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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
     
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Fiscal Year Ended December 31, 2004
 
o
  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.)
 
411 First Avenue South, Suite 600
Seattle, Washington
(Address of Principal Executive Office)
 
98104-2860
(Zip Code)
Registrant’s Telephone Number, Including Area Code: (206) 701-2000
Securities Registered Pursuant to Section 12(b) of the Exchange Act: NONE
Securities Registered Pursuant to Section 12(g) of the Exchange Act:
Common Stock, $.01 par value
      Indicate by check mark 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 past 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:     Yes þ     No o
      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o
      Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2):     Yes þ     No o
      The aggregate market value of the Common Stock held by non-affiliates of the Registrant as of June 30, 2004, was approximately $553,000,000, based upon the closing price of $6.62 reported for such date on the Nasdaq National Market System.
      As of March 1, 2005, there were 87,638,651 shares of Common Stock issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
      Portions of the Proxy Statement to be delivered to shareholders in connection with the Registrant’s Annual Meeting of Shareholders to be held on May 11, 2005, are incorporated by reference into Part III.
 
 


CRAY INC.
FORM 10-K
For Fiscal Year Ended December 31, 2004
INDEX
                 
        Page
         
 PART I
 Item 1.    Business     3  
 Item 2.    Properties     29  
 Item 3.    Legal Proceedings     30  
 Item 4.    Submission of Matters to a Vote of Security Holders     30  
 Item E.O.    Executive Officers of the Company     30  
 PART II
 Item 5.    Market for the Company’s Common Equity and Related Stockholder Matters     32  
 Item 6.    Selected Financial Data     33  
 Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations     34  
 Item 7A.    Quantitative and Qualitative Disclosures About Market Risk     43  
 Item 8.    Financial Statements and Supplementary Data     44  
 Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     45  
 Item 9A.    Controls and Procedures     45  
 Item 9B.    Other Information     47  
 PART III
 Item 10.    Directors and Executive Officers of the Company     48  
 Item 11.    Executive Compensation     48  
 Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     48  
 Item 13.    Certain Relationships and Related Transactions     48  
 Item 14.    Principal Accountant Fees and Services     48  
 PART IV
 Item 15.    Exhibits and Financial Statement Schedules     49  
 EXHIBIT 10.15
 EXHIBIT 10.17
 EXHIBIT 10.18
 EXHIBIT 10.19
 EXHIBIT 10.20
 EXHIBIT 10.21
 EXHIBIT 10.32
 EXHIBIT 10.33
 EXHIBIT 10.34
 EXHIBIT 10.35
 EXHIBIT 21.1
 EXHIBIT 23.1
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 
      Cray, Cray-1, UNICOS and UNICOS/mk are federally registered trademarks of Cray Inc., and Cray Y-MP, Cray C90, Cray J90, Cray T90, Cray T3E, Cray SV1, Cray SV1ex, Cray MTA, Cray MTA-2, Cray MTX, Cray X1, Cray X1E, Cray XT3 and Cray XD1 are trademarks of Cray Inc. Other trademarks used in this report are the property of their respective owners.

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Forward-Looking Statements
      This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause our results to differ materially from those expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including any projections of earnings, revenue or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new products, services or developments; any statements regarding future economic conditions or performance; statements of belief and any statement of assumptions underlying any of the foregoing.
      The risks, uncertainties and assumptions referred to above include fluctuating quarterly results; the possibility of quarterly and annual net losses; uneven and possibly negative cash flow from operations; the timing of product orders, deliveries and customer acceptances; the timely development, production and acceptance of products and services and their features, including stable system software for our Cray XT3 systems; the timing and level of governmental support for supercomputers; the market impact of a conclusion that our internal control over financial reporting is ineffective; a volatile market price for our common stock; our dependency on third-party suppliers to build and deliver necessary components; the challenge of managing asset levels, including inventory; the difficulty of keeping expense growth at modest levels while increasing revenue; our ability to retain and motivate key employees; and other risks that are described from time to time in our reports filed with the Securities and Exchange Commission (“SEC” or “Commission”), including but not limited to the items discussed in “Factors That Could Affect Future Results” set forth in Item 1 below in this report, and in subsequently filed reports. We assume no obligation to update these forward-looking statements.
      In this report, we rely on and refer to information and statistics regarding the markets for various products. We obtained this information from third-party sources, discussions with our customers and our own internal estimates. We believe that these third-party sources are reliable, but we have not independently verified them and there can be no assurance that they are accurate.
PART I
Item 1. Business
General
      We design, develop, market and service high performance computer systems, commonly known as supercomputers. These systems provide capability and capacity far beyond typical server-based computer systems and address challenging scientific and engineering computing problems for government, industry and academia.
      We are dedicated solely to the high performance computing market. We have concentrated our product roadmap on building purpose-built, balanced systems combining highly capable processors (whether developed by ourselves or others) with rapid interconnect and communications capabilities throughout the entire computing system, not solely processor-to-processor. We believe we are in the best position to meet the high performance computer market’s demanding needs by providing superior supercomputer systems with performance and cost advantages over low-bandwidth and cluster systems when sustained performance on challenging applications and workloads and total cost of ownership are taken into account.
      Our 2004 product revenue primarily came from sales of our Cray X1 system and government funding for our Red Storm and Cascade development projects. In the second half of 2004, we were in transition from offering one product, the Cray X1 system, to the three products that we currently offer: the Cray X1E, XT3 and XD1 systems. We also derive revenue from providing maintenance and support services to the worldwide installed base of Cray computers and professional services that leverage our technical knowledge. See “Product Offerings, Projects and Services” below.

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      Our revenue, net income or loss and cash balances are likely to fluctuate significantly from quarter to quarter and within a quarter due to the high average sales prices and limited number of sales of our larger products, the timing of purchase orders and product deliveries, our general policy of not recognizing product revenue for our larger systems until customer acceptance and other contractual provisions have been fulfilled, and the uncertain timing of payments for product sales, maintenance services, government research and development funding, and inventory.
      We were incorporated under the laws of the State of Washington in December 1987. Our corporate headquarter offices are located at 411 First Avenue South, Suite 600, Seattle, Washington, 98104-2860, our telephone number is (206) 701-2000 and our web site address is: www.cray.com. The contents of our web site are not incorporated by reference into this Annual Report on Form 10-K or our other SEC reports and filings.
Our History
      In many ways our current history began on April 1, 2000, when we, as Tera Computer Company, acquired the operating assets of the Cray Research division from Silicon Graphics, Inc. (“SGI”), and renamed ourselves Cray Inc.
Tera Computer
      Tera Computer Company was founded in 1987 with the purpose of developing a new supercomputer system based on multithreaded architecture. We completed an initial public offering in 1995. In 2000 we were still in the development stage with limited revenue and approximately 125 employees, almost all of whom were located in our Seattle office.
Cray Research
      Cray Research was founded in 1972 by Seymour Cray and introduced its first product, the Cray-1, in 1976. Cray Research pioneered the use of vector systems in a variety of market sectors and dominated the supercomputer market in the late 1970’s and 1980’s. Cray Research introduced a series of vector-based systems, including the Cray Y-MP, C90, J90, T90 and SV1 systems. Cray Research also developed leading high-bandwidth massively parallel systems, notably the Cray T3E system, using Alpha microprocessors from Digital Equipment and later Compaq Computer. In 1996 SGI acquired Cray Research and cancelled the development of the successors to the only two U.S. produced capability-class supercomputers at the time, the Cray T90 and T3E systems. In 1997, at the instigation of Cray Research, the U.S. government imposed extensive anti-dumping duties on Japanese vector supercomputers, effectively preventing them from entering the U.S. market. These developments combined to eliminate the availability of high-bandwidth computer systems in the United States high performance computing market, greatly diminishing the U.S. market’s access to these systems. In 1998 SGI and the Department of Defense entered into a cost-sharing contract for the development of the Cray X1 system (then code-named the Cray SV2). In 1999, having moved a substantial number of established Cray Research customers to its Origin product line, SGI announced that it would consider offers to purchase the Cray Research division.
Cray Research Acquisition
      On April 1, 2000, we acquired the operating assets of the Cray Research business unit from SGI and changed our corporate name to Cray Inc. In that transaction, we acquired the Cray T90, SV1, T3E and other product lines, the Cray X1 development project and related cost-sharing contract, a worldwide service organization supporting Cray supercomputers installed at customer sites, integration and final assembly operations, software products and related experience and expertise, approximately 775 employees, product and service inventory, real property located in Chippewa Falls, Wisconsin, and the Cray brand name. Pursuant to a technology agreement, SGI assigned to us various patents and other intellectual property and licensed to us the rights to other patents and intellectual property. We paid SGI $50.3 million in cash and issued SGI 1,000,000 shares of our common stock.

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      As part of the acquisition, we assumed responsibility for the cost of servicing the Cray T90 vector computers. We agreed with SGI that we would not utilize specified technology to develop specific successor products to the Cray T3E product line, and we agreed to limit our use of SGI’s IRIX operating system to the Cray X1 product family.
Post-Acquisition
      Following the acquisition, we integrated our approximately 900 employees into one company, established company-wide financial, communication and other networks, moved employees out of SGI facilities into new offices, established over 20 subsidiaries for our foreign sales and service operations, either had service, sales and other contracts assigned to us or entered into new contracts with customers and vendors, continued the development of the Cray X1 system and continued to sell the then-existing Cray products, principally the Cray T3E and SV1 systems.
      In May 2001 the U.S. anti-dumping order against Japanese vector supercomputers was lifted, NEC Corporation invested $25 million in us and we became a distributor of the NEC SX series of supercomputers, with exclusive rights in North America and non-exclusive rights outside of North America. In 2003 NEC sold its investment in us, cancelled our exclusive rights and we became a non-exclusive distributor world-wide.
      In 2001 and 2002 we focused our development efforts on the Cray X1 system; initial deliveries of the Cray X1 system began in late 2002. The Cray X1 system, designed for the high end of the supercomputer market, was the only new product we were selling in 2003 and the first three quarters of 2004. In 2004 we developed the Cray X1E system that significantly increased the system’s processor speed and capability; the first Cray X1E system customer shipment occurred at the end of 2004.
      In mid-2002 we began our Red Storm development project with Sandia National Laboratories to design and deliver a new high-bandwidth, massively parallel processing supercomputer system. The Red Storm hardware system was shipped in installments to Sandia, with the final hardware shipment in the first quarter of 2005, subject to subsequent installation of certain component upgrades when they become available. We are currently developing and installing system software designed to run applications programs successfully across the entire 10,000-processor system. The Red Storm project provides the basis for a commercial product, our Cray XT3 system, targeting the need for highly scalable, high-bandwidth, microprocessor-based supercomputers using a Linux-based operating system. The Cray XT3 system initial customer shipment occurred in the fourth quarter of 2004, and full production ramp is planned for 2005.
      In mid-2002 we also began work under a contract awarded by the Defense Advanced Research Projects Agency (“DARPA”) to develop a system capable of sustained performance in excess of one petaflops (1,000 trillion floating point operations per second), which we call our Cascade program. We are currently involved in phase 2 (the research phase) of this project, which ends in mid-2006.
      On April 1, 2004, we acquired OctigaBay Systems Corporation, a privately-held company located in Burnaby, B.C. OctigaBay was developing a balanced, high-bandwidth system, designed to be highly reliable and easy-to-use, targeted for the midrange market. We renamed OctigaBay Systems Corporation as Cray Canada Inc. and renamed the OctigaBay product as the Cray XD1 system. Initial commercial shipments of the Cray XD1 system began late in the third quarter of 2004, and full production ramp is planned for 2005.
      Discussions that relate to periods prior to April 1, 2000, refer to our operations as Tera Computer Company, and discussions that relate to periods after April 1, 2000, refer to our combined operations as Cray Inc.
The High Performance Computing Industry
      Since the pioneering Cray-1 system arrived in 1976, supercomputers — defined simply as the most powerful class of computers at any time — have contributed substantially to the advancement of knowledge and the quality of human life. Problems of major economic, scientific and strategic importance typically are addressed by supercomputers, which usually sell for several millions of dollars each, years before becoming tractable with less capable systems. For scientific applications, the increased need for computing power has

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been driven by highly challenging problems that can be solved only through numerically intensive computation. For engineering applications, high performance computers boost productivity and decrease risk and the time to market for companies and products in a broad range of industries. The U.S. government has recognized that the continued development of high performance computer systems is of critical importance to national defense and the economic, scientific and strategic competitiveness of the United States.
Increasing Demand for Supercomputer Power
      Applications promising future competitive and scientific advantage demand 10 to 1,000 times more supercomputer power than anything available today, including current low-bandwidth systems and existing enterprise-class and mainframe servers. We believe there are three principal factors driving the growth in the high performance computing market: the continuing demand for advanced design and simulation capability, continuing concerns about national security issues and the recognized need to advance scientific research for domestic competitiveness of many major countries around the world.
      The demand for design capabilities grows seemingly without limit. Automotive companies are targeting increased passenger cabin comfort, better fuel mileage and improved safety and handling. Aerospace firms envision more efficient planes and space vehicles. Using genomic and proteomic technologies for drug development are areas of intensive research and substantial spending by research centers and biotechnology and pharmaceutical companies.
      Governments have a wide range of unmet security needs, heightened by an emphasis on anti-terrorism. These needs primarily relate to burgeoning cryptanalysis requirements arising from a more diverse and growing number of sources and requirements for rapid and accurate analysis and integration of information from many disparate sources. In addition, governments need better simulation and modeling of a wide range of weapons and battlefield scenarios and the computational ability to address various classified applications.
      In 2002 the Japanese government announced the completion of the Japanese Earth Simulator project. This high-bandwidth, vector-based system remains acknowledged as one of the world’s most powerful installed computer system with a peak speed of approximately 40 teraflops (40 trillion floating point operations per second) and high sustained operating performance on real applications. The Japanese Earth Simulator validated our proposition that high-bandwidth and sustained performance are critical, and has provided Japan with the opportunity to lead in scientific research in fields such as weather and climate, geophysics, nanotechnology and metallurgy. The Japanese government recently declared that increased supercomputing technology was a high priority for the rest of this decade, and we believe that its stated intent to upgrade the Japanese Earth Simulator should reinforce the U.S. government’s desire to recapture and maintain supercomputing leadership.
The Advantages of Bandwidth
      When we speak of “bandwidth,” we mean the ability of processors to communicate with other processors, with the system’s internal memory subsystem and with input/output (“I/ O”) connections.
      Today’s supercomputer market is replete with low-bandwidth systems and off-the-shelf commodity-based cluster systems that loosely link together multiple commodity servers or personal computers by means of commercially available interconnect products for several reasons. In recent years, the speed and capabilities of off-the-shelf interconnect systems and processors have continued to improve and independent software vendors have adapted their application codes to exploit the capabilities and partially mask the weaknesses of these systems. These systems offer significant performance and price/performance on small problems and larger problems lacking communications complexity. Secondly, the U.S. scientific, engineering and government users have had to turn to these systems for their more difficult problems primarily because they had no alternative. The imposition by the U.S. government in 1997 of anti-dumping duties on Japanese vector supercomputer vendors and the SGI cancellation of the development of successors to the Cray T90 and Cray T3E systems combined to eliminate the availability of high-bandwidth supercomputers to U.S. users. With no competitor planning to offer next-generation high-bandwidth systems in the United States, customer interest in these systems diminished substantially.

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      We are dedicated solely to the high performance computer market. We differentiate ourselves from our competitors primarily by emphasizing the communication capabilities of our systems. We have concentrated our product roadmap on building purpose-built systems combining highly capable processors (whether developed by ourselves or others) with rapid interconnect and communication capabilities throughout the entire computing system. Our supercomputer systems are “balanced” in that our systems are fast not only processor-to-processor but also with memory subsystems and I/ O systems. Competitive systems may use processors with higher rated or theoretical speeds than some of ours — although at 18 gigaflops our Cray X1E processor is currently the world’s fastest — but even in those cases our systems typically outperform competing products by using their high-bandwidth communications to deliver more data to the Cray processors and keep them busier.
      As we design our supercomputer systems for the needs of the high performance computing market, we say they are “purpose-built” for this market. Vendors of low-bandwidth systems, such as IBM, design and build their processors and systems to meet the requirements of their larger commercial computer markets — for servers and personal computers — and then attempt to leverage these commercial server-based products into the supercomputer market.
      Low-bandwidth and cluster systems may offer higher theoretical peak performance than do our systems. Theoretical peak performance is the highest theoretical possible speed at which a computer system could, but never does, operate (obtained simply by multiplying the number of processors by the designed rated speed of each processor). Sustained performance, always lower than peak, is the actual speed at which a supercomputer system runs an application program. Due to their low internal bandwidth and distributed memory, however, the sustained performance of low-bandwidth and cluster systems on complex applications frequently is a small fraction, often less than 10%, of their theoretical peak performance, and as these systems become larger, their efficiency declines even further. Our systems, designed for balanced total system communications capability, provide high actual sustained performance on difficult computational problems, even though in some cases they may have a lower theoretical peak performance than competitors’ systems. While sustained performance may vary widely on different applications, our systems generally operate on a sustained basis from 1.5 to 10 times that of competitors’ systems. We expect our systems to provide price/performance advantages over low-bandwidth and cluster systems when performance on real applications is taken into account.
      The advent of the Cray X1 system in late 2002 provided the first new high-bandwidth alternative for the U.S. high-end high performance computer customers since the mid-1990’s. Our introduction in late 2004 of the Cray XT3 and XD1 systems extended the availability of high-bandwidth systems to all segments of the high performance computing market.
The High Performance Computing Market
      Industry analyst firm, International Data Corporation (“IDC”), provides information regarding the high performance computing systems market, including historical data and projections. IDC estimates that the revenue for the entire high performance computing market totaled approximately $5.6 billion in 2003, and that the market added another $1.4 billion in 2004 for a total of $7.0 billion. IDC segments the high performance computing systems market based on prices and, at the higher end, intended use. IDC descriptions and estimates of revenue in recent years for each of these segments follow:
  •  Capability. Systems configured and purchased to solve the largest, most demanding problems, and generally priced at $1 million or more. The size of the capability segment has ranged in recent years from about $800 million to $1.2 billion.
 
  •  Enterprise. Systems purchased to support technical applications in throughput environments and sold for $1.0 million or more, with 2003 estimated revenue of $900 million.
 
  •  Divisional. Systems purchased to support technical applications in throughput environments and sold for $250,000 to $999,999, with 2003 estimated revenue of $1.1 billion.
 
  •  Departmental. Systems purchased to support technical applications in throughput environments and sold for less than $250,000, with 2003 estimated revenue of $2.5 billion.

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      Traditionally, we have focused on the capability segment of the high performance computing market where the features we are known for — high speed processors coupled with very fast communications — are widely recognized as necessary to solve the world’s most difficult computing problems. With the Cray XT3 system, our addressable market expanded into the enterprise segment. The Cray XD1 system further extends our reach into the divisional segment and parts of the departmental segment. We expect these two products will effectively quadruple our addressable market in 2005.
Our Target Market and Customers
      Our target markets for 2005 and beyond principally include the government/classified, scientific research, weather/environmental, and automotive and aerospace markets as well as exploratory opportunities into other markets such as life sciences and petroleum. In certain of our targeted markets, such as the government/classified and scientific research markets, customers have their own application programs and are accustomed to using new, less proven systems. Other target customers, such as automotive and aerospace firms and some governmental agencies, require third-party application programs in production environments. We devote significant resources to porting widely used third-party application programs to all of our systems to expand their respective markets.
Government/ Classified
      Government agencies have represented a significant segment for Cray Research and ourselves for many years. Certain governmental departments continue to provide funding support for our research and development efforts to meet their objectives. We expect long-term spending on national security and defense to increase. Current and target customers, primarily for our Cray X1E and XT3 systems, include Department of Defense classified customers and the Department of Energy, which funds the Sandia National Laboratories, Los Alamos National Laboratory and Lawrence Livermore National Laboratory, and certain foreign counterparts.
Scientific Research
      The scientific research segment includes both unclassified governmental and academic research laboratories and centers. The success of the Japanese Earth Simulator has been important in spurring increased interest in balanced high-bandwidth supercomputers in basic research in areas such as climate and physics. The Department of Defense, through its Defense High Performance Computing Modernization Program, funds a number of research organizations. Network Computing Services, Inc., the system integrator for the Army High Performance Computing Research Center in Minneapolis, and the Arctic Region Supercomputing Center in Fairbanks, for example, were early purchasers of our Cray X1 system, and the Army Center is acquiring an additional Cray X1E system. The Office of Science in the Department of Energy, which funds the Oak Ridge National Laboratory, Argonne National Laboratory and National Energy Research Scientific Computing Center, is a key target customer as is the National Aeronautics and Space Administration. Oak Ridge National Laboratory is a significant customer for Cray X1, X1E and XT3 systems and related services. The National Science Foundation, which funds the Pittsburgh Supercomputing Center, has acquired a Cray XT3 system with 10 teraflops peak performance. The Maui High Performance Computing Center, a U.S. Air Force Research Laboratory’s Directed Energy Directorate facility funded by the Defense High Performance Computing Modernization Program, has selected a Cray XD1 system with a peak performance of about 1.4 teraflops to increase the Center’s capabilities in space surveillance and image processing. Cray XD1 systems have been acquired by governmental and academic research laboratories and centers in Italy, Germany, India, United Kingdom and the United States.
Weather/ Environmental
      While short-term weather forecasting has largely moved to low-bandwidth and cluster systems, more challenging climate modeling applications require increasing speed and larger volumes of data and thus are targets for our high-bandwidth systems. Cray supercomputers are used in weather centers worldwide, from the United Kingdom to Korea. We have announced deliveries of Cray X1 systems with later upgrades to

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Cray X1E systems to Warsaw University’s Interdisciplinary Center for Mathematical and Computational Modeling, the Spanish National Institute of Meteorology and the Korea Meteorological Administration. Using a Cray X1 system, the Army High Performance Computing Research Center ran a 5-kilometer resolution weather model for the entire continental United States and is currently validating the results of a 2.5-kilometer model. These models require eight and 64 times more computing power, respectively, than the 10-kilometer model that is the highest resolution typically used today. Scientists at the U.S. National Center for Atmospheric Research recently stated, based on their experience using Japan’s Earth Simulator and the Cray X1 system at Oak Ridge National Laboratory, that today’s vector systems deliver substantially greater performance on climate applications than other types of high performance computers.
Automotive and Aerospace
      These industries use supercomputers to design lighter, safer and more durable vehicles as well as to study wind noise and airflow around the vehicle. Several of the major automobile companies and aerospace companies are Cray customers. We have installed a Cray X1 system at The Boeing Company, which uses the system primarily to run structural analysis and computational fluid dynamics codes. The Cray XD1 system has demonstrated early impressive results on certain crash and computational fluid dynamics codes widely used in the automotive industry.
Product Offerings, Projects and Services
      Our high performance computer products provide high-bandwidth and other capabilities needed for exploiting new and existing market opportunities. Among supercomputer vendors, our intent is to offer the most comprehensive range of high-bandwidth products and related services to the high performance computing market. Our decisions to develop and market both the Cray XT3 system and the Cray XD1 system further this strategy. Our goal is to bring major enhancements and/or new products to market every 12 to 24 months. With the availability of the Cray X1E, XT3 and XD1 systems, we now offer the most comprehensive and capable lineup of systems for the high performance computing market.
Current Products
Cray X1E System
      In late 2002 we completed hardware development of the new Cray X1 system, which incorporates in its design both vector-processing capabilities from the long line of Cray Research vector systems and massively parallel capabilities analogous to those of our prior generation Cray T3E system. Designed to provide efficient scalability and high-bandwidth to run complex applications at high sustained speeds, the Cray X1 system is an “extreme performance” supercomputer aimed at the high end of the vector processing and massively parallel systems markets. We commenced delivering production systems late in the fourth quarter of 2002. In 2003 we enhanced the Cray X1 system hardware and software, ported application programs to provide the features and stability required in a production environment by governmental and industrial users, and delivered ever-larger integrated systems. The Cray X1E system, first shipped in December 2004, nearly triples the peak performance of the Cray X1 system and features the world’s most powerful processor, at 18 gigaflops, and the highest compute density. Our selling focus for the Cray X1E system covers a range of peak performance from 500 gigaflops to over 50 teraflops. Many of our Cray X1 customers are upgrading to Cray X1E systems.
Cray XT3 System
      The Cray XT3 system uses Advanced Micro Devices Inc. (“AMD”) HyperTransporttm and Opterontm processors connected via our low-latency, high-bandwidth interconnect network. It incorporates a massively parallel optimized Linux-based operating system and a standards-based programming environment designed to deliver unmatched sustained application performance in configurations from 200 to 30,000 processors. The Cray XT3 system features a tightly integrated management and operating system to provide high reliability and to run full-system applications to completion. The Cray XT3 system is based on the Red Storm architecture co-developed by Sandia National Laboratories and us. We began shipments of early versions of

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the Cray XT3 system in the fourth quarter of 2004 and full production ramp is planned for 2005. Our selling focus for the Cray XT3 systems covers a range of peak performance from one to over 50 teraflops. List selling prices for a one cabinet system start at under $2 million.
Cray XD1 System
      The Cray XD1 system, like the Cray XT3 system, is a purpose-built, balanced high-bandwidth system that employs standard microprocessors but is designed for the mid-range market. It provides superior sustained application performance employing the direct connected processor architecture to link processors directly to each other and memory, eliminating interconnect bottlenecks and providing greater bandwidth and lower latency than typical cluster systems currently available. The Cray XD1 system leverages high volume technologies such as the AMD HyperTransport and Opteron technology and a Linux-based operating system in connection with our automated management infrastructure and provides the opportunity to accelerate application performance through the use of field programmable gate arrays. Our selling focus for the Cray XD1 system ranges from 58 gigaflops to over 2.5 teraflops with processor counts from 12 to more than 512. List prices for one unit (chassis) systems start at under $100,000, with multiple units providing enhanced application scaling performance.
NEC SX Vector Supercomputers
      Pursuant to our distribution agreement with NEC, we currently market on a non-exclusive basis the NEC SX series of vector supercomputers to industrial, academic and governmental customers requiring intense computing power, very large high performance memory and high I/ O rates on a vector platform. These classic vector systems offer high reliability in a balanced, commercial quality system. We have sold several SX systems to Canadian customers.
Current Projects
Red Storm
      In mid-2002 we contracted with Sandia National Laboratories to design and deliver a new massively parallel 40-teraop processing system, called Red Storm, that will use 10,000 Opteron processors from AMD connected via our low-latency, high-bandwidth, three-dimensional interconnect network based on HyperTransport technology. The Red Storm project involves critical network and Linux-based operating system development. We completed delivery and installation of the Red Storm hardware at Sandia in the first quarter of 2005, subject to installation of certain component upgrades when they become available. We are developing and installing system software designed to run applications programs across the entire system.
Cascade Project
      In mid-2002 DARPA selected Cray and four other companies for phase 1 of an advanced research program leading to the development of a commercially available high productivity system capable of running real-world applications with sustained performance in excess of one petaflops by 2010. In addition to having high sustained performance, the resulting system is to be designed to be much easier to program, more broadly applicable and more robust than current designs. In mid-2003 we signed a phase 2 research agreement with DARPA that will provide us and our research partners, Stanford University, California Institute of Technology/ Jet Propulsion Laboratories and the University of Notre Dame, with just under $50 million over three years to investigate advanced design concepts for the petaflops system. IBM and Sun Microsystems received similar awards. In mid-2006 DARPA plans to select up to two vendors for the final full-scale development phase with initial prototype deliveries scheduled for 2010.
Other Research and Development Activities
      We are involved in several substantial research projects to develop vector-based, multithreaded and scalar-based offerings that will continue to advance performance and scalability. These activities include a successor to the Cray X1/ X1E line, code-named the Black Widow project; continued development of our

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multithreaded system; and development of an integrated technology platform providing a single user interface and environment and improved performance by matching the appropriate processors to the needs of the user’s applications, code-named the Rainier project. These projects are expensive undertakings in terms of dollars, people and time. We seek government funding, such as funding provided for the Red Storm and Cascade projects and the Cray X1/ X1E systems, to help defray the costs of this advanced research.
Services
      Our extensive worldwide maintenance and support systems provide us with a competitive advantage and a predictable flow of revenue and cash. Support services are provided under separate maintenance contracts with our customers. These contracts generally provide for support services on an annual basis, although some cover multiple years. While most customers pay for support monthly, others pay on a quarterly or annual basis.
      Our professional services organization supports our emphasis on providing solutions rather than just computer systems to our customers. This organization provides consulting, integration of Cray products, custom hardware and software engineering, advanced computer training, site engineering, data center operation and computing-on-demand services. These services leverage our reputation and skills for services and industry technical leadership.
Technology
      Our leadership in the high performance computer industry depends on successful development and introduction of new products and enhancements to existing products. Our research and development activities are focused on system architecture, hardware and software necessary to implement our product roadmap.
Architecture
      We are the only company in the world to provide systems that use or combine all three of the basic high performance computer architectures — vector processing, massively parallel processing and multithreading.
      Cray Research pioneered the use of vector systems, from the Cray-1 to the Cray T90 systems. These systems traditionally have used a moderate number (one to 32) of very fast custom processors in connection with a shared memory. Vector processing has proven to be highly effective for many scientific and engineering application programs that have been written to maximize the number of long vectors.
      Massively parallel processing architectures typically link tens, hundreds or thousands of standard or commodity processors to work either on multiple tasks at the same time or together in concert on a single computationally-intensive task. We build only massively parallel systems that have high-bandwidth and low-latency interconnect systems. As our systems employ very densely packaged connections and transfer data at very high speeds, they are best suited for computing problems that require many processors to communicate with each other, large memory systems and I/ O connections frequently. Cray XT3 and XD1 systems are purpose-built, balanced high-bandwidth systems that employ standard microprocessors.
      The Cray X1/ X1E system is the first supercomputer that combines the attributes of both vector and high-bandwidth massively parallel systems. With up to 64 processors per cabinet and a shared memory, the Cray X1/ X1E system can run small problems as a vector processor would or, by focusing many processors on a task, the Cray X1/ X1E system operates as a massively parallel system with a system-wide shared memory and a single-system image.
      Our multithreaded products are designed to have sustainable high speed, be broadly applicable and easy to program, provide scalability as systems increase in size and have balanced I/ O capability. The multithreading processors make the system latency tolerant and, with flat shared memory, are able to address data anywhere in the system.

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Hardware
      We have extensive experience in designing all of the components of high performance computer systems — the processors, the interconnect system and controls, the I/ O system and the supporting cooling infrastructure — to operate together. Our hardware research and development experience includes:
  •  Integrated circuit design — we have experience in designing custom and standard cell integrated circuits. Our processors and other integrated circuits have special features that let them use the high available memory bandwidth efficiently. We work closely with our suppliers to take advantage of the latest advances in high speed, high density integrated circuit technology.
 
  •  High speed interconnect systems — we design high speed interconnect systems using a combination of conventional and microwave circuits, high density connectors and carefully chosen transmission media together with complex memory and cache controls to operate with our network protocols and highly optimized logic design. We are investigating the use of optical interconnects for future systems.
 
  •  Printed circuit board design — our printed circuit boards are some of the most sophisticated in the world, often more than 40 layers packed with wires and inter-layer connections.
 
  •  System I/ O — we design high performance I/ O interfaces that deliver high-bandwidth transfer rates and large capacity storage capabilities using low cost devices in highly reliable configurations.
 
  •  Packaging and cooling — we use very dense packaging in order to produce systems with the necessary bandwidth at reasonable costs. This generates more heat per unit volume. We use specialized cooling techniques to address this issue, including immersion, conductive and spray cooling using various liquids and high volume air cooling.
 
  •  Fault tolerance — we design our systems to be tolerant of component failure. As individual components fail, our systems operate with minimal adverse performance impact due to designed alternative circuits and paths. We closely coordinate our hardware and operating system design with field service requirements for fast repair with minimal impact to users.
      Our hardware engineers are located primarily in our Chippewa Falls, Wisconsin, Seattle, Washington, and Burnaby, B.C. offices.
Software
      We design and maintain our system software internally. The Cray XT3 and XD1 systems exploit commercially available versions of the Linux operating system, as does the Red Storm system. In conjunction with the development of our integrated approach, we anticipate that we will merge our operating systems to one or more variants of the Linux operating systems. We currently provide and support separate UNIX-based operating systems for the Cray X1/ X1E system, our multithreaded system and the NEC SX products.
      We continue to design and build highly optimized programming environments and performance management diagnostic software products that allow our customers to obtain maximum benefit from our systems. In addition to supporting third-party applications, we develop advanced algorithms and other approaches to improving application performance. We also purchase or license software technologies from third parties when necessary to provide appropriate support to our customers, while focusing our own resources where we add the highest value.
      Our software personnel are located principally in our Mendota Heights, Minnesota, Seattle, Washington, and Burnaby, B.C. offices.
Sales and Marketing
      We primarily sell our Cray X1E and XT3 products through a direct sales force that operates throughout the United States and in Europe, Canada, Japan and Asia-Pacific. We serve smaller foreign markets through sales representatives. We sell our Cray XD1 systems through our direct sales force and through channels we are developing in all of our geographical markets. About half of our sales force is located in the United States

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and Canada, with the rest overseas. Our marketing staff has a strategic focus on our target markets and those solutions that will facilitate our customers’ success in solving their most challenging scientific and engineering problems. Our marketing personnel are located in the United States and Canada.
      In 2004 one customer, Sandia National Laboratories, through our Red Storm project, accounted for 27% of our total revenue. In 2003 one customer, Oak Ridge National Laboratory, accounted for 11% of our total revenue and in 2002, no single end-user customer accounted for 10% or more of our revenue. Agencies of the United States government, both directly and indirectly through system integrators and other resellers, accounted for approximately 72% of our 2004 revenue, 74% of our 2003 revenue and 79% of our 2002 revenue. Information with respect to our international operations and export sales is set forth in Note 16 of the Notes to the Consolidated Financial Statements.
Manufacturing and Procurement
      While we design many of the hardware components for all of our products, we subcontract the manufacture of these components, including integrated circuits, printed circuit boards, flex circuits, memory modules, machined enclosures and support structures, cooling systems, high performance cables and other items to third-party suppliers. Our strategy is to avoid the large capital commitment and overhead associated with establishing full-scale manufacturing facilities and to maintain the flexibility to adopt new technologies as they become available without the risk of equipment obsolescence. We perform final system integration and testing of our hardware systems. Our manufacturing personnel are located in Chippewa Falls, Wisconsin.
      Our systems incorporate some components that are available from one or limited sources. Key components that are sole-sourced include our integrated circuits and processors, interconnect systems and memory products. We obtain integrated circuits for our Cray X1E systems from IBM and for the Cray XT3 and XD1 systems from AMD, and field programmable gate array circuits for our Cray XD1 system from Xilinx, Inc. Texas Instruments will be acting as our foundry for future vector processors. IBM currently provides packaging for our Cray X1E and XT3 systems. We obtain custom cables and interconnect components for our Cray X1E from InterCon Systems, Inc. We obtain custom memory products for our Cray X1E systems from Samsung Semiconductor, Inc. Hitachi America Inc. is our sole supplier for Cray X1E printed circuit boards. We acquire power modules and spray cap cooling systems for the Cray X1E from SAE Power Incorporated and Parker Hannifin Corporation, respectively. We obtain power supplies for the Cray X1E system from Pioneer Magnetics, Inc., and for the Cray XT3 system from Valere Power, Inc. We use Benchmark Electronics to assemble our Cray X1E and XT3 systems and for repair of components for our vector and Cray X1 systems.
      Our procurements from these vendors are primarily through purchase orders. We have chosen to deal with sole sources in these cases because of the availability of specific technologies, economic advantages and other factors. We also have sole or limited sources for less critical components, such as peripherals, power supplies, cooling and chassis hardware. Reliance on single or limited source vendors involves several risks, including the possibility of shortages of key components, long lead times, reduced control over delivery schedules and changes in direction by vendors. See “Factors That Could Affect Future Results — Our reliance on third-party supplies poses significant risks to our business and prospects” below. Procurement personnel primarily are located in Chippewa Falls, Wisconsin.
Competition
      The high performance computing market is intensely competitive. There are significant barriers to entry into the capability and enterprise segments of the high performance computing market and the cost of remaining competitive is high. Many of our competitors are established companies that are well known in the high performance computer market, including IBM, NEC, Hewlett-Packard, SGI, Dell and Sun Microsystems. These competitors have substantially greater research, engineering, manufacturing, marketing and financial resources than we do.
      We also compete with systems builders and resellers of systems that are constructed from commodity components using microprocessors manufactured by Intel, AMD, IBM and others. These competitors include

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the previously named companies as well as smaller firms active primarily in the divisional and department markets that benefit from the low research and development costs needed to assemble systems from commercially available technology. These companies have capitalized on developments in parallel processing and increased computer performance in commodity-based networking and cluster systems. While these companies’ products are limited in applicability and scalability and can be difficult to program, they have achieved growing market acceptance. They offer significant performance and price/performance on small problems and larger problems lacking complexity and offer higher theoretical peak performance.
      Internationally we compete primarily with IBM, Hewlett-Packard, SGI and NEC. While the first three companies offer massively parallel systems, NEC offers vector-based systems with a large suite of ported application programs. We have non-exclusive rights to market NEC vector processing supercomputers throughout the world. Competition with NEC is difficult due to NEC’s aggressive pricing strategies and strong classic vector products.
      We compete primarily on the basis of product performance, breadth of features, availability of application software, price, quality, reliability, service and support, corporate reputation, brand image and account relationships. Our market approach is more focused than our competitors, as we concentrate solely on high-performance computing. Our products are designed for the needs of this specific market. We offer systems that provide greater performance on the largest, most difficult computational problems and superior price/performance on many important applications. Our systems offer total cost of ownership advantages as they typically use far less electric power for operations and cooling and occupy less space than low-bandwidth and cluster systems.
Intellectual Property
      We attempt to protect our trade secrets and other proprietary rights through formal agreements with our employees, customers, suppliers and consultants, and through patent protection. Although we intend to protect our rights vigorously, there can be no assurance that our contractual and other security arrangements will be successful. There can be no assurance that such arrangements will not be terminated or that we will be able to enter into similar arrangements on favorable terms if required in the future. In addition, if such agreements were breached, there can be no assurance that we would have adequate remedies for any breach.
      We have a number of patents relating to our hardware and software systems. We license certain patents and other intellectual property from SGI as part of our acquisition of the Cray Research operations. These licenses contain restrictions on our use of the underlying technology, generally limiting the use to historic Cray products, vector processor computers and the Cray X1/X1E system. Our general policy is to seek patent protection for those inventions and improvements likely to be incorporated into our products and services or to give us a competitive advantage. While we believe our patents and applications have value, no single patent or group of patents is in itself essential to us as a whole or to any of our key products. Any of our proprietary rights could be challenged, invalidated or circumvented and may not provide significant competitive advantage.
      There can be no assurance that the steps we take will be adequate to protect or prevent the misappropriation of our intellectual property. We may infringe or be subject to claims that we infringe the intellectual property rights of others. Litigation may be necessary in the future to enforce patents we obtain, and to protect copyrights, trademarks, trade secrets and know-how we own, or to defend infringement claims from others. Such litigation could result in substantial expense to us and a diversion of our efforts.
Employees
      As of December 31, 2004, we employed 889 employees. We have no collective bargaining agreement with our employees. We have never experienced a work stoppage and believe that our employee relations are excellent.

