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CRAY > SEC Filings for CRAY > Form 10-K on 27-Feb-2012All Recent SEC Filings

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Form 10-K for CRAY INC


27-Feb-2012

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

The information set forth in "Management's Discussion and Analysis of Financial Condition and Results of Operations" below includes "forward-looking statements" as described in the section "Forward-Looking Statements" preceding Part I of this annual report on Form 10-K, and is subject to the safe harbor created by
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. 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 in Item 1A. Risk Factors in Part I and other sections of this report and our other filings with the Securities and Exchange Commission. The following discussion should also be read in conjunction with the Consolidated Financial Statements and accompanying Notes thereto.

Overview and Executive Summary

We design, develop, manufacture, market and service high-performance computing, or HPC, systems, commonly known as supercomputers, and provide storage solutions and engineering services related to HPC systems and solutions to our customers, which include government agencies, academic institutions and commercial entities. Our supercomputer systems provide capability and sustained performance far beyond typical server-based computer systems and address challenging scientific, engineering, commercial and national security computing problems. Our current strategy is to gain market share in the high-end supercomputer market segment, extend our technology leadership, maintain our focus on execution and profitability and expand our addressable market in areas where we can leverage our experience and technology, such as in storage & data management, "big data" analytics, midrange HPC systems and custom engineered solutions.

Summary of 2011 Results

Revenue decreased by $83.3 million in 2011 compared to 2010 to $236.0 million. Product revenue decreased by $83.5 million and service revenue increased by $0.2 million. The decrease in product revenue was principally the result of our inability to complete the acceptance process of the Cray XK6 upgrade at Oak Ridge National Laboratory due to supply issues related to a key component, which resulted in a delay in the recognition of the associated revenue. As our revenue is driven by relatively few, large transactions, significant variability in annual and quarterly results is expected. If the Oak Ridge National Laboratory acceptance had not been delayed, our 2011 revenue would have been approximately $65 million higher and the decreases in revenue and product revenue would have been less pronounced. Additionally, product revenue from sales of our external storage systems was lower in 2011. Gross profit margin from services was higher in 2011 compared to 2010 on approximately the same revenue. The higher service gross profit margin was partially attributable to higher margins on maintenance services due to an increased number of systems in the field with low associated variable costs. Also contributing to the increase in service gross profit margin was an additional $6.2 million in revenue recorded on a Custom Engineering contract in 2011, where the associated costs were recorded in prior periods, as revenue was recognized on the cash basis as our ability to collect payment was not reasonably assured.

We recorded income from operations of $1.2 million in 2011 compared to income from operations of $17.5 million in 2010. Total gross profit decreased $15.6 million in 2011 from 2010 due to lower product revenue. This was partially offset by higher gross profit on service revenue. Operating expenses increased $0.7 million principally due to lower reimbursements for research and development from our DARPA HPCS Phase III program, which was largely offset by lower incentive compensation expense and outside services expense. Incentive compensation costs are principally driven by pre-bonus operating income and, to a lesser extent, product revenue.

Net income decreased from $15.1 million in 2010 to $14.3 million in 2011. Net income in 2011 includes $14.7 million ($.41 per diluted share) attributable to a partial reduction of the valuation allowance held against our U.S. deferred tax assets and a complete reduction of the valuation allowance held against the deferred tax assets of our German subsidiary.

Net cash used in operations during 2011 was $3.8 million, as compared to net cash used in operations of $49.2 million in 2010. The decrease in net cash used in operations was principally due to higher collections from customers, partially offset by higher inventory levels on hand at the end of 2011.


Table of Contents

Market Overview and Challenges

Significant trends in the HPC industry include:

The commoditization of HPC hardware, particularly processors and interconnect systems;

The growing commoditization of software, including plentiful building blocks and more capable open source software;

Supercomputing with many-core commodity processors driving increasing scalability requirements;

Electrical power requirements becoming a design constraint and driver in total cost of ownership determinations;

Increased micro-architectural diversity, including increased usage of many-core processors and growing experimentation with accelerators, as the rate of per-core performance increases slows; and

Data needs growing faster than computational needs.

