##### 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 June 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 June 30, 2006
    
    
    1Statements of Operations for the Three and Six Months Ended June 30, 2005 and 2006
    
    
    2Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2006
    
    
    3Notes to Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    12Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    22Item 4. Controls and Procedures
    
    
    23PART II OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    23Item 1A. Risk Factors
    
    
    24Item 4. Submission of Matters to a Vote of Security Holders
    
    
    36Item 5. Other Information
    
    
    37Item 6. Exhibits
    
    
    37SIGNATURES
    
    
    39EXHIBIT 10.1EXHIBIT 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,
    
    
    June 30,2005
    
    
    2006ASSETSCurrent assets:Cash and cash equivalents
    
    $
    46,026
    
    
    $
    43,372Accounts receivable, net
    
    
    55,064
    
    
    
    42,234Inventory
    
    
    67,712
    
    
    
    78,643Prepaid expenses and other current assets
    
    
    2,909
    
    
    
    3,853Total current assets
    
    
    171,711
    
    
    
    168,102Property and equipment, net
    
    
    31,292
    
    
    
    26,347Service inventory, net
    
    
    3,285
    
    
    
    3,220Goodwill
    
    
    56,839
    
    
    
    58,818Deferred tax asset
    
    
    575
    
    
    
    602Intangible assets, net
    
    
    1,113
    
    
    
    1,203Other non-current assets
    
    
    8,190
    
    
    
    7,448TOTAL ASSETS
    
    $
    273,005
    
    
    $
    265,740LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    14,911
    
    
    $
    22,652Accrued payroll and related expenses
    
    
    12,145
    
    
    
    13,820Other accrued liabilities
    
    
    10,702
    
    
    
    7,560Deferred revenue
    
    
    81,749
    
    
    
    76,846Total current liabilities
    
    
    119,507
    
    
    
    120,878Long-term deferred revenue
    
    
    5,234
    
    
    
    4,361Other non-current liabilities
    
    
    2,317
    
    
    
    2,309Convertible notes payable
    
    
    80,000
    
    
    
    80,000TOTAL LIABILITIES
    
    
    207,058
    
    
    
    207,548Commitments 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 23,041,752 shares, respectively
    
    
    422,691
    
    
    
    423,019Exchangeable 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
    
    
    
    8,418Accumulated deficit
    
    
    (360,767
    )
    
    
    (373,245
    )TOTAL SHAREHOLDERS EQUITY
    
    
    65,947
    
    
    
    58,192TOTAL LIABILITIES AND SHAREHOLDERS EQUITY
    
    $
    273,005
    
    
    $
    265,740
 See accompanying notes
 1




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Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Revenue:Product
    
    $
    40,201
    
    
    $
    24,647
    
    
    $
    66,511
    
    
    $
    58,916Service
    
    
    13,218
    
    
    
    13,866
    
    
    
    24,542
    
    
    
    28,112Total revenue
    
    
    53,419
    
    
    
    38,513
    
    
    
    91,053
    
    
    
    87,028Operating expenses:Cost of product revenue
    
    
    41,210
    
    
    
    18,099
    
    
    
    67,562
    
    
    
    44,776Cost of service revenue
    
    
    7,531
    
    
    
    7,901
    
    
    
    15,106
    
    
    
    15,594Research and development, net
    
    
    13,427
    
    
    
    6,371
    
    
    
    26,459
    
    
    
    13,586Sales and marketing
    
    
    7,574
    
    
    
    5,682
    
    
    
    14,173
    
    
    
    10,667General and administrative
    
    
    4,607
    
    
    
    4,600
    
    
    
    8,874
    
    
    
    10,194Restructuring and severance
    
    
    1,947
    
    
    
    549
    
    
    
    1,732
    
    
    
    1,287Total operating expenses
    
    
    76,296
    
    
    
    43,202
    
    
    
    133,906
    
    
    
    96,104Loss from operations
    
    
    (22,877
    )
    
    
    (4,689
    )
    
    
    (42,853
    )
    
    
    (9,076
    )Other income (expense), net
    
    
    153
    
    
    
    (1,831
    )
    
    
    (349
    )
    
    
    (1,872
    )Interest expense, net
    
    
    (767
    )
    
