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CRAY > SEC Filings for CRAY > Form 10-Q on 31-Jul-2012All Recent SEC Filings

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Form 10-Q for CRAY INC


31-Jul-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 our management; 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. 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" graph analytics, technical enterprise/midrange supercomputing systems and custom engineered solutions.


Table of Contents

Summary of First Six Months of 2012 Results

Total revenue increased $88.7 million for the first six months of 2012 compared to the first six months of 2011, from $107.8 million to $196.5 million, largely due to increased product revenue of $100.1 million. The increase in product revenue was primarily due to the revenue for the first phase of the upgrade at Oak Ridge National Laboratory that was recognized in the first three months of 2012. The increase in product revenue was partially offset by an $11.4 million decrease in service revenue, principally due to lower service revenue from our former Special Purpose Systems practice.

Net income for the first six months of 2012 was $152.4 million compared to a net loss of $4.4 million for the same period in 2011. The increase in net income was primarily attributable to the $139.1 million gain on the sale of our interconnect hardware development program to Intel and an increase in gross profit of $36.7 million. These were partially offset by an increase in income tax expense of $7.6 million and higher incentive compensation of $11.0 million.

Net cash provided by operating activities was $25.7 million for the first six months of 2012 compared to net cash provided by operating activities of $75.5 million for the first six months of 2011. Cash provided from operating activities in the first six months of 2012 was driven by large cash collections from multiple customers that accepted large systems in the fourth quarter of 2011 and first quarter of 2012, particularly the first phase of the upgrade at Oak Ridge National Laboratory. Cash provided by operating activities was partially offset by significant inventory purchases. Cash and cash equivalents, including restricted cash balances, were $223.0 million as of June 30, 2012 compared to $54.2 million as of December 31, 2011. The increase in cash and cash equivalents was principally from the $140 million in proceeds from the sale of our interconnect hardware development program and large cash collections, partially offset by a large increase in inventory.

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 use of accelerators, as the rate of per-core performance increase slows; and

Data needs growing faster than computational needs, which is driving the need for "Big Data".

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, such as Infiniband and Ethernet, 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 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" graph analytics through our YarcData subsidiary, technical enterprise/midrange supercomputing 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 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. We believe product revenue growth over several sequential 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 family and our longer-term product roadmap are efforts to increase product revenue. We also plan to increase our engineering services offerings and market new products, such as the Cray XE6m and successor systems, to increase revenue. 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 33% for the six months ended June 30, 2011 to 41% during the same period in 2012 principally due to a small number of high margin transactions and lower component costs. Service gross profit margin decreased from 50% for the six months ended June 30, 2011 to 38% for the six months ended June 30, 2012. The decrease in service gross profit margin was due to higher incentive compensation in 2012 and an additional $3.5 million in revenue recorded on a Custom Engineering contract in the first six months of 2011 where revenue was recorded on the cash basis as our ability to collect payment was not reasonably assured.

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 the level of incentive compensation accrued. 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. Incentive compensation, excluding sales commissions, is recorded based on year-to-date operating income relative to the expected full year operating income. Operating expenses for the six months ended June 30, 2012 were $12.1 million higher than for the same period in 2011, increasing from $46.7 million to $58.9 million. The increase in operating expenses was caused by higher incentive compensation of $8.8 million, higher commissions as well as investments in new initiatives. These were partially offset by a $1.9 million increase in recognized co-funding R&D credits in 2012 and a non-recurring restructuring expense of $1.2 million in 2011.

Liquidity and cash flows. Due to the variability in product revenue and new contracts, our cash position also 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

Our revenue, results of operations and cash balances are likely to fluctuate significantly from quarter-to-quarter. These fluctuations are due to such factors as the high average sales prices and limited number of sales of our products, the timing of purchase orders and product deliveries, the revenue recognition accounting policy of generally not recognizing product revenue until customer acceptance and other contractual provisions have been fulfilled, the timing of payments for product sales, maintenance services, government research and development funding, the impact of the timing of new products on customer orders, and purchases of inventory during periods of inventory build-up. As a result of these factors, revenue, gross margin, expenses, cash and inventory are expected to vary significantly from quarter-to-quarter and year-to-year.

