SEC Filings

10-Q
CRAY INC filed this Form 10-Q on 10/30/2018
Entire Document
 
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________________________________________ 
FORM 10-Q
 ______________________________________________
 
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended: September 30, 2018
Or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from:              to             
Commission File Number: 0-26820
 
______________________________________________ 
CRAY INC.
(Exact name of registrant as specified in its charter)
______________________________________________ 
 
Washington
 
93-0962605
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
 
 
901 Fifth Avenue, Suite 1000
Seattle, Washington
 
98164
(Address of Principal Executive Office)
 
(Zip Code)
(206) 701-2000
(Registrant’s telephone number, including area code)
 ______________________________________________ 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ý    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
ý
Accelerated filer
¨
 
 
 
 
Non-accelerated filer
¨
Smaller reporting company
¨
 
 
Emerging growth company
¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act ¨




Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
As of October 26, 2018, there were 40,836,694 shares of Common Stock issued and outstanding.




CRAY INC.
TABLE OF CONTENTS
 
 
Page No.
 
 
Condensed Consolidated Balance Sheets as of September 30, 2018 and December 31, 2017
Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2018 and September 30, 2017
Condensed Consolidated Statements of Comprehensive Loss for the Three and Nine Months Ended September 30, 2018 and September 30, 2017
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2018 and September 30, 2017

CRAY, ClusterStor, DataWarp, and Sonexion are registered trademarks of Cray Inc. in the United States and other countries. The CS and XC families of supercomputers and other Cray technologies are all trademarks of Cray Inc. Other trademarks used in this report are the property of their respective owners.
Available Information
Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports and proxy statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are available free of charge at our website at www.cray.com as soon as reasonably practicable after we electronically file such reports with the U.S. Securities and Exchange Commission.


3



PART I. FINANCIAL INFORMATION
Item 1. Unaudited Condensed Consolidated Financial Statements
CRAY INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited and in thousands, except share data)
 
September 30,
2018
 
December 31,
2017
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
166,848

 
$
137,326

Restricted cash
1,303

 
1,964

Short-term investments

 
6,997

Accounts and other receivables, net
74,961

 
162,034

Inventory
141,561

 
186,307

Prepaid expenses and other current assets
21,231

 
25,015

Total current assets
405,904

 
519,643

 
 
 
 
Long-term restricted cash
16,030

 
1,030

Long-term investment in sales-type lease, net
13,024

 
23,367

Property and equipment, net
36,325

 
36,623

Goodwill
14,182

 
14,182

Intangible assets other than goodwill, net
3,471

 
4,345

Other non-current assets
17,433

 
19,567

TOTAL ASSETS
$
506,369

 
$
618,757

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
28,956

 
$
57,207

Accrued payroll and related expenses
17,768

 
18,546

Other accrued liabilities
7,717

 
9,471

Customer contract liabilities
57,290

 
80,119

Total current liabilities
111,731

 
165,343

 
 
 
 
Long-term customer contract liabilities
31,661

 
38,622

Other non-current liabilities
12,725

 
14,495

TOTAL LIABILITIES
156,117

 
218,460

 
 
 
 
Shareholders’ equity:
 
 
 
Preferred stock — Authorized and undesignated, 5,000,000 shares; no shares issued or outstanding

 

Common stock and additional paid-in capital, par value $.01 per share — Authorized, 75,000,000 shares; issued and outstanding 40,825,905 and 40,464,963 shares, respectively
643,059

 
633,408

Accumulated other comprehensive income
707

 
915

Accumulated deficit
(293,514
)
 
(234,026
)
TOTAL SHAREHOLDERS’ EQUITY
350,252

 
400,297

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
506,369

 
$
618,757


The accompanying notes are an integral part of these condensed consolidated financial statements

4



CRAY INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited and in thousands, except per share data)
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Revenue:
 
 
 
 
 
 
 
 
Product
 
$
57,990

 
$
45,280

 
$
185,823

 
$
117,939

Service
 
34,806

 
34,420

 
106,770

 
107,927

Total revenue
 
92,796

 
79,700

 
292,593

 
225,866

Cost of revenue:
 
 
 
 
 
 
 
 
Cost of product revenue
 
49,053

 
35,090

 
148,372

 
89,356

Cost of service revenue
 
18,932

 
16,118

 
54,651

 
55,866

Total cost of revenue
 
67,985

 
51,208

 
203,023

 
145,222

Gross profit
 
24,811

 
28,492

 
89,570

 
80,644

Operating expenses:
 
 
 
 
 
 
 
 
Research and development, net
 
26,162

 
26,626

 
85,436

 
76,591

Sales and marketing
 
15,282

 
13,392

 
46,165

 
43,292

General and administrative
 
6,580

 
7,022

 
17,983

 
23,024

Restructuring
 

 
7,653

 
476

 
7,653

Total operating expenses
 
48,024

 
54,693

 
150,060

 
150,560

Loss from operations
 
(23,213
)
 
(26,201
)
 
(60,490
)
 
(69,916
)
 
 
 
 
 
 
 
 
 
Other income, net
 
151

 
4,161

 
199

 
5,358

Interest income, net
 
908

 
880

 
2,288

 
2,655

Gain on strategic transaction
 

 
4,389

 

 
4,389

Loss before income taxes
 
(22,154
)
 
(16,771
)
 
(58,003
)
 
(57,514
)
Income tax benefit (expense)
 
(239
)
 
6,539

 
(348
)
 
21,227

Net loss
 
$
(22,393
)
 
$
(10,232
)
 
$
(58,351
)
 
$
(36,287
)
 
 
 
 
 
 
 
 
 
Basic net loss per common share
 
$
(0.55
)
 
$
(0.25
)
 
$
(1.44
)
 
$
(0.91
)
Diluted net loss per common share
 
$
(0.55
)
 
$
(0.25
)
 
$
(1.44
)
 
$
(0.91
)
 
 
 
 
 
 
 
 
 
Basic weighted average shares outstanding
 
40,778

 
40,199

 
40,611

 
40,082

Diluted weighted average shares outstanding
 
40,778

 
40,199

 
40,611

 
40,082


The accompanying notes are an integral part of these condensed consolidated financial statements

5



CRAY INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(Unaudited and in thousands)
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Net loss
 
$
(22,393
)
 
$
(10,232
)
 
$
(58,351
)
 
$
(36,287
)
Other comprehensive loss, net of tax:
 
 
 
 
 
 
 
 
Unrealized gain (loss) on available-for-sale investments
 

 
(98
)
 
7

 
(4
)
Foreign currency translation adjustments
 
(126
)
 
(118
)
 
(1,285
)
 
322

Unrealized gain (loss) on cash flow hedges
 
(651
)
 
(1,004
)
 
423

 
(2,178
)
Reclassification adjustments on cash flow hedges included in net loss
 
(462
)
 
56

 
647

 
94

Other comprehensive loss
 
(1,239
)
 
(1,164
)
 
(208
)
 
(1,766
)
Comprehensive loss
 
$
(23,632
)
 
$
(11,396
)
 
$
(58,559
)
 
$
(38,053
)

The accompanying notes are an integral part of these condensed consolidated financial statements

6



CRAY INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited and in thousands)
 
Nine Months Ended
September 30,
 
2018
 
2017
Operating activities:
 
 
 
Net loss
$
(58,351
)
 
$
(36,287
)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization
12,158

 
12,134

Share-based compensation expense
9,648

 
7,643

Deferred income taxes
(115
)
 
(21,419
)
Gain on strategic transaction

 
(4,389
)
Gain on sale of equity investment
(429
)
 
(3,350
)
Other
232

 
741

Cash provided (used) due to changes in operating assets and liabilities:
 
 
 
Accounts and other receivables
84,583

 
137,559

Long-term investment in sales-type lease, net
9,888

 
7,065

Inventory
38,124

 
(107,621
)
Prepaid expenses and other assets
516

 
1,939

Accounts payable
(28,029
)
 
(3,512
)
Accrued payroll and related expenses and other liabilities
1,511

 
(3,982
)
Customer contract liabilities
(29,315
)
 
(25,205
)
Net cash provided by (used in) operating activities
40,421

 
(38,684
)
Investing activities:
 
 
 
Sales/maturities of available-for-sale investments
7,000

 
66,610

Purchases of available-for-sale investments

 
(94,902
)
Cash received in strategic transaction
1,584

 
8,000

Proceeds from sale of equity investment
429

 
4,481

Purchases of property and equipment
(3,813
)
 
(15,647
)
Net cash provided by (used in) investing activities
5,200

 
(31,458
)
Financing activities:
 
 
 
Proceeds from issuance of common stock through employee stock purchase plan

 
365

Purchase of employee restricted shares to fund related statutory tax withholding

(2,934
)
 
(1,869
)
Proceeds from exercises of stock options
1,801

 
693

Net cash used in financing activities
(1,133
)
 
(811
)
Effect of foreign exchange rate changes on cash, cash equivalents and restricted cash
(627
)
 
1,152

Net increase (decrease) in cash, cash equivalents and restricted cash
43,861

 
(69,801
)
Cash, cash equivalents and restricted cash:
 
 
 
Beginning of period
140,320

 
224,617

End of period
$
184,181

 
$
154,816

 
 
 
 
Supplemental disclosure of cash flow information:
 
 
 
Cash paid for income taxes
$
741

 
$
1,202

Non-cash investing and financing activities:
 
 
 
Inventory transfers to fixed assets and service spares
$
6,572

 
$
1,248

Strategic transaction:
 
 
 
Non-cash assets acquired:
 
 
 
Receivable from Seagate
$

 
$
1,404


7



Inventory

 
4,170

Property and equipment

 
2,684

Intangible assets

 
3,350

Liabilities assumed:
 
 
 
Deferred revenue
$

 
$
11,700

Deferred tax liabilities

 
3,019

Other liabilities

 
500

The following is a reconciliation of cash, cash equivalents and restricted cash reported within the Condensed Consolidated Balance Sheets that sum to the total of the same such amounts shown in the Condensed Consolidated Statements of Cash Flows:
 
September 30,
2018
 
December 31,
2017
Cash and cash equivalents
$
166,848

 
$
137,326

Restricted cash (1)
1,303

 
1,964

Long-term restricted cash (1)
16,030

 
1,030

Total cash, cash equivalents and restricted cash
$
184,181

 
$
140,320

(1)
Restricted cash primarily associated with certain letters of credit to secure customer prepayments and other customer related obligations.

