PACIFIC BIOSCIENCES OF CALIFORNIA, INC. 10-Q

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of our financial condition and results of operations together with our condensed consolidated financial statements and the related notes included in this Quarterly Report on Form 10-Q and those in our Annual Report on Form 10-K for the year ended December 31, 2019. Some of the information contained in this discussion and analysis or set forth elsewhere in this report, including statements related to our expectations regarding the potential impacts of the COVID-19 pandemic on our business, financial condition, and results of operations, and information with respect to our products, plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties, including statements regarding our expected financial results in future periods. The words “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “may,” “might,” “plans,” “potential,” “predicts,” “projects,” “seeks,” “should,” “target,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. You should read the “Risk Factors” section of this Quarterly Report on Form 10-Q for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. We do not assume any obligation to update any forward-looking statements. Termination of Merger with Illumina, Inc. On January 2, 2020, we, Illumina and Merger Subsidiary entered into the Termination Agreement. As part of the Termination Agreement, Illumina paid us a $98.0 million Reverse Termination Fee, from which we paid our financial advisor associated fees of $6 million in April 2020. In addition, Illumina paid us the final Continuation Advances of $34 million during the first quarter of 2020. However, pursuant to the Termination Agreement, in the event that, on or prior to September 30, 2020, we enter into a definitive agreement providing for, or consummate, a Change of Control Transaction (as defined in the Termination Agreement), then we may be required to repay the Reverse Termination Fee (without interest) to Illumina in connection with the consummation of such Change of Control Transaction. If such Change of Control Transaction is not consummated by the two-year anniversary of the execution of the definitive agreement for such Change of Control Transaction, then we will not be required to repay the Reverse Termination Fee. In addition, up to the $52.0 million of Continuation Advances paid to us are repayable without interest to Illumina if, within two years of March 31, 2020, we enter into a Change of Control Transaction or raise at least $100 million in equity in a single transaction or debt financing (that may have multiple closings), with the amount repayable dependent on the amount raised by us. Senior Management On April 1, 2020, Michael Phillips retired as Sr. Vice President of Research and Development. Dr. Phillips transitioned to a consultant role on the same date. The consulting services are scheduled to end in March 2021. On May 26, 2020, we announced that Eric E. Schaefer was appointed to the role of Vice President and Chief Accounting Officer and designated as the Company’s principal accounting officer. On June 10, 2020, we announced that Dr. Michael Hunkapiller will retire as Chief Executive Officer and President by the end of the year. Dr. Hunkapiller will continue to serve on the board until the end of his term in 2021. On the same date, we announced that Susan Barnes will retire as Executive Vice President and Chief Financial Officer in August 2020. On July 31, 2020, our Board of Directors appointed Ben Gong to the role of interim Chief Financial Officer and designated him as the Company’s principal financial officer, effective August 8, 2020. Mr. Gong will replace Susan K. Barnes who will retire as the Company’s Executive Vice President, Chief Financial Officer and principal financial officer on August 7, 2020. Business Overview We design, develop and manufacture sequencing systems to help scientists resolve genetically complex problems. Based on our novel Single Molecule, Real-Time (SMRT®) sequencing technology, our products enable: de novo genome assembly to finish genomes in order to more fully identify, annotate and decipher genomic structures; full-length transcript analysis to improve annotations in reference genomes, characterize alternatively spliced isoforms in important gene families, and find novel genes; targeted sequencing to more comprehensively characterize genetic variations; and real-time kinetic information for epigenome characterization. Our technology provides high accuracy, ultra-long reads, uniform coverage and the ability to simultaneously detect epigenetic changes. PacBio® sequencing systems, including consumables and software, provide a simple and fast end-to-end workflow for SMRT sequencing. 21 Table of Contents Our current products include the Sequel II instrument and SMRT Cell 8M, which together are capable of sequencing up to approximately eight million DNA molecules simultaneously, and the previous generation Sequel instrument and Sequel SMRT Cell 1M, which together are capable of sequencing up to approximately one million DNA molecules simultaneously. Our customers and our scientific collaborators have published numerous peer-reviewed articles in journals including Nature, Science, Cell, PNAS and The New England Journal of Medicine highlighting the power and applications of SMRT sequencing in projects such as finishing genomes, structural variation discovery, isoform transcriptome characterization, rare mutation discovery and the identification of chemical modifications of DNA related to virulence and pathogenicity. Our research and development efforts are focused on developing new