    
    (441
    )
    
    
    (1,204
    )
    
    
    (1,049
    )Loss before income taxes
    
    
    (23,491
    )
    
    
    (6,961
    )
    
    
    (44,406
    )
    
    
    (11,997
    )Provision for income taxes
    
    
    305
    
    
    
    212
    
    
    
    425
    
    
    
    481Net loss
    
    $
    (23,796
    )
    
    $
    (7,173
    )
    
    $
    (44,831
    )
    
    $
    (12,478
    )Basic and diluted net loss per share
    
    $
    (1.08
    )
    
    $
    (0.32
    )
    
    $
    (2.03
    )
    
    $
    (0.56
    )Basic and diluted weighted average shares outstanding
    
    
    22,098
    
    
    
    22,451
    
    
    
    22,063
    
    
    
    22,395
 See accompanying notes
 2




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##### Table of Contents



Six Months EndedJune 30,2005
    
    
    2006Operating activities:Net loss
    
    $
    (44,831
    )
    
    $
    (12,478
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation and amortization
    
    
    9,903
    
    
    
    8,751Share-based compensation cost
    
    
    2,993
    
    
    
    999Inventory write-down
    
    
    3,935
    
    
    
    383Amortization of issuance costs, convertible notes payable and line of credit
    
    
    337
    
    
    
    676Deferred income taxes
    
    
    (102
    )
    
    
    (27
    )Changes in operating assets and liabilities:Accounts receivable
    
    
    (15,061
    )
    
    
    12,836Inventory
    
    
    (46,621
    )
    
    
    (13,589
    )Prepaid expenses and other current assets
    
    
    (2,315
    )
    
    
    (944
    )Other non-current assets
    
    
    (1,153
    )
    
    
    (173
    )Service inventory
    
    
    140
    
    
    
    22Accounts payable
    
    
    12,265
    
    
    
    7,745Accrued payroll and related expenses and other accrued liabilities
    
    
    4,039
    
    
    
    (634
    )Other non-current liabilities
    
    
    1,888
    
    
    
    (8
    )Deferred revenue
    
    
    (617
    )
    
    
    (5,773
    )Net cash used in operating activities
    
    
    (75,200
    )
    
    
    (2,214
    )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
    
    
    (3,359
    )
    
    
    (1,475
    )Net cash provided by (used in) investing activities
    
    
    42,331
    
    
    
    (1,236
    )Financing activities:Proceeds from issuance of common stock through employee stock purchase plan
    
    
    791
    
    
    
    288Proceeds from exercise of options
    
    
    138
    
    
    
    880Line of credit issuance costs
    
    
    (755
    )
    
    
    (375
    )Principal payments on capital leases
    
    
    (269
    )
    
    
    (59
    )Net cash provided by (used in) financing activities
    
    
    (95
    )
    
    
    734Effect of foreign exchange rate changes on cash and cash equivalents
    
    
    (240
    )
    
    
    62Net decrease in cash and cash equivalents
    
    
    (33,204
    )
    
    
    (2,654
    )Cash and cash equivalentsBeginning of period
    
    
    41,732
    
    
    
    46,026End of period
    
    $
    8,528
    
    
    $
    43,372Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    1,300
    
    
    $
    1,880Non-cash investing and financing activities:Issuance of warrants in connection with financing arrangement
    
    $
    219
    
    
    $
    Inventory transfers to fixed assets and service inventory
    
    $
    7,572
    
    
    $
    2,275
 See accompanying notes
 3




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Note 1  Basis of Presentation
    Principles of Consolidation
  Reclassifications
  Use of Estimates
  4




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##### Table of Contents



Reverse Stock Split
  Note 2 Summary of New Accounting Policies
 Foreign Currency Derivatives
  Note 3 Recent Accounting Developments
 Accounting for Uncertainty in
Income Taxes-an Interpretation of FASB Statement No. 109
 Note 4  Earnings Per Share (EPS)
   5




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Note 5  Comprehensive Loss
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Net loss
    
    $
    (23,796
    )
    
    $
    (7,173
    )
    
    $
    (44,831
    )
    
    $
    (12,478
    )Unrealized gain on available-for-sale investments
    
    
    87
    
    
    