Several of these trends have resulted in the expansion and acceptance of lower-bandwidth cluster systems using processors manufactured by Intel, AMD and others combined with commercially available commodity networking and other components, particularly in the middle and lower segments of the HPC market. These systems may offer higher theoretical peak performance for equivalent cost, and "price/peak performance" is often the dominant factor in HPC procurements outside of the high-end supercomputer market segment. Vendors of such systems often put pricing pressure on us in competitive procurements.

In the markets for the largest systems, those costing significantly in excess of $3 million, the use of commodity components can result in increasing data transfer bottlenecks as these components do not balance processor power with network communication capability. With the arrival of increasing processor core counts due to new many-core processors, these unbalanced systems will typically have even lower productivity, especially in larger systems running more complex applications. We and other vendors have also begun to augment standard microprocessors with other processor types, such as field programmable gate arrays and graphics processing units, in order to increase computational power, further complicating programming models. In addition, with increasing scale, bandwidth and processor core counts, large computer systems use progressively higher amounts of power to operate and require special cooling capabilities.

To position ourselves to meet the market's demanding needs, we concentrate our research and development efforts on technologies that enable our supercomputers to perform at scale - that is, to continue to increase actual performance as systems grow ever larger in size - and in areas where we can leverage our core expertize in other markets. We also have demonstrated expertise in several processor technologies. We expect to be in a comparatively advantageous position as larger many-core processors become available and as multiple processing technologies become integrated into single systems in heterogeneous environments. In addition, we intend to expand our addressable market by leveraging our technologies and customer base, the Cray brand and industry trends by introducing complementary products and services to new and existing customers, as demonstrated by our emphasis on strategic initiatives, such as storage & data management, "big data" analytics, midrange HPC systems and custom engineered solutions.


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Key Performance Indicators

Our management monitors and analyzes several key performance indicators in order to manage our business and evaluate our financial and operating performance, including:

Revenue. Product revenue generally constitutes the major portion of our revenue in any reporting period and, for the reasons discussed elsewhere in this annual report on Form 10-K, is subject to significant variability from period to period. In the short term, we closely review the status of product shipments, installations and acceptances in order to forecast revenue and cash receipts; longer-term, we monitor the status of the pipeline of product sales opportunities and product development cycles. Product revenue growth over several quarters is an indicator of whether we are achieving our objective of increased market share in the supercomputing market. The introduction of the Cray XE and Cray XK families and our longer-term product roadmap are efforts to increase product revenue. We are also increasing our business and product development efforts on certain new initiatives such as storage & data management, "big data" analytics, midrange HPC systems and custom engineered solutions. Maintenance service revenue is more constant in the short term and assists, in part, to offset the impact that the variability in product revenue has on total revenue.

Gross profit margin. Our product gross profit margin was 35% in 2010 and 2011. Service gross profit margin increased from 32% in 2010 to 49% in 2011. The increase in service gross profit margin is due to higher margins from our maintenance services due to an increased number of systems in the field with low associated variable costs and an additional $6.2 million in revenue recorded on a Custom Engineering contract in 2011 where revenue was recognized on the cash basis, where the associated costs were recorded in prior periods, as our ability to collect payment was not reasonably assured. The increase in our service gross margin drove the increase in our total gross profit margin from 34% in 2010 to 40% in 2011.

Operating expenses. Our operating expenses are driven largely by headcount, the level of recognized co-funding for research and development, contracted third-party research and development services, and incentive compensation. As part of our ongoing efforts to control operating expenses, we monitor headcount levels in specific geographic and operational areas.

Liquidity and cash flows. Due to the variability in product revenue, new contracts, and payment terms, our cash position also varies significantly from quarter-to-quarter and within a quarter. We monitor our expected cash levels, particularly in light of increased inventory purchases for large system installations and the risk of delays in product shipments and acceptances and, longer-term, in product development. Cash receipts often lag customer acceptances and, because we had a number of large customer acceptances in the fourth quarter of 2011, we anticipate significant cash receipts in the first quarter of 2012.


