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Cray Inc. (NASDAQ:CRAY)

Q4 2008 Earnings Call

February 10, 2009 9:10 pm ET

Executives

Paul Hiemstra – Investor Relations

Peter J. Ungaro – President and Chief Executive Officer

Kenneth W. Johnson – Senior Vice President, General Counsel and Corporate Secretary

Brian C. Henry – Executive Vice President and Chief Financial Officer

Analysts

Chad Bennett – Northland Securities

Douglas Reid – Thomas Weisel Partners

Glenn Hanus – Needham & Company

Sid Parakh – McAdams Wright Ragen

Daniel Berkley – O’Conner

Operator

Good afternoon, ladies and gentlemen, thank you for standing by. Welcome to the Cray reports Fourth Quarter 2008 financial results conference call. During the presentation all parties will be in a listen-only mode and following today’s presentation the conference will be opened for questions. (Operator instructions) This conference is being recorded today Tuesday, February 10 of 2009. At this time I would like to turn the conference over to Mr. Paul Hiemstra. Mr. Hiemstra is Director of Treasury and Investor Relations. Please go ahead, sir.

Paul Hiemstra

Good afternoon. I’d like to thank everyone for joining us today. Participating from Cray are Pete Ungaro, President and Chief Executive Officer; Brian Henry, Executive Vice President and Chief Financial Officer; and Ken Johnson, Senior Vice President and General Counsel.

This call is being broadcast live on the Internet and recorded for replay purposes. A replay will be available shortly after the call. You can access the replay by dialing 1-800-405-2236. International callers can dial 303-590-3000. You must then enter the access code 11126368 followed by the pound sign. A replay will also be also available in the Investor Relations section of the Cray website for 180 days at www.cray.com.

During the course of this call management will make projections or other forward-looking statements regarding potential future events or the financial performance of the company. We want to caution you that such statements are current expectations, and actual events or results may differ materially. Please refer to the documents, which the company files from time-to-time with the Securities and Exchange Commission. They contain and identify important risk factors that could cause the actual results to differ materially from those contained in the projections or forward-looking statements.

With that, I would like to turn the call over to Pete Ungaro.

Peter J. Ungaro

Thanks you Paul and thank you all for joining the call today. I’d like to begin with some comments around our 2008 performance and progress on our key focus areas for the year. Brian Henry will then discuss the financial results and our outlook for 2009, and following Brian's comments, I will lay out our priorities going forward, and open up the call for Q&A.

Without a doubt, 2008 was an exceptional year across the board. We made great strides toward our corporate goals of growth and sustained profitability, while expanding our addressable market and improving the balance sheet. We delivered strong growth both year-over-year and historically posting a 52% annual increase in revenue, driven by strong growth in both products and services.

Gross margins also increased for the fourth straight year, a solid streak as we continue to improve internal processes and deliver highly differentiated supercomputers at exceptional value. Our $111 million gross profit in 2008 was also a company record and a 70% increase over 2007.

When excluding the non-cash goodwill impairment from our results, we posted a significant profit for both the quarter and the year. Now, I’d like to take some time to give you a view of our progress against the three key priorities we discussed throughout 2008, which were designed to enable us to achieve our long-term goal.

First we continue to focus on our product development, delivery, and acceptance plans. Along these lines, we launched two new products in 2008. The XT5 and CX1, both designed to expand our addressable market, improve our competitive position in the HPC industry, and grow market share.

Our flagship XT5 system began shipping in the third quarter, and is a most scalable Linux-based supercomputer in the world, combining unprecedented sustained application performance with exceptional manageability, and lower cost of ownership. This outstanding value continues to drive strong demand in the market as we now ship more processors through our XT line than any other supercomputer line in our history, even going back to the days of Cray Research. Since we started shipping in Q3, we have delivered nearly 400 XT5 cabinets, an additional 100 cabinets worth of XT5 upgrades to customers around the globe.

In order to satisfy this unprecedented demand, we need substantial enhancements and improvements to our manufacturing facility and processes, a concerted effort to increase efficiency and repeatability. We expect these improvements to continue to pay dividends throughout 2009 and beyond.

Of all of the Cray XT5 systems in service, the largest installation known as Jaguar, resides at the Oak Ridge National Laboratory. This system is remarkable on several levels and I want to try to give you a feel for the scope of this amazing supercomputer. Jaguar consists of 284 refrigerator size cabinets, all scaled together to form an incredibly powerful and efficient system, cooled by innovative ECOflex liquid cooling technology. This system takes up a little more floor space than a basketball court. Its peak performance is 1.64 petaflops, which is equal to 250,000 computations every second by every human on the planet.

This performance is driven by a 180,000 processor cores computing data held in 362 terabytes of memory, which is over three times more memory than the next largest memory system in the world. Over 4,300 miles of Cray C-STAR cables tie all the processors in the system together and over 4 miles of Infiniband cables connect the system to more than 16,000 discs, serving data to and from the machine at a rate of over 280 gigabytes a second.

In just a few days after we installed the system, Jaguar is up and running scientific applications ranging from material science to combustion research across the entire machine, and one of the first and still the only system in the world to run a scientific application at over one petaflops of sustained performance. It did this on two different applications all within a month of booting the full system for the first time. It is truly an amazing system and one that we are very proud of.

With worldwide acceptance and strong demand, the XT5 is well on its way to becoming the most successful product in Cray’s history. Our second priority was closing new business.

During 2008, we announced several significant wins, which contributed to our results and will contribute substantial revenue during 2009. We were awarded four of the five high performance computing system awards by the Department of Defense, as part of its HPC modernization program. This contract to provide four XT5 systems to be located at top military research centers is one of the largest in the Department of Defense’s history. As of the end of the fourth quarter, all four systems have been installed and three of the four were accepted contributing to our strong financial results for the quarter and the year

Also during 2008 as part of the National Science Foundation’s HPC initiative, we were awarded a multi-phase contract to deliver Cray XT supercomputers to the University of Tennessee with a plan to upgrade this system to near petaflops computing capability in 2009.