    
    
    
    
    24
    
    
    
    Foreign currency translation adjustment
    
    
    (449
    )
    
    
    2,088
    
    
    
    (1,481
    )
    
    
    2,160Comprehensive loss
    
    $
    (24,158
    )
    
    $
    (5,085
    )
    
    $
    (46,288
    )
    
    $
    (10,318
    )
 Note 6  Accounts Receivable
  December 31,
    
    
    June 30,2005
    
    
    2006Trade accounts receivable
    
    $
    14,547
    
    
    $
    13,600Unbilled receivables
    
    
    12,340
    
    
    
    8,589Government funding pass-through
    
    
    8,476
    
    
    
    8,195Advance billings
    
    
    19,894
    
    
    
    11,98555,257
    
    
    
    42,369Allowance for doubtful accounts
    
    
    (193
    )
    
    
    (135
    )Accounts receivable, net
    
    $
    55,064
    
    
    $
    42,234
   Note 7  Inventory
  December 31,
    
    
    June 30,2005
    
    
    2006Components and subassemblies
    
    $
    10,706
    
    
    $
    19,936Work in process
    
    
    8,314
    
    
    
    4,692Finished goods
    
    
    48,692
    
    
    
    54,015Total
    
    $
    67,712
    
    
    $
    78,643
  6




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##### Table of Contents



Note 8  Deferred Revenue
  December 31,
    
    
    June 30,2005
    
    
    2006Deferred product revenue
    
    $
    58,593
    
    
    $
    56,605Deferred service revenue
    
    
    28,390
    
    
    
    24,602Total deferred revenue
    
    
    86,983
    
    
    
    81,207Less long-term deferred revenue
    
    
    (5,234
    )
    
    
    (4,361
    )Deferred revenue in current liabilities
    
    $
    81,749
    
    
    $
    76,846
  Note 9  Restructuring and Severance Charges
   Six Months EndedJune 30,2005
    
    
    2006Balance, January 1
    
    $
    4,690
    
    
    $
    3,582Payments
    
    
    (3,058
    )
    
    
    (2,152
    )Adjustments to previously accrued amounts
    
    
    (236
    )
    
    
    104Current period charges
    
    
    1,968
    
    
    
    1,183Foreign currency translation adjustment
    
    
    (211
    )
    
    
    78Total liability balance, June 30
    
    
    3,153
    
    
    
    2,795Less long-term restructuring and severance liability
    
    
    
    
    
    
    (181
    )Current restructuring and severance liability
    
    $
    3,153
    
    
    $
    2,614
 7




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Note 10  Share-Based Compensation
 Share-Based Payment Accounting for Stock
Issued to Employees Accounting for Stock-Based Compensation
    Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2005
    
    2006
    
    2005
    
    2006Risk-free interest rate
    
    
    3.9
    %
    
    
    4.8
    %
    
    
    3.9
    %
    
    
    4.6
    %Expected dividend yield
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %
    
    
    0
    %Volatility
    
    
    88
    %
    
    
    76
    %
    
    
    89
    %
    
    
    64
    %Expected life
    
    5.8 years
    
    4.0 years
    
    5.9 years
    
    4.3 years
  8




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##### Table of Contents



Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Cost of product revenue
    
    $
    
    
    
    $
    14
    
    
    $
    
    
    
    $
    29Research and development, net
    
    
    1,541
    
    
    
    93
    
    
    
    2,569
    
    
    
    186Sales and marketing
    
    
    242
    
    
    
    106
    
    
    
    411
    
    
    
    211General and administrative
    
    
    11
    
    
    
    305
    
    
    
    13
    
    
    
    573Total
    
    $
    1,794
    
    
    $
    518
    
    
    $
    2,993
    
    
    $
    999
  WeightedWeighted
    
    
    AverageAverage
    
    
    Remaining
    
    
    AggregateExercise
    
    
    Contractual
    
    
    IntrinsicOptions
    
    
    Price
    
    
    Term
    
    
    ValueOutstanding at December 31, 2005
    
    
    4,500,145
    
    
    $
    16.56Grants
    
    
    35,530
    
    
    
