(Exact name of registrant as specified in its charter)
Washington
(State or Other Jurisdiction of
Incorporation or Organization)
93-0962605
(I.R.S. Employer
Identification No.)
411 First Avenue South, Suite 600
Seattle, Washington
(Address of Principal Executive Office)
98104-2860
(Zip Code)
Registrant’s telephone number, Including Area Code:
(206) 701-2000
Securities Registered Pursuant to Section 12(b) of the
Exchange Act: NONE
Securities Registered Pursuant to Section 12(g) of the
Exchange Act:
Common Stock, $.01 par value
Indicate by check mark if the Registrant is a well-known
seasoned issuer, as defined in Rule 405 of the Securities
Act:
Yes o No
þ
Indicate by check mark if the Registrant is not required to file
reports pursuant to Section 13 or Section 15(d) of the
Act:
Yes o No
þ
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
þ No
o
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of
Regulation S-K is
not contained herein, and will not be contained, to the best of
registrant’s knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this
Form 10-K or any
amendment to this
Form 10-K. þ
Indicate by check mark whether the registrant is a large
accelerated filer, an accelerated filer, or a non-accelerated
filer. See definition of “accelerated filer and large
accelerated filer” in
Rule 12b-2 of the
Exchange Act. (Check
one): o Large
accelerated
filer þ Accelerated
filer o
Non-accelerated
Indicate by check mark whether the registrant is a shell company
(as defined in
Rule 12b-2 of the
Exchange Act)
Yes o No
þ
The aggregate market value of the Common Stock held by
non-affiliates of the Registrant as of June 30, 2005, was
approximately $108,175,000, based upon the closing price of
$1.24 per share reported for such date on the Nasdaq
National Market System.
As of April 17, 2006, there were 91,750,299 shares of
Common Stock issued and outstanding.
Portions of the Proxy Statement to be delivered to shareholders
in connection with the Registrant’s Annual Meeting of
Shareholders to be held on June 6, 2006, are incorporated
by reference into Part III.
Cray, Cray-1, UNICOS
and UNICOS/mk are federally registered trademarks of Cray Inc.,
and Cray Y-MP,
Cray C90, Cray J90, Cray T90, Cray T3E,
Cray SV1, Cray SV1ex, Cray X1, Cray X1E,
Cray XT3 and Cray XD1 are trademarks of Cray Inc.
Other trademarks used in this report are the property of their
respective owners.
This Annual Report on
Form 10-K contains
forward-looking statements that involve risks and uncertainties,
as well as assumptions that, if they never materialize or prove
incorrect, could cause our results to differ materially from
those expressed or implied by such forward-looking statements.
All statements other than statements of historical fact are
statements that could be deemed forward-looking statements,
including any projections of earnings, revenue or other
financial items; any statements of the plans, strategies and
objectives of management for future operations; any statements
concerning proposed new products, services or developments; any
statements regarding future economic conditions or performance;
statements of belief and any statement of assumptions underlying
any of the foregoing. We assume no obligation to update these
forward-looking statements.
The risks, uncertainties and assumptions referred to above
include fluctuating operating results with possibility of
periodic losses and uneven and possibly negative cash flows;
need for increased product revenue and margin, particularly from
our Cray XT3 system and upgrade and successor systems; the
technical challenges of developing new supercomputer systems on
time and budget; the timing of product orders, shipments and
customer acceptances; the timing and level of government support
for supercomputer system development; whether we will be awarded
a phase 3 contract under the DARPA High Productivity
Computing Systems program; our dependency on third-party
suppliers to build and deliver components timely that meet our
specifications; the challenge of maintaining expense growth at
modest levels while increasing revenue; our ability to attract,
retain and motivate key employees, including executive officers
and managers; and other risks that are described from time to
time in our reports filed with the Securities and Exchange
Commission (“SEC” or “Commission”),
including but not limited to the items discussed in “Risk
Factors” set forth in Item 1A below in this report,
and in subsequently filed reports.
In this report, we rely on and refer to information and
statistics regarding the markets for various products. We
obtained this information from third-party sources, discussions
with our customers and our own internal estimates. We believe
that these third-party sources are reliable, but we have not
independently verified them and there can be no assurance that
they are accurate.
PART I
Item 1.
Business
General
We design, develop, manufacture, market and service high
performance computer systems, commonly known as supercomputers.
These systems provide capability and capacity far beyond typical
server-based computer systems and address challenging scientific
and engineering computing problems for government, industry and
academia.
We are dedicated solely to the supercomputing market. We have
concentrated our product roadmap on building balanced systems
combining highly capable processors (whether developed by
ourselves or others) along with highly scalable software with
very high speed interconnect and communications capabilities
throughout the entire computing system, not solely from
processor-to-processor.
We believe we are very well positioned to meet the high
performance computing market’s demanding needs by providing
superior supercomputer systems with performance and cost
advantages over low-bandwidth and cluster systems when sustained
performance on challenging applications and workloads and total
cost of ownership are taken into account.
Our 2005 product revenue primarily came from sales of our three
principal products, the Cray X1E, Cray XT3 and Cray XD1 systems,
and government funding for our Red Storm and Cascade development
projects. We also derive revenue from providing maintenance and
support services to the worldwide installed base of Cray
computers and professional services that leverage our technical
knowledge. See “Product Offerings, Projects and
Services” below.
Our revenue, net income or loss and cash balances are likely to
fluctuate significantly from quarter to quarter and within a
quarter due to the high average sales prices and limited number
of sales of our larger products, the timing of purchase orders
and product deliveries, our general policy of not recognizing
product revenue for our larger systems until customer acceptance
and other contractual provisions have been fulfilled, and the
uncertain timing of payments for product sales, maintenance
services, government research and development funding, and
inventory.
We were incorporated under the laws of the State of Washington
in December 1987. Our corporate headquarter offices are located
at 411 First Avenue South, Suite 600, Seattle, Washington,
98104-2860, our telephone number is (206) 701-2000 and our
website address is: www.cray.com. The contents of our website
are not incorporated by reference into this Annual Report on
Form 10-K or our
other SEC reports and filings.
Our History
In many ways our current history began on April 1, 2000,
when we, as Tera Computer Company, acquired the operating assets
of the Cray Research division from Silicon Graphics, Inc.
(“SGI”), and renamed ourselves Cray Inc. Tera Computer
Company was founded in 1987 with the purpose of developing a new
supercomputer system based on multithreaded architecture. In
early 2000 we were still in the development stage with limited
revenue and approximately 125 employees, almost all of whom were
located in our Seattle office.
Cray Research, Inc., founded in 1972 by Seymour Cray, pioneered
the use of vector systems in a variety of market sectors and
dominated the supercomputer market in the late 1970’s and
1980’s. Cray Research introduced a series of vector-based
systems, including the Cray 1,
Y-MP, C90, J90, T90 and
SV1 systems. Cray Research also developed leading high-bandwidth
massively parallel systems, notably the Cray T3E system, using
Alpha microprocessors from Digital Equipment and later Compaq
Computer. In 1996 SGI acquired Cray Research and cancelled the
development of the successors to the only two U.S. produced
capability-class supercomputers at the time, the Cray T90
and T3E systems. In 1997 the U.S. government imposed
extensive anti-dumping duties on Japanese vector supercomputers,
effectively preventing them from entering the U.S. market.
These developments combined to eliminate the availability of
high-bandwidth computer systems in the United States high
performance computing market, greatly diminishing the
U.S. market’s access to these systems. In 1998 SGI and
the Department of Defense (“DOD”) entered into a
cost-sharing contract for the development of the Cray X1 system
(then code-named the Cray SV2). In 1999 SGI announced that it
would consider offers to purchase the Cray Research division.
Cray Research Acquisition
On April 1, 2000, we acquired the operating assets of the
Cray Research business unit from SGI and changed our corporate
name to Cray Inc. In that transaction, we acquired the Cray
product lines, the Cray X1 development project and related
cost-sharing contract, a worldwide service organization
supporting Cray supercomputers installed at customer sites,
integration and final assembly operations, software products and
related experience and expertise, approximately
775 employees, product and service inventory, real property
located in Chippewa Falls, Wisconsin, and the Cray brand name.
Pursuant to a technology agreement, SGI assigned to us various
patents and other intellectual property and licensed to us the
rights to other patents and intellectual property. As part of
the acquisition, we assumed responsibility for the cost of
servicing the Cray T90 vector computers. We agreed with SGI
that we would not utilize specified technology to develop
specific successor products to the Cray T3E product line,
and we agreed to limit our use of SGI’s IRIX operating
system to the Cray X1 product family.
Post-Acquisition
Following the acquisition, we integrated our approximately 900
employees into one company, either had service, sales and other
contracts assigned to us or entered into new contracts with
customers and vendors, continued the development of the Cray X1
system and continued to sell the then-existing Cray products,
principally the Cray T3E and SV1 systems.
In May 2001 the U.S. anti-dumping order against Japanese
vector supercomputers was lifted, NEC Corporation invested
$25 million in us and we became a distributor of the
NEC SX series of supercomputers, with exclusive rights in
North America and non-exclusive rights outside of North America.
In 2003 NEC sold its investment in us, cancelled our exclusive
rights and we became a non-exclusive distributor worldwide.
In 2001 and 2002 we focused our development efforts on the Cray
X1 system; initial deliveries of the Cray X1 system began
in late 2002. The Cray X1 system, designed for the high end
of the supercomputer market, was the only new product we were
selling in 2003 and the first three quarters of 2004. In 2004 we
developed the Cray X1E system that significantly increased
the system’s processor speed and capability; the first
Cray X1E system customer shipment occurred at the end of
2004.
In mid-2002 we began our Red Storm development project with
Sandia National Laboratories to design and deliver a new
high-bandwidth, massively parallel processing supercomputer
system. The Red Storm hardware system was shipped in
installments to Sandia, with the final hardware shipment in the
first quarter of 2005, with further installation of component
upgrades as they become available. Working with Sandia, we
developed and installed system software designed to run
applications programs across the entire system of over 10,000
processors. Recently the Red Storm system became the first
computer system to surpass the one terabyte-per-second
performance mark on the PTRANS interconnect bandwidth test, a
key indicator of the network’s total communications
capability. The Red Storm project provided the development basis
for a commercial product, our Cray XT3 system, targeting
the need for highly scalable, high-bandwidth,
microprocessor-based supercomputers. The Cray XT3 system
initial customer shipment occurred in the fourth quarter of
2004, with full production ramp in the first half of 2005, and
we expect that the Cray XT3 and planned upgrade and
successor systems will provide a majority of our product revenue
in 2006 and be an important revenue contributor in succeeding
years.
In mid-2002 we also began work under a contract awarded by the
Defense Advanced Research Projects Agency (“DARPA”)
pursuant to its High Productivity Computing Systems
(HPCS) program to develop a system capable of sustained
performance in excess of one petaflops (1,000 trillion floating
point operations per second), which we call our Cascade program.
We are currently completing phase 2 (the research phase) of
this project, which ends in mid-2006, and we intend to bid on
phase 3 (the prototype phase) later this spring;
phase 3 awards are expected to be announced in July 2006.
On April 1, 2004, we acquired OctigaBay Systems
Corporation, a privately-held company located in Burnaby, B.C.,
Canada. OctigaBay was developing a balanced, high-bandwidth
system, designed to be highly reliable and
easy-to-use, targeted
for the midrange market. We renamed OctigaBay Systems
Corporation as Cray Canada Inc. and renamed the OctigaBay
product as the Cray XD1 system. Initial commercial
shipments of the Cray XD1 system began late in the third
quarter of 2004, with full production ramp in the first half of
2005. We plan to combine the capabilities of the Cray XD1
system with our Cray XT3 system into a single product in
2007.
Discussions that relate to periods prior to April 1, 2000,
refer to our operations as Tera Computer Company, and
discussions that relate to periods after April 1, 2000,
refer to our combined operations as Cray Inc.
The High Performance Computing Industry
Since the pioneering
Cray-1 system arrived
in 1976, supercomputers — often defined simply as the
most powerful class of computers at any time — have
contributed substantially to the advancement of knowledge and
the quality of human life. Problems of major economic,
scientific and strategic importance typically are addressed by
supercomputers, which usually sell for several millions of
dollars each, years before becoming tractable with less capable
systems. For scientific applications, the increased need for
computing power has been driven by highly challenging problems
that can be solved only through numerically intensive
computation and large data set manipulation. For engineering
applications, high performance computers boost productivity and
decrease risk and the time to market for companies and products
in a broad range of industries. The U.S. government has
recognized that the continued development of high performance
computer systems is of
critical importance to national defense and the economic,
scientific and strategic competitiveness of the United States.
Increasing Demand for Supercomputer Power
Many applications promising future competitive and scientific
advantage demand 10 to 1,000 times more supercomputer power than
anything available today. We believe there are three principal
factors driving the demand in the high performance computing
market: the continuing demand for advanced design and simulation
capability, continuing concerns about national security issues
and the recognized need to advance scientific research for
domestic competitiveness of many countries around the world.
The demand for design capabilities grows seemingly without
limit. Weather forecasting and climate modeling centers need
increasing computer speeds to handle larger volumes of data to
produce more accurate and localized short-term and longer-term
forecasts and climate change models. Aerospace firms envision
more efficient planes and space vehicles. Automotive companies
are targeting increased passenger cabin comfort, better fuel
mileage and improved safety and handling. Using genomic and
proteomic technologies for drug development are areas of
intensive research and substantial spending by research centers
and biotechnology and pharmaceutical companies.
Governments have a wide range of unmet security needs,
heightened by an emphasis on anti-terrorism. These needs
primarily relate to burgeoning cryptanalysis requirements
arising from a more diverse and growing number of sources and
requirements for rapid and accurate analysis and integration of
information from many disparate sources. In addition,
governments need better simulation and modeling of a wide range
of weapons and the computational ability to address various
classified applications.
In 2002 the Japanese government announced the completion of the
Japanese Earth Simulator project. This high-bandwidth,
vector-based system remains acknowledged as one of the
world’s most powerful installed computer systems with high
sustained operating performance on real applications. The
Japanese Earth Simulator validated our proposition that
high-bandwidth and sustained performance are critical, and has
provided Japan with the opportunity to lead in scientific
research in fields such as weather and climate, geophysics,
nanotechnology and metallurgy.
The Advantages of Bandwidth
When we speak of “bandwidth,” we mean the rate at
which processors can communicate with other processors, with the
system’s internal memory subsystem and with input/output
(“I/O”) connections.
Today’s high performance computer market is replete with
low-bandwidth systems and
off-the-shelf
commodity-based cluster systems that loosely link together
multiple commodity servers or personal computers by means of
commercially available interconnect products. In recent years,
the speed and capabilities of
off-the-shelf
interconnect systems and processors have continued to improve,
and independent software vendors have adapted their application
codes to exploit the capabilities and partially mask the
weaknesses of these systems. These systems offer competitive
price/performance on small problems and larger problems lacking
communications complexity.
We are dedicated solely to the supercomputing market. Although
we are a comparatively small company, we have invested
significantly to develop advanced supercomputing systems. We
differentiate ourselves from our competitors primarily by
emphasizing the processing and communication capabilities of our
systems. We have concentrated our product roadmap on building
balanced systems combining highly capable processors (whether
developed by ourselves or others) along with scalable software
with very high speed interconnect and communication capabilities
throughout the entire computing system. Our supercomputer
systems are “balanced” in that our systems are fast
not only between processors but also between processors and
memory and I/O subsystems, allowing the entire system to scale
to deliver the highest levels of capability so that users may
run their largest and most challenging problems significantly
faster. Competitive systems may use processors with higher rated
or theoretical speeds than some of our systems —
although at 18 gigaflops (billions of floating point
operations per second) our Cray X1E processor is currently one
of the world’s
fastest — but even in those cases our systems
typically outperform competing products on the most challenging
applications by using their high-bandwidth communications and
scaling software capabilities to deliver more data to the Cray
processors and keep them busier and more efficient, especially
at large scale.
As we design our supercomputer systems for the needs of the high
performance computing market, we say they are
“purpose-built” for this market. Vendors of
low-bandwidth systems, such as Dell and several other companies
building clusters with commercially available commodity
technology, design and build their processors and systems to
meet the requirements of their larger commercial computer
markets — for servers and personal
computers — and then attempt to leverage these
commercial server-based products into the supercomputer market.
Low-bandwidth and cluster systems may offer higher theoretical
peak performance, for equivalent cost, than do our systems.
Theoretical peak performance is the highest theoretical possible
speed at which a computer system could, but never does, operate
(obtained simply by multiplying the number of processors by the
designed rated peak speed of each processor, assuming no
bottlenecks or inefficiences). Sustained performance, always
lower than peak, is the actual speed at which a supercomputer
system runs an application program. The sustained performance of
low-bandwidth and cluster systems on complex applications
frequently is a small fraction, often less than 5-10%, of their
theoretical peak performance, and as these systems become
larger, their efficiency declines even further, sometimes below
1% for the most challenging applications. Our systems, designed
for balanced total system communications capability, provide
high actual sustained performance on difficult computational
problems, even though in some cases they may have a lower
theoretical peak performance than competitors’ systems.
While sustained performance may vary widely on different
applications, our systems generally operate on a sustained basis
from 1.5 to 10 times that of competitors’ systems. We
expect our systems to provide price/performance advantages over
low-bandwidth and cluster systems when actual performance on
real applications is taken into account.
The advent of the Cray X1 system in late 2002 provided the first
new high-bandwidth alternative for the U.S. high-end high
performance computer customers since the mid-1990’s. Our
introduction in late 2004 of the Cray XT3 and Cray XD1 systems
extended the availability of high-bandwidth systems to systems
that use commodity processors.
The High Performance Computing Market
Industry analyst firm, International Data Corporation
(“IDC”), provides information regarding the high
performance computing systems market, including historical data
and projections. IDC preliminarily estimates that the revenue
for the entire high performance technical computing market
totaled approximately $9.1 billion in 2005. IDC segments
the high performance computing systems market based on prices
and, at the higher end, intended use. IDC descriptions and
estimates of revenue in recent years for each of these segments
(preliminary estimates for 2005) follow:
•
Capability. Systems configured and purchased to solve the
largest, most demanding problems, and generally priced at
$1 million or more. The size of the capability segment has
ranged in recent years from about $800 million to
$1.2 billion, with 2005 estimated revenue of
$870 million.
•
Enterprise. Systems purchased to support technical
applications in throughput environments and sold for
$1.0 million or more, with 2005 estimated revenue of
$1.2 billion.
•
Divisional. Systems purchased to support technical
applications in throughput environments and sold for $250,000 to
$999,999, with 2005 estimated revenue of $1.9 billion.
•
Departmental. Systems purchased to support technical
applications in throughput environments and sold for $50,000 to
$250,000, with 2005 estimated revenue of $2.9 billion.
•
Workgroup. Systems purchased to support technical
applications in throughput environments and sold for less than
$50,000, with 2005 estimated revenue of $2.2 billion.
We focus on the capability segment of the high performance
computing market where the features we are known for —
high speed processors coupled with very fast
communications — are widely recognized as
necessary to solve the world’s most difficult computing
problems. With the Cray XT3 and Cray XD1 systems, our
addressable market expanded into parts of the enterprise segment.
Our Target Market and Customers
Our target markets for 2006 and beyond principally include the
government/classified, scientific research,
weather/environmental, and automotive, aerospace and
manufacturing markets. In certain of our targeted markets, such
as the government/classified and scientific research markets,
customers have their own application programs and are accustomed
to using new, less proven systems. Other target customers, such
as automotive and aerospace firms and some governmental
agencies, require third-party application programs in production
environments.
Government/Classified
Government agencies have represented a significant segment for
Cray Research and ourselves for many years. Certain governmental
departments continue to provide funding support for our research
and development efforts to meet their objectives. We expect
long-term spending on national security and defense to increase.
Current and target customers for our products include DOD
classified customers and parts of the Department of Energy,
which funds the Sandia National Laboratories, Los Alamos
National Laboratory and Lawrence Livermore National Laboratory,
and certain foreign counterparts.
Scientific Research
The scientific research segment includes both unclassified
governmental and academic research laboratories and centers. The
DOD, through its Defense High Performance Computing
Modernization Program, funds a number of research organizations.
Network Computing Services, Inc., the system integrator for the
Army High Performance Computing Research Center in Minneapolis,
the U.S. Army Corps of Engineers’ Engineering,
Research and Development Center (ERDC) in Vicksburg,
Mississippi, the Corp’s Major Shared Resource Center, and
the Arctic Region Supercomputing Center in Fairbanks, for
example, were early purchasers of our Cray X1 system, and
the Army Center upgraded its Cray X1 system to a
Cray X1E system. The Office of Science in the Department of
Energy, which funds the Oak Ridge National Laboratory, Argonne
National Laboratory and National Energy Research Scientific
Computing Center, is a key target customer as is the National
Aeronautics and Space Administration. Oak Ridge National
Laboratory is a significant customer for Cray X1, X1E and
XT3 systems and related services. The Pittsburgh Supercomputing
Center, funded by the National Science Foundation, has acquired
a Cray XT3 system with 10 teraflops (trillions of
calculations per second) peak performance, and ERDC recently
accepted a Cray XT3 system with 20 teraflops peak
performance. The Maui High Performance Computing Center, a
U.S. Air Force Research Laboratory’s Directed Energy
Directorate facility funded by the Defense High Performance
Computing Modernization Program, acquired a Cray XD1 system
with a peak performance of about 1.4 teraflops to increase
the Center’s capabilities in space surveillance and image
processing. Cray XD1 systems have been acquired by
governmental and academic research laboratories and centers in
Italy, Germany, India, the United Kingdom and the United States.
Weather/Environmental
Weather forecasting and climate modeling applications require
increasing speed and larger volumes of data and thus are targets
for our high-bandwidth systems. Cray supercomputers are used in
weather centers worldwide, from the United Kingdom to Korea. We
have installed Cray X1 and Cray X1E systems at the
Spanish National Institute of Meteorology and the Korea
Meteorological Administration, where the Cray X1E system is
the most powerful operational weather forecasting system in the
world.
Automotive, Aerospace and Manufacturing
These industries use supercomputers to design lighter, safer and
more durable vehicles as well as to study wind noise and airflow
around the vehicle and in many other computer-aided engineering
applications. Several
of the major automobile companies and aerospace companies are
Cray customers. We have installed a Cray X1 system at The
Boeing Company, which uses the system primarily to run
structural analysis and computational fluid dynamics codes. The
Cray XD1 system, especially in larger configurations, has
demonstrated early impressive results on certain automotive
crash, computational fluid dynamics and other important
manufacturing applications, with both Toyota Auto Body and Sony
Corporation in Japan as recent customers.
Product Offerings, Projects and Services
Our supercomputing products provide high-bandwidth and other
capabilities needed for exploiting new and existing market
opportunities. Among supercomputer vendors, our intent is to
offer the most scalable and highest (sustained) performing
systems in the high performance computing market. Our goal is to
bring major enhancements and/or new products to market every 12
to 24 months using both custom and commodity
processor-based supercomputers.
Current Products
Cray XT3 System
The Cray XT3 system uses Advanced Micro Devices Inc.
(“AMD”) single-core and dual-core
Opterontm
processors connected via our high-bandwidth interconnect
network. It incorporates a massively parallel optimized
operating system and a standards-based programming environment
designed to deliver very high sustained application performance
in configurations from 200 to 30,000 processors. The
Cray XT3 system features a tightly integrated management
system to provide high reliability and to run full-system
applications to completion. The Cray XT3 system is based on
the Red Storm architecture we co-developed with Sandia National
Laboratories. We began shipments of early versions of the
Cray XT3 system in the fourth quarter of 2004, with full
production ramp in the first half of 2005. Our selling focus for
the Cray XT3 systems covers a range of peak performance
from one to over 100 teraflops. List selling prices for a one
cabinet system start at under $2 million. We expect the
Cray XT3 system, including planned upgrade and successor
systems, to provide a majority of our product revenue in 2006
and to be an important revenue contributor in succeeding years.
Cray X1E System
In late 2002 we completed hardware development of the new Cray
X1 system, which incorporates in its design both
vector-processing capabilities from the long line of Cray
Research vector systems and massively parallel capabilities
analogous to those of our prior generation Cray T3E system.
Designed to provide efficient scalability and high-bandwidth to
run complex applications at high sustained speeds, the Cray X1
system is an “extreme performance” supercomputer aimed
at the high end of the vector processing and massively parallel
systems markets. We commenced delivering production systems late
in the fourth quarter of 2002. In 2003 we enhanced the Cray X1
system hardware and software, ported application programs to
provide the features and stability required in a production
environment by governmental and industrial users, and delivered
ever-larger integrated systems. The Cray X1E system, first
shipped in December 2004, nearly triples the peak performance of
the Cray X1 system and features one of the world’s most
powerful processors, at 18 gigaflops. Our selling focus for the
Cray X1E system covers a range of performance from 500 gigaflops
to 20 teraflops. Many of our Cray X1 customers upgraded to Cray
X1E systems. The last Cray X1E system will ship in 2006 as we
finish development of a successor system, code-named
“BlackWidow,” designed to improve system performance
and scalability for delivery in 2007.
Cray XD1 System
The Cray XD1 system, like the Cray XT3 system, is a
purpose-built, balanced high-bandwidth system that employs
standard microprocessors but is designed for the mid-range
market. It provides superior sustained application performance
employing the direct connected processor architecture to link
processors directly to each other and memory, eliminating
interconnect bottlenecks and providing greater bandwidth and
lower latency than typical cluster systems currently available.
The Cray XD1 system leverages high volume
technologies such as AMD’s HyperTransport and Opteron
technologies. It also uses a Linux-based operating system in
connection with our automated management infrastructure and
provides the opportunity to accelerate application performance
through the use of field programmable gate arrays. Our selling
focus for the Cray XD1 system ranges from 58 gigaflops to over
2.5 teraflops with processor counts from 12 to more than 512.
List prices for one unit (chassis) systems start at under
$100,000, with multiple units providing enhanced application
scaling performance. We plan to combine the capabilities of the
Cray XD1 system with our Cray XT3 system into a single product
in 2007.
Resale of Products of Other Companies
We offer the NEC SX series of vector supercomputers on a
non-exclusive basis, and sell to our supercomputer customers
storage systems from DataDirect Networks, Inc., Engenio Storage
Group of LSI Logic Corporation, and Advanced Digital Information
Corporation. We do not expect to record significant revenue in
2006 from this activity.
Current Projects
Cascade Project
In mid-2002 DARPA selected Cray and four other companies for
phase 1 of its HPCS program leading to the development of a
commercially available high productivity system capable of
running real-world applications with sustained performance in
excess of one petaflops by 2010. In addition to having high
sustained performance, the resulting system is to be designed to
be much easier to program, more broadly applicable and more
robust than current designs. In mid-2003 we signed a
phase 2 research agreement with DARPA that provided us and
our research partners, Stanford University, California Institute
of Technology/ Jet Propulsion Laboratories and the University of
Notre Dame, with just under $50 million over three years to
investigate advanced design concepts for the petaflops system.
IBM and Sun Microsystems received similar awards. We expect to
complete phase 2 in July 2006 and we are preparing our bid
for phase 3, the prototype phase. In July 2006 DARPA is
expected to select one or two vendors for phase 3 with
initial prototype deliveries scheduled for late 2010.
Phase 3 awards are expected to be in the range of
$200 million to $250 million each, payable over about
five years, with awardees contributing a significant portion of
the total costs.
Red Storm
In mid-2002 we contracted with Sandia National Laboratories to
design and deliver a new massively parallel 40-teraflop
processing system, called Red Storm, that uses over 10,000
Opteron processors from AMD connected via our low-latency,
high-bandwidth interconnect network based on HyperTransport
technology. The Red Storm project involves critical network and
operating system development. We completed delivery and
installation of the Red Storm hardware at Sandia in the first
quarter of 2005, with subsequent installation of certain
component upgrades as they become available. Together with
Sandia, we developed and installed system software designed to
run applications programs across the entire system. In November
2005 we announced that we will expand the Red Storm system to
more than 14,000 Opteron processors with a peak performance of
more than 50 teraflops (trillions of calculations per second)
from its current 40-teraflop capacity.
Other Research and Development Activities
We are involved in several substantial research projects to
develop vector, multithreaded and commodity processor-based
offerings that will continue to advance performance and
scalability. These activities include successors to the Cray XT3
system, with an upgrade system scheduled for delivery in the
fourth quarter of 2006; a successor to the Cray X1/ X1E line,
code-named BlackWidow, with initial product deliveries scheduled
for 2007; and continued development of our multithreaded system,
code-named our Eldorado project, with initial product deliveries
scheduled for 2007. We have established a long-term vision,
which we refer to as “Adaptive Supercomputing,” to
support the anticipated future needs of high performance
computing customers. With Adaptive Supercomputing, the concept
of heterogeneous computing — access to multiple
processor technologies — is expanded to a fully
integrated view of both hardware and software supporting
multiple processing technologies within a single system. We
believe we have a significant foundation in making this vision a
reality because of our unique background in custom processor
architectures, including vector and multithreaded technologies,
as well as commodity and new co-processor technologies such as
field programmable gate arrays. Our plan is to increasingly
integrate these processing technologies over the next few years
into a single Linux-based platform. We expect to include
powerful compilers and related software that will analyze and
match application code to the most appropriate processing
elements, which is expected to allow programmers to write code
in a more natural way and users to benefit from substantially
better performance.
These projects are expensive undertakings in terms of dollars,
people and time. We seek government funding, such as funding
provided for the Red Storm, Cascade, Cray X1/ X1E, BlackWidow
and Eldorado projects, to help defray the costs of this advanced
research and development.
Services
Our extensive worldwide maintenance and support organization
provides us with a competitive advantage and a predictable flow
of revenue and cash. Support services are provided under
separate maintenance contracts with our customers. These
contracts generally provide for support services on an annual
basis, although some cover multiple years. While most customers
pay for support monthly, others pay on a quarterly or annual
basis.
