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 the Linux operating
          system and more capable open source software;


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


•         Electrical power requirements becoming a design constraint and major
          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" solutions.

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 a more dominant factor in HPC procurements outside of the high-end supercomputer market segment where Cray focuses.
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 (GPUs), 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.
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 nine months ended September 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 51% for the nine months ended September 30, 2011 to 44% for the nine months ended September 30, 2012. The decrease in service gross profit margin was due to higher incentive compensation

expense in 2012 and an additional $5.7 million in revenue recorded on a Custom Engineering contract in the first nine months of 2011 where revenue was recorded on the cash basis as our ability to collect payment was not reasonably assured and the related costs were incurred in a prior period.
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 expense 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 expense, excluding sales commissions, is recorded based on year-to-date operating income relative to the expected full year operating income. Operating expenses for the nine months ended September 30, 2012 were $8.9 million higher than for the same period in 2011, increasing from $75.3 million to $84.2 million. The increase in operating expenses was caused by higher incentive compensation expense, higher commissions and investments in new initiatives. These were partially offset by a $0.9 million increase in recognized co-funding research and development credits in 2012 and a non-recurring restructuring expense of $1.9 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 nine months ended September 30, 2012 and 2011, respectively, were (in thousands, except for percentages):

                                 Three Months Ended          Nine Months Ended
                                   September 30,               September 30,
                                 2012          2011         2012          2011
Product revenue               $  18,313     $ 15,988     $ 182,806     $  80,338
Less: Cost of product revenue    10,474       11,151       107,545        54,106
Product gross profit          $   7,839     $  4,837     $  75,261     $  26,232
Product gross profit margin          43 %         30 %          41 %          33 %
Service revenue               $  17,426     $ 20,717     $  49,423     $  64,154
Less: Cost of service revenue     7,933        9,270        27,701        31,148
Service gross profit          $   9,493     $ 11,447     $  21,722     $  33,006
Service gross profit margin          54 %         55 %          44 %          51 %
Total revenue                 $  35,739     $ 36,705     $ 232,229     $ 144,492
Less: Total cost of revenue      18,407       20,421       135,246        85,254
Total gross profit            $  17,332     $ 16,284     $  96,983     $  59,238
Total gross profit margin            48 %         44 %          42 %          41 %

Product Revenue
Product revenue for the three and nine months ended September 30, 2012 was $18.3 million and $182.8 million, respectively, primarily from sales of Cray XE6, Cray XK6 and Sonexion storage systems. Product revenue for the three and nine months ended September 30, 2011 was $16.0 million and $80.3 million, respectively, primarily from sales of Cray XE

systems and XE system upgrades. Product revenue for the nine months ended September 30, 2012 was significantly higher than the prior year period primarily due to the recognition of revenue for several large systems in the nine months ended September 30, 2012, including revenue for a significant product sale to a commercial customer and revenue of approximately $65 million for the first phase of the upgrade at Oak Ridge National Laboratory. Service Revenue
Service revenue for the three months ended September 30, 2012 was $17.4 million compared to $20.7 million for the same period in 2011. Service revenue for the nine months ended September 30, 2012 was $49.4 million compared to $64.2 million for the same period in 2011, a decrease of $14.7 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 nine months ended September 30, 2012, cost of product revenue decreased $0.7 million and increased $53.4 million, respectively, as a result of higher product revenues from the same period in 2011. For the three months ended September 30, 2012, product gross profit margin increased 13 percentage points to 43% from the same period in 2011. The increase in product gross profit margin for the three months ended September 30, 2012 was attributable to a small number of higher margin transactions and lower costs on certain commodity components. 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 $1.3 million and service gross profit margin decreased 1 percentage point to 54% during the three months ended September 30, 2012 compared to the same period in 2011. For the nine months ended September 30, 2012, cost of service revenue decreased $3.4 million and service gross profit margin decreased by 7 percentage points to 44% 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 $5.7 million in revenue recorded on a Custom Engineering contract in the first nine 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 nine months ended September 30, 2012 and 2011, respectively, were (in thousands, except for percentages):