    8.18Exercises
    
    
    (143,909
    )
    
    
    6.11Cancellations
    
    
    (775,040
    )
    
    
    23.87Outstanding at June 30, 2006
    
    
    3,616,726
    
    
    $
    15.32
    
    
    6.1 years
    
    $
    4,308,376Exercisable at June 30, 2006
    
    
    3,582,979
    
    
    $
    15.37
    
    
    6.1 years
    
    $
    4,253,992Available for grant at June 30, 2006
    
    
    3,254,443
  9




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##### Table of Contents



Three Months
    
    
    Six MonthsEnded
    
    
    EndedJune 30, 2005
    
    
    June 30, 2005Net loss, as reported
    
    $
    (23,796
    )
    
    $
    (44,831
    )Add:Stock-based compensation included
in reported net loss
    
    
    1,794
    
    
    
    2,993Total stock-based compensation
expense determined under fair
value-based method for all awards
    
    
    (1,806
    )
    
    
    (20,889
    )Pro forma net loss
    
    $
    (23,808
    )
    
    $
    (62,727
    )Basic and diluted net loss per share:As reported
    
    $
    (1.08
    )
    
    $
    (2.03
    )Pro forma
    
    $
    (1.08
    )
    
    $
    (2.84
    )
 Note 11  Taxes
  Note 12  Geographic Segment Information
 Disclosure about Segments of an Enterprise and Related Information
  10




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United States
    
    
    Other Countries
    
    
    Total2005
    
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005
    
    
    2006Three months ended June 30,Product revenue
    
    $
    18,342
    
    
    $
    13,845
    
    
    $
    21,859
    
    
    $
    10,802
    
    
    $
    40,201
    
    
    $
    24,647Service revenue
    
    
    8,463
    
    
    
    9,971
    
    
    
    4,755
    
    
    
    3,895
    
    
    
    13,218
    
    
    
    13,866Total revenue
    
    $
    26,805
    
    
    $
    23,816
    
    
    $
    26,614
    
    
    $
    14,697
    
    
    $
    53,419
    
    
    $
    38,513
 2005
    
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005
    
    
    2006Six months ended June 30,Product revenue
    
    $
    33,903
    
    
    $
    45,273
    
    
    $
    32,608
    
    
    $
    13,643
    
    
    $
    66,511
    
    
    $
    58,916Service revenue
    
    
    16,287
    
    
    
    20,435
    
    
    
    8,255
    
    
    
    7,677
    
    
    
    24,542
    
    
    
    28,112Total revenue
    
    $
    50,190
    
    
    $
    65,708
    
    
    $
    40,863
    
    
    $
    21,320
    
    
    $
    91,053
    
    
    $
    87,028
   Note 13  Foreign Currency Derivative
  Note 14  Litigation
   11




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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
   Strategic Focus
   12




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##### Table of Contents



Market Overview, Trends and Challenges
    Key Performance Indicators
  Revenue
 Gross margins
 Operating expenses 13
    Table of Contents  Liquidity and cash flows
  Critical Accounting Policies and Estimates
    Revenue Recognition
 Revenue
Recognition in Financial Statements
 14
    Table of Contents  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 determinable and collection is reasonably assured. A customer-signed notice of
acceptance or similar document is required from the customer prior to revenue
recognition.
 
    
    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 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
  15
    Table of Contents  Goodwill
   Accounting for Income Taxes
 Accounting for
Income Taxes,
 Accounting for Loss Contracts
  16
    Table of Contents  Share Based Compensation
 Share-Based Payment Accounting for Stock Issued to Employees Accounting for
Stock-Based Compensation
   Results of Operations
 Revenue and Gross Margins
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Product revenue
    
    $
    40,201
    
    
    $
    24,647
    
    
    $
    66,511
    
    
    $
    58,916Less: Cost of product revenue
    
    
    41,210
    
    
    
    18,099
    
    
    
    67,562
    
    
    
    44,776Product gross margin
    
    $
    (1,009
    )
    
    $
    6,548
    
    
    $
    (1,051
    )
    
    $
    14,140Product gross margin percentage
    

    (3%)
    
    
    
     27%
    
    
    (2%)
    