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Factors That Could Affect Future Results
      The following factors should be considered in evaluating our business, operations and prospects, they may affect our future results and financial condition and they may affect an investment in our securities. Factors specific to our 3.0% Convertible Senior Subordinated Notes due 2024 (the “Notes”) and our common stock are set forth under the subheading “Factors Pertaining to Our Notes and Underlying Common Stock” below.
      Our quarterly operating results may fluctuate significantly. Our operating results are subject to significant fluctuations due to many factors, which make forecasting revenue and earnings for any period very difficult. First, one or a few system sales may account for a substantial percentage of our quarterly revenue, and thus revenue, net income or loss and cash flow are likely to fluctuate significantly from quarter to quarter and within a quarter. This is due to the high average sales prices and limited number of sales of our larger systems per quarter, the timing of purchase orders and product delivery, and our general policy of not recognizing product revenue until customers accept our products and other contractual provisions have been fulfilled and the uncertain timing of payments for product sales, maintenance services, government research and development funding and inventory. A delay in an acceptance of a system at the end of a quarter or year or other factors affecting revenue recognition could move the associated revenue into a subsequent quarter or year and have a significant impact on revenue, earnings and cash receipts. For example, in 2003 we were successful in obtaining timely acceptances of major Cray X1 systems at the end of each quarter. In the fourth quarter of 2004, however, we were not able to record revenue for any of our late quarter shipments, which adversely affected fourth quarter and 2004 results. Delays in developing systems and enhancements could also result in cancellation or loss of orders. These factors will continue to apply to sales of our Cray X1E and Cray XT3 systems in 2005. We anticipate continued deferrals in recognition of revenue and associated costs for sales of products due to contractual provisions despite earlier installation and, in most cases, significant prepayment. At the end of 2004, we had approximately $38 million of deferred product revenue.
      Second, excluding revenue from our development projects, almost all of our product revenue in 2004 was due to sales of one product, our Cray X1 system, and was significantly less than anticipated. In 2005, our quarterly revenue and product margins will depend on the success in the marketplace of each of our newly introduced products — the Cray X1E, Cray XT3 and Cray XD1 systems — the timing of revenue recognition for several large transactions, and early product cycle sales at lower margins due to higher early manufacturing costs.
      Third, a number of our prospective customers receive funding from the U.S. or foreign governments. The timing of orders from these government customers is subject to the funding schedules for the relevant government agencies and delays that may be experienced in competitive procurements. Delays in the government appropriations process, including competitive procurements, could defer purchases and revenue recognition for transactions with government agencies.
      The timing of orders and shipments and quarterly results also could be affected by additional events outside our control, such as:
  •  the timely availability of acceptable components in sufficient quantities to meet customer delivery schedules;
 
  •  changes in levels of customer capital spending;
 
  •  the introduction or announcement of competitive products;
 
  •  the receipt and timing of necessary export licenses; and
 
  •  currency fluctuations and international conflicts or economic crises.
      If we were unable to complete system software development successfully for the Red Storm project and the Cray XT3 system, our 2005 results would be materially and adversely impacted. The acceptance of the Red Storm system at Sandia National Laboratories and the acceptance of several large system installations of our Cray XT3 system are dependent on our ability to complete the development of and to install stable system software that enables the scaling of application programs over a large number of processors. We are engaged in

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a significant effort to complete this system software development project. A substantial delay in completing this work, or a failure to do so, could result in a delay in receiving acceptance or a default under our Red Storm project, delay or prevent revenue recognition on several large Cray XT3 installations, and adversely affect the possibility of additional orders for the Cray XT3 systems and our other products, particularly from the U.S. government.
      We were not successful in completing the Red Storm project on time and on budget, which adversely affected our 2004 earnings and could adversely affect our 2005 earnings and financial condition. Our 2005 revenue goals are dependent on the successful completion of the Red Storm project with Sandia National Laboratories. Our work is pursuant to a fixed-price contract with payment against significant monthly milestones setting out a tight development schedule and technically challenging performance requirements. We have experienced delays in receiving timely deliveries of acceptable components from third parties and development delays, which caused us to miss the contractual third quarter 2004 delivery date. Hardware shipments of the Red Storm system to Sandia commenced in the third quarter of 2004, and were completed in the first quarter of 2005, subject to the installation of certain component upgrades when they become available. We are developing and installing system software designed to run application programs successfully across the entire 10,000-processor system. Falling behind schedule and incurring cost overruns on the Red Storm project has adversely affected our cash flow and earnings, and we recognized the estimated loss in 2004. The Red Storm delays also prevented us from delivering Cray XT3 systems, the productized version of the Red Storm system, in time to recognize revenue in 2004. It is possible that we may have additional losses on the Red Storm contract in 2005. Failure to pass acceptance tests for the Red Storm system or to receive full payment for the Red Storm system would result in additional charges to earnings, and if severe enough could result in a contract default or termination. In the event of a contract default, we could be required to deliver all our knowledge and data that materially concerns the Red Storm systems, subject to the trade secret and intellectual property rights of third parties, and assign to Sandia all of our rights to our contractor developed technology, as such term is defined in the contract, subject to a paid-up non-exclusive and non-transferable license to practice such technology. In the event of a contract termination, we may be liable to pay Sandia for excess costs required to complete the contract. Such delays, default declaration and/or termination could adversely affect other transactions with other U.S. government agencies and our 2005 results and financial condition.
      Our product revenue and margins in 2005 depend on the success of three new products. Whether we achieve planned 2005 product revenue and margins will depend on whether we have sufficient internal engineering, marketing and sales resources to complete development and to market and sell successfully each of our newly introduced products — the Cray X1E, Cray XT3 and Cray XD1 systems — at sufficient margins in a highly competitive market. We must target each of these products at the appropriate markets so that there is minimal market confusion about our products. If we are not successful in these efforts, we may not achieve our planned product revenue and margins.
      We will use a significant amount of working capital in the first half of 2005, which could restrict our operations and could make it advisable for us to raise additional equity or debt which could be dilutive to our shareholders. At any particular time, our cash position is affected by the timing of payments for product sales, receipt of prepaid and regular maintenance payments, receipt of government funding for research and development activities and payment for inventory, resulting in significant quarter to quarter and within a quarter fluctuations in our cash balances. Our principal sources of liquidity are our cash and cash equivalents, short-term investments and our operations. We experienced lower than anticipated product sales and delays in the availability of new products in 2004, which adversely affects our current cash flow. We face increased inventory purchases and higher start-up manufacturing and selling costs with the introduction of three new products in late 2004 and early 2005. Our 2004 restructuring will lower our overall operating cash expenditures but not until severance and related obligations are satisfied. Until we are able to ship our new products, obtain product acceptances and receive payment, we expect to use significant working capital, particularly in the first half of 2005. Meanwhile, we are focused on expense controls and working capital efficiencies to maintain adequate levels of cash within each quarter.

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      Depending on operating results, it could be advisable to enhance and strengthen our cash and working capital position by raising additional equity or debt capital. A financing may not be available to us when needed or, if available, may not be available on satisfactory terms, may contain restrictions on our operations, would reduce the percentage ownership of our shareholders, may cause additional dilution to our shareholders and the securities may have rights, preferences and privileges senior to the Notes and/or our common stock.
      If the U.S. government purchases fewer supercomputers, our revenue would be reduced and our earnings would be adversely affected. Historically, sales to the U.S. government and customers primarily serving the U.S. government have represented a significant market for supercomputers, including our products. From January 1, 2001, through December 31, 2002, approximately $101 million of our product revenue was derived from sales to various agencies of the U.S. government; in 2003 and 2004, approximately $145 million and $81 million of our product revenue was derived from such sales, respectively. Our sales of Cray X1 systems and contracts for Cray X1E systems have been largely to government agencies in the United States and other countries, and we expect that will continue throughout 2005. To date, however, we have entered into a limited number of significant new contracts for sales of Cray X1E systems to U.S. government customers, especially in the defense segment, and we do not expect sales of the Cray X1E systems in 2005 to match the level of Cray X1 system sales in 2003 to such customers. Sales to government agencies may be affected by factors outside our control, such as changes in procurement policies, budget considerations and international political developments. If agencies and departments of the United States or other governments were to stop, reduce or delay their use and purchases of supercomputers, our revenue would be reduced, which could lead to reduced profitability or losses in future periods.
      Failure to manufacture and sell Cray XD1 systems in planned quantities would adversely affect revenue and earnings in 2005. To be successful, the Cray XD1 system must be manufactured and sold in quantities much higher than our high-end products. We are redesigning our supply and manufacturing processes to accommodate significant daily production and shipment of Cray XD1 systems. The redesign of our supply processes includes finding and qualifying new suppliers. We experienced delays in receiving acceptable components from third parties, which delayed shipments of Cray XD1 systems in the fall of 2004. We are revamping our sales procedures to accommodate high volume sales through the retraining of our current sales personnel and adding sales channels — both distributors and agents — in various markets. We need to market these systems at sufficient margins in a highly competitive market and lower the cost of goods for the Cray XD1 system to achieve an acceptable rate of return. We are changing our service processes to accommodate the expected increased number of Cray XD1 systems in the field. Lack of success in so adapting our processes and sales channels and our manufacturing and marketing processes will adversely affect revenue and earnings from the Cray XD1 system in 2005.
      The decline in the vector processor market may make sales of the Cray X1 and Cray X1E systems more difficult, which would adversely affect our revenue and earnings. The market for vector-based systems has declined over the past several years, and is now served only by NEC and us. We expect that sales of Cray X1E systems primarily will be to domestic and foreign government agencies, including upgrades to existing Cray X1 customers. The Cray X1E system offers processor speed improvements and enhanced price-performance characteristics. We anticipate difficult competition with NEC for vector-based procurements in overseas markets and perhaps in the United States. If we are unable to market and sell the Cray X1E system successfully, our revenue and earnings will be adversely affected.
      Our inability to overcome the technical challenges of completing the development of our high performance computer systems would adversely affect our revenue and earnings in 2005 and beyond. Our success in 2005 and in the following years depends on completing the Red Storm project; completing initial development (particularly of system software) and successfully selling the Cray XT3 system, which involves adapting the Red Storm concept for the broader governmental, industrial and academic markets; successfully selling the Cray X1E system as a significant enhancement to the Cray X1 system; and completing enhancements to the Cray XD1 system, completing stable system software to scale application programs across multiple units and successfully selling the Cray XD1 system in the midrange market. In subsequent years we must develop further hardware and software enhancements to the Cray XT3 and the Cray XD1 systems, and develop our integrated technologies plan, which will allow customers to take advantage of

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innovative scalar, vector and future processor technologies within a common high-bandwidth infrastructure. These hardware and software development efforts are lengthy and technically challenging processes, and require a significant investment of capital, engineering and other resources. Our engineering and technical personnel resources are limited, and our 2004 restructuring has strained our engineering resources further. Given the breadth of our engineering challenges, we periodically review the anticipated contributions and expense of our product programs to determine their long-term viability. We may not be successful in meeting our development schedules for technical reasons and/or because of insufficient engineering resources. Delays in completing the design of the hardware components, developing requisite system software or in integrating the full systems would make it difficult for us to develop and market these systems successfully and could cause a lack of confidence in our capabilities among our key customers. At the beginning of 2004, we had planned on generating sizeable revenue shipments of the Cray X1E and XT3 systems in the second half of 2004. Due to development delays, however, we did not record any Cray X1E or Cray XT3 system revenue in 2004. We may incur similar delays in the future, which would adversely affect our revenue and earnings.
      Our reliance on third-party suppliers poses significant risks to our business and prospects. We subcontract the manufacture of substantially all of our hardware components for all of our products, including integrated circuits, printed circuit boards, connectors, cables, power supplies, software components and certain memory parts, on a sole or limited source basis to third-party suppliers. We use contract manufacturers to assemble our components for all of our systems. We are subject to substantial risks because of our reliance on these and other limited or sole source suppliers. For example:
  •  if a supplier did not provide components that met our specifications in sufficient quantities, then production and sale of our systems would be delayed;
 
  •  if a reduction or an interruption of supply of our components occurred, either because of a significant problem with a supplier or a single-source supplier deciding to no longer provide those components to us, it could take us a considerable period of time to identify and qualify alternative suppliers to redesign our products as necessary and to begin manufacture of the redesigned components or we may not be able to so redesign such components;
 
  •  if we were ever unable to locate a supplier for a key component, we would be unable to deliver our products;
 
  •  one or more suppliers could make strategic changes in their product offerings, which might delay, suspend manufacture or increase the cost of our components or systems; and
 
  •  some of our key suppliers are small companies with limited financial and other resources, and consequently may be more likely to experience financial and operational difficulties than larger, well-established companies.
      Our products must meet demanding specifications, such as integrated circuits that perform reliably at high frequencies in order to meet acceptance criteria. From time to time we have incurred delays in the development and production of key components for the Cray X1E, Red Storm, Cray XT3 and the Cray XD1 systems. The consequent delays in product shipments and acceptances adversely affected 2004 revenue and may affect adversely 2005 revenue and margins.
      We have used IBM as a key foundry supplier of our integrated circuits for many years. In 2004 IBM informed us that it would no longer act as our foundry supplier on a long-term basis, although it will continue production of our current products for a limited time. We have negotiated a termination of the relationship with IBM and we are completing contracts with Texas Instruments Incorporated to act as our foundry for certain key integrated circuits for new products planned for 2006 and later. Moving to a new foundry involves a costly redesign of components and processes that will adversely affect operating results in 2005, and may cause delays in the development of these future products.
      Our Cray XT3 and XD1 systems utilize AMD Opteron processors. If AMD suffers delays in the development of enhancements to its processors, such as in the delivery of its planned dual-core processors, our

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Cray XT3 and XD1 system sales would be adversely affected. Changing our product designs to utilize another supplier’s microprocessors would be a costly and time-consuming process.
      We face last-time-buy deadlines for certain key components for which there is no practical alternative supplier. We may have to place such last-time-buy orders before we know all possible sales prospects. We may either estimate low, in which case we limit the number of possible sales of products, or we may estimate too high, and incur inventory write-downs. Either way, our earnings would be adversely affected.
      We may not achieve quarterly or annual net income on a consistent basis. We experienced net losses in each full year of our development-stage operations prior to 2002. We incurred net losses of approximately $35.2 million in 2001, $25.4 million in 2000, and $34.5 million in 1999. For 2002, we had net income of $5.4 million and for 2003 we had net income of $63.2 million (including an income tax benefit of $42.5 million from the reversal of a valuation allowance against deferred tax assets). For 2004, we had a net loss of $204.0 million (including an expense for in-process research and development of $43.4 million and an income tax expense of $58.5 million related to the establishment of a valuation allowance against deferred tax assets). Whether we will achieve net income on a consistent quarterly and annual basis will depend on a number of factors, including:
  •  successfully selling the Cray X1E, Cray XT3 and Cray XD1 systems and other products, and the timing and funding of government purchases, especially in the United States;
 
  •  maintaining our other development projects on schedule and within budgetary limitations;
 
  •  the level of revenue in any given period, including the timing of product acceptances by customers and contractual provisions affecting revenue recognition;
 
  •  the level of product margin contribution in any given period;
 
  •  our expense levels, particularly for research and development and manufacturing and service costs;
 
  •  the terms and conditions of sale or lease for our products; and
 
  •  the impact of expensing our stock-based compensation under SFAS 123(R), once effective.
      Because of the numerous factors affecting our results of operations, we cannot assure you that we will have consistent net income on a quarterly or annual basis in the future.
      If we cannot establish the value of our high-bandwidth sustained performance systems, we may not have long-term success. We are dedicated solely to the high performance computing market. We have concentrated our product roadmap on building purpose-built, balanced systems combining highly capable processors with rapid interconnect and communications capabilities throughout the entire computing system. The high performance computing market currently is replete with low-bandwidth systems and off-the-shelf commodity-based cluster systems offered by larger competitors with significant resources and smaller companies with minimal research and development expenditures. Many customers are able to meet their computer needs through the use of such systems, and are willing to accept lower capability (lower bandwidth and higher latency) and less accurate modeling in return for lower acquisition costs, even in the face of higher post-sale operating expense. If we are not successful in establishing the value of our balanced high-bandwidth systems beyond a core of customers, largely certain agencies of the U.S. government, that require systems with the performance and features we offer, we may not be successful on a long-term basis.
      If we are unable to compete successfully in the high performance computer market, our revenue will decline. The performance of our products may not be competitive with the computer systems offered by our competitors. Many of our competitors are established companies that are well known in the high performance computer market, including IBM, NEC, Hewlett-Packard, SGI, Dell and Sun Microsystems. These competitors have substantially greater research, engineering, manufacturing, marketing and financial resources than we do.
      We also compete with systems builders and resellers of systems that are constructed from commodity components using microprocessors manufactured by Intel, AMD, IBM and others. These competitors include

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the previously named companies as well as smaller firms that benefit from the low research and development costs needed to assemble systems from commercially available technology. These companies have capitalized on developments in parallel processing and increased computer performance through networking and cluster systems. While these products are limited in applicability and scalability and can be difficult to program, they have achieved growing market acceptance.
      Periodic announcements by our competitors of new high performance computer systems (or plans for future systems) and price adjustments may reduce customer demand for our products. Many of our potential customers already own or lease very high performance computer systems. Some of our competitors offer trade-in allowances or substantial discounts to potential customers, and engage in other aggressive pricing tactics, and we have not always been able to match these sales incentives. We have in the past and may again be required to provide substantial discounts to make strategic sales, which may reduce or eliminate any positive margin on such transactions, or to provide lease financing for our products, which would result in a deferral of our receipt of cash for these systems. These developments limit our revenue and resources and reduce our ability to be profitable.
      Our market is characterized by rapidly changing technology, accelerated product obsolescence and continuously evolving industry standards. Our success depends upon our ability to sell our current products, and to develop successor systems and enhancements in a timely manner to meet evolving customer requirements. We may not succeed in these efforts. Even if we succeed, products or technologies developed by others may render our products or technologies noncompetitive or obsolete. A breakthrough in architecture or software technology could make low-bandwidth and cluster systems even more attractive to our existing and potential customers. Such a breakthrough would impair our ability to sell our products and reduce our revenue and earnings.
      If we lose government support for supercomputer systems, our capital requirements would increase and our ability to conduct research and development would decrease. A few government agencies and research laboratories fund a significant portion of our development efforts. Agencies of the U.S. government historically have facilitated the development of, and have constituted a market for, new and enhanced very high performance computer systems. U.S. government agencies may delay or decrease funding of our future product development efforts due to a change of priorities, international political developments, overall budgetary considerations or for any other reason. Any such decrease or delay would cause an increased need for capital, increase significantly our research and development expenditures and adversely impact our profitability and our ability to implement our product roadmap.
      If we cannot attract, retain and motivate key personnel, we may be unable to effectively implement our business plan. Our success also depends in large part upon our ability to attract, retain and motivate highly skilled management, technical and marketing and sales personnel. We are in the process of recruiting a chief financial officer. As part of our restructuring in 2004, we had significant change in senior management. The loss of key engineering management and personnel could adversely affect our multiple development efforts. Recruitment for highly skilled management, technical, marketing and sales personnel is very competitive, and we may not be successful in attracting and retaining such personnel.
      The adoption of SFAS 123(R) will lower our earnings and may adversely affect the market price of our common stock. We have used stock-based compensation, primarily stock options and an employee stock purchase plan, as a key component in our employee compensation. We currently grant stock options to each new employee and to all employees on an annual basis. We believe we have structured these programs to align the incentives for employees with those of our long-term shareholders. We are reviewing our stock-based compensation programs and their structure in light of the imposition of SFAS 123(R) which, without Congressional action, will become effective for us on July 1, 2005. In previous years, as we have reported in the footnotes to our financial statements, our stock option program as currently structured would add approximately $7 million to $13 million of additional non-cash expense and consequently would reduce our operating results by that amount. These estimates are based on use of the Black-Scholes valuation method, which was developed for estimating the fair value of fully transferable short-lived exchange traded options, in which a key component is the price volatility of the underlying common stock; this methodology was not

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designed to value longer-term employee stock options with vesting requirements and transferability restrictions. In March 2005 we accelerated the vesting of our outstanding employee stock options with a per share exercise price of $2.36 or higher in order in part to minimize this expense, at least in the short term. We do not know how analysts and investors will react to the additional expense recorded in our statement of operations rather than in the footnotes, and the effect on the market price of our common stock may be adverse.
      Although we are continuing to evaluate our internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002, we will conclude that our internal control over financial reporting is ineffective, which could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price and access to capital. We are in the process of completing the testing of the effectiveness of our internal control over financial reporting for purposes of Section 404 of the Sarbanes-Oxley Act of 2002 and assessing the significance of those situations in which the testing to date found control deficiencies. We will avail ourselves of the 45-day exemptive order of the Commission to complete our procedures and assessment and submit our report in an amendment to this Annual Report on Form 10-K. Although our formal assessment process is not completed, we will identify one or more material weaknesses and both we and our independent auditors consequently will conclude, as required, that our system of internal control over financial reporting is ineffective. See Item 9A, “Controls and Procedures,” below.
      The existence of control deficiencies and, in particular, of material weaknesses may increase the risk of financial statement errors; at the least, they result in increased time, effort and expense to complete the preparation of our financial statements and for our auditors to complete their audit of our financial statements.
      Our independent auditors have expressed their serious reservations to management and to the Audit Committee as to whether we can complete our assessment within the 45-day exemptive order period in accordance with the applicable standards.
      As both we and our auditors continue testing and assessment of our internal control over financial reporting, we or they may uncover additional significant deficiencies and material weaknesses. Remedying the significant deficiencies and material weaknesses could require us to incur additional significant costs through additional personnel and systems and expend significant time and management resources. We may be required to report in our subsequent reports filed with the Commission that material weaknesses in our internal control over financial reporting continue to exist. Delays or failures to design and implement new or improved controls, or difficulties encountered in their implementation or operation, could harm our operating results, cause us to fail to meet our financial reporting obligations or prevent us from providing reliable and accurate financial reports or avoiding or detecting fraud. Disclosure of our material weaknesses, any failure to remediate such material weaknesses in a timely fashion, having or maintaining ineffective internal controls and the failure of our auditors to render an unqualified opinion on our assessment could cause investors to lose confidence in our reported financial information, have an adverse effect on the trading price of our common stock and restrict our access to capital.
      If we were unable to port application programs to our new products successfully, we would have difficulty in selling these systems to a number of customers. To sell our products in the automotive, aerospace, chemistry and other engineering and technical markets, including certain governmental users, we must have application programs ported to these systems and tuned so that they will achieve high performance. These application programs are owned in some instances by independent software vendors and in others by potential customers. We must induce these vendors and potential customers to undertake this activity. We must also modify and rewrite third-party and customer specific application programs. We have had limited success in porting such applications to the Cray X1/ X1E systems with sufficient performance to make sales of this product compelling in industrial markets. There can be no assurance that we will be able to induce third-party vendors and customers to rewrite successfully third-party and customer specific applications for use on our new products. In addition, our Cray XD1 and Cray XT3 systems use a modified version of standard Linux kernels that may result in delays in having independent software vendor certified applications available on our systems and/or a reduced number of certified applications, which would limit our ability to address some part of our target markets.

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      Requests for proposals based on theoretical peak performance could reduce our ability to sell our systems. Our high performance computer systems are designed to provide high actual sustained performance on difficult computational problems. Some of our competitors offer systems with higher theoretical peak performance at lower prices, although their actual sustained performance on real applications frequently is a small fraction of their theoretical peak performance. Nevertheless, a number of requests for proposals, primarily from governmental agencies in the United States and elsewhere, continue to have criteria based wholly or significantly on theoretical peak performance. Under such criteria, the price/peak performance ratio of our products compares unfavorably to the price/peak performance ratio of our competitors’ products. To the extent that these criteria are not changed to favor actual performance, we will continue to be disadvantaged in these instances by being unable to submit competitive bids, which would limit our revenue potential.
      Lower than anticipated sales of new supercomputers would further reduce our service revenue from maintenance service contracts. High performance computer systems are typically sold with maintenance service contracts. These contracts generally are for annual periods, although some are for multi-year periods, and provide a predictable revenue base. Our revenue from maintenance service contracts has declined from a run-rate of approximately $95 million in 2000 to approximately $42 million in 2004. We expect maintenance service revenue to continue to decline slightly over the next year as our older systems continue to be withdrawn from service and then to stabilize as our new systems are placed in service. In addition, we expect that our newer products will require less hardware maintenance than our historic vector systems, which will affect adversely the rate of service revenue growth.
      U.S. export controls could hinder our ability to make sales to foreign customers and our future prospects. The U.S. government regulates the export of high performance computer systems such as our products. Occasionally we have experienced delays in receiving appropriate approvals necessary for certain sales, which have delayed the shipment of our products. Delay or denial in the granting of any required licenses could make it more difficult to make sales to foreign customers, eliminating an important source of potential revenue.
      We incorporate software licensed from third parties into the operating systems for our products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for our products. The operating system software we develop for our high performance computer systems contains components that are licensed to us under “open source” software licenses. Our business could be disrupted if this software, or functional equivalents of this software, were either no longer available to us or no longer offered to us on commercially reasonable terms. In either case we would be required either to redesign our operating system software to function with alternate third-party software, or develop these components ourselves, which would result in increased costs and could result in delays in product shipments. Furthermore, we might be forced to limit the features available in our current or future operating system software offerings. Our Cray XD1 and Cray XT3 systems utilize operating system variants that incorporate Linux technology. The SCO Group, Inc., has filed and threatened to file lawsuits against companies that operate Linux for commercial purposes, alleging that such use of Linux infringes The SCO Group’s rights. It is possible that The SCO Group could assert a claim of infringement against us with respect to our use of Linux technology. The open source licenses under which we have obtained certain components of our operating system software may not be enforceable. Any ruling by a court that these licenses are not enforceable, or that Linux-based operating systems, or significant portions of them, may not be copied, modified or distributed as provided in those licenses, would adversely affect our ability to sell our systems. In addition, as a result of concerns about The SCO Group’s lawsuit and open source generally, we may be forced to protect our customers from potential claims of infringement by The SCO Group or other parties. In any such event, our financial condition and results of operations may be adversely affected.
      The failure to integrate Cray Canada Inc. could adversely affect our business. With the acquisition of OctigaBay Systems Corporation (now named Cray Canada Inc.) at the beginning of the 2004 second quarter, we added an additional product line, 66 employees and a fourth major office location, our first major office outside of the United States. We need to increase our sales force and develop new sales channels to handle the Cray XD1 product, develop a different approach for manufacturing and servicing of the Cray XD1 product,

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integrate our financial and information systems and over time integrate our development programs. These changes may place a significant strain on our management resources. The failure to retain the current Cray Canada engineers and employees would adversely affect the development schedule and delay introduction of the Cray XD1 system and enhancements to that system. Difficulties in integrating our operations would divert our management’s time and resources. Failure to complete this integration successfully could cause us to increase expenditures and adversely affect our revenue and results of operations.
      General economic and market conditions could decrease our revenue, increase our need for cash and adversely affect our profitability. While much of our business is related to the government sector, which is less affected by short-term economic cycles, a slow-down in the overall U.S. and global economy and resultant decreases in capital expenditures have affected sales to our industrial customers and may continue to do so. Cancellations, delays or reductions in purchases would decrease our revenue, increase our need for working capital and adversely affect our profitability.
      We may infringe or be subject to claims that we infringe the intellectual property rights of others. Third parties may assert intellectual property infringement claims against us, and such claims, if proved, could require us to pay substantial damages or to redesign our existing products. Regardless of the merits, any claim of infringement requires management attention and causes us to incur significant expense to defend.
      We may not be able to protect our proprietary information and rights adequately. We rely on a combination of patent, copyright and trade secret protection, nondisclosure agreements and licensing arrangements to establish, protect and enforce our proprietary information and rights. We have a number of patents and have additional applications pending. There can be no assurance, however, that patents will be issued from the pending applications or that any issued patents will protect adequately those aspects of our technology to which such patents will relate. Despite our efforts to safeguard and maintain our proprietary rights, we cannot be certain that we will succeed in doing so or that our competitors will not independently develop or patent technologies that are substantially equivalent or superior to our technologies. The laws of some countries do not protect intellectual property rights to the same extent or in the same manner as do the laws of the United States. Although we continue to implement protective measures and intend to defend our proprietary rights vigorously, these efforts may not be successful.
Factors Pertaining to our Notes and Underlying Common Stock
      Our indebtedness may adversely affect our financial strength. With the sale of the Notes, we incurred $80.0 million of indebtedness. As of December 31, 2004, we had no other outstanding indebtedness for money borrowed and no material equipment lease obligations. We have a $15.0 million secured credit facility in place to support the issuance of letters of credit of which $11.4 million were outstanding as of December 31, 2004. In the future, we may incur additional indebtedness for money borrowed, which may include borrowing under new credit facilities. The level of our indebtedness could, among other things:
  •  make it difficult or impossible for us to make payments on the Notes;
 
  •  increase our vulnerability to general economic and industry conditions, including recessions;
 
  •  require us to use cash flow from operations to service our indebtedness, thereby reducing our ability to fund working capital, capital expenditures, research and development efforts and other expenses;
 
  •  limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;
 
  •  place us at a competitive disadvantage compared to competitors that have less indebtedness; and
 
  •  limit our ability to borrow additional funds that may be needed to operate and expand our business.
      We may enter into agreements for future credit facilities that may affect our ability to make payments under the Notes. We anticipate that future credit facilities will contain various financial covenants; our current credit facility requires that we maintain collateral consisting of cash and cash-equivalents in excess of our outstanding letters or credit. Our failure to comply with those covenants could result in an event of default,

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which, if not cured or waived, could result in the acceleration of our indebtedness. Such covenants may include agreements that, if a credit facility is in default, we will not make payments to other creditors, including payments under the Notes. Because our credit facilities will constitute senior indebtedness, any enforcement by the Note holders of their rights under the indenture to such payments could lead to our insolvency and a proceeding in which our senior and secured indebtedness would have priority over claims under the Notes.
      We will require a significant amount of cash to service our indebtedness and to fund planned capital expenditures, research and development efforts and other corporate expenses. Our ability to make payments on our indebtedness, including the Notes, and to fund planned capital expenditures, research and development efforts and other corporate expenses will depend on our future operating performance and on economic, financial, competitive, legislative, regulatory and other factors. Many of these factors are beyond our control. Our business may not generate sufficient cash flow from operations and future borrowings may not be available to us in an amount sufficient to enable us to pay our indebtedness, including the Notes, or to fund our other needs.
      If we are unable to generate sufficient cash flow to enable us to pay our indebtedness, we may need to pursue one or more alternatives, such as:
  •  reducing our operating expenses;
 
  •  reducing or delaying capital expenditures or research and development;
 
  •  selling assets; and
 
  •  raising additional equity capital.
      Any reduction in operating expenses, reduction or delay in capital expenditures, or sale of assets may materially and adversely affect our future revenue prospects. In addition, we may not be able to raise additional equity capital on commercially reasonable terms or at all. Finally, any of the above actions may not provide sufficient cash to repay our indebtedness, including the Notes.
      There are no covenants in the indenture for the Notes restricting our ability or the ability of our subsidiaries to incur future indebtedness or restricting the terms of any such indebtedness. The indenture governing the Notes does not contain any financial or operating covenants or restrictions on the amount or terms of indebtedness that we or any of our subsidiaries may incur. We may therefore incur additional debt without limitation, including senior indebtedness, to which the Notes are contractually subordinated, and secured indebtedness, to which the Notes are effectively subordinated. In addition, our subsidiaries may incur additional debt to which the Notes are structurally subordinated, without limitation. We or our subsidiaries may also agree to terms of any such indebtedness that may restrict our flexibility in complying with our obligations under the Notes. If we or any of our subsidiaries incur additional indebtedness, the related risks that we and they now face may intensify.
      The Notes are subordinated in right of payment to our existing and future senior indebtedness. The Notes are our general unsecured senior subordinated obligations. The Notes rank junior in right of payment to our existing and future senior indebtedness and equal in right of payment with any future indebtedness or other obligation that is not, by its terms, either senior or subordinated to the Notes. The indenture for the Notes does not limit our ability to incur additional indebtedness of any kind. In the event of our bankruptcy, liquidation or reorganization, the note holders will share in any assets available to our general creditors, only after all obligations to the holders of senior indebtedness have been paid. The note holders do not have the right to limit the amount of senior indebtedness or the competing claims of our general creditors.
      The Notes are effectively subordinated to our secured indebtedness and are structurally subordinated to all indebtedness and other liabilities of our current and future subsidiaries. The Notes are general unsecured obligations and are effectively subordinated to our current and future secured indebtedness to the extent of the assets securing the indebtedness. The indenture for the Notes does not limit our ability to incur secured indebtedness. In the event of bankruptcy, liquidation or reorganization or upon acceleration of our secured indebtedness and in certain other events, our assets pledged in support of secured indebtedness will

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not be available to pay our obligations under the Notes. As a result, we may not have sufficient assets to pay amounts due on any or all of the Notes.
      In addition, the Notes are structurally subordinated to all indebtedness and other liabilities of our current and future subsidiaries. Note holders do not have any claim as a creditor against our subsidiaries, and indebtedness and other liabilities, including trade payables, of our subsidiaries effectively are senior to Note holders’ claims against our subsidiaries. The indenture for the Notes does not limit the ability of our subsidiaries to incur indebtedness or other liabilities. In the event of a bankruptcy, liquidation or reorganization of any of our subsidiaries, holders of their indebtedness and their trade creditors will generally be entitled to payment on their claims from assets of that subsidiary before any assets are made available for distribution to our direct creditors.
      In certain circumstances, holders of senior debt can require us to suspend or defer cash payments due in respect of the Notes. If we are in default as to any payment obligation under any Senior Debt, as defined in the indenture governing the Notes, including a payment default that results from the acceleration of such Senior Debt as a result of a non-payment default, we will be prohibited, under the terms of the indenture from making any further cash payments in respect of the Notes until such default has been cured or waived or shall have ceased to exist. In addition, if we incur a non-payment default under any Designated Senior Debt, as defined in the indenture, the holder or holders may provide, or cause to be provided, a notice to the indenture trustee that will have the effect of prohibiting any further cash payments in respect of the Notes for a period not exceeding 179 days from the date on which the trustee receives the notice or until such default is earlier cured or waived. A holder of Designated Senior Debt may have the right to accelerate such debt as a result of the non-payment default during the 179 day blockage period or otherwise, in which event future payments in respect of the Notes will be prohibited as described above.
      Unless a condition to conversion is met prior to the maturity of the Notes, the Notes will not be convertible at any time. The Notes are convertible only upon the occurrence of stated conditions. If none of these conditions occurs during the term of the Notes, the Notes will never be convertible and the holders may never have an opportunity to realize any appreciation in value based on the value of our common stock.
      Upon conversion of the Notes, we may pay cash or a combination of cash and shares of our common stock in lieu of issuing shares of our common stock. Therefore, Note holders may receive no shares of our common stock or fewer shares than the number into which their Notes are convertible. We have the right to satisfy our conversion obligation to Note holders by issuing shares of our common stock into which the Notes are convertible, paying the cash value of the shares of our common stock into which the Notes are convertible, or a combination thereof. In addition, we have the right to irrevocably elect to satisfy our conversion obligation in cash with respect to the principal amount of the Notes to be converted after the date of such election. Accordingly, upon a conversion of a Note, a holder may not receive any shares of our common stock, or it might receive fewer shares of our common stock relative to the conversion value of the Note. Our liquidity may be reduced to the extent that we choose to deliver cash rather than shares of our common stock upon conversion of Notes.
      If a principal conversion settlement election is made, we may not have sufficient funds to pay the cash settlement upon conversion. If we make a principal conversion settlement election, upon conversion of the Notes, we will be required to satisfy our conversion obligation relating to the principal amount of such Notes in cash. If a significant number of holders were to tender their Notes for conversion at any given time, we may not have the financial resources available to pay the principal amount in cash on all such Notes tendered for conversion.
      The conversion rate of the Notes may not be adjusted for all dilutive events, including third-party tender or exchange offers, that may adversely affect the trading price of the Notes or our common stock issuable upon conversion of the Notes. The conversion rate of the Notes is subject to adjustment upon specified events, including specified issuances of stock dividends on our common stock, issuances of rights or warrants, subdivisions, combinations, distributions of capital stock or assets, cash dividends and issuer tender or exchange offers. The conversion rate will not be adjusted upon other events, such as third-party tender or exchange offers, that may adversely affect the trading price of the Notes or our common stock.