Revenue and Gross Profit Margins

Our revenue, cost of revenue and gross profit margin for the three and six
months ended June 30, 2012 and 2011, respectively, were (in thousands, except
for percentages):



                                      Three Months Ended             Six Months Ended
                                           June 30,                      June 30,
                                      2012           2011          2012           2011
    Product revenue                 $  68,516      $ 47,654      $ 164,493      $  64,350
    Less: Cost of product revenue      39,521        31,638         97,071         42,955

    Product gross profit            $  28,995      $ 16,016      $  67,422      $  21,395

    Product gross profit margin            42 %          34 %           41 %           33 %
    Service revenue                 $  15,667      $ 20,266      $  31,997      $  43,437
    Less: Cost of service revenue      10,167        10,528         19,768         21,878

    Service gross profit            $   5,500      $  9,738      $  12,229      $  21,559

    Service gross profit margin            35 %          48 %           38 %           50 %
    Total revenue                   $  84,183      $ 67,920      $ 196,490      $ 107,787
    Less: Total cost of revenue        49,688        42,166        116,839         64,833

    Total gross profit              $  34,495      $ 25,754      $  79,651      $  42,954

    Total gross profit margin              41 %          38 %           41 %           40 %


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Product Revenue

Product revenue for the three and six months ended June 30, 2012 was $68.5 million and $164.5 million, respectively, primarily from sales of Cray XE6, Cray XK6 and Sonexion storage systems. Product revenue for the three and six months ended June 30, 2011 was $47.7 million and $64.4 million, respectively, primarily from sales of Cray XE systems and XE system upgrades. Product revenue for the six months ended June 30, 2012 was significantly higher than the prior year period primarily due to the recognition of revenue for several large systems in the six months ended June 30, 2012, including revenue of approximately $65 million for the first phase of the upgrade at Oak Ridge National Laboratory and a significant product sale to a commercial customer.

Service Revenue

Service revenue for the three months ended June 30, 2012 was $15.7 million compared to $20.3 million for the same period in 2011. Service revenue for the six months ended June 30, 2012 was $32.0 million compared to $43.4 million for the same period in 2011, a decrease of $11.4 million. The decrease in service revenue was primarily 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 and six months ended June 30, 2012, cost of product revenue increased $7.9 million and $54.1 million, respectively, as a result of higher product revenues from the same period in 2011. For the three months ended June 30, 2012, product gross profit margin increased eight percentage points to 42% from the same period in 2011. The increase in product gross profit margin for the three months ended June 30, 2012 was attributable to a small number of large, higher margin transactions and lower costs on certain commodity components, partially offset by $0.8 million in inventory write-downs. Historical product gross profit margins may not be indicative of future results as product gross profit margins can vary significantly between contracts for many reasons.

Cost of Service Revenue and Service Gross Profit

Cost of service revenue decreased $0.4 million and service gross profit margin decreased by 13 percentage points to 35% during the three months ended June 30, 2012 compared to the same period in 2011. For the six months ended June 30, 2012, cost of service revenue decreased $2.1 million and service gross profit margin decreased by 12 percentage points to 38% compared to the same period in 2011. The decrease in service gross profit margin percentage was due to higher incentive compensation expense in 2012 and an additional $3.5 million in revenue recorded on a Custom Engineering contract in the first six 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 and six months ended June 30,
2012 and 2011, respectively, were (in thousands, except for percentages):



                                                   Three Months Ended              Six Months Ended
                                                       June  30,                       June  30,
                                                  2012            2011           2012            2011
Gross research and development expenses         $  22,015       $ 19,187       $  46,037       $  38,405
Less: Amounts included in cost of revenue            (122 )         (108 )          (232 )          (216 )
Less: Reimbursed research and development
(excludes amounts in cost of revenue)             (15,000 )         (615 )       (15,162 )       (13,269 )

Net research and development expenses           $   6,893       $ 18,464       $  30,643       $  24,920

Percentage of total revenue                             8 %           27 %            16 %            23 %

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 and six months ended June 30, 2012, gross research and development expenses increased $2.8 million and $7.6 million, respectively, from the same period in 2011, due to higher research and development on our uRiKA product and higher incentive compensation. The total of reimbursed research and development expense and amounts included in cost of revenue increased $14.4 million and $1.9 million for the three and six months ended June 30, 2012, respectively, compared to the same periods in 2011, primarily due to higher reimbursement from our ongoing Defense Advanced Research Projects Agency, or DARPA, High Productivity Computing Systems program. As a result of the sale of our interconnect hardware intellectual property and the transfer of 73 personnel to Intel, we currently expect that gross research and development expenses should be somewhat lower for the remainder of 2012.


Table of Contents

In October 2011, we amended the Phase III agreement with 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 June 30, 2012, we had earned and received $173.0 million of reimbursement under the DARPA Phase III agreement, leaving $7.0 million to be earned and received. Assuming our development plans remain on schedule, we expect to earn the remaining $7.0 million in the fourth quarter of 2012.

