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. 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 genetic analysis. Combining recent 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 use our SMRT technology in the DNA sequencing market where we have developed and commercialized our first product, the PacBio RS , a third generation sequencing platform. The PacBio RSconsists of an instrument platform that uses our proprietary consumables, including our SMRT Cells and reagent kits.

From our incorporation in 2000 through the first quarter of 2011 we primarily focused on developing our technology, undertaking engineering activities to develop our products, conducting initial marketing of our products, and pre-production activities associated with the commercial launch of the PacBio RS during April 2011. We have financed our operations primarily through the issuance of common stock and convertible preferred stock resulting in $575.0 million in net proceeds. 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 initial customers, development of enhancements and updates to existing products, development of future products, and sales and administrative infrastructure. As of March 31, 2012, we had an accumulated deficit of $469.1 million.

Basis of Presentation

Revenue

During the three month period ended March 31, 2012, the majority of our revenue related to the sale of PacBio RS 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. During the three month period ended March 31, 2011, all of our revenue was comprised solely of government grant revenue.

We anticipate that our future revenue will be generated primarily from sales of our PacBio RS instruments and consumables, comprised of SMRT Cells and reagent kits, and system maintenance agreements.

As of March 31, 2012, our backlog was approximately $4.7 million comprised of seven systems. We define backlog as purchase orders or signed contracts for systems from our customers which we believe are firm and for which we have not yet recognized revenue. We expect to convert most, if not all of this backlog to revenue during the second quarter of 2012.

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.

Manufacturing overhead, comprised mainly of labor costs, 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 during the period exceeds the amounts absorbed into inventory and included in cost of revenue. 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 included the direct costs of components used in support, repair and maintenance of customer instruments as well as the cost of personnel, materials and support infrastructure necessary to support the installed customer base. As we are in the early stages of the commercial launch of our products, the capacity of our existing service infrastructure exceeds the number of installed customer instruments. Therefore, management has estimated the capacity of the existing service infrastructure and recognizes service related cost of revenue based on the installed base. As a result, total service infrastructure costs exceed the costs associated with the support of customer instruments and such excess costs are 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 , 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 and 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. Selling, general and administrative recurring expenses are expected to increase gradually over time as we continue to add resources to our sales and support infrastructure.

While such trends 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.

Other (Expense) Income, Net

Other (expense) income, net consists primarily of interest income earned, accretion of discounts and amortization of premiums on investment balances, net gains or losses on foreign currency transactions and foreign income taxes. Our interest income will vary each reporting period depending on our average investment balances during the period and market interest rates. Other income, net also includes interest expense relating to our facility financing obligations resulting from lease agreements entered into in 2010. We expect interest expense to fluctuate in the future with changes in the obligations.

Income Taxes

Provision for (Benefit from) 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.

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. Management has discussed the development, selection and disclosure of significant estimates with the Audit Committee of our Board of Directors. 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. During the three-month period ended March 31, 2012, there have been no significant changes in our critical accounting policies and estimates as compared to the disclosures in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2011.

Results of Operations

Comparison of the Three-month Periods Ended March 31, 2012 and 2011



                                                                                Increase/         % Increase/
                                         Three Months Ended March 31,           (Decrease)        (Decrease)
(in thousands, except percentages)        2012                  2011
                                                 (unaudited)
Revenue:
Product revenue                      $        8,715        $           -       $      8,715                 -
Service and other revenue                     1,053                    -              1,053                 -
Grant revenue                                   270                   270                -                  -

Total revenue                                10,038                   270             9,768               3618 %

Cost of Revenue:
Cost of product revenue                       8,607                    -              8,607                 -
Cost of service and other revenue             1,583                    -              1,583                 -

Total cost of revenue                        10,190                    -             10,190                 -

Gross (loss) profit                            (152 )                 270              (422 )             (156 %)

Operating Expense:
Research and development                     12,073                24,118           (12,045 )              (50 %)
Sales, general and administrative            15,285                11,119             4,166                 37 %

Total operating expense                      27,358                35,237            (7,879 )              (22 %)

Operating loss                              (27,510 )             (34,967 )          (7,457 )              (21 %)
Other (expense) income, net                     (70 )                 158              (228 )             (144 %)

