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(Registrant’s telephone number, including area code)
______________________________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨
Indicate by check mark whether the
registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated
filer,”“accelerated filer”“smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
ý
Accelerated filer
¨
Non-accelerated
filer
¨ (Do not check if a smaller reporting company)
Smaller reporting company
¨
Emerging growth company
¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards
provided pursuant to Section 13(a) of the Exchange Act ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No ý
As of April 28, 2017, there were 40,286,804 shares of Common Stock issued and outstanding.
CRAY
and SONEXION are registered trademarks of Cray Inc. in the United States and other countries. The CS and XC families of supercomputers, DataWarp and other Cray technologies are all trademarks of Cray Inc. Other trademarks used in this report are the property of their respective owners.
Available Information
Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports and proxy statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge at our website at www.cray.com as soon as reasonably practicable after we
electronically file such reports with the U.S. Securities and Exchange Commission.
Preferred stock — Authorized and undesignated, 5,000,000 shares; no shares issued or outstanding
—
—
Common stock and additional paid-in capital, par value $.01 per share — Authorized, 75,000,000 shares; issued and outstanding 40,300,399 and 40,757,458 shares,
respectively
NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1— Basis of Presentation
In these notes, Cray Inc. and its wholly-owned subsidiaries are collectively referred to as the “Company.” In the opinion of management, the accompanying Condensed Consolidated Balance Sheets, Statements of Operations, Statements of Comprehensive Loss, and Statements of Cash Flows have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by
GAAP for complete financial statements. Management believes that all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included. Interim results are not necessarily indicative of results for a full year. The information included in this quarterly report on Form 10-Q should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and notes thereto included in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2016.
The Company’s 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 the Company’s 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 and the timing of payments for product sales, maintenance services, government research and development funding and purchases of inventory. Given the nature of the Company’s business, its revenue, receivables and other related accounts are likely to be concentrated among a relatively small number of customers.
Principles of Consolidation
The
accompanying condensed consolidated financial statements include the accounts of Cray Inc. and its wholly-owned subsidiaries. All material intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the Company’s condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.
Revenue Recognition
The Company
recognizes revenue, including transactions under sales-type leases, when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when it has persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Delivery does not occur until the products have been shipped or services provided to the customer, risk of loss has transferred to the customer, and, where applicable, a customer acceptance has been obtained. The sales price is not considered to be fixed or determinable until all material contingencies related to the sales have been resolved. The Company records revenue in the Condensed Consolidated Statements of Operations net of any sales, use, value added or certain excise
taxes imposed by governmental authorities on specific sales transactions. In addition to the aforementioned general policy, the following are the Company’s statements of policy with regard to multiple-element arrangements and specific revenue recognition policies for each major category of revenue.
Multiple-Element Arrangements. The Company commonly enters into revenue arrangements that include multiple deliverables of its product and service offerings due to the needs of its customers. Products may be delivered in phases over time periods which can be as long as five years. Maintenance services generally begin upon acceptance of the first equipment delivery and future deliveries of equipment
generally have an associated maintenance period. The Company considers the maintenance period to commence upon acceptance of the product or installation in situations where a formal acceptance is not required, which may include a warranty period and accordingly allocates a portion of the arrangement consideration as a separate deliverable which is recognized as service revenue over the entire service period. Other services such as training and engineering services can be delivered as a discrete delivery or over the term of the contract. A multiple-element arrangement is separated into more than one unit of accounting if the following criteria are met:
•
The
delivered item(s) has value to the customer on a standalone basis; and
8
•
If the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the Company.
If these criteria are met for each element, the arrangement consideration is allocated to the separate units of accounting based on each unit’s relative
selling price. If these criteria are not met, the arrangement is accounted for as one unit of accounting which would result in revenue being recognized ratably over the contract term or being deferred until the earlier of when such criteria are met or when the last undelivered element is delivered.
The Company follows a selling price hierarchy in determining the best estimate of the selling price of each deliverable. Certain products and services are sold separately in standalone arrangements for which the Company is sometimes able to determine vendor specific objective evidence, or VSOE. The
Company determines VSOE based on normal pricing and discounting practices for the product or service when sold separately.
When the Company is not able to establish VSOE for all deliverables in an arrangement with multiple elements, the Company attempts to establish the selling price of each remaining element based on third-party evidence, or TPE. The Company’s inability to establish VSOE is often due to a relatively small sample of customer contracts that differ in system size and contract
terms which can be due to infrequently selling each element separately, not pricing products within a narrow range, or only having a limited sales history, such as in the case of certain advanced and emerging technologies. TPE is determined based on the Company’s prices or competitor prices for similar deliverables when sold separately. However, the Company is often unable to determine TPE, as the Company’s offerings usually contain a significant level of customization and differentiation from those of competitors and the Company is often unable to reliably determine what similar competitor products’ selling prices are on a standalone
basis.
When the Company is unable to establish selling price using VSOE or TPE, the Company uses estimated selling price, or ESP, in its allocation of arrangement consideration. The objective of ESP is to determine the price at which the Company would transact a sale if the product or service were sold on a standalone basis. In determining ESP, the Company uses the cost to provide the product or service plus a margin, or considers other factors. When using cost plus a margin, the Company considers the total
cost of the product or service, including customer-specific and geographic factors. The Company also considers the historical margins of the product or service on previous contracts and several factors including any changes to pricing methodologies, competitiveness of products and services and cost drivers that would cause future margins to differ from historical margins.
Products. The Company most often recognizes revenue from sales of products upon customer acceptance of the system. Where formal acceptance is not required, the Company recognizes revenue upon
delivery or installation. When the product is part of a multiple element arrangement, the Company allocates a portion of the arrangement consideration to product revenue based on estimates of selling price.
Services. Maintenance services are provided under separate maintenance contracts with customers. These contracts generally provide for maintenance services for one year, although some are for multi-year periods, often with prepayments for the term of the contract. The
Company considers the maintenance period to commence upon acceptance of the product, or installation of the product where a formal acceptance is not required, which may include a warranty period. When service is part of a multiple element arrangement, the Company allocates a portion of the arrangement consideration to maintenance service revenue based on estimates of selling price. Maintenance contracts that are billed in advance of revenue recognition are recorded as deferred revenue. Maintenance revenue is recognized ratably over the term of the maintenance contract.
Revenue from engineering services is recognized as services are performed.
Project
Revenue. Revenue from design and build contracts is recognized under the percentage-of-completion, or POC, method. Under the POC method, revenue is recognized based on the costs incurred to date as a percentage of the total estimated costs to fulfill the contract. If circumstances arise that change the original estimates of revenues, costs, or extent of progress toward completion, revisions to the estimates are made. These revisions may result in increases or decreases in estimated revenues or costs, and such revisions are recorded in income in the period in which the circumstances that gave rise to the revision become known by management. The Company performs ongoing profitability
analyses of its contracts accounted for under the POC method in order to determine whether the latest estimates of revenue, costs and extent of progress require updating. If at any time these estimates indicate that the contract will be unprofitable, the entire estimated loss for the remainder of the contract is recorded immediately.
The Company records revenue from certain research and development contracts which include milestones using the milestone method if the milestones are determined
to be substantive. A milestone is considered to be substantive if management believes there is substantive uncertainty that it will be achieved and the milestone consideration meets all of the following criteria:
•
It is commensurate with either of the following:
•
The Company’s performance to achieve the milestone; or
9
•
The
enhancement of value of the delivered item or items as a result of a specific outcome resulting from the Company’s performance to achieve the milestone.
•
It relates solely to past performance.
•
It is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement.
The individual milestones are determined
to be substantive or non-substantive in their entirety and milestone consideration is not bifurcated.
Revenue from projects is classified as Product Revenue or Service Revenue, based on the nature of the work performed.
Nonmonetary Transactions. The Company values and records nonmonetary transactions at the fair value of the asset surrendered unless the fair value of the asset received is more clearly evident, in which case the fair value of the asset received is used.
Note 2— New Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2014-09,
Revenue from Contracts with Customers: Topic 606, or ASU 2014-09, to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance
obligation. Adoption of ASU 2014-09 was initially required for fiscal and interim reporting periods beginning after December 15, 2016 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined per ASU 2014-09.
In August 2015, FASB issued Accounting Standards Update No. 2015-14, Revenue from Contracts with Customers - Deferral of the Effective Date: Topic 606, or ASU 2015-14, that deferred the effective date of ASU 2014-09 by one year. Application of the new revenue standard is permitted for fiscal
and interim reporting periods beginning after December 15, 2016 and required for fiscal and interim reporting periods beginning after December 15, 2017. The Company is currently evaluating the impact of the adoption of ASU 2014-09. The Company will be required to make additional disclosures under the new guidance. However, at this time, the Company does not expect adoption of ASU 2014-09 to have a material impact on its consolidated financial statements.
In July 2015, FASB issued Accounting Standards Update No. 2015-11, Simplifying the Measurement of Inventory: Topic 330, or
ASU 2015-11. Topic 330 previously required an entity to measure inventory at the lower of cost or market. Market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. ASU 2015-11 requires that inventory measured using either the first-in-first-out (FIFO) or average cost method now be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. The Company adopted ASU 2015-11 at the beginning of the first quarter of 2017. Adoption of ASU 2015-11 did not have a material impact on the Company's consolidated financial statements.
In November
2015, FASB issued Accounting Standards Update No. 2015-17, Balance Sheet Classification of Deferred Taxes: Topic 740, or ASU 2015-17. Current GAAP requires the deferred taxes for each jurisdiction to be presented as a net current asset or liability and net noncurrent asset or liability. This requires a jurisdiction-by-jurisdiction analysis based on the classification of the assets and liabilities to which the underlying temporary differences relate, or, in the case of loss or credit carryforwards, based on the period in which the attribute is expected to be realized. Any valuation allowance is then required to be allocated on a pro rata basis, by jurisdiction, between current and noncurrent deferred tax assets. The new guidance requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. As a result, each jurisdiction will now only have one net noncurrent deferred tax asset or liability.
The guidance does not change the existing requirement that only permits offsetting within a jurisdiction. The Company adopted ASU 2015-17 at the beginning of the first quarter of 2017. At the time of adoption, all of the Company’s deferred tax assets and liabilities, along with any related valuation allowance, were classified as noncurrent on its Condensed Consolidated Balance Sheet. The Company adopted ASU 2015-17 on a retrospective basis. As such, prior period amounts have been adjusted to reflect the retrospective application of ASU 2015-17. This resulted in $19.1 million of current net deferred tax assets being reclassified as noncurrent on the
Company's December 31, 2016 Consolidated Balance Sheet.
10
In January 2016, FASB issued Accounting Standards Update No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities: Topic 825, or ASU 2016-01. The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. Adoption of ASU 2016-01 is required for fiscal reporting periods beginning after December 15, 2017, including interim reporting periods within those fiscal years. The Company
does not expect the adoption of ASU 2016-01 to have a material impact on its consolidated financial statements.
In February 2016, FASB issued Accounting Standards Update No. 2016-02, Leases: Topic 842, or ASU 2016-02, that replaces existing lease guidance. The new standard is intended to provide enhanced transparency and comparability by requiring lessees to record right-of-use assets and corresponding lease liabilities on the balance sheet. Under the new guidance, leases will continue to be classified as either finance or operating, with classification affecting the pattern of expense recognition in the Consolidated Statements of Operations. Lessor accounting is largely unchanged under ASU 2016-02. Adoption of ASU 2016-02 is required for fiscal reporting periods beginning after December 15, 2018, including interim reporting periods within those fiscal years with early adoption
being permitted. The new standard is required to be applied with a modified retrospective approach to each prior reporting period presented with various optional practical expedients. While the Company expects adoption to lead to a material increase in the assets and liabilities recorded on its Consolidated Balance Sheet, the Company is still evaluating the overall impact on its consolidated financial statements.
In August 2016, FASB issued Accounting Standards Update No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, or ASU 2016-15. The updated guidance clarifies how companies present and classify certain cash receipts and cash payments in the statement of cash flows. Adoption of ASU 2016-15 is required
for fiscal reporting periods beginning after December 15, 2017, including interim reporting periods within those fiscal years with early adoption being permitted. The Company does not expect the adoption of ASU 2016-15 to have a material impact on its consolidated financial statements.
In November 2016, FASB issued Accounting Standards Update No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, or ASU 2016-18, which amends ASC 230 to add or clarify guidance on the classification and presentation of restricted cash in the statement of cash flows. The amended guidance requires that amounts that are deemed to be restricted cash and restricted cash equivalents be included in the cash and cash-equivalent balances in the statement of cash flows. A reconciliation between the consolidated
balance sheet and the statement of cash flows must be disclosed when the consolidated balance sheet includes more than one line item for cash, cash equivalents, restricted cash, and restricted cash equivalents. The guidance also requires that changes in restricted cash and restricted cash equivalents that result from transfers between cash, cash equivalents, and restricted cash and restricted cash equivalents should not be presented as cash flow activities in the statement of cash flows. An entity with a material balance of amounts generally described as restricted cash and restricted cash equivalents must disclose information about the nature of the restrictions. Adoption of ASU 2016-18 is required for fiscal reporting periods beginning after December 15, 2017, including interim reporting periods within those fiscal years with early adoption being permitted. The
Company does not expect the adoption of ASU 2016-18 to have a material impact on its consolidated financial statements.
In January 2017, FASB issued Accounting Standards Update No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, or ASU 2017-04, which eliminates Step 2 from the goodwill impairment test. ASU 2017-04 also eliminates the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Adoption of ASU 2017-04 is required for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019 with
early adoption being permitted for annual or interim goodwill impairment tests performed on testing dates after January 1, 2017. The Company does not expect the adoption of ASU 2017-04 to have a material impact on its consolidated financial statements.
