Cray Positioned For Growth But Still Too Pricey

| About: Cray Inc (CRAY)
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Cray’s revenue is expected to grow 14% in 2014. The rapid revenue growth should continue because recently management has been able to win several sizable contracts.

The High Performance Computing and Big Data industries are expected to grow rapidly over the next several years. Cray is well positioned to take advantage of this growth.

Although there are only 3 major competitors, the High Performance Computing market is very competitive and profitability is suffering.

Cray is positioned for growth but investors are pricing in a significant amount of future growth. At the current valuation, the company’s stock is very risky.

Gaining Momentum

Cray Inc. (CRAY) is a technology company specializing in the manufacturing and servicing of high performance computers and data storage systems. In Q2 2014, Cray reported revenue of $85 million and a net income loss of $6.7 million. On a year over year basis, Cray grew revenue by 0.6% and narrowed its net income loss by $3.1 million. The company's second quarter results were aided by better than expected Q2 revenue. Second quarter revenue was $10 million higher than management had forecast. Management attributes the higher revenue to several deals closing in Q2 instead of Q3. Since the $10 million wasn't additional revenue, management was only able to reaffirm their full year guidance of $600 million rather than raise it. Even so, Cray is still on pace to grow revenue 14% y/y. Cray's double digit growth should continue into the future due to the industry's rapid growth and management's ability to close deals.

The High Performance Computing industry is expected to grow 7.3% from 2012 to 2017, according to the IDC. Big data revenue is estimated to reach $16.1 billion by 2014, according to the IDC. The IDC estimates the big data industry will continue to grow rapidly with some segments growing as fast as 50% annually.

Recently, management has been awarded contracts in excess of $400 million. In the last month alone, management was awarded a contract from the National Nuclear Security Administration worth $174 million. The National Nuclear Security Administration contract also known as Trinity represents the company's largest contract ever. With the trinity deal, management is integrating their big data solutions with their high performance computing business. Along with the installation of high performance computer hardware, Trinity will require the installation of a storage system three times larger than anything the company has ever installed, according to the CEO Peter J. Ungaro on the Q2 conference call. Additionally, Cray is preparing to install several more storage systems in the second half. The company is beta testing their second generation data analytics software with an overseas commercial client.

Cray's first half performance has been good and they are set up to have a good second half. Management has reaffirmed guidance and the company has been awarded several large contracts. Management has shown the ability to significantly grow revenue but hasn't been able to generate significant operating growth and sustainable net income growth.

Cray's Inconsistent Margins

Cray's management has been able to consistently deliver high gross margins. The company's product revenue margin has been near 35% and service gross margin has been near or above 40%, since 2009. Management expects this to continue into 2014 with gross margin estimated to be in the mid 30s. Despite sizeable gross margins, management hasn't been able to deliver sizeable operating margin.

Margins 2009 2010 2011 2012 2013
Operating -0.1% 5.5% 0.5% 40.0% 4.1%

Cray has produced low to mid single digit operating margins since 2009 with the exception of 2012. However, the 40% operating margin in 2012 was achieved with the help of a onetime sale of Cray's interconnect hardware development program to Intel (INTC). After removing the onetime item, the company's operating profit margin was 6.9%. Using 6.9% for 2012, Cray's average operating profit margin was 3.2%, from 2009-2013. Cray's inability to generate consistent and high operating margin has resulted in a significant difference in the company's revenue and operating growth. Since 2010, Cray's total revenue has grown 64.6% but operating revenue has only grown 23.8%. Cray needs to improve their operating margin along with increasing revenue growth or the company's operating income will continue to lag.

Although operating margins have been inconsistent and low, Cray's net income has been relatively stable. Yet, Cray's net income margins are unsustainable. Cray's net income margin has been supported by tax benefits.

Net Income Breakdown 2009 2010 2011 2012 2013
Tax Benefit (Provision) 874 -1,878 14,194 -7,491 11,194
Net Income -604 15,062 14,329 161,241 32,223
Net Income Margin -0.2% 4.7% 6.0% 38.2% 6.1%

In fact, Cray's net income in several years can mainly be attributed to tax benefits. Tax benefits accounted for 99% of net income in 2011 and 34% in 2013. In 2009, tax benefits prevented a $1.5 million net income loss. The company can't sustain net income growth through temporary tax benefits and onetime sales. Ultimately, Cray will have to improve operating margins which will in turn improve net income margins and growth. Cray's operating margin issues can't entirely be attributed to the company's inefficiencies. Several major companies in the HPC industry are struggling to remain profitable.