    
    24%Service revenue
    
    $
    13,218
    
    
    $
    13,866
    
    
    $
    24,542
    
    
    $
    28,112Less: Cost of service revenue
    
    
    7,531
    
    
    
    7,901
    
    
    
    15,106
    
    
    
    15,594Service gross margin
    
    $
    5,687
    
    
    $
    5,965
    
    
    $
    9,436
    
    
    $
    12,518Service gross margin percentage
    
    43%
    
        43%
    
        38%
    
        45%Total revenue
    
    $
    53,419
    
    
    $
    38,513
    
    
    $
    91,053
    
    
    $
    87,028Less: Total cost of revenue
    
    
    48,741
    
    
    
    26,000
    
    
    
    82,668
    
    
    
    60,370Total gross margin
    
    $
    4,678
    
    
    $
    12,513
    
    
    $
    8,385
    
    
    $
    26,658Total gross margin percentage
        9%
    
    
    33%
    
        9%
    
    
    31%
 17
    Table of Contents  Service Revenue
   Product Gross Margin
  Service Gross Margin
  18
    Table of Contents  Research and Development Expenses
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Gross research and development expenses
    
    $
    24,205
    
    
    $
    26,135
    
    
    $
    46,494
    
    
    $
    52,208Less: Amounts included in cost of product revenue
    
    
    (5,145
    )
    
    
    (8,734
    )
    
    
    (9,535
    )
    
    
    (15,112
    )Less: Reimbursed research and development
(excludes amounts in revenue)
    
    
    (5,633
    )
    
    
    (11,030
    )
    
    
    (10,500
    )
    
    
    (23,510
    )Net research and development expenses
    
    $
    13,427
    
    
    $
    6,371
    
    
    $
    26,459
    
    
    $
    13,586Percentage of total revenue
    

    25%
    
    

    17%
    
    

    29%
    
    

    16%
    Other Operating Expenses
  Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2005
    
    2006
    
    2005
    
    2006Sales and marketing
    
    $
    7,574
    
    
    $
    5,682
    
    
    $
    14,173
    
    
    $
    10,667Percentage of total revenue
    

    14%

    

    15%

    

    16%

    

    12%General and administrative
    
    $
    4,607
    
    
    $
    4,600
    
    
    $
    8,874
    
    
    $
    10,194Percentage of total revenue
    

    9%

    

    12%

    

    10%

    

    12%Restructuring and severance
    
    $
    1,947
    
    
    $
    549
    
    
    $
    1,732
    
    
    $
    1,287Percentage of total revenue
    

    4%

    

    1%

    

    2%

    

    1%
 19
    Table of Contents  Sales and Marketing .
 General and Administrative
 Restructuring and Severance .
 Other Expense, net
  Interest Income (Expense)
  Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2005
    
    
    2006
    
    
    2005
    
    
    2006Interest income
    
    $
    77
    
    
    $
    629
    
    
    $
    415
    
    
    $
    1,114Interest expense
    
    
    (844
    )
    
    
    (1,070
    )
    
    
    (1,619
    )
    
    
    (2,163
    )Net interest income (expense)
    
    $
    (767
    )
    
    $
    (441
    )
    
    $
    (1,204
    )
    
    $
    (1,049
    )
   20
    Table of Contents  Taxes
  Liquidity and Capital Resources
      Amounts Committed by YearLess than
    
    
    1-3
    
    
    4-5Contractual Obligations
    
    Total
    
    
    1 year
    
    
    years
    
    
    years
    
    
    ThereafterDevelopment agreements
    
    $
    12,216
    
    
    $
    9,154
    
    
    $
    3,062
    
    
    $
    
    
    
    $
    Capital lease obligations
    
    
    94
    
    
    
    94
    
    
    
    
    
    
    
    
    
    
    
    Operating leases
    
    
    7,900
    
    
    
    3,285
    
    
    
    4,456
    
    
    
    159
    
    
    
    Total contractual cash obligations
    
    $
    20,210
    
    
    $
    12,533
    
    
    $
    7,518
    
    
    $
    159
    
    
    $
    
  21
    Table of Contents  Item 3. Quantitative and Qualitative Disclosures About Market Risk
  Interest Rate Risk
 Foreign Currency Risk
 22
    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
     23
    Table of Contents  Item 1A. Risk Factors
  Risk Factors Pertaining to Our Business and Operations
 Our operating results may fluctuate significantly.
  