Our professional services organization supports our emphasis on
providing solutions rather than just computer systems to our
customers. This organization provides consulting, integration of
Cray products, custom hardware and software engineering,
advanced computer training, site engineering, data center
operation and project management services. These services
leverage our reputation and skills for services and industry
technical leadership.
Technology
Our leadership in the high performance computer industry depends
on successful development and introduction of new products and
enhancements to existing products. Our research and development
activities are focused on system architecture, hardware and
software necessary to implement our product roadmap.
Architecture
We believe we are the only company in the world with significant
demonstrated expertise in four primary processor technologies:
vector processing, massively parallel processing, multithreading
and co-processing with field programmable gate arrays.
Cray Research pioneered the use of vector systems, from the
Cray-1 to the Cray T90 systems. These systems traditionally have
used a moderate number (one to 32) of very fast custom
processors in connection with a shared memory. Vector processing
has proven to be highly effective for many scientific and
engineering application programs that have been written to
maximize the number of long vectors. The system stemming from
our BlackWidow project will have the same basic attributes as
our current Cray X1E system but will provide increased
performance and scalability.
Massively parallel processing architectures typically link
hundreds or thousands of standard or commodity processors to
work either on multiple tasks at the same time or together in
concert on a single computationally-intensive task. We focus on
building massive parallel processing systems with scalable
architectures using high-bandwidth interconnect networks. These
systems are best suited for large computing problems that can be
segmented into many parts and distributed across a large number
of processors. Both the Cray XT3 and the Cray XD1 systems are
based on this concept.
Multithreading technology was the core concept behind the
original supercomputers designed by Tera Computer. We are
currently developing a new generation of multithreading systems
as part of our Eldorado
project which is being designed to deliver high sustained speed
on challenging applications requiring sparse access to very
large data sets, provide scalability as systems increase in size
and have balanced I/ O capability. The multithreading processors
make the system latency tolerant and, with shared memory, are
able to address data anywhere in the system.
The Cray XD1 system introduced the concept of reconfigurable
computing with field programmable gate arrays to our product
portfolio. The field programmable gate arrays can be
reconfigured or reprogrammed to implement specific functionality
more suitable and more efficiently than on a general-purpose
processor.
Hardware
We have extensive experience in designing all of the components
of high performance computer systems — the processors,
the interconnect system and controls, the I/ O system and the
supporting cooling infrastructure — to operate
together. Our hardware research and development experience
includes:
•
Integrated circuit design — we have experience in
designing custom and standard cell integrated circuits. Our
processors and other integrated circuits have special features
that let them use the high available memory bandwidth
efficiently.
•
High speed interconnect systems — we design high speed
interconnect systems using a combination of custom I/ O
circuits, high density connectors and carefully chosen
transmission media together with complex memory and cache
controls to operate with our network protocols and highly
optimized logic design. We are investigating the use of optical
interconnects for future systems.
•
Printed circuit board design — our printed circuit
boards are some of the most sophisticated in the world, some
with more than 40 layers packed with wires and inter-layer
connections.
•
System I/ O — we design high performance I/ O
interfaces that deliver high-bandwidth transfer rates and large
capacity storage capabilities using low cost devices in highly
reliable configurations.
•
Packaging and cooling — we use very dense packaging in
order to produce systems with the necessary bandwidth at
reasonable costs. This generates more heat per unit volume. We
use specialized cooling techniques to address this issue,
including immersion, conductive and spray cooling using various
liquids and high volume air cooling.
Our hardware engineers are located primarily in our Chippewa
Falls, Wisconsin, and Seattle, Washington, offices.
Software
We have extensive experience in designing and developing
software for high performance computer systems. This includes
the operating system, the hardware supervisory system and the
programming environment. Our software research and development
experience includes:
•
Operating Systems — For our Cray XT3 and Cray XD1
systems, we exploit and enhance commercially available versions
of the Linux operating system. Additionally, on our Cray XT3
systems, we develop and support a micro-kernel for the compute
resources. On the Cray X1E, multithreading and NEC SX systems,
we currently provide and support separate UNIX-based operating
systems. In the future, we anticipate that all of our systems
will exploit commercial versions of Linux for all nodes.
•
Hardware Supervisory Systems (HSS) — For all of our
systems, we provide a scalable hardware control infrastructure
for managing hardware, including power control, monitoring of
environmental data and hardware diagnostics. In the future, we
anticipate providing a common HSS infrastructure for all of our
systems.
•
Programming Environment — For our Cray XT3 and Cray
XD1 systems, we exploit commercially available compilers and
tools. We also provide Cray developed tools that make our
systems easier to optimize. For our Cray X1E and multithreading
systems, we develop our own compilers and tools.
We purchase or license software technologies from third parties
when necessary to provide appropriate support to our customers,
while focusing our own resources where we believe we add the
highest value.
Our software personnel are located principally in our Mendota
Heights, Minnesota, and Seattle, Washington, offices.
Sales and Marketing
We primarily sell our products through a direct sales force that
operates throughout the United States and in Europe, Canada,
Japan and Asia-Pacific. We serve smaller foreign markets through
sales representatives. About half of our sales force is located
in the United States and Canada, with the rest overseas. Our
marketing staff has a strategic focus on our target markets and
those solutions that will facilitate our customers’ success
in solving their most challenging scientific and engineering
problems. Our marketing personnel are located in the United
States and Canada.
In 2005, one customer, Oak Ridge National Laboratory
(“ORNL”), accounted for approximately 18% of our total
revenue. In 2004, one customer, Sandia National Laboratories,
through our Red Storm project, accounted for 27% of our total
revenue. In 2003, one customer, ORNL, accounted for 11% of our
total revenue. Agencies of the United States government, both
directly and indirectly through system integrators and other
resellers, accounted for approximately 55% of our 2005 revenue,
72% of our 2004 revenue and 74% of our 2003 revenue. Information
with respect to our international operations and export sales is
set forth in Note 17 — Segment Information
of the Notes to Consolidated Financial Statements.
Manufacturing and Procurement
While we design many of the hardware components for all of our
products, we subcontract the manufacture of, or buy
common-off-the-shelf
technology for, all major assemblies of our systems, including
integrated circuits, printed circuit boards, flex circuits,
memory modules, machined enclosures and support structures,
cooling systems, high performance cables and other items to
third-party suppliers. Our manufacturing strategy is on
build-to-order systems,
focusing on obtaining competitive assembly and component costs
and concentrating on the final assembly, test and quality
assurance stages. This strategy allows us to avoid the large
capital commitment and overhead associated with establishing
full-scale manufacturing facilities and to maintain the
flexibility to adopt new technologies as they become available
without the risk of equipment obsolescence, provide near
real-time configuration changes to exploit faster and/or less
expensive technologies, and provide a higher level of large
scale system quality. We perform final system integration,
testing and check out of our hardware systems. Our manufacturing
personnel are located in Chippewa Falls, Wisconsin.
Our systems incorporate some components that are available from
one or limited sources, often containing Cray proprietary
designs. Such components include integrated circuits,
interconnect systems and certain memory devices. Prior to
development of a particular product, proprietary components are
competitively bid to a shortlist of technology partners. The
technology partner that provides the best solution for the
component is generally awarded the contract for the life of the
component. Once we have engaged a technology partner, changing
our product designs to utilize another supplier’s
integrated circuits would be a costly and time-consuming
process. We also have sole or limited sources for less critical
components, such as peripherals, power supplies, cooling and
chassis hardware. We obtain key integrated circuits from IBM for
our Cray X1E and Cray XT3 systems, from Texas Instruments
Incorporated (“TI”) for our BlackWidow project and
from Taiwan Semiconductor Manufacturing Company for our Eldorado
project and commodity processors from AMD for our Cray XT3 and
Cray XD1 systems. Our procurements from these vendors are
primarily through purchase orders. We have chosen to deal with
sole sources in specific cases due to the availability of
specific technologies, economic advantages and other factors.
Reliance on single or limited source vendors involves several
risks, including the possibility of shortages of key components,
long lead times, reduced control over delivery schedules and
changes in direction by vendors. See “Item 1A. Risk
Factors — Our reliance on third-party supplies poses
significant risks to our business and prospects” below.
The high performance computing market is very competitive. Many
of our competitors are established companies that are well known
in the high performance computing market, including IBM, NEC,
Hewlett-Packard, SGI, Dell, Bull S.A. and Sun Microsystems. Most
of these competitors have substantially greater research,
engineering, manufacturing, marketing and financial resources
than we do.
We also compete with systems builders and resellers of systems
that are constructed from commodity components using
microprocessors manufactured by Intel, AMD, IBM and others.
These competitors include the previously named companies as well
as smaller firms, such as Linux Networx and Verari Systems, that
benefit from the low research and development costs needed to
assemble systems from commercially available commodity products.
These companies have capitalized on developments in parallel
processing and increased computer performance in commodity-based
networking and cluster systems. While these companies’
products are more limited in applicability and scalability, they
have achieved growing market acceptance. They offer significant
performance and price/peak performance on smaller problems and
on larger problems lacking complexity, which is a part of the
growing capacity computing marketplace (as opposed to the
capability marketplace that is our focus). Such companies,
because they can offer high peak performance per dollar, often
put pricing pressure on us in competitive procurements.
Internationally we compete primarily with IBM, Hewlett-Packard,
Sun Microsystems, SGI and NEC. While the first four companies
offer large systems based on commodity processors, NEC also
offers vector-based systems with a large suite of ported
application programs. We have non-exclusive rights to market NEC
vector processing supercomputers throughout the world. As in the
United States, high performance computing suppliers like Dell,
Linux Networx and Bull offer systems with significantly better
price/peak performance.
We compete primarily on the basis of product performance,
breadth of features, price/performance, scalability, quality,
reliability, service and support, corporate reputation, brand
image and account relationships. Our market approach is more
focused than our competitors, as we concentrate solely on
supercomputing, with products designed for the needs of this
specific market. We offer systems that provide greater
performance on the largest, most difficult computational
problems and superior price/performance on many important
applications in the capability market. Our systems often offer
total cost of ownership advantages as they typically use less
electric power and cooling for operations and cooling and occupy
less space than low-bandwidth and cluster systems.
Intellectual Property
We attempt to protect our trade secrets and other proprietary
rights through formal agreements with our employees, customers,
suppliers and consultants, and through patent protection.
Although we intend to protect our rights vigorously, there can
be no assurance that our contractual and other security
arrangements will be successful. There can be no assurance that
such arrangements will not be terminated or that we will be able
to enter into similar arrangements on favorable terms if
required in the future. In addition, if such agreements were
breached, there can be no assurance that we would have adequate
remedies for any breach.
We have a number of patents and pending patent applications
relating to our hardware and software systems. We license
certain patents and other intellectual property from SGI as part
of our acquisition of the Cray Research operations. These
licenses contain restrictions on our use of the underlying
technology, generally limiting the use to historic Cray
products, vector processor computers and the Cray X1/ X1E
system. Our general policy is to seek patent protection for
those inventions and improvements likely to be incorporated into
our products and services or to give us a competitive advantage.
While we believe our patents and applications have value, no
single patent or group of patents is in itself essential to us
as a whole or to any of our key products. Any of our proprietary
rights could be challenged, invalidated or circumvented and may
not provide significant competitive advantage.
There can be no assurance that the steps we take will be
adequate to protect or prevent the misappropriation of our
intellectual property. We may infringe or be subject to claims
that we infringe the intellectual property rights of others.
Litigation may be necessary in the future to enforce patents we
obtain,
and to protect copyrights, trademarks, trade secrets and
know-how we own, or to defend infringement claims from others.
Such litigation could result in substantial expense to us and a
diversion of our efforts.
Employees
As of December 31, 2005, we employed 787 employees. We have
no collective bargaining agreement with our employees. We have
not experienced a work stoppage and believe that our employee
relations are very good.
Available Information
Our annual reports on
Form 10-K,
quarterly reports on
Form 10-Q, current
reports on
Form 8-K and
amendments to those reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act are
available free of charge at our website at www.cray.com as soon
as reasonably practicable after we file such reports with the
SEC electronically. In addition, we have set forth our Code of
Business Conduct, Corporate Governance Guidelines, the charters
of our Board committees and other governance documents on our
website, www.cray.com, under “Investors —
Corporate Governance.”
Item 1A.
Risk Factors.
The following factors should be considered in evaluating our
business, operations and prospects; they may affect our future
results and financial condition and they may affect an
investment in our securities. Factors specific to our
3.0% Convertible Senior Subordinated Notes due 2024 (the
“Notes”) and our common stock are set forth under the
subheading “Risk Factors Pertaining to Our Notes and Our
Common Stock” below.
Risk Factors Pertaining to Our Business and Operations
Our operating results may fluctuate significantly. Our
operating results are subject to significant fluctuations due to
the factors listed below, which make planning revenue and
earnings for any specific period very difficult. We experienced
net losses in each full year of our development-stage operations
prior to 2002. For 2002 we had net income of $5.4 million
and for 2003 we had net income of $63.2 million (including
an income tax benefit of $42.2 million, much of which came
from the reversal of a valuation allowance against deferred tax
assets). For 2004 we had a net loss of $207.4 million
(including an expense for in-process research and development of
$43.4 million and an income tax expense of
$59.1 million, of which $58.9 million related to the
establishment of a valuation allowance against deferred tax
assets) and for 2005 we had a net loss of $64.3 million.
Whether we will achieve anticipated revenue and net income on a
quarterly and annual basis in 2006 and subsequent years depends
on a number of factors, including:
•
successfully selling the Cray XT3, Cray X1E and Cray XD1
systems, including upgrades and successor systems, new products,
and the timing and funding of government purchases, especially
in the United States;
•
the level of product margin contribution in any given period;
•
maintaining our other product development projects on schedule
and within budgetary limitations;
•
the level of revenue recognized in any given period,
particularly for the high average sales prices and limited
number of sales of our larger systems in any quarter, including
the timing of product acceptances by customers and contractual
provisions affecting revenue recognition;
•
revenue delays or losses due to customers postponing purchases
to await future upgraded or new systems, delays in delivery of
upgraded or new systems and longer than expected customer
acceptance cycles;
•
our expense levels, including research and development net of
government funding, which may be affected by the timing of such
funding;
the terms and conditions of sale or lease for our products;
•
whether we conclude that all or some part of our recorded
goodwill has been impaired, which may be due to changes in our
business plans and strategy and/or a decrease in our fair value
(i.e., the market value of our outstanding shares of common
stock); and
•
the impact of expensing our stock-based compensation under
Statement of Financial Accounting Standards No. 123(R),
Share-Based Payment,
(“SFAS No. 123(R)”).
The timing of orders and shipments and quarterly and annual
results also could be affected by additional events outside our
control, such as:
•
the timely availability of acceptable components in sufficient
quantities to meet customer delivery schedules;
•
timing of government funding for products and research and
development contracts;
•
changes in levels of customer capital spending;
•
the introduction or announcement of competitive products;
•
the receipt and timing of necessary export licenses; and
•
currency fluctuations, international conflicts or economic
crises.
Because of the numerous factors affecting our revenue and
results of operations, we cannot assure our investors that we
will have net income on a quarterly or annual basis in the
future. We currently anticipate that our quarterly results in
2006 will vary significantly, with a major portion of our
revenue to be recognized in the second half of the year. Delays
in product development, receipt of orders or product acceptances
could have a substantial adverse effect on our 2006 results.
Failure to sell Cray XT3 and upgrade systems in planned
quantities and margins would adversely affect 2006 revenue and
earnings. We expect that a majority of our product revenue
in 2006 will come from a limited number of sales of the Cray XT3
system and an upgraded system to governmental purchasers in the
United States and overseas. We have not yet signed contracts for
a majority of these system sales, and if we fail to receive such
contracts, our 2006 performance would be adversely affected. We
do not expect to complete development of the upgrade system
until the fourth quarter of 2006, and thus completion of
delivery, installation and customer acceptance in the fourth
quarter is at significant risk. The availability of an upgrade
system may also adversely affect sales of Cray XT3 systems in
2006 if customers decide to wait until 2007 to receive the
upgrade system. We also face significant margin pressure for our
Cray XT3 system and other commodity processor-based products
from competitors.
Improved future performance is highly dependent on increased
product revenue and margins. In 2005, we had lower revenue
and margins than anticipated for our principal products. Product
revenue was adversely affected by delays in product shipments
due to development delays, including system software development
for large systems, and at times by the availability of key
components from third party vendors. Product margins have been
adversely impacted by competitive pressures, lower volumes than
planned and higher than anticipated manufacturing variances,
including scrap, rework and excess and obsolete inventory. We
sometimes do not meet all of the contract requirements for
customer acceptance of our systems, which has resulted in
contract penalties. Most often these penalties adversely affect
the gross margin on a sale through the provision of additional
equipment and services to satisfy delivery delays and
performance shortfalls, although there is the risk of contract
defaults and product return. The risk of contract penalties is
increased when we bid for new business prior to completion of
product development.
To improve our financial performance, we need to receive higher
margin orders, particularly for the Cray XT3 and its upgrade
system; deliver shipments of new products on time, particularly
the upgrade to the Cray XT3 system in the fourth quarter of
2006; limit negative manufacturing variances, contract penalties
and other charges that adversely affect product margin; and
complete the Red Storm project without additional losses.
Our inability to overcome the technical challenges of
completing the development of our supercomputer systems would
adversely affect our revenue and earnings in 2006 and
beyond. Our success in 2006 and in the following years
depends on completing development of hardware and software
enhancements to the Cray XT3 systems, including the timely and
successful introduction of dual-core processor technology and
successfully completing, shipping and recognizing revenue for an
upgrade to the Cray XT3 system by the fourth quarter of 2006. We
also must successfully and timely complete several key projects
on our product roadmap, including the products based on our
BlackWidow and Eldorado projects for 2007 revenue and successor
systems to the Cray XT3. These hardware and software development
efforts are lengthy and technically challenging processes, and
require a significant investment of capital, engineering and
other resources. Our engineering and technical personnel
resources are limited, have suffered from increased turnover,
and our employee restructurings have strained our engineering
resources further. Unanticipated performance and/or development
issues may require more engineers or time or testing resources
than are available currently. Given the breadth of our
engineering challenges and our limited resources, we
periodically review the anticipated contributions and expense of
our product programs to determine their long-term viability. We
may not be successful in meeting our development schedules for
technical reasons and/or because of insufficient hardware and
software engineering resources. Delays in completing the design
of the hardware components, including several custom integrated
circuits, and developing requisite system software, operating
system software stability, needed software features and
integrating the full systems, would make it difficult for us to
develop and market these systems timely and successfully and
could cause a lack of confidence in our capabilities among our
key customers. We have suffered significantly from product
delays in the past, especially in 2004 and 2005, that adversely
affected our financial performance, and may incur similar delays
in the future, which would adversely affect our revenue and
earnings.
If we lose government support for development of our
supercomputer systems, our research and development expenses and
capital requirements would increase and our ability to conduct
research and development would decrease. A few government
agencies and research laboratories fund a significant portion of
our development efforts, including our vector and multithreaded
products, which significantly reduces our reported level of net
research and development expenses. To date, our 2006 development
contracts for our BlackWidow and Eldorado projects are not
funded fully or have not yet been completed. Agencies of the
U.S. government historically have facilitated the
development of, and have constituted a market for, new and
enhanced very high performance computer systems.
U.S. government agencies may delay or decrease funding of
our future product development efforts due to a change of
priorities, international political developments, overall
budgetary considerations or for any other reason. Any delay in
completing the currently planned contracts for these projects or
a delay or decrease in other governmental support would cause an
increased need for capital, increase significantly our research
and development expenditures and adversely impact our
profitability and our ability to implement our product roadmap.
We will be adversely affected if we are not awarded a
contract for phase 3 of the DARPA HPCS Program.
Proposals for phase 3 of the DARPA HPCS program are due in
late April 2006 and awards for phase 3 are to be announced
in mid-2006. In addition to ourselves, we expect that IBM and
Sun Microsystems, the other participants in phase 2, will
submit proposals. Phase 3 awards are for the delivery of
prototype systems by late 2010 and are expected to be in the
range of $200 million to $250 million payable over
about five years, with awardees to contribute a significant
portion of the cost. We anticipate that there will be one or two
awardees. Our 2006 plan is based on a successful phase 3
proposal. Winning a phase 3 award likely will result in
increased research and development expenditures by us for the
cost-sharing portion of the program. If we do not receive a
phase 3 award, we would look for alternative funding for
all or some portion of our proposal, which may not be available.
We would need to revise our long-term development plans and
possibly redeploy and/or reduce our engineering staff. We also
may experience decreased confidence in us and our long-term
viability from our customers, particularly
U.S. governmental agencies. If we do not receive a
phase 3 award, our expenses in 2006 likely will increase
and our longer-term revenue and earnings probably would be
adversely affected.
We face last-time buy decisions affecting all of our
products, which may adversely affect our revenue and
earnings. We face a last-time-buy deadline for a key
component for our Cray XT3 and successor
systems and our Eldorado project. We expect to no longer produce
the Cray XD1 past 2006, and must plan our inventory purchases
accordingly. We may have to place such last-time-buy orders and
inventory purchases before we know all possible sales prospects.
In determining last-time-by orders and inventory purchases, we
may either estimate low, in which case we limit the number of
possible sales of products and reduce potential revenue, or we
may estimate too high, and incur inventory obsolescence
write-downs. Either way, our earnings would be adversely
affected.
To be successful we need to establish the value of our
high-bandwidth sustained performance systems, increase
differentiation of our massively parallel commodity
processor-products and reduce doubts about our long-term
viability. We are a comparatively small company dedicated
solely to the supercomputing market. We have concentrated our
product roadmap on building balanced systems combining highly
capable processors with very high speed interconnect and
communications capabilities throughout the entire computing
system. We achieve performance differentiation from our
competitors through our custom processors in our vector-based
and multithreading products, although the markets for those
products may be limited in size. We need to establish greater
performance differentiation from our competitors in our Cray XT3
and successor massively parallel products in order to command
higher margins. The market for such products is much larger but
currently replete with low-bandwidth systems and
off-the-shelf
commodity-based cluster systems offered by larger competitors
with significant resources and smaller companies with minimal
research and development expenditures. Many customers are able
to meet their computing needs through the use of such systems,
and are willing to accept lower capability and less accurate
modeling in return for lower acquisition costs. Vendors of such
systems, because they can offer high peak performance per
dollar, often put pricing pressure on us in competitive
procurements. In addition, even when we have the best technical
solution, our financial losses in 2004 and 2005 may raise
questions with our customers and potential customers about our
long-term viability. Our long-term success may be adversely
affected if we are not successful in establishing the value of
our balanced high-bandwidth systems with the capability of
solving challenging problems quickly to a market beyond our core
of customers, largely certain agencies of the U.S. and other
governments, that require systems with the performance and
features we offer.
Our reliance on third-party suppliers poses significant risks
to our business and prospects. We subcontract the
manufacture of substantially all of our hardware components for
all of our products, including integrated circuits, printed
circuit boards, connectors, cables, power supplies, and certain
memory parts, on a sole or limited source basis to third-party
suppliers. We use contract manufacturers to assemble our
components for all of our systems. We also rely on third parties
to supply key software capabilities, such as file systems and
storage subsystems. We are subject to substantial risks because
of our reliance on these and other limited or sole source
suppliers. For example:
•
if a supplier did not provide components that met our
specifications in sufficient quantities, then production and
sale of our systems would be delayed;
•
if a reduction or an interruption of supply of our components
occurred, either because of a significant problem with a
supplier not providing parts on time or providing parts that
later prove to be defective or a single-source supplier deciding
to no longer provide those components to us, it could take us a
considerable period of time to identify and qualify alternative
suppliers to redesign our products as necessary and to begin
manufacture of the redesigned components or we may not be able
to so redesign such components; see also “We face last-time
buy decisions affecting all of our products, which may adversely
affect our earnings and prospects,” above;
•
if we were unable to locate a supplier for a key component, we
would be unable to complete and deliver our products;
•
one or more suppliers could make strategic changes in their
product offerings, which might delay, suspend manufacture or
increase the cost of our components or systems; and
•
some of our key 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.
Our products must meet demanding specifications, such as
integrated circuits that perform reliably at high frequencies in
order to meet acceptance criteria. From time to time in 2004 and
2005 we incurred delays in the receipt of key components for the
Cray X1E, Red Storm, Cray XT3 and the Cray XD1 systems, which
delayed product shipments and acceptances. The delays in product
shipments and acceptances adversely affected 2004 and 2005
revenue and margins, and may continue to so. We have also
received parts that later proved defective, particularly for the
Cray XD1 system, which adversely affects our margins and
customer confidence.
We have used IBM as a key foundry supplier of our integrated
circuits for many years. In 2004 IBM informed us that it would
no longer act as our foundry supplier on a long-term basis,
although it will continue production of components for our
current products for a limited time. We have negotiated a
termination of the relationship with IBM and completed a general
contract with TI to act as our foundry for certain key
integrated circuits for our BlackWidow project in 2006 and
successor products in subsequent years. We need to develop a
mutually beneficial relationship with TI on a long-term basis,
including negotiating and completing agreements for the design
and delivery of specific components. If we do not conclude such
agreements or if TI is not able to meet our schedules
successfully, we will be adversely affected.
Our Cray XT3 and Cray XD1 systems utilize AMD Opteron
processors, as do our planned successor products. Our Eldorado
project is based on processors from Taiwan Semiconductor
Manufacturing Company. If any of these suppliers suffers delays
or cancels the development of enhancements to its processors,
our product revenue would be adversely affected. Changing our
product designs to utilize another supplier’s integrated
circuits would be a costly and time-consuming process.
Lower than anticipated sales of new supercomputers and the
termination of maintenance contracts on older and/or
decommissioned systems would further reduce our service revenue
and margins from maintenance service contracts. High
performance computer systems are typically sold with maintenance
service contracts. These contracts generally are for annual
periods, although some are for multi-year periods, and provide a
predictable revenue base. Our revenue from maintenance service
contracts has declined from approximately $95 million in
2000 to approximately $42 million in 2005. While we expect
our maintenance service revenue to stabilize over the next year,
we may have periodic revenue and margin declines as our older,
higher margin service contracts are ended and newer, lower
margin contracts are established, based on the timing of system
withdrawals from service. Adding service personnel to new
locations when we win contracts where we have previously had no
presence and servicing installed products when we discover
defective components in the field create additional pressure on
service margins.
We face increased liquidity risk if we do not receive cash
flow from operating activities as planned. During 2005, we
incurred a net loss of $64.3 million and used
$36.7 million of cash in operating activities. Although we
generated cash from operations in the second half of 2005 of
approximately $40.5 million, we used significant working
capital in the first half of 2005 to fund our operating loss,
increased inventory purchases, increased accounts receivable and
additional equipment purchases associated with the introduction
of three new products. Our plans project that our current cash
resources, including our credit facility, and cash to be
generated from operating activities should be adequate for at
least the next 12 months, although we may face short-term
dislocations between receipts and expenditures. Our plans assume
customer acceptances and subsequent collections from several
large customers, as well as cash receipts on new bookings.
Should acceptances and payments be delayed significantly, we
could face a significant liquidity challenge which may require
us to pursue additional initiatives to reduce costs further,
including reductions in inventory purchases and commitments
and/or seek additional financing. There can be no assurance that
we will be successful in our efforts to achieve future
profitable operations or generate sufficient cash from
operations, or that we would be able to obtain additional
funding through a financing in the event our financial resources
became insufficient. Financing, even if available, may not be
available on satisfactory terms, may contain restrictions on our
operations, and if involving equity or debt securities could
reduce the percentage ownership of our shareholders, may cause
additional dilution to our shareholders and the securities may
have rights, preferences and privileges senior to the Notes and
our common stock.
We may not meet the covenants imposed by our current credit
agreement. We are subject to various financial and other
covenants related to our line of credit with Wells Fargo
Foothill, Inc. If we were to fail to satisfy any of the
covenants, we could be subject to fees and/or the possible
termination of the credit facility. We failed to meet a covenant
with regard to minimum EBITDA for 2005, which was waived by
Wells Fargo Foothill, Inc. Termination of our credit facility
would have a material adverse impact on our liquidity.
We were not successful in completing the Red Storm project on
time and on budget, which adversely affected our 2004 and 2005
earnings and could adversely affect our future earnings and
financial condition. Falling behind schedule and incurring
cost overruns on the Red Storm project adversely affected our
cash flow and earnings in 2004 and 2005, and we recognized an
estimated loss of $7.6 million in 2004 and recognized
additional losses of $7.7 million in 2005 on that project.
It is possible that we may have additional losses on the Red
Storm contract in 2006. Although we have made considerable
progress on the Red Storm project, achieved a series of critical
milestones, and clarified the path to system acceptance, failure
to complete the Red Storm system or to receive full payment for
the Red Storm system would result in the recognition of
additional losses, and if severe enough, could result in a
contract default or termination. Such delays, default
declaration and/or termination could materially adversely affect
other transactions with other U.S. government agencies, our
2006 results and our financial condition.
If the U.S. government purchases fewer supercomputers,
our revenue would be reduced and our earnings would be adversely
affected. Historically, sales to the U.S. government
and customers primarily serving the U.S. government have
represented a significant market for supercomputers, including
our products. From January 1, 2001, through
December 31, 2002, approximately $101 million of our
product revenue was derived from sales to various agencies of
the U.S. government; in 2003 and 2004, approximately
$145 million and $78 million, respectively, of our
product revenue was derived from such sales. In 2005,
approximately $84 million of our product revenue was
derived from U.S. government sales. Our 2006 plan is based
on significant sales to U.S. government agencies,
particularly of Cray XT3 and successor systems. Sales to
government agencies may be affected by factors outside our
control, such as changes in procurement policies, budget
considerations, domestic crisis, and international political
developments. 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 earnings would be
reduced, which could lead to reduced profitability or losses.