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      If we pay cash dividends on our common stock, Note holders may be deemed to have received a taxable dividend without the receipt of cash. If we pay cash dividends on our common stock and there is a resulting adjustment to the conversion rate, a Note holder could be deemed to have received a taxable dividend subject to U.S. federal income tax without the receipt of any cash.
      If we elect to settle upon conversion in cash or a combination of cash and shares of common stock, there will be a delay in settlement. Upon conversion, if we elect to settle in cash or a combination of cash and shares of our common stock, there will be a significant delay in settlement. In addition, because the amount of cash or common stock that a Note holder will receive in these circumstances will be based on the sale price of our common stock for an extended period between the conversion date and such settlement date, holders will bear the market risk with respect to the value of the common stock for such extended period.
      Some significant corporate transactions may not constitute a fundamental change, in which case we would not be obligated to offer to repurchase the Notes. Upon the occurrence of a fundamental change, as defined in the indenture governing the Notes, which includes specified change of control events, we will be required to offer to repurchase all outstanding Notes. The fundamental change provisions, however, will not require us to offer to repurchase the Notes in the event of some significant corporate transactions. For example, various transactions, such as leveraged recapitalizations, refinancings, restructurings or acquisitions initiated by us, would not constitute a change of control and, therefore, would not constitute a fundamental change requiring us to repurchase the Notes. Other transactions may not constitute a fundamental change because they do not involve a change in voting power or beneficial ownership of the type described in the definition of fundamental change. Accordingly, Note holders may not have the right to require us to repurchase their Notes in the event of a significant transaction that could increase the amount of our indebtedness, adversely affect our capital structure or any credit ratings or otherwise adversely affect the holders of Notes.
      In addition, a fundamental change includes a sale of all or substantially all of our properties and assets. Although there is limited law interpreting the phrase “substantially all,” there is no precise established definition of the phrase under the laws of New York, which govern the indenture and the Notes, or under the laws of Washington, our state of incorporation. Accordingly, a Note holder’s ability to require us to repurchase Notes as a result of a sale of less than all of our properties and assets may be uncertain.
      Our Notes may not be rated or may receive a lower rating than investors anticipate, which could cause a decline in the trading volume and market price of the Notes and our common stock. We do not intend to seek a rating on the Notes, and we believe it is unlikely the Notes will be rated. If, however, one or more rating agencies rates the Notes and assigns a rating lower than the rating expected by investors, or reduces any rating in the future, the trading volume and market price of the Notes and our common stock may be adversely affected.
      We may not have the funds necessary to purchase the Notes upon a fundamental change or other purchase date and our ability to purchase the Notes in such events may be limited. On December 1, 2009, December 1, 2014 and December 1, 2019, holders of the Notes may require us to purchase their Notes for cash. In addition, holders may also require us to purchase their Notes upon a fundamental change, as defined in the indenture governing the Notes. Our ability to repurchase the Notes in such events may be limited by law, and by the terms of other indebtedness, including the terms of senior indebtedness, we may have outstanding at the time of such events. Our credit facility does not permit us to use it to fund a repurchase of the Notes, and does not permit repurchase of the Notes prior to maturity unless there is no outstanding amount and no default under that credit facility. Any subsequent credit facility may include similar provisions. If we do not have sufficient funds, we will not be able to repurchase the Notes tendered to us for purchase. If a repurchase event occurs, we expect that we would require third-party financing to repurchase the Notes, but we may not be able to obtain that financing on favorable terms or at all. Our failure to repurchase tendered Notes at a time when the repurchase is required by the indenture would constitute a default under the indenture. In addition, a default under the indenture or a fundamental change, in and of itself, could lead to a default under our credit facility and other existing and future agreements governing our indebtedness. In these circumstances, the subordination provisions in the indenture governing the Notes may limit or prohibit

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payments to Note holders. If, due to a default, the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness or repurchase the Notes.
      The make whole premium payable on Notes that are converted in connection with certain fundamental changes may not adequately compensate Note holders for the lost option time value of the Notes as a result of that fundamental change. If any of certain fundamental changes occurs on or prior to December 1, 2009, we will under certain circumstances pay a make whole premium on the Notes that are converted in connection with such fundamental change. The amount of the make whole premium and additional shares delivered depends on the date on which the fundamental change becomes effective and the price paid per share of our common stock in the transaction constituting the fundamental change, as defined in the indenture governing the Notes. Although the make whole premium is designed to compensate Note holders for the lost option value of the Notes as a result of the fundamental change, the amount of the make whole premium is only an approximation of the lost value and may not adequately compensate Note holders for the loss. In addition, if a fundamental change occurs after December 1, 2009, or if the applicable price is less than or equal to $3.51 per share or greater than $10.50 per share (in each case, subject to adjustment), then we will not pay any make whole premium. Also, a holder may not receive the make whole premium payable upon conversion until the fundamental change repurchase date relating to the applicable fundamental change, or even later, which could be a significant period of time after the date the holder has tendered its Notes for conversion.
      There are restrictions on the Note holders’ ability to transfer or resell the Notes without registration under applicable securities laws, and if we fail to fulfill our obligations to register the Notes for resale, we will be required to pay additional interest on the Notes affected by that failure and to issue additional shares of common stock on Notes converted during such failure and satisfied by us in common stock. We sold the Notes under an exemption from registration under applicable U.S. federal and state securities laws. Although we have filed a registration statement covering the resale of the Notes and underlying common stock it is not yet effective. The Notes have not been registered under the Securities Act and, therefore, until we fulfill our obligations under the registration rights agreement, the Notes may be offered and sold by Note holders only pursuant to an exemption from, or in transactions not subject to, the registration requirements of the Securities Act and applicable state securities laws.
      Although under the registration rights agreement we are required to use our reasonable best efforts to register for resale the Notes and the shares of common stock issuable upon conversion of the Notes, we may not be able to successfully register these securities. In addition, under the registration rights agreement, we are permitted to suspend the use of an effective registration statement for specific periods of time for certain specified reasons. If the registration statement which we have filed covering resale of the Notes and the underlying common stock is not declared effective by the SEC by July 1, 2005, or if we fail to fulfill other obligations specified in the registration rights agreement governing the Notes, we will be required to pay additional interest on Notes adversely affected by such failure. Such additional interest will accrue from the date of such failure at a rate per year equal to 0.25% for the first 90 days, and 0.50% thereafter, on the principal amount of such Notes until such failure is cured or until the registration statement is no longer required to be kept effective and is payable on the scheduled interest payment dates. If a holder converts Notes during a registration default, no accrued and unpaid additional interest will be paid with respect to the Notes converted, but the holder would receive on any conversion that we elect to satisfy in common stock 103% of the number of shares of our common stock that such holder would have received in the absence of such default. We would have no other liability for monetary damages for a failure to fulfill our registration obligations.
      There is no active market for the Notes and if an active trading market does not develop for these Notes, the holders of the Notes may be unable to resell them. The Notes are a new issue of securities for which the only current trading market is the Nasdaq’s screen-based automated trading system known as PORTAL, which facilitates the trading of unregistered securities eligible to be resold by qualified institutional buyers pursuant to SEC Rule 144A. Once the Notes are registered under the Securities Act and resold using an effective prospectus, the Notes will no longer be eligible for trading in the PORTAL market. Moreover, if enough Notes are converted, redeemed or sold pursuant to an effective prospectus, trading of Notes in the PORTAL market may become inactive or may cease altogether. In that event, and in the absence of an

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alternative trading market, there would exist no organized market for the Notes from which their market value could be determined or realized. We do not intend to list the Notes on any national securities exchange or to seek the admission of the Notes for trading in the Nasdaq National Market or SmallCap Market. We have been advised by Bear, Stearns & Co. Inc. that it intends to make a market in the Notes. However, it is not obligated to do so and any market-making activities with respect to the Notes may be discontinued at any time without notice. In addition, market-making activity is subject to the limits imposed by law.
      Further, even if a market in the Notes develops, the Notes could trade at prices lower than the initial offering price. In addition, the liquidity of, and the trading market for, the Notes may be adversely affected by many factors, including prevailing interest rates, the markets for similar securities, general economic conditions, our financial condition, performance and prospects and general declines or disruptions in the market for non-investment grade debt.
      Our stock price is volatile. The stock market has been and is subject to price and volume fluctuations that particularly affect the market prices for small capitalization, high technology companies like us. The trading price of our common stock is subject to significant fluctuations in response to many factors, including our quarterly operating results (particularly if they are less than our or analysts’ previous estimates), changes in analysts’ estimates, our capital raising activities, announcements of technological innovations by us or our competitors and general conditions in our industry.
      A substantial number of our shares are eligible for future sale and may depress the market price of our common stock and may hinder our ability to obtain additional financing. As of December 31, 2004, we had outstanding:
  •  87,919,604 shares of common stock, including 570,963 shares of common stock issuable upon exchange of certain exchangeable securities issued in connection with the acquisition of OctigaBay Systems Corporation;
 
  •  warrants to purchase 5,439,850 shares of common stock;
 
  •  stock options to purchase an aggregate of 14,284,391 shares of common stock, of which 8,857,598 options were then exercisable (as of March 21, 2005, we had stock options outstanding covering 13,754,297 shares of which 13,410,110 were then exercisable); and
 
  •  Notes convertible into 16,576,016 shares of common stock.
      Almost all of our outstanding shares of common stock may be sold without substantial restrictions. All of the shares of common stock that may be issued on exercise of the warrants and options will be available for sale in the public market when issued, subject in some cases to volume and other limitations. The warrants outstanding at December 31, 2004, consisted of warrants to purchase 300,442 shares of common stock, with exercise prices ranging from $4.50 to $6.00 per share, expiring between November 8, 2005, and September 3, 2006, and warrants to purchase 5,139,408 shares of common stock, with an exercise price of $2.53 per share, expiring on June 21, 2009. The Notes are not now convertible, and only become convertible upon the occurrence of certain events. We have agreed to register the resale of the Notes and of the underlying common stock under the Securities Act of 1933, as amended, which will facilitate transferability of those securities. Sales in the public market of substantial amounts of our common stock, including sales of common stock issuable upon the exercise of warrants, options and Notes, may depress prevailing market prices for the common stock. Even the perception that sales could occur may impact market prices adversely. The existence of outstanding warrants, options and Notes may prove to be a hindrance to our future financings. Further, the holders of warrants, options and Notes may exercise or convert them for shares of common stock at a time when we would otherwise be able to obtain additional equity capital on terms more favorable to us. Such factors could impair our ability to meet our capital needs.
      Provisions of our Articles of Incorporation and Bylaws could make a proposed acquisition that is not approved by our Board of Directors more difficult. Provisions of our Restated Articles of Incorporation and Bylaws could make it more difficult for a third party to acquire us. These provisions could limit the price that

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investors might be willing to pay in the future for our common stock. For example, our Articles of Incorporation and Bylaws provide for:
  •  removal of a director only in limited circumstances and only upon the affirmative vote of not less than two-thirds of the shares entitled to vote to elect directors;
 
  •  the ability of our board of directors to issue preferred stock, without shareholder approval, with rights senior to those of the common stock;
 
  •  no cumulative voting of shares;
 
  •  calling a special meeting of the shareholders only upon demand by the holders of not less than 30% of the shares entitled to vote at such a meeting;
 
  •  amendments to our Restated Articles of Incorporation require the affirmative vote of not less than two-thirds of the outstanding shares entitled to vote on the amendment, unless the amendment was approved by a majority of our continuing directors, who are defined as directors who have either served as a director since August 31, 1995, or were nominated to be a director by the continuing directors;
 
  •  special voting requirements for mergers and other business combinations, unless the proposed transaction was approved by a majority of continuing directors;
 
  •  special procedures to bring matters before our shareholders at our annual shareholders’ meeting; and
 
  •  special procedures to nominate members for election to our board of directors.
      These provisions could delay, defer or prevent a merger, consolidation, takeover or other business transaction between us and a third party.
      We do not anticipate declaring any cash dividends on our common stock. We have never paid any dividends on our common stock, and we do not anticipate paying any cash dividends on our common stock in the foreseeable future. In addition, our credit facility prohibits us, and any future credit facility is likely to prohibit us from paying cash dividends without the consent of our lender.
Available Information
      Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act are available free of charge at our web site at www.cray.com as soon as reasonably practicable after we file such reports with the SEC electronically. In addition, we have set forth our Code of Business Conduct, Corporate Governance Principles, the charters of our Board committees and other governance documents on our web site, www.cray.com, under “Investors — Corporate Governance.”
Item 2. Properties
      Our principal properties are as follows:
             
        Approximate
Location of Property   Uses of Facility   Square Footage
         
Chippewa Falls, WI
  Manufacturing, hardware development, central service and warehouse     228,000  
Seattle, WA
  Executive offices, hardware and software development, sales and marketing     85,000  
Mendota Heights, MN
  Software development, sales and marketing operations     55,000  
Burnaby, B.C., Canada
  Software and hardware development, sales and marketing     19,000  
      We own 179,000 square feet of manufacturing, development, service and warehouse space in Chippewa Falls, Wisconsin, and lease the remaining space described above.

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      We also lease a total of approximately 12,000 square feet, primarily for sales and service offices, in various domestic locations. In addition, various foreign sales and service subsidiaries have leased an aggregate of approximately 25,000 square feet of office space. We believe our facilities are adequate to meet our needs in 2005.
Item 3. Legal Proceedings
      We are not a party to any material legal proceeding.
Item 4. Submission of Matters to a Vote of Security Holders
      No matters were submitted to a vote of our shareholders during the fourth quarter of 2004.
Item E.O.      Executive Officers of the Company
      Our executive officers, as of March 14, 2005, were as follows:
             
Name   Age   Position
         
James E. Rottsolk
    60     Chief Executive Officer and Chairman of the Board of Directors
Burton J. Smith
    63     Chief Scientist and Director
Peter J. Ungaro
    36     President
Christopher Jehn
    62     Vice President
Kenneth W. Johnson
    62     Senior Vice President, Chief Financial Officer, General Counsel and Corporate Secretary
David R. Kiefer
    56     Senior Vice President
Ly-Huong T. Pham
    46     Senior Vice President
      James E. Rottsolk is one of our co-founders and serves as Chief Executive Officer and Chairman of the Board of Directors. He served as Chief Executive Officer from our inception through September 2001, and was reappointed to that position in March 2002. He served as President from our inception through September 2001 and from March 2002, until March 7, 2005. He has served as Chairman of the Board since December 2000. Prior to 1987, Mr. Rottsolk served as an executive officer with several high technology companies. Mr. Rottsolk received a B.A. degree from St. Olaf College and A.M. and J.D. degrees from the University of Chicago.
      Burton J. Smith is one of our co-founders and has been Chief Scientist and a Director since 1988. He served as Chairman from 1988 to June 1999. He is a recognized authority on high performance computer architecture and programming languages for parallel computers. He is the principal architect of the Cray MTA system and heads our Cascade project. Mr. Smith was a Fellow of the Supercomputing Research Center (now the Center for Computing Sciences), a division of the Institute for Defense Analyses, from 1985 to 1988. In 2003 he received the Seymour Cray Computing Engineering Award from the IEEE Computer Society and was elected as a member of the National Academy of Engineering. He was honored in 1990 with the Eckert-Mauchly Award given jointly by the Institute for Electrical and Electronic Engineers and the Association for Computing Machinery, and was elected a Fellow of both organizations in 1994. Mr. Smith received S.M., E.E. and Sc.D. degrees from the Massachusetts Institute of Technology.
      Peter J. Ungaro serves as President, to which position he was appointed on March 7, 2005. He previously served as Senior Vice President responsible for sales, marketing and services from September 2004. Prior to joining us in August 2003 as Vice President responsible for sales and marketing, he served as Vice President, Worldwide Deep Computing Sales for IBM. In that role, he led global sales of all IBM server and storage products for high performance computing, life sciences, digital media and business intelligence markets. Mr. Ungaro coordinated IBM solutions teams that included sales, technical, marketing and product development personnel. Prior to that assignment, he was IBM’s vice president, worldwide high performance

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computing sales. He has also held a variety of other sales leadership positions since joining IBM in 1991. Mr. Ungaro received a B.A. in business administration from Washington State University in 1990.
      Christopher Jehn serves as Vice President responsible for government programs, a position he has held since joining us in July 2001. He served as the Assistant Director for National Security in the Congressional Budget Office from 1998 to 2001. From 1997 to 1998, he was a member of the Commission on Servicemembers and Veterans Transition Assistance, and also served in 1997 as the Executive Director of the National Defense Panel. Mr. Jehn was a Senior Vice President at ICF Kaiser International, Inc., from 1995 to 1997. Prior to 1995, he held executive positions at the Institute for Defense Analyses and the Center for Naval Analyses and served as Assistant Secretary of Defense for Force Management and Personnel from 1989 to 1993. He received a B.A. from Beloit College and a Master’s degree in economics from the University of Chicago.
      Kenneth W. Johnson serves as Senior Vice President, Chief Financial Officer, General Counsel and Corporate Secretary. He has held the position of General Counsel and Corporate Secretary since joining us in September 1997. From September 1997 to December 2001 he also served as Vice President Finance and Chief Financial Officer and he was reappointed Chief Financial Officer in November 2004. Prior to joining us, Mr. Johnson practiced law in Seattle for 20 years with Stoel Rives LLP and predecessor firms, where his practice emphasized corporate finance. Mr. Johnson received an A.B. degree from Stanford University and a J.D. degree from Columbia University Law School.
      David R. Kiefer has served as a Senior Vice President heading our hardware engineering activities since September 2004. He has held various engineering management positions since joining us in April 2000. From 1996 to 2000, Mr. Kiefer was Director of Hardware Engineering at the Cray Research operations of Silicon Graphics, Inc. Prior to joining Silicon Graphics, he held a variety of engineering and engineering management positions with Univac and Cray Research, Inc. Mr. Kiefer received his B.S. in Electrical Engineering from the University of Wisconsin.
      Ly-Huong T. Pham serves as Senior Vice President responsible for corporate assessment and development. From September 2004 until March 7, 2005, she was responsible for engineering, manufacturing, employee support and information services operations. Ms. Pham joined us in February 2004 as Vice President responsible for software. Prior to joining us, she served as chief executive officer at Turbolinux Inc., chief operating officer at Onscreen24, and chief technology officer and vice president of research and development at VTEL Corporation. Prior to VTEL, Ms. Pham led the development of the MacIntosh OS 8 user experience at Apple Computer. Prior to Apple, she held numerous technical and management roles at Wang Laboratories, Inc. She has been granted ten patents as a co-inventor in the area of data object integration and visual communications. Ms. Pham received a B.A. in Mathematics, an M.S. in Information Systems from Boston University, and a Presidential/ Key Executive M.B.A. from Pepperdine University.

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PART II
Item 5. Market for the Company’s Common Equity and Related Stockholder Matters
Price Range of Common Stock and Dividend Policy
      Our common stock is traded on the Nasdaq National Market under the symbol CRAY; prior to April 1, 2000, our stock traded under the symbol TERA. On March 14, 2005, we had 87,703,979 shares of common stock outstanding that were held by 789 holders of record.
      The quarterly high and low sales prices of our common stock for the periods indicated are as follows:
                                 
    2003   2004
         
    High   Low   High   Low
                 
First Quarter
  $ 8.94     $ 5.92     $ 11.75     $ 6.06  
Second Quarter
    8.50       6.57       8.03       5.84  
Third Quarter
    13.99       7.70       6.68       2.85  
Fourth Quarter
    13.68       8.27       4.83       3.02  
      We have not paid cash dividends on our common stock and we do not anticipate paying any cash dividends on our common stock in the foreseeable future. In addition, our credit facility prohibits us from paying cash dividends without the consent of our lender.
Unregistered Sales of Securities
      In separate closings held on December 6 and 21, 2004, we issued and sold a total of $80 million in aggregate principal amount of our 3.0% Convertible Senior Subordinated Notes due 2024 in a private placement to Bear, Stearns & Co. Inc., the initial purchaser, which was entitled to resell the Notes to “qualified institutional buyers” pursuant to Rule 144A under the Securities Act of 1933, as amended.
      We received net proceeds of approximately $76.6 million from the offering of $80 million in aggregate principal amount of the Notes, after deducting the initial purchaser’s discount of $3 million and offering expenses. We are using the net proceeds to support our operations and growth and for other general corporate purposes.
      The offering of the Notes was made pursuant to the terms of a Purchase Agreement, dated December 1, 2004, between Bear, Stearns & Co. Inc. and us. The Notes are issued under an Indenture by and between The Bank of New York Trust Company, N.A. and us and benefit from a Registration Rights Agreement between Bear, Stearns & Co. Inc., as the initial purchaser, and us.
      The material terms and conditions of the Indenture, the Notes, the Registration Rights Agreement and the Purchase Agreement were described in our Form 8-K current report filed on December 7, 2004, and the agreements relating to the offering and a description of our capital stock were filed as exhibits to that report.

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Item 6. Selected Financial Data
      The following table shows selected historical consolidated financial data for Cray Inc. and its subsidiaries. Financial data for fiscal year 2000 in the following table includes nine months of activity of the Cray Research business unit acquired on April 1, 2000. See “Business — Our History — Cray Research Acquisition” above.
                                               
    Years Ended December 31,
     
    2000   2001   2002   2003   2004
                     
    (In thousands, except for per share data)
Operating Data:
                                       
 
Revenue:
                                       
   
Product
  $ 46,617     $ 51,105     $ 76,519     $ 175,004     $ 99,236  
   
Service
    71,455       82,502       78,550       61,958       49,948  
                               
     
Total revenue
    118,072       133,607       155,069       236,962       149,184  
 
Operating Expenses:
                                       
   
Cost of product revenue
    32,505       30,657       41,187       97,354       107,264  
   
Cost of service revenue
    34,077       41,181       42,581       40,780       30,338  
   
Research and development
    48,426       53,926       32,861       37,762       45,130  
   
Marketing and sales
    14,365       19,961       20,332       27,038       32,111  
   
General and administrative
    7,033       9,226       8,923       10,908       16,222  
   
Acquisition-related deferred compensation
                            11,134  
   
In-process research and development charge
                            43,400  
   
Restructuring costs
          3,802       1,878       4,019       8,182  
   
Amortization of goodwill
    5,217       6,981                    
                               
 
Income (loss) from operations
    (23,551 )     (32,127 )     7,307       19,101       (144,597 )
 
Other income (expense), net
    675       (336 )     3,104       1,496       (699 )
 
Interest income (expense), net
    (1,681 )     (1,771 )     (2,832 )     444       365  
                               
 
Income (loss) before income taxes
    (24,557 )     (34,234 )     7,579       21,041       (144,931 )
 
Provision (benefit) for income taxes
    831       994       2,176       (42,207 )     59,092  
                               
 
Net income (loss)
  $ (25,388 )   $ (35,228 )   $ 5,403     $ 63,248     $ (204,023 )
                               
 
Net income (loss) per diluted common share
  $ (0.78 )   $ (0.87 )   $ 0.10     $ 0.81     $ (2.45 )
                               
                                             
    Years Ended December 31,
     
    2000   2001   2002   2003   2004
                     
    (In thousands, except for ratios)
Cash Flow Data:
                                       
 
Cash provided by (used in):
                                       
   
Operating activities
  $ 5,084     $ (26,641 )   $ (8,689 )   $ (9,263 )   $ (53,301 )
   
Investing activities
    (57,420 )     (9,472 )     (5,992 )     (41,169 )     (18,471 )
   
Financing activities
    47,021       44,045       25,335       65,629       73,361  
 
Depreciation and amortization
    14,349       14,157       15,364       15,860       16,836  
 
Purchases of property and equipment
    5,835       9,472       6,038       6,599       12,518  
Other Data:
                                       
 
Ratio of earnings to fixed charges(1)
                3.4       52.6        

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    December 31,
     
    2000   2001   2002   2003   2004
                     
    (In thousands)
Balance Sheet Data:
                                       
Cash, cash equivalents, restricted cash and short-term investments
  $ 5,387     $ 12,377     $ 23,916     $ 74,343     $ 87,422  
Total assets
    136,193       127,087       145,245       291,589       308,789  
Obligations under capital leases
    633       768       393       152       823  
Total debt
    8,611       14,944       4,144             80,000  
Shareholders’ equity
    36,147       14,804       58,615       222,633       125,300  
 
(1)  The ratio of earnings to fixed charges is computed by dividing earnings by fixed charges. Earnings consist of net income (loss) plus provision (benefit) for income taxes and fixed charges. Fixed charges consist of interest expense plus the portion of operating rental expense management believes represents the interest component of rent expense. The pretax net loss for the years ended December 31, 2000, 2001 and 2004 was not sufficient to cover fixed charges by approximately $24.6 million, $34.2 million and $144.4 million, respectively. As a result, the ratio of earnings to fixed charges has not been computed for these periods.
Item 7.      Management’s Discussion and Analysis of Financial Condition and Results of Operations
Preliminary Note Regarding Forward-Looking Statements
      The information set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” below includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, and is subject to the safe harbor created by those Sections. Factors that realistically could cause results to differ materially from those projected in the forward-looking statements are set forth in this section and earlier in this report under “Business — Factors That Could Affect Future Results” beginning on page 15. The following discussion should also be read in conjunction with the Consolidated Financial Statements and accompanying Notes thereto.
Overview
      We design, develop, market and service high performance computer systems, commonly known as supercomputers. These systems provide capability and capacity far beyond typical server-based computer systems and address challenging scientific and engineering computing problems for government, industry and academia.
      We are dedicated solely to the high performance computing market. We have concentrated our product roadmap on building purpose-built, balanced systems combining highly capable processors (whether developed by ourselves or others) with rapid interconnect and communications capabilities throughout the entire computing system, not solely processor-to-processor. We believe we are in the best position to meet the high performance computer market’s demanding needs by providing superior supercomputer systems with performance and cost advantages over low-bandwidth and cluster systems when sustained performance on challenging applications and workloads and total cost of ownership are taken into account.
      We also derive revenue from providing maintenance and support services to the worldwide installed base of Cray computers and professional services that leverage our industry technical knowledge.
      Our revenue, net income or loss and cash balances are likely to fluctuate significantly from quarter to quarter and within a quarter due to the high average sales prices and limited number of sales of our larger products, the timing of purchase orders and product deliveries, our general policy of not recognizing product revenue for our larger systems until customer acceptance and other contractual provisions have been fulfilled, and the uncertain timing of payments for product sales, maintenance services, government research and development funding, and inventory.

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      In 2002 we completed hardware development of and began selling our Cray X1 system. We were then also selling other hardware products we obtained with the acquisition of the Cray Research assets from SGI. In mid-2002 we began development of the Red Storm project for Sandia National Laboratories and began work on the Cascade project under a DARPA grant. In 2003 we were principally selling Cray X1 systems and continuing work on the Red Storm and Cascade projects. In 2004 we were in transition from a single product, the Cray X1 system, to three new products: the Cray X1E system, an enhancement to the Cray X1 system that significantly increases processor speed and capability; the Cray XT3 system, developed through the Red Storm project; and the Cray XD1 system, a product in development we acquired with the April 2004 acquisition of OctigaBay Systems Corporation. Initial customer shipments for each of these products occurred in late 2004, with full production ramp planned for 2005. See “Business — History” and “— Product Offerings, Projects and Services” in Item 1 above.
      We experienced net losses in each full year of our development stage operations prior to 2002. We incurred net losses of approximately $35.2 million in 2001, $25.4 million in 2000 and $34.5 million in 1999. For 2002, we had net income of $5.4 million and for 2003 we had net income of $63.2 million (including an income benefit of $42.5 million from the reversal of a valuation allowance against deferred tax assets) and for 2004 we had a net loss of $204.0 million (including an expense for acquired in-process research and development of $43.4 million and an income tax expense of $58.5 million related to the establishment of a valuation allowance against deferred tax assets). Our challenges to achieving a profitable 2005 include introduction and ramp-up of our three new products, including completion of system software development, obtaining sufficient revenue and margins in a highly competitive market, and maintaining controls on expense levels while not adversely impacting future growth.
      Our fiscal year is the calendar year, and references to a particular year are to the year ended December 31 of that year.
      Factors that should be considered in evaluating our business, operations and prospects and that could affect our future results, financial condition and market prices of our securities are set forth above under “Business — Factors That Could Affect Future Results” in Item 1 above.
Critical Accounting Policies and Estimates
      This discussion as well as disclosures included elsewhere in this Annual Report on Form 10-K are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingencies. On an ongoing basis, we evaluate the estimates used, including those related to estimates of deferred tax realizability, valuation of inventory at the lower of cost or market, the percentage complete and estimated gross profit on the Red Storm and Cascade contracts, and impairment of goodwill. We base our estimates on historical experience, current conditions and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources as well as identifying and assessing our accounting treatment with respect to commitments and contingencies. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies involve the more significant judgments and estimates used in the preparation of the Consolidated Financial Statements.
Revenue Recognition
      We recognize revenue when it is realized or realizable and earned. In accordance with the Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition in Financial Statements, we consider revenue realized or realizable and earned when it has persuasive evidence of an arrangement, the product has been shipped or the services have been provided to the customer, title and risk of loss of products has passed to the customer, the sales price is fixed or determinable and collectibility is

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reasonable assured. In addition to the aforementioned general policy, the following are the specific revenue recognition policies for each major category of revenue and for multiple-element arrangements:
      Product. We recognize revenue based upon product line, as follows:
  •  Cray X1/ X1E and XT3 Product Line: We generally recognize revenue from product sales upon customer acceptance and when there are no unfulfilled company obligations that affect the customer’s final acceptance. A customer-signed notice of acceptance or similar document is required from the customer prior to revenue recognition.
 
  •  XD1 Product Line: The Company generally recognizes revenue from product sales of Cray XD1 systems upon shipment to or delivery to the customer, depending upon contract terms. If there is a contractual requirement for customer acceptance, revenue is recognized upon receipt of the notice of acceptance and when there are no unfulfilled company obligations.
      Revenue from contracts that require us to design, develop, manufacture or modify complex information technology systems to a customer’s specifications, and to provide services related to the performance of such contracts, is recognized using the percentage of completion method for long-term development projects. Percentage of completion is measured based on the ratio of costs incurred to date compared to the total estimated costs. Total estimated costs are based on several factors, including estimated labor hours to complete certain tasks and the estimated cost of purchased components at future dates. Estimates may need to be adjusted from quarter to quarter, which would impact revenue and margins on a cumulative basis.
      Revenue from contracts structured as operating leases is recorded as earned over the lease terms.
      Services: Service revenue for the maintenance of computers is recognized ratably over the term of the maintenance contract. Funds from maintenance contracts that are paid in advance are recorded as deferred revenue. High-performance computing service revenue is recognized as the services are rendered.
      Multiple-Element Arrangements. We commonly enter into transactions that include multiple-element arrangements, which may include any combination of hardware, maintenance and other services and/or software. In accordance with Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, when some elements are delivered prior to others in an arrangement and all of the following criteria are met, revenue for the delivered element is recognized upon delivery and acceptance of such item:
  •  The fair value of the elements, or for residual method calculations the undelivered element, is established;
 
  •  The functionality of the delivered elements are not dependent on the undelivered elements; and
 
  •  Delivery of the delivered element represents the culmination of the earnings process.
      If all of the criteria are not met, revenue is deferred until delivery of the last element.
Inventories
      We record our inventories at the lower of cost or market. We regularly evaluate the technological usefulness of various inventory components. When it is determined that previously inventoried components do not function as intended in a fully operational system, the costs associated with these components are expensed. Due to rapid changes in technology and the increasing demands of our customers, we are continually developing new products. As a result, it is possible that older products we have developed may become obsolete or we may sell these products below cost. When we determine that we will likely not recover the cost of inventory items through future sales, we write down the related inventory to our estimate of its market value. In the third quarter of 2004, we wrote down our Cray X1 system inventory by $7.8 million and our Cray XD1 system inventory by $0.2 million. Because the products we sell have high average sales prices and because a high number of our prospective customers receive funding from U.S. or foreign governments, it is difficult to estimate future sales of our products and the timing of such sales. It also is difficult to determine whether the cost of our inventories will ultimately be recovered through future sales. While we believe our

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inventory is stated at the lower of cost or market and that our estimates and assumptions to determine any adjustments to the cost of our inventories are reasonable, our estimates may prove to be inaccurate. We have sold inventory previously reduced in part or in whole to zero, and we may have future sales of previously written down inventory. We also may have additional expense to write down inventory to its estimated market value. Adjustments to these estimates in the future may materially impact our operating results.
Goodwill
      Approximately 18% of our assets as of December 31, 2004, consisted of goodwill resulting from our acquisitions of the Cray Research business unit from SGI in 2000 and our acquisition of OctigaBay Systems Corporation in April 2004. We no longer amortize goodwill associated with the acquisitions, but we are required to conduct ongoing analyses of the recorded amount of goodwill in comparison to its estimated fair value. We performed annual impairment tests effective January 1, 2004 and January 1, 2005 and determined that our recorded goodwill was not impaired. These analyses and ongoing analyses of whether the fair value of recorded goodwill is impaired will involve a substantial amount of judgment. Future charges related to goodwill could be material depending on future developments and changes in technology and our business. In 2003 we decreased goodwill by $9.3 million due to the reversal of our valuation allowance for deferred tax assets. See Note 12 — Income Taxes of the Notes to the Consolidated Financial Statements.
Accounting for Income Taxes
      Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 109, Accounting for Income Taxes, a valuation allowance for deferred tax assets is provided when it is estimated that it is more likely than not that all or a portion of the deferred tax assets may not be realized through future operations. The provision for or benefit from income taxes represents taxes payable or receivable for the current period plus the net change in deferred tax and valuation allowance amounts during the period. In 2003 we recorded an income tax benefit of $42.5 million related to the reversal of a valuation allowance against deferred tax assets. In accordance with SFAS No. 109, we determined that, based on our historical operating performance and reasonably expected future performance, we would be able to utilize most of our net deferred tax asset. In 2004 we reestablished the valuation allowance and recorded an income tax expense of $58.5 million. Based on the results of our operations in 2004 and based on our revised projections, we now believe that it is more likely than not that the deferred tax assets will not be realized through future operations.
Allowance for Doubtful Accounts
      Our management must make estimates of allowances for potential future uncollectible amounts related to current period revenues of our products and services. Our allowance for doubtful accounts is a management estimate that considers actual facts and circumstances of individual customers and other debtors, such as financial condition and historical payment trends. We evaluate the adequacy of the allowance utilizing a combination of specific identification of potentially problematic accounts and identification of accounts that have exceeded payment terms. As of December 31, 2004 and 2003, our allowance for doubtful accounts was $1.4 million and $1.2 million, respectively.
Red Storm Loss Reserves
      As noted in our revenue recognition policy, revenue from our Red Storm development project is recognized using the percentage of completion method. Percentage of completion is measured based on the ratio of costs incurred to date compared to total estimated costs. During 2004, we adjusted our estimate of total estimated costs and now expect to incur a loss on this contract. As of December 31, 2004, our estimated cumulative loss is $7.6 million, which is included within accrued liabilities in the December 31, 2004 balance sheet.