Net loss                             $      (27,580 )      $      (34,809 )    $     (7,229 )              (21 %)

Revenue

Our total revenue for the first quarter of 2012 was $10.0 million compared to $0.3 million in the first quarter of 2011. During the first quarter of 2011, our revenue was limited to grant revenue as we began commercially shipping our PacBio RS during the second quarter of 2011. Product revenue in the first quarter of 2012 consisted of approximately $7.8 million from sales of our PacBio RS instruments and approximately $0.9 million from sales of consumables. Instrument revenue reflects the 11 instrument installations and acceptances during the period. Service and other revenue of $1.1 million for the first quarter of 2012 was primarily derived from product maintenance agreements sold in conjunction with PacBio RS instruments.

Grant revenue earned is dependent on the grant received, the amount of the grant and subsequent work performed pursuant to the grant. For the first quarter of 2012, grant revenue remained consistent with the first quarter of 2011 at $0.3 million.

Gross (loss) profit

Cost of revenue of $10.2 million and gross loss of $0.2 million for the first quarter of 2012 corresponds to the recognition of revenue on 11 PacBio RS instruments, as well as consumable shipment and services provided on our installed base of instruments. Cost of revenue for the first quarter of 2012 also includes $0.7 million of expense associated with our C2 product release, including the write-off of certain inventory and field upgrade costs. Cost of product revenue of $8.6 million for the period reflects the costs relating to components and manufacturing overhead incurred on the 11 instruments that were installed and consumables that were shipped during the period. Cost of service and other revenue of $1.6 million for the period reflect the costs of personnel, materials and support infrastructure necessary to support the installed base of PacBio RS instruments. We did not realize product costs during the first quarter of 2011 as revenue was derived solely from government grants.

Research and Development Expense

During the first quarter of 2012, research and development expenses decreased $12.0 million, or 50%, compared to the first quarter of 2011. The decrease was driven primarily by a $4.5 million decrease in personnel related expense, including stock-based compensation, due to lower headcount in 2012 compared to 2011. The decrease in expenses also includes a $3.0 million decrease related to expensed instrument development components accounted for as development expense in 2011, a $1.4 million decrease in supplies, development materials and prototype-related expenses and a $0.8 million decrease in facility and technology expenses. Research and development expenses incurred in the first quarter of 2011 included costs associated with the finalization of commercial designs, specifications and configurations for our products prior to commercial launch during the second quarter of 2011. The 2012 results reflect an increase in the capitalization of $1.6 million of manufacturing overhead into inventory. Research and development expense included stock-based compensation expense of $1.1 million and $1.7 million during the first quarter of 2012 and 2011, respectively.

Sales, General and Administrative Expense

For the first quarter of 2012, selling, general and administrative expenses increased $4.2 million, or 37%, compared to the first quarter of 2011. The increase was driven primarily by a $3.6 million increase in legal expenses primarily related to litigation, including settlement charges of $1.8 million relating to resolution of two intellectual property matters. Sales, general and administrative expense included stock-based compensation expense of $0.9 million and $1.4 million during the first quarter of 2012 and 2011, respectively.

Other (Expense) Income, Net

The change in other (expense) income, net primarily reflects an increase in realized foreign currency transaction losses and lower interest income in the first quarter of 2012 compared to the same period in 2011. The decrease in interest income was primarily a result of lower average investment balances in 2012 as compared to 2011.

Liquidity and Capital Resources

Since our inception we have financed our operations primarily through the issuance of convertible preferred stock and the issuance of common stock through our initial public offering resulting in $575.0 million in net proceeds. As of March 31, 2012, we had cash, cash equivalents and investments of $161.3 million, a decrease of $16.1 million compared to December 31, 2011, reflecting approximately $17.3 million of cash used during the period to fund operations partially offset by $1.8 million of financing activities. We believe that existing cash, cash equivalents and investments will be sufficient to fund our projected operating requirements for at least 12 months. This expectation is based on our current operating and financing plans, which are subject to change, and therefore we could require additional funding. Factors that may effect our capital needs include, but are not limited to, slower than expected adoption of our products resulting in lower sales of our products and services; future acquisitions; our ability to maintain new collaboration and customer arrangements; the progress of our research and development programs; initiation or expansion of research programs and collaborations; the costs involved in preparing, filing, prosecuting, defending and enforcing intellectual property rights; the purchase of patent licenses; and other factors.