The accompanying notes are an integral part of these condensed consolidated financial statements

8



CRAY INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1— Basis of Presentation
In these notes, the Company and its wholly-owned subsidiaries are collectively referred to as the “Company.” In the opinion of management, the accompanying Condensed Consolidated Balance Sheets, Statements of Operations, Statements of Comprehensive Loss, and Statements of Cash Flows have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. Management believes that all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included. Interim results are not necessarily indicative of results for a full year. The information included in this quarterly report on Form 10-Q should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and notes thereto included in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2017.
The Company’s revenue, results of operations and cash balances are likely to fluctuate significantly from quarter to quarter. These fluctuations are due to such factors as the high average sales prices and limited number of sales of the Company’s products, the timing of purchase orders and product deliveries, the revenue recognition accounting policy of generally not recognizing product revenue until customer acceptance and other contractual provisions have been fulfilled and the timing of payments for product sales, maintenance services, government research and development funding and purchases of inventory. Given the nature of the Company’s business, its revenue, receivables and other related accounts are likely to be concentrated among a relatively small number of customers.
Principles of Consolidation
The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All material intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the Company’s condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.
Revenue Recognition
On January 1, 2018, the Company adopted the new accounting standard ASC 606, Revenue from Contracts with Customers, which superseded nearly all existing revenue recognition guidance under GAAP, to all contracts using the modified retrospective method. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. Adoption of the new standard did not have a material impact on the Company’s net loss during the first nine months of 2018. The Company expects the impact of the adoption of the new standard to be immaterial to its net income on an ongoing basis.
The Company’s performance obligations are satisfied over time as work is performed or at a point in time. The majority of the Company’s revenue is recognized at a point in time when products are accepted, installed or delivered. Most of the Company’s revenue is derived from long-term contracts that can span several years. Revenue is recognized when performance obligations under the terms of a contract with the customer are satisfied; generally, this occurs with the transfer of control of the Company’s systems or services. In general, this does not occur until the products have been shipped or services provided to the customer, risk of loss has transferred to the customer, and, where applicable, a customer acceptance has been obtained. Revenue is measured as the amount of consideration the Company expects to receive in exchange for transferring goods or providing services. Sales, value add, and other taxes that the Company collects concurrent with revenue-producing activities are excluded from revenue. Incidental items that are immaterial in the context of the contract are recognized as expense.
To determine the proper revenue recognition method for contracts, the Company evaluates whether two or more contracts should be combined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than one performance obligation. Contracts are often modified to account for changes in contract specifications and requirements. To determine the proper revenue recognition method for contract modifications, the Company evaluates whether the contract modification should be accounted for as a separate contract, part of an existing contract, or termination of an existing contract and the creation of a new contract. This evaluation requires significant judgment and the decision to combine a group of contracts or separate the combined or single contract into multiple performance obligations could change the amount of revenue and profit recorded in a given period. For contracts with multiple performance obligations, the Company allocates the contract’s

9



transaction price to each performance obligation using the Company’s estimate of the standalone selling price of each distinct good or service in the contract.
The Company determines the transaction price by reviewing the established contractual terms and other relevant information. Contracts can include penalty clauses and contracts with government customers may not be fully funded, both of which represent variable consideration. Generally, the Company includes both the funded and unfunded portions of a contract with a government customer in the transaction price, as most often it is deemed the contract will become fully funded. The Company also assesses the likelihood of certain penalties that would result in contract price reductions and, if deemed probable, the transaction price is adjusted.
The majority of the Company’s contracts include multiple promised goods and services, which are assessed at contract inception. Each distinct good or service is identified as a performance obligation, which may be an individual good or service or a bundle of goods or services. In order to determine whether the promises are distinct, the Company assesses the use of its products and services by its customers to determine whether the customer can benefit from the good or service on its own or from other readily available resources, and whether the promised transfer of goods or services is separately identifiable from other promises in the contract.
The majority of the Company’s revenues are from product solutions which include supercomputers, storage, and data analytics systems, each of which are usually separate performance obligations. Revenue is recognized when obligations under the terms of a contract with a customer are satisfied. Product revenue is typically recognized upon customer acceptance, or upon installation or delivery if formal acceptance is not required. Service revenue is typically recognized over time and consists mainly of system maintenance, analyst services, and engineering services, each of which are usually separate performance obligations. System maintenance commences upon customer acceptance or installation, depending on the contract terms, and revenue is recognized ratably over the remaining term of the maintenance contract. On-site analysts provide specialized services to customers, the revenue for which is recognized ratably over the contract period. Service revenue is recognized on a straight-line basis over the service period as the services are available continuously to the customer. Revenue from engineering services can be recognized as services are performed or as milestones are achieved, depending on the terms of the contract and nature of services performed. If, in a contract, the customer has an option to acquire additional goods or services, that option gives rise to a performance obligation if the option provides a material right to the customer that it would not receive without entering into that contract. Revenue from purchase options can be recognized as those future goods or services are transferred or when the option expires.
The Company performs an assessment to determine whether a significant financing component is present in a contract. If a contract is determined to include a significant financing component, the interest rate used in the calculation is based on the prevailing interest rates at contract inception and the entity’s creditworthiness. When the period between providing a good or service to the customer is expected to be less than one year from payment, the Company applies the practical expedient and does not adjust the consideration for the effects of a significant financing component.
Occasionally, the Company’s contracts include noncash consideration. This typically consists of returned parts when a system is upgraded or de-installed. Noncash consideration is measured at contract inception at estimated fair value.
The total transaction price is allocated to each performance obligation identified in the contract based on its relative standalone selling price. The Company does not have directly observable standalone selling prices for the majority of its performance obligations due to a relatively small number of customer contracts that differ in system size and contract terms which can be due to infrequently selling each performance obligation separately, not pricing products within a narrow range, or only having a limited sales history, such as in the case of certain advanced and emerging technologies. When a directly observable standalone selling price is not available, the Company estimates the standalone selling price. In determining the estimated standalone selling price, the Company uses the cost to provide the product or service plus a margin, or considers other factors. When using cost plus a margin, the Company considers the total cost of the product or service, including customer-specific and geographic factors as appropriate. The Company also considers the historical margins of the product or service on previous contracts and several other factors including any changes to pricing methodologies, competitiveness of products and services, and cost drivers that would cause future margins to differ from historical margins.
The Company sometimes offers discounts to its customers. As these discounts are offered on bundles of goods and services, the discounts are applied to all performance obligations in the contract on a pro-rata basis.

10



The following table provides information about contract receivables, contract assets, and contract liabilities from contracts with customers (in thousands) and includes both short-term and long-term portions:
 
 
September 30,
2018
 
December 31, 2017
 
Change
Contract receivables
 
$
70,927

 
$
167,346

 
$
(96,419
)
Contract assets
 
3,801

 
9,321

 
(5,520
)
Contract liabilities
 
88,951

 
118,741

 
(29,790
)
Contract receivables consist of amounts billed to customers and include the Company's investment in a sales type lease, a portion of which is due beyond one year. Generally, billing occurs subsequent to product revenue recognition and payment is expected within 30 days. Contract assets primarily relate to the Company's rights to consideration for work completed but not billed where right to payment is not just subject to the passage of time. Contract assets become contract receivables when the rights become unconditional. The Company sometimes receives advances or deposits from customers before revenue is recognized, resulting in customer contract liabilities (formerly deferred revenue). These assets and liabilities are reported on the Condensed Consolidated Balance Sheet on a contract-by-contract basis at the end of each reporting period. The Company’s payment terms vary from contract to contract. Contracts may require payment before, at or after the Company’s performance obligations have been satisfied. The decrease in the Company's contract asset balance for the nine months ended September 30, 2018 is primarily due to the transfer from contract assets to contract receivables that were included in the contract asset balance at the beginning of the period, partially offset by the addition of new contract assets.
For the nine month period ended September 30, 2018, the Company recognized $64.1 million in revenues from the contract liability balance at the beginning of the period.
The Company’s incremental direct costs of obtaining a contract come primarily from sales commissions, a portion of which are paid upon contract signing. These commissions are generally capitalized upon payment and expensed at the time of revenue recognition. These deferred commissions are included in prepaid expenses in the Condensed Consolidated Balance Sheet. As of September 30, 2018 and December 31, 2017, the Company had $2.5 million and $1.3 million, respectively, of deferred commissions. For the three and nine months ended September 30, 2018, the Company recognized $1.1 million and $3.7 million, respectively, in commissions expense. For the three and nine months ended September 30, 2017, the Company recognized $0.6 million and $2.2 million, respectively, in commissions expense.

11



The following data presents the Company's operating segment revenues disaggregated by primary geographic market, which is determined based on a customer's geographic location (in thousands). Regions represent Europe, the Middle East, and Africa (EMEA); Asia-Pacific and Japan; and the United States, Canada, and Latin America (Americas). Revenues were increased by $0.5 million for the three months ended September 30, 2018 and reduced by $0.6 million for the nine months ended September 30, 2018 related to hedging gains and losses which do not represent revenues recognized from contracts with customers.
 
