement on Form S-3 with the SEC pursuant to which we may, from time to time, sell up to an aggregate of $150.0 million of our common stock, warrants or debt securities.  On May 1, 2012, the registration statement was declared effective by the SEC.  On October 5, 2012, we entered into a Controlled Equity Offering Sales Agreement (the “Sales Agreement”) with Cantor Fitzgerald & Co. (“Cantor”), pursuant to which we may offer and sell, from time to time, through Cantor, shares of our common stock having an aggregate offering price of up to $30.0 million through an “at-the-market” offering.  We are not obligated to make any sales of shares under the Sales Agreement.  We pay Cantor a commission equal to 3.0% of the gross proceeds from the sale of shares of our common stock under the Sales Agreement and reimburse up to $50,000 of legal expenses incurred by Cantor.  During the quarter ended September 30, 2013, no shares were sold through our “at-the-market” offering. As of September 30, 2013, we have sold a total of 8.3 million shares of our common stock at an average price of $2.51 through our “at-the-market” offering.

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NOTE 9. STOCK OPTION PLANS

As of September 30, 2013, we had three active equity compensation plans, the 2010 Equity Incentive Plan, or 2010 Plan, the 2010 Outside Director Equity Incentive Plan, or 2010 Director Plan, and the 2010 Employee Stock Purchase Plan, or “ESPP”.

As of September 30, 2013, no shares of our common stock remain available for issuance under our ESPP. The Employee Stock Purchase Plan provides for an annual increase to the shares available for issuance at the beginning of each calendar year equal to two percent of the common shares then outstanding. Our ESPP permits eligible employees to purchase common stock at a discount through payroll deductions during defined offering periods. Each offering period generally consists of four purchase periods, each purchase period being six months. The price at which the stock is purchased is equal to the lower of 85% of the fair market value of the common stock at the beginning of an offering period or at the end of a purchase period.  Shares issued under the ESPP totaled 1,519,366 and 832,878 shares during the nine-month periods ended September 30, 2013 and 2012, respectively. We estimate the value of the employee stock purchase rights on the grant date using the Black-Scholes option pricing model.

The following table summarizes stock option activity for all stock option plans (in thousands, except per share amounts):

 

 

Stock-based Compensation

Total stock-based compensation expense for employee stock options and stock purchases under the ESPP consists of the following (in thousands):

 

 

 

We estimated the fair value of employee stock options using the Black-Scholes option pricing model. The fair value of employee stock options is being amortized on a straight-line basis over the requisite service period of the awards.

 

The fair value of employee stock options was estimated using the following weighted average assumptions:

 

 

 

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The fair value of ESPP was estimated using the following assumptions:

 

 

 

 

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to them. Such forward looking statements include, but are not limited to, statements related to: our expectations regarding our future losses, our expectations regarding our future sources of revenue and regarding our development, commercialization and license agreement, the timing of the conversion of our backlog, our expectations regarding our operating expenses; our expectations regarding our interest expense, our financial outlook; our expected revenues, gross margin, research and development expenses, and sales, general and administrative expenses, revenue recognition; our ability to fulfill customer orders; our investments and financing obligations; the effect of global market fluctuations; our expected expenses, including research and development expenses and administrative expenses; our beliefs about our ability to finance our operations; the development and marketability of our products; the potential dilution of current stockholders; our use of any funds raised through the sale of securities; as well as statements of belief and statements of assumptions underlying any of the foregoing. In some cases you can identify forward-looking statements by words such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “potential” and similar expressions intended to identify forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described under the heading “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q and our other filings with the SEC. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. You should read this Quarterly Report on Form 10-Q completely and with the understanding that our actual future results may be materially different from those we expect. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

Overview

We develop, manufacture and market an integrated platform for high resolution genetic analysis. Combining advances in nanofabrication, biochemistry, molecular biology, surface chemistry and optics, we created a technology platform called single molecule, real-time, or SMRT, technology. Our initial focus is to offer our SMRT technology to the DNA sequencing market where we have developed the PacBio RS High Resolution Genetic Analyzer and the PacBio RS II Sequencing System. The PacBio RS and the PacBio RS II consist of instrument platforms  that use our proprietary consumables, including our SMRT Cells and reagent kits.

We have financed our operations primarily through the issuance of common and convertible preferred stock resulting in $609.8 million in net proceeds, in addition to debt financing.  Since our inception, we have incurred significant net losses and we expect to continue to experience significant losses as we invest in developing and taking advantage of market opportunities for our products, servicing and supporting customers, development of enhancements and updates to existing products, development of future products, and sales and administrative infrastructure. As of September 30, 2013, we had an accumulated deficit of $598.1 million.

