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CRAY > SEC Filings for CRAY > Form 10-Q on 26-Apr-2012All Recent SEC Filings

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Form 10-Q for CRAY INC


26-Apr-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Preliminary Note Regarding Forward-Looking Statements

This quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or if they prove incorrect, could cause our actual results to differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements are based on our management's beliefs and assumptions and on information currently available to them. In some cases you can identify forward-looking statements by terms such as "may," "will," "should," "could," "would," "expect," "plans," "anticipates," "believes," "estimates," "projects," "predicts" and "potential" and similar expressions, but the absence of these words does not mean that a statement is not forward-looking. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, and examples of forward-looking statements include any projections of earnings, revenue or other results of operations or financial results; any statements of the plans, strategies, objectives and beliefs of management of the Company; any statements concerning proposed new products, technologies or services; any statements regarding future research and development or co-funding for such efforts; any statements regarding future economic conditions; and any statements of assumptions underlying any of the foregoing. These forward-looking statements are 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 II and other sections of this report and our other filings with the U.S. Securities and Exchange Commission, or SEC, or Commission. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this report. You should read this report completely and with the understanding that our actual future results may be materially different from what we expect. We assume no obligation to update these forward-looking statements, whether as a result of new information, future events, or otherwise.

Overview

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 storage and data management, "big data" analytics, midrange HPC systems and custom engineered solutions.

Summary of First Three Months of 2012 Results

Total revenue increased $72.4 million for the first three months of 2012 compared to the first three months of 2011, from $39.9 million to $112.3 million, primarily due to the revenue for the upgrade at Oak Ridge National Laboratory being recognized in the first quarter of 2012.

Operating income was $8.4 million for the first three months of 2012 compared to a $0.9 million operating loss during the first three months of 2011. The increase was primarily attributable to higher revenues and gross profit, partially offset by fewer research and development co-funding credits. In the first three months of 2012, the total gross profit margin percentage decreased primarily as a result of lower service gross profit margin percentages. Our gross profit margin percentage often


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varies from quarter to quarter as a result of a few, large customer contracts where product revenue is recognized during a particular quarter. The service gross margin percentage was negatively impacted in the first three months of 2012 by higher incentive compensation expense and the percentage in the first three months of 2011 was high due to an additional $2.3 million in revenue recorded on a Custom Engineering contract where revenue was recorded on a cash basis.

Net cash provided from operating activities was $57.9 million for the first three months of 2012 compared to net cash provided by operations of $64.8 million for the first three months of 2011. Cash provided by operating activities in the first three months of 2012 was driven by large cash collections during the quarter from multiple customers that accepted large systems in the final three months of 2011 and first three months of 2012, particularly Oak Ridge National Laboratory. Cash balances, including restricted cash balances, were $112.3 million as of March 31, 2012 compared to $54.2 million as of December 31, 2011.

Market Overview and Challenges

Significant trends in the HPC industry include:

The commoditization of HPC hardware, particularly processors and system interconnects;

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 increase 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.

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 and accelerators, 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 expertise 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, our 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 and data management, "big data" analytics, midrange HPC systems and custom engineered solutions.

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 from a small number of transactions generally constitutes the major portion of our revenue in any reporting period and, for the reasons discussed elsewhere in this quarterly report on Form 10-Q, 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 periods 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


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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 and 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 increased from 32% for the three months ended March 31, 2011 to 40% during the same period in 2012 principally due to certain large, higher margin transactions, that also benefited from lower than anticipated component costs, in the first three months of 2012. Service gross profit margin decreased from 51% for the three months ended March 31, 2011 to 41% for the three months ended March 31, 2012. The decrease in service gross profit margin is due to higher incentive compensation expense in the first three months of 2012 and an additional $2.3 million in revenue recorded on a Custom Engineering contract in the first three months of 2011 where revenue was recorded on a cash basis.

Operating expenses. Our operating expenses are driven largely by headcount, the level of recognized co-funding for research and development and contracted third-party research and development services. The level of government co-funding can vary significantly from quarter to quarter and year to year as we do not record a receivable from the U.S. government prior to completing the requirements necessary to bill for a milestone or cost reimbursement largely due to varying milestone schedules, milestone completion risk and because funding from the U.S. government is subject to certain budget restrictions. Operating expenses for the three months ended March 31, 2012 were $18.7 million higher than for the same period in 2011, increasing from $18.1 million to $36.8 million. The increase in operating expenses was caused by higher incentive compensation of $3.8 million and $12.5 million less in recognized co-funding for research and development.

Liquidity and cash flows. Due to the variability in cash collections due to the timing of new contracts, product deliveries and acceptances, our cash position varies significantly from quarter to quarter and within a quarter. We closely 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. Sustained profitability over annual periods is our primary objective and should improve our cash position.