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Recent Accounting Pronouncements
      In November 2004 the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, Inventory Costs-an amendment of ARB No. 43, Chapter 4. SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) and requires that those items be recognized as current-period charges regardless of whether they meet the criterion set forth in ARB No. 43. This statement also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We have not yet determined the impact of the adoption of SFAS No. 151 on the Company’s financial position or results of operations.
      In December 2004 the FASB issued SFAS No. 123(R), Share-Based Payment. SFAS No. 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in the financial statements. That cost should be measured based on the fair value of the equity or liability instruments issued. SFAS No. 123(R) covers a wide range of share-based compensation arrangements including employee share options, performance-based awards and employee stock purchase plans. SFAS No. 123(R) is effective for us as of July 1, 2005. The impact of the adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the pro forma disclosure in the Notes to the Consolidated Financial Statements.
Results of Operations
Revenue
Product Revenue
      We recorded product revenue of $99.2 million in 2004, $175.0 million in 2003 and $76.5 million in 2002. Product revenue represented 67% of total revenue for 2004, compared to 74% in 2003 and 49% in 2002. The decline in product revenue in 2004 was primarily due to limited Cray X1 system sales and lower than planned revenue on the Red Storm contract. In 2004 we recognized approximately $52.8 million of revenue for the Red Storm and Cascade development projects with the remaining product revenue primarily relating to Cray X1 system sales. We were unable to recognize revenue on deliveries of Cray X1E and Cray XT3 systems made late in the fourth quarter. The growth in product revenue in 2003 was principally due to the availability of the Cray X1 system for the entire year as well as contributions from the Red Storm and Cascade projects; in 2003 we recognized approximately $19.6 million of revenue for the Red Storm and Cascade projects, with the remaining primarily due to Cray X1 system sales. Product revenue in 2002 related principally to products we no longer market with approximately $14.7 million due to early Cray X1 system sales and approximately $3.7 million from the Red Storm and Cascade projects.
      We expect product revenue to grow in 2005 in both absolute amounts and as a percentage contribution to total revenue. This revenue growth depends on sales of our three new products — Cray X1E, Cray XT3 and Cray XD1 systems — with expected total revenue from our Red Storm and Cascade projects of approximately $25 to $30 million. We expect our product revenue to vary significantly from quarter to quarter due to the product ramp-up for each of our products in the first part of 2005 as well as the uncertainty as to the timing of revenue recognition for several large transactions.
Service Revenue
      We recorded service revenue of $49.9 million, including revenue from maintenance services of $42.3 million in 2004, compared to service revenue of $62.0 million in 2003 and $78.6 million in 2002. Service revenue represented 33% of total revenue for 2004, 26% for 2003 and 51% in 2002. The increase in percentage contribution to total revenue, despite the decline in the amount of service revenue, is due to the steeper decline in 2004 product revenue. The decline in percentage contribution between 2003 and 2002 is due to the

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significant increase in product revenue in 2003 from sales of the Cray X1 system and the contributions from the Red Storm and Cascade projects, as well as the decline in maintenance revenue.
      Maintenance services are provided under separate maintenance contracts with our customers. These contracts generally provide for maintenance services for one year, although some are for multi-year periods. Maintenance service revenue has declined on an annual basis as older systems are withdrawn from service. We expect maintenance service revenue to continue to decline slightly over the next year as our older systems continue to be withdrawn from service and then to stabilize as our new systems are placed in service. In addition, we expect that our newer products will require less hardware maintenance than our historic vector systems, which will affect adversely the rate of service revenue growth.
Operating Expenses
      Cost of Product Revenue. We recorded cost of product revenue of $107.3 million in 2004, $97.4 million in 2003 and $41.2 million in 2002. Our cost of product represented 108% of product revenue in 2004, compared to 56% in 2003 and 54% in 2002. Revenue for 2004, 2003 and 2002 includes $498,000, $316,000 and $5.9 million, respectively, from the sale of obsolete inventory recorded at a zero cost basis. Cost of product revenue in 2004 was adversely affected by inventory write-downs of $8.0 million, a $7.4 million reserve for estimated additional costs to be incurred in completing the Red Storm project, a $1.0 million adjustment for unabsorbed manufacturing overhead relating to lower than planned production of Cray X1 systems and by the product mix, with proportionately less revenue from the limited sales of Cray X1 systems.
      We presently estimate that we will recognize a cumulative loss of approximately $7.6 million on the Red Storm contract. In 2004, we recorded negative margin on the Red Storm contract, and we expect to record zero margin on future Red Storm revenue. The negative Red Storm margin, low margin contribution from the Cascade project, increasing margin pressure on the Cray X1 systems, and low initial margin contribution from the Cray XD1 system, which is marketed in the more competitive massively parallel processor market and had higher start-up manufacturing costs, together with the adjustments described in the preceding paragraph, eliminated overall product margins in 2004. The minimal margin contribution from the Red Storm and Cascade projects, ramp-up costs associated with each of our new products, and the competitive market pressure on our products will impact 2005 margins adversely.
      Cost of Service Revenue. We recorded cost of service revenue of $30.3 million in 2004, $40.8 million in 2003 and $42.6 million in 2002. Our cost of service revenue represented 61% of service revenue for 2004, compared to 66% in 2003 and 54% in 2002. In 2004 our cost of service revenue was favorably impacted by high margin professional service contracts, service cost reductions implemented in the fourth quarter of 2003 and the second half of 2004, and the completed amortization of legacy spare parts inventory by March 31, 2004. In 2003 and 2002 cost of service revenue was favorably impacted by a reduction in Cray T90 warranty reserves of $2.6 million and $3.8 million, respectively. As we continue to experience declines in maintenance revenue before new shipments into the installed base offset retirements, we may continue to reduce maintenance service personnel and experience associated severance expenses. We expect maintenance costs for the next several quarters to approximate 65% of revenue.
Research and Development
      Research and development expenses in 2004 reflect our costs associated with the development of the Cray X1E, Cray XT3, Cray XD1 systems and successor projects, including related software development, and the Cray MTA-2 to a lesser extent. Research and development expenses in 2003 and 2002 reflect our costs associated with the development of the Cray X1 system and in 2003 its enhancements and successors, and to a lesser extent, the Cray MTA-2 in both periods, including related software development. Research and development expenses also include personnel expenses, allocated overhead and operating expenses, software, materials and engineering expenses, including payments to third parties. Gross research and development expenses in the table below reflect all research and development expenditures, including expenses related to our research and development activities on the Red Storm and Cascade projects. The government funding reflects reimbursement by the government for research and development and services, including development

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of the Cray X1/ X1E systems, enhancements and successors to the Cray X1/ X1E system and other products, and our research and development personnel dedicated to the Red Storm and Cascade projects. The Red Storm and Cascade research and development costs are reflected on our financial statements as cost of product revenue and the related reimbursements are recorded on our financial statements as product revenue.
      Research and development expenses for the years ended December 31, 2004, 2003 and 2002 were as follows (in thousands):
                         
    2004   2003   2002
             
Gross research and development
  $ 93,776     $ 68,801     $ 48,650  
Government funding
    (48,646 )     (31,039 )     (15,789 )
                   
Net research and development
  $ 45,130     $ 37,762     $ 32,861  
                   
      Net research and development expenditures represented 30%, 16% and 21%, of revenue in 2004, 2003 and 2002, respectively, even though we have received increased government funding each year. The higher 2004 percentage is due to lower revenue earned in 2004 and to increases in research and development expenses for most of our products and projects (including an increase of approximately $2.0 million to $2.5 million per quarter due to the OctigaBay acquisition at the beginning of the 2004 second quarter), other than for our Red Storm project. We expect that gross and net research and development expenses will decline in 2005, given the 2004 restructuring actions and completion of the Red Storm project coupled with an increase in government funding. These reductions will be offset in part by increased non-recurring engineering and other expenses related to using Texas Instruments as our foundry for certain of our future products.
Marketing and Sales
      Marketing and sales expenses were $32.1 million in 2004, $27.0 million in 2003 and $20.3 million in 2002. As a percentage of revenue, marketing and sales expenses were 21.5%, 11.4% and 13.1% in 2004, 2003 and 2002, respectively. The increase in these expenses in 2004 was primarily due to the write-off of prepaid computer access services and additional benchmarking, application and sales personnel as well as to the introduction of our three new products. We also experienced an unfavorable currency exchange rate in our overseas personnel expenses in 2004 compared to 2003. We expect marketing and sales expenses to decline in 2005 due to cost reductions relative to the 2004 restructuring offset in part by the introduction of Cray X1E, Cray XT3 and Cray XD1 systems and increased sales commissions due to higher sales activities.
General and Administrative
      General and administrative expenses were $16.2 million in 2004, $10.9 million in 2003 and $8.9 million in 2002. General and administrative expenses were 10.9%, 4.6% and 5.8% of revenue for 2004, 2003 and 2002, respectively. The increase in these expenses in 2004 was due primarily to consulting costs related to Sarbanes-Oxley Act of 2002 compliance and additional expenses as a result of our acquisition of Octiga Bay, including additional depreciation, insurance and utilities. We expect general and administrative expenses to decline in 2005 due to the 2004 restructuring and lesser expenditures on outside services for Sarbanes-Oxley compliance, offset in part by staff increases in our finance department.
Restructuring Charges
      Restructuring charges were $8.2 million in 2004, $4.0 million in 2003 and $1.9 million in 2002. The 2004 costs primarily represented severance expenses related to the termination of 114 employees in the United States and an additional 20 employees throughout the rest of the world in the second half of 2004. Of the 2003 amount, $3.3 million represented severance expenses related to the termination of 27 employees, primarily associated with our service activities in Europe and Japan, and the remaining $721,000 related to expensing certain technology that we no longer use. The 2002 charge represented severance expenses related to the termination of 20 employees.

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Acquisition-Related Compensation Expense
      Acquisition-related compensation expense relates to deferred compensation resulting from retention agreements with key OctigaBay personnel and existing stock options held by OctigaBay employees which we assumed in the acquisition. The retention agreements expire in November 2005 and the assumed stock options vest over the next three to four years. In December 2004 we terminated the retention agreements of three key employees and accelerated the recognition of the related deferred compensation accordingly. Total acquisition-related compensation expense recognized during 2004 was $11.1 million. Subject to currency fluctuations, we expect to incur a quarterly amortization expense of approximately $800,000 per quarter through December 2005 and approximately $175,000 per quarter thereafter through April 2007.
In-Process Research and Development Charge
      As part of the acquisition of OctigaBay, we incurred an expense associated with acquired in-process research and development of $43.4 million in the second quarter of 2004.
Other Income (Expense), net
      Other expense was $699,000 in 2004, compared to other income of $1.5 million in 2003 and $3.1 million in 2002. Other expense in 2004 primarily consisted of foreign currency losses and an impairment charge related to one of our investments. Other income in 2003 primarily consisted of foreign currency gains, based on net payables/receivables situations with our foreign subsidiaries, and other income in 2002 primarily consisted of a negotiated settlement of an accrued cancellation charge on a purchase commitment.
Interest Income (Expense), net
      Interest income was $666,000 in 2004, $657,000 in 2003 and $147,000 in 2002. Interest income in 2004 was related primarily to our cash and short-term investments balances, which, on average, were consistent with the balances during 2003. The 2003 interest income reflects our increased average cash position in 2003 over 2002 following our public offering in February 2003 in which we raised $49.1 million.
      Interest expense was $301,000 in 2004, $213,000 in 2003 and $3.0 million for 2002. The interest expense for 2004 reflects approximately one month of interest on our convertible notes, one month of amortization of the related capitalized issuance costs and interest on our capital leases. The interest expense for 2003 reflects interest on our term loan for the first four months of the year and interest on our capital leases. Interest expense for 2002 was largely due to a non-cash charge of $2.1 million associated with the convertible debenture financing completed in November 2001 and $900,000 of interest paid on our term loan, line of credit and capital leases.
Taxes
      We recorded an income tax provision of $58.5 million in 2004 related to the establishment of a valuation allowance against deferred tax assets primarily consisting of accumulated net operating losses and acquisition related deferred tax assets. Under the criteria set forth in SFAS No. 109, Accounting for Income Taxes, management concluded that it was unlikely that the future benefits of these deferred tax assets would be realized. In 2003 we recorded an income tax benefit of $42.5 million as part of the reversal of a valuation allowance for deferred tax assets. In 2002 we had an income tax provision of $2.2 million, primarily relating to income taxes in foreign countries and certain states. There has been no provision for U.S. federal income taxes for any period. We have income taxes currently payable due to our operations in certain foreign countries, particularly in Canada, and in certain states where taxes are based upon capital and other non-income basis.
      As of December 31, 2004, we had tax net operating loss carryforwards of approximately $224.0 million that begin to expire in 2010 if not utilized.

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Net Income (Loss)
      Net loss was $204.0 million in 2004 compared to net income of $63.2 million for 2003 and $5.4 million for 2002. The 2004 net loss included $127.1 million of significant charges consisting of an income tax expense of $58.5 million related to the recognition of a valuation allowance against deferred tax assets, a $43.4 million write-off of in-process research and development acquired as part of the OctigaBay acquisition, a $9.0 million cost adjustment recognized on the Red Storm fixed-price contract, an $8.2 million restructuring charge and an $8.0 million write-down of excess inventory. Without these significant items our net loss would have been $76.9 million.
      Net income for 2003 was favorably impacted by the net effect of two significant items: recognition of an income tax benefit for the reversal of a valuation allowance for deferred tax assets of $42.5 million which was partially offset by a $4.0 million restructuring charge. We reversed the valuation allowance based on our determination at that time that realization of these assets was more likely than not. Without these items, net income would have been $24.7 million. The improvement in 2003 net income compared to 2002, as so adjusted, was due to increased product revenue and expenditures that grew less than the revenue growth, principally net research and development expenses.
Liquidity and Capital Resources
      Cash, cash equivalents, restricted cash, short-term investments and accounts receivable totaled $120.6 million at December 31, 2004, compared to $122.8 million at December 31, 2003. At December 31, 2004, we had working capital of $96.0 million compared to $115.8 million at December 31, 2003. In the fourth quarter of 2004, we completed a convertible note Rule 144A offering in which we received net proceeds of $76.6 million.
      Net cash used by operating activities was $53.3 million in 2004, $9.3 million in 2003 and $8.7 million for 2002. For the year ended December 31, 2004, net operating cash was used primarily by our net operating loss and increases in inventory offset in part by increases in deferred revenue and accounts payable and decreases in accounts receivable. In 2003 net operating cash was used primarily by increases in accounts receivable and inventory and decreases in other accrued liabilities, warranty reserve and deferred revenues. For 2002 net operating cash was used primarily by increases in accounts receivable and inventory and decreases in other accrued liabilities, warranty reserve and deferred revenues.
      Net cash used by investing activities was $18.5 million in 2004, $41.2 million in 2003 and $6.0 million in 2002. For the year ended December 31, 2004, net cash used by investing activities consisted $12.5 million of capital expenditures and $6.3 million used for the acquisition of OctigaBay (which consisted of $15.9 million in cash used in connection with the acquisition netted against $9.6 million in cash we acquired from OctigaBay’s existing business), offset by net sales of $320,000 of short-term investments. In 2003 our net cash used in investing activities was primarily for purchases of short-term investments and in 2002 net cash used by investing activities consisted primarily of purchases of computers and electronic test equipment, computer software and furniture and fixtures.
      Net cash provided by financing activities was $73.4 million in 2004, $65.6 million in 2003 and $25.3 million for 2002. The 2004 net cash provided by financing activities was primarily related to our convertible note Rule 144A offering in which we received net proceeds of $76.6 million. We also received approximately $8.9 million through stock option and warrant exercises as well as through the issuance of common stock in connection with our employee stock purchase plan and our annual 401(k) match. These proceeds were offset by an increase of $11.4 million in our restricted cash balance. The 2003 net cash provided by financing activities was primarily from our public offering, in which we received net proceeds of $49.1 million, and $18.7 million from warrant and stock option exercises. We used $3.9 million to retire our term loan debt. In 2002 we raised $16.2 million primarily through the sale of common stock and employee option exercises, and received another $11.8 million through warrant exercises.

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      Over the next twelve months, our significant cash requirements will relate to operational expenses, consisting primarily of personnel costs, costs of inventory and spare parts as we ramp-up production of Cray X1E, Cray XT3 and Cray XD1 systems, third-party engineering expenses, and acquisition of property and equipment. Our fiscal year 2005 capital expenditure budget for property and equipment is estimated currently at $7.4 million. In addition, we lease certain equipment used in our operations under operating or capital leases in the normal course of business. The following table is a summary of our contractual cash obligations as of December 31, 2004 (in thousands):
                                         
    Payments Due by Periods
     
        Less than   1 - 3   4 - 5   After 5
Contractual Obligations   Total   1 year   years   years   years
                     
Development agreements
  $ 13,979     $ 9,159     $ 4,820     $     $  
Capital lease obligations
    539       539                          
Operating leases
    15,202       5,058       9,565       579          
                               
Total contractual cash obligations
  $ 29,720     $ 14,756     $ 14,385     $ 579     $  
                               
      At any particular time, our cash position is affected by the timing of payment for product sales, receipt of prepaid and regular maintenance payments, receipt of government funding of research and development activities and payment for inventory, resulting in significant quarter to quarter and within a quarter fluctuations in our cash balances. Our principal sources of liquidity are our cash and cash equivalents, short-term investments and our operations. We experienced lower than anticipated product sales and delays in the availability of new products in 2004, and we face increased inventory purchases and higher start-up manufacturing and selling costs with the introduction of three new products in late 2004 and early 2005. Our 2004 restructuring will lower our overall operating cash expenditures after the severance and related obligations are satisfied. Until we are able to ship our new products, obtain product acceptances and receive payment, we expect to use significant working capital, particularly in the first half of the year. Meanwhile, we are focused on expense controls and working capital efficiencies to maintain adequate levels of cash within each quarter. We believe our current cash resources and cash expected to be generated in 2005 will be adequate for the next twelve months.
      Our current $15.0 million secured line of credit is used only to support outstanding letters of credit. At December 31, 2004, we had $11.4 million of outstanding letters of credit. We are required to maintain cash and short-term investment balances at least equal to the outstanding letters of credit. As such, we have designated $11.4 million of our cash as restricted cash at December 31, 2004.
      If we were to experience a material shortfall in our 2005 plan, we would take all appropriate actions to ensure the continuing operation of our business and to mitigate any negative impact on our profitability and cash reserves. The range of actions we could take includes, in the short-term, reductions in inventory purchases and commitments, obtaining a credit facility based on service revenue and seeking further financing from strategic partners and other financial sources and, on a longer-term basis, further reducing headcount-related expenses, reevaluating our global sales model, restricting or eliminating unfunded product development programs and licensing intellectual property. There can be no assurance that we would succeed in these efforts or that additional funding would be available.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
      Substantially all of our cash equivalents and marketable securities are held in money market funds or commercial paper of less than 90 days that is held to maturity. Accordingly, we believe that the market risk arising from our holdings of these financial instruments is minimal. We sell our products primarily in North America, but with significant sales in Asia and Europe. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Our products are generally priced in U.S. dollars, and a strengthening of the dollar could make our products less competitive in foreign markets. While we commonly sell products with payments in U.S. dollars, our product sales contracts occasionally call for payment in foreign currencies and to the extent we do so, we are

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subject to foreign currency exchange risks. We believe that a 10% change in foreign exchange rates would not have a material impact on the financial statements. Our foreign maintenance contracts are paid in local currencies and provide a natural hedge against local expenses. To the extent that we wish to repatriate any of these funds to the United States, however, we are subject to foreign exchange risks. We do not hold any derivative instruments and have not engaged in hedging transactions.
Item 8. Financial Statements and Supplementary Data
INDEX TO FINANCIAL STATEMENTS*
         
Consolidated Balance Sheets at December 31, 2003 and December 31, 2004
    F-1  
Consolidated Statements of Operations and Comprehensive Income (Loss) for each of the three years in the period ended December 31, 2004
    F-2  
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended December 31, 2004
    F-3  
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2004
    F-4  
Notes to Consolidated Financial Statements
    F-5  
Report of Independent Registered Public Accounting Firm
    F-26  
 
The Financial Statements are located following page 54.

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QUARTERLY FINANCIAL DATA
(Unaudited, in thousands, except per share data)
      The following table presents unaudited quarterly financial information for the two years ended December 31, 2004. In the opinion of management, this information contains all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation thereof. The operating results are not necessarily indicative of results for any future periods. Quarter-to-quarter comparisons should not be relied upon as indicators of future performance.
                                                                 
    2003   2004
         
For the Quarter Ended   3/31   6/30   9/30   12/31   3/31   6/30   9/30   12/31
                                 
Revenue
  $ 44,129     $ 61,760     $ 63,845     $ 67,228     $ 42,135     $ 21,710     $ 45,924     $ 39,415  
Cost of Sales
    27,956       35,187       35,339       39,652       28,336       17,066       52,961       39,239  
Gross Margin
    16,173       26,573       28,506       27,576       13,799       4,644       (7,037 )     176  
Research and Development
    7,475       10,363       10,533       9,391       9,042       11,321       12,190       12,577  
Marketing and Sales
    5,521       6,185       6,727       8,605       7,646       8,163       8,267       8,035  
General and Administrative
    1,874       2,664       3,164       3,206       2,873       3,961       4,386       5,002  
Restructuring Charge
                            4,019                       7,129       1,053  
Acquisition-Related Compensation Expense
                                            2,039       2,195       6,900  
In-process Research and Development
                                            43,400                  
Net Income (loss)
    1,197       7,858       8,463       45,730       (3,843 )     (54,504 )     (110,999 )     (34,677 )
Comprehensive Income (loss)
    1,162       8,120       8,453       44,997       (3,594 )     (56,607 )     (106,928 )     (31,527 )
Net Income (loss) Per Common Share, Basic
  $ 0.02     $ 0.12     $ 0.12     $ 0.63     $ (0.05 )   $ (0.64 )   $ (1.27 )   $ (0.40 )
Net Income (loss) Per Common Share, Diluted
  $ 0.02     $ 0.10     $ 0.10     $ 0.56     $ (0.05 )   $ (0.64 )   $ (1.27 )   $ (0.40 )
      The in-process research and development charge in the second quarter of 2004 related to our acquisition of OctigaBay. The acquisition was accomplished pursuant to an Arrangement Agreement, dated February 25, 2004. The amortization of acquisition-related compensation expense also related to the acquisition and resulted from retention agreements with key OctigaBay personnel and from existing stock options acquired from OctigaBay employees. See “Notes to Consolidated Financial Statements.” The restructuring charge in the second half of 2004 related to severance expenses in connection with the termination of 134 employees. Net loss for the third quarter of 2004 included a $69.8 million tax charge related to the recognition of a valuation allowance against deferred tax assets.
      The restructuring charge in the fourth quarter of 2003 related to severance expenses in connection with the termination of 27 employees. Net income for the fourth quarter of 2003 included a benefit of $42.5 million related to the reversal of a valuation allowance for deferred tax assets.
      Our future operating results may be subject to quarterly fluctuations as a result of a number of factors, including the timing of deliveries and acceptances of our products. See “Business — Factors That Could Affect Future Results.”
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
      None.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
      We evaluated the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”) as of the end of the period covered by this report. Our principal executive and financial officers supervised and participated in the evaluation. Based on the evaluation, our principal executive and financial officers each

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concluded that, as of the end of the period covered by this report, and except for material weaknesses in our internal control over financial reporting described below, our disclosure controls and procedures were effective in providing reasonable assurance that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s form and rules.
Internal Control Over Financial Reporting
      Pursuant to Securities Exchange Act Release No. 50754, we are delaying filing in this Annual Report on Form 10-K both Management’s Annual Report on Internal Control over Financial Reporting, required by Item 308(a) of Regulation S-K, and the related Attestation Report of the Registered Public Accounting Firm, required by Item 308(b) of Regulation S-K. We expect to file both reports within the 45-day period set forth in Condition (e) of Release No. 50754 through an amendment to this Annual Report on Form 10-K no later than April 29, 2005.
      A material weakness is a control deficiency, or combination of control deficiencies, that results in a more than remote likelihood that a material misstatement of our annual or interim financial statements could occur. We have not completed our testing and evaluation of our internal control over financial reporting. Our evaluation to date has revealed the following material weaknesses:
        • A lack of effective detective and monitoring controls, coupled with insufficiently trained accounting personnel and management, were manifested in a number of adjustments to the financial statements for the quarter and year ended December 31, 2004, that affected various financial statement line items and resulted in differences from our previously announced financial results. The adjustments and changes arose from improper classification of accounts, incorrect account entry and lack of effective overview of decentralized operations, including review of third-party vendor contracts, leases and licenses.
 
        • We did not maintain effective review and controls over the determination and reporting of the provision for income taxes, particularly the tax effect due to subsidiary dividend analysis, the tax effect of a correction of foreign net operating losses and adjustments to deferred taxes. These adjustments were of such magnitude they were determined to constitute material weaknesses.
      As a result of the material weaknesses discussed above, our management’s report on internal control over financial reporting, under applicable Commission rules, will conclude that our internal control over financial reporting was not effective at December 31, 2004, and our independent registered public accounting firm has advised us that their report will reach the same conclusion. Notwithstanding these conclusions, we believe that the consolidated financial statements contained in this Annual Report on Form 10-K fairly present our financial condition and results of operations for the fiscal years covered thereby in all material respects, and we have received an unqualified audit report from our independent auditors on these consolidated financial statements.
      The identification of these material weaknesses is based on our findings to date. We will be continuing our assessment of deficiencies noted so far in our testing process, including a number of deficiencies related to our general computer controls and financial application controls, and others that may be identified as we complete our testing. We expect that we and our independent auditors will identify additional material weaknesses between the date of this Annual Report and the date our amended Annual Report on Form 10-K containing Management’s Annual Report on Internal Control Over Financial Reporting is filed with the Commission.
      Based on our evaluation to date, we do not believe that the material weaknesses identified above materially impacted our financial information for prior periods, and accordingly we currently do not expect that we will be required to restate our financial statements for any prior periods.
      In the fourth quarter of 2004, both our chief financial officer and financial reporting manager separately left for other opportunities. We are actively searching for an experienced chief financial officer, and meanwhile are using consultants and our General Counsel to help fill these positions until a new chief financial officer is

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hired. In the first quarter of 2005 we added a director of internal audit and Sarbanes-Oxley compliance, which with the fourth quarter 2004 addition of an operations controller reduced the demands on our corporate controller. With these changes, we will institute fuller review, additional controls and institute training programs to remediate the material weaknesses described above as well as other deficiencies detected by this process. We do not expect to remediate and test the material weaknesses identified above by the end of our first quarter of fiscal 2005, however, and we will report in our Quarterly Report on Form 10-Q for the first quarter of fiscal 2005, and possibly in subsequent reports filed with the Commission, that material weaknesses in our internal control over financial reporting continue to exist.
Changes in Internal Control over Financial Reporting
      The following changes in our internal control over financial reporting occurred in the fourth quarter of 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting:
  •  Implementation of additional control procedures over various aspects of our operations, including improvements in policies and procedures for account reconciliation, separation of treasury duties, independent review of revenue recognition processes for multiple-element contracts and enhancement of controls over the accounting activities of our foreign subsidiaries by regional controllers in Asia-Pacific and Europe; and
 
  •  Hiring of an operations controller.
Item 9B. Other Information
      None.

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PART III
      Certain information required by Part III is omitted from this Report as we will file a definitive proxy statement for the Annual Meeting of Shareholders to be held on May 11, 2005, pursuant to Regulation 14A (the “Proxy Statement”) not later than 120 days after the end of the fiscal year covered by this Report, and certain information included in the Proxy Statement is incorporated herein by reference. Only those sections of the Proxy Statement which specifically address the items set forth herein are incorporated by reference.
Item 10. Directors and Executive Officers of the Company
      Information with respect to our directors may be found in the section titled “Corporate Governance” under the caption “The Board of Directors” and in the section titled “Discussion of Proposals Recommended by the Board” under the heading “Proposal 1: To Elect Nine Directors” in our Proxy Statement. Such information is incorporated herein by reference. Information with respect to executive officers may be found beginning on page 30 above, under the caption “Executive Officers of the Company.” Information with respect to compliance with Section 16(a) of the Exchange Act by the persons subject thereto may be found under the section titled “Our Common Stock Ownership” under the heading “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement and is incorporated herein by reference.
      Our Board of Directors has adopted a Code of Business Conduct applicable to all of our directors, officers and employees. The Code of Business Conduct, our Corporate Governance Guidelines, charters for each of our Board committees and other governance documents may be found on our web site: http://www.cray.com under “Investors-Corporate Governance.”
Item 11. Executive Compensation
      The information in the Proxy Statement set forth in the section titled “Corporate Governance” under the captions “The Committees of the Board,” “How We Compensate Directors,” “How We Compensate Executive Officers” and “Compensation Committee Interlocks and Insider Participation” is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
      The information in the Proxy Statement set forth under the section “Our Common Stock Ownership” and under the caption “Equity Compensation Plan Information” is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
      The information in the Proxy Statement set forth under the caption “Management Agreements and Policies” in the section “The Executive Officers” is incorporated herein by reference.
Item 14. Principal Accountant Fees and Services
      The information set forth in the section titled “Independent Public Accountants” under the caption “Information Regarding Our Independent Public Accountants” in the Proxy Statement is incorporated herein by reference.

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PART IV
Item 15. Exhibits and Financial Statement Schedules
(a)(1) Financial Statements
  Consolidated Balance Sheets at December 31, 2003 and December 31, 2004
 
  Consolidated Statements of Operations and Comprehensive Income (Loss) for each of the three years in the period ended December 31, 2004
 
  Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended December 31, 2004
 
  Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2004
 
  Notes to Consolidated Financial Statements
 
  Report of Independent Registered Public Accounting Firm
(a)(2) Financial Statement Schedules
      Supplemental schedules are not provided because they are not required or because the required information is provided in the financial statements or in the notes thereto.
(a)(3) Exhibits
      The Exhibits listed in the Exhibit Index, which appears immediately following the signature page and certifications and is incorporated herein by reference, are filed as part of this Annual Report on Form 10-K.

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SIGNATURES
      Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Seattle, State of Washington, on March 31, 2005.
  CRAY INC.
  By  /s/ James E. Rottsolk
 
 
  James E. Rottsolk
  Chief Executive Officer and Chairman of the
  Board of Directors
      Each of the undersigned hereby constitutes and appoints James E. Rottsolk, Burton J. Smith, and Kenneth W. Johnson and each of them, the undersigned’s true and lawful attorney-in-fact and agent, with full power of substitution, for the undersigned and in his or her name, place and stead, in any and all capacities, to sign any or all amendments to this Annual Report on Form 10-K and any other instruments or documents that said attorneys-in-fact and agents may deem necessary or advisable, to enable Cray Inc. to comply with the Securities Exchange Act of 1934 and any requirements of the Securities and Exchange Commission in respect thereof, and to file the same, with all exhibits thereto, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents and each of them full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as the undersigned might or could do in person, hereby ratifying and confirming all that each such attorney-in-fact and agent, or his substitute, may lawfully do or cause to be done by virtue hereof.
      Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Company and in the capacities indicated on March 31, 2005.
     
Signature   Title
     
 
      By /s/ James E. Rottsolk
 
                
James E. Rottsolk
  Chief Executive Officer and Chairman of the
Board of Directors
 
      By /s/ Burton J. Smith
 
                
Burton J. Smith
  Director
 
      By /s/ Kenneth W. Johnson
 
                
Kenneth W. Johnson
  Principal Financial Officer and
Principal Accounting Officer
 
      By /s/ Daniel J. Evans
 
                
Daniel J. Evans
  Director
 
      By /s/ John B. Jones, Jr.
 
                
John B. Jones, Jr.
  Director
 
      By /s/ Kenneth W. Kennedy, Jr.
 
                
Kenneth W. Kennedy, Jr.
  Director
 
      By /s/ Stephen C. Kiely
 
                
Stephen C. Kiely
  Director
 
      By /s/ Frank L. Lederman
 
                
Frank L. Lederman
  Director

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Signature   Title
     
 
      By /s/ Sally G. Narodick
 
                
Sally G. Narodick
  Director
 
      By /s/ Daniel C. Regis
 
                
Daniel C. Regis
  Director
 
      By /s/ Stephen C. Richards
 
                
Stephen C. Richards
  Director

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EXHIBIT INDEX
         
Exhibit    
Number   Description
     
  3 .1   Restated Articles of Incorporation(1)
 
  3 .2   Amended and Restated Bylaws(9)
 
  4 .1   Form of Common Stock Purchase Warrants due August 30, 2006(16)
 
  4 .2   Form of Common Stock Purchase Warrants due June 21, 2009(17)
 
  4 .3   Indenture dated as of December 6, 2004, by and between the Company and The Bank of New York Trust Company, N.A. as Trustee(14)
 
  10 .1   2000 Non-Executive Employee Stock Option Plan(5)
 
  10 .2   2001 Employee Stock Purchase Plan(13)*
 
  10 .3   2003 Stock Option Plan(2)*
 
  10 .4   2004 Long-Term Equity Compensation Plan(15)*
 
  10 .5   Cray Canada Inc. Amended and Restated Key Employee Stock Option Plan(21)
 
  10 .6   Form of Management Continuation Agreement between the Company and its Executive Officers and certain other Employees(10)*
 
  10 .7   Executive Severance Policy(19)*
 
  10 .8   Lease Agreement between Merrill Place, LLC and the Company, dated November 21, 1997(6)
 
  10 .9   FAB I Building Lease Agreement between Union Semiconductor Technology Corporation and the Company, dated as of June 30, 2000(7)
 
  10 .10   Amendment No. 1 to the FAB Building Lease Agreement between Union Semiconductor Technology Corporation and the Company, dated as of August 19, 2002(3)
 
  10 .11   Conference Center Lease Agreement between Union Semiconductor Technology Corporation and the Company, dated as of June 30, 2000(7)
 
  10 .12   Amendment No. 1 to the Conference Center Lease Agreement between Union Semiconductor Technology Corporation and the Company dated as of August 19, 2002(3)
 
  10 .13   Mendota Heights Office Lease Agreement between the Teachers’ Retirement System of the State of Illinois and the Company, dated as of August 10, 2000(7)
 
  10 .14   First Amendment to the Mendota Heights Office Lease Agreement between the Teachers’ Retirement System of the State of Illinois and the Company, dated as of January 17, 2003(3)
 
  10 .15   Sublease Agreement between Trillium Digital Systems Canada, Ltd. and OctigBay Systems Corporation, dated as of January 13, 2003, with Consent to Subletting by and among 391102 B.C, Ltd. and Dominion Construction and Development Inc., Trillium Digital Systems Canada, Ltd., OctigaBay Systems Corporation and Intel Corporation, dated January 20, 2003, and Lease Agreement between Dominion Construction Company Inc. and 391102 B.C. Ltd., Trillium Digital Systems Canada, Ltd. and Intel Corporation, dated March 5, 2001
 
  10 .16   Credit Agreement between Wells Fargo Bank, N.A. and the Company, dated April 10, 2003, and Related Note(8)
 
  10 .17   First Amendment to Credit Agreement between Wells Fargo Bank and the Company, dated March 5, 2004
 
  10 .18   Second Amendment to Credit Agreement between Wells Fargo Bank and the Company, dated June 7, 2004
 
  10 .19   Third Amendment to Credit Agreement between Wells Fargo Bank, N.A. and the Company, dated November 29, 2004
 
  10 .20   Fourth Amendment to Credit Agreement between Wells Fargo Bank, N.A. and the Company, dated December 15, 2004
 
  10 .21   Securities Account Control Agreement, with Addendum, by and among Wells Fargo Bank, National Association and the Company, dated as of December 15, 2004

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Exhibit    
Number   Description
     
 
  10 .22   Technology Agreement between Silicon Graphics, Inc. and the Company, effective as of March 31, 2000(4)
 
  10 .23   Distribution Agreement between NEC Corporation and the Company, dated as of February 28, 2001(12)+
 
  10 .24   Sales and Marketing Services Agreement among NEC Corporation, HNSX Supercomputers, Inc. and Cray Inc., dated as of February 28, 2001(12)+
 
  10 .25   Maintenance Agreement between NEC Corporation and the Company, dated as of February 28, 2001(12)+
 
  10 .26   Amendment to Maintenance Agreement between NEC Corporation and the Company, dated June 9, 2003(11)+
 
  10 .27   Letter from NEC Corporation notifying the Company that its distribution rights in North America will be non-exclusive, dated April 24, 2003(11)
 
  10 .28   Arrangement Agreement, dated as of February 25, 2004, by and among the Company, 3084317 Nova Scotia Limited and OctigaBay Systems Corporation(18)
 
  10 .29   Purchase Agreement, dated December 1, 2004, by and between the Company and Bear, Stearns & Co. Inc. as Initial Purchaser(14)
 
  10 .30   Registration Rights Agreement dated December 6, 2004, by and between the Company and Bear, Stearns & Co. Inc., as Initial Purchaser(14)
 
  10 .31   2005 Executive Bonus Plan*(20)
 
  10 .32   Form of Officer Non-Qualified Stock Option Agreement*
 
  10 .33   Form of Officer Incentive Stock Option Agreement*
 
  10 .34   Form of Director Stock Option Agreement*
 
  10 .35   Form of Director Stock Option, immediate vesting*
 
  21 .1   Subsidiaries of the Company
 
  23 .1   Consent of Independent Registered Public Accounting Firm
 
  24 .1   Power of Attorney (included on the signature page of this report)
 
  31 .1   Rule 13a-14(a)/15d-14(a) Certification of Mr. Rottsolk, Chief Executive Officer
 
  31 .2   Rule 13a-14(a)/15d-14(a) Certification of Mr. Johnson, Chief Financial and Accounting Officer
 
  32 .1   Certification pursuant to 18 U.S.C. Section 1350 by the Chief Executive Officer and the Chief Financial and Accounting Officer
 
  * Management contract or compensatory plan or arrangement.
  + Subject to confidential treatment. The omitted confidential information has been filed with the Securities and Exchange Commission.
  (1)  Incorporated by reference to the Company’s Report on Form 8-K, as filed with the Commission on May 14, 2004.
 
  (2)  Incorporated by reference to the Company’s definitive Proxy Statement for the 2003 Annual Meeting, as filed with the Commission on March 31, 2003.
 
  (3)  Incorporated by reference to the Company’s Report on Form 10-K, as filed with the Commission for the year ended December 31, 2002.
 
  (4)  Incorporated by reference to the Company’s Report on Form 10-Q, as filed with the Commission on May 15, 2000.
 
  (5)  Incorporated by reference to the Company’s Registration Statement on Form S-8 (SEC No. 333-57970), as filed with the Commission on March 30, 2001.
 
  (6)  Incorporated by reference to the Company’s Report on Form 10-K, as filed with the Commission for the fiscal year ended December 31, 1997.

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  (7)  Incorporated by reference to the Company’s Report on Form 10-K, as filed with the Commission for the fiscal year ended December 31, 2000.
 
  (8)  Incorporated by reference to the Company’s Report on Form 10-Q, as filed with the Commission on May 15, 2003.
 
  (9)  Incorporated by reference to the Company’s Report on Form 8-K, as filed with the Commission on December 10, 2004.
(10)  Incorporated by reference to the Company’s Report on Form 10-Q, as filed with the Commission on May 17, 1999.
 
(11)  Incorporated by reference to the Company’s Report on Form 10-Q, as filed with the Commission on August 14, 2003.
 
(12)  Incorporated by reference to the Company’s Report on Form 8-K, as filed with the Commission on May 14, 2001.
 
(13)  Incorporated by reference to the Company’s Registration Statement on Form S-8 (SEC No. 333-70238), filed on September 26, 2001.
 
(14)  Incorporated by reference to the Company’s Report on Form 8-K, as filed with the Commission on December 7, 2004.
 
(15)  Incorporated by reference to the Company’s definitive Proxy Statement for the 2004 Annual Meeting, as filed with the Commission on March 24, 2004.
 
(16)  Incorporated by reference to the Company’s Report on Form 8-K, as filed with the Commission on September 4, 2002.
 