Agreement with Roche 

On September 24, 2013 we entered into the Roche Agreement, pursuant to which we: (i) will develop diagnostic products for clinical use including sequencing systems and consumables based on our proprietary SMRT technology; (ii) granted to Roche an exclusive right to commercialize, and an exclusive license to sell, the developed diagnostic products for clinical use; and (iii) will manufacture and supply certain products intended for clinical use as the exclusive supplier to Roche. We received  a non-refundable up-front payment of $35.0 million and may receive up to an additional $40.0 million based upon the achievement of development milestones. The Roche Agreement has an initial term of thirteen years and provisions allowing Roche 5-year renewals.

As of September 30, 2013, revenue relating to the $35.0 million upfront cash payment was deferred with $6.8 million and $28.2 million allocated to current and long-term deferred revenue, respectively.      

Basis of Presentation

While the trends below are important to understanding and evaluating our financial results, the other transactions, events and trends discussed in “Risk Factors” in this report may also materially impact our business operations and financial results.

Revenue

During the three- and nine-month periods ended September 30, 2012, the majority of our revenue related to the sale of PacBio RS instruments and associated consumables and services, and during the three- and nine-month periods ended September 30, 2013, the majority of our revenue related to the sale of PacBio RS and PacBio RS II instruments and associated consumables and services. Service and other revenue primarily consists of product maintenance agreements, while grant revenue represents amounts earned under research agreements with government entities which are recognized in the period during which the related costs are incurred. In

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addition to existing revenue sources, during future periods we expect to recognize revenue from development and services relating to the Roche Agreement.

As of September 30, 2013, our backlog was comprised of nine instruments. We define backlog as purchase orders or signed contracts for systems from customers which we believe are firm and for which we have not yet recognized revenue.

Cost of Revenue

Cost of revenue reflects the direct cost of product components, third party manufacturing services and our internal manufacturing overhead and customer service infrastructure costs incurred to produce, deliver, maintain and support our instruments, consumables, and services.

Product costs include the direct costs incurred to manufacture products and install instruments combined with allocated manufacturing overhead.  Manufacturing overhead is determined and capitalized into inventory based on management’s estimate of normal manufacturing capacity. Normal capacity is the production level expected to be achieved over a number of periods under normal circumstances with available resources. Our current manufacturing volumes are below expected normal capacities, therefore manufacturing overhead incurred exceeds the amounts absorbed into inventory and included in cost of revenue. During the nine-month periods ended September 30, 2013 and 2012, $5.4 million and $6.5 million, respectively, of manufacturing overhead were capitalized into inventory.  As we engage excess manufacturing resources in product research and development, production of product used internally for research and development, and other research and development support activities, manufacturing costs in excess of amounts reflected in inventory and cost of revenue are expensed as a component of research and development expense during the period in which the expenses are incurred.

Service costs include the direct costs of components used in support, repair and maintenance of customer instruments as well as the cost of personnel and support infrastructure necessary to support the installed customer base. As we have been in the early stages of the commercial launch of our products, the capacity of our service infrastructure has exceeded the demand for installing and servicing customer instruments. Management has estimated the capacity of the existing service infrastructure and has recognized service related cost of revenue based on the installed base. From our initial commercial launch, total service infrastructure costs have generally exceeded the costs associated with the support of customer instruments and such excess costs have been included as a component of sales, general and administrative expense.

Operating Expense

Research and Development Expense. Research and development expense consists primarily of expenses for personnel engaged in the development of our SMRT technology, the design and development of our products, including the PacBio RS and PacBio RS II, SMRT Cells and reagent kits and the scientific research necessary to produce commercially viable applications of our technology. These expenses also include prototype-related expenditures, development equipment, supplies, facilities costs and other related overhead.

Sales, General and Administrative Expense. Sales, general and administrative expense consists primarily of personnel-related expense related to our executive, legal, finance, sales, marketing, field service, customer support, and human resource functions, as well as fees for professional services and facility costs. Professional services consist principally of external legal, accounting and other consulting services.

Interest Expense

Interest expense is primarily related to the debt facility entered into during the first quarter of 2013 and includes the amortization of debt discount and other related costs.  To a lesser extent, amounts also include interest expense relating to our facility financing obligations resulting from a lease agreement entered into in 2010. We expect interest expense to increase during future periods as a result of the debt issued during the first quarter of 2013 and subsequently as a result of the accounting treatment of the debt as the recorded value accretes to the amount due at maturity.

Other Income (Expense), Net

Other income (expense), net consists primarily of interest income earned on cash and investments, accretion of discounts and amortization of premiums related to investments, net gains or losses on foreign currency transactions, net gains or losses from disposal of fixed assets, net gains or losses resulting from changes in fair value of the Financing Derivative, and foreign income taxes.