Our third key area of focus has been our drive to expand our addressable market by leveraging our products, technologies, and core competencies. To that end, we announced the start of a custom engineering team within Cray focused on designing and delivering custom computing and storage solutions. I am extremely excited about this opportunity and believe our ability to leverage a world-class engineering talent within Cray will give us a competitive advantage within this technology-led services market.

Previously, we have discussed our award for the first phase of a potentially multi-phase custom engineering project to develop the infrastructure for a specialized processing system for the U.S. government.

During the fourth quarter, we completed the first phase of this project and have since shifted our focus to compete for the next phase of the program. This type of project is representative of the opportunities we are pursuing to leverage our expertise in building the world’s most advanced supercomputers.

Though this is a modest beginning and the financial impact is still ramping, we’re optimistic about our prospects in this space and we are starting to gain traction. We announced the Cray CX1 personal supercomputer which effectively doubled our addressable market. This system announced in partnership with Microsoft and Intel is a most affordable supercomputer we have ever offered and is designed to drive high productivity computing further into the mainstream, including new industries for us, such as petroleum, transportation, manufacturing, and financial services.

We recently announced several resellers covering different territories around the world, including the Unites States and Japan, and we hope to announce several more in the near future, further expanding our sales reach.

We announced an extremely exciting initiative during 2008 to add Intel processors into our product line. This initiative is already underway as we use Intel processors in our CX1 systems and we expect to deliver Intel based high-end supercomputers to the market by 2012, further evidence of our commitment to deliver on our adaptive supercomputing vision.

We also undertook a significant repurchase of our convertible notes during the fourth quarter. We repurchased over half of our outstanding debt at a significant discount substantially improving our balance sheet. I want to take a moment and thank all of our employees around the globe for their exceptional efforts to make 2008 a record year for the company. 2008 was a great example of what Cray can accomplish in this exciting marketplace.

With that, I’d now like to pass the call over to Brian Henry

Brian C. Henry

Thanks Pete and good afternoon everyone. As Pete mentioned, we had a very strong 2008 and fourth quarter. We were able to deliver outstanding revenue growth and significantly improved our gross profit margin. As Pete mentioned, excluding goodwill, we delivered very healthy net income. In addition we successfully executed a substantial convertible note repurchase program reducing our debt by over 65%, resulting in a non-operating gain of $4 million.

But before I get to the outlook, let me first take you through the 2008 full year and fourth quarter financial results. For the full year 2008, revenue grew 52% to $282.9 million, compared to $186.2 million in the prior year.

The result significantly exceeded our most recent outlook. Product revenue for the year was $219 million, with the service revenue making up the rest of $63.9 million, both strong growth over the prior year. Fourth quarter revenue was a $155.4 million driven by the acceptance of the $100 million Oak Ridge National Labs petaflops system. For the quarter, product revenue was a $137.4 million and service revenue was $18 million.

As we anticipated on our last call, the end of the year was the most remarkable time for Cray system acceptances, which resulted from a combination of an extraordinary effort across the entire company. Revenue for the fourth quarter was approximately $20 million higher than what we had anticipated during our last earnings outlook. The majority of the difference resulted from the acceptance of the three XT5 systems for the Department of Defense as Pete mentioned earlier.

For the full year, our reported net loss was $31.3 million or $0.96 per share as a consequence of $54.5 million non-cash goodwill impairment recorded in the fourth quarter. Without the recorded impairment and excluding the gain on the note repurchases, Cray would have had annual net income of $19.1 million as net income. And after adding back stock compensation as many of you do, 2008 annual income would have been $22.5 million. For the fourth quarter, we have reported a net loss of $20.7 million or $0.63 a share, again excluding goodwill and stock compensation and the gain on the note repurchases.

Net income for the fourth quarter was $30.7 million, or you can compute that as a percentage of market cap it’s pretty high percent. For the year, total gross profit margin improved to 39.3%, this compares to 35.1% in 2007 and was driven by significantly improved product margin of 38.9%. With strong growth in revenue and margins during 2008, our annual gross profit Cray’s value added increased 70% to $111 million over 2007 a record for Cray.

For the fourth quarter, total gross margin was 36.2% compared to 29.6% in the prior year, product margin for that quarter was 35.9% and service margin was approximately 38.5%. Core operating expenses consisting of research and development, sales and marketing, and general and administrative expenses, for the year were $93.5 million, this compares to $75 million in 2007. Fourth quarter 2008 core operating expenses were $27.2 million, compared to $21.9 million in the prior year period.

As anticipated, the annual and the fourth quarter increase to core operating expenses was driven by higher R&D costs as well as commissions and variable compensation associated with the company’s strong performance. For the year, depreciation and amortization was $10.2 million and stock compensation was $3.4 million, for the fourth quarter, these non-cash items were $2.2 million for depreciation and amortization and $0.9 million related to stock compensation

We ended the quarter and the year with a very strong balance sheet. Net cash, consisting of cash and short-term investments, less the outstanding notes, was $52.7 million. This compares to $23.6 million as of September 30, 2008. Inventory decreased substantially in the fourth quarter to $80.4 million from $152.6 million at the end of Q3, this is a reflection of a huge amount of product revenue recognized during the fourth quarter.

Inventory at customer sites at year-end and in the acceptance process was approximately $56 million. We began the fourth quarter with $80 million in outstanding convertible notes, which are expected to be put to us by the holders on December 1, 2009. After careful analysis of our cash forecast and position, we repurchased a total of $52.3 million of these notes in a series of private transactions during the fourth quarter.

Our average purchase price on these transactions was approximately 91% of par value plus secured interest and fees and at significant savings resulting in that $4 million gain mentioned earlier. While these transactions clearly reduce our short-term cash position, this has had a positive impact on our net cash position as shown at the end of the quarter and reduces our net cash interest expense over the remaining life of the notes.