(17)  Incorporated by reference to the Company’s Registration Statement on Form S-3 (SEC No. 333-57972), filed on March 30, 2001.
 
(18)  Incorporated by reference to the Company’s Report on Form 8-K, as filed with the Commission on April 2, 2004.
 
(19)  Incorporated by reference to the Company’s Report on Form 8-K, as filed with the Commission on March 8, 2005.
 
(20)  Incorporated by reference to the Company’s Report on Form 8-K, as filed with the Commission on March 25, 2005.
 
(21)  Incorporated by reference to the Company’s Registration Statement on Form S-8 (SEC No. 333-114243), filed on April 8, 2004.

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CRAY INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
                     
    December 31,   December 31,
    2003   2004
         
ASSETS
Current assets:
               
 
Cash and cash equivalents
  $ 39,773     $ 41,732  
 
Restricted cash
            11,437  
 
Short-term investments, available for sale
    34,570       34,253  
 
Accounts receivable, net of allowance of $1,125 and $1,439, respectively
    48,474       33,185  
 
Inventory
    43,022       71,521  
 
Prepaid expenses and other current assets
    18,932       5,225  
             
   
Total current assets
    184,771       197,353  
Property and equipment, net
    26,157       36,875  
Service spares, net
    4,925       3,590  
Goodwill
    13,344       55,644  
Deferred tax asset
    58,595          
Intangible assets, net
            6,197  
Other non-current assets
    3,797       9,130  
             
   
TOTAL
  $ 291,589     $ 308,789  
             
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
               
 
Accounts payable
  $ 12,553     $ 23,875  
 
Accrued payroll and related expenses
    19,035       14,970  
 
Other accrued liabilities
    4,135       8,214  
 
Deferred revenue
    33,233       54,246  
             
   
Total current liabilities
    68,956       101,305  
Deferred tax liability
            1,662  
Other non-current liabilities
            522  
Notes payable
            80,000  
Commitments and Contingencies (Note 11)
               
Shareholders’ equity:
               
 
Common Stock and additional paid in capital, par $.01 — Authorized, 150,000,000 shares; issued and outstanding, 72,812,118 and 87,348,641 shares, respectively
    312,646       413,911  
 
Exchangeable shares, no par value — Unlimited shares authorized; 0 and 570,963 shares outstanding, respectively
            4,173  
 
Deferred compensation
    (105 )     (4,220 )
 
Accumulated other comprehensive income (loss)
    (807 )     4,560  
 
Accumulated deficit
    (89,101 )     (293,124 )
             
      222,633       125,300  
             
   
TOTAL
  $ 291,589     $ 308,789  
             
See accompanying notes

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CRAY INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(in thousands, except per share data)
                             
    Years Ended December 31,
     
    2002   2003   2004
             
Revenue:
                       
 
Product
  $ 76,519     $ 175,004     $ 99,236  
 
Service
    78,550       61,958       49,948  
                   
   
Total revenue
    155,069       236,962       149,184  
                   
Operating expenses:
                       
 
Cost of product revenue
    41,187       97,354       107,264  
 
Cost of service revenue
    42,581       40,780       30,338  
 
Research and development
    32,861       37,762       45,130  
 
Marketing and sales
    20,332       27,038       32,111  
 
General and administrative
    8,923       10,908       16,222  
 
Restructuring charge
    1,878       4,019       8,182  
 
Acquisition-related compensation expense(1)
                    11,134  
 
In-process research and development charge
                    43,400  
                   
   
Total operating expenses
    147,762       217,861       293,781  
                   
Income (loss) from operations
    7,307       19,101       (144,597 )
Other income (expense), net
    3,104       1,496       (699 )
Interest income (expense), net
    (2,832 )     444       365  
                   
Income (loss) before income taxes
    7,579       21,041       (144,931 )
Income tax expense (benefit)
    2,176       (42,207 )     59,092  
                   
Net income (loss)
    5,403       63,248       (204,023 )
Other comprehensive income (loss):
                       
 
Unrealized gain (loss) on investments
            9       (33 )
 
Currency translation adjustment
    471       (525 )     5,400  
                   
Comprehensive income (loss)
  $ 5,874     $ 62,732     $ (198,656 )
                   
Basic net income (loss) per common share
  $ 0.11     $ 0.94     $ (2.45 )
                   
Diluted net income (loss) per common share
  $ 0.10     $ 0.81     $ (2.45 )
                   
Weighted average shares outstanding — basic
    47,969       67,098       83,387  
                   
Weighted average shares outstanding — diluted
    54,417       77,861       83,387  
                   
 
(1)  Acquisition-related compensation expense is allocated as follows (see Note 18):
                         
    Years Ended December 31,
     
    2002   2003   2004
             
Research and development
                  $ 5,068  
Marketing and sales
                    2,837  
General and administrative
                    3,229  
                   
                    $ 11,134  
                   
See accompanying notes

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CRAY INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands)
                                                                     
    Common Stock                    
    and Additional   Exchangeable           Accumulated    
    Paid In Capital   Shares           Other    
                    Comprehensive    
    Number       Number       Deferred   Accumulated   Income    
    of Shares   Amount   of Shares   Amount   Compensation   Deficit   (Loss)   Total
                                 
BALANCE, January 1, 2002
    42,408     $ 173,318                             $ (157,752 )   $ (762 )   $ 14,804  
 
Common stock issued, less issuance costs of $973
    4,881       12,927                                               12,927  
 
Convertible debentures converted to common stock, less issuance costs of $398
    3,957       8,902                                               8,902  
 
Issuance of shares under Employee Stock Purchase Plan
    408       1,317                                               1,317  
 
Issuance of shares under Company 401(k) Plan
    257       568                                               568  
 
Common stock issued for accrued interest on convertible debentures
    182       670                                               670  
 
Exercise of stock options
    530       1,413                                               1,413  
 
Exercise of warrants, less issuance costs of $545
    3,627       11,759                                               11,759  
 
Warrants issued for consulting services
            230                                               230  
 
Compensation expense on related party notes
            151                                               151  
 
Other comprehensive income:
                                                               
   
Cumulative currency translation adjustment
                                                    471       471  
   
Net income
                                            5,403               5,403  
                                                 
BALANCE, December 31, 2002
    56,250       211,255                               (152,349 )     (291 )     58,615  
 
Common stock issued, less issuance costs of $3,165
    7,355       42,500                                               42,500  
 
Exercise of underwriter over-allotment option
    1,125       6,559                                               6,559  
 
Common stock issued in conversion of Series A Preferred stock
    3,269       24,946                                               24,946  
 
Issuance of shares under Company 401(k) Plan
    76       550                                               550  
 
Issuance of shares under Employee Stock Purchase Plan
    243       1,646                                               1,646  
 
Exercise of stock options
    2,752       12,019                                               12,019  
 
Exercise of warrants, less issuance costs of $397
    1,722       6,665                                               6,665  
 
Issuance of restricted stock
    20       180                     $ (180 )                        
 
Compensation expense on restricted stock
                                    75                       75  
 
Tax benefit on non-qualified stock options
            6,326                                               6,326  
 
Other comprehensive income:
                                                               
   
Unrealized gain on available for sale investments
                                                    9       9  
   
Cumulative currency translation adjustment
                                                    (525 )     (525 )
   
Net income
                                            63,248               63,248  
                                                 
BALANCE, December 31, 2003
    72,812       312,646                       (105 )     (89,101 )     (807 )     222,633  
 
Common stock issued in acquisition of OctigaBay
    7,382       56,756                                               56,756  
 
Exchangeable shares issued in acquisition of OctigaBay
                    3,158     $ 24,207                               24,207  
 
Deferred compensation related to acquisition of OctigaBay
    179       1,190       1,682       11,185       (14,599 )                     (2,224 )
 
Exchangeable shares converted into common shares
    4,269       31,219       (4,269 )     (31,219 )                                
 
Acquisition-related compensation expense
                                    11,134                       11,134  
 
Fair value of OctigaBay options acquired
            2,579                                               2,579  
 
Issuance of shares under Employee Stock Purchase Plan
    404       1,796                                               1,796  
 
Exercise of stock options
    876       2,841                                               2,841  
 
Issuance of shares under Company 401(k) plan
    94       645                                               645  
 
Exercise of warrants, less issuance costs of $191
    1,279       3,634                                               3,634  
 
Common stock issued for bonus
    54       374                                               374  
 
Compensation expense on restricted stock
                                    105                       105  
 
Compensation expense on modification of stock options
            196                                               196  
 
Compensation expense on stock options issued to contractors
            35                                               35  
 
Other comprehensive income:
                                                               
   
Unrealized loss on available for sale investments
                                                    (33 )     (33 )
   
Cumulative currency translation adjustment
                                    (755 )             5,400       4,645  
   
Net loss
                                            (204,023 )             (204,023 )
                                                 
BALANCE, December 31, 2004
    87,349     $ 413,911       571     $ 4,173     $ (4,220 )   $ (293,124 )   $ 4,560     $ 125,300  
                                                 
See accompanying notes

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CRAY INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
                           
    Years Ended December 31,
     
    2002   2003   2004
             
Operating activities:
                       
Net income (loss)
  $ 5,403     $ 63,248     $ (204,023 )
Adjustments to reconcile net income (loss) to net cash used by operating activities:
                       
 
Depreciation and amortization
    15,364       15,860       16,836  
 
Acquisition-related compensation expense
                    11,134  
 
In-process research and development charge
                    43,400  
 
Loss (gain) on disposal of assets
    (38 )     231          
 
Interest paid through issuance of common stock
    670                  
 
Amortization of beneficial conversion feature of notes payable
    1,127                  
 
Inventory write-down
                    7,991  
 
Compensation expense on related party notes
    151                  
 
Other stock-based compensation
    230               710  
 
Tax benefit on stock options
            6,326          
 
Deferred income taxes
    480       (48,996 )     59,188  
Cash provided (used) by changes in operating assets and liabilities, net of the effects of the OctigaBay acquisition:
                       
 
Accounts receivable
    (6,434 )     (18,553 )     15,471  
 
Inventory
    (8,442 )     (27,084 )     (46,921 )
 
Prepaid expenses and other assets
    (3,005 )     (11,893 )     11,898  
 
Service spares
    (121 )     (180 )     (58 )
 
Long-term receivable
    550                  
 
Accounts payable
    1,932       (678 )     9,609  
 
Accrued payroll and related expenses
    3,612       3,786       (4,257 )
 
Other accrued liabilities
    (15,685 )     (6,158 )     4,673  
 
Deferred revenue
    (4,483 )     14,828       21,048  
                   
Net cash used by operating activities
    (8,689 )     (9,263 )     (53,301 )
Investing activities:
                       
 
Sales/maturities of short-term investments
            14,563       68,635  
 
Purchases of short-term investments
            (49,133 )     (68,318 )
 
Proceeds from sale of property and equipment
    46                  
 
Acquisition of OctigaBay, net of cash acquired
                    (6,270 )
 
Purchases of property and equipment
    (6,038 )     (6,599 )     (12,518 )
                   
Net cash used by investing activities
    (5,992 )     (41,169 )     (18,471 )
Financing activities:
                       
 
Decrease (increase) in restricted cash
    353               (11,437 )
 
Sale of common stock, net of issuance costs
    12,927       42,500          
 
Proceeds from issuance of common stock through Employee Stock Purchase Plan and Company 401(k) plan
    1,885       2,196       2,441  
 
Proceeds from exercise of options
    1,413       18,653       2,841  
 
Proceeds from exercise of warrants
    11,759       6,665       3,634  
 
Proceeds from issuance of convertible debenture notes
                    80,000  
 
Debt issuance costs
                    (3,376 )
 
Principal payments on term loan
    (2,142 )     (3,929 )        
 
Principal payments on bank note
    (485 )     (215 )        
 
Principal payments on capital leases
    (375 )     (241 )     (742 )
                   
Net cash provided by financing activities
    25,335       65,629       73,361  
                   
Effect of foreign exchange rate changes on cash and cash equivalents
    885       660       370  
                   
Net increase in cash and cash equivalents
    11,539       15,857       1,959  
Cash and cash equivalents
                       
 
Beginning of period
    12,377       23,916       39,773  
                   
 
End of period
  $ 23,916     $ 39,773     $ 41,732  
                   
Supplemental disclosure of cash flow information:
                       
 
Cash paid for interest
  $ 944     $ 213     $ 153  
 
Cash paid for income taxes
    1,381       2,741       590  
Non-cash investing and financing activities:
                       
 
Inventory transfers to fixed assets and spares
    595       8,095       11,281  
 
Note payable converted to common stock
    9,300                  
 
Preferred stock converted to common stock
            24,946          
 
Shares issued in acquisition
                    83,542  
See accompanying notes

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 DESCRIPTION OF BUSINESS
      Cray Inc. (“Cray” or the “Company”) designs, develops, markets and services high performance computer systems, commonly known as supercomputers. These systems provide capability and capacity far beyond typical mainframe computer systems and address the world’s most challenging computing problems for government, industry and academia. The Company is currently in transition from a single product, Cray X1, to three new products — Cray X1E, which has significantly increased processor speed and capability; Cray XT3, a product line based on the Red Storm system which was developed for Sandia National Laboratories pursuant to a long-term development contract; and Cray XD1, a balanced, high-bandwidth system acquired from OctigaBay Systems Corporation.
      In 2004 the Company incurred a net loss of $204.0 million and used $53.3 million in cash by operating activities and $18.5 million by investing activities. In December 2004 the Company raised net proceeds of $76.6 million from the sale of convertible senior subordinated notes. Management expects to use significant working capital, particularly in the first half of 2005, primarily to fund growth in inventory until product shipments and acceptances and receipt of payment. Management’s plans project that the Company’s current cash resources and cash to be generated from operations in 2005 will be adequate for the next twelve months. If the Company were to experience a material shortfall in its plans, however, it would pursue additional initiatives to reduce costs further, including reductions in inventory purchases and commitments, and/or seek additional financing. There can be no assurance the Company will be successful in its efforts to achieve future profitable operations or generate sufficient cash from operations, or obtain additional funding in the event its financial resources became insufficient.
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Accounting Principles
      The consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America.
Principles of Consolidation
      The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Intercompany balances and transactions have been eliminated.
Business Combinations
      Business combinations accounted for under the purchase method of accounting include the results of operations of the acquired business from the date of acquisition. Net assets of the company acquired are recorded at their fair value at the date of acquisition. Amounts allocated to in-process research and development are expensed in the period of acquisition. The valuation of the shares issued is based on a seven-day stock price average using the measurement date and three days prior to and after this date. If the Company issued a public announcement of the acquisition, the measurement date is the date of such announcement. If the purchase consideration is based on a formula, the measurement date is based on the requirements in Emerging Issues Task Force (“EITF”) Issue No. 99-12, Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination. If no public announcement was made and a formula is not used in determining the purchase consideration, then the measurement date is the date of purchase.

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Use of Estimates
      Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Cash and Cash Equivalents
      Cash and cash equivalents consist of highly liquid financial instruments that are readily convertible to cash and have original maturities of three months or less at the time of acquisition.
Short-term Investments
      Short-term investments generally mature between three months and two years from the purchase date. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All short-term investments are classified as available for sale and are recorded at fair value, based on quoted market prices; unrealized gains and losses are reflected in other comprehensive income.
Concentration of Credit Risk
      The Company currently derives the majority of revenues from sales of products and services to U.S. government agencies or commercial customers primarily serving the U.S. government. See Note 16 — Segment Information for additional information. Given the type of customers, the Company does not believe its accounts receivable represent credit risk.
      As of December 31, 2004, accounts receivable included $14.9 million due from a single customer.
Accounts Receivable
      Accounts receivable is primarily composed of amounts due from government funded research and development projects and amounts contractually due from customers for products and services.
Fair Values of Financial Instruments
      The Company had the following financial instruments: cash and cash equivalents, short-term investments, accounts receivable, accounts payable, accrued liabilities and notes payable. The carrying value of cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities and notes payable approximate their fair value based on the short-term nature of these financial instruments, or borrowing rates currently available to the company. Short-term investments are recorded at their fair value.
Inventories
      Inventories are valued at the lower of cost (first-in, first-out) or market. The Company regularly evaluates the technological usefulness of various inventory components and the expected use of the inventory. When it is determined that previously inventoried components do not function as intended in a fully operational system, or quantities on hand are in excess of requirements, the costs associated with these components are written off.
Property and Equipment, net
      Property and equipment are recorded at cost less accumulated depreciation and amortization. Depreciation is calculated on a straight-line basis over the estimated useful lives of the related assets, ranging from 18 months to seven years for furniture, fixtures and computer equipment, and eight to 25 years for buildings

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
and land improvements. Equipment under capital leases is depreciated over the lesser of the lease term or its estimated useful life. Leasehold improvements are amortized over the lesser of their estimated useful lives or the term of the lease. The cost of software obtained or inventory transferred for internal use are capitalized and depreciated over their estimated useful lives, generally four years.
      In accordance with Statement of Position (“SOP”) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, the Company has capitalized certain costs associated with the implementation of software obtained for internal use. Costs capitalized primarily consist of employee salaries and benefits allocated to the implementation project. The Company capitalized approximately $0.8 million, $1.1 million and $0 of costs associated with computer software obtained for internal use during the years ended December 31, 2004, 2003 and 2002, respectively.
Service Spares
      Service spares are primarily utilized to fulfill the Company’s service obligations related to the Cray product line. The cost of service spares is allocated as the related assets are used in service.
Goodwill
      In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 142, Goodwill and Other Intangible Assets, the Company tests goodwill for impairment on an annual basis as of January 1, and between annual tests if indicators of potential impairment exist, using a fair-value based approach. No impairment of goodwill has been identified during any of the periods presented. However, in 2003, the Company decreased goodwill by $9.3 million due to the reversal of the valuation allowance against the deferred tax asset. See Note 8 — Goodwill.
Intangible Assets, net
      As part of the OctigaBay Systems Corporation acquisition (see Note 18 — OctigaBay Acquisition) the Company purchased core technology which will be amortized over five years, resulting in a charge to cost of product of approximately $336,000 per quarter through the first quarter of 2009, subject to currency fluctuations.
Impairment of Long-lived Assets
      In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, management tests long-lived assets to be held and used for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. No impairments were recorded during 2004 or 2002. During 2003, the Company recorded an impairment loss of $1.1 million on certain inventory and fixed assets related to the MTA product line, of which $343,000 was included in cost of product sales and $721,000 was included in restructuring expense in the Consolidated Statements of Operations and Comprehensive Income (Loss).
Revenue Recognition
      The Company recognizes revenue when it is realized or realizable and earned. In accordance with the Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition in Financial Statements, the Company considers revenue realized or realizable and earned when it has persuasive evidence of an arrangement, the product has been shipped or the services have been provided to the customer, title and risk of loss for products has passed to the customer, the sales price is fixed or determinable and collectibility is reasonably assured. In addition to the aforementioned general policy, the following are the

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
specific revenue recognition policies for each major category of revenue and for multiple-element arrangements.
      Product. The Company recognizes revenue based upon product line, as follows:
  •  Cray X1/ X1E and XT3 Product Line: The Company generally recognizes revenue from product sales upon customer acceptance and when there are no unfulfilled Company obligations that affect the customer’s final acceptance. A customer-signed Notice of Acceptance or similar document is required from the customer prior to revenue recognition.
 
  •  XD1 Product Line: The Company generally recognizes revenue from product sales of Cray XD1 systems upon shipment to or delivery to the customer, depending upon contract terms. If there is a contractual requirement for customer acceptance, revenue is recognized upon receipt of the notice of acceptance and when there are no unfulfilled Company obligations.
      Revenue from contracts that require the Company to design, develop, manufacture or modify complex information technology systems to a customer’s specifications, and to provide services related to the performance of such contracts, is recognized using the percentage of completion method for long-term development projects. Percentage of completion is measured based on the ratio of costs incurred to date compared to the total estimated costs. Total estimated costs are based on several factors, including estimated labor hours to complete certain tasks and the estimated cost of purchased components at future dates. Estimates may need to be adjusted from quarter to quarter, which would impact revenue and margins on a cumulative basis.
      Revenue from contracts structured as operating leases is recorded as earned over the lease terms.
      Service: Service revenue for the maintenance of computers is recognized ratably over the term of the maintenance contract. Funds from maintenance contracts that are paid in advance are recorded as deferred revenue. High-performance computing service revenue is recognized as the services are rendered.
      Multiple-Element Arrangements. The Company commonly enters into transactions that include multiple-element arrangements, which may include any combination of hardware, maintenance and other services and/or software. In accordance with EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, when some elements are delivered prior to others in an arrangement and all of the following criteria are met, revenue for the delivered element is recognized upon delivery and acceptance of such item:
  •  The fair value of the elements, or for residual method calculations the undelivered element, is established;
 
  •  The functionality of the delivered elements are not dependent on the undelivered elements; and
 
  •  Delivery of the delivered element represents the culmination of the earnings process.
      If all of the criteria are not met, revenue is deferred until delivery of the last element.
Foreign Currency Translation
      The functional currency of the Company’s foreign subsidiaries is the local currency. Assets and liabilities of foreign subsidiaries are translated into US dollars at year-end exchange rates, and revenues and expenses are translated at average rates prevailing during the year. Translation adjustments are included in accumulated other comprehensive income (loss), a separate component of shareholders’ equity. Transaction gains and losses arising from transactions denominated in a currency other than the functional currency of the entity involved, which have been insignificant, are included in the consolidated statements of operations.

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Research and Development
      Research and development costs include costs incurred in the development and production of the Company’s hardware and software, costs incurred to enhance and support existing software features and expenses related to future implementations of systems. Research and development costs are expensed as incurred, and are offset in part by government funding for development and services. Non-recurring engineering costs are expensed over the term of the development period. SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, requires the capitalization of certain software product costs after technological feasibility of the software is established. Due to the relatively short period between the technological feasibility of a product and completion of product development, and the insignificance of related costs incurred during this period, no software development costs have been capitalized.
Income Taxes
      The Company accounts for income taxes under SFAS No. 109, Accounting for Income Taxes. Deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company provides a valuation allowance, as necessary, to reduce deferred tax assets to their estimated realizable value.
Stock-Based Compensation
      The Company applies Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, in accounting for its stock option and purchase plans. Had compensation cost for the Company’s stock option plans and its stock purchase plan been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123, Accounting for Stock-Based Compensation, the Company’s net income (loss) and net income (loss) per common share for the years ended December 31, 2002, 2003, and 2004 would have been the pro forma amounts indicated below (in thousands):
                           
    2002   2003   2004
             
Net income (loss), as reported
  $ 5,403     $ 63,248     $ (204,023 )
Add:
                       
 
Stock-based compensation included in reported net income (loss)
    151       75       11,844  
Less:
                       
 
Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects
    (13,332 )     (10,207 )     (19,423 )
                   
Pro forma net income (loss)
  $ (7,778 )   $ 53,116     $ (211,602 )
                   

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      Basic and diluted net income (loss) per common share for the years ended December 31 are as follows:
                           
    2002   2003   2004
             
Basic:
                       
 
As reported
  $ 0.11     $ 0.94     $ (2.45 )
 
Pro forma
  $ (0.16 )   $ 0.79     $ (2.54 )
Diluted:
                       
 
As reported
  $ 0.10     $ 0.81     $ (2.45 )
 
Pro forma
  $ (0.16 )   $ 0.68     $ (2.54 )
      The weighted average Black-Scholes value of options granted under the stock option plans during 2002, 2003 and 2004 was $2.90, $8.43 and $3.75, respectively. Fair values were estimated as of the dates of grant using the Black-Scholes option-pricing model with the following assumptions: no dividend yield, expected volatility of 95%, 84% and 82% for 2002, 2003 and 2004, respectively, risk-free interest rate of 3.8%, 4.3%, and 4.2% for 2002, 2003 and 2004, respectively, and an expected term of 8.2 years for 2002, 7.1 years for 2003 and 6.9 years for 2004.
      For purposes of this pro forma disclosure, the value of the options is estimated using a Black-Scholes option pricing model and amortized ratably to expense over the options’ vesting periods. Because the estimated value is determined as of the date of grant, the actual value ultimately realized by the employee may be significantly different.
      SFAS No. 123 requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, option pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of employee stock options.
      In accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 44, Accounting for Certain Transactions Involving Stock Compensation, deferred compensation includes the unamortized intrinsic value of vested and unvested options assumed in the April 2004 acquisition of OctigaBay. For this acquisition, the Company measured the intrinsic value based on the number of options granted and the difference between the converted exercise price of the options and the fair value of the underlying common stock based on the quoted price of the Company’s common stock at the date the options were assumed. See Note 18 — OctigaBay Acquisition.
Reclassifications
      Certain prior-year amounts have been reclassified to conform with the current-year presentation.
Earnings (Loss) Per Share
      Basic earnings per share (“EPS”) is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income available to common shareholders by the weighted average number of common and common equivalent shares outstanding during the period, which includes the additional dilution related to conversion of stock options as computed under the treasury stock method and the conversion of the preferred stock under the if-converted method (for 2002 only).

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      The following data show the amounts used in computing the weighted average number of shares of potentially dilutive common stock (in thousands):
                           
    Years ended December 31,
     
    2002   2003   2004
             
Weighted average number of shares used in basic EPS
    47,969       67,098       83,387  
Effect of dilutive securities:
                       
 
Stock options and warrants
    3,323       10,763          
 
Convertible preferred stock
    3,125                  
                   
Weighted average number of common shares and potentially dilutive common stock used in diluted EPS
    54,417       77,861       83,387  
                   
Potentially dilutive securities excluded from computations because they are anti-dilutive
    19,022       8,654       36,300  
                   
Segment Information
      The Company has organized and managed its operations in a single operating segment providing global sales and service of high performance computers. See Note 16 — Segment Information.
Warranty Reserve
      The Company does not accrue for a general warranty reserve but instead, provides warranty-type services under its maintenance contracts. Maintenance contracts are either sold separately to customers or are included as part of multiple element arrangements.
      Certain components in the T90 vector computers manufactured by SGI prior to the Company’s April 2000 acquisition of the Cray Research operations had an unusually high failure rate. The cost of servicing the Cray T90 computers has historically exceeded the related service revenues. Included in warranty reserves at December 31, 2003 and 2004 is an accrual of $586,000 and $0, respectively, for estimated losses on service contracts covering the T90 product line.
      A summary of the warranty reserve, including the T90 warranty reserve, is as follows (in thousands):
                                 
    Balance           Balance
    January 1,   2002   2002   December 31,
    2002   Additions   Deductions   2002
                 
Warranty Reserve
  $ 15,053     $ 354     $ (9,808 )   $ 5,599  
                         
                                 
    Balance           Balance
    January 1,   2003   2003   December 31,
    2003   Additions   Deductions   2003
                 
Warranty Reserve
  $ 5,599     $ 380     $ (5,324 )   $ 655  
                         
                                 
    Balance           Balance
    January 1,   2004   2004   December 31,
    2004   Additions   Deductions   2004
                 
Warranty Reserve
  $ 655     $     $ (655 )   $  
                         

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
Recent Accounting Pronouncements
      In November 2004 the FASB issued SFAS No. 151, Inventory Costs — an amendment of ARB No. 43, Chapter 4. SFAS No. 151 clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) and requires that those items be recognized as current-period charges regardless of whether they meet the criterion set forth in ARB No. 43. This statement also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company has not yet determined the impact of adopting SFAS No. 151.
      In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment. SFAS No. 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in the financial statements. That cost should be measured based on the fair value of the equity or liability instruments issued. SFAS No. 123(R) covers a wide range of share-based compensation arrangements including employee share options, performance-based awards and employee stock purchase plans. SFAS No. 123(R) will be effective for the Company as of July 1, 2005. The impact of the adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had the Company adopted SFAS No. 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net loss and net loss per share in the Stock-Based Compensation section above.
NOTE 3 SHORT-TERM INVESTMENTS
      As of December 31, 2004, the Company’s short-term investments consisted of the following (in thousands):
                                   
    Amortized   Gross   Gross    
    Cost   Unrealized   Unrealized    
    Basis   Gains   Losses   Fair Value
                 
Commercial paper
  $ 1,294                     $ 1,294  
U.S. government and agency securities
    18,026     $ 3     $ (9 )     18,020  
Asset-backed securities
    2,515               (2 )     2,513  
Corporate notes and bonds
    12,442               (16 )     12,426  
                         
 
Total short-term investments
  $ 34,277     $ 3     $ (27 )   $ 34,253  
                         
      As of December 31, 2003, the Company’s short-term investments consisted of the following (in thousands):
                                   
    Amortized   Gross   Gross    
    Cost   Unrealized   Unrealized    
    Basis   Gains   Losses   Fair Value
                 
Commercial paper
  $ 4,243                     $ 4,243  
U.S. government and agency securities
    16,820     $ 6               16,826  
Asset-backed securities
    4,303       2     $ (9 )     4,296  
Corporate notes and bonds
    9,195       10               9,205  
                         
 
Total short-term investments
  $ 34,561     $ 18     $ (9 )   $ 34,570  
                         

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      Realized gains (losses) for the years ended December 31, 2002, 2003 and 2004 were immaterial. Investments at December 31, 2004 mature as follows (in thousands):
         
2005
  $ 28,777  
2006
    2,963  
2007
    1,256  
2008
    1,257  
       
    $ 34,253  
       
NOTE 4 ACCOUNTS RECEIVABLE, NET
      A summary of accounts receivable is as follows (in thousands):
                 
    December 31,
     
    2003   2004
         
Trade accounts receivable
  $ 31,838     $ 23,737  
Unbilled receivables
    8,098       6,770  
Government funding pass-through
    5,828       4,015  
Advance billings
    3,835       102  
             
      49,599       34,624  
Allowance for doubtful accounts
    (1,125 )     (1,439 )
             
Accounts receivable, net
  $ 48,474     $ 33,185  
             
                                 
    Balance           Balance
    January 1,   2002   2002   December 31,
    2002   Additions   Deductions   2002
                 
Allowance for doubtful accounts
  $ 936     $ 334     $ (172 )   $ 1,098  
                         
                                 
    Balance           Balance
    January 1,   2003   2003   December 31,
    2003   Additions   Deductions   2003
                 
Allowance for doubtful accounts
  $ 1,098     $ 113     $ (86 )   $ 1,125  
                         
                                 
    Balance           Balance
    January 1,   2004   2004   December 31,
    2004   Additions   Deductions   2004
                 
Allowance for doubtful accounts
  $ 1,125     $ 373     $ (59 )   $ 1,439  
                         

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
NOTE 5 PROPERTY AND EQUIPMENT, NET
      A summary of property and equipment is as follows (in thousands):
                 
    December 31,
     
    2003   2004
         
Land
  $ 131     $ 131  
Building
    9,017       9,590  
Furniture and equipment
    7,589       8,971  
Computer equipment
    47,745       66,305  
Leasehold improvements
    3,183       3,854  
             
      67,665       88,851  
Accumulated depreciation
    (41,508 )     (51,976 )
             
Property and equipment, net
  $ 26,157     $ 36,875  
             
NOTE 6 INVENTORY
      A summary of inventory is as follows (in thousands):
                 
    December 31,
     
    2003   2004
         
Components and subassemblies
  $ 16,916     $ 24,615  
Red Storm inventory
    1,698       1,839  
Work in process
    14,178       17,702  
Finished goods
    10,230       27,365  
             
    $ 43,022     $ 71,521  
             
      Revenue for 2002, 2003, and 2004 includes $5.9 million, $316,000, and $498,000, respectively, from the sale of obsolete inventory recorded at a zero cost basis.
      During 2004, the Company wrote off $8.0 million of inventory, primarily related to the Cray X1 system. The Company did not write off any inventory during 2002 or 2003.
      As of December 31, 2003 and 2004, total inventory included $10.2 million and $27.4 million, respectively, of inventory located at customer sites pending customer acceptance.
NOTE 7 SERVICE SPARES, NET
      A summary of service spares is as follows (in thousands):
                 
    December 31,
     
    2003   2004
         
Service spares
  $ 26,977     $ 29,899  
Accumulated depreciation
    (22,052 )     (26,309 )
             
Service spares, net
  $ 4,925     $ 3,590  
             

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
NOTE 8 GOODWILL
      On April 1, 2004, the Company completed its acquisition of OctigaBay Systems Corporation. See Note 18 — OctigaBay Acquisition. As part of the acquisition, the Company recorded $38.8 million of goodwill. The following table provides information about activity in goodwill for the twelve months ended December 31, 2003 and 2004, respectively (in thousands):
                 
    Years Ended
    December 31,
     
    2003   2004
         
Goodwill, at January 1
  $ 22,680     $ 13,344  
Acquisition
            38,836  
Foreign currency translation adjustments
            3,464  
Other adjustments
    (9,336 )        
             
Goodwill, at December 31
  $ 13,344     $ 55,644  
             
      In 2003, the Company decreased goodwill by $9.3 million due to the reversal of a valuation allowance against the Company’s deferred tax asset. As discussed in Note 12 — Income Taxes, in 2004 the Company re-established a full valuation allowance against its deferred tax assets.
NOTE 9 DEFERRED REVENUE
      Deferred revenue consisted of the following (in thousands):
                 
    December 31,
     
    2003   2004
         
Deferred product revenue
  $ 2,230     $ 37,519  
Deferred service revenue
    21,726       16,606  
Deferred Red Storm revenue
    9,136          
Other deferred revenue
    141       121  
             
Total
  $ 33,233     $ 54,246  
             
      Deferred revenue as of December 31, 2004 includes $23.6 million of deferred product revenue not expected to be realized until 2006. The Company considers this balance to be a current liability as the customer has contractual cancellation rights. No such amounts were included in deferred revenue as of December 31, 2003.
NOTE 10 RELATED PARTY TRANSACTIONS
      During 1997, the Company issued full recourse notes for $345,000 related to the exercise of employee stock options. These notes had an original maturity of twelve months from date of issuance and were secured by a stock pledge agreement. The notes were reissued several times and were last due on December 31, 2004. The notes bear interest at a rate of 2.5% per year. Given the uncertainty related to collectibility, the notes were fully reserved in 2001. In 2002, the Company and the employees to whom these notes were issued agreed that the Company would forgive 50% of the outstanding principal balance of the notes if the employees remained employed by the Company through December 31, 2002, and the remaining 50% of the outstanding principal balance if they remain employed by the Company through December 31, 2004, with 25% to be forgiven at the end of 2003 and 2004, respectively. Two of the loans totaling $45,000 were forgiven on December 31, 2004 and the third loan was extended until January 1, 2005. The amount forgiven on that date was $49,000. The related stock options were considered variable in nature in 2002 given that the employees had then pledged their

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
shares of common stock as security for the notes. The Company accordingly recorded compensation expense of $151,000 for the year ended December 31, 2002, related to the shares of common stock securing these notes. In February 2003, the Company released the pledged common shares as security for the notes.
      The Company paid fees related to private debt and equity placements to a company whose Chairman, Chief Executive Officer and principal shareholder was one of the Company’s directors until February 2002. Amounts incurred for the year ended December 31, 2002, totaled $973,000.
NOTE 11 COMMITMENTS AND CONTINGENCIES
      The Company leases certain property and equipment under capital leases pursuant to master equipment lease agreements and has non-cancelable operating leases for facilities. Under the master equipment lease agreements, the Company has acquired computer and other equipment in the amount of $5.0 million for which $2.6 million and $4.0 million of accumulated depreciation was recorded as of December 31, 2003, and 2004, respectively.
      Rent expense under leases accounted for as operating leases in 2002, 2003, and 2004 was $3.7 million, $3.9 million and $4.2 million, respectively.
      Minimum contractual commitments as of December 31, 2004, were as follows (in thousands):
                         
    Capital   Operating   Development
    leases   leases   agreements
             
2005
  $ 539     $ 5,058     $ 9,159  
2006
            4,152       2,750  
2007
            2,936       2,027  
2008
            2,477       43  
2009
            579          
                   
      539     $ 15,202     $ 13,979  
                   
Less amounts representing interest
    (8 )                
                   
    $ 531                  
                   
NOTE 12 INCOME TAXES
      As of December 31, 2004, the Company had federal net operating loss carryforwards of approximately $224 million and federal research and experimentation tax credit carryforwards of approximately $4.7 million. The net operating loss carryforwards will expire from 2010 through 2022, if not utilized.
      Income (loss) before provision for income taxes consisted of (in thousands):
                         
    Year ended December 31,
     
    2002   2003   2004
             
United States
  $ 5,124     $ 31,202     $ (89,319 )
International
    2,455       (10,161 )     (55,612 )
                   
    $ 7,579     $ 21,041     $ (144,931 )
                   

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      The provision (benefit) for income taxes related to operations consists of the following (in thousands):
                           
    Years ended December 31,
     
    2002   2003   2004
             
Federal:
                       
 
Current
          $ 134          
 
Deferred
            (42,012 )   $ 61,906  
State:
                       
 
Current
  $ 343       (44 )        
 
Deferred
            (482 )     (3,466 )
Foreign:
                       
 
Current
    1,353       294       581  
 
Deferred
    480       (97 )     71  
                   
Total provision (benefit) for income taxes
  $ 2,176     $ (42,207 )   $ 59,092  
                   
      The following table reconciles the federal statutory income tax rate to the Company’s effective tax rate.
                         
