##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 Form 10-Q
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition period from          to
 Commission file number 0-26820
 
 CRAY INC.
 (Exact name of registrant as specified in its charter)
 
 Washington
    
    93-0962605(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 
 
 
 þ o
  o þ o
 o þ




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##### 



CRAY INC.
  
 TABLE OF CONTENTS
 Page No.PART I FINANCIAL INFORMATIONItem 1. Unaudited Condensed Consolidated Financial Statements:Balance Sheets as of December 31, 2005 and September 30, 2006
    
    
    1Statements of Operations for the Three and Nine Months Ended September 30, 2005 and 2006
    
    
    2Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2006
    
    
    3Notes to Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    24Item 4. Controls and Procedures
    
    
    25PART II OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    25Item 1A. Risk Factors
    
    
    25Item 5. Other Information
    
    
    36Item 6. Exhibits
    
    
    37SIGNATURES
    
    
    38EXHIBIT 12.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1
   Available Information




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. Unaudited Condensed Consolidated Financial Statements
  
 
 December 31,
    
    
    September 30,2005
    
    
    2006ASSETSCurrent assets:Cash and cash equivalents
    
    $
    46,026
    
    
    $
    44,164Accounts receivable, net
    
    
    55,064
    
    
    
    45,852Inventory
    
    
    67,712
    
    
    
    89,225Prepaid expenses and other current assets
    
    
    2,909
    
    
    
    3,899Total current assets
    
    
    171,711
    
    
    
    183,140Property and equipment, net
    
    
    31,292
    
    
    
    24,392Service inventory, net
    
    
    3,285
    
    
    
    2,937Goodwill
    
    
    56,839
    
    
    
    59,082Deferred tax asset
    
    
    575
    
    
    
    696Intangible assets, net
    
    
    1,113
    
    
    
    1,359Other non-current assets
    
    
    8,190
    
    
    
    7,172TOTAL ASSETS
    
    $
    273,005
    
    
    $
    278,778LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    14,911
    
    
    $
    19,036Accrued payroll and related expenses
    
    
    12,145
    
    
    
    13,064Other accrued liabilities
    
    
    10,702
    
    
    
    11,683Deferred revenue
    
    
    81,749
    
    
    
    96,683Total current liabilities
    
    
    119,507
    
    
    
    140,466Long-term deferred revenue
    
    
    5,234
    
    
    
    3,381Other non-current liabilities
    
    
    2,317
    
    
    
    2,351Convertible notes payable
    
    
    80,000
    
    
    
    80,000TOTAL LIABILITIES
    
    
    207,058
    
    
    
    226,198Commitments and Contingencies (Note 14)Shareholders equity:Preferred Stock  Authorized and undesignated, 5,000,000 shares; no shares issued or outstanding
    
    
    
    
    
    
    Common Stock and additional paid in capital, par value $.01 per share  Authorized, 75,000,000
shares; issued and outstanding, 22,743,377 and 23,255,597 shares, respectively
    
    
    422,691
    
    
    
    425,196Exchangeable shares, no par value  Unlimited shares authorized; 19,710 and no shares
outstanding, respectively
    
    
    576
    
    
    
    Deferred compensation
    
    
    (2,811
    )
    
    
    Accumulated other comprehensive income
    
    
    6,258
    
    
    
    8,953Accumulated deficit
    
    
    (360,767
    )
    
    
    (381,569
    )TOTAL SHAREHOLDERS EQUITY
    
    
    65,947
    
    
    
    52,580TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    273,005
    
    
    $
    278,778
 See accompanying notes
 1




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##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Revenue:Product
    
    $
    33,285
    
    
    $
    19,074
    
    
    $
    99,796
    
    
    $
    77,990Service
    
    
    11,456
    
    
    
    13,491
    
    
    
    35,998
    
    
    
    41,603Total revenue
    
    
    44,741
    
    
    
    32,565
    
    
    
    135,794
    
    
    
    119,593Operating expenses:Cost of product revenue
    
    
    29,005
    
    
    
    13,927
    
    
    
    96,567
    
    
    
    58,703Cost of service revenue
    
    
    7,546
    
    
    
    7,242
    
    
    
    22,652
    
    
    
    22,836Research and development, net
    
    
    6,472
    
    
    
    9,692
    
    
    
    32,932
    
    
    
    23,278Sales and marketing
    
    
    5,778
    
    
    
    4,924
    
    
    
    19,951
    
    
    
    15,591General and administrative
    
    
    3,617
    
    
    
    4,134
    
    
    
    12,491
    
    
    
    14,328Restructuring and severance
    
    
    1,201
    
    
    
    3
    
    
    
    2,933
    
    
    
    1,290Total operating expenses
    
    
    53,619
    
    
    
