NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1— Basis of Presentation
In these notes, Cray Inc. and its wholly-owned subsidiaries are collectively referred to as the “Company.” In the opinion of management, the accompanying Condensed Consolidated Balance Sheets, Statements of Operations, Statements of Comprehensive Income (Loss), and Statements of Cash Flows have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP, for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. Management believes that all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included. Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and notes thereto included in the Company’s annual report on Form 10-K for the fiscal year ended
December 31, 2015
.
The Company’s revenue, results of operations and cash balances are likely to fluctuate significantly from quarter to quarter. These fluctuations are due to such factors as the high average sales prices and limited number of sales of the Company’s products, the timing of purchase orders and product deliveries, the revenue recognition accounting policy of generally not recognizing product revenue until customer acceptance and other contractual provisions have been fulfilled and the timing of payments for product sales, maintenance services, government research and development funding and purchases of inventory. Given the nature of the Company’s business, its revenue, receivables and other related accounts are likely to be concentrated among a relatively small number of customers.
Principles of Consolidation
The accompanying condensed consolidated financial statements include the accounts of Cray Inc. and its wholly-owned subsidiaries. All material intercompany accounts and transactions have been eliminated.
Use of Estimates
The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the amounts reported in the Company’s condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.
Revenue Recognition
The Company recognizes revenue, including transactions under sales-type leases, when it is realized or realizable and earned. The Company considers revenue realized or realizable and earned when it has persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Delivery does not occur until the products have been shipped or services provided to the customer, risk of loss has transferred to the customer, and, where applicable, a customer acceptance has been obtained. The sales price is not considered to be fixed or determinable until all material contingencies related to the sales have been resolved. The Company records revenue in the Condensed Consolidated Statements of Operations net of any sales, use, value added or certain excise taxes imposed by governmental authorities on specific sales transactions. In addition to the aforementioned general policy, the following are the Company’s statements of policy with regard to multiple-element arrangements and specific revenue recognition policies for each major category of revenue.
Multiple-Element Arrangements.
The Company commonly enters into revenue arrangements that include multiple deliverables of its product and service offerings due to the needs of its customers. Products may be delivered in phases over time periods which can be as long as
five years
. Maintenance services generally begin upon acceptance of the first equipment delivery and future deliveries of equipment generally have an associated maintenance period. The Company considers the maintenance period to commence upon acceptance of the product or installation in situations where a formal acceptance is not required, which may include a warranty period and accordingly allocates a portion of the arrangement consideration as a separate deliverable which is recognized as service revenue over the entire service period. Other services such as training and engineering services can be delivered as a discrete delivery or over the term of the contract. A multiple-element arrangement is separated into more than one unit of accounting if the following criteria are met:
|
|
•
|
The delivered item(s) has value to the customer on a standalone basis; and
|
|
|
•
|
If the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in the control of the Company.
|
If these criteria are met for each element, the arrangement consideration is allocated to the separate units of accounting based on each unit’s relative selling price. If these criteria are not met, the arrangement is accounted for as one unit of accounting which would result in revenue being recognized ratably over the contract term or being deferred until the earlier of when such criteria are met or when the last undelivered element is delivered.
The Company follows a selling price hierarchy in determining the best estimate of the selling price of each deliverable. Certain products and services are sold separately in standalone arrangements for which the Company is sometimes able to determine vendor specific objective evidence, or VSOE. The Company determines VSOE based on normal pricing and discounting practices for the product or service when sold separately.
When the Company is not able to establish VSOE for all deliverables in an arrangement with multiple elements, the Company attempts to establish the selling price of each remaining element based on third-party evidence, or TPE. The Company’s inability to establish VSOE is often due to a relatively small sample of customer contracts that differ in system size and contract terms which can be due to infrequently selling each element separately, not pricing products within a narrow range, or only having a limited sales history, such as in the case of certain advanced and emerging technologies. TPE is determined based on the Company’s prices or competitor prices for similar deliverables when sold separately. However, the Company is often unable to determine TPE, as the Company’s offerings usually contain a significant level of customization and differentiation from those of competitors and the Company is often unable to reliably determine what similar competitor products’ selling prices are on a standalone basis.
When the Company is unable to establish selling price using VSOE or TPE, the Company uses estimated selling price, or ESP, in its allocation of arrangement consideration. The objective of ESP is to determine the price at which the Company would transact a sale if the product or service were sold on a standalone basis. In determining ESP, the Company uses the cost to provide the product or service plus a margin, or considers other factors. When using cost plus a margin, the Company considers the total cost of the product or service, including customer-specific and geographic factors. The Company also considers the historical margins of the product or service on previous contracts and several factors including any changes to pricing methodologies, competitiveness of products and services and cost drivers that would cause future margins to differ from historical margins.
Products
. The Company most often recognizes revenue from sales of products upon customer acceptance of the system. Where formal acceptance is not required, the Company recognizes revenue upon delivery or installation. When the product is part of a multiple element arrangement, the Company allocates a portion of the arrangement consideration to product revenue based on estimates of selling price.
Services
. Maintenance services are provided under separate maintenance contracts with customers. These contracts generally provide for maintenance services for
one year
, although some are for multi-year periods, often with prepayments for the term of the contract. The Company considers the maintenance period to commence upon acceptance of the product, or installation of the product where a formal acceptance is not required, which may include a warranty period. When service is part of a multiple element arrangement, the Company allocates a portion of the arrangement consideration to maintenance service revenue based on estimates of selling price. Maintenance contracts that are billed in advance of revenue recognition are recorded as deferred revenue. Maintenance revenue is recognized ratably over the term of the maintenance contract.
Revenue from engineering services is recognized as services are performed.
Project Revenue
. Revenue from design and build contracts is recognized under the percentage-of-completion, or POC, method. Under the POC method, revenue is recognized based on the costs incurred to date as a percentage of the total estimated costs to fulfill the contract. If circumstances arise that change the original estimates of revenues, costs, or extent of progress toward completion, revisions to the estimates are made. These revisions may result in increases or decreases in estimated revenues or costs, and such revisions are recorded in income in the period in which the circumstances that gave rise to the revision become known by management. The Company performs ongoing profitability analyses of its contracts accounted for under the POC method in order to determine whether the latest estimates of revenue, costs and extent of progress require updating. If at any time these estimates indicate that the contract will be unprofitable, the entire estimated loss for the remainder of the contract is recorded immediately.
The Company records revenue from certain research and development contracts which include milestones using the milestone method if the milestones are determined to be substantive. A milestone is considered to be substantive if management believes there is substantive uncertainty that it will be achieved and the milestone consideration meets all of the following criteria:
|
|
•
|
It is commensurate with either of the following:
|
|
|
•
|
The Company’s performance to achieve the milestone; or
|
|
|
•
|
The enhancement of value of the delivered item or items as a result of a specific outcome resulting from the Company’s performance to achieve the milestone.
|
|
|
•
|
It relates solely to past performance.
|
|
|
•
|
It is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement.
|
The individual milestones are determined to be substantive or non-substantive in their entirety and milestone consideration is not bifurcated.
Revenue from projects is classified as Product Revenue or Service Revenue, based on the nature of the work performed.
Nonmonetary Transactions
. The Company values and records nonmonetary transactions at the fair value of the asset surrendered unless the fair value of the asset received is more clearly evident, in which case the fair value of the asset received is used.
Note 2— New Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers: Topic 606 (ASU 2014-09), to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. Adoption of ASU 2014-09 was initially required for fiscal and interim reporting periods beginning after December 15, 2016 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined per ASU 2014-09.
In August 2015, FASB issued Accounting Standards Update No. 2015-14, Revenue from Contracts with Customers - Deferral of the Effective Date: Topic 606 (ASU 2015-14) that deferred the effective date of ASU 2014-09 by one year. Application of the new revenue standard is permitted for fiscal and interim reporting periods beginning after December 15, 2016 and required for fiscal and interim reporting periods beginning after December 15, 2017. The Company is currently evaluating the potential impact of the pending adoption of ASU 2014-09 on its consolidated financial statements.
In July 2015, FASB issued Accounting Standards Update No. 2015-11, Simplifying the Measurement of Inventory: Topic 330 (ASU 2015-11). Topic 330 currently requires an entity to measure inventory at the lower of cost or market. Market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. ASU 2015-11 requires that inventory measured using either the FIFO or average cost method be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. Adoption of ASU 2015-11 is required for fiscal reporting periods beginning after December 15, 2016, including interim reporting periods within those fiscal years. The Company does not expect the adoption of ASU 2015-11 to have a material impact on its consolidated financial statements.
In November 2015, FASB issued Accounting Standards Update No. 2015-17, Balance Sheet Classification of Deferred Taxes: Topic 740 (ASU 2015-17). Current GAAP requires the deferred taxes for each jurisdiction to be presented as a net current asset or liability and net noncurrent asset or liability. This requires a jurisdiction-by-jurisdiction analysis based on the classification of the assets and liabilities to which the underlying temporary differences relate, or, in the case of loss or credit carryforwards, based on the period in which the attribute is expected to be realized. Any valuation allowance is then required to be allocated on a pro rata basis, by jurisdiction, between current and noncurrent deferred tax assets. The new guidance requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. As a result, each jurisdiction will now only have one net noncurrent deferred tax asset or liability. The guidance does not change the existing requirement that only permits offsetting within a jurisdiction. Adoption of ASU 2015-17 is required for fiscal reporting periods beginning after December 15, 2016, including interim reporting periods within those fiscal years, and either prospective or retrospective application is permitted. Early adoption of ASU 2015-17 is permitted. At the time of adoption, all of the Company’s deferred tax assets and liabilities, along with any related valuation allowance, will be classified as noncurrent on its Consolidated Balance Sheet. Currently, the Company does not plan to early-adopt ASU 2015-17.
In January 2016, FASB issued Accounting Standards Update No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities: Topic 825 (ASU 2016-01). The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. Adoption of ASU 2016-01 is required for fiscal reporting periods beginning after December 15, 2017, including interim reporting periods within those fiscal years. The Company is currently evaluating the potential impact of the pending adoption of ASU 2016-01 on its consolidated financial statements.
In February 2016, FASB issued Accounting Standards Update No. 2016-02, Leases: Topic 842 (ASU 2016-02) that replaces existing lease guidance. The new standard is intended to provide enhanced transparency and comparability by requiring lessees to record right-of-use assets and corresponding lease liabilities on the balance sheet. Under the new guidance, leases will continue to be classified as either finance or operating, with classification affecting the pattern of expense recognition in the Consolidated Statement of Operations. Lessor accounting is largely unchanged under ASU 2016-02. Adoption of ASU 2016-02 is required for fiscal reporting periods beginning after December 15, 2018, including interim reporting periods within those fiscal years with early adoption being permitted. The new standard is required to be applied with a modified retrospective approach to each prior reporting period presented with various optional practical expedients. The Company is currently evaluating the potential impact of the pending adoption of ASU 2016-02 on its consolidated financial statements.
In March 2016, FASB issued Accounting Standards Update No. 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09). The updated guidance simplifies and changes how companies account for certain aspects of share-based payment awards to employees, including accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification of certain items in the statement of cash flows. Adoption of ASU 2016-09 is required for fiscal reporting periods beginning after December 15, 2016, including interim reporting periods within those fiscal years with early adoption being permitted. The Company early-adopted ASU 2016-09 in the first quarter of 2016.
At the time of adoption, the Company recognized
$16.6 million
in deferred tax assets for all excess tax benefits that had not been previously recognized because the related tax deduction had not reduced taxes payable. This was accomplished through a cumulative-effect adjustment to accumulated deficit. All excess tax benefits and all tax deficiencies generated in the current and future periods will be recorded as income tax benefit or expense in the Company’s Consolidated Statement of Operations in the reporting period in which they occur. This will result in increased volatility in the Company’s effective tax rate. The Company has determined that none of the other provisions of ASU 2016-09 will have a significant impact on its consolidated financial statements.