If we are unable to compete successfully in the high
performance computer market, our revenue will decline. The
performance of our products may not be competitive with the
computer systems offered by our competitors. Many of our
competitors are established companies well known in the high
performance computing market, including IBM, NEC,
Hewlett-Packard, SGI, Dell, Bull S.A. and Sun Microsystems. Most
of these competitors have substantially greater research,
engineering, manufacturing, marketing and financial resources
than we do.
We also compete with systems builders and resellers of systems
that are constructed from commodity components using
microprocessors manufactured by Intel, AMD, IBM and others.
These competitors include the previously named companies as well
as smaller firms, such as Linux Networx and Verari Systems, that
benefit from the low research and development costs needed to
assemble systems from commercially available commodity products.
These companies have capitalized on developments in parallel
processing and increased computer performance in commodity-based
networking and cluster systems. While these companies’
products are more limited in applicability and scalability, they
have achieved growing market acceptance. They offer significant
performance and price/peak performance on smaller problems and
on larger problems lacking complexity, which is a part of the
growing capacity computing marketplace (as opposed to the
capability marketplace that is our focus). Such companies,
because they can offer high peak performance per dollar, often
put pricing pressure on us in competitive procurements.
Internationally we compete primarily with IBM, Hewlett-Packard,
Sun Microsystems, SGI, and NEC. While the first four companies
offer large systems based on commodity processors, NEC also
offers vector-based systems with a large suite of ported
application programs. We have non-exclusive rights to market NEC
vector processing supercomputers throughout the world. As in the
United States, commodity high perform-
ance computing suppliers like Dell, Linux Networx and Bull offer
systems with significantly better price/peak performance.
Periodic announcements by our competitors of new high
performance computer 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 very high
performance computer systems. Some of our competitors offer
trade-in allowances or substantial discounts to potential
customers, and engage in other aggressive pricing tactics, and
we have not always been able to match these sales incentives. We
have in the past and may again be required to provide
substantial discounts to make strategic sales, which may reduce
or eliminate any positive margin on such transactions, or to
provide lease financing for our products, which would result in
a deferral of our receipt of cash for these systems. These
developments limit our revenue and resources and reduce our
ability to be profitable.
Our market is characterized by rapidly changing technology,
accelerated product obsolescence and continuously evolving
industry standards. Our success depends upon our ability to sell
our current products, and to develop successor systems and
enhancements in a timely manner to meet evolving customer
requirements. We may not succeed in these efforts. Even if we
succeed, products or technologies developed by others may render
our products or technologies noncompetitive or obsolete. A
breakthrough in architecture or software technology could make
low-bandwidth and cluster systems even more attractive to our
existing and potential customers. Such a breakthrough would
impair our ability to sell our products and reduce our revenue
and earnings.
If we cannot retain, attract and motivate key personnel, we
may be unable to effectively implement our business plan.
Our success also depends in large part upon our ability to
retain, attract and motivate highly skilled management,
technical, marketing, sales and service personnel. The loss of
and failure to replace key engineering management and personnel
could adversely affect multiple development efforts. Turnover of
our research and development personnel was higher than normal in
2005 due to programmatic decisions and aggressive hiring
pressure from competitors and other high technology companies,
resulting in increased risks to our ability to complete product
development projects on schedule. We face staffing shortages and
high workloads in many key areas, including sales leadership,
engineering, field services, marketing, finance and legal. We
need to develop and implement succession plans for key
personnel, some of whom are approaching retirement age.
Recruitment for senior management and highly skilled technical,
sales and other personnel is very competitive, and we may not be
successful in either attracting or retaining such personnel. As
part of our strategy to attract and retain personnel, we offer
equity compensation through stock options and restricted stock
grants. However, given the fluctuations of the market price of
our common stock and concerns about our long-term viability,
potential employees may not perceive our equity incentives as
attractive, and current employees whose options have exercise
prices significantly above current market values for our common
stock may choose not to remain employed by us. We expect to seek
shareholder approval for a new equity incentive plan that would
provide additional authorized options and restricted stock to
provide appropriate hiring and retention incentives; if our
shareholders do not approve the new plan, we may be limited in
our ability to provide such incentives. In addition, due to the
intense competition for qualified employees, we may be required
to increase the level of compensation paid to existing and new
employees, which could materially increase our operating
expenses.
New European environmental rules may adversely affect our
operations. In 2006 members of the European Union
(EU) and certain other European countries will implement
the Restrictions on Hazardous Substances (RoHS) Directive, which
prohibits or limits the use in electrical and electronic
equipment of the following substances: lead, mercury, cadmium,
hexavalent, chromium, polybrominated biphenyls, and
polybrominated diphenyl ethers. After July 1, 2006, a
U.S. company shipping products to the EU or such other
European countries that do not comply with RoHS could have its
products detained and could be subject to penalties. We have
decided not to ship any Cray X1E or Cray XD1 systems to Europe
after July 1, 2006, due to these restrictions, and we are
working with our suppliers to assure RoHS compliance with
respect to our other products. We may have to redesign and
re-qualify certain components in order to meet RoHS
requirements, may face increased engineering expenses in this
process, and could face shipment delays, penalties and possible
product detentions or seizures if a regulatory authority
determines that one of our products is not RoHS compliant.
A separate EU Directive on Waste Electrical and Electronic
Equipment (WEEE) was scheduled to become effective in
August 2005, but many EU member states have delayed its
implementation. Under the WEEE Directive, companies that put
electrical and electronic equipment on the EU market must
register with individual member states, mark their products,
submit annual reports, provide recyclers with information about
product recycling, and either recycle their products or
participate in or fund mandatory recycling schemes. In addition,
some EU member states require recycling fees to be paid in
advance to ensure funds are available for product recycling at
the end of the product’s useful life or de-installation. We
have begun to mark our products as required by the WEEE
Directive and are registering with those EU member states where
our products are sold. Each EU member state is responsible for
implementing the WEEE Directive and some member states have not
yet established WEEE registrars or established or endorsed the
recycling schemes required by the WEEE Directive. We are
actively monitoring implementation of the WEEE Directive by the
member states. Compliance with the WEEE Directive could increase
our costs and any failure to comply with the WEEE Directive
could lead to monetary penalties.
Class action and derivative lawsuits are pending and
additional lawsuits may be filed. We and certain of our
former and current officers and directors have been named as
defendants in a consolidated class action lawsuit pending in
federal district court for the Western District of Washington
alleging certain violations of the federal securities laws. A
consolidated derivative action purporting to be brought on our
behalf against certain of our former and current officers and
directors is also pending in the same federal district court. A
similar consolidated derivative action is pending in a state
court in King County, Washington. These cases are still in their
early stages. Additional lawsuits may be filed against us. See
“Item 3. Legal Proceedings” below for a
description of this litigation. An adverse result in the federal
securities cases could have a material negative financial impact
on us. Regardless of the outcome, it is likely that such actions
would cause a diversion of our management’s time, resources
and attention, and the expense of defending the litigation may
be costly.
We are subject to the risk of additional litigation and
regulatory proceedings or actions in connection with the
restatement of prior period financial statements. We have
restated our previously issued financial statement for the
fiscal year 2004, including interim periods in 2004. We may in
the future be subject to class action suits, other litigation or
regulatory proceedings arising in relation to the restatement of
our prior period financial statements. Any expenses incurred in
connection with this potential litigation or regulatory
proceeding not covered by available insurance or any adverse
resolution of this potential litigation or regulatory proceeding
could have a material adverse impact on us. Regardless of the
outcome, it is likely that such actions or proceedings would
cause a diversion of our management’s time, resources and
attention, and the expense of defending any litigation or
proceeding may be costly.
The adoption of SFAS 123(R) will lower our earnings and
may adversely affect the market price of our common stock.
We have used stock-based compensation, primarily stock options
and an employee stock purchase plan, as a key component in our
employee compensation. We previously granted stock options to
each new employee and to all employees on an annual basis. We
believe we have structured these programs to align the
incentives for employees with those of our long-term
shareholders. We are reviewing our stock-based compensation
programs and their structure in light of the imposition of
SFAS 123(R) which became effective for us on
January 1, 2006. In previous years, as we have reported in
the notes to our financial statements, our stock option program,
as currently structured, would add approximately $7 million
to $26 million of additional non-cash expense annually and
consequently would reduce our operating results by that amount.
These estimates are based on use of the Black-Scholes valuation
method. In the first half of 2005, we accelerated the vesting of
our outstanding employee stock options with a per share exercise
price of $1.47 or higher, resulting in the complete vesting of
almost all of our then outstanding options, and we granted new
stock options that vested on or before December 31, 2005,
in order in part to minimize this expense, at least in the
short-term. We recently have granted some stock options to
certain new employees with four-year vesting periods and have
issued restricted stock grants to certain employees and
officers, which will be recorded as an expense in 2006 and
subsequent years. We do not know how
analysts and investors will react to the additional expense
recorded in our statement of operations rather than in the
notes, which may adversely affect the market price of our common
stock.
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 high performance
computer systems such as our products. Occasionally we have
experienced delays 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 foreign
customers, eliminating an important source of potential revenue.
We incorporate software licensed from third parties into the
operating systems for our 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. The operating system software we develop
for our high performance computer systems 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 either to
redesign our operating system software to function with
alternate third-party software, or develop these components
ourselves, which would result in increased costs and could
result in delays in product shipments. Furthermore, we might be
forced to limit the features available in our current or future
operating system software offerings. Our Cray XD1 and Cray XT3
systems utilize software system variants that incorporate Linux
technology. The SCO Group, Inc. has filed and threatened to file
lawsuits against companies that operate Linux for commercial
purposes, alleging that such use of Linux infringes The SCO
Group’s rights. It is possible that The SCO Group could
assert a claim of infringement against us with respect to our
use of 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 SCO Group’s
lawsuit and open source generally, we may be forced to protect
our customers from potential claims of infringement by The SCO
Group or other parties. In any such event, our financial
condition and results of operations may be adversely affected.
We also incorporate proprietary 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. These
issues, if repeated, may result in additional expense by us in
integrating this software more fully and/or loss of customer
confidence.
We have recently formed a new senior management team that
must work together effectively for us to be successful. In
2005 we revamped our senior management team, obtaining the
services of Margaret A. Williams as Senior Vice President
responsible for research and development, Brian C. Henry as
Executive Vice President and Chief Financial Officer, Jan C.
Silverman as Senior Vice President responsible for corporate
strategy and business development and Steven L. Scott as Senior
Vice President and Chief Technology Officer, and Peter J. Ungaro
was elevated to Chief Executive Officer. We recently added a new
vice president/corporate controller and a new vice president
responsible for human resources. Additional changes to our
senior management team, and the integration of new senior
executives, could result in some disruption to our business
while these new executives become familiar with our business
culture and model and establish their management systems. If our
new management team, including any additional senior executives
who join us in the future, is unable to work together
effectively to implement our strategies, manage our operations
and accomplish our business objectives, our ability to grow our
business and successfully meet operational challenges could be
severely impaired. The loss of any key senior management could
have a significant impact on our efforts to improve operating
results.
While we believe that we have adequate internal control over
financial reporting as of December 31, 2005, as of the end
of each subsequent fiscal year we are required to evaluate our
internal control over financial reporting under Section 404
of the Sarbanes-Oxley Act of 2002 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, beginning with our Annual
Report on
Form 10-K for the
fiscal year ended December 31, 2004, we are required to
furnish a report by our management on our internal control over
financial reporting. Such report must contain, among other
items, an assessment of the effectiveness of our internal
control over financial reporting as of the end of each fiscal
year, including a statement as to whether or not our internal
control over financial reporting is effective. This assessment
must include disclosure of any material weaknesses in our
internal control over financial reporting identified by
management. Such report must also contain a statement that our
independent registered public accounting firm has issued an
attestation report on management’s assessment of such
internal control. In our amended 2004 Annual Report on
Form 10-K/ A, we
identified and described a number of material weaknesses in our
internal control over financial reporting, which required our
assessment that our internal control over financial reporting
was not effective, and our independent registered public
accounting firm disclaimed an opinion with respect to our
management’s assessment of our internal control over
financial reporting as of December 31, 2004.
We implemented remediation plans to address the identified
material weaknesses, and our management has concluded, as set
forth under “Item 9A. Controls and
Procedures,” below, that our internal control over
financial reporting was effective as of December 31, 2005,
and we received a favorable opinion from our independent
registered public accounting firm with respect to our
management’s assessment, also as set forth under
“Item 9A. Controls and Procedures,” below.
However, each year we must continue to monitor and assess our
internal control over financial reporting and determine whether
we have any material weaknesses. 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 Nasdaq,
loss of financing sources such as our line of credit, and
litigation based on the events themselves or their consequences.
We may infringe or be subject to claims that we infringe the
intellectual property rights of others. Third parties may
assert intellectual property infringement claims against us, and
such claims, if proved, could require us to pay substantial
damages or to redesign our existing products. Regardless of the
merits, any claim of infringement requires management attention
and causes us to incur significant expense to defend.
We may not be able to protect our proprietary information and
rights adequately. We rely on a combination of patent,
copyright 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 protect adequately
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. Although we
continue to implement protective measures and intend to defend
our proprietary rights vigorously, these efforts may not be
successful.
Risk Factors Pertaining to our Notes and Our Common Stock
Our indebtedness may adversely affect our financial
strength. With the sale of the Notes, we incurred
$80.0 million of indebtedness. As of December 31,2005, we had no other outstanding indebtedness for money
borrowed and no material equipment lease obligations. We have a
$30.0 million secured credit facility which supports the
issuance of letters of credit, of which $11.3 million were
outstanding as of December 31, 2005 (the outstanding
letters of credit were reduced to $1.4 million as of
February 1, 2006), and provides us the remaining
availability for potential borrowing. As of February 6,2006, the line of credit also supports a forward currency
contract designated as a cash flow hedge on a specific sales
contract. See Note 20 — Subsequent Events
of the Notes to Consolidated Financial Statements, below. We may
incur additional
indebtedness for money borrowed, which may include borrowing
under new credit facilities or the issuance of new debt
securities. The level of our indebtedness could, among other
things:
•
make it difficult or impossible for us to make payments on the
Notes;
•
increase our vulnerability to general economic and industry
conditions, including recessions;
•
require us to use cash flow from operations to service our
indebtedness, thereby reducing our ability to fund working
capital, capital expenditures, research and development efforts
and other expenses;
•
limit our flexibility in planning for, or reacting to, changes
in our business and the industry in which we operate;
•
place us at a competitive disadvantage compared to competitors
that have less indebtedness; and
•
limit our ability to borrow additional funds that may be needed
to operate and expand our business.
Our existing and any future credit facilities may adversely
affect our ability to make payments under the Notes. Our
existing senior secured credit agreement contains covenants
relating to our business, including covenants that require us to
maintain or achieve specified financial performance standards,
and contains specified events of default. We anticipate that any
future credit facility would contain similar types of
provisions. Our failure to comply with any of those covenants or
the occurrence of any of those specified events of default, if
not cured (to the extent cure is permitted under the agreement)
or waived, could result in the acceleration of our indebtedness
under the existing or any future credit facilities. If our
credit facility is in default, we will be required by the
indenture, or in certain cases after a notice from our lender
pursuant to the indenture, to suspend or defer payments under
the Notes. Because our credit facility constitutes senior
indebtedness, any enforcement by the Note holders of their
rights under the indenture to such payments could lead to our
insolvency and a proceeding in which our senior and secured
indebtedness would have priority over claims under the Notes.
We will require a significant amount of cash to service our
indebtedness and to fund planned capital expenditures, research
and development efforts and other corporate expenses. Our
ability to make payments on our indebtedness, including the
Notes, and to fund planned capital expenditures, research and
development efforts and other corporate expenses will depend on
our future operating performance and on economic, financial,
competitive, legislative, regulatory and other factors. Many of
these factors are beyond our control. Our business may not
generate sufficient cash flow from operations and future
borrowings may not be available to us in an amount sufficient to
enable us to pay our indebtedness, including the Notes, or to
fund our other needs.
If we are unable to generate sufficient cash flow to enable us
to pay our indebtedness, we may need to pursue one or more
alternatives, such as:
•
reducing our operating expenses;
•
reducing or delaying capital expenditures or research and
development;
•
selling assets;
•
raising additional equity capital and/or debt; and
•
seeking legal protection from our creditors.
Any reduction in operating expenses, reduction or delay in
capital expenditures, or sale of assets may materially and
adversely affect our future revenue prospects. In addition, we
may not be able to raise additional equity capital or debt on
commercially reasonable terms or at all. Finally, any of the
above actions may not provide sufficient cash to repay our
indebtedness, including the Notes.
There are no covenants in the indenture for the Notes
restricting our ability or the ability of our subsidiaries to
incur future indebtedness or restricting the terms of any such
indebtedness. The indenture governing the Notes does not
contain any financial or operating covenants or restrictions on
the amount or terms of indebtedness that we or any of our
subsidiaries may incur. We may therefore incur additional debt
without limitation by the indenture for the Notes, including
senior indebtedness, to which the Notes are contractually
subordinated, and secured indebtedness, to which the Notes are
effectively subordinated. In addition, our subsidiaries may
incur additional debt to which the Notes are structurally
subordinated, without limitation. We or our subsidiaries may
also agree to terms of any such indebtedness that may restrict
our flexibility in complying with our obligations under the
Notes. If we or any of our subsidiaries incur additional
indebtedness, the related risks that we and they now face may
intensify. Our credit facility, however, currently restricts our
ability, directly or through our subsidiaries, to incur
additional indebtedness.
The Notes are subordinated in right of payment to our
existing and future senior indebtedness. The Notes are our
general unsecured senior subordinated obligations. The Notes
rank junior in right of payment to our existing and future
senior indebtedness, including our existing line of credit, and
equal in right of payment with any future indebtedness or other
obligation that is not, by its terms, either senior or
subordinated to the Notes. The indenture for the Notes does not
limit our ability to incur additional indebtedness of any kind.
In the event of our bankruptcy, liquidation or reorganization,
the note holders will share in any assets available to our
general creditors, only after all obligations to the holders of
senior indebtedness have been paid. The note holders do not have
the right to limit the amount of senior indebtedness or the
competing claims of our general creditors.
The Notes are effectively subordinated to our secured
indebtedness and are structurally subordinated to all
indebtedness and other liabilities of our current and future
subsidiaries. The Notes are general unsecured obligations
and are effectively subordinated to our current and future
secured indebtedness to the extent of the assets securing the
indebtedness. The indenture for the Notes does not limit our
ability to incur secured indebtedness. In the event of
bankruptcy, liquidation or reorganization or upon acceleration
of our secured indebtedness and in certain other events, our
assets pledged in support of secured indebtedness will not be
available to pay our obligations under the Notes. As a result,
we may not have sufficient assets to pay amounts due on any or
all of the Notes.
In addition, the Notes are structurally subordinated to all
indebtedness and other liabilities of our current and future
subsidiaries. Note holders do not have any claim as a creditor
against our subsidiaries, and indebtedness and other
liabilities, including trade payables, of our subsidiaries
effectively are senior to Note holders’ claims against our
subsidiaries. The indenture for the Notes does not limit the
ability of our subsidiaries to incur indebtedness or other
liabilities. In the event of a bankruptcy, liquidation or
reorganization of any of our subsidiaries, holders of their
indebtedness and their trade creditors will generally be
entitled to payment on their claims from assets of that
subsidiary before any assets are made available for distribution
to our direct creditors.
We and one of our subsidiaries, Cray Federal Inc., are obligated
for all indebtedness under our senior secured credit agreement
with Wells Fargo Foothill, Inc., and that agreement is secured
by all of our assets and those of Cray Federal Inc. and by
pledges of the stock of our subsidiaries, and is supported by
guaranties by certain of our subsidiaries.
In certain circumstances, holders of senior debt can require
us to suspend or defer cash payments due in respect of the
Notes. If we are in default as to any payment obligation
under any Senior Debt, as defined in the indenture governing the
Notes, including a payment default that results from the
acceleration of such Senior Debt as a result of a non-payment
default, we will be prohibited, under the terms of the indenture
from making any further cash payments in respect of the Notes
until such default has been cured or waived or shall have ceased
to exist. In addition, if we incur a non-payment default under
any Designated Senior Debt, as defined in the indenture, the
holder or holders may provide, or cause to be provided, a notice
to the indenture trustee that will have the effect of
prohibiting any further cash payments in respect of the Notes
for a period not exceeding 179 days from the date on which
the trustee receives the notice or until such default is earlier
cured or waived. A holder of Designated Senior Debt may have the
right to accelerate such debt as a result of the non-payment
default during the 179 day blockage period or otherwise, in
which event future payments in respect of the Notes will be
prohibited as described above. Our obligations under our
existing senior secured credit agreement constitute Senior Debt
and Designated Senior Debt under the indenture.
Unless a condition to conversion is met prior to the maturity
of the Notes, the Notes will not be convertible at any time.
The Notes are convertible only upon the occurrence of stated
conditions. If none of these conditions occurs during the term
of the Notes, the Notes will never be convertible and the
holders may never have an opportunity to realize any
appreciation in value based on the value of our common stock.
Upon conversion of the Notes, we may pay cash or a
combination of cash and shares of our common stock in lieu of
issuing shares of our common stock. Therefore, Note holders may
receive no shares of our common stock or fewer shares than the
number into which their Notes are convertible. We have the
right to satisfy our conversion obligation to Note holders by
issuing shares of our common stock into which the Notes are
convertible, paying the cash value of the shares of our common
stock into which the Notes are convertible, or a combination
thereof. In addition, we have the right to irrevocably elect to
satisfy our conversion obligation in cash with respect to the
principal amount of the Notes to be converted after the date of
such election. Accordingly, upon a conversion of a Note, a
holder may not receive any shares of our common stock, or it
might receive fewer shares of our common stock relative to the
conversion value of the Note. Our liquidity may be reduced to
the extent that we choose to deliver cash rather than shares of
our common stock upon conversion of Notes.
If a principal conversion settlement election is made, we may
not have sufficient funds to pay the cash settlement upon
conversion. If we make a principal conversion settlement
election, upon conversion of the Notes, we will be required to
satisfy our conversion obligation relating to the principal
amount of such Notes in cash. If a significant number of holders
were to tender their Notes for conversion at any given time, we
may not have the financial resources available to pay the
principal amount in cash on all such Notes tendered for
conversion.
The conversion rate of the Notes may not be adjusted for all
dilutive events, including third-party tender or exchange
offers, that may adversely affect the trading price of the Notes
or our common stock issuable upon conversion of the Notes.
The conversion rate of the Notes is subject to adjustment upon
specified events, including specified issuances of stock
dividends on our common stock, issuances of rights or warrants,
subdivisions, combinations, distributions of capital stock or
assets, cash dividends and issuer tender or exchange offers. The
conversion rate will not be adjusted upon other events, such as
third-party tender or exchange offers, that may adversely affect
the trading price of the Notes or our common stock.
If we pay cash dividends on our common stock, Note holders
may be deemed to have received a taxable dividend without the
receipt of cash. If we pay cash dividends on our common
stock and there is a resulting adjustment to the conversion
rate, a Note holder could be deemed to have received a taxable
dividend subject to U.S. federal income tax without the
receipt of any cash.
If we elect to settle upon conversion in cash or a
combination of cash and shares of common stock, there will be a
delay in settlement. Upon conversion, if we elect to settle
in cash or a combination of cash and shares of our common stock,
there will be a significant delay in settlement. In addition,
because the amount of cash or common stock that a Note holder
will receive in these circumstances will be based on the sale
price of our common stock for an extended period between the
conversion date and such settlement date, holders will bear the
market risk with respect to the value of the common stock for
such extended period.
Some significant corporate transactions may not constitute a
fundamental change, in which case we would not be obligated to
offer to repurchase the Notes. Upon the occurrence of a
fundamental change, as defined in the indenture governing the
Notes, which includes specified change of control events, we
will be required to offer to repurchase all outstanding Notes.
The fundamental change provisions, however, will not require us
to offer to repurchase the Notes in the event of some
significant corporate transactions. For example, various
transactions, such as leveraged recapitalizations, refinancings,
restructurings or acquisitions initiated by us, would not
constitute a change of control and, therefore, would not
constitute a fundamental change requiring us to repurchase the
Notes. Other transactions may not constitute a fundamental
change because they do not involve a change in voting power or
beneficial ownership of the type described in the definition of
fundamental change. Accordingly, Note holders may not have the
right to require us to repurchase their Notes in the event of a
significant transaction that could increase the amount of our
indebtedness, adversely affect our capital structure or any
credit ratings or otherwise adversely affect the holders of
Notes.
In addition, a fundamental change includes a sale of all or
substantially all of our properties and assets. Although there
is limited law interpreting the phrase “substantially
all,” there is no precise established definition of the
phrase under the laws of New York, which govern the indenture
and the Notes, or under the laws of Washington, our state of
incorporation. Accordingly, a Note holder’s ability to
require us to repurchase Notes as a result of a sale of less
than all of our properties and assets may be uncertain.
Our Notes may not be rated or may receive a lower rating than
investors anticipate, which could cause a decline in the trading
volume and market price of the Notes and our common stock.
We do not intend to seek a rating on the Notes, and we believe
it is unlikely the Notes will be rated. If, however, one or more
rating agencies rates the Notes and assigns a rating lower than
the rating expected by investors, or reduces any rating in the
future, the trading volume and market price of the Notes and our
common stock may be adversely affected.
We may not have the funds necessary to purchase the Notes
upon a fundamental change or other purchase date and our ability
to purchase the Notes in such events may be limited. On
December 1, 2009, December 1, 2014 and
December 1, 2019, holders of the Notes may require us to
purchase their Notes for cash. In addition, holders may also
require us to purchase their Notes upon a fundamental change, as
defined in the indenture governing the Notes. Our ability to
repurchase the Notes in such events may be limited by law, and
by the terms of other indebtedness, including the terms of
senior indebtedness, we may have outstanding at the time of such
events. Our existing senior secured credit facility does not
permit us to repurchase any of the Notes without the prior
written consent of the lender, including any repurchase
following a fundamental change as defined in the indenture. Any
subsequent credit facility may include similar provisions. If we
do not have sufficient funds, we will not be able to repurchase
the Notes tendered to us for purchase. If a repurchase event
occurs, we expect that we would require third-party financing to
repurchase the Notes, but we may not be able to obtain that
financing on favorable terms or at all. Our failure to
repurchase tendered Notes at a time when the repurchase is
required by the indenture would constitute a default under the
indenture. In addition, a default under the indenture or the
occurrence of a fundamental change which results in any Note
holder delivering a fundamental change purchase notice electing
repurchase of any notes each constitutes a default under our
existing senior secured credit facility and could lead to
defaults under other existing and future agreements governing
our indebtedness. In these circumstances, the subordination
provisions in the indenture governing the Notes may limit or
prohibit payments to Note holders. If, due to a default, the
repayment of the related indebtedness were to be accelerated
after any applicable notice or grace periods, we may not have
sufficient funds to repay the indebtedness or repurchase the
Notes.
The make whole premium payable on Notes that are converted in
connection with certain fundamental changes may not adequately
compensate Note holders for the lost option time value of the
Notes as a result of that fundamental change. If any of
certain fundamental changes occurs on or prior to
December 1, 2009, we will under certain circumstances pay a
make whole premium on the Notes that are converted in connection
with such fundamental change. The amount of the make whole
premium and additional shares delivered depends on the date on
which the fundamental change becomes effective and the price
paid per share of our common stock in the transaction
constituting the fundamental change, as defined in the indenture
governing the Notes. Although the make whole premium is designed
to compensate Note holders for the lost option value of the
Notes as a result of the fundamental change, the amount of the
make whole premium is only an approximation of the lost value
and may not adequately compensate Note holders for the loss. In
addition, if a fundamental change occurs after December 1,2009, or if the applicable price is less than or equal to
$3.51 per share or greater than $10.50 per share (in
each case, subject to adjustment), then we will not pay any make
whole premium. Also, a holder may not receive the make whole
premium payable upon conversion until the fundamental change
repurchase date relating to the applicable fundamental change,
or even later, which could be a significant period of time after
the date the holder has tendered its Notes for conversion.
There are restrictions on the Note holders’ ability to
transfer or resell the Notes without registration under
applicable securities laws, and if we fail to fulfill our
obligations to keep effective the registration
statement covering the resale of the Notes, we will be
required to pay additional interest on the Notes affected by
that failure and to issue additional shares of common stock on
Notes converted during such failure and satisfied by us in
common stock. We sold the Notes under an exemption from
registration under applicable U.S. federal and state
securities laws. The registration statement covering the resale
of the Notes and underlying common stock became effective in
July 2005. Under the registration rights agreement, we are
permitted to suspend the use of the effective registration
statement for specific periods of time for certain specified
reasons. If we fail to fulfill our obligations specified in the
registration rights agreement governing the Notes, we will be
required to pay additional interest on Notes adversely affected
by such failure. Such additional interest will accrue from the
date of such failure at a rate per year equal to 0.25% for the
first 90 days, and 0.50% thereafter, on the principal
amount of such Notes until such failure is cured or until the
registration statement is no longer required to be kept
effective and is payable on the scheduled interest payment
dates. If a holder converts Notes during a registration default,
no accrued and unpaid additional interest will be paid with
respect to the Notes converted, but the holder would receive on
any conversion that we elect to satisfy in common stock 103% of
the number of shares of our common stock that such holder would
have received in the absence of such default. We would have no
other liability for monetary damages for a failure to fulfill
our registration obligations.
There is no active market for the Notes and if an active
trading market does not develop for these Notes, the holders of
the Notes may be unable to resell them. The Notes are a new
issue of securities for which the only current trading market is
the Nasdaq’s screen-based automated trading system known as
PORTAL, which facilitates the trading of unregistered securities
eligible to be resold by qualified institutional buyers pursuant
to SEC Rule 144A. The resale of the Notes is registered
under the Securities Act. Any Notes resold using an effective
prospectus will no longer be eligible for trading in the PORTAL
market. Moreover, if enough Notes are converted, redeemed or
sold pursuant to an effective prospectus, trading of Notes in
the PORTAL market may become inactive or may cease altogether.