11
Note
3— Fair Value Measurement
Based on the observability of the inputs used in the valuation techniques used to determine the fair value of certain financial assets and liabilities, the Company is required to provide the following information according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values.
In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data
for substantially the full term of the related assets or liabilities. Fair values determined by Level 3 inputs are unobservable data points for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. The following table presents information about the Company’s financial assets and liabilities that have been measured at fair value as of March 31, 2017, and indicates the fair value hierarchy of the valuation inputs utilized to determine such fair value (in thousands):
Included
in “Short-term investments” on the Company’s Condensed Consolidated Balance Sheets.
(2)
Included in “Prepaid expenses and other current assets” and “Other non-current assets” on the Company’s Condensed Consolidated Balance Sheets.
(3)
Included in “Other accrued liabilities” and “Other non-current liabilities” on the
Company’s Condensed Consolidated Balance Sheets.
Foreign Currency Derivatives
The Company may enter into foreign currency derivatives to hedge future cash receipts on certain sales transactions that are payable in foreign currencies.
As of March 31, 2017 and December 31, 2016, the Company had outstanding foreign currency exchange contracts that were designated and accounted
for as cash flow hedges of anticipated future cash receipts on sales contracts payable in foreign currencies. The outstanding notional amounts were approximately (in millions):
The
Company had hedged foreign currency exposure related to these designated cash flow hedges of approximately $77.7 million and $46.9 million as of March 31, 2017 and December 31, 2016, respectively.
12
As of March 31, 2017 and December 31,
2016, the Company had outstanding foreign currency exchange contracts that had been dedesignated for the purposes of hedge accounting treatment. The outstanding notional amounts were approximately (in millions):
The foreign currency exposure related to these contracts was approximately $56.2 million as of March 31, 2017 and $107.5 million as of December 31, 2016. Unrealized gains or losses
related to these dedesignated contracts are recorded in the Condensed Consolidated Statements of Operations and are generally offset by foreign currency adjustments on related receivables. These foreign currency exchange contracts are considered to be economic hedges.
Cash receipts associated with the foreign currency exchange contracts are expected to be received from 2017 through 2022, during which time the revenue on the associated sales contracts is expected to be recognized, or in the case of receivables denominated in a foreign currency, the receivables balances
will be collected. Any gain or loss on hedged foreign currency will be recognized at the time of customer acceptance, or in the case of receivables denominated in a foreign currency, over the period during which hedged receivables denominated in a foreign currency are outstanding.
Fair values of derivative instruments designated as cash flow hedges (in thousands):
Total
fair value of derivative instruments not designated as cash flow hedges
$
6,538
$
10,785
13
Note
4— Accumulated Other Comprehensive Income
The following table shows the impact on product revenue of reclassification adjustments from accumulated other comprehensive income resulting from hedged foreign currency transactions recorded by the Company for the three months ended March 31, 2017 and 2016 (in thousands). The gross reclassification adjustments increased product revenue for the three months ended March 31, 2016.
The following tables show the changes in accumulated other comprehensive income by component for the three months ended March 31, 2017 and 2016 (in thousands):
Income
tax expense (benefit) associated with current-period change
$
6
$
(7
)
$
(251
)
$
(252
)
Note
5— Loss Per Share ("EPS")
Basic EPS is computed by dividing net loss available to common shareholders by the weighted average number of common shares, excluding unvested restricted stock, outstanding during the period. Diluted EPS is computed by dividing net loss available to common shareholders by the weighted average number of common and potential common shares outstanding during the period, which includes the additional dilution related to conversion of stock options, unvested restricted stock and unvested restricted stock units as computed under the treasury stock method.
For the three months ended March 31, 2017 and 2016, outstanding stock options, unvested restricted stock and unvested restricted stock units were antidilutive
because of the net losses and, as such, their effect has not been included in the calculation of basic or diluted net loss per share. For the three months ended March 31, 2017 and 2016, potential gross common shares of 2.7 million and 2.6 million, respectively, were antidilutive and not included in computing diluted EPS. An additional 0.7 million and 1.2 million performance vesting restricted stock and performance vesting restricted stock units were excluded from the computation of potential common shares for the three months ended March 31, 2017 and 2016,
respectively, because the conditions for vesting had not been met as of the balance sheet date.
14
Note 6— Investments
The Company’s investments in debt securities with maturities at purchase greater than three months are classified as “available-for-sale.” Changes in fair value are reflected in other comprehensive income. The carrying amounts of the Company’s investments in available-for-sale securities as of March 31,
2017 are shown in the table below (in thousands):
Unrealized
Cost
Gains
Fair
Value
Short-term available-for-sale securities
$
84,785
$
28
$
84,813
Note
7— Accounts and Other Receivables, Net
Net accounts and other receivables consisted of the following (in thousands):
Unbilled
receivables represent amounts where the Company has recognized revenue in advance of the contractual billing terms. Advance billings represent billings made based on contractual terms for which revenue has not been recognized.
As of March 31, 2017 and December 31, 2016, accounts receivable included $13.9 million and $104.6 million, respectively, that resulted from sales to the U.S. government and system acquisitions primarily funded by the U.S. government (“U.S. Government”). Of these amounts, $1.6 million and
$1.4 million were unbilled as of March 31, 2017 and December 31, 2016, respectively, based upon contractual billing arrangements with these customers. As of March 31, 2017, one non-U.S. Government customer accounted for 16% of total accounts and other receivables. As of December 31, 2016, two non-U.S. Government customers accounted for 24% of total accounts and other
receivables.
Note 8— Sales-type Lease
The Company has a sales-type lease with one of its customers, under which it will receive quarterly payments over the term of the lease, which expires in September 2020. The lease is denominated in British Pounds and the Company has entered into certain foreign currency exchange contracts that act as an economic hedge for the foreign currency exposure associated with this arrangement.
The following table shows the components of the net investment
in the sales-type lease as of March 31, 2017 and December 31, 2016 (in thousands):
Finished
goods inventory of $32.1 million and $10.5 million was located at customer sites pending acceptance as of March 31, 2017 and December 31, 2016, respectively. At March 31, 2017, one customer accounted for $34.7 million of finished goods inventory, and at December 31, 2016, two customers accounted for $11.9 million of finished
goods inventory.
As of March 31, 2017 and December 31, 2016, the U.S. Government accounted for $52.2 million and
$60.3 million, respectively, of total deferred revenue. As of March 31, 2017 and December 31, 2016, no non-U.S. Government customers accounted for more than 10% of total deferred revenue.
Note 11— Contingencies
The Company is subject to patent lawsuits brought by Raytheon Company, or Raytheon. The first suit was brought by Raytheon on September 25, 2015
in the Eastern District of Texas (Civil Action No. 2:15-cv-1554) asserting infringement of four patents owned by Raytheon. Two of the asserted patents relate to computer hardware alleged to be encompassed by Cray’s current and past products, and the two remaining asserted patents relate to features alleged to be performed by certain third-party software that Cray optionally includes as part of its product offerings. A second suit was brought by Raytheon on April 22, 2016 in the Eastern District of Texas (Civil Action No. 2:16-cv-423) asserting infringement of five patents owned by Raytheon. In this second suit, all five asserted patents relate to features alleged to be performed by certain third-party
software that Cray optionally includes as part of its product offerings. Trial in the first action has been rescheduled to commence in September 2017 and trial in the second action is currently scheduled to commence in October 2017. The Company is vigorously defending these actions. The probable outcome of either litigation cannot be determined, nor can the Company estimate a range of potential loss. Based on its review of the matters to date, the Company believes that it has valid defenses and claims in each of the two lawsuits. As a result, the Company considers the likelihood of a material
loss related to these matters to be remote.
16
Note 12— Share-Based Compensation
The Company accounts for its share-based compensation based on an estimate of fair value of the grant on the date of grant.
In determining the fair value of stock options, the Company uses the Black-Scholes option pricing model. The following key weighted average assumptions were employed in the calculation for the three
month periods ended March 31, 2017 and March 31, 2016:
Weighted average Black-Scholes value of options granted
$7.51
$16.90
The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The Company does not anticipate declaring
dividends in the foreseeable future. Volatility is based on historical data. The expected life of an option is based on the assumption that options will be exercised, on average, about two years after vesting occurs. The Company recognizes compensation expense for only the portion of options that are expected to vest. Therefore, management applies an estimated forfeiture rate that is derived from historical employee termination data and adjusted for expected future employee turnover rates. The estimated forfeiture rate applied to the Company’s stock option grants during the three months ended March 31, 2017 and 2016
was 8.0%. If the actual number of forfeitures differs from those estimated by management, additional adjustments to compensation expense may be required in future periods. The Company’s stock price volatility, option lives and expected forfeiture rates involve management’s best estimates at the time of such determination, which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the vesting period or requisite service period of the option. The Company typically issues stock options with a four year vesting period (the requisite service period) and amortizes the fair value of stock options (stock compensation cost) ratably
over the requisite service period.
A summary of the Company’s year-to-date stock option activity and related information follows:
As
of March 31, 2017, there was $15.1 million of aggregate intrinsic value of outstanding stock options, including $15.0 million of aggregate intrinsic value of exercisable stock options. Intrinsic value represents the total pretax intrinsic value for all “in-the-money” options (i.e., the difference between the Company’s closing stock price on the last trading day of its first quarter of 2017 and the exercise price, multiplied by the number of shares of common stock underlying the stock options) that would have been received by the option holders had all option
holders exercised their options on March 31, 2017. During the three months ended March 31, 2017, stock options covering 10,147 shares of common stock with a total intrinsic value of $0.1 million were exercised. During the three months ended March 31, 2016, stock options covering 122,327 shares of common stock with a total intrinsic value of $3.5 million were exercised.
The fair value of unvested restricted stock and unvested restricted stock units is based on the
market price of a share of the Company’s common stock on the date of grant and is amortized over the vesting period.
17
A summary of the Company’s unvested restricted stock grants and changes during the three months ended March 31, 2017 is as follows:
The
estimated forfeiture rate applied to the Company’s service vesting restricted share grants during the three months ended March 31, 2017 and 2016, was 8%. The aggregate fair value of restricted stock vested during the three months ended March 31, 2017, was $0.1 million. The aggregate fair value of restricted stock vested during the three months ended March 31, 2016, was $0.2 million. The performance vesting restricted
shares are subject to performance measures that are currently not considered “probable” of attainment and as such, no compensation cost has been recorded for these shares. The performance vesting restricted shares are eligible to vest in 2017.
A summary of the Company’s unvested restricted stock unit grants and changes during the three months ended March 31, 2017 is as follows:
The
estimated forfeiture rate applied to the Company’s service vesting restricted stock unit grants during the three months ended March 31, 2017 and 2016, was 8.0%. The aggregate fair value of restricted stock units vested during the three months ended March 31, 2017, was $0.1 million. Restricted stock units are not outstanding shares and do not have any voting or dividend rights. At the time of vesting, a share of common stock representing each restricted stock unit vested will be issued by the
Company. The performance vesting restricted stock units are subject to performance measures that are currently not considered “probable” of attainment and as such, no compensation cost has been recorded for these units. The performance vesting restricted stock units are eligible to vest between 2017 and 2020.
Including performance-based equity awards, the Company had $34.6 million of total unrecognized compensation cost related to unvested stock options, unvested restricted stock and unvested restricted stock units as of March 31, 2017. Excluding the $21.2 million
of unrecognized compensation cost related to unvested restricted stock and unvested restricted stock units that are subject to performance measures that are currently not considered “probable” of attainment, unrecognized compensation cost is $13.4 million. No compensation expense is recognized for unvested restricted stock or unvested restricted stock units subject to performance measures that are not considered “probable” of attainment. Unrecognized compensation cost related to unvested stock options and unvested non-performance-based restricted stock is expected to be recognized over a weighted average period of 2.4 years.
18
The following table sets forth
the gross share-based compensation cost resulting from stock options, unvested restricted stock and unvested restricted stock units that were recorded in the Company’s Condensed Consolidated Statements of Operations for the three months ended March 31, 2017 and 2016 (in thousands):
The
Company also has an employee stock purchase plan, or ESPP, which allows employees to purchase shares of the Company’s common stock at 95% of fair market value on the fourth business day after the end of each offering period. The ESPP is deemed non-compensatory and therefore is not subject to the fair value provisions.
The primary reason for the difference between the expected statutory tax rate of 35% and the actual tax rate of 37%
for the three months ended March 31, 2017, was the result of state taxes and other permanent items. The primary reason for the difference between the expected statutory tax rate of 35% and the actual tax rate of 45% for the three months ended March 31, 2016 was $1.0 million in additional tax deductions from share-based compensation, sometimes referred to as excess tax benefits.
The Company continues to provide a valuation allowance against specific U.S. deferred tax assets and a valuation allowance against deferred tax assets arising in a limited number of foreign
jurisdictions as the realization of such assets is not considered to be more likely than not at this time. As of March 31, 2017, the Company had $96.9 million of net deferred tax assets which included deferred tax assets of $9.0 million related to federal net operating loss carryforwards that will expire between 2019 and 2021 and a deferred tax asset of $1.3 million related to a federal research and development tax credit that will expire in 2021. The assessment of the Company's ability to utilize its deferred tax assets includes an assessment of all known business risks and industry trends, forecasted domestic and
international earnings over a number of years, and certain tax planning strategies. In a future period the Company’s assessment of the realizability of its deferred tax assets and therefore the appropriateness of the valuation allowance could change based on an assessment of all available evidence, both positive and negative in that future period. If the Company’s conclusion about the realizability of its deferred tax assets and therefore the appropriateness of the valuation allowance changes in a future period it could record a substantial tax provision or benefit in the Condensed Consolidated Statement of Operations when that occurs.
