Market Overview and Challenges
Significant trends in the HPC industry include:
• Supercomputing with many-core commodity processors driving increasing scalability requirements;

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

• Data needs growing faster than computational needs;

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

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

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

• Cloud Computing for cost-effective computing on loosely-coupled HPC applications.

Several of these trends have resulted in the expansion and acceptance of loosely-coupled cluster systems using processors manufactured by Intel, AMD and others combined with commercially available, low cost, 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, and most scalable systems, those often 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 graphics processing units and field programmable gate arrays , 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 whose applications demand these tightly-coupled architectures. 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 have begun 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 and data management and "Big Data" analytics. We have also recently significantly expanded our addressable market with the acquisition of Appro. Appro provides cluster systems and solutions to the HPC market. Appro had the third-highest number of systems in the top 100 of the November 2012 Top500 Supercomputer Sites ranking. Appro became Cray Cluster Solutions, or CCS, following the acquisition.

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 XC30 and the addition of CCS products, along with longer-term product roadmap are efforts to increase product revenue. We are also increasing our business and product development efforts in storage and data management, "Big Data" analytics, technical enterprise 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 2011 and 2012. The new cluster systems products typically have lower gross margins than our other products, which is somewhat offset by lower operating costs. Service gross profit margin decreased from 49% in 2011 to 43% in 2012. The decrease in service gross profit margin is due to higher incentive compensation expense and an additional $6.2 million in revenue recorded on a Custom Engineering contract in 2011 where revenue was recognized on the cash basis, and the associated costs were recorded in prior periods, as our ability to collect payment was not reasonably assured. The decrease in our service gross margin drove the decrease in our total gross profit margin from 40% in 2011 to 36% in 2012.
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 expense. 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. The net proceeds from the sale of our interconnect hardware development program to Intel of $139.2 million in 2012 substantially increased our liquidity position.

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,
                                     2012         2011         2010
Product revenue                   $ 353,767    $ 155,561    $ 239,085
Less: Cost of product revenue       231,237      101,000      155,027
Product gross profit              $ 122,530    $  54,561    $  84,058
Product gross profit percentage      35%          35%          35%

Service revenue                      67,291       80,485       80,303
Less: Cost of service revenue        38,643       40,680       54,404
Service gross profit              $  28,648    $  39,805    $  25,899
Service gross profit percentage      43%          49%          32%

Total revenue                     $ 421,058    $ 236,046    $ 319,388
Less: Total cost of revenue         269,880      141,680      209,431
Total gross profit                $ 151,178    $  94,366    $ 109,957
Total gross profit percentage        36%          40%          34%

Product Revenue
Product revenue in 2012 increased $198.2 million, or 127%, over 2011 principally as the result of two significant system acceptances, one at NCSA at the University of Illinois (Blue Waters) and another for the first phase of the upgrade at the Oak Ridge National Laboratory. Additionally, revenue from our Storage and Data Management business unit increased from $7.2 million in 2011 to $50.2 million in 2012. A large portion of Storage and Data Management revenues in 2012 were attributable to the Blue Waters system at the University of Illinois.
Product revenue in 2011 decreased $83.5 million, or 35%, over 2010 principally due to our inability to complete the acceptance process of the first phase of the upgrade at the Oak Ridge National Laboratory in 2011, which resulted in a delay in the recognition of the associated revenue until 2012. Additionally, revenue from sales of our external storage systems was lower in 2011 as fewer customers implemented large storage systems during the year. Service Revenue
Service revenue for 2012 decreased $13.2 million from 2011. Service revenue decreased in part due to an additional $6.2 million in revenue recorded on a Custom Engineering contract in 2011, as revenue was recognized on the cash basis as our ability to collect payment was not reasonably assured in 2010. 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 where revenue was recognized on the cash basis as our ability to collect payment was not reasonably assured.
Cost of Product Revenue and Product Gross Profit Cost of product revenue for 2012 increased by $130.2 million compared to 2011 driven by significantly higher product revenue. Product gross profit percentage was 35% in 2012 and 2011.
Product gross profit percentage was unchanged at 35% in 2011 and 2010. 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.
Cost of Service Revenue and Service Gross Profit Cost of service revenue decreased $2.0 million and service gross profit margin decreased by six percentage points to 43% in 2012 compared to 2011. Gross profit margin from services was lower in 2012 compared to 2011 due to an additional $6.2 million in revenue in 2011 recorded on a Custom Engineering contract where revenue was being recorded on a cash basis, and the associated costs were recorded in prior periods, as the Company's ability to collect payment was not reasonably assured, as well as $2.1 million in higher incentive compensation in 2012.