During the fourth quarter, we also were notified that we passed a milestone in the amended agreement covering the DARPA high-performance computing systems program, passing of the milestones was achieved in coordination with an updated agreement between DARPA and Cray that now includes the use of Intel technology.

We recorded a goodwill impairment of $54.5 million due to the plan of our market capitalization during the fourth quarter. The impairment charge does not impact our cash balances, cash flow from operating activities, or our ongoing operations. I would now like to take a moment to discuss our outlook.

For 2009, a wide range of potential outcomes remained, with key drivers being customer acceptances and winning new business. We now expect revenues in the range of $260 million, quarterly revenue will fluctuate depending on system acceptances. However, we currently anticipate quarterly revenue to be weighted more evenly throughout 2009 than previous years.

As we discussed previously, about $20 million was recognized during the fourth quarter that was previously expected to be recognized in 2009. So by reaffirming our previous 2009 revenue target, we actually are improving our revenue guidance by $20 million for the combined 2008 and 2009 period. So, we're upping our guidance by $20 million. We are now more confident in our ability to close new deals and recognize revenue on the remaining business necessary to achieve this new increased target.

Overall gross profit is expected to decline to the low to mid 30% range driven primarily by the unfavorable impact of a multi-phase contract for about $40 million. Core operating expenses are anticipated to be down roughly $2 million from 2008 levels, based on these revenue margin assumptions and a small operating loss for 2009 remains likely. Other income and expenses are expected to be neutral in 2009 with income taxes anticipated to be about $1 million. We expect net cash to be generally above the year-end 2008 level of $53 million.

In summary, I am very pleased with our fourth quarter results, 2008 was a banner year in terms of revenue and gross profit, with the solid supercomputing business and a significantly expanded addressable markets through our new initiatives, we are well positioned for the future growth and improved profitability. Pete?

Peter J. Ungaro

Thanks Brian. We are clearly very pleased with our 2008 annual and fourth quarter achievements. Having said that we remain firmly focused on execution for 2009 and beyond. We’ve made it this far into the call without mentioning the worldwide economic crisis and that is for good reason. Today Cray has not been materially impacted. We are growing and see the potential in the market to continue to grow through this crisis. We are in extremely unique position as well our largest competitors are reducing their investment in high-performance computing, we are increasing ours.

We have the cash and balance sheet to sustain us during this period and with our continued focus and investment in future growth, we are driving to come out of 2009 in a better market position than we are entering it and that saying a lot with our 2008 results. For 2009, we remain focused on the same three key priorities.

First, to close new business in 2009 and beyond. We have already closed a good portion of the business needed to deliver on our 2009 outlook. However, we still need to work - we still have work left to do to drive to our goals of growth and profitability, despite the current economic climate, the opportunities for new wins are out there

As I mentioned earlier, our products and services offerings remain very competitive on both performance and value. Given where we are in the year and looking at our current sales opportunities, we believe that the potential for upside to our 2009 outlook exists. Second, to continue to make headway against our development, delivery, and acceptance plans.

Execution on product development is and will continue to be a critical focus area. We have two major upgrades to our XT5 system planned in 2009, and two more planned for 2010. Finally, our third key priority is to leverage our engineering talent and technology, along with partners such as Intel, AMD, Microsoft, and our own Cray brand in order to expand our addressable market.

Here, our focus is on ramping our CX1 and custom engineering businesses. We are also planning to further expand the addressable market of our XT5 system with an announcement we have coming in the first half of this year. Since the beginning of 2008, we have more than doubled our addressable market as we continue to seek out ways to broaden our reach within the HPC industry and expand our market share.

With the progress and momentum discussed today, and continued focus on execution, we are well positioned to deliver on our long-term goals of growth and sustained profitability. With that, I would now like to turn the call over to the operator to begin the Q&A.

Question-And-Answer Session

Operator

Thank you, sir. (Operator Instructions). And our first question is from the line of Chad Bennett with Northland Securities. Please go ahead.

Chad Bennett – Northland Securities

Yeah hi, good afternoon guys, and I don’t know what to say, but great quarter and the working capital and cash improvement in this environment is phenomenal. So, I just want to say that first.

Peter J. Ungaro

Okay, thanks Chad

Chad Bennett – Northland Securities

I guess Brian, maybe I will start out with you real quick and just trying to understand kind of what’s in and what’s not in your net cash that you ended up within the quarter. Can you give me a sense, I am not sure how much we had left from a cash perspective to get from Oak Ridge, did we in fact get whatever we were owed. And then secondly, I know we recognize the milestones for achievement in terms of the offset to R&D, but did we physically get that cash in the quarter?

Brian C. Henry

Okay, good questions, Chad. Well as you look at the balance sheet that we have accounts receivable of almost $96 million. We have a lot of money to collect. About $45 million of that is the remaining portion of the Oak Ridge petaflop machine. We did actually receive cash on the at DARPA milestone before the end of the quarter, which is very helpful.

Chad Bennett – Northland Securities

Okay.

Brian C. Henry

We feel very good with the cash balance that we have and the accounts receivable that we carry into the year to have strong cash flows at least at the beginning of the year.

Chad Bennett – Northland Securities

Okay so, is it, I don’t know if it’s fair to say, however you want to term it -- at the end of the March quarter net cash should likely improve again all else equal?

Brian C. Henry

Yes, I would say that. In what we disclose we indicated that we expected net cash to generally be above the $53 million throughout 2009. It’s possible that at quarter end it could be lower than that but in general we expect it to be above that.

Chad Bennett – Northland Securities

Okay and then Pete you talk about - you guys sound very confident in the guidance and outlook I guess you gave for fiscal year ‘09 and indicate, a decent amount is away there. I guess is there anyway to, I don’t know if we can compare your visibility going into this year, compared to last year, because I think last year your visibility was pretty darn good, but is there any way to characterize the confidence in the 260 and how far down we are in terms of to that number and then also on top of that, can you give us a sense of your conviction related to -- your new I guess products and services that being the custom engineering and kind of the material nature of that in ‘09 and then the CX1 kind of what should we expect from a incremental opportunity there, I guess looking out over the next 12 months?