In that event, and in the absence of an alternative trading
market, there would exist no organized market for the Notes from
which their market value could be determined or realized. We do
not intend to list the Notes on any national securities exchange
or to seek the admission of the Notes for trading in the Nasdaq
National Market or SmallCap Market. We have been advised by
Bear, Stearns & Co. Inc. that it is currently making a
market in the Notes. However, it is not obligated to do so and
any market-making activities with respect to the Notes may be
discontinued at any time without notice. In addition,
market-making activity is subject to the limits imposed by law.
Further, even if a market in the Notes develops, the Notes could
trade at prices lower than the initial offering price. In
addition, the liquidity of, and the trading market for, the
Notes may be adversely affected by many factors, including
prevailing interest rates, the markets for similar securities,
general economic conditions, our financial condition,
performance and prospects and general declines or disruptions in
the market for non-investment grade debt.
Our stock price is volatile. The stock market has been
and is subject to price and volume fluctuations that
particularly affect the market prices for small capitalization,
high technology companies like us. The trading price of our
common stock is subject to significant fluctuations in response
to many factors, including our quarterly operating results
(particularly if they are less than our or analysts’
previous estimates), changes in analysts’ estimates, our
capital raising activities, announcements of technological
innovations by us or our competitors and general conditions in
our industry.
A substantial number of our shares are eligible for future
sale and may depress the market price of our common stock and
may hinder our ability to obtain additional financing. As of
December 31, 2005, we had outstanding:
•
90,973,506 shares of common stock, and 78,840 shares
of common stock issuable upon exchange of certain exchangeable
securities issued in connection with the acquisition of
OctigaBay Systems Corporation in April 2004 (all 78,840
exchangeable shares were exchanged for an equivalent number of
shares of our common stock in January 2006);
•
warrants to purchase 5,634,049 shares of common stock;
stock options to purchase an aggregate of 18,000,580 shares
of common stock, of which 17,982,045 options were then
exercisable; and
•
Notes convertible into up to 22,792,016 shares of common
stock.
Almost all of our outstanding shares of common stock may be sold
without substantial restrictions, with certain exceptions
including approximately two million shares held by
executive officers and key managers that may be forfeited and
are restricted against transfer until June 30, 2007. Almost
all of the shares of common stock that may be issued on exercise
of the warrants and options will be available for sale in the
public market when issued, subject in some cases to volume and
other limitations. The warrants outstanding at December 31,2005, consisted of warrants to purchase 294,641 shares
of common stock, with exercise prices ranging from $4.50 to
$6.00 per share, expiring between May 21, 2006, and
September 3, 2006, warrants to
purchase 200,000 shares of common stock, with an
exercise price of $1.65 per share, expiring on May 30,2009, and warrants to purchase 5,139,408 shares of
common stock, with an exercise price of $2.53 per share,
expiring on June 21, 2009. We have authorized
5,000,000 shares of undesignated preferred stock, although
no shares are currently outstanding. The Notes are not now
convertible, and only become convertible upon the occurrence of
certain events. We have registered the resale of the Notes and
of the underlying common stock under the Securities Act of 1933,
as amended, which facilitates transferability of those
securities. Sales in the public market of substantial amounts of
our common stock, including sales of common stock issuable upon
the exercise of warrants, options and Notes, may depress
prevailing market prices for the common stock. Even the
perception that sales could occur may impact market prices
adversely. The existence of outstanding warrants, options and
Notes may prove to be a hindrance to our future financings.
Further, the holders of warrants, options and Notes may exercise
or convert them for shares of common stock at a time when we
would otherwise be able to obtain additional equity capital on
terms more favorable to us. Such factors could impair our
ability to meet our capital needs.
Provisions of our Articles of Incorporation and Bylaws could
make a proposed acquisition that is not approved by our Board of
Directors more difficult. Provisions of our Restated
Articles of Incorporation and 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 Articles of
Incorporation and 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 preferred stock,
without shareholder approval, with rights senior to those of the
common stock;
•
no cumulative voting of shares;
•
calling 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;
•
amendments to our Restated Articles of Incorporation require the
affirmative vote of not less than two-thirds of the outstanding
shares entitled to vote on the 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.
We do not anticipate declaring any cash dividends on our
common stock. We have never paid any dividends on our common
stock, and we do not anticipate paying any cash dividends on our
common stock in the foreseeable future. In addition, our credit
facility prohibits us, and any future credit facility is likely
to prohibit us, from paying cash dividends without the consent
of our lender.
Item 1B. Unresolved
Staff Comments
None.
Item 2.
Properties
Our principal properties as of April 1, 2006, were as
follows:
Approximate
Location of Property
Uses of Facility
Square Footage
Chippewa Falls, WI
Manufacturing, hardware development, central service and
warehouse
228,000
Seattle, WA
Executive offices, hardware and software development, sales and
marketing
59,600
Mendota Heights, MN
Software development, sales and marketing operations
55,000
We own 179,000 square feet of manufacturing, development,
service and warehouse space in Chippewa Falls, Wisconsin, and
lease the remaining space described above. The real property we
own in Chippewa Falls, Wisconsin, is pledged as collateral in
favor of Wells Fargo Foothill, Inc. See Note 14 —
Convertible Notes Payable and Lines of Credit of the
Notes to Consolidated Financial Statements, below. We lease
19,000 square feet of office space in Burnaby, British
Columbia, Canada; we are reducing our operations in that office.
The lease expires at the end of 2006.
We also lease a total of approximately 9,600 square feet,
primarily for sales and service offices, in various domestic
locations. In addition, various foreign sales and service
subsidiaries have leased an aggregate of approximately
17,300 square feet of office space. We believe our
facilities are adequate to meet our needs in 2006.
Item 3.
Legal Proceedings
Beginning on May 25, 2005, we and certain current and
former officers were served with six securities class action
complaints filed in the U.S. District Court for the Western
District of Washington. On October 19, 2005, the Court
ordered the consolidation of these cases into a single action,
and on November 15, 2005, the plaintiffs filed an amended
consolidated complaint. Plaintiffs seek to represent a class of
purchasers of our securities from October 23, 2002, through
May 9, 2005. The consolidated complaint alleges federal
securities law violations in connection with the issuance of
various reports, press releases and statements in investor
telephone conference calls, and seeks unspecified damages,
interest, attorneys’ fees, costs and other relief. On
December 19, 2005, we and the individual defendants moved
to dismiss the consolidated complaint, which motion is pending
before the Court.
On June 3 and June 17, 2005, two shareholder
derivative complaints were filed in the U.S. District Court
for the Western District of Washington against members of our
Board of Directors and certain current and former officers. The
derivative plaintiffs purport to act on our behalf and assert
allegations substantially similar to those asserted in the
putative class action complaints, as well as allegations of
breach of fiduciary duty, abuse of control, gross mismanagement,
waste of corporate assets, and unjust enrichment. The complaints
seek to recover on our behalf unspecified damages and seek
attorney’s fees, costs and other relief. On August 29,2005, the Court ordered the consolidation of these two cases
into a single action, and in October 2005 we were served with an
amended derivative complaint containing substantially identical
allegations as in the earlier complaints. On November 18,2005, we and the individual defendants moved to dismiss the
consolidated derivative complaint, which motions are pending
before the Court.
On January 9, 2006, we were served in two additional
shareholder derivative complaints filed in the Superior Court of
the State of Washington for King County against members of our
Board of Directors and certain current and former officers and
former directors. The derivative plaintiffs purport to act on
our behalf and make allegations substantially similar to those
asserted in the consolidated derivative case previously filed in
the U.S. District Court for the Western District of
Washington. The complaints seek to recover on our behalf
unspecified damages and seek attorneys’ fees, costs and
other relief. On February 15, 2006, the two state court
derivative actions were consolidated by order of the Court. On
April 5, 2006, we and the individual defendants moved to
dismiss the state court derivative action, which motions are
pending before the Court.
We are indemnifying our current and former officers and
directors named in each of the foregoing actions, subject to an
undertaking by each of them to repay the advanced fees and costs
if it is ultimately determined that he or she is not entitled to
such indemnification.
Item 4.
Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of our shareholders during
the fourth quarter of 2005.
Executive Vice President and Chief Financial Officer
Christopher Jehn
63
Vice President
Kenneth W. Johnson
64
Senior Vice President, General Counsel and Corporate Secretary
Steven L. Scott
40
Senior Vice President and Chief Technology Officer
Jan C. Silverman
55
Senior Vice President
Margaret A. Williams
48
Senior Vice President
Peter J. Ungarohas served as Chief Executive Officer and
as a member of our Board of Directors since August 2005 and as
President since March 2005; he previously served as Senior Vice
President responsible for sales, marketing and services since
September 2004 and before then served as Vice President
responsible for sales and marketing from when he joined us in
August 2003. Prior to joining us, he served as Vice President,
Worldwide Deep Computing Sales for IBM since April 2003. Prior
to that assignment, he was IBM’s vice president, worldwide
high performance computing sales, a position he held since
February 1999. He also held a variety of other sales leadership
positions since joining IBM in 1991. Mr. Ungaro received a
B.A. in business administration from Washington State University.
Brian C. Henry joined us in May 2005 as Executive Vice
President and Chief Financial Officer. He has 20 years of
experience as a technology company chief financial officer.
Mr. Henry joined Cray after having served as executive vice
president and chief financial officer of Onyx Software
Corporation, a full suite customer relationship management
company, which he joined in 2001. He previously served from 1999
to 2001 as executive vice president and chief financial officer
of Lante Corporation, a public internet consulting company
focused on e-markets
and collaborative business models. From 1998 to 1999 he was
chief operating officer, information management group, of
Convergys Corporation, which he helped spin-off from Cincinnati
Bell Inc., a diversified service company where he served as
executive vice president and chief financial officer from 1993
to 1998. From 1983 to 1993 he was with Mentor Graphics
Corporation in key financial management roles, serving as chief
financial officer from 1986 to 1993. Mr. Henry received his
B.S. degree from Portland State University and an M.B.A. at
Harvard University where he was a Baker Scholar.
Christopher Jehn serves as Vice President responsible for
government programs, a position he has held since joining us in
July 2001. He served as the Assistant Director for National
Security in the Congressional Budget Office from 1998 to 2001.
From 1997 to 1998, he was a member of the Commission on Service
members and Veterans Transition Assistance, and also served in
1997 as the Executive Director of the National Defense Panel.
Mr. Jehn was a Senior Vice President at ICF Kaiser
International, Inc., from 1995 to 1997. Prior to 1995, he held
executive positions at the Institute for Defense Analyses and
the Center for Naval Analyses and served as Assistant Secretary
of Defense for Force Management and Personnel from 1989 to 1993.
He received a B.A. from Beloit College and a Master’s
degree in economics from the University of Chicago.
Kenneth W. Johnson serves as Senior Vice President,
General Counsel and Corporate Secretary. He has held the
position of General Counsel and Corporate Secretary since
joining us in September 1997. From September 1997 to December
2001 he also served as Vice President Finance and Chief
Financial Officer and he again served as Chief Financial Officer
from November 2004 to May 2005. Prior to joining us,
Mr. Johnson practiced law in Seattle for 20 years with
Stoel Rives LLP and predecessor firms, where his practice
emphasized corporate finance. Mr. Johnson received an A.B.
degree from Stanford University and a J.D. degree from Columbia
University Law School.
Steven L. Scott has served as Senior Vice President since
October 2005. He originally served as an employee, having joined
Cray Research in 1992, through mid-July 2005, and rejoined us in
October, 2005. He
was named as Chief Technology Officer in October 2004. He is
responsible for designing the integrated infrastructure that
will drive our next generation of supercomputers. Prior to his
appointment as Chief Technology Officer, Dr. Scott held a
variety of technology leadership positions. He was formerly the
chief architect of the Cray X1 system and was instrumental in
the design of the Red Storm supercomputer system. Dr. Scott
holds fourteen U.S. patents in the areas of interconnection
networks, cache coherence, synchronization mechanisms, and
scalable parallel architectures. Dr. Scott has served on
numerous program committees and as an associate editor for the
IEEE Transactions on Parallel and Distributed Systems, and is a
noted expert in high performance computer architecture and
interconnection networks. In 2005 he was the recipient of both
the Seymour Cray Computing Award from the IEEE Computer Society
and the Maurice Wilkes Award from the Association of Computing
Machinery. He received his B.S. in electrical and computing
engineering, M.S. in computer science and Ph.D. in computer
architecture all from the University of Wisconsin where he was a
Wisconsin Alumni Research Foundation and Hertz Foundation Fellow.
Jan C. Silverman joined us in November 2005 as Senior
Vice President responsible for corporate strategy and business
development. In this capacity, he is responsible for our
business and marketing strategies and leads our product
management and marketing organizations. Mr. Silverman has
20 years of computer systems experience. From 1999 to 2005
he held senior marketing positions at SGI, including Senior Vice
President Strategic Initiatives from 2004 to 2005, Senior Vice
President and General Manager, Industry Solutions and Service
Group in 2003, Senior Vice President Worldwide Marketing from
2000 to 2003 and Vice President Product Marketing responsible
for servers, storage and graphics from 1999 to 2000. Before
joining SGI, Mr. Silverman was with Hewlett-Packard from
1989 to 1999, holding senior product marketing positions in
Hewlett-Packard’s server and workstation groups and also
led its early Internet program and microprocessor strategy.
Prior to joining Hewlett-Packard, he was with Apollo Computer
and Lockheed Martin in management and research and development
positions. Mr. Silverman holds a B.S. degree in mechanical
engineering from Rensselaer Polytechnic Institute and an M.S.
degree in computer science from Lehigh University.
Margaret A. “Peg” Williams is Senior Vice
President responsible for our software and hardware research and
development efforts, including our current and future products
and projects. Dr. Williams, who has more than 20 years
of experience in the high performance computing industry, joined
us in May 2005. From 1997 through 2005, she held various
positions with IBM including Vice President of Database
Technology and Director and then Vice President of HPC Software
and AIX Development (1998-2004). She also led the user support
team at the Maui High Performance Computing Center from 1993
through 1996. From 1987 through 1993, Dr. Williams held
various positions in high performance computing software
development at IBM. Dr. Williams holds a B.S. in
mathematics and physics from Ursinus College and an M.S. in
mathematics and a Ph.D. in applied mathematics from Lehigh
University.
Market for the Company’s Common Equity, Related
Shareholder Matters and Issuer Repurchases of Equity
Securities
Price Range of Common Stock and Dividend Policy
Our common stock is traded on the Nasdaq National Market under
the symbol CRAY; prior to April 1, 2000, our stock traded
under the symbol TERA. On April 17, 2006, we had
91,750,299 shares of common stock outstanding that were
held by 782 holders of record.
The quarterly high and low sales prices of our common stock for
the periods indicated are as follows:
2004
2005
High
Low
High
Low
First Quarter
$
11.75
$
6.06
$
4.91
$
2.08
Second Quarter
8.03
5.84
2.75
1.18
Third Quarter
6.68
2.85
1.41
0.85
Fourth Quarter
4.83
3.02
1.73
0.89
We have not paid cash dividends on our common stock and we do
not anticipate paying any cash dividends on our common stock in
the foreseeable future. In addition, our credit facility
prohibits us from paying cash dividends without the consent of
our lender.
Unregistered Sales of Securities
In connection with the acquisition of OctigaBay Systems
Corporation on April 1, 2004, we reserved
4,840,421 shares of our Common Stock for issuance upon
exchange of exchangeable securities issued to certain OctigaBay
shareholders by our Nova Scotia subsidiary. In the quarter ended
December 31, 2005, we issued an aggregate of
25,200 shares of our common stock upon exchange of the
exchangeable shares.
In connection with the surrender to our landlord, Merrill Place,
LLC, of certain space in our Seattle, Washington headquarters
office and related amendments to our lease in the fourth quarter
of 2005, we issued an aggregate of 70,000 shares of our
common stock to our landlord.
The issuances of the shares described above, because of the
nature of the investors and the manner in which the offering was
conducted, were exempt from the registration provisions of the
Securities Act of 1933 under Sections 4(2) and 4(6) and the
rules and regulations thereunder and, with respect to the shares
issued upon exchange of exchangeable shares, also under
Regulation S under the Securities Act.
Issuer Repurchases
We did not repurchase any of our equity securities in the fourth
quarter of 2005.
The following table presents selected historical consolidated
financial data for Cray Inc. and its subsidiaries, which is
derived from our audited consolidated financial statements:
The ratio of earnings to fixed charges is computed by dividing
earnings by fixed charges. Earnings consist of net income (loss)
plus provision (benefit) for income taxes and fixed charges.
Fixed charges consist of interest expense, including
amortization of fees paid for the line of credit and Convertible
Senior Subordinated Note offering, plus the portion of operating
rental expense management believes represents the interest
component of rent expense. The pretax net loss for the years
ended December 31, 2001, 2004 and 2005 was not sufficient
to cover fixed charges by approximately $34.2 million,
$148.3 million and $65.8 million, respectively. As a
result, the ratio of earnings to fixed charges has not been
computed for these periods.
(2)
See Note 2 — Restatement of Previously Issued
Financial Statements of the Notes to the Consolidated
Financial Statements.
Item 7. Management’s
Discussion and Analysis of Financial Condition and Results of
Operations
Forward-Looking Statements
The information set forth in “Management’s Discussion
and Analysis of Financial Condition and Results of
Operations” below includes “forward-looking
statements” within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, and is subject to the safe
harbor created by those Sections. Factors that realistically
could cause results to differ materially from those projected in
the forward-looking statements are set forth in this section and
earlier in this report under “Item 1A. —
Risk Factors,” beginning on page 14. The following
discussion should also be read in conjunction with the
Consolidated Financial Statements and accompanying Notes thereto.
Restatement of Consolidated Financial Statements
We have restated our previously issued financial statements as
of and for the year ending December 31, 2004, including
interim periods in 2004, to correct a $3.3 million non-cash
error with respect to revenue recognized under one of our
product development contracts. We have determined that certain
costs were incorrectly charged to this contract in 2004. The
contract is accounted for under the percentage of completion
method of accounting. As restated, 2004 revenue was decreased by
$3.3 million, cost of product revenue was decreased by
$3.1 million, research and development expense was
increased by $3.1 million, and net loss was increased by
$3.3 million. There was no impact on our cash or short-term
investment position.
All amounts referenced for 2004 in this Annual Report, including
the following discussion and analysis of our financial condition
and results of operations, reflect the relevant amounts on a
restated basis.
See Note 2 — Restatement of Previously Issued
Financial Statements of the Notes to Consolidated Financial
Statements for a summary of the effects of these changes to our
consolidated statement of operations for 2004 and consolidated
balance sheet as of December 31, 2004.
Overview and Executive Summary
We design, develop, manufacture, market and service high
performance computer systems, commonly known as supercomputers.
These systems provide capability and capacity far beyond typical
server-based computer systems and address challenging scientific
and engineering computing problems for government, industry and
academia. During 2005, our revenue primarily came from sales of
our Cray XT3, Cray X1E and Cray XD1 systems, from
government funding for our Red Storm and Cascade development
projects and from providing maintenance and other services to
our customers.
We are dedicated solely to the supercomputing market. We have
concentrated our product roadmap on building balanced systems
combining highly capable processors (whether developed by
ourselves or by others) along with highly scalable software with
very high speed interconnect and communications capabilities
throughout the entire computing system, not solely from
processor-to-processor.
We believe we are very well positioned to meet the high
performance computing market’s demanding needs by providing
superior supercomputer systems with performance and cost
advantages over low-bandwidth and cluster systems when sustained
performance on challenging applications and workloads and total
cost of ownership are taken into account.
Strategic Focus
We are focused on strategies that we believe will improve our
financial results and increase returns for our shareholders. Our
financial goals include sustained annual revenue growth, annual
operating income improvement, and increased operating cash
flows. Our revenue, results of operations and cash balances are
likely to fluctuate significantly from
quarter-to-quarter and
within a quarter. These fluctuations are due to such factors as
the high average sales prices and limited number of sales of our
larger products, the timing of product orders and deliveries,
our revenue recognition accounting policy under which we
generally do not recognize product revenue until customer
acceptance and other contractual provisions have been fulfilled,
the timing of cash receipts for product sales, maintenance
services, government research and development funding and our
purchases of inventory. Given the nature of our business, our
revenue, receivables and other related accounts are likely to be
concentrated among a few customers.
To achieve these goals over time, we are focused on recapturing
the leadership position in the capability-class supercomputing
market (which represents the largest and most complex systems in
the world), estimated to be a $800 million to
$1.2 billion market in recent years. Our total addressable
market, which we view as the capability market and those parts
of the enterprise market where we have competitive advantages,
is approximately $1.5 billion. To further this goal, we
have aligned our research and development and sales and
marketing efforts to achieve our Adaptive Supercomputing vision,
which is intended to integrate multiple processing technologies
into a single, highly scalable system to provide high
performance and enhanced user productivity. Our Adaptive
Supercomputing vision, which we will roll out over time starting
in 2007, incorporates many of our technical
strengths — massively parallel, vector, multithreading
and other hardware
co-processing
technologies and high-bandwidth networks — into a
single system.
Summary of 2005 Results
Revenue increased by $55.2 million or 38% from 2004 due to
initial product sales of our Cray XT3 and Cray XD1
products and a 38% year-over-year increase in Cray X1/X1E
sales, partially offset by lower revenue recognized on our
Cascade and Red Storm projects.
Loss from operations improved to a loss of $60.9 million in
2005 from a loss of $147.9 million in 2004. The improvement
was primarily due to three factors: a $21.2 million
increase in gross margin on higher 2005 sales;
$24.0 million of operating cost containment and
improvements due to the second quarter restructuring activities,
including workforce reduction and pay reduction program and
increased government funding of research and development; and a
$43.4 million charge in 2004 for the write-off of in
process research and development in connection with the
acquisition of OctigaBay Systems.
Net cash used in operations improved in 2005 from a use of cash
of $52.7 million in 2004 to a use of cash of
$36.7 million in 2005. Cash balances increased
$4.3 million during 2005 and we did not borrow amounts
under our line of credit agreement. However, during 2005 we sold
$34.3 million of short-term investments and utilized
$11.4 million of cash previously restricted during the year.
Market Overview and Challenges
The most significant trend in the high performance computing
market is the continuing expansion and acceptance of
low-bandwidth and cluster systems using microprocessors
manufactured by Intel, AMD, IBM and others with commercially
available commodity networking and other components throughout
the high
performance computing market, especially in capacity computing
situations. These systems may offer higher theoretical peak
performance for equivalent cost, and vendors of such systems
often put pricing pressure on us in competitive procurements,
even at times in capability market procurements.
To compete against these systems in the longer term, we need to
incorporate greater performance differentiation across our
products. We believe we will have such differentiation through
our new vector-based product being developed in our BlackWidow
project and our new multithreaded product being developed in our
Eldorado project. These products, which focus initially on a
narrower market than our commodity processor products, are
expected to be available in 2007. One of our challenges is to
broaden the markets for these products. We must add greater
performance differentiation to our high-bandwidth massively
parallel commodity processor-based products, such as the
Cray XT3 and successor systems, while balancing the
business strategy trade-offs between using commodity parts,
which are available to our competitors, and proprietary
components, which are both expensive and time-consuming to
develop. We intend to grow our share of the capability market
and concentrate on those parts of the enterprise market where we
have competitive advantages.
Our success depends on several other factors, including timely,
efficient execution of our research and development plans which
should provide us with leading-edge technologies. We must
effectively market and sell products that utilize these
technologies as differentiated products and continue to broaden
our geographic markets in Europe and Asia. We need to continue
to successfully obtain
co-development funding
for certain of our research and development efforts. Longer
term, our Adaptive Supercomputing vision incorporates our broad
technical strengths into a single system, reducing our expected
development costs. Our ability to innovate and execute in these
areas will determine the extent to which we are able to grow
existing revenue profitably despite the high level of
competitive activity. There continue to be competitive pressures
that we must respond to related to pricing, product performance
and availability of application software. We must manage each of
these factors, as well as maintain mutually beneficial
relationships with our customers, in order to compete
effectively and achieve our business goals.
Our product costs are subject to fluctuations, particularly due
to changes in our production levels. Higher sales volumes allow
us to achieve lower component pricing and recover our fixed
overhead more effectively than if volumes are low. Technological
changes in our products may result in writing down certain
inventories below cost based upon their estimated future use.
Our operating costs are subject to fluctuations due to the
timing and level of development
co-funding and other
factors. As our international business expands, we must manage
our foreign currency risks as we enter into agreements that are
not denominated in the U.S. dollar and not naturally hedged
by expenses that are incurred in the same foreign currency.
The major uncertainties that should be considered in evaluating
our business, operations and prospects and that could affect our
future results and financial condition are set forth above under
“Item 1A. Risk Factors.”
Critical Accounting Policies and Estimates
This discussion as well as disclosures included elsewhere in
this Annual Report on
Form 10-K are
based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally
accepted in the United States of America
(“U.S. 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 U.S. GAAP,
there are certain accounting policies that are particularly
important. These include revenue recognition, inventory
valuation, goodwill and intangible assets, income taxes, the
accounting for loss contracts and stock-based compensation. We
believe these accounting policies and others set forth in
Note 3 — Summary of Significant Accounting
Policies of the Notes to Consolidated Financial Statements
should be reviewed as they are integral to understanding our
results of operations and financial condition. In some cases,
these policies represent required accounting. In other cases,
they may represent a choice between acceptable accounting
methods or may require substantial judgment or estimation.
Additionally, we consider certain judgments and estimates to be
significant, including those related to valuation estimates of
deferred tax assets, valuation of inventory at the lower of cost
or market, estimates to complete for percentage of completion
accounting on the Red Storm and Cascade contracts and impairment
of goodwill and other intangible assets. 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 from these estimates
under different assumptions or conditions.
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 when it is realized or realizable and
earned. In accordance with the Securities and Exchange
Commission Staff Accounting Bulletin (“SAB”)
No. 104, Revenue Recognition in Financial Statements, we
consider revenue realized or realizable and earned when we have
persuasive evidence of an arrangement, the product has been
shipped or the services have been provided to our customer,
title and risk of loss for products has passed to our customer,
the sales price is fixed or determinable, no significant
unfulfilled obligations exist and collectibility is reasonably
assured. In addition to the aforementioned general policy, the
following are the specific revenue recognition policies for each
major category of revenue and for multiple-element arrangements.
Products: We recognize revenue from our product lines, as
follows:
•
Cray X1/X1E and Cray XT3 Product Lines: We
recognize revenue from product sales upon customer acceptance of
the system, when we have no significant unfulfilled obligations
stipulated by the contract that affect the customer’s final
acceptance, the price is determinable and collection is
reasonably assured. A customer-signed notice of acceptance or
similar document is required from the customer prior to revenue
recognition.
•
Cray XD1 Product Line: We recognize revenue from
product sales of Cray XD1 systems upon shipment to, or
delivery to, the customer, depending upon contract terms, when
we have no significant unfulfilled obligations stipulated by the
contract, the price is determinable and collection is reasonably
assured. If there is a contractual requirement for customer
acceptance, revenue is recognized upon receipt of the notice of
acceptance and when we have no unfulfilled obligations.
Revenue from contracts that require us to design, develop,
manufacture or modify complex information technology systems to
a customer’s specifications is recognized using the
percentage of completion method for long-term development
projects under AICPA Statement of Position
81-1, Accounting for
Performance of
Construction-Type and
Certain Production-Type
Contracts. Percentage of completion is measured based on the
ratio of costs incurred to date compared to the total estimated
costs. Total estimated costs are based on several factors,
including estimated labor hours to complete certain tasks and
the estimated cost of purchased components or services.
Estimates may need to be adjusted from quarter to quarter, which
would impact revenue and margins on a cumulative basis. To the
extent the estimate of total costs to complete the contract
indicates a loss, such amount is recognized in full at that time.
Services: Revenue for the maintenance of computers is
recognized ratably over the term of the maintenance contract.
Maintenance contracts that are paid in advance are recorded as
deferred revenue. We consider fiscal funding clauses as
contingencies for the recognition of revenue until the funding
is assured. High performance computing service revenue is
recognized as the services are rendered.
Multiple-Element Arrangements. We commonly enter into
transactions that include multiple-element arrangements, which
may include any combination of hardware, maintenance and other
services. In accordance with Emerging Issues Task Force Issue
No. 00-21,
Revenue Arrangements with Multiple Deliverables, when
some elements are delivered prior to others in an arrangement
and all of the following criteria are met, revenue for the
delivered element is recognized upon delivery and acceptance of
such item:
The fair value of the undelivered element is
established; and
•
In cases with any general right of return, our performance with
respect to any undelivered element is within our control and
probable.
If all of the criteria are not met, revenue is deferred until
delivery of the last element as the elements would not be
considered a separate unit of accounting and revenue would be
recognized as described above under our product line or service
revenue recognition policies. We consider the maintenance period
to commence upon installation and acceptance of the product,
which may include a warranty period and accordingly allocate a
portion of the sales price as a separate deliverable which is
recognized as service revenue over the entire service period.
Inventory Valuation
We record our inventory at the lower of cost or market. We
regularly evaluate the technological usefulness and anticipated
future demand of 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 market
value. During 2005, we charged a total of $5.8 million for
write down of inventory of which $3.2 million was related
to Cray X1E inventory, $2.0 million was related to
Cray XD1 inventory, and $0.6 million was related to
Cray XT3 inventory. In 2004, we wrote down Cray X1
inventory by $8.3 million and Cray XD1 inventory by
$0.2 million, for a total of $8.5 million.
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
market 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
have additional expense to write down inventory to its estimated
market value. Adjustments to these estimates in the future may
materially impact our operating results.
