PACIFIC BIOSCIENCES OF CALIFORNIA, INC. - Quarter Report: 2012 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

For the quarterly period ended June 30, 2012

Or

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 July 31, 2012: 55,760,380

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

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)

1. Overview

Pacific Biosciences of California, Inc., (“Pacific Biosciences”, the “Company”, “we”, “us”) has commercialized the PacBio RS High Resolution Genetic Analyzer 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.

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, 2011 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 disclosure necessary to present the statements in accordance with U.S. generally accepted accounting principles (“U.S. 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, 2011, which was filed on February 29, 2012. The results of operations for the first six months of fiscal 2012 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, amounts relating to the resolution of legal matters, the valuation of options, assumptions used in computing stock-based compensation expense, provisions for income taxes, inventory valuation and reserves, 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

The carrying amount of our financial assets and liabilities, including accounts receivable, prepaid expenses, other current assets, accounts payable, accrued expenses and other current liabilities, approximate fair value due to their short maturities. The carrying value of our facility financing obligation approximates fair value based on currently available borrowing rates and after consideration of non-performance risk and credit risk.

The fair value hierarchy established under GAAP requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level input that is significant to the fair value measurement. The three levels of inputs that may be used to measure fair value are as follows:

We consider an active market as one in which transactions for the asset or liability occurs with sufficient frequency and volume to provide pricing information on an ongoing basis. Conversely, we view an inactive market as one in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers. Where appropriate, our non-performance risk, or that of our counterparty, is considered in determining the fair values of liabilities and assets, respectively.

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All of our cash and money market funds, which include bank deposits, 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.

Assets and liabilities measured at fair value are classified in their entirety based on the lowest level input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the entire fair value measurement requires management to make judgments and consider factors specific to the asset or liability.

Level 2 inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including rate curves, foreign exchange rates, and forward and spot prices for currencies and commodities. Our Level 2 investments consist primarily of U.S. treasury and U.S. government agency securities, corporate debt securities and commercial paper. For the three- and six-month periods ended June 30, 2012, there were no transfers between Level 1 and Level 2 investments and there were no changes in our valuation technique.

Cash and Cash Equivalents

We consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents consist of money market funds, corporate debt securities and commercial paper.

Investments

Our investments consist of U.S. treasury and U.S. government agency securities, corporate debt securities, commercial paper, and cash equivalents. We have designated all investments as available-for-sale and therefore, such investments are reported at fair value, with unrealized gains and losses recorded in accumulated other comprehensive income. For securities sold prior to maturity, the cost of securities sold is based on the specific identification method. Realized gains and losses on the sale of investments are recorded in other income, net.

We periodically review our investments for indicators of impairment and recognize an impairment charge when a decline in the fair value of our investments below the cost basis is judged to be other-than-temporary. Factors considered in determining whether a loss is temporary include the length of time and extent to which the investment’s fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, extent of the loss related to credit of the issuer, the expected cash flows from the security, our intent to sell the security and whether or not we will be required to sell the security before the recovery of its amortized cost. During the three- and six-month periods ended June 30, 2012 and 2011, we did not record impairment charges on our investments as it is more likely than not that we will recover their amortized cost basis upon sale or maturity.

Concentration of Credit Risk

The carrying amounts for financial instruments consisting of cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities approximate fair value due to their short maturities. Investments are stated at their estimated fair values, based on quoted market prices for the same or similar instruments. The counterparties to the agreements relating to our investment securities consist of various major corporations, financial institutions, municipalities and government agencies of high credit standing.

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Our accounts receivable are derived from revenue from customers and distributors located in the United States and other countries. We perform credit evaluations of our customers’ financial condition and, generally, require no collateral from our customers. We regularly review our accounts receivable including consideration of factors such as historical experience, credit quality, the age of the accounts receivable balances and current economic conditions that may affect a customer’s ability to pay. We have not provided reserves for potential credit losses to date and there have been no such losses to date.

Inventory

Inventory is valued at the lower of the standard cost, which approximates actual cost, or market. Cost is determined using the FIFO (first-in, first-out) method. Adjustments to reduce the cost of inventory to its net realizable value, if required, are made when carrying cost exceeds net realizable value and for estimated excess or obsolete inventory.

Revenue Recognition

Our revenue is generated primarily from the sale of products and services. Product revenue primarily consists of sales of our PacBio RS instrument and related consumables, and service and other revenue primarily consists of revenue earned from product maintenance agreements. Grant revenue reflects revenue from government grants that generally provide cost reimbursement for certain types of expenditures in return for research and development activities over a contractually defined period. Revenue from grants is recognized in the period during which the related costs are incurred, provided that the conditions under which the grants were provided have been met.