Note 14— Segment Information
The
Company has the following reportable segments: Supercomputing, Storage and Data Management, Maintenance and Support, and Engineering Services and Other. The Company’s reportable segments represent components of the Company for which separate financial information is available that is utilized on a regular basis by the Chief Executive Officer, who is the Chief Operating Decision Maker, in determining how to allocate the Company’s resources and evaluate performance. The segments are determined based on several factors, including the Company’s internal operating structure, the manner in which the
Company’s operations are managed, client base, similar economic characteristics and the availability of separate financial information.
Supercomputing
Supercomputing includes a suite of highly advanced, tightly integrated and cluster supercomputer systems which are used by large research and engineering centers in universities, government laboratories, and commercial institutions. Supercomputing also includes the ongoing maintenance of these systems as well as system analysts.
19
Storage and Data Management
Storage and Data Management offers Cray DataWarp, Sonexion as well as other third-party storage products and their ongoing
maintenance as well as system analysts.
Maintenance and Support
Maintenance and Support provides ongoing maintenance of Cray supercomputers, big data storage and analytics systems, as well as system analysts.
Engineering Services and Other
Included within Engineering Services and Other are the Company’s analytics business and Custom Engineering.
The following table presents revenues and gross margins for the Company’s operating segments for the three months ended March
31, 2017 and 2016 (in thousands):
Revenue and cost of revenue is the only discrete financial information the Company prepares for its segments. Other financial results or assets are not separated by segment.
The
Company’s geographic operations outside the United States include sales and service offices in Europe and the Middle East, South America, Asia Pacific and Canada. The following data represents the Company’s revenue for the United States and all other countries, which is determined based upon a customer’s geographic location (in thousands):
United
States
Other Countries
Total
2017
2016
2017
2016
2017
2016
Three
months ended March 31,
Product revenue
$
13,315
$
33,878
$
7,813
$
37,532
$
21,128
$
71,410
Service
revenue
26,561
24,270
11,342
9,869
37,903
34,139
Total
revenue
$
39,876
$
58,148
$
19,155
$
47,401
$
59,031
$
105,549
Sales
to the U.S. Government totaled approximately $34.2 million for the three months ended March 31, 2017 compared to approximately $52.7 million for the three months ended March 31, 2016. For the three months ended March 31, 2017, no non-U.S. Government or international customers accounted for more than 10% of total revenue. For the three months ended March 31, 2016, two
non-U.S. Government customers accounted for 33% of total revenue, while revenue in the United Kingdom and Australia accounted for 36% of total revenue.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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,”“continue,”“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 potential new markets or applications for our products; any statements regarding technological developments or trends; any statements regarding future research and development or co-funding for such efforts; any statements regarding future expansions of our facilities and offices; 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, or the Exchange Act. 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, except as otherwise required by law.
Overview
We design, develop, manufacture, market and service the high-end of the high performance computing, or HPC, market, primarily categories of systems commonly known as supercomputers and provide data analytics, artificial intelligence and storage solutions leveraging more than four decades of delivering the world’s most advanced computing systems. We also provide software,
system maintenance and support services and engineering services related to supercomputer systems and our data analytics, artificial intelligence and storage solutions. Our customers include domestic and foreign government and government-funded entities, academic institutions and commercial entities. Our key target markets are the supercomputing portion of the HPC market and the expanding big data markets. We provide customer-focused solutions based on three main models: (1) tightly integrated supercomputing and/or storage solutions, complete with highly tuned software, that stress capability, scalability, sustained performance and reliability at scale; (2) differentiated “cluster” supercomputing and storage solutions based upon utilizing best-of-breed components and working with our customers to define solutions that meet specific needs; and (3) integrated solutions that combine industry standard tools for large-scale analytics and artificial intelligence applications,
as well as innovative graph analysis tools, and specialized computing platforms. All of our solutions also emphasize total cost of ownership, scalable performance and data center flexibility as key features. Our continuing strategy is to gain market share in the supercomputer market segment, extend our technology leadership and differentiation, maintain our focus on execution and profitability and grow by continuing to expand our share and addressable market in areas where we can leverage our experience and technology, such as in high performance storage systems and powerful analytic tools for large volumes of data, popularly referred to as “big data.” We also meet diverse customer requirements by combining supercomputing, cluster supercomputing, and big data described above, into unique solutions offerings that work in a workflow-driven datacenter environment.
Summary of First Three
Months of 2017 Results
Total revenue decreased $46.5 million for the first three months of 2017 compared to the first three months of 2016, from $105.5 million to $59.0 million, due to lower product revenue. Product revenue was $50.3 million lower in the first three months of 2017 as compared to the first three months of 2016, substantially driven by a slow-down in the segments of the high-end of the supercomputing market that we target, as well as the timing of contracts
and deliveries. The higher revenue in the prior year period was driven by large system acceptances in Australia, the United Kingdom and the United States. Our product revenue is subject to significant quarter-to-quarter fluctuations and can be concentrated in particular quarters, often the fourth quarter. It is dependent on factors such as the timing of new product releases, the timing of customer acceptances, the timing and level of customer procurements and budgets, market conditions, and the availability of certain key components, among other factors as described under Item 1A. Risk Factors.
Net loss for the first three months of 2017 was $19.2 million compared to net loss of $5.0
million for the same period in 2016. The year over year change was primarily attributable to lower revenue and a $6.9 million increase in operating expenses
21
resulting primarily from increased spending on research and development. These amounts were partially offset by an improved gross margin percentage and a $7.1 million increase in income tax benefit.
Net cash provided by operating activities was $69.9 million for the first three
months of 2017 compared to net cash provided by operating activities of $33.6 million for the first three months of 2016. Net cash provided by operating activities in the first three months of 2017 was primarily driven by collections from customers that resulted in a decrease of $144.0 million in accounts and other receivables, partially offset by an increase of $25.8 million in inventory as a result of system builds for future deliveries, the net loss, adjusted for non-cash expenses, of $23.8
million and a decrease in our accounts payable balance of $14.5 million.
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 accelerators, as the rate of increases
in per-core performance slows;
•
data I/O and capacity needs growing much faster than computational needs;
•
technology innovations in memory and storage allowing for faster data access such as NVRAM, SSDs and flash devices;
•
the commoditization of HPC hardware, particularly processors and system
interconnects;
•
the growing concentration of very large suppliers of key computing and storage components in the industry;
•
the growing commoditization of software, including plentiful building blocks and more capable open source software;
•
electrical power requirements becoming a design constraint
and driver in total cost of ownership determinations;
•
increasing use of analytics technologies (Hadoop, Spark, NoSQL and Graph) in both the HPC and big data markets;
•
the rise of artificial intelligence along with machine learning and deep learning technologies which utilize HPC technologies for performance and scale;
•
cloud
computing as a solution for loosely-coupled HPC applications; and
•
significant variability in market demand from quarter-to-quarter and year-to-year.
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, 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 sometimes the dominant factor in HPC procurements. Vendors of such systems often put pricing pressure on us, resulting
in lower margins in competitive procurements.
In the market for the largest, and most scalable systems, those often costing in excess of $3 million, the use of generally available network components can result in increasing data transfer bottlenecks as these components do not balance processor power with network communication and system software capability. With increasing processor core counts due to new many-core processors, these unbalanced systems will typically have lower productivity, especially in larger systems running more complex applications. We and others augment standard microprocessors with other processor types, such as graphics processing units and many-core attached processors, 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 whose applications demand these tightly coupled architectures. We also have demonstrated expertise in system software and 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 continued to expand our addressable market by leveraging our technologies, customer base, the Cray brand and by introducing complementary products and services to new and
existing customers, as demonstrated by our emphasis on strategic initiatives, such as “big data” analytics, artificial intelligence and storage and data management.
In analytics, we are developing and delivering high performance data discovery and advanced analytics solutions. These solutions compete with open source software, running on commodity cluster systems. Although these competitive systems have low acquisition costs, the total cost of ownership, or TCO, is driven up by management, power and efficiency challenges. We concentrate our efforts on developing solutions that minimize the TCO, delivering faster time-to-solution and advanced capabilities
22
that are key drivers for many of our data analytics
customers. We support open source technologies such as Hadoop and Spark to design large-scale data analytics stacks that simplify analyses of scientific and commercial applications.
In storage, we are developing and delivering high value products for the high performance storage market. Our storage products are primarily positioned to enable tight integration of storage to computing solutions and/or utilize parallel file processing technologies and facilitate storage across multiple data tiers. We support open source parallel file systems and protocols such as Lustre and we are a founding member of the OpenSFS (Open Scalable File System) consortia for Lustre.
We have also expanded our addressable market by providing cluster systems and solutions to the supercomputing market that allow us to offer flexible platforms to incorporate best of breed components to allow customers to optimize
the system to fit their unique requirements.
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 in this quarterly report on Form 10-Q or in our annual report on Form 10-K for the year ended December 31, 2016, is subject to significant variability from period to period. In the short term, we closely review the status of customer proposals, customer contracts,
product shipments, installations and acceptances in order to forecast revenue and cash receipts. In the longer-term, we monitor the status of the pipeline of product sales opportunities and product development cycles. We believe product revenue growth measured over several quarters is a better indicator of whether we are achieving our objective of increased market share in the supercomputing market. The Cray XC and Cray CS products, along with our longer-term product roadmap are efforts to increase product revenue. We have been increasing our business and product development efforts in big data analytics, artificial intelligence and storage and data management. We have also been increasing the size of our sales force. Service revenue related to our maintenance offerings is subject to less variations in the short term and may assist, in part, to offset the impact that the variability in product revenue has on total revenue.
Gross
profit margin. Gross profit margin is impacted by revenue and our cost to build and deliver our products and services. Our services tend to carry higher gross profit margins than our products. We monitor the cost of components, manufacturing, and installation of our products. In assessing our service gross profit margin, we monitor headcount levels and third-party costs.
Operating expenses. Our operating expenses are driven primarily by headcount and compensation expense, contracted third-party research and development services, and incentive compensation expense. As part of our ongoing expense management efforts, we continue to monitor headcount levels in specific geographic and operational areas.
Liquidity and cash flows. Due to the variability in product revenue, new contracts,
acceptance 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, customer acceptances and, in the long-term, product development. Cash receipts generally lag customer acceptances.
Results of Operations
Our revenue, results of operations and cash balances fluctuate significantly from period-to-period. These fluctuations are due to such factors as the high average sales prices and limited number of sales of our products with variable gross margin levels, the timing of purchase orders and product deliveries, the availability of components, 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, receivables, inventory and other related financial statement items have in the past varied, and are expected to continue to vary, significantly from quarter-to-quarter and year-to-year.
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Revenue and Gross Profit Margins
Our revenue, cost of revenue and gross profit margin for the three
months ended March 31, 2017 and 2016, respectively, were (in thousands, except for percentages):
Product revenue for the three months ended March 31, 2017 and 2016 was primarily from sales of our Cray XC and Cray CS supercomputing systems and Sonexion storage systems. Product revenue was $50.3 million lower in the first three months of 2017 as compared to the first three months of 2016, substantially driven by a slow-down in the segments of the high-end of the supercomputing market that we target, as well as the timing of contracts and deliveries. The higher revenue in the prior year period was driven by large system acceptances in Australia, the United Kingdom and the United States.
Service
Revenue
Service revenue for the three months ended March 31, 2017 was $37.9 million compared to $34.1 million for the same period in 2016. The increase in service revenue was primarily driven by increased maintenance revenue, which has continued to benefit from our larger installed system base.
Cost of Product Revenue and Product Gross Profit
Cost of product revenue decreased by $31.4 million for the three months ended March 31, 2017
compared to the same period in 2016, primarily driven by lower product revenue. For the three months ended March 31, 2017, product gross profit margin decreased 5 percentage points to 30% from 35% in the same period in 2016. We received fewer customer acceptances in the first quarter of 2017 compared to the first quarter of 2016 and these acceptances carried a lower margin. Product gross profit margin in any one period may not be indicative of future results as product gross profit margin can vary significantly between contracts
for many reasons.
Cost of Service Revenue and Service Gross Profit
For the three months ended March 31, 2017, cost of service revenue increased by $1.1 million compared to the same period in 2016. This increase was driven by a larger installed base of systems to service which also resulted in higher service revenue. Service gross profit margin for the three months ended March 31, 2017 increased by 3 percentage points to 46%
compared to 43% in the same period in 2016. The improved gross profit margin resulted from the leveraging of our fixed service costs.
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Research and Development Expenses
Research and development expenses for the three months ended March 31, 2017 and 2016, respectively, were (in thousands, except for percentages):
Less: Reimbursed research and development (excludes amounts in cost of revenue)
(811
)
(1,384
)
Net
research and development expenses
$
32,640
$
25,840
Percentage of total revenue
55
%
24
%
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 third party contractor engineering expenses.
For the three months ended March 31, 2017, gross research and development expenses increased by $6.5 million compared to the same period in 2016. The increase in gross research and development expenses for the three months ended March 31, 2017 was due to increased
investments in the development of new products and higher costs related to our engineering services contracts, which included higher third party costs. Total third party costs increased by $4.2 million, associated primarily with revenue generating contracts or expenditures for which we expect to be reimbursed in the future. We also increased our average headcount, which resulted in compensation costs increasing by $1.6 million for the three months ended March 31, 2017 compared to the same period in 2016.
Net research and development expenses increased by $6.8 million
for the three months ended March 31, 2017 compared to the same period in 2016. The amount and timing of research and development costs related to engineering development contracts and the level of reimbursement from third parties for research and development projects varies significantly from period to period, and can have a significant impact on net reported research and development expense in any period.
Sales and Marketing and General and Administrative Expenses
Our sales and marketing and general and administrative expenses for the three months ended March 31, 2017 and 2016,
respectively, were (in thousands, except for percentages):
Sales
and Marketing. Sales and marketing expense for the three months ended March 31, 2017 decreased by $1.3 million from the same period in 2016. The decrease in sales and marketing expense for the three months ended March 31, 2017 was primarily a result of a decrease of $1.0 million in incentive compensation and commissions.