Goodwill and Other Intangible Assets
Approximately 21% of our total assets as of December 31,2005, consisted of goodwill resulting from our acquisition of
the Cray Research business unit assets from SGI in 2000 and our
acquisition of OctigaBay Systems Corporation in April 2004. We
no longer amortize goodwill associated with the acquisitions,
but we are required to conduct ongoing analyses of the recorded
amount of goodwill in comparison to its estimated fair value. We
currently have one operating segment and reporting unit. As
such, we evaluate any potential goodwill impairment by comparing
our net assets against the market value of our outstanding
shares of common stock. We performed annual impairment tests
effective January 1, 2006 and January 1, 2005, and
determined that our recorded goodwill was not impaired.
The analysis of whether the fair value of recorded goodwill is
impaired and the number and nature of our reporting units
involves a substantial amount of judgment. Future changes
related to the amounts recorded for goodwill could be material
depending on future developments and changes in technology and
our business.
In connection with our 2004 acquisition of OctigaBay Systems
Corporation, we assigned $6.7 million of value to core
technology. In December 2005 we announced plans to further
integrate our technology platforms, and combine the
Cray XD1 and the Cray XT3 products into a unified
product offering. The expected undiscounted cash flows from the
product using the core technology were not sufficient to recover
the
carrying value of the asset. We performed a fair value
assessment similar to the original valuation and determined the
asset had no continuing value. We wrote off the unamortized
balance of our core technology intangible asset of
$4.9 million Accordingly, we recorded a $4.9 million
charge in 2005 to “Restructuring, Severance and
Impairment” in the accompanying Consolidated Statements of
Operations. In connection with this charge, we reversed the
remaining deferred tax liability of $1.5 million that was
established in the purchase accounting as amortization of this
intangible asset was not deductible for income tax purposes.
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. In accordance with Statement of
Financial Accounting Standards (“SFAS”) No. 109,
Accounting for Income Taxes, a valuation allowance for
deferred tax assets is provided when it is estimated that it is
more likely than not that all or a portion of the deferred tax
assets may not be realized through future operations. This
assessment is based upon consideration of available positive and
negative evidence, which includes, among other things, our most
recent results of operations and expected future profitability.
We consider our actual historical results to have stronger
weight than other more subjective indicators when considering
whether to establish or reduce a valuation allowance on deferred
tax assets.
The provision for or benefit from income taxes represents taxes
payable or receivable for the current period plus the net change
in deferred tax assets and liabilities and valuation allowance
amounts during the period. In 2003, we reversed
$58.0 million of the valuation allowance against deferred
tax assets (principally U.S. loss carryforwards) based
primarily upon our consideration of our most recent profitable
operating performance as well as our reasonably expected future
performance. Based upon our judgment of the positive and
negative evidence, we concluded that we would more likely than
not be able to utilize most of our net deferred tax asset. In
late 2004, we established a valuation allowance and recorded an
income tax expense of $58.9 million based on our losses
from operations in 2004 and based on our revised projections
indicating continued challenging financial results. Based upon
our most recent negative operating results, which we consider as
a strong indicator of our future ability to utilize our deferred
tax assets, we established a valuation allowance on certain
deferred tax assets (principally U.S. loss carryforwards)
created during 2005 in accordance with SFAS No. 109.
In accordance with our revenue recognition policy, certain
production contracts are accounted for using the percentage of
completion accounting method. We recognize revenue based on a
measurement of completion comparing the ratio of costs incurred
to date with total estimated costs multiplied by the contract
value. Inherent in these estimates are uncertainties about the
total cost to complete the project. If the estimate to complete
results in a loss on the contract, we will record the amount of
the estimated loss in the period the determination is made. On a
regular basis, we update our estimates of total costs. Changes
to the estimate may result in a charge or benefit to operations.
In 2004, we estimated that the Red Storm contract would result
in a loss of $7.6 million, which was charged to cost of
product revenue. During 2005, we increased the estimate of the
loss on the contract by $7.7 million (cumulative loss of
$15.3 million) due to additional hardware to be delivered
to satisfy contractual and performance issues. This amount was
charged to cost of product revenue. As of December 31,2005, and 2004, the balance in the Red Storm loss contract
accrual was $5.7 million and $3.1 million,
respectively and is included in other accrued liabilities on the
accompanying Consolidated Balance Sheets.
Stock-Based Compensation
Through December 31, 2005, we accounted for stock-based
compensation under the intrinsic value method in accordance with
Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees (“APB No. 25”).
Under the intrinsic value method, we did not record any expense
when stock options granted were priced at the fair market value
of our common stock at the date of grant. Certain of the
stock options granted in connection with the OctigaBay Systems
acquisition in 2004 had exercise prices below the fair market
value of our common stock at the grant date and accordingly, we
have recorded compensation expense over the vesting period based
on the intrinsic value method.
In March and May 2005, we accelerated vesting of certain
unvested and
“out-of-the-money”
stock options with exercise prices equal to or greater than the
current market price at the date of the acceleration. These
options were accelerated to avoid recording future compensation
expense with respect to such options in 2006 and thereafter when
we will be using the fair value method of
SFAS No. 123(R), Share-Based Payment,
(“SFAS No. 123(R)”) to account for
stock-based compensation. We believed that because such options
had exercise prices substantially in excess of the current
market value of our stock, the options were not achieving their
original objective. Options to purchase 4.6 million
shares of common stock were subject to the acceleration and the
weighted average exercise price of the options subject to the
acceleration was $5.33. Due to this acceleration, an additional
$14.9 million is included in the pro forma stock-based
compensation expense for the year ended December 31, 2005.
In December 2005, we repriced 1,274,260 existing stock options
to $1.49 per share and also issued 1,237,060 additional
stock options at $1.49 per share (fair market price of our
common stock on the date of issuance) that had immediate
vesting, in order to enhance short-term retention and also to
avoid future option expense charges.
Commencing January 1, 2006, we adopted
SFAS No. 123(R), which requires us to record stock
compensation expense for equity based awards granted, including
stock options, for which expense will be recognized over the
service period of the equity based award based on the fair value
of the award at the date of grant. The actual effects of
adopting SFAS No. 123(R) will be dependent on numerous
factors including, but not limited to, the number of options
granted in the future; the valuation model chosen by us to value
stock-based awards; the assumed and actual award forfeiture
rate; the accounting policies adopted concerning the method of
recognizing the fair value of awards over the requisite service
period; and the transition method chosen for adopting
SFAS No. 123(R). See “Recent Accounting
Pronouncements” below for further information.
Recent Accounting Pronouncements
As of December 31, 2005, we accounted for stock-based
compensation awards using the intrinsic value measurement
provisions of APB No. 25. Accordingly, we recorded
no compensation expense in 2005 and previous years for stock
options granted with exercise prices greater than or equal to
the fair value of the underlying common stock at the date of
grant. On December 16, 2004, the Financial Accounting
Standards Board (the “FASB”) issued
SFAS No. 123(R), and in March 2005, the SEC issued
Staff Accounting Bulletin No. 107
(“SAB No. 107”) relating to the adoption of
SFAS No. 123(R). SFAS No. 123(R) eliminates
the alternative of applying the intrinsic value measurement
provisions of APB Opinion No. 25 to stock compensation
awards. Rather, SFAS No. 123(R) requires enterprises
to measure the cost of services received in exchange for an
award of equity instruments based on the fair value of the award
at the date of grant.
We adopted SFAS No. 123(R) effective January 1,2006, using the Modified Prospective Application Method and the
Black-Scholes fair value option-pricing model. Under this method
SFAS No. 123(R) is applied to new awards and to awards
modified, repurchased, or cancelled after the effective date.
Additionally, compensation cost for the portion of awards for
which the requisite service has not been rendered (such as
unvested options) that are outstanding as of the date of
adoption is recognized as the remaining requisite services are
rendered. The compensation cost relating to unvested awards at
the date of adoption is based on the fair value at the date of
grant of those awards as calculated for pro forma disclosures
under the original SFAS No. 123, Stock Based
Compensation.
We expect that the adoption of SFAS No. 123(R) will
impact our financial results in the future, as it is expected to
reduce our net income or increase our net losses. As of
December 31, 2005, we have unamortized stock-based
compensation expense of $3.0 million, of which
$1.9 million is expected to be expensed in 2006. However,
this amount does not reflect the expense associated with equity
awards that are expected to be granted to employees in 2006.
Management is currently reviewing its alternatives for granting
equity based
awards and, while we expect to continue granting equity-based
awards to our employees, the type, frequency and amount of award
are still under consideration. Accordingly, the overall effect
of adopting this new standard on the financial results for 2006
has not yet been quantified. The pro forma effects on net income
and earnings per share, if we had applied the fair value
recognition provisions of the original SFAS No. 123 on
stock compensation awards (rather than applying the intrinsic
value measurement provisions of APB No. 25), are disclosed
in Note 3 to the Consolidated Financial
Statements — Summary of Significant Accounting
Policies, Stock-Based Compensation of the Notes to
Consolidated Financial Statements. Although such pro forma
effects of applying the original SFAS No. 123 may be
indicative of the effects of adopting SFAS No. 123(R)
except for the impact of the acceleration of vesting of
substantially all employee stock options in 2005, the provisions
of these two statements differ in important respects.
In March 2005, the FASB issued Interpretation (“FIN”)
47, Accounting for Conditional Asset Retirement
Obligations. This clarifies the term “conditional asset
retirement obligation” as used in SFAS No. 143,
Accounting for Asset Retirement Obligations, and provides
guidance to ensure consistency in recording legal obligations
associated with long-lived tangible asset retirements. The
adoption of FIN 47 did not have a material effect on our
financial position, cash flows or results of operations.
In May 2005, the FASB issued SFAS No. 154,
Accounting Changes and Error Corrections, a replacement
of Accounting Principles Board Opinion No. 20,
Accounting Changes, and SFAS No. 3,
Reporting Accounting Changes in Interim Financial Statements
(“SFAS No. 154”). SFAS No. 154
changes the requirements for the accounting for, and reporting
of, a change in accounting principle. Previously, voluntary
changes in accounting principles were generally required to be
recognized by way of a cumulative effect adjustment within net
income during the period of the change. SFAS No. 154
requires retrospective application to prior periods’
financial statements, unless it is impracticable to determine
either the period-specific effects or the cumulative effect of
the change. SFAS No. 154 is effective for accounting
changes made in fiscal years beginning after December 15,2005; however, the statement does not change the transition
provisions of any existing accounting pronouncements.
In June 2005, the FASB issued Staff Position
No. FAS 143-1,
Accounting for Electronic Equipment Waste Obligations
(“FSP No. 143-1”). The European Union issued
a directive to its member states to adopt legislation regulating
the collection, treatment, recovery and disposal of electrical
and electronic waste equipment. The directive distinguished
between “new waste” and “historical waste.”
FSP No. 143-1
provides guidance concerning the accounting for historical waste
and states that the obligation associated with historical waste
qualifies as an asset retirement obligation to be accounted for
in accordance with SFAS No. 143, Accounting for
Asset Retirement Obligations, and FIN No. 47,
Accounting for Conditional Asset Retirement Obligations.
We have certain inventory components that must comply with this
new directive but at this time we cannot quantify the impact to
our financial results, as many of the European Union member
states have not finalized legislation.
In November 2005, the FASB issued Staff Position
No. FAS 115-1 and FAS
124-1, The Meaning
of Other-Than-Temporary Impairment and Its Application to
Certain Investments, (“FSP
No. 115-1”).
FSP No. 115-1
provides accounting guidance for identifying and recognizing
other-than-temporary impairments of debt and equity securities,
as well as cost method investments in addition to disclosure
requirements. FSP
No. 115-1 is
effective for reporting periods beginning after
December 15, 2005, and earlier application is permitted.
This new pronouncement will be effective in 2006 and we do not
believe that adoption of FSP
No. 115-1 will
have a material effect on our financial position, cash flows or
results of operations.
The increase in 2005 product revenue over 2004 levels was due to
increased sales of all three of our principal products, the
Cray X1E, the Cray XT3 and the Cray XD1 systems,
which became available after a production
ramp-up during the
first half of the year. In 2005, we recorded approximately
$22.1 million in product revenue from the Cascade and Red
Storm development projects which was a reduction of
$27.4 million compared to 2004 due to reduced expenditures
and associated revenue, in particular on the Red Storm
development project. Product revenue declined in 2004 from 2003
due to significantly reduced Cray X1 system sales and the
inability to recognize revenue on certain Cray X1E and
Cray XT3 systems delivered in the fourth quarter of 2004,
offset in part by an increase in Red Storm and Cascade
development project revenue of $29.9 million to
$49.5 million for 2004.
We expect product as well as total revenue to grow in 2006 by
approximately 5% to 15%, with revenue primarily coming from
sales of Cray XT3 and upgrade systems. A wider range of
product revenue results is reasonably possible — see
“Item 1A. Risk Factors,” above. Included in this
expected product revenue growth is approximately
$38 million to be recognized for our Cray X1/X1E
installation at the Korea Meteorological Administration
(“KMA”). This system was accepted in the fourth
quarter of 2005, is in production, and we have received full
payment but contract provisions with regard to significant
unfulfilled obligations have delayed our ability to recognize
revenue on the contract until the fourth quarter of 2006. We
expect our product revenue to vary from quarter to quarter with
nearly 60% of 2006 product revenue expected to be recognized in
the fourth quarter. Our 2006 plan is dependent on having an
upgraded version of the Cray XT3 system delivered,
installed and accepted by customers before year-end. Product
revenue generated from the phase 2 portion of the Cascade
program should end in July 2006. Any future Cascade project
funding in phase 3 may not be recorded as revenue, but
rather as a reduction to research and development expense, as we
expect the total amount of funding to be received in
phase 3 to be less than the total estimated development
effort.
Service Revenue
Service revenue in 2005 decreased slightly from 2004 due to
lower revenue on maintenance contracts as older systems were
withdrawn from service. Revenue from professional services
increased by $2.8 million from $3.7 million in 2004
due principally to a contract to refurbish certain components
for a customer. Service revenue decreased in 2004 from 2003 due
to expiring maintenance contracts as older systems were
withdrawn from service.
Maintenance services are provided under separate maintenance
contracts with our 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
installation of the product, which may include a warranty
period. We allocate a portion of the sales price to
maintenance service revenue based on estimates of fair value. We
recognize revenue ratably over the entire service period.
Maintenance service revenue has declined on an annual basis as
older systems are withdrawn from service. While we expect our
maintenance service revenue to stabilize over the next year, we
may have periodic revenue and margin declines as our older, high
margin service contracts are ended and newer, lower margin
contracts are established, based on the timing of system
withdrawals from service. Our newer products will likely require
less hardware maintenance and therefore generate less
maintenance revenue than our historic vector systems.
Operating Expenses
Cost of Revenue
Cost of product revenue and cost of service revenue for the
years ended December 31, 2003, 2004 and 2005 were (in
thousands, except for percentages):
Cost of Product Revenue. Cost of 2005 product revenue as
a percentage of product revenue, although improved compared to
2004, was impacted by several factors, including higher sales of
the lower margin Cray XD1 product, an additional
$7.7 million charge for a change in the estimate to
complete the Red Storm project due principally to the addition
of hardware deliverables to settle contract and performance
issues, and $5.8 million of charges for inventory
write-downs, which includes scrap and obsolete inventory. Cost
of 2004 product revenue was negatively impacted by inventory
write-downs of $8.5 million, a $7.6 million charge to
record the initial estimated loss on the Red Storm project, a
$1.0 million adjustment for unabsorbed manufacturing
overhead relating to lower than planned production of
Cray X1 systems and significant revenue recognized on the
Cascade and Red Storm projects, which have a high cost to
revenue percentage, with Red Storm cost equal to revenue. The
Red Storm and Cascade research and development costs totaling
$28.6 million, $57.3 million and $18.7 million in
2005, 2004 and 2003, respectively, are reflected on our
financial statements as cost of product revenue and the related
reimbursements are recorded in our financial statements as
product revenue. Revenue for 2005, 2004 and 2003 includes
$2.1 million, $498,000 and $316,000, respectively, from the
sale of obsolete inventory recorded at a zero cost basis. In
2005, this amount consisted mainly of the sale of a refurbished
Cray T3E supercomputer, one of our legacy systems.
We anticipate increased product margins in 2006, although still
below our desired levels. Sales of Cray XT3 and
Cray XD1 systems face margin pressure from the highly
competitive clustered systems market. In addition, we expect
total product margin will be adversely affected by low margin
contribution from the KMA system, which we expect to recognize
in the fourth quarter of 2006, low margin contribution from the
Cascade project in the first half of the year and anticipated
zero margin on revenue from the Red Storm project, for which we
have recorded estimated losses in 2005 and 2004. We also face
increased risk of excess and obsolete inventory as the
Cray X1E and Cray XD1 products reach the end of their
product life. We also face increased risk and expense related to
compliance with new European environmental rules. See
“Item 1A. Risk Factors — New European
environmental rules may adversely affect our operations.”
Cost of Service Revenue. In both 2005 and 2004, our cost
of service revenue was favorably impacted by high margin
professional service contracts, service cost reductions
implemented in the fourth quarter of 2003 and the second half of
both 2004 and 2005, and the completed amortization of legacy
spare parts inventory by March 31, 2004, offset in 2005 in
part by increased costs incurred to achieve customer acceptances
of large Cray XT3 systems. We expect service costs for 2006
to approximate 58% to 65% of service revenue.
Less: Reimbursed research and development (excludes amounts in
revenue)
(12,325
)
(22,607
)
(34,822
)
Net research and development expenses
$
37,762
$
53,266
$
41,711
Percentage of total revenue
16%
37%
21%
Net research and development expenses in 2005 primarily reflect
our costs associated with the hardware and software associated
with the Cray X1E, Cray XT3 and Cray XD1 systems,
and the Eldorado multithreaded system, and their upgrade and
successor projects. Net research and development expenses in
2004 reflect our costs associated with the development of the
Cray X1E, Cray XT3, Cray XD1 systems and upgrade
and successor projects, including related software development.
Research and development expenses include personnel expenses,
depreciation, allocations for certain overhead expenses,
software, prototype materials and outside contracted engineering
expenses.
Gross research and development expenses in the table above
reflect all research and development expenditures, including
expenses related to our research and development activities on
the Red Storm and Cascade projects. Research and development
expenses on our Red Storm and Cascade projects are reflected as
cost of product revenue and government
co-funding on our other
projects are recorded as reimbursed research and development.
We have received increased government funding each year during
this period. In 2005, net research and development expenses as a
percentage of total revenue decreased as compared to 2004 due to
higher revenue, increased funding for our BlackWidow project,
and the effect of the pay reduction program in the second half
of 2005, partially offset by option expense as we accelerated
vesting on options issued in connection with the OctigaBay
acquisition in 2004. The higher 2004 percentage of total
revenue compared to 2003 is due to lower revenue earned in 2004
and to increases in research and development expenses for most
of our products and projects (including an increase of
approximately $2.0 million to $2.5 million per quarter
due to the OctigaBay acquisition at the beginning of the second
quarter in 2004).
In 2006, we expect higher gross research and development
expenses but lower net research and development expenses, based
on increased government project funding. This expectation
assumes that we will receive a phase 3 award in the DARPA
HPCS program and thus have increased Cascade project activity in
the second half of the year. We will continue to incur
development expenses for our Cray XT3 and upgrade and
successor systems and we expect increased activity on our
BlackWidow and Eldorado projects. If we receive a phase 3
DARPA award, our development costs will no longer be fully
funded for that work and we must contribute a portion of such
costs that will be recorded in net research and development
expenses. We expect to receive additional funding for our
BlackWidow and Eldorado projects, although anticipated
reimbursements on these projects have not yet been fully
authorized and all necessary contracts have not been completed.
If these projects are not funded by the government as
anticipated, or if we do not receive a phase 3 of DARPA
HPCS project, our research and development expense could be much
higher than anticipated and have an adverse impact on our
earnings in 2006.
Our marketing and sales, general and administrative and
restructuring, severance and impairment charges for the years
ended December 31, 2003, 2004 and 2005 were (in thousands):
Marketing and sales. The decrease in 2005 marketing and
sales expenses compared to 2004 is due to lower headcount, the
pay reduction program in the second half of 2005 and lower
discretionary spending, offset in part by higher commissions on
increased product revenue. The increase in 2004 compared to 2003
was primarily due to an acceleration of expenses related to
certain prepaid computer access services no longer utilized and
additional benchmarking, application and sales personnel related
to the introduction of our three new products. We also
experienced an unfavorable currency exchange rate in our
overseas personnel expenses in 2004 compared to 2003. We expect
marketing and sales expenses to decline in 2006 due to reduced
headcount, offset in part by re-establishment of full salaries
and increased sales commissions due to higher potential sales
activity.
General and administrative. The decrease in general and
administrative expense in 2005 compared to 2004 was primarily
due to the effects of our
reduction-in-force, as
well as the pay reduction program in the second half of 2005;
savings from which were offset in part by increased fees for
external audit, Sarbanes-Oxley compliance and legal fees. The
increase in 2004 compared to 2003 was due primarily to
consulting costs related to Sarbanes-Oxley compliance and
additional expenses as a result of our acquisition of OctigaBay,
including additional depreciation, insurance and utilities. We
expect general and administrative expenses to increase slightly
in 2006 due to reestablishment of salaries, the executive
retention and restricted stock grant programs instituted in
December 2005 and additional personnel in finance.
Restructuring, severance and impairment. Restructuring,
severance and impairment charges include costs related to our
efforts to reduce our overall cost structure by reducing
headcount. During 2005, we implemented a worldwide reduction in
workforce of approximately 90 employees, or 10% of our
worldwide workforce, primarily in manufacturing, sales, service
and marketing in the second quarter and we incurred additional
severance charges primarily for the retirement of our former
Chief Executive Officer, James Rottsolk, in the third quarter.
In the fourth quarter, we implemented an additional reduction of
approximately 65 employees from our international sales,
service and engineering operations, largely based in our
Burnaby, British Columbia, Canada facility with the remainder in
Europe. We expect to incur additional restructuring and
severance costs in 2006 related to this fourth quarter 2005
action.
In connection with the 2004 acquisition of OctigaBay, we
allocated $6.7 million of the purchase price to a core
technology intangible asset, which was associated with the
Cray XD1 system. In connection with the fourth quarter 2005
decision to incorporate the Cray XD1 system technology into
the Cray XT3 line, as well as limited expected future
benefits of the core technology obtained in the acquisition, we
evaluated the carrying value of the unamortized balance of the
intangible asset of $4.9 million and determined that the
carrying value of the asset was impaired and accordingly
recorded a charge for the $4.9 million in the fourth
quarter of 2005.
The 2004 costs primarily represented severance expenses related
to the termination of 114 employees in the United States
and an additional 20 employees throughout the rest of the world
in the second half of 2004. Of the 2003 amount,
$3.3 million represented severance expenses related to the
termination of 27 employees,
primarily associated with our service activities in Europe and
Japan, and the remaining $721,000 related to expensing certain
technology that we no longer use.
In-Process
Research and Development Charge
As part of the acquisition of OctigaBay, we incurred an expense
associated with acquired in-process research and development of
$43.4 million in the second quarter of 2004.
Other Income (Expense),
net
During 2005, we recorded $1.4 million of net other expense,
compared to net other expense of $699,000 in 2004 and net other
income of $1.5 million in 2003. Other expense in 2005 and
2004 primarily consisted of foreign currency losses on the
remeasurement of foreign currency balances, principally
intercompany balances. Other income in 2003 primarily consisted
of gains resulting from the remeasurement of foreign currency
balances, principally intercompany balances.
Interest Income (Expense),
net
Interest income was $741,000 in 2005, $666,000 in 2004 and
$657,000 in 2003. Interest income in 2005 and 2004 was related
primarily to our cash and short-term investments balances,
which, on average, were consistent with the balances during
2003. The 2003 interest income reflects our increased average
cash position in 2003 following our public offering in February
2003 in which we raised $49.1 million.
Interest expense was $4.2 million in 2005, $301,000 in 2004
and $213,000 in 2003. Interest expense in 2005 represents
$2.4 million of interest on our Notes, $1.0 million of
non-cash amortization of fees capitalized in connection with
both our line of credit with Wells Fargo Foothill, Inc.
(“WFF”) and our long-term debt offering costs, and
$765,000 of interest and related fees on our line of credit with
WFF. The interest expense for 2004 reflects approximately one
month of interest on our Notes, one month of amortization of the
related capitalized issuance costs and interest on our capital
leases. The interest expense for 2003 reflects interest on our
term loan for the first four months of the year and interest on
our capital leases.
Taxes
Benefit from income taxes in 2005 was $1.5 million, which
consisted of a $2.3 million benefit for foreign deferred
taxes, offset by current tax expense for local, state and
foreign tax jurisdictions. We recorded an income tax provision
of $59.1 million in 2004, principally related to the
establishment of a $58.9 million valuation allowance
against deferred tax assets, primarily consisting of accumulated
net operating losses. Under the criteria set forth in
SFAS No. 109, Accounting for Income Taxes,
management concluded that it was unlikely that the future
benefits of these deferred tax assets would be realized. In
2003, we recorded an income tax benefit of $42.2 million,
principally as a result of the reversal of $58.0 million
valuation allowance on deferred tax assets. There has been no
current provision for U.S. federal income taxes for any
period. We have income taxes currently payable due to our
operations in certain foreign countries, particularly in Canada
and certain European and Asian countries and in certain states.
As of December 31, 2005, we had tax net operating loss
carryforwards of approximately $288 million that will begin
to expire in 2010 if not utilized.
Net Income (Loss)
Net loss was $64.3 million in 2005 and $207.4 million
in 2004, compared to net income of $63.2 million in 2003.
The 2005 loss included a $7.7 million charge for additional
2005 estimated losses on the Red Storm fixed-price contract and
the restructuring, severance and impairment charges of
$9.8 million.
The 2004 net loss included significant charges consisting
of an income tax expense of $59.1 million principally
related to the establishment of a valuation allowance against
deferred tax assets, a $43.4 million write-off of
in-process research and development acquired as part of the
OctigaBay acquisition, a $7.6 million
charge to recognize the initial loss estimated on the Red Storm
fixed-price contract, an $8.2 million restructuring charge,
and an $8.5 million write-down of inventory.
Net income for 2003 was favorably impacted by the recognition of
an income tax benefit for the reversal of a valuation allowance
for deferred tax assets of $58.0 million which was
partially offset by a $4.0 million restructuring charge. We
reversed the valuation allowance based on our determination at
that time that realization of these assets was more likely than
not based on the criteria of SFAS No. 109.
We believe that year-over-year changes in net income are not
necessarily predictive of our future net income results for a
variety of reasons. Accordingly, we encourage readers of our
financial statements to evaluate the effect on our operating
trends in addition to the effect of future income tax provisions
and changes in currency exchange rates that may create
significant additional variability in our future operating
results.
Liquidity and Capital Resources
Cash, cash equivalents, restricted cash, short-term investments
and accounts receivable totaled $101.1 million at
December 31, 2005, compared to $120.6 million at
December 31, 2004. At December 31, 2005, we had
working capital of $52.2 million compared to
$93.6 million at December 31, 2004. In the fourth
quarter of 2004, we completed an offering of our Notes under
Rule 144A in which we received net proceeds of
$76.6 million.
Net cash used by operating activities was $36.7 million in
2005, $52.7 million in 2004 and $8.7 million in 2003.
For the year ended December 31, 2005, net operating cash
was used primarily by our net operating loss, decreases in
accounts payable and payroll liabilities, and increases in
accounts receivable and inventory, partially offset by an
increase in deferred revenue. For 2004, net operating cash was
used primarily by our net operating loss and an increase in
inventory, offset in part by increases in deferred revenue and
accounts payable and a decrease in accounts receivable. In
2003 net operating cash was used primarily by increases in
accounts receivable, inventory and prepaid expenses and other
assets, which was offset in part by an increase in deferred
revenue.
Net cash provided by investing activities was $41.7 million
in 2005, while net cash used in investing activities was
$29.9 million in 2004 and $41.2 million in 2003. For
the year ended December 31, 2005, net cash provided by
investing activities consisted of the sale of short-term
investments, partially offset by the purchases of short-term
investments and equipment as well as a decrease in restricted
cash. In 2004, net cash used in investing activities consisted
primarily of $12.5 million of capital expenditures,
$11.4 million increase in restricted cash and
$6.3 million used for the acquisition of OctigaBay (which
consisted of $15.9 million in cash used in connection with
the acquisition netted against $9.6 million in cash we
acquired from OctigaBay’s existing business), offset by net
sales of $317,000 of short-term investments. In 2003 net
cash used in investing activities was primarily for net
purchases of short-term investments and equipment.
Net cash used in financing activities was $137,000 in 2005,
while net cash provided by financing activities was
$84.2 million in 2004 and $65.1 million in 2003. For
the year ended December 31, 2005, net cash used in
financing activities consisted primarily of $755,000 paid for
line of credit issuance costs and $731,000 for payments on
capital leases, offset by $1.3 million in proceeds from the
issuance of common stock through the employee stock purchase
plan and exercise of stock options. The 2004 net cash
provided by financing activities was primarily related to our
Note offering under Rule 144A in which we received net
proceeds of $76.6 million. In 2004 we also received
approximately $8.3 million through stock option and warrant
exercises as well as through the issuance of common stock in
connection with our employee stock purchase plan. The
2003 net cash provided by financing activities was
primarily from our public offering, in which we received net
proceeds of $42.5 million, and $27.0 million from
stock option and warrant exercises and the issuance of common
stock through the employee stock purchase plan, while we used
$4.1 million to pay down a portion of our debt.