    39,922
    
    
    
    187,526
    
    
    
    136,026Loss from operations
    
    
    (8,878
    )
    
    
    (7,357
    )
    
    
    (51,732
    )
    
    
    (16,433
    )Other expense, net
    
    
    (254
    )
    
    
    (92
    )
    
    
    (602
    )
    
    
    (1,964
    )Interest expense, net
    
    
    (1,115
    )
    
    
    (608
    )
    
    
    (2,319
    )
    
    
    (1,657
    )Loss before income taxes
    
    
    (10,247
    )
    
    
    (8,057
    )
    
    
    (54,653
    )
    
    
    (20,054
    )Provision for income taxes
    
    
    3
    
    
    
    267
    
    
    
    428
    
    
    
    748Net loss
    
    $
    (10,250
    )
    
    $
    (8,324
    )
    
    $
    (55,081
    )
    
    $
    (20,802
    )Basic and diluted net loss per share
    
    $
    (0.46
    )
    
    $
    (0.37
    )
    
    $
    (2.49
    )
    
    $
    (0.93
    )Basic and diluted weighted average shares outstanding
    
    
    22,155
    
    
    
    22,634
    
    
    
    22,094
    
    
    
    22,475
 See accompanying notes
 2




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##### Table of Contents



Nine Months EndedSeptember 30,2005
    
    
    2006Operating activities:Net loss
    
    $
    (55,081
    )
    
    $
    (20,802
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    14,863
    
    
    
    12,615Share-based compensation cost
    
    
    3,772
    
    
    
    1,539Inventory write-down
    
    
    4,883
    
    
    
    806Amortization of issuance costs, convertible notes payable and line of credit
    
    
    672
    
    
    
    1,017Deferred income taxes
    
    
    48
    
    
    
    (121
    )Changes in operating assets and liabilities:Accounts receivable
    
    
    (27,573
    )
    
    
    9,074Inventory
    
    
    (37,253
    )
    
    
    (25,309
    )Prepaid expenses and other current assets
    
    
    705
    
    
    
    (981
    )Other non-current assets
    
    
    (1,626
    )
    
    
    (555
    )Service inventory
    
    
    141
    
    
    
    Accounts payable
    
    
    (3,160
    )
    
    
    4,163Accrued payroll and related expenses and other accrued liabilities
    
    
    7,983
    
    
    
    3,117Other non-current liabilities
    
    
    2,908
    
    
    
    34Deferred revenue
    
    
    28,658
    
    
    
    13,202Net cash used in operating activities
    
    
    (60,060
    )
    
    
    (2,201
    )Investing activities:Sales/maturities of short-term investments
    
    
    44,414
    
    
    
    Purchases of short-term investments
    
    
    (10,161
    )
    
    
    Proceeds from sale of investment
    
    
    
    
    
    
    239Decrease in restricted cash
    
    
    11,437
    
    
    
    Purchases of property and equipment
    
    
    (3,771
    )
    
    
    (2,301
    )Net cash provided by (used in) investing activities
    
    
    41,919
    
    
    
    (2,062
    )Financing activities:Proceeds from issuance of common stock through employee stock purchase plan
    
    
    1,037
    
    
    
    424Proceeds from exercise of options
    
    
    138
    
    
    
    2,381Line of credit issuance costs
    
    
    (755
    )
    
    
    (375
    )Principal payments on capital leases
    
    
    (693
    )
    
    
    (91
    )Net cash provided by (used in) financing activities
    
    
    (273
    )
    
    
    2,339Effect of foreign exchange rate changes on cash and cash equivalents
    
    
    (595
    )
    
    
    62Net decrease in cash and cash equivalents
    
    
    (19,009
    )
    
    
    (1,862
    )Cash and cash equivalentsBeginning of period
    
    
    41,732
    
    
    
    46,026End of period
    
    $
    22,723
    
    
    $
    44,164Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    1,556
    
    
    $
    1,977Non-cash investing and financing activities:Issuance of warrants in connection with financing arrangement
    
    $
    219
    
    
    $
    Inventory transfers to property and equipment and service inventory
    
    $
    8,323
    
    
    $
    2,990
 See accompanying notes
 3




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Note 1  Basis of Presentation
     Principles of Consolidation
  Reclassifications
  4




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##### Table of Contents



Use of Estimates
  Reverse Stock Split
  Note 2  Summary of New Accounting Policies
 Foreign Currency Derivatives
  Note 3  Recent Accounting Developments
 Accounting for Uncertainty in Income Taxes
 Fair Value Measurements
 Employers Accounting for Defined Benefit Pension and Other Postretirement Plans
 5




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##### Table of Contents



Note 4  Earnings Per Share (EPS)
   Note 5  Comprehensive Loss
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Net loss
    