                                             Three Months Ended            Nine Months Ended
                                                September 30,                September 30,
                                             2012           2011          2012          2011
Gross research and development expenses  $    15,587     $  19,030     $  61,623     $  57,435
Less: Amounts included in cost of
revenue                                         (104 )        (103 )        (335 )        (320 )
Less: Reimbursed research and
development (excludes amounts in cost of
revenue)                                           -          (978 )     (15,162 )     (14,246 )
Net research and development expenses    $    15,483     $  17,949     $  46,126     $  42,869
Percentage of total revenue                       43 %          49 %          20 %          30 %

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 September 30, 2012, gross research and development expenses decreased $3.4 million partially due to the reversal of a portion of accrued bonuses due to the operating loss during the three months ended September 30, 2012. For the nine months ended September 30, 2012, gross research and development expenses increased $4.2 million from the same period in 2011, due to higher research and development on our YarcData uRiKA product and higher incentive compensation expense. The total of reimbursed research and development expense and amounts included in cost of revenue increased $0.9 million for the nine September 30, 2012 compared to the same period 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.

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 September 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. Sales and Marketing and General and Administrative Expenses Our sales and marketing and general and administrative expenses for the three and nine months ended September 30, 2012 and 2011, respectively, were (in thousands, except for percentages):

                               Three Months Ended         Nine Months Ended
                                 September 30,              September 30,
                                2012         2011         2012         2011
Sales and marketing         $   6,495      $ 6,233     $ 24,601     $ 18,962
Percentage of total revenue        18 %         17 %         11 %         13 %
General and administrative  $   3,324      $ 3,693     $ 13,425     $ 11,607
Percentage of total revenue         9 %         10 %          6 %          8 %

Sales and Marketing. Sales and marketing expense for the three months ended September 30, 2012 increased $0.3 million from the same period in 2011, primarily due to higher headcount and commissions. Sales and marketing expense for the nine months ended September 30, 2012 increased $5.6 million from the same period in 2011, primarily due to higher headcount, commissions, and accrued incentive compensation expense.
General and Administrative. General and administrative expense for the three months ended September 30, 2012 decreased by $0.4 million from the same period in 2011, primarily due to the reversal of a portion of accrued bonuses due to the operating loss during the quarter. General and administrative expense for the nine months ended September 30, 2012 increased by $1.8 million from the same period 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 $1.9 million for the nine months ended September 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 nine months ended September 30, 2012. Other Income (Expense), net
For the three months ended September 30, 2012 and 2011, we recognized net other income of $0.1 million and $13,000. For the nine months ended September 30, 2012, we recognized net other income of $0.6 million compared to net other expense of $0.3 million for the same period in 2011. Net other income and expense for the three and nine months ended September 30, 2012 and 2011 was principally the result of foreign currency transaction gains and losses.

Interest Income, net
Our interest income and interest expense for the three and nine months ended
September 30, 2012 and 2011, respectively, were (in thousands):

                        Three Months Ended          Nine Months Ended
                           September 30,              September 30,
                         2012          2011         2012          2011
Interest income      $     137       $    50     $    247       $  206
Interest expense           (29 )         (30 )       (103 )       (146 )
Interest income, net $     108       $    20     $    144       $   60

Taxes
Cray's effective tax rates were approximately (34)% and 4% for the three and nine months ended September 30, 2012 compared to 0% and 2%for the three and nine months ended September 30, 2011.
The primary reason for the difference between the expected statutory tax rate and our actual tax rate for the three months ended September 30, 2012 was the result of an increase in the expected realization of the Company's existing deferred tax assets during the year ending December 31, 2012 that were subject to valuation allowances. The primary reason for the difference between the expected statutory tax rate and the Company's actual tax rate for the nine months ended September 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 nine months ended September 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. 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 $177.6 million from December 31, 2011 to September 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 nine months 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 $169.2 . . .