Cray's Big Contract Wins Not Priced In

| About: Cray Inc (CRAY)
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"Actual results for any future period are subject to large fluctuations given the nature of Cray's business."

That disclaimer is attached to every earnings report released by Cray, Inc. (NASDAQ:CRAY), a maker of supercomputers for governments, businesses, and universities. The company's focus on large-scale projects makes revenue reports uneven. In fiscal year 2010, for instance, the company generated $100 million in revenue for the first three quarters -- and $219.4 million in the fourth quarter, pushing the company into the black for the year.

Despite the quarterly fluctuations in sales, Cray has clearly been moving in the right direction. Revenue has climbed steadily over the past five years, with only a hiccup in 2007. The company turned a profit in 2010 and (according to guidance) 2011, after posting annual losses from 2004-2009. (The 2008 loss was driven by a non-cash goodwill impairment charge.)

The good news has accelerated as of late, as the company has announced three big wins in the last two months:

  • Oak Ridge National Laboratory upgrades its Cray supercomputer, at a cost of $97 million. The size of the deal tops the company's previous disclosure that it was awaiting a contract worth "at least $60 million".
  • The University of Illinois' National Center for Supercomputing Applications taps Cray for a new contract, worth $188 million. Cray replaces IBM (NYSE:IBM) on the project, after Big Blue pulled out due to cost and technical concerns. Cray then issues guidance for a profitable 2012.
  • Cray goes international, agreeing to build two new supercomputers for Japan's Kyoto University. The first will be built in 2012, the second in 2014.

The stock has rallied along with the news, jumping over 20% from around $5 per share at the beginning of October to close Wednesday at $6.18.

Despite the rise, the stock still looks undervalued. Cray offers $2.27 per share in net cash, a number that will rise in the fourth quarter. The company received a $12 million milestone payment from DARPA (the Defense Department's research arm) in conjunction with supercomputing R&D, and should also see much of the previous quarters' inventory buildup turned into cash as the balance of revenues is booked in the fourth quarter. (Based on guidance, roughly half of the FY2011 sales will come in the December quarter.) If half of the $47 million inventory buildup is turned into cash, the cash per share balance will rise by at least $1 per share after the fourth quarter, easily putting the company's cash balance at over 50% of its market capitalization.

From an earnings perspective, the company should be profitable in both 2011 and 2012. FY11 earnings should be between $2 and $12 million, according to guidance issued in conjunction with third quarter earnings. On a per-share basis, investors can expect between 6 and 34 cents per share in 2011. FY12 revenue, at the midpoint, is guided to grow 15 percent, with earnings expected to be around $10 million, or 30 cents a share. Given the company's potential for a cash balance in the range of $3.50-$4 a share, such earnings would give the company a forward enterprise value-to-earnings ratio in the range of 7 to 10 at current prices.

None of these numbers are especially eye-catching; yet they show the strength of Cray's balance sheet. Going forward, the multi-year nature of the recent deals should provide earnings momentum past 2012. Additionally, the company's ability to clean up after IBM's mess in Illinois no doubt will impress potential clients. The company had touted its new XE6 and XK6 systems, and the recent wins should give investors confidence that Cray's new products can compete with the likes of IBM and Hewlett-Packard (NYSE:HPQ).

One of the big worries for CRAY investors is its focus on government sales. The company has been slowly diversifying away from its troubling reliance on the federal government, which accounted for 62% of sales in 2010, down from 81% in 2008, according to the company's 10-K. Budgetary worries in DC may cut down on demand for the company's supercomputers. In addition, the DARPA reimbursement -- through which the U.S. Department of Defense has covered some $190 million in R&D expenses for the company -- expires in 2012.

It's hard to predict what effect the debt battle in DC will have on Cray. As noted, the company has successfully grown its customer base outside of the Beltway, and even after the DARPA agreement ends in 2012, the company should have a new product-- its "Cascade" system, available for commercial sales in 2013. Political worries certainly make sense, but it is also very likely that even a negotiated budget deal could have little or no effect on Cray's revenue. R&D spending seems too small an area to become a political football, while defense spending remains a sacred cow to Congressional members on both sides of the aisle.

In the meantime, Cray is executing well, generating earnings, and should offer a cash balance well above half of its current share price of $6.18. Investors may get an uneven ride, waiting for the next big win. But the company's expertise and strong balance sheet make Cray stock worth owning.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.