The table below shows the accumulated deficit activity for the
six months ended June 30, 2016
(in thousands):
|
|
|
|
|
|
|
|
Accumulated
Deficit
|
|
|
BALANCE, December 31, 2015
|
|
$
|
(125,411
|
)
|
Purchase of employee restricted shares to fund related statutory tax withholding
|
|
(696
|
)
|
Cumulative-effect adjustment resulting from adoption of ASU 2016-09
|
|
16,600
|
|
Net Loss
|
|
(18,139
|
)
|
BALANCE, June 30, 2016
|
|
$
|
(127,646
|
)
|
Note 3— Fair Value Measurement
Based on the observability of the inputs used in the valuation techniques used to determine the fair value of certain financial assets and liabilities, the Company is required to provide the following information according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values.
In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related assets or liabilities. Fair values determined by Level 3 inputs are unobservable data points for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. The following table presents information about the Company’s financial assets and liabilities that have been measured at fair value as of
June 30, 2016
, and indicates the fair value hierarchy of the valuation inputs utilized to determine such fair value (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Description
|
|
Fair Value
as of
June 30,
2016
|
|
Quoted
Prices in
Active
Markets
(Level 1)
|
|
Significant
Other
Observable
Inputs
(Level 2)
|
Assets:
|
|
|
|
|
|
|
Cash and cash equivalents and restricted cash
|
|
$
|
214,400
|
|
|
$
|
214,400
|
|
|
$
|
—
|
|
Available-for-sale investments (1)
|
|
9,318
|
|
|
9,318
|
|
|
—
|
|
Foreign currency exchange contracts (2)
|
|
17,727
|
|
|
—
|
|
|
17,727
|
|
Assets measured at fair value at June 30, 2016
|
|
$
|
241,445
|
|
|
$
|
223,718
|
|
|
$
|
17,727
|
|
Liabilities:
|
|
|
|
|
|
|
Foreign currency exchange contracts (3)
|
|
1,478
|
|
|
—
|
|
|
1,478
|
|
Liabilities measured at fair value at June 30, 2016
|
|
$
|
1,478
|
|
|
$
|
—
|
|
|
$
|
1,478
|
|
|
|
(1)
|
Included in “Short-term investments” on the Company’s Condensed Consolidated Balance Sheets.
|
|
|
(2)
|
Included in “Prepaid expenses and other current assets” and “Other non-current assets” on the Company’s Condensed Consolidated Balance Sheets.
|
|
|
(3)
|
Included in “Other accrued liabilities” and “Other non-current liabilities” on the Company’s Condensed Consolidated Balance Sheets.
|
Foreign Currency Derivatives
The Company may enter into foreign currency derivatives to hedge future cash receipts on certain sales transactions that are payable in foreign currencies.
As of
June 30, 2016
and
December 31, 2015
, the Company had outstanding foreign currency exchange contracts that were designated and accounted for as cash flow hedges of anticipated future cash receipts on sales contracts payable in foreign currencies. The outstanding notional amounts were approximately (in millions):
|
|
|
|
|
|
|
|
|
|
June 30,
2016
|
|
December 31, 2015
|
British Pounds (GBP)
|
|
30.3
|
|
|
39.2
|
|
Euros (EUR)
|
|
8.5
|
|
|
6.0
|
|
Swiss Francs (CHF)
|
|
37.9
|
|
|
33.0
|
|
Canadian Dollars (CAD)
|
|
105.3
|
|
|
—
|
|
Japanese Yen (JPY)
|
|
2,230.9
|
|
|
—
|
|
The Company had hedged foreign currency exposure related to these designated cash flow hedges of approximately
$202.2 million
and
$107.3 million
as of
June 30, 2016
and
December 31, 2015
, respectively.
As of
June 30, 2016
and
December 31, 2015
, the Company had outstanding foreign currency exchange contracts that had been dedesignated for the purposes of hedge accounting treatment. The outstanding notional amounts were approximately (in millions):
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
British Pounds (GBP)
|
39.8
|
|
|
31.5
|
|
Euros (EUR)
|
1.9
|
|
|
3.8
|
|
Swiss Francs (CHF)
|
—
|
|
|
0.3
|
|
Japanese Yen (JPY)
|
—
|
|
|
274.0
|
|
The foreign currency exposure related to these contracts was approximately
$61.7 million
as of
June 30, 2016
and
$55.6 million
as of
December 31, 2015
. Unrealized gains or losses related to these dedesignated contracts are recorded in the Condensed Consolidated Statement of Operations and are generally offset by foreign currency adjustments on related receivables. These foreign currency exchange contracts are considered to be economic hedges.
Cash receipts associated with the foreign currency exchange contracts are expected to be received from 2016 through 2024, during which time the revenue on the associated sales contracts is expected to be recognized, or in the case of receivables denominated in a foreign currency, the receivables balances will be collected. Any gain or loss on hedged foreign currency will be recognized
at the time of customer acceptance, or
in the case of receivables denominated in a foreign currency,
over the period during which hedged receivables denominated in a foreign currency are outstanding.
Fair values of derivative instruments designated as cash flow hedges (in thousands):
|
|
|
|
|
|
|
|
|
|
|
Hedge Classification
|
Balance Sheet Location
|
|
Fair Value
as of
June 30,
2016
|
|
Fair Value
as of
December 31,
2015
|
Foreign currency exchange contracts
|
Prepaid expenses and other current assets
|
|
$
|
11,543
|
|
|
$
|
3,956
|
|
Foreign currency exchange contracts
|
Other non-current assets
|
|
—
|
|
|
5,183
|
|
Foreign currency exchange contracts
|
Other accrued liabilities
|
|
(716
|
)
|
|
—
|
|
Foreign currency exchange contracts
|
Other non-current liabilities
|
|
(762
|
)
|
|
(2
|
)
|
Total fair value of derivative instruments designated as cash flow hedges
|
|
|
$
|
10,065
|
|
|
$
|
9,137
|
|
Fair values of derivative instruments not designated as cash flow hedges (in thousands):
|
|
|
|
|
|
|
|
|
|
|
Hedge Classification
|
Balance Sheet Location
|
|
Fair Value
as of
June 30,
2016
|
|
Fair Value
as of
December 31,
2015
|
Foreign currency exchange contracts
|
Prepaid expenses and other current assets
|
|
$
|
1,758
|
|
|
$
|
1,807
|
|
Foreign currency exchange contracts
|
Other non-current assets
|
|
4,426
|
|
|
656
|
|
Foreign currency exchange contracts
|
Other accrued liabilities
|
|
—
|
|
|
(1
|
)
|
Foreign currency exchange contracts
|
Other non-current liabilities
|
|
—
|
|
|
—
|
|
Total fair value of derivative instruments not designated as cash flow hedges
|
|
|
$
|
6,184
|
|
|
$
|
2,462
|
|
Note 4— Accumulated Other Comprehensive Income
The following table shows the impact on product revenue of reclassification adjustments from accumulated other comprehensive income resulting from hedged foreign currency transactions recorded by the Company for the
three and six months ended June 30, 2016 and 2015
(in thousands). The gross reclassification adjustments increased product revenue for the
three and six months ended June 30, 2016 and 2015
.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
June 30,
|
|
Six Months Ended
June 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
|
|
|
|
|
|
|
|
Gross of tax reclassifications
|
|
$
|
2,753
|
|
|
$
|
1
|
|
|
$
|
4,378
|
|
|
$
|
118
|
|
Net of tax reclassifications
|
|
$
|
1,652
|
|
|
$
|
1
|
|
|
$
|
2,627
|
|
|
$
|
71
|
|
The following tables show the changes in accumulated other comprehensive income by component for the
three and six months ended June 30, 2016 and 2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended June 30, 2016
|
|
|
Unrealized Gain on Investments
|
|
Foreign Currency Translation Adjustments
|
|
Unrealized Gain on Cash Flow Hedges
|
|
Accumulated Other Comprehensive Income
|
Beginning balance
|
|
$
|
1
|
|
|
$
|
1,915
|
|
|
$
|
5,588
|
|
|
$
|
7,504
|
|
Current-period change, net of tax
|
|
(1
|
)
|
|
677
|
|
|
1,478
|
|
|
2,154
|
|
Ending balance
|
|
$
|
—
|
|
|
$
|
2,592
|
|
|
$
|
7,066
|
|
|
$
|
9,658
|
|
|
|
|
|
|
|
|
|
|
Income tax expense (benefit) associated with current-period change
|
|
$
|
—
|
|
|
$
|
(74
|
)
|
|
$
|
986
|
|
|
$
|
912
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended June 30, 2015
|
|
|
Unrealized Loss on Investments
|
|
Foreign Currency Translation Adjustments
|
|
Unrealized Gain on Cash Flow Hedges
|
|
Accumulated Other Comprehensive Income
|
Beginning balance
|
|
$
|
(2
|
)
|
|
$
|
2,552
|
|
|
$
|
8,672
|
|
|
$
|
11,222
|
|
Current-period change, net of tax
|
|
(6
|
)
|
|
(170
|
)
|
|
(3,410
|
)
|
|
(3,586
|
)
|
Ending balance
|
|
$
|
(8
|
)
|
|
$
|
2,382
|
|
|
$
|
5,262
|
|
|
$
|
7,636
|
|
|
|
|
|
|
|
|
|
|
Income tax expense (benefit) associated with current-period change
|
|
$
|
(4
|
)
|
|
$
|
57
|
|
|
$
|
(2,273
|
)
|
|
$
|
(2,220
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended June 30, 2016
|
|
|
Unrealized Gain (Loss) on Investments
|
|
Foreign Currency Translation Adjustments
|
|
Unrealized Gain on Cash Flow Hedges
|
|
Accumulated Other Comprehensive Income
|
Beginning balance
|
|
$
|
(8
|
)
|
|
$
|
1,675
|
|
|
$
|
5,975
|
|
|
$
|
7,642
|
|
Current-period change, net of tax
|
|
8
|
|
|
917
|
|
|
1,091
|
|
|
2,016
|
|
Ending balance
|
|
$
|
—
|
|
|
$
|
2,592
|
|
|
$
|
7,066
|
|
|
$
|
9,658
|
|
|
|
|
|
|
|
|
|
|
Income tax expense (benefit) associated with current-period change
|
|
$
|
6
|
|
|
$
|
(81
|
)
|
|
$
|
735
|
|
|
$
|
660
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended June 30, 2015
|
|
|
Unrealized Gain (Loss) on Investments
|
|
Foreign Currency Translation Adjustments
|
|
Unrealized Gain on Cash Flow Hedges
|
|
Accumulated Other Comprehensive Income
|
Beginning balance
|
|
$
|
12
|
|
|
$
|
2,069
|
|
|
$
|
4,422
|
|
|
$
|
6,503
|
|
Current-period change, net of tax
|
|
(20
|
)
|
|
313
|
|
|
840
|
|
|
1,133
|
|
Ending balance
|
|
$
|
(8
|
)
|
|
$
|
2,382
|
|
|
$
|
5,262
|
|
|
$
|
7,636
|
|
|
|
|
|
|
|
|
|
|
Income tax expense (benefit) associated with current-period change
|
|
$
|
(13
|
)
|
|
$
|
(271
|
)
|
|
$
|
551
|
|
|
$
|
267
|
|
Note 5— Income (Loss) Per Share ("EPS")
Basic EPS is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares, excluding unvested restricted stock, outstanding during the period. Diluted EPS is computed by dividing net income (loss) available to common shareholders by the weighted average number of common and potential common shares outstanding during the period, which includes the additional dilution related to conversion of stock options, unvested restricted stock and unvested restricted stock units as computed under the treasury stock method.
For the
three and six months ended June 30, 2016
and the
six months ended June 30, 2015
, outstanding stock options, unvested restricted stock and unvested restricted stock units were antidilutive because of the net losses and, as such, their effect has not been included in the calculation of basic or diluted net loss per share. For the
three months ended June 30, 2015
, the added shares from these items included in the calculation of diluted shares and EPS totaled
1.7 million
. For the
three and six months ended June 30, 2016
, potential gross common shares of
2.8 million
and
2.8 million
, respectively, were antidilutive and not included in computing diluted EPS. For the
three and six months ended June 30, 2015
, potential gross common shares of
0.9 million
and
3.1 million
, respectively, were antidilutive and not included in computing diluted EPS. An additional
1.2 million
and
1.4 million
performance vesting restricted stock and performance vesting restricted stock units were excluded from the computation of potential common shares for the
three and six months ended June 30, 2016 and 2015
, respectively, because the conditions for vesting had not been met as of the balance sheet date.