 
Americas
 
EMEA
 
Asia Pacific & Japan
 
Total
Three Months Ended September 30, 2018
 
 
 
 
 
 
 
 
Supercomputing
 
$
45,263

 
$
16,251

 
$
11,101

 
$
72,615

Storage and Data Management
 
8,897

 
2,368

 
998

 
12,263

Maintenance and Support
 
20,567

 
7,329

 
5,453

 
33,349

Engineering Services and Other
 
3,832

 
494

 
3,592

 
7,918

Elimination of inter-segment revenue
 
(20,567
)
 
(7,329
)
 
(5,453
)
 
(33,349
)
Total revenue
 
$
57,992

 
$
19,113

 
$
15,691

 
$
92,796

 
 
 
 
 
 
 
 
 
 
 
Americas
 
EMEA
 
Asia Pacific & Japan
 
Total
Nine Months Ended September 30, 2018
 
 
 
 
 
 
 

Supercomputing
 
$
110,189

 
$
39,057

 
$
81,006

 
$
230,252

Storage and Data Management
 
23,810

 
9,813

 
12,354

 
45,977

Maintenance and Support
 
62,229

 
22,571

 
15,677

 
100,477

Engineering Services and Other
 
11,742

 
612

 
4,010

 
16,364

Elimination of inter-segment revenue
 
(62,229
)
 
(22,571
)
 
(15,677
)
 
(100,477
)
Total revenue
 
$
145,741

 
$
49,482

 
$
97,370

 
$
292,593

The Company’s remaining performance obligations reflect the deliverables within contracts with customers that will have revenue recognized in a future period (this may also be referred to as backlog). Due to the nature of the Company’s business and the size of individual transactions, forecasting the timing and total amount of revenue recognition is subject to significant uncertainties. As of September 30, 2018, the Company has an aggregate of $615 million in remaining performance obligations stemming from a mixture of system contracts with their related service obligations and other service obligations. Included in this balance are $0.6 million in losses resulting from hedged foreign currency transactions, which offset the related increase in revenue from currency fluctuations. These gains will be reclassified from accumulated other comprehensive income to revenue in the period the related transactions are recognized as revenue. These obligations are anticipated to be recognized as revenue over approximately the next six years. The Company estimates that about 60% of these obligations are expected to be recognized as revenue in the next 18 months, with the remainder thereafter.
Note 2— New Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers: Topic 606 (ASU 2014-09) to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under prior GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. The new guidance also requires additional disclosures and several terminology changes, such as amounts previously referred to as deferred revenue now being referred to as customer contract liabilities. The Company adopted ASU 2014-09 at the beginning of the first quarter of 2018 using the modified retrospective method. No cumulative effect adjustment was required to be recorded for this change in accounting as the Company determined the impact of the change to not be material. The comparative information for the three and nine months ended September 30, 2017, and as of December 31, 2017 has not been restated and continues to be reported under the accounting standards in effect for those periods. The effect of initially applying the new revenue standard had an immaterial effect on the Company’s financial statements. Adoption of the new standard did not have a material impact on the Company’s net loss during the first nine months of 2018. The Company expects the impact of the adoption of the new standard to be immaterial to its net income on an ongoing basis.

12



In January 2016, FASB issued Accounting Standards Update No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities: Topic 825 (ASU 2016-01). The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. The Company adopted ASU 2016-01 at the beginning of the first quarter of 2018. Adoption of ASU 2016-01 did not have a material impact on the Company’s consolidated financial statements.
In February 2016, FASB issued Accounting Standards Update No. 2016-02, Leases: Topic 842 (ASU 2016-02), that replaces existing lease guidance. The new standard is intended to provide enhanced transparency and comparability by requiring lessees to record right-of-use assets and corresponding lease liabilities on the balance sheet. Under the new guidance, leases will continue to be classified as either finance or operating, with classification affecting the pattern of expense recognition in the Consolidated Statements of Operations. Lessor accounting is largely unchanged under ASU 2016-02. Adoption of ASU 2016-02 is required for fiscal reporting periods beginning after December 15, 2018, including interim reporting periods within those fiscal years with early adoption being permitted. The new standard initially required application with a modified retrospective approach to each prior reporting period presented with various optional practical expedients. In July 2018, this requirement was amended with the issuance of Accounting Standards Update No. 2018-11, Leases: Topic 842: Targeted Improvements (ASU 2018-11), which permits an additional (and optional) transition method to adopt the new leases standard. Under this new transition method, an entity initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. Consequently, an entity’s reporting for the comparative periods presented in the financial statements in which it adopts the new leases standard will continue to be in accordance with current GAAP (Topic 840, Leases). An entity that elects this additional (and optional) transition method must provide the required Topic 840 disclosures for all periods that continue to be in accordance with Topic 840. The amendments do not change the existing disclosure requirements in Topic 840. While the Company expects adoption of ASU 2016-02 to lead to a material increase in the assets and liabilities recorded on its Consolidated Balance Sheet, the Company is still evaluating the overall impact on its consolidated financial statements.
In August 2016, FASB issued Accounting Standards Update No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments (ASU 2016-15). The updated guidance clarifies how companies present and classify certain cash receipts and cash payments in the statement of cash flows. The Company adopted ASU 2016-15 at the beginning of the first quarter of 2018. Adoption of ASU 2016-15 did not have a material impact on the Company’s consolidated financial statements.
In November 2016, FASB issued Accounting Standards Update No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (ASU 2016-18), which amends ASC 230 to add or clarify guidance on the classification and presentation of restricted cash in the statement of cash flows. The amended guidance requires that amounts that are deemed to be restricted cash and restricted cash equivalents be included in the cash and cash-equivalent balances in the statement of cash flows. A reconciliation between the consolidated balance sheet and the statement of cash flows must be disclosed when the consolidated balance sheet includes more than one line item for cash, cash equivalents, restricted cash, and restricted cash equivalents. The guidance also requires that changes in restricted cash and restricted cash equivalents that result from transfers between cash, cash equivalents, and restricted cash and restricted cash equivalents should not be presented as cash flow activities in the statement of cash flows. An entity with a material balance of amounts generally described as restricted cash and restricted cash equivalents must disclose information about the nature of the restrictions. The Company adopted ASU 2016-18 at the beginning of the first quarter of 2018. Restricted cash amounts have been combined with the cash and cash equivalent balances in the Condensed Consolidated Statement of Cash Flows for each period presented. Adoption of ASU 2016-18 did not have a material impact on the Company’s consolidated financial statements.
In August 2017, FASB issued Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (ASU 2017-12). The new standard simplifies and expands the eligible hedging strategies for financial and nonfinancial risks. It also enhances the transparency of how hedging results are presented and disclosed. Further, the new standard provides partial relief on the timing of certain aspects of hedge documentation and eliminates the requirement to recognize hedge ineffectiveness separately in earnings. Adoption of ASU 2017-12 is required for fiscal reporting periods beginning after December 15, 2018, including interim reporting periods within those fiscal years with early adoption being permitted. The Company does not expect the adoption of ASU 2017-12 to have a material impact on its consolidated financial statements.
In February 2018, FASB issued Accounting Standards Update No. 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (ASU 2018-02). The new standard amends ASC 220 to allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the “Tax Cuts and Jobs Act” and requires entities to provide certain disclosures regarding stranded tax effects. Adoption of ASU 2018-02 is required for fiscal reporting periods beginning after December 15, 2018, including interim reporting periods within those fiscal years with early adoption being permitted. The Company does not expect the adoption of ASU 2018-02 to have a material impact on its consolidated financial statements.

13



In August 2018, FASB issued Accounting Standards Update No. 2018-13, Fair Value Measurement (Topic 820): Disclosure Framework—Changes to the Disclosure Requirements for Fair Value Measurement (ASU 2018-13). The new standard makes various modifications to the disclosure requirements on fair value measurement in Topic 820. Adoption of ASU 2018-13 is required for fiscal reporting periods beginning after December 15, 2019, including interim reporting periods within those fiscal years with early adoption being permitted. The Company does not expect the adoption of ASU 2018-13 to have a material impact on its consolidated financial statements.
Note 3— Fair Value Measurement
Based on the observability of the inputs used in the valuation techniques used to determine the fair value of certain financial assets and liabilities, the Company is required to provide the following information according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values.
In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related assets or liabilities. Fair values determined by Level 3 inputs are unobservable data points for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. The following table presents information about the Company’s financial assets and liabilities that have been measured at fair value as of September 30, 2018, and indicates the level within the fair value hierarchy of the valuation inputs utilized to determine such fair value (in thousands):
Description
 
Fair Value
as of
September 30,
2018
 
Quoted
Prices in
Active
Markets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
Assets:
 
 
 
 
 
 
Cash, cash equivalents and restricted cash
 
$
184,181

 
$
184,181

 
$

Foreign currency exchange contracts (1)
 
2,876

 

 
2,876

Assets measured at fair value at September 30, 2018
 
$
187,057

 
$
184,181

 
$
2,876

Liabilities:
 
 
 
 
 
 
Foreign currency exchange contracts (2)
 
789

 

 
789

Liabilities measured at fair value at September 30, 2018
 
$
789

 
$

 
$
789

(1)
Included in “Prepaid expenses and other current assets” and “Other non-current assets” on the Company’s Condensed Consolidated Balance Sheets.
(2)
Included in “Other accrued liabilities” and “Other non-current liabilities” on the Company’s Condensed Consolidated Balance Sheets.
Foreign Currency Derivatives
The Company may enter into foreign currency derivatives to hedge future cash receipts on certain sales transactions that are payable in foreign currencies.
As of September 30, 2018 and December 31, 2017, the Company had outstanding foreign currency exchange contracts that were designated and accounted for as cash flow hedges of anticipated future cash receipts on sales contracts payable in foreign currencies. The outstanding notional amounts were approximately (in millions):
 
 
September 30,
2018
 
December 31, 2017
Canadian Dollars (CAD)
 
54.4

 
56.0

Singapore Dollars (SGD)
 
2.0

 

Euros (EUR)
 

 
2.1

Japanese Yen (JPY)
 

 
4,345.6

New Zealand Dollars (NZD)
 

 
16.2

The Company had hedged foreign currency exposure related to these designated cash flow hedges of approximately $43.1 million and $96.3 million as of September 30, 2018 and December 31, 2017, respectively.

