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: 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 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 High Resolution Genetic Analyzer. The PacBio RS consists 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 June 30, 2012, we had an accumulated deficit of $491.6 million.

Basis of Presentation

Revenue

During the three- and six-month periods ended June 30, 2012 and 2011, 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 revenue derived from 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.

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

We have recognized revenue relating to all instrument backlog from previous quarters. As of June 30, 2012, our backlog consisted of one instrument and comprised less than $1.0 million. 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 this backlog to revenue during the third 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.

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 Income (Expense), Net

Other income (expense), 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

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- and six-month periods ended June 30, 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 June 30, 2012 and 2011



                                                                                     Increase/         % Increase/
                                         Three-Month Period Ended June 30,           (Decrease)        (Decrease)
(in thousands, except percentages)         2012                     2011
                                                    (unaudited)
Revenue:
Product revenue                      $          5,827         $         10,148      $     (4,321 )              (43 %)
Service and other revenue                       1,284                      192             1,092                569 %
Grant revenue                                     180                      290              (110 )              (38 %)

Total revenue                                   7,291                   10,630            (3,339 )              (31 %)

Cost of Revenue:
Cost of product revenue                         5,382                    2,537             2,845                112 %
Cost of service and other revenue               1,634                      194             1,440                742 %

Total cost of revenue                           7,016                    2,731             4,285                157 %

Gross profit                                      275                    7,899            (7,624 )              (97 %)

Operating Expense:
Research and development                       11,272                   19,546            (8,274 )              (42 %)
Sales, general and administrative              11,558                   11,016               542                  5 %

Total operating expense                        22,830                   30,562            (7,732 )              (25 %)

Operating loss                                (22,555 )                (22,663 )            (108 )               (0 %)
Other income, net                                  68                      188              (120 )              (64 %)

Net loss                             $        (22,487 )       $        (22,475 )    $         12                  0 %

Revenue

Our total revenue for the second quarter of 2012 was $7.3 million compared to $10.6 million in the second quarter of 2011. Product revenue in the second quarter of 2012 consisted of approximately $4.6 million from sales of our PacBio RS instruments and approximately $1.2 million from sales of consumables compared to $10.0 million from sales of our PacBio RS instruments and $0.2 million from sales of consumables in the second quarter of 2011. Instrument revenue in the three-month periods ended June 30, 2012 and 2011 reflects the seven and 16 instrument installations and acceptances during the period, respectively. Service and other revenue of $1.3 million and $0.2 million, for the second quarter of 2012 and 2011, respectively, was primarily derived from product maintenance agreements sold in conjunction with PacBio RS instruments.

We expect our third quarter revenues to decrease sequentially from the second quarter of 2012. We expect our revenues during the third quarter of 2012 to be primarily comprised of recurring consumable revenue within product revenue as well as recurring service revenues.

Grant revenue of $0.2 million and $0.3 million was recognized in the second quarter of 2012 and 2011 respectively. The decrease of $0.1 million or 38% was driven primarily by a decrease in the amount of work performed pursuant to the grants. Grant revenue earned is dependent on the grant received, the amount of the grant and subsequent work performed pursuant to the grant.

Gross Profit

Gross profit of $0.3 million and $7.9 million for the second quarter of 2012 and 2011 corresponds to the recognition of revenue on seven and 16 PacBio RS instruments, respectively, as well as consumable shipments and services provided to our installed base of instruments. Cost of product revenue of $5.4 million for the second quarter of 2012 reflects the costs relating to components and manufacturing overhead incurred on the seven instruments that were installed and consumables that were shipped during the period. Cost of revenue for the second quarter of 2012 also includes a $0.6 million charge associated with provision for excess and obsolete inventory based on a review of on hand inventory and future demand. Cost of product revenue of $2.5 million for the three-month period ended June 30, 2011 reflects part of the costs relating to components and manufacturing overhead incurred on the 16 instruments that were delivered and installed during the period. A significant portion of the costs associated with the instrument revenue recognized during the second quarter of 2011 were expensed as research and development costs during earlier periods prior to the finalization of the commercial designs, specifications and configurations of our products. Cost of service and other revenue of $1.6 million and $0.2 million for the second quarter of 2012 and 2011, respectively, reflect the costs of personnel, materials and support infrastructure necessary to support the installed base of PacBio RS instruments. We expect our gross margin will likely be negative during the third quarter of 2012.