Note 6— Investments
The Company’s investments in debt securities with maturities at purchase greater than three months are classified as “available-for-sale.” Changes in fair value are reflected in other comprehensive income (loss). The carrying amounts of the Company’s investments in available-for-sale securities as of
June 30, 2016
are shown in the table below (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Unrealized
|
|
|
|
|
Cost
|
|
Gains
|
|
Fair Value
|
Short-term available-for-sale securities
|
|
$
|
9,318
|
|
|
$
|
—
|
|
|
$
|
9,318
|
|
The carrying amounts of the Company’s investments in available-for-sale securities as of
December 31, 2015
are shown in the table below (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Unrealized
|
|
|
|
|
Cost
|
|
Losses
|
|
Fair Value
|
Short-term available-for-sale securities
|
|
$
|
14,939
|
|
|
$
|
(14
|
)
|
|
$
|
14,925
|
|
Note 7— Accounts and Other Receivables, Net
Net accounts and other receivables consisted of the following (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
June 30,
2016
|
|
December 31, 2015
|
Trade accounts receivable
|
|
$
|
26,818
|
|
|
$
|
83,750
|
|
Unbilled receivables
|
|
9,834
|
|
|
7,685
|
|
Advance billings
|
|
2,102
|
|
|
11,637
|
|
Short-term investment in sales-type lease
|
|
9,168
|
|
|
10,004
|
|
Other receivables
|
|
7,713
|
|
|
11,662
|
|
|
|
55,635
|
|
|
124,738
|
|
Allowance for doubtful accounts
|
|
(22
|
)
|
|
(19
|
)
|
Accounts and other receivables, net
|
|
$
|
55,613
|
|
|
$
|
124,719
|
|
Unbilled receivables represent amounts where the Company has recognized revenue in advance of the contractual billing terms. Advance billings represent billings made based on contractual terms for which revenue has not been recognized.
As of
June 30, 2016
and
December 31, 2015
, accounts receivable included
$16.3 million
and
$44.2 million
, respectively, that resulted from sales to the U.S. government and system acquisitions primarily funded by the U.S. government (“U.S. Government”). Of these amounts,
$4.0 million
and
$2.2 million
were unbilled as of
June 30, 2016
and
December 31, 2015
, respectively, based upon contractual billing arrangements with these customers. As of
June 30, 2016
,
one
non-U.S. Government customer accounted for
16%
of total accounts and other receivables. As of
December 31, 2015
,
one
non-U.S. Government customer accounted for
18%
of total accounts and other receivables.
Note 8— Sales-type Lease
The Company has a sales-type lease with one of its customers. Under the terms of the original agreement, the Company provided a high performance computing solution to the customer for a term of four years, beginning at the customer’s acceptance of the system. In the three months ended June 30, 2016, the Company delivered a second high performance computing solution and extended the original agreement, which will now end in September 2020. The lease extension, and delivery of the second high performance computing solution, has been accounted for as a separate sale and is not considered a lease modification. The lease is designated in British Pounds and the Company has entered into certain foreign currency exchange contracts that act as an economic hedge for the foreign currency exposure associated with this arrangement.
The following table shows the components of the net investment in the sales-type lease as of
June 30, 2016
and
December 31, 2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
June 30,
2016
|
|
December 31, 2015
|
Total minimum lease payments to be received
|
|
$
|
62,583
|
|
|
$
|
36,863
|
|
Less: executory costs
|
|
(12,994
|
)
|
|
(7,434
|
)
|
Net minimum lease payments receivable
|
|
49,589
|
|
|
29,429
|
|
Less: unearned income
|
|
(3,232
|
)
|
|
(1,108
|
)
|
Net investment in sales-type lease
|
|
46,357
|
|
|
28,321
|
|
Less: long-term investment in sales-type lease
|
|
(37,189
|
)
|
|
(18,317
|
)
|
Investment in sales-type lease included in accounts and other receivables
|
|
$
|
9,168
|
|
|
$
|
10,004
|
|
As of
June 30, 2016
, minimum lease payments for each of the succeeding five fiscal years are as follows (in thousands):
|
|
|
|
|
|
2016 (less than 1 year)
|
|
$
|
6,474
|
|
2017
|
|
14,698
|
|
2018
|
|
14,888
|
|
2019
|
|
15,165
|
|
2020
|
|
11,358
|
|
Total minimum lease payments to be received
|
|
$
|
62,583
|
|
Note 9— Inventory
Inventory consisted of the following (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
June 30,
2016
|
|
December 31, 2015
|
Components and subassemblies
|
|
$
|
57,549
|
|
|
$
|
20,806
|
|
Work in process
|
|
92,517
|
|
|
43,071
|
|
Finished goods
|
|
46,743
|
|
|
49,778
|
|
Total
|
|
$
|
196,809
|
|
|
$
|
113,655
|
|
Finished goods inventory of
$46.6 million
and
$49.5 million
was located at customer sites pending acceptance as of
June 30, 2016
and
December 31, 2015
, respectively. At
June 30, 2016
,
two
customers accounted for
$40.9 million
of finished goods inventory, and at
December 31, 2015
,
three
customers accounted for
$41.7 million
of finished goods inventory.
During the six months ended June 30, 2016, the Company wrote off
$0.1 million
of inventory. During the
six months ended June 30, 2015
, the Company wrote off
$0.5 million
of inventory.
Note 10— Deferred Revenue
Deferred revenue consisted of the following (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
June 30,
2016
|
|
December 31, 2015
|
Deferred product revenue
|
|
$
|
15,052
|
|
|
$
|
22,215
|
|
Deferred service revenue
|
|
87,178
|
|
|
97,822
|
|
Total deferred revenue
|
|
102,230
|
|
|
120,037
|
|
Less: long-term deferred revenue
|
|
(22,539
|
)
|
|
(33,306
|
)
|
Deferred revenue in current liabilities
|
|
$
|
79,691
|
|
|
$
|
86,731
|
|
As of
June 30, 2016
and
December 31, 2015
, the U.S. Government accounted for
$52.9 million
and
$57.7 million
, respectively, of total deferred revenue. As of
June 30, 2016
and
December 31, 2015
,
no
non-U.S. Government customers accounted for more than
10%
of total deferred revenue.
Note 11— Contingencies
A customer has recently experienced significant reliability issues with a high-value third party component in its Cray system after several years of use. We incurred $500,000 in expense related to this matter in the three months ended June 30, 2016, which was recorded as Cost of Service Revenue. The Company is working with the principal customer impacted and vendor to develop an effective solution. While it is possible the Company could incur a material loss under its multi-year service arrangement, management believes the ultimate cost will likely not be material. The Company is currently unable to estimate an amount or range of loss because this matter involves significant uncertainties.
Note 12— Share-Based Compensation
The Company accounts for its share-based compensation based on an estimate of fair value of the grant on the date of grant.
In determining the fair value of stock options, the Company uses the Black-Scholes option pricing model. The following key weighted average assumptions were employed in the calculation for the three and
six
month periods ended
June 30, 2016
and
June 30, 2015
:
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended June 30, 2016
|
|
Three Months Ended June 30, 2015
|
|
Six Months Ended June 30, 2016
|
|
Six Months Ended June 30, 2015
|
Risk-free interest rate
|
|
1.20%
|
|
1.29%
|
|
1.19%
|
|
1.30%
|
Expected dividend yield
|
|
—%
|
|
—%
|
|
—%
|
|
—%
|
Volatility
|
|
50.74%
|
|
50.66%
|
|
50.82%
|
|
50.66%
|
Expected life
|
|
4.0 years
|
|
4.0 years
|
|
4.0 years
|
|
4.0 years
|
Weighted average Black-Scholes value of options granted
|
|
$13.11
|
|
$11.38
|
|
$13.46
|
|
$11.49
|
The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The Company does not anticipate declaring dividends in the foreseeable future. Volatility is based on historical data. The expected life of an option is based on the assumption that options will be exercised, on average, about
two
years after vesting occurs. The Company recognizes compensation expense for only the portion of options that are expected to vest. Therefore, management applies an estimated forfeiture rate that is derived from historical employee termination data and adjusted for expected future employee turnover rates. The estimated forfeiture rate applied to the Company’s stock option grants during the
three and six months ended June 30, 2016 and 2015
was
8.0%
. If the actual number of forfeitures differs from those estimated by management, additional adjustments to compensation expense may be required in future periods. The Company’s stock price volatility, option lives and expected forfeiture rates involve management’s best estimates at the time of such determination, which impact the fair value of the option calculated under the Black-Scholes methodology and, ultimately, the expense that will be recognized over the vesting period or requisite service period of the option. The Company typically issues stock options with a
four
year vesting period (the requisite service period) and amortizes the fair value of stock options (stock compensation cost) ratably over the requisite service period.
A summary of the Company’s year-to-date stock option activity and related information follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
Options
|
|
Weighted
Average
Exercise
Price
|
|
Weighted
Average
Remaining
Contractual
Term
|
Outstanding at December 31, 2015
|
|
1,948,475
|
|
|
$
|
14.83
|
|
|
|
Grants
|
|
163,500
|
|
|
$
|
33.37
|
|
|
|
Exercises
|
|
(140,545
|
)
|
|
$
|
13.24
|
|
|
|
Canceled and forfeited
|
|
(22,576
|
)
|
|
$
|
26.04
|
|
|
|
Outstanding at June 30, 2016
|
|
1,948,854
|
|
|
$
|
16.37
|
|
|
6.1
|
Exercisable at June 30, 2016
|
|
1,393,239
|
|
|
$
|
11.91
|
|
|
5.1
|
Available for grant at June 30, 2016
|
|
3,747,568
|
|
|
|
|
|
As of
June 30, 2016
, there was
$27.0 million
of aggregate intrinsic value of outstanding stock options, including
$25.3 million
of aggregate intrinsic value of exercisable stock options. Intrinsic value represents the total pretax intrinsic value for all “in-the-money” options (
i.e.
, the difference between the Company’s closing stock price on the last trading day of its
second
quarter of
2016
and the exercise price, multiplied by the number of shares of common stock underlying the stock options) that would have been received by the option holders had all option holders exercised their options on
June 30, 2016
. During the
three and six months ended June 30, 2016
, stock options covering
18,218
and
140,545
shares of common stock, respectively, with a total intrinsic value of
$0.2 million
and
$3.7 million
, respectively, were exercised. During the
three and six months ended June 30, 2015
, stock options covering
48,613
and
107,620
shares of common stock, respectively, with a total intrinsic value of
$0.9 million
and
$2.6 million
, respectively, were exercised.
The fair value of unvested restricted stock and unvested restricted stock units is based on the market price of a share of the Company’s common stock on the date of grant and is amortized over the vesting period.