14



As of September 30, 2018 and December 31, 2017, the Company had outstanding foreign currency exchange contracts that had been dedesignated for the purposes of hedge accounting treatment. The Company dedesignates cash flow hedges when the receivable related to the hedged cash flow is recorded. The outstanding notional amounts were approximately (in millions):
 
September 30,
2018
 
December 31, 2017
British Pounds (GBP)
20.2

 
26.1

Euros (EUR)
0.8

 
4.7

Swiss Francs (CHF)

 
2.6

Canadian Dollars (CAD)

 
0.3

The foreign currency exposure related to these contracts was approximately $30.7 million as of September 30, 2018 and $46.9 million as of December 31, 2017. Unrealized gains or losses related to these dedesignated contracts are recorded in other income (loss) in the Condensed Consolidated Statements of Operations and are generally offset by foreign currency adjustments on related receivables. These foreign currency exchange contracts are considered to be economic hedges.
Cash receipts associated with the foreign currency exchange contracts are expected to be received from 2018 through 2022, during which time the revenue on the associated sales contracts is expected to be recognized, or in the case of receivables denominated in a foreign currency, the receivables balances will be collected. Any gain or loss on hedged foreign currency will be recognized at the time of customer acceptance, or in the case of receivables denominated in a foreign currency, over the period during which hedged receivables denominated in a foreign currency are outstanding.
Fair values of derivative instruments designated as cash flow hedges (in thousands):
Balance Sheet Location
 
Fair Value
as of
September 30,
2018
 
Fair Value
as of
December 31,
2017
Prepaid expenses and other current assets
 
$

 
$
546

Other accrued liabilities
 
(672
)
 
(129
)
Other non-current liabilities
 
(117
)
 
(1,907
)
Total fair value of derivative instruments designated as cash flow hedges
 
$
(789
)
 
$
(1,490
)
Fair values of derivative instruments not designated as cash flow hedges (in thousands):
Balance Sheet Location
 
Fair Value
as of
September 30,
2018
 
Fair Value
as of
December 31,
2017
Prepaid expenses and other current assets
 
$
1,591

 
$
1,252

Other non-current assets
 
1,285

 
1,453

Other accrued liabilities
 

 
(395
)
Total fair value of derivative instruments not designated as cash flow hedges
 
$
2,876

 
$
2,310


Note 4— Accumulated Other Comprehensive Income
The following table shows the impact on product revenue of reclassification adjustments from accumulated other comprehensive income resulting from hedged foreign currency transactions recorded by the Company for the three and nine months ended September 30, 2018 and 2017 (in thousands). The reclassification adjustments increased product revenue for the three months ended September 30, 2018 and decreased product revenue for the nine months ended September 30, 2018 and the three and nine months ended September 30, 2017.
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
 
 
 
 
 
 
 
 
 
Gross of tax reclassifications
 
$
462

 
$
(93
)
 
$
(647
)
 
$
(157
)
Net of tax reclassifications
 
$
462

 
$
(56
)
 
$
(647
)
 
$
(94
)

15



The following tables show the changes in accumulated other comprehensive income by component for the three and nine months ended September 30, 2018 and 2017 (in thousands):
Three Months Ended September 30, 2018
 
 
Unrealized Gain on Investments
 
Foreign Currency Translation Adjustments
 
Unrealized Gain on Cash Flow Hedges
 
Accumulated Other Comprehensive Income
Beginning balance
 
$

 
$
452

 
$
1,494

 
$
1,946

Current-period change, net of tax
 

 
(126
)
 
(1,113
)
 
(1,239
)
Ending balance
 
$

 
$
326

 
$
381

 
$
707

 
 
 
 
 
 
 
 
 
Income tax expense (benefit) associated with current-period change
 
$

 
$

 
$

 
$

Three Months Ended September 30, 2017
 
 
Unrealized Gain (Loss) on Investments
 
Foreign Currency Translation Adjustments
 
Unrealized Loss on Cash Flow Hedges
 
Accumulated Other Comprehensive Income
Beginning balance
 
$
94

 
$
2,541

 
$
(455
)
 
$
2,180

Current-period change, net of tax
 
(98
)
 
(118
)
 
(948
)
 
(1,164
)
Ending balance
 
$
(4
)
 
$
2,423

 
$
(1,403
)
 
$
1,016

 
 
 
 
 
 
 
 
 
Income tax expense (benefit) associated with current-period change
 
$
(66
)
 
$
148

 
$
(632
)
 
$
(550
)
Nine Months Ended September 30, 2018
 
 
Unrealized Loss on Investments
 
Foreign Currency Translation Adjustments
 
Unrealized Gain (Loss) on Cash Flow Hedges
 
Accumulated Other Comprehensive Income
Beginning balance
 
$
(7
)
 
$
1,611

 
$
(689
)
 
$
915

Current-period change, net of tax
 
7

 
(1,285
)
 
1,070

 
(208
)
Ending balance
 
$

 
$
326

 
$
381

 
$
707

 
 
 
 
 
 
 
 
 
Income tax expense (benefit) associated with current-period change
 
$

 
$

 
$

 
$

Nine Months Ended September 30, 2017
 
 
Unrealized Loss on Investments
 
Foreign Currency Translation Adjustments
 
Unrealized Gain (Loss) on Cash Flow Hedges
 
Accumulated Other Comprehensive Income
Beginning balance
 
$

 
$
2,101

 
$
681

 
$
2,782

Current-period change, net of tax
 
(4
)
 
322

 
(2,084
)
 
(1,766
)
Ending balance
 
$
(4
)
 
$
2,423

 
$
(1,403
)
 
$
1,016

 
 
 
 
 
 
 
 
 
Income tax expense (benefit) associated with current-period change
 
$
(3
)
 
$
343

 
$
(1,389
)
 
$
(1,049
)
Note 5— Loss Per Share ("EPS")
Basic EPS is computed by dividing net loss available to common shareholders by the weighted average number of common shares, excluding unvested restricted stock, outstanding during the period. Diluted EPS is computed by dividing net loss available to common shareholders by the weighted average number of common and potential common shares outstanding during the period, which includes the additional dilution related to conversion of stock options, unvested restricted stock and unvested restricted stock units as computed under the treasury stock method.
For the three and nine months ended September 30, 2018 and 2017, outstanding stock options, unvested restricted stock and unvested restricted stock units were antidilutive because of the net losses and, as such, their effect has not been included in the

16



calculation of basic or diluted net loss per share. For the three and nine months ended September 30, 2018 and 2017, potential gross common shares of 3.2 million were antidilutive and not included in computing diluted EPS. An additional 0.5 million and 0.6 million performance vesting restricted stock and performance vesting restricted stock units were excluded from the computation of potential common shares for the three and nine months ended September 30, 2018 and 2017, respectively, because the conditions for vesting had not been met as of the balance sheet date.
Note 6— Investments
The Company’s investments in debt securities with maturities at purchase greater than three months are classified as “available-for-sale.” Changes in fair value are reflected in other comprehensive loss. The Company had no investments in available-for-sale securities as of September 30, 2018. The carrying amounts of the Company’s investments in available-for-sale securities as of December 31, 2017 are shown in the table below (in thousands):
 
 
 
 
 Unrealized Loss
 
 
 
 
 Cost
 
 
 Fair Value
Short-term available-for-sale securities
 
$
7,007

 
$
(10
)
 
$
6,997

Note 7— Accounts and Other Receivables, Net
Net accounts and other receivables consisted of the following (in thousands):
 
 
September 30,
2018
 
December 31, 2017
Trade accounts receivable
 
$
46,132

 
$
131,151

Current contract assets
 
3,801

 
9,321

Advance billings
 
5,208

 
3,569

Short-term investment in sales-type lease
 
12,642

 
10,684

Other receivables
 
7,203

 
7,337

 
 
74,986

 
162,062

Allowance for doubtful accounts
 
(25
)
 
(28
)
Accounts and other receivables, net
 
$
74,961

 
$
162,034

Contract assets represent amounts where the Company has recognized revenue in advance of the contractual billing terms. Advance billings represent billings made based on contractual terms for which revenue has not been recognized.
As of September 30, 2018 and December 31, 2017, accounts receivable included $24.6 million and $45.3 million, respectively, that resulted from sales to the U.S. government and system acquisitions primarily funded by the U.S. government (“U.S. Government”). Of these amounts, $1.1 million and $2.1 million were unbilled and included in contract assets as of September 30, 2018 and December 31, 2017, respectively, based upon contractual billing arrangements with these customers. As of September 30, 2018, one non-U.S. Government customer accounted for 17% of total accounts and other receivables. As of December 31, 2017, two non-U.S. Government customers accounted for 38% of total accounts and other receivables.
Note 8— Sales-type Lease
The Company has a sales-type lease with one non-U.S. Government customer, under which it will receive quarterly payments over the term of the lease, which expires in September 2020. The lease is denominated in British Pounds and the Company has entered into certain foreign currency exchange contracts that act as an economic hedge for the foreign currency exposure associated with this arrangement.

17



The following table shows the components of the net investment in the sales-type lease as of September 30, 2018 and December 31, 2017 (in thousands):
 
 
September 30,
2018
 
December 31, 2017
Total minimum lease payments to be received
 
$
29,849

 
$
42,268

Less: executory costs
 
(3,487
)
 
(6,831
)
Net minimum lease payments receivable
 
26,362

 
35,437

Less: unearned income
 
(696
)
 
(1,386
)
Net investment in sales-type lease
 
25,666

 
34,051

Less: long-term investment in sales-type lease
 
(13,024
)
 
(23,367
)
Investment in sales-type lease included in accounts and other receivables
 
$
12,642

 
$
10,684

As of September 30, 2018, minimum lease payments for each of the succeeding three fiscal years are as follows (in thousands):
2018 (less than 1 year)
 
$
3,733

2019
 
14,932

2020
 
11,184

Total minimum lease payments to be received
 
$
29,849

Note 9— Inventory
Inventory consisted of the following (in thousands):
 
 
September 30,
2018
 
December 31, 2017
Components and subassemblies
 
$
47,384

 
$
37,219

Work in process
 
47,908

 
59,456

Finished goods
 
46,269

 
89,632

Total
 
$
141,561

 
$
186,307

Finished goods inventory of $45.7 million and $48.1 million was located at customer sites pending acceptance as of September 30, 2018 and December 31, 2017, respectively. At September 30, 2018, one customer accounted for $38.3 million of finished goods inventory, and at December 31, 2017, two customers accounted for $67.7 million of finished goods inventory.
The Company wrote off $0.3 million of excess and obsolete inventory during the three and nine months ended September 30, 2018. The Company did not write off any inventory during the three and nine months ended September 30, 2017.
Note 10— Customer Contract Liabilities
Liabilities from contracts with customers consisted of the following (in thousands):
 
 
September 30,
2018
 
December 31, 2017
Contract liability - product
 
$
9,315

 
$
22,245

Contract liability - service
 
79,636

 
96,496

Total contract liabilities
 
88,951

 
118,741

Less: long-term contract liabilities
 
(31,661
)
 
(38,622
)
Current contract liabilities
 
$
57,290

 
$
80,119

As of September 30, 2018 and December 31, 2017, the U.S. Government accounted for $30.1 million and $32.5 million, respectively, of total customer contract liabilities. As of September 30, 2018, one non-U.S. Government customer accounted for 10% of total customer contract liabilities. As of December 31, 2017, no non-U.S. Government customers accounted for more than 10% of total customer contract liabilities.
Note 11— Contingencies
The Company is subject to patent lawsuits brought by Raytheon Company, or Raytheon. The first suit was brought by Raytheon on September 25, 2015 in the Eastern District of Texas (Civil Action No. 2:15-cv-1554) asserting infringement of four