Table of Contents

Results of Operations

Revenue and Gross Profit

Our product and service revenue for the indicated years ended December 31 were
(in thousands, except for percentages):



                                                  Year Ended December 31,
                                             2011          2010          2009
         Product revenue                   $ 155,561     $ 239,085     $ 199,114
         Less: Cost of product revenue       101,000       155,027       130,444

         Product gross profit              $  54,561     $  84,058     $  68,670

         Product gross profit percentage       35%           35%           34%
         Service revenue                   $  80,485     $  80,303     $  84,933
         Less: Cost of service revenue        40,680        54,404        47,719

         Service gross profit              $  39,805     $  25,899     $  37,214

         Service gross profit percentage       49%           32%           44%
         Total revenue                     $ 236,046     $ 319,388     $ 284,047
         Less: Total cost of revenue         141,680       209,431       178,163

         Total gross profit                $  94,366     $ 109,957     $ 105,884

         Total gross profit percentage         40%           34%           37%

Product Revenue

Product revenue in 2011 decreased $83.5 million, or 35%, over 2010 principally due to our inability to complete the acceptance process of the Cray XK6 upgrade at Oak Ridge National Laboratory in 2011, which resulted in a delay in the recognition of the associated revenue. Additionally, revenue from sales of our external storage systems was lower in 2011 as fewer customers implemented large storage systems during the year.

Product revenue in 2010 increased $40.0 million, or 20%, over 2009 due primarily to the release of the Cray XE6 system and higher external storage sales as part of our data management practice.

Service Revenue

Service revenue for 2011 increased $0.2 million from 2010. Lower revenues on certain Custom Engineering projects were offset by a $6.3 million increase in revenue from our Maintenance and Support group due to an increased number of systems in the field. Custom Engineering service revenue in 2011 included an additional $6.2 million in revenue recorded on a contract in 2011 where revenue was recognized on the cash basis as our ability to collect payment was not reasonably assured.

Service revenue for 2010 decreased $4.6 million, or 5%, from 2009 primarily due to our inability to record revenue on a Custom Engineering contract in 2010 for services that were performed but where not all revenue recognition criteria had been met.

Cost of Product Revenue and Product Gross Profit

Cost of product revenue for 2011 decreased by $54.0 million compared to 2010 driven by lower product revenue. Product gross profit percentage in 2011 was unchanged from the gross profit percentage in 2010 of 35%. Lower component costs, principally memory, contributed to maintaining product gross margin levels in 2011. This was partially offset by penalties incurred on 2011 product acceptances resulting from delays in the availability of a key component.

Product gross profit percentage improved one percentage point in 2010 compared to 2009. The improvement in product gross profit percentage was due to lower charges for excess and obsolete inventory of $0.9 million in 2010 compared to $5.4 million in 2009. Cost of product revenue increased $24.6 million due to higher product revenue partially offset by lower charges for excess and obsolete inventory.


Table of Contents

Cost of Service Revenue and Service Gross Profit

Cost of service revenue decreased $13.7 million and service gross profit margin increased by 17 percentage points to 49% in 2011 compared to 2010. The increase in service gross profit margin was due to increases in revenue from our Maintenance and Support group from the large systems that were accepted in the fourth quarter of 2010 with a minimal increase in costs and an additional $6.2 million in revenue in 2011 recorded on a Custom Engineering contract where revenue was being recorded on a cash basis, where the associated costs were recorded in prior periods, as the Company's ability to collect payment was not reasonably assured. The Company's workforce reductions in March 2011 and other cost reduction actions also contributed to an increase in service gross profit for 2011.

Service gross profit percentage declined 12 percentage points and cost of service revenue increased $6.7 million in 2010 as compared to 2009. Custom Engineering service revenue was negatively impacted by the transition of certain projects from development (service revenue) to production (product revenue). In addition, revenue was not recognized on a contract in 2010 for services that were performed but where not all revenue recognition criteria had been met, while related project costs were expensed in 2010.