During the second quarter of 2012, research and development expenses decreased $8.3 million, or 42%, compared to the second quarter of 2011. The decrease was driven primarily by a $4.8 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 $1.1 million decrease in supplies, a $0.9 million decrease related to expensed instrument development components accounted for as development expense in 2011, development materials and prototype-related expenses and a $0.7 million decrease in facility and technology expenses. Research and development expense included stock-based compensation expense of $1.1 million and $1.5 million during the second quarter of 2012 and 2011, respectively. Research and development expenses are expected to be moderately higher in the third quarter of 2012 as compared to the second quarter of 2012. Research and development expenses can fluctuate due to the timing of when certain activities such as prototype expenses occur.

Sales, General and Administrative Expense

For the second quarter of 2012, selling, general and administrative expenses increased $0.5 million, or 5%, compared to the second quarter of 2011. The increase was driven primarily by a $0.4 million increase in personnel related expense, including stock-based compensation, due to increased headcount in 2012 compared to 2011. The increase in expenses also includes a $0.4 million increase in travel, $0.4 million increase in depreciation, and $0.3 million increase in professional services, partially offset by $1.0 million of service cost allocations to cost of service. Allocation of service related costs from sales, general and administrative expense to cost of service began in conjunction with the commercial launch during the second quarter of 2011. Sales, general and administrative expense included stock-based compensation expense of $1.4 million and $1.3 million during the second quarter of 2012 and 2011, respectively. Sales, general and administrative expenses during the third quarter of 2012 are expected to be relatively consistent with the second quarter of 2012.

Other Income, Net

The decrease in other income, net of $0.1 million primarily reflects lower interest income in the second 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.

Comparison of the Six-month Periods Ended June 30, 2012 and 2011



                                                                                   Increase/         % Increase/
                                         Six-Month Period Ended June 30,           (Decrease)        (Decrease)
(in thousands, except percentages)        2012                    2011
                                                   (unaudited)
Revenue:
Product revenue                      $        14,542         $        10,148      $      4,394                 43 %
Service and other revenue                      2,337                     192             2,145              1,117 %
Grant revenue                                    450                     560              (110 )              (20 %)

Total revenue                                 17,329                  10,900             6,429                 59 %

Cost of Revenue:
Cost of product revenue                       13,989                   2,537            11,452                451 %
Cost of service and other revenue              3,217                     194             3,023              1,558 %

Total cost of revenue                         17,206                   2,731            14,475                530 %

Gross profit                                     123                   8,169            (8,046 )              (98 %)

Operating Expense:
Research and development                      23,345                  43,664           (20,319 )              (47 %)
Sales, general and administrative             26,843                  22,135             4,708                 21 %

Total operating expense                       50,188                  65,799           (15,611 )              (24 %)

Operating loss                               (50,065 )               (57,630 )          (7,565 )              (13 %)
Other income (expense), net                       (2 )                   346              (348 )             (101 %)

Net loss                             $       (50,067 )       $       (57,284 )    $     (7,217 )              (13 %)

Our total revenue for the six-month period ended June 30, 2012 was $17.3 million compared to $10.9 million in the six-month period ended June 30, 2011. Product revenue in the six-month period ended June 30, 2012 consisted of approximately $12.5 million from sales of our PacBio RS instruments and approximately $2.0 million from sales of consumables compared to $10.0 million from sales of our PacBio RS instruments and $0.2 million from sales of consumables in the six-month period ended June 30, 2011. Instrument revenue in the six-month periods ended June 30, 2012 and 2011 reflects the 18 and 16 instrument installations and acceptances during the periods, respectively. Service and other revenue of $2.3 million and $0.2 million, for the six-month periods ended June 30, 2012 and 2011, respectively, was primarily derived from product maintenance agreements sold in conjunction with PacBio RS instruments.