Peter J. Ungaro

Okay, great questions Chad. First of all the visibility, so, to the 260 number we have excellent visibility into the outlook. We see all the potential transactions. We haven’t won them all, we got a lot of work left to do in order to convert those opportunities into sales and then shipping products and getting those accepted by the end of the year, but as we sit here in early February, we feel like we have a really solid visibility into our current outlook which gives us a lot of I guess bullishness on our ability to maybe convert some other opportunities and improve that outlook overtime although clearly it's way too early to call that. I will say that our pipeline has improved over the last quarter across virtually every geography So, one of the things we talked about last time on the call was that our pipeline was, we needed to continue to really work on our pipeline. The sales team did a great job of improving that pipeline both in quantity as well as quality of that pipeline and virtually every geography around the world.

When we look at kind of our two major strategic initiatives that we have going on custom engineering and the CX1, we are obviously, very excited about both of them. When we think about custom engineering in our current outlook at 260, we plan on custom engineering contributing somewhere north of $20 million to that overall. So, it’s starting to become something that’s pretty material overall to our business. We also have a pipeline in custom engineering that gives us the opportunities to hopefully go even above that number, but it is becoming, as we talked about last year, kind of small for 2008 in its first year, but in 2009 being material to our business overall. You did see the service number come up in the fourth quarter and lot of that is starting to see a little bit of the impact of custom engineering team.

On the CX1, we have sold a number of early systems and we are really just starting to ramp that product. Really we have two major keys for us in 2009, for the CX1 the first is supporting Intel Nehalem processor. Intel has announced that in 2009 they are going to come out with a new processor known as Nehalem and of course our CX1 needs to be there right with it and we definitely have plans for that once Intel brings that to market. The second and even more importantly in my mind is building out our sales channel partners around the world. This is a product that we need to have broader distribution on than we have in our current high end product And our plan for that is to build out a sales channel around the world. You’ve seen kind of the first announcements of a few partners mostly in U.S. and in Japan for the CX1 and over the next couple quarters, we are going to be very focused in building up that distribution channel around the world.

Chad Bennett – Northland Securities

Can the CX1 business just it’s not necessarily comparable in terms of opportunity, can it be equivalent to the custom engineering in terms of materiality to your business in ’09?

Kenneth W. Johnson

Yeah while we think that it’s going to be a very important business for us in 2009, I don’t believe that it’s going to be at the level of materiality that the custom engineering business is going to be for us.

Chad Bennett – Northland Securities

Okay good. And then Pete, you talked about a couple upgrades to the XT5.I believe in ’09 and then a couple in ’010, or any of the upgrades related to or connected to upgrades with your chip partner AMD in terms of going to the next level of course at some point mid year and can you give us a sense for, if that impact is what it’s connected to I guess?

Peter J. Ungaro

Yeah, so one of the upgrades is definitely support, that’s a major upgrade for us. It’s support for a next generation AMD processor that’s targeted kind of in the second half of 2009 right now. They’ve announced a little bit about it publicly, they call it Istanbul and that’s going to be a pretty major upgrade for us overall. It really increases the performance on a per processor basis and AMD has been executing very nicely along their development of that processor. So, we are very excited about that and that should be to us and in our systems in the second half of this year.

Chad Bennett – Northland Securities

Okay, all right. And then, I guess the last question is, do you expect, I guess, what are you seeing from a competitive standpoint in business you are kind of currently bidding on or is coming through the funnel right now in light of, one of your competitors having I think serious financial issues again that being Silicon Graphics and I know you don’t compete with them as much as you do IBM but any opportunity there?

Peter J. Ungaro

We definitely see opportunity broadly in the market. As I mentioned, despite the economic crisis, I think people understand that the value of high performance computing can really aid then in this kind of time. I mean, this is the time when people focus more on efficiency and doing things efficiently in high performance computing is a way for companies to improve and governments to improve their efficiency overall. So we do see that. On the competitive front, we haven’t seen too many major announcements - product announcements from our competitors. I think the biggest one Chad, is the IBM award with Lawrence Livermore National Laboratory that’s called Sequoia, which is a pretty large system out in the 2012 timeframe with a next generation BlueGene project that they called BlueGene/Q. It’s pretty much well known in the industry that Livermore was going to likely select IBM because Livermore has selected IBM I think for 15 years in a row for all of their high end computing. So I don’t think that that was a surprise to anyone and of course our Cascade program that we are doing for DARPA, comes out roughly that same timeframe. So we think that we are going to have very competitive products in that timeframe. We have our own plans out in that timeframe for a system. So, we really feel like our products are very nicely positioned out there competitively and we haven’t seen anything from any of our competitors that we weren’t expecting and continued opportunities because of some of the, investment changes at some of our competitors are making in the market i.e. Lowering their investments overall in HPC.

Chad Bennett – Northland Securities

Okay, I think I might know the answer to this one, but this is my last question, care to share any details on the market expansion opportunity that you plan to announce related to the XT5 in the first half?

Kenneth W. Johnson

You know my marketing team just allowed me to give you that one little insight to it Chad, so, we’re going to save them, but watch the space in a couple months and that we’re planning on a nice announcement, to really continue our path in growing our addressable market, that's been a big focus for us. Over the past year, we did that in our high end line when we announced the XT5 that got us into a bigger part of the high end market. Clearly the CX1 opens up that addressable market, the custom engineering program opens up that addressable market even more, and then what we want to do is take our XD to an even even broader market and then we plan on announcing that in the first half of this year. So, we will keep you, on that one for a couple more months Chad.

Chad Bennett – Northland Securities

Okay, thanks. Look forward to it. I will jump off.