    $
    (10,250
    )
    
    $
    (8,324
    )
    
    $
    (55,081
    )
    
    $
    (20,802
    )Unrealized gain on available-for-sale investments
    
    
    
    
    
    
    
    
    
    
    24
    
    
    
    Cash flow hedge
    
    
    
    
    
    
    105
    
    
    
    
    
    
    
    105Foreign currency translation adjustment
    
    
    2,452
    
    
    
    430
    
    
    
    971
    
    
    
    2,590Comprehensive loss
    
    $
    (7,798
    )
    
    $
    (7,789
    )
    
    $
    (54,086
    )
    
    $
    (18,107
    )
 Note 6  Accounts Receivable
  December 31,
    
    
    September 30,2005
    
    
    2006Trade accounts receivable
    
    $
    23,023
    
    
    $
    26,710Unbilled receivables
    
    
    12,340
    
    
    
    6,569Advance billings
    
    
    19,894
    
    
    
    12,75555,257
    
    
    
    46,034Allowance for doubtful accounts
    
    
    (193
    )
    
    
    (182
    )Accounts receivable, net
    
    $
    55,064
    
    
    $
    45,852
   6




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##### Table of Contents



Note 7  Inventory
  December 31,
    
    
    September 30,2005
    
    
    2006Components and subassemblies
    
    $
    10,706
    
    
    $
    20,961Work in process
    
    
    8,314
    
    
    
    6,632Finished goods
    
    
    48,692
    
    
    
    61,632Total
    
    $
    67,712
    
    
    $
    89,225
   Note 8  Deferred Revenue
  December 31,
    
    
    September 30,2005
    
    
    2006Deferred product revenue
    
    $
    58,593
    
    
    $
    72,750Deferred service revenue
    
    
    28,390
    
    
    
    27,314Total deferred revenue
    
    
    86,983
    
    
    
    100,064Less long-term deferred revenue
    
    
    (5,234
    )
    
    
    (3,381
    )Deferred revenue in current liabilities
    
    $
    81,749
    
    
    $
    96,683
  Note 9  Restructuring and Severance Charges
  7




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##### Table of Contents



Nine Months EndedSeptember 30,2005
    
    
    2006Balance, January 1
    
    $
    4,690
    
    
    $
    3,582Payments
    
    
    (3,058
    )
    
    
    (2,152
    )Adjustments to previously accrued amounts
    
    
    (236
    )
    
    
    104Expense for
the period January 1 to June 30
    
    
    1,968
    
    
    
    1,183Foreign currency translation adjustment
    
    
    (211
    )
    
    
    78Balance, June 30
    
    
    3,153
    
    
    
    2,795Payments
    
    
    (1,410
    )
    
    
    (1,496
    )Adjustments to previously accrued amounts
    
    
    53
    
    
    
    (99
    )Current period charges
    
    
    1,148
    
    
    
    102Foreign currency translation adjustment
    
    
    2
    
    
    
    11Total liability balance, September 30
    
    
    2,946
    
    
    
    1,313Less long-term restructuring and severance liability
    
    
    (453
    )
    
    
    (91
    )Current restructuring and severance liability
    
    $
    2,493
    
    
    $
    1,222
 Note 10  Share-Based Compensation
 Share-Based Payment Accounting for Stock Issued to Employees Accounting for Stock-Based
Compensation
   8




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##### Table of Contents



Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2005
    
    2006
    
    2005
    
    2006Risk-free interest rate
    
    
    4.1
    %
    
    
    
    
    
    
    3.9
    %
    
    
    4.6
    %Expected dividend yield
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    0
    %Volatility
    
    
    87
    %
    
    
    
    
    
    
    87
    %
    
    
    64
    %Expected life
    
    6 years
    
    
    
    
    
    5.8 years
    
    4.3 years
     Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Cost of product revenue
    
    $
    
    
    
    $
    15
    
    
    $
    
    
    
    $
    44Research and development, net
    
    
    696
    
    
    
    101
    
    
    
    3,264
    
    
    
    287Sales and marketing
    
    
    85
    
    
    
    106
    
    
    
    495
    
    
    
    317General and administrative
    
    
    
    
    
    
    318
    
    
    
    13
    
    
    
    891Total
    
    $
    781
    
    
    $
    540
    
    
    $
    3,772
    
    
    $
    1,539
 9




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##### Table of Contents



WeightedWeighted
    
    AverageAverage
    
    Remaining
    
    AggregateExercise
    
    Contractual
    
    IntrinsicOptions
    
    Price
    
    Term
    
    ValueOutstanding at December 31, 2005
    
    
    4,500,145
    
    
    $
    16.56Grants
    
    
    35,530
    
    
    
    8.18Exercises
    
    
    (344,429
    )
    