Industry Competition Causing Profitability Issues

The HPC industry's revenue was $10.3 billion in 2013. The $10.3 billion in revenue was down 7.2% from 2012. Although the industry declined in 2013, the IDC estimates the industry will grow 7.3% from 2014-2017. The HPC industry is highly concentrated with 3 major competitors International Business Machines (IBM), Hewlett-Packard (HPQ), and Cray. Hewlett-Packard is the market leader with an estimated 36.4% market share, according to Server Watch. Server Watch estimates IBM is second with a 35.2% market share and Cray is third with a 10.2% market share. These three companies represent over 81% of the HPC market. Yet even in a rapidly growing market with few competitors, companies are struggling to sustain profitability.

Operating Margins 2011 2012 2013
Cray 0.5% *6.9% 4.1%
HP 20.0% 17.4% 15.3%
IBM(EBT Margin) 8.2% 6.7% -3.4%

*excludes onetime gain on sale of interconnect program.

Hewlett-Packard and IBM have experienced rapid declines in profitability over the last three years. Cray's operating margins have been inconsistent and declined from 2012. The intense competition is causing operating margins to compress. Profitability should remain an issue into the future.

Hewlett-Packard has introduced their Apollo 8000 water cooled system. The system isn't the first water cooled system but Hewlett-Packard is using water and piping instead of submersing the servers in liquid. This improves the flexibility of the system by allowing workers to quickly fix and repair servers. IBM is expanding their HPC efforts through the cloud. They are offering customers of SoftLayer (cloud based computing) access to InfiniBand which drastically improves network speed and reduces latency. Despite the industry's rapid growth, margins should continue to be pressured because of the competitiveness of the industry. Despite Cray's margin issues investors are still willing to pay a significant premium for their shares.

High Valuation

Cray is well positioned to grow revenue rapidly. The HPC and big data industries should continue to grow substantially over the next few years. This anticipated growth has driven investors to pay high multiples for Cray's stock. Comparing Cray to their closest competitors shows the company's high valuation.

Valuation Metrics Cray HP IBM
P/E 43.6 12.7 13.3
Forward P/E 29.0 9.2 9.8
P/S 2.1 0.6 2.0
EV/EBITDA 32.2 5.7 9.1
Market CAP/EV 126.6% 89.8% 84.1%

Data Source: Yahoo Finance- Key Statistics

Cray is trading at a significant premium according to several valuation metrics. Cray is trading higher than Hewlett-Packard and IBM based on the P/E, Forward P/E, P/S, and EV/EBITDA ratios. Cray's stock trading at a higher valuation isn't surprising given the company's growth rate compared to IBM and Hewlett-Packard. The surprise is the spread between Cray and the other two companies. Cray is trading at nearly 3.5 times IBM and HP on a P/E basis. The company is trading nearly 2.5 times on forward P/E. Additionally, the company is trading at a significant premium to their enterprise value. Even though Cray is expected to grow rapidly, the company's equity is very risky at the current valuation.

For example, Cray reported earnings on July 29th and due to softer than expected Q3 guidance, the stock has fallen from $29.00 to around $26.70 a decline of 7.9% in less than two days. Cray is well positioned and management has been performing well but the company's stock is trading at significant premium. Investing at these high levels requires Cray to execute nearly perfectly in order to generate a risk adjusted profit.

Cray Has Great Growth Potential But High Valuation

Cray has established a significant market position in the HPC industry. They are starting to establish a foothold in the big data industry. Recently, management has been able to secure over $400 million in contracts. The company is expanding their big data penetration with the Trinity project and several additional installations in the second half. Management is beta testing their second generation data analytics software. The company is positioned to grow rapidly along with the HPC and big data industries.

Yet, the company still has issues. Management hasn't shown the ability to maintain high operating margins. After temporary drivers of net income disappear, Cray's low operating margins will cause issues with net profits. Investors are excited about the future growth prospects of Cray and have priced this growth into the stock. Currently, Cray is trading at a very high valuation and will need to continue executing flawlessly in order for the stock to out-perform. Cray's current valuation and extremely low profitability make the stock a very risky investment.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.