Kenneth W. Johnson

Thanks Chad.

Peter J. Ungaro

Thank you, Chad

Operator

Thank you. Our next question is from the line of Doug Reid with Thomas Weisel Partners. Please go ahead

Douglas Reid - Thomas Weisel Partners

Thanks. Most of my questions have just been answered, but couple more. If you could help me to understand, of the remaining $55 million striping out Oak Ridge, can you give a number on the custom engineering and what kind of ramp rate, I mean linear ramp through ’09? Or how should we think of modeling that custom engineering revenue on it?

Brian C. Henry

You are taking the 95 and backing out Oak Ridge in accounts receivable, is that the question just to confirm?

Douglas Reid - Thomas Weisel Partners

Yes

Brian C. Henry

Okay, the custom engineering part on the remaining receivables is just pretty small. So, at year-end that wasn’t a material number in terms of accounts receivable, and then your second question?

Douglas Reid - Thomas Weisel Partners

Sure, just going back to original guidance for the December quarter you just reported. Wondering if you had three of the four systems embedded in your original guidance? Or how many was it and then how many to be filed?

Brian C. Henry

We actually had none of the four systems expected. We thought for a variety of reasons that we wouldn’t get acceptance until the first quarter, early in the first quarter we thought in January for all four of those systems. It turns out with really very good execution by a combination of all our field team and manufacturing. We had got three of those acceptances in Q4 and they weren’t all of the $20 million in difference, but they were a significant part of the $20 million.

Douglas Reid - Thomas Weisel Partners

Okay that’s it for me. Thanks and congratulations on the execution.

Kenneth W. Johnson

Thank you, Doug.

Operator

Thank you, our next question is from the line of Glenn Hanus with Needham & Company. Please go ahead.

Glenn Hanus – Needham & Company

Good afternoon guys and congratulations to you.

Peter J. Ungaro

Thanks Glenn.

Brian C. Henry

Thanks Glenn.

Glenn Hanus – Needham & Company

Maybe you could talk about your positive outlook in light of, talk about the government budgets, and is the outlook more based on some of that what’s going on with the available budgets or competitive advances that you are feeling maybe you could sort of talk about those topics and tie it into your improved guidance?

Peter J. Ungaro

Okay that’s a great question Glenn. So, I just want to start off by saying that the current stimulus packages are not built into our 2009 outlook. Our 2009 outlook has come up because of two things really, the competitiveness of our products that we’re seeing in the market holding and really improving as well as the ramping up of our initiatives such as custom engineering and the CX1. So, that’s really that the main driver in the outlook coming up $20 million. One of the options going around right now with government budgets, by the way we see no weaknesses right now in the government budget as far as what our plans are for 2009. We do see some potential upside right now which is the stimulus build, which just passed the Senate today, it already had passed the House previously. So now we have two different stimulus bills, very different contents in each bill and now the Senate and House are going to conference to try and figure out what the final version that they are going to take to the White House.

And we’ve heard that they have a hope to take it to the White House by the weekend although, they may not quite make that goal, see how that plays out in conference. But there is a potential that some of the stimulus will include supercomputing budgets, which we’d get a chance to compete for and we think would open up some incremental opportunities for us that aren’t currently in our pipeline right now and once obviously we would go after aggressively. So, we do see some upside potential with the stimulus budget and but we’ll just have to wait a little while to hear what’s going to play out, then it’s probably going to take a few months before we really know how that money is going to play out and work its way through the budget. So probably by the next call, we’ll able to give you a better insight to, if that’s going to have any impact on our ’09 or even 2010 outlook as we go forward.

Glenn Hanus – Needham & Company

So is it in the $400 million to $500 million range, sort of mark for supercomputing depending on, which bill you look at right now?

Brian C. Henry

Yeah it’s a tricky thing. So on the House side, it’s somewhere just north of 400, the Senate side, it was lower than that. And you never know Glenn, at the end of the day, how much is going to go to systems versus facilities and infrastructure, and people, and everything like that, but those are roughly the numbers that have been kicked around. Again the House is kind of quite high in the 400 plus range. Senate is much lower than that, and now they go to conference and work things out and figure out the final package that they going to bring forward. So, until they go through conference, anything can change and we’ll just have to keep a watch for that.

Glenn Hanus – Needham & Company

Then outside of the stimulus package, what about, kind of what’s the state of the rest of the budget in the U.S. and then kind of what you are seeing around the world?

Brian C. Henry

Okay. So in the U.S., the budgets, most of the agencies are on a continuing resolution except majority for us is Department of Defense is not. So, they are already gotten an improved budget and those look very strong for us. Both the agencies are in continuing resolution because we’re in existing programs which continuing resolutions cover. So we see that as strong for us for 2009, as well as in Department of Defense where they’ve gotten an improved budget and they have a plan for 2009. So that’s in the U.S. strong on both sides of the equation.

Outside of the U.S., we still continue to see growing opportunities around the world for us. In Europe, in Asia, and Japan, all three are our kind of major geographies outside of the U.S., we continue to see, like I said, a growing pipeline out there, at both in size of pipeline, as well as quality of that pipeline, which for me is almost more important. So I feel good about the opportunities that we have going on and we’ve even seen some of the other government stimulus packages around the world potentially having a little bit of supercomputing in it. So there may be some other opportunities on more of a worldwide basis as other countries are trying to do, something very similar to what we are doing in the U.S. with stimulus packages that may open up some new opportunities for us and of course we’ll aggressively go after.

Glenn Hanus – Needham & Company

And then Brian, on the model on the gross margin side, how should we model kind of the service margins versus the product margins on average next year?

Brian C. Henry

I think when we say low to mid 30s, you are going to have a service margin that's in the probably high 30s throughout 40%. Service revenues are anticipated to grow over what they were in the current year, peaks are largely from custom engineering. So, that’s a little higher in the mix and probably it should help you to derive what we think product margins could be, but product margins could be in the high 20s to low 30s depending on many variables that we have and that’s why we say low to mid 30s on a weighted both product and services.