    
    6.91Cancellations
    
    
    (967,676
    )
    
    
    23.28Outstanding at September 30, 2006
    
    
    3,223,570
    
    
    $
    15.48
    
    
    6.1 years
    
    $5.4 millionExercisable at September 30, 2006
    
    
    3,190,358
    
    
    $
    15.55
    
    
    6.1 years
    
    $5.3 millionAvailable for grant at September 30, 2006
    
    
    3,447,358
     Three Months
    
    
    Nine MonthsEnded
    
    
    EndedSept 30, 2005
    
    
    Sept 30, 2005Net loss, as reported
    
    $
    (10,250
    )
    
    $
    (55,081
    )Add:Stock-based compensation included
in reported net loss
    
    
    781
    
    
    
    3,772Total stock-based compensation
expense determined under fair
value-based method for all awards
    
    
    (2,406
    )
    
    
    (23,295
    )Pro forma net loss
    
    $
    (11,875
    )
    
    $
    (74,604
    )Basic and diluted net loss per share:As reported
    
    $
    (0.46
    )
    
    $
    (2.49
    )Pro forma
    
    $
    (0.54
    )
    
    $
    (3.38
    )
 Note 11  Taxes
  10




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Note 12  Geographic Segment Information
 Disclosure about Segments of an Enterprise and Related Information
  United States
    
    
    Other Countries
    
    
    Total2005
    
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005
    
    
    2006Three months ended September 30,Product revenue
    
    $
    31,071
    
    
    $
    13,735
    
    
    $
    2,214
    
    
    $
    5,339
    
    
    $
    33,285
    
    
    $
    19,074Service revenue
    
    
    7,879
    
    
    
    9,411
    
    
    
    3,577
    
    
    
    4,080
    
    
    
    11,456
    
    
    
    13,491Total revenue
    
    $
    38,950
    
    
    $
    23,146
    
    
    $
    5,791
    
    
    $
    9,419
    
    
    $
    44,741
    
    
    $
    32,565
 2005
    
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005
    
    
    2006Nine months ended September 30,Product revenue
    
    $
    64,974
    
    
    $
    59,008
    
    
    $
    34,822
    
    
    $
    18,982
    
    
    $
    99,796
    
    
    $
    77,990Service revenue
    
    
    24,166
    
    
    
    29,846
    
    
    
    11,832
    
    
    
    11,757
    
    
    
    35,998
    
    
    
    41,603Total revenue
    
    $
    89,140
    
    
    $
    88,854
    
    
    $
    46,654
    
    
    $
    30,739
    
    
    $
    135,794
    
    
    $
    119,593
   Note 13  Foreign Currency Derivative
   Note 14  Litigation
  11




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Note 15  Shareholders Equity
  AccumulatedCommon Stock
    
    Exchangeable Shares
    
    
    
    
    
    OtherNumber of
    
    
    
    
    
    Number of
    
    
    
    
    
    Deferred
    
    Comprehensive
    
    AccumulatedShares
    
    Amount
    
    Shares
    
    Amount
    
    Compensation
    
    Income (Loss)
    
    Deficit
    
    TotalBALANCE, January 1,
2006
    
    
    22,743
    
    
    $
    422,691
    
    
    
    20
    
    
    $
    576
    
    
    $
    (2,811
    )
    
    $
    6,258
    
    
    $
    (360,767
    )
    
    $
    65,947Issuance of
shares under
401(k) plan
    
    
    49
    
    
    
    396
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    396Issuance of
shares under
employee stock
purchase plan
    
    
    54
    
    
    
    424
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    424Exercise of
stock options
    
    
    344
    
    
    
    2,381
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,381Exchangeable
shares
converted into
common shares
    
    
    20
    
    
    
    576
    
    
    
    (20
    )
    
    
    (576
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Adoption of FAS
123(R)
    
    
    
    
    
    
    (2,811
    )
    
    
    
    
    
    
    
    
    
    
    2,811
    
    
    
    
    
    
    
    
    
    
    
    Stock-based
compensation
    
    
    46
    
    
    
    1,539
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,539Other
comprehensive
income:Cash flow
hedge
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    105
    
    
    
    
    
    
    
    105Foreign
currency
translation
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,590
    
    
    
    
    
    
    
    2,590Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (20,802
    )
    
    
    (20,802
    )BALANCE, September
30, 2006
    
    
    23,256
    
    
    $
    425,196
    
    
    
    
    
    
    $
    
    
    
    $
    
    
    
    $
    8,953
    
    
    $
    (381,569
    )
    
    $
    52,580
 12




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of
Operations
 Preliminary Note Regarding Forward-Looking Statements
  Overview and Executive Summary
    Market Overview, Trends and Challenges
   13




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##### Table of Contents



Our Strategy
   Gain
Share in Our Core HPC Market.
 Maintain Focus on Execution and Profitability.
 Extend Technology Leadership.
 Expand Total Addressable Market.
 Key Performance Indicators
  Revenue.
 Gross margins.
 Operating expenses.
 14




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##### Table of Contents



Liquidity and cash flows.
 Critical Accounting Policies and Estimates
    Revenue Recognition
 Revenue
Recognition in Financial Statements
 Products.
 