Over the next twelve months, our significant cash requirements
will relate to operational expenses, consisting primarily of
personnel costs, costs of inventory and spare parts, outside
engineering expenses, particularly as we continue development of
our Cray XT3 and successor line and internally fund a portion of
the expenses resulting from the anticipated phase 3 of the
Cascade program, interest expense and acquisition of property
and equipment. Our fiscal year 2006 capital budget for property
and equipment is currently estimated at approximately
$10 million. In addition, we lease certain equipment used
in our operations under operating or capital leases in the
normal course of business. In the fourth quarter of 2005, we
completed negotiation of changes to our lease for corporate
office space, which will lead to a decrease in our future cash
obligations in the amount of approximately $1.8 million
over the lease term, which extends into 2008. The following
table summarizes our contractual cash obligations as of
December 31, 2005 (in thousands):
Amounts Committed by Year
Contractual Obligations
Total
2006
2007
2008
2009
Development agreements
$
15,170
$
13,100
$
2,027
$
43
$
—
Capital lease obligations
154
123
31
—
—
Operating leases
9,807
3,473
2,950
2,534
850
Total contractual cash obligations
$
25,131
$
16,696
$
5,008
$
2,577
$
850
We have $80 million of outstanding Convertible Senior
Subordinated Notes (“Notes”) which are due in 2024.
These Notes bear interest at 3.0% (approximately
$2.4 million per year) and holders of these Notes may
require us to purchase these Notes on December 1, 2009.
Additionally, we have a
two-year revolving line
of credit for up to $30 million, which expires in May 2007.
No amounts were outstanding under this line as of
December 31, 2005. As of February 6, 2006, the Company was
eligible to borrow $25.8 million against this line of
credit.
In our normal course of operations, we engage in development
arrangements under which we hire outside engineering resources
to augment our existing internal staff in order to complete
research and development projects, or parts thereof. For the
years ended December 31, 2005, 2004 and 2003, we incurred
$20.3 million, $16.8 million and $5.8 million,
respectively, for such arrangements.
At any particular time, our cash position is affected by the
timing of cash receipts for product sales, maintenance
contracts, government funding for research and development
activities and our payments for inventory, resulting in
significant
quarter-to-quarter, as
well as within a quarter, fluctuations in our cash balances. Our
principal sources of liquidity are our cash and cash
equivalents, operations and credit facility. We experienced
lower than anticipated product sales and delays in the
availability of our new products in 2004, which adversely
affected cash flows in 2005. We have used significant working
capital in 2005, due to our operating loss, increased inventory
purchases and increased accounts receivable. Cash used in
operating activities during the first half of 2005 was partially
offset by improved second-half cash flow. Assuming acceptances
and payment for large new systems to be sold and benefit from
our 2004 and 2005 restructurings and other recent cost reduction
efforts, we expect our cash flow to be slightly negative in
2006, although a wide range of results is possible. Currently,
we do not anticipate borrowing from our credit line during 2006,
although it is possible that we may have to do so.
If we were to experience a material shortfall in our plans, we
would take all appropriate actions to ensure the continuing
operation of our business and to mitigate any negative impact on
our operating results and available cash resources. The range of
actions we could take includes, in the short-term, reductions in
inventory purchases and commitments, seeking financing from
investors, strategic partners and vendors and other financial
sources and further reducing headcount-related expenses.
We have been focusing on expense controls, negotiating sales
contracts with advance partial payments where possible,
implementing tighter purchasing and manufacturing processes and
improving working capital management in order to maintain
adequate levels of cash. While we believe these steps will
generate sufficient cash to fund our operations for at least the
next twelve months, we may consider enhancing our cash and
working capital position by raising additional equity or debt
capital. There can be no assurance that we would succeed in
these efforts or that additional funding would be available.
Additionally, the adequacy of our cash resources is dependent on
the amount and timing of government funding as well as our
ability to sell our products, particularly the Cray XT3 and
upgraded systems, with adequate margins. Beyond the next twelve
months, the adequacy of our cash resources will largely depend
on our success in re-establishing profitable operations and
positive operating cash flows on a sustained basis. See
“Item 1A. Risk Factors,” above.
Item 7A.
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
investment-grade debt instruments of corporate issuers and debt
instruments of the U.S. government and its agencies. We do
not have any derivative instruments 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 risk. 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. At
December 31, 2005, we did not have any short-term
investments.
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 in U.S. dollars,
and a strengthening of the dollar could make our products less
competitive in foreign markets. While we commonly sell products
with payments in U.S. dollars, our product sales contracts
occasionally call for receipt of cash in foreign currencies and
to the extent we do so, or engage with our foreign subsidiaries
in transactions deemed to be short-term in nature, we are
subject to foreign currency exchange risks. In order to limit
such risks on large transactions that may extend over a longer
period of time, we may choose to hedge this risk with a forward
exchange contract. Our foreign maintenance contracts are paid in
local currencies and provide a 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. As of December 31, 2005, a 10%
change in foreign exchange rates could impact our earnings and
cash flows by approximately $924,000.
The following table presents unaudited quarterly financial
information for the two years ended December 31, 2005, with
2004 results as previously reported and as restated. For
additional information, refer to Note 2 —
Restatement of Previously Issued Financial Statements of
the Notes to Consolidated Financial Statements. In the opinion
of management, this information contains all adjustments,
consisting only of normal recurring adjustments, necessary for a
fair presentation thereof. The operating results for each of the
quarters in the year ended December 31, 2004 have been
appropriately restated. Additionally, certain 2004 quarterly
reclassifications have been made to conform to 2005
presentation. The operating results are not necessarily
indicative of results for any future periods.
Quarter-to-quarter
comparisons should not be relied upon as indicators of future
performance.
2004 (As Previously Reported)
2004 (Restated)
For the Quarter Ended
3/31
6/30
9/30
12/31
3/31
6/30
9/30
12/31
Revenue
$
42,135
$
21,710
$
45,924
$
39,415
$
41,781
$
21,152
$
44,821
$
38,095
Cost of revenue
28,336
17,066
52,961
39,239
28,010
16,552
51,946
38,026
Gross margin
13,799
4,644
(7,037
)
176
13,771
4,600
(7,125
)
69
Research and development
9,042
12,393
13,344
15,419
9,368
12,907
14,359
16,632
Marketing and sales
7,646
8,584
8,720
9,998
7,646
8,584
8,720
9,998
General and administrative
2,873
4,507
4,974
7,097
2,873
4,507
4,974
7,097
Restructuring, severance and impairment
—
—
7,129
1,053
—
—
7,129
1,053
In-process research and development
—
43,400
—
—
—
43,400
—
—
Net loss
(3,843
)
(54,504
)
(110,999
)
(34,677
)
(4,097
)
(54,862
)
(112,402
)
(35,997
)
Net loss per common share, basic and diluted
$
(0.05
)
$
(0.64
)
$
(1.27
)
$
(0.40
)
$
(0.06
)
$
(0.64
)
$
(1.29
)
$
(0.41
)
2005
For the Quarter Ended
3/31
6/30
9/30
12/31
Revenue
$
37,634
$
53,419
$
44,741
$
65,257
Cost of revenue
33,927
48,741
36,551
49,331
Gross margin
3,707
4,678
8,190
15,926
Research and development
13,032
13,427
6,472
8,780
Marketing and sales
6,599
7,574
5,778
5,857
General and administrative
4,267
4,607
3,617
3,654
Restructuring, severance and impairment
(215
)
1,947
1,201
6,817
In-process research and development
—
—
—
—
Net loss
(21,035
)
(23,796
)
(10,250
)
(9,227
)
Net loss per common share, basic and diluted
$
(0.24
)
$
(0.27
)
$
(0.12
)
$
(0.10
)
The in-process research and development charge in the 2004
second quarter related to our acquisition of OctigaBay Systems
Corporation. The large net loss in the third quarter of 2004
included the establishment of a valuation allowance against our
deferred tax asset of approximately $59 million.
Since the second half of 2004, we have reviewed our workforce
requirements in light of our operating results and have engaged
in workforce reductions, particularly in the third quarter of
2004 and the second and fourth quarters of 2005. The 2005 fourth
quarter also reflects a $4.9 million charge related to
impairment of a core technology intangible asset.
Our operating results are subject to quarterly fluctuations as a
result of a number of factors. See “Item 1A. Risk
Factors — Risk Factors Pertaining to Our Business and
Operations.”
Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure
None.
Item 9A.
Controls and Procedures
Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed
to ensure that information required to be disclosed in our
reports under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the
SEC’s rules and forms, and that such information is
accumulated and communicated to management, as appropriate, to
allow timely decisions regarding required disclosure. Our
management, with the participation and supervision of our Chief
Executive Officer, Chief Financial Officer and Chief Accounting
Officer/ Corporate Controller, evaluated the effectiveness of
our disclosure controls and procedures as of the end of the
period covered by this report and determined that our disclosure
controls and procedures were effective.
Changes in Internal Control over Financial
Reporting
As disclosed in our 2004 Annual Report on
Form 10-K/ A, and
in our Quarterly Reports on
Form 10-Q for each
of the first three quarters of 2005, we reported material
weaknesses in our internal controls over financial reporting as
discussed in more detail below.
As of December 31, 2005, we have remediated the previously
reported material weaknesses in internal controls over financial
reporting. The reported material weaknesses and remediation
results are as follows:
Control Environment. In 2004, our control
environment did not sufficiently promote effective internal
control over financial reporting throughout our management
structure, and this material weakness was a contributing factor
in the development of other material weaknesses described below.
Principal contributing factors included the lack of permanent
employees in key financial reporting positions, resistance to
change of long-held practices developed in an entrepreneurial
and trust culture, the lack of a formal program for training
members of our finance and accounting group and a lack of a full
evaluation of our financial system applications due to
incomplete documentation and testing of key controls. Our
control environment also contributed to our inability to fully
evaluate our general computer controls, financial system
application controls and tax controls, as described more fully
below.
Remediation:
We have hired permanent employees in key financial reporting
positions including Chief Financial Officer, Chief Accounting
Officer/Corporate Controller, Director of SEC Reporting,
Internal Audit Director and Sarbanes-Oxley Compliance Executive,
all of whom have worked to promote effective internal control
over financial reporting and improve our overall Company
culture. We have instituted a training program for the
accounting personnel and have completed a full evaluation of our
control environment which included our general computer
controls, financial system application controls and tax controls.
Risk Assessment. In 2004, we did not perform a
formal entity-level risk assessment to evaluate the implications
of relevant risks on financial reporting, including the impact
of our diversifying business and non-routine transactions, if
any, on our internal control over financial reporting. Based on
the significance a sufficient entity-level risk assessment has
on effective internal control over financial reporting, this
represented a design deficiency and constituted a material
weakness.
Remediation:
We have performed a formalized entity level risk assessment
using the criteria established by the Commission of Sponsoring
Organizations of the Treadway Commission in “Internal
Control — Integrated Framework” report. This
assessment was considered in the scope of our testing.
Segregation of Duties. In 2004, we did not
segregate duties in several important functions, including:
permitting one person the ability to receive inventory, perform
cycle counts and process adjustments, and
another individual to initiate and authorize the scrapping of
obsolete and excess inventory; permitting changes to inventory
quantity information within the financial application system
without appropriate review; providing users access within our
financial application system to areas outside of their
responsibilities; and permitting the creation, modification and
updating of customer or vendor data without a secondary level of
review or approval.
Remediation:
We implemented changes to the various roles and responsibilities
within the accounting department. These changes addressed each
of the above issues to ensure that adequate segregation was
achieved or that enhanced mitigating controls were in place and
operating effectively. Specifically, we have added independent
inventory counts and levels of independent review of inventory
cycle counts, inventory adjustments, adjustments for scrapping
excess and obsolete inventory, and creation or modification of
customer and vendor data.
Additionally, a complete general computer control review was
performed of JD Edwards (the financial system of record) which
included related access controls and all other programs
affecting the integrity of financial data.
Inadequate Staffing and Training in Finance and
Accounting. In 2004, we had a lack of resources and
inadequate training within our finance and accounting
departments. In the second half of 2004 our corporate controller
was assigned primary responsibility for our Sarbanes-Oxley
compliance effort and in late 2004 both our chief financial
officer and financial reporting manager separately left for
other opportunities, stretching our limited resources even
further. Training for our accounting staff with respect to
generally accepted accounting principles (“GAAP”) had
been ad hoc rather than systematic. As a result of these
factors, certain transactions were not recorded initially in
accordance with GAAP, such as a limited number of third-party
vendor contracts, leases and licenses; the capitalization of
sales and use taxes on fixed assets and the internal labor
component of a financial application system implementation; and
appropriate period-end cut-off for “FOB Origin”
inventory received shortly after the end of the period. These
deficiencies represented a design deficiency in internal
controls which resulted in more than a remote likelihood that a
material error would not have been prevented or detected, and
constituted a material weakness.
Remediation:
We have added staffing in a number of critical areas over the
last year and since our last quarterly reporting period. Those
positions include a permanent Chief Financial Officer, Chief
Accounting Officer/ Corporate Controller; Director of SEC
Reporting, Internal Audit Director and Sarbanes-Oxley Compliance
Executive. In addition, the accounting managers and controllers
have all received training during the last year. Training
occurred at all appropriate levels and there is a requirement
for 16 hours of continued training in 2006 and forward.
This training requirement has also been incorporated into
employees’ performance evaluations.
Inadequate Oversight of Accounting Transactions.
In 2004, we had insufficient processes and personnel to provide
adequate oversight of financially significant transactions and
determinations by our finance and accounting personnel in our
offices outside of headquarters. These deficiencies represented
a design deficiency in internal controls which resulted in more
than a remote likelihood that a material error would not have
been prevented or detected, and constituted a material weakness.
Remediation:
In addition to the staffing added that provided additional
levels of review, we have added additional documentation of
review of accounting entries and balance sheet reconciliation
accounts. This review and analysis has resulted in
management’s ability to identify errors and additional
required disclosures through the closing process rather than
through external examinations. In addition, management has
maintained a schedule for the year-end closing process which has
enhanced the review for completeness.
Inadequate Controls Over Journal Entry Approvals.
In 2004, we did not have appropriate controls around the process
for recording and approving journal entries. We also noted
instances where material journal
entries were recorded before subsequently provided supporting
documentation was prepared or reviewed by the accounting
department. Instances also occurred in which journal entries
were not adequately documented and reviewed. These deficiencies
represented an operating effectiveness deficiency in internal
controls which resulted in more than a remote likelihood that a
material error would not have been prevented or detected, and
constituted a material weakness.
Remediation:
We have implemented procedures requiring completed supporting
documentation for all journal entries. The entries and the
supporting documentation are reviewed by someone other than the
preparer and checked for accuracy, completeness, disclosure
requirements and appropriateness.
Complex Contract Accounting Procedures. In 2004,
we did not have a consistent process in place to document the
significant terms of all important product sales contracts and
our accounting for these contracts. We enter into a small number
of high dollar amount contracts for our product sales. These
contracts often contain complex terms that impact our
recognition and determination of revenue (including customer
rights of return, multiple elements and contingencies that can
have a material impact on the recognition or deferral of
revenue) and balance sheet classification of deferred revenue.
In a limited number of cases, we did not evaluate and document
the consideration of such terms, and until late 2004 we did not
have a process for independent review of the accounting
treatment and the associated revenue determinations for such
contracts. These deficiencies represented a design deficiency in
internal controls which resulted in more than a remote
likelihood that a material error would not have been prevented
or detected, and constituted a material weakness.
Remediation:
We performed a fair market analysis for all significant sales
contracts for 2005 which have been reviewed by the Chief
Financial Officer or Chief Accounting Officer/ Corporate
Controller. In addition, large contracts and those with long
terms of installation and acceptance are now reviewed by the
Chief Financial Officer and Chief Accounting Officer/ Corporate
Controller.
Tax Controls. In 2004, our processes for
preparation and review of tax provisions were documented late
and complete testing was not possible. We were unable to
demonstrate through testing that such internal controls were
implemented and operating as expected in 2004. The following
deficiencies noted in our limited testing of tax controls
constituted a material weakness: a failure to maintain effective
review and controls over the determination and reporting of the
provision for income taxes, particularly the tax effect due to
analysis of subsidiary dividends; the tax effect of a correction
of foreign net operating losses; and adjustments to deferred
taxes. These deficiencies represented a design deficiency in
internal controls which resulted in more than a remote
likelihood that a material error would not have been prevented
or detected, and constituted a material weakness.
Remediation:
Procedures were implemented requiring the review of the tax
provision and the related tax entries by the Chief Financial
Officer and Chief Accounting Officer/ Corporate Controller where
appropriate to determine the sufficiency of the entries.
In the third and fourth quarters of 2005, we undertook and
completed, our testing to validate compliance with the newly
implemented policies, procedures and controls. We have
undertaken this testing over these two quarters in order to be
able to demonstrate operating effectiveness over a period of
time that is sufficient to support our conclusions. In reviewing
the result from this testing, management has concluded that the
internal controls over financial reporting have been
significantly improved and that the material weaknesses
described above have been remediated as of December 31,2005.
Except for the remediations discussed above, there have been no
changes in our internal controls over financial reporting during
the most recently completed fiscal quarter that have materially
affected, or are reasonably likely to materially affect our
internal controls over financial reporting.
Management’s Report on Internal Control Over
Financial Reporting
Our management is responsible for establishing and maintaining
adequate internal control over financial reporting as defined by
Rule 13a-15(f)
under the Exchange Act. Internal control over financial
reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in
accordance with accounting principles generally accepted in the
United States of America.
Our internal control over financial reporting includes those
policies and procedures that (i) pertain to the maintenance
of records that, in reasonable detail, accurately and fairly
reflect our transactions and dispositions of assets;
(ii) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial
statements in accordance with accounting principles generally
accepted in the United States of America, and that our receipts
and expenditures are being made only in accordance with
authorizations of our management and directors; and
(iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or
disposition of our assets that could have a material effect on
the financial statements.
Because of its inherent limitations, internal control over
financial reporting may not prevent or detect misstatements.
Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.
Our management conducted an evaluation of the effectiveness of
our internal control over financial reporting based on the
framework in “Internal Control — Integrated
Framework” issued by the Committee of Sponsoring
Organizations of the Treadway Commission (“COSO”).
Based on this evaluation under the framework in “Internal
Control — Integrated Framework,” our management
concluded that our internal control over financial reporting was
effective as of December 31, 2005.
Management’s assessment of the effectiveness of our
internal controls over financial reporting as of
December 31, 2005 has been audited by Peterson Sullivan
PLLC, an independent registered public accounting firm, as
stated in their report which is included below.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
To the Board of Directors and Shareholders
Cray Inc.
We have audited management’s assessment, included in the
accompanying Management’s Report on Internal Control over
Financial Reporting, that Cray Inc. and subsidiaries (“the
Company”) maintained effective internal control over
financial reporting as of December 31, 2005, based on
criteria established in Internal Control —
Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). The
Company’s management is responsible for maintaining
effective internal control over financial reporting and for its
assessment of the effectiveness of internal control over
financial reporting. Our responsibility is to express an opinion
on management’s assessment and an opinion on the
effectiveness of the Company’s internal control over
financial reporting based on our audit.
We conducted our audit in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control
over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of
internal control over financial reporting, evaluating
management’s assessment, testing and evaluating the design
and operating effectiveness of internal control, and performing
such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable
basis for our opinions.
A company’s internal control over financial reporting is a
process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with
accounting principles generally accepted in the United States of
America. A company’s internal control over financial
reporting includes those policies and procedures that
(1) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial
statements in accordance with accounting principles generally
accepted in the United States of America, and that receipts and
expenditures of the company are being made only in accordance
with authorizations of management and directors of the company;
and (3) provide reasonable assurance regarding prevention
or timely detection of unauthorized acquisition, use, or
disposition of the company’s assets that could have a
material effect on the financial statements.
Because of its inherent limitations, internal control over
financial reporting may not prevent or detect misstatements.
Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree
of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company
maintained effective internal control over financial reporting
as of December 31, 2005, is fairly stated, in all material
respects, based on criteria established in Internal
Control — Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission
(COSO). Also in our opinion, the Company maintained, in all
material respects, effective internal control over financial
reporting as of December 31, 2005, based on criteria
established in Internal Control — Integrated
Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the
Public Company Accounting Oversight Board (United States), the
consolidated balance sheet of Cray Inc. and subsidiaries as
of December 31, 2005, and the related consolidated
statements of operations, shareholders’ equity and
comprehensive income (loss), and cash flows for the year then
ended, and our report dated March 15, 2006, expressed an
unqualified opinion.
Certain information required by Part III is omitted from
this Report as we will file a definitive proxy statement for the
Annual Meeting of Shareholders to be held on June 6, 2006,
pursuant to Regulation 14A (the “Proxy
Statement”) not later than 120 days after the end of
the fiscal year covered by this Report, and certain information
included in the Proxy Statement is incorporated herein by
reference. Only those sections of the Proxy Statement which
specifically address the items set forth herein are incorporated
by reference.
Information with respect to our directors may be found in the
section titled “Corporate Governance — The Board
of Directors” and in the section titled “Discussion of
Proposals Recommended by the Board — Proposal 1:
To Elect Eight Directors For One-Year Terms” in our Proxy
Statement. Such information is incorporated herein by reference.
Information with respect to executive officers may be found
beginning on page 32 above, under the caption
“Executive Officers of the Company.” Information with
respect to compliance with Section 16(a) of the Exchange
Act by the persons subject thereto may be found under the
section titled “Our Common Stock Ownership —
Section 16(a) Beneficial Ownership Reporting
Compliance” in the Proxy Statement and is incorporated
herein by reference.
Our Board of Directors has adopted a Code of Business Conduct
applicable to all of our directors, officers and employees. The
Code of Business Conduct, our Corporate Governance Guidelines,
charters for each of our Board committees and other governance
documents may be found on our website: www.cray.com under
“Investors — Corporate Governance.”
Item 11.
Executive Compensation
The information in the Proxy Statement set forth in the section
titled “Corporate Governance — The Board of
Directors” under the captions “The Committees of the
Board” and “How We Compensate Directors,” in the
section titled “Corporate Governance — The
Executive Officers,” in the section titled “Corporate
Governance — Report on Executive Compensation for 2005
by the Compensation Committee” and in the section titled
“Stock Performance Graph” is incorporated herein by
reference.
Item 12.
Security Ownership of Certain Beneficial Owners and
Management and Related Shareholder Matters
The information in the Proxy Statement set forth in the section
“Our Common Stock Ownership” and in the subpart
“Corporate Governance — The Executive
Officers — How We Compensate Executive
Officers — Equity Compensation Plan Information”
is incorporated herein by reference.
Item 13.
Certain Relationships and Related Transactions
The information in the Proxy Statement set forth in the section
titled “Corporate Governance” under the caption
“The Executive Officers — Management Agreements
and Policies” and in the section titled “Corporate
Governance — Legal Proceedings and
Indemnification” is incorporated herein by reference.
Item 14.
Principal Accountant Fees and Services
The information set forth in the section titled
“Independent Registered Public Accounting Firms” under
the caption “Information Regarding Our Independent Public
Accountants” in the Proxy Statement is incorporated herein
by reference.
Consolidated Statements of Operations for the years ended
December 31, 2003, 2004 (Restated) and 2005
Consolidated Statements of Shareholders’ Equity and
Comprehensive Income (Loss) for the years ended
December 31, 2003, 2004 (Restated) and 2005
Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2004 (Restated) and 2005
Notes to Consolidated Financial Statements
Reports of Independent Registered Public Accounting Firms
(a)(2) Financial Statement Schedules
Schedule II — Valuation and Qualifying
Accounts — The financial statement schedule for the
years ended December 31, 2005, 2004, and 2003 should be
read in conjunction with the consolidated financial statements
of Cray Inc. filed as part of this Annual Report on
Form 10-K.
Schedules other than that listed above have been omitted since
they are either not required, not applicable, or because the
information required is included in the consolidated financial
statements or the notes thereto.
(a)(3) Exhibits
The Exhibits listed in the Exhibit Index, which appears
immediately following the signature page and certifications and
is incorporated herein by reference, are filed as part of this
Annual Report on
Form 10-K.
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the Company has duly caused
this report to be signed on its behalf by the undersigned,
thereunto duly authorized, in the City of Seattle, State of
Washington, on April 20, 2006.
Each of the undersigned hereby constitutes and appoints Peter J.
Ungaro, Brian C. Henry and Kenneth W. Johnson and each of them,
the undersigned’s true and lawful
attorney-in-fact and
agent, with full power of substitution, for the undersigned and
in his or her name, place and stead, in any and all capacities,
to sign any or all amendments to this Annual Report on
Form 10-K and any
other instruments or documents that said
attorneys-in-fact and
agents may deem necessary or advisable, to enable Cray Inc. to
comply with the Securities Exchange Act of 1934 and any
requirements of the Securities and Exchange Commission in
respect thereof, and to file the same, with all exhibits
thereto, with the Securities and Exchange Commission, granting
unto said
attorneys-in-fact and
agents and each of them full power and authority to do and
perform each and every act and thing requisite and necessary to
be done, as fully to all intents and purposes as the undersigned
might or could do in person, hereby ratifying and confirming all
that each such
attorney-in-fact and
agent, or his substitute, may lawfully do or cause to be done by
virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of
1934, this report has been signed below by the following persons
on behalf of Company and in the capacities indicated on
April 20, 2006.
FAB I Building Lease Agreement between Union Semiconductor
Technology Corporation and the Company, dated as of June 1,2000(7)
10
.10
Amendment No. 1 to the FAB Building Lease Agreement between
Union Semiconductor Technology Corporation and the Company,
dated as of August 19, 2002(3)
10
.11
Conference Center Lease Agreement between Union Semiconductor
Technology Corporation and the Company, dated as of June 1,2000(7)
10
.12
Amendment No. 1 to the Conference Center Lease Agreement
between Union Semiconductor Technology Corporation and the
Company dated as of August 19, 2002(3)
10
.13
Mendota Heights Office Lease Agreement between the
Teachers’ Retirement System of the State of Illinois and
the Company, dated as of August 10, 2000(7)
10
.14
First Amendment to the Mendota Heights Office Lease Agreement
between the Teachers’ Retirement System of the State of
Illinois and the Company, dated as of January 17, 2003(3)
10
.15
Sublease Agreement between Trillium Digital Systems Canada, Ltd.
and OctigaBay Systems Corporation, dated as of January 13,2003, with Consent to Subletting by and among 391102 B.C, Ltd.
and Dominion Construction and Development Inc., Trillium Digital
Systems Canada, Ltd., OctigaBay Systems Corporation and Intel
Corporation, dated January 20, 2003, and Lease Agreement
between Dominion Construction Company Inc. and 391102 B.C. Ltd.,
Trillium Digital Systems Canada, Ltd. and Intel Corporation,
dated March 5, 2001(22)
10
.16
Credit Agreement between Wells Fargo Bank, N.A. and the Company,
dated April 10, 2003, and Related Revolving Line of Credit
Note(8)
10
.17
First Amendment to Credit Agreement between Wells Fargo Bank,
N.A. and the Company, dated March 5, 2004(22)
10
.18
Second Amendment to Credit Agreement between Wells Fargo Bank,
N.A. and the Company, dated June 7, 2004(22)
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,
150,000,000 shares; issued and outstanding, 87,348,641 and
90,973,506 shares, respectively
413,911
422,691
Exchangeable shares, no par value — Unlimited shares
authorized; 570,963 and 78,840 shares outstanding,
respectively
Cray Inc. (“Cray” or the “Company”) designs,
develops, manufactures, markets and services high performance
computer systems, commonly known as supercomputers. These
systems provide capability and capacity far beyond typical
server-based computer systems and address challenging scientific
and engineering computing problems for government, industry and
academia. The Company has transitioned from offering a single
principal product in 2003, the Cray X1 system which incorporates
both vector and massively parallel technologies, to offering
three principal products in 2005 — the Cray X1E
system, an upgrade to the Cray X1 system with increased
processor speed and capability; the Cray XT3 system, a massively
parallel high-bandwidth system using standard commodity
processors; and the Cray XD1 system, a balanced high-bandwidth
system employing standard commodity processors targeted for the
mid-range market.
In 2005, the Company incurred a net loss of $64.3 million
and used $36.7 million in cash for operating activities.
Management’s plans project that the Company’s current
cash resources and cash to be generated from operations in 2006
will be adequate to meet the Company’s liquidity needs for
at least the next twelve months. These plans assume sales,
shipment acceptance and subsequent collections from several
large customers, as well as cash receipts on new bookings.
Should acceptances and payments be delayed significantly, the
Company could face a significant liquidity challenge which would
require it to pursue additional initiatives to reduce costs
and/or to seek additional financing. There can be no assurance
that the Company will be successful in its efforts to achieve
future profitable operations or generate sufficient cash from
operations, or obtain additional funding in the event that its
financial resources become insufficient.
NOTE 2
RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
Subsequent to the issuance of the December 31, 2004
consolidated financial statements, the Company determined that
certain research and development costs were incorrectly charged
to one of its product development contracts in 2004. The
contract is accounted for under the percentage of completion
method of accounting. The error resulted in revenue being
recognized prematurely on the contract. Accordingly, the
accompanying 2004 financial statements have been restated from
the amounts previously reported to correct this error.
Additionally, the Company has reclassified the cash flow impact
of changes in restricted cash from financing activities to
investing activities.
Previously reported amount was increased by $5,068 to conform to
2005 financial statement presentation. Amount was reclassified
from Acquisition-related Compensation Expense.
(b)
Previously reported amount was decreased by $1,027 to conform to
2005 financial statement presentation. Amount was reclassified
to Long-term Deferred Revenue.
NOTE 3
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Accounting Principles
The consolidated financial statements and accompanying notes are
prepared in accordance with accounting principles generally
accepted in the United States of America.
Principles of Consolidation
The consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries. Intercompany
balances and transactions have been eliminated.
Reclassifications
Certain prior year amounts have been reclassified to conform
with the current year presentation. There has been no impact on
previously reported net income (loss) or shareholders’
equity.