Peter J. Ungaro

And I think Glenn it’s important to point out that the product margin side is really significantly impacted by one specific opportunity, about $40 million that has a low margin. So, it’s not - I just want to make a point that we’re not discounting aggressively to get a lower margin there. We are keeping our margins at a good level, but we do have this one opportunity that we talked about last quarter. We talked about before that is holding those a little bit lower than it’s kind of our normal run rate.

Brian C. Henry

And as a reminder, that low margin was a consequence of delays that we had in our ability to deliver the systems as key components were delayed.

Glenn Hanus – Needham & Company

Okay, thank you.

Peter J. Ungaro

Thanks Glenn.

Operator

Thank you. Our next question comes from the line of Sid Parakh with McAdams Wright Ragen. Please go ahead

Sid Parakh – McAdams Wright Ragen

Hey good afternoon, everyone good quarter guys.

Peter J. Ungaro

Thanks Sid.

Brian C. Henry

Thanks Sid.

Sid Parakh – McAdams Wright Ragen

So, just a question along the deferred revenue line, it seems like deferred revenues were lower in the quarter and I am just trying to get a feel for what that means for service revenues going forward? And maybe if you can help us understand what the quarter-to-quarter variation might look like?

Peter J. Ungaro

As you look at deferred revenues, what those really are for the most part is not maintenance, which is part of that when people rebill in advance, people pay us in advance, but the vast majority of our deferred revenues are for product billings for systems not yet accepted and the reason it went down is on Oak Ridge for example they had made a payment to us before revenue recognition that was significant for example. And when we recognized revenue that moved out of deferred revenues lowering it and into revenues that’s where it really goes. And that was just a prebilling before revenue recognition and we have those on several contracts. The big one and the big change was the Oak Ridge deal.

Sid Parakh – McAdams Wright Ragen

Okay and can you help us on the quarter-to-quarter variation?

Brian C. Henry

Yeah that one we said it’s more evenly weighted than in past years, obviously what things get accepted in any particular quarter can move revenue around. So, right now we think that, at least the scenarios we draw, have relatively even revenues in each of the quarters. Now, if we happen to get some delay or some acceleration that could shift that around a little bit, but right now we think that will be relatively even and I say that in the Cray context, big deals and variety of different acceptances

Sid Parakh – McAdams Wright Ragen

Okay.

Peter J. Ungaro

Well, of course to give you, as we go forward in the year on -- at the earnings call we will give you a new kind of update from that perspective, but as Brian said as we see it today it looks pretty even which is a unusual for us.

Sid Parakh – McAdams Wright Ragen

So, just kind of moving on can you maybe help us understand by when do you need all the orders to be in your, I mean, contracted to you to actually be able to fulfill your 2009 outlook?

Peter J. Ungaro

Yeah because we increased the manufacturing capacity of our manufacturing department this year, we’re actually able to have a little bit more flexibility in that area than we’ve had before, but we pretty much would need all the orders sometime by the mid third quarter, maybe late third quarter in order to, in order to really have a view of what’s going to happen for the full year. So, in years past, we would have had to have a little bit longer lead timing there so, we’re able to shrink that down which gives us more flexibility to at the end of the year for instance, they have a stronger year than we had originally expected so clearly, increasing that manufacturing capability to be able to accomplish, what we had to for the XT5 ramp-up has given us other business flexibility that hopefully we’re going to get a chance to advantage of.

Sid Parakh – McAdams Wright Ragen

Okay and then I mean based on your current outlook, do you think you can get in all orders much before that or do you think that’s kind of a reasonable timeframe?

Peter J. Ungaro

You know I hope we continued to get orders every quarter.

Sid Parakh – McAdams Wright Ragen

Right but you know…

Peter J. Ungaro

You know I think we should have a pretty good view when we do our second quarter call kind of whenever that is, then we will have a pretty good view of where the year is going to end up.

Sid Parakh – McAdams Wright Ragen

Okay. Can you also talk about some puts and takes that might actually have an impact on this 260 number being much higher or much lower?

Peter J. Ungaro

Yeah, I will start with the much lower. I don’t see too many scenarios, where it could be much lower. But it can be lower and I would say the majority of that is going to be if we don’t ramp-up the custom engineering with CX1 businesses like we currently plan to, or if we have a major acceptance that we are expecting to get down in the year, today, that we just don’t complete by the end of the year. I would say that those are the two major scenarios…

Brian C. Henry

No, there is a couple orders that if somehow got delayed that we think we might win, it could hurt us too. So, we have work across the front.

Sid Parakh – McAdams Wright Ragen

Right.

Brian C. Henry

So, there are scenarios to have lower, we wouldn’t give you the number of we didn’t think, whereas as many scenarios to do better.

Sid Parakh – McAdams Wright Ragen

Right, right.

Peter J. Ungaro

And so on the flip side of that Sid, I think, clearly it’s almost the opposite right? So, if we can ramp our CX1 and/or our custom engineering business just faster than we currently are projecting, those would be able to really help us out overall in the year. Or if we can convert some of these new orders – some of these new opportunities that we have in the pipeline, that we currently, or maybe a little bit too early in the pipeline to get a good perspective on, if we can convert a few of those extra opportunities to win or as Glenn was talking about, if we get something through a stimulus package either in the United States or abroad, could have a chance to give us some upside overall.

Sid Parakh – McAdams Wright Ragen

Can you maybe help us to understand what may be the majority of the pipeline is, in the sense, I mean how much of your pipeline is focused on 2009 versus 2010 verus maybe even 2011 and again and how you are seeing some of the outer years develop too.