Operating Expenses

Research and Development

Research and development expenses for the indicated years ended December 31 were
as follows (in thousands, except for percentages):



                                                   2011             2010             2009
Gross research and development expenses          $  76,993        $  82,525        $  91,874
Less: Amounts included in cost of revenue             (410 )            (79 )         (1,789 )
Less: Reimbursed research and development
(excludes amounts in revenue)                      (27,131 )        (38,828 )        (27,138 )

Net research and development expenses            $  49,452        $  43,618        $  62,947

Percentage of total revenue                          21%              14%              22%

Gross research and development expenses in the table above reflect all research and development expenditures. Research and development expenses include personnel expenses, depreciation, allocations for certain overhead expenses, software, prototype materials and outside contracted expenses.

In February 2010 and again in October 2011, we amended the Phase III agreement with DARPA. As with the previous contract, we expect to receive reimbursement after the achievement of a series of predefined milestones culminating in the delivery of a prototype system. Consistent with the changes, certain deliverables have been eliminated from the contract, reducing the overall scope and cost of the project. Pursuant to the amended contract, the full co-funding amount was revised to $180.0 million from $190 million. As of December 31, 2011, we had earned and received $158.0 million of reimbursement under the DARPA Phase III agreement, leaving $22 million to be earned and received. We expect to earn and receive the remaining $22 million in 2012.

In 2011, gross research and development expenses decreased $5.5 million from 2010 levels primarily due to decreased incentive based compensation expense and lower third-party service expenses, partially offset by higher salary expense resulting from higher headcount. Reimbursed research and development decreased $11.7 million in 2011 compared to 2010 due to $12.5 million less in reimbursements recognized in connection with our DARPA HPCS Phase III project as we passed two milestones in 2011 compared to three milestones in 2010.

In 2010, gross research and development expenses decreased $9.3 million from 2009 primarily due to lower spending on the DARPA HPCS Phase III project, as a result of lower third-party costs, primarily related to a modification in the DARPA contract, which was partially offset by higher incentive-based compensation expenses. Reimbursed research and development increased by $11.7 million in 2010 compared to 2009 due to higher DARPA HPCS Phase III reimbursements as we passed three milestones in 2010 compared to passing two milestones in 2009.


Table of Contents

Other Operating Expenses

Our sales and marketing and general and administrative expenses for the
indicated years ended December 31 were (in thousands, except for percentages):



                                              Year Ended December 31,
                                             2011      2010      2009
              Sales and marketing           $26,134   $31,085   $26,601
              Percentage of total revenue     11%       10%       9%
              General and administrative    $15,840   $17,767   $16,579
              Percentage of total revenue     7%        6%        6%
              Restructuring                 $1,783       -         -
              Percentage of total revenue     1%         -         -

Sales and Marketing. The $5.0 million decrease in sales and marketing expenses in 2011 compared to 2010 was due principally to lower incentive-based compensation and lower commissions.

The $4.5 million increase in sales and marketing expenses in 2010 compared to 2009 was due principally to $1.0 million in higher commissions on higher revenues, increased headcount in strategic initiatives and higher other incentive-based compensation.

General and Administrative. The $1.9 million decrease in general and administrative expenses in 2011 compared to 2010 was primarily due to lower incentive-based compensation and lower salary expense due to lower headcount.

The $1.2 million increase in general and administrative expenses in 2010 compared to 2009 was primarily due to higher incentive-based compensation.

Restructuring. Restructuring expenses in 2011 were primarily due to the elimination of positions in our workforce rebalancing announced in March 2011.

Other Expense, Net

We recorded $1.0 million and $0.8 million of net other expense for the years ended December 31, 2011 and 2010, respectively, principally due to foreign exchange transaction losses. For the year ended December 31, 2009, we recognized $0.4 million of net other expense due principally to foreign exchange transaction gains offset by a $0.9 million loss on the repurchase of $27.6 million principal amount of our 3.0% Convertible Senior Subordinated Notes due in 2024 ("Notes").

Interest Income (Expense), Net

Our interest income and interest expense for the years ended December 31 were
(in thousands):





                                                Year Ended December 31,
                                             2011        2010         2009
            Interest income                   $229        $485         $477
            Interest expense                  (262 )      (266 )      (1,282 )

            Net interest income (expense)   $  (33 )    $  219      $   (805 )

Interest income in 2011 decreased as compared to 2010 due to lower average invested balances and lower short-term interest rates. Interest income in 2010 was consistent with interest income in 2009. The higher interest expense in 2009 compared to 2011 and 2010 resulted from outstanding convertible debt that was fully repurchased in late 2009.