We recognize product and service revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price is fixed or determinable, and collectability is reasonably assured. In instances where final acceptance of the product or system is required, revenue is deferred until all acceptance criteria have been met. Revenue for product sales is generally recognized upon customer acceptance. Revenue for product maintenance agreements is recognized when earned, which is generally ratably over the service period.

In order to assess whether the price is fixed or determinable, we evaluate whether refund rights exist. If refund rights exist or payment terms are based on future performance, we defer revenue recognition until the price becomes fixed or determinable. We assess collectability based on a number of factors, including customer creditworthiness. If we determine that collection of amounts due is not reasonably assured, revenue recognition is deferred until receipt of payment.

We regularly enter into contracts from which revenue is derived from multiple deliverables including a mix of products and or services. Revenue recognition for contracts with multiple deliverables is based on the individual units of accounting determined to exist in the contract. A delivered item is considered a separate unit of accounting when 1) the delivered item has value to the customer on a stand-alone basis; and 2) when a general right of return exists, the delivery or performance of an undelivered item is considered probable and under our control. Items are considered to have stand-alone value when they are sold separately by any vendor or when the customer could resell the item on a stand-alone basis. Our revenue arrangements generally do not have a general right of return. When a deliverable does not meet the criteria to be considered a separate unit of accounting, we group it with other deliverables that, when combined, meet the criteria, and the appropriate allocation of arrangement consideration and revenue recognition is determined. Consideration is allocated at the inception of the contract to all deliverables based on their relative selling price. In order to determine the relative selling price of a deliverable, we apply, in order, the following hierarchy: 1) vendor-specific objective evidence (“VSOE”); 2) third-party evidence if VSOE is not available; and 3) our best estimate of selling price for the deliverable if neither VSOE nor third-party evidence is available.

In order to establish VSOE, we must regularly sell the product or service on a standalone basis with a substantial majority of sales priced within a relatively narrow range. If an insufficient number of standalone sales exist and VSOE cannot be determined, we then consider whether third party evidence can be used to establish selling price. Due to the lack of similar products and services sold by other companies within our industry, we have not established selling price using third-party evidence. If neither VSOE nor third party evidence of selling price exists, we determine our best estimate of selling price using a combination of prices set by our pricing committee adjusted for applicable discounts and customer orders received to date.

Deferred revenue primarily represents product maintenance agreement revenue that is expected to be recognized over the related service period, generally one to three years.

Stock-based Compensation

Stock-based compensation expense for all stock-based compensation awards is based on the grant date fair value estimated using the Black-Scholes option pricing model. Although we have limited historical information available to support the underlying

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estimates of certain assumptions required to value stock options, we have considered our historical stock volatility when developing an estimate of expected volatility, and we estimate the term of equity grants using historical data and peer data. We recognize compensation expense on a straight-line basis over the requisite service period. We have elected to use the simplified method to calculate the beginning pool of excess tax benefits.

Employee and director stock option plans are more fully described in Note 6.

Net Loss Per Share

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

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

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 had no impact on our financial position or results of operations.

In 2011 the FASB issued Accounting Standards Update No. 2011-05, requiring companies to present the components of other comprehensive income (“OCI”) 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.

3. Cash, Cash Equivalents and Investments

Our investments consist of marketable debt securities, including U.S. Government and Agency securities; corporate debt securities, bonds and asset-backed securities; and publicly traded equity securities. We report all securities with stated maturities of 90 days or less at the date of purchase that are readily convertible into cash and have insignificant interest rate risk as cash equivalents. Our investments are carried at fair value with unrealized gains and losses reported in accumulated other comprehensive income (loss) (“OCI”) in stockholders’ equity. The cost of marketable securities is adjusted for the amortization of premiums and discounts to expected maturity. Premium and discount amortization is included in other income (expense), net. Realized gains and losses, as well as interest income, on available-for-sale securities are also included in other income (expense), net. The cost of securities sold is based on the specific identification method. The fair values of securities are based on quoted market prices. We include all of our available-for-sale securities in current assets.

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The following table summarizes our investments as of June 30, 2012 and December 31, 2011 (in thousands):

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The estimated fair value of marketable debt securities (corporate debt securities, municipal bonds, U.S. government and agency securities, and U.S. treasury securities) as of June 30, 2012, 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.

4. Balance Sheet Components

As of June 30, 2012 and December 31, 2011 our inventory, net, consisted of the following components (in thousands):

As of June 30, 2012 and December 31, 2011, our accrued expenses and other current liabilities consisted of the following (in thousands):

5. Contingencies

We may 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.