General and Administrative. General and administrative expense for the three months ended March 31,
2017 increased by $1.5 million from the same period in 2016. The increase was primarily attributable to legal costs related to our ongoing litigation with Raytheon, which is described in Note 11, “Contingencies” in the Notes to our Condensed Consolidated Financial Statements in the quarterly report on Form 10-Q. Due to our ongoing litigation with Raytheon, we currently expect legal expenses to remain at above historical levels through at least the end of 2017.
Other Income (Expense), net
For the three months ended March 31, 2017, we recognized net other income of $1.0 million
compared to net other expense of $0.4 million for the same period in 2016. Net other income and expense for the three months ended March 31, 2017 and 2016 included gains and losses from foreign currency transactions, investments and disposals of assets.
25
Interest Income, net
Our interest income and interest expense for the three months ended March 31, 2017 and 2016,
respectively, were (in thousands):
Interest income, net for the three months ended March 31, 2017 increased as compared to the same period in 2016 due to amortization of unearned income on a sales-type lease
with a customer. Amortization was higher for the three months ended March 31, 2017 compared to the same period in 2016 due to our having delivered a second high performance computing solution in the second quarter of 2016.
Taxes
Our effective tax rate was approximately 37% for the three months ended March 31, 2017 compared to 45% for the three months ended March 31, 2016. The primary reason for the difference between the expected statutory tax rate of 35%
and the actual tax rate of 37% for the three months ended March 31, 2017 was the result of state taxes and other permanent items. The primary reason for the difference between the expected statutory tax rate of 35% and the actual tax rate of 45% for the three months ended March 31, 2016 was $1.0 million in additional tax deductions from share-based compensation, sometimes referred to as excess tax benefits.
New Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2014-09, Revenue from
Contracts with Customers: Topic 606, or ASU 2014-09, to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation.
Adoption of ASU 2014-09 was initially required for fiscal and interim reporting periods beginning after December 15, 2016 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined per ASU 2014-09.
In August 2015, FASB issued Accounting Standards Update No. 2015-14, Revenue from Contracts with Customers - Deferral of the Effective Date: Topic 606, or ASU 2015-14, that deferred the effective date of ASU 2014-09 by one year. Application of the new revenue standard is permitted for fiscal and interim
reporting periods beginning after December 15, 2016 and required for fiscal and interim reporting periods beginning after December 15, 2017. We are currently evaluating the impact of the adoption of ASU 2014-09. We will be required to make additional disclosures under the new guidance. However, at this time, we do not expect adoption of ASU 2014-09 to have a material impact on our consolidated financial statements.
In July 2015, FASB issued Accounting Standards Update No. 2015-11, Simplifying the Measurement of Inventory: Topic 330, or ASU 2015-11, to amend Topic 330, Inventory. Topic 330 previously required an entity to measure inventory at the lower of cost or market. Market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. ASU 2015-11 requires that inventory
measured using either the first-in, first-out, or FIFO, or average cost method now be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. We adopted ASU 2015-11 at the beginning of the first quarter of 2017. Adoption of ASU 2015-11 did not have a material impact on our consolidated financial statements.
In November 2015, FASB issued Accounting Standards Update No. 2015-17, Balance Sheet Classification of Deferred Taxes: Topic 740, or ASU 2015-17. Current GAAP requires the deferred taxes for each jurisdiction to be presented as a net current asset or liability and net noncurrent asset or liability. This requires a jurisdiction-by-jurisdiction analysis based on the classification of the assets and liabilities to which the underlying temporary differences relate,
or, in the case of loss or credit carryforwards, based on the period in which the attribute is expected to be realized. Any valuation allowance is then required to be allocated on a pro rata basis, by jurisdiction, between current and noncurrent deferred tax assets. The new guidance requires that all deferred tax
26
assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. As a result, each jurisdiction will now only have one net noncurrent deferred tax asset or liability. The guidance does not change the existing requirement that only permits offsetting within a jurisdiction. We adopted ASU 2015-17 at the beginning of the first quarter of 2017. At the time of adoption, all of our deferred tax assets
and liabilities, along with any related valuation allowance, were classified as noncurrent on our Condensed Consolidated Balance Sheet. We adopted ASU 2015-17 on a retrospective basis. As such, prior period amounts have been adjusted to reflect the retrospective application of ASU 2015-17. This resulted in $19.1 million of current net deferred tax assets being reclassified as noncurrent on our December 31, 2016 Consolidated Balance Sheet.
In January 2016, FASB issued Accounting Standards Update No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities: Topic 825, or ASU 2016-01. The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. Adoption of ASU 2016-01 is required for fiscal reporting periods beginning after December
15, 2017, including interim reporting periods within those fiscal years. We do not expect the adoption of ASU 2016-01 to have a material impact on our consolidated financial statements.
In February 2016, FASB issued Accounting Standards Update No. 2016-02, Leases: Topic 842, or ASU 2016-02, that replaces existing lease guidance. The new standard is intended to provide enhanced transparency and comparability by requiring lessees to record right-of-use assets and corresponding lease liabilities on the balance sheet. Under the new guidance, leases will continue to be classified as either finance or operating, with classification affecting the pattern of expense recognition in the Consolidated Statements of Operations. Lessor accounting is largely unchanged under ASU 2016-02. Adoption of ASU 2016-02 is required for fiscal reporting periods beginning after December 15, 2018,
including interim reporting periods within those fiscal years with early adoption being permitted. The new standard is required to be applied with a modified retrospective approach to each prior reporting period presented with various optional practical expedients. While we expect adoption to lead to a material increase in the assets and liabilities recorded on our Consolidated Balance Sheet, we are still evaluating the overall impact on our consolidated financial statements.
In August 2016, FASB issued Accounting Standards Update No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, or ASU 2016-15. The updated guidance clarifies how companies present and classify certain cash receipts and cash payments in the statement of cash flows. Adoption of ASU 2016-15 is required for fiscal reporting periods beginning after December 15,
2017, including interim reporting periods within those fiscal years with early adoption being permitted. We do not expect the adoption of ASU 2016-15 to have a material impact on our consolidated financial statements.
In November 2016, FASB issued Accounting Standards Update No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash, or ASU 2016-18, which amends ASC 230 to add or clarify guidance on the classification and presentation of restricted cash in the statement of cash flows. The amended guidance requires that amounts that are deemed to be restricted cash and restricted cash equivalents be included in the cash and cash-equivalent balances in the statement of cash flows. A reconciliation between the consolidated balance sheet and the statement of cash flows must be disclosed when the consolidated balance sheet includes more than one line item for cash, cash equivalents, restricted cash, and restricted cash
equivalents. The guidance also requires that changes in restricted cash and restricted cash equivalents that result from transfers between cash, cash equivalents, and restricted cash and restricted cash equivalents should not be presented as cash flow activities in the statement of cash flows. An entity with a material balance of amounts generally described as restricted cash and restricted cash equivalents must disclose information about the nature of the restrictions. Adoption of ASU 2016-18 is required for fiscal reporting periods beginning after December 15, 2017, including interim reporting periods within those fiscal years with early adoption being permitted. We do not expect the adoption of ASU 2016-18 to have a material impact on our consolidated financial statements.
In January 2017, FASB issued Accounting Standards Update No. 2017-04, Intangibles - Goodwill and Other
(Topic 350): Simplifying the Test for Goodwill Impairment, or ASU 2017-04, which eliminates Step 2 from the goodwill impairment test. ASU 2017-04 also eliminates the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. Adoption of ASU 2017-04 is required for annual or interim goodwill impairment tests in fiscal years beginning after December 15, 2019 with early adoption being permitted for annual or interim goodwill impairment tests performed on testing dates after January 1, 2017. We do not expect the adoption of ASU 2017-04 to have a material impact on our consolidated
financial statements.
Liquidity and Capital Resources
We generate cash from operations predominantly from the sale of supercomputing systems and related services. We typically have a small number of significant contracts that make up the majority of total revenue. We have also entered into a sales-type lease agreement with a customer, under which we will receive quarterly payments over the term of the lease, which expires in September 2020. Material changes in certain of our balance sheet accounts were due to the timing of product deliveries and customer acceptances, contractually determined billings, timing and level of cash collections of receivables, timing and level of inventory purchased for future deliveries, and
timing and level of incentive compensation. Working capital requirements, including inventory purchases and normal capital expenditures, are generally funded with cash from operations.
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We previously contemplated expanding our manufacturing capabilities in Chippewa Falls, Wisconsin in order to increase our manufacturing capacity. This project has now been suspended. The decision of when and whether to undertake this project in the future will be dependent on our expectations of future needs. If undertaken, we had estimated that this project would require total capital expenditures in the range of $25.0 million. If the project is pursued in the future, we may choose to externally finance these activities.
Operating
Activities. Net cash provided by operating activities was $69.9 million for the first three months of 2017 compared to net cash provided by operating activities of $33.6 million for the first three months of 2016. Net cash provided by operating activities in the first three months of 2017 was primarily driven by collections from customers that resulted in a decrease of $144.0 million in accounts and other
receivables, partially offset by an increase of $25.8 million in inventory as a result of system builds for future deliveries, the net loss, adjusted for non-cash expenses, of $23.8 million and a decrease in our accounts payable balance of $14.5 million.
For the three months ended March 31, 2016, net cash provided by operating activities was primarily driven by collections from customers that resulted in a decrease of $63.4 million in accounts and other receivables and an increase in our accounts payable balance of $17.8 million. These amounts were partially offset by an increase of $10.9 million in inventory as a result of system builds for future
deliveries and a decrease of $30.5 million in accrued payroll and related expenses and other accrued liabilities, largely resulting from payment of 2015 accrued incentive compensation.
Investing Activities. Net cash used in investing activities was $95.6 million for the three months ended March 31, 2017, compared to $9.3 million net cash used in investing activities for the same period in 2016. Net cash used in investing activities for the three months ended March 31,
2017 was primarily due to purchases of debt securities of $84.9 million and purchases of property and equipment of $10.3 million, mostly related to leasehold improvements for our new facilities in Bloomington, Minnesota. For the three months ended March 31, 2016, net cash used in investing activities was primarily due to purchases of debt securities of $15.0 million, partially offset by sales and maturities of debt securities of $5.0 million.
Financing Activities. Net cash provided by financing activities for the three months ended March
31, 2017 was $0.1 million compared to $1.6 million net cash provided by financing activities for the same period in 2016. Net cash flows from financing activities for both periods resulted primarily from cash received from the issuance of common stock from the exercise of options and from the issuance of stock through our employee stock purchase plan, partially offset by statutory tax withholding amounts made in exchange for the forfeiture of common stock by holders of vesting restricted stock awards.
In addition, we lease certain equipment and facilities used in our operations under operating leases in the normal course of business and have contractual commitments under certain development arrangements. The following
table summarizes our contractual obligations as of March 31, 2017 (in thousands):
Amounts Committed by Year
Contractual Obligations
Total
2017
(Less
than
1 Year)
2018-2019
2020-2021
Thereafter
Development agreements
$
17,728
$
12,750
$
4,963
$
15
$
—
Operating
leases
57,180
5,274
13,417
11,769
26,720
Total
contractual cash obligations
$
74,908
$
18,024
$
18,380
$
11,784
$
26,720
As
of March 31, 2017, we had a $50.0 million revolving line of credit, or Credit Facility, with Wells Fargo Bank, National Association, designed to be used for general corporate purposes, including working capital requirements and capital expenditures.
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The Credit Facility also supports the issuance of letters of credit. The Credit Facility is secured by a first priority lien in all of our accounts receivable and other rights to payment, general intangibles, inventory and equipment.
Any borrowings under the Credit Facility bear interest at either a fluctuating rate equal to the daily one month LIBOR rate plus a margin of
1.25% or a fixed interest rate for one, three or six months equal to the LIBOR rate for the applicable period plus a margin of 1.25%. We are also required to pay the lender customary letter of credit fees, and a commitment fee of 0.18% per annum in respect of the unutilized commitment amount under the Credit Facility. The Credit Facility requires that we maintain certain financial ratios and restricts our ability to incur additional indebtedness, pay dividends or distributions, create liens on assets, and engage in certain other activities. We were in compliance with all of our financial covenants as of March 31, 2017. The Credit Facility matures in December 2017.
We made no draws and had no outstanding cash borrowings on the line of credit as of March 31, 2017.
As
of March 31, 2017, we had $3.3 million in USD equivalent value in outstanding letters of credit and $2.1 million in restricted cash, primarily associated with certain letters of credit to secure customer prepayments and other customer related obligations.
In our normal course of operations, we have development arrangements under which we engage third-party engineering resources to work on our research and development projects. For the three months ended March 31, 2017, we incurred $7.5 million for such arrangements.
At any particular time, our cash position is affected by the timing of cash receipts for product sales, maintenance contracts,
government co-funding for research and development activities and our payments for inventory, resulting in significant fluctuations in our cash balance from quarter-to-quarter and within a quarter. Our principal sources of liquidity are our cash and cash equivalents, short-term investments and cash from operations. We expect our cash resources to be adequate for at least the next twelve months.
Critical Accounting Policies and Estimates
This discussion, as well as disclosures included elsewhere in this quarterly report on Form 10-Q, are based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingencies. In preparing our financial statements
in accordance with GAAP, there are certain accounting policies that are particularly important. These include revenue recognition, inventory valuation, accounting for income taxes, research and development expenses and share-based compensation. Our significant accounting policies are set forth in Note 2 to the Consolidated Financial Statements included in our annual report on Form 10-K for the year ended December 31, 2016 and should be reviewed in conjunction with the accompanying Condensed Consolidated Financial Statements and notes thereto as of March 31, 2017 in this quarterly report on Form 10-Q, as they are integral to understanding our results of operations and financial condition in this interim period. In some cases, these policies represent required accounting. In other
cases, they may represent a choice among acceptable accounting methods or may require substantial judgment or estimation.