18



patents owned by Raytheon. Two of the originally asserted patents relate to computer hardware alleged to be encompassed by Cray’s current and past products (the “Hardware Patents”), and the two remaining asserted patents relate to features alleged to be performed by certain third-party software that Cray optionally includes as part of its product offerings (the “Software Patents”).  A second suit was brought by Raytheon on April 22, 2016 in the Eastern District of Texas (Civil Action No. 2:16-cv-423) asserting infringement of five patents owned by Raytheon. In this second suit, all five asserted patents relate to features alleged to be performed by certain third-party software that Cray optionally includes as part of its product offerings. On September 21, 2017, the United States Court of Appeals for the Federal Circuit granted Cray’s petition for writ of mandamus and overturned the trial court’s determination that venue in the first action was proper in the Eastern District of Texas, and accordingly on April 5, 2018, the trial court ordered that the first action should be transferred to the Western District of Wisconsin as had been requested by Cray, which was effective on April 30, 2018 (Civil Action No. 3:18-cv-00318-wmc). After transfer, Raytheon indicated its desire to withdraw its claims for infringement of the Hardware Patents. Accordingly, the Wisconsin court, upon joint motion of the parties, has dismissed with prejudice the counts related to the Hardware Patents, and Raytheon has served on the Company and filed with the court covenants not to sue for infringement of the Hardware Patents. The Wisconsin court has also scheduled summary judgment proceedings on the remaining two counts, relating to the Software Patents, and trial has been set for June 3, 2019. The Texas court, upon joint motion of the parties, has also transferred the second action to the Northern District of California (Civil Action No. 3:18-cv-03388-RS). Per joint motion of the parties, the California court has stayed the second action pending resolution of the first action. The Company is vigorously defending these actions. The probable outcome of either litigation cannot be determined, nor can the Company estimate a range of potential loss. Based on its review of the matters to date, the Company believes that it has valid defenses and claims in each of the two lawsuits.  As a result, the Company considers the likelihood of a material loss related to these matters to be remote.
Note 12— Share-Based Compensation
The Company accounts for its share-based compensation based on an estimate of fair value of the grant on the date of grant.
In determining the fair value of stock options, the Company uses the Black-Scholes option pricing model. The following key weighted average assumptions were employed in the calculation for the three month period ended September 30, 2018 and the nine month periods ended September 30, 2018 and September 30, 2017. There were no option grants during the three month period ended September 30, 2017:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
 
2018
 
2017
Risk-free interest rate
 
2.68%
 
 
2.84%
 
1.61%
Expected dividend yield
 
—%
 
 
—%
 
—%
Volatility
 
48.67%
 
 
48.92%
 
54.20%
Expected life
 
4.0 years
 
 
4.0 years
 
4.0 years
Weighted average Black-Scholes value of options granted
 
$10.31
 
 
$11.12
 
$7.75
The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The Company does not anticipate declaring dividends in the foreseeable future. Volatility is based on historical data. The expected life of an option is based on the assumption that options will be exercised, on average, about two years after vesting occurs. The Company recognizes compensation expense for only the portion of options that are expected to vest. Therefore, management applies an estimated forfeiture rate that is derived from historical employee termination data and adjusted for expected future employee turnover rates. The estimated forfeiture rate applied to the Company’s stock option grants during the three and nine months ended September 30, 2018 and 2017 was 8.0%. If the actual number of forfeitures differs from those estimated by management, additional adjustments to compensation expense may be required in future periods. The Company’s stock price volatility, option lives and expected forfeiture rates involve management’s best estimates at the time of such determination, which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the vesting period or requisite service period of the option. The Company typically issues stock options with a four year vesting period (the requisite service period) and amortizes the fair value of stock options (stock compensation cost) ratably over the requisite service period.

19



A summary of the Company’s year-to-date stock option activity and related information follows:
 
 
Options
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual
Term
Outstanding at December 31, 2017
 
2,034,474

 
$
17.26

 
 
Grants
 
170,053

 
$
27.09

 
 
Exercises
 
(194,954
)
 
$
9.24

 
 
Canceled and forfeited
 
(69,952
)
 
$
26.76

 
 
Outstanding at September 30, 2018
 
1,939,621

 
$
18.58

 
5.4
Exercisable at September 30, 2018
 
1,467,362

 
$
16.79

 
4.4
Available for grant at September 30, 2018
 
2,329,513

 
 
 
 
As of September 30, 2018, there was $11.2 million of aggregate intrinsic value of outstanding stock options, including $10.5 million of aggregate intrinsic value of exercisable stock options. Intrinsic value represents the total pretax intrinsic value for all “in-the-money” options (i.e., the difference between the Company’s closing stock price on the last trading day of its third quarter of 2018 and the exercise price, multiplied by the number of shares of common stock underlying the stock options) that would have been received by the option holders had all option holders exercised their options on September 30, 2018. During the three and nine months ended September 30, 2018, stock options covering 2,140 and 194,954 shares of common stock, respectively, with a total intrinsic value of $37 thousand and $2.7 million, respectively, were exercised. During the three and nine months ended September 30, 2017, stock options covering 67,234 and 80,757 shares of common stock, respectively, with a total intrinsic value of $0.7 million and $0.9 million, respectively, were exercised.
The fair value of unvested restricted stock and unvested restricted stock units is based on the market price of a share of the Company’s common stock on the date of grant and is amortized over the vesting period.
A summary of the Company’s unvested restricted stock grants and changes during the nine months ended September 30, 2018 is as follows:
 
 
Service Vesting Restricted Shares
 
 
Shares
 
Weighted
Average
Grant Date
Fair Value
Outstanding at December 31, 2017
 
112,325

 
$
24.09

Granted
 
28,469

 
$
27.10

Forfeited
 
(680
)
 
$
26.26

Vested
 
(105,595
)
 
$
23.58

Outstanding at September 30, 2018
 
34,519

 
$
27.68

The estimated forfeiture rate applied to the Company’s restricted stock grants during the three and nine months ended September 30, 2018 and 2017, was 8.0%. The aggregate fair value of restricted stock vested during the three and nine months ended September 30, 2018, was $0.5 million and $2.5 million, respectively. The aggregate fair value of restricted stock vested during the three and nine months ended September 30, 2017, was $0.5 million and $2.8 million, respectively.

20



A summary of the Company’s unvested restricted stock unit grants and changes during the nine months ended September 30, 2018 is as follows:
 
 
Service Vesting Restricted Stock Units
 
Performance Vesting Restricted Stock Units
 
Total Restricted Stock Units
 
 
Units
 
Weighted
Average
Grant Date
Fair Value
 
Units
 
Weighted
Average
Grant Date
Fair Value
 
Units
 
Weighted Average Grant Date Fair Value
Outstanding at December 31, 2017
 
988,023

 
$
21.29

 
482,485

 
$
30.13

 
1,470,508

 
$
24.19

Granted
 
499,681

 
$
26.00

 

 
$

 
499,681

 
$
26.00

Forfeited
 
(57,412
)
 
$
21.44

 

 
$

 
(57,412
)
 
$
21.44

Vested
 
(252,813
)
 
$
22.57

 

 
$

 
(252,813
)
 
$
22.57

Outstanding at September 30, 2018
 
1,177,479

 
$
23.00

 
482,485

 
$
30.13

 
1,659,964

 
$
25.07

The estimated forfeiture rate applied to the Company’s service vesting restricted stock unit grants during the three and nine months ended September 30, 2018 and 2017, was 8.0%. The aggregate fair value of restricted stock units vested during the three and nine months ended September 30, 2018, was $0.6 million and $5.7 million, respectively. The aggregate fair value of restricted stock units vested during the three and nine months ended September 30, 2017, was $0.6 million and $2.2 million, respectively. Restricted stock units are not outstanding shares and do not have any voting or dividend rights. At the time of vesting, a share of common stock representing each restricted stock unit vested will be issued by the Company. The performance vesting restricted stock units are subject to performance measures that are currently not considered “probable” of attainment and as such, no compensation cost has been recorded for these units. The performance measures are based on Company performance for fiscal years 2018 and 2019.
Including performance-based equity awards, the Company had $37.6 million of total unrecognized compensation cost related to unvested stock options, unvested restricted stock and unvested restricted stock units as of September 30, 2018. Excluding the $14.5 million of unrecognized compensation cost related to unvested restricted stock units that are subject to performance measures that are currently not considered “probable” of attainment, unrecognized compensation cost is $23.1 million. No compensation expense is recognized for unvested restricted stock units subject to performance measures that are not considered “probable” of attainment. Unrecognized compensation cost related to unvested stock options and unvested non-performance-based restricted stock is expected to be recognized over a weighted average period of 3.0 years.
The following table sets forth the gross share-based compensation cost resulting from stock options, unvested restricted stock and unvested restricted stock units that were recorded in the Company’s Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2018 and 2017 (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Cost of product revenue
 
$
88

 
$
73

 
$
304

 
$
189

Cost of service revenue
 
112

 
59

 
312

 
194

Research and development, net
 
1,139

 
798

 
3,100

 
2,596

Sales and marketing
 
937

 
650

 
2,415

 
1,850

General and administrative
 
1,238

 
1,005

 
3,517

 
2,814

Total
 
$
3,514

 
$
2,585

 
$
9,648

 
$
7,643

Note 13— Taxes
The Company’s effective tax rates for the three and nine months ended September 30, 2018 and 2017 were as follows:
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Effective tax rates
 
(1)%
 
39%
 
(1)%
 
37%
The difference between the expected statutory tax rate of 21% and the actual tax rate of (1)% for the three and nine months ended September 30, 2018 was attributable to the Company’s decision to continue to provide a full valuation allowance against the Company’s U.S. federal deferred tax assets offset, in part, by foreign taxes. The primary reason for the difference between the