On October 21, 2011, and October 24, 2011, we and certain of our officers and directors were named in two identical putative class action lawsuits filed in the Superior Court of the State of California, County of San Mateo (Young v. Pacific Biosciences of California, Inc., et al., Case No. CIV509210 and Sandnas v. Pacific Biosciences of California, Inc., et al., Case No. CIV509259). On April 4, 2012, we and certain of our officers and directors were named in another putative class action lawsuit filed in the Superior Court of the State of California, County of San Mateo (Oklahoma Firefighters Pension and Retirement System v. Pacific Biosciences of California, Inc., et al., Case No. CIV512976). The Young, Sandnas and Oklahoma Firefighters Actions have since been consolidated as In re Pacific Biosciences of California Inc. S’holder Litig., Case No. CIV509210 (the “State Court Action”). The State Court Action is a putative class action brought on behalf of all persons or entities who purchased or otherwise acquired our common stock pursuant or traceable to our initial public offering (“IPO”) of common stock in October 2010. The plaintiffs in the State Court Action seek to allege on behalf of the putative class violations of several provisions of the federal securities laws in connection with our August 16, 2010, registration statement (effective, as amended, on October 26, 2010). The plaintiffs in the State Court Action seek, among other things, compensatory damages, rescission, and attorneys’ fees and costs on behalf of the putative class. Defendants in the State Court Action filed a motion to stay that lawsuit in deference to the Primo action pending in federal district court. On May 25, 2012, the Superior Court denied Defendants’ motion to stay. Defendants in the State Court Action have filed a demurrer to certain of plaintiffs’ claims. A hearing on Defendants’ demurrer is presently scheduled for August 20, 2012.

On December 21, 2011, we and certain of our officers and directors were named in a putative class action lawsuit filed in United States District Court for the Northern District of California (Primo v. Pacific Biosciences of California, Inc., et al., Case No. 4:11-CV-06599). On April 11, 2012, an amended complaint was filed in the Primo action, which added another plaintiff, Evan Powell. As amended, the complaint alleges violations of several provisions of the federal securities laws arising out of alleged misstatements or

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omissions in our August 16, 2010 registration statement (effective, as amended, on October 26, 2010), and by us and/or our employees during the class period. The complaint seeks, among other things, compensatory damages, rescission, and attorneys’ fees and costs on behalf of the putative class. On April 6, 2012, Mr. Primo was appointed lead plaintiff in the action. Defendants in the Primo action have filed a motion to dismiss the amended complaint. A hearing on Defendants’ motion to dismiss is presently scheduled for October 11, 2012.

On December 29, 2011, we were named as a nominal defendant, along with certain of our directors as individual defendants, in a purported shareholder derivative lawsuit filed in United States District Court for the Northern District of California (Burlingame v. Martin et al., Case No. 4:11-CV-06703). The complaint alleges that the director defendants breached various fiduciary duties owed to us, engaged in waste of corporate assets, and were, as a result, unjustly enriched. The complaint seeks, among other things, restitution of director profits allegedly obtained as a result of the aforesaid conduct, improvement of our corporate governance procedures, and attorneys’ fees and costs. On February 28, 2012, the Burlingame action was related to the Primo action and transferred to the same judge hearing the Primo action.

Pursuant to Delaware law, we may have obligations, under certain circumstances, to hold harmless and indemnify each of our directors and certain officers, including those named in the State Court Action or the Primo or Burlingame actions, against 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. Such obligations for indemnification may apply to these lawsuits. In addition, we may have obligations, under certain circumstances, to hold harmless and indemnify each of the underwriters from our IPO and their respective affiliates, directors and officers against any and all losses, claims, damages and liabilities related to claims arising against such parties pursuant to the terms of the underwriting agreement between the underwriters and the Company.

We believe that the allegations in each of these pending actions are without merit and intend to vigorously contest the actions. However, there can be no assurance that we will be successful in our defense.

In addition, from time to time, we are a party to litigation and subject to claims incident to the ordinary course of business.

We cannot determine the ultimate outcome of these lawsuits. We cannot provide an estimate of the possible loss or possible range of loss associated with the resolution of these contingencies with certainty or confidence; therefore we have not provided an estimate and we have not recorded a liability.

6. Stock Option Plans

As of June 30, 2012, 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. Prior to the adoption of these plans, we granted options pursuant to the 2004 Equity Incentive Plan, through August 2005, and the 2005 Stock Plan, through October 2010. Upon termination of the predecessor plans, the shares available for grant at the time of termination, and shares subsequently returned to the plans upon forfeiture or option termination, were transferred to the successor plan in effect at the time of share return.