A summary of the Company’s unvested restricted stock grants and changes during the
six months ended June 30, 2016
is as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Service Vesting Restricted Shares
|
|
Performance Vesting Restricted Shares
|
|
Total Restricted Shares
|
|
|
Shares
|
|
Weighted
Average
Grant Date
Fair Value
|
|
Shares
|
|
Weighted
Average
Grant Date
Fair Value
|
|
Shares
|
|
Weighted Average Grant Date Fair Value
|
Outstanding at December 31, 2015
|
|
516,443
|
|
|
$
|
24.12
|
|
|
585,500
|
|
|
$
|
15.07
|
|
|
1,101,943
|
|
|
$
|
19.31
|
|
Granted
|
|
9,893
|
|
|
$
|
34.86
|
|
|
—
|
|
|
$
|
—
|
|
|
9,893
|
|
|
$
|
34.86
|
|
Forfeited
|
|
(17,325
|
)
|
|
$
|
24.64
|
|
|
(57,000
|
)
|
|
$
|
15.02
|
|
|
(74,325
|
)
|
|
$
|
17.26
|
|
Vested
|
|
(68,352
|
)
|
|
$
|
28.55
|
|
|
—
|
|
|
$
|
—
|
|
|
(68,352
|
)
|
|
$
|
28.55
|
|
Outstanding at June 30, 2016
|
|
440,659
|
|
|
$
|
23.66
|
|
|
528,500
|
|
|
$
|
15.08
|
|
|
969,159
|
|
|
$
|
18.98
|
|
The estimated forfeiture rate applied to the Company’s service vesting restricted share grants during the
three and six months ended June 30, 2016 and 2015
, was
8%
. The aggregate fair value of restricted stock vested during the
three and six months ended June 30, 2016
, was
$2.2 million
and
$2.4 million
, respectively. The aggregate fair value of restricted stock vested during the
three and six months ended June 30, 2015
, was
$2.6 million
and
$3.1 million
, respectively. The performance vesting restricted shares are subject to performance measures that are currently not considered “probable” of attainment and as such, no compensation cost has been recorded for these shares. The performance vesting restricted shares are eligible to vest in
2016
and
2017
.
A summary of the Company’s unvested restricted stock unit grants and changes during the
six months ended June 30, 2016
is as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Service Vesting Restricted Stock Units
|
|
Performance Vesting Restricted Stock Units
|
|
Total Restricted Stock Units
|
|
|
Units
|
|
Weighted
Average
Grant Date
Fair Value
|
|
Units
|
|
Weighted
Average
Grant Date
Fair Value
|
|
Units
|
|
Weighted Average Grant Date Fair Value
|
Outstanding at December 31, 2015
|
|
273,050
|
|
|
$
|
29.75
|
|
|
632,700
|
|
|
$
|
30.04
|
|
|
905,750
|
|
|
$
|
29.95
|
|
Granted
|
|
149,000
|
|
|
$
|
32.18
|
|
|
23,585
|
|
|
$
|
42.65
|
|
|
172,585
|
|
|
$
|
33.61
|
|
Forfeited
|
|
(6,000
|
)
|
|
$
|
30.27
|
|
|
—
|
|
|
$
|
—
|
|
|
(6,000
|
)
|
|
$
|
30.27
|
|
Vested
|
|
(37,000
|
)
|
|
$
|
31.02
|
|
|
—
|
|
|
$
|
—
|
|
|
(37,000
|
)
|
|
$
|
31.02
|
|
Outstanding at June 30, 2016
|
|
379,050
|
|
|
$
|
30.57
|
|
|
656,285
|
|
|
$
|
30.49
|
|
|
1,035,335
|
|
|
$
|
30.52
|
|
The estimated forfeiture rate applied to the Company’s service vesting restricted stock unit grants during the
three and six months ended June 30, 2016 and 2015
, was
8.0%
. The aggregate fair value of restricted stock vested during the
three and six months ended June 30, 2016
, was
$1.2 million
. Restricted stock units are not outstanding shares and do not have any voting or dividend rights. At the time of vesting, a share of common stock representing each restricted stock unit vested will be issued by the Company. The performance vesting restricted stock units are subject to performance measures that are currently not considered “probable” of attainment and as such, no compensation cost has been recorded for these units. The performance vesting restricted stock units are eligible to vest between
2017
and
2020
.
Including performance-based equity awards, the Company had
$45.8 million
of total unrecognized compensation cost related to unvested stock options, unvested restricted stock and unvested restricted stock units as of
June 30, 2016
. Excluding the
$28.0 million
of unrecognized compensation cost related to unvested restricted stock and unvested restricted stock units that are subject to performance measures that are currently not considered “probable” of attainment, unrecognized compensation cost is
$17.8 million
. No compensation expense is recognized for unvested restricted stock or unvested restricted stock units subject to performance measures that are not considered “probable” of attainment. Unrecognized compensation cost related to unvested stock options and unvested non-performance-based restricted stock is expected to be recognized over a weighted average period of
2.7
years.
The following table sets forth the gross share-based compensation cost resulting from stock options, unvested restricted stock and unvested restricted stock units that were recorded in the Company’s Condensed Consolidated Statements of Operations for the
three and six months ended June 30, 2016 and 2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
June 30,
|
|
Six Months Ended
June 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Cost of product revenue
|
|
$
|
83
|
|
|
$
|
78
|
|
|
$
|
165
|
|
|
$
|
148
|
|
Cost of service revenue
|
|
68
|
|
|
73
|
|
|
136
|
|
|
139
|
|
Research and development, net
|
|
582
|
|
|
978
|
|
|
1,531
|
|
|
1,851
|
|
Sales and marketing
|
|
872
|
|
|
514
|
|
|
1,707
|
|
|
1,452
|
|
General and administrative
|
|
1,190
|
|
|
1,111
|
|
|
2,108
|
|
|
2,337
|
|
Total
|
|
$
|
2,795
|
|
|
$
|
2,754
|
|
|
$
|
5,647
|
|
|
$
|
5,927
|
|
The Company also has an employee stock purchase plan, or ESPP, which allows employees to purchase shares of the Company’s common stock at
95%
of fair market value on the fourth business day after the end of each offering period. The ESPP is deemed non-compensatory and therefore is not subject to the fair value provisions.
Note 13— Taxes
The Company’s effective tax rates for the
three and six months ended June 30, 2016 and 2015
were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
June 30,
|
|
Six Months Ended
June 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Effective Tax Rates
|
|
15%
|
|
41%
|
|
26%
|
|
39%
|
The primary reason for the difference between the expected statutory tax rate of
35%
and the actual tax rates of
15%
and
26%
for the
three and six months ended June 30, 2016
, was a a reduction in the Company’s business outlook with respect to the current year which substantially increased the impact that the Company’s research and development tax credit had on its effective tax rate. Other significant reconciling items that impacted the Company’s effective tax rate included excess tax benefits, and state and foreign taxes. Prior to the adoption of ASU 2016-09 excess tax benefits did not impact the Company’s effective tax rate. The primary reason for the difference between the expected statutory tax rate of
35%
and the actual tax rates of
41%
and
39%
for the
three and six months ended June 30, 2015
was the result of state taxes.
The Company continues to provide a valuation allowance against specific U.S. deferred tax assets and a valuation allowance against deferred tax assets arising in a limited number of foreign jurisdictions as the realization of such assets is not considered to be more likely than not at this time. No changes were required to previously recorded valuation allowances as a result of the adoption of ASU 2016-09. In a future period the Company’s assessment of the realizability of its deferred tax assets and therefore the appropriateness of the valuation allowance could change based on an assessment of all available evidence, both positive and negative in that future period. If the Company’s conclusion about the realizability of its deferred tax assets and therefore the appropriateness of the valuation allowance changes in a future period it could record a substantial tax provision or benefit in the Condensed Consolidated Statement of Operations when that occurs.
Note 14— Segment Information
The Company has the following reportable segments: Supercomputing (formerly HPC Systems), Storage and Data Management, Maintenance and Support, and Engineering Services and Other. The Company’s reportable segments represent components of the Company for which separate financial information is available that is utilized on a regular basis by the Chief Executive Officer, who is the Chief Operating Decision Maker, in determining how to allocate the Company’s resources and evaluate performance. The segments are determined based on several factors, including the Company’s internal operating structure, the manner in which the Company’s operations are managed, client base, similar economic characteristics and the availability of separate financial information.
Supercomputing
Supercomputing includes a suite of highly advanced, tightly integrated and cluster supercomputer systems which are used by large research and engineering centers in universities, government laboratories, and commercial institutions. Supercomputing also includes the ongoing maintenance of these systems as well as system analysts.
Storage and Data Management
Storage and Data Management offers the Cray Data Warp, Sonexion as well as other third-party storage products and their ongoing maintenance as well as system analysts.
Maintenance and Support
Maintenance and Support provides ongoing maintenance of Cray supercomputers, big data storage and analytics systems, as well as system analysts.
Engineering Services and Other
Included within Engineering Services and Other are the Company’s analytics business and Custom Engineering.
The following table presents revenues and gross margins for the Company’s operating segments for the
three and six months ended June 30, 2016 and 2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
June 30,
|
|
Six Months Ended
June 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Revenue:
|
|
|
|
|
|
|
|
|
Supercomputing
|
|
$
|
70,667
|
|
|
$
|
153,704
|
|
|
$
|
155,395
|
|
|
$
|
213,534
|
|
Storage and Data Management
|
|
24,958
|
|
|
26,474
|
|
|
38,425
|
|
|
41,668
|
|
Maintenance and Support
|
|
26,767
|
|
|
22,774
|
|
|
53,570
|
|
|
45,727
|
|
Engineering Services and Other
|
|
4,610
|
|
|
5,983
|
|
|
11,964
|
|
|
10,603
|
|
Elimination of inter-segment revenue
|
|
(26,767
|
)
|
|
(22,774
|
)
|
|
(53,570
|
)
|
|
(45,727
|
)
|
Total revenue
|
|
$
|
100,235
|
|
|
$
|
186,161
|
|
|
$
|
205,784
|
|
|
$
|
265,805
|
|
|
|
|
|
|
|
|
|
|
Gross Profit:
|
|
|
|
|
|
|
|
|
Supercomputing
|
|
$
|
24,532
|
|
|
$
|
38,625
|
|
|
$
|
56,571
|
|
|
$
|
58,049
|
|
Storage and Data Management
|
|
9,328
|
|
|
8,557
|
|
|
14,174
|
|
|
12,278
|
|
Maintenance and Support
|
|
10,429
|
|
|
10,208
|
|
|
22,083
|
|
|
21,532
|
|
Engineering Services and Other
|
|
2,301
|
|
|
2,403
|
|
|
5,378
|
|
|
3,294
|
|
Elimination of inter-segment gross profit
|
|
(10,429
|
)
|
|
(10,208
|
)
|
|
(22,083
|
)
|
|
(21,532
|
)
|
Total gross profit
|
|
$
|
36,161
|
|
|
$
|
49,585
|
|
|
$
|
76,123
|
|
|
$
|
73,621
|
|
Revenue and cost of revenue is the only discrete financial information the Company prepares for its segments. Other financial results or assets are not separated by segment.
The Company’s geographic operations outside the United States include sales and service offices in Europe and the Middle East, South America, Asia Pacific and Canada. The following data represents the Company’s revenue for the United States and all other countries, which is determined based upon a customer’s geographic location (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
United States
|
|
Other Countries
|
|
Total
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Three months ended June 30,
|
|
|
|
|
|
|
|
|
|
|
|
|
Product revenue
|
|
$
|
22,056
|
|
|
$
|
96,528
|
|
|
$
|
46,873
|
|
|
$
|
61,409
|
|
|
$
|
68,929
|
|
|
$
|
157,937
|
|
Service revenue
|
|
20,474
|
|
|
20,582
|
|
|
10,832
|
|
|
7,642
|
|
|
31,306
|
|
|
28,224
|
|
Total revenue
|
|
$
|
42,530
|
|
|
$
|
117,110
|
|
|
$
|
57,705
|
|
|
$
|
69,051
|
|
|
$
|
100,235
|
|
|
$
|
186,161
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
United States
|
|
Other Countries
|
|
Total
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Six months ended June 30,
|
|
|
|
|
|
|
|
|
|
|
|
|
Product revenue
|
|
$
|
55,934
|
|
|
$
|
128,093
|
|
|
$
|
84,405
|
|
|
$
|
82,585
|
|
|
$
|
140,339
|
|
|
$
|
210,678
|
|
Service revenue
|
|
44,745
|
|
|
39,501
|
|
|
20,700
|
|
|
15,626
|
|
|
65,445
|
|
|
55,127
|
|
Total revenue
|
|
$
|
100,679
|
|
|
$
|
167,594
|
|
|
$
|
105,105
|
|
|
$
|
98,211
|
|
|
$
|
205,784
|
|
|
$
|
265,805
|
|
Sales to the U.S. Government totaled approximately
$36.2 million
and
$89.0 million
for the
three and six months ended June 30, 2016
, compared to approximately
$80.5 million
and
$128.3 million
for the
three and six months ended June 30, 2015
. For the
six months ended June 30, 2016
,
two
non-U.S. Government customers accounted for
28%
of total revenue, while revenue in the United Kingdom and Australia accounted for
41%
of total revenue. For the
six months ended
June 30, 2015
,
one
commercial customer accounted for
11%
of total revenue and revenue from a customer in Saudi Arabia accounted for
21%
of total revenue.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Preliminary Note Regarding Forward-Looking Statements
This quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or if they prove incorrect, could cause our actual results to differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to them. In some cases you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts” and “potential” and similar expressions, but the absence of these words does not mean that a statement is not forward-looking. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, and examples of forward-looking statements include any projections of earnings, revenue or other results of operations or financial results; any statements of the plans, strategies, objectives and beliefs of our management; any statements concerning proposed new products, technologies or services; any statements regarding future research and development or co-funding for such efforts; any statements regarding future expansions of our facilities and offices; any statements regarding future economic conditions; and any statements of assumptions underlying any of the foregoing. These forward-looking statements are subject to the safe harbor created by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Item 1A. Risk Factors in Part II and other sections of this report and our other filings with the U.S. Securities and Exchange Commission, or SEC. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this report. You should read this report completely and with the understanding that our actual future results may be materially different from what we expect. We assume no obligation to update these forward-looking statements, whether as a result of new information, future events, or otherwise.