products and further improving our existing products including continuing chemistry and sample preparation improvements to increase throughput and expand our supported applications. By providing access to genetic information that was previously inaccessible, we enable scientists to confidently increase their understanding of biological systems. COVID-19 Update The COVID-19 pandemic and efforts to control its spread have significantly curtailed the movement of people, goods, and services worldwide, including in the regions in which we sell our products and services and conduct our business operations. The financial results for the three and six months ended June 30, 2020 were impacted negatively as many of our customers in multiple regions around the world shut down operations for various periods of time in efforts to curb the spread of the COVID-19 pandemic. This resulted in lower product revenues for the three and six months ended June 30, 2020 as compared to the same period of 2019. A significant number of our customer sites that had shut down due to COVID-19 have re-opened. However, those that have re-opened have not necessarily resumed operating at their prior run rates, which has negatively impacted the sale of our consumables. As of June 30, 2020, approximately 20% of the sites remained inactive. This dynamic continues to negatively impact the recognition of revenue related to the sale of our Sequel and Sequel II instruments. The negative impacts of COVID-19 on our customers will likely continue to adversely impact our revenues during the second half of 2020, including the third quarter of 2020. Due to the uncertain scope and duration of the pandemic, we cannot reasonably estimate the future impact to our operations and financial results. In response to local stay-at-home orders and in alignment with CDC recommendations, we have limited our manufacturing and commercial operations based in Menlo Park, California. We will, however, continue to provide consumables, instruments and support to scientists at government, academic, and commercial labs that remain open. To aid in containing the spread of COVID-19, we have implemented remote-work options and are limiting employee travel as much as possible. We are monitoring this rapidly evolving situation. Even after the COVID-19 pandemic has subsided, we may continue to experience an adverse impact to our business as a result of its global economic impact, including any recession that has occurred or may occur in the future. Specifically, difficult macroeconomic conditions, decreases in discretionary capital spending, increased and prolonged unemployment or a decline in consumer confidence as a result of the COVID-19 pandemic could have a continuing adverse effect on the demand for some of our products. Such economic disruption could have a material adverse effect on our business, results of operations and liquidity. The degree of impact of COVID-19 on our business will depend on several factors, such as the duration and the extent of the pandemic, as well as actions taken by governments, businesses and consumers in response to the pandemic, all of which continue to evolve and remain uncertain at this time. See the Risk Factors section for further discussion of the possible impact of the COVID-19 pandemic on our business. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based upon our unaudited Financial Statements, which have been prepared in accordance with the rules and regulations of the SEC. The preparation of these Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe 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. We adopted ASU 2016-13 Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments on January 1, 2020, using the modified retrospective method. Please see “Recently Adopted Accounting Standards” in the Note 3. Summary of Significant Accounting Policies of Item 1. Financial Statements. Except as noted above, there have been no other material changes to our significant accounting policies as discussed in our Annual Report on Form 10-K for the year ended December 31, 2019 . 22 Table of Contents Results of Operations Comparison of the three months ended June 30, 2020 and 2019 Three Months Ended June 30, $ Change % Change (in thousands, except percentages) 2020 2019 (unaudited) Revenue: Product revenue $ 13,756 $ 21,250 $ (7,494) (35%) Service and other revenue 3,321 3,371 (50) (1%) Total revenue 17,077 24,621 (7,544) (31%) Cost of Revenue: Cost of product revenue 8,225 11,980 (3,755) (31%) Cost of service and other revenue 2,239 3,028 (789) (26%) Total cost of revenue 10,464 15,008 (4,544) (30%) Gross profit 6,613 9,613 (3,000) (31%) Operating Expense: Research and development 15,010 14,910 100 1% Sales, general and administrative 15,127 19,083 (3,956) (21%) Total operating expense 30,137 33,993 (3,856) (11%) Operating loss (23,524) (24,380) 856 4% Interest expense — (644) 644 100% Other income, net 438 428 10 2% Net loss $ (23,086) $ (24,596) $ 1,510 6% Revenue Total revenue for the three months ended June 30, 2020 was $17.1 million compared to $24.6 million for the same period during 2019. Product revenue of $13.8 million for the three months ended June 30, 2020 consisted primarily of $8.9 million from sales of Sequel and Sequel II instruments and $4.8 million from sales of consumables, compared to total product revenue of $21.3 million for the same period during 2019, consisting of $12.7 million from sales of Sequel instruments and $8.6 million from sales of consumables. The decrease in instrument sales was primarily attributable to a lower number of instrument shipments and installations due to COVID-19 as discussed