As of June 30, 2012, 800,247 shares of our common stock have been reserved for issuance under the ESPP. 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 approximately 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 428,604 shares during the six-month period ended June 30, 2012, and no shares were issued during the three-month period ended June 30, 2011. We estimate the value of the employee stock purchase rights on the date of grant using the Black-Scholes model.

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

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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 values of the common stock underlying stock options granted through the date of our initial public offering, (“IPO”), were estimated by our board of directors, which intended all options granted to be exercisable at a price per share not less than the per share fair value of our common stock underlying those options on the date of grant. The fair value of the shares of common stock underlying the stock options has historically been the responsibility of and determined by our board of directors. Because there was no public market for our common stock, our board of directors determined fair value of the common stock at the time of grant of the option by considering a number of objective and subjective factors including independent third-party valuations of our common stock, sales of convertible preferred stock to unrelated third parties, operating and financial performance, the lack of liquidity of capital stock and general and industry specific economic outlook, amongst other factors. The fair value of the underlying common stock was determined by our board of directors until such time as our common stock was publicly traded. Our common stock became publicly listed upon our IPO from which time options granted are issued with a strike price equal to the closing price on the date of grant.

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

Expected term — Expected term represents the period that our stock-based awards are expected to be outstanding. Our assumptions about the expected term have been on our historic cancellation and exercise experience and trends as well as our expectations for future periods.

Expected volatility — We do not have sufficient trading history to solely rely on the volatility of our own common stock for establishing expected volatility. Therefore, we based our expected volatility on the historical stock volatilities of our common stock as well as several comparable publicly listed companies over a period equal to the expected terms of the options.

Risk-free interest rate — The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for zero coupon U.S. Treasury notes with maturities approximately equal to the option’s expected term.

Expected dividend yield — We have never paid dividends and do not expect to pay dividends in the foreseeable future.

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Expected forfeiture rate — We estimate our forfeiture rate based on an analysis of our actual forfeitures and will continue to evaluate the adequacy of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover behavior and other factors. The impact from a forfeiture rate adjustment will be recognized in full in the period of adjustment, and if the actual number of future forfeitures differs from that estimated, we may be required to record adjustments to stock-based compensation expense in future periods.

7. Segment Reporting and Geographic Information

We are organized as, and operate in, one reportable segment: the development, manufacturing and marketing of an integrated platform for genetic analysis. Our chief operating decision-maker is our Chief Executive Officer. The Chief Executive Officer reviews financial information presented on a consolidated basis for purposes of evaluating financial performance and allocating resources, accompanied by information about revenue by geographic regions. Our assets are primarily located in the United States of America and not allocated to any specific region and we do not measure the performance of our geographic regions based upon asset-based metrics. Therefore, geographic information is presented only for revenue. Revenue by geographic region is based on the ship to address on the customer order.

As of June 30, 2012 and December 31, 2011, approximately 66% and 62%, respectively, of our accounts receivable were from domestic customers. As of June 30, 2012 and December 31, 2011, approximately 78% and 85%, respectively, of our net accounts receivable were from three and five individual customers, respectively, each representing at least 10% of our accounts receivable.

During the three- and six-month periods ended June 30, 2012, domestic revenue accounted for 52% and 34%, respectively, of total revenue. For the three- and six-month periods ended June 30, 2011, domestic revenue accounted for 87% of total revenue in both periods.

8. Litigation Settlements

In April 2012, the Company entered into a settlement agreement with Life Technologies Corporation to settle a complaint filed by Life Technologies Corporation seeking review of a patent interference decision of the U.S. Patent and Trademark Office. Additionally, in April 2012, the Company entered into a settlement and release agreement with Helicos Biosciences Corporation, or Helicos, and Arizona Science and Technology Enterprises LLC d/b/a Arizona Technology Enterprises, or AzTE, to resolve all existing patent litigation between the parties. The settlement terms with Helicos and AzTE also include other features such as worldwide, non-exclusive limited licenses for the Company to all patents owned by Helicos and the two asserted patents in-licensed by Helicos from AzTE in the field relevant to the Company’s current products, and a perpetual covenant not to sue. The Company determined the principal benefit of the settlement with Helicos and AzTE was the economic benefit of avoiding litigation expenses and that the value attributable to other settlement features was believed to be de minimus. No value was assigned to the licenses from Helicos and AzTE as the Company does not believe any of our current or future products would fall under any valid and enforceable claims in the licensed applications and patents.

As a result of these settlement agreements, we recorded a $1.8 million charge to selling, general and administrative expense during the first quarter of fiscal 2012. The payment of the $1.8 million was made during the six-month period ended June 30, 2012.

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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 RS instruments 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.

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Service costs include 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 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.

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Results of Operations

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