21



expected statutory tax rate of 35% and the actual tax rates of 39% and 37% for the three and nine months ended September 30, 2017, respectively, was the Company’s research and development tax credit and other permanent items. One of the permanent items for the three and nine months ended September 30, 2017 was the $4.4 million gain from the strategic transaction which was not taxable under Federal income tax law.
On December 22, 2017, the President of the United States signed into law H.R. 1, “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” (the “Tax Cuts and Jobs Act”). ASC Topic 740, Accounting for Income Taxes, requires companies to recognize the effect of tax law changes in the period of enactment. The Tax Cuts and Jobs Act made significant changes to existing U.S. tax law, including, but not limited to, a permanent reduction to the U.S. federal corporate income tax rate from 35% to 21% and the imposition of a one-time tax on deferred foreign income (“Repatriation Transition Tax”). Given the significance of the Tax Cuts and Jobs Act, the FASB issued Accounting Standards Update No. 2018-05, Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 that recognized that a company’s review of the income tax effects attributable to the enactment of the Tax Cuts and Jobs Act may be incomplete at the time financial statements were issued for the reporting period that included the date of enactment and allowed a company to record provisional amounts during a one year measurement period. During the measurement period, income tax effects attributable to the enactment of the Tax Cuts and Jobs Act can be adjusted and recognized, as a discreet item in the applicable reporting period, as information becomes available, prepared or analyzed. The measurement period is deemed to have ended when the company has obtained, prepared and analyzed the information necessary to finalize its accounting. During the year ended December 31, 2017 the Company recorded provisional tax expense, in the amount of $0.3 million, attributable to the Repatriation Transition Tax and provisional tax expense, in the amount of $0.3 million, as a result of the Company’s decision to no longer consider the undistributed earnings of its foreign subsidiaries to be permanently reinvested outside of the U.S. During the third quarter of 2018, the Company finalized its accounting with respect to the items for which provisional tax expense was recorded. No significant adjustments were made to the provisional amounts recorded by the Company.
As of September 30, 2018, the Company continued to provide a full valuation allowance against its U.S. federal deferred tax assets and against the majority of its deferred tax assets arising in state and foreign jurisdictions as the realization of such assets is not considered to be more likely than not at this time. In a future period, the Company’s assessment of the realizability of its deferred tax assets and therefore the appropriateness of the valuation allowance could change based on an assessment of all available evidence, both positive and negative in that future period. If the Company’s conclusion about the realizability of its deferred tax assets and therefore the appropriateness of the valuation allowance changes in a future period, the Company could record a substantial tax benefit in its Condensed Consolidated Statements of Operations when that occurs.
Note 14— Segment Information
The Company has the following reportable segments: Supercomputing, Storage and Data Management, Maintenance and Support, and Engineering Services and Other. The Company’s reportable segments represent components of the Company for which separate financial information is available that is utilized on a regular basis by the Chief Executive Officer, who is the Chief Operating Decision Maker, in determining how to allocate the Company’s resources and evaluate performance. The segments are determined based on several factors, including the Company’s internal operating structure, the manner in which the Company’s operations are managed, client base, similar economic characteristics and the availability of separate financial information.
Supercomputing
Supercomputing includes a suite of highly advanced, tightly integrated and cluster supercomputer systems which are used by large research and engineering centers in universities, government laboratories, and commercial institutions. Supercomputing also includes the ongoing maintenance of these systems as well as system analysts.
Storage and Data Management
Storage and Data Management offers Cray DataWarp and ClusterStor (formerly branded Sonexion), as well as other third-party storage products and their ongoing maintenance as well as system analysts.
Maintenance and Support
Maintenance and Support provides ongoing maintenance of Cray supercomputers, big data storage and analytics systems, as well as system analysts.
Engineering Services and Other
Included within Engineering Services and Other are the Company’s analytics and artificial intelligence businesses and Custom Engineering.


22



The following table presents revenues and gross margins for the Company’s operating segments for the three and nine months ended September 30, 2018 and 2017 (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Revenue:
 
 
 
 
 
 
 
 
Supercomputing
 
$
72,615

 
$
47,918

 
$
230,252

 
$
142,933

Storage and Data Management
 
12,263

 
11,046

 
45,977

 
42,335

Maintenance and Support
 
33,349

 
31,701

 
100,477

 
92,483

Engineering Services and Other
 
7,918

 
20,736

 
16,364

 
40,598

Elimination of inter-segment revenue
 
(33,349
)
 
(31,701
)
 
(100,477
)
 
(92,483
)
Total revenue
 
$
92,796

 
$
79,700

 
$
292,593

 
$
225,866

 
 
 
 
 
 
 
 
 
Gross Profit:
 
 
 
 
 
 
 
 
Supercomputing
 
$
18,163

 
$
18,807

 
$
65,335

 
$
50,630

Storage and Data Management
 
5,192

 
3,345

 
17,541

 
15,564

Maintenance and Support
 
15,024

 
16,501

 
47,970

 
45,078

Engineering Services and Other
 
1,456

 
6,340

 
6,694

 
14,450

Elimination of inter-segment gross profit
 
(15,024
)
 
(16,501
)
 
(47,970
)
 
(45,078
)
Total gross profit
 
$
24,811

 
$
28,492

 
$
89,570

 
$
80,644

Revenue and cost of revenue is the only discrete financial information the Company prepares for its segments. Other financial results or assets are not separated by segment.
The Company’s geographic operations outside the United States include sales and service offices in Europe and the Middle East, South America, Asia Pacific and Canada. Service revenue includes engineering services which can vary significantly from period to period. The following data represents the Company’s revenue for the United States and all other countries, which is determined based upon a customer’s geographic location (in thousands):
 
 
United States
 
Other Countries
 
Total
 
 
2018
 
2017
 
2018
 
2017
 
2018
 
2017
Three months ended September 30,
 
 
 
 
 
 
 
 
 
 
 
 
Product revenue
 
$
35,968

 
$
38,007

 
$
22,022

 
$
7,273

 
$
57,990

 
$
45,280

Service revenue
 
20,936

 
23,298

 
13,870

 
11,122

 
34,806

 
34,420

Total revenue
 
$
56,904

 
$
61,305

 
$
35,892

 
$
18,395

 
$
92,796

 
$
79,700

 
 
United States
 
Other Countries
 
Total
 
 
2018
 
2017
 
2018
 
2017
 
2018
 
2017
Nine months ended September 30,
 
 
 
 
 
 
 
 
 
 
 
 
Product revenue
 
$
74,140

 
$
90,148

 
$
111,683

 
$
27,791

 
$
185,823

 
$
117,939

Service revenue
 
65,166

 
74,500

 
41,604

 
33,427

 
106,770

 
107,927

Total revenue
 
$
139,306

 
$
164,648

 
$
153,287

 
$
61,218

 
$
292,593

 
$
225,866

Sales to the U.S. Government totaled approximately $38.5 million and $99.9 million for the three and nine months ended September 30, 2018, respectively, compared to approximately $53.7 million and $145.3 million for the three and nine months ended September 30, 2017, respectively. For the nine months ended September 30, 2018, one non-U.S. Government customer in Japan accounted for 12% of total revenue. For the nine months ended September 30, 2018, total revenue in Japan accounted for 21% of total revenue. For the nine months ended September 30, 2017, no non-U.S. Government or international customer accounted for more than 10% of total revenue.

23



Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Preliminary Note Regarding Forward-Looking Statements
This quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or if they prove incorrect, could cause our actual results to differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to them. In some cases you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “continue,” “estimates,” “projects,” “predicts” and “potential” and similar expressions, but the absence of these words does not mean that a statement is not forward-looking. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, and examples of forward-looking statements include any projections of earnings, revenue or other results of operations or financial results; any statements of the plans, strategies, objectives and beliefs of our management; any statements concerning proposed new products, technologies or services such as our next generation “Shasta” system; any statements regarding potential new markets or applications for our products or our ability to sell into any market or to any customer; any statements regarding technological developments or trends; any statements regarding future research and development or co-funding for such efforts; any statements regarding future market and economic conditions; any statements regarding the expected vesting of our performance-based equity awards; and any statements of assumptions underlying any of the foregoing. These forward-looking statements are subject to the safe harbor created by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Item 1A. Risk Factors in Part II and other sections of this report and our other filings with the U.S. Securities and Exchange Commission, or SEC. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this report. You should read this report completely and with the understanding that our actual future results may be materially different from what we expect. We assume no obligation to update these forward-looking statements, whether as a result of new information, future events, or otherwise, except as otherwise required by law.
Overview
We focus on designing, developing, manufacturing, marketing and servicing computing products that magnify and enhance human capital, foster innovation and create competitive advantages. That means our products are aimed primarily at the upper-end of the high performance computing (HPC), data analytics and artificial intelligence (AI) markets - the segments populated by the pioneers, executives and entrepreneurs leading their industries in both the private and public sectors. These products include compute systems commonly known as supercomputers, and storage, data analytics and AI solutions. We offer them individually, integrated into a complete solution or hosted in the cloud, depending on a customer’s need. We also provide related software and system maintenance, support, and engineering services. Our customers include domestic and foreign government and government-funded entities, academic institutions and commercial companies. We currently provide customer-focused solutions based on four main models: (1) tightly integrated supercomputing designed throughout for scalability and sustained performance; (2) customizable cluster supercomputing based on highest-performance industry-standard components; (3) robust high-performance storage solutions; and (4) integrated solutions for large-scale analytics and AI applications. All of our solutions also emphasize total cost of ownership, scalable performance and data center flexibility as key features. Our continuing strategy is to gain market share by extending our technology leadership and differentiation and expanding our share and addressable market in areas where we can leverage our experience and technology, such as in AI applications and data analytics. We also meet diverse customer requirements by combining supercomputing, cluster supercomputing, and data analytics and AI into unique offerings that work in a workflow-driven datacenter environment.
Summary of First Nine Months of 2018 Results
Total revenue increased by $66.7 million for the first nine months of 2018 compared to the first nine months of 2017, from $225.9 million to $292.6 million, due to higher product revenue. Product revenue was $67.9 million higher in the first nine months of 2018 compared to the first nine months of 2017, driven by improvement in the market in which we operate during the first nine months of 2018.
Net loss for the first nine months of 2018 was $58.4 million compared to net loss of $36.3 million for the same period in 2017. The increase in net loss was primarily driven by a decrease of $21.6 million in income tax benefit for the first nine months of 2018 compared to the first nine months of 2017.
Net cash provided by operating activities was $40.4 million for the first nine months of 2018 compared to net cash used in operating activities of $38.7 million for the first nine months of 2017. Net cash provided by operating activities for the first nine months of 2018 was primarily driven by collections from customers that resulted in a decrease of $84.6 million in accounts and other receivables, and a decrease of $38.1 million in inventory due to customer acceptances of systems that were delivered during the first nine months of 2018. These amounts were largely offset by the net loss, adjusted for non-cash expenses, of $36.9 million,