Results of Operations

Revenue and Gross Profit Margins

Our revenue, cost of revenue and gross profit margin for the three months ended
March 31, 2012 and 2011, respectively, were (in thousands, except for
percentages):



                                                 Three Months Ended
                                                      March 31,
                                                 2012           2011
               Product revenue                 $  95,977      $ 16,696
               Less: Cost of product revenue      57,550        11,317

               Product gross profit            $  38,427      $  5,379

               Product gross profit margin            40 %          32 %
               Service revenue                 $  16,330      $ 23,171
               Less: Cost of service revenue       9,601        11,350

               Service gross profit            $   6,729      $ 11,821

               Service gross profit margin            41 %          51 %
               Total revenue                   $ 112,307      $ 39,867
               Less: Total cost of revenue        67,151        22,667

               Gross profit                    $  45,156      $ 17,200

               Gross profit margin                    40 %          43 %

Product Revenue

Product revenue for the three months ended March 31, 2012 was $96.0 million, primarily from sales of Cray XK6 and Cray XE6 systems. Product revenue for the three months ended March 31, 2011 was $16.7 million, primarily from sales of Cray XE6 systems. Product revenue for the three months ended March 31, 2012 increased by $79.3 million over the same prior year period primarily due to revenue of approximately $65 million for the upgrade at Oak Ridge National Laboratory being recognized in the first quarter of 2012.


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Service Revenue

Service revenue for the three months ended March 31, 2012 was $16.3 million compared to $23.2 million for the same period in 2011. The decrease in service revenue is due to lower service revenue from our former Custom Engineering practices, particularly Special Purpose systems.

Cost of Product Revenue and Product Gross Profit

For the three months ended March 31, 2012, product gross profit increased $33.0 million, while product gross profit margin increased 8 percentage points to 40% compared to the same period in 2011. The increase in product gross profit was primarily due to the acceptance at Oak Ridge National Laboratory in the first three months of 2012. The gross profit margin percentage increase was driven by certain higher margin contracts, lower component costs and value realized from returned systems. These gross profit margin benefits were partially offset by a loss recorded on the write-off of inventory of approximately $1.5 million.

Cost of Service Revenue and Service Gross Profit

Cost of service revenue decreased $1.7 million during the three months ended March 31, 2012 compared to the same period in 2011, due to lower service revenue in Custom Engineering. Service gross profit margin percentage decreased by 10 percentage points for the three month period ended March 31, 2012 to 41% as compared to the same period in 2011. The decrease in service gross profit margin percentage is due to higher incentive compensation expense in the first three months of 2012 and an additional $2.3 million in revenue recorded on a Custom Engineering contract in the first three months of 2011where revenue was recorded on a cash basis as our ability to collect payment was not reasonably assured and the related costs were incurred in a prior period.

Research and Development Expenses

Research and development expenses for the three months ended March 31, 2012 and
2011, respectively, were (in thousands, except for percentages):



                                                                   Three Months Ended
                                                                       March 31,
                                                                  2012           2011
Gross research and development expenses                         $ 24,021       $  19,218
Less: Amounts included in cost of revenue                           (109 )          (108 )
Less: Reimbursed research and development (excludes amounts
in cost of revenue)                                                 (162 )       (12,654 )

Net research and development expenses                           $ 23,750       $   6,456

Percentage of total revenue                                           21 %            16 %

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 engineering expenses.

For the three months ended March 31, 2012, gross research and development expenses increased $4.8 million from the same period in 2011, due to higher headcount and higher incentive compensation. Net research and development expenses increased $17.3 million, primarily due to $12.5 million less in co-funding. Research and development amounts included in cost of revenue were $0.1 million for the first three months of 2012 and 2011.

In October 2011, we amended the Phase III agreement with the Defense Advances Research Projects Agency (DARPA). As with the previous Phase III agreement, 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 down to $180.0 million. As of March 31, 2012, we had earned and received $158.0 million of reimbursement under the DARPA Phase III agreement, leaving $22 million to be earned and received. Assuming our development plans remain on schedule, we expect to earn and receive the remaining $22 million in 2012.


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Sales and Marketing and General and Administrative Expenses

Our sales and marketing and general and administrative expenses for the three
months ended March 31, 2012 and 2011, respectively, were (in thousands, except
for percentages):



                                                Three Months Ended
                                                     March 31,
                                                2012           2011
                Sales and marketing           $   7,873       $ 6,356
                Percentage of total revenue           7 %          16 %
                General and administrative    $   5,130       $ 4,137
                Percentage of total revenue           5 %          10 %

Sales and Marketing. Sales and marketing expense for the three months ended March 31, 2012 increased by $1.5 million from the same period in 2011, primarily due to increased headcount, higher commissions and higher incentive compensation.

General and Administrative. General and administrative expenses for the three months ended March 31, 2012 increased $1.0 million from the same period in 2011, primarily due to higher incentive compensation.

Restructuring

We eliminated approximately 50 positions in the first three months of 2011 and recorded a restructuring charge of $1.1 million. The restructuring was designed to rebalance our headcount to areas of more need in the future such as software development, custom engineering and customer service, and in select international geographies.