Income Taxes

Since inception, we have incurred net losses and have not recorded any U.S. federal or state income tax benefits for such losses as they have been offset by valuation allowances.

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Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon our Condensed Consolidated Financial Statements, which we have prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, cost of revenue, and operating expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably likely to occur could materially impact the financial statements.

In conjunction with the Facility Agreement with Deerfield various assumptions were used to value the Notes, Warrant and Financing Derivative. These assumptions are described above in "Part I, Item 1. Financial Statements - Note 7.  Debt Facility" of the condensed consolidated financial statements.

The Roche Agreement includes contingent event-based payments relating to the achievement of certain milestones and were evaluated based on Accounting Standard Codification (ASC) Topic 605-28, Revenue Recognition — Milestone Method (ASC 605-28).  We evaluated the contingent event-based payments, including milestones, at inception of the Roche Agreement and determined that we should recognize consideration that is contingent upon the achievement of substantive milestones as revenue in the period in which the milestone is achieved.  Milestones are considered substantive if the consideration earned from the achievement of the milestone (i) is consistent with performance required to achieve the milestone or the increase in value to the delivered item, (ii) relates solely to past performance and (iii) is reasonable relative to all of the other deliverables and payments within the arrangement. The Roche Agreement included contingent deliverables relating to the receipt of additional payments totaling $40.0 million upon the achievement of certain development milestones. The milestone payments will be recognized as revenue in their entirety upon our achievement of each substantive milestone.  Please refer to “Part I, Item 1. Financial Statements - Note 3.  Agreement with Roche”  for additional details.

During the three-month period ended September 30, 2013, there have been no other significant changes in our critical accounting policies and estimates during the nine months ended September 30, 2013, as compared to the disclosures in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2012

Results of Operations

 

Comparison of the Three-month Periods Ended September 30, 2013 and 2012

 

 

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Revenue

Our total revenue for the third quarter of 2013 was $7.4 million compared to $2.8 million during the third quarter of 2012. Product revenue in the third quarter of 2013 consisted of $3.7  million from sales of our PacBio RS II instruments and instrument upgrades and $2.1  million from sales of consumables compared to no sales of our PacBio RS instruments and $1.3 million from sales of consumables during the third quarter of 2012. Instrument revenue in the third quarter of 2013 reflects revenue from six PacBio RS II instruments as compared to no PacBio RS instruments during the third quarter of 2012.  Service and other revenue of $1.6 million and $1.3 million for the third quarters of 2013 and 2012, respectively, was primarily derived from product maintenance agreements sold on our installed instruments.

Gross Profit

Gross profit for the third quarter of 2013 increased to $1.2 million compared to $0.2 million for the third quarter of 2012. The higher third quarter 2013 gross profit was driven by higher revenue. Cost of product revenue of $4.6 million for the third quarter of 2013 reflects the costs relating to the sale of six instruments, instrument upgrades installed, and consumables shipped during the period while cost of product revenue of $1.0 million for the third quarter of 2012 reflects the costs relating to the consumables shipped during the period. Cost of service and other revenue of $1.6  million for the third quarter of both 2013 and 2012,  reflect the costs of personnel, materials and support infrastructure necessary to support the installed base of our instruments.

Research and Development Expense

During the third quarter of 2013, research and development expense decreased $2.2 million, or 17%, compared to the third quarter of 2012. The decrease in research and development expense was primarily attributed to a  decrease of $0.6 million in personnel related expense, including stock-based compensation, a decrease of $0.5 million in manufacturing resources allocated to research and development as a result of increased commercial production volumes, a decrease of $0.5 million in equipment and supplies, and a decrease of $0.6 million in other net expenses. Research and development expense included stock-based compensation expense of $0.8 million and $1.2 million during the third quarters of 2013 and 2012, respectively.  

Sales, General and Administrative Expense

For the third quarter of 2013, selling, general and administrative expense increased $0.6 million, or 6%, compared to the third quarter of 2012. The increase was largely due to $2.0 million of expenses incurred in relation to the Roche Agreement, partially offset by a decrease of $0.4 million in marketing and travel related costs and a decrease of $1.0 million in other net expense.  Sales, general and administrative expense included stock-based compensation expense of $1.2 million and $1.1 million during the third quarters of 2013 and 2012, respectively.

Interest Expense

Interest expense increased $0.6 million from $0.1 million in the third quarter of 2012 to $0.7 million in the third quarter of 2013, primarily as a result of the debt facility entered into during the first quarter of 2013.

 

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Comparison of the Nine-month Periods Ended September 30, 2013 and 2012