    
    Cray X1/X1E and Cray XT3 Product Lines.We recognize revenue from product sales
upon customer acceptance of the system, when we have no significant unfulfilled
obligations stipulated by the contract that affect the customers final acceptance, the
price is fixed or determinable and collection is reasonably assured. A customer-signed
notice of acceptance or similar document is required from the customer prior to revenue
recognition.
 15




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##### Table of Contents




    
    Cray XD1 Product Line.We recognize revenue from product sales of Cray XD1
systems upon shipment to, or delivery to, the customer, depending upon contract terms,
when we have no significant unfulfilled obligations stipulated by the contract, the
price is fixed or determinable and collection is reasonably assured. If there is a
contractual requirement for customer acceptance, revenue is recognized upon receipt of
the notice of acceptance and when we have no unfulfilled obligations.
 Accounting
for Performance of Construction-Type and Certain Production-Type Contracts.
 Services.
 Multiple-Element Arrangements. Revenue
Arrangements with Multiple Deliverables
 
    
    The element could be sold separately;
 
    
    The fair value of the undelivered element is established; and
 
    
    In cases with any general right of return, our performance with respect to any
undelivered element is within our control and probable.
  Inventory Valuation
  16




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##### Table of Contents



Goodwill and Other Intangible Assets
   Accounting for Income Taxes
 Accounting for
Income Taxes,
  Accounting for Loss Contracts
  17




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##### Table of Contents



Share-Based Compensation
 Share-Based Payment Accounting for Stock Issued to Employees Accounting for
Stock-Based Compensation
   Recent Accounting Pronouncements
 Accounting for Uncertainty in Income Taxes
 Fair Value Measurements
 Employers Accounting for Defined Benefit Pension and Other Postretirement Plans
 Results of Operations
 Revenue and Gross Margins
  18




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##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Product revenue
    
    $
    33,285
    
    
    $
    19,074
    
    
    $
    99,796
    
    
    $
    77,990Less: Cost of product revenue
    
    
    29,005
    
    
    
    13,927
    
    
    
    96,567
    
    
    
    58,703Product gross margin
    
    $
    4,280
    
    
    $
    5,147
    
    
    $
    3,229
    
    
    $
    19,287Product gross margin percentage
    
    
    13
    %
    
    
    27
    %
    
    
    3
    %
    
    
    25
    %Service revenue
    
    $
    11,456
    
    
    $
    13,491
    
    
    $
    35,998
    
    
    $
    41,603Less: Cost of service revenue
    
    
    7,546
    
    
    
    7,242
    
    
    
    22,652
    
    
    
    22,836Service gross margin
    
    $
    3,910
    
    
    $
    6,249
    
    
    $
    13,346
    
    
    $
    18,767Service gross margin percentage
    
    
    34
    %
    
    
    46
    %
    
    
    37
    %
    
    
    45
    %Total revenue
    
    $
    44,741
    
    
    $
    32,565
    
    
    $
    135,794
    
    
    $
    119,593Less: Total cost of revenue
    
    
    36,551
    
    
    
    21,169
    
    
    
    119,219
    
    
    
    81,539Total gross margin
    
    $
    8,190
    
    
    $
    11,396
    
    
    $
    16,575
    
    
    $
    38,054Total gross margin percentage
    
    
    18
    %
    
    
    35
    %
    
    
    12
    %
    
    
    32
    %
 Product
Revenue
    Service Revenue
  19




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##### Table of Contents



Product Gross Margin
   Service Gross Margin
   Research and Development Expenses
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Gross research and development expenses
    
    $
    24,196
    
    
    $
    24,095
    
    
    $
    70,691
    
    
    $
    76,303Less: Amounts included in cost of product revenue
    
    
    (4,905
    )
    
    
    (1,546
    )
    
    
    (14,441
    )
    
    
    (16,658
    )Less: Reimbursed research and development
(excludes amounts in revenue)
    
    
    (12,819
    )
    
    
    (12,857
    )
    
    
    (23,318
    )
    
    
    (36,367
    )Net research and development expenses
    
    $
    6,472
    
    
    $
    9,692
    
    
    $
    32,932
    
    
    $
    23,278Percentage of total revenue
    
    
    14
    %
    
    
    30
    %
    
    
    24
    %
    
    
    19
    %
   20




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##### Table of Contents



Other Operating Expenses
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2005
    