Taxes

We recorded an income tax benefit of $14.2 million in 2011, income tax expense of $1.9 million in 2010, and an income tax benefit of $0.9 million in 2009.


Table of Contents

An income tax benefit, in the amount of $14.7 million ($.41 per diluted share), was recorded in 2011 as a result of the partial reduction of the valuation allowance held against the Company's U.S. deferred tax assets, as well as to a much lesser extent the complete reduction of the valuation allowance held against the deferred tax assets of the Company's German subsidiary. The foregoing tax benefit was partially offset by income taxes due in the U.S. and certain foreign jurisdictions. Income tax expense recorded in 2010 related primarily to higher pre-tax earnings. The income tax benefit recorded in 2009 related primarily to the partial reduction of the valuation allowance held against the deferred tax assets of our Japanese subsidiary and a $0.7 million benefit recorded as a result of tax legislation that enabled a corporation to recover certain previously generated U.S. income tax credits, offset somewhat by income taxes due in the U.S. and various foreign jurisdictions.

The partial reduction of the valuation allowance held against the Company's U.S. deferred tax assets and the complete reduction of the valuation allowance held against the deferred tax assets of our German subsidiary was based upon an evaluation of all available positive and negative evidence. We consider our actual historical results over several years to have stronger weight than other more subjective indicators, including forecasts, when considering whether to establish or reduce a valuation allowance on deferred tax assets. As of December 31, 2011 we have generated cumulative pre-tax income in recent years. In addition to our cumulative income position, our assessment of our ability to utilize our deferred tax assets included an assessment of all known business risks and industry trends, as well as forecasted domestic and international earnings over a number of years. Our ability to forecast results significantly into the future is severely limited due to the rapid rate of technological change in the industry in which we operate. Included in our forecast was the impact of two unusually large contracts that were finalized during the fourth quarter of 2011; namely a $188.0 million contract with the University of Illinois National Center for Supercomputing Applications and a $97.0 million contract with the Department of Energy's Oak Ridge National Laboratory.

Our conclusion about the realizability of our deferred tax assets and therefore the appropriateness of the valuation allowance will be reviewed quarterly and could change in future periods depending on our future assessment of all available evidence in support of the likelihood of realization of our deferred tax assets.

As of December 31, 2011, we had federal income tax net operating loss carryforwards of approximately $215.9 million that will expire between 2019 through 2031, if not utilized.

Liquidity and Capital Resources

We generate cash from operations predominantly from the sale of high performance computer systems and related services. We typically have a small number of significant contracts that make up the majority of total revenue. The material changes in certain of our balance sheet accounts were due to the timing of product deliveries, customer acceptances, contractually determined billings and cash collections. Working capital requirements, including inventory purchases and normal capital expenditures, are generally funded with cash from operations.

Inventory increased from $49.2 million at December 31, 2010 to $97.9 million at December 31, 2011 as certain systems and system upgrades had been delivered to customer sites but had not completed the acceptance process as of December 31, 2011. Partially offsetting these impacts on our liquidity position has been a decrease in accounts and other receivables from $106.3 million at December 31, 2010 to $72.4 million at December 31, 2011 as we received a higher number of customer acceptances in the fourth quarter of 2010 than 2011. The final payments for these systems are not due until early in the following year.

In early 2012 we anticipate that our cash position will improve, at least in part, as we collect payment for the receivables related to significant system acceptances in late fourth quarter 2011 and in the first part of 2012.

Cash and cash equivalents and restricted cash totaled $54.2 million at December 31, 2011 compared to $61.3 million at December 31, 2010. As of December 31, 2011, we had working capital of $137.7 million compared to $125.4 million as of December 31, 2010.

Cash flow information for the years ended December 31 included the following (in thousands):

                                       2011          2010           2009
              Operating Activities   $ (3,823 )    $ (49,164 )    $  66,684
. . .
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