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

                                                      2012           2011           2010
Gross research and development expenses           $   86,305     $   76,993     $   82,525
Less: Amounts included in cost of revenue             (1,080 )         (410 )          (79 )
Less: Reimbursed research and development
(excludes amounts in revenue)                        (20,922 )      (27,131 )      (38,828 )
Net research and development expenses             $   64,303     $   49,452     $   43,618
Percentage of total revenue                           15%            21%            14%

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 2012, the Company's Phase III agreement with DARPA was amended to eliminate certain deliverables and reduce the co-funding amount to $178.5 million. As of December 31, 2012, the DARPA Phase III agreement was substantially complete and we have received all $178.5 million in reimbursement.
In 2012, gross research and development expenses increased $9.3 million from 2011 levels primarily due to increased investments in the development of new products for our new initiatives as well as $5.8 million in additional incentive based compensation expense. Reimbursed research and development decreased $6.2 million in 2012 compared to 2011 primarily due to $3.5 million less in reimbursements recognized in connection with our DARPA HPCS Phase III project. 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. 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,
                                2012        2011        2010
Sales and marketing           $ 37,180    $ 26,134    $ 31,085
Percentage of total revenue      9%          11%         10%
General and administrative    $ 20,707    $ 15,840    $ 17,767
Percentage of total revenue      5%          7%          6%
Restructuring                     -       $  1,783        -
Percentage of total revenue       -          1%           -

Sales and Marketing. The $11.0 million increase in sales and marketing expenses in 2012 compared to 2011 was due to higher headcount and $4.5 million in additional incentive-based compensation and commissions.
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.

General and Administrative. The $4.9 million increase in general and administrative expenses in 2012 compared to 2011 was partly due to $2.5 million higher incentive-based compensation and $0.9 million of costs incurred for the Appro acquisition.
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.
Restructuring. Restructuring expenses in 2011 were primarily due to the elimination of positions in our workforce rebalancing. 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 year ended December 31, 2012. Other Income (Expense), Net
We recorded $0.5 million in net other income and $1.0 million and $0.8 million of net other expense for the years ended December 31, 2012, 2011 and 2010, respectively, principally due to foreign exchange transaction gains and losses. Interest Income (Expense), Net
Our interest income and interest expense for the years ended December 31 were (in thousands):

                                     Year Ended December 31,
                                   2012          2011      2010
Interest income                 $    397       $  229     $ 485
Interest expense                    (193 )       (262 )    (266 )
Net interest income (expense)   $    204       $  (33 )   $ 219

Interest income in 2012 increased as compared to 2011 due to higher average invested balances. Interest income in 2011 decreased as compared to 2010 due to lower average invested balances and lower short-term interest rates. Interest expense decreased modestly in 2012 as a result of changes in our credit arrangements. Interest expense in 2011 was consistent with 2010. Taxes
We recorded income tax benefit (expense) for the years ended December 31 as follows (in thousands):

                                         Year Ended December 31,
                                     2012          2011         2010
Net income before income taxes   $ 168,732      $    135     $ 16,940
Tax benefit (expense)               (7,491 )      14,194       (1,878 )
Net income                       $ 161,241      $ 14,329     $ 15,062
Effective tax rate                      (4 )%     10,514 %        (11 )%

The primary reason for the difference between the income tax provision at the federal statutory rate of 35.0% and our effective income tax rate of (4)% for the year ended December 31, 2012 is that the 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 restructuring a subsidiary, resulted in our ability to experience a relatively small tax consequence from the sale. The tax benefit recorded by us during the year ended December 31, 2011 was primarily attributable to a partial reduction, in the amount of $13.9 million, of the valuation allowance held against our U.S. deferred tax assets and the complete reduction, in the amount of $0.8 million, of the valuation allowance held against the deferred tax assets of the Company's German subsidiary. Income tax expense recorded in 2010 related primarily to income taxes payable.
During the year ended December 31, 2012, we reduced the valuation allowance held against our deferred tax assets by $18.4 million as a result of the sale of the Company's interconnect hardware development program. The Company further reduced the valuation allowance held against its U.S. deferred tax assets by $10.7 million during the year ended December 31, 2012 due to actual income from operations during the year ended December 31, 2012 exceeding amounts previously used in the evaluation of the realizability of the Company's deferred tax assets at the beginning of the year and based upon an assessment of all positive

and negative evidence relating to future years, including changes resulting from the Company's acquisition of Appro. We consider our actual historical results over several years to have stronger weight than other more subjective indicators when considering whether to establish or reduce a valuation allowance on deferred tax assets. The 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 and competitive change in the industry in which we operate. Our conclusion about the realizability of our deferred tax assets, and therefore the appropriateness of the valuation allowance, is 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, 2012, we had federal income tax net operating loss carryforwards of approximately $153.7 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. Cash and cash equivalents and restricted cash increased by $198.9 million from December 31, 2011 to December 31, 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 such as the NCSA Blue Waters system and the first phase of the upgrade at Oak Ridge National Laboratory. Partially offsetting these items were the net cash used in the Appro acquisition of $24.2 million and the purchases of debt instruments of others of $70.2 million. No debt securities were held at December 31, 2011.
Accrued payroll and related expenses increased from $11.3 million at December 31, 2011 to $25.9 million at December 31, 2012 primarily due to higher accruals for incentive compensation expense. The current portion of deferred . . .