Overview
We design, develop, manufacture, market and service the high-end of the high performance computing, or HPC, market, primarily categories of systems commonly known as supercomputers and provide storage and data analytics solutions. We also provide software, system maintenance and support services and engineering services related to supercomputer systems and our storage and data analytics solutions. Our customers include domestic and foreign government and government-funded entities, academic institutions and commercial entities. Our key target markets are the supercomputing portion of the HPC market and the expanding big data storage and analytics market. We provide customer-focused solutions based on three models: (1) tightly integrated supercomputing and/or storage solutions, complete with highly tuned software, that stress capability, scalability, sustained performance and reliability at scale; (2) flexible commodity-based “cluster” supercomputing and storage solutions based upon utilizing best-of-breed components and working with our customers to define solutions that meet specific needs; and (3) integrated data analytics solutions that combine industry standard tools for large-scale data analytics with our Cray Graph Engine . All of our solutions also emphasize total cost of ownership, scalable price-performance and data center flexibility as key features. Our continuing strategy is to gain market share in the supercomputer market segment, extend our technology leadership and differentiation, maintain our focus on execution and profitability and grow by continuing to expand our share and addressable market in areas where we can leverage our experience and technology, such as in high performance storage systems and powerful analytic tools for large volumes of data, popularly referred to as “big data”. We also meet diverse customer requirements by combining supercomputing, cluster supercomputing, storage and analytics technologies described above, into unique solutions offerings that work in a workflow-driven datacenter environment.
Summary of First
Six
Months of
2016
Results
Total revenue
decrease
d
$60.0 million
for the first
six
months of
2016
compared to the first
six
months of
2015
, from
$265.8 million
to
$205.8 million
, due mainly to lower product revenue. Product revenue was
$70.3 million
higher in the first six months of 2015 as compared to the first six months of 2016 as a result of customer acceptance of multiple Cray systems by a customer in Saudi Arabia in the second quarter of 2015 and customer acceptances of two large systems in the first quarter of 2015 for which we had previously anticipated acceptance to occur in the fourth quarter of 2014. Our product revenue is subject to significant quarter-to-quarter fluctuations and can be concentrated in particular quarters, often the fourth quarter. It is dependent on factors such as the timing of new product releases, the timing of customer acceptances, the timing and level of customer procurements and budgets, and the availability of certain key components, among other factors.
Net
loss
for the first
six
months of
2016
was
$18.1 million
compared to net
loss
of
$3.6 million
for the same period in
2015
. The year over year change was primarily attributable to lower revenue and a
$20.1 million
increase in operating expenses resulting from growth in the business and the impact of a $2.3 million charge related to the early termination of our lease in St. Paul. These amounts were partially offset by an improved gross margin percentage and a
$4.1 million
increase in income tax benefit.
Net cash
used in
operating activities was
$60.5 million
for the first
six
months of
2016
compared to net cash
used in
operating activities of
$38.8 million
for the first
six
months of
2015
. Net cash
used in
operating activities in the first
six
months of
2016
was primarily driven by a larger operating loss and an increase of
$84.3 million
in inventory as a result of system builds for future deliveries and a decrease of
$32.4 million
in accrued payroll and related expenses and other accrued liabilities, largely resulting from payment of 2015 accrued incentive compensation. We also leased a second system to a customer which increased our long-term investment in leases by
$22.2 million
. These amounts were partially offset by collections from customers in the first half of 2016 that resulted in a decrease of
$66.3 million
in accounts and other receivables and an increase in our accounts payable balance of
$43.1 million
due to inventory purchases and the timing of payments..
Market Overview and Challenges
Significant trends in the HPC industry include:
|
|
•
|
supercomputing with many-core commodity processors driving increasing scalability requirements;
|
|
|
•
|
increased micro-architectural diversity, including increased usage of many-core processors and accelerators, as the rate of increases in per-core performance slows;
|
|
|
•
|
data IO and capacity needs growing much faster than computational needs;
|
|
|
•
|
technology innovations in memory and storage allowing for faster data access such as NVRAM, SSDs and flash devices;
|
|
|
•
|
the commoditization of HPC hardware, particularly processors and system interconnects;
|
|
|
•
|
the growing concentration of very large suppliers of key computing and storage components in the industry;
|
|
|
•
|
the growing commoditization of software, including plentiful building blocks and more capable open source software;
|
|
|
•
|
electrical power requirements becoming a design constraint and driver in total cost of ownership determinations;
|
|
|
•
|
increasing use of analytics technologies (Hadoop, Spark, NoSQL and Graph) in both the HPC and big data markets;
|
|
|
•
|
cloud computing as a solution for loosely-coupled HPC applications; and
|
|
|
•
|
significant variability of market demand quarter-to-quarter and year-to-year.
|
Several of these trends have resulted in the expansion and acceptance of loosely-coupled cluster systems using processors manufactured by Intel, AMD and others combined with commercially available, commodity networking and other components, particularly in the middle and lower segments of the HPC market. These systems may offer higher theoretical peak performance for equivalent cost, and “price/peak performance” is sometimes the dominant factor in HPC procurements. Vendors of such systems often put pricing pressure on us, resulting in lower margins in competitive procurements.
In the market for the largest, and most scalable systems, those often costing in excess of $3 million, the use of generally available network components can result in increasing data transfer bottlenecks as these components do not balance processor power with network communication and system software capability. With the arrival of increasing processor core counts due to new many-core processors, these unbalanced systems will typically have lower productivity, especially in larger systems running more complex applications. We and others augment standard microprocessors with other processor types, such as graphics processing units and many-core attached processors, in order to increase computational power, further complicating programming models. In addition, with increasing scale, bandwidth and processor core counts, large computer systems use progressively higher amounts of power to operate and require special cooling capabilities.
To position ourselves to meet the market’s demanding needs, we concentrate our research and development efforts on technologies that enable our supercomputers to perform at scale - that is, to continue to increase actual performance as systems
grow ever larger in size - and in areas where we can leverage our core expertise in other markets whose applications demand these tightly-coupled architectures. We also have demonstrated expertise in system software and several processor technologies. We expect to be in a comparatively advantageous position as larger many-core processors become available and as multiple processing technologies become integrated into single systems in heterogeneous environments. In addition, we have continued to expand our addressable market by leveraging our technologies, customer base, the Cray brand and industry trends by introducing complementary products and services to new and existing customers, as demonstrated by our emphasis on strategic initiatives, such as storage and data management and “big data” analytics.
In storage, we are developing and delivering high value products for the high performance storage and data archiving markets. Our storage products are primarily positioned to enable tight integration of storage to computing solutions and/or utilize parallel file processing technologies and facilitate storage across multiple data tiers. We support open source parallel file systems and protocols such as Lustre and we are a founding member of the OpenSFS (Open Scalable File System) consortia for Lustre.
In analytics, we are developing and delivering high performance data discovery and advanced analytics solutions. These solutions compete with open source software, running on commodity cluster systems. Although these competitive systems have low acquisition costs, the total cost of ownership, or TCO, is driven up by management, power and efficiency challenges. We concentrate our efforts on developing solutions that minimize the TCO, delivering faster time-to-solution and advanced capabilities that are key drivers for many of our data analytics customers. We support open source technologies such as Hadoop and Spark and partner with UC Berkeley’s AMPLab and Berkeley Lab’s National Energy Research Scientific Computing Center to design large-scale data analytics stacks that simplify analyses of scientific and commercial applications.
We have also expanded our addressable market by providing cluster systems and solutions to the supercomputing market that allow us to offer flexible platforms to incorporate best of breed components to allow customers to optimize the system to fit their unique requirements.
Key Performance Indicators
Our management monitors and analyzes several key performance indicators in order to manage our business and evaluate our financial and operating performance, including:
Revenue.
Product revenue generally constitutes the major portion of our revenue in any reporting period and, for the reasons discussed in this Form 10-Q or in our annual report on Form 10-K, is subject to significant variability from period to period. In the short term, we closely review the status of customer proposals, customer contracts, product shipments, installations and acceptances in order to forecast revenue and cash receipts. In the longer-term, we monitor the status of the pipeline of product sales opportunities and product development cycles. We believe product revenue growth measured over several quarters is a better indicator of whether we are achieving our objective of increased market share in the supercomputing market. The introduction of new generations of Cray XC and Cray CS products, along with our longer-term product roadmap are efforts to increase product revenue. We have been increasing our business and product development efforts in storage and data management along with big data analytics. We have also been increasing the size of our sales force. Service revenue related to our maintenance offerings is more constant in the short term and assists, in part, to offset the impact that the variability in product revenue has on total revenue.
Gross profit margin.
Gross profit margin is impacted by revenue and our cost to build and deliver our products and services. Our services tend to carry higher gross profit margins than our products. We monitor the cost of components, manufacturing, and installation of our products. In assessing our service gross profit margin, we monitor headcount levels and third-party costs.
Operating expenses.
Our operating expenses are driven primarily by headcount, contracted third-party research and development services, and incentive compensation expense. As part of our ongoing expense management efforts, we continue to monitor headcount levels in specific geographic and operational areas.
Liquidity and cash flows.
Due to the variability in product revenue, new contracts, customer acceptance and payment terms, our cash position also varies significantly from quarter-to-quarter and within a quarter. We monitor our expected cash levels, particularly in light of increased inventory purchases for large system installations and the risk of delays in product shipments and customer acceptances and, longer-term, in product development. Cash receipts generally lag customer acceptances.
Results of Operations
Our revenue, results of operations and cash balances fluctuate significantly from quarter-to-quarter. These fluctuations are due to such factors as the high average sales prices and limited number of sales of our products with variable gross margin levels, the timing of purchase orders and product deliveries, the availability of components, the revenue recognition accounting policy of generally not recognizing product revenue until customer acceptance and other contractual provisions have been fulfilled, the timing of payments for product sales, maintenance services, government research and development funding, the impact of the timing of new products on customer orders, and purchases of inventory during periods of inventory build-up. As a result of these factors, revenue, gross margin, expenses, cash, receivables, inventory and other related financial statement items have in the past varied, and are expected to continue to vary, significantly from quarter-to-quarter and year-to-year.