Additionally, we consider certain judgments and estimates to be significant, including those relating to the estimated selling price determination used in revenue recognition, percentage of completion accounting, estimates of proportional performance on co-funded engineering contracts, collectibility of receivables, determination of inventory at the lower of cost or net realizable value, the value of used equipment returned or to be returned associated with customer contracts, useful lives for depreciation and amortization, determination of future cash flows associated with impairment testing of long-lived assets, including goodwill
and other intangibles, determination of the implicit interest rate used in the sales-type lease calculation, estimated warranty liabilities, determination of the fair value of stock options and other assessments of fair value, evaluation of the probability of vesting of performance-based restricted stock and restricted stock units, calculation of deferred income tax assets, including estimates of future financial performance in the determination of the likely recovery of deferred income tax assets, our ability to utilize such assets, potential income tax assessments, the outcome of any legal proceedings and other contingencies. We base our estimates on historical experience, current conditions and on other assumptions that we believe to be reasonable under the circumstances. Actual results may differ materially from these estimates and assumptions.
Our management has discussed the selection of significant accounting policies
and the effect of judgments and estimates with the Audit Committee of our Board of Directors.
Revenue Recognition
We recognize revenue, including transactions under sales-type leases, when it is realized or realizable and earned. We consider revenue realized or realizable and earned when we have persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Delivery does not occur until the products have been shipped or services provided to the customer, the risk of loss has transferred to the customer, and, where applicable, a customer acceptance has been obtained. The sales price is not considered to be fixed or determinable until all material contingencies related to the sales have been resolved. We record revenue in the Condensed Consolidated Statements of Operations net of any sales, use, value
added
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or certain excise taxes imposed by governmental authorities on specific sales transactions. In addition to the aforementioned general policy, the following are our statements of policy with regard to multiple-element arrangements and specific revenue recognition policies for each major category of revenue.
Multiple-Element Arrangements. We commonly enter into revenue arrangements that include multiple deliverables of our product and service offerings due to the needs of our customers. Products may be delivered in phases over time periods which can be as long as five years. Maintenance services generally begin upon acceptance of the first equipment delivery and future deliveries of
equipment generally have an associated maintenance period. We consider the maintenance period to commence upon acceptance of the product, or installation of the product where a formal acceptance is not required, which may include a warranty period and accordingly allocate a portion of the arrangement consideration as a separate deliverable which is recognized as service revenue over the entire service period. Other services such as training and engineering services can be delivered as a discrete delivery or over the term of the contract. A multiple-element arrangement is separated into more than one unit of accounting if the following criteria are met:
•
The delivered item(s)
has value to the customer on a standalone basis; and
•
If the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control.
If these criteria are met for each element, the arrangement consideration is allocated to the separate units of accounting based on each unit’s relative selling price. If these criteria are not met, the arrangement is accounted for as one unit of accounting which would result in revenue being recognized ratably over the contract term or being deferred
until the earlier of when such criteria are met or when the last undelivered element is delivered.
We follow a selling price hierarchy in determining the best estimate of the selling price of each deliverable. Certain products and services are sold separately in standalone arrangements for which we are sometimes able to determine vendor specific objective evidence, or VSOE. We determine VSOE based on normal pricing and discounting practices for the product or service when sold separately.
When we are not able to establish VSOE for all deliverables in an arrangement with multiple elements, we attempt to establish the selling price of each remaining element based on third-party evidence, or TPE. Our inability to establish VSOE is often due to a relatively small sample of customer contracts that
differ in system size and contract terms which can be due to infrequently selling each element separately, not pricing products within a narrow range, or only having a limited sales history, such as in the case of certain advanced and emerging technologies. TPE is determined based on our prices or competitor prices for similar deliverables when sold separately. However, we are often unable to determine TPE, as our offerings usually contain a significant level of customization and differentiation from those of competitors and we are often unable to reliably determine what similar competitor products’ selling prices are on a standalone basis.
When we are unable to establish selling price using VSOE or TPE, we use estimated selling price, or ESP, in our allocation of arrangement consideration. The objective of ESP is to determine the price
at which we would transact a sale if the product or service were sold on a standalone basis. In determining ESP, we use the cost to provide the product or service plus a margin, or consider other factors. When using cost plus a margin, we consider the total cost of the product or service, including customer-specific and geographic factors. We also consider the historical margins of the product or service on previous contracts and several factors including any changes to pricing methodologies, competitiveness of products and services and cost drivers that would cause future margins to differ from historical margins.
Products. We most often recognize revenue from sales of products upon delivery or customer acceptance of the system. Where formal acceptance is not required, we recognize revenue upon delivery or installation.
When the product is part of a multiple element arrangement, we allocate a portion of the arrangement consideration to product revenue based on estimates of selling price.
Services. Maintenance services are provided under separate maintenance contracts with customers. These contracts generally provide for maintenance services for one year, although some are for multi-year periods, often with prepayments for the term of the contract. We consider the maintenance period to commence upon acceptance of the product or installation in situations where a formal acceptance is not required, which may include a warranty period. When service is
part of a multiple element arrangement, we allocate a portion of the arrangement consideration to maintenance service revenue based on estimates of selling price. Maintenance contracts that are billed in advance of revenue recognition are recorded as deferred revenue. Maintenance revenue is recognized ratably over the term of the maintenance contract.
Revenue from engineering services is recognized as services are performed.
Project Revenue. Revenue from design and build contracts is recognized under the percentage-of-completion (or POC method). Under the POC method, revenue is recognized
based on the costs incurred to date as a percentage of the total estimated costs to fulfill the contract. If circumstances arise that change the original estimates of revenues, costs, or extent of progress toward
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completion, revisions to the estimates are made. These revisions may result in increases or decreases in estimated revenues or costs, and such revisions are recorded in income in the period in which the circumstances that gave rise to the revision become known by management. We perform ongoing profitability analyses of our contracts accounted for under the POC method
in order to determine whether the latest estimates of revenue, costs and extent of progress require updating. If at any time these estimates indicate that the contract will be unprofitable, the entire estimated loss for the remainder of the contract is recorded immediately.
We record revenue from certain research and development contracts which include milestones using the milestone method if the milestones are determined to be substantive. A milestone is considered to be substantive if management believes there is substantive uncertainty that it will be achieved and the milestone consideration meets all of the following criteria:
•
It
is commensurate with either of the following:
•
Our performance to achieve the milestone; or
•
The enhancement of value of the delivered item or items as a result of a specific outcome resulting from our performance to achieve the milestone.
•
It relates solely to past performance.
•
It
is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement.
The individual milestones are determined to be substantive or non-substantive in their entirety and milestone consideration is not bifurcated.
Revenue from projects is classified as Product Revenue or Service Revenue, based on the nature of the work performed.
Nonmonetary Transactions. We value and record nonmonetary transactions at the fair value of the asset surrendered unless the fair value of the asset received is more clearly evident, in which case the fair value of the asset received is used.
Inventory Valuation
We record our inventory at the lower of cost or net
realizable value. We regularly evaluate the technological usefulness and anticipated future demand for our inventory components. Due to rapid changes in technology and the increasing demands of our customers, we are continually developing new products. Additionally, during periods of product or inventory component upgrades or transitions, we may acquire significant quantities of inventory to support estimated current and future production and service requirements. As a result, it is possible that older inventory items we have purchased may become obsolete, be sold below cost or be deemed in excess of quantities required for production or service requirements. When we determine it is not likely we will recover the cost of inventory items through future sales, we write-down the related inventory to our estimate of its net realizable value.
Because the products we sell have high average sales prices and because a high number of
our prospective customers receive funding from U.S. or foreign governments, it is difficult to estimate future sales of our products and the timing of such sales. It also is difficult to determine whether the cost of our inventories will ultimately be recovered through future sales. While we believe our inventory is stated at the lower of cost or net realizable value and that our estimates and assumptions to determine any adjustments to the cost of our inventories are reasonable, our estimates may prove to be inaccurate. We have sold inventory previously reduced in part or in whole to zero, and we may have future sales of previously written-down inventory. We also may incur additional expenses to write-down inventory to its estimated net realizable value. Adjustments to these estimates in the future may materially impact our operating results.
Accounting for Income Taxes
Deferred
tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and operating loss and tax credit carryforwards and are measured using the enacted tax rates and laws that will be in effect when the differences and carryforwards are expected to be recovered or settled. Currently, there are a number of proposals that are being considered that would substantially reduce the maximum U.S. corporate income tax rate. If any of these proposals are enacted into law, we anticipate that we would be required to record a significant non-cash charge to earnings at that time.
A valuation allowance for deferred tax assets is provided when we estimate that it is more likely than not that all or a portion of the deferred tax assets will not be realized through future operations. This assessment is based upon consideration of available positive and negative evidence, which includes,
among other things, our recent results of operations and expected future profitability. We consider our actual historical results over several years to have stronger weight than other more subjective indicators, including forecasts, when considering whether to establish or reduce a valuation allowance on deferred tax assets. We have significant difficulty projecting future results due to the nature of the business and the industry in which we operate.
As of March 31, 2017, we had approximately $106 million of net deferred tax assets, against which we provided a $9 million valuation allowance, resulting in a net deferred tax asset of $97 million. Included in our deferred tax assets are deferred tax assets
31
of
$9.0 million related to federal net operating loss carryforwards that will expire between 2019 and 2021 and a deferred tax asset of $1.3 million related to a federal research and development tax credit that will expire in 2021. The assessment of our ability to utilize our deferred tax assets included an assessment of all known business risks and industry trends, forecasted domestic and international earnings over a number of years, and certain tax planning strategies. 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.
We continue to provide a valuation allowance against specific U.S. deferred tax assets and a full valuation allowance against deferred tax assets arising in a limited number of foreign jurisdictions as the realization of such assets is not considered to be more likely than not at this
time. In a future period our assessment of the realizability of our deferred tax assets and therefore the appropriateness of the valuation allowance could change based on an assessment of all available evidence, both positive and negative in that future period. If our conclusion about the realizability of our deferred tax assets and therefore the appropriateness of the valuation allowance changes in a future period we could record a substantial tax provision or benefit in our Condensed Consolidated Statement of Operations when that occurs. We recognize the income tax benefit from a tax position only if it is more likely than not that the tax position will be sustained on examination by the applicable taxing authorities, based on the technical merits of our position. The tax benefit recognized in the financial statements from such a position is measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement.
Estimated
interest and penalties are recorded as a component of interest expense and other expense, respectively.
Research and Development Expenses
Research and development expenses include costs incurred in the development and production of our hardware and software, costs incurred to enhance and support existing product features, costs incurred to support and improve our development processes, and costs related to future product development. Research and development costs are expensed as incurred, and may be offset by co-funding from third parties. We may also enter into arrangements whereby we make advance, non-refundable payments to a vendor to perform certain research and development services. These payments are deferred and recognized over the vendor’s estimated performance period.
Amounts to be received under co-funding arrangements with the
U.S. government or other customers are based on either contractual milestones or costs incurred. These co-funding milestone payments are recognized in operations as performance is estimated to be completed and are measured as milestone achievements occur or as costs are incurred. These estimates are reviewed on a periodic basis and are subject to change, including in the near term. If an estimate is changed, net research and development expense could be impacted significantly.
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. Funding from the U.S. government is subject to certain budget restrictions and milestones may be subject to completion risk, and as a result, there may be periods in which research and development costs are expensed as incurred for which no reimbursement is recorded, as milestones have not been completed
or the U.S. government has not funded an agreement. Accordingly, there can be substantial variability in the amount of net research and development expenses from quarter to quarter and year to year.
We classify amounts to be received from funded research and development projects as either revenue or a reduction to research and development expense based on the specific facts and circumstances of the contractual arrangement, considering total costs expected to be incurred compared to total expected funding and the nature of the research and development contractual arrangement. In the event that a particular arrangement is determined to represent revenue, the corresponding costs are classified as cost of revenue.
Share-based Compensation
We measure compensation cost for share-based payment awards at fair value and recognize it as compensation
expense over the service period for awards expected to vest. We recognize share-based compensation expense for all share-based payment awards, net of an estimated forfeiture rate. We recognize compensation cost for only those shares expected to vest on a straight-line basis over the requisite service period of the award.
Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We utilize the Black-Scholes options pricing model to value the stock options granted under our options plans. In this model, we utilize assumptions related to stock price volatility, stock option term and forfeiture rates that are based upon both historical factors as well as management’s judgment.
The fair value of restricted stock and restricted
stock units is determined based on the number of shares or units granted and the quoted price of our common stock at the date of grant.
We grant performance vesting restricted stock and performance vesting restricted stock units to executives as one of the ways to align compensation with shareholder interests. Vesting of these awards is contingent upon achievement of certain
32
performance conditions. Compensation expense for these awards is only recognized when vesting is deemed to be “probable”. Awards are evaluated for probability of vesting during each reporting period.
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Item 3.
Quantitative and Qualitative Disclosures About Market Risk
We are exposed to financial market risks, including changes in interest rates and equity price fluctuations.
Interest Rate Risk: We invest our available cash in money market mutual funds whose underlying investments include investment-grade debt instruments of corporate issuers and in debt instruments of the U.S. government and its agencies. We do not have any derivative instruments or auction rate securities in our investment portfolio. We protect and preserve invested funds by limiting default, market and reinvestment risk. Investments in both fixed-rate and floating-rate interest earning instruments carry a degree of interest rate risks. Fixed-rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating-rate securities may produce less income
than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates. Although we are subject to the above noted risks, we believe that a 0.5% change in interest rates would not be material.