Sales and Marketing and General and Administrative Expenses

Our sales and marketing and general and administrative expenses for the three
and six months ended June 30, 2012 and 2011, respectively, were (in thousands,
except for percentages):



                                      Three Months Ended            Six Months Ended
                                           June  30,                    June 30,
                                       2012          2011          2012          2011
      Sales and marketing           $   10,233      $ 6,373      $ 18,106      $ 12,729
      Percentage of total revenue           12 %          9 %           9 %          12 %
      General and administrative    $    4,971      $ 3,777      $ 10,101      $  7,914
      Percentage of total revenue            6 %          6 %           5 %           7 %

Sales and Marketing. Sales and marketing expense for the three and six months ended June 30, 2012 increased $3.9 million and $5.4 million, respectively, from the same periods in 2011, primarily due to higher headcount, commissions, and accrued incentive compensation.

General and Administrative. General and administrative expense for the three and six months ended June 30, 2012 increased $1.2 million and $2.2 million, respectively, from the same periods in 2011, primarily due to higher accrued incentive compensation.

Restructuring

We eliminated approximately 50 positions in the first quarter of 2011 and recorded a restructuring charge of $1.2 million for the six months ended June 30, 2011. The restructuring was designed to rebalance our headcount to areas of more need in the future such as software development, "Big Data", storage, and customer service, and in select international geographies.

Sale of Interconnect Hardware Development Program

On May 2, 2012, we sold our interconnect hardware development program to Intel for cash consideration of $140 million. As part of the transaction, 73 of our employees joined Intel, and certain intellectual property and fixed assets were transferred to Intel. We retained certain rights to use the transferred assets and intellectual property. As a result of the sale, we recorded a gain of $139.1 million for the three and six month periods ended June 30, 2012.

Other Income (Expense), net

For the three months ended June 30, 2011 and 2012, we recognized net other income of $0.2 million. For the six months ended June 30, 2012, we recognized net other income of $0.5 million compared to net other expense of $0.4 million for the same period in 2011. Net other income and expense for the three and six months ended June 30, 2012 and 2011 was principally the result of foreign currency transaction gains and losses.


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Interest Income, net

Our interest income and interest expense for the three and six months ended
June 30, 2012 and 2011, respectively, were (in thousands):



                                   Three Months Ended           Six Months Ended
                                        June 30,                    June 30,
                                   2012            2011        2012           2011
          Interest income        $     79         $   76      $   110        $  156
          Interest expense            (42 )          (53 )        (74 )        (116 )

          Interest income, net   $     37         $   23      $    36        $   40

Taxes

Cray's effective tax rates were approximately 3% and 5% for the three and six months ended June 30, 2012 compared to (9%) and (8%) for the three and six months ended June 30, 2011.

The primary reason for the difference between the expected statutory rate of 35% and our actual tax rates of 3% and 5% for the three and six months ended June 30, 2012 was that our gain from the sale of our interconnect hardware development program did not result in significant income tax expense. We had existing deferred tax assets that were subject to valuation allowances and deductible temporary differences that were previously unrecognized. The sale of the interconnect hardware development program was never anticipated in previous evaluations of the realizability of our deferred tax assets and consequently the sale, together with a tax benefit that was recognized as a result of a restructuring of the Company's Canadian operations, resulted in our ability to experience a relatively small tax consequence from the sale.

Our effective tax rate for the three and six months ended June 30, 2011 was primarily attributable to foreign income taxes payable.

Liquidity and Capital Resources

We generate cash from operations predominantly from the sale of high performance computing systems and related services. We typically have a small number of significant contracts that make up the majority of total revenue. In the second quarter of 2012, we received proceeds of $140 million from the sale of our interconnect hardware development program. 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.

Cash and cash equivalents and restricted cash increased by $168.8 million from December 31, 2011 to June 30, 2012. The increase is attributable to the $140 million received from the sale of our interconnect hardware development program to Intel and large collections from systems that accepted in the fourth quarter of 2011 and the first quarter of 2012, including the first phase of the upgrade at Oak Ridge National Laboratory. Partially offsetting these items was an increase in inventory from $97.9 million at December 31, 2011 to $131.5 million at June 30, 2012. Accounts and other receivables also increased from $72.4 million at December 31, 2011 to $101.7 million at June 30, 2012.

Accrued payroll and related expenses increased from $11.3 million at December 31, 2011 to $19.6 million at June 30, 2012 primarily due to higher accruals for incentive compensation of $11.0 million. The current portion of deferred revenues increased to $83.3 million as of June 30, 2012 from $44.6 million at December 31, 2011, resulting principally from advance payments billed . . .

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