Revenue and Gross Profit Margins
Our revenue, cost of revenue and gross profit margin for the
three and six months ended June 30, 2016 and 2015
, respectively, were (in thousands, except for percentages):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
June 30,
|
|
Six Months Ended
June 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Product revenue
|
|
$
|
68,929
|
|
|
$
|
157,937
|
|
|
$
|
140,339
|
|
|
$
|
210,678
|
|
Less: Cost of product revenue
|
|
45,459
|
|
|
120,789
|
|
|
91,637
|
|
|
161,545
|
|
Product gross profit
|
|
$
|
23,470
|
|
|
$
|
37,148
|
|
|
$
|
48,702
|
|
|
$
|
49,133
|
|
Product gross profit margin
|
|
34
|
%
|
|
24
|
%
|
|
35
|
%
|
|
23
|
%
|
Service revenue
|
|
$
|
31,306
|
|
|
$
|
28,224
|
|
|
$
|
65,445
|
|
|
$
|
55,127
|
|
Less: Cost of service revenue
|
|
18,615
|
|
|
15,787
|
|
|
38,024
|
|
|
30,639
|
|
Service gross profit
|
|
$
|
12,691
|
|
|
$
|
12,437
|
|
|
$
|
27,421
|
|
|
$
|
24,488
|
|
Service gross profit margin
|
|
41
|
%
|
|
44
|
%
|
|
42
|
%
|
|
44
|
%
|
Total revenue
|
|
$
|
100,235
|
|
|
$
|
186,161
|
|
|
$
|
205,784
|
|
|
$
|
265,805
|
|
Less: Total cost of revenue
|
|
64,074
|
|
|
136,576
|
|
|
129,661
|
|
|
192,184
|
|
Total gross profit
|
|
$
|
36,161
|
|
|
$
|
49,585
|
|
|
$
|
76,123
|
|
|
$
|
73,621
|
|
Total gross profit margin
|
|
36
|
%
|
|
27
|
%
|
|
37
|
%
|
|
28
|
%
|
Product Revenue
Product revenue for the
three and six months ended June 30, 2016 and 2015
,was primarily from sales of our Cray XC and Cray CS supercomputing systems and Sonexion storage systems. Product revenue was
$89.0 million
higher for the
three months ended June 30, 2015
, as compared to the
three months ended June 30, 2016
, primarily due to customer acceptance of multiple Cray systems by one customer in Saudi Arabia in the second quarter of 2015. Product revenue was
$70.3 million
higher in the first six months of 2015 as compared to the first six months of 2016, also primarily due to the acceptances in Saudi Arabia as well as customer acceptances of two large systems in the first quarter of 2015 for which we had previously anticipated acceptance to occur in the fourth quarter of 2014.
Service Revenue
Service revenue for the
three months ended June 30, 2016
, was
$31.3 million
compared to
$28.2 million
for the same period in
2015
. Service revenue for the
six months ended June 30, 2016
, was
$65.4 million
compared to
$55.1 million
for the same period in
2015
. The
increase
in service revenue in both periods was driven by increases in maintenance revenue, which has continued to benefit from our larger installed system base, as well as an increase in engineering services as a result of milestone completions on certain projects in 2016.
Cost of Product Revenue and Product Gross Profit
Cost of product revenue
decrease
d by
$75.3 million
for the
three months ended June 30, 2016
, compared to the
three months ended June 30, 2015
, and by
$69.9 million
for the
six months ended June 30, 2016
, compared to the
six months ended June 30, 2015
. This decrease in both periods was driven by lower product revenue and improved gross margins. For the
three months ended June 30, 2016
, product gross profit margin
increase
d
10
percentage points to
34%
from
24%
in the same period in
2015
. For the
six months ended June 30, 2016
, product gross profit margin
increase
d
12
percentage points to
35%
from
23%
in the same period in
2015
. The product gross profit margins for the
three and six months ended June 30, 2015
were considered low and was impacted by higher costs on a few large contracts that were not anticipated at the time of bidding, driven both by economic factors and
technical issues. Product gross profit margins in any one period may not be indicative of future results as product gross profit margins can vary significantly between contracts for many reasons.
Cost of Service Revenue and Service Gross Profit
For the
three months ended June 30, 2016
, cost of service revenue
increase
d by
$2.8 million
compared to the same period in
2015
. For the
six months ended June 30, 2016
, cost of service revenue
increase
d by
$7.4 million
compared to the same period in
2015
. The increase for both periods was driven by a larger installed base of systems to service which also resulted in higher service revenue. Service gross profit margin for the
three months ended June 30, 2016
,
decrease
d by
3
percentage points to
41%
compared to
44%
in the same period in
2015
. Service gross profit margin for the
six months ended June 30, 2016
,
decrease
d by
2
percentage points to
42%
compared to
44%
in the same period in
2015
. The
decrease
in service gross profit margin in both periods was primarily the result of higher headcount and compensation expense, and higher third party costs.
Research and Development Expenses
Research and development expenses for the
three and six months ended June 30, 2016 and 2015
, respectively, were (in thousands, except for percentages):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
June 30,
|
|
Six Months Ended
June 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Gross research and development expenses
|
|
$
|
30,502
|
|
|
$
|
27,613
|
|
|
$
|
61,976
|
|
|
$
|
53,259
|
|
Less: Amounts included in cost of revenue
|
|
(2,476
|
)
|
|
(3,194
|
)
|
|
(6,726
|
)
|
|
(6,407
|
)
|
Less: Reimbursed research and development (excludes amounts in cost of revenue)
|
|
(627
|
)
|
|
(4,313
|
)
|
|
(2,011
|
)
|
|
(4,559
|
)
|
Net research and development expenses
|
|
$
|
27,399
|
|
|
$
|
20,106
|
|
|
$
|
53,239
|
|
|
$
|
42,293
|
|
Percentage of total revenue
|
|
27
|
%
|
|
11
|
%
|
|
26
|
%
|
|
16
|
%
|
Gross research and development expenses in the table above reflect all research and development expenditures. Research and development expenses include personnel expenses, depreciation, allocations for certain overhead expenses, software, prototype materials and third party contractor engineering expenses.
For the
three months ended June 30, 2016
, gross research and development expenses
increase
d by
$2.9 million
compared to the same period in
2015
. For the
six months ended June 30, 2016
, gross research and development expenses
increase
d by
$8.7 million
compared to the same period in
2015
. The increase in both periods was due to increased investments in the development of new products and higher costs related to our engineering services contracts, which included higher third party costs. We increased our average headcount which resulted in compensation costs increasing by $2.4 million and $5.9 million for the
three and six months ended June 30, 2016
, respectively, compared to the same periods in 2015.
Net research and development expenses
increase
d by
$7.3 million
for the
three months ended June 30, 2016
, compared to the same period in
2015
. Net research and development expenses
increase
d by
$10.9 million
for the
six months ended June 30, 2016
, compared to the same period in
2015
. In addition to higher gross research and development expenses, we had lower reimbursements and amounts included in cost of revenue in the three and six month periods. The amount and timing of research and development costs related to engineering development contracts and the level of reimbursement from third parties for research and development projects varies significantly from period to period, and can have a significant impact on net reported research and development expense.
Sales and Marketing and General and Administrative Expenses
Our sales and marketing and general and administrative expenses for the
three and six months ended June 30, 2016 and 2015
, respectively, were (in thousands, except for percentages):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
June 30,
|
|
Six Months Ended
June 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Sales and marketing
|
|
$
|
15,380
|
|
|
$
|
13,412
|
|
|
$
|
31,381
|
|
|
$
|
25,964
|
|
Percentage of total revenue
|
|
15
|
%
|
|
7
|
%
|
|
15
|
%
|
|
10
|
%
|
General and administrative
|
|
$
|
9,019
|
|
|
$
|
6,435
|
|
|
$
|
16,357
|
|
|
$
|
12,575
|
|
Percentage of total revenue
|
|
9
|
%
|
|
3
|
%
|
|
8
|
%
|
|
5
|
%
|
Sales and Marketing
.
Sales and marketing expense for the
three months ended June 30, 2016
,
increase
d by
$2.0 million
from the same period in
2015
. Sales and marketing expense for the
six months ended June 30, 2016
,
increase
d by
$5.4 million
from the same period in
2015
. The increases have resulted in part from an increase in our average headcount which resulted in higher compensation costs of $1.4 million and $3.8 million, respectively, compared to the same periods in 2015.
General and Administrative
. General and administrative expense for the
three months ended June 30, 2016
,
increase
d by
$2.6 million
from the same period in
2015
. General and administrative expense for the
six months ended June 30, 2016
,
increase
d by
$3.8 million
from the same period in
2015
. The increase in the three and six month periods was largely attributable to a $2.3 million termination fee for our St. Paul facility and increased legal costs in the three and six months ended June 30, 2016.
Other Income (Expense), net
For the
three and six months ended June 30, 2016
, we recognized net other expense of
$0.4 million
and
$0.9 million
, respectively, compared to net other expense of
$0.3 million
and net other income of
$0.5 million
, respectively for the same periods in
2015
. Net other income and expense for the
three and six months ended June 30, 2016 and 2015
included gains and losses from foreign currency transactions, investments and the disposals of assets.
Interest Income, net
Our interest income and interest expense for the
three and six months ended June 30, 2016 and 2015
, respectively, were (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
June 30,
|
|
Six Months Ended
June 30,
|
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Interest income
|
|
$
|
464
|
|
|
$
|
418
|
|
|
$
|
1,049
|
|
|
$
|
787
|
|
Interest expense
|
|
62
|
|
|
(5
|
)
|
|
61
|
|
|
(10
|
)
|
Interest income, net
|
|
$
|
526
|
|
|
$
|
413
|
|
|
$
|
1,110
|
|
|
$
|
777
|
|
Interest income, net for the
three and six months ended June 30, 2016
increase
d as compared to the same periods in
2015
due to higher average investment balances as a result of the significant year over year increase in our cash balance.
Taxes
Our effective tax rates were approximately
15%
and
26%
for the
three and six months ended June 30, 2016
, compared to
41%
and
39%
for the
three and six months ended June 30, 2015
. The primary reason for the difference between the expected statutory tax rate of
35%
and the actual tax rates of
15%
and
26%
for the
three and six months ended June 30, 2016
, was a reduction in our business outlook with respect to the current year which substantially increased the impact that our research and development tax credit had on our effective tax rate. Other significant reconciling items that impacted our effective tax rate included excess tax benefits, and state and foreign taxes. Prior to the adoption of ASU 2016-09 excess tax benefits did not impact our effective tax rate. The adoption of ASU 2016-09 will result in increased volatility in our effective tax rate. The primary reason for the difference between the expected statutory tax rate of
35%
and the actual tax rates of
41%
and
39%
for the
three and six months ended June 30, 2015
, was state taxes.
New Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers: Topic 606 (ASU 2014-09), to supersede nearly all existing revenue recognition guidance under GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration that is expected to be received for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process than required under existing GAAP, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. Adoption of ASU 2014-09 was initially required for fiscal and interim reporting periods beginning after December 15, 2016 using either of two methods: (i) retrospective to each prior reporting period presented with the option to elect certain practical expedients as defined within ASU 2014-09; or (ii) retrospective with the cumulative effect of initially applying ASU 2014-09 recognized at the date of initial application and providing certain additional disclosures as defined per ASU 2014-09.
In August 2015, FASB issued Accounting Standards Update No. 2015-14, Revenue from Contracts with Customers - Deferral of the Effective Date: Topic 606 (ASU 2015-14) that deferred the effective date of ASU 2014-09 by one year. Application of the new revenue standard is permitted for fiscal and interim reporting periods beginning after December 15, 2016 and required for fiscal and interim reporting periods beginning after December 15, 2017. We are currently evaluating the potential impact of the pending adoption of ASU 2014-09 on our consolidated financial statements.
In July 2015, FASB issued Accounting Standards Update No. 2015-11, Simplifying the Measurement of Inventory: Topic 330 (ASU 2015-11) to amend Topic 330, Inventory. Topic 330 currently requires an entity to measure inventory at the lower of cost or market. Market could be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. ASU 2015-11 requires that inventory measured using either the first-in, first-out (FIFO) or average cost method be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. Adoption of ASU 2015-11 is required for fiscal reporting periods beginning after December 15, 2016, including interim reporting periods within those fiscal years. We do not expect the adoption of ASU 2015-11 to have a material impact on our consolidated financial statements.