24



a decrease in our accounts payable balance of $28.0 million due to the timing of payments to vendors, largely in connection with inventory purchases in the fourth quarter of 2017, and a decrease in customer contract liabilities of $29.3 million.
Market Overview and Challenges
Significant trends in the HPC industry include:
convergence of traditional supercomputing modeling simulation with big data analytics and AI;
supercomputing with many-core commodity processors driving increasing scalability requirements;
increased micro-architectural diversity, including increased usage of many-core processors and accelerators (such as graphics processors or GPU’s), as the rate of increases in per-core performance slows;
data I/O and storage capacity needs growing as fast as computational needs;
the rise of AI along with machine learning and deep learning algorithms that utilize HPC technologies for performance and scale;
technology innovations in memory and storage allowing for faster data access such as high bandwidth memory, non-volatile memory and storage, solid state and flash devices;
the increasing commoditization of HPC hardware, particularly processors and system interconnects;
the growing concentration of very large suppliers of key computing, memory and storage components in the industry;
the growing commoditization of software, including more capable open source software;
electrical power and system cooling requirements becoming a design constraint and driver in total cost of ownership determinations;
increasing use of AI and analytics technologies in both the HPC and big data markets;
increased adoption of cloud computing as a solution for loosely-coupled HPC applications;
much higher memory costs during the past year; and
significant variability in market demand for high-end supercomputers from quarter-to-quarter and year-to-year.
Several of these trends have recently impacted the growth rate and related improvements in price-performance of products in the industry and has contributed to the expansion and acceptance of loosely-coupled cluster systems using processors manufactured by Intel, AMD and others combined with commercially available, commodity networking and other components, particularly in the middle and lower portions of the supercomputing market. These systems may offer higher theoretical peak performance for equivalent cost, and “price/peak performance” is sometimes the dominant factor in HPC procurements. Vendors of such systems often put pricing pressure on us, resulting in lower margins in competitive procurements.
In the market for the largest, and most scalable systems, those often costing in excess of $10 million, the use of generally available network components can result in increasing data transfer bottlenecks as these components do not balance processor power with network communication and system software capability. With increasing processor core counts due to new many-core processors, these unbalanced systems will typically have lower productivity, especially in larger systems running more complex applications. We and others augment standard microprocessors with other processor types, such as graphics processing units, in order to increase computational power, further complicating programming models. In addition, with increasing scale, bandwidth and processor core counts, large computer systems use progressively higher amounts of power to operate and require special cooling capabilities.
To position ourselves to meet the market’s demanding needs, we concentrate our research and development efforts on technologies that enable our supercomputers to perform at scale - that is, to continue to increase actual performance as systems and applications grow ever larger in size - and in areas where we can leverage our core expertise in other markets whose applications demand these tightly coupled architectures. We also invest relatively significantly in next-generation technology to successfully and uniquely address the challenges of “Exascale computing” (systems with exaflops-levels of performance, one to two orders of magnitude faster than current supercomputers). In addition, we have industry leadership in developing an integrated supercomputing software stack with demonstrated expertise in system and performance software for several processor architectures. We expect to be in a comparatively advantageous position as larger many-core processors become available and as multiple processing technologies become integrated into single systems in heterogeneous environments. In addition, we have continued to expand our

25



addressable market by leveraging our technologies, customer base, the Cray brand and by introducing complementary products and services to new and existing customers, as demonstrated by our emphasis on strategic initiatives, such as big data analytics, AI and storage.
In analytics and AI, we are developing and delivering high performance data discovery, advanced analytics, machine learning and deep learning solutions. These solutions use both Cray developed and open source software, delivering faster time-to-solution and advanced capabilities that are key drivers for many of our data analytics and AI customers. We support open source technologies such as Hadoop, Spark and Jupyter Notebook to design large-scale data analytics stacks that simplify analyses of scientific and commercial application and Python and R, distributed Dask, BigDL, TensorFlow and TensorBoard for advanced AI solutions, as well as many others.
In storage, we are developing and delivering high value products for the high performance parallel storage market. Our 2017 transaction with Seagate enhances our capabilities in storage and data management. Our storage products are primarily positioned to enable tight integration of storage with computing solutions and/or utilize parallel file processing technologies and facilitate storage across multiple data tiers. We support open source parallel file systems and protocols such as Lustre.
We have also expanded our addressable market by providing cluster systems and solutions to the supercomputing market that allow us to offer flexible platforms to incorporate best of breed components to allow customers to optimize the system to fit their unique requirements.
Key Performance Indicators
Our management monitors and analyzes several key performance indicators in order to manage our business and evaluate our financial and operating performance, including:
Revenue.    Product revenue generally constitutes the major portion of our revenue in any reporting period and, for the reasons discussed in this quarterly report on Form 10-Q or in our annual report on Form 10-K for the year ended December 31, 2017, is subject to significant variability from period to period and is very difficult to forecast. In the short term, we closely review the status of customer proposals, customer contracts, product shipments, installations and acceptances in order to forecast revenue and cash receipts. In the longer-term, we monitor the status of the pipeline of product sales opportunities and product development cycles. We believe product revenue growth measured over several quarters is a better indicator of whether we are achieving our objective of growth and increased market share in the supercomputing market. The Cray XC and Cray CS products, along with our longer-term product roadmap are efforts to increase product revenue. We have increased our business and product development efforts in big data analytics, AI and storage and data management. Service revenue related to our maintenance offerings is subject to less variations in the short term and may assist, in part, to offset the impact that the variability in product revenue has on total revenue.
Gross profit margin.    Gross profit margin is impacted by the level of revenue, different customer requirements, competitive considerations, product type and our anticipated and actual cost to build and deliver our products and services. Our services tend to carry higher gross profit margins than our products. We often bid contracts and commit to future system performance where certain key components are not available in the market at the time of bid and/or whose price might change from what was expected. While we have significant experience doing so, such actions are inherently risky and can impact our gross profit margin significantly in any period. For example, memory prices have more than doubled in less than a year which has had a significant impact on our reported product gross profit margin. Our costs are also currently being impacted by tariffs on certain parts we buy from suppliers. To mitigate this and other similar risks, we monitor the cost of components, manufacturing, and installation of our products. In assessing our service gross profit margin, we monitor headcount levels and third-party costs.
Operating expenses.    Our operating expenses are driven primarily by headcount and compensation expense, including variable incentive compensation and contracted third-party research and development services. As part of our ongoing expense management efforts, we continue to monitor headcount levels in specific geographic and operational areas. With the recent reduction in revenue levels, we reduced the size of our workforce in 2017. However, the 2017 transaction with Seagate has partially offset this reduction but should help increase revenue and improve storage gross profit.
Liquidity and cash flows.   Due to the variability in product revenue, new contracts, acceptance and payment terms, our cash position also varies significantly from quarter-to-quarter and within a quarter. We monitor our expected cash levels, particularly in light of increased inventory purchases for large system installations and the risk of delays in product shipments, customer acceptances and, in the long-term, product development. Cash receipts generally lag customer acceptances.

26



Results of Operations
We adopted Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers : Topic 606 (ASU 2014-09) at the beginning of the first quarter of 2018. Adoption of ASU 2014-09 did not have a material impact on our results of operations or the comparability of the current and prior periods presented below.
Our revenue, results of operations and cash balances fluctuate significantly from period-to-period. These fluctuations are due to such factors as the strength or weakness of the HPC market, high average sales prices and limited number of sales of our products with variable gross margin levels, the timing of purchase orders and product deliveries, the availability of components, the revenue recognition accounting policy of generally not recognizing product revenue until customer acceptance and other contractual provisions have been fulfilled, the timing of payments for product sales, maintenance services, government research and development funding, the impact of the timing of new products on customer orders, and purchases of inventory during periods of inventory build-up. As a result of these factors, revenue, gross margin, expenses, cash, receivables, inventory and other related financial statement items have in the past varied, and are expected to continue to vary, significantly from quarter-to-quarter and year-to-year.
Revenue and Gross Profit Margins
Our revenue, cost of revenue and gross profit margin for the three and nine months ended September 30, 2018 and 2017, respectively, were (in thousands, except for percentages):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Product revenue
 
$
57,990

 
$
45,280

 
$
185,823

 
$
117,939

Less: Cost of product revenue
 
49,053

 
35,090

 
148,372

 
89,356

Product gross profit
 
$
8,937

 
$
10,190

 
$
37,451

 
$
28,583

Product gross profit margin
 
15
%
 
23
%
 
20
%
 
24
%
Service revenue
 
$
34,806

 
$
34,420

 
$
106,770

 
$
107,927

Less: Cost of service revenue
 
18,932

 
16,118

 
54,651

 
55,866

Service gross profit
 
$
15,874

 
$
18,302

 
$
52,119

 
$
52,061

Service gross profit margin
 
46
%
 
53
%
 
49
%
 
48
%
Total revenue
 
$
92,796

 
$
79,700

 
$
292,593

 
$
225,866

Less: Total cost of revenue
 
67,985

 
51,208

 
203,023

 
145,222

Total gross profit
 
$
24,811

 
$
28,492

 
$
89,570

 
$
80,644

Total gross profit margin
 
27
%
 
36
%
 
31
%
 
36
%
Product Revenue
Product revenue for the three and nine months ended September 30, 2018 and 2017 was primarily from sales of our Cray XC and Cray CS supercomputing systems, and ClusterStor storage systems. Product revenue was $12.7 million higher for the three months ended September 30, 2018, compared to the three months ended September 30, 2017 and $67.9 million higher for the nine months ended September 30, 2018, compared to the nine months ended September 30, 2017, driven by an improvement in the market in which we operate during the first nine months of 2018.
Service Revenue
Service revenue was $0.4 million higher for the three months ended September 30, 2018, compared to the three months ended September 30, 2017 and $1.2 million lower for the nine months ended September 30, 2018, compared to the nine months ended September 30, 2017. Our maintenance revenue increased by $1.6 million and $8.0 million, respectively, over the prior year periods, driven by our larger installed system base, including the benefit from longer lifetimes of installed systems due to the slowdown in acquisitions of new replacement systems. Over the same periods, engineering services revenue, which varies significantly from period to period, decreased by $1.3 million and $9.2 million, respectively, driven by the completion of several engineering services contracts that we recognized revenue on during the first nine months of 2017.
Cost of Product Revenue and Product Gross Profit
Cost of product revenue increased by $14.0 million for the three months ended September 30, 2018 compared to the three months ended September 30, 2017, and increased by $59.0 million for the nine months ended September 30, 2018 compared to the nine months ended September 30, 2017, due mainly to higher product revenue. For the three months ended September 30,