Use of Estimates
Preparation of financial statements in conformity with
accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions
that affect the amounts reported in the consolidated financial
statements and accompanying notes. These estimates are based on
management’s best knowledge of current events and actions
the Company may undertake in the future. Estimates are used in
accounting for, among other items, fair value allocation used in
revenue recognition, percentage of completion accounting,
determination of inventory lower of cost or market, useful lives
for
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
depreciation and amortization, future cash flows associated with
impairment testing for goodwill and long-lived assets, as well
as any fair value assessment, restructuring costs, deferred
income tax assets, potential income tax assessments and
contingencies. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents consist of highly liquid financial
instruments that are readily convertible to cash and have
original maturities of three months or less at the time of
acquisition. The Company maintains cash and cash equivalent
balances with financial institutions that exceed federally
insured limits. The Company has not experienced any losses
related to these balances, and management believes its credit
risk to be minimal. The Company had no pledges nor any
restrictions on any of its cash balances at December 31,2005, except as described in Note 14 —
Convertible Notes Payable and Lines of Credit. At
December 31, 2004, $11.4 million of the Company’s
cash balance was restricted for outstanding letters of credit
(see Note 14 — Convertible Notes Payable
and Lines of Credit).
Short-term Investments
Short-term investments generally mature between three months and
two years from the purchase date. Investments with maturities
beyond one year may be classified as short-term based on their
highly liquid nature and because such marketable securities are
readily convertible into cash which could be used in current
operations. All short-term investments are classified as
available-for-sale and are recorded at fair value, based on
quoted market prices; unrealized gains and losses are reflected
in other comprehensive income. The Company held no short-term
investments as of December 31, 2005. The Company had no
pledges nor any restrictions on its short-term investment
balance as of December 31, 2004.
Concentration of Credit Risk
The Company currently derives the majority of revenue from sales
of products and services to U.S. government agencies or
commercial customers primarily serving the U.S. government.
See Note 17 — Segment Information for
additional information. Given the type of customers, the Company
does not believe its accounts receivable represent significant
credit risk.
As of December 31, 2005 and 2004, accounts receivable
included $8.8 million and $15.1 million, respectively,
due from Sandia National Laboratories on the Red Storm project.
Of this amount, $8.3 million and $5.5 million,
respectively, was unbilled, based upon a milestone billing
arrangement with this customer.
Accounts Receivable
Accounts receivable are stated at principal amounts and are
primarily comprised of amounts contractually due from customers
for products and services and amounts due from government funded
research and development projects. The Company provides for an
allowance for doubtful accounts based on an evaluation of
customer account balances past due ninety days from the date of
invoicing. In determining whether to record an allowance for a
specific customer, the Company considers a number of factors,
including prior payment history and financial information for
the customer. The Company had no pledges nor any restrictions on
its accounts receivable balances in 2005 or 2004, except as
described in Note 14 — Convertible
Notes Payable and Lines of Credit.
Fair Values of Financial Instruments
The Company generally has the following financial instruments:
cash and cash equivalents, short-term investments, accounts
receivable, accounts payable, accrued liabilities and
convertible notes payable. The carrying value of cash and cash
equivalents, accounts receivable, accounts payable and accrued
liabilities
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
approximate their fair value based on the short-term nature of
these financial instruments. The fair value of convertible notes
payable is based on quoted market prices. The Company’s
convertible notes payable are traded in a market with low
liquidity and are therefore subject to price volatility. As of
December 31, 2005, the fair value of these convertible
notes payable was approximately $44.0 million compared to
their carrying value of $80.0 million. As of
December 31, 2004, the fair value of the convertible notes
payable approximated their carrying value. Short-term
investments are recorded at their fair value.
Inventories
Inventories are valued at cost (on a
first-in, first-out
basis) which is not in excess of estimated current market
prices. The Company regularly evaluates the technological
usefulness and anticipated future demand for various inventory
components and the expected use of the inventory. When it is
determined that these components do not function as intended, or
quantities on hand are in excess of estimated requirements, the
costs associated with these components are charged to expense.
The Company has no pledges nor any restrictions on any inventory
balances at December 31, 2005 or 2004, except as described
in Note 14 — Convertible Notes Payable
and Lines of Credit.
In connection with certain of its sales agreements, the Company
may receive used equipment from a customer. This inventory
generally will be recorded at no value based on the expectation
that the Company will not be able to resell or otherwise use the
equipment. In the event that the Company has a specific
contractual plan for resale at the date the inventory is
acquired, the inventory is recorded at its estimated fair value.
Property and Equipment, net
Property and equipment are recorded at cost less accumulated
depreciation and amortization. Depreciation is calculated on a
straight-line basis over the estimated useful lives of the
related assets, ranging from 18 months to seven years for
furniture, fixtures and computer equipment, and eight to
25 years for buildings and land improvements. Equipment
under capital lease is amortized over the lesser of the lease
term or its estimated useful life. Leasehold improvements are
amortized over the lesser of their estimated useful lives or the
term of the lease. The cost of software obtained or inventory
transferred for internal use is capitalized and depreciated over
their estimated useful lives, generally four years. The Company
had no pledges nor any restrictions on any of its net property
and equipment balance at December 31, 2005 or 2004, except
as described in Note 14 — Convertible
Notes Payable and Lines of Credit.
In accordance with Statement of Position (“SOP”) 98-1,
Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use, the Company has capitalized
certain costs associated with the implementation of software
developed for internal use. Costs capitalized primarily consist
of employee salaries and benefits allocated to the
implementation project. The Company capitalized no costs in 2005
and approximately $0.8 million, and $1.1 million of
costs associated with computer software developed for internal
use during the years ended December 31, 2004, and 2003,
respectively.
Service Inventory
Service inventory is valued at the lower of cost or estimated
market and represents inventory used to support service and
maintenance agreements with customers. As inventory is utilized,
replaced items are returned and are either repaired or scrapped.
Costs incurred to repair inventory to a usable state are charged
to expense as incurred. Service inventory is recorded at cost
and is amortized over the estimated service life of the related
product platform (generally four years). The Company has no
pledges nor any restrictions on any service inventory balances
at December 31, 2005 or 2004, except as described in
Note 14 — Convertible Notes Payable and
Lines of Credit.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Goodwill and Other Intangible Assets
In accordance with Statement of Financial Accounting Standards
(“SFAS”) No. 142, Goodwill and Other
Intangible Assets, the Company tests goodwill for impairment
on an annual basis as of January 1, and between annual
tests if indicators of potential impairment exist, using a
fair-value based approach. The Company currently has one
operating segment and reporting unit. As such, the Company
evaluates impairment based on certain external factors, such as
its market capitalization. No impairment of goodwill has been
identified during any of the periods presented.
The Company capitalizes certain external legal costs incurred
for patent filings. The Company begins amortization of these
costs as each patent is awarded. Patents are amortized over
their estimated useful lives (generally five years). The Company
performs periodic review of its capitalized patent costs to
ensure that the patents have continuing value to the Company. As
of both December 31, 2005 and 2004, the Company had a
balance of $1.1 million of net capitalized patent costs.
Impairment of Long-Lived Assets
In accordance with SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, management
tests long-lived assets to be held and used for recoverability
whenever events or changes in circumstances indicate that their
carrying amount may not be recoverable. As part of the 2004
OctigaBay Systems Corporation acquisition, the Company assigned
$6.7 million of value to core technology. In December 2005
the Company announced plans to further integrate its technology
platforms, and combine the Cray XD1 and the Cray XT3 products
into a unified product offering. The expected undiscounted cash
flows from the product using the core technology were not
sufficient to recover the carrying value of the asset. The
Company performed a fair value assessment similar to the
original valuation and determined the asset had no continuing
value. The Company wrote off the unamortized balance of its core
technology intangible asset of $4.9 million which is
included in “Restructuring, Severance and Impairment”
in the accompanying 2005 Consolidated Statements of Operations.
No impairment of intangible assets was recorded during 2004 or
2003.
Revenue Recognition
The Company recognizes revenue when it is realized or realizable
and earned. In accordance with the Securities and Exchange
Commission Staff Accounting Bulletin (“SAB”)
No. 104, Revenue Recognition in Financial
Statements, the Company considers revenue realized or
realizable and earned when it has persuasive evidence of an
arrangement, the product has been shipped or the services have
been provided to the customer, title and risk of loss for
products has passed to the customer, the sales price is fixed or
determinable, no significant unfulfilled Company obligations
exist, and collectibility is reasonably assured. In addition to
the aforementioned general policy, the following are the
specific revenue recognition policies for each major category of
revenue and for multiple-element arrangements.
Products:The Company recognizes revenue from its product
lines, as follows:
•
Cray X1/X1E and Cray XT3 Product Lines: The
Company recognizes revenue from product sales upon customer
acceptance of the system, when there are no significant
unfulfilled Company obligations stipulated by the contract that
affect the customer’s final acceptance, the price is
determinable and collection is reasonably assured. A
customer-signed notice of acceptance or similar document is
required from the customer prior to revenue recognition.
•
Cray XD1 Product Line:The Company recognizes
revenue from product sales of Cray XD1 systems upon
shipment to, or delivery to, the customer, depending upon
contract terms, when there are no significant unfulfilled
Company obligations stipulated by the contract, the price is
determinable and collection is reasonably assured. If there is a
contractual requirement for customer acceptance, revenue is
recognized upon receipt of the notice of acceptance and when
there are no unfulfilled obligations.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Revenue from contracts that require the Company to design,
develop, manufacture or modify complex information technology
systems to a customer’s specifications, is recognized using
the percentage of completion method for long-term development
projects under AICPA Statement of
Position 81-1,
Accounting for Performance of Construction-Type and Certain
Production-Type Contracts. Percentage of completion is
measured based on the ratio of costs incurred to date compared
to the total estimated costs. Total estimated costs are based on
several factors, including estimated labor hours to complete
certain tasks and the estimated cost of purchased components or
services. Estimates may need to be adjusted from quarter to
quarter, which would impact revenue and margins on a cumulative
basis. To the extent the estimate of total costs to complete the
contract indicates a loss, such amount is recognized in full at
that time. On a regular basis, the Company updates its estimates
of total costs; changes to the estimate may result in a charge
or benefit to operations.
In 2004, the Company concluded that its Red Storm contract would
result in an estimated loss of $7.6 million. This amount
was charged to cost of product revenue. During 2005, the Company
increased the estimate of the loss on the contract by
$7.7 million (cumulative loss of $15.3 million) due to
additional hardware to be delivered to satisfy contractual and
performance issues. This amount was also charged to cost of
product revenue. As of December 31, 2005 and 2004, the
balance in the Red Storm loss contract accrual was
$5.7 million and $3.1 million, respectively, and is
included in “Other Accrued Liabilities” on the
accompanying Consolidated Balance Sheets.
Services: Revenue for the maintenance of computers is
recognized ratably over the term of the maintenance contract.
Maintenance contracts that are paid in advance are recorded as
deferred revenue. The Company considers fiscal funding clauses
as contingencies for the recognition of revenue until the
funding is assured. High performance computing service revenue
is recognized as the services are rendered.
Multiple-Element Arrangements.The Company commonly
enters into transactions that include multiple-element
arrangements, which may include any combination of hardware,
maintenance, and other services. In accordance with Emerging
Issues Task Force Issue
No. 00-21,
Revenue Arrangements with Multiple Deliverables, when
some elements are delivered prior to others in an arrangement
and all of the following criteria are met, revenue for the
delivered element is recognized upon delivery and acceptance of
such item:
•
The element could be sold separately;
•
The fair value of the undelivered element is
established; and
•
In cases with any general right of return, our performance with
respect to any undelivered element is within our control and
probable.
If all of the criteria are not met, revenue is deferred until
delivery of the last element as the elements would not be
considered a separate unit of accounting and revenue would be
recognized as described above, under our product line or service
revenue recognition policies. The Company considers the
maintenance period to commence upon installation and acceptance
of the product, which may include a warranty period and
accordingly allocates a portion of the sales price as a separate
deliverable which is recognized as service revenue over the
entire service period.
Foreign Currency Translation
The functional currency of the Company’s foreign
subsidiaries is the local currency. Assets and liabilities of
foreign subsidiaries are translated into U.S. dollars at
year-end exchange rates, and revenue and expenses are translated
at average rates prevailing during the year. Translation
adjustments are included in accumulated other comprehensive
income (loss), a separate component of shareholders’
equity. Transaction gains and losses arising from transactions
denominated in a currency other than the functional currency of
the entity involved are included in the Consolidated Statements
of Operations. Aggregate transaction gains and losses
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
included in net income or loss in 2005, 2004 and 2003 was a loss
of $1.4 million, a loss of $361,000, and a gain of
$1.6 million, respectively.
Research and Development
Research and development costs include costs incurred in the
development and production of the Company’s hardware and
software, costs incurred to enhance and support existing
software features and expenses related to future product
development. Research and development costs are expensed as
incurred, and may be offset in part by government funding for
certain development and services. Contract engineering costs are
expensed as incurred over the term of the development period.
SFAS No. 86, Accounting for the Costs of Computer
Software to Be Sold, Leased, or Otherwise Marketed, requires
the capitalization of certain software product costs after
technological feasibility of the software is established. Due to
the relatively short period between the technological
feasibility of a product and completion of product development,
and the insignificance of related costs incurred during this
period, no software development costs have been capitalized.
The Company classifies 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 research and development costs are classified as
cost of revenue.
Income Taxes
The Company accounts for income taxes under
SFAS No. 109, Accounting for Income Taxes.
Deferred tax assets and liabilities are determined based on
temporary differences between financial reporting and tax bases
of assets and liabilities, operating loss and tax credit
carryforwards, and are measured using the enacted tax rates and
laws that will be in effect when the differences are expected to
be recovered or settled. Realization of certain deferred tax
assets is dependent upon generating sufficient taxable income in
the appropriate jurisdiction. The Company records a valuation
allowance to reduce deferred tax assets to amounts that are more
likely than not to be realized. The initial recording and any
subsequent changes to valuation allowance are based on a number
of factors (positive and negative evidence), as required by
SFAS No. 109. The Company considers its actual
historical results to have stronger weight than other more
subjective indicators when considering whether to establish or
reduce a valuation allowance.
Stock-Based Compensation
The Company accounts for its stock-based compensation plans
under the intrinsic value method, which follows the recognition
and measurement principles of Accounting Principles Board
(“APB”) Opinion No. 25, Accounting for Stock
Issued to Employees. In accordance with APB Opinion
No. 25, the Company does not record any expense when stock
options are granted to employees and are priced at the fair
market value of the Company’s stock at the date of grant.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
To estimate compensation expense which would be recognized under
SFAS No. 123, Accounting for Stock-based
Compensation, the Company uses the modified Black-Scholes
fair value option-pricing model with the following
weighted-average assumptions for options granted during the
years ended December 31:
2003
2004
2005
Risk-free interest rate
4.3%
4.2%
4.1%
Expected dividend yield
0%
0%
0%
Volatility
84%
82%
85%
Expected life
7.1 years
6.9 years
4.6 years
Weighted average Black-Scholes value of options granted
$8.43
$3.75
$1.36
The weighted average Black-Scholes value of shares granted under
the employee stock purchase plans during 2005 and 2004 was $0.46
and $1.30, respectively. Fair values were estimated as of the
dates of purchase using the Black-Scholes fair value model with
the following assumptions for 2005 and 2004: expected volatility
of 72% and 83%, respectively; risk-free interest rate of 3.5%
and 1.5%, respectively; an expected term of 3 months for
both years; and no dividend yield in either year.
If compensation cost for the Company’s stock option plans
and its stock purchase plan had been determined based on the
fair value at the grant dates for awards under those plans in
accordance with a fair value based method of
SFAS No. 123, the Company’s net income (loss) and
net income (loss) per common share for the years ended
December 31 would have been the pro forma amounts indicated
below (in thousands). For purposes of this pro forma disclosure,
the value of the options is amortized ratably to expense over
the options’ vesting periods. Because the estimated value
is determined as of the date of grant, the actual value
ultimately realized by the employee may be significantly
different.
2004
2003
(Restated)
2005
Net income (loss), as reported
$
63,248
$
(207,358
)
$
(64,308
)
Add:
Stock-based employee compensation included in reported net
income (loss), net of related tax effects
75
11,844
4,106
Less:
Amortized stock-based employee compensation expense determined
under fair value based method for all awards, net of related tax
effects
(10,207
)
(19,423
)
(30,524
)
Pro forma net income (loss)
$
53,116
$
(214,937
)
$
(90,726
)
Amortization of pro forma stock-based employee compensation
expense increased significantly in 2005 due to the actions taken
to accelerate vesting described in Note 15 —
Shareholders’ Equity, Stock Option Plans.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Pro forma basic and diluted net income (loss) per common share
for the years ended December 31 are as follows:
2004
2003
(Restated)
2005
Basic:
As reported
$
0.94
$
(2.49
)
$
(0.73
)
Pro forma
$
0.79
$
(2.58
)
$
(1.03
)
Diluted:
As reported
$
0.81
$
(2.49
)
$
(0.73
)
Pro forma
$
0.68
$
(2.58
)
$
(1.03
)
Shipping and Handling Costs
Costs related to shipping and handling are included in
“Cost of Product Revenue” and “Cost of Service
Revenue” on the accompanying Consolidated Statements of
Operations.
Advertising Costs
Marketing and sales expenses in the accompanying Consolidated
Statements of Operations include advertising expenses of
$747,000, $683,000 and $392,000 in 2005, 2004 and 2003,
respectively. The Company incurs advertising costs for
representation at certain trade shows, promotional events, sales
lead generation, as well as design and printing costs for
promotional materials. The Company expenses all advertising
costs as incurred.
Earnings (Loss) Per Share (“EPS”)
Basic EPS is computed by dividing net income available to common
shareholders by the weighted average number of common shares,
including exchangeable shares but excluding unvested restricted
stock, outstanding during the period. Diluted EPS is computed by
dividing net income 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 common stock purchase warrants as computed
under the treasury stock method and the common shares issuable
upon conversion of the outstanding convertible notes. For the
years ended December 31, 2005 and 2004, outstanding stock
options, unvested restricted stock, warrants, and shares
issuable upon conversion of the convertible notes are
antidilutive because of net losses, and as such, their effect
has not been included in the calculation of basic or diluted net
loss per share.
The following table presents the amounts used in computing the
weighted average number of shares of potentially dilutive common
stock (in thousands):
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Accumulated Other Comprehensive Income (Loss)
Accumulated other comprehensive income (loss), a component of
shareholders’ equity, consisted of the following at
December 31 (in thousands):
2003
2004
2005
Accumulated unrealized gain (loss) on available-for-sale
investments
$
9
$
(24
)
$
—
Accumulated currency translation adjustment
(816
)
4,584
6,258
Accumulated other comprehensive income (loss)
$
(807
)
$
4,560
$
6,258
Recent Accounting Pronouncements
As of December 31, 2005, the Company accounted for
stock-based compensation awards using the intrinsic value
measurement provisions of APB No. 25. Accordingly, no
compensation expense is recorded for stock options granted with
exercise prices greater than or equal to the fair value of the
underlying common stock at the date of grant. On
December 16, 2004, the Financial Accounting Standards Board
(the “FASB”) issued SFAS No. 123 (revised
2004), Share-Based Payment
(“SFAS No. 123(R)”) and in March 2005, the
SEC issued SAB No. 107 relating to the adoption of
SFAS No. 123(R). SFAS No. 123(R) eliminates
the alternative of applying the intrinsic value measurement
provisions of APB No. 25 to stock compensation awards.
Rather, SFAS No. 123(R) requires enterprises to
measure the cost of services received in exchange for an award
of equity instruments based on the fair value of the award at
the date of grant.
The Company adopted SFAS No. 123(R) effective
January 1, 2006, using the Modified Prospective Application
Method and the Black-Scholes fair value option-pricing model.
Under this method, SFAS No. 123(R) is applied to new
awards and to awards modified, repurchased, or cancelled after
the effective date. Additionally, compensation cost for the
portion of awards for which the requisite service has not been
rendered (such as unvested options) that are outstanding as of
the date of adoption will be recognized as the remaining
requisite services are rendered. The compensation cost relating
to unvested awards at the date of adoption was based on the fair
value at the date of grant of those awards as calculated for pro
forma disclosures under SFAS No. 123, Stock-Based
Compensation.
The Company expects that the adoption of
SFAS No. 123(R) will impact its financial results in
the future. As of December 31, 2005, the Company has
unamortized stock-based compensation expense of
$3.0 million, of which $1.9 million is expected to be
expensed in 2006. However, this amount does not reflect any
expense associated with equity awards that are expected to be
granted to employees in 2006. Management is currently reviewing
its alternatives for granting equity-based awards and, while the
Company expects to continue granting equity-based awards to its
employees, the type and amount of award is still under
consideration. Accordingly, the overall effect of adopting this
new standard on the financial results for 2006 has not yet been
quantified. The actual effects of adopting
SFAS No. 123(R) will be dependent on numerous factors
including, but not limited to, the number of options granted in
the future, the assumed and actual award forfeiture rate, and
the accounting policies adopted concerning the method of
recognizing the fair value of awards over the requisite service
period.
In March 2005 the FASB issued FASB Interpretation
(“FIN”) 47, Accounting for Conditional Asset
Retirement Obligations. This clarifies the term
“conditional asset retirement obligation” as used in
SFAS No. 143, Accounting for Asset Retirement
Obligations, and provides guidance to ensure consistency in
recording legal obligations associated with long-lived tangible
asset retirements. The adoption of FIN 47 did not have a
material effect on the Company’s financial position, cash
flows or results of operations.
In May 2005 the FASB issued SFAS No. 154,
Accounting Changes and Error Corrections, a replacement
of Accounting Principles Board Opinion No. 20,
Accounting Changes, and SFAS No. 3,
Reporting Accounting
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Changes in Interim Financial Statements
(“SFAS No. 154”). SFAS No. 154
changes the requirements for, the accounting for, and reporting
of, a change in accounting principle. Previously, voluntary
changes in accounting principles were generally required to be
recognized by way of a cumulative effect adjustment within net
income during the period of the change. SFAS No. 154
requires retrospective application to prior periods’
financial statements, unless it is impracticable to determine
either the period-specific effects or the cumulative effect of
the change. SFAS No. 154 is effective for accounting
changes made in fiscal years beginning after December 15,2005; however, the statement does not change the transition
provisions of any existing accounting pronouncements.
In June 2005, the FASB issued Staff Position
No. FAS 143-1,
Accounting for Electronic Equipment Waste Obligations
Pursuant to a European Union Directive, (“FSP
No. 143-1”).
The European Union issued a directive to its member states to
adopt legislation regulating the collection, treatment, recovery
and disposal of electrical and electronic waste equipment. The
directive distinguished between “new waste” and
“historical waste.” FSP
No. 143-1 provides
guidance concerning the accounting for historical waste and
states that the obligation associated with historical waste
qualifies as an asset retirement obligation to be accounted for
in accordance with SFAS No. 143, Accounting for
Asset Retirement Obligations, and FIN No. 47,
Accounting for Conditional Asset Retirement Obligations.
The Company has certain of its components that must comply with
this new directive but at this time cannot quantify the impact
to its financial results, as many of the European Union member
states have not finalized legislation.
In November 2005 the FASB issued Staff Position
No. FAS 115-1 and FAS 124-1, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain
Investments, (“FSP
No. 115-1”).
FSP No. 115-1
provides accounting guidance for identifying and recognizing
other-than-temporary impairments of debt and equity securities,
as well as cost method investments in addition to disclosure
requirements. FSP
No. 115-1 is
effective for reporting periods beginning after
December 15, 2005, and earlier application is permitted.
This new pronouncement will be effective in 2006 and the Company
does not believe that adoption of FSP
No. 115-1 will
have a material effect on its financial position, cash flows or
results of operations.
Unbilled receivables represent amounts where the Company has
recognized revenue in advance of the contractual billing terms.
The increase in the balance at December 31, 2005, is due to
revenue recognized based on percentage of completion accounting
for the Red Storm contract in excess of contractual billing
milestones and a receivable with non-standard payment terms.
Advance billings represent billings made based on contractual
terms for which no revenue is recognized. The increase in the
advanced billings balance as of December 31, 2005 is due to
billings made to two customers; in one case based on a milestone
agreement with a U.S. government customer and in another
case for maintenance services that will not be performed until
2006 and 2007.
The Company makes estimates of allowances for potential future
uncollectible amounts related to current period revenue of
products and services. The allowance for doubtful accounts is an
estimate that considers actual facts and circumstances of
individual customers and other debtors, such as financial
condition and historical payment trends. Management evaluates
the adequacy of the allowance utilizing a combination of
specific identification of potentially problematic accounts and
identification of accounts that have exceeded payment terms.
The decrease in the allowance for doubtful accounts during 2005
was related to management’s decision to write off certain
aged receivables that had previously been fully provided for in
the allowance for doubtful accounts.
NOTE 6
INVENTORY
A summary of inventory is as follows (in thousands):
At December 31, 2005 and 2004, all finished goods inventory
was located at customer sites pending acceptance. At
December 31, 2005 and 2004, $33.2 million and
$13.8 million, respectively, was related to a single
customer. Revenue for 2005, 2004, and 2003 includes
$2.1 million, $498,000, and $316,000, respectively, from
the sale of refurbished inventory recorded at a zero cost basis.
In 2005, the amount consisted mainly of the sale of a
refurbished Cray T3E supercomputer, one of the Company’s
legacy systems.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
During 2005, the Company wrote off $5.8 million of
inventory, primarily related to the Cray X1E and Cray XD1
product lines. During 2004, the Company wrote off
$8.5 million of inventory, primarily related to the Cray X1
product line.
NOTE 7
PROPERTY AND EQUIPMENT, NET
A summary of property and equipment is as follows (in thousands):
On April 1, 2004, the Company completed its acquisition of
OctigaBay Systems Corporation. As part of the acquisition, the
Company recorded $38.8 million of goodwill. The following
table provides information about activity in goodwill for the
years ended December 31, 2005 and 2004, respectively (in
thousands):
2004
2005
Goodwill, at January 1
$
13,344
$
55,644
Acquisition
38,836
—
Foreign currency translation adjustments and other
As of December 31, 2005 and 2004, deferred revenue included
$43.5 million and $23.6 million, respectively, of
deferred product revenue from a single customer. The Company
expects to recognize this amount as revenue in the latter part
of 2006, upon fulfillment of its contractual obligations.
NOTE 11
RESTRUCTURING AND SEVERANCE CHARGES
During 2005, the Company recognized restructuring charges of
$4.8 million, which is included in “Restructuring,
Severance and Impairment” on the accompanying Consolidated
Statements of Operations, net of adjustments for previously
accrued amounts, mainly related to severance expenses for a
worldwide reduction in work force which was announced on
June 27, 2005, and affected employees in operations, sales
and marketing. The restructuring charge was also increased for a
December 12, 2005 announcement of a plan to reduce
full-time staff by another 65 employees, principally based in
the Company’s Burnaby, British Columbia, Canada facility,
based upon Company plans to increase research and development
efficiencies, lower costs and integrate technology platforms,
with the remainder occurring in Europe. The $4.8 million
charge does not include $4.9 million of core technology
impairment charges, as described in Note 3 —
Summary of Significant Accounting Policies, Impairment of
Long-Lived Assets.
During 2004, the Company recognized restructuring costs of
$8.2 million in “Restructuring, Severance and
Impairment” on the accompanying Consolidated Statements of
Operations, including a $196,000 compensation charge related to
the modification of stock options for certain individuals
affected by the restructuring. The $196,000 charge was recorded
directly to common stock. Substantially all of the restructuring
costs represent severance expenses for 131 terminated employees.
During 2003, the Company recorded a restructuring charge of
$3.3 million in “Restructuring, Severance and
Impairment” on the accompanying Consolidated Statements of
Operations relating to the termination of
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
approximately 27 employees. The $3.3 million charge did not
include $721,000 of multithreaded architecture impairment
charges.
Activity related to the Company’s restructuring liability,
included in “Accrued Payroll and Related Expenses” on
the accompanying Consolidated Balance Sheets, during the years
ended December 31 is as follows (in thousands):
2003
2004
2005
Balance, January 1
$
866
$
3,069
$
4,690
Additional restructuring charge
3,298
8,077
5,092
Payments
(1,097
)
(6,420
)
(5,724
)
Adjustments to previously accrued amounts
—
(91
)
(255
)
Foreign currency translation adjustment
2
55
(221
)
Total restructuring and severance liability, December 31
3,069
4,690
3,582
Less long-term restructuring and severance liability
—
—
(362
)
Current restructuring and severance liability
$
3,069
$
4,690
$
3,220
NOTE 12
COMMITMENTS AND CONTINGENCIES
The Company leases certain property and equipment under capital
leases pursuant to master equipment lease agreements and has
non-cancelable operating leases for facilities. Under the master
equipment lease agreements, the Company had fixed asset balances
of $7.5 million and $9.2 million as of
December 31, 2005 and 2004, respectively, net of
accumulated amortization of $5.4 million and
$4.2 million, respectively.
The Company has recorded rent expense under leases for buildings
or office space accounted for as operating leases in 2005, 2004
and 2003 of $4.1 million, $4.2 million, and
$3.9 million, respectively.
As of December 31, 2005, the Company had no commitments
past 2009, except for principal and interest due on its
convertible notes payable described in Note 14 —
Convertible Notes Payable and Lines of Credit. Minimum
contractual commitments as of December 31, 2005, were as
follows (in thousands):
Capital
Operating
Development
leases
leases
agreements
2006
$
128
$
3,473
$
13,100
2007
31
2,950
2,027
2008
—
2,534
43
2009
—
850
—
Minimum contractual commitments
159
$
9,807
$
15,170
Less amount representing interest
(5
)
Recorded capital lease obligations
$
154
In its normal course of operations, the Company engages in
development arrangements under which it hires outside
engineering resources to augment its existing internal staff in
order to complete research and development projects, or parts
thereof. For the years ended December 31, 2005, 2004 and
2003, the Company incurred $20.3 million,
$16.8 million and $5.8 million, respectively, for such
arrangements.
In October 2005, the Company renegotiated one of its facility
leases to consolidate its floor space in its headquarters in
Seattle, Washington. The Company issued 70,000 shares of
common stock to the landlord, Merrill Place, LLC, for release
from certain of its operating lease obligations. The Company
charged $80,000,
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
representing the fair value of the shares issued, to
“Restructuring, Severance and Impairment” on the
accompanying Consolidated Statements of Operations for this
issuance and related release from future obligations.