    2006
    
    2005
    
    2006Sales and marketing
    
    $
    5,778
    
    
    $
    4,924
    
    
    $
    19,951
    
    
    $
    15,591Percentage of total revenue
    
    
    13
    %
    
    
    15
    %
    
    
    15
    %
    
    
    13
    %General and administrative
    
    $
    3,617
    
    
    $
    4,134
    
    
    $
    12,491
    
    
    $
    14,328Percentage of total revenue
    
    
    8
    %
    
    
    13
    %
    
    
    9
    %
    
    
    12
    %Restructuring and severance
    
    $
    1,201
    
    
    $
    3
    
    
    $
    2,933
    
    
    $
    1,290Percentage of total revenue
    
    
    3
    %
    
    
    0
    %
    
    
    2
    %
    
    
    1
    %
 Sales and Marketing .
 General and Administrative
 Restructuring and Severance .
 21




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##### Table of Contents



Other Expense, net
  Interest Income (Expense)
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Interest income
    
    $
    76
    
    
    $
    460
    
    
    $
    491
    
    
    $
    1,574Interest expense
    
    
    (1,191
    )
    
    
    (1,068
    )
    
    
    (2,810
    )
    
    
    (3,231
    )Interest
expense, net
    
    $
    (1,115
    )
    
    $
    (608
    )
    
    $
    (2,319
    )
    
    $
    (1,657
    )
   Taxes
  Liquidity and Capital Resources
    22




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##### Table of Contents



Amounts Committed by YearLess than
    
    
    1-3
    
    
    4-5Contractual Obligations
    
    Total
    
    
    1 year
    
    
    years
    
    
    years
    
    
    ThereafterDevelopment agreements
    
    $
    12,892
    
    
    $
    11,997
    
    
    $
    895
    
    
    $
    
    
    
    $
    Capital lease obligations
    
    
    63
    
    
    
    63
    
    
    
    
    
    
    
    
    
    
    
    Operating leases
    
    
    7,034
    
    
    
    3,164
    
    
    
    3,734
    
    
    
    136
    
    
    
    Total contractual cash obligations
    
    $
    19,989
    
    
    $
    15,224
    
    
    $
    4,629
    
    
    $
    136
    
    
    $
    
     23




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##### Table of Contents



Item 3. Quantitative and Qualitative Disclosures About Market Risk
  Interest Rate Risk
 Foreign Currency Risk
 24




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##### Table of Contents



Item 4. Controls and Procedures
 Evaluation of disclosure controls and procedures.
 Changes in internal control over financial reporting.
 
 PART II. OTHER INFORMATION
 
 Item 1. Legal Proceedings
    
 Item 1A. Risk Factors
  Risk Factors Pertaining to Our Business and Operations
 Our operating results may fluctuate significantly and we may not achieve profitability
in any given period.
 25




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##### Table of Contents




    
    successfully selling the Cray XT3 system, including upgrades and successor
systems, new products based on our BlackWidow and Eldorado projects, and the timing and
funding of government purchases, especially in the United States;
    
    the level of revenue recognized in any given period, particularly with very high
average sales prices and limited number of system sales in any quarter, the timing of
product acceptances by customers and contractual provisions affecting revenue
recognition;
    
    the level of product margin contribution in any given period due to product mix,
strategic transactions, product life cycle and component costs;
    
    maintaining our product development projects on schedule and within budgetary
limitations;
    
    revenue delays or losses due to customers postponing purchases to wait for future
upgraded or new systems, delays in delivery of upgraded or new systems and longer than
expected customer acceptance cycles;
    
    our expense levels, including research and development net of government funding,
which may be affected by the level and timing of such funding;
    
    the terms and conditions of sale or lease for our products;
    
    whether we conclude that all or some part of our recorded goodwill has been
impaired, which may be due to changes in our business plans and strategy and/or a
decrease in our fair value, primarily based on the market value of our outstanding shares of common stock; and
    
    the impact of expensing our share-based compensation under FAS 123R.
  
    
    the timely availability of acceptable components in sufficient quantities to meet customer delivery schedules;
    
    timing and level of government funding for products and research and development contracts;
    
    general economic trends, including changes in levels of customer capital spending;
    
    the introduction or announcement of competitive products;
    
    currency fluctuations, international conflicts or economic
crises; and
    
    the receipt and timing of necessary export licenses.
  26




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##### Table of Contents



Failure to sell Cray XT3 and the Hood successor systems in planned quantities and at
expected gross margins could adversely affect 2006 and 2007 revenue and operating results.
 The achievement of our business plan is highly dependent on increased product revenue
and margins.
  Phase III of the DARPA HPCS program will affect our operations.
 27