    2002   2003   2004
             
Federal statutory income tax rate
    35.0 %     35.0 %     (35.0 )%
State taxes
    3.0       2.2       (2.4 )
Impact of change in state rate
    5.8       (1.4 )        
Foreign taxes
    1.2       (5.2 )     (0.3 )
IPR&D write off
                    10.8  
Permanent differences
                    3.9  
Foreign tax credit
                    (0.3 )
R&D tax credit
            (5.3 )     (1.1 )
Other
    0.4       1.2       0.1  
Effect of change in valuation allowance on deferred tax assets
    (16.7 )     (227.1 )     65.1  
                   
Effective income tax rate
    28.7 %     (200.6 )%     40.8 %
                   

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      Deferred income taxes reflect the net tax effects of temporary differences between the tax basis of assets and liabilities and the corresponding financial statement amounts. Significant components of the Company’s deferred income tax assets and liabilities are as follows (in thousands):
                 
    December 31,
     
    2003   2004
         
Assets
               
Current
               
Warranty reserve
  $ 254          
Inventory
    46     $ 2,714  
Accrued compensation
    2,689       2,731  
Deferred service revenue
    1,844       1,452  
             
Gross current deferred tax assets
    4,833       6,897  
Valuation allowance
    (453 )     (6,848 )
             
Net current deferred tax assets
    4,380       49  
             
Long Term
               
Fixed assets
    1,819       1,724  
Research and experimentation
    3,177       4,721  
Net operating loss carryforwards
    54,768       87,764  
Accrued restructuring charge
            801  
Other
    65       568  
             
Gross long-term deferred tax assets
    59,829       95,578  
Valuation allowance
    (5,614 )     (94,909 )
             
Net long-term deferred tax assets
    54,215       669  
             
Total net deferred tax assets
  $ 58,595     $ 718  
             
Liabilities
               
Current
               
Other
            (173 )
Long-Term
               
Fixed assets
            (2,028 )
Other
            (179 )
             
Gross long-term deferred tax liabilities
            (2,207 )
             
Total deferred tax liabilities
    0       (2,380 )
             
Net deferred tax asset (liability)
  $ 58,595     $ (1,662 )
             
      In 2004 the Company recorded an income tax expense of $58.5 million related to establishing a valuation allowance against deferred tax assets consisting of accumulated net operating losses. Under the criteria set forth in SFAS No. 109, Accounting for Income Taxes, the Company concluded that, given its cumulative losses over the past three years, the valuation allowance was appropriate. Once the Company has been profitable for an extended period and the Company is able to then conclude, under the criteria of SFAS No. 109, that the valuation allowance is no longer appropriate in part or in full, it would then reduce or eliminate the valuation allowance and record a tax benefit.

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      In 2003 the Company recorded an income tax benefit of $42.5 million. In the fourth quarter of 2003, management determined that, based on its historical operating performance and reasonably expected future performance at that time, the Company expected to be able to utilize most of its net deferred tax asset and therefore reduced the valuation allowance by approximately $58.5 million.
      The net change in the valuation allowance during the years ended December 31, 2002, 2003 and 2004 was an increase of $821,000, a decrease of $58.5 million and an increase of $95.6 million, respectively.
NOTE 13 NOTES PAYABLE
      In December 2004 the Company issued $80 million aggregate principal amount of 3.0% Convertible Senior Subordinated Notes due 2024 (Notes) in a private placement pursuant to Rule 144A under the Securities Act of 1933, as amended. These unsecured Notes bear interest at an annual rate of 3.00%, payable semiannually on June 1 and December 1 of each year through the maturity date of December 1, 2024.
      The Notes are convertible, under certain circumstances, into the Company’s common stock at an initial conversion rate of 207.2002 shares of common stock per $1,000 principal amount of Notes, which is equivalent to an initial conversion price of approximately $4.83 per share of common stock (subject to adjustment in certain events). Upon conversion of the Notes, in lieu of delivering common stock, the Company may, at its discretion, deliver cash or a combination of cash and common stock.
      The Notes are general unsecured senior subordinated obligations, ranking junior in right of payment to the Company’s existing and future senior indebtedness, equally in right of payment with the Company’s existing and future indebtedness or other obligations that are not, by their terms, either senior or subordinated to the Notes and senior in right of payment to the Company’s future indebtedness that, by its terms, is subordinated to the Notes. In addition, the Notes are effectively subordinated to any of the Company’s existing and future secured indebtedness to the extent of the assets securing such indebtedness and structurally subordinated to the claims of all creditors of the Company’s subsidiaries.
      Holders may convert the Notes during a conversion period beginning with the mid-point date in a fiscal quarter to, but not including, the mid-point date (or, if that day is not a trading day, then the next trading day) in the immediately following fiscal quarter, if on each of at least 20 trading days in the period of 30 consecutive trading days ending on the first trading day of the conversion period, the closing sale price of the Company’s common stock exceeds 120% of the conversion price in effect on that 30th trading day of such period. The “mid-point dates” for the fiscal quarters are February 15, May 15, August 15 and November 15. Holders may also convert the Notes if the Company has called the Notes for redemption or, during prescribed periods, upon the occurrence of specified corporate transactions or a fundamental change, in each case as described in the indenture governing the Notes. As of December 31, 2004, none of the conditions for conversion of the Notes were satisfied.
      The Company may, at its option, redeem all or a portion of the Notes for cash at any time on or after December 1, 2007 and prior to December 1, 2009 at a redemption price of 100% of the principal amount of the Notes plus accrued and unpaid interest plus a make whole premium of $150.00 per $1,000 principal amount of Notes, less the amount of any interest actually paid or accrued and unpaid on the Notes prior to the redemption date, if the closing sale price of the Company’s common stock exceeds 150% of the conversion price for at least 20 trading days in the 30-trading day period ending on the trading day prior to the date of mailing of the redemption notice. On or after December 1, 2009, the Company may redeem for cash all or a portion of the Notes at a redemption price of 100% of the principal amount of the Notes plus accrued and unpaid interest. Holders may require the Company to purchase all or a part of their Notes for cash at a purchase price of 100% of the principal amount of the Notes plus accrued and unpaid interest on December 1, 2009, 2014, and 2019, or upon the occurrence of certain events provided in the indenture governing the Notes.

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CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      In connection with the issuance of the Notes, the Company incurred $3.4 million of issuance costs, which primarily consisted of investment banker fees, legal and other professional fees. These costs are being amortized to interest expense over the five-year period from December 2004 through November 2009. The unamortized balance of these costs is included in other non-current assets in the accompanying consolidated balance sheets.
      The Company’s $25.0 million revolving line of credit with Wells Fargo Bank expired on April 29, 2004. Subsequent to April 29, 2004, the Company was granted extensions of the line of credit through December 1, 2004, with no material changes to the terms and conditions. Subsequent to December 1, 2004, the Company negotiated a $15.0 million secured credit facility with Wells Fargo Bank which is used only to support outstanding letters of credit. At December 31, 2004, the Company had $11.4 million of outstanding letters of credit. The Company is required to maintain cash and short-term investment balances at least equal to the outstanding letters of credit. As such, the Company has designated $11.4 million of its cash as restricted cash at December 31, 2004.
NOTE 14 SHAREHOLDERS’ EQUITY
      Common Stock: In the first quarter of 2003, the Company completed a public offering of 8,480,000 shares of newly issued common stock, and an additional 145,000 shares of common stock from certain selling shareholders, at a public offering price of $6.20 per share. The Company received from the offering, after underwriting discount and selling expenses, net proceeds of $49.1 million. The Company used the net proceeds for general corporate purposes.
      On April 1, 2004, the Company issued 7,560,885 shares of Cray common stock and 4,840,421 exchangeable shares in connection with the acquisition of OctigaBay Systems Corporation. See Note 18 — OctigaBay Acquisition.
      Preferred Stock: The Company has 5,000,000 shares of undesignated preferred stock authorized, and no shares of preferred stock outstanding.
      Convertible Debentures: In November 2001 the Company entered into debentures agreements with certain investors, under which it issued $9.3 million of aggregate convertible debentures bearing interest at 5% per annum. These debentures were all converted to common stock in December 2002 at the rate of $2.35 per share. The debentures were convertible into common stock at a discount. In conjunction with these debentures, the Company issued warrants to purchase 367,590 shares of its common stock at $4.4275 per share. The warrants expired on November 8, 2004. Upon issuance, the Company allocated $318,000 of the proceeds to the warrants based on their fair value, as determined using the Black-Scholes option pricing model with the following assumptions: risk-free interest rate of 2.76%, an expected life of 3 years, volatility of 98% and no dividends. In accordance with EITF Issue No. 00-27, the Company also recorded a discount related to a beneficial conversion feature in the amount of $876,000. The total discount of $1,194,000, representing the total of the fair value of the warrants and the beneficial conversion feature, was being amortized as interest expense over the related term of the debentures. In connection with the conversion of the debentures to common stock in December 2002, the Company recorded as interest expense the remaining unamortized balance of the beneficial conversion feature portion of the discount and recorded the remaining unamortized balance of $398,000 as an offset to paid-in capital. Total amortization expense was $1.1 million for the year ended December 31, 2002.
      In connection with the conversion of all the debentures in December 2002, the Company issued to the holders of the debentures an aggregate of 3,973,935 shares of common stock.

F-20


Table of Contents

CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      Shareholder Warrants: At December 31, 2004, the Company had outstanding and exercisable warrants to purchase an aggregate of 5,439,850 shares of common stock, as follows:
                 
Shares of   Exercise Price   Expiration
Common Stock   per share   Date of Warrants
         
  5,801     $ 6.00     November 8, 2005
  524     $ 6.00     May 21, 2006
  294,117     $ 4.50     September 3, 2006
  5,139,408     $ 2.53     June 21, 2009
             
  5,439,850              
             
      Stock Option Plans: The Company has stock option plans that provide for option grants to employees, directors and others. Options granted to employees under the Company’s option plan generally vest over four years or as otherwise determined by the plan administrator. Options to purchase shares expire no later than ten years after the date of grant.
      A summary of Cray’s stock option activity and related information follows:
                                   
        Weighted       Weighted
        Average       Average
    Options   Exercise   Options   Exercise
    Outstanding   Price   Exercisable   Price
                 
Balance, January 1, 2002
    10,990,772     $ 4.68       4,936,938     $ 5.59  
 
Granted
    4,742,908       3.38                  
 
Exercised
    (529,125 )     2.61                  
 
Canceled
    (1,823,953 )     2.79                  
                         
Balance, December 31, 2002
    13,380,602       4.52       6,811,975       5.36  
                         
 
Granted
    1,637,465       9.63                  
 
Exercised
    (2,759,187 )     4.37                  
 
Canceled
    (118,748 )     4.07                  
                         
Balance, December 31, 2003
    12,140,132       5.23       7,380,453       5.14  
                         
 
Granted
    4,019,830       4.59                  
 
Exercised
    (875,856 )     3.23                  
 
Canceled
    (999,715 )     5.52                  
                         
Balance, December 31, 2004
    14,284,391     $ 5.16       8,857,598     $ 5.01  
                         
Available for grant at December 31, 2004
    6,527,948                          
                         

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Table of Contents

CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      Outstanding and exercisable options by price range as of December 31, 2004, are as follows:
                                         
Options Outstanding   Options Exercisable
     
        Weighted   Weighted       Weighted
Range of       Average   Average       Average
Exercise Price   Number   Remaining   Exercise   Number   Exercise
Per Share   Outstanding   Life (Years)   Price   Exercisable   Price
                     
$ 0.35 – $ 3.00
    2,881,903       6.7     $ 2.23       2,091,351     $ 2.27  
  3.01 –   6.00
    6,516,450       6.0       4.27       4,223,347       4.55  
  6.01 –   9.00
    4,189,096       6.7       7.56       2,326,170       7.74  
  9.01 –  12.00
    652,937       8.5       11.04       196,625       11.03  
 12.01 –  15.00
    44,005       6.5       12.85       20,105       13.11  
                               
$ 0.35 – $15.00
    14,284,391       6.5     $ 5.16       8,857,598     $ 5.01  
                               
      In 1996, the Company established an Employee Stock Purchase Plan (“1996 ESPP”). The maximum number of shares of the Company’s common stock that employees could acquire under the 1996 ESPP was 1,000,000 shares. Eligible employees were permitted to acquire shares of the Company’s common stock through payroll deductions not exceeding 15% of base wages. The purchase price per share under the 1996 ESPP was the lower of (a) 85% of the fair market value of the Company’s common stock at the beginning of each six month offering period or (b) the fair market value of the common stock at the end of each six month offering period. As of December 31, 2001, a total of 988,344 shares have been issued under the 1996 ESPP. The Company replaced the 1996 ESPP with the 2001 Employee Stock Purchase Plan (“2001 ESPP”) upon shareholder approval in May 2002. The 2001 ESPP allows employees to acquire a maximum of 4,000,000 shares. The terms of the 2001 ESPP are the same as the 1996 ESPP, except that the 2001 ESPP uses three month offering periods rather than six months as used in the 1996 ESPP. As of December 31, 2003 and 2004, 644,567 and 1,048,889 shares, respectively, had been issued under the 2001 ESPP.
NOTE 15 401(k) PLAN
      The Company has a retirement plan covering substantially all U.S. employees that provides for voluntary salary deferral contributions on a pre-tax basis in accordance with Section 401(k) of the Internal Revenue Code of 1986, as amended. The Company matches 25% of employee contributions each calendar year. The Company matches 12.5% of employee contributions in cash 45 days after each quarter. The remaining 12.5% matching contribution is determined annually by the Board of Directors, and may be payable in cash or common stock of the Company. The Company’s matching contribution expenses were $1.1 million, $1.3 million and $1.6 million for the years ended December 31, 2002, 2003 and 2004, respectively.
NOTE 16 SEGMENT INFORMATION
      SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, establishes standards for reporting information about operating segments and for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision-maker, or decision-making group, in making decisions on allocating resources and assessing performance. Cray’s chief decision-maker, as defined under SFAS No. 131, is the Chief Executive Officer. As of December 31, 2004, Cray operates in one business segment: global sales and service of high performance computers.
      The Company had one customer, Sandia National Laboratories, which accounted for 27% of total revenue in 2004 and one customer, Oak Ridge National Laboratory (ORNL), which accounted for 11% of total revenue in 2003. The Company had no single customer that accounted for 10% or more of total revenue

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Table of Contents

CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
in 2002. Accounts receivable as of December 31, 2004 included $14.9 million due from Sandia National Laboratories and as of December 31, 2003 included $1.2 million from ORNL.
      Revenue from U.S. government agencies or commercial customers primarily serving the U.S. government totaled approximately $122.1 million, $175.4 million and $107.8 million in 2002, 2003 and 2004, respectively.
      The Company’s significant operations outside the Americas include sales and service offices in Europe, the Middle East and Africa (EMEA), and Asia Pacific (Japan, Australia, Korea, China and Taiwan). Intercompany transfers between operating segments and geographic areas are primarily accounted for at prices that approximate arm’s length transactions.
      Geographic revenue and long-lived assets related to operations were as follows (in thousands):
      Twelve months ended December 31, 2002:
                                 
            Asia    
    Americas   EMEA   Pacific   Total
                 
Product revenue
  $ 59,630     $ 12,857     $ 4,032     $ 76,519  
                         
Service revenue
  $ 50,867     $ 20,848     $ 6,835     $ 78,550  
                         
Long-lived assets
  $ 58,412     $ 1,044     $ 1,018     $ 60,474  
                         
      Twelve months ended December 31, 2003:
                                 
            Asia    
    Americas   EMEA   Pacific   Total
                 
Product revenue
  $ 162,278     $ 6,463     $ 6,263     $ 175,004  
                         
Service revenue
  $ 41,353     $ 14,813     $ 5,792     $ 61,958  
                         
Long-lived assets
  $ 104,892     $ 1,005     $ 921     $ 106,818  
                         
      Twelve months ended December 31, 2004:
                                 
            Asia    
    Americas   EMEA   Pacific   Total
                 
Product revenue
  $ 89,938     $ 4,566     $ 4,732     $ 99,236  
                         
Service revenue
  $ 37,293     $ 8,102     $ 4,553     $ 49,948  
                         
Long-lived assets
  $ 106,150     $ 3,324     $ 1,962     $ 111,436  
                         
NOTE 17 RESTRUCTURING CHARGES
      During 2004, the Company recognized restructuring costs of $8.2 million, including a $196,000 compensation charge related to the modification of stock options for certain individuals affected by the restructuring. The $196,000 charge was recorded directly to common stock. Substantially all of the restructuring costs represent severance expenses for 131 terminated employees. The restructuring liability is included within accrued payroll and related expenses on the accompanying consolidated balance sheets as of December 31, 2003 and 2004.
      During 2003, the Company recorded a restructuring charge of $3.3 million relating to the termination of approximately 27 employees. The $3.3 million charge did not include $721,000 of multithreaded architecture impairment charges. Substantially all of the restructuring charge incurred in 2002 represented severance expenses for terminated employees.

F-23


Table of Contents

CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      The liability activity related to restructuring during the years ended December 31, 2002, 2003 and 2004 is as follows (in thousands):
                         
    2002   2003   2004
             
Balance, January 1
  $ 1,702     $ 866     $ 3,069  
Additional restructuring charge
    1,878       3,298       8,077  
Payments
    (2,714 )     (1,097 )     (6,420 )
Adjustments to previously accrued amounts
                    (91 )
Foreign currency translation adjustment
            2       55  
                   
Balance, December 31
  $ 866     $ 3,069     $ 4,690  
                   
NOTE 18 OCTIGABAY ACQUISITION
      On April 1, 2004, the Company completed the acquisition of OctigaBay Systems Corporation (“OctigaBay”), a privately-held company located in Burnaby, British Columbia. The acquisition was accomplished pursuant to an Arrangement Agreement, dated February 25, 2004, among Cray, 3084317 Nova Scotia Limited, a Nova Scotia company and wholly-owned subsidiary of Cray, and OctigaBay. In the acquisition, the Company paid $14,925,000 in cash and issued 7,560,885 shares of Cray common stock and 4,840,421 exchangeable shares. The Company also assumed outstanding OctigaBay stock options exercisable for 740,722 shares of Cray common stock. Of the total shares issued and reserved, 1,861,000 shares were not included in the purchase price calculation because they represent repurchaseable shares that will be earned over the repurchase period. After the acquisition, the name of OctigaBay Systems Corporation was changed to Cray Canada Inc. OctigaBay was in the process of developing an innovative high-performance computing system designed to make supercomputing performance accessible to the growing community of scientific and technical computing users. The fair value of the in-process research and development (“IPR&D”) was estimated by an independent valuation using the income approach, which reflects the net present value of the projected cash flows expected to be generated by the products incorporating the in–process technology. The discount rate applicable to the cash flows of the products reflects the estimated stage of completion and other risks inherent in the project. The discount rate used in the valuation of IPR&D was 24.5%. The fair value of IPR&D is estimated to be $43.4 million with an estimated cost to complete of $8.0 million. The in–process technology was substantially completed in 2004. The IPR&D fair value was expensed in April 2004. The purchased intangibles consist of core technology and will be amortized over five years, resulting in a charge to cost of product of approximately $336,000 per quarter through the first quarter of 2009, subject to currency fluctuations. The allocation of the purchase price is as follows (in thousands):
           
Fair value of net assets acquired
  $ 10,521  
Core technology
    6,700  
In-process research and development
    43,400  
Goodwill
    38,836  
       
 
Net assets acquired
  $ 99,457  
       
      The Company recorded deferred compensation of $12.4 million resulting from retention agreements with key OctigaBay personnel and $2.2 million from existing stock options assumed in the OctigaBay acquisition. The retention agreements expire in November 2005 and the assumed stock options vest over the next three to four years. The retention agreements for three employees were terminated at the end of 2004, and the related deferred compensation of approximately $4.7 million was immediately recognized. Subject to currency fluctuations, the Company expects to incur a quarterly amortization expense of approximately $800,000 per quarter through December 2005 and approximately $175,000 thereafter per quarter through April 2007.

F-24


Table of Contents

CRAY INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
      The following pro forma results are based on the individual historical results of Cray Inc. and OctigaBay (prior to acquisition on April 1, 2004) with adjustment to give effect to the combined operations as if the acquisition had been consummated January 1, 2003. The significant adjustments relate to amortization of identified intangibles, the write-off of the IPR&D and the amortization of deferred compensation.
                 
    Year Ended December 31,
     
    2003   2004
         
    (in thousands)
Total revenue
  $ 236,962     $ 149,184  
             
Net income (loss)
  $ 2,095     $ (210,795 )
             
Net income (loss) per share, basic
  $ 0.03     $ (2.44 )
             
Net income (loss) loss per share, diluted
  $ 0.02     $ (2.44 )
             
Weighted average shares outstanding, basic
    79,499       86,470  
             
Weighted average shares outstanding, diluted
    91,003       86,470  
             
      The unaudited pro forma results of operations do not purport to present what the Company’s results of operations would have been had the events leading to the pro forma adjustments in fact occurred at the beginning of the periods indicated or to project the Company’s results of operations for any future date or period.
NOTE 19     SUBSEQUENT EVENTS
      On March 21, 2005, the Board of Directors approved the acceleration of the vesting of all unvested outstanding stock options previously granted to employees and executive officers under the Company’s stock option plans with a per share exercise price of $2.36 or greater (the last sale price on the Nasdaq National Market System for the Company’s common stock on March 21, 2005). As a result of that acceleration, options to acquire approximately 4.2 million shares of the Company’s common stock (representing approximately 30% of all outstanding options), with per share exercise prices ranging from $2.39 to $13.40, which otherwise would have vested from time to time over the next four years, became immediately exercisable, including options for 1,698,976 shares held by executive officers, with per share exercise prices ranging from $3.95 to $9.00 (other than options for 5,209 shares which otherwise would have vested in full in July 2005). Options covering a total of 344,187 shares of common stock, including 67,720 shares held by executive officers, remain subject to vesting. The vesting of options previously granted to non-employee directors was not accelerated.
      All other terms and conditions applicable to outstanding employee stock option grants, including the exercise prices and numbers of shares subject to the accelerated options, were unchanged.
      The acceleration eliminates future compensation expense that the Company would have recognized in its statement of operations with respect to these options upon the adoption of SFAS No. 123(R) on July 1, 2005.

F-25


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Cray Inc.
Seattle, Washington
We have audited the accompanying consolidated balance sheets of Cray Inc. and subsidiaries (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Cray Inc. and subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.
DELOITTE & TOUCHE LLP
Seattle, Washington
March 31, 2005

F-26

<PAGE>

                                                                   EXHIBIT 10.15

                               SUBLEASE AGREEMENT

      THIS SUBLEASE AGREEMENT ("Sublease") dated as of JAN. 13, 2003 is made by 
and between Trillium Digital Systems Canada, Ltd. ("Sublandlord") and OctigaBay
Systems Corporation ("Subtenant"), who agree as follows:

                                    RECITALS

      A. Sublandlord is the tenant under an Office Lease (the "Master Lease")
with 391102 B.C. Ltd. (the "Master Landlord"), which was originally, executed on
March 5, 2001 between the Master Landlord and the Subtenant. The Master Lease,
together with all of its amendments, is attached hereto as Exhibit "A." Under
the Master Lease, Sublandlord leases approximately 35,983 rentable square feet
of office space (the "Premises") located in Suites 300 and 400 of the building
(the "Building") located at 4621 Canada Way, Burnaby, BC.

      B. Subtenant desires to sublease from Sublandlord a portion of the
Premises (the "Subleased Premises"), which Subleased Premises are defined as
Suite 300 (entire 3rd floor), 4621 Canada Way, Burnaby, BC and further described
in the Sublease Summary attached hereto. Sublandlord has agreed to sublease the
Subleased Premises to Subtenant on the terms, covenants and conditions stated in
this Sublease, which includes any terms, covenants and conditions in the
exhibits attached
 hereto.

      NOW, THEREFORE, in consideration of the mutual covenants contained in this
Sublease, and for valuable consideration, the receipt and sufficiency of which
are hereby acknowledged by the parties, the parties agree as follows:

      1. SUBLEASE. Sublandlord hereby subleases to Subtenant and Subtenant
subleases from Sublandlord the Subleased Premises, subject to the terms,
covenants, and conditions contained in this Sublease. Sublandlord and Subtenant
agree that the Subleased Premises contain the rentable area as specified in the
Sublease Summary.

      2. TERM. The term of this Sublease shall commence on the "Commencement
Date" set forth in the Sublease Summary and, unless sooner terminated as
provided in the Master Lease, will expire on the "Expiration Date" set forth in
the Sublease Summary.

      3. BASIC RENT. Subtenant shall pay to Sublandlord as basic monthly rental
for the Premises the amount set forth in Clause 6 of the Sublease Summary hereto
(the "Basic Rent") in advance of the first day of each month. Basic Rent and
Additional Expenses shall be payable to Sublandlord at the address set forth
above and to the Attention of Lease Coordinator, or at such other places as
Sublandlord may designate in writing.

      4. ADDITIONAL EXPENSES. In addition to the Basic Rent, Subtenant agrees to
pay to Sublandlord any additional expenses ("Additional Expenses") identified in
Clause 7 of the Sublease Summary hereto as being the responsibility of
Subtenant.

      5. USE. Subtenant agrees to use the Subleased Premises in accordance with
the purposes set forth in Clause 11 of the Sublease Summary hereto, and for no
other purpose.


<PAGE>

      6. MASTER LEASE. As applied to this Sublease, the words "Landlord" and
"Tenant" in the Master Lease will be deemed to refer to Sublandlord and
Subtenant, respectively, under this Sublease. The covenants, agreements,
provisions, and conditions of the Master Lease -- to the extent that they relate
to the Subleased Premises and to the extent that they are not inconsistent with
the terms of this Sublease -- are made a part of and incorporated into this
Sublease as if recited in full in this Sublease. As between the parties to this
Sublease only, in the event of a conflict between the terms of the Master Lease
and the terms of this Sublease, the terms of this Sublease will control.

            6.1. MASTER LANDLORD'S PERFORMANCE. Subtenant recognizes that
Sublandlord is not in a position to render any of the services or to perform any
of the obligations required of Master Landlord by the terms of the Master Lease.
Therefore, despite anything to the contrary in this Sublease, Subtenant agrees
that performance by Sublandlord of its obligations under this Sublease is
conditioned on performance by the Master Landlord of its corresponding
obligations under the Master Lease, and Sublandlord will not be liable to
Subtenant for any default of the Master Landlord under the Master Lease,
provided that the Master Landlord's failure to perform is not related to a
default by the Sublandlord under the Master Lease and further provided that the
Sublandlord is using all commercially reasonable efforts to cause the Master
Landlord to perform such obligations.

            6.2 MASTER LANDLORD'S CONSENT. Whenever the consent of the Master
Landlord is required by the Subtenant under the Master Lease, Sublandlord shall
use all commercially reasonably efforts to obtain, at Subtenant's sole cost and
expense, that consent on behalf of Subtenant.

            6.3 PRESERVATION OF MASTER LEASE. Sublandlord agrees to perform all
of its obligations under the Master Lease and not to terminate or surrender the
Master Lease voluntarily, or modify the Master Lease in a manner that adversely
affects Subtenant's rights under this Sublease.

      7. VARIATIONS FROM MASTER LEASE. As between Sublandlord and Subtenant, the
terms and conditions of the Master Lease are modified as stated below in this
section 7:

            7.1 INSURANCE AND CONDEMNATION PROCEEDS. Despite anything contained
in the Master Lease to the contrary, as between Sublandlord and Subtenant only,
in the event of damage to or condemnation of the Subleased Premises, all
insurance proceeds or condemnation awards received by Sublandlord under the
Master Lease will be deemed to be the property of Sublandlord, and Sublandlord
will have no obligation to rebuild or restore the Subleased Premises.

            7.2 NOTICES. Any notice required or permitted to be given under this
Sublease shall be in writing and shall be by personal delivery or by mail.
Mailed notices shall be deemed given upon actual receipt at the address
required, or forty-eight (48) hours following deposit in the mail, postage
prepaid, whichever first occurs. At the date of execution of this Lease, the
addresses of Sublandlord and Subtenant are as set forth above. After the
Commencement Date, the address of Subtenant shall be the address of the Premises
and Sublandlord may change its address by giving notice to Tenant in accordance
with this section 7.2.

            7.3 AMOUNTS PAYABLE. All amounts payable under this Sublease by
Subtenant are payable directly to Sublandlord.


<PAGE>

            7.4 "AS-IS." Sublandlord will deliver the Subleased Premises to
Subtenant in their current "as is" condition without warranty of any nature as
to condition or otherwise.

            8.1. INDEMNITY BY SUBTENANT. Subtenant agrees to protect, defend,
indemnify, and hold Sublandlord harmless from and against any and all
liabilities, claims, demands, expenses, losses and damages (including reasonable
attorney fees and costs), that may at any time be asserted against Sublandlord
by (a) the Master Landlord for failure of Subtenant to perform any of the
covenants, agreements, terms, provisions, or conditions contained in the Master
Lease that Subtenant is obligated to perform under the provisions of this
Sublease; or (b) any person as a result of Subtenant's use or occupancy of the
Subleased Premises, except to the extent any of the foregoing is caused by the
negligence or willful misconduct of Sublandlord. The provisions of this section
8.1 will survive the expiration or earlier termination of the Master Lease or
this Sublease.

      8.2. INDEMNITY BY SUBLANDLORD. Sublandlord agrees to protect, defend,
indemnify, and hold Subtenant harmless from and against any and all liabilities,
claims, demands, expenses, losses and damages (including reasonable attorney
fees and costs), that may at any time be suffered by the Subtenant due to a
failure by the Sublandlord to perform its obligations under this Sublease,
including without limitation, its obligation to maintain the Master Lease in
good standing. The provisions of this section 8.2 will survive the expiration or
earlier termination of the Master Lease or this Sublease.

      9.  MASTER LANDLORD'S CONSENT: This Sublease and the obligations of the
parties hereunder are expressly conditioned upon Sublandlord obtaining prior
written consent hereto by Master Landlord. Sublandlord shall be responsible at
its sole expense for obtaining such consent. Subtenant shall promptly deliver to
Sublandlord any information reasonably requested by Master Landlord in
connection with Master Landlord's approval of the Sublease.

      10. BROKERAGE: Each party warrants and represents for the benefit of the
other that it has had no dealings with any broker or agent in connection with
this Sublease other than Royal LePage Commercial Inc. and Cushman & Wakefield of
Illinois, Inc. representing the Sublandlord and Colliers Macaulay Nicolls Inc.
representing Subtenant.

      11. SURRENDER: Upon the expiration of this Sublease, or upon the
termination of the Sublease or of the Subtenant's right to possession of the
Subleased Premises, Subtenant will at once surrender and deliver up the
Subleased Premises, together with all improvements thereon (excepting the
Subtenant's furniture, trade fixtures and equipment and any other improvements
the Subtenant elects at its option to remove), to Sublandlord in good condition
and repair, subject to Clause 14(i) contained in the Sublease Summary.

      12. GENERAL PROVISIONS.

            12.1 TIME. Time is of the essence with respect to the obligations to
be performed under this Sublease.


<PAGE>

            12.2 SEVERABILITY. The invalidity of any provision of this Sublease
as determined by a court of competent jurisdiction shall in no way affect the
validity of any other provision hereof.

            12.3 CHOICE OF LAW. This Sublease shall be construed and enforced in
accordance with the laws of the Province of British Columbia.

            12.4 BINDING EFFECT. The covenants and agreement contained in this
Sublease shall be binding on the parties hereto and on their respective
successors and assigns to the extent this Sublease is assignable.

            12.5 WAIVER. No waiver by Sublandlord or Subtenant of any provision
hereof shall be deemed to be a waiver of such provision or any subsequent breach
of the same or any other term, condition or covenant of this Sublease. No
covenant, term or condition of this Sublease shall be deemed to have been waived
by Sublandlord or Subtenant unless the waiver is in writing signed by such
party.

            12.6 ENTIRE AGREEMENT. This Sublease contains all understandings and
agreements of the parties with respect to any matters mentioned herein and
supersedes any prior or contemporaneous agreement or understanding. This
Sublease may be modified in writing only, signed by the parties in interest at
the time of the modification.

            12.7 EXHIBITS. All exhibits attached hereto are hereby incorporated
herein and made a part hereof.

            12.8 EARLY POSSESSION. Subtenant will be granted early possession of
the Subleased Premises effective the date of the execution of the Sublease by
the Sublandlord and Subtenant and will be responsible for all its obligations
under this Sublease subject to Clause 14(a) contained in the Sublease Summary.

IN WITNESS WHEREOF, the parties hereto have executed this Sublease as of the
date first written above. 

                                       SUBTENANT

                                                                             
                                       By: /s/ James E. Rottsolk
                                           ----------------------------------

                                       Title: CEO

                                       SUBLANDLORD
                                                                                
                                       By: /s/ Sunil K. Das
                                           ----------------------------------
                                                                                
                                       Title: Worldwide Real Estate Manager

<PAGE>

As required under the terms of the Master Lease attached as Exhibit "A," the
undersigned Master Landlord hereby consents to the subletting of the Subleased
Premises described herein on the terms and conditions contained in this
Sublease. This consent shall apply only to this Sublease and shall not be deemed
to be a consent of Master Landlord to any other sublease. Master Landlord herby
represents that (i) the Master Lease is in full force and effect; (ii) neither
Master Landlord nor Sublandlord (referred to as Landlord and Tenant in the
Master Lease) are in breach or default under the terms of the Master Lease; and
(iii) the copy of the Master Lease attached as Exhibit "A" is true and accurate,
and constitutes the entire agreement between Master Landlord and Sublandlord
concerning the Premises (known as the "Leased Premises" under the Master Lease).

Date: __________________________                       Master Landlord
                                                       391102 B.C. LTD.

                                           By: _________________________________

                                           Title: ______________________________


<PAGE>

                                   EXHIBIT "A"

                       MASTER LEASE, INCLUDING AMENDMENTS


<PAGE>

SUBLEASE SUMMARY

1.    SUBLANDLORD: Trillium Digital Systems Canada, Ltd.

2.    SUBTENANT: OctigaBay Systems Corporation

3.    DESCRIPTION OF SUBLEASED PREMISES: Entire 3rd Floor, 4621 Canada Way,
      Burnaby, BC

4.    RENTABLE AREA OF SUBLEASED PREMISES BY SUBTENANT: 18,593 sq. ft.

5.    DEPOSIT: A cheque for Three (3) months Gross Rent inclusive of GST:
      $76,998.81 (the "Deposit") payable to the Sublandlord, shall be tendered
      within two (2) business days of the execution of the Sublease. The Deposit
      will be held by the Sublandlord and applied as provided for herein. The
      Deposit is to be credited in payment towards the first and last months
      Gross Rent due, inclusive of any applicable Goods and Services Tax. The
      remainder shall be held as security until the expiry of the Sublease term
      and returned to the Subtenant without deduction within fifteen (15) days
      of the expiry of the Sublease term to the extent it has not been applied
      on account of any default of the Subtenant.

6.    BASIC RENT: The Basic Rent, plus any applicable Goods and Services Tax,
      shall be payable monthly in advance by the Subtenant on the first day of
      each month during the term to the Sublandlord. The Basic Rent shall be
      based on the Rentable Area of the Subleased Premises and measured in a
      manner prescribed by the Master Lease. The Basic Rent shall be calculated
      as follows:


<TABLE>
<S>                                   <C>
May 1, 2003 to October 31, 2003:      -    Basic Rent Free on 10,000 square
                                           feet

                                      -    Gross Rent Free on 8,593 square
                                           feet

November 1, 2003 to October 31,       -    Ten Dollars ($10.00) per square foot
2004:                                      per annum based on 10,000 square
                                           feet

                                      -    Gross Rent Free on 8,593 square feet


November 1, 2004 to December          -    Ten Dollars ($10.00) per square foot
30, 2006:                                  per annum based on 18,593 square
                                           feet
</TABLE>


      Note: For the purposes of this Sublease agreement Gross Rent is defined as
      Basic Rent plus Additional Expenses as defined in the Sublease.

7.    ADDITIONAL EXPENSES: The Subtenant's proportionate share (based on
      Rentable Area of the Subleased Premises relative to the Rentable Area of
      the entire 3rd and 4th Floor of the Building) of operating costs and
      property taxes (including daily in-suite janitorial), currently estimated
      at Ten Dollars and Forty-two Cents ($10.42) per square foot for the 2003
      fiscal


<PAGE>

      year, plus Goods and Services Tax, shall be payable by the Subtenant to
      the Sublandlord as Additional Expenses as per the terms of the Sublease in
      addition to the Basic Rent and shall be calculated as follows:


<TABLE>
<S>                                   <C>
May 1, 2003 to October 31, 2003:      -     Additional Expenses only on 10,000 square
                                            feet

                                      -     Gross Rent Free on 8,593 square feet

November 1, 2003 to October 31,       -     Additional Expenses in addition to Basic Rent
2004:                                       on 10,000 square feet

                                      -     Gross Rent Free on 8,593 square feet


November 1, 2004 to December          -     Additional Expenses in addition to Basic Rent
30, 2006:                                   on 18,593 square feet
</TABLE>


8.    OTHER EXPENSES: ALL operating expenses will be paid by Sublandlord except
      after- hours HVAC to the Subleased Premises, which cost will be borne by
      the Subtenant and may be billed directly to the Subtenant pursuant to the
      Master Lease.

9.    SUBLEASE COMMENCEMENT DATE: MAY 1, 2003.

10.   SUBLEASE EXPIRATION DATE: December 30, 2006.

11.   USE OF SUBLEASED PREMISES: The Subtenant shall use the Subleased Premises
      for general office purposes and a development laboratory. The Subtenant
      acknowledges that the Master Landlord has the right under the Master Lease
      to restrict certain uses.

12.   SIGNAGE: The Subtenant shall be entitled to two (2) entries on the
      Building directory as governed in accordance with the Master Lease. All
      further signage rights available to the Subtenant shall be pursuant to the
      Master Lease.