To the extent we raise additional funds through the sale of equity or convertible debt securities, the issuance of such securities could result in dilution to our stockholders. There can be no assurance that such funds will be available on favorable terms, or at all. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of such securities could result in dilution to our stockholders. If adequate funds are not available, we may be required to curtail operations significantly or to obtain funds by entering into collaboration agreements on unattractive terms. Our inability to raise capital would have a material adverse effect on our business, financial condition and results of operations.

Operating Activities

Our primary uses of cash from operating activities are for the manufacturing and sale of PacBio RS instruments and consumables, development of ongoing product enhancements and future product releases, and support functions related to our selling, general and administrative activities. The net cash used for the three-month periods ended March 31, 2012 and 2011 primarily reflects the net loss for those periods, offset by non-cash operating expenses including depreciation, stock-based compensation, and changes in operating assets and liabilities.

Net cash used in operating activities was $17.3 million for the three-month period ended March 31, 2012 as compared to $33.5 million for the three-month period ended March 31, 2011, due primarily to net losses of $27.6 million and $34.8 million, respectively, offset by depreciation and stock-based compensation of $3.8 million and $4.6 million, respectively. In addition, cash used in operating activities decreased for the three-month period ended March 31, 2012 as compared to the same period last year primarily as a result of decreased accounts receivable balance and inventory levels in the first quarter of 2012.

Investing Activities

Our investing activities consist primarily of net investment purchases, maturities and sales and capital expenditures. Net cash provided by investing activities was $13.0 million for the three-month period ended March 31, 2012, comprised of net maturities of investments of $13.3 million partially offset by purchases of property and equipment of $0.3 million. Net cash used in investing activities during the same period in 2011 totaled $29.9 million, comprised of net purchases of investments of $28.4 million and purchases of property and equipment of $1.5 million.

Financing Activities

For the three-month period ended March 31, 2012, we received $1.8 million of proceeds from the issuance of our common stock through stock option exercises and the sale of shares under our Employee Stock Purchase Plan and for the three-month period ended March 31, 2011, we received $0.3 million from stock option exercises.

Off-Balance Sheet Arrangements

As of March 31, 2012 we did not have any off-balance sheet arrangements.

In the ordinary course of business, we enter into standard indemnification arrangements with our customers, suppliers, licensors and collaborators. Pursuant to these arrangements, we indemnify, hold harmless and agree to reimburse the indemnified parties for losses suffered or incurred by the indemnified party, in connection with a trade secret, copyright, patent or other intellectual property infringement claim by a third party with respect to its technology, or from our performance or non-performance under a contract, or any defective products supplied by us, or any negligent acts or omissions, or willful misconduct, committed by us or any of our employees, agents or representatives. The term of these indemnification agreements is generally perpetual any time after the execution of the agreement. The maximum potential amount of future payments we could be required to make under these agreements is not determinable because it involves claims that may be made against us in future periods, but have not yet been made. To date, we have not incurred costs to defend lawsuits or settle claims related to these indemnification agreements. We also have certain indemnification obligations to our directors and certain officers, as well as the underwriters from our IPO, and we are incurring costs to defend our directors, certain officers and the underwriters in connection with the securities litigation we are currently a party to (see " Part I, Item 1. Financial Statements-Note 5. Contingencies" to the consolidated financial statements).

Recent Accounting Pronouncements

In 2011 the FASB issued Accounting Standards Update No. 2011-04, to provide guidance on achieving a consistent definition of and common requirements for measurement of and disclosure concerning fair value as between U.S. GAAP and International Financial Reporting Standards. ASU 2011-04 is required to be applied prospectively in interim and annual periods beginning after December 15, 2011. We adopted this guidance beginning January 1, 2012. The adoption of this amendment did not have a material effect on our Consolidated Financial Statements.

In 2011 the FASB issued Accounting Standards Update No. 2011-05, requiring companies to present the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements of net income and other comprehensive income. We adopted this guidance during the first quarter of 2012 and elected to disclose the OCI in a single continuous statement during interim reporting periods.