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##### Table of Contents



We face increased liquidity risks if we do not complete our proposed public offering.
 Our reliance on third-party suppliers poses significant risks to our business and
prospects.
 
    
    if a supplier does not provide components that meet our specifications in
sufficient quantities on time, then production and sales of our systems would be
delayed, adversely affecting revenue and cash flow  these risks are accentuated during
steep ramp periods as we introduce new or successor products;
    
    if an interruption of supply of our components occurs, because of a significant
problem with a supplier providing parts that later prove to be defective or because a
single-source supplier imposes allocations on its customers, decides to no longer
provide those components to us or increases the price of those parts significantly, it
could take us a considerable period of time to identify and qualify alternative
suppliers, to redesign our products as necessary and to begin manufacture of the
redesigned components. In some cases, we may not be able to redesign such components.
See also the Risk Factor captioned We face last-time buy decisions affecting all of our
current products, which may adversely affect our revenue and operating results, below;
    
    if a supplier cannot provide a competitive key component, our systems may be less
competitive than systems using components with greater capability; and
    
    some of our key suppliers are small companies with limited financial and other
resources, and consequently may be more likely to experience financial and operational
difficulties than are larger, well-established companies.
  28




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##### Table of Contents



We face last-time buy decisions affecting all of our current products, which may
adversely affect our revenue and operating results.
 Our inability to overcome the technical challenges of completing the development of our
supercomputer systems would adversely affect our revenue and operating results in 2006 and
beyond.
 If we are unable to compete successfully in the HPC market, our revenue will decline.
 29




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30




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##### Table of Contents



To be successful, we need to increase differentiation of our Cray XT3 and successor
systems.
 If the U.S. government purchases fewer supercomputers, our revenue would be reduced and
our operating results would be adversely affected.
 If we lose government support for development of our supercomputer systems, our net
research and development expenditures and capital requirements would increase and our
ability to conduct research and development would decrease.
 We may infringe or be subject to claims that we infringe the intellectual property
rights of others.
 If we cannot retain, attract and motivate key personnel, we may be unable to
effectively implement our business plan.
  Lower than anticipated sales of new supercomputers and the termination of maintenance
contracts on older and/or decommissioned systems may reduce our service revenue and margins
from maintenance service contracts.
 U.S. export controls could hinder our ability to make sales to foreign customers and
our future prospects.
 31




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##### Table of Contents



We may not meet the covenants imposed by our current credit agreement.
 The adoption of FAS 123R has and will continue to adversely affect our operating
results and may adversely affect the market price of our common stock.
 We are required to evaluate our internal control over financial reporting under Section
404 of the Sarbanes-Oxley Act of 2002 at the end of each fiscal year, and any adverse
results from such future evaluations could result in a loss of investor confidence in our
financial reports and have an adverse effect on our stock price.
  32




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##### Table of Contents



We incorporate software licensed from third parties into the operating systems for our
products and any significant interruption in the availability of these third-party software
products or defects in these products could reduce the demand for our products.
  New environmental rules in Europe and other jurisdictions may adversely affect our
operations.
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##### Table of Contents



In 2005 we formed a new senior management team that must work together effectively for
us to be successful.
 We may not be able to protect our proprietary information and rights adequately.
 Risk Factors Pertaining to our Notes and Our Common Stock
 Our indebtedness may adversely affect our financial strength.
 Our existing and any future credit facilities may adversely affect our ability to make
payments under the Notes.
 We will require a significant amount of cash to service our indebtedness and to fund
planned capital expenditures, research and development efforts and other corporate expenses.
 There are no covenants in the indenture for the Notes restricting our ability or the
ability of our subsidiaries to incur future indebtedness or restricting the terms of any
such indebtedness.
 The Notes are subordinated in right of payment to our existing and future senior
indebtedness.
 The Notes are effectively subordinated to our secured indebtedness and are structurally
subordinated to all indebtedness and other liabilities of our current and future
subsidiaries.
 In certain circumstances, holders of senior debt can require us to suspend or defer
cash payments due in respect of the Notes.
 34