13.   BUILDING HOURS AND ACCESS: Pursuant to the Master Lease

14.   OTHER TERMS:

      a)    Early Possession

       Upon execution of the Sublease, the Subtenant shall have access to the
       Subleased Premises for the purposes of planning and the construction of
       its Leasehold Improvements, installing its wiring and to conduct its day
       to day business. During this period, the Subtenant shall not be obligated
       to pay any Basic Rent or Additional Expenses, but shall abide by all
       other terms of the Master Lease and Sublease.

      b)    Allowance


<PAGE>

      The Sublandlord shall pay or the Sublandlord shall provide the authority
      to the Master Landlord to pay directly to the Subtenant, as a contribution
      towards the cost of the Leasehold Improvements, installed by or on behalf
      of the Subtenant, the sum of Twenty-Three Dollars ($23.00) multiplied by
      the Rentable Area of the Subleased Premises, plus Goods and Services Tax.
      The Leasehold Improvement Allowance shall be paid to the Subtenant on the
      Commencement Date of the Sublease Term, provided the Subtenant provides
      the Sublandlord with reasonable evidence of expenditure of the Leasehold
      Improvement Allowance on improvements that will benefit the Subleased
      Premises. 

    c)    Sublandlord's Work

      The Sublandlord shall provide the Subleased Premises in a clean, vacant 
      and broom swept condition.

    d)    Leasehold Improvements

      The Subleased Premises are leased on an "as is" basis. Any alterations the
      Subtenant wishes to carry out shall comply with the terms of the Master
      Lease and Sublease and the Subtenant shall obtain any applicable approvals
      of the local Municipal Authority and of the Master Landlord's architects,
      mechanical, electrical and structural consultants, at the Subtenant's
      cost.

    e)    Sublandlord's Options and Rights

      The Sublandlord waives and agrees not to exercise the following options
      and rights from the Master Lease pursuant to the 3rd floor of the 
      Building: Option to Renew and Right of First Refusal to Lease.

    f)    Right Of First Refusal To Sublease Adjoining Space

      Provided the Subtenant has not been in material breach of the Sublease,
      the Sublandlord hereby grants to the Subtenant the right of first refusal
      to lease, during the Sublease Term, any portion of the Fourth (4th) floor
      of the Building that becomes available to be subleased on the terms and
      conditions of a bona fide offer to sublease acceptable to the Sublandlord.
      The Sublandlord shall deliver a true copy of any such bona fide offer to
      the Subtenant. The Subtenant shall have five (5) business days from such
      delivery within which to exercise this Right of First Refusal to sublease
      the offered space. This right may only be exercised, within such time, by
      the Subtenant delivering notice in writing of acceptance to the
      Sublandlord whereupon a binding agreement to sublease such premises shall
      exist between the Sublandlord and Subtenant on the terms and conditions
      contained in the said bona fide offer. 

      If the Subtenant does not exercise its right to sublease the adjoining
      premises, such premises may thereafter be Subleased by the Sublandlord to
      the person identified in said bona fide offer and subject to the terms and
      conditions contained therein, but not otherwise, and failing subleasing as
      aforesaid the provisions of this section shall remain in force.

    g)    Parking


<PAGE>

      The Sublandlord shall provide, at the Subtenant's cost, up to Seventy Four
      (74) random or reserved parking stalls in the Building at the prevailing
      market rates. The Subtenant shall specify the number of parking stalls it
      requires prior to the Commencement Date. The rental rates for stalls are
      subject to adjustment to comparable parking rates in the area and shall be
      paid directly to the Master Landlord or its agent.

    h)    Sub-Sublease/Assignment

      The Sublandlord acknowledges and agrees that the Subtenant, at anytime
      throughout the Sublease term, may assign this Sublease or Sub-Sublease the
      Subleased Premises. Written consent for any Sub-Sublease or Assignment
      shall be given by the Sublandlord within five (5) business days of
      receiving a letter of request to consent from the Subtenant and if no
      consent has been received during this period of time by the Subtenant then
      such consent shall have been deemed to have been given by the Sublandlord.
      Notwithstanding the above, the Subtenant may not assign the Sublease or
      Sub-Sublease the Subleased Premises without obtaining the consent of the
      Master Landlord in accordance with the Master Lease.

    i)    Restoration of Subleased Premises

      The Subtenant shall have no obligation to restore the Subleased Premises
      to shell condition at the end of the Sublease term.

IN WITNESS WHEREOF, the parties hereto have executed this Sublease Summary as of
the date first written in the Sublease.

      SUBLANDLORD

      By: /s/ Sunil K. Das  
          --------------------------------  
            
      Title: Worldwide Real Estate Manager

      SUBTENANT

      By: /s/ James E. Rottsolk
          --------------------------------
             
      Title: CEO


<PAGE>

                                     - 1 -

                              CONSENT TO SUBLETTING

THIS AGREEMENT dated the 20th day of January, 2003.

AMONG

                   391102 B.C. LTD. AND
                   DOMINION CONSTRUCTION AND DEVELOPMENT INC.
                   c/o Touchstone Property Management Ltd.
                   Suite 107 - 4585 Canada Way
                   Burnaby, British Columbia V5G 4L6

                   (the "Landlord")

AND:

                   TRILLIUM DIGITAL SYSTEMS CANADA, LTD.
                   c/o Trillium Digital Systems Inc.
                   12100 Wilshire Boulevard, Suite 1800
                   Los Angeles, California, USA 90025

                   (the "Sublandlord")

AND:

                   OCTIGABAY SYSTEMS CORPORATION
                   8644 Commerce Court
                   Burnaby, British Columbia, V5A 4N6

                   (the "Subtenant")

AND:

                   INTEL CORPORATION
                   4501 South Dobson Road, OC2-151
                   Chandler, Arizona, USA 85048

                   (the "Indemnifier")


<PAGE>

                                     - 2 -

WHEREAS:

(A) By a Lease made the 5th day of March, 2001 (the "Lease"), the Landlord did
demise and lease to the Sublandlord those premises being more particularly
described in Schedule A attached to the Lease (the "Leased Premises") for a term
of Five (5) years (the "Term") commencing on January 1, 2002and expiring on
December 31, 2006, upon the terms and conditions contained in the Lease;

(B) Pursuant to a sublease made the 13th day of January, 2003 (the "Sublease")
the Sublandlord has agreed to sublease the Leased Premises to the Subtenant
effective the 1st day of May, 2003 on the terms and conditions contained in the
Sublease, subject to the consent of the Landlord thereto as required under the
Lease;

(C) By an indemnity agreement made the 5th day of March, 2001 (the "Indemnity
Agreement") the Indemnifier agreed with the Landlord to indemnify the
Sublandlord's obligations under the Lease on the terms and conditions contained
in the Indemnity Agreement;

(D) The Landlord has agreed to consent to the Sublease on the terms and
conditions contained herein.

NOW THEREFORE THIS AGREEMENT WITNESSES that in consideration of the Landlord's
consent herein contained and other good and valuable consideration, the parties
agree as follows:

1.    The Landlord hereby consents to the subletting of the Leased Premises by
      the Sublandlord to the Subtenant pursuant to the terms of the Sublease for
      a term commencing on the 1st day of May, 2003 and expiring on the 30th day
      of December, 2006 (the "Sublease Term"), subject to the performance and
      observance of the terms, covenants and conditions in the Lease (save only
      for payment of Minimum Rent reserved in the Lease) and subject to the
      Subtenant using the Leased Premises only for the purposes permitted by the
      Lease. This consent is given upon the basis that the Landlord does not
      acknowledge or approve of any of the terms of the Sublease between the
      Subtenant and the Sublandlord except for the said subletting itself.

2.    The Subtenant hereby confirms that it accepts the current state of repair
      of the Leased Premises and covenants and agrees with the Landlord to
      observe, comply with and perform all terms, covenants and conditions in
      the Lease insofar as they are applicable to the Leased Premises during all
      of the Sublease Term and any renewals or extensions thereof (save only for
      payment of the Minimum Rent reserved therein) as and when the same are to
      be performed by the tenant thereunder pursuant to the terms of the Lease,
      including without limitation, all of the repair and restoration
      obligations set forth in the Lease arising after the commencement of the
      Sublease Term. The Subtenant acknowledges that it has received and
      reviewed a copy of the Lease.

      "NOTWITHSTANDING THE ABOVE, THE SUBLANDLORD ACKNOWLEDGES THAT THE
      SUBTENANT SHALL HAVE NO OBLIGATION TO RESTORE THE SUBLEASED PREMISES TO
      SHELL CONDITION AT THE END OF


<PAGE>

                                       - 3 -

      THE SUBLEASE TERM AND WILL INDEMNIFY THE SUBTENANT OF THESE OBLIGATIONS
      ACCORDINGLY."

3.    This Agreement shall in no way affect or release the Sublandlord from its
      liabilities and responsibilities under the Lease, notwithstanding the
      Landlord's grant of consent to the Sublease, which is given without
      prejudice to the Landlord's rights under the Lease. The Sublandlord hereby
      acknowledges and agrees with the Landlord that it shall remain liable to
      the Landlord in respect of all the terms, covenants and conditions in the
      Lease on the part of the tenant to be observed and performed including,
      without limiting the generality of the foregoing, the payment of all Rent
      due to the Landlord under the Lease:

4.    This Agreement shall not be deemed to authorize any further assignments or
      subletting or parting with or sharing possession of the Leased Premises or
      any part thereof without the further consent of the Landlord as required
      under the Lease.

5.    The Subtenant hereby covenants and agrees with the Landlord not to assign
      this Agreement, or sublet or otherwise part with or share possession of
      the Leased Premises or any part thereof, without the prior written consent
      of the Landlord. In no event shall any such consent release (or be deemed
      to release) the Subtenant in any regard whatsoever from any of its
      obligations or liabilities under or pursuant to this Agreement, unless
      agreed otherwise in writing by the Landlord in such consent.

6.    The Subtenant hereby covenants and agrees with the Landlord that in no
      event shall the Landlord be:

      (a)   liable to the Subtenant for any act, omission or circumstances of
            the Sublandlord; or

      (b)   subject to any set-offs or defences that the Subtenant might have as
            against the Sublandlord.

7.    Notwithstanding the Landlord's grant of consent herein, the Sublease
      shall, at the option of the Landlord, terminate if the Lease shall
      terminate pursuant to the terms thereof or by operation of law or by
      re-entering and termination by the Landlord for breach of the Lease. In
      the event of such termination, the Subtenant shall deliver up the Leased
      Premises to the Landlord in compliance with all of the provisions of the
      Lease and in the condition required under the Lease.

8.    The Sublandlord and the Subtenant hereby covenant and agree with the
      Landlord that all monies owing by the Subtenant to the Sublandlord under
      the Sublease in respect of the Leased Premises shall, at the sole option
      of the Landlord, be paid directly by the Subtenant to the Landlord, if so
      directed by the Landlord in writing. All payments received by the Landlord
      pursuant to this Section shall be credited by the Landlord as against the
      amounts payable by the Sublandlord to the Landlord under the Lease.

9.    The Sublandlord covenants and agrees to pay to the Landlord any and all
      excess rent, monies or other consideration received from the Subtenant
      under the Sublease over and


<PAGE>

                                       - 4 -

      above the Rent payable by the Sublandlord to the Landlord under the Lease
      upon receipt thereof from the Subtenant.

10.   The Sublandlord and the Subtenant shall jointly and severally be liable
      for and shall indemnify the Landlord against all legal costs incurred by
      the Landlord with respect to the subletting referred to herein and the
      Landlord's consent with respect thereto.

11.   The Indemnifier covenants and agrees with the Landlord that its
      indemnification of the Sublandlord's obligations under the Indemnity
      Agreement shall continue in full force and effect notwithstanding the
      Landlord's grant of consent herein and the Indemnifier shall continue to
      be bound to the Landlord on the terms and as provided in the Indemnity
      Agreement.

12.   This Agreement shall be governed by and construed in accordance with the
      laws of the Province in which the Building is situated and the federal
      laws of Canada applicable therein.

13.   This Agreement shall enure to the benefit of and be binding upon the
      parties hereto and their respective heirs, administrators, personal
      representatives, successors and permitted assigns.

14.   Words and phrases used in this Agreement shall have the same meanings
      ascribed to them in the Lease unless otherwise specifically defined
      herein.

15.   This Agreement is not personally binding upon and that resort shall not be
      had to, nor shall recourse or satisfaction be sought from, the private
      property of the unitholders of Investors Real Property Fund (the "Fund"),
      trustees, directors, officers, employees or agents of the trustee or
      manager of the fund, it being intended and agreed that only the property
      of the Fund shall be bound by this Agreement.


<PAGE>

                                       - 5 -

IN WITNESS WHEREOF the parties hereto have executed this Agreement.

391102 B.C. LTD.

Per: /s/ Donald J. MacDonald
     -----------------------------
Authorized Signatory

Donald J. MacDonald, Assistant Secretary

Per: /s/ Murray J. Mitchell
     ------------------------------
Authorized Signatory

Murray J. Mitchell, Vice President

DOMINION CONSTRUCTION & DEVELOPMENT INC.

Per: /s/ Vance Hackett
     --------------------------------
Authorized Signatory

OCTIGABAY SYSTEMS CORPORATION

Per: /s/ James E. Rottsolk
     --------------------------------
Per:
     --------------------------------

TRILLIUM DIGITAL SYSTEMS CANADA, LTD.

Per: /s/ Sunil K. Das
     --------------------------------

     Sunil K. Das
Per: ---------------------------------
     Worldwide Real Estate Manager

INTEL CORPORATION

Per: /s/ Sunil K. Das
     ---------------------------------

Per: Sunil K. Das
     ---------------------------------
     Worldwide Real Estate Manager


<PAGE>

LEASE AGREEMENT BETWEEN:

                   Dominion Construction Company Inc. and 391102 B.C. Ltd.

                   ("LANDLORD")

                   AND:

                   Trillium Digital Systems Canada, Ltd.

                   ("TENANT")

                   AND:

                   Intel Corporation

                   ("GUARANTOR")

                   PREMISES: Unit #_____ , being 35,983 Square Feet at 4621
                             Canada Way, Canada Way Business Park, Burnaby, B.C.

                   TERM OF LEASE: Five Years

Dominion/Investors/Trillium Lease                                 Kuhn & Company

<PAGE>

                                      LEASE

THIS LEASE dated March 5, 2001, is made and entered into by the Landlord and
Tenant who, after receiving all required advice, and in consideration of the
rents and covenants contained herein, agree as follows:

                                    ARTICLE 1
                           BASIC TERMS AND DEFINITIONS

1.1         BASIC TERMS.

(a)  (i)    Landlord:              Dominion Construction Company Inc.
                                   ("Dominion") (as to an undivided 1/4
                                   interest) and 391102 B.C. Ltd. ("Investors")
                                   (as to an undivided 3/4 interest)

     (ii)   Address of Landlord:   Dominion: Suite 300, 555 Burrard Street
                                   Two Bentall Centre,
                                   Vancouver, British Columbia
                                   V7X 1S9; and
                                   Investors: 447 Portage Avenue, Winnipeg,
                                   Manitoba, R3C 3B6

     (iii)  Contact Numbers:       Dominion:
                                   Telephone: (604)631-1000
                                   Facsimile: (604)631-1054

                                   Investors:
                                   Telephone: (204)956-8545
                                   Facsimile: (204)942-1931

     (iv)   Contact Person:        Dominion: Peter Duyker
                                   Investors: Maurice Toutant

(b)  (i)    Tenant (legal name):   Trillium Digital Systems Canada, Ltd.

     (ii)   Address of Tenant:     Trillium Digital Systems Inc.
                                   12100 Wilshire Boulevard, Suite 1800
                                   Los Angeles, CA 90025

                                   Tel: (310)481-7831(Bus.)

                                   Fax: (310)442-1162

     (iii)  Individual to contact: Ron Vaisbort

(c)  (i)    Guarantor(s):          Intel Corporation

     (ii)   Address of
            Guarantor(s):          4501 South Dobson Road, OC2-151,
                                   Chandler, Arizona, USA 85048

                                   Tel: (480)715-5094 (Bus.)
                                   Fax: (480)715-7340

     (iii)  Individual to contact: Nancy Ward, Lease Administration

Dominion/Investors/Trillium Lease                                 Kuhn & Company

<PAGE>

                                       - 2 -

(d)         Premises:              Full 3rd and 4th floors of the Building as
                                   shown outlined in heavy black on the plan
                                   attached as Schedule "A", with the municipal
                                   address:

                                   4621 Canada Way, Canada Way Business Park,
                                   Burnaby, British Columbia

(e)         Floor Area of
            the Premises:          Third Floor 18,593 sq.ft., more or less
                                   Fourth Floor 17,390 sq.ft., more or less
                                   TOTAL 35,983 sq.ft., more or less

(f)         Term                   Five years

(g)         Commencement Date:     The Term will commence on the 1st day of
                                   January, 2002

(h)         Minimum Rent:          (based on $ 19.30 per sq.ft.)

            Year of the Term       Per Sq.Ft.       Per Annum        Per Month
            ----------------       ----------       ---------        ---------
              Years 1 to 5         $ 19.30         $694,471.90      $ 57,872.69

(i)         Permitted Business:    For the purpose of an office and laboratory
                                   for the conduct of the Tenant's or
                                   Guarantor's business or such other use as may
                                   be approved by the Landlord, acting
                                   reasonably, but not any use that would be
                                   contrary to any other tenant's lease with the
                                   Landlord.

            Under the Business Name of the Tenant or Guarantor.

(j)         Security Deposit: $ N/A of which $ N/A will be applied to the first
            month's Rent.

(k)         Premises Preparation
            Period:                90 days, commencing April 1,2001 and ending
                                   June 30,2001 (subject to Sections 2.4 and
                                   2.5).

(l)         Parking Entitlement: 4 unreserved stalls for each 1000 square feet
            rentable area of Premises leased by the Tenant pursuant to this
            Lease.

1.2            DEFINITIONS:

               Capitalized terms or expressions have the following meanings:

1.2.1       "ADDITIONAL RENT" means any money other than Minimum Rent required
to be paid by the Tenant under this Lease, whether or not the same be designated
as Rent or whether the same be payable to the Landlord or otherwise.

1.2.2       "ADDITIONAL SERVICES" means the services, labour, material and
supervision supplied by the Landlord and referred to in this Lease as Additional
Services; any other services which from time to time the Landlord supplies to
the Tenant and which are additional to other services that the Landlord has
agreed to supply pursuant to this Lease or that the Landlord may elect to supply
as included within the standard level of services available to tenants generally
and in addition to those normally supplied; the provision of labour and
supervision in connection with the moving of any furniture or equipment of the
Tenant; the making of any repairs, improvements, or alterations for the Tenant;
and the provision to the Tenant or the Premises of maintenance or other services
not normally furnished to tenants or other

Dominion/Investors/Trillium Lease                                Kuhn & Company


<PAGE>

                                       - 3 -

premises generally.

1.2.3       "BUILDING" means that certain office building having an approximate
Floor Area of 73,692 square feet (inclusive of all areas, improvements,
amenities, equipment and apparatus therein) constructed on a portion of the Land
consisting of tenanted areas, and any additions or replacements thereto from
time to time, in which the Premises are located, and which together with the
Land and all other buildings and improvements constructed or to be constructed
on the Land and adjoining lands and premises is hereinafter called the "Business
Park". It is intended by the Landlord that Phase II of the Business Park will in
due course consist of the Building and two other buildings (Building "A" having
an approximate Floor Area of 86,576 square feet and Building "C" having an
approximate Floor Area of 70,322 square feet), in addition to Phase I, being a
building comprising Floor Area of 96,637 square feet and related facilities and
areas. Phase II of the Business Park will also consist of a 756 vehicle
underground parking structure and 98 metered surface parking stalls.

1.2.4       "BUILDING HOURS" means the hours from 8:00 a.m. to 6:00 p.m. Monday
to Friday, inclusive, of each week, holidays excepted.

1.2.5       "COMMON AREAS AND FACILITIES" means those areas, facilities,
utilities, improvements, equipment and installations which, from time to time:
(i) are not designated or intended by the Landlord to be leased to tenants of
the Building; (ii) are designated by the Landlord to serve or benefit the Land
and Building; (iii) are designated by the Landlord as part of the Common Areas
and Facilities; (iv) are provided or designated by the Landlord for the use or
benefit of the Tenant, their employees, customers and other invitees in common
with others entitled to the use or benefit thereof, as permitted by this Lease,
and which may be changed from time to time. Without limitation, Common Areas and
Facilities include roofs and roof membranes, exterior wall assemblies including
weather walls, exterior and interior structural elements and bearing walls and
the foundations and footings of the Building; parking areas; common entrances or
exits; lobbies; access roads; driveways and truckways; delivery passages;
mechanical, electrical or automatically operated doors; loading docks and
related areas and equipment; pedestrian sidewalks; landscaped and planted areas;
service areas; corridors; equipment, furniture, furnishings and fixtures;
storage facilities; stairways, hoists, ramps, elevators and other transportation
equipment and systems; fire prevention or response systems, security and
communication systems; public washrooms; pylon and other general signs and
information facilities; public telephones; columns; pipes; electrical, plumbing,
drainage, mechanical, heating, ventilating and air conditioning and all other
installations, equipment or services located in the Building as well as the
structures housing the same.

1.2.6       "COST OF ADDITIONAL SERVICES" means (i) in the case of Additional
Services provided by the Landlord, a reasonable charge made therefor by the
Landlord which shall not exceed the cost of obtaining such services from
independent contractors and (ii) in the case of Additional Services provided by.
independent contractors, the Landlord's total cost of providing Additional
Services to the Tenant, including the cost of all labour, salaries, wages and
fringe benefits, materials and other direct expenses incurred, and a reasonable
charge by the Landlord for the cost of supervision and other indirect expenses
capable of being allocated thereto.

1.2.7       "FLOOR AREA" whether in the case of a whole floor of the Building or
in the case of premises comprising part of a floor of the Building, shall be
determined by the Landlord's architect or land surveyor, as determined by the
Landlord from time to time and be the area measured in accordance with the
Building Owners and Managers Association ("BOMA") standard of measurement
(1996).

1.2.8       "FLOOR AREA OF THE BUILDING" means the aggregate, from time to time,
expressed in square feet, as certified by the Landlord's surveyor or architect,
as determined by the Landlord from time to time, in accordance with the BOMA
standard of measurement (1996) of the Floor Areas of all leasable premises
(including the Premises) of the Building, whether rented or not.

1.2.9       "INSURABLE HAZARDS" means fire and other perils for which insurance
is available and which a reasonably prudent Landlord would obtain in similar
circumstances.

1.2.10      "LAND" means all and singular those certain parcels or tracts of
land, situate, lying and being in the Municipality of Burnaby, Province of
British Columbia, and currently more particularly described as:

Dominion/Investors/Trillium Lease                                Kuhn & Company


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                                       - 4 -

            Parcel Identifier 018-651-721
            Lot A, Block 2, District Lot 73, Group 1
            New Westminster District Plan LMP14893

or as the boundaries or the legal description of the land may be varied from
time to time.

1.2.11      "LEASE YEAR" means a twelve (12) month period, commencing with the
first day of January in one calendar year and ending on the last day of December
in that calendar year; providing that the first Lease Year shall commence on the
Commencement Date of the Term and end on the last day of December in the
calendar year of the Commencement Date of the Term and the last Lease Year shall
end on the last day of the Term of this Lease and commence on the first day of
January preceding that date.

1.2.12      "OPERATING COSTS" means WITHOUT DUPLICATION the total of all
expenses, costs, fees, rentals, disbursements and outlays of every nature and
kind incurred, accrued, paid, payable or attributable, whether by or on behalf
of the Landlord for operating, managing, owning, maintaining, servicing,
repairing, restoring, renewing, improving, equipping, insuring, cleaning,
lighting, securing, policing, supervising, managing and administering the
Building and the Common Areas and Facilities, Land or any portion thereof in
each Lease Year, calculated as if the Building was fully occupied and fully
operational at all times during the Term, and irrespective whether such expenses
are incurred by or on behalf of tenants of premises in the Building with whom
the Landlord may from time to time have agreements whereby in respect of their
premises such tenants perform any cleaning, maintenance or other work or
services usually performed by the Landlord, and which expenses if directly
incurred by the Landlord would have been included in Operating Costs. Without
limitation, Operating Costs shall include the following costs and expenses:

            (a)   the cost of obtaining and maintaining insurance coverage
                  (including related expenses and deductibles payable) on the
                  Building, and the Common Areas and Facilities;

            (b)   the cost of cleaning (including window cleaning) and
                  janitorial services and all supplies; landscaping, gardening,
                  snow and ice removal; garbage and waste collection and
                  disposal; the cost of all gas, oil, electricity, lighting,
                  telephone and other communications, water, sewer, heating,
                  ventilating and air-conditioning and other utilities and
                  services supplied to or in connection with the Building and
                  the Common Areas and Facilities; the cost of security,
                  supervision, traffic control and parking facilities for the
                  Building and the Common Areas and Facilities; the cost of
                  repairing and restriping parking areas and roadways; all costs
                  paid or incurred by the Landlord in installing energy
                  conservation equipment and in complying with energy
                  conservation laws and regulations or upgrading to comply with
                  the requirements of (i) any existing or future municipal or
                  fire law, bylaw or regulation which applies to the Land and
                  Building or any part thereof or (ii) any insurer of the Land
                  and Building; all costs of leasing, operating, maintaining,
                  repairing, servicing and replacing any pylon sign(s) or other
                  exterior sign(s), directory boards and information facilities
                  erected on the Land and Building;

            (c)   the wages, salaries and expenses of employees (including
                  contributions and premiums towards fringe benefits,
                  unemployment and Workers'Compensation insurance, pension plan
                  and similar premiums and contributions) and termination
                  severance costs, and fees and expenses paid to obtain and
                  discharge the services of independent contractors engaged in
                  the operation, servicing, maintenance, repair, replacement,
                  security and administration of the Land and Building;

            (d)   the cost of consultant's, accountants and engineer's fees for
                  the determination and apportionment of Operating Costs;

            (e)   the amounts payable by the Landlord for the control,
                  management, maintenance, and administration of the Land,
                  Building and the Common Areas and Facilities or any portion
                  thereof in each Lease Year;

            (f)   the cost of all corporate capital, business, machinery or
                  other taxes, charges and licence fees which are

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                                       - 5 -

                  levied against the Landlord or which are not directly levied
                  against or payable by any tenant or occupier of the Building
                  individually (provided that such cost shall be computed by the
                  Landlord's accountant (whose decision shall be final and
                  binding on the parties) on the basis that the Landlord's sole
                  assets are the Land and Building;

            (g)   the cost of, WITHOUT DUPLICATION, operating, servicing,
                  maintaining, repairing (including major repairs), improving,
                  replacing and acquiring all machinery, equipment and fixtures
                  used in or kept on or about the Building, Land, or the Common
                  Areas and Facilities which may require periodic or substantial
                  replacement, including without limitation, elevators, heating,
                  ventilating and air conditioning systems and equipment;
                  plumbing, electrical (including light bulbs, ballasts, tubes,
                  starters and fixtures, pylon signs and sound equipment and
                  systems); roofing and waterproofing, garbage, storage and
                  service room equipment and machinery; communication equipment
                  and systems; maintenance, janitorial and cleaning equipment
                  and machinery;

            (h)   depreciation or amortization at generally accepted commercial
                  rates, WITHOUT DUPLICATION, on (i) all fixtures, machinery,
                  equipment and apparatus forming part of or serving the Common
                  Areas and Facilities or the Building and (ii) the cost of all
                  repairs or replacements required to be performed by the
                  Landlord unless they are charged or chargeable fully in the
                  Lease Year in which they are incurred or in which such
                  fixtures, machinery, equipment or apparatus are acquired, in
                  accordance with generally accepted accounting principles as
                  reasonably determined by the Landlord;

            (i)   the costs and expenses referred to in article 1.2.12(h) shall
                  also include, without duplication, an annual contribution to a
                  contingency reserve fund (the "Contingency Reserve Fund") for
                  expenditures for attending to major repairs and replacements
                  (other than regular expenditures incurred on a monthly or
                  annual basis and other than structural repairs and
                  replacements) the cost of which is not included in the items
                  listed elsewhere in article 1.2.12 that may occur from time to
                  time throughout the economic life of the Building. The
                  Landlord may, from time to time, use such portion of the
                  Contingency Reserve Fund as it, in its sole discretion,
                  determines advisable or necessary towards attending to major
                  repair and replacement of the various components of the Lands
                  and Building. The Tenant acknowledges that contributions to
                  the Contingency Reserve Fund are for attending to major
                  repairs and replacements and may not be applied in the Lease
                  Year in which they are collected from the Tenant and other
                  tenants of the Building. The Tenant shall be entitled to a
                  statement of the amount of such Contingency Reserve Fund and
                  the Tenant's Proportionate Share thereof (determined in the
                  manner set out in article 6.1(a) together with a statement of
                  any expenditures made from the Contingency Reserve Fund. At
                  the expiration or earlier termination of this Lease the Tenant
                  shall have no claim against the Contingency Reserve Fund.

            (j)   all costs and expenses not otherwise expressly excluded in
                  this Lease but attributable to the operation, maintenance,
                  replacement, repair, supervision, management, ownership and
                  administration of the Building, Land and the Common Areas and
                  Facilities;

            (k)   an administration fee which when combined with the items set
                  out in article 1.2.12(e) hereof shall in total not exceed five
                  (5%) percent of all Rent, excluding Operating Costs, payable
                  by all tenants of the Building to the Landlord.

THERE SHALL BE NO DUPLICATION OF COSTS IN DETERMINING THE AMOUNT OF OPERATING
COSTS PAYABLE BY THE TENANT. In particular, there shall not be included in
Operating Costs either the costs of replacing or repairing any part of the Land
or Building if such costs would normally be paid from the Contingency Reserve
Fund or any depreciation or amortization charge in respect of any repair or
replacement of any part of the Building if the cost of such repair or
replacement is included in Operating Costs or would normally be paid from the
Contingency Reserve Fund.

1.2.13      "PREMISES" means that portion of the Building having the municipal
address and located on the floor(s) set out in article 1.1(d), containing the
approximate Floor Area set forth in article 1.1(e) and having the approximate
location and configuration shown outlined in heavy black on Schedule "A" hereto.

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                                      - 6 -

1.2.14      "PREMISES PREPARATION PERIOD" subject to Section 2.3 and 2.4, means
the period of time set out in article 1.1(k) during which the Tenant shall have
possession of the Premises for purposes of completing its leasehold
improvements, moving its business and its Trade Fixtures into the Premises and
during which time the Tenant shall comply with all other terms of this Lease
except the Tenant shall not be obliged to pay Minimum Rent or Operating Costs to
the Landlord.

1.2.15      "RENT" means all amounts payable by the Tenant, including without
limitation, Minimum Rent (as set out for the Term in Section 3.1) and Additional
Rent. All monies payable pursuant to this Lease, whether as Rent or otherwise,
shall be paid in Canadian currency.

1.2.16      "SCHEDULES" means the following schedules, which form a part of this
            Lease:

                  Schedule "A" -   Site plans and floor plan showing the
                                   approximate location of the Premises

                  Schedule "B" -   Construction Schedule - Landlord's Work and
                                   Tenant's Work

                  Schedule "C" -   Rules and Regulations

                  Schedule "D" -   Other Terms and Conditions

                  Schedule "E" -   Guaranty

1.2.17      "TAXES " means the aggregate of all real property, sewer, municipal,
corporation capital and other taxes and rates, whether general or special, of
any nature whatsoever, including school and local improvement taxes and business
taxes levied or assessed by any lawful authority against the Land, the Building,
(based on the Business Park being its sole asset) or deferred payments and
interest or penalties, together with the costs of the Landlord in contesting or
negotiating the same, including, without limitation, any such taxes which are
imposed in lieu of or as a substitute for any such taxes, or on account of the
Landlord's ownership of the Land and Building. All Taxes will be computed by
the Landlord's accountant (whose decision shall be final and binding on the
parties) on the basis that the Landlord's sole assets are the Land and Building.

1.2.18      "TERM" means the period set forth in article 1.1(f).

1.2.19      "TRADE FIXTURES" means any and all fixtures and equipment used by 
the Tenant in connection with its business conducted from the Premises and
installed in the Premises in a fashion such that they may be removed by the
Tenant without causing damage to the Premises or the Building and including,
without limitation, office equipment, files, data, furnishings, computers and
computer equipment.

1.2.20      "YEAR OF THE TERM" means each successive twelve (12) calendar month
period (or part thereof) throughout the Term commencing on the Commencement
Date.

                                    ARTICLE 2
                                     GRANT

2.1         PREMISES. In consideration of the rents, covenants and agreements
hereinafter reserved and contained on the part of the Tenant to be observed and
performed, the Landlord hereby demises and leases the Premises to the Tenant and
the Tenant takes the Premises on lease from the Landlord, TO HAVE AND TO HOLD
during the Term on the terms and conditions of this Lease. The Tenant shall
examine the Premises before taking possession hereunder and such taking of
possession shall be conclusive evidence as against the Tenant that at that time
the Premises were in good order and satisfactory condition.

2.2         PROVISO. If the actual Floor Area of the Premises differs from that
specified in article 1.1(e) of this Lease,

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                                       - 7 -

then the Minimum Rent, the Tenant's Proportionate Share and all other amounts
calculated and payable with reference to this area shall be adjusted and payable
in accordance with such certification.

2.3         TERM. The Term of this Lease will be for the period set out in
article 1.1(f) commencing on the Commencement Date.

2.4         CONSTRUCTION OF PREMISES. The Landlord agrees to perform the
Landlord's Work described in Schedule "B" hereto at its expense. Provided the
Tenant contracts with the Landlord's base building contractor to undertake the
Tenant's Work, the Landlord will complete the Landlord's Work, to the extent
necessary to permit the Tenant's contractor to begin construction of the
Tenant's Work, by March 15, 2001, and for the Tenant to legally occupy the
Premises by June 30, 2001. The Tenant shall commence and complete the Tenant's
work necessary to make the Premises fit for their intended purposes utilizing
such contractors, consultants and suppliers as may be approved by the Landlord,
acting reasonably, at the Tenant's sole cost, risk and expense within the
Premises Preparation Period specified in article 1.1(k) commencing upon receipt
of a written notice from the Landlord that the Landlord's Work has progressed to
the stage where the Tenant's Work may commence. The Tenant acknowledges that
development of and construction on the Land may proceed in phases. Further, the
Landlord and the Tenant have agreed that the base building contractor's
contingency allowance applies only if that contractor's fee under the base
building contract is less than 6% of the Building construction costs and that
base building contractor has provided for competitive bids for all major trades
in undertaking construction of the work on the Building.

2.5         DELAYED POSSESSION.  If for any reason whatsoever the Landlord is
delayed in delivering possession of the Premises to the Tenant on or before
March 15, 2001, or June 30, 2001, as set out in Section 2.3, the Commencement
Date and Premises Preparation Period will be delayed for a period commensurate
with the delay in delivery of possession of the Premises to the Tenant. If the
Landlord is delayed in delivering possession of the Premises to the Tenant for
Commencement of its Premises Preparation Period past May 15, 2001, or for legal
occupation of the Premises past August 30, 2001, the Tenant may terminate this
Lease, with no further obligations to or by any party hereunder by delivering
notice to the Landlord within 10 business days of the applicable date, or such
other date as the Landlord and Tenant may agree in writing. The Tenant and
Landlord shall use all reasonable efforts to complete their respective work on
or in relation to the Premises so as to enable the Tenant to take possession of
and occupy the Premises within the times set out above. Nothing shall make the
Landlord liable to the Tenant for any loss or damage resulting from any delay in
delivering possession of the Premises to the Tenant, but unless the Tenant
terminates the Lease pursuant to this Section 2.4, the Premises Preparation
Period and the Rental Concession set out in Schedule D, shall apply.

2.6         PREMISES PREPARATION. During the Premises Preparation Period, the
Tenant shall have possession of the Premises for purposes of completing its
leasehold improvements, moving its business and its Trade Fixtures into the
Premises without being required to pay Minimum Rent or Operating Costs to the
Landlord. Notwithstanding that the Tenant is not obliged to pay Rent during the
Premises Preparation Period, the Tenant shall in all other respects be in
possession of the Premises pursuant to and comply with the terms and conditions
of this Lease, including, without limitation, the Tenant's insurance obligations
hereunder.

                                    ARTICLE 3
                                      RENT

3.1         MINIMUM RENT. The Tenant agrees to pay to the Landlord at the office
of the Landlord, or at such other place designated by the Landlord, in lawful
money of Canada, without any prior demand therefor and without any deduction or
set-off whatsoever a Minimum Rent for each Year of the Term in the amount per
square foot set out in article 1.1(h) multiplied by the Floor Area of the
Premises, payable in equal monthly installments in advance on the first day of
each calendar month, commencing on the Commencement Date.

3.2         ADDITIONAL RENT. The Tenant shall pay all Additional Rent when
payable or on demand without any deduction or set off whatsoever. If such
amounts or charges are not paid at the time provided in this Lease, they shall
be collectible as Rent with the next installment of Minimum Rent thereafter
falling due hereunder, but nothing herein

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<PAGE>

                                      - 8 -

contained shall be deemed to suspend or delay the payment of any amount of money
or charge at the time the same becomes due and payable hereunder, or limit any
other remedy of the Landlord.

3.3         SECURITY DEPOSIT. Intentionally deleted.

3.4         POST-DATED CHEQUES. Intentionally deleted.

3.5         IRREGULAR PERIODS. All Rent payments required to be made by the
Tenant under this Lease shall be deemed to accrue from day to day and if for any
reason it shall become necessary to calculate Rent for irregular periods of less
than one year, an appropriate pro-rata adjustment shall be made on a daily basis
in order to compute payment for such irregular period.