Foreign Currency Risk: We sell our products primarily in North America, Asia and Europe. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Our products are generally priced based on U.S. dollars, and a strengthening of the U.S. dollar could make our products less competitive in foreign markets. While we often sell products with payments in U.S. dollars, our product sales contracts
may call for payment in foreign currencies and to the extent we do so, or engage with our foreign subsidiaries in transactions deemed to be either short-term or long-term in nature, we are subject to foreign currency exchange risks.
As of March 31, 2017, we had entered into foreign currency exchange contracts that were designated as cash flow hedges that hedge approximately $77.7 million of anticipated cash receipts on specific foreign currency denominated sales contracts. These foreign currency exchange contracts
hedge the risk of foreign exchange rate changes between the time that the related contracts were signed and when the cash receipts are expected to be received. As of March 31, 2017, we had entered into foreign currency exchange contracts that had been dedesignated for the purposes of hedge accounting treatment totaling $56.2 million. Unrealized gains or losses recorded in the Condensed Consolidated Statement of Operations related to these contracts are generally offset by foreign currency adjustments on related receivables. These foreign currency exchange contracts
are considered to be economic hedges.
Our foreign maintenance contracts are typically paid in local currencies and provide a partial natural hedge against foreign exchange exposure. To the extent that we wish to repatriate any of these funds to the United States, however, we are subject to foreign exchange risks. We do not hold or purchase any currency forward exchange contracts for trading purposes. As of March 31, 2017, a hypothetical 10% unfavorable change in foreign currency exchange rates would impact our annual operating results by approximately $0.2 million.
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Item 4.
Controls and Procedures
Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our senior management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this quarterly report on Form 10-Q. Based on this evaluation, our chief executive officer and chief financial officer concluded as of March 31, 2017 that our disclosure controls and procedures were effective such that the information required to be disclosed in our SEC reports (i) is recorded, processed, summarized and reported within the time
periods specified in SEC rules and forms, and (ii) is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in internal control over financial reporting. There have been no changes in our internal control over financial reporting that occurred during the quarter ended March 31, 2017 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
Limitations on effectiveness of control. Our management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or our internal controls
will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected.
35
Part II. OTHER INFORMATION
Item 1.
Legal Proceedings
For a discussion of legal proceedings, see “Note 11-Contingencies” in the Notes to Condensed Consolidated Financial Statements in this quarterly report on Form 10-Q.
Item 1A. Risk Factors
You should carefully consider the risks described below together with all of the other information in this quarterly report on Form 10-Q and in our annual report on Form 10-K for the year ended December 31, 2016, filed with the SEC on February 10, 2017.
If any of these risks actually occur, our business, financial condition or operating results could be materially adversely affected and the trading price of our common stock could decline.
Our operating results fluctuate significantly and we may not achieve profitability in any given period. Our operating results are subject to significant fluctuations which make predicting revenue and operating results for any specific period very difficult, particularly because a material portion of product revenue recognized in any given quarter or year typically depends on a limited number of system sales expected for that quarter or year and the product revenue generally depends on the timing of product acceptances by customers and contractual provisions affecting revenue recognition. Receiving less than anticipated customer orders for delivery and acceptance of product for a particular period, delays in achieving
customer acceptances of installed systems and recognizing revenue from a product transaction or transactions due to development or product delivery delays, unexpected manufacturing delays or defects, not receiving needed components on time or not receiving them with anticipated quality and performance or the inability of a system to meet performance requirements or targets or other contractual obligations, among other factors, could have a material adverse effect on our operating results in any specific quarter or year, such as by reducing or delaying associated revenue, gross profit and cash receipts from one quarter to another, or even from one year to another in the case of revenue expected to be realized in the fourth quarter of any year, as occurred in the fourth quarter of 2014. In addition, because our revenue can be concentrated in particular quarters, often the fourth quarter, rather than evenly spread throughout a year, we generally do not expect to sustain
profitability over successive quarters even if we are profitable for the year.
Although we have recorded positive annual net income since 2010, we experienced net losses in earlier periods and could experience a net loss in any future year in addition to quarterly losses. Net income may fluctuate significantly as a result of many factors, including as a result of significant investments we may make to grow our business even though the benefits of those investments often require many years to come to fruition and may not be realized when expected or at all. For example, we anticipate incurring significant expenditures in connection with the expansion of our facilities and continued investments in research and development. Due to the inherent difficulty in estimating costs associated with projects of this scale and nature, certain of the costs associated with these potential projects may be higher than estimated and it may take
longer than expected to complete, if at all. In addition, while we were profitable in 2016, our revenue and profitability declined year over year, substantially driven by a slow-down in the segments of the high-end of the supercomputing market that we target. It is uncertain whether or when the segments of the high-end of the supercomputing market that we target will rebound and resume growing.
Whether we will be able to increase our revenue and achieve and sustain profitability on a quarterly and annual basis depends on a number of factors, including:
•
our ability to secure sufficient orders for our Cray XC and Cray CS systems as well as upgrades and successor systems, such as our next generation “Shasta” system;
•
successfully
delivering and obtaining sufficient customer acceptances of our Cray XC and Cray CS systems, including attached Sonexion storage systems;
•
our ability to successfully generate revenue and profitability from sales of our analytics and storage and data management products, as well as upgrades and successor systems;
•
our ability to successfully and timely design for, procure and integrate competitive processors for our Cray XC and Cray CS systems and upgrades and successor systems;
•
our
expense levels, including research and development expense net of government funding;
•
delays in delivery of upgraded or new systems, longer than expected customer acceptance cycles or penalties resulting from system acceptance issues;
•
our ability to efficiently scale our internal processes to meet necessary peak requirements and growth in our business;
•
the
level of revenue recognized in any given period, which is affected by the very high average sales prices and limited number of significant system sales and resulting potential acceptances in any quarter, the timing of product
36
orders and acceptances by customers and contractual provisions affecting the timing and amount of revenue recognition;
•
our ability to continue to broaden our customer base beyond our traditional customers;
•
revenue
delays or losses due to customers postponing purchases as a result of delays in available budgets or waiting times related to the availability of future upgraded or new systems, including those containing new processors;
•
the level of product gross profit contribution in any given period due to volume, competition or product mix, particularly with the introduction of flexible commodity-based supercomputers, competitive factors, strategic transactions, product life cycle, currency fluctuations, acceptance penalties and component costs;
•
the
competitiveness of our products, services and prices;
•
our ability to secure additional government funding for future development projects;
•
maintaining and successfully completing our product development projects on schedule and within budgetary limitations;
•
our ability to resolve and the costs
incurred in connection with any actual or alleged issues with our products, including third-party components of such products, such as those that relate to product defects or intellectual property rights;
•
the level and timing of maintenance contract renewals with existing customers; and
•
the terms and conditions of sale or lease for our products and services.
The receipt
of orders and the timing of shipments and acceptances impacts our quarterly and annual results, including cash flows, and is affected by events outside our control, such as:
•
whether or when the segments of the high-end of the supercomputing market that we target, which is currently experiencing a slow-down, rebounds and resumes growing;
•
the timely availability of acceptable components, including, but not limited to, processors, in sufficient quantities to meet customer delivery schedules and other customer commitments at a competitive
cost;
•
the timing and level of government funding and resources available for product acquisitions and research and development contracts, which have been, and may continue to be, adversely affected by the current global economic and fiscal uncertainties, increased governmental budgetary limitations and disruptions in the operations of the United States and other governments;
•
competitor and supplier pricing strategies;
•
currency
fluctuations, international conflicts or economic crises, including the ongoing economic challenges in the United States, Japan and Europe, and fluctuations in oil prices that can affect the resources available to potential customers to purchase products;
•
new tariffs or taxes imposed on components and products sourced or manufactured outside of the United States;
•
the introduction or announcement of competitive or key industry supplier products;
•
price
fluctuations or product shortages in the processors and other commodity electronics and memory markets;
•
the availability of adequate customer facilities to install and operate new Cray systems;
•
general economic trends, including changes in levels of customer capital spending; and
•
our customers’
ability to make future payments in accordance with contractual terms of their purchase or sales-type lease agreements.
Because of the numerous factors affecting our revenue and results of operations, we may not achieve profitability on a quarterly or annual basis in the future. We anticipate that our quarterly results will fluctuate significantly, and include losses, even in years where we expect or achieve positive annual net income. Delays in the availability of acceptable third-party components, product development, receipt of orders, product acceptances, issues with third-party component performance or reliability, reductions in outside funding for our research and development efforts, a reduction in the size in the segments of the high-end of the supercomputing market that we target, the level and timing of approved government fiscal budgets and achieving contractual development milestones have had a
substantial adverse effect on our past results and are expected to continue to have such an effect on our results in 2017 and in future years.
Our business could be adversely affected by conditions affecting the HPC market. A substantial portion of our business depends on the demand for HPC products by large enterprise, the U.S. government and foreign government
37
customers, and we are dependent upon the overall economic health of the high-end of the supercomputing market. Demand for our products and services depends substantially upon the general demand for supercomputers and associated services, as well as technological needs in the data analytics, artificial intelligence
and storage markets, which fluctuate based on numerous factors, including capital spending levels and growth of our current and prospective customers. Moreover, the purchase of our products is often discretionary and may involve a significant commitment of capital and other resources. As a result, spending priorities for our current and future customers may vary and demand for our products and services may also fluctuate. For instance, while we were profitable in 2016, our revenue and profitability declined year over year, substantially driven by a slow-down in the segments of the high-end of the supercomputing market that we target. It is uncertain whether or when these segments will recover from the ongoing downturn. While we believe that the market’s long-term growth drivers remain intact, there is no assurance that these markets will rebound and resume growing. A prolonged slow-down in these markets could harm our financial condition and results of operations.
If
we are unable to successfully develop, sell and deliver our Cray XC systems and successor systems, such as our next generation Shasta system, and recognize revenue for these systems, our operating results will be adversely affected. We expect that a substantial portion of our revenue in the foreseeable future will come from acceptances of delivered Cray XC systems and successor systems, such as our next generation Shasta system, including systems integrating future processors and accelerators where we are dependent upon third-party suppliers to deliver according to expected plans. The development efforts related to these systems are lengthy and technically challenging processes, and require a significant investment of capital, engineering and other resources often years ahead of the time when we can be assured that they will result in competitive products. We may invest significant resources that may prove ultimately unsuccessful. Unanticipated
performance and/or development issues may require more engineers, time or testing resources than are currently available. Given the breadth of our engineering challenges, changes in the market and technology and our limited engineering and technical personnel resources, we periodically review the anticipated contributions and expense of our product programs to determine their long-term viability, and we may substantially modify or terminate one or more development programs. We may not be successful in meeting our development schedules for technical reasons, including those related to our dependence on third-party suppliers of components such as processors and accelerators, and/or because of insufficient engineering resources, which could result in an uncompetitive product or cause a lack of confidence in our capabilities among our key customers. To the extent that we incur delays in completing the design, development and production of hardware components, delays in development
of requisite system software, cancellation of or changes to programs due to technical or economic infeasibility, inability to source acceptable third-party components such as processors and accelerators or investment in unproductive development efforts, our revenue, results of operations and cash flows, and the reputation of such systems in the market, could be adversely affected.
In addition, many factors affect our ability to successfully sell and recognize revenue for these systems, including the following:
•
the level of product differentiation in our Cray XC systems and successor systems, such as our next generation Shasta system. We need to compete successfully against HPC systems from both large, established companies
and smaller companies and demonstrate the value of our balanced, tightly integrated systems to our customers in a variety of markets;
•
our ability to meet all customer requirements for acceptance. Even once a system has been delivered, we sometimes do not meet all of the contract requirements for customer acceptance and ongoing reliability of our systems within the provided-for acceptance period, which has resulted in contract penalties and delays in our ability to recognize revenue from system deliveries. Most often these penalties have adversely affected revenue
and gross profit at the time of revenue recognition through the provision of additional equipment and services and/or service credits to satisfy delivery delays and performance shortfalls. The risk of contract penalties is increased when we bid for new business prior to us or our suppliers completing development of new products and when we must estimate future system performance, such as has been required with our Cray XC systems and our Sonexion storage systems, and will be frequently required for subsequent systems, such as our next generation Shasta system;
•
our ability to source competitive, key components in appropriate quantities (to have enough
to sell without ending up with excess inventory that can lead to obsolescence charges), in a timely fashion and on acceptable terms and conditions and that meet the performance criteria required; and
•
whether potential customers delay purchases of our products because they decide to wait for successor systems or upgrades that we or our suppliers have announced or they believe will be available in the future.
Failure to successfully develop and sell our Cray XC systems and successor systems, such as our next generation Shasta system, into the supercomputing market and recognize revenue for such systems will adversely affect our operating results.
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If
our current and future products targeting markets outside of our traditional markets, primarily products targeting the big data and commercial markets, are not successful, our ability to grow or even maintain our revenues and achieve and sustain profitability will be adversely affected. Our ability to materially grow or even maintain our revenues and achieve and sustain profitability will be adversely affected if we are unable to generate sufficient revenue from products targeting markets outside of our traditional markets, including if those market segments do not grow significantly. We are currently focusing on big data analytics, artificial intelligence and storage and data management opportunities as well as the commercial market for all of our products. To grow our revenue from opportunities outside our primary markets, we must successfully and in a cost-effective manner design and develop products utilizing technologies different from our
traditional supercomputing products, compete successfully with many established companies and new entrants in these markets, continue to win awards for new contracts, timely perform on existing contracts, develop our capability for broader market sales and business development and successfully develop and introduce new solution-oriented offerings, notwithstanding that these are relatively new businesses for us and we do not have significant experience targeting these markets. Big data analytics, artificial intelligence and storage and data management opportunities require significant monetary investments ahead of revenue, including product development efforts, adding experienced personnel and initiating new marketing and sales efforts and therefore may reduce net income in the short term
even if successful.