Litigation
Beginning on May 25, 2005, the Company and certain current
and former officers were served with six securities class action
complaints filed in the U.S. District Court for the Western
District of Washington. On October 19, 2005, the Court
ordered the consolidation of these cases into a single action,
and on November 15, 2005, the plaintiffs filed an amended
consolidated complaint. Plaintiffs seek to represent a class of
purchasers of the Company’s securities from
October 23, 2002, through May 9, 2005. The
consolidated complaint alleges federal securities law violations
in connection with the issuance of various reports, press
releases and statements in investor telephone conference calls,
and seeks unspecified damages, interest, attorneys’ fees,
costs and other relief. On December 19, 2005, the Company
and the individual defendants moved to dismiss the consolidated
complaint, which motion is pending before the Court.
On June 3 and June 17, 2005, two shareholder
derivative complaints were filed in the U.S. District Court
for the Western District of Washington against members of the
Company’s Board of Directors and certain current and former
officers. The derivative plaintiffs purport to act on the
Company’s behalf and assert allegations substantially
similar to those asserted in the putative class action
complaints, as well as allegations of breach of fiduciary duty,
abuse of control, gross mismanagement, waste of corporate
assets, and unjust enrichment. The complaints seek to recover on
the Company’s behalf unspecified damages and seek
attorney’s fees, costs and other relief. On August 29,2005, the Court ordered the consolidation of these two cases
into a single action, and in October 2005 the Company was served
with an amended derivative complaint containing substantially
identical allegations as in the earlier complaints. On
November 18, 2005, the Company and the individual
defendants moved to dismiss the consolidated derivative
complaint, which motions are pending before the Court.
On January 9, 2006, the Company was served in two
additional shareholder derivative complaints filed in the
Superior Court of the State of Washington for King County
against members of the Company’s Board of Directors and
certain current and former officers and former directors. The
derivative plaintiffs purport to act on the Company’s
behalf and assert allegations substantially similar to those
asserted in the consolidated derivative case previously filed in
the U.S. District Court for the Western District of
Washington. The complaints seek to recover on the Company’s
behalf unspecified damages and seek attorneys’ fees, costs
and other relief. On February 15, 2006, the two state court
derivative actions were consolidated by order of the Court.
The Company is indemnifying its current and former officers and
directors named in each of the foregoing actions, subject to an
undertaking by each of them to repay the advanced fees and costs
if it is ultimately determined that he or she is not entitled to
such indemnification.
Other
From time to time the Company is subject to various other legal
proceedings that arise in the ordinary course of business or are
not material to the Company’s business. Additionally, the
Company is subject to income taxes in the U.S. and several
foreign jurisdictions and, in the ordinary course of business,
there are transactions and calculations where the ultimate tax
determination is uncertain. Although the Company cannot predict
the outcomes of these matters with certainty, the Company’s
management does not believe that the disposition of these
ordinary course matters will have a material adverse effect on
the Company’s financial position, results of operations or
cash flows. Because the Company is not at this time able to
determine the probability of outcome or any estimable losses, no
amounts have been accrued for potential settlements.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
NOTE 13
INCOME TAXES
Under SFAS No. 109, Accounting for Income
Taxes, income taxes are recognized for the amount of taxes
payable for the current year and for the impact of deferred tax
assets and liabilities, which represent consequences of events
that have been recognized differently in the financial
statements under GAAP than for tax purposes. As of
December 31, 2005, the Company had federal net operating
loss carryforwards of approximately $288 million and gross
federal research and experimentation tax credit carryforwards of
approximately $12.4 million. The net operating loss
carryforwards will expire from 2010 through 2025, if not
utilized, and research and development tax credits will expire
from 2006 through 2025, if not utilized.
Income (loss) before provision for income taxes consists of the
following (in thousands):
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The following table reconciles the federal statutory income tax
rate to the Company’s effective tax rate:
2004
2003
(Restated)
2005
Federal statutory income tax rate
35.0
%
(35.0
)%
(35.0
)%
State taxes, net of federal effect
2.2
(2.4
)
(3.1
)
Impact of change in state rate
(1.4
)
—
—
Foreign taxes
(5.2
)
(0.3
)
1.0
In-process research and development write-off
—
10.6
—
Permanent differences
—
3.9
1.5
Foreign tax credit
—
(0.3
)
—
Research and development tax credit
(5.3
)
(1.0
)
(2.1
)
Other
1.2
(0.1
)
(0.4
)
Effect of change in valuation allowance on deferred tax assets
(227.1
)
64.5
35.8
Effective income tax rate
(200.6
)%
39.9
%
(2.3
)%
Deferred income taxes reflect the net tax effects of temporary
differences between the tax bases of assets and liabilities and
the corresponding financial statement amounts, operating loss,
and tax credit carryforwards. Significant components of the
Company’s deferred income tax assets and liabilities are as
follows (in thousands):
The 2004 net current deferred tax liability of $124,000 is
included in “Other Accrued Liabilities” on the
accompanying Consolidated Balance Sheets, while the
2005 net current deferred tax asset of $23,000 is included
in “Prepaid Expenses and Other Current Assets” of the
same statement.
In September 2004, as a result of substantial losses during the
year and based on revised projections indicating continued
challenging operating results, the Company established the
valuation allowance of $58.9 million. In the fourth quarter
of 2003, management determined that, based on its most recent
operating performance and its expected future performance, the
Company was more likely than not able to utilize certain of its
U.S.-based deferred tax assets and therefore reduced the
valuation allowance by approximately $58.0 million. A
summary of the changes to the valuation allowance on deferred
tax assets for the years ended December 31, 2005, 2004 and
2003 was an increase of $29.6 million, an increase of
$96.7 million, and a decrease of $58.0 million,
respectively.
Undistributed earnings of the Company’s foreign
subsidiaries are considered to be permanently reinvested;
accordingly, no provision for U.S. federal and state income
taxes has been provided thereon. Upon repatriation of those
earnings, in the form of dividends or otherwise, the Company
would be subject to both U.S. income taxes (subject to an
adjustment for foreign tax credits) and withholding taxes
payable to the various foreign countries. Determination of the
amount of unrecognized deferred U.S. income tax liability
is not practicable due to the complexities associated with this
hypothetical calculation.
NOTE 14
CONVERTIBLE NOTES PAYABLE AND LINES OF CREDIT
In December 2004 the Company issued $80 million aggregate
principal amount of 3.0% Convertible Senior Subordinated
Notes due 2024 (“Notes”) in a private placement
pursuant to Rule 144A under the Securities Act of 1933, as
amended. These unsecured Notes bear interest at an annual rate
of 3.0%, payable semiannually on June 1 and December 1
of each year through the maturity date of December 1, 2024.
The Notes are convertible, under certain circumstances, into the
Company’s common stock at an initial conversion rate of
207.2002 shares of common stock per $1,000 principal amount
of Notes, which is equivalent to an initial conversion price of
approximately $4.83 per share of common stock (subject to
adjustment in certain events). Upon conversion of the Notes, in
lieu of delivering common stock, the Company may, at its
discretion, deliver cash or a combination of cash and common
stock.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
The Notes are general unsecured senior subordinated obligations,
ranking junior in right of payment to the Company’s
existing and future senior indebtedness, equally in right of
payment with the Company’s existing and future indebtedness
or other obligations that are not, by their terms, either senior
or subordinated to the Notes and senior in right of payment to
the Company’s future indebtedness that, by its terms, is
subordinated to the Notes. In addition, the Notes are
effectively subordinated to any of the Company’s existing
and future secured indebtedness to the extent of the assets
securing such indebtedness and structurally subordinated to the
claims of all creditors of the Company’s subsidiaries.
Holders may convert the Notes during a conversion period
beginning with the mid-point date in a fiscal quarter to, but
not including, the mid-point date (or, if that day is not a
trading day, then the next trading day) in the immediately
following fiscal quarter, if on each of at least 20 trading days
in the period of 30 consecutive trading days ending on the first
trading day of the conversion period, the closing sale price of
the Company’s common stock exceeds 120% of the conversion
price in effect on that 30th trading day of such period.
The “mid-point dates” for the fiscal quarters are
February 15, May 15, August 15 and November 15.
Holders may also convert the Notes if the Company has called the
Notes for redemption or, during prescribed periods, upon the
occurrence of specified corporate transactions or a fundamental
change, in each case as described in the indenture governing the
Notes. As of December 31, 2004 and 2005, none of the
conditions for conversion of the Notes were satisfied.
The Company may, at its option, redeem all or a portion of the
Notes for cash at any time on or after December 1, 2007,
and prior to December 1, 2009, at a redemption price of
100% of the principal amount of the Notes plus accrued and
unpaid interest plus a make whole premium of $150.00 per
$1,000 principal amount of Notes, less the amount of any
interest actually paid or accrued and unpaid on the Notes prior
to the redemption date, if the closing sale price of the
Company’s common stock exceeds 150% of the conversion price
for at least 20 trading days in the 30-trading day period ending
on the trading day prior to the date of mailing of the
redemption notice. On or after December 1, 2009, the
Company may redeem for cash all or a portion of the Notes at a
redemption price of 100% of the principal amount of the Notes
plus accrued and unpaid interest. Holders may require the
Company to purchase all or a part of their Notes for cash at a
purchase price of 100% of the principal amount of the Notes plus
accrued and unpaid interest on December 1, 2009, 2014, and
2019, or upon the occurrence of certain events provided in the
indenture governing the Notes.
In connection with the issuance of the Notes, the Company
incurred $3.4 million of issuance costs, which primarily
consisted of investment banker fees, legal and other
professional fees. These costs are being amortized using the
effective interest method to interest expense over the five-year
period from December 2004 through November 2009. A total of
$676,000 was amortized into interest expense during 2005. The
unamortized balance of these costs of $2.7 million as of
December 31, 2005, is included in “Other Non-current
Assets” on the accompanying Consolidated Balance Sheets.
Lines of Credit
On May 31, 2005, the Company entered into a Senior Secured
Credit Agreement with Wells Fargo Foothill, Inc. (“the
Credit Agreement”), providing for a two-year revolving line
of credit for up to $30.0 million. The credit line replaces
the Company’s previous line of credit with Wells Fargo
Bank, N.A. The Credit Agreement provides support for the
Company’s existing letters of credit while permitting the
Company to use previously restricted cash of $11.4 million
and permitting additional cash advances, subject to a borrowing
base composed of (a) up to $20.0 million based on 100%
of the Company’s maintenance service revenue for the
trailing six-month period and (b) up to $10.0 million
based on 85% of eligible accounts receivable, as defined in the
Credit Agreement, subject to other limitations provided in the
Credit Agreement. As of December 31, 2005, the Company was
eligible to use all $30.0 million of the credit line, which
was reduced by the amount of outstanding letters of credit at
that date, or $11.3 million, to arrive at the calculated
borrowing base as of that date of approximately
$18.7 million. As of February 1, 2006, outstanding
letters of
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
credit were reduced from $11.3 million to
$1.4 million, effectively increasing the calculated
borrowing base to $28.6 million; as of February 6,2006, the calculated borrowing base was reduced by another
$2.8 million to $25.8 million as the credit line was
used to support a forward currency contract on a specific sales
contract. See Note 20 — Subsequent Events,
below. The Credit Agreement provides for interest on a
performance-based formula, contains covenants to maintain or
achieve certain financial performance standards and is
collateralized by all of the Company’s assets and pledges
of the stock of its subsidiaries.
As of December 31, 2005, the Company had met all but one of
its covenants on the credit line, and received a waiver from
Wells Fargo Foothill, Inc. for the applicable covenant. The
Company also renegotiated this covenant for the remainder of the
agreement, which reduces the risk of future violation of this
same covenant. In connection with the initiation of the line of
credit, the Company was obligated to pay a closing fee of 2.5%
of the maximum amount of the credit line, or $750,000, and other
fees and costs customary for such transactions. Half of the
closing fee was paid at closing and half is payable one year
from closing. These costs have been capitalized and are being
amortized over the two-year life of the Credit Agreement. The
indebtedness under the Credit Agreement constitutes senior
indebtedness under the indenture governing the Company’s
outstanding convertible senior subordinated notes issued in
December 2004. As of December 31, 2005, the Company had not
drawn upon the credit facility.
In connection with the Credit Agreement, the Company issued the
lender a four-year warrant to purchase 200,000 shares
of its common stock, with an exercise price of $1.65 per
share, the closing price of its common stock on the date the
warrant was issued. Using the Black-Scholes pricing model, the
fair value of the warrant was estimated at $219,000 and is also
being amortized over the two-year life of the Credit Agreement,
along with the fees described above. A total of
$1.3 million in fees was capitalized in connection with the
line of credit which has been recorded in “Other
Non-current Assets” on the accompanying Consolidated
Balance Sheets. As of December 31, 2005, $962,000 is the
unamortized balance, with $332,000 included in interest expense
during 2005.
The Company’s $25.0 million revolving line of credit
with Wells Fargo Bank, N.A. expired on April 29, 2004.
Subsequent to April 29, 2004, the Company was granted
extensions of the line of credit through December 1, 2004,
with no material changes to the terms and conditions. Subsequent
to December 1, 2004, the Company negotiated a
$15.0 million secured credit facility with Wells Fargo
Bank, N.A. which was used only to support outstanding letters of
credit. At December 31, 2004, the Company had
$11.4 million of outstanding letters of credit. The Company
was required to maintain cash and short-term investment balances
at least equal to the outstanding letters of credit. As such,
the Company designated $11.4 million of its cash as
restricted cash at December 31, 2004.
NOTE 15
SHAREHOLDERS’ EQUITY
Common Stock: In the first quarter of 2003, the Company
completed a public offering of 8,480,000 shares of newly
issued common stock, and an additional 145,000 shares of
common stock from certain selling shareholders, at a public
offering price of $6.20 per share. The Company received
from the offering, after underwriting discount and selling
expenses, net proceeds of $49.1 million. The Company used
the net proceeds for general corporate purposes.
On April 1, 2004, the Company issued 7,560,885 shares
of its common stock and 4,840,421 exchangeable shares in
connection with the acquisition of OctigaBay Systems
Corporation. See Note 18 — OctigaBay
Acquisition.
Exchangeable Shares: Shares of exchangeable stock were
issued by one of the Company’s Nova Scotia subsidiaries in
connection with the April 2004 acquisition of OctigaBay Systems
Corporation (“OctigaBay”). Exchangeable stock is, as
nearly as practicable, the economic equivalent of the
Company’s common stock. Through the provisions of the
exchangeable stock and related acquisition documents, holders of
the
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
exchangeable stock have the right to exchange such stock for the
Company’s common stock on a one-for-one basis. Holders also
have the right to receive the same dividends and distributions
paid on the Company’s common stock and the right to
participate in certain liquidation events on a pro rata basis
with holders of the Company’s common stock. Holders of
exchangeable stock do not have the right to vote, however, as
holders of the Company’s common stock. All remaining shares
of exchangeable stock outstanding on December 31, 2005,
were exchanged for an equivalent number of shares of the
Company’s common stock in January 2006.
Preferred Stock:The Company has 5,000,000 shares of
undesignated preferred stock authorized, and no shares of
preferred stock outstanding.
Shareholder Warrants: At December 31, 2005, the
Company had outstanding and exercisable warrants to purchase an
aggregate of 5,634,049 shares of common stock, as follows:
Restricted Stock: In the fourth quarter of 2005, the
Company issued an aggregate of 1,965,000 shares of
restricted stock to certain executives and management employees
from the Company’s 2004 Long Term Equity Compensation Plan.
These shares will become fully vested on June 30, 2007. The
Company has recorded a deferred compensation charge of
$2.8 million for the issuance of these shares, and will
recognize compensation expense ratably over the
18-month vesting
period. The Company recorded $70,000 for amortization of
deferred compensation on these shares in December 2005.
Stock Option Plans: As of December 31, 2005, the
Company had five active stock option plans that provide for
option grants to employees, directors and others. Options
granted to employees under the Company’s option plans
generally vest over four years or as otherwise determined by the
plan administrator; however, options granted during 2005 were
generally granted with full vesting on or before
December 31, 2005, in order to avoid additional expense
related to the options under the implementation of
SFAS No. 123(R). Options to purchase shares expire no
later than ten years after the date of grant.
On December 20, 2005, the Company announced a stock option
repricing for certain outstanding options as of that date, the
purpose of which was to reduce the number of new options needed
for grant at the same time, since the Company had a limited
number of shares available for such grant. A total of 1,274,260
options with original exercise prices from $3.63 to
$8.53 per share were repriced to an exercise price of
$1.49 per share, all of which were fully vested at the time
of repricing. Per the requirements of FIN No. 44,
Accounting for Certain Transactions Involving Stock
Compensation, the stock option modification resulted in
variable stock option accounting from the date of repricing
until the end of the year; however, because the closing price of
the Company’s common stock on December 31, 2005, was
less than the re-grant price, no compensation expense was
recorded.
Twice during 2005, the Board of Directors approved the
acceleration of the vesting of all unvested outstanding stock
options previously granted to employees and executive officers
under the Company’s stock option plans which exceeded
certain exercise price thresholds. In March 2005 the threshold
for accelerated vesting was all options with a per share
exercise price of $2.36 or higher (the market price of the
Company’s common stock on the date of the change), while in
May 2005 the threshold was all options with a per share exercise
price of $1.47 or greater (the market price of the
Company’s common stock on the date of the
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
change). This acceleration resulted in options to acquire
approximately 4.6 million shares of the Company’s
common stock becoming immediately exercisable. Options granted
to consultants and to non-employee directors were not
accelerated. All other terms and conditions applicable to
outstanding stock option grants, including the exercise prices
and numbers of shares subject to the accelerated options, were
unchanged. The acceleration resulted in a charge to income of
approximately $1.1 million related to the deferred
compensation of previously unvested options granted as part of
the OctigaBay acquisition in April 2004. The acceleration
eliminates future compensation expense that the Company would
have recognized in its statement of operations with respect to
these options upon the adoption of SFAS No. 123(R) on
January 1, 2006, which requires expensing of stock options
over the service period in which they vest.
In connection with a restructuring plan announced in June 2005,
the Company amended the stock option grants for certain
terminated employees to extend the exercise period of vested
stock options, which is normally three months from the date
of termination. No compensation expense was recorded as the fair
market value of the Company’s stock (the closing market
price of the Company’s stock on the date of the change) was
less than the respective stock option exercise prices.
A summary of the Company’s stock option activity and
related information follows:
The weighted average exercise price of outstanding options at
December 31, 2005 includes the impact of the 2005 repricing
of 1,274,260 options, as described above.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Outstanding and exercisable options by price range as of
December 31, 2005, are as follows:
Outstanding Options
Exercisable Options
Weighted
Weighted
Weighted
Average
Average
Average
Range of Exercise
Number
Remaining
Exercise
Number
Exercise
Prices Per Share
Outstanding
Life (Years)
Price
Exercisable
Price
$
0.26
–
$
1.00
386,452
9.4
$
0.92
386,452
$
0.92
$
1.01
–
$
2.00
4,281,445
7.7
$
1.55
4,281,445
$
1.55
$
2.01
–
$
3.00
3,318,953
5.9
$
2.54
3,318,953
$
2.54
$
3.01
–
$
4.00
3,912,043
5.2
$
3.71
3,911,661
$
3.71
$
4.01
–
$
6.00
1,566,132
2.2
$
5.16
1,559,960
$
5.16
$
6.01
–
$
8.00
2,904,209
3.3
$
7.10
2,892,542
$
7.10
$
8.01
–
$
11.00
1,050,426
4.8
$
8.90
1,050,426
$
8.90
$
11.01
–
$
13.69
580,920
7.1
$
11.18
580,606
$
11.18
$
0.26
–
$
13.69
18,000,580
5.5
$
4.14
17,982,045
$
4.14
In accordance with FIN 44, the unamortized intrinsic value
of unvested options assumed in the April 2004 acquisition of
OctigaBay is included in deferred compensation. The Company
measured this intrinsic value based on the number of options
granted and the difference between the converted exercise price
of the options and the fair value of the underlying common
stock-based on the quoted price of the Company’s common
stock at the date the options were assumed. The deferred
compensation has been amortized over the requisite service
periods. Allocation of this acquisition-related deferred
compensation expense to the operating categories for years ended
December 31 is as follows (in thousands):
2003
2004
2005
Research and development
$
—
$
5,068
$
3,444
Sales and marketing
—
2,837
579
General and administrative
—
3,229
13
Total acquisition-related compensation expense
$
—
$
11,134
$
4,036
Employee Stock Purchase Plan: In 2001, the Company
established an Employee Stock Purchase Plan (“2001
ESPP”), which received shareholder approval in May 2002.
The maximum number of shares of the Company’s common stock
that employees could acquire under the 2001 ESPP is
4,000,000 shares. Eligible employees are permitted to
acquire shares of the Company’s common stock through
payroll deductions not exceeding 15% of base wages. The purchase
price per share under the 2001 ESPP was the lower of
(a) 85% of the fair market value of the Company’s
common stock at the beginning of each three month offering
period, or (b) the fair market value of the common stock at
the end of each three month offering period. As of
December 31, 2005 and 2004, 1,850,131 and
1,048,889 shares, respectively, had been issued under the
2001 ESPP.
As of the purchase period that began on December 16, 2005,
the Company has amended the purchase price per share in order to
avoid additional expense that would otherwise be recorded under
the SFAS 123(R) rules. For purchase periods commencing on
or after that date, the purchase price per share under the 2001
ESPP will be 95% of the closing market price on the fourth
business day after the end of each offering period.
NOTE 16
BENEFIT PLANS
401(k) Plan
The Company has a retirement plan covering substantially all
U.S. employees that provides for voluntary salary deferral
contributions on a pre-tax basis in accordance with
Section 401(k) of the Internal Revenue
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
Code of 1986, as amended. Prior to 2005, the Company matched 25%
of employee contributions each calendar year, comprised of a
12.5% match of employee contributions in cash 45 days after
each quarter and a 12.5% match determined annually by the Board
of Directors and payable in cash or common stock of the Company.
The Company eliminated its matching obligation as of
June 30, 2005. The Company’s 2005, 2004, and 2003
matching contribution expenses were $795,000, $1.6 million,
and $1.3 million, respectively.
NOTE 17
SEGMENT INFORMATION
SFAS No. 131, Disclosure about Segments of an
Enterprise and Related Information
(“SFAS 131”), establishes standards for
reporting information about operating segments and for related
disclosures about products, services and geographic areas.
Operating segments are identified as components of an enterprise
about which separate discrete financial information is available
for evaluation by the chief operating decision-maker, or
decision-making group, in making decisions regarding allocation
of resources and assessing performance. Cray’s chief
decision-maker, as defined under SFAS 131, is the Chief
Executive Officer. During 2003, 2004, and 2005, Cray had one
operating segment.
Product and service revenue and long-lived assets classified by
major geographic areas are as follows (in thousands):
Revenue attributed to foreign countries are derived from sales
to external customers. Revenue derived from U.S. government
agencies or commercial customers primarily serving the
U.S. government, and therefore under their control, totaled
approximately $111.2 million, $107.8 million, and
$175.4 million in 2005, 2004 and 2003, respectively. In
2005 and 2003, one customer, Oak Ridge National Laboratory,
contributed approximately 18% and 11% of total revenue,
respectively. In 2004, one customer, Sandia National
Laboratories, accounted for 27% of total revenue.
NOTE 18
OCTIGABAY ACQUISITION
On April 1, 2004, the Company completed the acquisition of
OctigaBay, a privately-held company located in Burnaby, British
Columbia. The acquisition was accounted for as a purchase,
pursuant to the
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
requirements of SFAS No. 141, Business
Combinations. The Company paid $14,925,000 in cash and
issued 7,560,885 shares of Cray common stock and 4,840,421
exchangeable shares. The Company also assumed outstanding
OctigaBay stock options exercisable for 740,722 shares of
Cray common stock. Of the total shares issued and reserved,
1,861,000 shares were not included in the purchase price
calculation because they represented repurchaseable shares that
were earned over the repurchase period. OctigaBay was a
development stage company and was in the process of developing
an innovative high-performance computing system. The fair value
of the in-process research and development
(“IPR&D”) and the core technology was estimated
using the income approach, which reflects the net present value
of the projected cash flows expected to be generated by the
products incorporating the in-process technology. The discount
rate applicable to the cash flows of the products reflected the
estimated stage of completion and other risks inherent in the
project. The discount rate used in the valuation of IPR&D
was 24.5%. The fair value of IPR&D was estimated to be
$43.4 million with an estimated cost to complete of
$8.0 million. The in-process technology was substantially
completed in 2004. The IPR&D fair value was expensed in
April 2004. The purchased intangibles consisted of core
technology and were to be amortized over five years. However, as
described above, the Company wrote off the unamortized balance
of the core technology intangible asset late in 2005, after
performing an impairment analysis as required by
SFAS No. 144. The allocation of the purchase price was
as follows (in thousands):
Fair value of net tangible assets acquired
$
10,521
Core technology
6,700
In-process research and development
43,400
Goodwill
38,836
Net assets acquired
$
99,457
The Company recorded deferred compensation of $12.4 million
resulting from retention agreements with key OctigaBay personnel
and $2.2 million from existing stock options assumed in the
OctigaBay acquisition. The retention agreements expired in
November 2005, although the retention agreements for three
employees were terminated at the end of 2004, and the related
deferred compensation of approximately $4.7 million was
immediately recognized. The assumed stock options were
accelerated in 2005 with the rest of the applicable groups of
stock options, as described in Note 15 —
Shareholders’ Equity, and resulted in a charge to
income of approximately $1.1 million related to the
deferred compensation of previously unvested options granted as
part of the OctigaBay acquisition.
NOTE 19
INTEREST INCOME (EXPENSE)
The detail of interest income (expense) for the years ended
December 31, 2005, 2004 and 2003 is as follows (in
thousands):
2003
2004
2005
Interest income
$
657
$
666
$
741
Interest expense
(213
)
(301
)
(4,203
)
Net interest income (expense)
$
444
$
365
$
(3,462
)
Interest income is earned by the Company on overnight balances,
which are invested in short-term debt securities.
Interest expense in 2005 consists of $2.4 million for
interest on the $80 million Notes, $1.0 million of
amortization of all associated fees capitalized for attainment
of the line of credit and issuance of the Notes, and $765,000 in
interest and fees on the line of credit with Wells Fargo
Foothill, Inc.
NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS — (Continued)
NOTE 20
SUBSEQUENT EVENTS
On February 6, 2006, the Company entered into a forward
contract for £14,994,000 (British pound sterling) as a cash
flow hedge on the foreign currency exposure related to a sales
contract denominated in British pound sterling. This sales
contract is expected to be billed in milestones based on the
Company meeting contractual and product delivery commitments.
The forward contract matures in April 2006 and the Company plans
to rollover the forward contract for amounts yet to be collected
until the underlying transactions (milestone cash payment from
the customer) have been completed, which is expected to be
December 2006. The Company has an approved hedging policy which
requires specific designation of transactions to be hedged. This
forward contract was designated as a cash flow hedge on the
specific sales contract. As a result of entering into the
forward contract, the availability under the line of credit with
Wells Fargo Foothill, Inc. was reduced by $2.8 million.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Cray Inc.
We have audited the accompanying consolidated balance sheet of
Cray Inc. and subsidiaries as of December 31, 2005, and the
related consolidated statements of operations,
shareholders’ equity and comprehensive income (loss), and
cash flows for the year then ended. These financial statements
are the responsibility of the company’s management. Our
responsibility is to express an opinion on these financial
statements based on our audit.
We conducted our audit in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by
management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred
to above present fairly, in all material respects, the financial
position of Cray Inc. and subsidiaries as of December 31,2005, and the results of their operations and their cash flows
for the year ended December 31, 2005, in conformity with
accounting principles generally accepted in the United States of
America.
Our audit was conducted for the purpose of forming an opinion on
the 2005 basic consolidated financial statements taken as a
whole. The financial statement schedule listed in the index at
Item 15(a)(2) is presented for purposes of additional
analysis and is not a required part of the basic consolidated
financial statements. This schedule, for one year ended
December 31, 2005, has been subjected to the auditing
procedures applied in the audit of the 2005 basic consolidated
financial statements and, in our opinion, is fairly stated in
all material respects in relation to the 2005 basic consolidated
financial statements taken as a whole.
We have also audited, in accordance with the standards of the
Public Company Accounting Oversight Board (United States), the
effectiveness of Cray Inc. and subsidiaries’ internal
control over financial reporting as of December 31, 2005,
based on criteria established in Internal Control —
Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO), and our report
dated March 15, 2006, expressed an unqualified opinion on
management’s assessment of the effectiveness of internal
control over financial reporting and an unqualified opinion on
the effectiveness of internal control over financial reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Cray Inc.
Seattle, Washington
We have audited the accompanying consolidated balance sheet of
Cray Inc. and subsidiaries (the “Company”) as of
December 31, 2004, and the related consolidated statements
of operations, shareholders’ equity and comprehensive
income (loss), and cash flows for each of the two years in the
period ended December 31, 2004. Our audits also included
the financial statement schedule for each of the two years in
the period ended December 31, 2004, listed in the Index at
Item 15. These financial statements and financial statement
schedule are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these
financial statements and financial statement schedule based on
our audits.
We conducted our audits in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are
free of material misstatement. An audit also includes examining,
on a test basis, evidence supporting the amounts and disclosures
in the financial statements, assessing the accounting principles
used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our
opinion.
In our opinion, such consolidated financial statements present
fairly, in all material respects, the financial position of Cray
Inc. and subsidiaries at December 31, 2004 and 2003, and
the results of their operations and their cash flows for the
years then ended, in conformity with accounting principles
generally accepted in the United States of America. Also, in our
opinion, such financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as
a whole, presents fairly, in all material respects, the
information set forth therein.
As discussed in Note 2, the accompanying financial
statements as of and for the year ended December 31, 2004,
have been restated.