Peter J. Ungaro

Okay. I will try to do this, kind of qualitatively to you. Clearly, the majority of our pipeline is in 2009. Although, we definitely have pipeline out to 2010 and even all the way. So, we have a few opportunities that reach all the way into 2012 in our pipeline because we have been developing these cascade products and there is a lot of people that are very excited about those products. We are just starting to see the front edges of some opportunities that are going all the way out to 2011 and 2012 in our pipeline, but clearly, majority of them are in ’09. I wanted to give you a perspective earlier about the product roadmap because we do have major upgrades to the XT system, and by the way, most of the pipeline is around the high end XT system today while we do have a growing pipeline in both the CX1 and CE - custom engineering areas, it's still relatively small, compared to the volume that we see in the XT business today, which I think is from my perspective what you would expect because that’s been our core business for so long.

And the one thing I wanted to say is we do have a nice upgrade coming this year, as we talked about earlier. Chad was asking questions around the future AMD processors. As well as next year, we have two major upgrades to our systems, the XT system overall, which so that’s really building I think a nice pipeline out ’09 and 2010 and then some people even looking beyond that out to our Cascade projects, which is, in 2011, 2012 kind of timeframe. So I feel like it’s a nice pipeline of course, I like to see it bigger and most importantly, I would like see a convert and that’s really a big focus of ours over the next two quarters.

Sid Parakh – McAdams Wright Ragen

And just going back to the question, on the lower product margins in 2009. Is there any additional risk to that margin numbers, based on that specific contract, are cost basically locked down for that contract?

Brian C. Henry

Yeah. Well, there is always risk. We’ve shipped a significant first phase of that, so we are pretty clear on that, but it is a multi-phase thing and so there are risks. And then somehow that’s one of the phases gets delayed and then it can be punishing.

Sid Parakh – McAdams Wright Ragen

Okay.

Brian C. Henry

So but, I would say that there are always risk. We don’t anticipate them being particularly high at this moment and on that particular thing because the vast majority of the system is already delivered and built.

Sid Parakh – McAdams Wright Ragen

Okay. And would it be fair to say that for 2009, you would be, EBITDA positive? I mean given that you….

Brian C. Henry

No, if you follow the guidance that we gave, there are clearly several scenarios that are EBITDA positive there.

Sid Parakh – McAdams Wright Ragen

Right, okay, and then final question I mean given, where the stock is trading, it’s probably trading at under normalized net cash, at the current level. Do you anticipate..

Peter J. Ungaro

I think that’s an understatement by the way. So that’s okay, keep going.

Sid Parakh – McAdams Wright Ragen

No, I am just saying, so have you guys thought about maybe deploying some of that cash to maybe buyback at least some stock. And I'm not I don’t mean to say an aggressive buyback here, but maybe some of it?

Brian C. Henry

Well we can set our options all the time that’s part of our job. I think our focus is maintaining the net cash, retiring that remaining amount of convertible debt, when it’s put to us at the end of the year as the primary use for that. And when we use cash, when things are really good, so we hope things are real good and we use some cash to support stronger revenue growth than we had anticipated.

Sid Parakh – McAdams Wright Ragen

Okay

Peter J. Ungaro

I’d just add the other thing we are using and investing in for 2009 is in sales and marketing. We are making some pretty targeted investments in sales and marketing where we see good opportunities to continue to grow our business. As I mentioned, we see this as a really exciting time in the market because of the opportunity to growth at a time when others aren’t as focused on the growth side of their business. And we’re making investments for instance in geographies like Europe, as well as of course as you would imagine in our initiatives the CX1 and custom engineering on the sales and marketing side.

Sid Parakh – McAdams Wright Ragen

So just on that front, can you maybe talk about how many distributors do you have at this point for the CXI or any more color on there?

Peter J. Ungaro

Yeah, we have just about a handful of distributors right now for the CX1. We have a couple in Japan, and a few in the U.S. We’re clearly getting a lot of excitement around distributors, around the world. We are going to be very careful in making sure that we set up, we get the opportunity to build the distribution channel from scratch. So that gives us the opportunity to do it rightly and to be very careful in how we set that up. But we plan to have, grow the distribution channel to something that’s manageable. So kind of low double-digits number of distributors with territories kind of spanning the world. So we really want to make sure that we set it out, so that each of our distributors have the chance to do very good with the product and make money and not be competing against other distributors all the time, but competing against our competitors for the customers' budgets.

Sid Parakh – McAdams Wright Ragen

Okay, that’s all right. And I did want to touch the buyback issue again here. Brian, what I’m trying to get there is I mean, you could conceivably probably allocate maybe $10 million to your buyback program, without hurting your working capital needs and $10 million today is probably almost 15% of market capital or outstanding equity?

Brian C. Henry

Yeah, I understand your point. We’ve done work and analysis on that. We have no current plans to do any buyback. It doesn’t mean that that won’t change at some point in the future, but we don’t have any current plans at this point.

Sid Parakh – McAdams Wright Ragen

Okay, that’s all I have, thanks.

Peter J. Ungaro

Thanks Sid.

Operator

Thank you. (Operator Instructions) One moment please. And we do have a question from the line of Dan Berkley with O’Conner. Please go ahead.

Daniel Berkley – O’Conner

Hello, Brian. Hello?

Brian C. Henry

Hi.

Daniel Berkley – O’Conner

Hey, okay sorry to know if I get in here. I guess couple questions. So if we look at the accounts receivable, could you repeat, I think you said the Oak Ridge number that $95 was $45 million?

Brian C. Henry

Roughly, yes.

Daniel Berkley – O’Conner

Roughly and no reason to assume that that won’t be collected in this March quarter?

Brian C. Henry

Yeah, very little concern about that at this point.

Daniel Berkley – O’Conner

Okay, so that’s basically another sort of doubling of your net cash taking out of a couple of the other, both gives and takes in working capital and EBITDA losses for the third quarter, is that the right way to look at, I am sorry for the March quarter?

Brian C. Henry

Yeah we do have, while payables are down tremendously, we do have some other accrued liabilities that will have some cash.

Daniel Berkley – O’Conner

Okay.