 
 
 
 
 
 
 
 24
    Table of Contents  
  
    
    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;
    
    changes in levels of customer capital spending;
    
    the introduction or announcement of competitive products;
    
    the receipt and timing of necessary export licenses; and
    
    currency fluctuations, international conflicts or economic crises.
  Failure to sell Cray XT3 and upgrade systems in planned quantities and gross margins
would adversely affect 2006 revenue and earnings.
 Improved future performance is highly dependent on increased product revenue and
margins
  Phase III of the DARPA HPCS Program will affect our operations.
 25
    Table of Contents  We face increased liquidity risks that may require us to seek additional financing.
 Our reliance on third-party suppliers poses significant risks to our business and
prospects.
 
 
 26
    Table of Contents  
 
 
 
   TM
 We face last-time buy decisions affecting all of our current products, which may
adversely affect our revenue and earnings.
 Our inability to overcome the technical challenges of completing the development of our
supercomputer systems would adversely affect our revenue and earnings in 2006 and beyond.
 27
    Table of Contents  If we cannot retain, attract and motivate key personnel, we may be unable to
effectively implement our business plan.
  To be successful we need to establish the value of our high-bandwidth sustained
performance systems, increase differentiation of our massively parallel commodity processor
products and reduce doubts about our long-term viability.
 28
    Table of Contents  If the U.S. government purchases fewer supercomputers, our revenue would be reduced and
our earnings would be adversely affected.
 If we lose government support for development of our supercomputer systems, our
research and development expenditures and capital requirements would increase and our
ability to conduct research and development would decrease.
 Lower than anticipated sales of new supercomputers and the termination of maintenance
contracts on older and/or decommissioned systems would further reduce our service revenue
and margins from maintenance service contracts.
 If we are unable to compete successfully in the high performance computer market, our
revenue will decline.
  29
    Table of Contents  We were not successful in completing the Red Storm project on time and on budget, which
adversely affected our 2004 and 2005 earnings and could adversely affect our future earnings
and financial condition.
 We may not meet the covenants imposed by our current credit agreement.
 New European environmental rules may adversely affect our operations.
 30
    Table of Contents  Federal class action and derivative lawsuits were recently dismissed without prejudice,
a state court derivative action is pending and additional lawsuits may be filed
 The adoption of FAS 123R will lower our earnings and may adversely affect the market
price of our common stock.
 While we determined that we have adequate internal control over financial reporting as
of December 31, 2005, as of the end of each subsequent fiscal year we are required to
evaluate our internal control over financial reporting under Section 404 of the
Sarbanes-Oxley Act of 2002 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.
 31
    Table of Contents  U.S. export controls could hinder our ability to make sales to foreign customers and
our future prospects.
 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.
  32
    Table of Contents  We have recently formed a new senior management team that must work together
effectively for us to be successful.
 We may infringe or be subject to claims that we infringe the intellectual property
rights of others.
 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.
 
 
 
 
 
 
 33
    Table of Contents  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.
 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.
 34
    Table of Contents  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.
 
    
    23,041,752 shares of common stock;
    
    warrants to purchase 1,408,381 shares of common stock;
    
    stock options to purchase an aggregate of 3,616,726 shares of common stock, of which
3,582,979 options were then exercisable; and
    
    Notes convertible into a maximum of 5,698,006 shares of common stock.
  35
    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.
 We do not anticipate declaring any cash dividends on our common stock.
 
 Item 4. Submission of Matters to a Vote of Security Holders
   Name
    
    Votes For
    
    % For
    
    Withheld
    
    % WithheldJohn B. Jones, Jr.
    
    
    72,902,004
    
    
    
    95.83
    
    
    
    3,169,391
    
    
    
    4.17Kenneth W. Kennedy, Jr.
    