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##### Table of Contents



Unless a condition to conversion is met prior to the maturity of the Notes, the Notes
will not be convertible at any time.
 Upon conversion of the Notes, we may pay cash or a combination of cash and shares of
our common stock in lieu of issuing shares of our common stock. Therefore, Note holders may
receive no shares of our common stock or fewer shares than the number into which their Notes
are convertible.
 If a principal conversion settlement election is made, we may not have sufficient funds
to pay the cash settlement upon conversion.
 The conversion rate of the Notes may not be adjusted for all dilutive events, including
third-party tender or exchange offers, that may adversely affect the trading price of the
Notes or our common stock issuable upon conversion of the Notes.
 If we pay cash dividends on our common stock, Note holders may be deemed to have
received a taxable dividend without the receipt of cash.
 If we elect to settle upon conversion in cash or a combination of cash and shares of
common stock, there will be a delay in settlement.
 Some significant corporate transactions may not constitute a fundamental change, in
which case we would not be obligated to offer to repurchase the Notes.
 Our Notes may not be rated or may receive a lower rating than investors anticipate,
which could cause a decline in the trading volume and market price of the Notes and our
common stock.
 We may not have the funds necessary to purchase the Notes upon a fundamental change or
other purchase date and our ability to purchase the Notes in such events may be limited.
 The make whole premium payable on Notes that are converted in connection with certain
fundamental changes may not adequately compensate Note holders for the lost option time
value of the Notes as a result of that fundamental change.
 There are restrictions on the Note holders ability to transfer or resell the Notes
without registration under applicable securities laws, and if we fail to fulfill our
obligations to keep effective the registration statement covering the resale of the Notes,
we will be required to pay additional interest on the Notes affected by that failure and to
issue additional shares of common stock on Notes converted during such failure and satisfied
by us in common stock.
 There is no active market for the Notes and if an active trading market does not
develop for these Notes, the holders of the Notes may be unable to resell them.
 Our stock price is volatile.
 A substantial number of our shares are eligible for future sale and may depress the
market price of our common stock and may hinder our ability to obtain additional financing.
 
    
    23,255,597 shares of common stock;
    
    warrants to purchase 1,334,852 shares of common stock;
    
    options to purchase an aggregate of 3,223,570 shares of common stock, of which
options to purchase 3,190,358 shares of common stock were then exercisable; and
    
    Notes convertible into an aggregate of 4,144,008 shares of common stock or, under
certain circumstances specified in the indenture governing the Notes, a maximum of 5,698,006
shares of common stock.
 35




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##### Table of Contents



Provisions of our Articles of Incorporation and Bylaws could make a proposed
acquisition that is not approved by our Board of Directors more difficult.
 
 Item 5. Other Information
    Nine MonthsYear Ended December 31,
    
    
    Ended Sept 30,2001
    
    
    2002
    
    
    2003
    
    
    2004
    
    
    2005
    
    
    2006(In thousands, except for ratios)Fixed Charges:Interest expense
    
    $
    1,976
    
    
    $
    2,965
    
    
    $
    213
    
    
    $
    301
    
    
    $
    4,203
    
    
    $
    3,231Portion of rental expense deemed to represent
interest
    
    
    166
    
    
    
    185
    
    
    
    195
    
    
    
    209
    
    
    
    207
    
    
    
    132Total fixed charges
    
    $
    2,142
    
    
    $
    3,150
    
    
    $
    408
    
    
    $
    510
    
    
    $
    4,410
    
    
    $
    3,363Earnings:Net income (loss)
    
    $
    (35,228
    )
    
    $
    5,403
    
    
    $
    63,248
    
    
    $
    (207,358
    )
    
    $
    (64,308
    )
    
    $
    (20,802
    )Provision (benefit) for income taxes
    
    
    994
    
    
    
    2,176
    
    
    
    (42,207
    )
    
    
    59,092
    
    
    
    (1,488
    )
    
    
    748Fixed charges
    
    
    2,142
    
    
    
    3,150
    
    
    
    408
    
    
    
    510
    
    
    
    4,410
    
    
    
    3,363Total earnings (loss) for computation of ratio
    
    $
    (32,092
    )
    
    $
    10,729
    
    
    $
    21,449
    
    
    $
    (147,756
    )
    
    $
    (61,386
    )
    
    $
    (16,691
    )Ratio of earnings to fixed charges(1)
    
    
    
    
    
    
    3.4
    
    
    
    52.6
    
    
    
    
    
    
    
    
    
    
    
    
 
 (1)
    
    The pretax net loss for the years ended December 31, 2001, 2004 and 2005, and the
nine months ended September 30, 2006, was not sufficient to cover fixed charges by
approximately $34.2 million, $148.3 million, $65.8 million and $20.1 million,
respectively. As a result, the ratio of earnings to fixed charges has not been
computed for these periods. 36




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##### Table of Contents



Item 6. Exhibits
 12.1
    
    Statement of Computation of Ratios31.1
    
    Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2
    
    Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) of the
Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1
    
    Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
 Items 2, 3 and 4 of Part II are not applicable and have been omitted.
 37




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SIGNATURES
  CRAY INC.November 9, 2006
    
    /s/ PETER J. UNGAROPeter J. UngaroChief Executive Officer and President/s/ BRIAN C. HENRYBrian C. HenryChief Financial Officer/s/ KENNETH D. ROSELLIKenneth D. RoselliChief Accounting Officer
 38