above. The decrease in consumable sales was primarily attributable to lower utilization of the installed base of instruments due to COVID-19 as discussed above. The negative impact of COVID-19 on our customers will likely continue to adversely impact our revenues during the second half of 2020. Service and other revenue of $3.3 million and $3.4 million for the three months ended June 30, 2020 and 2019, respectively, was primarily derived from product maintenance agreements sold on our installed instruments. Gross Profit Cost of product revenue was $8.2 million for the three months ended June 30, 2020, compared to cost of product revenue of $12.0 million for the same period during 2019. Cost of service and other revenue for the three months ended June 30, 2020 was $2.2 million, compared to $3.0 million for the same period during 2019. Gross profit for the three months ended June 30, 2020 was $6.6 million, resulting in a gross margin of 38.7%, compared to gross profit of $9.6 million, resulting in a gross margin of 39.0% for the same period during 2019. Gross profit decreased $3.0 million for the three months ended June 30, 2020 compared to the same period in 2019 primarily due to lower product revenue realized for the three months ended June 30, 2020. Research and Development Expense During the three months ended June 30, 2020, research and development expense remained relatively flat compared to the same period during 2019. Research and development expense included stock-based compensation expense of $1.4 million and $1.9 million during the three months ended June 30, 2020 and 2019, respectively. Sales, General and Administrative Expense 23 Table of Contents During the three months ended June 30, 2020, sales, general and administrative expense decreased by $4.0 million, or 21%, compared to the same period during 2019. The decrease in sales, general and administrative expense was primarily attributable to $3.3 million in merger related expenses during the three months ended June 30, 2019, which did not recur during the three months ended June 30, 2020, and a decrease of $1.1 million in patent litigation expenses incurred during the three months ended June 30, 2020 as compared to the same period in 2019. Sa les, general and administrative expense included stock-based compensation expense of $1.3 million and $1.7 million during the three months ended June 30, 2020 and 2019, respectively. Interest Expense Interest expense for the three months ended June 30, 2020 decreased $0.6 million compared to the same period in 2019, as the debt agreement with Deerfield entered into in February 2013 (the “Facility Agreement”) matured in February 2020. Comparison of the six months ended June 30, 2020 and 2019 Six Months Ended June 30, $ Change % Change (in thousands, except percentages) 2020 2019 (unaudited) Revenue: Product revenue $ 26,049 $ 34,707 $ (8,658) (25%) Service and other revenue 6,626 6,339 287 5% Total revenue 32,675 41,046 (8,371) (20%) Cost of Revenue: Cost of product revenue 13,646 20,598 (6,952) (34%) Cost of service and other revenue 4,928 5,718 (790) (14%) Total cost of revenue 18,574 26,316 (7,742) (29%) Gross profit 14,101 14,730 (629) (4%) Operating Expense: Research and development 30,260 30,395 (135) 0% Sales, general and administrative 40,074 38,849 1,225 3% Total operating expense 70,334 69,244 1,090 2% Operating loss (56,233) (54,514) (1,719) (3%) Gain from Continuation Advances from Illumina 34,000 — Interest expense (267) (1,269) 1,002 79% Other income, net 676 863 (187) (22%) Net loss $ (21,824) $ (54,920) $ 33,096 60% Revenue Total revenue for the six months ended June 30, 2020 was $32.7 million, compared to $41.0 million for the same period during 2019. Product revenue of $26.0 million for the six months ended June 30, 2020 consisted of $13.0 million from sales of Sequel and Sequel II instruments and $13.0 million from sales of consumables, compared to total product revenue of $34.7 million for the same period during 2019, consisting of $18.3 million from sales of Sequel and Sequel II instruments and $16.4 million from sales of consumables. The decrease in instrument sales was primarily attributable to a lower number of instrument shipments and installations due to COVID-19 as discussed above. The decrease in consumable sales was primarily attributable to lower utilization of the installed base of instruments due to COVID-19 as discussed above. The negative impact of COVID-19 on our customers will likely continue to adversely impact our revenues during the second half of 2020. Service and other revenue of $6.6 million and $6.3 million for the six months ended June 30, 2020 and 2019, respectively, was primarily derived from product maintenance agreements sold on our installed instruments. Gross Profit Gross profit for the six-month period ended June 30, 2020 was $14.1 million, resulting in a gross margin of 43.2%, compared to gross profit of $14.7 million, resulting in a gross margin of 35.9% for the same period during 2019. 