27



2018, product gross profit margin decreased 8 percentage points to 15% from 23% in the same period in 2017. For the nine months ended September 30, 2018, product gross profit margin decreased 4 percentage points to 20% from 24% in the same period in 2017. Product gross profit margins for the three and nine months ended September 30, 2018 and 2017 were below our target margins. In the third quarter of 2017, it was determined that a large contract with product deliveries scheduled in the first and second quarters of 2018 would be performed at a loss of $4.1 million. The loss was attributable in part to higher component costs, predominantly for memory, changes in the configuration of the system from the time of bid, and changes in the exchange rate. We recorded the full amount of the loss in the third quarter of 2017 and no material gross profit on the accepted systems and related services in the first and second quarters of 2018, which negatively impacted gross profit margins for those periods. The decrease in gross profit margins for the three and nine months ended September 30, 3018, compared to the same periods in 2017, also resulted from a higher mix of cluster sales, which typically carry a lower margin, including one relatively large lower margin cluster sale to a U.S. Government customer in the third quarter of 2018. Product gross profit margin in any one period may not be indicative of future results as product gross profit margin can vary significantly between contracts for many reasons.
Cost of Service Revenue and Service Gross Profit
For the three months ended September 30, 2018, cost of service revenue increased by $2.8 million compared to the same period in 2017, primarily due to higher compensation, including incentive compensation, and increased charges for spares. For the nine months ended September 30, 2018, cost of service revenue was largely in line with the same period in 2017. Service gross profit margin for the three months ended September 30, 2018 decreased 7 percentage points to 46% compared to 53% in the same period in 2017, primarily due to higher compensation, including incentive compensation, and increased charges for spares. Service gross profit margin for the nine months ended September 30, 2018 increased 1 percentage point to 49% compared to 48% in the same period in 2017.
Research and Development Expenses
Research and development expenses for the three and nine months ended September 30, 2018 and 2017, respectively, were (in thousands, except for percentages):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Gross research and development expenses
 
$
39,346

 
$
32,836

 
$
113,626

 
$
104,637

Less: Amounts included in cost of revenue
 
(615
)
 
(927
)
 
(2,170
)
 
(8,486
)
Less: Reimbursed research and development (excludes amounts in cost of revenue)
 
(12,569
)
 
(5,283
)
 
(26,020
)
 
(19,560
)
Net research and development expenses
 
$
26,162

 
$
26,626

 
$
85,436

 
$
76,591

Percentage of total revenue
 
28
%
 
33
%
 
29
%
 
34
%
Gross research and development expenses in the table above reflect all research and development expenditures. Research and development expenses include personnel expenses, depreciation, allocations for certain overhead expenses, software, prototype materials and third party contract engineering expenses.
For the three and nine months ended September 30, 2018, gross research and development expenses increased by $6.5 million and $9.0 million, respectively, over the prior year comparative periods, driven by higher compensation and third party costs. For the three and nine months ended September 30, 2018, compensation, including incentive and share-based compensation costs increased by $3.6 million and $6.9 million, respectively, over the prior year comparative period due to increased average headcount and higher compensation costs. For the three and nine months ended September 30, 2018, third party costs increased by $2.2 million and $1.8 million, respectively, over the prior year comparative periods, driven primarily by expenditures under co-funding arrangements for which we will be partially reimbursed.
Net research and development expenses decreased by $0.5 million for the three months ended September 30, 2018 compared to the same period in 2017 as the increase in gross research and development discussed above was offset by an increase in reimbursements for research and development related to new development projects, primarily our next generation “Shasta” system. Net research and development expense increased by $8.8 million for the nine months ended September 30, 2018 compared to the same period in 2017, primarily driven by the increase in gross research and development expenses and a decrease in amounts reclassified to cost of revenue due to the completion of several engineering services contracts, partially offset by higher reimbursements. The amount and timing of research and development costs related to engineering development contracts and the level of reimbursement from third parties for research and development projects varies significantly from period to period, often due to the timing of milestone acceptances, and can have a significant impact on net reported research and development expense in any period. We anticipate that reimbursed research and development will remain at relatively high levels over the next couple of years as a result of these projects.

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Sales and Marketing and General and Administrative Expenses
Our sales and marketing and general and administrative expenses for the three and nine months ended September 30, 2018 and 2017, respectively, were (in thousands, except for percentages):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Sales and marketing
 
$
15,282

 
$
13,392

 
$
46,165

 
$
43,292

Percentage of total revenue
 
16
%
 
17
%
 
16
%
 
19
%
General and administrative
 
$
6,580

 
$
7,022

 
$
17,983

 
$
23,024

Percentage of total revenue
 
7
%
 
9
%
 
6
%
 
10
%
Sales and Marketing. Sales and marketing expense for the three and nine months ended September 30, 2018 increased by $1.9 million and $2.9 million, respectively, compared to the same periods in 2017, primarily driven by an increase in commissions and incentive compensation.
General and Administrative. General and administrative expense for the three and nine months ended September 30, 2018 decreased by $0.4 million and $5.0 million, respectively, compared to the same periods in 2017. The decrease in general and administrative expense for the three and nine months ended September 30, 2018 was primarily attributable to a decrease in legal costs compared to the same periods in 2017, related to our ongoing litigation with Raytheon, which is described in Note 11, “Contingencies” in the Notes to our Condensed Consolidated Financial Statements in this quarterly report on Form 10-Q. Due to our ongoing litigation with Raytheon, legal expenses may vary over the next several quarters.
Restructuring
In the third quarter of 2017, we implemented a restructuring plan to reduce our operating costs and better align our workforce with long-term business strategies. The restructuring plan reduced our workforce by approximately 190 employees, with the vast majority of such terminations effective in July 2017. For the nine months ended September 30, 2018, we recorded $0.5 million in expense in connection with the restructuring plan. For the three and nine months ended September 30, 2017, we recorded $7.7 million in expense in connection with the restructuring plan. The restructuring expenses primarily related to employee severance.
Other Income (Expense), net
For the three and nine months ended September 30, 2018, we recognized net other income of $0.2 million, compared to net other income of $4.2 million and $5.4 million, respectively, for the same periods in 2017. Net other income and expense for the three and nine months ended September 30, 2018 and 2017 included gains and losses from foreign currency transactions, investments and disposals of assets. Net other income for the three and nine months ended September 30, 2017, included a $3.3 million gain from the sale of an investment in a private company.
Interest Income, net
Our interest income and interest expense for the three and nine months ended September 30, 2018 and 2017, respectively, were (in thousands):
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2018
 
2017
 
2018
 
2017
Interest income
 
$
910

 
$
941

 
$
2,279

 
$
2,732

Interest expense
 
(2
)
 
(61
)
 
9

 
(77
)
Interest income, net
 
$
908

 
$
880

 
$
2,288

 
$
2,655

Interest income is earned on cash and cash equivalents, investment balances and the investment in sales-type lease.
Gain on Strategic Transaction
In the third quarter of 2017, we completed a strategic transaction with Seagate Cloud Systems Inc. centered around the addition of Seagate’s ClusterStor high-performance storage business. As part of the transaction, we assumed customer support obligations associated with the ClusterStor product line and added more than 125 employees and contractors. For the three and nine months ended September 30, 2017, we recognized a gain of approximately $4.4 million associated with the transaction.

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Taxes
Our effective tax rate was approximately (1)% for the three and nine months ended September 30, 2018, compared to 39% and 37% for the three and nine months ended September 30, 2017, respectively. The difference between the expected statutory tax rate of 21% and the actual tax rate of (1)% for the three and nine months ended September 30, 2018, was attributable to our decision to continue to provide a full valuation allowance against our U.S. federal deferred tax assets offset, in part, by foreign taxes. The primary reason for the difference between the expected statutory tax rate of 35% and the actual tax rates of 39% and 37% for the three and nine months ended September 30, 2017, respectively, was our research and development tax credit and other permanent items. One of the permanent items for the three and nine months ended September 30, 2017 was the $4.4 million gain from the strategic transaction which was not taxable under Federal income tax law.
New Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers: Topic 606 (ASU 2014-09) to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under prior GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. The new guidance also requires additional disclosures and several terminology changes, such as amounts previously referred to as deferred revenue now being referred to as customer contract liabilities. We adopted ASU 2014-09 at the beginning of the first quarter of 2018 using the modified retrospective method. The comparative information for the three and nine months ended September 30, 2017, and as of December 31, 2017 has not been restated and continues to be reported under the accounting standards in effect for those periods. The effect of initially applying the new revenue standard had an immaterial effect on our financial statements. Adoption of the new standard did not have a material impact on our net loss during the first nine months of 2018. We expect the impact of the adoption of the new standard to be immaterial to our net income on an ongoing basis.
In January 2016, FASB issued Accounting Standards Update No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities: Topic 825 (ASU 2016-01). The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. We adopted ASU 2016-01 at the beginning of the first quarter of 2018. Adoption of ASU 2016-01 did not have a material impact on our consolidated financial statements.
In February 2016, FASB issued Accounting Standards Update No. 2016-02, Leases: Topic 842 (ASU 2016-02), that replaces existing lease guidance. The new standard is intended to provide enhanced transparency and comparability by requiring lessees to record right-of-use assets and corresponding lease liabilities on the balance sheet. Under the new guidance, leases will continue to be classified as either finance or operating, with classification affecting the pattern of expense recognition in the Consolidated Statements of Operations. Lessor accounting is largely unchanged under ASU 2016-02. Adoption of ASU 2016-02 is required for fiscal reporting periods beginning after December 15, 2018, including interim reporting periods within those fiscal years with early adoption being permitted. The new standard initially required application with a modified retrospective approach to each prior reporting period presented with various optional practical expedients. In July 2018, this requirement was amended with the issuance of Accounting Standards Update No. 2018-11, Leases: Topic 842: Targeted Improvements (ASU 2018-11), which permits an additional (and optional) transition method to adopt the new leases standard. Under this new transition method, an entity initially applies the new leases standard at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. Consequently, an entity’s reporting for the comparative periods presented in the financial statements in which it adopts the new leases standard will continue to be in accordance with current GAAP (Topic 840, Leases)