Our reliance on third-party suppliers poses significant risks to our operating results, business and prospects. We rely upon third-party vendors, particularly Intel, to supply processors, including graphics processing units, and for most of the products, we sell and use service providers to co-develop key technologies. We subcontract the manufacturing of a majority of the hardware components for our high-end products, including integrated circuits, printed circuit boards, memory parts, cables and power supplies, on a sole or limited source basis to third-party suppliers. We use contract manufacturers to assemble certain important components for all of our systems. We also rely on third parties to supply key software and hardware capabilities, such as file systems, solution-specific servers and
storage subsystems, and in the case of our Sonexion products, we rely on third-party original equipment manufacturers to supply complete storage systems. Because specific components must be designed into our systems well in advance of initial deliveries of those systems, we are particularly reliant on our processor vendors, particularly Intel, to deliver on the capabilities and pricing expected at the time we design key elements of the system and make binding bids to customers. We are subject to substantial risks because of our reliance on these and other limited or sole source suppliers, including the following risks:
•
if a supplier does not provide components or systems that meet our or their specifications in sufficient quantities and with acceptable performance
or quality on time or deliver when required, or delays future components or systems beyond anticipated delivery dates, then sales, production, delivery, acceptance and revenue from our systems could be delayed and/or reduced and we could be subject to costly penalties even once delivered and accepted, which is currently happening and has happened multiple times in the past and has at times significantly lowered our revenue for a particular quarter or year;
•
if our relationship with a key supplier, such as Intel, is adversely affected, for example, due to competitive pressures, our ability to obtain components on competitive financial terms could be adversely affected;
•
if
a supplier cannot provide a competitive key component, for example, due to inadequate performance or a prohibitive price, or eliminates key features from components, such as with the processors we design into our systems, our systems may be less competitive than systems using components with greater capabilities;
•
if an interruption of supply of our components, services or capabilities occurs because a supplier changes its technology roadmap, suffers damage to its manufacturing facilities, decides to no longer provide those products or services, increases the price of those products or services significantly or imposes reduced delivery allocations on its customers, it could take us a considerable period of time to identify and qualify alternative
suppliers, to redesign our products as necessary and to begin to manufacture the redesigned components or otherwise obtain those services or capabilities. In some cases, such as with key integrated circuits and memory parts or processors, we may not be able to redesign such components or find alternate sources that we could use in any realistic timeframe;
•
if a supplier plans future processors that are made available in a way that encourages customers to delay purchases of our products because they decide to wait for successor systems or upgrades they believe will be available in the future or to purchase products with the future processors from our competitors who are willing to take greater risk on delivery;
•
if
Cray systems at customer sites develop significant issues with third-party components, as has occurred, the cost to Cray to repair or replace the components or otherwise address such issue may be material. If we are unable to effectively address such problem or a problem causes customer disruption, our relationship with our customers may also be harmed;
39
•
if a supplier of a component is subject to a claim that the component infringes a third-party’s intellectual property rights, as has happened with multiple suppliers, our ability to obtain necessary components could be adversely
affected or our cost to obtain such components could increase significantly;
•
if a supplier providing us with key research and development and design services or core technology components with respect to integrated circuit design, network communication capabilities or software is late, fails to provide us with effective functionality or loses key internal talent, our development programs may be delayed or prove to be impossible to complete;
•
if a supplier provides us with hardware or software that contains bugs or other
errors or defects, or is different from what we expected, our development projects and production systems may be adversely affected through reduced performance or capabilities, additional design testing and verification efforts, re-spins of integrated circuits and/or development of replacement components, and the production and sales of our systems could be delayed and systems installed at customer sites could require significant, expensive field component replacements or result in penalties;
•
some of our key component and service suppliers are small companies with limited financial and other resources, and consequently may be more likely to experience financial and operational difficulties than larger, well-established companies, which increases
the risk that they will be unable to deliver products as needed; and
•
if a key supplier is acquired or has a significant business change, as has occurred in the past with the acquisition of the third-party original equipment manufacturer that supplies complete storage systems for our Sonexion product, the production and sales of our systems and services may be delayed or adversely affected, or our development programs may be delayed or may be impossible to complete.
Delays in the availability of components with acceptable performance, features and reliability, or our inability to obtain such acceptable components in the quantities we need or at all, and increases in prices and order
lead times for certain components, have occurred in the past, and we are currently experiencing increased delivery timelines of memory and other key components. These types of issues have adversely affected our revenue and operating results in multiple prior periods, in some cases significantly, and could adversely affect future results.
The continuing commoditization of HPC hardware and software has resulted in increased pricing pressure and may adversely affect our operating results. The continuing commoditization of HPC hardware, such as processors, interconnects, storage and other infrastructure, and the growing commoditization of software, including plentiful building blocks and more capable open source software, as well as the potential for integration of differentiated technology into already-commoditized components, has resulted in, and may result in increased pricing pressure that may cause us
to reduce our pricing in order to remain competitive, which can negatively impact our gross margins and adversely affect our operating results.
If the U.S. government and other governments purchase, or fund the purchase of, fewer supercomputers or delay such purchases, our revenue would be reduced and our operating results would be adversely affected. Historically, sales to the U.S. Government have represented the largest single market segment for supercomputer sales worldwide, including our products and services. In 2014, 2015, 2016 and the first three months of 2017, approximately 48%, 47%, 47% and 58%, respectively, of our total revenue was derived from such sales. Our plans
for the foreseeable future contemplate significant sales to the U.S. Government. Sales to the U.S. Government and other governments, including further sales pursuant to existing contracts, have been, and may continue to be, adversely affected by factors outside our control, such as by:
•
uncertainties relating to priorities of the new administration or adverse decisions by the new administration to reduce or eliminate budgets for governmental agencies or departments that purchase or fund the purchase of our products and services;
•
Congressional
decisions in addressing budget concerns and current economic uncertainty;
•
disruptions in the operations of the U.S. government, including impacts of the new administration;
•
“sequestration”;
•
the downgrading of U.S. government debt or the possibility of such action;
•
the
political climate in the United States focusing on cutting or limiting budgets and its affect on government budgets;
•
the limits on federal borrowing capacity;
•
changes in procurement policies;
•
budgetary considerations, including Congressional delays in completing appropriation bills as has
occurred in the past and which is the case right now as Congress is operating under a Continuing Resolution at fiscal year 2016 levels until May 5, 2017;
40
•
domestic crises;
•
political efforts to limit the activities of U.S. intelligence community agencies, including proposed state legislation that would
limit or even criminalize doing business with the U.S. National Security Agency for certain companies doing business with state governments; and
•
international political developments, such as the downgrading of European debt or the United Kingdom's departure from the European Union.
If agencies and departments of the United States or other governments were to stop, reduce or delay their use and purchases of supercomputers, our revenue and operating results would be adversely affected.
If we cannot retain, attract and motivate key personnel, we may be unable to effectively implement our business plan. Our success depends
in large part upon our ability to retain, attract and motivate highly skilled management, development, marketing, sales and service personnel. The loss of and failure to replace key technical management and personnel could adversely affect multiple development efforts. Recruitment and retention of senior management and skilled technical, sales and other personnel is very competitive, and we may not be successful in either attracting or retaining such personnel. We have lost key personnel to other high technology companies, and many larger companies with significantly greater resources than us have aggressively recruited, and continue to aggressively recruit, key personnel. As part of our strategy to attract and retain key personnel, we may offer equity compensation through grants of stock options, restricted stock awards or restricted stock units. Potential employees, however, may not perceive our equity incentives as attractive enough. In addition, due to the intense
competition for qualified employees, we may be required to, and have had to, increase the level of compensation paid to existing and new employees, which could materially increase our operating expenses.
We may infringe or be subject to claims that we infringe the intellectual property rights of others. We are and may in the future be subject to patent infringement and other intellectual property claims and lawsuits in various jurisdictions, and we cannot be certain that our products or activities do not violate the patents, trademarks, or other intellectual property rights of third-party claimants. Companies in the technology industry and other patent, copyright, and trademark holders seeking to profit from royalties in connection with grants of licenses own large numbers of patents, copyrights, trademarks, domain names, and trade secrets and frequently commence litigation based on allegations of infringement,
misappropriation, or other violations of intellectual property or other rights. As we face increasing competition and gain an increasingly high profile, the intellectual property rights claims against us have grown and will likely continue to grow. For example, we are currently involved in litigation with Raytheon Company, or Raytheon, which is described in Note 11, “Contingencies” in the Notes to our Condensed Consolidated Financial Statements in this quarterly report on Form 10-Q.
We intend to vigorously defend and prosecute these litigation matters and, based on our reviews to date, we believe we have valid defenses with respect to each of these matters. However, litigation is inherently uncertain, and any judgment or injunctive relief entered against us or any adverse settlement could materially and adversely impact our business, financial condition, operating results, and prospects. As a result of these or other
intellectual property infringement claims, we could be required or otherwise decide that it is appropriate to:
•
pay third-party infringement claims;
•
discontinue manufacturing, using or selling particular products subject to infringement claims;
•
discontinue using the technology or processes subject to infringement
claims;
•
develop other technology not subject to infringement claims, which could be time-consuming and costly or may not be possible; and/or
•
license technology from the third-party claiming infringement, which license may not be available on commercially reasonable terms, or at all.
In addition, litigation can involve significant management time and attention and can be expensive, as it has been with Raytheon, regardless of outcome. During the course of these
litigation matters, there may be announcements of the results of hearings and motions, and other interim developments related to the litigation matters. If securities analysts or investors regard these announcements as negative, the market price of our common stock may decline.
If our cluster systems are not successful, our operating results will be adversely affected. Our cluster products were first introduced in late 2012. We have had relatively limited experience selling cluster-based solutions, including into the same markets we sell our core supercomputers, and if we cannot successfully sell these solutions with acceptable margins, our operating results will be adversely affected.
41
We
have made in the past, and may make in the future, acquisitions which could require significant management attention, disrupt our business, result in dilution to our shareholders, deplete our cash reserves and adversely affect our financial results. Acquisitions involve numerous risks, including the following:
•
difficulties in successfully integrating the operations, systems, technologies, products, offerings and personnel of the acquired company or companies;
•
insufficient revenue to offset increased expenses associated
with acquisitions;
•
diversion of management’s attention from normal daily operations of the business and the challenges of managing larger and more widespread operations resulting from acquisitions;
•
potential difficulties in completing projects associated with in-process research and development intangibles;
•
difficulties
in entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions;
•
initial dependence on unfamiliar supply chains or relatively small supply partners; and
•
the potential loss of key employees, customers, distributors, vendors and other business partners of the companies we acquire following and continuing after announcement of acquisition plans.
Acquisitions may also cause us to:
•
use
a substantial portion of our cash reserves or incur debt;
•
issue equity securities or grant equity incentives to acquired employees that would dilute our current shareholders’ percentage ownership;
•
assume liabilities, including potentially unknown liabilities;
•
record goodwill and non-amortizable
intangible assets that are subject to impairment testing on a regular basis and potential periodic impairment charges;
•
incur amortization expenses related to certain intangible assets;
•
incur large and immediate write-offs and restructuring and other related expenses; or
•
become subject to intellectual
property litigation or other litigation.
Acquisitions of high-technology companies and assets are inherently risky and subject to many factors outside of our control, and no assurance can be given that our recently completed or future acquisitions will be successful and will not materially adversely affect our business, operating results, or financial condition. Failure to manage and successfully integrate acquisitions could materially harm our business and operating results.
If we are unable to compete successfully in the highly competitive HPC market, our business will not be successful. The market for HPC systems is very competitive. An increase in competitive pressures in our market or our failure to compete effectively may result in pricing reductions, reduced gross margins and loss of market share and revenue. Many of our competitors
are established well-known companies in the HPC market, including IBM, HPE, Lenovo, Dell/EMC, NEC, Hitachi, Fujitsu and Atos. Most of these competitors have substantially greater research, engineering, manufacturing, marketing and financial resources than we do. In addition, certain Chinese companies are investing significantly in HPC and are becoming more aggressive and more competitive in the HPC global arena.
We also compete with systems builders and resellers of systems that are constructed from commodity components using processors manufactured and/or designed by Intel, ARM, AMD, NVIDIA and others. These competitors include the companies named above, as well as smaller companies that benefit from the low research and development costs needed to assemble systems from commercially available commodity products. Such companies, because they can offer high peak performance per dollar, can put pricing
pressure on us in certain competitive procurements. In addition, to the extent that Intel, IBM and other processor suppliers develop processors with greater capabilities or at a lower cost than the processors we currently use, our Cray XC systems may be at a competitive disadvantage to systems utilizing such other processors until we can design in, integrate and secure competitive processors, if at all. Also, to the extent any component supplier successfully adds differentiating capabilities to their HPC products that compete with what we provide, we may experience greater competitive pressures.
Our growth initiatives in the big data analytics, artificial intelligence and storage and data management markets must also compete successfully with many established companies and new entrants, many of whom have significantly greater resources and brand recognition in these markets than we do.
Periodic
announcements by our competitors of new HPC, storage or data analytics systems or plans for future systems and price adjustments may reduce customer demand for our products. Many of our potential customers already own or lease high
42
performance computer, storage or data analytics systems. Some of our competitors have offered substantial discounts to potential customers. We have in the past been and may again be required to provide substantial discounts to make strategic sales, which may reduce or eliminate any gross profit on such transactions, or require us to provide lease financing for our products, which could result in a multi-year deferral of our receipt of cash and revenue for these systems. These developments limit our revenue and financial resources
and reduce our ability to be profitable and grow.