In November 2015, FASB issued Accounting Standards Update No. 2015-17, Balance Sheet Classification of Deferred Taxes: Topic 740 (ASU 2015-17). Current GAAP requires the deferred taxes for each jurisdiction to be presented as a net current asset or liability and net noncurrent asset or liability. This requires a jurisdiction-by-jurisdiction analysis based on the classification of the assets and liabilities to which the underlying temporary differences relate, or, in the case of loss or credit carryforwards, based on the period in which the attribute is expected to be realized. Any valuation allowance is then required to be allocated on a pro rata basis, by jurisdiction, between current and noncurrent deferred tax assets. The new guidance requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. As a result, each jurisdiction will now only have one net noncurrent deferred tax asset or liability. The guidance does not change the existing requirement that only permits offsetting within a jurisdiction. Adoption of ASU 2015-17 is required for fiscal reporting periods beginning after December 15, 2016, including interim reporting periods within those fiscal years, and either prospective or retrospective application is permitted. Early adoption of ASU 2015-17 is permitted. At the time of adoption, all of our deferred tax assets and liabilities, along with any related valuation allowance, will be classified as noncurrent on our Consolidated Balance Sheet. Currently, we do not plan to early-adopt ASU 2015-17.
In January 2016, FASB issued Accounting Standards Update No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities: Topic 825 (ASU 2016-01). The updated guidance enhances the reporting model for financial instruments, which includes amendments to address aspects of recognition, measurement, presentation and disclosure. Adoption of ASU 2016-01 is required for fiscal reporting periods beginning after December 15, 2017, including interim reporting periods within those fiscal years. We are currently evaluating the potential impact of the pending adoption of ASU 2016-01 on our consolidated financial statements.
In February 2016, FASB issued Accounting Standards Update No. 2016-02, Leases: Topic 842 (ASU 2016-02) that replaces existing lease guidance. The new standard is intended to provide enhanced transparency and comparability by requiring lessees to record right-of-use assets and corresponding lease liabilities on the balance sheet. Under the new guidance, leases will continue to be classified as either finance or operating, with classification affecting the pattern of expense recognition in the Consolidated Statement of Operations. Lessor accounting is largely unchanged under ASU 2016-02. Adoption of ASU 2016-02 is required for fiscal reporting periods beginning after December 15, 2018, including interim reporting periods within those fiscal years with early adoption being permitted. The new standard is required to be applied with a modified retrospective approach to each prior reporting period presented with various optional practical expedients. We are currently evaluating the potential impact of the pending adoption of ASU 2016-02 on our consolidated financial statements.
In March 2016, FASB issued Accounting Standards Update No. 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (ASU 2016-09). The updated guidance simplifies and changes how
companies account for certain aspects of share-based payment awards to employees, including accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification of certain items in the statement of cash flows. Adoption of ASU 2016-09 is required for fiscal reporting periods beginning after December 15, 2016, including interim reporting periods within those fiscal years with early adoption being permitted. We early-adopted ASU 2016-09 at the beginning of the first quarter of 2016.
At the time of adoption, we recognized $16.6 million in deferred tax assets for all excess tax benefits that had not been previously recognized because the related tax deduction had not reduced taxes payable. This was accomplished through a cumulative-effect adjustment to accumulated deficit. All excess tax benefits and all tax deficiencies generated in the current and future periods will be recorded as income tax benefit or expense in our Consolidated Statement of Operations in the reporting period in which they occur. This will result in increased volatility in our effective tax rate. We have determined that none of the other provisions of ASU 2016-09 will have a significant impact on our consolidated financial statements.
Liquidity and Capital Resources
We generate cash from operations predominantly from the sale of supercomputing systems and related services. We typically have a small number of significant contracts that make up the majority of total revenue. We have also entered into a sales-type lease agreement with a customer, under which we will receive quarterly payments over a four year period. Material changes in certain of our balance sheet accounts were due to the timing of product deliveries and customer acceptances, contractually determined billings, timing and level of inventory purchased for future deliveries, timing and level of incentive compensation and cash collections. Working capital requirements, including inventory purchases and normal capital expenditures, are generally funded with cash from operations.
We are currently planning to expand our manufacturing facility in Chippewa Falls, Wisconsin in order to increase capacity. We estimate that this project will require total capital expenditures in the range of $20.0 million to $25.0 million. Our current expectation is that the project will begin in the second half of 2016 and conclude in 2017. We may choose to externally finance these activities.
Cash and cash equivalents
decrease
d by
$53.9 million
from
December 31, 2015
to
June 30, 2016
. As of
June 30, 2016
, we had working capital of
$380.8 million
compared to
$415.2 million
as of
December 31, 2015
. During the
six months ended June 30, 2016
, our net investments in debt securities decreased by $5.6 million and we had a total of
$9.3 million
in debt security investments as of
June 30, 2016
.
Cash flow information included the following (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended
June 30,
|
|
|
2016
|
|
2015
|
Cash provided by (used in):
|
|
|
|
|
Operating Activities
|
|
$
|
(60,546
|
)
|
|
$
|
(38,810
|
)
|
Investing Activities
|
|
$
|
4,769
|
|
|
$
|
(5,488
|
)
|
Financing Activities
|
|
$
|
978
|
|
|
$
|
397
|
|
Operating Activities.
Net cash
used in
operating activities was
$60.5 million
for the first
six
months of
2016
compared to net cash
used in
operating activities of
$38.8 million
for the first
six
months of
2015
. Net cash
used in
operating activities in the first
six
months of
2016
was primarily driven by an increase in net loss year-to date and an increase of
$84.3 million
in inventory as a result of system builds for future deliveries and a decrease of
$32.4 million
in accrued payroll and related expenses and other accrued liabilities, largely resulting from payment of 2015 accrued incentive compensation. We also leased an additional system to a customer which increased our long-term investment in leases by
$22.2 million
. These amounts were partially offset by collections from customers that resulted in a decrease of
$66.3 million
in accounts and other receivables, and an increase in our accounts payable balance of
$43.1 million
due to inventory purchases and the timing of payments.
For the
six months ended June 30, 2015
, net cash
used in
operating activities was primarily driven by an increase of
$82.8 million
in inventory as a result of systems builds for future deliveries and a decrease of
$21.2 million
in other accrued liabilities and payroll related accruals, partly as a result of payment of the 2014 accrued compensation expense. These amounts were partially offset by an increase of
$29.7 million
in our accounts payable balance and collections from customers that resulted in a decrease of
$28.4 million
in accounts receivable from December 31, 2014 to June 30, 2015.
Investing Activities.
Net cash
provided by
investing activities was
$4.8 million
for the
six months ended June 30, 2016
, compared to
$5.5 million
net cash
used in
investing activities for the same period in
2015
. Net cash
provided by
investing activities
for the
six months ended June 30, 2016
was due to sales and maturities of debt securities of
$21.7 million
, partially offset by purchases of debt securities of
$16.2 million
. For the
six months ended June 30, 2015
, net cash
used in
investing activities was due principally to sales and maturities of debt securities of
$8.5 million
, being less than purchases of debt securities and property and equipment of
$10.0 million
and
$4.0 million
, respectively.
Financing Activities.
Net cash
provided by
financing activities for the
six months ended June 30, 2016
was
$1.0 million
compared to
$0.4 million
for the same period in
2015
. Net cash flows from financing activities for both periods resulted primarily from cash received from the issuance of common stock from the exercise of options and from the issuance of stock through our employee stock purchase plan, offset by statutory tax withholding amounts made in exchange for the forfeiture of common stock by holders of vesting restricted stock awards.
In addition, we lease certain equipment and facilities used in our operations under operating leases in the normal course of business and have contractual commitments under certain development arrangements. The following table summarizes our contractual obligations as of
June 30, 2016
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amounts Committed by Year
|
Contractual Obligations
|
Total
|
|
2016
(Less than
1 Year)
|
|
2017-2018
|
|
2019-2020
|
|
Thereafter
|
Development agreements
|
$
|
27,582
|
|
|
$
|
17,388
|
|
|
$
|
10,169
|
|
|
$
|
25
|
|
|
$
|
—
|
|
Operating leases
|
61,646
|
|
|
2,823
|
|
|
12,984
|
|
|
12,750
|
|
|
33,089
|
|
Total contractual cash obligations
|
$
|
89,228
|
|
|
$
|
20,211
|
|
|
$
|
23,153
|
|
|
$
|
12,775
|
|
|
$
|
33,089
|
|
On April 21, 2016, we entered into a new operating lease for facilities in Bloomington, Minnesota that will principally be staffed with teams from software development, sales and service. This new lease will replace our existing lease in St. Paul, Minnesota. The new lease is for a minimum period of eight years beginning on May 1, 2017. Minimum contractual obligations under the new lease total $31.9 million. We paid an early termination fee of approximately $2.3 million to terminate our existing lease in St. Paul, Minnesota which was recorded as an operating expense in the second quarter of 2016. We received a lease incentive of $2.3 million as part of our new lease agreement to cover the termination fee, which will be amortized over the term of the new lease.
On January 7, 2016, we entered into an Amended and Restated Credit Agreement, or Amended Credit Agreement, with Wells Fargo Bank, National Association which provides a revolving line of credit, or Credit Facility, through December 1, 2017, for up to
$50.0 million
to be used for general corporate purposes, including working capital requirements and capital expenditures. The Credit Facility will also support the issuance of letters of credit. The Credit Facility is secured by a first priority lien in all of our accounts receivable and other rights to payment, general intangibles, inventory and equipment.
Any borrowings under the Credit Facility bear interest at either a fluctuating rate equal to the daily one month LIBOR rate plus a margin of
1.25%
or a fixed interest rate for one, three or six months equal to the LIBOR rate for the applicable period plus a margin of
1.25%
. We are also required to pay the lender customary letter of credit fees, and a commitment fee of
0.18%
per annum in respect of the unutilized commitment amount under the Credit Facility. The Credit Facility requires that we maintain certain financial ratios.
The Amended Credit Agreement restates and replaces the Restated Credit Agreement with Wells Fargo Bank, National Association dated as of October 1, 2012, as amended, which provided a
$10.0 million
line of credit to secure letters of credit and foreign currency exchange hedging transactions.
We made no draws and had no outstanding cash borrowings on any lines of credit as of
June 30, 2016
.
As of
June 30, 2016
, we had $5.3 million in USD equivalent value in outstanding letters of credit and
$1.7 million
in restricted cash associated with certain letters of credit to secure customer prepayments and other customer related obligations.
In our normal course of operations, we have development arrangements under which we engage third-party engineering resources to work on our research and development projects. For the six months ended June 30, 2016, we incurred
$6.0 million
for such arrangements.
At any particular time, our cash position is affected by the timing of cash receipts for product sales, maintenance contracts, government co-funding for research and development activities and our payments for inventory, resulting in significant fluctuations in our cash balance from quarter-to-quarter and within a quarter. Our principal sources of liquidity are our cash and cash equivalents, short-term investments and cash from operations. We expect our cash resources to be adequate for at least the next twelve months.
Critical Accounting Policies and Estimates
This discussion, as well as disclosures included elsewhere in this quarterly report on Form 10-Q, are based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with GAAP. 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. In preparing our financial statements in accordance with GAAP, there are certain accounting policies that are particularly important. These include revenue recognition, inventory valuation, accounting for income taxes, research and development expenses and share-based compensation. Our significant accounting policies are set forth in Note 2 to the Consolidated Financial Statements included in our
2015
Annual Report on Form 10-K and should be reviewed in conjunction with the accompanying Condensed Consolidated Financial Statements and notes thereto as of
June 30, 2016
in this quarterly report on Form 10-Q, as they are integral to understanding our results of operations and financial condition in this interim period. In some cases, these policies represent required accounting. In other cases, they may represent a choice among acceptable accounting methods or may require substantial judgment or estimation.