Brian C. Henry

So in the first part of year as well. So…

Daniel Berkley – O’Conner

Okay, and then the third the fourth of the four upgrades, the DOD projects you weren’t planning on. I think you said that’s roughly $50 million in or I am sorry, it was total of $56 million in inventory, is the things that haven’t been accepted yet? Is that DoD most of that or is it a number of products?

Brian C. Henry

There is a number, the DoD is probably less than a quarter of that.

Dan Berkley with O'Conner

Okay, so,

Brian C. Henry

Well, less than quarter.

Dan Berkley with O'Conner

56, okay, so, sort of $10 million order of magnitude that…

Brian C. Henry

Yeah more or less.

Dan Berkley with O'Conner

Then how much of that $56 million that is pending customer acceptance do you think, you can cycle into cash, if it were accepted in this March quarter, can you cycle through receivables and get it to the cash line by the March 31 deadline?

Brian C. Henry

Well, there is clearly some of that, now some of that has already been pre-billed and is sitting in both the accounts receivable and deferred revenues. So, the full effect of that is partial plus not all of that will get accepted in final billings in time to get it collected in the first quarter.

Dan Berkley with O'Conner

Of that $56 million, would 25% of it get through into cash in the quarter, did you think? Would that be too far of a stretch?

Brian C. Henry

You know honestly, I haven’t done that kind of an analysis on those particular items.

Dan Berkley with O'Conner

Well I’m just because the reason…

Brian C. Henry

It’s way off from probably what it is, but I haven’t done the analysis so I can’t confirm it.

Dan Berkley – O'Conner

Okay, the reason I’m doing, is if you take the 45 of AR in the 95, you take the almost 50 million of cash, you have on the balance sheet now, or net cash on the balance sheet now, and then you take a percentage of that inventory and figure that cycles through, you can make an argument that you have over, $100 million of net cash in the March quarter. Now I mean there is going to be some usage. So, I mean to tell us that your cash is substantially higher during the year it seems like a bit of a low target. I mean, am I thinking about that the right way? Am I missing some, uses of cash in the March quarter?

Brian C. Henry

Well, we need to get revenue on book and collect cash and other receivables as part of that forecast. We will have pretty strong incoming cash flow in the first part of the year, there is no doubt led by where we are in accounts receivable and as you state, converting that inventory into revenue and some additional billings related to that probably not all the revenue, because we’ve had some pre-billings. We would also state that we had a very strong year and we have a different set of liabilities out there that many of which will be paid off in the first part of the year as well. And so, net cash, while we anticipate it being up for most of the year, it’s hard to say in any particular quarter, what the level will be, there is a view point that we could have more than our market cap and cash and I don’t think that is unreasonable at least for many parts of 2009.

Dan Berkley – O'Conner

Okay and my last question and I'll let you go is, as you look at sort of the pipeline and the acceptances knowing the lumpiness again everything of the business, what do you think would be the low quarter from a net cash standpoint as you look throughout the year?

Brian C. Henry

Well, it’s really hard to tell. If we end up having a strong year and things that we have a lot of activity in the end of the year, the key issue is how much of are we building for revenue late in the fourth quarter or end of the first half of 2010, if there is a tremendous amount of that, then we will tend to use cash and so, I would say, the bigger room for cash go in either direction would be towards the end of 2009. And it’s all a function of what kind of activities and the timing of those, which aren’t typically in our 2009 outlook they may factor into our view of 2010.

Dan Berkley – O'Conner

Okay.

Brian C. Henry

Does that make sense, our cash working capital cycle will like if things are going real well, we’ll be building systems of some magnitude, late in the year working toward 2010.

Dan Berkley – O'Conner

Okay, well. Thank you very much and good luck.

Peter J. Ungaro

Yeah, thank you.

Brian C. Henry

Thank you.

Operator

Thank you (Operator Instructions). And we do have a follow up question from the line of Chad Bennett with Northland Securities. Please go ahead.

Chad Bennett – Northland Securities

Yeah, just one follow up for Brian on the back of the last caller’s questions around cash. Considering your outlook Brian, $260 million in revenue for ’09, I know this is a tough question considering how much things swing, but what type of inventory level would correlate with -- run rate would correlate with kind of a mid $200 million year because if I look at, everything is different, orders are different and what not, but I look at last year, you ended the year in kind of mid 50s in terms of inventory and you did, 280 this year, not that that’s a good way to look at it. But, is $80 million where you ended at right now is that a decent level or can we improve from here?

Brian Henry

Well, we try to manage inventory very close and link us to anticipate that orders that we’re pretty sure about. And we try not to buy the expensive inventory until we need to an order to get things shift out. So, those are our plans and I would say, if you looked at history, $80 million is pretty high, not high compared to the second half of 2008, but it is pretty high and so if we were pretty flat, and we are flat this year, and flat going into next year, then we have probably most quarters everything else equal --- be down in inventory. Again, if we are having a good year and we’re building things for 2010, then we could have inventory in this range.

Chad Bennett – Northland Securities

So I think people accept this if 260 is really 300 a little bit more inventory.

Brian Henry

Yeah. And I won’t be happy if we are not moving along well and inventory stays as high, I assure you.

Chad Bennett – Northland Securities

Okay I get it. Got it, that’s all I have thanks.

Operator

Thank you. And at this time we have no further questions in the queue. Like to turn it back to Mr. Ungaro for any closing remarks. Thank you.

Peter J. Ungaro

Thank you. As we have discussed, we are focused on three key priorities for 2009. Winning new business, delivering on our differentiated product roadmap, and ramping up our new offerings to expand our addressable markets. We’re continuing execution on these priorities. We’re making strides towards our strategic objectives of long-term growth, profitability, and market leadership. Thank you all for joining the call this afternoon and for your continued support of Cray. Have a great evening.

Operator

Thank you, sir. Ladies and gentlemen that does conclude our conference for this afternoon. Thank you very much for your participation and for using ACT Teleconferencing. You may now disconnect.

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