24 Table of Contents Cost of product revenue was $13.6 million for the six months ended June 30, 2020, compared to cost of product revenue of $20.6 million for the same period during 2019. Cost of product revenue decreased $7.0 million for the six months ended June 30, 2020 compared to the same period in 2019 primarily resulting from lower product shipments. In addition, during the six months ended June 30, 2019, we incurred product transition costs including an inventory reserve taken in connection with the transition from Sequel to Sequel II. Cost of service and other revenue for the six-month period ended June 30, 2020 was $4.9 million, compared to $5.7 million for the same period during 2019. Research and Development Expense During the six months ended June 30, 2020, research and development expense remained flat compared to the same period during 2019. Research and development expense included stock-based compensation expense of $3.2 million and $3.9 million during the six months ended June 30, 2020 and 2019, respectively. Sales, General and Administrative Expense During the six months ended June 30, 2020, sales, general and administrative expense increased by $1.2 million, or 3%, compared to the same period during 2019. The increase in sales, general and administrative expense was primarily attributable to an increase of $0.9 million in compensation expense. Sales, general and administrative expense included stock-based compensation expense of $3.1 million and $3.6 million during the six-month periods ended June 30, 2020 and 2019, respectively. Interest Expense Interest expense for the six m onths ended June 30, 2020 decreased $1.0 million compared to the same period in 2019, as the Facility Agreement matured in February 2020. Liquidity and Capital Resources Liquidity Cash, cash equivalents and investments at June 30, 2020 totaled $120.0 million, compared to $49.1 million at December 31, 2019. The increase was attributable to the Reverse Termination Fee and Continuation Advances we received from Illumina partially offset by cash used in operations and the $16.0 million repayment of debt associated with the Facility Agreement. We believe that our existing cash, cash equivalents and investments will be sufficient to fund our projected operating requirements for at least the next 12 months from the filing date of the Quarterly Report on Form 10-Q for the quarter ended June 30, 2020. However, the potential economic or other disruptions caused by the COVID-19 pandemic could have a material adverse effect on our business, results of operations and liquidity. W e will continue to monitor our operating expenses and cash flows in response to the evolving market conditions. On January 2, 2020, we and Illumina mutually agreed to terminate the Merger Agreement. As part of the Termination Agreement, Illumina paid us the Reverse Termination Fee of $98.0 million from which we paid our financial advisor associated fees of $6.0 million. In addition, Illumina paid us the additional Continuation Advances of $6.0 million in January 2020 and $22.0 million in February 2020 and made the last Continuation Advance payment to us of $6.0 million in March 2020. P ursuant to the Termination Agreement, in the event that, on or prior to September 30, 2020, we enter into a definitive agreement providing for, or consummate, a Change of Control Transaction, then we may be required to repay the Reverse Termination Fee (without interest) to Illumina in connection with the consummation of such Change of Control Transaction. If such Change of Control Transaction is not entered into on or prior to September 30, 2020 or if such change of control transaction is entered into on or prior to September 30, 2020 but is not consummated by the two-year anniversary of the execution of the definitive agreement for such Change of Control Transaction, then we will not be required to repay the Reverse Termination Fee. In addition, up to $52.0 million of the Continuation Advances that we received are repayable without interest to Illumina if, within two years of March 31, 2020, we enter into, or consummate a Change of Control Transaction or raise at least $100 million in equity in a single transaction or debt financing (may have multiple closings), with the amount repayable dependent on the amount raised by us. If we are required to repay the Termination Fee or the Continuation Advances, we may not be able to fund our projected operating requirements for at least twelve months from the date of filing this Quarterly Report. 25 Table of Contents Factors that may affect our capital needs include, but are not limited to, whether we will have to repay the Reverse Termination Fee or Continuation Advances; the pace of adoption of our products which affects the sales of our products and services; our ability to obtain new collaboration and customer arrangements; the progress of our research and development programs; initiation or expansion of research programs and collaborations; the purchase of patent licenses; future acquisitions; manufacturing costs, service costs, the impact of product quality, litigation costs, including the costs involved in preparing, filing, prosecuting, defending and enforcing intellectual property rights; costs of developing new and enhanced products; and other factors. We may raise additional capital in the future. To the extent that we raise additional funds through the sale of equity or convertible debt, 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, particularly in light of restrictions under the Termination Agreement. If adequate funds are not available, we may be required to obtain funds by entering into collaboration, licensing or debt agreements on unfavorable terms. If we are unable to raise funds on favorable terms, or at all, we may have to reduce our cash burn rate and may not be able to support our commercialization efforts, or to increase or maintain the level of our research and development activities. If we are unable to generate sufficient cash flows or to raise adequate funds to finance our forecasted expenditures, we may have to make significant changes to our operations, including delaying or reducing the scope of, or eliminating some or all of, our development programs. We also may have to reduce sales, marketing, engineering, customer support or other