Additionally, we consider certain judgments and estimates to be significant, including those relating to the estimated selling price determination used in revenue recognition, percentage of completion accounting, estimates of proportional performance on co-funded engineering contracts, collectibility of receivables, determination of inventory at the lower of cost or market, the value of used equipment returned or to be returned associated with customer contracts, useful lives for depreciation and amortization, determination of future cash flows associated with impairment testing of long-lived assets, including goodwill and other intangibles, determination of the implicit interest rate used in the sales-type lease calculation, estimated warranty liabilities, determination of the fair value of stock options and other assessments of fair value, evaluation of the probability of vesting of performance-based restricted stock and restricted stock units, calculation of deferred income tax assets, including estimates of future financial performance in the determination of the likely recovery of deferred income tax assets, our ability to utilize such assets, potential income tax assessments, the outcome of any legal proceedings and other contingencies. We base our estimates on historical experience, current conditions and on other assumptions that we believe to be reasonable under the circumstances. Actual results may differ materially from these estimates and assumptions.
Our management has discussed the selection of significant accounting policies and the effect of judgments and estimates with the Audit Committee of our Board of Directors.
Revenue Recognition
We recognize revenue, including transactions under sales-type leases, when it is realized or realizable and earned. We consider revenue realized or realizable and earned when we have persuasive evidence of an arrangement, delivery has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. Delivery does not occur until the products have been shipped or services provided to the customer, risk of loss has transferred to the customer, and, where applicable, a customer acceptance has been obtained. The sales price is not considered to be fixed or determinable until all material contingencies related to the sales have been resolved. We record revenue in the Condensed Consolidated Statements of Operations net of any sales, use, value added or certain excise taxes imposed by governmental authorities on specific sales transactions. In addition to the aforementioned general policy, the following are our statements of policy with regard to multiple-element arrangements and specific revenue recognition policies for each major category of revenue.
Multiple-Element Arrangements.
We commonly enter into revenue arrangements that include multiple deliverables of our product and service offerings due to the needs of our customers. Products may be delivered in phases over time periods which can be as long as five years. Maintenance services generally begin upon acceptance of the first equipment delivery and future deliveries of equipment generally have an associated maintenance period. We consider the maintenance period to commence upon acceptance of the product, or installation of the product where a formal acceptance is not required, which may include a warranty period and accordingly allocate a portion of the arrangement consideration as a separate deliverable which is recognized as service revenue over the entire service period. Other services such as training and engineering services can be delivered as a discrete delivery or over the term of the contract. A multiple-element arrangement is separated into more than one unit of accounting if the following criteria are met:
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The delivered item(s) has value to the customer on a standalone basis; and
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If the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control.
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If these criteria are met for each element, the arrangement consideration is allocated to the separate units of accounting based on each unit’s relative selling price. If these criteria are not met, the arrangement is accounted for as one unit of accounting which would result in revenue being recognized ratably over the contract term or being deferred until the earlier of when such criteria are met or when the last undelivered element is delivered.
We follow a selling price hierarchy in determining the best estimate of the selling price of each deliverable. Certain products and services are sold separately in standalone arrangements for which we are sometimes able to determine vendor specific objective evidence, or VSOE. We determine VSOE based on normal pricing and discounting practices for the product or service when sold separately.
When we are not able to establish VSOE for all deliverables in an arrangement with multiple elements, we attempt to establish the selling price of each remaining element based on third-party evidence, or TPE. Our inability to establish VSOE is often due to a relatively small sample of customer contracts that differ in system size and contract terms which can be due to infrequently selling each element separately, not pricing products within a narrow range, or only having a limited sales history, such as in the case of certain advanced and emerging technologies. TPE is determined based on our prices or competitor prices for similar deliverables when sold separately. However, we are often unable to determine TPE, as our offerings usually contain a significant level of customization and differentiation from those of competitors and we are often unable to reliably determine what similar competitor products’ selling prices are on a standalone basis.
When we are unable to establish selling price using VSOE or TPE, we use estimated selling price, or ESP, in our allocation of arrangement consideration. The objective of ESP is to determine the price at which we would transact a sale if the product or service were sold on a standalone basis. In determining ESP, we use the cost to provide the product or service plus a margin, or consider other factors. When using cost plus a margin, we consider the total cost of the product or service, including customer-specific and geographic factors. We also consider the historical margins of the product or service on previous contracts and several factors including any changes to pricing methodologies, competitiveness of products and services and cost drivers that would cause future margins to differ from historical margins.
Products
. We most often recognize revenue from sales of products upon delivery or customer acceptance of the system. Where formal acceptance is not required, we recognize revenue upon delivery or installation. When the product is part of a multiple element arrangement, we allocate a portion of the arrangement consideration to product revenue based on estimates of selling price.
Services
. Maintenance services are provided under separate maintenance contracts with customers. These contracts generally provide for maintenance services for one year, although some are for multi-year periods, often with prepayments for the term of the contract. We consider the maintenance period to commence upon acceptance of the product or installation in situations where a formal acceptance is not required, which may include a warranty period. When service is part of a multiple element arrangement, we allocate a portion of the arrangement consideration to maintenance service revenue based on estimates of selling price. Maintenance contracts that are billed in advance of revenue recognition are recorded as deferred revenue. Maintenance revenue is recognized ratably over the term of the maintenance contract.
Revenue from engineering services is recognized as services are performed.
Project Revenue
. Revenue from design and build contracts is recognized under the percentage-of-completion (or POC method). Under the POC method, revenue is recognized based on the costs incurred to date as a percentage of the total estimated costs to fulfill the contract. If circumstances arise that change the original estimates of revenues, costs, or extent of progress toward completion, revisions to the estimates are made. These revisions may result in increases or decreases in estimated revenues or costs, and such revisions are recorded in income in the period in which the circumstances that gave rise to the revision become known by management. We perform ongoing profitability analyses of our contracts accounted for under the POC method in order to determine whether the latest estimates of revenue, costs and extent of progress require updating. If at any time these estimates indicate that the contract will be unprofitable, the entire estimated loss for the remainder of the contract is recorded immediately.
We record revenue from certain research and development contracts which include milestones using the milestone method if the milestones are determined to be substantive. A milestone is considered to be substantive if management believes there is substantive uncertainty that it will be achieved and the milestone consideration meets all of the following criteria:
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It is commensurate with either of the following:
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Our performance to achieve the milestone; or
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The enhancement of value of the delivered item or items as a result of a specific outcome resulting from our performance to achieve the milestone.
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It relates solely to past performance.
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It is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement.
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The individual milestones are determined to be substantive or non-substantive in their entirety and milestone consideration is not bifurcated.
Revenue from projects is classified as Product Revenue or Service Revenue, based on the nature of the work performed.
Nonmonetary Transactions
. We value and record nonmonetary transactions at the fair value of the asset surrendered unless the fair value of the asset received is more clearly evident, in which case the fair value of the asset received is used.
Inventory Valuation
We record our inventory at the lower of cost or market. We regularly evaluate the technological usefulness and anticipated future demand for our inventory components. Due to rapid changes in technology and the increasing demands of our customers, we are continually developing new products. Additionally, during periods of product or inventory component upgrades or transitions, we may acquire significant quantities of inventory to support estimated current and future production and service requirements. As a result, it is possible that older inventory items we have purchased may become obsolete, be sold below cost or be deemed in excess of quantities required for production or service requirements. When we determine it is not likely we will recover the cost of inventory items through future sales, we write-down the related inventory to our estimate of its market value.
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 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 incur additional expenses to write-down inventory to its estimated market value. Adjustments to these estimates in the future may materially impact our operating results.
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 operating loss and tax credit carryforwards and are measured using the enacted tax rates and laws that will be in effect when the differences and carryforwards are expected to be recovered or settled. A valuation allowance for deferred tax assets is provided when we estimate that it is more likely than not that all or a portion of the deferred tax assets will not be realized through future operations. This assessment is based upon consideration of available positive and negative evidence, which includes, among other things, our recent results of operations and expected future profitability. We consider our actual historical results over several years to have stronger weight than other more subjective indicators, including forecasts, when considering whether to establish or reduce a valuation allowance on deferred tax assets. We have significant difficulty projecting future results due to the nature of the business and the industry in which we operate.
Our deferred tax assets increased by $16.6 million as a result of the adoption of ASU 2016-09. No changes were required to previously recorded valuation allowances at the time of adoption. ASU 2016-09 will result in increased volatility in our effective tax rate.
As of June 30, 2016, we had approximately $97 million of net deferred tax assets, against which we provided a $10 million valuation allowance, resulting in a net deferred tax asset of $87 million. The assessment of our ability to utilize our deferred tax assets included an assessment of all known business risks and industry trends as well as forecasted domestic and international earnings over a number of years. Our ability to forecast results significantly into the future is severely limited due to the rapid rate of technological and competitive change in the industry in which we operate.
We continue to provide a valuation allowance against specific U.S. deferred tax assets and a full valuation allowance against deferred tax assets arising in a limited number of foreign jurisdictions as the realization of such assets is not considered to be more likely than not at this time. In a future period our assessment of the realizability of our deferred tax assets and therefore the appropriateness of the valuation allowance could change based on an assessment of all available evidence, both positive and negative in that future period. If our conclusion about the realizability of our deferred tax assets and therefore the appropriateness of the valuation allowance changes in a future period we could record a substantial tax provision or benefit in our Condensed Consolidated Statement of Operations when that occurs.We recognize the income tax benefit from a tax position only if it is more
likely than not that the tax position will be sustained on examination by the applicable taxing authorities, based on the technical merits of our position. The tax benefit recognized in the financial statements from such a position is measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement.
Estimated interest and penalties are recorded as a component of interest expense and other expense, respectively.
Research and Development Expenses
Research and development expenses include costs incurred in the development and production of our hardware and software, costs incurred to enhance and support existing product features, costs incurred to support and improve our development processes, and costs related to future product development. Research and development costs are expensed as incurred, and may be offset by co-funding from third parties. We may also enter into arrangements whereby we make advance, non-refundable payments to a vendor to perform certain research and development services. These payments are deferred and recognized over the vendor’s estimated performance period.
Amounts to be received under co-funding arrangements with the U.S. government or other customers are based on either contractual milestones or costs incurred. These co-funding milestone payments are recognized in operations as performance is estimated to be completed and are measured as milestone achievements occur or as costs are incurred. These estimates are reviewed on a periodic basis and are subject to change, including in the near term. If an estimate is changed, net research and development expense could be impacted significantly.
We do not record a receivable from the U.S. government prior to completing the requirements necessary to bill for a milestone or cost reimbursement. Funding from the U.S. government is subject to certain budget restrictions and milestones may be subject to completion risk, and as a result, there may be periods in which research and development costs are expensed as incurred for which no reimbursement is recorded, as milestones have not been completed or the U.S. government has not funded an agreement. Accordingly, there can be substantial variability in the amount of net research and development expenses from quarter to quarter and year to year.
We classify amounts to be received from funded research and development projects as either revenue or a reduction to research and development expense based on the specific facts and circumstances of the contractual arrangement, considering total costs expected to be incurred compared to total expected funding and the nature of the research and development contractual arrangement. In the event that a particular arrangement is determined to represent revenue, the corresponding costs are classified as cost of revenue.
Share-based Compensation
We measure compensation cost for share-based payment awards at fair value and recognize it as compensation expense over the service period for awards expected to vest. We recognize share-based compensation expense for all share-based payment awards, net of an estimated forfeiture rate. We recognize compensation cost for only those shares expected to vest on a straight-line basis over the requisite service period of the award.
Determining the appropriate fair value model and calculating the fair value of share-based payment awards requires subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. We utilize the Black-Scholes options pricing model to value the stock options granted under our options plans. In this model, we utilize assumptions related to stock price volatility, stock option term and forfeiture rates that are based upon both historical factors as well as management’s judgment.
The fair value of restricted stock and restricted stock units is determined based on the number of shares or units granted and the quoted price of our common stock at the date of grant.
We grant performance vesting restricted stock and performance vesting restricted stock units to executives as one of the ways to align compensation with shareholder interests. Vesting of these awards is contingent upon achievement of certain performance conditions. Compensation expense for these awards is only recognized when vesting is deemed to be “probable”. Awards are evaluated for probability of vesting during each reporting period.