Grant revenue for the six-month period ended June 30, 2012 and 2011 was $0.5 million and $0.6 million, respectively. The decrease of $0.1 million or 20% was driven primarily by a decrease in the amount of work performed pursuant to the grants. Grant revenue earned is dependent on the grant received, the amount of the grant and subsequent work performed pursuant to the grant.

Gross Profit

Gross profit of $0.1 million and $8.2 million for the six-month periods ended June 30, 2012 and 2011 corresponds to the recognition of revenue on 18 and 16 PacBio RS instruments, respectively, as well as consumable shipments and services provided to our installed base of instruments. Cost of product revenue of $14.0 million for the six-month period ended June 30, 2012 reflects the costs relating to components and manufacturing overhead incurred on the 18 instruments that were installed and consumables that were shipped during the period. Cost of product revenue of $2.5 million for the six-month period ended June 30, 2011 reflects a portion of the costs relating to components and manufacturing overhead incurred on the 16 instruments that were delivered and installed during the period. A significant portion of the costs associated with the instrument revenue recognized during the period in 2011 were expensed as research and development costs during earlier periods prior to the finalization of the commercial designs, specifications and configurations of our products. Cost of revenue for the six-month period ended June 30, 2012 also includes $0.7 million of expense associated with our C2 release in the first quarter of 2012 and a $0.7 million charge associated with provision for excess and obsolete inventory based on a review of on hand inventory and future demand. Cost of service and other revenue of $3.2 million and $0.2 million for the six-month periods ended June 30, 2012 and 2011, respectively, reflect the costs of personnel, materials and support infrastructure necessary to support the installed base of PacBio RS instruments.

Research and Development Expense

During the six-month period ended June 30, 2012, research and development expenses decreased $20.3 million, or 47%, compared to the same period ended June 30, 2011. The decrease was driven primarily by a $9.3 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 $3.9 million decrease related to expensed instrument development components accounted for as development expense in 2011, a $2.4 million decrease in supplies, development materials and prototype-related expenses, a $1.7 million increase in amounts allocated to cost of product revenue as a result of the commercial launch during the second quarter of 2011, a $1.4 million decrease in facility and technology expenses and a net decrease of $1.6 million in other research and development expenses. Research and development expense included stock-based compensation expense of $2.2 million and $3.3 million during the six-month periods ended June 30, 2012 and 2011, respectively.

Research and development expenses incurred during the first quarter of 2011 include costs associated with the finalization of commercial designs, specifications and configurations for our products prior to commercial launch during the second quarter of 2011. During the six-month periods ended June 30, 2012 and 2011, research and development expenses were reduced by the capitalization of $5.3 million and $3.6 million, respectively, of manufacturing overhead into inventory.

Sales, General and Administrative Expense

For the six-month period ended June 30, 2012, selling, general and administrative expenses increased $4.7 million, or 21%, compared to the same period ended June 30, 2011. The increase was driven primarily by a $3.7 million increase in legal

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 six-month period ended June 30, 2012 compared to the six-month period ended June 30, 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 June 30, 2012, we had cash, cash equivalents and investments of $137.1 million, a decrease of $40.3 million compared to December 31, 2011, reflecting approximately $41.0 million of cash used during the period to fund operations partially offset by $2.0 million of proceeds from financing activities. Although we believe that existing cash, cash equivalents and investments will be sufficient to fund our projected operating requirements for at least 12 months, we will likely raise additional funds to support our operations through public or private equity or debt financing in the future. 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 affect 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 will 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 . . .