    
    72,873,115
    
    
    
    95.80
    
    
    
    3,198,280
    
    
    
    4.20Stephen C. Kiely
    
    
    72,946,866
    
    
    
    95.89
    
    
    
    3,124,529
    
    
    
    4.11Frank L. Lederman
    
    
    72,917,601
    
    
    
    95.85
    
    
    
    3,153,794
    
    
    
    4.15Sally G. Narodick
    
    
    73,212,375
    
    
    
    96.24
    
    
    
    2,859,020
    
    
    
    3.76Daniel C. Regis
    
    
    73,180,784
    
    
    
    96.20
    
    
    
    2,890,611
    
    
    
    3.80Stephen C. Richards
    
    
    72,848,067
    
    
    
    95.76
    
    
    
    3,223,328
    
    
    
    4.24Peter J. Ungaro
    
    
    73,208,681
    
    
    
    96.24
    
    
    
    2,862,714
    
    
    
    3.76
    36
    Table of Contents  Item 5. Other Information
    Six MonthsEndedYear Ended December 31,
    
    
    June 30,2001
    
    
    2002
    
    
    2003
    
    
    2004
    
    
    2005
    
    
    2006(In thousands, except for ratios)Fixed Charges:Interest expense
    
    $
    1,976
    
    
    $
    2,965
    
    
    $
    213
    
    
    $
    301
    
    
    $
    4,203
    
    
    $
    2,163Portion of rental expense deemed to represent
interest
    
    
    166
    
    
    
    185
    
    
    
    195
    
    
    
    209
    
    
    
    207
    
    
    
    90Total fixed charges
    
    $
    2,142
    
    
    $
    3,150
    
    
    $
    408
    
    
    $
    510
    
    
    $
    4,410
    
    
    $
    2,253Earnings:Net income (loss)
    
    $
    (35,228
    )
    
    $
    5,403
    
    
    $
    63,248
    
    
    $
    (207,358
    )
    
    $
    (64,308
    )
    
    $
    (12,478
    )Provision (benefit) for income taxes
    
    
    994
    
    
    
    2,176
    
    
    
    (42,207
    )
    
    
    59,092
    
    
    
    (1,488
    )
    
    
    481Fixed charges
    
    
    2,142
    
    
    
    3,150
    
    
    
    408
    
    
    
    510
    
    
    
    4,410
    
    
    
    2,253Total earnings (loss) for computation of ratio
    
    $
    (32,092
    )
    
    $
    10,729
    
    
    $
    21,449
    
    
    $
    (147,756
    )
    
    $
    (61,386
    )
    
    $
    (9,744
    )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
six months ended June 30, 2006, was not sufficient to cover fixed charges by
approximately $34.2 million, $148.3 million, $65.8 million and $12.0 million,
respectively. As a result, the ratio of earnings to fixed charges has not been
computed for these periods. 
 Item 6. Exhibits
 3.1
    
    Restated Articles of Incorporation of Cray Inc., as in effect on June 8, 2006
(1)3.2
    
    Amended and Restated Bylaws of Cray Inc., as amended through June 7, 2006 (1)10.1
    
    Amendment Number Three to Senior Secured Credit Agreement, dated as of July 12,
2006, between Wells Fargo Foothill, Inc., Cray Inc. and Cray Federal Inc.10.2
    
    Form of Director Restricted Stock Agreement (1)10.3
    
    2006 Long-Term Equity Compensation Plan (2)10.4
    
    2006 Bonus Plan for Cray Inc. executives and other officers (3)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 2002
 37
    Table of Contents  31.2
    
    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
 
 (1)
    
    Incorporated by reference to the Companys Current Report on Form 8-K, as filed
with the Commission June 8, 2006(2)
    
    Incorporated by reference to the Companys definitive Proxy Statement for the
2006 Annual Meeting, as filed with the Commission on April 28, 2006(3)
    
    Incorporated by reference to the Companys Current Report on Form 8-K, as filed
with the Commission May 4, 2006 Items 2 and 3 of Part II are not applicable and have been omitted.
 38
    Table of Contents  SIGNATURES
  CRAY INC.August 8, 2006
    
    /s/ PETER J. UNGARO

Peter J. UngaroChief Executive Officer and President/s/ BRIAN C. HENRYBrian C. HenryChief Financial Officer/s/ KENNETH D. ROSELLIKenneth D. RoselliChief Accounting Officer
 39