Other Income (Expense), net

For the three months ended March 31, 2012, we recognized net other income of $0.2 million compared to net other expense of $0.5 million for the same period in 2011. Net other income for the three months ended March 31, 2012 was principally the result of foreign currency transaction gains. Net other expense for the three months ended March 31, 2011 was principally the result of foreign currency transaction losses.

Interest Income (Expense)

Our interest income and interest expense for the three months ended March 31,
2012 and 2011, respectively, were (in thousands):



                                                 Three Months Ended
                                                      March 31,
                                                 2012            2011
               Interest income                 $     32         $   36
               Interest expense                     (33 )          (19 )

               Net interest income (expense)   $     (1 )       $   17

Taxes

Cray's effective tax rates were approximately 42% and negative 7% for the three months ended March 31, 2012 and 2011 respectively. The vast majority of our income tax expense will not be paid in cash as it is offset by net operating loss carryforwards that were generated in previous periods. Our effective tax rate for the three months ended March 31, 2012 was higher than the U.S. federal statutory rate primarily as a result of state taxes. Our effective tax rate for the three months ended March 31, 2011 was significantly lower that the U.S. federal statutory rate primarily as a result of the maintenance of a full valuation allowance against our U.S. deferred tax assets.

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 are 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.


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We received acceptances on a large number of systems in the final three months of 2011 and the first three months of 2012. The final payments for many of these systems were received in the first three months of 2012, including a relatively large payment from Oak Ridge National Laboratory, which resulted in an increase in cash and cash equivalents and restricted cash of $58.1 million from December 31, 2011 to March 31, 2012. These cash collections, largely offset by new advance billings on certain large systems being built in 2012, decreased accounts and other receivables from $72.4 million at December 31, 2011 to $63.9 million at March 31, 2012. Inventory increased from $97.9 million at December 31, 2011 to $121.2 million at March 31, 2012 as we build certain large systems to be installed in 2012, particularly the system for the National Center for Supercomputing Applications (NCSA). The current portion of deferred revenues increased to $82.1 million as of March 31, 2012 from $44.6 million at December 31, 2011, resulting principally from contractual rights to bill certain customers for a portion of the contract before full customer acceptance and related revenue recognition.

Cash and cash equivalents and restricted cash totaled $112.3 million at March 31, 2012 compared to $54.2 million at December 31, 2011. As of March 31, 2012, we had working capital of $146.7 million compared to $137.7 million as of December 31, 2011.

Cash flow information includes the following (in thousands):

                                                Three Months Ended
                                                     March 31,
                                                2012           2011
                Cash provided by (used in):
                Operating Activities          $  57,927      $ 64,838
                Investing Activities          $    (482 )    $   (976 )
                Financing Activities          $     766      $    561

Operating Activities. Net cash provided by operating activities was $57.9 million in the three months ended March 31, 2012 compared to net cash provided by operating activities of $64.8 million in the same period in 2011. For the three months ended March 31, 2012, cash provided by operating activities was principally the result of cash collections, including a relatively large payment from Oak Ridge National Laboratory, partially offset by purchases of inventory. For the three months ended March 31, 2011, cash provided by operating activities was principally the result of a large decrease in accounts receivable due to the receipt of final payments related to fourth quarter 2010 acceptances of multiple large systems.

Investing Activities. Net cash used in investing activities was $0.5 million in the first three months of 2012 compared to net cash used in investing activities of $1.0 million in the same period in 2011. For the three months ended March 31, 2012, net cash used in investing activities was due to purchases of property and equipment, partially offset by a decrease in restricted cash. For the three months ended March 31, 2011, net cash used in investing activities was due to purchases of property and equipment.

Financing Activities. Net cash provided by financing activities was $0.8 million in the three months ending March 31, 2012 compared to net cash provided by financing activities of $0.6 million in the same quarter in 2011. For the three months ended March 31, 2012 and March 31, 2011, cash provided by financing activities related to proceeds from stock option exercises and stock purchases pursuant to our employee stock purchase plan.

Over the next twelve months, we expect our significant cash requirements will relate to operational expenses, consisting primarily of personnel costs, costs of inventory associated with certain large-scale product deliveries, spare parts, and the acquisition of property and equipment. In addition, we lease certain equipment and facilities used in our operations under operating leases in the normal course of business. The following table summarizes our contractual cash obligations as of March 31, 2012 (in thousands):

                                                             Amounts Committed by Year
                                                         2012
                                                      (Less than       2013 -       2015 -
Contractual Obligations                 Total          1 Year)          2014         2016         Thereafter
Development agreements                 $  3,818      $      3,495      $   323      $    -       $         -
Operating leases                         25,367             3,232        8,049        7,434             6,652

Total contractual cash obligations     $ 29,185      $      6,727      $ 8,372      $ 7,434      $      6,652

We have a line of credit with Wells Fargo Bank, National Association of $3.5 million which has a maturity date of June 1, 2012. We also have a secured line of credit with Silicon Valley Bank in the amount of $25.0 million. The first $15.0 . . .

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