3.6         INTEREST ON UNPAID RENT. Any unpaid amounts of Rent shall bear
interest, payable as Additional Rent, from the due date thereof to the date of
payment at a rate per annum equal to the greater of eighteen percent (18%) or
five (5%) percentage points in excess of the prime commercial lending rate
("Prime Rate") per annum charged or chargeable from time to time by a Canadian
chartered bank designated by the Landlord on loans made in Canadian funds to its
most favoured commercial borrowers, calculated and compounded monthly, with any
adjustment in such rate to be effective on the first day of the month next
following such change in the Prime Rate. Any cheque payable to the Landlord for
Rent which is not honoured by the financial institution on which it is drawn
shall bear a $75.00 administration charge, payable by the Tenant forthwith upon
demand. Nothing contained herein shall be construed so as to compel the Landlord
to accept any payment of Rent in arrears should the Landlord elect to apply its
remedies under the forfeiture or any other article of this Lease in the event of
default hereunder by the Tenant.

                                    ARTICLE 4
                                    NET LEASE

4.1         INTENT. The Tenant covenants that this Lease shall be a completely
carefree absolutely net lease for the Landlord, except as shall be otherwise
provided, and that the Landlord shall not be responsible during the Term for any
costs, charges, expenses and outlays of any nature whatsoever, arising from or
connected with relating to the Premises, the Land, the Building, or the contents
thereof, excepting only the Landlord's income tax in respect of income received
from leasing the Premises and other premises in the Building and the Landlord's
structural repairs resulting from construction deficiencies as required herein.
Except as otherwise provided, the Tenant shall pay in the manner more
particularly described in this Lease, all charges, impositions and costs of
every nature and kind relating to or connected with the Premises and the
Building whether or not referred to in the Lease and whether or not of a kind
now existing or contemplated by the parties.

                                   ARTICLE 5
                                     TAXES

5.1         TAXES. During each Lease Year the Tenant shall pay to the Landlord
its share of Taxes, being a fraction which has as its numerator, the Floor Area
of the Premises and as its denominator, the aggregate from time to time
expressed in square feet, as certified by the Landlord's surveyor or architect,
as determined by the Landlord from time to time, of the Floor Area of all
leasable areas (including the Premises) of the Building (whether unoccupied or
occupied.

            The tax year of any lawful authority commencing during any Lease
Year shall be deemed to correspond to such Lease Year. The Landlord may estimate
in advance for each Lease Year the Tenant's share of Taxes and the Tenant agrees
to pay the Landlord such estimated amount in monthly installments in advance
during the Term. A certified statement of a responsible officer of the Landlord
to the Tenant as to the amount of the tax bill shall be sufficient evidence of
the amount of taxes assessed or levied against the parcel or real property to
which such bill relates. If the Tenant shall have paid in excess of the Tenant's
share of Taxes for such Lease Year, the excess shall be refunded by the

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                                      - 9 -

Landlord within a reasonable period of time. If the amount paid by the Tenant is
less than the Tenant's share of Taxes, the Tenant agrees to pay such deficiency
to the Landlord with the next due monthly payments of Minimum Rent.

5.2         BUSINESS AND OTHER TAXES. The Tenant shall pay, promptly when due,
to the taxing authorities or to the Landlord if it so directs, all business,
sales, machinery and equipment taxes, rates or duties as well as any permit or
licence fees, attributable to the use and occupancy of the Premises and the
property, business, sales or income of the Tenant in respect of the Premises. If
paid directly to the taxing authorities, the Tenant shall furnish to the
Landlord evidence of payment satisfactory to the Landlord.

5.3         GOODS AND SERVICES TAX. If any business transfer tax, value-added
tax, multi-stage sales tax, sales tax, goods and services tax, or any like tax
("Sales Tax")is imposed on or collectible by the Landlord by any governmental
authority on any Rent payable by the Tenant under this Lease, the Tenant shall
reimburse (and hereby indemnifies) the Landlord for the amount of Sales Tax,
forthwith upon demand or at any time designated from time to time by the
Landlord. The amount of Sales Tax so payable by the Tenant shall be calculated
by the Landlord in accordance with the applicable legislation. The parties
acknowledge that the Sales Tax shall be deemed not to be Rent but the Landlord
shall have all of the same remedies for and rights of recovery of the Sales Tax
as it has for recovery of Rent under this Lease.

                                   ARTICLE 6
                                OPERATING COSTS

6.1         TENANT TO PAY PROPORTIONATE SHARE. During each Lease Year the Tenant
shall pay to the Landlord:

            (a)   the Tenant's share of Operating Costs for the Building, being
                  a fraction which has as its numerator, the Floor Area of the
                  Premises and as its denominator, the Floor Area of the
                  Building; and

            (b)   the Tenant's share of Operating Costs for the exterior Common
                  Areas and Facilities being a fraction which has as its
                  numerator, the Floor Area of the Premises and as its
                  denominator, the aggregate from time to time expressed in
                  square feet, as certified by the Landlord's surveyor or
                  architect, of the Floor Area of all leasable areas (including
                  the Premises) of the Business Park.

6.2         PAYMENT OF TENANT'S SHARE. Operating Costs shall be estimated by the
Landlord for such period as the Landlord may determine and the Tenant agrees to
pay to the Landlord its share of such amounts, in monthly installments in
advance, during such period together with other rental payments provided for in
this Lease. If the Tenant shall have paid in excess of the actual amount due,
the excess shall be refunded by the Landlord within a reasonable period of time
or be credited on account of Rent next falling due. If the amount the Tenant has
paid is less than the actual amount due, the Tenant shall pay such deficiency
with the next Minimum Rent payment due.

6.3         LANDLORD'S ALLOCATION OF OPERATING COSTS. In the reasonable opinion
of the Landlord, whenever any item(s) of Operating Cost or portions thereof
properly relates to a particular tenant or tenants within the Building, the
Landlord may allocate or attribute such item or items to such tenant or tenants,
and the amount so allocated or attributed shall be payable forthwith upon
demand.

                                    ARTICLE 7
                 USE OF COMMON AREAS AND FACILITIES AND PARKING

7.1         CONTROL OF COMMON AREAS & FACILITIES BY THE LANDLORD. All Common
Areas and Facilities from time to time provided by the Landlord shall at all
times be subject to the exclusive control and management of the Landlord, and
the Landlord shall have the right from time to time to establish, modify and
enforce reasonable rules and regulations with respect to the Premises and all
Common Areas and Facilities.

7.2         CHANGES AND ADDITIONS TO BUILDINGS. The Landlord hereby reserves the
right at any time to change the

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                                     - 10 -

configurations of the Common Areas and Facilities and to make alterations or
additions to and build additional storeys on the Building. The Landlord also
reserves the right to construct other buildings or improvements on the Land from
time to time and to make alterations or additions thereto and to construct
multi-deck or elevated or underground parking facilities.

7.3         PARKING.

            (a)   Subject to the by-laws, rules and regulations of the Landlord,
                  the Tenant and its employees, agents, customers and invitees
                  shall have the right, while at the Premises, in common with
                  all others from time to time entitled thereto, to park their
                  passenger motor vehicles for a reasonable period of time each
                  day upon that portion of the Land designated for vehicle
                  parking and not exclusively reserved for the use of other
                  Tenants of the Building. The Landlord may cause to be removed
                  at the cost of the Tenant, such vehicles as may be left on the
                  Land while apparently uninsured, unlicensed or abandoned. The
                  Landlord grants to the Tenant for the Term, for use by the
                  Tenant, the right and license to use that number of parking
                  spaces set out in article 1.1(l), and during the first year
                  of the Term the Tenant shall pay to the Landlord or its
                  parking lot operator the rental rates of $40.00 for each
                  surface parking space and $50.00 for each underground parking
                  space. After the first year of the Term, the Tenant shall pay
                  for parking the reasonable rental rates established by the
                  Landlord or its parking lot operator from time to time. It is
                  understood and agreed that in setting its parking rental rates
                  the Landlord and its parking lot operator shall not
                  unreasonably exceed the then prevailing market rates for
                  comparable parking spaces.

            (b)   The Tenant will not park or suffer or permit to be parked, any
                  vehicles owned, leased or controlled by it or by any of its
                  employees, agents or invitees or suffer or permit any loading
                  or unloading of vehicles upon any portion of the Land, except
                  in areas designated for such purposes by the Landlord. The
                  Landlord may, without notice and at any time and from time to
                  time (i) designate parking, loading, and no parking areas;
                  (ii) change or reduce designated parking, paid parking,
                  loading and no parking areas; (iii) cause any parking or
                  loading areas to be shared with other tenants; and (iv) use
                  any parking or loading areas for any reasonable purpose
                  required by the Landlord. From time to time and upon
                  reasonable written notice to the Tenant, the Landlord or its
                  parking lot operator may impose and vary from time to time
                  rates or charges on the Tenant for the use by the Tenant or
                  its employees, agents or invitees of designated parking areas.
                  Whenever requested by the Landlord, the Tenant shall furnish
                  to the Landlord the current licence plate numbers for all
                  vehicles owned, leased or controlled by the Tenant and its
                  employees, agent or invitees.

            (c)   The Tenant will advise the Landlord upon or prior to the
                  Commencement Date, and at such other times as the Landlord may
                  require, as to the greatest number of employees and agents
                  reasonably expected on the Premises at any one time, so as to
                  permit the Landlord to comply with all municipal and other
                  parking bylaws and regulations in respect of the Land,
                  including the Landlord's parking regulations, if any, as
                  determined by it from time to time.

                                   ARTICLE 8
                                USE OF PREMISES

8.1         USE OF PREMISES.

            (a)   The Tenant shall use the Premises solely for the purpose set
                  forth in article 1.1(i). The Tenant will not use or permit or
                  suffer the Premises or any part thereof to be used for any
                  other business or purpose. Furthermore, the Tenant shall not
                  at any time use or permit or suffer the Premises or any part
                  thereof to be used for any business or purpose (even if
                  included in the permitted use hereunder) for which the
                  Landlord has granted an exclusive use to another tenant in the
                  Building and notice of which exclusive

Dominion/Investors/Trillium Lease                                Kuhn & Company


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                                     - 11 -

                  use has been given by the Landlord to the Tenant, provided the
                  Tenant has not so used the Premises prior to such notice being
                  given. Furthermore, the Tenant shall not carry on the business
                  of auto body or auto or boat repairing, woodworking, fibre
                  glass working, painting or silk screening, automated teller or
                  bank machines or lottery machines. Throughout the whole of the
                  Term, the Tenant shall continuously operate, occupy and use
                  the entire Premises and conduct its business therein pursuant
                  to this Lease.

            (b)   The Tenant shall not commit or suffer to be committed (i) any
                  waste upon the Premises or (ii) any nuisance or other thing
                  which may disturb the quiet enjoyment of any other occupier of
                  premises in the Building; or (iii) any acts or practices which
                  may damage the Building or any improvements on the Land or in
                  the Business Park.

            (c)   The Tenant shall use its best efforts to prevent anything
                  being done on the Premises or the Land which may result in the
                  Land or Building or any part thereof being picketed or
                  otherwise subjected to labour, political or other
                  demonstration or action. In the event of such picketing,
                  action or demonstration, the Tenant shall immediately take all
                  reasonable action and proceedings necessary to cause such
                  picketing, action and demonstration to cease without delay.

            (d)   The Tenant shall use only the business name specified in
                  article 1.1(i) for its business in the Premises and shall not
                  change or permit the change of that name without the prior
                  written consent of the Landlord, which consent shall not be
                  unreasonably withheld so long as the name to which the Tenant
                  changes its business operated in the Premises is the same as
                  the name to which the Tenant changes its other business
                  operations in all its other locations.

            (e)   The Tenant shall comply with all reasonable requests of the
                  Landlord with respect to conservation of energy, recycling and
                  environmental care, and shall pay its Proportionate Share of
                  the costs of acquiring and installing such conservation,
                  recycling and environmental care equipment and systems for the
                  Building.

            (f)   The Tenant shall turn off all lights and other energy-using
                  equipment or systems within the Premises, except where
                  reasonably required to be left on for valid purposes,
                  including security.

            (g)   The Tenant shall not bring onto the Premises or Land, nor
                  discharge nor permit the discharge of any waste, oil or
                  grease, hazardous substance or any deleterious, objectionable,
                  dangerous, radioactive, poisonous or explosive matter or
                  noxious or unpleasant fumes, gases or substance (the
                  "Pollutants") onto the Premises or Land, or into any air,
                  waters, ditches, culverts, drains or sewers on or adjacent to
                  the Premises or Land, and the Tenant shall take all measures
                  necessary to ensure that any effluent or other substance
                  discharged by it is not corrosive, poisonous or otherwise
                  harmful to any sewage disposal works or to the bacteriological
                  process of sewage purification. The Landlord shall be
                  permitted access to the Premises from time to time to test and
                  monitor the effluent from the Tenant's operations and
                  compliance with this section. In addition, the Tenant shall
                  not dispose of, discharge or accumulate or permit to be
                  disposed or, discharged or accumulated on, in or under the
                  Lands any Pollutants. The Tenant shall promptly pay to the
                  Landlord any and all costs incurred by the Landlord in
                  containing, cleaning up, removal and disposal of any materials
                  deemed hazardous or deleterious by the Landlord or and such
                  experts and inspections as it, from time to time, shall
                  employ. These costs are acknowledged to be Additional Rent.
                  This clause and the matters referred to herein may be modified
                  and expanded at the Landlord's sole discretion to comply with
                  requirements imposed by applicable insurers, financial
                  institutions or government authorities. Notwithstanding any
                  other provision of this Lease, the Tenant will comply with all
                  laws and regulations affecting the Lands, specifically
                  including those of an environmental nature. The Tenant will
                  indemnify and save harmless the Landlord of and from the costs
                  of disputing, investigating, remediating, resolving and
                  settling environmental claims against the Lands, or remedying
                  the Tenant's default of this provision.

            (h)   The Tenant shall not bring sharp objects onto the Premises or
                  Land, nor permit any sharp objects which could puncture the
                  skin or constitute a threat of potential harm to persons, and
                  will safeguard, store and dispose of such sharp objects so as
                  to comply with the highest standard of safety and care.

Dominion/Investors/Trillium Lease                                Kuhn & Company


<PAGE>

                                     - 12 -

                                    ARTICLE 9
                       UTILITIES AND ADDITIONAL SERVICES

9.1         UTILITIES. The Tenant shall pay as they become due and payable all
rates, charges and other amounts arising for, related to, or incurred in respect
of, services and utilities, including water, fuel, gas communications or other
utility or service and electrical power or energy, heating, ventilation or air
conditioning used upon or in respect of the Premises or any part thereof and for
fittings, machines, apparatus, meters or other things leased in respect thereof,
and for all work and services performed by any corporation or commission in
connection with such utilities or service. Where any such service or utility is
supplied by or through the Landlord, the Tenant shall pay to the Landlord an
amount (the "Charge") which is the total, without duplication, of:

            (a)   the cost incurred by the Landlord for water, fuel, power,
                  electricity, communications, heating, ventilation or air
                  conditioning or other utility or service (the "Utilities")
                  used in or for the Premises or allocated to them by the
                  Landlord;

            (b)   charges imposed in place of or in addition to Utilities as
                  determined by the Landlord; and

            (c)   the Landlord's costs of determining the Charge including, but
                  not limited to, professional, engineering and consulting fees.

                  If the Landlord supplies Utilities, the Tenant shall pay the
Landlord the Charge in advance on demand, which shall be based on estimates of
the Landlord but shall be subject to adjustment within a reasonable time after
the period for which the estimate had been made. The Landlord shall not be
liable for interruption or cessation of, or failure in the supply of Utilities,
services or systems in, to or servicing the Land or the Premises, whether they
are supplied by the Landlord or others, and whether the interruption or
cessation is caused by the Landlord's negligence or not. Upon occupancy of the
Premises, and provided that the Utilities are directly metered by a third party,
the Tenant covenants to transfer all accounts into its name. The Landlord will
disconnect these services as of the Commencement Date, and the Tenant will pay
any and all connection fees if it does not assume the account in its name. If no
separate metering exists for the Premises, the Landlord will, acting reasonably,
allocate the proportionate share of Utilities to each premises in the Building.

9.2         ADDITIONAL SERVICES.  At its option, the Landlord shall have the
exclusive right, by way of Additional Services, to provide or have its
designated agents or contractors provide any janitorial or cleaning services to
the Premises required by the Tenant which are additional to those required to be
provided by the Landlord under this Lease, including any additional services
which the Landlord agrees to provide by arrangement and to supervise the moving
of furniture or equipment of the Tenant and the making of repairs or alterations
conducted within the Premises and to supervise or make deliveries to the
Premises. The Tenant shall pay to the Landlord promptly upon receipt of invoices
therefor from the Landlord or as part of Operating Costs, the Cost of Additional
Services whether the Landlord shall be obligated hereunder or shall elect to
provide them as Additional Services. The Cost of Additional Services charged
directly to the Tenant and other tenants shall be credited in computing
Operating Costs to the extent that they would otherwise have been included. On
request by the Tenant, the Landlord may agree from time to time, in its sole
discretion, to arrange at the Tenant's cost for extra heating, ventilating, and
air conditioning supply, electrical supply or the supply of other services to
the Premises above those normally provided to tenants of the Building or outside
of Building Hours. At its option and at the Tenant's cost as an Additional
Service, the Landlord may install and maintain meters to check the Tenant's
consumption of electricity, water, gas, communication or other utilities or
facilities and provide and maintain garbage or waste receptacles for use of the
Tenant alone or in common with others.

9.3         SECURITY OF PREMISES. Notwithstanding sections 9.1, 9.2, 10.3, and
10.4 of this Lease, the Landlord shall only access the Premises with the consent
of the Tenant, acting reasonably to maintain adequate security of the Premises.

                                   ARTICLE 10
                            MAINTENANCE OF PREMISES

10.1        CLEANING.

Dominion/Investors/Trillium Lease                                Kuhn & Company


<PAGE>

                                     - 13 -

            (a)   The Tenant shall keep the Premises and, without limitation,
                  the inside, and, if on the ground floor, outside of all glass,
                  windows, window coverings and doors of the Premises and all
                  exterior surfaces of the Premises, in a neat, clean and
                  sanitary condition and shall not allow any refuse, garbage or
                  other loose or objectionable or waste material to accumulate
                  in or about the Premises but rather shall dispose of the same
                  in accordance with the Rules and Regulations.

            (b)   The Tenant shall, immediately before the expiration of the
                  Term, wash the floors, windows, and doors, and wash and
                  repaint the walls and woodwork of the Premises and shall not,
                  upon such expiration, leave upon the Premises any refuse,
                  garbage or waste material; all to the requirements of the
                  Landlord.

            (c)   The Tenant shall have the option to retain and pay for its own
                  janitor service, cleaning of debris, removal of garbage and
                  such other costs as may be incurred in cleaning the Premises.

            (d)   If the Tenant fails to clean and paint in accordance with its
                  obligations hereunder upon notice so to do from the Landlord,
                  the Landlord may clean and paint the same and the Tenant shall
                  pay the cost thereof to the Landlord as Additional Rent.

            (e)   The Tenant shall remove any ice or snow accumulating on the
                  sidewalks and other area immediately bordering the exterior of
                  the Premises, and keep such areas clean and clear.

10.2        TENANT'S REPAIRS.

            (a)   The Tenant shall repair the Premises, only excepting
                  reasonable wear and tear and repairs which are the
                  responsibility of the Landlord pursuant to this article 10,
                  but including any damage to or breakage of glass (excluding
                  all exterior windows), mouldings, signs, doors,locks,
                  hardware, lighting, wiring, plumbing, improvements,
                  partitions, walls, Utilities connections, wiring, lighting,
                  sprinkler systems, heating, ventilation and air conditioning
                  systems, pipes and plumbing, security systems, fixtures,
                  thresholds and all Trade Fixtures and furnishings of the
                  Tenant or otherwise in or for the Premises, and shall
                  redecorate and repaint as required by the Landlord, acting
                  reasonably, and maintain in good condition the interior of the
                  Premises, any appurtenances thereto, any improvements now or
                  hereafter erected or installed therein and any apparatus or
                  equipment of the Tenant therein or therefor.

            (b)   The Tenant shall keep the interior of the Premises
                  well-painted at all times in accordance with the reasonable
                  requests of the Landlord, using colours which shall first be
                  approved in writing by the Landlord; shall keep all plumbing
                  facilities within the Premises and all drains therefrom in
                  good repair and working order; will not enter, nor will it
                  cause, suffer or permit entry, on to any roof in the Building,
                  without being accompanied by an authorized representative of
                  the Landlord, and will not make any opening in the roof
                  without the prior written consent of the Landlord.

            (c)   The Tenant, its employees or agents shall not mark, paint,
                  drill or in any way deface any walls, ceilings, partitions,
                  floors, wood, stone or ironwork without the written approval
                  of the Landlord.

10.3        VIEW REPAIRS.

                  The Tenant shall provide the Landlord with keys to all
portions of the Premises and hereby authorizes the Landlord to enter the
Premises at any reasonable time during business hours and at any time during any
emergency to view the state of repair and the Tenant shall repair according to
notice in writing from the Landlord so to do, subject to the exceptions
contained in this article 10.

10.4        LANDLORD MAY REPAIR.

                  If the Tenant fails to repair or otherwise comply with this
article 10 within five (5) days of receipt thereof, the Landlord may make such
repairs or perform such other trades without liability to the Tenant for any
loss " damage that may occur to the Tenant's fixtures or other property or to
the Tenant's business by reason thereof, and upon , completion thereof, the
Tenant shall pay as Additional Rent the Landlord's costs for making such
repairs.

10.5        LANDLORD'S REPAIRS.

Dominion/Investors/Trillium Lease                                Kuhn & Company


<PAGE>

                                     - 14 -

            (a)   The Landlord shall conduct all maintenance, repairs and
                  replacements to the apparatus for heating, ventilating and
                  air-conditioning installed in the Building, including the
                  Premises; the cost of which shall be included in the Operating
                  Costs.

            (b)   The Landlord shall be responsible for the repairs to the
                  Premises or to the Building caused by Insurable Hazards.

            (c)   Notwithstanding the other provisions of this article 10.5, the
                  Landlord shall not be obligated to make repairs or
                  replacements caused by any default or negligence of the
                  Tenant, its agents, customers, employees, invitees or
                  licensees, but such repairs and replacements may be made by
                  the Landlord at the Tenant's cost in like manner as provided
                  in article 10.4.

            (d)   The Landlord shall not be liable for any loss or damage to any
                  person or property for its failure to repair in accordance
                  with this article 10.5, unless such loss or damage is caused
                  by the default or negligence of the Landlord, its agents,
                  employees or contractors and is not specifically excepted
                  pursuant to this Lease.

            (e)   The Landlord shall keep painted those parts of the exterior of
                  the Premises requiring painting other than such parts of the
                  exterior as may have been installed by or at the request of
                  the Tenant, the cost of which shall be included in Operating
                  Costs.

            (f)   In fulfilling its obligations pursuant to this article 10.5,
                  the Landlord shall be entitled to enter the Premises and shall
                  act as expeditiously as is reasonably possible in the
                  circumstances.

            (g)   The Landlord shall repair and maintain the structure of the
                  Building, including the exterior walls, roof, pipes, plumbing,
                  electrical wires and other installations of a structural
                  nature including the roof membrane and water tightness of the
                  Building. If any such repairs will be required to be made by
                  the Landlord by reason of negligence of the Tenant its agents,
                  employees invitees, or licensees, the Landlord will be
                  entitled to recover the costs thereof from the Tenant and if
                  the Tenant fails to pay the same on demand, the Landlord may
                  recover the amounts so due by all remedies available to it for
                  the recovery of rent in arrears.

10.6        COST OF REPAIR. If the Building, Land or the Common Areas and
            Facilities or any portion thereof, including without limiting the
            generality of the foregoing, the common loading areas, the exterior
            of the Premises, including the front thereof and entrance thereto,
            the boilers, engines, pipes and other apparatus (or any of them)
            used for the purpose of heating, ventilating or air-conditioning the
            Building, or if the water pipes, drainage pipes, electric lighting
            or any other equipment or system of the Building or the roof or
            outside walls of the Building become damaged or destroyed through
            the negligence, carelessness or misuse of the Tenant, its servants,
            agents, employees, contractors, lessees, licensees or
            concessionaires, or through it or them in any way stopping up,
            injuring or rendering inoperable the heating apparatus, water pipes,
            drainage pipes or other equipment or part of the Building, the
            expense of necessary repairs, replacements or alterations, plus a
            sum equal to fifteen percent thereof in relation to the Landlord's
            overhead costs, shall be borne by the Tenant, payable to the
            Landlord upon demand.

                                   ARTICLE 11
                            INSURANCE AND INDEMNITY

11.1        TENANT'S INSURANCE.

            (a)   During the whole of the Term and during such other time as the
                  Tenant occupies the Premises, the Tenant shall take out and
                  maintain in the names of the Tenant and the Landlord as their
                  respective interests may appear, the following insurance
                  coverage, at the Tenant's sole expense:

                        (i)   comprehensive general liability insurance against
                              claims for third party bodily injury, including
                              death, and property damage or loss arising out of
                              the use or

Dominion/Investors/Trillium Lease                                Kuhn & Company

<PAGE>

                                     - 15 -

                  occupation of the Premises, or the Tenant's business on or
                  about the Premises; such insurance to be in the joint names of
                  the Tenant and the Landlord, as well as the Landlord's
                  mortgagee, so as to indemnify and protect both the Tenant and
                  the Landlord, as well as the Landlord's mortgagee, and to
                  contain a "cross liability" or "severability of interest"
                  clause so that the Landlord and the Tenant, as well as the
                  Landlord's mortgagee, may be insured in the same manner and to
                  the same extent as if individual policies had been issued to
                  each, and shall be for the amount of not less than two million
                  ($2,000,000.00) dollars combined single limit or such greater
                  amount as may be reasonably required by the Landlord from time
                  to time which commercial general liability insurance shall
                  include, for the Tenant's benefit only, tenant's all risk
                  legal liability insurance in an amount equal to the
                  replacement cost of the Premises including loss of use
                  thereof;

            (ii)  all risks of physical loss insurance upon its merchandise,
                  stock-in-trade, furniture, fixtures, all glass and
                  improvements and upon all other property in the Premises owned
                  by the Tenant or for which the Tenant is legally liable,
                  including broad form boiler and machinery insurance, all in an
                  amount equal to the full replacement cost thereof, which
                  amount in the event of a dispute shall be determined by the
                  decision of the Landlord;

            (iii) business interruption coverage which shall provide for the
                  payment of Minimum Rent and all additional costs collectible
                  as Rent to the Landlord for a period of twelve (12) months;

            (iv)  coverage of breakage or damage from any cause to all internal
                  and external glass and plate glass in or forming part of the
                  Premises;

            (v)   insurance covering damage to the Building caused during
                  burglary, for the benefit of the Landlord and Tenant;

            (vi)  any other form of insurance as the Landlord or Landlord's
                  insurance agent, acting reasonably, may require from time to
                  time, in amounts and for insurance risks against which a
                  prudent tenant would insure.

      (b)   The Tenant's policies of insurance hereinbefore referred to shall
            contain the following:

            (i)   provisions that the Landlord is protected notwithstanding any
                  act, neglect or misrepresentation of the Tenant which might
                  otherwise result in the avoidance of claim under such policies
                  and such policies shall not be affected or invalidated by any
                  act, omission or negligence of the Tenant or any third party
                  which is not within the control of the Landlord;

            (ii)  provisions that such policies and the coverage evidenced
                  thereby shall be primary and noncontributing with respect to
                  any policies carried by the Landlord;

            (iii) provisions that such policies of insurance shall provide for
                  deductibles of not more than Fifty Thousand ($50,000.00)
                  Dollars in all other instances;

            (iv)  all insurance referred to above shall provide for waiver of
                  the insurer's rights of subrogation as against the Landlord;

            (v)   provisions that such policies of insurance shall not be
                  restricted, materially changed or cancelled without the
                  insurer providing the Landlord with Thirty (30) days written
                  notice stating when such restriction, change or cancellation
                  shall be, effective.

      (c)   The Tenant shall maintain such other insurance in such amounts and
            in such sums as the Landlord may

Dominion/Investors/Trillium Lease                                 Kuhn & Company

<PAGE>

                                     - 16 -

            reasonably determine from time to time. Evidence satisfactory to the
            Landlord and its insurance agent of all such policies of insurance
            shall be provided to the Landlord upon request.

      (d)   Notwithstanding anything in this subsection 11.1, and in any event,
            the Tenant shall be responsible for any deductibles not covered by
            insurance.

11.2        LANDLORD DISCLAIMER.

      (a)   Except to the extent within its control, the Landlord shall not be
            liable for any bodily injury to or death of, or loss or damage to
            any property belonging to the Tenant or its employees, invitees or
            licensees or any other person in or about the Premises, Building or
            the Land and in no event shall the Landlord be liable for any
            consequential injury, economic or financial loss or damage relating
            thereto, or, without limitation,

            (i)   for any injury or damage of any nature whatsoever to any
                  persons or property caused by the failure by reason of a
                  breakdown or other cause, either directly or indirectly, to
                  supply adequate drainage, snow or ice removal or by reason of
                  the interruption of any public utility or other service, or in
                  the event of gas, steam, water, rain, snow, ice or other
                  substances leaking into, issuing or flowing from the water,
                  steam, sprinkler or drainage pipes or plumbing of the Land,
                  Building or the Premises or from any other place or quarter
                  into any part of the Premises, or from any loss or damage
                  caused by or attributable to the condition or arrangement of
                  any electric or other wiring or for any damage caused by
                  anything done or omitted to be done by any other tenant of the
                  Building;

            (ii)  for any act or omission, including theft, malfeasance, or
                  negligence on the part of any agent, contractor or person from
                  time to time employed by the Landlord to perform security
                  services, maintenance, supervision, cleaning or any other work
                  or service in or about the Premises, Building or the Land;

            (iii) for loss or damage, however caused, to money, securities,
                  negotiable instruments, papers or other valuables of the
                  Tenant, including any consequential loss or damage resulting
                  therefrom; or

            (iv)  for loss or damage to any automobiles or their contents or for
                  the unauthorized use by other tenants or strangers of any
                  parking space allotted to the Tenant or for parking in or upon
                  the Common Areas and Facilities;

            and the Tenant covenants to indemnify and does hereby indemnify the
            Landlord against and from all loss, costs, claims and demands in
            respect of any such injury, death or loss to it or its employees,
            invitees or licensees or any other person in or on the Land or
            Building for the purpose of attending at the Premises or the Land or
            Building in respect of any such damage to property belonging to or
            entrusted to the care of any of the aforementioned;

      (b)   The Landlord shall have no responsibility or liability for the
            failure to supply, if required to do so under the terms of this
            Lease, interior and climate control and utilities, when prevented
            from doing so by strikes, the necessity of repairs, any order or
            regulation of anybody having jurisdiction, the failure of the supply
            of any utility required for the operation thereof or any other cause
            beyond the Landlord's reasonable control, and the Landlord shall in
            no event be held responsible or liable for indirect or consequential
            loss, damages or other damages for personal discomfort or illness or
            injury or death resulting therefrom;

      (c)   The Landlord shall be under no obligation to repair, maintain or
            insure any of the Tenant's Trade Fixtures or improvements installed
            by the Tenant or on its behalf or any other property of the Tenant
            in or upon the Premises;

      (d)   The Landlord shall be under no obligation to remedy any default of
            the Tenant and shall not incur any liability to the Tenant for any
            act or omission in the course of its curing or attempting to cure
            any such

Dominion/Investors/Trillium Lease                                 Kuhn & Company

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                                     - 17 -

            default or in the event of its entering upon the Premises to
            undertake any examination thereof or any work therein or in the case
            of any emergency.

11.3        INCREASE IN INSURANCE PREMIUMS. The Tenant shall not keep, use, sell
or offer for sale in or upon the Premises any article which may be prohibited by
the insurance policies in force from time to time covering the Land or Building.
In the event the Tenant's occupancy of, conduct of business in, or sale of any
merchandise from, or on the Premises, or in the event any activity carried on or
permitted to be carried on by the Tenant whether or not the Landlord has
consented to same, causes any increase in premiums for the insurance carried
from time to time by the Landlord for the Land or Building, the Tenant shall pay
any such increase in premiums as Additional Rent within ten (10) days after
bills for such additional premiums shall be rendered by the Landlord. In
determining whether increased premiums are a result of the Tenant's use or
occupancy of the Premises, or the sale of any article therein or therefrom, a
schedule issued by the organization making the insurance rate on the Land or
Building showing the various components of such rates shall be conclusive
evidence of the several items and charges which make up such rates.

11.4        CANCELLATION OF INSURANCE. If any insurance policy upon the
Premises, or any part thereof, shall be cancelled or shall be threatened by the
insurer to be cancelled, or the coverage thereunder reduced in any way by the
insurer by reason of the use and occupation of the Premises or any part thereof
by the Tenant or by any assignee or subtenant of the Tenant, or by anyone
permitted by the Tenant to be upon the Premises, and if the Tenant fails to
remedy the condition giving rise to cancellation or reduction of coverage within
forty-eight (48) hours after notice thereof by the Landlord, the Landlord may
remedy the condition giving rise to such cancellation, threatened cancellation
or reduction, and the Tenant shall forthwith pay the cost thereof to the
Landlord, which cost may be collected by the Landlord as Rent.

11.5        INDEMNIFICATION OF LANDLORD. The Tenant agrees to and does hereby
indemnify, defend and save harmless the Landlord in respect of any claims for
bodily injury or death, property damage or any other loss or damage, arising
howsoever, out of the use or occupation of the Premises or from the conduct of
any work by or any act or omission of the Tenant or any assignee, subtenants,
agent, employee, contractor, invitee, or licensee of the Tenant or anyone else
for whom the Tenant may be responsible and in respect of all costs, expenses and
liabilities incurred by the Landlord in connection with or arising out of all
such claims; including the expenses of any action or proceeding pertaining
thereto and in respect of any loss, cost, expense or damage suffered or incurred
by the Landlord arising from any breach or non-performance by the Tenant of any
of its covenants or obligations under this Lease. The Tenant's obligations to
observe or perform the foregoing covenants shall survive the expiration of other
termination of this Lease. The Tenant expressly releases the Landlord from any
claims, damages, judgments, losses or awards caused by or arising from perils
insured against or required to be insured against by the Tenant under this
Lease.

                                   ARTICLE 12
                            ASSIGNMENT AND SUBLETTING

12.1        ASSIGNMENT AND SUBLETTING.

      (a)   The Tenant shall not assign this Lease or sublet or otherwise part
            with possession of the whole or any part of the Premises unless: (1)
            it shall have received or procured a bona fide written offer to take
            an assignment or sublease which is not inconsistent with, and the
            acceptance of which would not breach any provision of this Lease if
            this article is complied with and which the Tenant has determined to
            accept subject to this article being complied with, and (2) it shall
            have first requested and obtained the consent in writing of the
            Landlord thereto. Any request for such consent shall be in writing
            and accompanied by a true copy of such offer, and the Tenant shall
            furnish to the Landlord all information available to the Tenant and
            requested by the Landlord as to the responsibility, reputation,
            financial standing and business of the proposed assignee or
            sub-tenant. Within fifteen (15) days after receipt by the Landlord
            of such request for consent and of all information which the
            Landlord shall have requested hereunder (and if no such information
            has been requested, within fifteen (15) days after receipt of such
            request for consent) the Landlord shall have the right upon written
            notice to the Tenant if the request is to assign this Lease or
            sublet the whole of the Premises, to cancel and terminate this
            Lease, or if the request is to sublet a part of the Premises only,
            to cancel and terminate this Lease with respect to such part, in
            each case as of a termination date to be stipulated in the notice of
            termination which shall be not less than sixty (60) days and not
            more than ninety (90) days following the giving of such notice, and
            in such event the Tenant shall surrender the whole or part (as the
            case may be) of the Premises in accordance with such notice and Rent
            shall be apportioned and paid to the date of

Dominion/Investors/Trillium Lease                                 Kuhn & Company

<PAGE>

                                     - 18 -

            surrender and, if only a part of the Premises is surrendered, Rent
            payable shall thereafter abate proportionately. If the Landlord does
            not exercise the foregoing right of cancellation, the Landlord's
            consent to the proposed assignment or sublease shall not be
            unreasonably withheld as long as the proposed assignment or sublease
            complies with article 12.1;

      (b)   Notwithstanding any such assignment, sublease, or parting with
            possession the Tenant shall not be released from performing any of
            the terms, covenants and conditions of this Lease during the Term;

      (c)   If this Lease is assigned or if the Premises or any part thereof are
            sublet or occupied by anybody other than the Tenant, and the Tenant
            is in default under this Lease, the Landlord may collect Rent
            directly from the assignee, sub-tenant or occupant, and apply the
            net amount collected, or the necessary portion thereof, to the Rent
            herein reserved;

      (d)   No assignment or sublease shall be made or proposed other than to
            responsible persons, firms, partnerships or bodies corporate who are
            experienced in and agree to carry on the type of business permitted
            to be conducted by the Tenant, and who undertake to perform and
            observe the obligations of the Tenant hereunder by entering into the
            Landlord's form of agreement directly with the Landlord;

      (e)   The prohibition against assigning or subletting without the consent
            required by this article 12.1 shall be construed to include a
            prohibition against any assignment or sublease by operation of law;
            and

      (f)   The consent by the Landlord to any assignment or sublease shall not
            constitute a waiver of the necessity for such consent to any
            subsequent assignment or sublease.

      (g)   The Tenant shall not suffer or permit any part of the Premises to be
            used or occupied by any licensee, franchisee or concessionaire other
            than in accordance with this article 12.

      (h)   The Tenant shall indemnify the Landlord for all costs incurred by it
            in respect of the Tenant's request to sublet or assign and
            preparation, review and consideration of any consent or document in
            respect thereof.

      (i)   If a Tenant is a corporation or the Landlord has consented to an
            assignment or subletting of this Lease to a corporation, then any
            transfer or issue by sale, assignment, bequest, inheritance,
            operation of law or other disposition, or by subscription, from time
            to time of all or any part of the corporate shares of the Tenant or
            of any parent or subsidiary corporation of the Tenant or any
            co