resources devoted to our existing or new products or cease operations. If our cash, cash equivalents and investments are insufficient to fund our projected operating requirements, and we are unable to raise capital, it would have a material adverse effect on our business, financial condition and results of operations. Operating Activities Our primary uses of cash in operating activities are for the development of ongoing product enhancements and future products, manufacturing, and support functions related to our sales, general and administrative activities. We had $51.6 million of cash provided from operating activities for the six months ended June 30, 2020, compared to cash usage of $42.9 million from operating activities for the same period in 2019. Cash provided by operating activities for the six months ended June 30, 2020 was due to the $98.0 million Reverse Termination Fee received from Illumina, non-cash items such as stock-based compensation of $7.3 million and depreciation of $3.2 million, partially offset by a net loss of $21.8 million and a gain from Continuation Advances from Illumina of $34.0 million, which is considered to be a financing activity. The change in net operating assets and liabilities was primarily attributed to a decrease of $3.9 million in accounts receivable, an increase of other liabilities of 2.0 million primarily relating to employee contributions for the Employee Stock Purchase Plan, partially offset by an increase of $3.8 million in inventory. Cash used in operating activities for the six months ended June 30, 2019 was due primarily to a net loss of $54.9 million, offset by non-cash items such as stock-based compensation of $8.5 million and depreciation of $3.6 million. The change in net operating assets and liabilities was primarily attributed to an increase of $3.5 million in accounts receivable, partially offset by an increase of $3.2 million in accrued expense. Investing Activities Our investing activities consist primarily of capital expenditures and investment purchases, sales and maturities. We used $57.2 million of cash for investing activities for the six months ended June 30, 2020, compared to receiving cash of $45.8 million from investing activities for the same period in 2019. Cash used in investing activities for the six months ended June 30, 2020 was due primarily to net purchases of investments of $56.8 million and purchases of property and equipment of $0.4 million. Cash provided in investing activities for the six months ended June 30, 2019 was due primarily to net maturities of investments of $47.7 million. Financing Activities Cash provided from financing activities was $18.8 million and $8.1 million for the six months ended June 30, 2020 and 2019, respectively. Cash provided by financing activities during the six months ended June 30, 2020 was due to $34.0 million of Continuation Advances from Illumina and proceeds of $0.8 million from the issuance of common stock through our equity compensation plans, partially offset by $16.0 million we repaid for the remaining outstanding principal to Deerfield upon the maturity of the Facility Agreement. 26 Table of Contents Cash provided by financing activities during the six months ended June 30, 2019 was due to $8.1 million from the issuance of common stock through our equity compensation plans. Capital Resources In June 2020, 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 $250.0 million of our common stock, preferred stock, depository shares, warrants, units or debt securities. On July 14, 2020, the registration statement was declared effective by the SEC, which allows us to access the capital markets for the three-year period following this effective date. However, the Termination Agreement currently limits our ability to issue additional securities or incur indebtedness as up to the $52.0 million of Continuation Advances paid to us are repayable without interest to Illumina if, within two years of March 31, 2020, we enter into a Change of Control Transaction or raise at least $100 million in equity or debt financing in a single transaction (with the amount repayable dependent on the amount raised by us). Off-Balance Sheet Arrangements As of June 30, 2020, we did not have any off-balance sheet arrangements. In the ordinary course of business, we enter into standard indemnification arrangements. 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 any trade secret, copyright, patent or other intellectual property infringement claim by any third party with respect to its technology, or from claims relating to our performance or non-performance under a contract, any defective products supplied by us, or any 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 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 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 fundraising 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 us and such third parties in connection with such fundraising efforts. To the extent that such indemnification obligations apply to the lawsuits described in “Note 6 . Commitments and Contingencies” in Part I, Item 1 of this Form 10-Q, any associated expenses incurred are included within the related accrued litigation expense amounts. No additional liability associated with such indemnification agreements has been recorded as of June 30, 2020. Item 3. Quantitative and Qualitative Disclosures About Market Risk Except for the broad effects of COVID-19 and its negative impact on the global economy and financial markets, there have been no material changes in market risk from the information provided in our Annual Report on Form 10-K for the year ended December 31, 2019.