We maintain confidential and proprietary information on our computer networks and employ security measures designed to protect this information from unauthorized access. If our security measures are breached, we could lose proprietary data and may suffer economic losses. We maintain confidential information on our computer networks, including information and data that are proprietary to our customers and third parties, as well as to us. Although we have designed and employed and continue to enhance a multitude of security measures to protect this information from unauthorized access, security breaches may occur, and in the past have occurred, as a result of third-party action, including computer hackers, employee error, malfeasance or otherwise. Security breaches can result in someone obtaining unauthorized access to our data or our customers’ data, including
our intellectual property and other confidential business information. Because the techniques employed by hackers to obtain unauthorized access or to sabotage systems change frequently, we may be unable to anticipate these techniques or to implement adequate preventative measures. A security breach could result in disclosure of our trade secrets or disclosure of confidential customer, supplier or employee data. If this should happen, we could be exposed to potentially significant legal liability, remediation expense, harm to our reputation and other harm to our business.
We may not be able to protect our proprietary information and rights adequately. We rely on a combination of patent, copyright, trademark and trade secret protection, nondisclosure agreements and licensing arrangements to establish, protect and enforce our proprietary information and rights. We have a number of patents and have additional
applications pending. There can be no assurance, however, that patents will be issued from the pending applications or that any issued patents will adequately protect those aspects of our technology to which such patents will relate. Despite our efforts to safeguard and maintain our proprietary rights, we cannot be certain that we will succeed in doing so or that our competitors will not independently develop or patent technologies that are substantially equivalent or superior to our technologies. The laws of some countries do not protect intellectual property rights to the same extent or in the same manner as do the laws of the United States. Additionally, under certain conditions, the U.S. government might obtain non-exclusive rights to certain of our intellectual property. Although we continue to implement protective measures and intend to defend our proprietary rights vigorously, these efforts may not be successful.
We
are subject to market and financial risks due to our international operations that could adversely affect those operations or our profitability and operating results. Our international operations include sales and service offices in Europe, the Middle East, South America, Asia, Australia and Canada. Our operations in countries outside of the United States, which accounted for approximately 32% of our total revenue for the three months ended March 31, 2017, expose us to greater risks associated with international sales and operations. Our profitability and international operations are, and will continue to be, subject to a number of risks and potential costs, including:
•
supporting
multiple languages;
•
recruiting sales and technical support personnel internationally with the skills to sell and support our products;
•
complying with governmental regulations, including obtaining required import or export approval for our products;
•
increased complexity and costs of managing
international operations;
•
increased exposure to foreign currency exchange rate fluctuations;
•
trade protection measures and business practices that favor local competition;
•
longer sales cycles and manufacturing lead times;
•
financial
risks such as longer payment cycles and difficulties in collecting accounts receivable;
•
difficulties associated with repatriating cash generated or held abroad in a tax-efficient manner;
•
ineffective legal protection of intellectual property rights;
•
more complicated logistics and distribution
arrangements;
•
additional taxes and penalties;
•
inadequate local infrastructure that could result in business disruptions;
•
global political and economic instability; and
•
other
factors beyond our control such as natural disasters, terrorism, civil unrest, war and infectious disease.
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Our global operations are also subject to numerous U.S. and foreign laws and regulations, including those related to anti-corruption, tax, corporate governance, imports and exports, financial and other disclosures, privacy and labor relations. These laws and regulations are complex and may have differing, conflicting and evolving legal standards, making compliance difficult and costly. If we or our employees, contractors or agents violate these laws and regulations, we could be subject to fines, penalties or criminal sanctions and may be prohibited from conducting business in one or more countries. Any violations, individually or in
the aggregate, could have a material adverse effect on our operations and financial condition.
In addition, the United Kingdom gave formal notice of withdrawal from the European Union in March 2017. Consequently, the British government is currently negotiating the terms of the United Kingdom’s future relationship with the European Union. The negotiated measures could potentially disrupt some of our target markets and jurisdictions in which we operate, including the United Kingdom and Germany, such as by adversely affecting tax benefits or liabilities in these or other jurisdictions or by restricting the movement of employees between the United Kingdom and other countries. Any such changes may adversely affect our operations and financial results.
Customers and other third parties may make statements speculating about or announcing the purchase, acceptance or intention to complete
purchases or acceptances of our products before such purchases or acceptances are substantially certain, and these proposed purchases or acceptances may not be completed when or as expected, if at all. From time to time, customers and other third parties may make statements speculating about or announcing a potential purchase of our products before we have obtained an order for such purchases or completed negotiations and signed a contract for the purchase of such products. In some instances, government and government-funded customers may announce possible purchases even before they have obtained the necessary budget to procure the products. As a result, these statements, postings or announcements do not mean that we will ultimately be able to secure the sale when or as expected or at all as it is not certain that the contract
or order negotiations will be completed successfully or as expected or that the customer will be able to obtain the budget they hope for or expect. In addition, from time to time, customers and other third parties may make statements speculating about or announcing the completion of an acceptance process of a delivery system before such acceptance is completed or certain. As a result, these statements or announcements do not mean that we will ultimately be able to obtain the acceptance when or as expected or recognize revenue.
We are subject to increasing government regulations and other requirements due to the nature of our business, which may adversely affect our business operations. In 2014, 2015, 2016 and the first three months of 2017,
approximately 48%, 47%, 47% and 58%, respectively, of our total revenue was derived from the U.S. Government. In addition to normal business risks, our contracts with the U.S. government are subject to unique risks, some of which are beyond our control. Our contracts with the U.S. government are subject to particular risks, including:
The funding of U.S. government programs is subject to Congressional appropriations. Many of the U.S. government programs in which we participate may extend for several years; however, these programs are normally funded annually. Changes in U.S. strategy and priorities may affect our future procurement opportunities and existing programs. Long-term
government contracts and related orders are subject to cancellation, or delay, if appropriations for subsequent performance periods are not made. The termination of funding for existing or new U.S. government programs could result in a material adverse effect on our results of operations and financial condition.
The U.S. government may modify, curtail or terminate its contracts with us. The U.S. government may modify, curtail or terminate its contracts and subcontracts with us, without prior notice at its convenience upon payment for work done and commitments made at the time of termination. Modification, curtailment or termination
of our major programs or contracts could have a material adverse effect on our results of operations and financial condition.
Our U.S. government contract costs are subject to audits by U.S. government agencies. U.S. government representatives may audit the costs we incur on our U.S. government contracts, including allocated indirect costs. Such audits could result in adjustments to our contract costs. Any costs found to be improperly allocated to a specific contract
will not be reimbursed, and such costs already reimbursed must be refunded. If any audit uncovers improper or illegal activities or non-compliance with the terms of a specific contract, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with the U.S. government.
Our business is subject to potential U.S. government inquiries and investigations. We may be subject to U.S. government inquiries and investigations of our business practices due to our participation in government contracts.
Any such inquiry or investigation could potentially result in a material adverse effect on our results of operations and financial condition.
Our U.S. government business is also subject to specific procurement regulations and other requirements. These requirements, although customary in U.S. government contracts, increase our performance and compliance costs. These costs might increase in the future, reducing our margins, which could have a negative effect on our financial condition. Failure to comply with these regulations and requirements could lead to suspension or debarment, for cause, from U.S. government contracting or subcontracting for a period of time and could have a negative effect on our reputation and ability to secure future U.S. government contracts.
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U.S.
export controls could hinder our ability to make sales to foreign customers and our future prospects. The U.S. government regulates the export of HPC systems such as our products. We have experienced delays for up to several months in receiving appropriate approvals necessary for certain sales, which have delayed the shipment of our products. Delay or denial in the granting of any required licenses could make it more difficult to make sales to certain foreign customers, eliminating an important source of potential revenue. Restrictions on the export of information needed to manufacture our products has in the past impacted and could in the future impact our ability to have certain products and components made in certain lower cost jurisdictions
Our stock price is volatile. The trading price of our common stock is subject to significant fluctuations in response to many factors, including
stock market trends and shareholder profile, our quarterly operating results, changes in analysts’ estimates or our outlook, our capital raising activities, announcements of technological innovations and customer contracts by us or our competitors, a significant aggressive seller or buyer, litigation activities, general economic conditions and conditions in our industry. From January 1, 2016 through December 31, 2016, the closing sales price of our common stock on the NASDAQ Global Market ranged from $18.40 to $43.06 per share. From January 1, 2017 through March 31, 2017, the closing sales price of our common stock on the NASDAQ Global Market ranged from $16.35 to $22.25 per share.
Because our stock price has been volatile, investing in our common stock is risky.
We incorporate software licensed from third parties into the operating systems for our products as well as in our tools to design products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for our products or cause delay in development. The operating system as well as other software we develop for our supercomputers contains components that are licensed to us under open source software licenses. Our business could be disrupted if this software, or functional equivalents of this software, were either no longer available to us or no longer offered to us on commercially reasonable terms. In either case we would be required to redesign our operating system software to function with alternative third-party software, or develop these
components ourselves, which would result in increased costs and could result in delays in product shipments. Our supercomputer systems utilize software system variants that incorporate Linux technology. The open source licenses under which we have obtained certain components of our operating system software may not be enforceable. Any ruling by a court that these licenses are not enforceable, or that Linux-based operating systems, or significant portions of them, may not be copied, modified or distributed as provided in those licenses, would adversely affect our ability to sell our systems. In addition, as a result of concerns about the risks of litigation and open source software generally, we may be forced to protect our customers from potential claims of infringement. In any such event, our financial condition and results of operations may be adversely affected.
We also incorporate proprietary incidental software from third
parties, such as for file systems, job scheduling and storage subsystems. We have experienced some functional issues in the past with implementing such software with our supercomputer systems. In addition, we may not be able to secure needed software systems on acceptable terms, which may make our systems less attractive to potential customers. These issues may result in lost revenue, additional expense by us and/or loss of customer confidence.
The “conflict minerals” rule of the SEC, has caused us to incur additional expenses, could limit the supply and increase the cost of certain metals used in manufacturing our products, and could make us less competitive in our target markets. The SEC requires public companies to disclose the origin, source and chain of custody of specified minerals, known as conflict minerals, that are necessary to the functionality
or production of products manufactured or contracted to be manufactured by us. Companies must obtain sourcing data from suppliers, engage in supply chain due diligence, and file annually with the SEC a specialized disclosure report on Form SD covering the prior calendar year. Implementation of our conflict minerals policy could limit our ability to source at competitive prices and to secure sufficient quantities of certain minerals used in the manufacture of our products, specifically tantalum, tin, gold and tungsten, as the number of suppliers that provide conflict-free minerals may be limited. In addition, we have incurred, and may continue to incur, material costs associated with complying with the conflict minerals rule, such as costs related to the determination of the origin, source and chain of custody of the minerals used in our products, the adoption of conflict minerals-related governance policies, processes and controls, and possible changes to products or
sources of supply as a result of such activities. Within our supply chain, we may not be able to sufficiently verify the origins of the relevant minerals used in our products through the data collection and due diligence procedures that we implement, which may harm our reputation. Furthermore, we may encounter challenges in satisfying those customers that require that all of the components of our products be certified as conflict free, and if we cannot satisfy these customers, they may choose a competitor’s products. We continue to investigate the presence of conflict materials within our supply chain.
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We are required to evaluate our internal control over financial
reporting under Section 404 of the Sarbanes-Oxley Act of 2002 at the end of each fiscal year, and any adverse results from such future evaluations could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price. Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to furnish a report by our management and a report by our independent registered public accounting firm on our internal control over financial reporting in our annual reports on Form 10-K as to whether we have any material weaknesses in our internal controls over financial reporting. Depending on their nature and severity, any future material weaknesses could result in our having to restate financial statements, could make it difficult or impossible for us to obtain an audit of our annual financial statements or could result in a qualification of any such audit. In such events, we could experience a number of adverse
consequences, including our inability to comply with applicable reporting and listing requirements, a loss of market confidence in our publicly available information, delisting from The NASDAQ Global Market, an inability to complete a financing, loss of other financing sources such as our line of credit, and litigation based on the events themselves or their consequences.
Our reported financial results may be adversely affected by changes in accounting principles generally accepted in the United States. Generally accepted accounting principles in the United States are subject to interpretation by the Financial Accounting Standards Board, the SEC and various bodies formed to promulgate and interpret appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions completed
before the announcement of a change.
Provisions of our Restated Articles of Incorporation and Amended and Restated Bylaws could make a proposed acquisition of our business that is not approved by our Board of Directors more difficult. Provisions of our Restated Articles of Incorporation and Amended and Restated Bylaws could make it more difficult for a third-party to acquire us. These provisions could limit the price that investors might be willing to pay in the future for our common stock. For example, our Restated Articles
of Incorporation and Amended and Restated Bylaws provide for:
•
removal of a director only in limited circumstances and only upon the affirmative vote of not less than two-thirds of the shares entitled to vote to elect directors;
•
the ability of our Board of Directors to issue up to 5,000,000 shares of preferred stock, without shareholder approval, with rights senior to those of the common stock;
•
no
cumulative voting of shares;
•
the right of shareholders to call a special meeting of the shareholders only upon demand by the holders of not less than 30% of the shares entitled to vote at such a meeting;
•
the affirmative vote of not less than two-thirds of the outstanding shares entitled to vote on an amendment, unless the amendment was approved by a majority of our continuing directors, who are defined as directors who have either served as a director since August 31, 1995,
or were nominated to be a director by the continuing directors;
•
special voting requirements for mergers and other business combinations, unless the proposed transaction was approved by a majority of continuing directors;
•
special procedures to bring matters before our shareholders at our annual shareholders’ meeting; and
•
special
procedures to nominate members for election to our Board of Directors.
These provisions could delay, defer or prevent a merger, consolidation, takeover or other business transaction between us and a third-party that is not approved by our Board of Directors.
Certification
of Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
X
31.2
Certification
of Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
X
32.1*
Certificate
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
*This certification is deemed not filed for purposes of section 18 of the Exchange Act of 1934, as amended, or the Exchange Act, or otherwise subject to the liability of that section, nor shall it be deemed incorporated by reference into any filing under the Securities Act of 1933, as amended, or the Securities Act.
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SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
